77
2The Players Their Supervisorsand Moral Hazard
Our review of costs and benefits in the previous chapter highlighted short-term bank debt as a particularly troublesome component of internationalcapital flows In this chapter our focus turns to the major suppliers ofcapital concentrated in the G-10 countries Much of the literature oninternational financial architecture implicitly assumes that the G-10financial institutions and their supervisors have their monitoring andincentive systems ldquoabout rightrdquo and that crisis conditions lie on thedemand side Is this assumption correct If not more problems lie aheadmdasheven if the IMF and emerging economies working together dramati-cally reform the demand side of international capital As we arguedpotential capital flows to and from emerging-market economies alreadylarge are likely to grow because of various strong incentives Largerflows and stocks of international capital will bring benefits but they alsowill create more worries about stability
In this chapter we examine the basis for the assumption that all iswell on the supply side of world capital markets We argue that dis-tortions contribute to the instability of the cross-border bank lendingdemonstrated in table 12mdashand could in the future affect portfolio flowsThe significant issue is the moral hazard that arises from the special statusof banks in national financial systems Although governments and super-visors have offset the safety nets they provide to banksmdashthrough legisla-tive and institutional changes discussed belowmdashconstant innovation infinancial markets creates opportunities to circumvent regulatory effortsMore can and should be done to achieve a better alignment betweenmarket forces and incentives for managers and shareholders of banksmdashand for their supervisors
Institute for International Economics | httpwwwiiecom
78 WORLD CAPITAL MARKETS
We argue in this chapter that the G-10 supervisors can improve theldquoplumbingrdquo of the international financial architecture In a coordinatedway the G-10 has a large role to play both in preventing and managingfuture crises We first distill a few supervisory lessons from the Asian andRussian crises Then we describe the private-market players paying par-ticular attention to the special role of banks in the international financialsystem and why moral hazard is such a persistent and subtle problem Wethen analyze key issues in offsetting moral hazard through prudentialsupervision beginning with national comparisons and ending with theG-10rsquos international system through the Bank for International Settlementsthe International Organization of Securities Commissions (IOSCO) andsimilar institutions in such related areas as insurance and accounting
Lessons from Asia and Russia
The main features of the 1997-98 episodes are well known Less under-stood however is the flavor of financial-institution involvement The crisisin East Asia was distinct from the crisis in Russia The Asian crisis wasmore gradual beginning in mid-1997 with the collapse of the Thai bahtfollowed by banking and economic shocks that spread to Thailandrsquosmajor regional trading partners and then to South Korea As the crisisunfolded Asians in the affected countries moved tens of billions of dol-lars offshoremdashusing the facilities of G-10 banks The bulk of the debtcontracts that were at risk in Asia were short-term nontraded interbankloans1 Most of these loans originated with Japanese and European banks(table 17)
By contrast the Russian crisis was a unilateral default (ldquorestructur-ingrdquo) of sovereign debtmdasha tradable financial instrument This instrumenthad been widely used as collateral to obtain credit from G-10 banksHence the default ldquoimmediately triggered the unwinding of leveragedpositions by large internationally active financial institutionsrdquo2 Much ofthe financing for Russian and other emerging-market sovereign debt hadbeen arranged and leveraged by US banks
Although the shocks and financial institutions differed from crisis tocrisis the use of debt instruments was a common element In the run-upto a crisis financial houses extended credit to increasingly risky borrow-ers and paid higher prices for emerging-market debt instruments Asknowledgeable players took more risks less knowledgeable playersfollowed them Many firms borrowed heavily to leverage their betsLeverage was easy with hedge funds borrowing from banks and banks
1 See IMF (1998)
2 IMF (1998 50)
Institute for International Economics | httpwwwiiecom
THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 79
borrowing from each other using emerging-market debt instruments ascollateral
Russia became the poster country of high-risk finance In 1996 Rus-sian treasury bills (GKOs) were sensibly regarded as time bombs nobank would accept them as collateral for a loan But gradually the viewtook hold in Wall Street that for political reasons Russia had becometoo big to fail Banks relented and began to accept GKOs as security butat half their market value By early 1998 some hedge funds were bor-rowing up to 95 percent of these assets as collateral3 Banks also lent toeach other on similar terms
When the IMF refused a bailout to prevent default on the GKOs wide-spread surprise turned to panic Everyone headed for the exits Losseswere huge because many firms had been doing the same thing usingthe same risk-management models All those positions could not be un-wound simultaneously Liquidity dried up For a period no one wouldlend even to strong North American corporate accounts The final chap-ter was the near-collapse of Long Term Capital Management a hugehedge fund run by brilliant managers The combination of unexpectedevents LTCMrsquos risk exposure and high leverage contributed to its prob-lems The size persistence and pervasiveness of the widening spreadsconfounded its risk-management models producing huge losses AfterLTCM was refinanced by its major counterparties in September 1998 itsweaknesses became clear They included its risk-management systemsthe inadequacy of its capital base and most important the failure of marketdiscipline LTCMrsquos counterparties did not understand the hedge fundrsquosrisk profile when they granted credit on generous terms mainly on thebasis of its managersrsquo reputations (FSF 2000b)
The Asian and Russian episodes illustrate key issues on the supplyside that deserve more attention bias in the incentive systems of G-10countries toward the use of debt and the significant role played by thelarge international financial institutions particularly banks We do notdispute the importance of reforms (including better exchange rate sys-tems) urged on the finance ministries central banks and borrowers inemerging economies Some of the criticisms aimed at the IMF are alsowarranted But we think the G-10 market players and financial super-visors deserve far more scrutiny
The top financial players constantly innovate as new technologiesmake financial engineering possible By the same token they quickly re-spond to any shifts in the incentive structure imposed through officialregulation The activities of the top players are beyond the reach of theIMF They must not however be beyond the reach of G-10 financialsupervisors particularly the bank and securities-market regulators
3 See Risk Management Too Clever by Half The Economist 14 November 1998 82-85
Institute for International Economics | httpwwwiiecom
80 WORLD CAPITAL MARKETS
The Market Players
As the tables in chapter 1 illustrate there are three main types of pri-vate-capital flows bank loans and deposits other portfolio investmentand foreign direct investment Each type is associated with particularinstitutionsmdashcommercial banks other financial institutions and non-financial firms In this section we describe the size and nationality ofthe large players
Commercial Banks
Table 21 lists the 50 largest commercial banks by market capitalizationas of October 2000 Market capitalization rather than sheer asset sizeprobably better measures a bankrsquos ability to move funds from one coun-try or sector to another4
The large continental European banks (those in the euro zone plusSwitzerland) in 1999 had market capital of about $524 billion and assetsof approximately $64 trillion When figures for UK commercial banksare added in European market capitalization rises to about $850 billionand assets to about $86 trillion Europe is a banking powerhouse In-deed the European role is so crucial that no approach to the regulationof international lending can survive without European support
The Maastricht Treaty did not make Europe a single entity for bank-ing supervision The European Central Bank is finding its way in ex-change rate and monetary policy For the foreseeable future nationalregulators will retain control over supervisory matters Changes in thefabric of international understandings over bank supervision will requireconsensus among the European powers
In market capitalization at $850 billion the large US banks are aboutthe same as their European counterparts but in asset size they are adistant second to the Europeans at $38 trillion The large Japanese com-mercial banks follow on market capitalization at $300 billion but aresecond to the Europeans with assets of $67 trillion
Commercial-banking power is clearly concentrated in Europe the UnitedStates and Japan Moreover banks based in the G-10 plus Spain accountfor 90 percent of the market capitalization and assets of the top 50 com-mercial banks in the world As table 22 shows banks based in the G-10countries plus Spain account for about 92 percent of the assets of allcommercial banks located in BIS reporting countries about 80 percent ofthe external assets of these banks and about 72 percent of claims on
4 Several banks in China and Europe rank among the top 50 in terms of asset size butpoor-quality loans sharply diminish their market capitalization-ndashand their ability to movemoney from country to country
Institute for International Economics | httpwwwiiecom
THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 81
Table 21 Worldrsquos largest 50 commercial banks by marketcapitalization October 2000 (billions of dollars)
Market capitalizatona Total Net Shareholderassets income equityb
Global Sept Oct National Dec Dec Decrank Banks 1999 2000 rankc 1999 1999 1999
Continental Europe
8 ING Bank 46 66 1 351 17 1412 UBS 58 55 2 614 39 2213 Creacutedit Suisse Group 50 54 3 452 33 2215 Deutsche Bank 36 48 4 843 26 2317 Banco Santander
Central Hispano 33 45 5 258 22 1719 BNP Paribas 43 6 702 17 22
Banque Nationalede Paris 26
Paribas 1621 ABN AMRO 29 34 7 460 26 1325 Banco Bilbao
Vizcaya Argentaria 25 28 8 240 22 1826 UniCredito Italiano 21 26 9 170 13 1030 Socieacuteteacute Geacuteneacuterale 19 22 10 408 24 1229 HypoVereinsbank 20 22d 11 505 04 1432 Dresdner Bank 21 21 12 398 11 1243 San Paolo IMI 16 17d 13 141 11 845 Fortis Bank 34 16 14 330 12 949 Commerzbank 17 14 15 374 09 1249 KBC Bank 13 14d 16 147 07 6
Total for Continental Europe 482 524d 6393 291 234
Japan
3 Mizuho Holdings Inc 115 1 51e
3 Dai-Ichi Kangyo Bankf 39 463 ndash38 203 Industrial Bank
of Japanf 32 390 ndash15 133 Fuji Bankf 42 489 ndash36 187 Sumitomo Sakura
(tentative) 68 2 56e
Sumitomo Bankg 47 464 ndash48 15Sakura Banki 31 414 ndash40 18
10 Bank of Tokyo Mitsubishi 72 56 3 664 ndash07 2311 UFJ Holdings Inc 55d 4 36e
Sanwa Bankh 39 425 ndash40 18Tokai Bankh 16 269 ndash24 13Toyo Trust amp Bankingh na 67 ndash13 5
40 Asahi Bank 20 18d 5 247 ndash21 1249 Mitsubishi Trust amp
Bankingi 16 14d 6 149 ndash14 750 Sumitomo Trust amp
Banking 11 10d 7 127 ndash12 6
Total for Japan 364 336e 6472 ndash481 260
(table continues mext page)
Institute for International Economics | httpwwwiiecom
82 WORLD CAPITAL MARKETS
Table 21 Worldrsquos largest 50 commercial banks by marketcapitalization October 2000 (billions of dollars) (continued )
Market capitalizatona Total Net Shareholderassets income equityb
Global Sept Oct National Dec Dec Decrank Banks 1999 2000 rankc 1999 1999 1999
United Kingdom
2 HSBC Holdings 97 122 1 569 54 379 Royal Bank of Scotland 19 58d 2 146 14 7
NatWestj 39 na na 292 na 1414 Lloyds TSB 68 52 3 285 41 1418 Barclays 44 44 4 402 28 1435 Abbey National 25 19 5 292 20 846 Standard Chartered 15 15d 6 88 06 646 Bank of Scotland 15 15d 7 116 10 6
Total for United Kingdom 322 324d 2191 173 106
United States
1 Citigroup 149 237 1 717 99 504 JP Morgan Chase amp Co 83 2 35e
Chase Manhattank 63 na na 406 54 24JP Morgank 20 na na 261 21 11
5 Bank of America 96 79 3 633 79 446 Wells Fargo amp Company 65 78 4 218 37 2216 Bank of New York
Company 25 46 5 75 17 520 Bank One 41 42 6 269 35 2022 Fleet Boston Financial 34 34 7 191 20 1523 MBNA 18 30 8 31 10 424 First Union 34 30 9 253 32 1727 Fifth Third Bancorp 17 24 10 42 07 427 Mellon Financial 17 24 11 48 10 433 State Street na 20 12 61 06 335 PNC Bank 16 19 13 75 13 635 Northern Trust na 19 14 29 04 235 Firstar 25 19 15 73 09 640 US Bancorp 22 18 16 82 15 846 SunTrust Banks 21 15 17 95 13 850 National City 16 13 18 87 14 650 Wachovia 16 11 19 67 10 650 KeyCorp 12 11 20 83 11 6
Total for United States 707 850 3796 517 271
Other
31 National Australia Bank 2 21 1 166 18 1234 Hang Seng Bank Ltd 20 20d 2 na na na35 Royal Bank of Canada 13 19 3 184 12 940 Commonwealth Bank
of Australia 14 18d 4 91 09 543 Toronto Dominion Bank 12 17 5 146 20 850 Westpac Banking Corp 12 13 6 92 10 650 Development Bank
of Singapore 12 13d 7 64 06 6
Total for other 105 121d 742 76 46
Institute for International Economics | httpwwwiiecom
THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 83
developing countries In turn the claims on developing countries repre-sent about 4 percent of the assets of G-10 and Spanish commercial banks
Portfolio Investors
Table 21 (continued )
Market capitalizatona Total Net Shareholderassets income equityb
Sept Oct National Dec Dec Dec1999 2000 rankc 1999 1999 1999
Total for largest 50 1980 2155 19594 58 917
Total for G-10 1900 2070 19182 53 888
na = not availablenot applicableG-10 = Group of Ten countries see note to table 11
a Market capitalization is defined as the number of ordinary shares currently in circulationmultiplied by the current share price Market capitalization as of October 2000 is presentedfor the banks that had a market capitalization higher than $11 billion as of September 1999b Shareholder equity is defined as the sum of issued common stock capital surplus or pre-mium various reserves and retained earnings Shareholder equity includes group equity at-tributable to consolidated minority interestsc Rankings within the country or regiond Estimates based on the available rates of change from September 1999 to October 2000The market capitalization and shareholder equity figures represent combined estimate for themerged bankse Total for the merged banksf Merged in September 2000g Merged in April 2001h Will merge in April 2002i Will merge with Nippon Trust and Tokyo Trust in October 2001j NatWest Bank merged with the Royal Bank of Scotland in March 2000k Announced a merger in September 2000
Sources Euromoney The Bank Atlas 2000 httpwwweuromoneycom American BankerThe Top 100 World Financial Companies Q3 1999 httpwwwamericanbankercom YahooFinance Company Profiles financeyahoocom Bloomberg Financials httpwwwbloombergcom
Three groups of financial institutions dominate the flow of portfolio capitalinvestment banks wealth managers and insurance companies Table 23lists nine large investment banks all based in New York with offices inLondon and other financial centers In 1998 these nine firms had a com-bined market capitalization in excess of $130 billion and controlled as-sets in excess of $18 trillion
Investment banks act as guardians to the securities markets Nearly allpublic and private shares bonds and asset-backed securities are broughtto market by an investment bank Fulfilling the same function they areexpanding the securities markets of emerging economies They also act asthe pilots of privatization mergers and takeoversmdashnow a core feature of
Institute for International Economics | httpwwwiiecom
84 WORLD CAPITAL MARKETS
Table 22 Total assets and external assets of all commercialbanks June 2000 (billions of dollars)
Claims onExternal assets developing countriesb
Share of Share ofTotal total assets total assets
Country assetsa Amount (percent) Amount (percent)
Austria 423 91 22 33 8Bahamas 316 244 77 61c 19Bahrain 100 92 92 46c 46Belgium 806 309 38 26 3Canada 720 98 14 31 4Denmark 244 58 24 6 2Finland 121 31 25 4 3France 2486 607 24 135 5Germany 4535 901 20 240 5Ireland 423 160 38 2 0Italy 1345 191 14 47 4Japan 8460 1199 14 258 3Luxembourg 821 495 60 124c 15Netherlands 1080 296 27 67 6Norway 157 14 9 3 3Singapore 574 405 70 202c 35Spain 889 124 14 57 6Sweden 348 67 19 12 2Switzerland 1632 709 43 177c 11United Kingdom 5802 1990 34 138 2United States 6223 889 14 144 2
Total for all BISreporting countries 37506 8968 24 1813 5
Total for G-10 34326 7378 21 1331 4
BIS = Bank for International SettlementsG-10 = Group of Ten countries see note to table 11
a Total assets are calculated as banking institutions (deposit institutions) reserve claims onthe public sector claims on the private sector (lines 20 21 22 from IFS) plus externalassets Figures are converted into US dollars using the market exchange rate at the end ofJune 2000b Developing countries are countries other than Andorra Australia Austria Belgium CanadaCyprus Denmark Finland France Germany Gibraltar Greece Iceland Ireland Italy JapanLiechtenstein Luxembourg Malta Netherlands New Zealand Norway Portugal Spain Swe-den Switzerland Turkey the United Kingdom the United States the Vatican City State andthe former Yugoslaviac These countries do not disclose their claims on developing countries Such claims arearbitrarily (and generously) estimated at half the external assets of commercial banks in Bahrainand Singapore and a quarter of the external assets of banks in the Bahamas Luxembourgand Switzerland
Sources IMF International Financial Statistics (IFS) November 2000 Bank for InternationalSettlements BIS Quarterly Review November 2000 httpwwwbisorg
Institute for International Economics | httpwwwiiecom
THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 85
global capitalism In addition to their underwriting role investment banksearn substantial profits from trading securities
Wealth-management firms are the second group of portfolio institu-tions They typically deal with the publicmdashindividuals and companiesthat want a trusted firm to manage their pensions and other funds Table24 lists 10 large wealth managers all based in the G-10 Together these10 firms control $64 trillion in assets and their own market capitalization
Table 23 Large investment banks 1998 (billions of dollars)
MarketRevenue Assets capitalizationa
Merrill Lynchb (United States) 36 300 25Morgan Stanley Dean Witterb (United States) 31 318 50c
Goldman Sachs (United States) 22d 217e 29c
Lehman Brothers Holdingsb (United States) 20 154 10c
Salomon Smith Barneyf (United States) 8 211 naCredit Suisse First Bostong (United States
Switzerland) 7 280 naPaine Webberh (United States) 7 54 6i
Bear Stearnsj (United States) 8 154 5i
Donaldson Lufkin amp Jenrettek (United States) 5 72 7i
Total 144 1760 132 plusTotal for G-10 144 1760 132 plus
na = not available (subsidiaries of large holding companies Citigroup and Creacutedit SuisseGroup respectively individual market capitalization is not available)G-10 = Group of Ten countries see note to table 11
a Market capitalization is calculated by multiplying the total number of shares by the shareprice at the companyrsquos fiscal year-endb Source Fortune Global 500 1999 Data shown are for the fiscal year ended on or before31 March 1999 Assets shown are those at the companyrsquos fiscal year-end httpwwwpathfindercomfortuneglobal500indexhtmlc Figures as of September 1999 are from American Banker httpwwwamericanbankercomBankRankingsd Source 1998 Goldman Sachs Annual Review Assets as of November 1998 httpwwwgscomaboutannual19984_fsindexhtmle Source Financial Times Company Financials Revenue as of 27 November 1998 httpwwwglobalarchiveftcomcbcb_searchhtmf Source 1998 Citigroup Annual Report 20 Revenue figures for year ending 31 December1998 Asset figures as of 31 December 1998 httpwwwcitigroupcomcitigroupfindatac1998ar2pdfg Source 19981999 Creacutedit Suisse Group Annual Report 23 httpwwwcsgchcsg_annual_report_98downloadcsg_ar98_p1_enpdfh Source 1998 Paine Webber Annual Report 34-35 httpwwwpainewebbercomannual98graphicsfininfoindexhtmi Individual figures are obtained from Yahoo The time for valuations is as follows BearStearns December 1999 Lehman Brothers November 1999 Paine Webber and DonaldsonLufkin amp Jenrette September 1999j Source 1999 Bear Stearns Annual Report 55-56 Figures are for fiscal year ending 30June 1998 httpwwwbearstearnscomcorporateinvestorindexhtmk Source 1999 Donaldson Lufkin and Jenrette Annual Report ldquoFinancial Highlightsrdquo httpwwwdljcompdfDLJ98_1pdf
Institute for International Economics | httpwwwiiecom
86 WORLD CAPITAL MARKETS
exceeds $260 billion For the most part wealth managers are long-termportfolio investors
Hedge funds represent a highly specialized investment vehicle that isnot widely available to the public Most hedge funds are leveraged theyemploy dynamic (and sometimes opportunistic) trading strategies involvingpositions in several different markets they adjust their investment port-folios frequently in anticipation of asset price movements or changes inyield differentials between related securities Hedge funds are opaque tomarket monitoring They are subject to little direct regulation and areunder few obligations to disclose information Hence the size of the in-dustry is difficult to measure
If they are measured by capital under management or by assets hedgefunds are small relative to established wealth managers As table 25shows the capital managed by 20 large hedge funds in late 1998 amountedto less than $50 billion Estimates vary widely but if all hedge funds arecounted their assets range from $100 to $300 billion Even the highestnumber is less than 5 percent of the combined assets of investment banksand traditional asset managers
The amount of leverage used by hedge funds depends on trading strate-gies that are in turn shaped by investor attitudes toward risk Leverage
Table 24 Large asset managers in 1998 (billions of dollars)
Total assets under Marketmanagementa capitalizationb
UBS (Switzerland) 1145 58c
Fidelity Investments (United States) 773 naKampo (Japan) 698 naCredit Suisse Group (Switzerland) 680 50c
AXA Group (France) 647 39c
Barclayrsquos Global Investors (United States) 616 44c
Merrill Lynch amp Co (United States) 501 25c
State Street Global Advisors (United States) 493 naCapital Group Cos (United States) 424 naZurich Financial Services (Switzerland) 415 45c
Total 6392 261 plusTotal for G-10 6392 261 plus
na = not available (usually a nonpublic company)G-10 = Group of Ten countries see note to table 11
a Figures are assets under management at fiscal year-end 1998b Market capitalization is calculated by multiplying the total number of shares by the shareprice at the companyrsquos fiscal year-endc Figures from American Banker httpwwwamericanbankercomBankRankings
Sources Institutional Investor 1999 httpwwwiimagazinecomresearchinterfacehtml US(II300) Asia (Asia200) and Europe (Euro100) Asset Management Rankings American BankerhttpwwwamericanbankercomBankRankings
Institute for International Economics | httpwwwiiecom
THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 87
is achieved using such instruments as repos (repurchase agreements)futures and forward contracts and other derivative products5 It is alsovery difficult to measure A Financial Stability Forum (FSF 2000b) studyof hedge funds noted thatmdashalthough there are problems with the waydata vendors report these positionsmdashestimates suggest most hedge fundsuse modest amounts of leverage averaging 21 but ranging to 41 insome FSF (2000b) further notes difficulties with evaluating the risk-adjusted performance of hedge funds because of their dynamic tradingstrategies
Table 25 Largest hedge funds according tocapitalization August 1998 (billions of dollars)
Fund Capital under management
Domestica
Tiger 51Moore Global Investment 40Highbridge Capital Corp 14Intercap 13Rosenberg Market Neutral 12Ellington Composite 11Hedged Taxable-Equivalent 10Quantitative LongShort 09Sr International Fund 09Perry Partners 08
OffshoreJaguar Fund NV 100Quantum Fund NV 60Quantum Industrial Fund 24Quota Fund NV 17Omega Overseas Partners 17Maverick Fund 17Zweig Dimenna International 16Quasar International Fund NV 15SBC Currency Portfolio 15Perry Partners International 13
Totalb 471
a Long Term Capital Management (LTCM) was in serious difficulty in August1998 and is omitted from the listb Estimates of hedge fund capital and the number of funds vary significantlyMARHedge estimated 1115 funds with $109 billion capital under managementat the end of 1997 Van Hedge Fund estimated 5500 funds with capital of $295billions at the same date
Source Adapted from Eichengreen (1999a)
5 Positions are established by posting margins rather than the face value of the position
Institute for International Economics | httpwwwiiecom
88 WORLD CAPITAL MARKETS
The positive role of hedge fundsmdashproviding diversification to inves-tors because their returns have low correlations with standard asset classesmdashis counterbalanced by some negative features Hedge funds and otherhighly leveraged institutions (HLIs) may take concentrated positions andengage in aggressive market practices that amount to ldquoganging uprdquo on asmall economy (such as Hong Kong)6 Under normal market conditionsHLI positions are not destabilizing but some of the aggressive practicesdocumented in 1998 are worrisome The FSF study group participantsagreed (2000b 112) that such practices raise important issues for marketintegrity but they could not agree that market manipulation was suffi-ciently widespread to be a serious concern for policymakers
Insurance companies are the third group of portfolio institutions Theseare divided into two categories property and casualty companies andlife and health insurance companies Ten large companies of each cat-egory are listed in table 26 In 1998 the 10 property and casualty insur-ance companies had $16 trillion in assets and more than $330 billion inmarket capitalization The 10 life insurance companies had $28 trillionin assets7 Combining both categories 100 percent of assets are controlledby insurance companies based in the G-10 and Spain In portfolio man-agement styles life insurance companies tend to hold longer-term assetswhereas property and casualty companies tend to hold shorter-term in-struments
Nonfinancial Multinational Enterprises
The last players are the nonfinancial multinational enterprises (MNEs)The worldrsquos 100 largest corporations measured by 1998 revenue are re-corded in tables 27 and 28 The 30 financial giants among the top 100are separately shown in table 27 Most of the firms appeared in previ-ous tables Together these 30 financial giants had revenues of $13 tril-lion and controlled assets of $113 trillion8
Table 28 lists the 70 top nonfinancial giants Their revenues in 1998were $40 trillion and their assets (at book value) measured $45 trillionMeasured by revenue or assets about 95 percent of the giants are basedin the G-10 These firms are responsible for a large share of the worldrsquos
6 See IMF (1999c) for a description of the ldquodouble playrdquo that hedge funds are accusedof using in an attempt to destabilize Hong Kong in August 1998
7 Many life insurance companies are owned by their policyholders and therefore donot have a market capitalization
8 By comparison the larger set of 96 financial firms listed in previous tables controlled$322 trillion in assets This is the total amount of assets recorded in tables 21 (50 com-mercial banks) 22 (9 investment banks) 24 (10 asset managers) and 26 (20 insurancecompanies) The largest hedge funds might add $300 billion to the total
Institute for International Economics | httpwwwiiecom
THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 89
Table 26 20 large insurance companies in 1998(billions of dollars)
Property and casualty insurance Marketcompanies Revenuea Assetsb capitalizationc
Allianz (Germany) 65 402 62d
Assicurazioni Generali (Italy) 48 178 30d
State Farm Insurance Cos (United States) 45 111 naZurich Financial Services (Switzerland) 39 215 45d
CGU (United Kingdom) 38 176 20d
Munich Re Group (Germany) 35 131 naAmerican International Group (United States) 33 194 135d
Allstate (United States) 26 88 20d
Royal amp Sun Alliance (United Kingdom) 25 76 11d
Loews (United States) 21 71 7e
Total 375 1642 330 plusTotal for G-10 375 1642 330 plus
MarketLife and health insurance Revenuea Assetsb capitalizationc
AXA (France) 79 452 39d
Nippon Life Insurance (Japan) 66 363 naING Group (Netherlands) 56 464 46d
Dai-ichi Mutual Life Insurance (Japan) 44 253 naSumitomo Life Insurance (Japan) 40 206 naTIAA-CREF (United States) 36 250 naPrudential Ins Co of America (United States) 34 279 naPrudential (United Kingdom) 34 197 30d
Meiji Life Insurance (Japan) 28 146 naMetropolitan Life Insurance (United States) 27 215 na
Total 444 2825 naTotal for G-10 444 2825 na
na = not available (usually an insurance company owned by its policyholders)G-10 = Group of Ten countries see note to table 11
a Data shown are for the fiscal year ended on or before 31 March 1999b Assets shown are those at the companyrsquos fiscal year-endc Market capitalization is calculated by multiplying the total number of shares by the shareprice at the companyrsquos fiscal year-endd Market capitalization data as of September 1999 from American Banker httpwwwamericanbankercome Individual companyrsquos market capitalization as of September 1999 from Yahoo yahoomarketguidecom
Sources Fortune Global 500 1999 httpwwwpathfindercomfortuneglobal500indexhtmlAmerican Banker httpwwwamericanbankercomRankingBanks1999 Yahoo Marketguideyahoomarketguidecom
Institute for International Economics | httpwwwiiecom
90 WORLD CAPITAL MARKETS
Table 27 Financial firms in the 100 largest companiesby revenue 1998 (billions of dollars)
Globalrank Company Revenuesa Assetsb Type
Continental Europe
15 AXA (France) 79 452 Insurance23 Allianz (Germany) 65 402 Insurance28 Ing Group (Netherlands) 56 464 Insurance37 Credit Suisse (Switzerland) 49 475 Banks commercial
and savings39 Assicurazioni Generali (Italy) 48 178 Insurance42 Deutsche Bank (Germany) 45 736 Banks commercial
and savings56 Zurich Financial Services (Switerland) 39 215 Insurance68 Munich Re Group (Germany) 35 131 Insurance72 ABN AMRO Holding (Netherlands) 34 507 Banks commercial
and savings77 Credit Agricole (France) 33 459 Banks commercial
and savings80 HypoVereinsbank (Germany) 32 541 Banks commercial
and savings84 Fortis (Belgium) 31 397 Banks commercial
and savings98 Socieacuteteacute Geacuteneacuterale (France) 30 450 Banks commercial
and savingsUnited Kingdom
47 HSBC Holdings 43 485 Banks commercialand savings
58 CGU 38 176 Insurance74 Prudential 34 197 Insurance
United States
16 Citigroup 76 669 Diversified financials35 Bank of America Corp 51 618 Banks commercial
and savings44 State Farm Insurance Cos 45 111 Insurance64 TIAA-CREF 36 250 Insurance67 Merrill Lynch 36 300 Securities71 Prudential Ins Co of America 34 279 Insurance76 American International Group 33 194 Insurance79 Chase Manhattan Corp 32 366 Banks commercial
and savings83 Fannie Mae 31 485 Diversified financials88 Morgan Stanley Dean Witter 31 318 Securities
Japan
21 Nippon Life Insurance 66 363 Insurance45 Dai-ichi Mutual Life Insurance 44 253 Insurance54 Sumitomo Life Insurance 40 206 Insurance91 Bank of Tokyo-Mitsubishi 31 664 Banks commercial
and savingsTotal 1279 11341Total for G-10 1279 11341
G-10 = Group of Ten countries see note to table 11
a Data shown are for the fiscal year ended on or before 31 March 1999b Assets shown are those at the companyrsquos fiscal year-end
Source Fortune Global 500 1999 httpwwwpathfindercomfortuneglobal500indexhtml
Institute for International Economics | httpwwwiiecom
THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 91
Tab
le 2
8N
on
fin
anci
al f
irm
s in
th
e 10
0 la
rges
t co
mp
anie
s b
y re
ven
ue
199
8 (b
illio
ns o
f do
llars
)
Glo
bal
Tra
nsn
atio
nal
ity
ran
k
Co
mp
any
Rev
enu
esa
Ass
etsb
ind
exc
Typ
e
Co
nti
nen
tal
Eu
rop
e
2D
aim
lerC
hrys
ler
(Ger
man
y)15
516
044
1M
otor
veh
icle
s an
d pa
rts
11R
oyal
Dut
chS
hell
Gro
up (
Net
herla
nds)
9411
058
9P
etro
leum
ref
inin
g17
Vol
ksw
agon
(G
erm
any)
7670
568
Mot
or v
ehic
les
and
part
s22
Sie
men
s (G
erm
any)
6667
521
Ele
ctro
nics
el
ectr
ical
equ
ipm
ent
32M
etro
(G
erm
any)
5222
n
a
Foo
d an
d dr
ug s
tore
s34
Fia
t (I
taly
)51
7640
8M
otor
veh
icle
s an
d pa
rts
36N
estle
(S
witz
erla
nd)
5041
932
Foo
d46
Veb
a G
roup
(G
erm
any)
4351
275
Tra
ding
49R
enau
lt (F
ranc
e)41
4545
7M
otor
veh
icle
s an
d pa
rts
53D
euts
che
Tel
ekom
(G
erm
any)
4093
n
a
Tel
ecom
mun
icat
ions
57R
oyal
Phi
lips
Ele
ctro
nics
(N
ethe
rland
s)38
3386
4E
lect
roni
cs
elec
tric
al e
quip
men
t59
Peu
geot
(F
ranc
e)38
4038
7M
otor
veh
icle
s an
d pa
rts
62E
lect
riciteacute
de
Fra
nce
(Fra
nce)
3711
3
na
Util
ities
ga
s an
d el
ectr
ic63
Rw
e G
roup
(G
erm
any)
3747
n
a
Util
ities
ga
s an
d el
ectr
ic65
BM
W (
Ger
man
y)36
3660
7M
otor
veh
icle
s an
d pa
rts
66E
lf A
quita
ine
(Fra
nce)
3643
576
Pet
role
um r
efin
ing
69V
iven
di (
Fra
nce)
3558
n
a
Eng
inee
ring
and
cons
truc
tion
70S
uez
Lyon
nais
e de
s E
aux
(Fra
nce)
3585
n
a
Ene
rgy
78E
NI
(Ita
ly)
3249
317
Pet
role
um r
efin
ing
86B
ayer
(G
erm
any)
3134
827
Che
mic
als
92A
BB
Ase
a B
row
n B
over
i (S
witz
erla
nd)
3132
957
Ele
ctro
nics
el
ectr
ical
equ
ipm
ent
93B
AS
F (
Ger
man
y)31
3159
5C
hem
ical
s95
Car
refo
ur (
Fra
nce)
3020
n
a
Foo
d an
d dr
ug s
tore
s
(tab
le c
ontin
ues
next
pag
e)
Institute for International Economics | httpwwwiiecom
92 WORLD CAPITAL MARKETS
Tab
le 2
8N
on
fin
anci
al f
irm
s in
th
e 10
0 la
rges
t co
mp
anie
s b
y re
ven
ue
199
8 (b
illio
ns o
f do
llars
) (c
ontin
ued
)
Glo
bal
Tra
nsn
atio
nal
ity
ran
k
Co
mp
any
Rev
enu
esa
Ass
etsb
ind
exc
Typ
e
Un
ited
Kin
gd
om
19B
P A
moc
o68
8559
2P
etro
leum
ref
inin
g43
Uni
leve
r45
3692
4F
ood
Un
ited
Sta
tes
1G
ener
al M
otor
s16
125
729
3M
otor
veh
icle
s an
d pa
rts
3F
ord
Mot
or14
423
835
2M
otor
veh
icle
s an
d pa
rts
4W
al-M
art
Sto
res
139
49
na
G
ener
al m
erch
andi
sers
8E
xxon
101
9365
9P
etro
leum
ref
inin
g9
Gen
eral
Ele
ctric
100
356
331
Ele
ctro
nics
el
ectr
ical
equ
ipm
ent
14In
tl B
usin
ess
Mac
hine
s82
8653
7C
ompu
ters
of
fice
equi
pmen
t25
US
Pos
tal
Ser
vice
6055
n
a
Mai
l pa
ckag
e a
nd f
reig
ht d
eliv
ery
27P
hilip
Mor
ris58
6051
1T
obac
co29
Boe
ing
5637
n
a
Aer
ospa
ce30
AT
ampT
5460
219
Tel
ecom
mun
icat
ions
40M
obil
4843
597
Pet
role
um r
efin
ing
41H
ewle
tt-P
acka
rd47
3451
1C
ompu
ters
of
fice
equi
pmen
t50
Sea
rs R
oebu
ck41
38
na
G
ener
al m
erch
andi
sers
55E
I d
u P
ont
de N
emou
rs39
40
na
C
hem
ical
s61
Pro
ctor
and
Gam
ble
3731
477
Soa
ps
cosm
etic
s75
Km
art
3414
n
a
Gen
eral
mer
chan
dise
rs81
Tex
aco
3229
453
Pet
role
um r
efin
ing
82B
ell
Atla
ntic
3255
n
a
Tel
ecom
mun
icat
ions
85E
nron
3129
n
a
Ene
rgy
87C
ompa
q C
ompu
ter
3123
n
a
Com
pute
rs
offic
e eq
uipm
ent
89D
ayto
n H
udso
n31
16
na
G
ener
al m
erch
andi
sers
94J
C
Pen
ney
3124
n
a
Gen
eral
mer
chan
dise
rs96
Hom
e D
epot
3013
n
a
Spe
cial
ty r
etai
lers
97Lu
cent
Tec
hnol
ogie
s30
27
na
E
lect
roni
cs
elec
tric
al e
quip
men
t10
0M
otor
ola
2929
n
a
Ele
ctro
nics
el
ectr
ical
equ
ipm
ent
Institute for International Economics | httpwwwiiecom
THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 93
Jap
an
5M
itsui
109
5635
8T
radi
ng6
Itoch
u10
957
333
Tra
ding
7M
itsub
ishi
107
7536
9T
radi
ng10
Toy
ota
Mot
or10
012
540
0M
otor
veh
icle
s an
d pa
rts
12M
arub
eni
9455
300
Tra
ding
13S
umito
mo
8946
259
Tra
ding
18N
ippo
n T
eleg
raph
amp T
elep
hone
7614
7
na
Tel
ecom
mun
icat
ions
20N
issh
o Iw
ai68
3938
8T
radi
ng24
Hita
chi
6282
214
Ele
ctro
nics
el
ectr
ical
equ
ipm
ent
26M
atsu
shita
Ele
ctric
Ind
ustr
ial
6067
332
Ele
ctro
nics
el
ectr
ical
equ
ipm
ent
31S
ony
5353
628
Ele
ctro
nics
el
ectr
ical
equ
ipm
ent
33N
issa
n M
otor
5158
511
Mot
or v
ehic
les
and
part
s38
Hon
da M
otor
4943
641
Mot
or v
ehic
les
and
part
s48
Tos
hiba
4151
252
Ele
ctro
nics
el
ectr
ical
equ
ipm
ent
51F
ujits
u41
4332
6C
ompu
ters
of
fice
equi
pmen
t52
Tok
yo E
lect
ric P
ower
4012
2
na
Util
ities
ga
s an
d el
ectr
ic60
NE
C37
42
na
E
lect
roni
cs
elec
tric
al e
quip
men
t90
Tom
en31
18
na
T
radi
ng99
Mits
ubis
hi E
lect
ric30
35
na
E
lect
roni
cs
elec
tric
al e
quip
men
t
Ch
ina
73S
inop
ec34
52
na
P
etro
leum
ref
inin
g
Tot
al (
aver
age
for
tran
snat
iona
lity
inde
x)3
988
447
949
0T
otal
for
G-1
0 (a
vera
ge f
or t
he i
ndex
)3
954
442
749
0
na
= n
ot a
vaila
ble
G-1
0 =
Gro
up o
f T
en c
ount
ries
see
not
e to
tab
le 1
1
a
Dat
a sh
own
are
for
the
fisca
l ye
ar e
nded
on
or b
efor
e 31
Mar
ch 1
999
b
Ass
ets
show
n ar
e th
ose
at t
he c
ompa
nyrsquos
fis
cal
year
-end
c
The
ind
ex o
f tr
ansn
atio
nalit
y is
cal
cula
ted
as t
he a
vera
ge o
f ra
tios
of f
orei
gn a
sset
s to
tot
al a
sset
s f
orei
gn s
ales
to
tota
l sa
les
and
for
eign
em
ploy
men
tto
tot
al e
mpl
oym
ent
as o
f 19
97 (
UN
CT
AD
)
Sou
rces
F
ortu
ne G
loba
l 50
0 1
999
http
w
ww
pat
hfin
der
com
fort
une
glob
al50
0in
dex
htm
l U
NC
TA
D (
1999
)
Institute for International Economics | httpwwwiiecom
94 WORLD CAPITAL MARKETS
foreign direct investment The ldquotransnationality indexrdquo (table 28) showsthat on average they conducted about half their business outside theirhome country9
Overview of the Players
Our review of the major players points to two major features First ahandful of big playersmdashfewer than 200 firms all toldmdashcontrol the ac-tion in international capital markets Their dominance will doubtless erodebut for now financial power is strikingly concentrated with them Sec-ond the big players are overwhelmingly based in the G-10 countriesplus Spain The responsibility to supervise them rests not in the IMFnor in Basel but squarely in Washington London Tokyo and the otherG-10 capitals At year-end 1999 the G-10 countries plus Spain accountedfor 84 percent of world banking assets 86 percent of world stock marketcapitalization and 76 percent of international debt securities (BIS 2000aWorld Bank 2000b)
International private capital flows are of three types bank loans anddeposits portfolio investment and foreign direct investment In cumula-tive total flows to emerging markets FDI was the biggest story in the1990s amounting to $954 billion (table 12) Portfolio flows were nextcumulatively amounting to somewhere between $612 billion (table 12)and $764 billion (table A1) Bank loans and deposits are the most com-plicated story
The Key Role of Banks
Banks are more important as an epicenter than as a wellspring Banksgenerate waves in the flow of capital to emerging markets rather than acontinuous steady stream According to data compiled by the Institute ofInternational Finance (table A1) net bank lending to emerging marketscumulated to $269 billion in the 1990s However deposits by emerging-market residents in G-10 banks more than offset G-10 bank lending tothese countries during the decade According to IMF data cumulativebank loans net of deposits amounted to a negative $135 billion (table 12)
In other words when loans and deposits are combined net bank ac-tivity that moves financial resources to emerging markets is small incomparison with portfolio investment and FDI But bank loans are thelubricant of any financial system Depending on circumstances bankscan be shock absorbers or shock propagators In recent decades with
9 The transnationality index is calculated as a simple average of the share of assetssales and employees outside the home country
Institute for International Economics | httpwwwiiecom
THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 95
respect to emerging markets banks have more often been propagatorsthan absorbers The average annual swing in bank lending to emergingmarkets was nearly $50 billionmdashby far the largest source of year-to-yearfluctuations in capital flows Both interbank loans between Europe Japanand Asia and sovereign Russian debt used as loan collateral played amajor role in the 1997-98 crisesmdashnot because banks are profligate playersbut because of the incentives they face and the instruments they useAccordingly our story begins with banks
Banks in the Modern Financial System
10 See Levine (2000) for a concise description of the role of banks in the financial system
11 The asymmetric information problem helps to explain why banks dominate the im-mature financial systems of emerging-market economies The general lack of informationon borrowers and undeveloped legal systems to enforce contracts hamper suppliers oflong-term financial instruments such as equities and bonds in evaluating risk and re-ward Banks are best suited in these circumstances to solve the asymmetric informationproblem by evaluating and monitoring private loans As more and better informationbecomes available capital markets develop and financial systems mature
As we noted in the previous paragraph the problem of financial volatil-ity in emerging-market economies is associated with bank lending Ifand when repayment problems arise cross-border private bank loansand bond placements are such that private creditors have no plausiblemeans of seizing assets from either private or sovereign borrowers Thusalthough international finance can nourish entrepreneurs and accelerategrowth a necessary complement may be a drastic creditor response inthe event of nonpaymentmdashto withhold fresh funds and force an eco-nomic crisis (Dooley 2000)
This argument is based on the characteristics of banks They are notldquobadrdquo per se They perform three essential functions in any financialsystem pooling the resources of disparate savers and channeling these re-sources into productive investment improving resource allocation throughtheir expertise in assessing and monitoring borrowers and facilitatingthe division of risk among numerous creditors10 But by their very na-ture banks are prone to two problems asymmetric information (the bor-rower knows more about the potential risk and return of its projectsthan the bank) and adverse selection (riskier borrowers will pay higherinterest rates and thus may constitute a disproportionate share of bankloan portfolios)11
Bank loans are illiquid fixed-price instruments They cannot easily beconverted to cash although they can be bundled into securities (knownas ldquosecuritizationrdquo) Once loan terms have been agreed on the only waya bank can adjust for shifting market conditions is by changing the quantityof its exposure When a borrower runs into trouble the bank can mix
Institute for International Economics | httpwwwiiecom
96 WORLD CAPITAL MARKETS
and match from two unpleasant menus It can roll over existing loansand extend new credit or it can call some part of existing loans andattempt to recover the principal It can also hedge by selling short otherclaims on the borrower These choices entail either an unwelcome exten-sion of the bankrsquos exposure or credit rationing against the borrower Whentrouble brews all banks encounter the same conditions in the aggregatethey prefer less exposure and ensuing credit restrictions lead to volatilebank lending
Innovation
12 Derivatives have no value of their own They ldquoderiverdquo their value from the value ofthe underlying asset They include swaps futures (contracts for future delivery at speci-fied prices) and options (which give one party the right but not the obligation to buyfrom or sell to a counterparty at an agreed price)
13 Maxfield (1998) analyzed available evidence of emerging-market investor objectivesmost of it before the crisis Analysis of portfolio equity flows is sensitive to the choice ofperiod with year-over-year data indicating that investors respond to country ldquofundamen-talsrdquo Other evidence suggests more ambiguity Ranking by ldquoinvestor impatiencerdquo ie thesearch for yield over value Tesar and Werner (1995) find short-term bank flows to be themost yield driven followed by portfolio investment FDI and long-term bank lending
14 Because market risk credit risk and country risk interact in complex ways newfinancial instruments have been created to help reduce negative interactions One is theldquototal return swaprdquo which has become an instrument of choice for hedge funds lookingfor high leverage Banks also use the total return swap to cover risks without increasingtheir capital requirements
Since the 1980s national and international banking systems have beentransformed by deregulation intensified competition and the informationand communications-technology revolutions The market environment isone of intense competition particularly in traditional banking activitiesThe innovations point away from traditional activities of plain vanilladeposit taking and loan making Three big themes are discernible Firstthe walls separating commercial banks investment banks portfolio man-agers and insurance firms are falling even if they are still distinct Sec-ond large banks are shifting toward securitizationmdashcreating securitiesout of everything from credit card debt to trade finance to disaster insur-ancemdashand earning fees in the process Third all large banks are shiftingtoward trading activity making markets and taking short-term stakes inbonds shares and derivatives12 These activities when successful satisfythe search for higher yields13
Many of the new financial instruments that banks trade are ldquooff bal-ance sheetrdquo This means that banks are not required to allocate capitalagainst them In swap contracts for example neither side pays cash at theoutset and therefore neither party has an asset in the traditional sense14
Futures and options contracts can be written with a relatively small initial
Institute for International Economics | httpwwwiiecom
THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 97
margin relative to the potential risk Credit derivatives limit credit risk bytransferring the potential loss associated with corporate loans and bondssovereign debt and other loan portfolios to counterparties15
Deregulation and innovation working in combination seem to havepushed banks into trading activity and leveraged plays but not into shareownershipmdasheven in jurisdictions that have no prohibition against equitystakes Among the G-10 banking systems the highest ratio of share own-ership to assets was only 5 percent in 1996 reached in Germany andJapan (Berlin 2000)16
The wave of innovation in financial instruments and the accompany-ing expansion of banking beyond its old boundaries is a two-edged swordOn one side it allows risk management far beyond what was tradition-ally possible Risk can now be shifted from firms that can ill afford lossesto those that can Banks can profitably act as intermediaries in shiftingrisk On the other side the innovation wave creates huge opportunitiesfor leveraged plays fostering a speculative search by banks themselvesfor high returns that in turn magnify their own risks17
15 Credit derivatives include total return swaps credit default swaps credit-linked notesand collateralized debt obligations They are the fastest-growing sector of the global de-rivatives market
16 Banks seem to specialize in lending even when they are allowed to mix finance andcommerce for reasons related both to how they are expected to behave with distressedfirms and to other intricacies of lender liability (Berlin 2000) Yet a recent cross-countrystudy found that restrictions on banking and commerce are associated with greater fi-nancial instability (Barth Caprio and Levine 2000)
17 Leverage is the magnification of the rate of return (positive or negative) on an in-vestment beyond the rate obtained by solely investing funds owned by the institution Itis often defined as the ratio of assets to equity Leverage is achieved by increasing thesize of an investment by borrowing or using derivative instruments such as futures oroptions These allow investors to earn a return on the notional amount underlying thecontract by committing a small portion of equity in the form of a margin deposit oroption premium payment
18 In a repo (repurchase agreement) one party (typically a trader) buys a bond andsells it to a dealer for cash with a promise to buy it back the next day at the same priceplus the overnight interest rate As long as the overnight interest rate is lower than theinterest accruing on the bond the trader earns some income on the bond The extremeform of these kinds of transactions was discovered at LTCM the failed US highly lever-aged institution which appears to have controlled more than $120 billion in assets froman investment of about $3 billion This leveraging was accomplished mostly through theuse of repos (Mayer 1999)
The potential for damage is illustrated in an extreme form by figure 21To precisely measure a firmrsquos leverage all positions must be known andrealistically valuedmdashwhich may be impossible to do Because many ac-tivitiesmdashsuch as repos18 and derivativesmdashdo not appear on the institutionrsquos
Leverage
Institute for International Economics | httpwwwiiecom
98W
OR
LD
CA
PIT
AL
MA
RK
ET
S
Figure 21 Hypothetical example of leverage
$1000 notional value of call option on equity in firms targeted for takeover
Repo FRN into cash and use cash to pay option premium
(repro is initially collateralized
Borrow $100 for margin purchase
$125 of US investment bank floating-rate notes (FRN) (secured by $25 equity in FRNs)
Repo off-the-run bond into cash and post margin
(repo is initially collateralizedSell (short) Borrow on-the-run bonds worth $20
$25 worth of off-the-run bonds (secured by $5 equity in bonds)
Exchange into $4
Cash $5 yen400 Japanese bank loans
$1 equity base
FRN = floating rate notesRepo = repurchase agreement
Source IMF (1998)
Institute for International Econom
ics | httpww
wiiecom
THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 99
balance sheet and because balance sheets are published quarterly at bestoutsiders have a difficult time assessing the extent of a firmrsquos leverage19
Leveraging by a single firm enhances its risk of default the widespreaduse of leverage in the financial system can magnify market adjustmentsespecially when they require ldquodeleveragingrdquomdashunwinding prior positionsRapid adjustments can cause credit to dry up and asset prices to plummetIn a mark-to-market environment falling asset prices trigger calls foradditional collateral that can ripple through markets
Risk Management
Because it is confronted with the widespread use of leverage and prolif-erating kinds of risk international finance is increasingly driven by riskevaluation and control20 Different institutions face various risk profilesand differing kinds of risk The most common risks can be quickly tickedoff Banks because of their traditional intermediary role of channelingthe resources from savers to borrowers face significant credit risk therisk of default or delay in the payment of principal and interest Theymust also manage market risk the risk that the prices of their liabilitiesmay change faster than their assets Market risk devastated US savingsand loan institutions in the late 1980s
Closely associated with market risk are interest-rate risk (unexpectedchanges in market interest rates that slash margins net income and theeconomic value of a bankrsquos equity) and foreign exchange risk (losses thatarise when assets denominated in an appreciating foreign currency areless than liabilities denominated in that currency) Banks make numer-ous loans to other banks around the world portfolio investors buy se-curities direct investors acquire fixed assets and all incur country risk(economic and political uncertainty in the host country) During the heightof the Asian crisis for example interbank loans to Japanese banksreflected the credit risk of lending to these banks the so-called Japanpremium
Substantial attention has been lavished on country risk analysis sincethe 1982 debt crisis in developing countries Yet in spite of this exper-tise the Asian crisis occurred in part because of a sudden upward reap-praisal of country risk after the Thai baht collapsed in April 1997 Banksand other financial institutions must also manage liquidity risk the riskthat market conditions will change unexpectedly depressing demand andprices of assets at the time they want to sell these assets And they mustmanage operational riskmdashfailures in control systems or people that cause
19 Another example of asymmetric information Both risk and leverage are difficult foroutsiders to assess without full timely disclosure
20 A longer discussion of these issues can be found in Managing Global Finance in IMF(1999c)
Institute for International Economics | httpwwwiiecom
100 WORLD CAPITAL MARKETS
financial loss or damage reputations Operational risk devastated BaringsBank in 1995
Financial institutions practice risk management to measure all theserisks the potential damage to their investment positions and ultimatelythe chance of becoming insolvent VAR (value at risk) risk models mea-sure subject to certain assumptions the amount of the firmrsquos capital thatis exposed in each period For example the VAR model might say thatin a 3-standard-deviation worst case (a case that is not supposed to hap-pen more than 1 percent of the time) the firm will loose 25 percent of itscapital during the next year
VAR models are widely used but like all models they have weak-nesses They rely on past values to estimate key variables in financialmarkets past values are not always good predictors of future risks More-over rising volatility and higher loss correlation among different assetclasses in a portfolio will cause all banks using these models to reducetheir exposures at the same time by switching to less volatile and lesscorrelated assets such as US Treasury bills (Persaud 2000)
Newer risk models entail stress testing and scenario analysis Scenarioanalysis envisages possible adverse changes one at a time that mightaffect the investment portfolio Stress testing estimates potential losseswhen several individual risk factors simultaneously move against thefirm but it too uses historical probabilities
Financial Volatility
21 For example derivative markets usually rely on underlying securities markets thatproduce continuous prices When these markets are interrupted financial shocks cantrigger a cascade of margin calls and sell orders that move prices very sharply
22 See IIF (1999a)
The combination of trading activity and modern risk management lie atthe root of financial volatility When risks increase banks must eitherraise more capital to cover the greater risk or reduce their exposure bycutting loan exposure by selling securities or by undertaking new de-rivative trades Raising more capital is time-consuming and in a crisisvery expensive because bank shares are depressed So banks look to theother alternatives If the bank can reduce lending it need not book aloss But most banks use the same VAR models and as indicated abovethese models will encourage them to reduce their outstanding loans atthe same time actually magnifying loan volatility
If banks attempt to reduce their exposure to risk by selling securitiesor undertaking new derivative trades they may trigger large priceshocks because of limited and shrinking market liquidity21 The liquid-ity problem is compounded when a small number of large institu-tions hold the same positions22 Take your pick loan volatility or price
Institute for International Economics | httpwwwiiecom
THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 101
volatility As two experts have observed (Folkerts-Landau and Garber1998)
[V]olatility even in one country will automatically generate an upward re-estimate of credit and market risk in a correlated country triggering automaticmargin calls and tightening of credit lines Thus apparently bizarre opera-tions that connect otherwise disconnected securities markets are not the re-sponses of panicked green screen traders arbitrarily driving economies from agood to a bad equilibrium Rather they work with relentless predictability andunder the seal of approval of supervisors in the main financial centers
23 See Ferguson (1999)
24 As Gerald Corrigan (1982) put the matter ldquoBanks are specialrdquo Corrigan (2000) reit-erated this view even after all the changes of the past two decades Unlike other institu-tions banks offer on-demand transactions are a backup liquidity source for other insti-tutions and serve as a ldquotransmission beltrdquo for monetary policy
These changes in the banking environment accentuate an existing anomalyThe anomaly is that banks even as they grow larger and increasinglyengage in more risky and complex transactions are perceived to enjoyimplicit and explicit public guarantees
The guarantees grow out of an incentive problem inherent in bankingasymmetric information which we mentioned above Depositors know lessabout a bankrsquos management and the quality of its balance sheet than doits managers and shareholders Thus in times of uncertainty or adver-sity bank depositorsmdashuncertain whether they will have access to theirdepositsmdashare prone to bank runs This prospect has in turn compelledgovernments to treat banks differently than other firms because a bankthat fails can disrupt the rest of the economy24
To prevent such crises governments have entered into quid pro quoarrangements with banks Governments provide them both with an im-plicit safety net in the form of an unstated promise by the central bankto act as a lender of last resort in a liquidity crisis and an explicit safetynet in the form of a public deposit insurance fund to reassure depositorsIn return the banks submit to closer government oversight and regu-lation of their activities than is usual for industries in the private sector
The ldquoinsurancerdquo provided by the public safety net contributes to an-other incentive problem moral hazard Banks acquire greater tastes forrisk and face less market discipline than other firms The explicit depositinsurance safety nets actually have or are perceived to have blanketcoverage that extends beyond the retail depositors (households and small
One of the lessons of the 1997-98 crisis must surely be that market par-ticipants and their regulatory supervisors relied too heavily on quantita-tive tools and insufficiently on judgment23
The Anomaly of Modern Banking
Institute for International Economics | httpwwwiiecom
102 WORLD CAPITAL MARKETS
businesses) for which they were originally intended The implicit centralbank safety nets extend in a crisis to nearly all depositors and banksThus banks are both viewed and behave as if they will be bailed out ifthey get into trouble
The existence of a public safety net raises a perennial question Dobanks have an unfair advantage over other financial institutions becauseof the subsidy provided by the safety net This question was at the heartof intensive study and debate in the United States leading up to thepassage in November 1999 of the Financial Services Modernization Act(also known as the Gramm-Leach-Bliley Act) The size of the gross sub-sidy is difficult to estimate despite determined research efforts Somesuggest it is well under 100 basis points and is at least partly offset bythe direct costs of deposit insurance premiums interest payments on bondsissued by the Financing Corporation25 reserve requirements regulatoryexpenses and operational costs associated with collecting deposits26 Con-versely Kwast and Passmore (2000) suggest that banks can expand theirscope far beyond the levels that other financial institutions could reachwith the same equity base but without the public safety net
A related concern in the US debate is whether allowing banks to ex-pand their activities into securities and insurance will ultimately extendthe safety net and add to the subsidy The Financial Services Moderniza-tion Act deals with this issue by maintaining a legal separation betweenbanks and the rest of the banking organization known as large com-plex banking organizations (LCBOs) They must engage in most securi-ties activities and insurance underwriting through separately capitalizedinvestment bank subsidiaries or holding company affiliates This act canbe said to have merely brought US banking laws closer to those of mostother industrial countries (Barth Brumbaugh and Wilcox 2000 BarthNolle and Rice 2000) If the fire wall is well-maintained and stoutly de-fended the safety net will neither expand in practice nor become a sourceof comfort to noncommercial bank subsidiaries of LCBOs
The quid pro quo exacted by governments to offset the subsidy iscloser public-sector monitoring of banksrsquo activities through prudentialsupervision The effectiveness of this closer official scrutinymdashand closermarket monitoringmdashare the subjects of the next section
25 The Financing Corporation was created by Congress in 1987 to sell bonds to raisefunds to help resolve the savings and loan crisis
26 See Levonian and Furlong (1995) Jones and Kolatch (1999) Shull and White (1998)and Whalen (1999a 1999b)
Are G-10 bank supervisors adequately responding In this section we firstassess the case for and compare the structures of prudential supervisory
Prudential Supervision
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 103
systems both within and among the G-10 economies plus Spain andconsider whether these offset the subsidy provided by the public safetynet Despite offsetting regulation and supervision implicit and explicitguarantees by G-10 governments to their banks are still a source of bank-ing instability in the emerging-market economies
National Systems for Prudential Supervision
Governments use prudential supervision to reduce the moral hazard andadverse selection created by their own safety nets Supervisors establishregulations and monitor compliance to limit risk taking and ensure thesafety and soundness of the banking system In a thoughtful analysis ofthe case for prudential supervision Frederic Mishkin (2000) identifiesthe main forms that supervision can take including the tasks of grantingbanking charters and licenses establishing capital requirements settingdeposit insurance premiums and defining disclosure requirements as wellas carrying out bank examinations Bank examiners gather informationfrom banks and evaluate whether they are following the regulatorsrsquo rulesin cases of weakness they are empowered to change banksrsquo behaviorand close them if necessary
Supervisors also may restrict competition define the activities in whichbanks may engage and restrict their asset holdings and separate banksand other financial (or nonfinancial) activities During the past two de-cades the barriers separating commercial banks investment banks in-surance firms and securities firms have been all but eliminated (tableB1) Deregulation has stimulated competitive forces that drive diversifi-cation and consolidation of the financial industry nowhere faster than inthe United States
The Financial Services Modernization Act of 1999 confirmed this trendIt eliminated restrictions dating back to the Glass Steagall Act of 1933which once prevented banking insurance and securities firms fromentering each otherrsquos businesses (Barth Brumbaugh and Wilcox 2000)Cross-pillar mergers among banks insurance and securities firms arewell under way to form giant financial holding companies The 1999merger between Citibank (banking) and Travelers (insurance) created themodel for megafinance and confirmed new challenges for supervisors
Mishkin (2000) notes the corresponding evolution in US supervisionfrom an emphasis on rules-based regulation (detailed rules for opera-tional behavior and the quality of line items in the balance sheet) to anapproach that stresses the soundness of bank management practices es-pecially risk management
Appendix B outlines the systems of financial supervision now in theplace in the G-10 countries plus Spain Some systems like the UK andCanadian approach are models of simplicitymdashorganized to keep pacewith the spreading reach of financial conglomerates Other systems like
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104 WORLD CAPITAL MARKETS
the US and French approaches show traces of the bureaucratic divisionsthat made sense in an era when banking securities and insurance weresharply separated
The US Model
27 See Meyer (1999a)
28 Canada has a similar degree of simplification with the exception that securities firmsare still regulated by provincial authorities
29 See Pratti and Schinasi (1999 67)
30 The agents are the bank regulators and the principals are the taxpayers Agents maypursue their own interests including bureaucratic survival and postgovernment employ-ment opportunities rather than the national interest in banking safety and soundness
The US model of financial regulation delineated in the Financial Ser-vices Modernization Act of 1999 blends functional and umbrella super-vision Bank and thrift regulators oversee depository institutions Newnonbank activities are subject to both functional regulation (eg by theSecurities and Exchange Commission and state insurance examiners) andumbrella supervision (of financial holding companies) by the FederalReserve27
The UK Model
Another supervisory model exists in the United Kingdom as well as inAustralia Canada and Switzerland28 In this model banking supervisionis separated from the monetary policy function The regulatory structureis considerably simplified by relying on a consolidated financial regula-tor separate from the central bank for both banking and nonbankingactivities The remaining question answered differently depending on thecountry is the extent to which the regulator relies on home-country sur-veillance of banks and conglomerates that have a local presence
Regulatory Models Compared
Appendix B provides more detail on the differences in these modelsGerman simplicity contrasts with French complexity In France the bankingcommission is chaired by the governor of the central bank and includesrepresentatives from the Treasury The commission supervises compli-ance with regulations but the central bank inspects banks on behalf ofthe commission29 In countries such as the United States and France withmultiple supervisors and crossover functions internal coordination is criticalAt the same time multiple agencies create regulatory competition Wheneach agency knows what the other is doing transparency within gov-ernment circles can help to limit principal-agent problems of regulation30
The discussion as to where in the public bureaucracy financial super-
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 105
vision should be placed goes back many years Peek Rosengren andTootell (1999) argue that a synergy exists between monetary policy andprudential supervision because information gained in the course of super-vision can increase the accuracy of macroeconomic forecasts A twist tothis argument is that the information on the state of financial institutionsavailable to the central bank as supervisor can facilitate its role as lenderof last resort Conversely there is the concern that a supervisory rolewill compromise the central bankrsquos independence of action with respectto its core mandatemdashmaintaining price stability As these arguments haveplayed out financial supervision has generally been shared between centralbanks and other regulators or placed entirely in the hands of an inde-pendent regulator However in Italy the Netherlands and Spain cen-tral banks are the sole banking supervisor
Goodhart (1995) examined the arguments and evidence for each modeland concluded that there were no overwhelming arguments or evidencefor one or the other31 Going forward a key problem for any financialsupervisory system is dealing with (and closing as necessary) weak banksIf both central banks and other regulators have this responsibility closecoordination between them is critical Another problem is large conglom-erate banks LCBOs Although they are less likely to fail because of thediversification of their assets and liabilities they are more likely to berescued They are also more likely to be multinational enterprises withinternational implications Goodhart observes that regulation of theseentities might be put in the hands of the central bank because it is lessamenable to political pressures In any event the complexity of LCBOoperations suggests that greater supervisory rigor is necessary
The US Congress was persuaded that broad oversight would help containthe moral hazard problem and accordingly gave the Federal Reservethe role of umbrella supervisor with the understanding that the Fed willscrutinize depository activity more intensely than nonbank financial ac-tivities Under this approach LCBOs such as Citigroup are subject tomuch closer monitoring than smaller and simpler institutions32 The USregulatory model requires enormous cooperation between the Fed otherbank supervisors and the functional regulators for insurance and securi-ties but it also benefits from regulatory competition
31 National systems of supervision are path dependent they are determined by the struc-ture of financial institutions and history in each country If Goodhart (1995) is right out-comes are not materially better or worse with one model of supervision rather than another
32 See Ferguson (1999)
Public Safety Nets
One of prudential supervisorsrsquo biggest challenges is to reduce moral hazardFor many years commercial banks engaged in communal self-insurance
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106 WORLD CAPITAL MARKETS
to deal with crises They formed voluntary groups that agreed to rescuetroubled members As financial markets evolved and competition inten-sified banks were no longer willing to play this role Private-sector in-surance is one alternative but moral hazard and adverse selection wouldappear to prevent it from happening Public safety nets have developedbecause of the low probability and high cost of potential bank runs Aclear trade-off is involved The effectiveness of insurance in preventingbank runs is greater the more comprehensive the coverage But the morecomprehensive the coverage the greater the moral hazardmdashbank man-agers bank directors investors and depositors all take on greater risksin the belief that the safety net will protect them against losses
All G-10 countries have compulsory public safety nets for banks (table29) Deposit insurance agencies are officially organized in Canada theNetherlands Sweden Switzerland and the United States organized bythe industry in France Germany Italy and the United Kingdom andjointly organized by the public and private sectors in Belgium Japanand Spain
How well do G-10 governments offset the subsidy provided by thepublic safety net This is a question on which there is substantial debateAs banking organizations have become more complex the challengesthat supervisors face have become more difficult One challenge is toalign the incentives facing bank managers and shareholders with thoseof depositors Another is the principal-agent problem in supervision Wehave discussed the incentive structures for financial institutions but wehave said little about the incentives for supervisors themselves and thedistortions they can generate in the financial system
In one of the many studies of the US savings and loan crisis of the1980s Kane (1989) documented both problems He described managersusing cosmetic approaches to disguise the magnitude of insolvency regulatorspracticing forbearance even though they knew of the deteriorating riskprofiles of the institutions for which they were responsible and legisla-tors increasing deposit insurance without regard for any offsetting changesin supervision A subsequent overhaul of the legislative framework forthe Federal Deposit Insurance Corporation (FDIC) known as the FDICImprovement Act of 1991 (FDICIA) aimed to introduce a clearer incen-tive structure for both regulators and regulated institutions
The changes introduced by this US legislation are worth discussionwith respect to the other G-10 countries as well First FDICIA created astronger signal to management and investors by targeting deposit insur-ance at small depositors only and by risk-weighting the deposit insur-ance premiums paid by banks to reflect their capital adequacy and bankexaminer ratings Among the G-10 countries rated in table 210 depositinsurance premiums vary considerablymdashbut it is not clear that the dif-ferences have much to do with risk-weighting Most G-10 countries em-ploy funding formulas based for example on the total domestic deposit
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Table 29 Deposit insurance schemes in the G-10 countries Explicit safety net
Coverage limit(dollar Foreign
equivalent currency Interbank Source Bankrsquos Contingency fundingDate Membership Co- at end of deposit deposit of premium from banks
Country established managementa insuranceb July 1998)c covered covered Fundingd funding costs or governments
United 1982 Compulsory Yes Larger of 90 No No Unfunded Banks only Callable (subject Parliament may increase Kingdom private percent co- to maximum the maximum payable
insurance to 03 percent of pound125 million advance 33000 total deposits) facility with Bank of
England
United 1934 Compulsory No 100000 Yes Yes Funded Banks and Up to 027 Borrowing up to $3 States official government percent total billion from US Treasury
domestic deposits
Japan 1971 Compulsory No 71000 but No No Funded Banks and 0084 percent of Borrowing up to yen500bn joint in full until government insured deposits from Bank of Japan
year 2000 subject to Ministry of Finance approval
Canada 1967 Compulsory No 40800 No Yes Funded Banks and 033 percent of Borrowing up to C$6 official government insured deposits billion authorized further
(maximum) borrowing subject to parliamentary approval
Germany 1966 Compulsory Yes 90 percent Yes No Funded Banks only 003 percent of Annual levy may be private coinsurance deposits doubled
to 22000
Italy 1987 Compulsory Yes 125000 Yes No Unfunded Banks and Callable Two options defer private government (maximum of payment or diminish
1 percent of compensation to be paid total deposits)
(table continues next page)
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Table 29 Deposit insurance schemes in the G-10 countries Explicit safety net (continued )
Coverage limit(dollar Foreign
equivalent currency Interbank Source Bankrsquos Contingency fundingDate Membership Co- at end of deposit deposit of premium from banks
Country established managementa insuranceb July 1998)c covered covered Fundingd funding costs or governments
Netherlands 1979 Compulsory No 22000 Yes No Unfunded Banks and On demand Government backing official government maximum of subject to parliamentary
5 percent of own approval funds
France 1980 Compulsory No 65400 No No Unfunded Banks only Callable (on Extra calls up to FFr1000 private demand calls million can be made in
up to FFr200 a 5-year period million)
Switzerland 1984 Voluntary No 19700 No No Unfunded Banks only Callable (on Underwritten by member official demand) banks
Sweden 1996 Compulsory No 31400 Yes No Funded Banks and 05 percent of Full emergency coverage official government deposits while replacing it with a
limited system after the emergency
Belgium 1974 Compulsory No 16600 No No Funded Banks and Callable 002 None insurance limited joint 22000 in government percent of to assets in fund
year 2000 deposits from clients
Spain 1977 Compulsory No 16439 Yes No Funded Banks and 02 percent of Government backing joint government deposits through the Banco de
(maximum) Espantildea subject to approval by royal decree
a Bank membership in the fund can be either compulsory or voluntary and the management of the fund can be official and official and private joint or privateb Coinsurance refers to the situation where depositors face a deductible against their insured fundsc Coverage limit refers to the explicit amount the authorities promise to insured Funded scheme means that it is funded ex ante unfunded otherwise
Sources Goodhart (1995) Demirguccedil-Kunt and Detragiache (2000) Demirguccedil-Kunt and Sabaci (2000)
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 109
base Explicit safety net protection also varies but only Canada focuseson the protected class33 All G-10 countries specify a limit on depositorprotection Under FDICIA the insurance fund is prohibited from pro-tecting uninsured depositors or creditors at a failed bank although adiscretionary system-wide override is provided for exceptional circum-stancesmdashbut with stringent requirements for consultation and account-ability Other G-10 countries allow for contingency funding from the publicpurse alongside unwritten lender-of-last-resort support Among large banksa significant and growing portion of deposit liabilities including foreigncurrency and interbank deposits are uninsuredmdashbut depositors assumethey will be protected in a crisis
FDICIA also made some significant qualitative changes to address theprincipal-agent problem by penalizing weak banks and rewarding strongbanks For example banks whose capital declined faced progressivelytougher regulatory sanctions that for example required them to elimi-nate dividends restrict their lending and change their managementsRegulators have also been forced to take prompt corrective action (toreduce the practice of regulatory forbearance in hopes that a bankrsquos for-tunes might improve)34 Unfortunately comparative qualitative assess-ments across the G-10 are difficult to make due to lack of information35
This discussion highlights the complexity of evaluating the extent towhich prudential supervision and market discipline reduce the moralhazard associated with G-10 safety nets Our argument is that publicsafety nets in the G-10 can be linked to banking instability in other coun-tries specifically in the emerging-market economies that have attractedG-10 cross-border bank lending This lending is a leading source of vola-tility in capital flows the large financial institutions many of which arecomplex banking organizations are based in and regulated by authori-ties in the G-10 economies These two features of the international finan-cial system are closely related although it is not possible to test thisrelationship econometrically
Two World Bank studies however indicate a basis for concern Onestudy is a cross-country econometric analysis of the relationship betweenbank stability and deposit insurance (Demirguccedil-Kunt and Detragiache2000) which found a negative relationship Their estimated model forbanking crises in a sample of 61 countries (both industrial and develop-ing) suggests that explicit deposit insurance raises the probability of acrisis by at least 30 percent36 Crises are especially likely in countries
33 Japanrsquos legislation says it does but recent experience shows this is not the case34 See Goldstein (1997) for a summary of the changes35 See Barth Nolle and Rice (2000) for a beginning in this area36 Demirguccedil-Kunt and and Detragiache (2000 table 1) report a logit coefficient of 0696with a standard error of 0397 (the coefficient is significant at the 8 percent threshold)This suggests that the ldquotruerdquo coefficient could well be as small as 030 (the reportedvalue minus the standard error)
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110 WORLD CAPITAL MARKETS
with immature financial supervisory systems (and not in the G-10) buttheir analysis does underscore the view that deposit insurance weakensmarket discipline37
An earlier World Bank analysis established similar results One wasthat market discipline is undermined by deposit insurance schemes an-other was that illiquid banks are forced to pay more for their funds un-less a generous deposit insurance scheme is in place (Demirguccedil-Kuntand Huizinga 1999) This econometric study also provides clear-cut evi-dence that depositor monitoring of banks declines with the existence ofdeposit insurance schemes At the heart of the problem is the questionof whether deposit insurance is accompanied by increased governmentmonitoring
This evidence and the weight of other arguments suggests that moralhazard is still an issue in the G-10 countries Consider the ongoing de-bate about instilling greater market discipline on risk taking by banksAt one extreme is the perennial proposal to do away with safety netsleaving markets to monitor the players and to force adjustments but toprotect small savers by creating ldquonarrow banksrdquo such as postal savingsystems that are allowed to invest these savings only in risk-free gov-ernment securities Whatever the merits of narrow banking this solutionis too extreme to be politically feasible
A moderate alternative is to force more disclosure by financial institu-tions to facilitate market monitoring But transparency has its own prob-lems Persaud (2000) argues that financial markets cannot reliably discernsustainable from unsustainable positions in the short term This uncer-tainty causes banks to ldquoherdrdquo behind market leaders to exploit theirsupposedly superior information ldquoThe more herding investors and bankersknow about what each other is up to the [more] unstable markets maybecomerdquo The implication is that greater transparency in the marketplaceby itself will not solve the problemmdashand in the short term more informa-tion may exacerbate herding Further supervisory steps (discussed in thenext chapter) are required
Yet another proposal is to promote private-sector involvement in bankmonitoring through market-based alternatives such as Calomirisrsquos sub-ordinated debt proposal (Calomiris 1997 Federal Reserve Board 1999)Banks could be required to issue and maintain a minimum amount of
37 Other findings in the Demirguccedil-Kunt and Detragiache (2000) study include thesepropositions The impact of deposit insurance on bank stability tends to be stronger themore extensive is the coverage offered to depositors when the scheme is funded andwhere the scheme is run by the government rather than by the private sector Con-versely deposit insurance is detrimental to bank stability where bank interest rates havebeen deregulated and where the institutional environment is weak Additional findingson deposit insurance are reported from a recent World Bank conference (8-9 June 2000httpwwwworldbankorgresearchinterestconfsupcomingdeposit_insurancehomehtm)Also see Smalhout (2001)
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 111
subordinated debt (eg uninsured certificates of deposit) to finance asmall fraction (such as 2 percent) of their total nonreserve assets Thesubordinated debt would be allowed to earn a set yield no more than 50basis points over the risk-free yield on government treasury bills Thisrule would supposedly force banks to operate in a safe manner Other-wise subordinated debt holders would redeem their uninsured certifi-cates of deposit and equity investors would sell their bank shares Despiteits practical problems the beauty of the subordinated debt requirementis that it enlists market incentives to push banks to avoid excessive port-folio risk38
The thrust of these proposals is very relevant to the arguments in ourstudy Even in the G-10 countries government monitoring by itself hasnot eliminated moral hazard among banks More work is needed to in-troduce market monitoring and to improve the incentive structures bothfor financial institutions and their supervisors We return to this issuewith our recommendations in the next chapter
38 In late 1996 Argentina began requiring its banks to finance 2 percent of total depos-its in the form of subordinated debt but without a maximum yield provision TheArgentine authorities expect that market discipline will act in concert with the publicsafety net One obvious problem with the subordinated debt proposal is that banks mayencourage some of their customers to buy the subordinated debt
Portfolio Institutions Tomorrowrsquos Problem
Before proceeding to the issues of international supervision we flag an-other potential problem for national regulators The big asset managersprofiled in tables 24 and 26 answer to diverse groups of pensionersshareholders and policyholders They allocate funds across a number ofcountries to diversify their risks They hold liquid assets that can be tradedand they have a higher proportion of long-term assets than banks Eco-nomic shocks can be absorbed through price changes and their effectsspread across time and markets Thus when conditions change in a par-ticular market they are more likely to ride out the storm than to flee Inother words they have less incentive than banks to pull their invest-ments in the face of adversity In the 1990s most large asset managersestablished a record of ldquoriding out the stormrdquo rather than ldquorunning withthe windrdquo although as we saw in chapter 1 instances of running withthe wind were detected in some portfolios As we write these insti-tutions have a good record overall in the emerging markets so whyworry
The Russian crisis and the near-collapse of LTCM previewed the dan-gers that may await future portfolio managers and G-10 financial minis-ters We have presented evidence indicating a systemic bias toward bank
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112 WORLD CAPITAL MARKETS
lending and debt finance to emerging markets and we have argued forsubstitution toward equity finance and direct investment39
That is not the end of the story We noted in the previous chapterthat institutional investors can become momentum investors selling in adownturn As more portfolio capital is invested in emerging marketssome players may adopt the high-risk high-leverage strategies of themost aggressive hedge funds Indeed the data in box 11 show that G-10portfolio investors held somewhat more long-term debt (more than $500billion) than equity (less than $400 billion) in emerging markets at theend of 1997 Long-term debt is an ideal vehicle for high-risk high-leveragestrategies These strategies practiced on a large scale could compound afuture crisis harming emerging markets A big enough crisis could inturn pressure G-10 central banks and finance ministers to arrange bail-out plans Instead of shrinking as a systemic financial problem moralhazard could increase
National securities regulators are the first line of defense against thisscenario They play a critical role in the safe evolution of capital mar-kets But regulators today are mandated to approve the issuance of newsecurities and to monitor the continuing disclosure of material informa-tion by issuers They are far less concerned with or empowered to monitorthe behavior of the increasingly large wealth-management firms that arethe major purchasers (and therefore resellers) of these securities
Within their mandates the goals of national securities regulators (table210 and appendix B) are similar to the concerns of bank regulators withsystem safety and soundness Their focus is also on the incentive sys-tems for management and boards of directors and on disclosure by cor-porations that issue marketable securities such as shares bonds andasset-backed securities 40 Issuers of securities possess greater knowledgeabout the quality of these assets than do the purchasers hence investorprotection is a key concern of regulators Moreover market disciplineworks best when markets know what is happening Well-functioning corpora-tions are key agents of wealth creation and social progress Underperform-ing corporations waste resources During recessions bad corporationsget into bad trouble often with severe social consequences Inadequateincentives for managers and inadequate accountability for boards andmanagers thus have negative externalities Regulators play a vital role inexposing weakness so that market disciplines come to bear sooner ratherthan later
Regulatory emphasis is constantly shifting as financial markets evolveand as the macroeconomic environment changes Regulators try to balance
39 See Rogoff (1999) Also see Berlin (2000) for a perspective on the limited role thatbanks play as share owners
40 See Habib and Ljungqvist (2000) for recent empirical analysis showing that corporateshare market values are higher when corporate executives have a larger ownership stake
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Table 210 Financial-sector regulation G-10 countries 2000
Financial institutions and their supervisors
Country and supervisory structure Retail banking Wholesale banking Securities Insurance
Financial conglomeratesFinancial Services Authority (FSA) = umbrella supervisor
United Kingdom FSA FSA FSA FSA
Treasury bull Commercial banks bull Investment funds (Securities and (Insurance Directorate(Securities and Investments Board) bull Unit trust groups Futures Authority) of the Treasury)
Bank of bull Building societies bull Pension funds England (Building Societies Commission) bull Merchant banks
bull Friendly societies bull Clearing houses bull Primary issuers bull Insurance FSA (Friendly Societies Commission) bull Venture capital of securities companies
bull Pensions and life insurance etc bull Stock exchanges bull Insurance brokers(Personal Investment Authority) bull Stockbrokers
Financial holding companiesFederal Reserve (FR) = umbrella supervisor
United States bull National banks(OCC) Securities and Regulated by
Treasury OCC bull State banks Federal Reserve Exchange Commission StatesMembers (FR)
OTS Nonmembers (FDIC) bull Investment banks bull Primary issuers of bull Insurance companies FR bull Cooperative banks (FDICFR) bull Finance companies securities bull Insurance brokers FDIC bull Insured industrial banks (FDIC) bull Stock exchanges
bull Thrift holding companies (OTS) bull Stockbrokers SEC bull Savings banks (OTSFDICFR) bull Investment advisors
bull Savings and loan associations bull Mutual funds(OTS) bull Public utility holding
bull Edge Act corporations (FR) companies
(table continues next page)
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Table 210 Financial-sector regulation G-10 countries 2000 (continued )
Financial institutions and their supervisors
Country and supervisory structure Retail banking Wholesale banking Securities Insurance
Financial holding companies Japan Financial Supervisory Authority (FSA) = umbrella supervisor
Prime FSA FSA FSA FSA ministerrsquos Ministry of office Finance (Securities and Exchange
Surveillance Commission) FRC Bureau of Financial bull City banks bull Investment banks bull Primary issuers of bull Insurance companies FSA Regulation bull Regional banks bull Asset managers securities bull Insurance brokers
bull Trust banks bull Stock exchanges SESC bull Long-term credit banks bull Stockbrokers
bull Pension funds
Financial holding companiesOffice of the Superintendent of Financial Institutions (OSFI) = umbrella supervisor
Canada Regulated by OSFI OSFI provinces OSFI
Department of Financebull Banks bull Cooperative credit bull Primary issuers of bull Insurance companies
(previously Office of the Inspector associations securities (previously Depart- OSFI General of the Banks) bull Fraternal benefit bull Stock exchanges ment of Insurance) Bank of bull Trust and loan companies society bull Stockbrokers bull Insurance brokers Canada bull Pension funds bull Asset managers
(previously Depart- CDIC ment of Insurance)
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Financial institutions and their supervisors
Country and supervisory structure Retail banking Wholesale banking Securities Insurance
Germany Financial holding groupsFederal Banking Supervisory Office (FBSO) = umbrella supervisor
Ministry of Finance FBSO BSO FSSO FISO
Bundesbankbull Universal banks bull Other financial bull Primary issuers of bull Insurance companies
Federal Banking bull Savings banks institutions (eg securities bull Insurance brokers Supervisory Office bull Securities banks management foreign bull Stock exchanges
currency dealings) bull Stockbrokers Federal Securities bull Financial enterprises bull Asset managers Supervisory Office (eg leasing bull Pension funds
organizations Federal Insurance credit card companies Supervisory Office investment advisors)
Italy Bank foundationsMinistry of Finance = umbrella supervisor
Ministry of Finance Bank of Italy Bank of Italy Consob ISVAP
Bank of Italy bull Commerical banks bull Asset managers bull Primary issuers of bull Insurance companies Consob bull Savings bank bull Open-end investment securities bull Insurance brokers
bull Securities banks companies (SICAVs) bull Stock exchangesbull Stockbrokers
ISVAP
(table continues next page)
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Table 210 Financial-sector regulation G-10 countries 2000 (continued )
Financial institutions and their supervisors
Country and supervisory structure Retail banking Wholesale banking Securities Insurance
The Netherlands Financial conglomeratesCouncil of Financial Supervisors = umbrella supervisor
Securities Board Securities Board Netherlandsche Netherlands Bank Netherlandsche Bank of the Netherlands Insurance Board Bank Insurance bull Credit institutions (universal banks bull Investment institutions bull Stock exchanges bull Insurance companies Board cooperative banks security credit (securities issuing bull Stockbrokers bull Insurance brokers
institutions mortgage banks) and tradingmdashprimary The Council of Financial and secondary Supervisors markets)
France Commission des Commission de Operations des Controcircle des
Banking and Banking Commission Bourse Assurances Financial Regulatory bull Ensuring that credit institutions (and investment firms since bull Primary issuers of bull Insurance companies Ministry for Committee the Financial Activity Modernization Act of 1996) comply securities bull Insurance brokers Economic with laws and regulations bull Stock exchanges Affairs and bull Execute instructions regarding all off-site monitoring and bull Stockbrokers Finance Credit on-site supervision Institutions and Banking and Financial Regulatory Committee Investment bull Formulates general regulations for credit institutions and investment firms Committee (capital adequacy requirements accounting rules etc) Bank of France Credit Institutions and Investment Committee Banking bull Authorizes and examines financial institutions except for those within the Commission competence of the Banking Commission
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117
Financial institutions and their supervisors
Country and supervisory structure Retail banking Wholesale banking Securities Insurance
Switzerland Large banking groupSwiss Federal Banking Commission (SFBC) = umbrella supervisor
Swiss National Bank Federal Office of
SFBC SFBC SFBC Private Insurance Swiss Federal Banking Commission bull Universal banks bull Investment banks bull Primary issuers of bull Insurance companies
bull Savings banks bull Asset management securities bull Insurance brokerscompanies bull Stock exchanges
Private audit Federal bull Investment funds bull Stockbrokers firms Office of bull Mortgage bond authorized by Private business SFBC Insurance
Sweden Financial holding company groupsFinancial Supervisory Authority = umbrella supervisor
Ministry of Finance Credit Market Securities Market Insurance Market
Credit Market Department Department Department Department
Financial bull Commercial banks bull Investment funds bull Primary issuers of bull Insurance companies Riksbank Supervisory bull Savings banks securities bull Insurance brokers Authority bull Friendly societies bull Stock exchanges
bull Stockbrokers
(table continues next page)
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Table 210 Financial-sector regulation G-10 countries 2000 (continued )
Financial institutions and their supervisors
Country and supervisory structure Retail banking Wholesale banking Securities Insurance
Belgium Bank holding companiesBanking and Finance Commission = umbrella supervisor
Bank of Belgium Banking Banking
Banking and Finance and Finance Insurance Controland Finance Commission Commission Commission Office
Banking and Insurance Finance Control bull Commercial banks bull Asset management bull Primary issuers of bull Insurance companies Commission Office bull Savings banks firms securities bull Insurance brokers
bull Securities banks bull Investment funds bull Stock exchanges bull Mortgage companiesbull Stockbrokers bull Pension funds
Securities Regulation Fund Securities Regulation Fund
bull Other investment firms and credit institutions(institutions participating in regulated off-exchangemarket in strips and Treasury certificates)
Bank holding companies Spain Banco de Espantildea = umbrella supervisor
Banco de Espantildea Comision Nacional del Mercado de Directorate General
Banco de Espantildea Valores (CNMV) Insurance
bull All credit institutions (commercial banks savings banks credit bull Primary issuers of (Ministry of Economy Ministry of cooperatives official credit institutions finance factoring and securities and Finance) Economy and CNMV leasing companies mortgage-loan companies etc) bull Stock exchanges bull Insurance companies Finance bull Interbank foreign exchange and book-entry public debt bull Stockbrokers bull Pension funds
markets bull Venture capital(companies and funds)
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wiiecom
TH
E P
LAY
ER
S T
HE
IR S
UP
ER
VIS
OR
S A
ND
MO
RA
L HA
ZA
RD
119
Financial institutions and their supervisors
Country and supervisory structure Banking Securities Insurance
Banking Advisory High Level Securities Supervisors Committee (BAC) Committee (HLSS) Insurance Committee (IC)
Supranational (EU) bull Formulates standards for prudential bull Coordination of securities market bull Formulates standards forsupervision supervision prudential supervision
BACICHLSS Banking Supervision
Conglomerates Committee (BSC) Securities Contact Committee Regulation of prudential bull Systemic risk monitoring bull Regulation and implementation of supervision securities admission
International Association International International Organization of of Insurance Supervisors
Basel Committee Securities Commisison (IOSCO) (IAIS) Joint Forum Conglomerates Supervision bull Supervision and regulation best bull Supervision and regulation best bull Supervision and regulation amp regulation Best practices practices practices best practices
FSF Coordination across supervisors of various functions
Notes See appendix B for more information Boldface type indicates senior or oversight supervisor normal type indicates adjunct or front-line supervisorsolid line indicates direct responsbility to the senior-ranking authority dotted line indicates coordination in supervisory activities
(table continues next page)
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120W
OR
LD
CA
PIT
AL
MA
RK
ET
S
Table 210 Financial-sector regulation G-10 countries 2000 (continued )
Glossary of names United Kingdom FSA = Financial Services Authority United States FR = Federal Reserve OCC = Office of the Comptroller of theCurrency FDIC = Federal Deposit Insurance Corporation SEC = Securities and Exchange Commission OTS = Office of Thrift Supervision Japan FRC =Financial Reconstruction Commission FSA = Financial Services Agency SESC = Securities and Exchange Surveillance Commission Canada OSFI =Office of the Superintendent of Financial Institutions CDIC = Canada Deposit Insurance Corporation Germany FBSO = Federal Banking SupervisoryOffice FSSO = Federal Securities Supervisory Office FISO = Federal Insurance Supervisory Office BSO = Banking Supervisory Office Italy Consob =Commissione Nazionale per le Societa e la Borsa ISVAP = Instituto per la Vigilanza sulle assicurazioni private e di Interesse colletivo Switzerland SFBC= Swiss Federal Banking Commission Spain CNMV = The Comision Nacional del Mercado de Valores Supranational BAC = Banking Advisory CommitteeBSC = Banking Supervision Committee IC = Insurance Committee HLSS = High Level Securities Supervisors Committee International Dimension FSF =Financial Stability Forum IOSCO = International Organization of Securities Commission IAIS = International Association of Insurance Supervisors
Sources United Kingdom Bank of England httpwwwbankofenglandcouk Financial Services Authority httpwwwfsagovuk United States Board ofGovernors of Federal Reserve System httpwwwfederalreservegov Japan Bank of Japan httpwwwbojorjo Financial Reconstruction Commissionhttpwwwfsagojpfrcindexehtml Financial Services Agency httpwwwfsagojp Canada Bank of Canada httpwwwbank-banque-canadaca Office ofthe Superintendent of Financial Institutions httpwwwosfi-bsifgccaAndreEindexhtml Germany Deutsche Bundesbank httpwwwbundesbankde Fed-eral Banking Supervisory Office httpwwwbakredde Italy Banca drsquoitalia httpwwwbancaditaliait Commissione Nazionale per le Societa e la Borsahttpwwwconsobit Instituto per la Vigilanza sulle assicurazioni private e di Interesse colletivo httpwwwisvapit The Netherlands De NederlandscheBank httpwwwdnbnl France Banque de France httpwwwbanque-francefr Switzerland Schweizerische Nationalbank httpwwwsnbchindex3htmlSweden Sveriges Riksbank httpwwwriksbanksedefaultasp Belgium National Bank of Belgium httpwwwbnbbesgindexhtm Spain Banco de Espantildeahttpwwwbdees The Comision Nacional del Mercado de Valores httpwwwcnmves Supranational (EU) Institutional Arrangements for the Regulationand Supervision of the Financial Sector 2000 International Dimension Bank for International Settlement httpwwwbisorg International Organization ofSecurities Commissions httpwwwioscoorg International Association of Insurance Supervisors httpwwwiaisorg Financial Stability Forum httpwwwfsforumorg
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 121
the inflexibility of tight surveillance against the need to encourage in-novation and growth The US Securities and Exchange Commission isworried about aggressive accounting by firms and biased reports bysecurities analysts in an equity environment that prizes steadily higherquarterly earnings41 Japanese regulators are preoccupied with opaqueinterconnections between portfolio institutions banks and nonfinancialfirms through the keiretsu system Canadian regulators reeling from high-profile scandals of managers intentionally misleading investors are strengtheningmarket discipline through legal penalties aimed at managers and directorsof offending firms
When panic strikes a securities regulator cannot do much As the 1987stock market crash and the LTCM debacle in the fall of 1998 both dem-onstrated steep stock and bond price declines can create systemic risksIf severe enough the wealth effect of falling securities values and thefear of widespread insolvency can depress real activity Flooding thesystem with liquidity is a central bankerrsquos solutionmdashsomething a securi-ties regulator cannot do42 But just as financial supervisors can changethe incentive structure to discourage bankers from making risky loans ingood times so securities regulators can pay more attention to incentiveson the demand side when capital markets are strong
Prudential Supervision and InnovationmdashA Footnote
In concluding this discussion of prudential supervision in the G-10 anadditional point is worth noting National regulators face a persistenttrade-off between emphasizing financial system safety and soundnesswhile encouraging innovationmdashin spite of the added risks innovationbrings to financial markets Former US Treasury Secretary Lawrence Summers(2000 3) has argued by analogy
The jet airplane made airplane air travel more comfortable more efficient andmore safe though the accidents were more spectacular and for a time morenumerous after the jet was invented In the same way modern global financialmarkets carry with them enormous potential for benefit even if some of theaccidents are that much more spectacular As the right public policy response
41 The problem is illustrated by the divergence since mid-1998 between reported earn-ings by the Standard amp Poorrsquos (SampP) 500 and the after-tax profits of all corporations inthe national accounts Generally these two series move closely with one another Be-tween mid-1998 and mid-1999 SampP 500 reported that earnings increased by more than20 percent while after-tax profits of all corporations increased by less than 5 percent(Chase Bank US Economic and Policy Research US Weekly Prospects Chase SecuritiesWeekly Newsletter 5 June 2000 5)
42 For example the US Securities and Exchange Commission had no direct role in calmingmarkets in the 1987 or 1998 panics
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122 WORLD CAPITAL MARKETS
to the jet was longer runways better air-traffic control and better training forpilots and not the discouragement of rapid travel so the right public policyresponse to financial innovation is to assure a safe framework so that the ben-efits can be realized not to stifle the change
Accepting Summersrsquos analogy for the international financial system better-informed supervisors and investors are a necessary part of the financialsystem framework Supervisors require more timely information on therisk profiles resulting from positions taken by financial institutions Theyalso need a better understanding of risk-management systems Snapshotsof an institutionrsquos risk profile and risk-management procedures are nolonger adequate In a world where huge bets are quickly made (andpossibly lostmdashas with Barings Bank in 1995 and LTCM in 1998) super-visors must focus on the soundness of banking systems for evaluatingand managing risk on a daily basis Some progress has been made inaddressing these issues US banking examiners are extending their in-formation requirements in banking examinations and increasing theirinvolvement in large complex institutions43 More awareness is alsorequired of the fact that they are national organizations in a world ofcross-border capital flows To a much greater extent they need a multi-national reach International supervision and coordination among super-visors are the subject of the next section
Our analysis suggests that G-10 supervisors have unfinished businessBank supervisors need to start yesterday securities regulators can waituntil tomorrow One G-10 member acting alone cannot correct the biasIn good times the lending business will simply migrate to other G-10banks In bad times financial problems will not stop at the national bor-der A way has to be found to establish common international standardsfor the key financial players in order to prevent crises and to agree onapproaches for managing them The path has already been laid out Inthe wake of the bank failures of the past 25 years bank supervisors havetried to establish such standards They have done this without creating anew global institution
The essence of the international framework is decentralizationmdashglobalrules and design standards without global institutions that are perceivedto intrude on national sovereignty The awkward jargon for this frame-work is vertical subsidiaritymdashldquothink internationally act nationallyrdquo Theinternational thinking is done by a committee of regulators that meets
International SupervisionA Decentralized Framework
43 These issues are discussed in Ferguson (1999) and Meyer (2000a)
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 123
regularly at the Bank for International Settlements in Basel The commit-tee establishes principles and standards that are interpreted implementedand enforced by national authorities44 In this section we describe thesesupervisory efforts and their weaknesses We present our recommenda-tions for addressing these weaknesses in the next chapter
Basel I
The Basel Capital Accord of 1988 (Basel I)45 drew the lesson from thefinancial crises of the mid-1970s that more adequate capital levels in in-ternational banks would help reduce the systemic risk of bank failureThe primary goal of Basel I was capital adequacy other standards wereput in place not so much for their own virtue as to defend the primarygoal
Capital adequacy requirements were designed to ensure that individualinstitutions have the ability to absorb losses particularly credit lossesAccordingly a backup system of scoring credit risk was devised thatrequired large amounts of bank capital for some types of loans smalleramounts for others and zero for a select list of preferred assets Report-ing requirements were designed to disclose problems and ensure that atroubled bank would take timely steps to restore its capital base in thewake of a loss The Basel I framework worked tolerably well in limitingthe call on the public purse in the G-10 countriesmdashwith the notable ex-ceptions of France and Japan The framework failed to moderate riskybank lending to emerging markets however
Basel I was not developed with emerging markets in mind The origi-nal idea behind it was to develop a common supervisory approach tocross-border banking operations It grew out of political pressure fromUS lawmakers who were determined to require international banks op-erating in the United States to meet US banking standards Toward thisgoal in 1983 Congress passed the International Lending Supervisory ActUS and British banking authorities subsequently agreed on a commontarget the adoption of strict common capital-adequacy standards In 1988other G-10 governments agreed to go along voluntary acceptance ofthe standards throughout much of the rest of the world followed46 Therationale for the capital targets was two-fold The first was to requirebanks to hold sufficient amounts of capital (8 percent of risk-adjusted
44 The international committee of financial authorities agreed on a common definitionof banksrsquo tier-one or ldquocorerdquo capital national authorities defined tier-two capital in theirown manner which permitted greater variations in national working definitions andpractices
45 International Convergence of Capital Measurement and Capital Standards (BIS 1988)was prepared by the Basel Committee on Banking Supervision
46 See Reineke (1998)
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124 WORLD CAPITAL MARKETS
assets) to cushion losses on those assets The second was to dull theirappetites for risk banks with large capital bases would have more tolose if they failed and therefore would take fewer risks
Rapid change in financial markets soon revealed flaws in the Basel IAccord In a complex world with numerous sources of risk it focusedheavily on credit risk but overlooked other risks in a bankrsquos portfolioand the correlation between returns on different asset classes The Baselformula required banks to maintain a fixed amount of capital againsteach of its asset classes But the formula did not distinguish the riskinessof the borrower within each class As a result one large loan to a low-risk corporate borrower such as General Electric would require the sameamount of capital as 10 smaller transactions with high-risk borrowers
The system was also biased toward short-term loans Loans maturingin less than a year required a 20 percent risk weight whereas those ma-turing after more than a year required a 100 percent risk weight Inter-bank lending was particularly favored For example loans to banks inOECD countries required less capital than loans to private firms in thesame countries creating the anomaly that interbank loans to South Ko-rean banks required less capital than loans to General Electric47 Thisanomaly encouraged banks to shed high-quality assets if the Basel rulesrequired the allocation of more capital than banks thought they needed
Another weakness was that financial innovators quickly circumventedthe Accord Because short-term loans required less provisioning than long-term loans banks responded by securitizing their long-term debt port-folios and lending short-term against the collateral of the newly createdasset This allowed banks to circumvent the capital requirements gearedto the terms of the underlying debt At the same time the Basel I Accordfailed to encourage risk mitigation techniques such as credit derivativescollateral guarantees and on-balance-sheet netting the flip side of fi-nancial innovation Because off-balance-sheet products were not coveredby the Accord another anomaly appeared when Barings Bank collapsedin 1995 Barings met capital adequacy standards but collapsed becauseits systems for managing risk failed traders were allowed to speculatein futures contracts that did not appear on the balance sheet
Basel II
Work to overhaul Basel I began in 1995 and produced consultativepapers issued in June 1999 and January 200148 These papers have been
47 South Korean banks have had notoriously weak balance sheets because the practiceof ldquodirected lendingrdquo left them with many poor loans (in making these loans the bankswere expected to follow government objectives rather than creditworthiness criteria)
48 Basel Committee on Banking Supervision (1999 2001)
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 125
the subject of extensive consultation and revision as a result the newAccord is expected to be introduced in 200449 The Basel II frameworkhas three parts (pillars) revisions to Basel I minimum-capital require-ments supervisory review criteria and greater emphasis on market dis-cipline Broadly Basel II aims to maintain the level of capital in the sys-tem but achieve better alignment of banksrsquo capital with their risk pro-files and keep up with financial innovation
To align capital requirements with market realities (the first pillar)Basel II concentrates on the 100 or so largest banksmdashthe type of playerslisted in table 21mdashand on the holding-company parents of banking groups50
Capital requirements will differentiate between an increased number ofcredit groups or ldquorisk bucketsrdquo including claims on governments otherbanks corporations mortgage-backed securities and other asset-backedsecurities
Basel II originally proposed to use external ratings to set capital chargesfor a number of these credit risks Many banks objected arguing thatthey assess credit risk better than Standard amp Poorrsquos Moodyrsquos or FitchIBCA51 Basel II thus proposes two approaches to rating a standard ap-proach using external ratings and an ldquoadvancedrdquo approach that allowsselected banks to use their own internal rating systems To encouragethe development of rigorous internal control systems based on these in-ternal rating systems Basel II also proposes to levy capital charges foroperational risk (the risk of direct or indirect loss resulting from inad-equate or failed internal processes people and systems or from exter-nal events)
Some critics of this proposal dismiss it as an abrogation of the prin-ciple of external independent monitoring and as ldquodangerously naiumlverdquo52
But regulators argue that the new capital charge on operational risk shouldoffset this concern It is also far from clear how cross-national compari-sons of rating and internal risk-assessment systems will be made (Engelen2000) The development by the European Union of its own capital rulescould well complicate the international resolution of these issues Publicassurances by EU officials in January 2001 however indicated that theirmain concerns are to create a level playing field and avoid regulatoryarbitrage (Hargreaves 2001) There is also the significant problem ofthe procyclical character of risk weights When a crisis hits losses are
49 See Berry (2000) for an update in an interview with William J McDonough chair ofthe Basel Committee on Banking Supervision
50 For obvious reasons these proposals are addressed to large banks and simpler capi-tal standards are allowed for small banks that focus on their domestic credit markets
51 See Ammer and Packer (2000) for an empirical critique of the success of rating agen-cies in distinguishing risk by sector and region
52 See Auerback (2001)
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126 WORLD CAPITAL MARKETS
incurred or accrued capital is lost and loan exposure must be reducedor securities sold to restore the requisite capital-adequacy ratios A morerisk-sensitive framework could amplify volatility
As the second pillar of Basel II supervisory review criteria are beingbeefed up to encourage supervisors to intervene earlier in potential problemsituations and to compel banks to align their capital positions with theirrisk profiles Bank supervisors will be authorized to require banks tohold capital in excess of minimum requirements if they have concernsabout general management overall strategy risk-management performanceor the macroeconomic environment Of course if one G-10 supervisorimposes higher capital requirements in isolation the same disparity willemerge that presaged Basel I Some banks will be disadvantaged in theinternational marketplace and will loudly complain that excessive super-vision is driving business to their competitors Hence close internationalcooperation among supervisors is critical
To implement the third pillar market discipline banks will be requiredto make fuller more timely disclosure of capital adequacy and the risksto which that capital is exposed A number of measures are being stud-ied that might help supervisors evaluate bank performance such as com-parisons of uninsured deposit interest rates subordinated debt yieldsand equity prices The idea is that these yields and prices might alertsupervisors to market perceptions of risk Of course market perceptionsare only as good as market information More direct and controversialways to reinforce market discipline would dramatically increase publicdisclosure of bank positions and risk management systems
Many questions are still outstanding about how to resolve the techni-cal details of capital requirements and whether the requirements willachieve their intended goal of better assessment and mitigation of therisks in banksrsquo portfolios There is no substitute for skilled supervisorsThe intricacies of effective design and implementation suggest that su-pervisors need to be highly competent technically knowledgeable aboutbanking portfolio characteristics and the factors that influence bank ex-posure to credit risk (Mishkin 2000) And they must be aided by vigilantshareholders market forces and transparency of information53
Standard setting at the global level is desirable but ultimately theeffectiveness of these efforts will be tested at the national level espe-cially in times of systemic financial distress Here the record of Basel Iwas not a bright shining success Japanese banking regulators havetraditionally allowed banks to include real estate and securities in theircapital base When the value of these assets plummeted in the early 1990sregulators allowed banks to continue valuing these depreciated (andoften bankrupt) assets at their old inflated levels Japanese authorities
53 Benedict Roth Complacency Towards Catastrophe Financial Times 23 January 2001
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 127
insisted until the mid-1990s that eroded capital bases could be rebuiltin a market-driven fashion They rightly foresaw that huge loan losseswould undermine public support for the ruling party and require a po-litically unpopular bailout
Japanese foot dragging on Basel I was the worst54 but not uniqueOther examples can be found of ldquopolitically mandated forbearancerdquo TheFederal Reserve Bank of New York held important hands during theLTCM crisis of 1998 Mexico is still resolving the banking crisis that eruptedin 1995 South Korea has not yet closed the insolvent banks that behavedso badly before the crisis of 1998 In the aftermath of a crisis nationalregulators cannot always be relied upon to discipline politically power-ful bankers55 One of the little-noticed consequences of these differingapproaches is that those banks with strong regulatory systems receivedan implicit ldquoexport subsidyrdquo for their services US banks which had notengaged extensively in emerging-market lending in the 1990s were bet-ter positioned than their German and Japanese counterparts to expandtheir international assets in the wake of the crises
Other Financial Forums
54 See Japanese Banks Fiddling while Marunouchi Burns The Economist 27 January2001 67-69
55 See Calomiris (1997)
The Basel model of vertical subsidiarity has already been extended toother financial regulatory bodies In 1993-94 the BIS established a Tri-partite Group of Banking Insurance and Securities Regulators In 1994-95 the BIS increased its cooperation with the International Organizationof Securities Commissions when the two organizations issued parallelpapers on guidelines for national regulators concerning risk managementand disclosure of derivative trades In 1996 a permanent Joint Forum onFinancial Conglomerates was established to examine supervisory issuesand develop working arrangements among the different functional super-visors of conglomerate institutions that offer combinations of bankingsecurities and insurance products Draft papers on the supervisionof conglomerates were released for comment in 1998 applying capital-adequacy principles to these groups and providing guidelines both forassessing the integrity and competence of top managers and for sharingassessments between regulators
In 1997 the Basel Committee on Banking Supervision extended itsreach beyond capital standards to broader aspects of banking supervi-sion with the publication of the Core Principles for Effective BankingSupervision In 1999 a wide range of regulatory and standard-settingbodies were gathered under the umbrella of the Financial Stability
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128 WORLD CAPITAL MARKETS
Forum (FSF) itself established under BIS aegis56 The FSF has alreadyissued recommendations for stepped-up supervision and transparencyas well as guidelines for best practices in a number of areas includingoffshore financial centers and highly leveraged institutions or hedge funds57
Conclusion
Although the structural weaknesses in emerging-market economies arewidely acknowledged to have been causal factors in international capi-tal-market volatility this chapter points to the role of large G-10 bankingorganizations as major suppliers of the most volatile instrument short-term debt We have examined evidence of the impact of public safetynets in the G-10 economiesmdashthe deposit insurance systems the pruden-tial supervisory systems and the lender-of-last-resort functions of centralbanksmdashon the incentive structures of these organizations
Although supervisors in most countries working nationally and to-gether in the BIS have made significant efforts to mimic market forcesin their prudential supervision the most sophisticated financial institu-tions find innovative ways to circumvent the rules New global regulatorybodies are not about to be created G-10 national bank regulators shouldthemselves address the short-term debt bias in the international financialsystem by changing incentive systems G-10 securities regulators shouldalso take steps to get ahead of the curve paying close attention to largeportfolio swings by institutional investors particularly in times of crisisIn short more needs to be done at national and international levels tochange the rules of the game That is the subject of the next chapter
56 The Financial Stability Forum includes banking securities insurance and accountingregulatory bodies the OECD on taxation corruption and corporate governance and theIMF
57 See Martin (2000)
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78 WORLD CAPITAL MARKETS
We argue in this chapter that the G-10 supervisors can improve theldquoplumbingrdquo of the international financial architecture In a coordinatedway the G-10 has a large role to play both in preventing and managingfuture crises We first distill a few supervisory lessons from the Asian andRussian crises Then we describe the private-market players paying par-ticular attention to the special role of banks in the international financialsystem and why moral hazard is such a persistent and subtle problem Wethen analyze key issues in offsetting moral hazard through prudentialsupervision beginning with national comparisons and ending with theG-10rsquos international system through the Bank for International Settlementsthe International Organization of Securities Commissions (IOSCO) andsimilar institutions in such related areas as insurance and accounting
Lessons from Asia and Russia
The main features of the 1997-98 episodes are well known Less under-stood however is the flavor of financial-institution involvement The crisisin East Asia was distinct from the crisis in Russia The Asian crisis wasmore gradual beginning in mid-1997 with the collapse of the Thai bahtfollowed by banking and economic shocks that spread to Thailandrsquosmajor regional trading partners and then to South Korea As the crisisunfolded Asians in the affected countries moved tens of billions of dol-lars offshoremdashusing the facilities of G-10 banks The bulk of the debtcontracts that were at risk in Asia were short-term nontraded interbankloans1 Most of these loans originated with Japanese and European banks(table 17)
By contrast the Russian crisis was a unilateral default (ldquorestructur-ingrdquo) of sovereign debtmdasha tradable financial instrument This instrumenthad been widely used as collateral to obtain credit from G-10 banksHence the default ldquoimmediately triggered the unwinding of leveragedpositions by large internationally active financial institutionsrdquo2 Much ofthe financing for Russian and other emerging-market sovereign debt hadbeen arranged and leveraged by US banks
Although the shocks and financial institutions differed from crisis tocrisis the use of debt instruments was a common element In the run-upto a crisis financial houses extended credit to increasingly risky borrow-ers and paid higher prices for emerging-market debt instruments Asknowledgeable players took more risks less knowledgeable playersfollowed them Many firms borrowed heavily to leverage their betsLeverage was easy with hedge funds borrowing from banks and banks
1 See IMF (1998)
2 IMF (1998 50)
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 79
borrowing from each other using emerging-market debt instruments ascollateral
Russia became the poster country of high-risk finance In 1996 Rus-sian treasury bills (GKOs) were sensibly regarded as time bombs nobank would accept them as collateral for a loan But gradually the viewtook hold in Wall Street that for political reasons Russia had becometoo big to fail Banks relented and began to accept GKOs as security butat half their market value By early 1998 some hedge funds were bor-rowing up to 95 percent of these assets as collateral3 Banks also lent toeach other on similar terms
When the IMF refused a bailout to prevent default on the GKOs wide-spread surprise turned to panic Everyone headed for the exits Losseswere huge because many firms had been doing the same thing usingthe same risk-management models All those positions could not be un-wound simultaneously Liquidity dried up For a period no one wouldlend even to strong North American corporate accounts The final chap-ter was the near-collapse of Long Term Capital Management a hugehedge fund run by brilliant managers The combination of unexpectedevents LTCMrsquos risk exposure and high leverage contributed to its prob-lems The size persistence and pervasiveness of the widening spreadsconfounded its risk-management models producing huge losses AfterLTCM was refinanced by its major counterparties in September 1998 itsweaknesses became clear They included its risk-management systemsthe inadequacy of its capital base and most important the failure of marketdiscipline LTCMrsquos counterparties did not understand the hedge fundrsquosrisk profile when they granted credit on generous terms mainly on thebasis of its managersrsquo reputations (FSF 2000b)
The Asian and Russian episodes illustrate key issues on the supplyside that deserve more attention bias in the incentive systems of G-10countries toward the use of debt and the significant role played by thelarge international financial institutions particularly banks We do notdispute the importance of reforms (including better exchange rate sys-tems) urged on the finance ministries central banks and borrowers inemerging economies Some of the criticisms aimed at the IMF are alsowarranted But we think the G-10 market players and financial super-visors deserve far more scrutiny
The top financial players constantly innovate as new technologiesmake financial engineering possible By the same token they quickly re-spond to any shifts in the incentive structure imposed through officialregulation The activities of the top players are beyond the reach of theIMF They must not however be beyond the reach of G-10 financialsupervisors particularly the bank and securities-market regulators
3 See Risk Management Too Clever by Half The Economist 14 November 1998 82-85
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80 WORLD CAPITAL MARKETS
The Market Players
As the tables in chapter 1 illustrate there are three main types of pri-vate-capital flows bank loans and deposits other portfolio investmentand foreign direct investment Each type is associated with particularinstitutionsmdashcommercial banks other financial institutions and non-financial firms In this section we describe the size and nationality ofthe large players
Commercial Banks
Table 21 lists the 50 largest commercial banks by market capitalizationas of October 2000 Market capitalization rather than sheer asset sizeprobably better measures a bankrsquos ability to move funds from one coun-try or sector to another4
The large continental European banks (those in the euro zone plusSwitzerland) in 1999 had market capital of about $524 billion and assetsof approximately $64 trillion When figures for UK commercial banksare added in European market capitalization rises to about $850 billionand assets to about $86 trillion Europe is a banking powerhouse In-deed the European role is so crucial that no approach to the regulationof international lending can survive without European support
The Maastricht Treaty did not make Europe a single entity for bank-ing supervision The European Central Bank is finding its way in ex-change rate and monetary policy For the foreseeable future nationalregulators will retain control over supervisory matters Changes in thefabric of international understandings over bank supervision will requireconsensus among the European powers
In market capitalization at $850 billion the large US banks are aboutthe same as their European counterparts but in asset size they are adistant second to the Europeans at $38 trillion The large Japanese com-mercial banks follow on market capitalization at $300 billion but aresecond to the Europeans with assets of $67 trillion
Commercial-banking power is clearly concentrated in Europe the UnitedStates and Japan Moreover banks based in the G-10 plus Spain accountfor 90 percent of the market capitalization and assets of the top 50 com-mercial banks in the world As table 22 shows banks based in the G-10countries plus Spain account for about 92 percent of the assets of allcommercial banks located in BIS reporting countries about 80 percent ofthe external assets of these banks and about 72 percent of claims on
4 Several banks in China and Europe rank among the top 50 in terms of asset size butpoor-quality loans sharply diminish their market capitalization-ndashand their ability to movemoney from country to country
Institute for International Economics | httpwwwiiecom
THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 81
Table 21 Worldrsquos largest 50 commercial banks by marketcapitalization October 2000 (billions of dollars)
Market capitalizatona Total Net Shareholderassets income equityb
Global Sept Oct National Dec Dec Decrank Banks 1999 2000 rankc 1999 1999 1999
Continental Europe
8 ING Bank 46 66 1 351 17 1412 UBS 58 55 2 614 39 2213 Creacutedit Suisse Group 50 54 3 452 33 2215 Deutsche Bank 36 48 4 843 26 2317 Banco Santander
Central Hispano 33 45 5 258 22 1719 BNP Paribas 43 6 702 17 22
Banque Nationalede Paris 26
Paribas 1621 ABN AMRO 29 34 7 460 26 1325 Banco Bilbao
Vizcaya Argentaria 25 28 8 240 22 1826 UniCredito Italiano 21 26 9 170 13 1030 Socieacuteteacute Geacuteneacuterale 19 22 10 408 24 1229 HypoVereinsbank 20 22d 11 505 04 1432 Dresdner Bank 21 21 12 398 11 1243 San Paolo IMI 16 17d 13 141 11 845 Fortis Bank 34 16 14 330 12 949 Commerzbank 17 14 15 374 09 1249 KBC Bank 13 14d 16 147 07 6
Total for Continental Europe 482 524d 6393 291 234
Japan
3 Mizuho Holdings Inc 115 1 51e
3 Dai-Ichi Kangyo Bankf 39 463 ndash38 203 Industrial Bank
of Japanf 32 390 ndash15 133 Fuji Bankf 42 489 ndash36 187 Sumitomo Sakura
(tentative) 68 2 56e
Sumitomo Bankg 47 464 ndash48 15Sakura Banki 31 414 ndash40 18
10 Bank of Tokyo Mitsubishi 72 56 3 664 ndash07 2311 UFJ Holdings Inc 55d 4 36e
Sanwa Bankh 39 425 ndash40 18Tokai Bankh 16 269 ndash24 13Toyo Trust amp Bankingh na 67 ndash13 5
40 Asahi Bank 20 18d 5 247 ndash21 1249 Mitsubishi Trust amp
Bankingi 16 14d 6 149 ndash14 750 Sumitomo Trust amp
Banking 11 10d 7 127 ndash12 6
Total for Japan 364 336e 6472 ndash481 260
(table continues mext page)
Institute for International Economics | httpwwwiiecom
82 WORLD CAPITAL MARKETS
Table 21 Worldrsquos largest 50 commercial banks by marketcapitalization October 2000 (billions of dollars) (continued )
Market capitalizatona Total Net Shareholderassets income equityb
Global Sept Oct National Dec Dec Decrank Banks 1999 2000 rankc 1999 1999 1999
United Kingdom
2 HSBC Holdings 97 122 1 569 54 379 Royal Bank of Scotland 19 58d 2 146 14 7
NatWestj 39 na na 292 na 1414 Lloyds TSB 68 52 3 285 41 1418 Barclays 44 44 4 402 28 1435 Abbey National 25 19 5 292 20 846 Standard Chartered 15 15d 6 88 06 646 Bank of Scotland 15 15d 7 116 10 6
Total for United Kingdom 322 324d 2191 173 106
United States
1 Citigroup 149 237 1 717 99 504 JP Morgan Chase amp Co 83 2 35e
Chase Manhattank 63 na na 406 54 24JP Morgank 20 na na 261 21 11
5 Bank of America 96 79 3 633 79 446 Wells Fargo amp Company 65 78 4 218 37 2216 Bank of New York
Company 25 46 5 75 17 520 Bank One 41 42 6 269 35 2022 Fleet Boston Financial 34 34 7 191 20 1523 MBNA 18 30 8 31 10 424 First Union 34 30 9 253 32 1727 Fifth Third Bancorp 17 24 10 42 07 427 Mellon Financial 17 24 11 48 10 433 State Street na 20 12 61 06 335 PNC Bank 16 19 13 75 13 635 Northern Trust na 19 14 29 04 235 Firstar 25 19 15 73 09 640 US Bancorp 22 18 16 82 15 846 SunTrust Banks 21 15 17 95 13 850 National City 16 13 18 87 14 650 Wachovia 16 11 19 67 10 650 KeyCorp 12 11 20 83 11 6
Total for United States 707 850 3796 517 271
Other
31 National Australia Bank 2 21 1 166 18 1234 Hang Seng Bank Ltd 20 20d 2 na na na35 Royal Bank of Canada 13 19 3 184 12 940 Commonwealth Bank
of Australia 14 18d 4 91 09 543 Toronto Dominion Bank 12 17 5 146 20 850 Westpac Banking Corp 12 13 6 92 10 650 Development Bank
of Singapore 12 13d 7 64 06 6
Total for other 105 121d 742 76 46
Institute for International Economics | httpwwwiiecom
THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 83
developing countries In turn the claims on developing countries repre-sent about 4 percent of the assets of G-10 and Spanish commercial banks
Portfolio Investors
Table 21 (continued )
Market capitalizatona Total Net Shareholderassets income equityb
Sept Oct National Dec Dec Dec1999 2000 rankc 1999 1999 1999
Total for largest 50 1980 2155 19594 58 917
Total for G-10 1900 2070 19182 53 888
na = not availablenot applicableG-10 = Group of Ten countries see note to table 11
a Market capitalization is defined as the number of ordinary shares currently in circulationmultiplied by the current share price Market capitalization as of October 2000 is presentedfor the banks that had a market capitalization higher than $11 billion as of September 1999b Shareholder equity is defined as the sum of issued common stock capital surplus or pre-mium various reserves and retained earnings Shareholder equity includes group equity at-tributable to consolidated minority interestsc Rankings within the country or regiond Estimates based on the available rates of change from September 1999 to October 2000The market capitalization and shareholder equity figures represent combined estimate for themerged bankse Total for the merged banksf Merged in September 2000g Merged in April 2001h Will merge in April 2002i Will merge with Nippon Trust and Tokyo Trust in October 2001j NatWest Bank merged with the Royal Bank of Scotland in March 2000k Announced a merger in September 2000
Sources Euromoney The Bank Atlas 2000 httpwwweuromoneycom American BankerThe Top 100 World Financial Companies Q3 1999 httpwwwamericanbankercom YahooFinance Company Profiles financeyahoocom Bloomberg Financials httpwwwbloombergcom
Three groups of financial institutions dominate the flow of portfolio capitalinvestment banks wealth managers and insurance companies Table 23lists nine large investment banks all based in New York with offices inLondon and other financial centers In 1998 these nine firms had a com-bined market capitalization in excess of $130 billion and controlled as-sets in excess of $18 trillion
Investment banks act as guardians to the securities markets Nearly allpublic and private shares bonds and asset-backed securities are broughtto market by an investment bank Fulfilling the same function they areexpanding the securities markets of emerging economies They also act asthe pilots of privatization mergers and takeoversmdashnow a core feature of
Institute for International Economics | httpwwwiiecom
84 WORLD CAPITAL MARKETS
Table 22 Total assets and external assets of all commercialbanks June 2000 (billions of dollars)
Claims onExternal assets developing countriesb
Share of Share ofTotal total assets total assets
Country assetsa Amount (percent) Amount (percent)
Austria 423 91 22 33 8Bahamas 316 244 77 61c 19Bahrain 100 92 92 46c 46Belgium 806 309 38 26 3Canada 720 98 14 31 4Denmark 244 58 24 6 2Finland 121 31 25 4 3France 2486 607 24 135 5Germany 4535 901 20 240 5Ireland 423 160 38 2 0Italy 1345 191 14 47 4Japan 8460 1199 14 258 3Luxembourg 821 495 60 124c 15Netherlands 1080 296 27 67 6Norway 157 14 9 3 3Singapore 574 405 70 202c 35Spain 889 124 14 57 6Sweden 348 67 19 12 2Switzerland 1632 709 43 177c 11United Kingdom 5802 1990 34 138 2United States 6223 889 14 144 2
Total for all BISreporting countries 37506 8968 24 1813 5
Total for G-10 34326 7378 21 1331 4
BIS = Bank for International SettlementsG-10 = Group of Ten countries see note to table 11
a Total assets are calculated as banking institutions (deposit institutions) reserve claims onthe public sector claims on the private sector (lines 20 21 22 from IFS) plus externalassets Figures are converted into US dollars using the market exchange rate at the end ofJune 2000b Developing countries are countries other than Andorra Australia Austria Belgium CanadaCyprus Denmark Finland France Germany Gibraltar Greece Iceland Ireland Italy JapanLiechtenstein Luxembourg Malta Netherlands New Zealand Norway Portugal Spain Swe-den Switzerland Turkey the United Kingdom the United States the Vatican City State andthe former Yugoslaviac These countries do not disclose their claims on developing countries Such claims arearbitrarily (and generously) estimated at half the external assets of commercial banks in Bahrainand Singapore and a quarter of the external assets of banks in the Bahamas Luxembourgand Switzerland
Sources IMF International Financial Statistics (IFS) November 2000 Bank for InternationalSettlements BIS Quarterly Review November 2000 httpwwwbisorg
Institute for International Economics | httpwwwiiecom
THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 85
global capitalism In addition to their underwriting role investment banksearn substantial profits from trading securities
Wealth-management firms are the second group of portfolio institu-tions They typically deal with the publicmdashindividuals and companiesthat want a trusted firm to manage their pensions and other funds Table24 lists 10 large wealth managers all based in the G-10 Together these10 firms control $64 trillion in assets and their own market capitalization
Table 23 Large investment banks 1998 (billions of dollars)
MarketRevenue Assets capitalizationa
Merrill Lynchb (United States) 36 300 25Morgan Stanley Dean Witterb (United States) 31 318 50c
Goldman Sachs (United States) 22d 217e 29c
Lehman Brothers Holdingsb (United States) 20 154 10c
Salomon Smith Barneyf (United States) 8 211 naCredit Suisse First Bostong (United States
Switzerland) 7 280 naPaine Webberh (United States) 7 54 6i
Bear Stearnsj (United States) 8 154 5i
Donaldson Lufkin amp Jenrettek (United States) 5 72 7i
Total 144 1760 132 plusTotal for G-10 144 1760 132 plus
na = not available (subsidiaries of large holding companies Citigroup and Creacutedit SuisseGroup respectively individual market capitalization is not available)G-10 = Group of Ten countries see note to table 11
a Market capitalization is calculated by multiplying the total number of shares by the shareprice at the companyrsquos fiscal year-endb Source Fortune Global 500 1999 Data shown are for the fiscal year ended on or before31 March 1999 Assets shown are those at the companyrsquos fiscal year-end httpwwwpathfindercomfortuneglobal500indexhtmlc Figures as of September 1999 are from American Banker httpwwwamericanbankercomBankRankingsd Source 1998 Goldman Sachs Annual Review Assets as of November 1998 httpwwwgscomaboutannual19984_fsindexhtmle Source Financial Times Company Financials Revenue as of 27 November 1998 httpwwwglobalarchiveftcomcbcb_searchhtmf Source 1998 Citigroup Annual Report 20 Revenue figures for year ending 31 December1998 Asset figures as of 31 December 1998 httpwwwcitigroupcomcitigroupfindatac1998ar2pdfg Source 19981999 Creacutedit Suisse Group Annual Report 23 httpwwwcsgchcsg_annual_report_98downloadcsg_ar98_p1_enpdfh Source 1998 Paine Webber Annual Report 34-35 httpwwwpainewebbercomannual98graphicsfininfoindexhtmi Individual figures are obtained from Yahoo The time for valuations is as follows BearStearns December 1999 Lehman Brothers November 1999 Paine Webber and DonaldsonLufkin amp Jenrette September 1999j Source 1999 Bear Stearns Annual Report 55-56 Figures are for fiscal year ending 30June 1998 httpwwwbearstearnscomcorporateinvestorindexhtmk Source 1999 Donaldson Lufkin and Jenrette Annual Report ldquoFinancial Highlightsrdquo httpwwwdljcompdfDLJ98_1pdf
Institute for International Economics | httpwwwiiecom
86 WORLD CAPITAL MARKETS
exceeds $260 billion For the most part wealth managers are long-termportfolio investors
Hedge funds represent a highly specialized investment vehicle that isnot widely available to the public Most hedge funds are leveraged theyemploy dynamic (and sometimes opportunistic) trading strategies involvingpositions in several different markets they adjust their investment port-folios frequently in anticipation of asset price movements or changes inyield differentials between related securities Hedge funds are opaque tomarket monitoring They are subject to little direct regulation and areunder few obligations to disclose information Hence the size of the in-dustry is difficult to measure
If they are measured by capital under management or by assets hedgefunds are small relative to established wealth managers As table 25shows the capital managed by 20 large hedge funds in late 1998 amountedto less than $50 billion Estimates vary widely but if all hedge funds arecounted their assets range from $100 to $300 billion Even the highestnumber is less than 5 percent of the combined assets of investment banksand traditional asset managers
The amount of leverage used by hedge funds depends on trading strate-gies that are in turn shaped by investor attitudes toward risk Leverage
Table 24 Large asset managers in 1998 (billions of dollars)
Total assets under Marketmanagementa capitalizationb
UBS (Switzerland) 1145 58c
Fidelity Investments (United States) 773 naKampo (Japan) 698 naCredit Suisse Group (Switzerland) 680 50c
AXA Group (France) 647 39c
Barclayrsquos Global Investors (United States) 616 44c
Merrill Lynch amp Co (United States) 501 25c
State Street Global Advisors (United States) 493 naCapital Group Cos (United States) 424 naZurich Financial Services (Switzerland) 415 45c
Total 6392 261 plusTotal for G-10 6392 261 plus
na = not available (usually a nonpublic company)G-10 = Group of Ten countries see note to table 11
a Figures are assets under management at fiscal year-end 1998b Market capitalization is calculated by multiplying the total number of shares by the shareprice at the companyrsquos fiscal year-endc Figures from American Banker httpwwwamericanbankercomBankRankings
Sources Institutional Investor 1999 httpwwwiimagazinecomresearchinterfacehtml US(II300) Asia (Asia200) and Europe (Euro100) Asset Management Rankings American BankerhttpwwwamericanbankercomBankRankings
Institute for International Economics | httpwwwiiecom
THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 87
is achieved using such instruments as repos (repurchase agreements)futures and forward contracts and other derivative products5 It is alsovery difficult to measure A Financial Stability Forum (FSF 2000b) studyof hedge funds noted thatmdashalthough there are problems with the waydata vendors report these positionsmdashestimates suggest most hedge fundsuse modest amounts of leverage averaging 21 but ranging to 41 insome FSF (2000b) further notes difficulties with evaluating the risk-adjusted performance of hedge funds because of their dynamic tradingstrategies
Table 25 Largest hedge funds according tocapitalization August 1998 (billions of dollars)
Fund Capital under management
Domestica
Tiger 51Moore Global Investment 40Highbridge Capital Corp 14Intercap 13Rosenberg Market Neutral 12Ellington Composite 11Hedged Taxable-Equivalent 10Quantitative LongShort 09Sr International Fund 09Perry Partners 08
OffshoreJaguar Fund NV 100Quantum Fund NV 60Quantum Industrial Fund 24Quota Fund NV 17Omega Overseas Partners 17Maverick Fund 17Zweig Dimenna International 16Quasar International Fund NV 15SBC Currency Portfolio 15Perry Partners International 13
Totalb 471
a Long Term Capital Management (LTCM) was in serious difficulty in August1998 and is omitted from the listb Estimates of hedge fund capital and the number of funds vary significantlyMARHedge estimated 1115 funds with $109 billion capital under managementat the end of 1997 Van Hedge Fund estimated 5500 funds with capital of $295billions at the same date
Source Adapted from Eichengreen (1999a)
5 Positions are established by posting margins rather than the face value of the position
Institute for International Economics | httpwwwiiecom
88 WORLD CAPITAL MARKETS
The positive role of hedge fundsmdashproviding diversification to inves-tors because their returns have low correlations with standard asset classesmdashis counterbalanced by some negative features Hedge funds and otherhighly leveraged institutions (HLIs) may take concentrated positions andengage in aggressive market practices that amount to ldquoganging uprdquo on asmall economy (such as Hong Kong)6 Under normal market conditionsHLI positions are not destabilizing but some of the aggressive practicesdocumented in 1998 are worrisome The FSF study group participantsagreed (2000b 112) that such practices raise important issues for marketintegrity but they could not agree that market manipulation was suffi-ciently widespread to be a serious concern for policymakers
Insurance companies are the third group of portfolio institutions Theseare divided into two categories property and casualty companies andlife and health insurance companies Ten large companies of each cat-egory are listed in table 26 In 1998 the 10 property and casualty insur-ance companies had $16 trillion in assets and more than $330 billion inmarket capitalization The 10 life insurance companies had $28 trillionin assets7 Combining both categories 100 percent of assets are controlledby insurance companies based in the G-10 and Spain In portfolio man-agement styles life insurance companies tend to hold longer-term assetswhereas property and casualty companies tend to hold shorter-term in-struments
Nonfinancial Multinational Enterprises
The last players are the nonfinancial multinational enterprises (MNEs)The worldrsquos 100 largest corporations measured by 1998 revenue are re-corded in tables 27 and 28 The 30 financial giants among the top 100are separately shown in table 27 Most of the firms appeared in previ-ous tables Together these 30 financial giants had revenues of $13 tril-lion and controlled assets of $113 trillion8
Table 28 lists the 70 top nonfinancial giants Their revenues in 1998were $40 trillion and their assets (at book value) measured $45 trillionMeasured by revenue or assets about 95 percent of the giants are basedin the G-10 These firms are responsible for a large share of the worldrsquos
6 See IMF (1999c) for a description of the ldquodouble playrdquo that hedge funds are accusedof using in an attempt to destabilize Hong Kong in August 1998
7 Many life insurance companies are owned by their policyholders and therefore donot have a market capitalization
8 By comparison the larger set of 96 financial firms listed in previous tables controlled$322 trillion in assets This is the total amount of assets recorded in tables 21 (50 com-mercial banks) 22 (9 investment banks) 24 (10 asset managers) and 26 (20 insurancecompanies) The largest hedge funds might add $300 billion to the total
Institute for International Economics | httpwwwiiecom
THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 89
Table 26 20 large insurance companies in 1998(billions of dollars)
Property and casualty insurance Marketcompanies Revenuea Assetsb capitalizationc
Allianz (Germany) 65 402 62d
Assicurazioni Generali (Italy) 48 178 30d
State Farm Insurance Cos (United States) 45 111 naZurich Financial Services (Switzerland) 39 215 45d
CGU (United Kingdom) 38 176 20d
Munich Re Group (Germany) 35 131 naAmerican International Group (United States) 33 194 135d
Allstate (United States) 26 88 20d
Royal amp Sun Alliance (United Kingdom) 25 76 11d
Loews (United States) 21 71 7e
Total 375 1642 330 plusTotal for G-10 375 1642 330 plus
MarketLife and health insurance Revenuea Assetsb capitalizationc
AXA (France) 79 452 39d
Nippon Life Insurance (Japan) 66 363 naING Group (Netherlands) 56 464 46d
Dai-ichi Mutual Life Insurance (Japan) 44 253 naSumitomo Life Insurance (Japan) 40 206 naTIAA-CREF (United States) 36 250 naPrudential Ins Co of America (United States) 34 279 naPrudential (United Kingdom) 34 197 30d
Meiji Life Insurance (Japan) 28 146 naMetropolitan Life Insurance (United States) 27 215 na
Total 444 2825 naTotal for G-10 444 2825 na
na = not available (usually an insurance company owned by its policyholders)G-10 = Group of Ten countries see note to table 11
a Data shown are for the fiscal year ended on or before 31 March 1999b Assets shown are those at the companyrsquos fiscal year-endc Market capitalization is calculated by multiplying the total number of shares by the shareprice at the companyrsquos fiscal year-endd Market capitalization data as of September 1999 from American Banker httpwwwamericanbankercome Individual companyrsquos market capitalization as of September 1999 from Yahoo yahoomarketguidecom
Sources Fortune Global 500 1999 httpwwwpathfindercomfortuneglobal500indexhtmlAmerican Banker httpwwwamericanbankercomRankingBanks1999 Yahoo Marketguideyahoomarketguidecom
Institute for International Economics | httpwwwiiecom
90 WORLD CAPITAL MARKETS
Table 27 Financial firms in the 100 largest companiesby revenue 1998 (billions of dollars)
Globalrank Company Revenuesa Assetsb Type
Continental Europe
15 AXA (France) 79 452 Insurance23 Allianz (Germany) 65 402 Insurance28 Ing Group (Netherlands) 56 464 Insurance37 Credit Suisse (Switzerland) 49 475 Banks commercial
and savings39 Assicurazioni Generali (Italy) 48 178 Insurance42 Deutsche Bank (Germany) 45 736 Banks commercial
and savings56 Zurich Financial Services (Switerland) 39 215 Insurance68 Munich Re Group (Germany) 35 131 Insurance72 ABN AMRO Holding (Netherlands) 34 507 Banks commercial
and savings77 Credit Agricole (France) 33 459 Banks commercial
and savings80 HypoVereinsbank (Germany) 32 541 Banks commercial
and savings84 Fortis (Belgium) 31 397 Banks commercial
and savings98 Socieacuteteacute Geacuteneacuterale (France) 30 450 Banks commercial
and savingsUnited Kingdom
47 HSBC Holdings 43 485 Banks commercialand savings
58 CGU 38 176 Insurance74 Prudential 34 197 Insurance
United States
16 Citigroup 76 669 Diversified financials35 Bank of America Corp 51 618 Banks commercial
and savings44 State Farm Insurance Cos 45 111 Insurance64 TIAA-CREF 36 250 Insurance67 Merrill Lynch 36 300 Securities71 Prudential Ins Co of America 34 279 Insurance76 American International Group 33 194 Insurance79 Chase Manhattan Corp 32 366 Banks commercial
and savings83 Fannie Mae 31 485 Diversified financials88 Morgan Stanley Dean Witter 31 318 Securities
Japan
21 Nippon Life Insurance 66 363 Insurance45 Dai-ichi Mutual Life Insurance 44 253 Insurance54 Sumitomo Life Insurance 40 206 Insurance91 Bank of Tokyo-Mitsubishi 31 664 Banks commercial
and savingsTotal 1279 11341Total for G-10 1279 11341
G-10 = Group of Ten countries see note to table 11
a Data shown are for the fiscal year ended on or before 31 March 1999b Assets shown are those at the companyrsquos fiscal year-end
Source Fortune Global 500 1999 httpwwwpathfindercomfortuneglobal500indexhtml
Institute for International Economics | httpwwwiiecom
THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 91
Tab
le 2
8N
on
fin
anci
al f
irm
s in
th
e 10
0 la
rges
t co
mp
anie
s b
y re
ven
ue
199
8 (b
illio
ns o
f do
llars
)
Glo
bal
Tra
nsn
atio
nal
ity
ran
k
Co
mp
any
Rev
enu
esa
Ass
etsb
ind
exc
Typ
e
Co
nti
nen
tal
Eu
rop
e
2D
aim
lerC
hrys
ler
(Ger
man
y)15
516
044
1M
otor
veh
icle
s an
d pa
rts
11R
oyal
Dut
chS
hell
Gro
up (
Net
herla
nds)
9411
058
9P
etro
leum
ref
inin
g17
Vol
ksw
agon
(G
erm
any)
7670
568
Mot
or v
ehic
les
and
part
s22
Sie
men
s (G
erm
any)
6667
521
Ele
ctro
nics
el
ectr
ical
equ
ipm
ent
32M
etro
(G
erm
any)
5222
n
a
Foo
d an
d dr
ug s
tore
s34
Fia
t (I
taly
)51
7640
8M
otor
veh
icle
s an
d pa
rts
36N
estle
(S
witz
erla
nd)
5041
932
Foo
d46
Veb
a G
roup
(G
erm
any)
4351
275
Tra
ding
49R
enau
lt (F
ranc
e)41
4545
7M
otor
veh
icle
s an
d pa
rts
53D
euts
che
Tel
ekom
(G
erm
any)
4093
n
a
Tel
ecom
mun
icat
ions
57R
oyal
Phi
lips
Ele
ctro
nics
(N
ethe
rland
s)38
3386
4E
lect
roni
cs
elec
tric
al e
quip
men
t59
Peu
geot
(F
ranc
e)38
4038
7M
otor
veh
icle
s an
d pa
rts
62E
lect
riciteacute
de
Fra
nce
(Fra
nce)
3711
3
na
Util
ities
ga
s an
d el
ectr
ic63
Rw
e G
roup
(G
erm
any)
3747
n
a
Util
ities
ga
s an
d el
ectr
ic65
BM
W (
Ger
man
y)36
3660
7M
otor
veh
icle
s an
d pa
rts
66E
lf A
quita
ine
(Fra
nce)
3643
576
Pet
role
um r
efin
ing
69V
iven
di (
Fra
nce)
3558
n
a
Eng
inee
ring
and
cons
truc
tion
70S
uez
Lyon
nais
e de
s E
aux
(Fra
nce)
3585
n
a
Ene
rgy
78E
NI
(Ita
ly)
3249
317
Pet
role
um r
efin
ing
86B
ayer
(G
erm
any)
3134
827
Che
mic
als
92A
BB
Ase
a B
row
n B
over
i (S
witz
erla
nd)
3132
957
Ele
ctro
nics
el
ectr
ical
equ
ipm
ent
93B
AS
F (
Ger
man
y)31
3159
5C
hem
ical
s95
Car
refo
ur (
Fra
nce)
3020
n
a
Foo
d an
d dr
ug s
tore
s
(tab
le c
ontin
ues
next
pag
e)
Institute for International Economics | httpwwwiiecom
92 WORLD CAPITAL MARKETS
Tab
le 2
8N
on
fin
anci
al f
irm
s in
th
e 10
0 la
rges
t co
mp
anie
s b
y re
ven
ue
199
8 (b
illio
ns o
f do
llars
) (c
ontin
ued
)
Glo
bal
Tra
nsn
atio
nal
ity
ran
k
Co
mp
any
Rev
enu
esa
Ass
etsb
ind
exc
Typ
e
Un
ited
Kin
gd
om
19B
P A
moc
o68
8559
2P
etro
leum
ref
inin
g43
Uni
leve
r45
3692
4F
ood
Un
ited
Sta
tes
1G
ener
al M
otor
s16
125
729
3M
otor
veh
icle
s an
d pa
rts
3F
ord
Mot
or14
423
835
2M
otor
veh
icle
s an
d pa
rts
4W
al-M
art
Sto
res
139
49
na
G
ener
al m
erch
andi
sers
8E
xxon
101
9365
9P
etro
leum
ref
inin
g9
Gen
eral
Ele
ctric
100
356
331
Ele
ctro
nics
el
ectr
ical
equ
ipm
ent
14In
tl B
usin
ess
Mac
hine
s82
8653
7C
ompu
ters
of
fice
equi
pmen
t25
US
Pos
tal
Ser
vice
6055
n
a
Mai
l pa
ckag
e a
nd f
reig
ht d
eliv
ery
27P
hilip
Mor
ris58
6051
1T
obac
co29
Boe
ing
5637
n
a
Aer
ospa
ce30
AT
ampT
5460
219
Tel
ecom
mun
icat
ions
40M
obil
4843
597
Pet
role
um r
efin
ing
41H
ewle
tt-P
acka
rd47
3451
1C
ompu
ters
of
fice
equi
pmen
t50
Sea
rs R
oebu
ck41
38
na
G
ener
al m
erch
andi
sers
55E
I d
u P
ont
de N
emou
rs39
40
na
C
hem
ical
s61
Pro
ctor
and
Gam
ble
3731
477
Soa
ps
cosm
etic
s75
Km
art
3414
n
a
Gen
eral
mer
chan
dise
rs81
Tex
aco
3229
453
Pet
role
um r
efin
ing
82B
ell
Atla
ntic
3255
n
a
Tel
ecom
mun
icat
ions
85E
nron
3129
n
a
Ene
rgy
87C
ompa
q C
ompu
ter
3123
n
a
Com
pute
rs
offic
e eq
uipm
ent
89D
ayto
n H
udso
n31
16
na
G
ener
al m
erch
andi
sers
94J
C
Pen
ney
3124
n
a
Gen
eral
mer
chan
dise
rs96
Hom
e D
epot
3013
n
a
Spe
cial
ty r
etai
lers
97Lu
cent
Tec
hnol
ogie
s30
27
na
E
lect
roni
cs
elec
tric
al e
quip
men
t10
0M
otor
ola
2929
n
a
Ele
ctro
nics
el
ectr
ical
equ
ipm
ent
Institute for International Economics | httpwwwiiecom
THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 93
Jap
an
5M
itsui
109
5635
8T
radi
ng6
Itoch
u10
957
333
Tra
ding
7M
itsub
ishi
107
7536
9T
radi
ng10
Toy
ota
Mot
or10
012
540
0M
otor
veh
icle
s an
d pa
rts
12M
arub
eni
9455
300
Tra
ding
13S
umito
mo
8946
259
Tra
ding
18N
ippo
n T
eleg
raph
amp T
elep
hone
7614
7
na
Tel
ecom
mun
icat
ions
20N
issh
o Iw
ai68
3938
8T
radi
ng24
Hita
chi
6282
214
Ele
ctro
nics
el
ectr
ical
equ
ipm
ent
26M
atsu
shita
Ele
ctric
Ind
ustr
ial
6067
332
Ele
ctro
nics
el
ectr
ical
equ
ipm
ent
31S
ony
5353
628
Ele
ctro
nics
el
ectr
ical
equ
ipm
ent
33N
issa
n M
otor
5158
511
Mot
or v
ehic
les
and
part
s38
Hon
da M
otor
4943
641
Mot
or v
ehic
les
and
part
s48
Tos
hiba
4151
252
Ele
ctro
nics
el
ectr
ical
equ
ipm
ent
51F
ujits
u41
4332
6C
ompu
ters
of
fice
equi
pmen
t52
Tok
yo E
lect
ric P
ower
4012
2
na
Util
ities
ga
s an
d el
ectr
ic60
NE
C37
42
na
E
lect
roni
cs
elec
tric
al e
quip
men
t90
Tom
en31
18
na
T
radi
ng99
Mits
ubis
hi E
lect
ric30
35
na
E
lect
roni
cs
elec
tric
al e
quip
men
t
Ch
ina
73S
inop
ec34
52
na
P
etro
leum
ref
inin
g
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al (
aver
age
for
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iona
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988
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otal
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)3
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ble
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ries
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e to
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le 1
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a sh
own
are
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or b
efor
e 31
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ch 1
999
b
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ets
show
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e th
ose
at t
he c
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-end
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ind
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ted
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orei
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gn s
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to
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l sa
les
and
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eign
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ploy
men
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oym
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f 19
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UN
CT
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rces
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ortu
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htm
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D (
1999
)
Institute for International Economics | httpwwwiiecom
94 WORLD CAPITAL MARKETS
foreign direct investment The ldquotransnationality indexrdquo (table 28) showsthat on average they conducted about half their business outside theirhome country9
Overview of the Players
Our review of the major players points to two major features First ahandful of big playersmdashfewer than 200 firms all toldmdashcontrol the ac-tion in international capital markets Their dominance will doubtless erodebut for now financial power is strikingly concentrated with them Sec-ond the big players are overwhelmingly based in the G-10 countriesplus Spain The responsibility to supervise them rests not in the IMFnor in Basel but squarely in Washington London Tokyo and the otherG-10 capitals At year-end 1999 the G-10 countries plus Spain accountedfor 84 percent of world banking assets 86 percent of world stock marketcapitalization and 76 percent of international debt securities (BIS 2000aWorld Bank 2000b)
International private capital flows are of three types bank loans anddeposits portfolio investment and foreign direct investment In cumula-tive total flows to emerging markets FDI was the biggest story in the1990s amounting to $954 billion (table 12) Portfolio flows were nextcumulatively amounting to somewhere between $612 billion (table 12)and $764 billion (table A1) Bank loans and deposits are the most com-plicated story
The Key Role of Banks
Banks are more important as an epicenter than as a wellspring Banksgenerate waves in the flow of capital to emerging markets rather than acontinuous steady stream According to data compiled by the Institute ofInternational Finance (table A1) net bank lending to emerging marketscumulated to $269 billion in the 1990s However deposits by emerging-market residents in G-10 banks more than offset G-10 bank lending tothese countries during the decade According to IMF data cumulativebank loans net of deposits amounted to a negative $135 billion (table 12)
In other words when loans and deposits are combined net bank ac-tivity that moves financial resources to emerging markets is small incomparison with portfolio investment and FDI But bank loans are thelubricant of any financial system Depending on circumstances bankscan be shock absorbers or shock propagators In recent decades with
9 The transnationality index is calculated as a simple average of the share of assetssales and employees outside the home country
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 95
respect to emerging markets banks have more often been propagatorsthan absorbers The average annual swing in bank lending to emergingmarkets was nearly $50 billionmdashby far the largest source of year-to-yearfluctuations in capital flows Both interbank loans between Europe Japanand Asia and sovereign Russian debt used as loan collateral played amajor role in the 1997-98 crisesmdashnot because banks are profligate playersbut because of the incentives they face and the instruments they useAccordingly our story begins with banks
Banks in the Modern Financial System
10 See Levine (2000) for a concise description of the role of banks in the financial system
11 The asymmetric information problem helps to explain why banks dominate the im-mature financial systems of emerging-market economies The general lack of informationon borrowers and undeveloped legal systems to enforce contracts hamper suppliers oflong-term financial instruments such as equities and bonds in evaluating risk and re-ward Banks are best suited in these circumstances to solve the asymmetric informationproblem by evaluating and monitoring private loans As more and better informationbecomes available capital markets develop and financial systems mature
As we noted in the previous paragraph the problem of financial volatil-ity in emerging-market economies is associated with bank lending Ifand when repayment problems arise cross-border private bank loansand bond placements are such that private creditors have no plausiblemeans of seizing assets from either private or sovereign borrowers Thusalthough international finance can nourish entrepreneurs and accelerategrowth a necessary complement may be a drastic creditor response inthe event of nonpaymentmdashto withhold fresh funds and force an eco-nomic crisis (Dooley 2000)
This argument is based on the characteristics of banks They are notldquobadrdquo per se They perform three essential functions in any financialsystem pooling the resources of disparate savers and channeling these re-sources into productive investment improving resource allocation throughtheir expertise in assessing and monitoring borrowers and facilitatingthe division of risk among numerous creditors10 But by their very na-ture banks are prone to two problems asymmetric information (the bor-rower knows more about the potential risk and return of its projectsthan the bank) and adverse selection (riskier borrowers will pay higherinterest rates and thus may constitute a disproportionate share of bankloan portfolios)11
Bank loans are illiquid fixed-price instruments They cannot easily beconverted to cash although they can be bundled into securities (knownas ldquosecuritizationrdquo) Once loan terms have been agreed on the only waya bank can adjust for shifting market conditions is by changing the quantityof its exposure When a borrower runs into trouble the bank can mix
Institute for International Economics | httpwwwiiecom
96 WORLD CAPITAL MARKETS
and match from two unpleasant menus It can roll over existing loansand extend new credit or it can call some part of existing loans andattempt to recover the principal It can also hedge by selling short otherclaims on the borrower These choices entail either an unwelcome exten-sion of the bankrsquos exposure or credit rationing against the borrower Whentrouble brews all banks encounter the same conditions in the aggregatethey prefer less exposure and ensuing credit restrictions lead to volatilebank lending
Innovation
12 Derivatives have no value of their own They ldquoderiverdquo their value from the value ofthe underlying asset They include swaps futures (contracts for future delivery at speci-fied prices) and options (which give one party the right but not the obligation to buyfrom or sell to a counterparty at an agreed price)
13 Maxfield (1998) analyzed available evidence of emerging-market investor objectivesmost of it before the crisis Analysis of portfolio equity flows is sensitive to the choice ofperiod with year-over-year data indicating that investors respond to country ldquofundamen-talsrdquo Other evidence suggests more ambiguity Ranking by ldquoinvestor impatiencerdquo ie thesearch for yield over value Tesar and Werner (1995) find short-term bank flows to be themost yield driven followed by portfolio investment FDI and long-term bank lending
14 Because market risk credit risk and country risk interact in complex ways newfinancial instruments have been created to help reduce negative interactions One is theldquototal return swaprdquo which has become an instrument of choice for hedge funds lookingfor high leverage Banks also use the total return swap to cover risks without increasingtheir capital requirements
Since the 1980s national and international banking systems have beentransformed by deregulation intensified competition and the informationand communications-technology revolutions The market environment isone of intense competition particularly in traditional banking activitiesThe innovations point away from traditional activities of plain vanilladeposit taking and loan making Three big themes are discernible Firstthe walls separating commercial banks investment banks portfolio man-agers and insurance firms are falling even if they are still distinct Sec-ond large banks are shifting toward securitizationmdashcreating securitiesout of everything from credit card debt to trade finance to disaster insur-ancemdashand earning fees in the process Third all large banks are shiftingtoward trading activity making markets and taking short-term stakes inbonds shares and derivatives12 These activities when successful satisfythe search for higher yields13
Many of the new financial instruments that banks trade are ldquooff bal-ance sheetrdquo This means that banks are not required to allocate capitalagainst them In swap contracts for example neither side pays cash at theoutset and therefore neither party has an asset in the traditional sense14
Futures and options contracts can be written with a relatively small initial
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 97
margin relative to the potential risk Credit derivatives limit credit risk bytransferring the potential loss associated with corporate loans and bondssovereign debt and other loan portfolios to counterparties15
Deregulation and innovation working in combination seem to havepushed banks into trading activity and leveraged plays but not into shareownershipmdasheven in jurisdictions that have no prohibition against equitystakes Among the G-10 banking systems the highest ratio of share own-ership to assets was only 5 percent in 1996 reached in Germany andJapan (Berlin 2000)16
The wave of innovation in financial instruments and the accompany-ing expansion of banking beyond its old boundaries is a two-edged swordOn one side it allows risk management far beyond what was tradition-ally possible Risk can now be shifted from firms that can ill afford lossesto those that can Banks can profitably act as intermediaries in shiftingrisk On the other side the innovation wave creates huge opportunitiesfor leveraged plays fostering a speculative search by banks themselvesfor high returns that in turn magnify their own risks17
15 Credit derivatives include total return swaps credit default swaps credit-linked notesand collateralized debt obligations They are the fastest-growing sector of the global de-rivatives market
16 Banks seem to specialize in lending even when they are allowed to mix finance andcommerce for reasons related both to how they are expected to behave with distressedfirms and to other intricacies of lender liability (Berlin 2000) Yet a recent cross-countrystudy found that restrictions on banking and commerce are associated with greater fi-nancial instability (Barth Caprio and Levine 2000)
17 Leverage is the magnification of the rate of return (positive or negative) on an in-vestment beyond the rate obtained by solely investing funds owned by the institution Itis often defined as the ratio of assets to equity Leverage is achieved by increasing thesize of an investment by borrowing or using derivative instruments such as futures oroptions These allow investors to earn a return on the notional amount underlying thecontract by committing a small portion of equity in the form of a margin deposit oroption premium payment
18 In a repo (repurchase agreement) one party (typically a trader) buys a bond andsells it to a dealer for cash with a promise to buy it back the next day at the same priceplus the overnight interest rate As long as the overnight interest rate is lower than theinterest accruing on the bond the trader earns some income on the bond The extremeform of these kinds of transactions was discovered at LTCM the failed US highly lever-aged institution which appears to have controlled more than $120 billion in assets froman investment of about $3 billion This leveraging was accomplished mostly through theuse of repos (Mayer 1999)
The potential for damage is illustrated in an extreme form by figure 21To precisely measure a firmrsquos leverage all positions must be known andrealistically valuedmdashwhich may be impossible to do Because many ac-tivitiesmdashsuch as repos18 and derivativesmdashdo not appear on the institutionrsquos
Leverage
Institute for International Economics | httpwwwiiecom
98W
OR
LD
CA
PIT
AL
MA
RK
ET
S
Figure 21 Hypothetical example of leverage
$1000 notional value of call option on equity in firms targeted for takeover
Repo FRN into cash and use cash to pay option premium
(repro is initially collateralized
Borrow $100 for margin purchase
$125 of US investment bank floating-rate notes (FRN) (secured by $25 equity in FRNs)
Repo off-the-run bond into cash and post margin
(repo is initially collateralizedSell (short) Borrow on-the-run bonds worth $20
$25 worth of off-the-run bonds (secured by $5 equity in bonds)
Exchange into $4
Cash $5 yen400 Japanese bank loans
$1 equity base
FRN = floating rate notesRepo = repurchase agreement
Source IMF (1998)
Institute for International Econom
ics | httpww
wiiecom
THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 99
balance sheet and because balance sheets are published quarterly at bestoutsiders have a difficult time assessing the extent of a firmrsquos leverage19
Leveraging by a single firm enhances its risk of default the widespreaduse of leverage in the financial system can magnify market adjustmentsespecially when they require ldquodeleveragingrdquomdashunwinding prior positionsRapid adjustments can cause credit to dry up and asset prices to plummetIn a mark-to-market environment falling asset prices trigger calls foradditional collateral that can ripple through markets
Risk Management
Because it is confronted with the widespread use of leverage and prolif-erating kinds of risk international finance is increasingly driven by riskevaluation and control20 Different institutions face various risk profilesand differing kinds of risk The most common risks can be quickly tickedoff Banks because of their traditional intermediary role of channelingthe resources from savers to borrowers face significant credit risk therisk of default or delay in the payment of principal and interest Theymust also manage market risk the risk that the prices of their liabilitiesmay change faster than their assets Market risk devastated US savingsand loan institutions in the late 1980s
Closely associated with market risk are interest-rate risk (unexpectedchanges in market interest rates that slash margins net income and theeconomic value of a bankrsquos equity) and foreign exchange risk (losses thatarise when assets denominated in an appreciating foreign currency areless than liabilities denominated in that currency) Banks make numer-ous loans to other banks around the world portfolio investors buy se-curities direct investors acquire fixed assets and all incur country risk(economic and political uncertainty in the host country) During the heightof the Asian crisis for example interbank loans to Japanese banksreflected the credit risk of lending to these banks the so-called Japanpremium
Substantial attention has been lavished on country risk analysis sincethe 1982 debt crisis in developing countries Yet in spite of this exper-tise the Asian crisis occurred in part because of a sudden upward reap-praisal of country risk after the Thai baht collapsed in April 1997 Banksand other financial institutions must also manage liquidity risk the riskthat market conditions will change unexpectedly depressing demand andprices of assets at the time they want to sell these assets And they mustmanage operational riskmdashfailures in control systems or people that cause
19 Another example of asymmetric information Both risk and leverage are difficult foroutsiders to assess without full timely disclosure
20 A longer discussion of these issues can be found in Managing Global Finance in IMF(1999c)
Institute for International Economics | httpwwwiiecom
100 WORLD CAPITAL MARKETS
financial loss or damage reputations Operational risk devastated BaringsBank in 1995
Financial institutions practice risk management to measure all theserisks the potential damage to their investment positions and ultimatelythe chance of becoming insolvent VAR (value at risk) risk models mea-sure subject to certain assumptions the amount of the firmrsquos capital thatis exposed in each period For example the VAR model might say thatin a 3-standard-deviation worst case (a case that is not supposed to hap-pen more than 1 percent of the time) the firm will loose 25 percent of itscapital during the next year
VAR models are widely used but like all models they have weak-nesses They rely on past values to estimate key variables in financialmarkets past values are not always good predictors of future risks More-over rising volatility and higher loss correlation among different assetclasses in a portfolio will cause all banks using these models to reducetheir exposures at the same time by switching to less volatile and lesscorrelated assets such as US Treasury bills (Persaud 2000)
Newer risk models entail stress testing and scenario analysis Scenarioanalysis envisages possible adverse changes one at a time that mightaffect the investment portfolio Stress testing estimates potential losseswhen several individual risk factors simultaneously move against thefirm but it too uses historical probabilities
Financial Volatility
21 For example derivative markets usually rely on underlying securities markets thatproduce continuous prices When these markets are interrupted financial shocks cantrigger a cascade of margin calls and sell orders that move prices very sharply
22 See IIF (1999a)
The combination of trading activity and modern risk management lie atthe root of financial volatility When risks increase banks must eitherraise more capital to cover the greater risk or reduce their exposure bycutting loan exposure by selling securities or by undertaking new de-rivative trades Raising more capital is time-consuming and in a crisisvery expensive because bank shares are depressed So banks look to theother alternatives If the bank can reduce lending it need not book aloss But most banks use the same VAR models and as indicated abovethese models will encourage them to reduce their outstanding loans atthe same time actually magnifying loan volatility
If banks attempt to reduce their exposure to risk by selling securitiesor undertaking new derivative trades they may trigger large priceshocks because of limited and shrinking market liquidity21 The liquid-ity problem is compounded when a small number of large institu-tions hold the same positions22 Take your pick loan volatility or price
Institute for International Economics | httpwwwiiecom
THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 101
volatility As two experts have observed (Folkerts-Landau and Garber1998)
[V]olatility even in one country will automatically generate an upward re-estimate of credit and market risk in a correlated country triggering automaticmargin calls and tightening of credit lines Thus apparently bizarre opera-tions that connect otherwise disconnected securities markets are not the re-sponses of panicked green screen traders arbitrarily driving economies from agood to a bad equilibrium Rather they work with relentless predictability andunder the seal of approval of supervisors in the main financial centers
23 See Ferguson (1999)
24 As Gerald Corrigan (1982) put the matter ldquoBanks are specialrdquo Corrigan (2000) reit-erated this view even after all the changes of the past two decades Unlike other institu-tions banks offer on-demand transactions are a backup liquidity source for other insti-tutions and serve as a ldquotransmission beltrdquo for monetary policy
These changes in the banking environment accentuate an existing anomalyThe anomaly is that banks even as they grow larger and increasinglyengage in more risky and complex transactions are perceived to enjoyimplicit and explicit public guarantees
The guarantees grow out of an incentive problem inherent in bankingasymmetric information which we mentioned above Depositors know lessabout a bankrsquos management and the quality of its balance sheet than doits managers and shareholders Thus in times of uncertainty or adver-sity bank depositorsmdashuncertain whether they will have access to theirdepositsmdashare prone to bank runs This prospect has in turn compelledgovernments to treat banks differently than other firms because a bankthat fails can disrupt the rest of the economy24
To prevent such crises governments have entered into quid pro quoarrangements with banks Governments provide them both with an im-plicit safety net in the form of an unstated promise by the central bankto act as a lender of last resort in a liquidity crisis and an explicit safetynet in the form of a public deposit insurance fund to reassure depositorsIn return the banks submit to closer government oversight and regu-lation of their activities than is usual for industries in the private sector
The ldquoinsurancerdquo provided by the public safety net contributes to an-other incentive problem moral hazard Banks acquire greater tastes forrisk and face less market discipline than other firms The explicit depositinsurance safety nets actually have or are perceived to have blanketcoverage that extends beyond the retail depositors (households and small
One of the lessons of the 1997-98 crisis must surely be that market par-ticipants and their regulatory supervisors relied too heavily on quantita-tive tools and insufficiently on judgment23
The Anomaly of Modern Banking
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102 WORLD CAPITAL MARKETS
businesses) for which they were originally intended The implicit centralbank safety nets extend in a crisis to nearly all depositors and banksThus banks are both viewed and behave as if they will be bailed out ifthey get into trouble
The existence of a public safety net raises a perennial question Dobanks have an unfair advantage over other financial institutions becauseof the subsidy provided by the safety net This question was at the heartof intensive study and debate in the United States leading up to thepassage in November 1999 of the Financial Services Modernization Act(also known as the Gramm-Leach-Bliley Act) The size of the gross sub-sidy is difficult to estimate despite determined research efforts Somesuggest it is well under 100 basis points and is at least partly offset bythe direct costs of deposit insurance premiums interest payments on bondsissued by the Financing Corporation25 reserve requirements regulatoryexpenses and operational costs associated with collecting deposits26 Con-versely Kwast and Passmore (2000) suggest that banks can expand theirscope far beyond the levels that other financial institutions could reachwith the same equity base but without the public safety net
A related concern in the US debate is whether allowing banks to ex-pand their activities into securities and insurance will ultimately extendthe safety net and add to the subsidy The Financial Services Moderniza-tion Act deals with this issue by maintaining a legal separation betweenbanks and the rest of the banking organization known as large com-plex banking organizations (LCBOs) They must engage in most securi-ties activities and insurance underwriting through separately capitalizedinvestment bank subsidiaries or holding company affiliates This act canbe said to have merely brought US banking laws closer to those of mostother industrial countries (Barth Brumbaugh and Wilcox 2000 BarthNolle and Rice 2000) If the fire wall is well-maintained and stoutly de-fended the safety net will neither expand in practice nor become a sourceof comfort to noncommercial bank subsidiaries of LCBOs
The quid pro quo exacted by governments to offset the subsidy iscloser public-sector monitoring of banksrsquo activities through prudentialsupervision The effectiveness of this closer official scrutinymdashand closermarket monitoringmdashare the subjects of the next section
25 The Financing Corporation was created by Congress in 1987 to sell bonds to raisefunds to help resolve the savings and loan crisis
26 See Levonian and Furlong (1995) Jones and Kolatch (1999) Shull and White (1998)and Whalen (1999a 1999b)
Are G-10 bank supervisors adequately responding In this section we firstassess the case for and compare the structures of prudential supervisory
Prudential Supervision
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 103
systems both within and among the G-10 economies plus Spain andconsider whether these offset the subsidy provided by the public safetynet Despite offsetting regulation and supervision implicit and explicitguarantees by G-10 governments to their banks are still a source of bank-ing instability in the emerging-market economies
National Systems for Prudential Supervision
Governments use prudential supervision to reduce the moral hazard andadverse selection created by their own safety nets Supervisors establishregulations and monitor compliance to limit risk taking and ensure thesafety and soundness of the banking system In a thoughtful analysis ofthe case for prudential supervision Frederic Mishkin (2000) identifiesthe main forms that supervision can take including the tasks of grantingbanking charters and licenses establishing capital requirements settingdeposit insurance premiums and defining disclosure requirements as wellas carrying out bank examinations Bank examiners gather informationfrom banks and evaluate whether they are following the regulatorsrsquo rulesin cases of weakness they are empowered to change banksrsquo behaviorand close them if necessary
Supervisors also may restrict competition define the activities in whichbanks may engage and restrict their asset holdings and separate banksand other financial (or nonfinancial) activities During the past two de-cades the barriers separating commercial banks investment banks in-surance firms and securities firms have been all but eliminated (tableB1) Deregulation has stimulated competitive forces that drive diversifi-cation and consolidation of the financial industry nowhere faster than inthe United States
The Financial Services Modernization Act of 1999 confirmed this trendIt eliminated restrictions dating back to the Glass Steagall Act of 1933which once prevented banking insurance and securities firms fromentering each otherrsquos businesses (Barth Brumbaugh and Wilcox 2000)Cross-pillar mergers among banks insurance and securities firms arewell under way to form giant financial holding companies The 1999merger between Citibank (banking) and Travelers (insurance) created themodel for megafinance and confirmed new challenges for supervisors
Mishkin (2000) notes the corresponding evolution in US supervisionfrom an emphasis on rules-based regulation (detailed rules for opera-tional behavior and the quality of line items in the balance sheet) to anapproach that stresses the soundness of bank management practices es-pecially risk management
Appendix B outlines the systems of financial supervision now in theplace in the G-10 countries plus Spain Some systems like the UK andCanadian approach are models of simplicitymdashorganized to keep pacewith the spreading reach of financial conglomerates Other systems like
Institute for International Economics | httpwwwiiecom
104 WORLD CAPITAL MARKETS
the US and French approaches show traces of the bureaucratic divisionsthat made sense in an era when banking securities and insurance weresharply separated
The US Model
27 See Meyer (1999a)
28 Canada has a similar degree of simplification with the exception that securities firmsare still regulated by provincial authorities
29 See Pratti and Schinasi (1999 67)
30 The agents are the bank regulators and the principals are the taxpayers Agents maypursue their own interests including bureaucratic survival and postgovernment employ-ment opportunities rather than the national interest in banking safety and soundness
The US model of financial regulation delineated in the Financial Ser-vices Modernization Act of 1999 blends functional and umbrella super-vision Bank and thrift regulators oversee depository institutions Newnonbank activities are subject to both functional regulation (eg by theSecurities and Exchange Commission and state insurance examiners) andumbrella supervision (of financial holding companies) by the FederalReserve27
The UK Model
Another supervisory model exists in the United Kingdom as well as inAustralia Canada and Switzerland28 In this model banking supervisionis separated from the monetary policy function The regulatory structureis considerably simplified by relying on a consolidated financial regula-tor separate from the central bank for both banking and nonbankingactivities The remaining question answered differently depending on thecountry is the extent to which the regulator relies on home-country sur-veillance of banks and conglomerates that have a local presence
Regulatory Models Compared
Appendix B provides more detail on the differences in these modelsGerman simplicity contrasts with French complexity In France the bankingcommission is chaired by the governor of the central bank and includesrepresentatives from the Treasury The commission supervises compli-ance with regulations but the central bank inspects banks on behalf ofthe commission29 In countries such as the United States and France withmultiple supervisors and crossover functions internal coordination is criticalAt the same time multiple agencies create regulatory competition Wheneach agency knows what the other is doing transparency within gov-ernment circles can help to limit principal-agent problems of regulation30
The discussion as to where in the public bureaucracy financial super-
Institute for International Economics | httpwwwiiecom
THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 105
vision should be placed goes back many years Peek Rosengren andTootell (1999) argue that a synergy exists between monetary policy andprudential supervision because information gained in the course of super-vision can increase the accuracy of macroeconomic forecasts A twist tothis argument is that the information on the state of financial institutionsavailable to the central bank as supervisor can facilitate its role as lenderof last resort Conversely there is the concern that a supervisory rolewill compromise the central bankrsquos independence of action with respectto its core mandatemdashmaintaining price stability As these arguments haveplayed out financial supervision has generally been shared between centralbanks and other regulators or placed entirely in the hands of an inde-pendent regulator However in Italy the Netherlands and Spain cen-tral banks are the sole banking supervisor
Goodhart (1995) examined the arguments and evidence for each modeland concluded that there were no overwhelming arguments or evidencefor one or the other31 Going forward a key problem for any financialsupervisory system is dealing with (and closing as necessary) weak banksIf both central banks and other regulators have this responsibility closecoordination between them is critical Another problem is large conglom-erate banks LCBOs Although they are less likely to fail because of thediversification of their assets and liabilities they are more likely to berescued They are also more likely to be multinational enterprises withinternational implications Goodhart observes that regulation of theseentities might be put in the hands of the central bank because it is lessamenable to political pressures In any event the complexity of LCBOoperations suggests that greater supervisory rigor is necessary
The US Congress was persuaded that broad oversight would help containthe moral hazard problem and accordingly gave the Federal Reservethe role of umbrella supervisor with the understanding that the Fed willscrutinize depository activity more intensely than nonbank financial ac-tivities Under this approach LCBOs such as Citigroup are subject tomuch closer monitoring than smaller and simpler institutions32 The USregulatory model requires enormous cooperation between the Fed otherbank supervisors and the functional regulators for insurance and securi-ties but it also benefits from regulatory competition
31 National systems of supervision are path dependent they are determined by the struc-ture of financial institutions and history in each country If Goodhart (1995) is right out-comes are not materially better or worse with one model of supervision rather than another
32 See Ferguson (1999)
Public Safety Nets
One of prudential supervisorsrsquo biggest challenges is to reduce moral hazardFor many years commercial banks engaged in communal self-insurance
Institute for International Economics | httpwwwiiecom
106 WORLD CAPITAL MARKETS
to deal with crises They formed voluntary groups that agreed to rescuetroubled members As financial markets evolved and competition inten-sified banks were no longer willing to play this role Private-sector in-surance is one alternative but moral hazard and adverse selection wouldappear to prevent it from happening Public safety nets have developedbecause of the low probability and high cost of potential bank runs Aclear trade-off is involved The effectiveness of insurance in preventingbank runs is greater the more comprehensive the coverage But the morecomprehensive the coverage the greater the moral hazardmdashbank man-agers bank directors investors and depositors all take on greater risksin the belief that the safety net will protect them against losses
All G-10 countries have compulsory public safety nets for banks (table29) Deposit insurance agencies are officially organized in Canada theNetherlands Sweden Switzerland and the United States organized bythe industry in France Germany Italy and the United Kingdom andjointly organized by the public and private sectors in Belgium Japanand Spain
How well do G-10 governments offset the subsidy provided by thepublic safety net This is a question on which there is substantial debateAs banking organizations have become more complex the challengesthat supervisors face have become more difficult One challenge is toalign the incentives facing bank managers and shareholders with thoseof depositors Another is the principal-agent problem in supervision Wehave discussed the incentive structures for financial institutions but wehave said little about the incentives for supervisors themselves and thedistortions they can generate in the financial system
In one of the many studies of the US savings and loan crisis of the1980s Kane (1989) documented both problems He described managersusing cosmetic approaches to disguise the magnitude of insolvency regulatorspracticing forbearance even though they knew of the deteriorating riskprofiles of the institutions for which they were responsible and legisla-tors increasing deposit insurance without regard for any offsetting changesin supervision A subsequent overhaul of the legislative framework forthe Federal Deposit Insurance Corporation (FDIC) known as the FDICImprovement Act of 1991 (FDICIA) aimed to introduce a clearer incen-tive structure for both regulators and regulated institutions
The changes introduced by this US legislation are worth discussionwith respect to the other G-10 countries as well First FDICIA created astronger signal to management and investors by targeting deposit insur-ance at small depositors only and by risk-weighting the deposit insur-ance premiums paid by banks to reflect their capital adequacy and bankexaminer ratings Among the G-10 countries rated in table 210 depositinsurance premiums vary considerablymdashbut it is not clear that the dif-ferences have much to do with risk-weighting Most G-10 countries em-ploy funding formulas based for example on the total domestic deposit
Institute for International Economics | httpwwwiiecom
TH
E P
LAY
ER
S T
HE
IR S
UP
ER
VIS
OR
S A
ND
MO
RA
L HA
ZA
RD
107
Table 29 Deposit insurance schemes in the G-10 countries Explicit safety net
Coverage limit(dollar Foreign
equivalent currency Interbank Source Bankrsquos Contingency fundingDate Membership Co- at end of deposit deposit of premium from banks
Country established managementa insuranceb July 1998)c covered covered Fundingd funding costs or governments
United 1982 Compulsory Yes Larger of 90 No No Unfunded Banks only Callable (subject Parliament may increase Kingdom private percent co- to maximum the maximum payable
insurance to 03 percent of pound125 million advance 33000 total deposits) facility with Bank of
England
United 1934 Compulsory No 100000 Yes Yes Funded Banks and Up to 027 Borrowing up to $3 States official government percent total billion from US Treasury
domestic deposits
Japan 1971 Compulsory No 71000 but No No Funded Banks and 0084 percent of Borrowing up to yen500bn joint in full until government insured deposits from Bank of Japan
year 2000 subject to Ministry of Finance approval
Canada 1967 Compulsory No 40800 No Yes Funded Banks and 033 percent of Borrowing up to C$6 official government insured deposits billion authorized further
(maximum) borrowing subject to parliamentary approval
Germany 1966 Compulsory Yes 90 percent Yes No Funded Banks only 003 percent of Annual levy may be private coinsurance deposits doubled
to 22000
Italy 1987 Compulsory Yes 125000 Yes No Unfunded Banks and Callable Two options defer private government (maximum of payment or diminish
1 percent of compensation to be paid total deposits)
(table continues next page)
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Table 29 Deposit insurance schemes in the G-10 countries Explicit safety net (continued )
Coverage limit(dollar Foreign
equivalent currency Interbank Source Bankrsquos Contingency fundingDate Membership Co- at end of deposit deposit of premium from banks
Country established managementa insuranceb July 1998)c covered covered Fundingd funding costs or governments
Netherlands 1979 Compulsory No 22000 Yes No Unfunded Banks and On demand Government backing official government maximum of subject to parliamentary
5 percent of own approval funds
France 1980 Compulsory No 65400 No No Unfunded Banks only Callable (on Extra calls up to FFr1000 private demand calls million can be made in
up to FFr200 a 5-year period million)
Switzerland 1984 Voluntary No 19700 No No Unfunded Banks only Callable (on Underwritten by member official demand) banks
Sweden 1996 Compulsory No 31400 Yes No Funded Banks and 05 percent of Full emergency coverage official government deposits while replacing it with a
limited system after the emergency
Belgium 1974 Compulsory No 16600 No No Funded Banks and Callable 002 None insurance limited joint 22000 in government percent of to assets in fund
year 2000 deposits from clients
Spain 1977 Compulsory No 16439 Yes No Funded Banks and 02 percent of Government backing joint government deposits through the Banco de
(maximum) Espantildea subject to approval by royal decree
a Bank membership in the fund can be either compulsory or voluntary and the management of the fund can be official and official and private joint or privateb Coinsurance refers to the situation where depositors face a deductible against their insured fundsc Coverage limit refers to the explicit amount the authorities promise to insured Funded scheme means that it is funded ex ante unfunded otherwise
Sources Goodhart (1995) Demirguccedil-Kunt and Detragiache (2000) Demirguccedil-Kunt and Sabaci (2000)
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 109
base Explicit safety net protection also varies but only Canada focuseson the protected class33 All G-10 countries specify a limit on depositorprotection Under FDICIA the insurance fund is prohibited from pro-tecting uninsured depositors or creditors at a failed bank although adiscretionary system-wide override is provided for exceptional circum-stancesmdashbut with stringent requirements for consultation and account-ability Other G-10 countries allow for contingency funding from the publicpurse alongside unwritten lender-of-last-resort support Among large banksa significant and growing portion of deposit liabilities including foreigncurrency and interbank deposits are uninsuredmdashbut depositors assumethey will be protected in a crisis
FDICIA also made some significant qualitative changes to address theprincipal-agent problem by penalizing weak banks and rewarding strongbanks For example banks whose capital declined faced progressivelytougher regulatory sanctions that for example required them to elimi-nate dividends restrict their lending and change their managementsRegulators have also been forced to take prompt corrective action (toreduce the practice of regulatory forbearance in hopes that a bankrsquos for-tunes might improve)34 Unfortunately comparative qualitative assess-ments across the G-10 are difficult to make due to lack of information35
This discussion highlights the complexity of evaluating the extent towhich prudential supervision and market discipline reduce the moralhazard associated with G-10 safety nets Our argument is that publicsafety nets in the G-10 can be linked to banking instability in other coun-tries specifically in the emerging-market economies that have attractedG-10 cross-border bank lending This lending is a leading source of vola-tility in capital flows the large financial institutions many of which arecomplex banking organizations are based in and regulated by authori-ties in the G-10 economies These two features of the international finan-cial system are closely related although it is not possible to test thisrelationship econometrically
Two World Bank studies however indicate a basis for concern Onestudy is a cross-country econometric analysis of the relationship betweenbank stability and deposit insurance (Demirguccedil-Kunt and Detragiache2000) which found a negative relationship Their estimated model forbanking crises in a sample of 61 countries (both industrial and develop-ing) suggests that explicit deposit insurance raises the probability of acrisis by at least 30 percent36 Crises are especially likely in countries
33 Japanrsquos legislation says it does but recent experience shows this is not the case34 See Goldstein (1997) for a summary of the changes35 See Barth Nolle and Rice (2000) for a beginning in this area36 Demirguccedil-Kunt and and Detragiache (2000 table 1) report a logit coefficient of 0696with a standard error of 0397 (the coefficient is significant at the 8 percent threshold)This suggests that the ldquotruerdquo coefficient could well be as small as 030 (the reportedvalue minus the standard error)
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110 WORLD CAPITAL MARKETS
with immature financial supervisory systems (and not in the G-10) buttheir analysis does underscore the view that deposit insurance weakensmarket discipline37
An earlier World Bank analysis established similar results One wasthat market discipline is undermined by deposit insurance schemes an-other was that illiquid banks are forced to pay more for their funds un-less a generous deposit insurance scheme is in place (Demirguccedil-Kuntand Huizinga 1999) This econometric study also provides clear-cut evi-dence that depositor monitoring of banks declines with the existence ofdeposit insurance schemes At the heart of the problem is the questionof whether deposit insurance is accompanied by increased governmentmonitoring
This evidence and the weight of other arguments suggests that moralhazard is still an issue in the G-10 countries Consider the ongoing de-bate about instilling greater market discipline on risk taking by banksAt one extreme is the perennial proposal to do away with safety netsleaving markets to monitor the players and to force adjustments but toprotect small savers by creating ldquonarrow banksrdquo such as postal savingsystems that are allowed to invest these savings only in risk-free gov-ernment securities Whatever the merits of narrow banking this solutionis too extreme to be politically feasible
A moderate alternative is to force more disclosure by financial institu-tions to facilitate market monitoring But transparency has its own prob-lems Persaud (2000) argues that financial markets cannot reliably discernsustainable from unsustainable positions in the short term This uncer-tainty causes banks to ldquoherdrdquo behind market leaders to exploit theirsupposedly superior information ldquoThe more herding investors and bankersknow about what each other is up to the [more] unstable markets maybecomerdquo The implication is that greater transparency in the marketplaceby itself will not solve the problemmdashand in the short term more informa-tion may exacerbate herding Further supervisory steps (discussed in thenext chapter) are required
Yet another proposal is to promote private-sector involvement in bankmonitoring through market-based alternatives such as Calomirisrsquos sub-ordinated debt proposal (Calomiris 1997 Federal Reserve Board 1999)Banks could be required to issue and maintain a minimum amount of
37 Other findings in the Demirguccedil-Kunt and Detragiache (2000) study include thesepropositions The impact of deposit insurance on bank stability tends to be stronger themore extensive is the coverage offered to depositors when the scheme is funded andwhere the scheme is run by the government rather than by the private sector Con-versely deposit insurance is detrimental to bank stability where bank interest rates havebeen deregulated and where the institutional environment is weak Additional findingson deposit insurance are reported from a recent World Bank conference (8-9 June 2000httpwwwworldbankorgresearchinterestconfsupcomingdeposit_insurancehomehtm)Also see Smalhout (2001)
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 111
subordinated debt (eg uninsured certificates of deposit) to finance asmall fraction (such as 2 percent) of their total nonreserve assets Thesubordinated debt would be allowed to earn a set yield no more than 50basis points over the risk-free yield on government treasury bills Thisrule would supposedly force banks to operate in a safe manner Other-wise subordinated debt holders would redeem their uninsured certifi-cates of deposit and equity investors would sell their bank shares Despiteits practical problems the beauty of the subordinated debt requirementis that it enlists market incentives to push banks to avoid excessive port-folio risk38
The thrust of these proposals is very relevant to the arguments in ourstudy Even in the G-10 countries government monitoring by itself hasnot eliminated moral hazard among banks More work is needed to in-troduce market monitoring and to improve the incentive structures bothfor financial institutions and their supervisors We return to this issuewith our recommendations in the next chapter
38 In late 1996 Argentina began requiring its banks to finance 2 percent of total depos-its in the form of subordinated debt but without a maximum yield provision TheArgentine authorities expect that market discipline will act in concert with the publicsafety net One obvious problem with the subordinated debt proposal is that banks mayencourage some of their customers to buy the subordinated debt
Portfolio Institutions Tomorrowrsquos Problem
Before proceeding to the issues of international supervision we flag an-other potential problem for national regulators The big asset managersprofiled in tables 24 and 26 answer to diverse groups of pensionersshareholders and policyholders They allocate funds across a number ofcountries to diversify their risks They hold liquid assets that can be tradedand they have a higher proportion of long-term assets than banks Eco-nomic shocks can be absorbed through price changes and their effectsspread across time and markets Thus when conditions change in a par-ticular market they are more likely to ride out the storm than to flee Inother words they have less incentive than banks to pull their invest-ments in the face of adversity In the 1990s most large asset managersestablished a record of ldquoriding out the stormrdquo rather than ldquorunning withthe windrdquo although as we saw in chapter 1 instances of running withthe wind were detected in some portfolios As we write these insti-tutions have a good record overall in the emerging markets so whyworry
The Russian crisis and the near-collapse of LTCM previewed the dan-gers that may await future portfolio managers and G-10 financial minis-ters We have presented evidence indicating a systemic bias toward bank
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112 WORLD CAPITAL MARKETS
lending and debt finance to emerging markets and we have argued forsubstitution toward equity finance and direct investment39
That is not the end of the story We noted in the previous chapterthat institutional investors can become momentum investors selling in adownturn As more portfolio capital is invested in emerging marketssome players may adopt the high-risk high-leverage strategies of themost aggressive hedge funds Indeed the data in box 11 show that G-10portfolio investors held somewhat more long-term debt (more than $500billion) than equity (less than $400 billion) in emerging markets at theend of 1997 Long-term debt is an ideal vehicle for high-risk high-leveragestrategies These strategies practiced on a large scale could compound afuture crisis harming emerging markets A big enough crisis could inturn pressure G-10 central banks and finance ministers to arrange bail-out plans Instead of shrinking as a systemic financial problem moralhazard could increase
National securities regulators are the first line of defense against thisscenario They play a critical role in the safe evolution of capital mar-kets But regulators today are mandated to approve the issuance of newsecurities and to monitor the continuing disclosure of material informa-tion by issuers They are far less concerned with or empowered to monitorthe behavior of the increasingly large wealth-management firms that arethe major purchasers (and therefore resellers) of these securities
Within their mandates the goals of national securities regulators (table210 and appendix B) are similar to the concerns of bank regulators withsystem safety and soundness Their focus is also on the incentive sys-tems for management and boards of directors and on disclosure by cor-porations that issue marketable securities such as shares bonds andasset-backed securities 40 Issuers of securities possess greater knowledgeabout the quality of these assets than do the purchasers hence investorprotection is a key concern of regulators Moreover market disciplineworks best when markets know what is happening Well-functioning corpora-tions are key agents of wealth creation and social progress Underperform-ing corporations waste resources During recessions bad corporationsget into bad trouble often with severe social consequences Inadequateincentives for managers and inadequate accountability for boards andmanagers thus have negative externalities Regulators play a vital role inexposing weakness so that market disciplines come to bear sooner ratherthan later
Regulatory emphasis is constantly shifting as financial markets evolveand as the macroeconomic environment changes Regulators try to balance
39 See Rogoff (1999) Also see Berlin (2000) for a perspective on the limited role thatbanks play as share owners
40 See Habib and Ljungqvist (2000) for recent empirical analysis showing that corporateshare market values are higher when corporate executives have a larger ownership stake
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Table 210 Financial-sector regulation G-10 countries 2000
Financial institutions and their supervisors
Country and supervisory structure Retail banking Wholesale banking Securities Insurance
Financial conglomeratesFinancial Services Authority (FSA) = umbrella supervisor
United Kingdom FSA FSA FSA FSA
Treasury bull Commercial banks bull Investment funds (Securities and (Insurance Directorate(Securities and Investments Board) bull Unit trust groups Futures Authority) of the Treasury)
Bank of bull Building societies bull Pension funds England (Building Societies Commission) bull Merchant banks
bull Friendly societies bull Clearing houses bull Primary issuers bull Insurance FSA (Friendly Societies Commission) bull Venture capital of securities companies
bull Pensions and life insurance etc bull Stock exchanges bull Insurance brokers(Personal Investment Authority) bull Stockbrokers
Financial holding companiesFederal Reserve (FR) = umbrella supervisor
United States bull National banks(OCC) Securities and Regulated by
Treasury OCC bull State banks Federal Reserve Exchange Commission StatesMembers (FR)
OTS Nonmembers (FDIC) bull Investment banks bull Primary issuers of bull Insurance companies FR bull Cooperative banks (FDICFR) bull Finance companies securities bull Insurance brokers FDIC bull Insured industrial banks (FDIC) bull Stock exchanges
bull Thrift holding companies (OTS) bull Stockbrokers SEC bull Savings banks (OTSFDICFR) bull Investment advisors
bull Savings and loan associations bull Mutual funds(OTS) bull Public utility holding
bull Edge Act corporations (FR) companies
(table continues next page)
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Table 210 Financial-sector regulation G-10 countries 2000 (continued )
Financial institutions and their supervisors
Country and supervisory structure Retail banking Wholesale banking Securities Insurance
Financial holding companies Japan Financial Supervisory Authority (FSA) = umbrella supervisor
Prime FSA FSA FSA FSA ministerrsquos Ministry of office Finance (Securities and Exchange
Surveillance Commission) FRC Bureau of Financial bull City banks bull Investment banks bull Primary issuers of bull Insurance companies FSA Regulation bull Regional banks bull Asset managers securities bull Insurance brokers
bull Trust banks bull Stock exchanges SESC bull Long-term credit banks bull Stockbrokers
bull Pension funds
Financial holding companiesOffice of the Superintendent of Financial Institutions (OSFI) = umbrella supervisor
Canada Regulated by OSFI OSFI provinces OSFI
Department of Financebull Banks bull Cooperative credit bull Primary issuers of bull Insurance companies
(previously Office of the Inspector associations securities (previously Depart- OSFI General of the Banks) bull Fraternal benefit bull Stock exchanges ment of Insurance) Bank of bull Trust and loan companies society bull Stockbrokers bull Insurance brokers Canada bull Pension funds bull Asset managers
(previously Depart- CDIC ment of Insurance)
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115
Financial institutions and their supervisors
Country and supervisory structure Retail banking Wholesale banking Securities Insurance
Germany Financial holding groupsFederal Banking Supervisory Office (FBSO) = umbrella supervisor
Ministry of Finance FBSO BSO FSSO FISO
Bundesbankbull Universal banks bull Other financial bull Primary issuers of bull Insurance companies
Federal Banking bull Savings banks institutions (eg securities bull Insurance brokers Supervisory Office bull Securities banks management foreign bull Stock exchanges
currency dealings) bull Stockbrokers Federal Securities bull Financial enterprises bull Asset managers Supervisory Office (eg leasing bull Pension funds
organizations Federal Insurance credit card companies Supervisory Office investment advisors)
Italy Bank foundationsMinistry of Finance = umbrella supervisor
Ministry of Finance Bank of Italy Bank of Italy Consob ISVAP
Bank of Italy bull Commerical banks bull Asset managers bull Primary issuers of bull Insurance companies Consob bull Savings bank bull Open-end investment securities bull Insurance brokers
bull Securities banks companies (SICAVs) bull Stock exchangesbull Stockbrokers
ISVAP
(table continues next page)
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Table 210 Financial-sector regulation G-10 countries 2000 (continued )
Financial institutions and their supervisors
Country and supervisory structure Retail banking Wholesale banking Securities Insurance
The Netherlands Financial conglomeratesCouncil of Financial Supervisors = umbrella supervisor
Securities Board Securities Board Netherlandsche Netherlands Bank Netherlandsche Bank of the Netherlands Insurance Board Bank Insurance bull Credit institutions (universal banks bull Investment institutions bull Stock exchanges bull Insurance companies Board cooperative banks security credit (securities issuing bull Stockbrokers bull Insurance brokers
institutions mortgage banks) and tradingmdashprimary The Council of Financial and secondary Supervisors markets)
France Commission des Commission de Operations des Controcircle des
Banking and Banking Commission Bourse Assurances Financial Regulatory bull Ensuring that credit institutions (and investment firms since bull Primary issuers of bull Insurance companies Ministry for Committee the Financial Activity Modernization Act of 1996) comply securities bull Insurance brokers Economic with laws and regulations bull Stock exchanges Affairs and bull Execute instructions regarding all off-site monitoring and bull Stockbrokers Finance Credit on-site supervision Institutions and Banking and Financial Regulatory Committee Investment bull Formulates general regulations for credit institutions and investment firms Committee (capital adequacy requirements accounting rules etc) Bank of France Credit Institutions and Investment Committee Banking bull Authorizes and examines financial institutions except for those within the Commission competence of the Banking Commission
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117
Financial institutions and their supervisors
Country and supervisory structure Retail banking Wholesale banking Securities Insurance
Switzerland Large banking groupSwiss Federal Banking Commission (SFBC) = umbrella supervisor
Swiss National Bank Federal Office of
SFBC SFBC SFBC Private Insurance Swiss Federal Banking Commission bull Universal banks bull Investment banks bull Primary issuers of bull Insurance companies
bull Savings banks bull Asset management securities bull Insurance brokerscompanies bull Stock exchanges
Private audit Federal bull Investment funds bull Stockbrokers firms Office of bull Mortgage bond authorized by Private business SFBC Insurance
Sweden Financial holding company groupsFinancial Supervisory Authority = umbrella supervisor
Ministry of Finance Credit Market Securities Market Insurance Market
Credit Market Department Department Department Department
Financial bull Commercial banks bull Investment funds bull Primary issuers of bull Insurance companies Riksbank Supervisory bull Savings banks securities bull Insurance brokers Authority bull Friendly societies bull Stock exchanges
bull Stockbrokers
(table continues next page)
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Table 210 Financial-sector regulation G-10 countries 2000 (continued )
Financial institutions and their supervisors
Country and supervisory structure Retail banking Wholesale banking Securities Insurance
Belgium Bank holding companiesBanking and Finance Commission = umbrella supervisor
Bank of Belgium Banking Banking
Banking and Finance and Finance Insurance Controland Finance Commission Commission Commission Office
Banking and Insurance Finance Control bull Commercial banks bull Asset management bull Primary issuers of bull Insurance companies Commission Office bull Savings banks firms securities bull Insurance brokers
bull Securities banks bull Investment funds bull Stock exchanges bull Mortgage companiesbull Stockbrokers bull Pension funds
Securities Regulation Fund Securities Regulation Fund
bull Other investment firms and credit institutions(institutions participating in regulated off-exchangemarket in strips and Treasury certificates)
Bank holding companies Spain Banco de Espantildea = umbrella supervisor
Banco de Espantildea Comision Nacional del Mercado de Directorate General
Banco de Espantildea Valores (CNMV) Insurance
bull All credit institutions (commercial banks savings banks credit bull Primary issuers of (Ministry of Economy Ministry of cooperatives official credit institutions finance factoring and securities and Finance) Economy and CNMV leasing companies mortgage-loan companies etc) bull Stock exchanges bull Insurance companies Finance bull Interbank foreign exchange and book-entry public debt bull Stockbrokers bull Pension funds
markets bull Venture capital(companies and funds)
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119
Financial institutions and their supervisors
Country and supervisory structure Banking Securities Insurance
Banking Advisory High Level Securities Supervisors Committee (BAC) Committee (HLSS) Insurance Committee (IC)
Supranational (EU) bull Formulates standards for prudential bull Coordination of securities market bull Formulates standards forsupervision supervision prudential supervision
BACICHLSS Banking Supervision
Conglomerates Committee (BSC) Securities Contact Committee Regulation of prudential bull Systemic risk monitoring bull Regulation and implementation of supervision securities admission
International Association International International Organization of of Insurance Supervisors
Basel Committee Securities Commisison (IOSCO) (IAIS) Joint Forum Conglomerates Supervision bull Supervision and regulation best bull Supervision and regulation best bull Supervision and regulation amp regulation Best practices practices practices best practices
FSF Coordination across supervisors of various functions
Notes See appendix B for more information Boldface type indicates senior or oversight supervisor normal type indicates adjunct or front-line supervisorsolid line indicates direct responsbility to the senior-ranking authority dotted line indicates coordination in supervisory activities
(table continues next page)
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Table 210 Financial-sector regulation G-10 countries 2000 (continued )
Glossary of names United Kingdom FSA = Financial Services Authority United States FR = Federal Reserve OCC = Office of the Comptroller of theCurrency FDIC = Federal Deposit Insurance Corporation SEC = Securities and Exchange Commission OTS = Office of Thrift Supervision Japan FRC =Financial Reconstruction Commission FSA = Financial Services Agency SESC = Securities and Exchange Surveillance Commission Canada OSFI =Office of the Superintendent of Financial Institutions CDIC = Canada Deposit Insurance Corporation Germany FBSO = Federal Banking SupervisoryOffice FSSO = Federal Securities Supervisory Office FISO = Federal Insurance Supervisory Office BSO = Banking Supervisory Office Italy Consob =Commissione Nazionale per le Societa e la Borsa ISVAP = Instituto per la Vigilanza sulle assicurazioni private e di Interesse colletivo Switzerland SFBC= Swiss Federal Banking Commission Spain CNMV = The Comision Nacional del Mercado de Valores Supranational BAC = Banking Advisory CommitteeBSC = Banking Supervision Committee IC = Insurance Committee HLSS = High Level Securities Supervisors Committee International Dimension FSF =Financial Stability Forum IOSCO = International Organization of Securities Commission IAIS = International Association of Insurance Supervisors
Sources United Kingdom Bank of England httpwwwbankofenglandcouk Financial Services Authority httpwwwfsagovuk United States Board ofGovernors of Federal Reserve System httpwwwfederalreservegov Japan Bank of Japan httpwwwbojorjo Financial Reconstruction Commissionhttpwwwfsagojpfrcindexehtml Financial Services Agency httpwwwfsagojp Canada Bank of Canada httpwwwbank-banque-canadaca Office ofthe Superintendent of Financial Institutions httpwwwosfi-bsifgccaAndreEindexhtml Germany Deutsche Bundesbank httpwwwbundesbankde Fed-eral Banking Supervisory Office httpwwwbakredde Italy Banca drsquoitalia httpwwwbancaditaliait Commissione Nazionale per le Societa e la Borsahttpwwwconsobit Instituto per la Vigilanza sulle assicurazioni private e di Interesse colletivo httpwwwisvapit The Netherlands De NederlandscheBank httpwwwdnbnl France Banque de France httpwwwbanque-francefr Switzerland Schweizerische Nationalbank httpwwwsnbchindex3htmlSweden Sveriges Riksbank httpwwwriksbanksedefaultasp Belgium National Bank of Belgium httpwwwbnbbesgindexhtm Spain Banco de Espantildeahttpwwwbdees The Comision Nacional del Mercado de Valores httpwwwcnmves Supranational (EU) Institutional Arrangements for the Regulationand Supervision of the Financial Sector 2000 International Dimension Bank for International Settlement httpwwwbisorg International Organization ofSecurities Commissions httpwwwioscoorg International Association of Insurance Supervisors httpwwwiaisorg Financial Stability Forum httpwwwfsforumorg
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 121
the inflexibility of tight surveillance against the need to encourage in-novation and growth The US Securities and Exchange Commission isworried about aggressive accounting by firms and biased reports bysecurities analysts in an equity environment that prizes steadily higherquarterly earnings41 Japanese regulators are preoccupied with opaqueinterconnections between portfolio institutions banks and nonfinancialfirms through the keiretsu system Canadian regulators reeling from high-profile scandals of managers intentionally misleading investors are strengtheningmarket discipline through legal penalties aimed at managers and directorsof offending firms
When panic strikes a securities regulator cannot do much As the 1987stock market crash and the LTCM debacle in the fall of 1998 both dem-onstrated steep stock and bond price declines can create systemic risksIf severe enough the wealth effect of falling securities values and thefear of widespread insolvency can depress real activity Flooding thesystem with liquidity is a central bankerrsquos solutionmdashsomething a securi-ties regulator cannot do42 But just as financial supervisors can changethe incentive structure to discourage bankers from making risky loans ingood times so securities regulators can pay more attention to incentiveson the demand side when capital markets are strong
Prudential Supervision and InnovationmdashA Footnote
In concluding this discussion of prudential supervision in the G-10 anadditional point is worth noting National regulators face a persistenttrade-off between emphasizing financial system safety and soundnesswhile encouraging innovationmdashin spite of the added risks innovationbrings to financial markets Former US Treasury Secretary Lawrence Summers(2000 3) has argued by analogy
The jet airplane made airplane air travel more comfortable more efficient andmore safe though the accidents were more spectacular and for a time morenumerous after the jet was invented In the same way modern global financialmarkets carry with them enormous potential for benefit even if some of theaccidents are that much more spectacular As the right public policy response
41 The problem is illustrated by the divergence since mid-1998 between reported earn-ings by the Standard amp Poorrsquos (SampP) 500 and the after-tax profits of all corporations inthe national accounts Generally these two series move closely with one another Be-tween mid-1998 and mid-1999 SampP 500 reported that earnings increased by more than20 percent while after-tax profits of all corporations increased by less than 5 percent(Chase Bank US Economic and Policy Research US Weekly Prospects Chase SecuritiesWeekly Newsletter 5 June 2000 5)
42 For example the US Securities and Exchange Commission had no direct role in calmingmarkets in the 1987 or 1998 panics
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122 WORLD CAPITAL MARKETS
to the jet was longer runways better air-traffic control and better training forpilots and not the discouragement of rapid travel so the right public policyresponse to financial innovation is to assure a safe framework so that the ben-efits can be realized not to stifle the change
Accepting Summersrsquos analogy for the international financial system better-informed supervisors and investors are a necessary part of the financialsystem framework Supervisors require more timely information on therisk profiles resulting from positions taken by financial institutions Theyalso need a better understanding of risk-management systems Snapshotsof an institutionrsquos risk profile and risk-management procedures are nolonger adequate In a world where huge bets are quickly made (andpossibly lostmdashas with Barings Bank in 1995 and LTCM in 1998) super-visors must focus on the soundness of banking systems for evaluatingand managing risk on a daily basis Some progress has been made inaddressing these issues US banking examiners are extending their in-formation requirements in banking examinations and increasing theirinvolvement in large complex institutions43 More awareness is alsorequired of the fact that they are national organizations in a world ofcross-border capital flows To a much greater extent they need a multi-national reach International supervision and coordination among super-visors are the subject of the next section
Our analysis suggests that G-10 supervisors have unfinished businessBank supervisors need to start yesterday securities regulators can waituntil tomorrow One G-10 member acting alone cannot correct the biasIn good times the lending business will simply migrate to other G-10banks In bad times financial problems will not stop at the national bor-der A way has to be found to establish common international standardsfor the key financial players in order to prevent crises and to agree onapproaches for managing them The path has already been laid out Inthe wake of the bank failures of the past 25 years bank supervisors havetried to establish such standards They have done this without creating anew global institution
The essence of the international framework is decentralizationmdashglobalrules and design standards without global institutions that are perceivedto intrude on national sovereignty The awkward jargon for this frame-work is vertical subsidiaritymdashldquothink internationally act nationallyrdquo Theinternational thinking is done by a committee of regulators that meets
International SupervisionA Decentralized Framework
43 These issues are discussed in Ferguson (1999) and Meyer (2000a)
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 123
regularly at the Bank for International Settlements in Basel The commit-tee establishes principles and standards that are interpreted implementedand enforced by national authorities44 In this section we describe thesesupervisory efforts and their weaknesses We present our recommenda-tions for addressing these weaknesses in the next chapter
Basel I
The Basel Capital Accord of 1988 (Basel I)45 drew the lesson from thefinancial crises of the mid-1970s that more adequate capital levels in in-ternational banks would help reduce the systemic risk of bank failureThe primary goal of Basel I was capital adequacy other standards wereput in place not so much for their own virtue as to defend the primarygoal
Capital adequacy requirements were designed to ensure that individualinstitutions have the ability to absorb losses particularly credit lossesAccordingly a backup system of scoring credit risk was devised thatrequired large amounts of bank capital for some types of loans smalleramounts for others and zero for a select list of preferred assets Report-ing requirements were designed to disclose problems and ensure that atroubled bank would take timely steps to restore its capital base in thewake of a loss The Basel I framework worked tolerably well in limitingthe call on the public purse in the G-10 countriesmdashwith the notable ex-ceptions of France and Japan The framework failed to moderate riskybank lending to emerging markets however
Basel I was not developed with emerging markets in mind The origi-nal idea behind it was to develop a common supervisory approach tocross-border banking operations It grew out of political pressure fromUS lawmakers who were determined to require international banks op-erating in the United States to meet US banking standards Toward thisgoal in 1983 Congress passed the International Lending Supervisory ActUS and British banking authorities subsequently agreed on a commontarget the adoption of strict common capital-adequacy standards In 1988other G-10 governments agreed to go along voluntary acceptance ofthe standards throughout much of the rest of the world followed46 Therationale for the capital targets was two-fold The first was to requirebanks to hold sufficient amounts of capital (8 percent of risk-adjusted
44 The international committee of financial authorities agreed on a common definitionof banksrsquo tier-one or ldquocorerdquo capital national authorities defined tier-two capital in theirown manner which permitted greater variations in national working definitions andpractices
45 International Convergence of Capital Measurement and Capital Standards (BIS 1988)was prepared by the Basel Committee on Banking Supervision
46 See Reineke (1998)
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124 WORLD CAPITAL MARKETS
assets) to cushion losses on those assets The second was to dull theirappetites for risk banks with large capital bases would have more tolose if they failed and therefore would take fewer risks
Rapid change in financial markets soon revealed flaws in the Basel IAccord In a complex world with numerous sources of risk it focusedheavily on credit risk but overlooked other risks in a bankrsquos portfolioand the correlation between returns on different asset classes The Baselformula required banks to maintain a fixed amount of capital againsteach of its asset classes But the formula did not distinguish the riskinessof the borrower within each class As a result one large loan to a low-risk corporate borrower such as General Electric would require the sameamount of capital as 10 smaller transactions with high-risk borrowers
The system was also biased toward short-term loans Loans maturingin less than a year required a 20 percent risk weight whereas those ma-turing after more than a year required a 100 percent risk weight Inter-bank lending was particularly favored For example loans to banks inOECD countries required less capital than loans to private firms in thesame countries creating the anomaly that interbank loans to South Ko-rean banks required less capital than loans to General Electric47 Thisanomaly encouraged banks to shed high-quality assets if the Basel rulesrequired the allocation of more capital than banks thought they needed
Another weakness was that financial innovators quickly circumventedthe Accord Because short-term loans required less provisioning than long-term loans banks responded by securitizing their long-term debt port-folios and lending short-term against the collateral of the newly createdasset This allowed banks to circumvent the capital requirements gearedto the terms of the underlying debt At the same time the Basel I Accordfailed to encourage risk mitigation techniques such as credit derivativescollateral guarantees and on-balance-sheet netting the flip side of fi-nancial innovation Because off-balance-sheet products were not coveredby the Accord another anomaly appeared when Barings Bank collapsedin 1995 Barings met capital adequacy standards but collapsed becauseits systems for managing risk failed traders were allowed to speculatein futures contracts that did not appear on the balance sheet
Basel II
Work to overhaul Basel I began in 1995 and produced consultativepapers issued in June 1999 and January 200148 These papers have been
47 South Korean banks have had notoriously weak balance sheets because the practiceof ldquodirected lendingrdquo left them with many poor loans (in making these loans the bankswere expected to follow government objectives rather than creditworthiness criteria)
48 Basel Committee on Banking Supervision (1999 2001)
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 125
the subject of extensive consultation and revision as a result the newAccord is expected to be introduced in 200449 The Basel II frameworkhas three parts (pillars) revisions to Basel I minimum-capital require-ments supervisory review criteria and greater emphasis on market dis-cipline Broadly Basel II aims to maintain the level of capital in the sys-tem but achieve better alignment of banksrsquo capital with their risk pro-files and keep up with financial innovation
To align capital requirements with market realities (the first pillar)Basel II concentrates on the 100 or so largest banksmdashthe type of playerslisted in table 21mdashand on the holding-company parents of banking groups50
Capital requirements will differentiate between an increased number ofcredit groups or ldquorisk bucketsrdquo including claims on governments otherbanks corporations mortgage-backed securities and other asset-backedsecurities
Basel II originally proposed to use external ratings to set capital chargesfor a number of these credit risks Many banks objected arguing thatthey assess credit risk better than Standard amp Poorrsquos Moodyrsquos or FitchIBCA51 Basel II thus proposes two approaches to rating a standard ap-proach using external ratings and an ldquoadvancedrdquo approach that allowsselected banks to use their own internal rating systems To encouragethe development of rigorous internal control systems based on these in-ternal rating systems Basel II also proposes to levy capital charges foroperational risk (the risk of direct or indirect loss resulting from inad-equate or failed internal processes people and systems or from exter-nal events)
Some critics of this proposal dismiss it as an abrogation of the prin-ciple of external independent monitoring and as ldquodangerously naiumlverdquo52
But regulators argue that the new capital charge on operational risk shouldoffset this concern It is also far from clear how cross-national compari-sons of rating and internal risk-assessment systems will be made (Engelen2000) The development by the European Union of its own capital rulescould well complicate the international resolution of these issues Publicassurances by EU officials in January 2001 however indicated that theirmain concerns are to create a level playing field and avoid regulatoryarbitrage (Hargreaves 2001) There is also the significant problem ofthe procyclical character of risk weights When a crisis hits losses are
49 See Berry (2000) for an update in an interview with William J McDonough chair ofthe Basel Committee on Banking Supervision
50 For obvious reasons these proposals are addressed to large banks and simpler capi-tal standards are allowed for small banks that focus on their domestic credit markets
51 See Ammer and Packer (2000) for an empirical critique of the success of rating agen-cies in distinguishing risk by sector and region
52 See Auerback (2001)
Institute for International Economics | httpwwwiiecom
126 WORLD CAPITAL MARKETS
incurred or accrued capital is lost and loan exposure must be reducedor securities sold to restore the requisite capital-adequacy ratios A morerisk-sensitive framework could amplify volatility
As the second pillar of Basel II supervisory review criteria are beingbeefed up to encourage supervisors to intervene earlier in potential problemsituations and to compel banks to align their capital positions with theirrisk profiles Bank supervisors will be authorized to require banks tohold capital in excess of minimum requirements if they have concernsabout general management overall strategy risk-management performanceor the macroeconomic environment Of course if one G-10 supervisorimposes higher capital requirements in isolation the same disparity willemerge that presaged Basel I Some banks will be disadvantaged in theinternational marketplace and will loudly complain that excessive super-vision is driving business to their competitors Hence close internationalcooperation among supervisors is critical
To implement the third pillar market discipline banks will be requiredto make fuller more timely disclosure of capital adequacy and the risksto which that capital is exposed A number of measures are being stud-ied that might help supervisors evaluate bank performance such as com-parisons of uninsured deposit interest rates subordinated debt yieldsand equity prices The idea is that these yields and prices might alertsupervisors to market perceptions of risk Of course market perceptionsare only as good as market information More direct and controversialways to reinforce market discipline would dramatically increase publicdisclosure of bank positions and risk management systems
Many questions are still outstanding about how to resolve the techni-cal details of capital requirements and whether the requirements willachieve their intended goal of better assessment and mitigation of therisks in banksrsquo portfolios There is no substitute for skilled supervisorsThe intricacies of effective design and implementation suggest that su-pervisors need to be highly competent technically knowledgeable aboutbanking portfolio characteristics and the factors that influence bank ex-posure to credit risk (Mishkin 2000) And they must be aided by vigilantshareholders market forces and transparency of information53
Standard setting at the global level is desirable but ultimately theeffectiveness of these efforts will be tested at the national level espe-cially in times of systemic financial distress Here the record of Basel Iwas not a bright shining success Japanese banking regulators havetraditionally allowed banks to include real estate and securities in theircapital base When the value of these assets plummeted in the early 1990sregulators allowed banks to continue valuing these depreciated (andoften bankrupt) assets at their old inflated levels Japanese authorities
53 Benedict Roth Complacency Towards Catastrophe Financial Times 23 January 2001
Institute for International Economics | httpwwwiiecom
THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 127
insisted until the mid-1990s that eroded capital bases could be rebuiltin a market-driven fashion They rightly foresaw that huge loan losseswould undermine public support for the ruling party and require a po-litically unpopular bailout
Japanese foot dragging on Basel I was the worst54 but not uniqueOther examples can be found of ldquopolitically mandated forbearancerdquo TheFederal Reserve Bank of New York held important hands during theLTCM crisis of 1998 Mexico is still resolving the banking crisis that eruptedin 1995 South Korea has not yet closed the insolvent banks that behavedso badly before the crisis of 1998 In the aftermath of a crisis nationalregulators cannot always be relied upon to discipline politically power-ful bankers55 One of the little-noticed consequences of these differingapproaches is that those banks with strong regulatory systems receivedan implicit ldquoexport subsidyrdquo for their services US banks which had notengaged extensively in emerging-market lending in the 1990s were bet-ter positioned than their German and Japanese counterparts to expandtheir international assets in the wake of the crises
Other Financial Forums
54 See Japanese Banks Fiddling while Marunouchi Burns The Economist 27 January2001 67-69
55 See Calomiris (1997)
The Basel model of vertical subsidiarity has already been extended toother financial regulatory bodies In 1993-94 the BIS established a Tri-partite Group of Banking Insurance and Securities Regulators In 1994-95 the BIS increased its cooperation with the International Organizationof Securities Commissions when the two organizations issued parallelpapers on guidelines for national regulators concerning risk managementand disclosure of derivative trades In 1996 a permanent Joint Forum onFinancial Conglomerates was established to examine supervisory issuesand develop working arrangements among the different functional super-visors of conglomerate institutions that offer combinations of bankingsecurities and insurance products Draft papers on the supervisionof conglomerates were released for comment in 1998 applying capital-adequacy principles to these groups and providing guidelines both forassessing the integrity and competence of top managers and for sharingassessments between regulators
In 1997 the Basel Committee on Banking Supervision extended itsreach beyond capital standards to broader aspects of banking supervi-sion with the publication of the Core Principles for Effective BankingSupervision In 1999 a wide range of regulatory and standard-settingbodies were gathered under the umbrella of the Financial Stability
Institute for International Economics | httpwwwiiecom
128 WORLD CAPITAL MARKETS
Forum (FSF) itself established under BIS aegis56 The FSF has alreadyissued recommendations for stepped-up supervision and transparencyas well as guidelines for best practices in a number of areas includingoffshore financial centers and highly leveraged institutions or hedge funds57
Conclusion
Although the structural weaknesses in emerging-market economies arewidely acknowledged to have been causal factors in international capi-tal-market volatility this chapter points to the role of large G-10 bankingorganizations as major suppliers of the most volatile instrument short-term debt We have examined evidence of the impact of public safetynets in the G-10 economiesmdashthe deposit insurance systems the pruden-tial supervisory systems and the lender-of-last-resort functions of centralbanksmdashon the incentive structures of these organizations
Although supervisors in most countries working nationally and to-gether in the BIS have made significant efforts to mimic market forcesin their prudential supervision the most sophisticated financial institu-tions find innovative ways to circumvent the rules New global regulatorybodies are not about to be created G-10 national bank regulators shouldthemselves address the short-term debt bias in the international financialsystem by changing incentive systems G-10 securities regulators shouldalso take steps to get ahead of the curve paying close attention to largeportfolio swings by institutional investors particularly in times of crisisIn short more needs to be done at national and international levels tochange the rules of the game That is the subject of the next chapter
56 The Financial Stability Forum includes banking securities insurance and accountingregulatory bodies the OECD on taxation corruption and corporate governance and theIMF
57 See Martin (2000)
Institute for International Economics | httpwwwiiecom
THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 79
borrowing from each other using emerging-market debt instruments ascollateral
Russia became the poster country of high-risk finance In 1996 Rus-sian treasury bills (GKOs) were sensibly regarded as time bombs nobank would accept them as collateral for a loan But gradually the viewtook hold in Wall Street that for political reasons Russia had becometoo big to fail Banks relented and began to accept GKOs as security butat half their market value By early 1998 some hedge funds were bor-rowing up to 95 percent of these assets as collateral3 Banks also lent toeach other on similar terms
When the IMF refused a bailout to prevent default on the GKOs wide-spread surprise turned to panic Everyone headed for the exits Losseswere huge because many firms had been doing the same thing usingthe same risk-management models All those positions could not be un-wound simultaneously Liquidity dried up For a period no one wouldlend even to strong North American corporate accounts The final chap-ter was the near-collapse of Long Term Capital Management a hugehedge fund run by brilliant managers The combination of unexpectedevents LTCMrsquos risk exposure and high leverage contributed to its prob-lems The size persistence and pervasiveness of the widening spreadsconfounded its risk-management models producing huge losses AfterLTCM was refinanced by its major counterparties in September 1998 itsweaknesses became clear They included its risk-management systemsthe inadequacy of its capital base and most important the failure of marketdiscipline LTCMrsquos counterparties did not understand the hedge fundrsquosrisk profile when they granted credit on generous terms mainly on thebasis of its managersrsquo reputations (FSF 2000b)
The Asian and Russian episodes illustrate key issues on the supplyside that deserve more attention bias in the incentive systems of G-10countries toward the use of debt and the significant role played by thelarge international financial institutions particularly banks We do notdispute the importance of reforms (including better exchange rate sys-tems) urged on the finance ministries central banks and borrowers inemerging economies Some of the criticisms aimed at the IMF are alsowarranted But we think the G-10 market players and financial super-visors deserve far more scrutiny
The top financial players constantly innovate as new technologiesmake financial engineering possible By the same token they quickly re-spond to any shifts in the incentive structure imposed through officialregulation The activities of the top players are beyond the reach of theIMF They must not however be beyond the reach of G-10 financialsupervisors particularly the bank and securities-market regulators
3 See Risk Management Too Clever by Half The Economist 14 November 1998 82-85
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80 WORLD CAPITAL MARKETS
The Market Players
As the tables in chapter 1 illustrate there are three main types of pri-vate-capital flows bank loans and deposits other portfolio investmentand foreign direct investment Each type is associated with particularinstitutionsmdashcommercial banks other financial institutions and non-financial firms In this section we describe the size and nationality ofthe large players
Commercial Banks
Table 21 lists the 50 largest commercial banks by market capitalizationas of October 2000 Market capitalization rather than sheer asset sizeprobably better measures a bankrsquos ability to move funds from one coun-try or sector to another4
The large continental European banks (those in the euro zone plusSwitzerland) in 1999 had market capital of about $524 billion and assetsof approximately $64 trillion When figures for UK commercial banksare added in European market capitalization rises to about $850 billionand assets to about $86 trillion Europe is a banking powerhouse In-deed the European role is so crucial that no approach to the regulationof international lending can survive without European support
The Maastricht Treaty did not make Europe a single entity for bank-ing supervision The European Central Bank is finding its way in ex-change rate and monetary policy For the foreseeable future nationalregulators will retain control over supervisory matters Changes in thefabric of international understandings over bank supervision will requireconsensus among the European powers
In market capitalization at $850 billion the large US banks are aboutthe same as their European counterparts but in asset size they are adistant second to the Europeans at $38 trillion The large Japanese com-mercial banks follow on market capitalization at $300 billion but aresecond to the Europeans with assets of $67 trillion
Commercial-banking power is clearly concentrated in Europe the UnitedStates and Japan Moreover banks based in the G-10 plus Spain accountfor 90 percent of the market capitalization and assets of the top 50 com-mercial banks in the world As table 22 shows banks based in the G-10countries plus Spain account for about 92 percent of the assets of allcommercial banks located in BIS reporting countries about 80 percent ofthe external assets of these banks and about 72 percent of claims on
4 Several banks in China and Europe rank among the top 50 in terms of asset size butpoor-quality loans sharply diminish their market capitalization-ndashand their ability to movemoney from country to country
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 81
Table 21 Worldrsquos largest 50 commercial banks by marketcapitalization October 2000 (billions of dollars)
Market capitalizatona Total Net Shareholderassets income equityb
Global Sept Oct National Dec Dec Decrank Banks 1999 2000 rankc 1999 1999 1999
Continental Europe
8 ING Bank 46 66 1 351 17 1412 UBS 58 55 2 614 39 2213 Creacutedit Suisse Group 50 54 3 452 33 2215 Deutsche Bank 36 48 4 843 26 2317 Banco Santander
Central Hispano 33 45 5 258 22 1719 BNP Paribas 43 6 702 17 22
Banque Nationalede Paris 26
Paribas 1621 ABN AMRO 29 34 7 460 26 1325 Banco Bilbao
Vizcaya Argentaria 25 28 8 240 22 1826 UniCredito Italiano 21 26 9 170 13 1030 Socieacuteteacute Geacuteneacuterale 19 22 10 408 24 1229 HypoVereinsbank 20 22d 11 505 04 1432 Dresdner Bank 21 21 12 398 11 1243 San Paolo IMI 16 17d 13 141 11 845 Fortis Bank 34 16 14 330 12 949 Commerzbank 17 14 15 374 09 1249 KBC Bank 13 14d 16 147 07 6
Total for Continental Europe 482 524d 6393 291 234
Japan
3 Mizuho Holdings Inc 115 1 51e
3 Dai-Ichi Kangyo Bankf 39 463 ndash38 203 Industrial Bank
of Japanf 32 390 ndash15 133 Fuji Bankf 42 489 ndash36 187 Sumitomo Sakura
(tentative) 68 2 56e
Sumitomo Bankg 47 464 ndash48 15Sakura Banki 31 414 ndash40 18
10 Bank of Tokyo Mitsubishi 72 56 3 664 ndash07 2311 UFJ Holdings Inc 55d 4 36e
Sanwa Bankh 39 425 ndash40 18Tokai Bankh 16 269 ndash24 13Toyo Trust amp Bankingh na 67 ndash13 5
40 Asahi Bank 20 18d 5 247 ndash21 1249 Mitsubishi Trust amp
Bankingi 16 14d 6 149 ndash14 750 Sumitomo Trust amp
Banking 11 10d 7 127 ndash12 6
Total for Japan 364 336e 6472 ndash481 260
(table continues mext page)
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82 WORLD CAPITAL MARKETS
Table 21 Worldrsquos largest 50 commercial banks by marketcapitalization October 2000 (billions of dollars) (continued )
Market capitalizatona Total Net Shareholderassets income equityb
Global Sept Oct National Dec Dec Decrank Banks 1999 2000 rankc 1999 1999 1999
United Kingdom
2 HSBC Holdings 97 122 1 569 54 379 Royal Bank of Scotland 19 58d 2 146 14 7
NatWestj 39 na na 292 na 1414 Lloyds TSB 68 52 3 285 41 1418 Barclays 44 44 4 402 28 1435 Abbey National 25 19 5 292 20 846 Standard Chartered 15 15d 6 88 06 646 Bank of Scotland 15 15d 7 116 10 6
Total for United Kingdom 322 324d 2191 173 106
United States
1 Citigroup 149 237 1 717 99 504 JP Morgan Chase amp Co 83 2 35e
Chase Manhattank 63 na na 406 54 24JP Morgank 20 na na 261 21 11
5 Bank of America 96 79 3 633 79 446 Wells Fargo amp Company 65 78 4 218 37 2216 Bank of New York
Company 25 46 5 75 17 520 Bank One 41 42 6 269 35 2022 Fleet Boston Financial 34 34 7 191 20 1523 MBNA 18 30 8 31 10 424 First Union 34 30 9 253 32 1727 Fifth Third Bancorp 17 24 10 42 07 427 Mellon Financial 17 24 11 48 10 433 State Street na 20 12 61 06 335 PNC Bank 16 19 13 75 13 635 Northern Trust na 19 14 29 04 235 Firstar 25 19 15 73 09 640 US Bancorp 22 18 16 82 15 846 SunTrust Banks 21 15 17 95 13 850 National City 16 13 18 87 14 650 Wachovia 16 11 19 67 10 650 KeyCorp 12 11 20 83 11 6
Total for United States 707 850 3796 517 271
Other
31 National Australia Bank 2 21 1 166 18 1234 Hang Seng Bank Ltd 20 20d 2 na na na35 Royal Bank of Canada 13 19 3 184 12 940 Commonwealth Bank
of Australia 14 18d 4 91 09 543 Toronto Dominion Bank 12 17 5 146 20 850 Westpac Banking Corp 12 13 6 92 10 650 Development Bank
of Singapore 12 13d 7 64 06 6
Total for other 105 121d 742 76 46
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 83
developing countries In turn the claims on developing countries repre-sent about 4 percent of the assets of G-10 and Spanish commercial banks
Portfolio Investors
Table 21 (continued )
Market capitalizatona Total Net Shareholderassets income equityb
Sept Oct National Dec Dec Dec1999 2000 rankc 1999 1999 1999
Total for largest 50 1980 2155 19594 58 917
Total for G-10 1900 2070 19182 53 888
na = not availablenot applicableG-10 = Group of Ten countries see note to table 11
a Market capitalization is defined as the number of ordinary shares currently in circulationmultiplied by the current share price Market capitalization as of October 2000 is presentedfor the banks that had a market capitalization higher than $11 billion as of September 1999b Shareholder equity is defined as the sum of issued common stock capital surplus or pre-mium various reserves and retained earnings Shareholder equity includes group equity at-tributable to consolidated minority interestsc Rankings within the country or regiond Estimates based on the available rates of change from September 1999 to October 2000The market capitalization and shareholder equity figures represent combined estimate for themerged bankse Total for the merged banksf Merged in September 2000g Merged in April 2001h Will merge in April 2002i Will merge with Nippon Trust and Tokyo Trust in October 2001j NatWest Bank merged with the Royal Bank of Scotland in March 2000k Announced a merger in September 2000
Sources Euromoney The Bank Atlas 2000 httpwwweuromoneycom American BankerThe Top 100 World Financial Companies Q3 1999 httpwwwamericanbankercom YahooFinance Company Profiles financeyahoocom Bloomberg Financials httpwwwbloombergcom
Three groups of financial institutions dominate the flow of portfolio capitalinvestment banks wealth managers and insurance companies Table 23lists nine large investment banks all based in New York with offices inLondon and other financial centers In 1998 these nine firms had a com-bined market capitalization in excess of $130 billion and controlled as-sets in excess of $18 trillion
Investment banks act as guardians to the securities markets Nearly allpublic and private shares bonds and asset-backed securities are broughtto market by an investment bank Fulfilling the same function they areexpanding the securities markets of emerging economies They also act asthe pilots of privatization mergers and takeoversmdashnow a core feature of
Institute for International Economics | httpwwwiiecom
84 WORLD CAPITAL MARKETS
Table 22 Total assets and external assets of all commercialbanks June 2000 (billions of dollars)
Claims onExternal assets developing countriesb
Share of Share ofTotal total assets total assets
Country assetsa Amount (percent) Amount (percent)
Austria 423 91 22 33 8Bahamas 316 244 77 61c 19Bahrain 100 92 92 46c 46Belgium 806 309 38 26 3Canada 720 98 14 31 4Denmark 244 58 24 6 2Finland 121 31 25 4 3France 2486 607 24 135 5Germany 4535 901 20 240 5Ireland 423 160 38 2 0Italy 1345 191 14 47 4Japan 8460 1199 14 258 3Luxembourg 821 495 60 124c 15Netherlands 1080 296 27 67 6Norway 157 14 9 3 3Singapore 574 405 70 202c 35Spain 889 124 14 57 6Sweden 348 67 19 12 2Switzerland 1632 709 43 177c 11United Kingdom 5802 1990 34 138 2United States 6223 889 14 144 2
Total for all BISreporting countries 37506 8968 24 1813 5
Total for G-10 34326 7378 21 1331 4
BIS = Bank for International SettlementsG-10 = Group of Ten countries see note to table 11
a Total assets are calculated as banking institutions (deposit institutions) reserve claims onthe public sector claims on the private sector (lines 20 21 22 from IFS) plus externalassets Figures are converted into US dollars using the market exchange rate at the end ofJune 2000b Developing countries are countries other than Andorra Australia Austria Belgium CanadaCyprus Denmark Finland France Germany Gibraltar Greece Iceland Ireland Italy JapanLiechtenstein Luxembourg Malta Netherlands New Zealand Norway Portugal Spain Swe-den Switzerland Turkey the United Kingdom the United States the Vatican City State andthe former Yugoslaviac These countries do not disclose their claims on developing countries Such claims arearbitrarily (and generously) estimated at half the external assets of commercial banks in Bahrainand Singapore and a quarter of the external assets of banks in the Bahamas Luxembourgand Switzerland
Sources IMF International Financial Statistics (IFS) November 2000 Bank for InternationalSettlements BIS Quarterly Review November 2000 httpwwwbisorg
Institute for International Economics | httpwwwiiecom
THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 85
global capitalism In addition to their underwriting role investment banksearn substantial profits from trading securities
Wealth-management firms are the second group of portfolio institu-tions They typically deal with the publicmdashindividuals and companiesthat want a trusted firm to manage their pensions and other funds Table24 lists 10 large wealth managers all based in the G-10 Together these10 firms control $64 trillion in assets and their own market capitalization
Table 23 Large investment banks 1998 (billions of dollars)
MarketRevenue Assets capitalizationa
Merrill Lynchb (United States) 36 300 25Morgan Stanley Dean Witterb (United States) 31 318 50c
Goldman Sachs (United States) 22d 217e 29c
Lehman Brothers Holdingsb (United States) 20 154 10c
Salomon Smith Barneyf (United States) 8 211 naCredit Suisse First Bostong (United States
Switzerland) 7 280 naPaine Webberh (United States) 7 54 6i
Bear Stearnsj (United States) 8 154 5i
Donaldson Lufkin amp Jenrettek (United States) 5 72 7i
Total 144 1760 132 plusTotal for G-10 144 1760 132 plus
na = not available (subsidiaries of large holding companies Citigroup and Creacutedit SuisseGroup respectively individual market capitalization is not available)G-10 = Group of Ten countries see note to table 11
a Market capitalization is calculated by multiplying the total number of shares by the shareprice at the companyrsquos fiscal year-endb Source Fortune Global 500 1999 Data shown are for the fiscal year ended on or before31 March 1999 Assets shown are those at the companyrsquos fiscal year-end httpwwwpathfindercomfortuneglobal500indexhtmlc Figures as of September 1999 are from American Banker httpwwwamericanbankercomBankRankingsd Source 1998 Goldman Sachs Annual Review Assets as of November 1998 httpwwwgscomaboutannual19984_fsindexhtmle Source Financial Times Company Financials Revenue as of 27 November 1998 httpwwwglobalarchiveftcomcbcb_searchhtmf Source 1998 Citigroup Annual Report 20 Revenue figures for year ending 31 December1998 Asset figures as of 31 December 1998 httpwwwcitigroupcomcitigroupfindatac1998ar2pdfg Source 19981999 Creacutedit Suisse Group Annual Report 23 httpwwwcsgchcsg_annual_report_98downloadcsg_ar98_p1_enpdfh Source 1998 Paine Webber Annual Report 34-35 httpwwwpainewebbercomannual98graphicsfininfoindexhtmi Individual figures are obtained from Yahoo The time for valuations is as follows BearStearns December 1999 Lehman Brothers November 1999 Paine Webber and DonaldsonLufkin amp Jenrette September 1999j Source 1999 Bear Stearns Annual Report 55-56 Figures are for fiscal year ending 30June 1998 httpwwwbearstearnscomcorporateinvestorindexhtmk Source 1999 Donaldson Lufkin and Jenrette Annual Report ldquoFinancial Highlightsrdquo httpwwwdljcompdfDLJ98_1pdf
Institute for International Economics | httpwwwiiecom
86 WORLD CAPITAL MARKETS
exceeds $260 billion For the most part wealth managers are long-termportfolio investors
Hedge funds represent a highly specialized investment vehicle that isnot widely available to the public Most hedge funds are leveraged theyemploy dynamic (and sometimes opportunistic) trading strategies involvingpositions in several different markets they adjust their investment port-folios frequently in anticipation of asset price movements or changes inyield differentials between related securities Hedge funds are opaque tomarket monitoring They are subject to little direct regulation and areunder few obligations to disclose information Hence the size of the in-dustry is difficult to measure
If they are measured by capital under management or by assets hedgefunds are small relative to established wealth managers As table 25shows the capital managed by 20 large hedge funds in late 1998 amountedto less than $50 billion Estimates vary widely but if all hedge funds arecounted their assets range from $100 to $300 billion Even the highestnumber is less than 5 percent of the combined assets of investment banksand traditional asset managers
The amount of leverage used by hedge funds depends on trading strate-gies that are in turn shaped by investor attitudes toward risk Leverage
Table 24 Large asset managers in 1998 (billions of dollars)
Total assets under Marketmanagementa capitalizationb
UBS (Switzerland) 1145 58c
Fidelity Investments (United States) 773 naKampo (Japan) 698 naCredit Suisse Group (Switzerland) 680 50c
AXA Group (France) 647 39c
Barclayrsquos Global Investors (United States) 616 44c
Merrill Lynch amp Co (United States) 501 25c
State Street Global Advisors (United States) 493 naCapital Group Cos (United States) 424 naZurich Financial Services (Switzerland) 415 45c
Total 6392 261 plusTotal for G-10 6392 261 plus
na = not available (usually a nonpublic company)G-10 = Group of Ten countries see note to table 11
a Figures are assets under management at fiscal year-end 1998b Market capitalization is calculated by multiplying the total number of shares by the shareprice at the companyrsquos fiscal year-endc Figures from American Banker httpwwwamericanbankercomBankRankings
Sources Institutional Investor 1999 httpwwwiimagazinecomresearchinterfacehtml US(II300) Asia (Asia200) and Europe (Euro100) Asset Management Rankings American BankerhttpwwwamericanbankercomBankRankings
Institute for International Economics | httpwwwiiecom
THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 87
is achieved using such instruments as repos (repurchase agreements)futures and forward contracts and other derivative products5 It is alsovery difficult to measure A Financial Stability Forum (FSF 2000b) studyof hedge funds noted thatmdashalthough there are problems with the waydata vendors report these positionsmdashestimates suggest most hedge fundsuse modest amounts of leverage averaging 21 but ranging to 41 insome FSF (2000b) further notes difficulties with evaluating the risk-adjusted performance of hedge funds because of their dynamic tradingstrategies
Table 25 Largest hedge funds according tocapitalization August 1998 (billions of dollars)
Fund Capital under management
Domestica
Tiger 51Moore Global Investment 40Highbridge Capital Corp 14Intercap 13Rosenberg Market Neutral 12Ellington Composite 11Hedged Taxable-Equivalent 10Quantitative LongShort 09Sr International Fund 09Perry Partners 08
OffshoreJaguar Fund NV 100Quantum Fund NV 60Quantum Industrial Fund 24Quota Fund NV 17Omega Overseas Partners 17Maverick Fund 17Zweig Dimenna International 16Quasar International Fund NV 15SBC Currency Portfolio 15Perry Partners International 13
Totalb 471
a Long Term Capital Management (LTCM) was in serious difficulty in August1998 and is omitted from the listb Estimates of hedge fund capital and the number of funds vary significantlyMARHedge estimated 1115 funds with $109 billion capital under managementat the end of 1997 Van Hedge Fund estimated 5500 funds with capital of $295billions at the same date
Source Adapted from Eichengreen (1999a)
5 Positions are established by posting margins rather than the face value of the position
Institute for International Economics | httpwwwiiecom
88 WORLD CAPITAL MARKETS
The positive role of hedge fundsmdashproviding diversification to inves-tors because their returns have low correlations with standard asset classesmdashis counterbalanced by some negative features Hedge funds and otherhighly leveraged institutions (HLIs) may take concentrated positions andengage in aggressive market practices that amount to ldquoganging uprdquo on asmall economy (such as Hong Kong)6 Under normal market conditionsHLI positions are not destabilizing but some of the aggressive practicesdocumented in 1998 are worrisome The FSF study group participantsagreed (2000b 112) that such practices raise important issues for marketintegrity but they could not agree that market manipulation was suffi-ciently widespread to be a serious concern for policymakers
Insurance companies are the third group of portfolio institutions Theseare divided into two categories property and casualty companies andlife and health insurance companies Ten large companies of each cat-egory are listed in table 26 In 1998 the 10 property and casualty insur-ance companies had $16 trillion in assets and more than $330 billion inmarket capitalization The 10 life insurance companies had $28 trillionin assets7 Combining both categories 100 percent of assets are controlledby insurance companies based in the G-10 and Spain In portfolio man-agement styles life insurance companies tend to hold longer-term assetswhereas property and casualty companies tend to hold shorter-term in-struments
Nonfinancial Multinational Enterprises
The last players are the nonfinancial multinational enterprises (MNEs)The worldrsquos 100 largest corporations measured by 1998 revenue are re-corded in tables 27 and 28 The 30 financial giants among the top 100are separately shown in table 27 Most of the firms appeared in previ-ous tables Together these 30 financial giants had revenues of $13 tril-lion and controlled assets of $113 trillion8
Table 28 lists the 70 top nonfinancial giants Their revenues in 1998were $40 trillion and their assets (at book value) measured $45 trillionMeasured by revenue or assets about 95 percent of the giants are basedin the G-10 These firms are responsible for a large share of the worldrsquos
6 See IMF (1999c) for a description of the ldquodouble playrdquo that hedge funds are accusedof using in an attempt to destabilize Hong Kong in August 1998
7 Many life insurance companies are owned by their policyholders and therefore donot have a market capitalization
8 By comparison the larger set of 96 financial firms listed in previous tables controlled$322 trillion in assets This is the total amount of assets recorded in tables 21 (50 com-mercial banks) 22 (9 investment banks) 24 (10 asset managers) and 26 (20 insurancecompanies) The largest hedge funds might add $300 billion to the total
Institute for International Economics | httpwwwiiecom
THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 89
Table 26 20 large insurance companies in 1998(billions of dollars)
Property and casualty insurance Marketcompanies Revenuea Assetsb capitalizationc
Allianz (Germany) 65 402 62d
Assicurazioni Generali (Italy) 48 178 30d
State Farm Insurance Cos (United States) 45 111 naZurich Financial Services (Switzerland) 39 215 45d
CGU (United Kingdom) 38 176 20d
Munich Re Group (Germany) 35 131 naAmerican International Group (United States) 33 194 135d
Allstate (United States) 26 88 20d
Royal amp Sun Alliance (United Kingdom) 25 76 11d
Loews (United States) 21 71 7e
Total 375 1642 330 plusTotal for G-10 375 1642 330 plus
MarketLife and health insurance Revenuea Assetsb capitalizationc
AXA (France) 79 452 39d
Nippon Life Insurance (Japan) 66 363 naING Group (Netherlands) 56 464 46d
Dai-ichi Mutual Life Insurance (Japan) 44 253 naSumitomo Life Insurance (Japan) 40 206 naTIAA-CREF (United States) 36 250 naPrudential Ins Co of America (United States) 34 279 naPrudential (United Kingdom) 34 197 30d
Meiji Life Insurance (Japan) 28 146 naMetropolitan Life Insurance (United States) 27 215 na
Total 444 2825 naTotal for G-10 444 2825 na
na = not available (usually an insurance company owned by its policyholders)G-10 = Group of Ten countries see note to table 11
a Data shown are for the fiscal year ended on or before 31 March 1999b Assets shown are those at the companyrsquos fiscal year-endc Market capitalization is calculated by multiplying the total number of shares by the shareprice at the companyrsquos fiscal year-endd Market capitalization data as of September 1999 from American Banker httpwwwamericanbankercome Individual companyrsquos market capitalization as of September 1999 from Yahoo yahoomarketguidecom
Sources Fortune Global 500 1999 httpwwwpathfindercomfortuneglobal500indexhtmlAmerican Banker httpwwwamericanbankercomRankingBanks1999 Yahoo Marketguideyahoomarketguidecom
Institute for International Economics | httpwwwiiecom
90 WORLD CAPITAL MARKETS
Table 27 Financial firms in the 100 largest companiesby revenue 1998 (billions of dollars)
Globalrank Company Revenuesa Assetsb Type
Continental Europe
15 AXA (France) 79 452 Insurance23 Allianz (Germany) 65 402 Insurance28 Ing Group (Netherlands) 56 464 Insurance37 Credit Suisse (Switzerland) 49 475 Banks commercial
and savings39 Assicurazioni Generali (Italy) 48 178 Insurance42 Deutsche Bank (Germany) 45 736 Banks commercial
and savings56 Zurich Financial Services (Switerland) 39 215 Insurance68 Munich Re Group (Germany) 35 131 Insurance72 ABN AMRO Holding (Netherlands) 34 507 Banks commercial
and savings77 Credit Agricole (France) 33 459 Banks commercial
and savings80 HypoVereinsbank (Germany) 32 541 Banks commercial
and savings84 Fortis (Belgium) 31 397 Banks commercial
and savings98 Socieacuteteacute Geacuteneacuterale (France) 30 450 Banks commercial
and savingsUnited Kingdom
47 HSBC Holdings 43 485 Banks commercialand savings
58 CGU 38 176 Insurance74 Prudential 34 197 Insurance
United States
16 Citigroup 76 669 Diversified financials35 Bank of America Corp 51 618 Banks commercial
and savings44 State Farm Insurance Cos 45 111 Insurance64 TIAA-CREF 36 250 Insurance67 Merrill Lynch 36 300 Securities71 Prudential Ins Co of America 34 279 Insurance76 American International Group 33 194 Insurance79 Chase Manhattan Corp 32 366 Banks commercial
and savings83 Fannie Mae 31 485 Diversified financials88 Morgan Stanley Dean Witter 31 318 Securities
Japan
21 Nippon Life Insurance 66 363 Insurance45 Dai-ichi Mutual Life Insurance 44 253 Insurance54 Sumitomo Life Insurance 40 206 Insurance91 Bank of Tokyo-Mitsubishi 31 664 Banks commercial
and savingsTotal 1279 11341Total for G-10 1279 11341
G-10 = Group of Ten countries see note to table 11
a Data shown are for the fiscal year ended on or before 31 March 1999b Assets shown are those at the companyrsquos fiscal year-end
Source Fortune Global 500 1999 httpwwwpathfindercomfortuneglobal500indexhtml
Institute for International Economics | httpwwwiiecom
THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 91
Tab
le 2
8N
on
fin
anci
al f
irm
s in
th
e 10
0 la
rges
t co
mp
anie
s b
y re
ven
ue
199
8 (b
illio
ns o
f do
llars
)
Glo
bal
Tra
nsn
atio
nal
ity
ran
k
Co
mp
any
Rev
enu
esa
Ass
etsb
ind
exc
Typ
e
Co
nti
nen
tal
Eu
rop
e
2D
aim
lerC
hrys
ler
(Ger
man
y)15
516
044
1M
otor
veh
icle
s an
d pa
rts
11R
oyal
Dut
chS
hell
Gro
up (
Net
herla
nds)
9411
058
9P
etro
leum
ref
inin
g17
Vol
ksw
agon
(G
erm
any)
7670
568
Mot
or v
ehic
les
and
part
s22
Sie
men
s (G
erm
any)
6667
521
Ele
ctro
nics
el
ectr
ical
equ
ipm
ent
32M
etro
(G
erm
any)
5222
n
a
Foo
d an
d dr
ug s
tore
s34
Fia
t (I
taly
)51
7640
8M
otor
veh
icle
s an
d pa
rts
36N
estle
(S
witz
erla
nd)
5041
932
Foo
d46
Veb
a G
roup
(G
erm
any)
4351
275
Tra
ding
49R
enau
lt (F
ranc
e)41
4545
7M
otor
veh
icle
s an
d pa
rts
53D
euts
che
Tel
ekom
(G
erm
any)
4093
n
a
Tel
ecom
mun
icat
ions
57R
oyal
Phi
lips
Ele
ctro
nics
(N
ethe
rland
s)38
3386
4E
lect
roni
cs
elec
tric
al e
quip
men
t59
Peu
geot
(F
ranc
e)38
4038
7M
otor
veh
icle
s an
d pa
rts
62E
lect
riciteacute
de
Fra
nce
(Fra
nce)
3711
3
na
Util
ities
ga
s an
d el
ectr
ic63
Rw
e G
roup
(G
erm
any)
3747
n
a
Util
ities
ga
s an
d el
ectr
ic65
BM
W (
Ger
man
y)36
3660
7M
otor
veh
icle
s an
d pa
rts
66E
lf A
quita
ine
(Fra
nce)
3643
576
Pet
role
um r
efin
ing
69V
iven
di (
Fra
nce)
3558
n
a
Eng
inee
ring
and
cons
truc
tion
70S
uez
Lyon
nais
e de
s E
aux
(Fra
nce)
3585
n
a
Ene
rgy
78E
NI
(Ita
ly)
3249
317
Pet
role
um r
efin
ing
86B
ayer
(G
erm
any)
3134
827
Che
mic
als
92A
BB
Ase
a B
row
n B
over
i (S
witz
erla
nd)
3132
957
Ele
ctro
nics
el
ectr
ical
equ
ipm
ent
93B
AS
F (
Ger
man
y)31
3159
5C
hem
ical
s95
Car
refo
ur (
Fra
nce)
3020
n
a
Foo
d an
d dr
ug s
tore
s
(tab
le c
ontin
ues
next
pag
e)
Institute for International Economics | httpwwwiiecom
92 WORLD CAPITAL MARKETS
Tab
le 2
8N
on
fin
anci
al f
irm
s in
th
e 10
0 la
rges
t co
mp
anie
s b
y re
ven
ue
199
8 (b
illio
ns o
f do
llars
) (c
ontin
ued
)
Glo
bal
Tra
nsn
atio
nal
ity
ran
k
Co
mp
any
Rev
enu
esa
Ass
etsb
ind
exc
Typ
e
Un
ited
Kin
gd
om
19B
P A
moc
o68
8559
2P
etro
leum
ref
inin
g43
Uni
leve
r45
3692
4F
ood
Un
ited
Sta
tes
1G
ener
al M
otor
s16
125
729
3M
otor
veh
icle
s an
d pa
rts
3F
ord
Mot
or14
423
835
2M
otor
veh
icle
s an
d pa
rts
4W
al-M
art
Sto
res
139
49
na
G
ener
al m
erch
andi
sers
8E
xxon
101
9365
9P
etro
leum
ref
inin
g9
Gen
eral
Ele
ctric
100
356
331
Ele
ctro
nics
el
ectr
ical
equ
ipm
ent
14In
tl B
usin
ess
Mac
hine
s82
8653
7C
ompu
ters
of
fice
equi
pmen
t25
US
Pos
tal
Ser
vice
6055
n
a
Mai
l pa
ckag
e a
nd f
reig
ht d
eliv
ery
27P
hilip
Mor
ris58
6051
1T
obac
co29
Boe
ing
5637
n
a
Aer
ospa
ce30
AT
ampT
5460
219
Tel
ecom
mun
icat
ions
40M
obil
4843
597
Pet
role
um r
efin
ing
41H
ewle
tt-P
acka
rd47
3451
1C
ompu
ters
of
fice
equi
pmen
t50
Sea
rs R
oebu
ck41
38
na
G
ener
al m
erch
andi
sers
55E
I d
u P
ont
de N
emou
rs39
40
na
C
hem
ical
s61
Pro
ctor
and
Gam
ble
3731
477
Soa
ps
cosm
etic
s75
Km
art
3414
n
a
Gen
eral
mer
chan
dise
rs81
Tex
aco
3229
453
Pet
role
um r
efin
ing
82B
ell
Atla
ntic
3255
n
a
Tel
ecom
mun
icat
ions
85E
nron
3129
n
a
Ene
rgy
87C
ompa
q C
ompu
ter
3123
n
a
Com
pute
rs
offic
e eq
uipm
ent
89D
ayto
n H
udso
n31
16
na
G
ener
al m
erch
andi
sers
94J
C
Pen
ney
3124
n
a
Gen
eral
mer
chan
dise
rs96
Hom
e D
epot
3013
n
a
Spe
cial
ty r
etai
lers
97Lu
cent
Tec
hnol
ogie
s30
27
na
E
lect
roni
cs
elec
tric
al e
quip
men
t10
0M
otor
ola
2929
n
a
Ele
ctro
nics
el
ectr
ical
equ
ipm
ent
Institute for International Economics | httpwwwiiecom
THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 93
Jap
an
5M
itsui
109
5635
8T
radi
ng6
Itoch
u10
957
333
Tra
ding
7M
itsub
ishi
107
7536
9T
radi
ng10
Toy
ota
Mot
or10
012
540
0M
otor
veh
icle
s an
d pa
rts
12M
arub
eni
9455
300
Tra
ding
13S
umito
mo
8946
259
Tra
ding
18N
ippo
n T
eleg
raph
amp T
elep
hone
7614
7
na
Tel
ecom
mun
icat
ions
20N
issh
o Iw
ai68
3938
8T
radi
ng24
Hita
chi
6282
214
Ele
ctro
nics
el
ectr
ical
equ
ipm
ent
26M
atsu
shita
Ele
ctric
Ind
ustr
ial
6067
332
Ele
ctro
nics
el
ectr
ical
equ
ipm
ent
31S
ony
5353
628
Ele
ctro
nics
el
ectr
ical
equ
ipm
ent
33N
issa
n M
otor
5158
511
Mot
or v
ehic
les
and
part
s38
Hon
da M
otor
4943
641
Mot
or v
ehic
les
and
part
s48
Tos
hiba
4151
252
Ele
ctro
nics
el
ectr
ical
equ
ipm
ent
51F
ujits
u41
4332
6C
ompu
ters
of
fice
equi
pmen
t52
Tok
yo E
lect
ric P
ower
4012
2
na
Util
ities
ga
s an
d el
ectr
ic60
NE
C37
42
na
E
lect
roni
cs
elec
tric
al e
quip
men
t90
Tom
en31
18
na
T
radi
ng99
Mits
ubis
hi E
lect
ric30
35
na
E
lect
roni
cs
elec
tric
al e
quip
men
t
Ch
ina
73S
inop
ec34
52
na
P
etro
leum
ref
inin
g
Tot
al (
aver
age
for
tran
snat
iona
lity
inde
x)3
988
447
949
0T
otal
for
G-1
0 (a
vera
ge f
or t
he i
ndex
)3
954
442
749
0
na
= n
ot a
vaila
ble
G-1
0 =
Gro
up o
f T
en c
ount
ries
see
not
e to
tab
le 1
1
a
Dat
a sh
own
are
for
the
fisca
l ye
ar e
nded
on
or b
efor
e 31
Mar
ch 1
999
b
Ass
ets
show
n ar
e th
ose
at t
he c
ompa
nyrsquos
fis
cal
year
-end
c
The
ind
ex o
f tr
ansn
atio
nalit
y is
cal
cula
ted
as t
he a
vera
ge o
f ra
tios
of f
orei
gn a
sset
s to
tot
al a
sset
s f
orei
gn s
ales
to
tota
l sa
les
and
for
eign
em
ploy
men
tto
tot
al e
mpl
oym
ent
as o
f 19
97 (
UN
CT
AD
)
Sou
rces
F
ortu
ne G
loba
l 50
0 1
999
http
w
ww
pat
hfin
der
com
fort
une
glob
al50
0in
dex
htm
l U
NC
TA
D (
1999
)
Institute for International Economics | httpwwwiiecom
94 WORLD CAPITAL MARKETS
foreign direct investment The ldquotransnationality indexrdquo (table 28) showsthat on average they conducted about half their business outside theirhome country9
Overview of the Players
Our review of the major players points to two major features First ahandful of big playersmdashfewer than 200 firms all toldmdashcontrol the ac-tion in international capital markets Their dominance will doubtless erodebut for now financial power is strikingly concentrated with them Sec-ond the big players are overwhelmingly based in the G-10 countriesplus Spain The responsibility to supervise them rests not in the IMFnor in Basel but squarely in Washington London Tokyo and the otherG-10 capitals At year-end 1999 the G-10 countries plus Spain accountedfor 84 percent of world banking assets 86 percent of world stock marketcapitalization and 76 percent of international debt securities (BIS 2000aWorld Bank 2000b)
International private capital flows are of three types bank loans anddeposits portfolio investment and foreign direct investment In cumula-tive total flows to emerging markets FDI was the biggest story in the1990s amounting to $954 billion (table 12) Portfolio flows were nextcumulatively amounting to somewhere between $612 billion (table 12)and $764 billion (table A1) Bank loans and deposits are the most com-plicated story
The Key Role of Banks
Banks are more important as an epicenter than as a wellspring Banksgenerate waves in the flow of capital to emerging markets rather than acontinuous steady stream According to data compiled by the Institute ofInternational Finance (table A1) net bank lending to emerging marketscumulated to $269 billion in the 1990s However deposits by emerging-market residents in G-10 banks more than offset G-10 bank lending tothese countries during the decade According to IMF data cumulativebank loans net of deposits amounted to a negative $135 billion (table 12)
In other words when loans and deposits are combined net bank ac-tivity that moves financial resources to emerging markets is small incomparison with portfolio investment and FDI But bank loans are thelubricant of any financial system Depending on circumstances bankscan be shock absorbers or shock propagators In recent decades with
9 The transnationality index is calculated as a simple average of the share of assetssales and employees outside the home country
Institute for International Economics | httpwwwiiecom
THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 95
respect to emerging markets banks have more often been propagatorsthan absorbers The average annual swing in bank lending to emergingmarkets was nearly $50 billionmdashby far the largest source of year-to-yearfluctuations in capital flows Both interbank loans between Europe Japanand Asia and sovereign Russian debt used as loan collateral played amajor role in the 1997-98 crisesmdashnot because banks are profligate playersbut because of the incentives they face and the instruments they useAccordingly our story begins with banks
Banks in the Modern Financial System
10 See Levine (2000) for a concise description of the role of banks in the financial system
11 The asymmetric information problem helps to explain why banks dominate the im-mature financial systems of emerging-market economies The general lack of informationon borrowers and undeveloped legal systems to enforce contracts hamper suppliers oflong-term financial instruments such as equities and bonds in evaluating risk and re-ward Banks are best suited in these circumstances to solve the asymmetric informationproblem by evaluating and monitoring private loans As more and better informationbecomes available capital markets develop and financial systems mature
As we noted in the previous paragraph the problem of financial volatil-ity in emerging-market economies is associated with bank lending Ifand when repayment problems arise cross-border private bank loansand bond placements are such that private creditors have no plausiblemeans of seizing assets from either private or sovereign borrowers Thusalthough international finance can nourish entrepreneurs and accelerategrowth a necessary complement may be a drastic creditor response inthe event of nonpaymentmdashto withhold fresh funds and force an eco-nomic crisis (Dooley 2000)
This argument is based on the characteristics of banks They are notldquobadrdquo per se They perform three essential functions in any financialsystem pooling the resources of disparate savers and channeling these re-sources into productive investment improving resource allocation throughtheir expertise in assessing and monitoring borrowers and facilitatingthe division of risk among numerous creditors10 But by their very na-ture banks are prone to two problems asymmetric information (the bor-rower knows more about the potential risk and return of its projectsthan the bank) and adverse selection (riskier borrowers will pay higherinterest rates and thus may constitute a disproportionate share of bankloan portfolios)11
Bank loans are illiquid fixed-price instruments They cannot easily beconverted to cash although they can be bundled into securities (knownas ldquosecuritizationrdquo) Once loan terms have been agreed on the only waya bank can adjust for shifting market conditions is by changing the quantityof its exposure When a borrower runs into trouble the bank can mix
Institute for International Economics | httpwwwiiecom
96 WORLD CAPITAL MARKETS
and match from two unpleasant menus It can roll over existing loansand extend new credit or it can call some part of existing loans andattempt to recover the principal It can also hedge by selling short otherclaims on the borrower These choices entail either an unwelcome exten-sion of the bankrsquos exposure or credit rationing against the borrower Whentrouble brews all banks encounter the same conditions in the aggregatethey prefer less exposure and ensuing credit restrictions lead to volatilebank lending
Innovation
12 Derivatives have no value of their own They ldquoderiverdquo their value from the value ofthe underlying asset They include swaps futures (contracts for future delivery at speci-fied prices) and options (which give one party the right but not the obligation to buyfrom or sell to a counterparty at an agreed price)
13 Maxfield (1998) analyzed available evidence of emerging-market investor objectivesmost of it before the crisis Analysis of portfolio equity flows is sensitive to the choice ofperiod with year-over-year data indicating that investors respond to country ldquofundamen-talsrdquo Other evidence suggests more ambiguity Ranking by ldquoinvestor impatiencerdquo ie thesearch for yield over value Tesar and Werner (1995) find short-term bank flows to be themost yield driven followed by portfolio investment FDI and long-term bank lending
14 Because market risk credit risk and country risk interact in complex ways newfinancial instruments have been created to help reduce negative interactions One is theldquototal return swaprdquo which has become an instrument of choice for hedge funds lookingfor high leverage Banks also use the total return swap to cover risks without increasingtheir capital requirements
Since the 1980s national and international banking systems have beentransformed by deregulation intensified competition and the informationand communications-technology revolutions The market environment isone of intense competition particularly in traditional banking activitiesThe innovations point away from traditional activities of plain vanilladeposit taking and loan making Three big themes are discernible Firstthe walls separating commercial banks investment banks portfolio man-agers and insurance firms are falling even if they are still distinct Sec-ond large banks are shifting toward securitizationmdashcreating securitiesout of everything from credit card debt to trade finance to disaster insur-ancemdashand earning fees in the process Third all large banks are shiftingtoward trading activity making markets and taking short-term stakes inbonds shares and derivatives12 These activities when successful satisfythe search for higher yields13
Many of the new financial instruments that banks trade are ldquooff bal-ance sheetrdquo This means that banks are not required to allocate capitalagainst them In swap contracts for example neither side pays cash at theoutset and therefore neither party has an asset in the traditional sense14
Futures and options contracts can be written with a relatively small initial
Institute for International Economics | httpwwwiiecom
THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 97
margin relative to the potential risk Credit derivatives limit credit risk bytransferring the potential loss associated with corporate loans and bondssovereign debt and other loan portfolios to counterparties15
Deregulation and innovation working in combination seem to havepushed banks into trading activity and leveraged plays but not into shareownershipmdasheven in jurisdictions that have no prohibition against equitystakes Among the G-10 banking systems the highest ratio of share own-ership to assets was only 5 percent in 1996 reached in Germany andJapan (Berlin 2000)16
The wave of innovation in financial instruments and the accompany-ing expansion of banking beyond its old boundaries is a two-edged swordOn one side it allows risk management far beyond what was tradition-ally possible Risk can now be shifted from firms that can ill afford lossesto those that can Banks can profitably act as intermediaries in shiftingrisk On the other side the innovation wave creates huge opportunitiesfor leveraged plays fostering a speculative search by banks themselvesfor high returns that in turn magnify their own risks17
15 Credit derivatives include total return swaps credit default swaps credit-linked notesand collateralized debt obligations They are the fastest-growing sector of the global de-rivatives market
16 Banks seem to specialize in lending even when they are allowed to mix finance andcommerce for reasons related both to how they are expected to behave with distressedfirms and to other intricacies of lender liability (Berlin 2000) Yet a recent cross-countrystudy found that restrictions on banking and commerce are associated with greater fi-nancial instability (Barth Caprio and Levine 2000)
17 Leverage is the magnification of the rate of return (positive or negative) on an in-vestment beyond the rate obtained by solely investing funds owned by the institution Itis often defined as the ratio of assets to equity Leverage is achieved by increasing thesize of an investment by borrowing or using derivative instruments such as futures oroptions These allow investors to earn a return on the notional amount underlying thecontract by committing a small portion of equity in the form of a margin deposit oroption premium payment
18 In a repo (repurchase agreement) one party (typically a trader) buys a bond andsells it to a dealer for cash with a promise to buy it back the next day at the same priceplus the overnight interest rate As long as the overnight interest rate is lower than theinterest accruing on the bond the trader earns some income on the bond The extremeform of these kinds of transactions was discovered at LTCM the failed US highly lever-aged institution which appears to have controlled more than $120 billion in assets froman investment of about $3 billion This leveraging was accomplished mostly through theuse of repos (Mayer 1999)
The potential for damage is illustrated in an extreme form by figure 21To precisely measure a firmrsquos leverage all positions must be known andrealistically valuedmdashwhich may be impossible to do Because many ac-tivitiesmdashsuch as repos18 and derivativesmdashdo not appear on the institutionrsquos
Leverage
Institute for International Economics | httpwwwiiecom
98W
OR
LD
CA
PIT
AL
MA
RK
ET
S
Figure 21 Hypothetical example of leverage
$1000 notional value of call option on equity in firms targeted for takeover
Repo FRN into cash and use cash to pay option premium
(repro is initially collateralized
Borrow $100 for margin purchase
$125 of US investment bank floating-rate notes (FRN) (secured by $25 equity in FRNs)
Repo off-the-run bond into cash and post margin
(repo is initially collateralizedSell (short) Borrow on-the-run bonds worth $20
$25 worth of off-the-run bonds (secured by $5 equity in bonds)
Exchange into $4
Cash $5 yen400 Japanese bank loans
$1 equity base
FRN = floating rate notesRepo = repurchase agreement
Source IMF (1998)
Institute for International Econom
ics | httpww
wiiecom
THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 99
balance sheet and because balance sheets are published quarterly at bestoutsiders have a difficult time assessing the extent of a firmrsquos leverage19
Leveraging by a single firm enhances its risk of default the widespreaduse of leverage in the financial system can magnify market adjustmentsespecially when they require ldquodeleveragingrdquomdashunwinding prior positionsRapid adjustments can cause credit to dry up and asset prices to plummetIn a mark-to-market environment falling asset prices trigger calls foradditional collateral that can ripple through markets
Risk Management
Because it is confronted with the widespread use of leverage and prolif-erating kinds of risk international finance is increasingly driven by riskevaluation and control20 Different institutions face various risk profilesand differing kinds of risk The most common risks can be quickly tickedoff Banks because of their traditional intermediary role of channelingthe resources from savers to borrowers face significant credit risk therisk of default or delay in the payment of principal and interest Theymust also manage market risk the risk that the prices of their liabilitiesmay change faster than their assets Market risk devastated US savingsand loan institutions in the late 1980s
Closely associated with market risk are interest-rate risk (unexpectedchanges in market interest rates that slash margins net income and theeconomic value of a bankrsquos equity) and foreign exchange risk (losses thatarise when assets denominated in an appreciating foreign currency areless than liabilities denominated in that currency) Banks make numer-ous loans to other banks around the world portfolio investors buy se-curities direct investors acquire fixed assets and all incur country risk(economic and political uncertainty in the host country) During the heightof the Asian crisis for example interbank loans to Japanese banksreflected the credit risk of lending to these banks the so-called Japanpremium
Substantial attention has been lavished on country risk analysis sincethe 1982 debt crisis in developing countries Yet in spite of this exper-tise the Asian crisis occurred in part because of a sudden upward reap-praisal of country risk after the Thai baht collapsed in April 1997 Banksand other financial institutions must also manage liquidity risk the riskthat market conditions will change unexpectedly depressing demand andprices of assets at the time they want to sell these assets And they mustmanage operational riskmdashfailures in control systems or people that cause
19 Another example of asymmetric information Both risk and leverage are difficult foroutsiders to assess without full timely disclosure
20 A longer discussion of these issues can be found in Managing Global Finance in IMF(1999c)
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100 WORLD CAPITAL MARKETS
financial loss or damage reputations Operational risk devastated BaringsBank in 1995
Financial institutions practice risk management to measure all theserisks the potential damage to their investment positions and ultimatelythe chance of becoming insolvent VAR (value at risk) risk models mea-sure subject to certain assumptions the amount of the firmrsquos capital thatis exposed in each period For example the VAR model might say thatin a 3-standard-deviation worst case (a case that is not supposed to hap-pen more than 1 percent of the time) the firm will loose 25 percent of itscapital during the next year
VAR models are widely used but like all models they have weak-nesses They rely on past values to estimate key variables in financialmarkets past values are not always good predictors of future risks More-over rising volatility and higher loss correlation among different assetclasses in a portfolio will cause all banks using these models to reducetheir exposures at the same time by switching to less volatile and lesscorrelated assets such as US Treasury bills (Persaud 2000)
Newer risk models entail stress testing and scenario analysis Scenarioanalysis envisages possible adverse changes one at a time that mightaffect the investment portfolio Stress testing estimates potential losseswhen several individual risk factors simultaneously move against thefirm but it too uses historical probabilities
Financial Volatility
21 For example derivative markets usually rely on underlying securities markets thatproduce continuous prices When these markets are interrupted financial shocks cantrigger a cascade of margin calls and sell orders that move prices very sharply
22 See IIF (1999a)
The combination of trading activity and modern risk management lie atthe root of financial volatility When risks increase banks must eitherraise more capital to cover the greater risk or reduce their exposure bycutting loan exposure by selling securities or by undertaking new de-rivative trades Raising more capital is time-consuming and in a crisisvery expensive because bank shares are depressed So banks look to theother alternatives If the bank can reduce lending it need not book aloss But most banks use the same VAR models and as indicated abovethese models will encourage them to reduce their outstanding loans atthe same time actually magnifying loan volatility
If banks attempt to reduce their exposure to risk by selling securitiesor undertaking new derivative trades they may trigger large priceshocks because of limited and shrinking market liquidity21 The liquid-ity problem is compounded when a small number of large institu-tions hold the same positions22 Take your pick loan volatility or price
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 101
volatility As two experts have observed (Folkerts-Landau and Garber1998)
[V]olatility even in one country will automatically generate an upward re-estimate of credit and market risk in a correlated country triggering automaticmargin calls and tightening of credit lines Thus apparently bizarre opera-tions that connect otherwise disconnected securities markets are not the re-sponses of panicked green screen traders arbitrarily driving economies from agood to a bad equilibrium Rather they work with relentless predictability andunder the seal of approval of supervisors in the main financial centers
23 See Ferguson (1999)
24 As Gerald Corrigan (1982) put the matter ldquoBanks are specialrdquo Corrigan (2000) reit-erated this view even after all the changes of the past two decades Unlike other institu-tions banks offer on-demand transactions are a backup liquidity source for other insti-tutions and serve as a ldquotransmission beltrdquo for monetary policy
These changes in the banking environment accentuate an existing anomalyThe anomaly is that banks even as they grow larger and increasinglyengage in more risky and complex transactions are perceived to enjoyimplicit and explicit public guarantees
The guarantees grow out of an incentive problem inherent in bankingasymmetric information which we mentioned above Depositors know lessabout a bankrsquos management and the quality of its balance sheet than doits managers and shareholders Thus in times of uncertainty or adver-sity bank depositorsmdashuncertain whether they will have access to theirdepositsmdashare prone to bank runs This prospect has in turn compelledgovernments to treat banks differently than other firms because a bankthat fails can disrupt the rest of the economy24
To prevent such crises governments have entered into quid pro quoarrangements with banks Governments provide them both with an im-plicit safety net in the form of an unstated promise by the central bankto act as a lender of last resort in a liquidity crisis and an explicit safetynet in the form of a public deposit insurance fund to reassure depositorsIn return the banks submit to closer government oversight and regu-lation of their activities than is usual for industries in the private sector
The ldquoinsurancerdquo provided by the public safety net contributes to an-other incentive problem moral hazard Banks acquire greater tastes forrisk and face less market discipline than other firms The explicit depositinsurance safety nets actually have or are perceived to have blanketcoverage that extends beyond the retail depositors (households and small
One of the lessons of the 1997-98 crisis must surely be that market par-ticipants and their regulatory supervisors relied too heavily on quantita-tive tools and insufficiently on judgment23
The Anomaly of Modern Banking
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102 WORLD CAPITAL MARKETS
businesses) for which they were originally intended The implicit centralbank safety nets extend in a crisis to nearly all depositors and banksThus banks are both viewed and behave as if they will be bailed out ifthey get into trouble
The existence of a public safety net raises a perennial question Dobanks have an unfair advantage over other financial institutions becauseof the subsidy provided by the safety net This question was at the heartof intensive study and debate in the United States leading up to thepassage in November 1999 of the Financial Services Modernization Act(also known as the Gramm-Leach-Bliley Act) The size of the gross sub-sidy is difficult to estimate despite determined research efforts Somesuggest it is well under 100 basis points and is at least partly offset bythe direct costs of deposit insurance premiums interest payments on bondsissued by the Financing Corporation25 reserve requirements regulatoryexpenses and operational costs associated with collecting deposits26 Con-versely Kwast and Passmore (2000) suggest that banks can expand theirscope far beyond the levels that other financial institutions could reachwith the same equity base but without the public safety net
A related concern in the US debate is whether allowing banks to ex-pand their activities into securities and insurance will ultimately extendthe safety net and add to the subsidy The Financial Services Moderniza-tion Act deals with this issue by maintaining a legal separation betweenbanks and the rest of the banking organization known as large com-plex banking organizations (LCBOs) They must engage in most securi-ties activities and insurance underwriting through separately capitalizedinvestment bank subsidiaries or holding company affiliates This act canbe said to have merely brought US banking laws closer to those of mostother industrial countries (Barth Brumbaugh and Wilcox 2000 BarthNolle and Rice 2000) If the fire wall is well-maintained and stoutly de-fended the safety net will neither expand in practice nor become a sourceof comfort to noncommercial bank subsidiaries of LCBOs
The quid pro quo exacted by governments to offset the subsidy iscloser public-sector monitoring of banksrsquo activities through prudentialsupervision The effectiveness of this closer official scrutinymdashand closermarket monitoringmdashare the subjects of the next section
25 The Financing Corporation was created by Congress in 1987 to sell bonds to raisefunds to help resolve the savings and loan crisis
26 See Levonian and Furlong (1995) Jones and Kolatch (1999) Shull and White (1998)and Whalen (1999a 1999b)
Are G-10 bank supervisors adequately responding In this section we firstassess the case for and compare the structures of prudential supervisory
Prudential Supervision
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 103
systems both within and among the G-10 economies plus Spain andconsider whether these offset the subsidy provided by the public safetynet Despite offsetting regulation and supervision implicit and explicitguarantees by G-10 governments to their banks are still a source of bank-ing instability in the emerging-market economies
National Systems for Prudential Supervision
Governments use prudential supervision to reduce the moral hazard andadverse selection created by their own safety nets Supervisors establishregulations and monitor compliance to limit risk taking and ensure thesafety and soundness of the banking system In a thoughtful analysis ofthe case for prudential supervision Frederic Mishkin (2000) identifiesthe main forms that supervision can take including the tasks of grantingbanking charters and licenses establishing capital requirements settingdeposit insurance premiums and defining disclosure requirements as wellas carrying out bank examinations Bank examiners gather informationfrom banks and evaluate whether they are following the regulatorsrsquo rulesin cases of weakness they are empowered to change banksrsquo behaviorand close them if necessary
Supervisors also may restrict competition define the activities in whichbanks may engage and restrict their asset holdings and separate banksand other financial (or nonfinancial) activities During the past two de-cades the barriers separating commercial banks investment banks in-surance firms and securities firms have been all but eliminated (tableB1) Deregulation has stimulated competitive forces that drive diversifi-cation and consolidation of the financial industry nowhere faster than inthe United States
The Financial Services Modernization Act of 1999 confirmed this trendIt eliminated restrictions dating back to the Glass Steagall Act of 1933which once prevented banking insurance and securities firms fromentering each otherrsquos businesses (Barth Brumbaugh and Wilcox 2000)Cross-pillar mergers among banks insurance and securities firms arewell under way to form giant financial holding companies The 1999merger between Citibank (banking) and Travelers (insurance) created themodel for megafinance and confirmed new challenges for supervisors
Mishkin (2000) notes the corresponding evolution in US supervisionfrom an emphasis on rules-based regulation (detailed rules for opera-tional behavior and the quality of line items in the balance sheet) to anapproach that stresses the soundness of bank management practices es-pecially risk management
Appendix B outlines the systems of financial supervision now in theplace in the G-10 countries plus Spain Some systems like the UK andCanadian approach are models of simplicitymdashorganized to keep pacewith the spreading reach of financial conglomerates Other systems like
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104 WORLD CAPITAL MARKETS
the US and French approaches show traces of the bureaucratic divisionsthat made sense in an era when banking securities and insurance weresharply separated
The US Model
27 See Meyer (1999a)
28 Canada has a similar degree of simplification with the exception that securities firmsare still regulated by provincial authorities
29 See Pratti and Schinasi (1999 67)
30 The agents are the bank regulators and the principals are the taxpayers Agents maypursue their own interests including bureaucratic survival and postgovernment employ-ment opportunities rather than the national interest in banking safety and soundness
The US model of financial regulation delineated in the Financial Ser-vices Modernization Act of 1999 blends functional and umbrella super-vision Bank and thrift regulators oversee depository institutions Newnonbank activities are subject to both functional regulation (eg by theSecurities and Exchange Commission and state insurance examiners) andumbrella supervision (of financial holding companies) by the FederalReserve27
The UK Model
Another supervisory model exists in the United Kingdom as well as inAustralia Canada and Switzerland28 In this model banking supervisionis separated from the monetary policy function The regulatory structureis considerably simplified by relying on a consolidated financial regula-tor separate from the central bank for both banking and nonbankingactivities The remaining question answered differently depending on thecountry is the extent to which the regulator relies on home-country sur-veillance of banks and conglomerates that have a local presence
Regulatory Models Compared
Appendix B provides more detail on the differences in these modelsGerman simplicity contrasts with French complexity In France the bankingcommission is chaired by the governor of the central bank and includesrepresentatives from the Treasury The commission supervises compli-ance with regulations but the central bank inspects banks on behalf ofthe commission29 In countries such as the United States and France withmultiple supervisors and crossover functions internal coordination is criticalAt the same time multiple agencies create regulatory competition Wheneach agency knows what the other is doing transparency within gov-ernment circles can help to limit principal-agent problems of regulation30
The discussion as to where in the public bureaucracy financial super-
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 105
vision should be placed goes back many years Peek Rosengren andTootell (1999) argue that a synergy exists between monetary policy andprudential supervision because information gained in the course of super-vision can increase the accuracy of macroeconomic forecasts A twist tothis argument is that the information on the state of financial institutionsavailable to the central bank as supervisor can facilitate its role as lenderof last resort Conversely there is the concern that a supervisory rolewill compromise the central bankrsquos independence of action with respectto its core mandatemdashmaintaining price stability As these arguments haveplayed out financial supervision has generally been shared between centralbanks and other regulators or placed entirely in the hands of an inde-pendent regulator However in Italy the Netherlands and Spain cen-tral banks are the sole banking supervisor
Goodhart (1995) examined the arguments and evidence for each modeland concluded that there were no overwhelming arguments or evidencefor one or the other31 Going forward a key problem for any financialsupervisory system is dealing with (and closing as necessary) weak banksIf both central banks and other regulators have this responsibility closecoordination between them is critical Another problem is large conglom-erate banks LCBOs Although they are less likely to fail because of thediversification of their assets and liabilities they are more likely to berescued They are also more likely to be multinational enterprises withinternational implications Goodhart observes that regulation of theseentities might be put in the hands of the central bank because it is lessamenable to political pressures In any event the complexity of LCBOoperations suggests that greater supervisory rigor is necessary
The US Congress was persuaded that broad oversight would help containthe moral hazard problem and accordingly gave the Federal Reservethe role of umbrella supervisor with the understanding that the Fed willscrutinize depository activity more intensely than nonbank financial ac-tivities Under this approach LCBOs such as Citigroup are subject tomuch closer monitoring than smaller and simpler institutions32 The USregulatory model requires enormous cooperation between the Fed otherbank supervisors and the functional regulators for insurance and securi-ties but it also benefits from regulatory competition
31 National systems of supervision are path dependent they are determined by the struc-ture of financial institutions and history in each country If Goodhart (1995) is right out-comes are not materially better or worse with one model of supervision rather than another
32 See Ferguson (1999)
Public Safety Nets
One of prudential supervisorsrsquo biggest challenges is to reduce moral hazardFor many years commercial banks engaged in communal self-insurance
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106 WORLD CAPITAL MARKETS
to deal with crises They formed voluntary groups that agreed to rescuetroubled members As financial markets evolved and competition inten-sified banks were no longer willing to play this role Private-sector in-surance is one alternative but moral hazard and adverse selection wouldappear to prevent it from happening Public safety nets have developedbecause of the low probability and high cost of potential bank runs Aclear trade-off is involved The effectiveness of insurance in preventingbank runs is greater the more comprehensive the coverage But the morecomprehensive the coverage the greater the moral hazardmdashbank man-agers bank directors investors and depositors all take on greater risksin the belief that the safety net will protect them against losses
All G-10 countries have compulsory public safety nets for banks (table29) Deposit insurance agencies are officially organized in Canada theNetherlands Sweden Switzerland and the United States organized bythe industry in France Germany Italy and the United Kingdom andjointly organized by the public and private sectors in Belgium Japanand Spain
How well do G-10 governments offset the subsidy provided by thepublic safety net This is a question on which there is substantial debateAs banking organizations have become more complex the challengesthat supervisors face have become more difficult One challenge is toalign the incentives facing bank managers and shareholders with thoseof depositors Another is the principal-agent problem in supervision Wehave discussed the incentive structures for financial institutions but wehave said little about the incentives for supervisors themselves and thedistortions they can generate in the financial system
In one of the many studies of the US savings and loan crisis of the1980s Kane (1989) documented both problems He described managersusing cosmetic approaches to disguise the magnitude of insolvency regulatorspracticing forbearance even though they knew of the deteriorating riskprofiles of the institutions for which they were responsible and legisla-tors increasing deposit insurance without regard for any offsetting changesin supervision A subsequent overhaul of the legislative framework forthe Federal Deposit Insurance Corporation (FDIC) known as the FDICImprovement Act of 1991 (FDICIA) aimed to introduce a clearer incen-tive structure for both regulators and regulated institutions
The changes introduced by this US legislation are worth discussionwith respect to the other G-10 countries as well First FDICIA created astronger signal to management and investors by targeting deposit insur-ance at small depositors only and by risk-weighting the deposit insur-ance premiums paid by banks to reflect their capital adequacy and bankexaminer ratings Among the G-10 countries rated in table 210 depositinsurance premiums vary considerablymdashbut it is not clear that the dif-ferences have much to do with risk-weighting Most G-10 countries em-ploy funding formulas based for example on the total domestic deposit
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E P
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Table 29 Deposit insurance schemes in the G-10 countries Explicit safety net
Coverage limit(dollar Foreign
equivalent currency Interbank Source Bankrsquos Contingency fundingDate Membership Co- at end of deposit deposit of premium from banks
Country established managementa insuranceb July 1998)c covered covered Fundingd funding costs or governments
United 1982 Compulsory Yes Larger of 90 No No Unfunded Banks only Callable (subject Parliament may increase Kingdom private percent co- to maximum the maximum payable
insurance to 03 percent of pound125 million advance 33000 total deposits) facility with Bank of
England
United 1934 Compulsory No 100000 Yes Yes Funded Banks and Up to 027 Borrowing up to $3 States official government percent total billion from US Treasury
domestic deposits
Japan 1971 Compulsory No 71000 but No No Funded Banks and 0084 percent of Borrowing up to yen500bn joint in full until government insured deposits from Bank of Japan
year 2000 subject to Ministry of Finance approval
Canada 1967 Compulsory No 40800 No Yes Funded Banks and 033 percent of Borrowing up to C$6 official government insured deposits billion authorized further
(maximum) borrowing subject to parliamentary approval
Germany 1966 Compulsory Yes 90 percent Yes No Funded Banks only 003 percent of Annual levy may be private coinsurance deposits doubled
to 22000
Italy 1987 Compulsory Yes 125000 Yes No Unfunded Banks and Callable Two options defer private government (maximum of payment or diminish
1 percent of compensation to be paid total deposits)
(table continues next page)
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108W
OR
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CA
PIT
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MA
RK
ET
S
Table 29 Deposit insurance schemes in the G-10 countries Explicit safety net (continued )
Coverage limit(dollar Foreign
equivalent currency Interbank Source Bankrsquos Contingency fundingDate Membership Co- at end of deposit deposit of premium from banks
Country established managementa insuranceb July 1998)c covered covered Fundingd funding costs or governments
Netherlands 1979 Compulsory No 22000 Yes No Unfunded Banks and On demand Government backing official government maximum of subject to parliamentary
5 percent of own approval funds
France 1980 Compulsory No 65400 No No Unfunded Banks only Callable (on Extra calls up to FFr1000 private demand calls million can be made in
up to FFr200 a 5-year period million)
Switzerland 1984 Voluntary No 19700 No No Unfunded Banks only Callable (on Underwritten by member official demand) banks
Sweden 1996 Compulsory No 31400 Yes No Funded Banks and 05 percent of Full emergency coverage official government deposits while replacing it with a
limited system after the emergency
Belgium 1974 Compulsory No 16600 No No Funded Banks and Callable 002 None insurance limited joint 22000 in government percent of to assets in fund
year 2000 deposits from clients
Spain 1977 Compulsory No 16439 Yes No Funded Banks and 02 percent of Government backing joint government deposits through the Banco de
(maximum) Espantildea subject to approval by royal decree
a Bank membership in the fund can be either compulsory or voluntary and the management of the fund can be official and official and private joint or privateb Coinsurance refers to the situation where depositors face a deductible against their insured fundsc Coverage limit refers to the explicit amount the authorities promise to insured Funded scheme means that it is funded ex ante unfunded otherwise
Sources Goodhart (1995) Demirguccedil-Kunt and Detragiache (2000) Demirguccedil-Kunt and Sabaci (2000)
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 109
base Explicit safety net protection also varies but only Canada focuseson the protected class33 All G-10 countries specify a limit on depositorprotection Under FDICIA the insurance fund is prohibited from pro-tecting uninsured depositors or creditors at a failed bank although adiscretionary system-wide override is provided for exceptional circum-stancesmdashbut with stringent requirements for consultation and account-ability Other G-10 countries allow for contingency funding from the publicpurse alongside unwritten lender-of-last-resort support Among large banksa significant and growing portion of deposit liabilities including foreigncurrency and interbank deposits are uninsuredmdashbut depositors assumethey will be protected in a crisis
FDICIA also made some significant qualitative changes to address theprincipal-agent problem by penalizing weak banks and rewarding strongbanks For example banks whose capital declined faced progressivelytougher regulatory sanctions that for example required them to elimi-nate dividends restrict their lending and change their managementsRegulators have also been forced to take prompt corrective action (toreduce the practice of regulatory forbearance in hopes that a bankrsquos for-tunes might improve)34 Unfortunately comparative qualitative assess-ments across the G-10 are difficult to make due to lack of information35
This discussion highlights the complexity of evaluating the extent towhich prudential supervision and market discipline reduce the moralhazard associated with G-10 safety nets Our argument is that publicsafety nets in the G-10 can be linked to banking instability in other coun-tries specifically in the emerging-market economies that have attractedG-10 cross-border bank lending This lending is a leading source of vola-tility in capital flows the large financial institutions many of which arecomplex banking organizations are based in and regulated by authori-ties in the G-10 economies These two features of the international finan-cial system are closely related although it is not possible to test thisrelationship econometrically
Two World Bank studies however indicate a basis for concern Onestudy is a cross-country econometric analysis of the relationship betweenbank stability and deposit insurance (Demirguccedil-Kunt and Detragiache2000) which found a negative relationship Their estimated model forbanking crises in a sample of 61 countries (both industrial and develop-ing) suggests that explicit deposit insurance raises the probability of acrisis by at least 30 percent36 Crises are especially likely in countries
33 Japanrsquos legislation says it does but recent experience shows this is not the case34 See Goldstein (1997) for a summary of the changes35 See Barth Nolle and Rice (2000) for a beginning in this area36 Demirguccedil-Kunt and and Detragiache (2000 table 1) report a logit coefficient of 0696with a standard error of 0397 (the coefficient is significant at the 8 percent threshold)This suggests that the ldquotruerdquo coefficient could well be as small as 030 (the reportedvalue minus the standard error)
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110 WORLD CAPITAL MARKETS
with immature financial supervisory systems (and not in the G-10) buttheir analysis does underscore the view that deposit insurance weakensmarket discipline37
An earlier World Bank analysis established similar results One wasthat market discipline is undermined by deposit insurance schemes an-other was that illiquid banks are forced to pay more for their funds un-less a generous deposit insurance scheme is in place (Demirguccedil-Kuntand Huizinga 1999) This econometric study also provides clear-cut evi-dence that depositor monitoring of banks declines with the existence ofdeposit insurance schemes At the heart of the problem is the questionof whether deposit insurance is accompanied by increased governmentmonitoring
This evidence and the weight of other arguments suggests that moralhazard is still an issue in the G-10 countries Consider the ongoing de-bate about instilling greater market discipline on risk taking by banksAt one extreme is the perennial proposal to do away with safety netsleaving markets to monitor the players and to force adjustments but toprotect small savers by creating ldquonarrow banksrdquo such as postal savingsystems that are allowed to invest these savings only in risk-free gov-ernment securities Whatever the merits of narrow banking this solutionis too extreme to be politically feasible
A moderate alternative is to force more disclosure by financial institu-tions to facilitate market monitoring But transparency has its own prob-lems Persaud (2000) argues that financial markets cannot reliably discernsustainable from unsustainable positions in the short term This uncer-tainty causes banks to ldquoherdrdquo behind market leaders to exploit theirsupposedly superior information ldquoThe more herding investors and bankersknow about what each other is up to the [more] unstable markets maybecomerdquo The implication is that greater transparency in the marketplaceby itself will not solve the problemmdashand in the short term more informa-tion may exacerbate herding Further supervisory steps (discussed in thenext chapter) are required
Yet another proposal is to promote private-sector involvement in bankmonitoring through market-based alternatives such as Calomirisrsquos sub-ordinated debt proposal (Calomiris 1997 Federal Reserve Board 1999)Banks could be required to issue and maintain a minimum amount of
37 Other findings in the Demirguccedil-Kunt and Detragiache (2000) study include thesepropositions The impact of deposit insurance on bank stability tends to be stronger themore extensive is the coverage offered to depositors when the scheme is funded andwhere the scheme is run by the government rather than by the private sector Con-versely deposit insurance is detrimental to bank stability where bank interest rates havebeen deregulated and where the institutional environment is weak Additional findingson deposit insurance are reported from a recent World Bank conference (8-9 June 2000httpwwwworldbankorgresearchinterestconfsupcomingdeposit_insurancehomehtm)Also see Smalhout (2001)
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 111
subordinated debt (eg uninsured certificates of deposit) to finance asmall fraction (such as 2 percent) of their total nonreserve assets Thesubordinated debt would be allowed to earn a set yield no more than 50basis points over the risk-free yield on government treasury bills Thisrule would supposedly force banks to operate in a safe manner Other-wise subordinated debt holders would redeem their uninsured certifi-cates of deposit and equity investors would sell their bank shares Despiteits practical problems the beauty of the subordinated debt requirementis that it enlists market incentives to push banks to avoid excessive port-folio risk38
The thrust of these proposals is very relevant to the arguments in ourstudy Even in the G-10 countries government monitoring by itself hasnot eliminated moral hazard among banks More work is needed to in-troduce market monitoring and to improve the incentive structures bothfor financial institutions and their supervisors We return to this issuewith our recommendations in the next chapter
38 In late 1996 Argentina began requiring its banks to finance 2 percent of total depos-its in the form of subordinated debt but without a maximum yield provision TheArgentine authorities expect that market discipline will act in concert with the publicsafety net One obvious problem with the subordinated debt proposal is that banks mayencourage some of their customers to buy the subordinated debt
Portfolio Institutions Tomorrowrsquos Problem
Before proceeding to the issues of international supervision we flag an-other potential problem for national regulators The big asset managersprofiled in tables 24 and 26 answer to diverse groups of pensionersshareholders and policyholders They allocate funds across a number ofcountries to diversify their risks They hold liquid assets that can be tradedand they have a higher proportion of long-term assets than banks Eco-nomic shocks can be absorbed through price changes and their effectsspread across time and markets Thus when conditions change in a par-ticular market they are more likely to ride out the storm than to flee Inother words they have less incentive than banks to pull their invest-ments in the face of adversity In the 1990s most large asset managersestablished a record of ldquoriding out the stormrdquo rather than ldquorunning withthe windrdquo although as we saw in chapter 1 instances of running withthe wind were detected in some portfolios As we write these insti-tutions have a good record overall in the emerging markets so whyworry
The Russian crisis and the near-collapse of LTCM previewed the dan-gers that may await future portfolio managers and G-10 financial minis-ters We have presented evidence indicating a systemic bias toward bank
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112 WORLD CAPITAL MARKETS
lending and debt finance to emerging markets and we have argued forsubstitution toward equity finance and direct investment39
That is not the end of the story We noted in the previous chapterthat institutional investors can become momentum investors selling in adownturn As more portfolio capital is invested in emerging marketssome players may adopt the high-risk high-leverage strategies of themost aggressive hedge funds Indeed the data in box 11 show that G-10portfolio investors held somewhat more long-term debt (more than $500billion) than equity (less than $400 billion) in emerging markets at theend of 1997 Long-term debt is an ideal vehicle for high-risk high-leveragestrategies These strategies practiced on a large scale could compound afuture crisis harming emerging markets A big enough crisis could inturn pressure G-10 central banks and finance ministers to arrange bail-out plans Instead of shrinking as a systemic financial problem moralhazard could increase
National securities regulators are the first line of defense against thisscenario They play a critical role in the safe evolution of capital mar-kets But regulators today are mandated to approve the issuance of newsecurities and to monitor the continuing disclosure of material informa-tion by issuers They are far less concerned with or empowered to monitorthe behavior of the increasingly large wealth-management firms that arethe major purchasers (and therefore resellers) of these securities
Within their mandates the goals of national securities regulators (table210 and appendix B) are similar to the concerns of bank regulators withsystem safety and soundness Their focus is also on the incentive sys-tems for management and boards of directors and on disclosure by cor-porations that issue marketable securities such as shares bonds andasset-backed securities 40 Issuers of securities possess greater knowledgeabout the quality of these assets than do the purchasers hence investorprotection is a key concern of regulators Moreover market disciplineworks best when markets know what is happening Well-functioning corpora-tions are key agents of wealth creation and social progress Underperform-ing corporations waste resources During recessions bad corporationsget into bad trouble often with severe social consequences Inadequateincentives for managers and inadequate accountability for boards andmanagers thus have negative externalities Regulators play a vital role inexposing weakness so that market disciplines come to bear sooner ratherthan later
Regulatory emphasis is constantly shifting as financial markets evolveand as the macroeconomic environment changes Regulators try to balance
39 See Rogoff (1999) Also see Berlin (2000) for a perspective on the limited role thatbanks play as share owners
40 See Habib and Ljungqvist (2000) for recent empirical analysis showing that corporateshare market values are higher when corporate executives have a larger ownership stake
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E P
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113
Table 210 Financial-sector regulation G-10 countries 2000
Financial institutions and their supervisors
Country and supervisory structure Retail banking Wholesale banking Securities Insurance
Financial conglomeratesFinancial Services Authority (FSA) = umbrella supervisor
United Kingdom FSA FSA FSA FSA
Treasury bull Commercial banks bull Investment funds (Securities and (Insurance Directorate(Securities and Investments Board) bull Unit trust groups Futures Authority) of the Treasury)
Bank of bull Building societies bull Pension funds England (Building Societies Commission) bull Merchant banks
bull Friendly societies bull Clearing houses bull Primary issuers bull Insurance FSA (Friendly Societies Commission) bull Venture capital of securities companies
bull Pensions and life insurance etc bull Stock exchanges bull Insurance brokers(Personal Investment Authority) bull Stockbrokers
Financial holding companiesFederal Reserve (FR) = umbrella supervisor
United States bull National banks(OCC) Securities and Regulated by
Treasury OCC bull State banks Federal Reserve Exchange Commission StatesMembers (FR)
OTS Nonmembers (FDIC) bull Investment banks bull Primary issuers of bull Insurance companies FR bull Cooperative banks (FDICFR) bull Finance companies securities bull Insurance brokers FDIC bull Insured industrial banks (FDIC) bull Stock exchanges
bull Thrift holding companies (OTS) bull Stockbrokers SEC bull Savings banks (OTSFDICFR) bull Investment advisors
bull Savings and loan associations bull Mutual funds(OTS) bull Public utility holding
bull Edge Act corporations (FR) companies
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Table 210 Financial-sector regulation G-10 countries 2000 (continued )
Financial institutions and their supervisors
Country and supervisory structure Retail banking Wholesale banking Securities Insurance
Financial holding companies Japan Financial Supervisory Authority (FSA) = umbrella supervisor
Prime FSA FSA FSA FSA ministerrsquos Ministry of office Finance (Securities and Exchange
Surveillance Commission) FRC Bureau of Financial bull City banks bull Investment banks bull Primary issuers of bull Insurance companies FSA Regulation bull Regional banks bull Asset managers securities bull Insurance brokers
bull Trust banks bull Stock exchanges SESC bull Long-term credit banks bull Stockbrokers
bull Pension funds
Financial holding companiesOffice of the Superintendent of Financial Institutions (OSFI) = umbrella supervisor
Canada Regulated by OSFI OSFI provinces OSFI
Department of Financebull Banks bull Cooperative credit bull Primary issuers of bull Insurance companies
(previously Office of the Inspector associations securities (previously Depart- OSFI General of the Banks) bull Fraternal benefit bull Stock exchanges ment of Insurance) Bank of bull Trust and loan companies society bull Stockbrokers bull Insurance brokers Canada bull Pension funds bull Asset managers
(previously Depart- CDIC ment of Insurance)
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Financial institutions and their supervisors
Country and supervisory structure Retail banking Wholesale banking Securities Insurance
Germany Financial holding groupsFederal Banking Supervisory Office (FBSO) = umbrella supervisor
Ministry of Finance FBSO BSO FSSO FISO
Bundesbankbull Universal banks bull Other financial bull Primary issuers of bull Insurance companies
Federal Banking bull Savings banks institutions (eg securities bull Insurance brokers Supervisory Office bull Securities banks management foreign bull Stock exchanges
currency dealings) bull Stockbrokers Federal Securities bull Financial enterprises bull Asset managers Supervisory Office (eg leasing bull Pension funds
organizations Federal Insurance credit card companies Supervisory Office investment advisors)
Italy Bank foundationsMinistry of Finance = umbrella supervisor
Ministry of Finance Bank of Italy Bank of Italy Consob ISVAP
Bank of Italy bull Commerical banks bull Asset managers bull Primary issuers of bull Insurance companies Consob bull Savings bank bull Open-end investment securities bull Insurance brokers
bull Securities banks companies (SICAVs) bull Stock exchangesbull Stockbrokers
ISVAP
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Table 210 Financial-sector regulation G-10 countries 2000 (continued )
Financial institutions and their supervisors
Country and supervisory structure Retail banking Wholesale banking Securities Insurance
The Netherlands Financial conglomeratesCouncil of Financial Supervisors = umbrella supervisor
Securities Board Securities Board Netherlandsche Netherlands Bank Netherlandsche Bank of the Netherlands Insurance Board Bank Insurance bull Credit institutions (universal banks bull Investment institutions bull Stock exchanges bull Insurance companies Board cooperative banks security credit (securities issuing bull Stockbrokers bull Insurance brokers
institutions mortgage banks) and tradingmdashprimary The Council of Financial and secondary Supervisors markets)
France Commission des Commission de Operations des Controcircle des
Banking and Banking Commission Bourse Assurances Financial Regulatory bull Ensuring that credit institutions (and investment firms since bull Primary issuers of bull Insurance companies Ministry for Committee the Financial Activity Modernization Act of 1996) comply securities bull Insurance brokers Economic with laws and regulations bull Stock exchanges Affairs and bull Execute instructions regarding all off-site monitoring and bull Stockbrokers Finance Credit on-site supervision Institutions and Banking and Financial Regulatory Committee Investment bull Formulates general regulations for credit institutions and investment firms Committee (capital adequacy requirements accounting rules etc) Bank of France Credit Institutions and Investment Committee Banking bull Authorizes and examines financial institutions except for those within the Commission competence of the Banking Commission
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117
Financial institutions and their supervisors
Country and supervisory structure Retail banking Wholesale banking Securities Insurance
Switzerland Large banking groupSwiss Federal Banking Commission (SFBC) = umbrella supervisor
Swiss National Bank Federal Office of
SFBC SFBC SFBC Private Insurance Swiss Federal Banking Commission bull Universal banks bull Investment banks bull Primary issuers of bull Insurance companies
bull Savings banks bull Asset management securities bull Insurance brokerscompanies bull Stock exchanges
Private audit Federal bull Investment funds bull Stockbrokers firms Office of bull Mortgage bond authorized by Private business SFBC Insurance
Sweden Financial holding company groupsFinancial Supervisory Authority = umbrella supervisor
Ministry of Finance Credit Market Securities Market Insurance Market
Credit Market Department Department Department Department
Financial bull Commercial banks bull Investment funds bull Primary issuers of bull Insurance companies Riksbank Supervisory bull Savings banks securities bull Insurance brokers Authority bull Friendly societies bull Stock exchanges
bull Stockbrokers
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Table 210 Financial-sector regulation G-10 countries 2000 (continued )
Financial institutions and their supervisors
Country and supervisory structure Retail banking Wholesale banking Securities Insurance
Belgium Bank holding companiesBanking and Finance Commission = umbrella supervisor
Bank of Belgium Banking Banking
Banking and Finance and Finance Insurance Controland Finance Commission Commission Commission Office
Banking and Insurance Finance Control bull Commercial banks bull Asset management bull Primary issuers of bull Insurance companies Commission Office bull Savings banks firms securities bull Insurance brokers
bull Securities banks bull Investment funds bull Stock exchanges bull Mortgage companiesbull Stockbrokers bull Pension funds
Securities Regulation Fund Securities Regulation Fund
bull Other investment firms and credit institutions(institutions participating in regulated off-exchangemarket in strips and Treasury certificates)
Bank holding companies Spain Banco de Espantildea = umbrella supervisor
Banco de Espantildea Comision Nacional del Mercado de Directorate General
Banco de Espantildea Valores (CNMV) Insurance
bull All credit institutions (commercial banks savings banks credit bull Primary issuers of (Ministry of Economy Ministry of cooperatives official credit institutions finance factoring and securities and Finance) Economy and CNMV leasing companies mortgage-loan companies etc) bull Stock exchanges bull Insurance companies Finance bull Interbank foreign exchange and book-entry public debt bull Stockbrokers bull Pension funds
markets bull Venture capital(companies and funds)
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119
Financial institutions and their supervisors
Country and supervisory structure Banking Securities Insurance
Banking Advisory High Level Securities Supervisors Committee (BAC) Committee (HLSS) Insurance Committee (IC)
Supranational (EU) bull Formulates standards for prudential bull Coordination of securities market bull Formulates standards forsupervision supervision prudential supervision
BACICHLSS Banking Supervision
Conglomerates Committee (BSC) Securities Contact Committee Regulation of prudential bull Systemic risk monitoring bull Regulation and implementation of supervision securities admission
International Association International International Organization of of Insurance Supervisors
Basel Committee Securities Commisison (IOSCO) (IAIS) Joint Forum Conglomerates Supervision bull Supervision and regulation best bull Supervision and regulation best bull Supervision and regulation amp regulation Best practices practices practices best practices
FSF Coordination across supervisors of various functions
Notes See appendix B for more information Boldface type indicates senior or oversight supervisor normal type indicates adjunct or front-line supervisorsolid line indicates direct responsbility to the senior-ranking authority dotted line indicates coordination in supervisory activities
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Table 210 Financial-sector regulation G-10 countries 2000 (continued )
Glossary of names United Kingdom FSA = Financial Services Authority United States FR = Federal Reserve OCC = Office of the Comptroller of theCurrency FDIC = Federal Deposit Insurance Corporation SEC = Securities and Exchange Commission OTS = Office of Thrift Supervision Japan FRC =Financial Reconstruction Commission FSA = Financial Services Agency SESC = Securities and Exchange Surveillance Commission Canada OSFI =Office of the Superintendent of Financial Institutions CDIC = Canada Deposit Insurance Corporation Germany FBSO = Federal Banking SupervisoryOffice FSSO = Federal Securities Supervisory Office FISO = Federal Insurance Supervisory Office BSO = Banking Supervisory Office Italy Consob =Commissione Nazionale per le Societa e la Borsa ISVAP = Instituto per la Vigilanza sulle assicurazioni private e di Interesse colletivo Switzerland SFBC= Swiss Federal Banking Commission Spain CNMV = The Comision Nacional del Mercado de Valores Supranational BAC = Banking Advisory CommitteeBSC = Banking Supervision Committee IC = Insurance Committee HLSS = High Level Securities Supervisors Committee International Dimension FSF =Financial Stability Forum IOSCO = International Organization of Securities Commission IAIS = International Association of Insurance Supervisors
Sources United Kingdom Bank of England httpwwwbankofenglandcouk Financial Services Authority httpwwwfsagovuk United States Board ofGovernors of Federal Reserve System httpwwwfederalreservegov Japan Bank of Japan httpwwwbojorjo Financial Reconstruction Commissionhttpwwwfsagojpfrcindexehtml Financial Services Agency httpwwwfsagojp Canada Bank of Canada httpwwwbank-banque-canadaca Office ofthe Superintendent of Financial Institutions httpwwwosfi-bsifgccaAndreEindexhtml Germany Deutsche Bundesbank httpwwwbundesbankde Fed-eral Banking Supervisory Office httpwwwbakredde Italy Banca drsquoitalia httpwwwbancaditaliait Commissione Nazionale per le Societa e la Borsahttpwwwconsobit Instituto per la Vigilanza sulle assicurazioni private e di Interesse colletivo httpwwwisvapit The Netherlands De NederlandscheBank httpwwwdnbnl France Banque de France httpwwwbanque-francefr Switzerland Schweizerische Nationalbank httpwwwsnbchindex3htmlSweden Sveriges Riksbank httpwwwriksbanksedefaultasp Belgium National Bank of Belgium httpwwwbnbbesgindexhtm Spain Banco de Espantildeahttpwwwbdees The Comision Nacional del Mercado de Valores httpwwwcnmves Supranational (EU) Institutional Arrangements for the Regulationand Supervision of the Financial Sector 2000 International Dimension Bank for International Settlement httpwwwbisorg International Organization ofSecurities Commissions httpwwwioscoorg International Association of Insurance Supervisors httpwwwiaisorg Financial Stability Forum httpwwwfsforumorg
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 121
the inflexibility of tight surveillance against the need to encourage in-novation and growth The US Securities and Exchange Commission isworried about aggressive accounting by firms and biased reports bysecurities analysts in an equity environment that prizes steadily higherquarterly earnings41 Japanese regulators are preoccupied with opaqueinterconnections between portfolio institutions banks and nonfinancialfirms through the keiretsu system Canadian regulators reeling from high-profile scandals of managers intentionally misleading investors are strengtheningmarket discipline through legal penalties aimed at managers and directorsof offending firms
When panic strikes a securities regulator cannot do much As the 1987stock market crash and the LTCM debacle in the fall of 1998 both dem-onstrated steep stock and bond price declines can create systemic risksIf severe enough the wealth effect of falling securities values and thefear of widespread insolvency can depress real activity Flooding thesystem with liquidity is a central bankerrsquos solutionmdashsomething a securi-ties regulator cannot do42 But just as financial supervisors can changethe incentive structure to discourage bankers from making risky loans ingood times so securities regulators can pay more attention to incentiveson the demand side when capital markets are strong
Prudential Supervision and InnovationmdashA Footnote
In concluding this discussion of prudential supervision in the G-10 anadditional point is worth noting National regulators face a persistenttrade-off between emphasizing financial system safety and soundnesswhile encouraging innovationmdashin spite of the added risks innovationbrings to financial markets Former US Treasury Secretary Lawrence Summers(2000 3) has argued by analogy
The jet airplane made airplane air travel more comfortable more efficient andmore safe though the accidents were more spectacular and for a time morenumerous after the jet was invented In the same way modern global financialmarkets carry with them enormous potential for benefit even if some of theaccidents are that much more spectacular As the right public policy response
41 The problem is illustrated by the divergence since mid-1998 between reported earn-ings by the Standard amp Poorrsquos (SampP) 500 and the after-tax profits of all corporations inthe national accounts Generally these two series move closely with one another Be-tween mid-1998 and mid-1999 SampP 500 reported that earnings increased by more than20 percent while after-tax profits of all corporations increased by less than 5 percent(Chase Bank US Economic and Policy Research US Weekly Prospects Chase SecuritiesWeekly Newsletter 5 June 2000 5)
42 For example the US Securities and Exchange Commission had no direct role in calmingmarkets in the 1987 or 1998 panics
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122 WORLD CAPITAL MARKETS
to the jet was longer runways better air-traffic control and better training forpilots and not the discouragement of rapid travel so the right public policyresponse to financial innovation is to assure a safe framework so that the ben-efits can be realized not to stifle the change
Accepting Summersrsquos analogy for the international financial system better-informed supervisors and investors are a necessary part of the financialsystem framework Supervisors require more timely information on therisk profiles resulting from positions taken by financial institutions Theyalso need a better understanding of risk-management systems Snapshotsof an institutionrsquos risk profile and risk-management procedures are nolonger adequate In a world where huge bets are quickly made (andpossibly lostmdashas with Barings Bank in 1995 and LTCM in 1998) super-visors must focus on the soundness of banking systems for evaluatingand managing risk on a daily basis Some progress has been made inaddressing these issues US banking examiners are extending their in-formation requirements in banking examinations and increasing theirinvolvement in large complex institutions43 More awareness is alsorequired of the fact that they are national organizations in a world ofcross-border capital flows To a much greater extent they need a multi-national reach International supervision and coordination among super-visors are the subject of the next section
Our analysis suggests that G-10 supervisors have unfinished businessBank supervisors need to start yesterday securities regulators can waituntil tomorrow One G-10 member acting alone cannot correct the biasIn good times the lending business will simply migrate to other G-10banks In bad times financial problems will not stop at the national bor-der A way has to be found to establish common international standardsfor the key financial players in order to prevent crises and to agree onapproaches for managing them The path has already been laid out Inthe wake of the bank failures of the past 25 years bank supervisors havetried to establish such standards They have done this without creating anew global institution
The essence of the international framework is decentralizationmdashglobalrules and design standards without global institutions that are perceivedto intrude on national sovereignty The awkward jargon for this frame-work is vertical subsidiaritymdashldquothink internationally act nationallyrdquo Theinternational thinking is done by a committee of regulators that meets
International SupervisionA Decentralized Framework
43 These issues are discussed in Ferguson (1999) and Meyer (2000a)
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 123
regularly at the Bank for International Settlements in Basel The commit-tee establishes principles and standards that are interpreted implementedand enforced by national authorities44 In this section we describe thesesupervisory efforts and their weaknesses We present our recommenda-tions for addressing these weaknesses in the next chapter
Basel I
The Basel Capital Accord of 1988 (Basel I)45 drew the lesson from thefinancial crises of the mid-1970s that more adequate capital levels in in-ternational banks would help reduce the systemic risk of bank failureThe primary goal of Basel I was capital adequacy other standards wereput in place not so much for their own virtue as to defend the primarygoal
Capital adequacy requirements were designed to ensure that individualinstitutions have the ability to absorb losses particularly credit lossesAccordingly a backup system of scoring credit risk was devised thatrequired large amounts of bank capital for some types of loans smalleramounts for others and zero for a select list of preferred assets Report-ing requirements were designed to disclose problems and ensure that atroubled bank would take timely steps to restore its capital base in thewake of a loss The Basel I framework worked tolerably well in limitingthe call on the public purse in the G-10 countriesmdashwith the notable ex-ceptions of France and Japan The framework failed to moderate riskybank lending to emerging markets however
Basel I was not developed with emerging markets in mind The origi-nal idea behind it was to develop a common supervisory approach tocross-border banking operations It grew out of political pressure fromUS lawmakers who were determined to require international banks op-erating in the United States to meet US banking standards Toward thisgoal in 1983 Congress passed the International Lending Supervisory ActUS and British banking authorities subsequently agreed on a commontarget the adoption of strict common capital-adequacy standards In 1988other G-10 governments agreed to go along voluntary acceptance ofthe standards throughout much of the rest of the world followed46 Therationale for the capital targets was two-fold The first was to requirebanks to hold sufficient amounts of capital (8 percent of risk-adjusted
44 The international committee of financial authorities agreed on a common definitionof banksrsquo tier-one or ldquocorerdquo capital national authorities defined tier-two capital in theirown manner which permitted greater variations in national working definitions andpractices
45 International Convergence of Capital Measurement and Capital Standards (BIS 1988)was prepared by the Basel Committee on Banking Supervision
46 See Reineke (1998)
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124 WORLD CAPITAL MARKETS
assets) to cushion losses on those assets The second was to dull theirappetites for risk banks with large capital bases would have more tolose if they failed and therefore would take fewer risks
Rapid change in financial markets soon revealed flaws in the Basel IAccord In a complex world with numerous sources of risk it focusedheavily on credit risk but overlooked other risks in a bankrsquos portfolioand the correlation between returns on different asset classes The Baselformula required banks to maintain a fixed amount of capital againsteach of its asset classes But the formula did not distinguish the riskinessof the borrower within each class As a result one large loan to a low-risk corporate borrower such as General Electric would require the sameamount of capital as 10 smaller transactions with high-risk borrowers
The system was also biased toward short-term loans Loans maturingin less than a year required a 20 percent risk weight whereas those ma-turing after more than a year required a 100 percent risk weight Inter-bank lending was particularly favored For example loans to banks inOECD countries required less capital than loans to private firms in thesame countries creating the anomaly that interbank loans to South Ko-rean banks required less capital than loans to General Electric47 Thisanomaly encouraged banks to shed high-quality assets if the Basel rulesrequired the allocation of more capital than banks thought they needed
Another weakness was that financial innovators quickly circumventedthe Accord Because short-term loans required less provisioning than long-term loans banks responded by securitizing their long-term debt port-folios and lending short-term against the collateral of the newly createdasset This allowed banks to circumvent the capital requirements gearedto the terms of the underlying debt At the same time the Basel I Accordfailed to encourage risk mitigation techniques such as credit derivativescollateral guarantees and on-balance-sheet netting the flip side of fi-nancial innovation Because off-balance-sheet products were not coveredby the Accord another anomaly appeared when Barings Bank collapsedin 1995 Barings met capital adequacy standards but collapsed becauseits systems for managing risk failed traders were allowed to speculatein futures contracts that did not appear on the balance sheet
Basel II
Work to overhaul Basel I began in 1995 and produced consultativepapers issued in June 1999 and January 200148 These papers have been
47 South Korean banks have had notoriously weak balance sheets because the practiceof ldquodirected lendingrdquo left them with many poor loans (in making these loans the bankswere expected to follow government objectives rather than creditworthiness criteria)
48 Basel Committee on Banking Supervision (1999 2001)
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 125
the subject of extensive consultation and revision as a result the newAccord is expected to be introduced in 200449 The Basel II frameworkhas three parts (pillars) revisions to Basel I minimum-capital require-ments supervisory review criteria and greater emphasis on market dis-cipline Broadly Basel II aims to maintain the level of capital in the sys-tem but achieve better alignment of banksrsquo capital with their risk pro-files and keep up with financial innovation
To align capital requirements with market realities (the first pillar)Basel II concentrates on the 100 or so largest banksmdashthe type of playerslisted in table 21mdashand on the holding-company parents of banking groups50
Capital requirements will differentiate between an increased number ofcredit groups or ldquorisk bucketsrdquo including claims on governments otherbanks corporations mortgage-backed securities and other asset-backedsecurities
Basel II originally proposed to use external ratings to set capital chargesfor a number of these credit risks Many banks objected arguing thatthey assess credit risk better than Standard amp Poorrsquos Moodyrsquos or FitchIBCA51 Basel II thus proposes two approaches to rating a standard ap-proach using external ratings and an ldquoadvancedrdquo approach that allowsselected banks to use their own internal rating systems To encouragethe development of rigorous internal control systems based on these in-ternal rating systems Basel II also proposes to levy capital charges foroperational risk (the risk of direct or indirect loss resulting from inad-equate or failed internal processes people and systems or from exter-nal events)
Some critics of this proposal dismiss it as an abrogation of the prin-ciple of external independent monitoring and as ldquodangerously naiumlverdquo52
But regulators argue that the new capital charge on operational risk shouldoffset this concern It is also far from clear how cross-national compari-sons of rating and internal risk-assessment systems will be made (Engelen2000) The development by the European Union of its own capital rulescould well complicate the international resolution of these issues Publicassurances by EU officials in January 2001 however indicated that theirmain concerns are to create a level playing field and avoid regulatoryarbitrage (Hargreaves 2001) There is also the significant problem ofthe procyclical character of risk weights When a crisis hits losses are
49 See Berry (2000) for an update in an interview with William J McDonough chair ofthe Basel Committee on Banking Supervision
50 For obvious reasons these proposals are addressed to large banks and simpler capi-tal standards are allowed for small banks that focus on their domestic credit markets
51 See Ammer and Packer (2000) for an empirical critique of the success of rating agen-cies in distinguishing risk by sector and region
52 See Auerback (2001)
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126 WORLD CAPITAL MARKETS
incurred or accrued capital is lost and loan exposure must be reducedor securities sold to restore the requisite capital-adequacy ratios A morerisk-sensitive framework could amplify volatility
As the second pillar of Basel II supervisory review criteria are beingbeefed up to encourage supervisors to intervene earlier in potential problemsituations and to compel banks to align their capital positions with theirrisk profiles Bank supervisors will be authorized to require banks tohold capital in excess of minimum requirements if they have concernsabout general management overall strategy risk-management performanceor the macroeconomic environment Of course if one G-10 supervisorimposes higher capital requirements in isolation the same disparity willemerge that presaged Basel I Some banks will be disadvantaged in theinternational marketplace and will loudly complain that excessive super-vision is driving business to their competitors Hence close internationalcooperation among supervisors is critical
To implement the third pillar market discipline banks will be requiredto make fuller more timely disclosure of capital adequacy and the risksto which that capital is exposed A number of measures are being stud-ied that might help supervisors evaluate bank performance such as com-parisons of uninsured deposit interest rates subordinated debt yieldsand equity prices The idea is that these yields and prices might alertsupervisors to market perceptions of risk Of course market perceptionsare only as good as market information More direct and controversialways to reinforce market discipline would dramatically increase publicdisclosure of bank positions and risk management systems
Many questions are still outstanding about how to resolve the techni-cal details of capital requirements and whether the requirements willachieve their intended goal of better assessment and mitigation of therisks in banksrsquo portfolios There is no substitute for skilled supervisorsThe intricacies of effective design and implementation suggest that su-pervisors need to be highly competent technically knowledgeable aboutbanking portfolio characteristics and the factors that influence bank ex-posure to credit risk (Mishkin 2000) And they must be aided by vigilantshareholders market forces and transparency of information53
Standard setting at the global level is desirable but ultimately theeffectiveness of these efforts will be tested at the national level espe-cially in times of systemic financial distress Here the record of Basel Iwas not a bright shining success Japanese banking regulators havetraditionally allowed banks to include real estate and securities in theircapital base When the value of these assets plummeted in the early 1990sregulators allowed banks to continue valuing these depreciated (andoften bankrupt) assets at their old inflated levels Japanese authorities
53 Benedict Roth Complacency Towards Catastrophe Financial Times 23 January 2001
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 127
insisted until the mid-1990s that eroded capital bases could be rebuiltin a market-driven fashion They rightly foresaw that huge loan losseswould undermine public support for the ruling party and require a po-litically unpopular bailout
Japanese foot dragging on Basel I was the worst54 but not uniqueOther examples can be found of ldquopolitically mandated forbearancerdquo TheFederal Reserve Bank of New York held important hands during theLTCM crisis of 1998 Mexico is still resolving the banking crisis that eruptedin 1995 South Korea has not yet closed the insolvent banks that behavedso badly before the crisis of 1998 In the aftermath of a crisis nationalregulators cannot always be relied upon to discipline politically power-ful bankers55 One of the little-noticed consequences of these differingapproaches is that those banks with strong regulatory systems receivedan implicit ldquoexport subsidyrdquo for their services US banks which had notengaged extensively in emerging-market lending in the 1990s were bet-ter positioned than their German and Japanese counterparts to expandtheir international assets in the wake of the crises
Other Financial Forums
54 See Japanese Banks Fiddling while Marunouchi Burns The Economist 27 January2001 67-69
55 See Calomiris (1997)
The Basel model of vertical subsidiarity has already been extended toother financial regulatory bodies In 1993-94 the BIS established a Tri-partite Group of Banking Insurance and Securities Regulators In 1994-95 the BIS increased its cooperation with the International Organizationof Securities Commissions when the two organizations issued parallelpapers on guidelines for national regulators concerning risk managementand disclosure of derivative trades In 1996 a permanent Joint Forum onFinancial Conglomerates was established to examine supervisory issuesand develop working arrangements among the different functional super-visors of conglomerate institutions that offer combinations of bankingsecurities and insurance products Draft papers on the supervisionof conglomerates were released for comment in 1998 applying capital-adequacy principles to these groups and providing guidelines both forassessing the integrity and competence of top managers and for sharingassessments between regulators
In 1997 the Basel Committee on Banking Supervision extended itsreach beyond capital standards to broader aspects of banking supervi-sion with the publication of the Core Principles for Effective BankingSupervision In 1999 a wide range of regulatory and standard-settingbodies were gathered under the umbrella of the Financial Stability
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128 WORLD CAPITAL MARKETS
Forum (FSF) itself established under BIS aegis56 The FSF has alreadyissued recommendations for stepped-up supervision and transparencyas well as guidelines for best practices in a number of areas includingoffshore financial centers and highly leveraged institutions or hedge funds57
Conclusion
Although the structural weaknesses in emerging-market economies arewidely acknowledged to have been causal factors in international capi-tal-market volatility this chapter points to the role of large G-10 bankingorganizations as major suppliers of the most volatile instrument short-term debt We have examined evidence of the impact of public safetynets in the G-10 economiesmdashthe deposit insurance systems the pruden-tial supervisory systems and the lender-of-last-resort functions of centralbanksmdashon the incentive structures of these organizations
Although supervisors in most countries working nationally and to-gether in the BIS have made significant efforts to mimic market forcesin their prudential supervision the most sophisticated financial institu-tions find innovative ways to circumvent the rules New global regulatorybodies are not about to be created G-10 national bank regulators shouldthemselves address the short-term debt bias in the international financialsystem by changing incentive systems G-10 securities regulators shouldalso take steps to get ahead of the curve paying close attention to largeportfolio swings by institutional investors particularly in times of crisisIn short more needs to be done at national and international levels tochange the rules of the game That is the subject of the next chapter
56 The Financial Stability Forum includes banking securities insurance and accountingregulatory bodies the OECD on taxation corruption and corporate governance and theIMF
57 See Martin (2000)
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80 WORLD CAPITAL MARKETS
The Market Players
As the tables in chapter 1 illustrate there are three main types of pri-vate-capital flows bank loans and deposits other portfolio investmentand foreign direct investment Each type is associated with particularinstitutionsmdashcommercial banks other financial institutions and non-financial firms In this section we describe the size and nationality ofthe large players
Commercial Banks
Table 21 lists the 50 largest commercial banks by market capitalizationas of October 2000 Market capitalization rather than sheer asset sizeprobably better measures a bankrsquos ability to move funds from one coun-try or sector to another4
The large continental European banks (those in the euro zone plusSwitzerland) in 1999 had market capital of about $524 billion and assetsof approximately $64 trillion When figures for UK commercial banksare added in European market capitalization rises to about $850 billionand assets to about $86 trillion Europe is a banking powerhouse In-deed the European role is so crucial that no approach to the regulationof international lending can survive without European support
The Maastricht Treaty did not make Europe a single entity for bank-ing supervision The European Central Bank is finding its way in ex-change rate and monetary policy For the foreseeable future nationalregulators will retain control over supervisory matters Changes in thefabric of international understandings over bank supervision will requireconsensus among the European powers
In market capitalization at $850 billion the large US banks are aboutthe same as their European counterparts but in asset size they are adistant second to the Europeans at $38 trillion The large Japanese com-mercial banks follow on market capitalization at $300 billion but aresecond to the Europeans with assets of $67 trillion
Commercial-banking power is clearly concentrated in Europe the UnitedStates and Japan Moreover banks based in the G-10 plus Spain accountfor 90 percent of the market capitalization and assets of the top 50 com-mercial banks in the world As table 22 shows banks based in the G-10countries plus Spain account for about 92 percent of the assets of allcommercial banks located in BIS reporting countries about 80 percent ofthe external assets of these banks and about 72 percent of claims on
4 Several banks in China and Europe rank among the top 50 in terms of asset size butpoor-quality loans sharply diminish their market capitalization-ndashand their ability to movemoney from country to country
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 81
Table 21 Worldrsquos largest 50 commercial banks by marketcapitalization October 2000 (billions of dollars)
Market capitalizatona Total Net Shareholderassets income equityb
Global Sept Oct National Dec Dec Decrank Banks 1999 2000 rankc 1999 1999 1999
Continental Europe
8 ING Bank 46 66 1 351 17 1412 UBS 58 55 2 614 39 2213 Creacutedit Suisse Group 50 54 3 452 33 2215 Deutsche Bank 36 48 4 843 26 2317 Banco Santander
Central Hispano 33 45 5 258 22 1719 BNP Paribas 43 6 702 17 22
Banque Nationalede Paris 26
Paribas 1621 ABN AMRO 29 34 7 460 26 1325 Banco Bilbao
Vizcaya Argentaria 25 28 8 240 22 1826 UniCredito Italiano 21 26 9 170 13 1030 Socieacuteteacute Geacuteneacuterale 19 22 10 408 24 1229 HypoVereinsbank 20 22d 11 505 04 1432 Dresdner Bank 21 21 12 398 11 1243 San Paolo IMI 16 17d 13 141 11 845 Fortis Bank 34 16 14 330 12 949 Commerzbank 17 14 15 374 09 1249 KBC Bank 13 14d 16 147 07 6
Total for Continental Europe 482 524d 6393 291 234
Japan
3 Mizuho Holdings Inc 115 1 51e
3 Dai-Ichi Kangyo Bankf 39 463 ndash38 203 Industrial Bank
of Japanf 32 390 ndash15 133 Fuji Bankf 42 489 ndash36 187 Sumitomo Sakura
(tentative) 68 2 56e
Sumitomo Bankg 47 464 ndash48 15Sakura Banki 31 414 ndash40 18
10 Bank of Tokyo Mitsubishi 72 56 3 664 ndash07 2311 UFJ Holdings Inc 55d 4 36e
Sanwa Bankh 39 425 ndash40 18Tokai Bankh 16 269 ndash24 13Toyo Trust amp Bankingh na 67 ndash13 5
40 Asahi Bank 20 18d 5 247 ndash21 1249 Mitsubishi Trust amp
Bankingi 16 14d 6 149 ndash14 750 Sumitomo Trust amp
Banking 11 10d 7 127 ndash12 6
Total for Japan 364 336e 6472 ndash481 260
(table continues mext page)
Institute for International Economics | httpwwwiiecom
82 WORLD CAPITAL MARKETS
Table 21 Worldrsquos largest 50 commercial banks by marketcapitalization October 2000 (billions of dollars) (continued )
Market capitalizatona Total Net Shareholderassets income equityb
Global Sept Oct National Dec Dec Decrank Banks 1999 2000 rankc 1999 1999 1999
United Kingdom
2 HSBC Holdings 97 122 1 569 54 379 Royal Bank of Scotland 19 58d 2 146 14 7
NatWestj 39 na na 292 na 1414 Lloyds TSB 68 52 3 285 41 1418 Barclays 44 44 4 402 28 1435 Abbey National 25 19 5 292 20 846 Standard Chartered 15 15d 6 88 06 646 Bank of Scotland 15 15d 7 116 10 6
Total for United Kingdom 322 324d 2191 173 106
United States
1 Citigroup 149 237 1 717 99 504 JP Morgan Chase amp Co 83 2 35e
Chase Manhattank 63 na na 406 54 24JP Morgank 20 na na 261 21 11
5 Bank of America 96 79 3 633 79 446 Wells Fargo amp Company 65 78 4 218 37 2216 Bank of New York
Company 25 46 5 75 17 520 Bank One 41 42 6 269 35 2022 Fleet Boston Financial 34 34 7 191 20 1523 MBNA 18 30 8 31 10 424 First Union 34 30 9 253 32 1727 Fifth Third Bancorp 17 24 10 42 07 427 Mellon Financial 17 24 11 48 10 433 State Street na 20 12 61 06 335 PNC Bank 16 19 13 75 13 635 Northern Trust na 19 14 29 04 235 Firstar 25 19 15 73 09 640 US Bancorp 22 18 16 82 15 846 SunTrust Banks 21 15 17 95 13 850 National City 16 13 18 87 14 650 Wachovia 16 11 19 67 10 650 KeyCorp 12 11 20 83 11 6
Total for United States 707 850 3796 517 271
Other
31 National Australia Bank 2 21 1 166 18 1234 Hang Seng Bank Ltd 20 20d 2 na na na35 Royal Bank of Canada 13 19 3 184 12 940 Commonwealth Bank
of Australia 14 18d 4 91 09 543 Toronto Dominion Bank 12 17 5 146 20 850 Westpac Banking Corp 12 13 6 92 10 650 Development Bank
of Singapore 12 13d 7 64 06 6
Total for other 105 121d 742 76 46
Institute for International Economics | httpwwwiiecom
THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 83
developing countries In turn the claims on developing countries repre-sent about 4 percent of the assets of G-10 and Spanish commercial banks
Portfolio Investors
Table 21 (continued )
Market capitalizatona Total Net Shareholderassets income equityb
Sept Oct National Dec Dec Dec1999 2000 rankc 1999 1999 1999
Total for largest 50 1980 2155 19594 58 917
Total for G-10 1900 2070 19182 53 888
na = not availablenot applicableG-10 = Group of Ten countries see note to table 11
a Market capitalization is defined as the number of ordinary shares currently in circulationmultiplied by the current share price Market capitalization as of October 2000 is presentedfor the banks that had a market capitalization higher than $11 billion as of September 1999b Shareholder equity is defined as the sum of issued common stock capital surplus or pre-mium various reserves and retained earnings Shareholder equity includes group equity at-tributable to consolidated minority interestsc Rankings within the country or regiond Estimates based on the available rates of change from September 1999 to October 2000The market capitalization and shareholder equity figures represent combined estimate for themerged bankse Total for the merged banksf Merged in September 2000g Merged in April 2001h Will merge in April 2002i Will merge with Nippon Trust and Tokyo Trust in October 2001j NatWest Bank merged with the Royal Bank of Scotland in March 2000k Announced a merger in September 2000
Sources Euromoney The Bank Atlas 2000 httpwwweuromoneycom American BankerThe Top 100 World Financial Companies Q3 1999 httpwwwamericanbankercom YahooFinance Company Profiles financeyahoocom Bloomberg Financials httpwwwbloombergcom
Three groups of financial institutions dominate the flow of portfolio capitalinvestment banks wealth managers and insurance companies Table 23lists nine large investment banks all based in New York with offices inLondon and other financial centers In 1998 these nine firms had a com-bined market capitalization in excess of $130 billion and controlled as-sets in excess of $18 trillion
Investment banks act as guardians to the securities markets Nearly allpublic and private shares bonds and asset-backed securities are broughtto market by an investment bank Fulfilling the same function they areexpanding the securities markets of emerging economies They also act asthe pilots of privatization mergers and takeoversmdashnow a core feature of
Institute for International Economics | httpwwwiiecom
84 WORLD CAPITAL MARKETS
Table 22 Total assets and external assets of all commercialbanks June 2000 (billions of dollars)
Claims onExternal assets developing countriesb
Share of Share ofTotal total assets total assets
Country assetsa Amount (percent) Amount (percent)
Austria 423 91 22 33 8Bahamas 316 244 77 61c 19Bahrain 100 92 92 46c 46Belgium 806 309 38 26 3Canada 720 98 14 31 4Denmark 244 58 24 6 2Finland 121 31 25 4 3France 2486 607 24 135 5Germany 4535 901 20 240 5Ireland 423 160 38 2 0Italy 1345 191 14 47 4Japan 8460 1199 14 258 3Luxembourg 821 495 60 124c 15Netherlands 1080 296 27 67 6Norway 157 14 9 3 3Singapore 574 405 70 202c 35Spain 889 124 14 57 6Sweden 348 67 19 12 2Switzerland 1632 709 43 177c 11United Kingdom 5802 1990 34 138 2United States 6223 889 14 144 2
Total for all BISreporting countries 37506 8968 24 1813 5
Total for G-10 34326 7378 21 1331 4
BIS = Bank for International SettlementsG-10 = Group of Ten countries see note to table 11
a Total assets are calculated as banking institutions (deposit institutions) reserve claims onthe public sector claims on the private sector (lines 20 21 22 from IFS) plus externalassets Figures are converted into US dollars using the market exchange rate at the end ofJune 2000b Developing countries are countries other than Andorra Australia Austria Belgium CanadaCyprus Denmark Finland France Germany Gibraltar Greece Iceland Ireland Italy JapanLiechtenstein Luxembourg Malta Netherlands New Zealand Norway Portugal Spain Swe-den Switzerland Turkey the United Kingdom the United States the Vatican City State andthe former Yugoslaviac These countries do not disclose their claims on developing countries Such claims arearbitrarily (and generously) estimated at half the external assets of commercial banks in Bahrainand Singapore and a quarter of the external assets of banks in the Bahamas Luxembourgand Switzerland
Sources IMF International Financial Statistics (IFS) November 2000 Bank for InternationalSettlements BIS Quarterly Review November 2000 httpwwwbisorg
Institute for International Economics | httpwwwiiecom
THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 85
global capitalism In addition to their underwriting role investment banksearn substantial profits from trading securities
Wealth-management firms are the second group of portfolio institu-tions They typically deal with the publicmdashindividuals and companiesthat want a trusted firm to manage their pensions and other funds Table24 lists 10 large wealth managers all based in the G-10 Together these10 firms control $64 trillion in assets and their own market capitalization
Table 23 Large investment banks 1998 (billions of dollars)
MarketRevenue Assets capitalizationa
Merrill Lynchb (United States) 36 300 25Morgan Stanley Dean Witterb (United States) 31 318 50c
Goldman Sachs (United States) 22d 217e 29c
Lehman Brothers Holdingsb (United States) 20 154 10c
Salomon Smith Barneyf (United States) 8 211 naCredit Suisse First Bostong (United States
Switzerland) 7 280 naPaine Webberh (United States) 7 54 6i
Bear Stearnsj (United States) 8 154 5i
Donaldson Lufkin amp Jenrettek (United States) 5 72 7i
Total 144 1760 132 plusTotal for G-10 144 1760 132 plus
na = not available (subsidiaries of large holding companies Citigroup and Creacutedit SuisseGroup respectively individual market capitalization is not available)G-10 = Group of Ten countries see note to table 11
a Market capitalization is calculated by multiplying the total number of shares by the shareprice at the companyrsquos fiscal year-endb Source Fortune Global 500 1999 Data shown are for the fiscal year ended on or before31 March 1999 Assets shown are those at the companyrsquos fiscal year-end httpwwwpathfindercomfortuneglobal500indexhtmlc Figures as of September 1999 are from American Banker httpwwwamericanbankercomBankRankingsd Source 1998 Goldman Sachs Annual Review Assets as of November 1998 httpwwwgscomaboutannual19984_fsindexhtmle Source Financial Times Company Financials Revenue as of 27 November 1998 httpwwwglobalarchiveftcomcbcb_searchhtmf Source 1998 Citigroup Annual Report 20 Revenue figures for year ending 31 December1998 Asset figures as of 31 December 1998 httpwwwcitigroupcomcitigroupfindatac1998ar2pdfg Source 19981999 Creacutedit Suisse Group Annual Report 23 httpwwwcsgchcsg_annual_report_98downloadcsg_ar98_p1_enpdfh Source 1998 Paine Webber Annual Report 34-35 httpwwwpainewebbercomannual98graphicsfininfoindexhtmi Individual figures are obtained from Yahoo The time for valuations is as follows BearStearns December 1999 Lehman Brothers November 1999 Paine Webber and DonaldsonLufkin amp Jenrette September 1999j Source 1999 Bear Stearns Annual Report 55-56 Figures are for fiscal year ending 30June 1998 httpwwwbearstearnscomcorporateinvestorindexhtmk Source 1999 Donaldson Lufkin and Jenrette Annual Report ldquoFinancial Highlightsrdquo httpwwwdljcompdfDLJ98_1pdf
Institute for International Economics | httpwwwiiecom
86 WORLD CAPITAL MARKETS
exceeds $260 billion For the most part wealth managers are long-termportfolio investors
Hedge funds represent a highly specialized investment vehicle that isnot widely available to the public Most hedge funds are leveraged theyemploy dynamic (and sometimes opportunistic) trading strategies involvingpositions in several different markets they adjust their investment port-folios frequently in anticipation of asset price movements or changes inyield differentials between related securities Hedge funds are opaque tomarket monitoring They are subject to little direct regulation and areunder few obligations to disclose information Hence the size of the in-dustry is difficult to measure
If they are measured by capital under management or by assets hedgefunds are small relative to established wealth managers As table 25shows the capital managed by 20 large hedge funds in late 1998 amountedto less than $50 billion Estimates vary widely but if all hedge funds arecounted their assets range from $100 to $300 billion Even the highestnumber is less than 5 percent of the combined assets of investment banksand traditional asset managers
The amount of leverage used by hedge funds depends on trading strate-gies that are in turn shaped by investor attitudes toward risk Leverage
Table 24 Large asset managers in 1998 (billions of dollars)
Total assets under Marketmanagementa capitalizationb
UBS (Switzerland) 1145 58c
Fidelity Investments (United States) 773 naKampo (Japan) 698 naCredit Suisse Group (Switzerland) 680 50c
AXA Group (France) 647 39c
Barclayrsquos Global Investors (United States) 616 44c
Merrill Lynch amp Co (United States) 501 25c
State Street Global Advisors (United States) 493 naCapital Group Cos (United States) 424 naZurich Financial Services (Switzerland) 415 45c
Total 6392 261 plusTotal for G-10 6392 261 plus
na = not available (usually a nonpublic company)G-10 = Group of Ten countries see note to table 11
a Figures are assets under management at fiscal year-end 1998b Market capitalization is calculated by multiplying the total number of shares by the shareprice at the companyrsquos fiscal year-endc Figures from American Banker httpwwwamericanbankercomBankRankings
Sources Institutional Investor 1999 httpwwwiimagazinecomresearchinterfacehtml US(II300) Asia (Asia200) and Europe (Euro100) Asset Management Rankings American BankerhttpwwwamericanbankercomBankRankings
Institute for International Economics | httpwwwiiecom
THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 87
is achieved using such instruments as repos (repurchase agreements)futures and forward contracts and other derivative products5 It is alsovery difficult to measure A Financial Stability Forum (FSF 2000b) studyof hedge funds noted thatmdashalthough there are problems with the waydata vendors report these positionsmdashestimates suggest most hedge fundsuse modest amounts of leverage averaging 21 but ranging to 41 insome FSF (2000b) further notes difficulties with evaluating the risk-adjusted performance of hedge funds because of their dynamic tradingstrategies
Table 25 Largest hedge funds according tocapitalization August 1998 (billions of dollars)
Fund Capital under management
Domestica
Tiger 51Moore Global Investment 40Highbridge Capital Corp 14Intercap 13Rosenberg Market Neutral 12Ellington Composite 11Hedged Taxable-Equivalent 10Quantitative LongShort 09Sr International Fund 09Perry Partners 08
OffshoreJaguar Fund NV 100Quantum Fund NV 60Quantum Industrial Fund 24Quota Fund NV 17Omega Overseas Partners 17Maverick Fund 17Zweig Dimenna International 16Quasar International Fund NV 15SBC Currency Portfolio 15Perry Partners International 13
Totalb 471
a Long Term Capital Management (LTCM) was in serious difficulty in August1998 and is omitted from the listb Estimates of hedge fund capital and the number of funds vary significantlyMARHedge estimated 1115 funds with $109 billion capital under managementat the end of 1997 Van Hedge Fund estimated 5500 funds with capital of $295billions at the same date
Source Adapted from Eichengreen (1999a)
5 Positions are established by posting margins rather than the face value of the position
Institute for International Economics | httpwwwiiecom
88 WORLD CAPITAL MARKETS
The positive role of hedge fundsmdashproviding diversification to inves-tors because their returns have low correlations with standard asset classesmdashis counterbalanced by some negative features Hedge funds and otherhighly leveraged institutions (HLIs) may take concentrated positions andengage in aggressive market practices that amount to ldquoganging uprdquo on asmall economy (such as Hong Kong)6 Under normal market conditionsHLI positions are not destabilizing but some of the aggressive practicesdocumented in 1998 are worrisome The FSF study group participantsagreed (2000b 112) that such practices raise important issues for marketintegrity but they could not agree that market manipulation was suffi-ciently widespread to be a serious concern for policymakers
Insurance companies are the third group of portfolio institutions Theseare divided into two categories property and casualty companies andlife and health insurance companies Ten large companies of each cat-egory are listed in table 26 In 1998 the 10 property and casualty insur-ance companies had $16 trillion in assets and more than $330 billion inmarket capitalization The 10 life insurance companies had $28 trillionin assets7 Combining both categories 100 percent of assets are controlledby insurance companies based in the G-10 and Spain In portfolio man-agement styles life insurance companies tend to hold longer-term assetswhereas property and casualty companies tend to hold shorter-term in-struments
Nonfinancial Multinational Enterprises
The last players are the nonfinancial multinational enterprises (MNEs)The worldrsquos 100 largest corporations measured by 1998 revenue are re-corded in tables 27 and 28 The 30 financial giants among the top 100are separately shown in table 27 Most of the firms appeared in previ-ous tables Together these 30 financial giants had revenues of $13 tril-lion and controlled assets of $113 trillion8
Table 28 lists the 70 top nonfinancial giants Their revenues in 1998were $40 trillion and their assets (at book value) measured $45 trillionMeasured by revenue or assets about 95 percent of the giants are basedin the G-10 These firms are responsible for a large share of the worldrsquos
6 See IMF (1999c) for a description of the ldquodouble playrdquo that hedge funds are accusedof using in an attempt to destabilize Hong Kong in August 1998
7 Many life insurance companies are owned by their policyholders and therefore donot have a market capitalization
8 By comparison the larger set of 96 financial firms listed in previous tables controlled$322 trillion in assets This is the total amount of assets recorded in tables 21 (50 com-mercial banks) 22 (9 investment banks) 24 (10 asset managers) and 26 (20 insurancecompanies) The largest hedge funds might add $300 billion to the total
Institute for International Economics | httpwwwiiecom
THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 89
Table 26 20 large insurance companies in 1998(billions of dollars)
Property and casualty insurance Marketcompanies Revenuea Assetsb capitalizationc
Allianz (Germany) 65 402 62d
Assicurazioni Generali (Italy) 48 178 30d
State Farm Insurance Cos (United States) 45 111 naZurich Financial Services (Switzerland) 39 215 45d
CGU (United Kingdom) 38 176 20d
Munich Re Group (Germany) 35 131 naAmerican International Group (United States) 33 194 135d
Allstate (United States) 26 88 20d
Royal amp Sun Alliance (United Kingdom) 25 76 11d
Loews (United States) 21 71 7e
Total 375 1642 330 plusTotal for G-10 375 1642 330 plus
MarketLife and health insurance Revenuea Assetsb capitalizationc
AXA (France) 79 452 39d
Nippon Life Insurance (Japan) 66 363 naING Group (Netherlands) 56 464 46d
Dai-ichi Mutual Life Insurance (Japan) 44 253 naSumitomo Life Insurance (Japan) 40 206 naTIAA-CREF (United States) 36 250 naPrudential Ins Co of America (United States) 34 279 naPrudential (United Kingdom) 34 197 30d
Meiji Life Insurance (Japan) 28 146 naMetropolitan Life Insurance (United States) 27 215 na
Total 444 2825 naTotal for G-10 444 2825 na
na = not available (usually an insurance company owned by its policyholders)G-10 = Group of Ten countries see note to table 11
a Data shown are for the fiscal year ended on or before 31 March 1999b Assets shown are those at the companyrsquos fiscal year-endc Market capitalization is calculated by multiplying the total number of shares by the shareprice at the companyrsquos fiscal year-endd Market capitalization data as of September 1999 from American Banker httpwwwamericanbankercome Individual companyrsquos market capitalization as of September 1999 from Yahoo yahoomarketguidecom
Sources Fortune Global 500 1999 httpwwwpathfindercomfortuneglobal500indexhtmlAmerican Banker httpwwwamericanbankercomRankingBanks1999 Yahoo Marketguideyahoomarketguidecom
Institute for International Economics | httpwwwiiecom
90 WORLD CAPITAL MARKETS
Table 27 Financial firms in the 100 largest companiesby revenue 1998 (billions of dollars)
Globalrank Company Revenuesa Assetsb Type
Continental Europe
15 AXA (France) 79 452 Insurance23 Allianz (Germany) 65 402 Insurance28 Ing Group (Netherlands) 56 464 Insurance37 Credit Suisse (Switzerland) 49 475 Banks commercial
and savings39 Assicurazioni Generali (Italy) 48 178 Insurance42 Deutsche Bank (Germany) 45 736 Banks commercial
and savings56 Zurich Financial Services (Switerland) 39 215 Insurance68 Munich Re Group (Germany) 35 131 Insurance72 ABN AMRO Holding (Netherlands) 34 507 Banks commercial
and savings77 Credit Agricole (France) 33 459 Banks commercial
and savings80 HypoVereinsbank (Germany) 32 541 Banks commercial
and savings84 Fortis (Belgium) 31 397 Banks commercial
and savings98 Socieacuteteacute Geacuteneacuterale (France) 30 450 Banks commercial
and savingsUnited Kingdom
47 HSBC Holdings 43 485 Banks commercialand savings
58 CGU 38 176 Insurance74 Prudential 34 197 Insurance
United States
16 Citigroup 76 669 Diversified financials35 Bank of America Corp 51 618 Banks commercial
and savings44 State Farm Insurance Cos 45 111 Insurance64 TIAA-CREF 36 250 Insurance67 Merrill Lynch 36 300 Securities71 Prudential Ins Co of America 34 279 Insurance76 American International Group 33 194 Insurance79 Chase Manhattan Corp 32 366 Banks commercial
and savings83 Fannie Mae 31 485 Diversified financials88 Morgan Stanley Dean Witter 31 318 Securities
Japan
21 Nippon Life Insurance 66 363 Insurance45 Dai-ichi Mutual Life Insurance 44 253 Insurance54 Sumitomo Life Insurance 40 206 Insurance91 Bank of Tokyo-Mitsubishi 31 664 Banks commercial
and savingsTotal 1279 11341Total for G-10 1279 11341
G-10 = Group of Ten countries see note to table 11
a Data shown are for the fiscal year ended on or before 31 March 1999b Assets shown are those at the companyrsquos fiscal year-end
Source Fortune Global 500 1999 httpwwwpathfindercomfortuneglobal500indexhtml
Institute for International Economics | httpwwwiiecom
THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 91
Tab
le 2
8N
on
fin
anci
al f
irm
s in
th
e 10
0 la
rges
t co
mp
anie
s b
y re
ven
ue
199
8 (b
illio
ns o
f do
llars
)
Glo
bal
Tra
nsn
atio
nal
ity
ran
k
Co
mp
any
Rev
enu
esa
Ass
etsb
ind
exc
Typ
e
Co
nti
nen
tal
Eu
rop
e
2D
aim
lerC
hrys
ler
(Ger
man
y)15
516
044
1M
otor
veh
icle
s an
d pa
rts
11R
oyal
Dut
chS
hell
Gro
up (
Net
herla
nds)
9411
058
9P
etro
leum
ref
inin
g17
Vol
ksw
agon
(G
erm
any)
7670
568
Mot
or v
ehic
les
and
part
s22
Sie
men
s (G
erm
any)
6667
521
Ele
ctro
nics
el
ectr
ical
equ
ipm
ent
32M
etro
(G
erm
any)
5222
n
a
Foo
d an
d dr
ug s
tore
s34
Fia
t (I
taly
)51
7640
8M
otor
veh
icle
s an
d pa
rts
36N
estle
(S
witz
erla
nd)
5041
932
Foo
d46
Veb
a G
roup
(G
erm
any)
4351
275
Tra
ding
49R
enau
lt (F
ranc
e)41
4545
7M
otor
veh
icle
s an
d pa
rts
53D
euts
che
Tel
ekom
(G
erm
any)
4093
n
a
Tel
ecom
mun
icat
ions
57R
oyal
Phi
lips
Ele
ctro
nics
(N
ethe
rland
s)38
3386
4E
lect
roni
cs
elec
tric
al e
quip
men
t59
Peu
geot
(F
ranc
e)38
4038
7M
otor
veh
icle
s an
d pa
rts
62E
lect
riciteacute
de
Fra
nce
(Fra
nce)
3711
3
na
Util
ities
ga
s an
d el
ectr
ic63
Rw
e G
roup
(G
erm
any)
3747
n
a
Util
ities
ga
s an
d el
ectr
ic65
BM
W (
Ger
man
y)36
3660
7M
otor
veh
icle
s an
d pa
rts
66E
lf A
quita
ine
(Fra
nce)
3643
576
Pet
role
um r
efin
ing
69V
iven
di (
Fra
nce)
3558
n
a
Eng
inee
ring
and
cons
truc
tion
70S
uez
Lyon
nais
e de
s E
aux
(Fra
nce)
3585
n
a
Ene
rgy
78E
NI
(Ita
ly)
3249
317
Pet
role
um r
efin
ing
86B
ayer
(G
erm
any)
3134
827
Che
mic
als
92A
BB
Ase
a B
row
n B
over
i (S
witz
erla
nd)
3132
957
Ele
ctro
nics
el
ectr
ical
equ
ipm
ent
93B
AS
F (
Ger
man
y)31
3159
5C
hem
ical
s95
Car
refo
ur (
Fra
nce)
3020
n
a
Foo
d an
d dr
ug s
tore
s
(tab
le c
ontin
ues
next
pag
e)
Institute for International Economics | httpwwwiiecom
92 WORLD CAPITAL MARKETS
Tab
le 2
8N
on
fin
anci
al f
irm
s in
th
e 10
0 la
rges
t co
mp
anie
s b
y re
ven
ue
199
8 (b
illio
ns o
f do
llars
) (c
ontin
ued
)
Glo
bal
Tra
nsn
atio
nal
ity
ran
k
Co
mp
any
Rev
enu
esa
Ass
etsb
ind
exc
Typ
e
Un
ited
Kin
gd
om
19B
P A
moc
o68
8559
2P
etro
leum
ref
inin
g43
Uni
leve
r45
3692
4F
ood
Un
ited
Sta
tes
1G
ener
al M
otor
s16
125
729
3M
otor
veh
icle
s an
d pa
rts
3F
ord
Mot
or14
423
835
2M
otor
veh
icle
s an
d pa
rts
4W
al-M
art
Sto
res
139
49
na
G
ener
al m
erch
andi
sers
8E
xxon
101
9365
9P
etro
leum
ref
inin
g9
Gen
eral
Ele
ctric
100
356
331
Ele
ctro
nics
el
ectr
ical
equ
ipm
ent
14In
tl B
usin
ess
Mac
hine
s82
8653
7C
ompu
ters
of
fice
equi
pmen
t25
US
Pos
tal
Ser
vice
6055
n
a
Mai
l pa
ckag
e a
nd f
reig
ht d
eliv
ery
27P
hilip
Mor
ris58
6051
1T
obac
co29
Boe
ing
5637
n
a
Aer
ospa
ce30
AT
ampT
5460
219
Tel
ecom
mun
icat
ions
40M
obil
4843
597
Pet
role
um r
efin
ing
41H
ewle
tt-P
acka
rd47
3451
1C
ompu
ters
of
fice
equi
pmen
t50
Sea
rs R
oebu
ck41
38
na
G
ener
al m
erch
andi
sers
55E
I d
u P
ont
de N
emou
rs39
40
na
C
hem
ical
s61
Pro
ctor
and
Gam
ble
3731
477
Soa
ps
cosm
etic
s75
Km
art
3414
n
a
Gen
eral
mer
chan
dise
rs81
Tex
aco
3229
453
Pet
role
um r
efin
ing
82B
ell
Atla
ntic
3255
n
a
Tel
ecom
mun
icat
ions
85E
nron
3129
n
a
Ene
rgy
87C
ompa
q C
ompu
ter
3123
n
a
Com
pute
rs
offic
e eq
uipm
ent
89D
ayto
n H
udso
n31
16
na
G
ener
al m
erch
andi
sers
94J
C
Pen
ney
3124
n
a
Gen
eral
mer
chan
dise
rs96
Hom
e D
epot
3013
n
a
Spe
cial
ty r
etai
lers
97Lu
cent
Tec
hnol
ogie
s30
27
na
E
lect
roni
cs
elec
tric
al e
quip
men
t10
0M
otor
ola
2929
n
a
Ele
ctro
nics
el
ectr
ical
equ
ipm
ent
Institute for International Economics | httpwwwiiecom
THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 93
Jap
an
5M
itsui
109
5635
8T
radi
ng6
Itoch
u10
957
333
Tra
ding
7M
itsub
ishi
107
7536
9T
radi
ng10
Toy
ota
Mot
or10
012
540
0M
otor
veh
icle
s an
d pa
rts
12M
arub
eni
9455
300
Tra
ding
13S
umito
mo
8946
259
Tra
ding
18N
ippo
n T
eleg
raph
amp T
elep
hone
7614
7
na
Tel
ecom
mun
icat
ions
20N
issh
o Iw
ai68
3938
8T
radi
ng24
Hita
chi
6282
214
Ele
ctro
nics
el
ectr
ical
equ
ipm
ent
26M
atsu
shita
Ele
ctric
Ind
ustr
ial
6067
332
Ele
ctro
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el
ectr
ical
equ
ipm
ent
31S
ony
5353
628
Ele
ctro
nics
el
ectr
ical
equ
ipm
ent
33N
issa
n M
otor
5158
511
Mot
or v
ehic
les
and
part
s38
Hon
da M
otor
4943
641
Mot
or v
ehic
les
and
part
s48
Tos
hiba
4151
252
Ele
ctro
nics
el
ectr
ical
equ
ipm
ent
51F
ujits
u41
4332
6C
ompu
ters
of
fice
equi
pmen
t52
Tok
yo E
lect
ric P
ower
4012
2
na
Util
ities
ga
s an
d el
ectr
ic60
NE
C37
42
na
E
lect
roni
cs
elec
tric
al e
quip
men
t90
Tom
en31
18
na
T
radi
ng99
Mits
ubis
hi E
lect
ric30
35
na
E
lect
roni
cs
elec
tric
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men
t
Ch
ina
73S
inop
ec34
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na
P
etro
leum
ref
inin
g
Tot
al (
aver
age
for
tran
snat
iona
lity
inde
x)3
988
447
949
0T
otal
for
G-1
0 (a
vera
ge f
or t
he i
ndex
)3
954
442
749
0
na
= n
ot a
vaila
ble
G-1
0 =
Gro
up o
f T
en c
ount
ries
see
not
e to
tab
le 1
1
a
Dat
a sh
own
are
for
the
fisca
l ye
ar e
nded
on
or b
efor
e 31
Mar
ch 1
999
b
Ass
ets
show
n ar
e th
ose
at t
he c
ompa
nyrsquos
fis
cal
year
-end
c
The
ind
ex o
f tr
ansn
atio
nalit
y is
cal
cula
ted
as t
he a
vera
ge o
f ra
tios
of f
orei
gn a
sset
s to
tot
al a
sset
s f
orei
gn s
ales
to
tota
l sa
les
and
for
eign
em
ploy
men
tto
tot
al e
mpl
oym
ent
as o
f 19
97 (
UN
CT
AD
)
Sou
rces
F
ortu
ne G
loba
l 50
0 1
999
http
w
ww
pat
hfin
der
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fort
une
glob
al50
0in
dex
htm
l U
NC
TA
D (
1999
)
Institute for International Economics | httpwwwiiecom
94 WORLD CAPITAL MARKETS
foreign direct investment The ldquotransnationality indexrdquo (table 28) showsthat on average they conducted about half their business outside theirhome country9
Overview of the Players
Our review of the major players points to two major features First ahandful of big playersmdashfewer than 200 firms all toldmdashcontrol the ac-tion in international capital markets Their dominance will doubtless erodebut for now financial power is strikingly concentrated with them Sec-ond the big players are overwhelmingly based in the G-10 countriesplus Spain The responsibility to supervise them rests not in the IMFnor in Basel but squarely in Washington London Tokyo and the otherG-10 capitals At year-end 1999 the G-10 countries plus Spain accountedfor 84 percent of world banking assets 86 percent of world stock marketcapitalization and 76 percent of international debt securities (BIS 2000aWorld Bank 2000b)
International private capital flows are of three types bank loans anddeposits portfolio investment and foreign direct investment In cumula-tive total flows to emerging markets FDI was the biggest story in the1990s amounting to $954 billion (table 12) Portfolio flows were nextcumulatively amounting to somewhere between $612 billion (table 12)and $764 billion (table A1) Bank loans and deposits are the most com-plicated story
The Key Role of Banks
Banks are more important as an epicenter than as a wellspring Banksgenerate waves in the flow of capital to emerging markets rather than acontinuous steady stream According to data compiled by the Institute ofInternational Finance (table A1) net bank lending to emerging marketscumulated to $269 billion in the 1990s However deposits by emerging-market residents in G-10 banks more than offset G-10 bank lending tothese countries during the decade According to IMF data cumulativebank loans net of deposits amounted to a negative $135 billion (table 12)
In other words when loans and deposits are combined net bank ac-tivity that moves financial resources to emerging markets is small incomparison with portfolio investment and FDI But bank loans are thelubricant of any financial system Depending on circumstances bankscan be shock absorbers or shock propagators In recent decades with
9 The transnationality index is calculated as a simple average of the share of assetssales and employees outside the home country
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 95
respect to emerging markets banks have more often been propagatorsthan absorbers The average annual swing in bank lending to emergingmarkets was nearly $50 billionmdashby far the largest source of year-to-yearfluctuations in capital flows Both interbank loans between Europe Japanand Asia and sovereign Russian debt used as loan collateral played amajor role in the 1997-98 crisesmdashnot because banks are profligate playersbut because of the incentives they face and the instruments they useAccordingly our story begins with banks
Banks in the Modern Financial System
10 See Levine (2000) for a concise description of the role of banks in the financial system
11 The asymmetric information problem helps to explain why banks dominate the im-mature financial systems of emerging-market economies The general lack of informationon borrowers and undeveloped legal systems to enforce contracts hamper suppliers oflong-term financial instruments such as equities and bonds in evaluating risk and re-ward Banks are best suited in these circumstances to solve the asymmetric informationproblem by evaluating and monitoring private loans As more and better informationbecomes available capital markets develop and financial systems mature
As we noted in the previous paragraph the problem of financial volatil-ity in emerging-market economies is associated with bank lending Ifand when repayment problems arise cross-border private bank loansand bond placements are such that private creditors have no plausiblemeans of seizing assets from either private or sovereign borrowers Thusalthough international finance can nourish entrepreneurs and accelerategrowth a necessary complement may be a drastic creditor response inthe event of nonpaymentmdashto withhold fresh funds and force an eco-nomic crisis (Dooley 2000)
This argument is based on the characteristics of banks They are notldquobadrdquo per se They perform three essential functions in any financialsystem pooling the resources of disparate savers and channeling these re-sources into productive investment improving resource allocation throughtheir expertise in assessing and monitoring borrowers and facilitatingthe division of risk among numerous creditors10 But by their very na-ture banks are prone to two problems asymmetric information (the bor-rower knows more about the potential risk and return of its projectsthan the bank) and adverse selection (riskier borrowers will pay higherinterest rates and thus may constitute a disproportionate share of bankloan portfolios)11
Bank loans are illiquid fixed-price instruments They cannot easily beconverted to cash although they can be bundled into securities (knownas ldquosecuritizationrdquo) Once loan terms have been agreed on the only waya bank can adjust for shifting market conditions is by changing the quantityof its exposure When a borrower runs into trouble the bank can mix
Institute for International Economics | httpwwwiiecom
96 WORLD CAPITAL MARKETS
and match from two unpleasant menus It can roll over existing loansand extend new credit or it can call some part of existing loans andattempt to recover the principal It can also hedge by selling short otherclaims on the borrower These choices entail either an unwelcome exten-sion of the bankrsquos exposure or credit rationing against the borrower Whentrouble brews all banks encounter the same conditions in the aggregatethey prefer less exposure and ensuing credit restrictions lead to volatilebank lending
Innovation
12 Derivatives have no value of their own They ldquoderiverdquo their value from the value ofthe underlying asset They include swaps futures (contracts for future delivery at speci-fied prices) and options (which give one party the right but not the obligation to buyfrom or sell to a counterparty at an agreed price)
13 Maxfield (1998) analyzed available evidence of emerging-market investor objectivesmost of it before the crisis Analysis of portfolio equity flows is sensitive to the choice ofperiod with year-over-year data indicating that investors respond to country ldquofundamen-talsrdquo Other evidence suggests more ambiguity Ranking by ldquoinvestor impatiencerdquo ie thesearch for yield over value Tesar and Werner (1995) find short-term bank flows to be themost yield driven followed by portfolio investment FDI and long-term bank lending
14 Because market risk credit risk and country risk interact in complex ways newfinancial instruments have been created to help reduce negative interactions One is theldquototal return swaprdquo which has become an instrument of choice for hedge funds lookingfor high leverage Banks also use the total return swap to cover risks without increasingtheir capital requirements
Since the 1980s national and international banking systems have beentransformed by deregulation intensified competition and the informationand communications-technology revolutions The market environment isone of intense competition particularly in traditional banking activitiesThe innovations point away from traditional activities of plain vanilladeposit taking and loan making Three big themes are discernible Firstthe walls separating commercial banks investment banks portfolio man-agers and insurance firms are falling even if they are still distinct Sec-ond large banks are shifting toward securitizationmdashcreating securitiesout of everything from credit card debt to trade finance to disaster insur-ancemdashand earning fees in the process Third all large banks are shiftingtoward trading activity making markets and taking short-term stakes inbonds shares and derivatives12 These activities when successful satisfythe search for higher yields13
Many of the new financial instruments that banks trade are ldquooff bal-ance sheetrdquo This means that banks are not required to allocate capitalagainst them In swap contracts for example neither side pays cash at theoutset and therefore neither party has an asset in the traditional sense14
Futures and options contracts can be written with a relatively small initial
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 97
margin relative to the potential risk Credit derivatives limit credit risk bytransferring the potential loss associated with corporate loans and bondssovereign debt and other loan portfolios to counterparties15
Deregulation and innovation working in combination seem to havepushed banks into trading activity and leveraged plays but not into shareownershipmdasheven in jurisdictions that have no prohibition against equitystakes Among the G-10 banking systems the highest ratio of share own-ership to assets was only 5 percent in 1996 reached in Germany andJapan (Berlin 2000)16
The wave of innovation in financial instruments and the accompany-ing expansion of banking beyond its old boundaries is a two-edged swordOn one side it allows risk management far beyond what was tradition-ally possible Risk can now be shifted from firms that can ill afford lossesto those that can Banks can profitably act as intermediaries in shiftingrisk On the other side the innovation wave creates huge opportunitiesfor leveraged plays fostering a speculative search by banks themselvesfor high returns that in turn magnify their own risks17
15 Credit derivatives include total return swaps credit default swaps credit-linked notesand collateralized debt obligations They are the fastest-growing sector of the global de-rivatives market
16 Banks seem to specialize in lending even when they are allowed to mix finance andcommerce for reasons related both to how they are expected to behave with distressedfirms and to other intricacies of lender liability (Berlin 2000) Yet a recent cross-countrystudy found that restrictions on banking and commerce are associated with greater fi-nancial instability (Barth Caprio and Levine 2000)
17 Leverage is the magnification of the rate of return (positive or negative) on an in-vestment beyond the rate obtained by solely investing funds owned by the institution Itis often defined as the ratio of assets to equity Leverage is achieved by increasing thesize of an investment by borrowing or using derivative instruments such as futures oroptions These allow investors to earn a return on the notional amount underlying thecontract by committing a small portion of equity in the form of a margin deposit oroption premium payment
18 In a repo (repurchase agreement) one party (typically a trader) buys a bond andsells it to a dealer for cash with a promise to buy it back the next day at the same priceplus the overnight interest rate As long as the overnight interest rate is lower than theinterest accruing on the bond the trader earns some income on the bond The extremeform of these kinds of transactions was discovered at LTCM the failed US highly lever-aged institution which appears to have controlled more than $120 billion in assets froman investment of about $3 billion This leveraging was accomplished mostly through theuse of repos (Mayer 1999)
The potential for damage is illustrated in an extreme form by figure 21To precisely measure a firmrsquos leverage all positions must be known andrealistically valuedmdashwhich may be impossible to do Because many ac-tivitiesmdashsuch as repos18 and derivativesmdashdo not appear on the institutionrsquos
Leverage
Institute for International Economics | httpwwwiiecom
98W
OR
LD
CA
PIT
AL
MA
RK
ET
S
Figure 21 Hypothetical example of leverage
$1000 notional value of call option on equity in firms targeted for takeover
Repo FRN into cash and use cash to pay option premium
(repro is initially collateralized
Borrow $100 for margin purchase
$125 of US investment bank floating-rate notes (FRN) (secured by $25 equity in FRNs)
Repo off-the-run bond into cash and post margin
(repo is initially collateralizedSell (short) Borrow on-the-run bonds worth $20
$25 worth of off-the-run bonds (secured by $5 equity in bonds)
Exchange into $4
Cash $5 yen400 Japanese bank loans
$1 equity base
FRN = floating rate notesRepo = repurchase agreement
Source IMF (1998)
Institute for International Econom
ics | httpww
wiiecom
THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 99
balance sheet and because balance sheets are published quarterly at bestoutsiders have a difficult time assessing the extent of a firmrsquos leverage19
Leveraging by a single firm enhances its risk of default the widespreaduse of leverage in the financial system can magnify market adjustmentsespecially when they require ldquodeleveragingrdquomdashunwinding prior positionsRapid adjustments can cause credit to dry up and asset prices to plummetIn a mark-to-market environment falling asset prices trigger calls foradditional collateral that can ripple through markets
Risk Management
Because it is confronted with the widespread use of leverage and prolif-erating kinds of risk international finance is increasingly driven by riskevaluation and control20 Different institutions face various risk profilesand differing kinds of risk The most common risks can be quickly tickedoff Banks because of their traditional intermediary role of channelingthe resources from savers to borrowers face significant credit risk therisk of default or delay in the payment of principal and interest Theymust also manage market risk the risk that the prices of their liabilitiesmay change faster than their assets Market risk devastated US savingsand loan institutions in the late 1980s
Closely associated with market risk are interest-rate risk (unexpectedchanges in market interest rates that slash margins net income and theeconomic value of a bankrsquos equity) and foreign exchange risk (losses thatarise when assets denominated in an appreciating foreign currency areless than liabilities denominated in that currency) Banks make numer-ous loans to other banks around the world portfolio investors buy se-curities direct investors acquire fixed assets and all incur country risk(economic and political uncertainty in the host country) During the heightof the Asian crisis for example interbank loans to Japanese banksreflected the credit risk of lending to these banks the so-called Japanpremium
Substantial attention has been lavished on country risk analysis sincethe 1982 debt crisis in developing countries Yet in spite of this exper-tise the Asian crisis occurred in part because of a sudden upward reap-praisal of country risk after the Thai baht collapsed in April 1997 Banksand other financial institutions must also manage liquidity risk the riskthat market conditions will change unexpectedly depressing demand andprices of assets at the time they want to sell these assets And they mustmanage operational riskmdashfailures in control systems or people that cause
19 Another example of asymmetric information Both risk and leverage are difficult foroutsiders to assess without full timely disclosure
20 A longer discussion of these issues can be found in Managing Global Finance in IMF(1999c)
Institute for International Economics | httpwwwiiecom
100 WORLD CAPITAL MARKETS
financial loss or damage reputations Operational risk devastated BaringsBank in 1995
Financial institutions practice risk management to measure all theserisks the potential damage to their investment positions and ultimatelythe chance of becoming insolvent VAR (value at risk) risk models mea-sure subject to certain assumptions the amount of the firmrsquos capital thatis exposed in each period For example the VAR model might say thatin a 3-standard-deviation worst case (a case that is not supposed to hap-pen more than 1 percent of the time) the firm will loose 25 percent of itscapital during the next year
VAR models are widely used but like all models they have weak-nesses They rely on past values to estimate key variables in financialmarkets past values are not always good predictors of future risks More-over rising volatility and higher loss correlation among different assetclasses in a portfolio will cause all banks using these models to reducetheir exposures at the same time by switching to less volatile and lesscorrelated assets such as US Treasury bills (Persaud 2000)
Newer risk models entail stress testing and scenario analysis Scenarioanalysis envisages possible adverse changes one at a time that mightaffect the investment portfolio Stress testing estimates potential losseswhen several individual risk factors simultaneously move against thefirm but it too uses historical probabilities
Financial Volatility
21 For example derivative markets usually rely on underlying securities markets thatproduce continuous prices When these markets are interrupted financial shocks cantrigger a cascade of margin calls and sell orders that move prices very sharply
22 See IIF (1999a)
The combination of trading activity and modern risk management lie atthe root of financial volatility When risks increase banks must eitherraise more capital to cover the greater risk or reduce their exposure bycutting loan exposure by selling securities or by undertaking new de-rivative trades Raising more capital is time-consuming and in a crisisvery expensive because bank shares are depressed So banks look to theother alternatives If the bank can reduce lending it need not book aloss But most banks use the same VAR models and as indicated abovethese models will encourage them to reduce their outstanding loans atthe same time actually magnifying loan volatility
If banks attempt to reduce their exposure to risk by selling securitiesor undertaking new derivative trades they may trigger large priceshocks because of limited and shrinking market liquidity21 The liquid-ity problem is compounded when a small number of large institu-tions hold the same positions22 Take your pick loan volatility or price
Institute for International Economics | httpwwwiiecom
THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 101
volatility As two experts have observed (Folkerts-Landau and Garber1998)
[V]olatility even in one country will automatically generate an upward re-estimate of credit and market risk in a correlated country triggering automaticmargin calls and tightening of credit lines Thus apparently bizarre opera-tions that connect otherwise disconnected securities markets are not the re-sponses of panicked green screen traders arbitrarily driving economies from agood to a bad equilibrium Rather they work with relentless predictability andunder the seal of approval of supervisors in the main financial centers
23 See Ferguson (1999)
24 As Gerald Corrigan (1982) put the matter ldquoBanks are specialrdquo Corrigan (2000) reit-erated this view even after all the changes of the past two decades Unlike other institu-tions banks offer on-demand transactions are a backup liquidity source for other insti-tutions and serve as a ldquotransmission beltrdquo for monetary policy
These changes in the banking environment accentuate an existing anomalyThe anomaly is that banks even as they grow larger and increasinglyengage in more risky and complex transactions are perceived to enjoyimplicit and explicit public guarantees
The guarantees grow out of an incentive problem inherent in bankingasymmetric information which we mentioned above Depositors know lessabout a bankrsquos management and the quality of its balance sheet than doits managers and shareholders Thus in times of uncertainty or adver-sity bank depositorsmdashuncertain whether they will have access to theirdepositsmdashare prone to bank runs This prospect has in turn compelledgovernments to treat banks differently than other firms because a bankthat fails can disrupt the rest of the economy24
To prevent such crises governments have entered into quid pro quoarrangements with banks Governments provide them both with an im-plicit safety net in the form of an unstated promise by the central bankto act as a lender of last resort in a liquidity crisis and an explicit safetynet in the form of a public deposit insurance fund to reassure depositorsIn return the banks submit to closer government oversight and regu-lation of their activities than is usual for industries in the private sector
The ldquoinsurancerdquo provided by the public safety net contributes to an-other incentive problem moral hazard Banks acquire greater tastes forrisk and face less market discipline than other firms The explicit depositinsurance safety nets actually have or are perceived to have blanketcoverage that extends beyond the retail depositors (households and small
One of the lessons of the 1997-98 crisis must surely be that market par-ticipants and their regulatory supervisors relied too heavily on quantita-tive tools and insufficiently on judgment23
The Anomaly of Modern Banking
Institute for International Economics | httpwwwiiecom
102 WORLD CAPITAL MARKETS
businesses) for which they were originally intended The implicit centralbank safety nets extend in a crisis to nearly all depositors and banksThus banks are both viewed and behave as if they will be bailed out ifthey get into trouble
The existence of a public safety net raises a perennial question Dobanks have an unfair advantage over other financial institutions becauseof the subsidy provided by the safety net This question was at the heartof intensive study and debate in the United States leading up to thepassage in November 1999 of the Financial Services Modernization Act(also known as the Gramm-Leach-Bliley Act) The size of the gross sub-sidy is difficult to estimate despite determined research efforts Somesuggest it is well under 100 basis points and is at least partly offset bythe direct costs of deposit insurance premiums interest payments on bondsissued by the Financing Corporation25 reserve requirements regulatoryexpenses and operational costs associated with collecting deposits26 Con-versely Kwast and Passmore (2000) suggest that banks can expand theirscope far beyond the levels that other financial institutions could reachwith the same equity base but without the public safety net
A related concern in the US debate is whether allowing banks to ex-pand their activities into securities and insurance will ultimately extendthe safety net and add to the subsidy The Financial Services Moderniza-tion Act deals with this issue by maintaining a legal separation betweenbanks and the rest of the banking organization known as large com-plex banking organizations (LCBOs) They must engage in most securi-ties activities and insurance underwriting through separately capitalizedinvestment bank subsidiaries or holding company affiliates This act canbe said to have merely brought US banking laws closer to those of mostother industrial countries (Barth Brumbaugh and Wilcox 2000 BarthNolle and Rice 2000) If the fire wall is well-maintained and stoutly de-fended the safety net will neither expand in practice nor become a sourceof comfort to noncommercial bank subsidiaries of LCBOs
The quid pro quo exacted by governments to offset the subsidy iscloser public-sector monitoring of banksrsquo activities through prudentialsupervision The effectiveness of this closer official scrutinymdashand closermarket monitoringmdashare the subjects of the next section
25 The Financing Corporation was created by Congress in 1987 to sell bonds to raisefunds to help resolve the savings and loan crisis
26 See Levonian and Furlong (1995) Jones and Kolatch (1999) Shull and White (1998)and Whalen (1999a 1999b)
Are G-10 bank supervisors adequately responding In this section we firstassess the case for and compare the structures of prudential supervisory
Prudential Supervision
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 103
systems both within and among the G-10 economies plus Spain andconsider whether these offset the subsidy provided by the public safetynet Despite offsetting regulation and supervision implicit and explicitguarantees by G-10 governments to their banks are still a source of bank-ing instability in the emerging-market economies
National Systems for Prudential Supervision
Governments use prudential supervision to reduce the moral hazard andadverse selection created by their own safety nets Supervisors establishregulations and monitor compliance to limit risk taking and ensure thesafety and soundness of the banking system In a thoughtful analysis ofthe case for prudential supervision Frederic Mishkin (2000) identifiesthe main forms that supervision can take including the tasks of grantingbanking charters and licenses establishing capital requirements settingdeposit insurance premiums and defining disclosure requirements as wellas carrying out bank examinations Bank examiners gather informationfrom banks and evaluate whether they are following the regulatorsrsquo rulesin cases of weakness they are empowered to change banksrsquo behaviorand close them if necessary
Supervisors also may restrict competition define the activities in whichbanks may engage and restrict their asset holdings and separate banksand other financial (or nonfinancial) activities During the past two de-cades the barriers separating commercial banks investment banks in-surance firms and securities firms have been all but eliminated (tableB1) Deregulation has stimulated competitive forces that drive diversifi-cation and consolidation of the financial industry nowhere faster than inthe United States
The Financial Services Modernization Act of 1999 confirmed this trendIt eliminated restrictions dating back to the Glass Steagall Act of 1933which once prevented banking insurance and securities firms fromentering each otherrsquos businesses (Barth Brumbaugh and Wilcox 2000)Cross-pillar mergers among banks insurance and securities firms arewell under way to form giant financial holding companies The 1999merger between Citibank (banking) and Travelers (insurance) created themodel for megafinance and confirmed new challenges for supervisors
Mishkin (2000) notes the corresponding evolution in US supervisionfrom an emphasis on rules-based regulation (detailed rules for opera-tional behavior and the quality of line items in the balance sheet) to anapproach that stresses the soundness of bank management practices es-pecially risk management
Appendix B outlines the systems of financial supervision now in theplace in the G-10 countries plus Spain Some systems like the UK andCanadian approach are models of simplicitymdashorganized to keep pacewith the spreading reach of financial conglomerates Other systems like
Institute for International Economics | httpwwwiiecom
104 WORLD CAPITAL MARKETS
the US and French approaches show traces of the bureaucratic divisionsthat made sense in an era when banking securities and insurance weresharply separated
The US Model
27 See Meyer (1999a)
28 Canada has a similar degree of simplification with the exception that securities firmsare still regulated by provincial authorities
29 See Pratti and Schinasi (1999 67)
30 The agents are the bank regulators and the principals are the taxpayers Agents maypursue their own interests including bureaucratic survival and postgovernment employ-ment opportunities rather than the national interest in banking safety and soundness
The US model of financial regulation delineated in the Financial Ser-vices Modernization Act of 1999 blends functional and umbrella super-vision Bank and thrift regulators oversee depository institutions Newnonbank activities are subject to both functional regulation (eg by theSecurities and Exchange Commission and state insurance examiners) andumbrella supervision (of financial holding companies) by the FederalReserve27
The UK Model
Another supervisory model exists in the United Kingdom as well as inAustralia Canada and Switzerland28 In this model banking supervisionis separated from the monetary policy function The regulatory structureis considerably simplified by relying on a consolidated financial regula-tor separate from the central bank for both banking and nonbankingactivities The remaining question answered differently depending on thecountry is the extent to which the regulator relies on home-country sur-veillance of banks and conglomerates that have a local presence
Regulatory Models Compared
Appendix B provides more detail on the differences in these modelsGerman simplicity contrasts with French complexity In France the bankingcommission is chaired by the governor of the central bank and includesrepresentatives from the Treasury The commission supervises compli-ance with regulations but the central bank inspects banks on behalf ofthe commission29 In countries such as the United States and France withmultiple supervisors and crossover functions internal coordination is criticalAt the same time multiple agencies create regulatory competition Wheneach agency knows what the other is doing transparency within gov-ernment circles can help to limit principal-agent problems of regulation30
The discussion as to where in the public bureaucracy financial super-
Institute for International Economics | httpwwwiiecom
THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 105
vision should be placed goes back many years Peek Rosengren andTootell (1999) argue that a synergy exists between monetary policy andprudential supervision because information gained in the course of super-vision can increase the accuracy of macroeconomic forecasts A twist tothis argument is that the information on the state of financial institutionsavailable to the central bank as supervisor can facilitate its role as lenderof last resort Conversely there is the concern that a supervisory rolewill compromise the central bankrsquos independence of action with respectto its core mandatemdashmaintaining price stability As these arguments haveplayed out financial supervision has generally been shared between centralbanks and other regulators or placed entirely in the hands of an inde-pendent regulator However in Italy the Netherlands and Spain cen-tral banks are the sole banking supervisor
Goodhart (1995) examined the arguments and evidence for each modeland concluded that there were no overwhelming arguments or evidencefor one or the other31 Going forward a key problem for any financialsupervisory system is dealing with (and closing as necessary) weak banksIf both central banks and other regulators have this responsibility closecoordination between them is critical Another problem is large conglom-erate banks LCBOs Although they are less likely to fail because of thediversification of their assets and liabilities they are more likely to berescued They are also more likely to be multinational enterprises withinternational implications Goodhart observes that regulation of theseentities might be put in the hands of the central bank because it is lessamenable to political pressures In any event the complexity of LCBOoperations suggests that greater supervisory rigor is necessary
The US Congress was persuaded that broad oversight would help containthe moral hazard problem and accordingly gave the Federal Reservethe role of umbrella supervisor with the understanding that the Fed willscrutinize depository activity more intensely than nonbank financial ac-tivities Under this approach LCBOs such as Citigroup are subject tomuch closer monitoring than smaller and simpler institutions32 The USregulatory model requires enormous cooperation between the Fed otherbank supervisors and the functional regulators for insurance and securi-ties but it also benefits from regulatory competition
31 National systems of supervision are path dependent they are determined by the struc-ture of financial institutions and history in each country If Goodhart (1995) is right out-comes are not materially better or worse with one model of supervision rather than another
32 See Ferguson (1999)
Public Safety Nets
One of prudential supervisorsrsquo biggest challenges is to reduce moral hazardFor many years commercial banks engaged in communal self-insurance
Institute for International Economics | httpwwwiiecom
106 WORLD CAPITAL MARKETS
to deal with crises They formed voluntary groups that agreed to rescuetroubled members As financial markets evolved and competition inten-sified banks were no longer willing to play this role Private-sector in-surance is one alternative but moral hazard and adverse selection wouldappear to prevent it from happening Public safety nets have developedbecause of the low probability and high cost of potential bank runs Aclear trade-off is involved The effectiveness of insurance in preventingbank runs is greater the more comprehensive the coverage But the morecomprehensive the coverage the greater the moral hazardmdashbank man-agers bank directors investors and depositors all take on greater risksin the belief that the safety net will protect them against losses
All G-10 countries have compulsory public safety nets for banks (table29) Deposit insurance agencies are officially organized in Canada theNetherlands Sweden Switzerland and the United States organized bythe industry in France Germany Italy and the United Kingdom andjointly organized by the public and private sectors in Belgium Japanand Spain
How well do G-10 governments offset the subsidy provided by thepublic safety net This is a question on which there is substantial debateAs banking organizations have become more complex the challengesthat supervisors face have become more difficult One challenge is toalign the incentives facing bank managers and shareholders with thoseof depositors Another is the principal-agent problem in supervision Wehave discussed the incentive structures for financial institutions but wehave said little about the incentives for supervisors themselves and thedistortions they can generate in the financial system
In one of the many studies of the US savings and loan crisis of the1980s Kane (1989) documented both problems He described managersusing cosmetic approaches to disguise the magnitude of insolvency regulatorspracticing forbearance even though they knew of the deteriorating riskprofiles of the institutions for which they were responsible and legisla-tors increasing deposit insurance without regard for any offsetting changesin supervision A subsequent overhaul of the legislative framework forthe Federal Deposit Insurance Corporation (FDIC) known as the FDICImprovement Act of 1991 (FDICIA) aimed to introduce a clearer incen-tive structure for both regulators and regulated institutions
The changes introduced by this US legislation are worth discussionwith respect to the other G-10 countries as well First FDICIA created astronger signal to management and investors by targeting deposit insur-ance at small depositors only and by risk-weighting the deposit insur-ance premiums paid by banks to reflect their capital adequacy and bankexaminer ratings Among the G-10 countries rated in table 210 depositinsurance premiums vary considerablymdashbut it is not clear that the dif-ferences have much to do with risk-weighting Most G-10 countries em-ploy funding formulas based for example on the total domestic deposit
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Table 29 Deposit insurance schemes in the G-10 countries Explicit safety net
Coverage limit(dollar Foreign
equivalent currency Interbank Source Bankrsquos Contingency fundingDate Membership Co- at end of deposit deposit of premium from banks
Country established managementa insuranceb July 1998)c covered covered Fundingd funding costs or governments
United 1982 Compulsory Yes Larger of 90 No No Unfunded Banks only Callable (subject Parliament may increase Kingdom private percent co- to maximum the maximum payable
insurance to 03 percent of pound125 million advance 33000 total deposits) facility with Bank of
England
United 1934 Compulsory No 100000 Yes Yes Funded Banks and Up to 027 Borrowing up to $3 States official government percent total billion from US Treasury
domestic deposits
Japan 1971 Compulsory No 71000 but No No Funded Banks and 0084 percent of Borrowing up to yen500bn joint in full until government insured deposits from Bank of Japan
year 2000 subject to Ministry of Finance approval
Canada 1967 Compulsory No 40800 No Yes Funded Banks and 033 percent of Borrowing up to C$6 official government insured deposits billion authorized further
(maximum) borrowing subject to parliamentary approval
Germany 1966 Compulsory Yes 90 percent Yes No Funded Banks only 003 percent of Annual levy may be private coinsurance deposits doubled
to 22000
Italy 1987 Compulsory Yes 125000 Yes No Unfunded Banks and Callable Two options defer private government (maximum of payment or diminish
1 percent of compensation to be paid total deposits)
(table continues next page)
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Table 29 Deposit insurance schemes in the G-10 countries Explicit safety net (continued )
Coverage limit(dollar Foreign
equivalent currency Interbank Source Bankrsquos Contingency fundingDate Membership Co- at end of deposit deposit of premium from banks
Country established managementa insuranceb July 1998)c covered covered Fundingd funding costs or governments
Netherlands 1979 Compulsory No 22000 Yes No Unfunded Banks and On demand Government backing official government maximum of subject to parliamentary
5 percent of own approval funds
France 1980 Compulsory No 65400 No No Unfunded Banks only Callable (on Extra calls up to FFr1000 private demand calls million can be made in
up to FFr200 a 5-year period million)
Switzerland 1984 Voluntary No 19700 No No Unfunded Banks only Callable (on Underwritten by member official demand) banks
Sweden 1996 Compulsory No 31400 Yes No Funded Banks and 05 percent of Full emergency coverage official government deposits while replacing it with a
limited system after the emergency
Belgium 1974 Compulsory No 16600 No No Funded Banks and Callable 002 None insurance limited joint 22000 in government percent of to assets in fund
year 2000 deposits from clients
Spain 1977 Compulsory No 16439 Yes No Funded Banks and 02 percent of Government backing joint government deposits through the Banco de
(maximum) Espantildea subject to approval by royal decree
a Bank membership in the fund can be either compulsory or voluntary and the management of the fund can be official and official and private joint or privateb Coinsurance refers to the situation where depositors face a deductible against their insured fundsc Coverage limit refers to the explicit amount the authorities promise to insured Funded scheme means that it is funded ex ante unfunded otherwise
Sources Goodhart (1995) Demirguccedil-Kunt and Detragiache (2000) Demirguccedil-Kunt and Sabaci (2000)
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 109
base Explicit safety net protection also varies but only Canada focuseson the protected class33 All G-10 countries specify a limit on depositorprotection Under FDICIA the insurance fund is prohibited from pro-tecting uninsured depositors or creditors at a failed bank although adiscretionary system-wide override is provided for exceptional circum-stancesmdashbut with stringent requirements for consultation and account-ability Other G-10 countries allow for contingency funding from the publicpurse alongside unwritten lender-of-last-resort support Among large banksa significant and growing portion of deposit liabilities including foreigncurrency and interbank deposits are uninsuredmdashbut depositors assumethey will be protected in a crisis
FDICIA also made some significant qualitative changes to address theprincipal-agent problem by penalizing weak banks and rewarding strongbanks For example banks whose capital declined faced progressivelytougher regulatory sanctions that for example required them to elimi-nate dividends restrict their lending and change their managementsRegulators have also been forced to take prompt corrective action (toreduce the practice of regulatory forbearance in hopes that a bankrsquos for-tunes might improve)34 Unfortunately comparative qualitative assess-ments across the G-10 are difficult to make due to lack of information35
This discussion highlights the complexity of evaluating the extent towhich prudential supervision and market discipline reduce the moralhazard associated with G-10 safety nets Our argument is that publicsafety nets in the G-10 can be linked to banking instability in other coun-tries specifically in the emerging-market economies that have attractedG-10 cross-border bank lending This lending is a leading source of vola-tility in capital flows the large financial institutions many of which arecomplex banking organizations are based in and regulated by authori-ties in the G-10 economies These two features of the international finan-cial system are closely related although it is not possible to test thisrelationship econometrically
Two World Bank studies however indicate a basis for concern Onestudy is a cross-country econometric analysis of the relationship betweenbank stability and deposit insurance (Demirguccedil-Kunt and Detragiache2000) which found a negative relationship Their estimated model forbanking crises in a sample of 61 countries (both industrial and develop-ing) suggests that explicit deposit insurance raises the probability of acrisis by at least 30 percent36 Crises are especially likely in countries
33 Japanrsquos legislation says it does but recent experience shows this is not the case34 See Goldstein (1997) for a summary of the changes35 See Barth Nolle and Rice (2000) for a beginning in this area36 Demirguccedil-Kunt and and Detragiache (2000 table 1) report a logit coefficient of 0696with a standard error of 0397 (the coefficient is significant at the 8 percent threshold)This suggests that the ldquotruerdquo coefficient could well be as small as 030 (the reportedvalue minus the standard error)
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110 WORLD CAPITAL MARKETS
with immature financial supervisory systems (and not in the G-10) buttheir analysis does underscore the view that deposit insurance weakensmarket discipline37
An earlier World Bank analysis established similar results One wasthat market discipline is undermined by deposit insurance schemes an-other was that illiquid banks are forced to pay more for their funds un-less a generous deposit insurance scheme is in place (Demirguccedil-Kuntand Huizinga 1999) This econometric study also provides clear-cut evi-dence that depositor monitoring of banks declines with the existence ofdeposit insurance schemes At the heart of the problem is the questionof whether deposit insurance is accompanied by increased governmentmonitoring
This evidence and the weight of other arguments suggests that moralhazard is still an issue in the G-10 countries Consider the ongoing de-bate about instilling greater market discipline on risk taking by banksAt one extreme is the perennial proposal to do away with safety netsleaving markets to monitor the players and to force adjustments but toprotect small savers by creating ldquonarrow banksrdquo such as postal savingsystems that are allowed to invest these savings only in risk-free gov-ernment securities Whatever the merits of narrow banking this solutionis too extreme to be politically feasible
A moderate alternative is to force more disclosure by financial institu-tions to facilitate market monitoring But transparency has its own prob-lems Persaud (2000) argues that financial markets cannot reliably discernsustainable from unsustainable positions in the short term This uncer-tainty causes banks to ldquoherdrdquo behind market leaders to exploit theirsupposedly superior information ldquoThe more herding investors and bankersknow about what each other is up to the [more] unstable markets maybecomerdquo The implication is that greater transparency in the marketplaceby itself will not solve the problemmdashand in the short term more informa-tion may exacerbate herding Further supervisory steps (discussed in thenext chapter) are required
Yet another proposal is to promote private-sector involvement in bankmonitoring through market-based alternatives such as Calomirisrsquos sub-ordinated debt proposal (Calomiris 1997 Federal Reserve Board 1999)Banks could be required to issue and maintain a minimum amount of
37 Other findings in the Demirguccedil-Kunt and Detragiache (2000) study include thesepropositions The impact of deposit insurance on bank stability tends to be stronger themore extensive is the coverage offered to depositors when the scheme is funded andwhere the scheme is run by the government rather than by the private sector Con-versely deposit insurance is detrimental to bank stability where bank interest rates havebeen deregulated and where the institutional environment is weak Additional findingson deposit insurance are reported from a recent World Bank conference (8-9 June 2000httpwwwworldbankorgresearchinterestconfsupcomingdeposit_insurancehomehtm)Also see Smalhout (2001)
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 111
subordinated debt (eg uninsured certificates of deposit) to finance asmall fraction (such as 2 percent) of their total nonreserve assets Thesubordinated debt would be allowed to earn a set yield no more than 50basis points over the risk-free yield on government treasury bills Thisrule would supposedly force banks to operate in a safe manner Other-wise subordinated debt holders would redeem their uninsured certifi-cates of deposit and equity investors would sell their bank shares Despiteits practical problems the beauty of the subordinated debt requirementis that it enlists market incentives to push banks to avoid excessive port-folio risk38
The thrust of these proposals is very relevant to the arguments in ourstudy Even in the G-10 countries government monitoring by itself hasnot eliminated moral hazard among banks More work is needed to in-troduce market monitoring and to improve the incentive structures bothfor financial institutions and their supervisors We return to this issuewith our recommendations in the next chapter
38 In late 1996 Argentina began requiring its banks to finance 2 percent of total depos-its in the form of subordinated debt but without a maximum yield provision TheArgentine authorities expect that market discipline will act in concert with the publicsafety net One obvious problem with the subordinated debt proposal is that banks mayencourage some of their customers to buy the subordinated debt
Portfolio Institutions Tomorrowrsquos Problem
Before proceeding to the issues of international supervision we flag an-other potential problem for national regulators The big asset managersprofiled in tables 24 and 26 answer to diverse groups of pensionersshareholders and policyholders They allocate funds across a number ofcountries to diversify their risks They hold liquid assets that can be tradedand they have a higher proportion of long-term assets than banks Eco-nomic shocks can be absorbed through price changes and their effectsspread across time and markets Thus when conditions change in a par-ticular market they are more likely to ride out the storm than to flee Inother words they have less incentive than banks to pull their invest-ments in the face of adversity In the 1990s most large asset managersestablished a record of ldquoriding out the stormrdquo rather than ldquorunning withthe windrdquo although as we saw in chapter 1 instances of running withthe wind were detected in some portfolios As we write these insti-tutions have a good record overall in the emerging markets so whyworry
The Russian crisis and the near-collapse of LTCM previewed the dan-gers that may await future portfolio managers and G-10 financial minis-ters We have presented evidence indicating a systemic bias toward bank
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112 WORLD CAPITAL MARKETS
lending and debt finance to emerging markets and we have argued forsubstitution toward equity finance and direct investment39
That is not the end of the story We noted in the previous chapterthat institutional investors can become momentum investors selling in adownturn As more portfolio capital is invested in emerging marketssome players may adopt the high-risk high-leverage strategies of themost aggressive hedge funds Indeed the data in box 11 show that G-10portfolio investors held somewhat more long-term debt (more than $500billion) than equity (less than $400 billion) in emerging markets at theend of 1997 Long-term debt is an ideal vehicle for high-risk high-leveragestrategies These strategies practiced on a large scale could compound afuture crisis harming emerging markets A big enough crisis could inturn pressure G-10 central banks and finance ministers to arrange bail-out plans Instead of shrinking as a systemic financial problem moralhazard could increase
National securities regulators are the first line of defense against thisscenario They play a critical role in the safe evolution of capital mar-kets But regulators today are mandated to approve the issuance of newsecurities and to monitor the continuing disclosure of material informa-tion by issuers They are far less concerned with or empowered to monitorthe behavior of the increasingly large wealth-management firms that arethe major purchasers (and therefore resellers) of these securities
Within their mandates the goals of national securities regulators (table210 and appendix B) are similar to the concerns of bank regulators withsystem safety and soundness Their focus is also on the incentive sys-tems for management and boards of directors and on disclosure by cor-porations that issue marketable securities such as shares bonds andasset-backed securities 40 Issuers of securities possess greater knowledgeabout the quality of these assets than do the purchasers hence investorprotection is a key concern of regulators Moreover market disciplineworks best when markets know what is happening Well-functioning corpora-tions are key agents of wealth creation and social progress Underperform-ing corporations waste resources During recessions bad corporationsget into bad trouble often with severe social consequences Inadequateincentives for managers and inadequate accountability for boards andmanagers thus have negative externalities Regulators play a vital role inexposing weakness so that market disciplines come to bear sooner ratherthan later
Regulatory emphasis is constantly shifting as financial markets evolveand as the macroeconomic environment changes Regulators try to balance
39 See Rogoff (1999) Also see Berlin (2000) for a perspective on the limited role thatbanks play as share owners
40 See Habib and Ljungqvist (2000) for recent empirical analysis showing that corporateshare market values are higher when corporate executives have a larger ownership stake
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Table 210 Financial-sector regulation G-10 countries 2000
Financial institutions and their supervisors
Country and supervisory structure Retail banking Wholesale banking Securities Insurance
Financial conglomeratesFinancial Services Authority (FSA) = umbrella supervisor
United Kingdom FSA FSA FSA FSA
Treasury bull Commercial banks bull Investment funds (Securities and (Insurance Directorate(Securities and Investments Board) bull Unit trust groups Futures Authority) of the Treasury)
Bank of bull Building societies bull Pension funds England (Building Societies Commission) bull Merchant banks
bull Friendly societies bull Clearing houses bull Primary issuers bull Insurance FSA (Friendly Societies Commission) bull Venture capital of securities companies
bull Pensions and life insurance etc bull Stock exchanges bull Insurance brokers(Personal Investment Authority) bull Stockbrokers
Financial holding companiesFederal Reserve (FR) = umbrella supervisor
United States bull National banks(OCC) Securities and Regulated by
Treasury OCC bull State banks Federal Reserve Exchange Commission StatesMembers (FR)
OTS Nonmembers (FDIC) bull Investment banks bull Primary issuers of bull Insurance companies FR bull Cooperative banks (FDICFR) bull Finance companies securities bull Insurance brokers FDIC bull Insured industrial banks (FDIC) bull Stock exchanges
bull Thrift holding companies (OTS) bull Stockbrokers SEC bull Savings banks (OTSFDICFR) bull Investment advisors
bull Savings and loan associations bull Mutual funds(OTS) bull Public utility holding
bull Edge Act corporations (FR) companies
(table continues next page)
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Table 210 Financial-sector regulation G-10 countries 2000 (continued )
Financial institutions and their supervisors
Country and supervisory structure Retail banking Wholesale banking Securities Insurance
Financial holding companies Japan Financial Supervisory Authority (FSA) = umbrella supervisor
Prime FSA FSA FSA FSA ministerrsquos Ministry of office Finance (Securities and Exchange
Surveillance Commission) FRC Bureau of Financial bull City banks bull Investment banks bull Primary issuers of bull Insurance companies FSA Regulation bull Regional banks bull Asset managers securities bull Insurance brokers
bull Trust banks bull Stock exchanges SESC bull Long-term credit banks bull Stockbrokers
bull Pension funds
Financial holding companiesOffice of the Superintendent of Financial Institutions (OSFI) = umbrella supervisor
Canada Regulated by OSFI OSFI provinces OSFI
Department of Financebull Banks bull Cooperative credit bull Primary issuers of bull Insurance companies
(previously Office of the Inspector associations securities (previously Depart- OSFI General of the Banks) bull Fraternal benefit bull Stock exchanges ment of Insurance) Bank of bull Trust and loan companies society bull Stockbrokers bull Insurance brokers Canada bull Pension funds bull Asset managers
(previously Depart- CDIC ment of Insurance)
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115
Financial institutions and their supervisors
Country and supervisory structure Retail banking Wholesale banking Securities Insurance
Germany Financial holding groupsFederal Banking Supervisory Office (FBSO) = umbrella supervisor
Ministry of Finance FBSO BSO FSSO FISO
Bundesbankbull Universal banks bull Other financial bull Primary issuers of bull Insurance companies
Federal Banking bull Savings banks institutions (eg securities bull Insurance brokers Supervisory Office bull Securities banks management foreign bull Stock exchanges
currency dealings) bull Stockbrokers Federal Securities bull Financial enterprises bull Asset managers Supervisory Office (eg leasing bull Pension funds
organizations Federal Insurance credit card companies Supervisory Office investment advisors)
Italy Bank foundationsMinistry of Finance = umbrella supervisor
Ministry of Finance Bank of Italy Bank of Italy Consob ISVAP
Bank of Italy bull Commerical banks bull Asset managers bull Primary issuers of bull Insurance companies Consob bull Savings bank bull Open-end investment securities bull Insurance brokers
bull Securities banks companies (SICAVs) bull Stock exchangesbull Stockbrokers
ISVAP
(table continues next page)
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Table 210 Financial-sector regulation G-10 countries 2000 (continued )
Financial institutions and their supervisors
Country and supervisory structure Retail banking Wholesale banking Securities Insurance
The Netherlands Financial conglomeratesCouncil of Financial Supervisors = umbrella supervisor
Securities Board Securities Board Netherlandsche Netherlands Bank Netherlandsche Bank of the Netherlands Insurance Board Bank Insurance bull Credit institutions (universal banks bull Investment institutions bull Stock exchanges bull Insurance companies Board cooperative banks security credit (securities issuing bull Stockbrokers bull Insurance brokers
institutions mortgage banks) and tradingmdashprimary The Council of Financial and secondary Supervisors markets)
France Commission des Commission de Operations des Controcircle des
Banking and Banking Commission Bourse Assurances Financial Regulatory bull Ensuring that credit institutions (and investment firms since bull Primary issuers of bull Insurance companies Ministry for Committee the Financial Activity Modernization Act of 1996) comply securities bull Insurance brokers Economic with laws and regulations bull Stock exchanges Affairs and bull Execute instructions regarding all off-site monitoring and bull Stockbrokers Finance Credit on-site supervision Institutions and Banking and Financial Regulatory Committee Investment bull Formulates general regulations for credit institutions and investment firms Committee (capital adequacy requirements accounting rules etc) Bank of France Credit Institutions and Investment Committee Banking bull Authorizes and examines financial institutions except for those within the Commission competence of the Banking Commission
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117
Financial institutions and their supervisors
Country and supervisory structure Retail banking Wholesale banking Securities Insurance
Switzerland Large banking groupSwiss Federal Banking Commission (SFBC) = umbrella supervisor
Swiss National Bank Federal Office of
SFBC SFBC SFBC Private Insurance Swiss Federal Banking Commission bull Universal banks bull Investment banks bull Primary issuers of bull Insurance companies
bull Savings banks bull Asset management securities bull Insurance brokerscompanies bull Stock exchanges
Private audit Federal bull Investment funds bull Stockbrokers firms Office of bull Mortgage bond authorized by Private business SFBC Insurance
Sweden Financial holding company groupsFinancial Supervisory Authority = umbrella supervisor
Ministry of Finance Credit Market Securities Market Insurance Market
Credit Market Department Department Department Department
Financial bull Commercial banks bull Investment funds bull Primary issuers of bull Insurance companies Riksbank Supervisory bull Savings banks securities bull Insurance brokers Authority bull Friendly societies bull Stock exchanges
bull Stockbrokers
(table continues next page)
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Table 210 Financial-sector regulation G-10 countries 2000 (continued )
Financial institutions and their supervisors
Country and supervisory structure Retail banking Wholesale banking Securities Insurance
Belgium Bank holding companiesBanking and Finance Commission = umbrella supervisor
Bank of Belgium Banking Banking
Banking and Finance and Finance Insurance Controland Finance Commission Commission Commission Office
Banking and Insurance Finance Control bull Commercial banks bull Asset management bull Primary issuers of bull Insurance companies Commission Office bull Savings banks firms securities bull Insurance brokers
bull Securities banks bull Investment funds bull Stock exchanges bull Mortgage companiesbull Stockbrokers bull Pension funds
Securities Regulation Fund Securities Regulation Fund
bull Other investment firms and credit institutions(institutions participating in regulated off-exchangemarket in strips and Treasury certificates)
Bank holding companies Spain Banco de Espantildea = umbrella supervisor
Banco de Espantildea Comision Nacional del Mercado de Directorate General
Banco de Espantildea Valores (CNMV) Insurance
bull All credit institutions (commercial banks savings banks credit bull Primary issuers of (Ministry of Economy Ministry of cooperatives official credit institutions finance factoring and securities and Finance) Economy and CNMV leasing companies mortgage-loan companies etc) bull Stock exchanges bull Insurance companies Finance bull Interbank foreign exchange and book-entry public debt bull Stockbrokers bull Pension funds
markets bull Venture capital(companies and funds)
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119
Financial institutions and their supervisors
Country and supervisory structure Banking Securities Insurance
Banking Advisory High Level Securities Supervisors Committee (BAC) Committee (HLSS) Insurance Committee (IC)
Supranational (EU) bull Formulates standards for prudential bull Coordination of securities market bull Formulates standards forsupervision supervision prudential supervision
BACICHLSS Banking Supervision
Conglomerates Committee (BSC) Securities Contact Committee Regulation of prudential bull Systemic risk monitoring bull Regulation and implementation of supervision securities admission
International Association International International Organization of of Insurance Supervisors
Basel Committee Securities Commisison (IOSCO) (IAIS) Joint Forum Conglomerates Supervision bull Supervision and regulation best bull Supervision and regulation best bull Supervision and regulation amp regulation Best practices practices practices best practices
FSF Coordination across supervisors of various functions
Notes See appendix B for more information Boldface type indicates senior or oversight supervisor normal type indicates adjunct or front-line supervisorsolid line indicates direct responsbility to the senior-ranking authority dotted line indicates coordination in supervisory activities
(table continues next page)
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Table 210 Financial-sector regulation G-10 countries 2000 (continued )
Glossary of names United Kingdom FSA = Financial Services Authority United States FR = Federal Reserve OCC = Office of the Comptroller of theCurrency FDIC = Federal Deposit Insurance Corporation SEC = Securities and Exchange Commission OTS = Office of Thrift Supervision Japan FRC =Financial Reconstruction Commission FSA = Financial Services Agency SESC = Securities and Exchange Surveillance Commission Canada OSFI =Office of the Superintendent of Financial Institutions CDIC = Canada Deposit Insurance Corporation Germany FBSO = Federal Banking SupervisoryOffice FSSO = Federal Securities Supervisory Office FISO = Federal Insurance Supervisory Office BSO = Banking Supervisory Office Italy Consob =Commissione Nazionale per le Societa e la Borsa ISVAP = Instituto per la Vigilanza sulle assicurazioni private e di Interesse colletivo Switzerland SFBC= Swiss Federal Banking Commission Spain CNMV = The Comision Nacional del Mercado de Valores Supranational BAC = Banking Advisory CommitteeBSC = Banking Supervision Committee IC = Insurance Committee HLSS = High Level Securities Supervisors Committee International Dimension FSF =Financial Stability Forum IOSCO = International Organization of Securities Commission IAIS = International Association of Insurance Supervisors
Sources United Kingdom Bank of England httpwwwbankofenglandcouk Financial Services Authority httpwwwfsagovuk United States Board ofGovernors of Federal Reserve System httpwwwfederalreservegov Japan Bank of Japan httpwwwbojorjo Financial Reconstruction Commissionhttpwwwfsagojpfrcindexehtml Financial Services Agency httpwwwfsagojp Canada Bank of Canada httpwwwbank-banque-canadaca Office ofthe Superintendent of Financial Institutions httpwwwosfi-bsifgccaAndreEindexhtml Germany Deutsche Bundesbank httpwwwbundesbankde Fed-eral Banking Supervisory Office httpwwwbakredde Italy Banca drsquoitalia httpwwwbancaditaliait Commissione Nazionale per le Societa e la Borsahttpwwwconsobit Instituto per la Vigilanza sulle assicurazioni private e di Interesse colletivo httpwwwisvapit The Netherlands De NederlandscheBank httpwwwdnbnl France Banque de France httpwwwbanque-francefr Switzerland Schweizerische Nationalbank httpwwwsnbchindex3htmlSweden Sveriges Riksbank httpwwwriksbanksedefaultasp Belgium National Bank of Belgium httpwwwbnbbesgindexhtm Spain Banco de Espantildeahttpwwwbdees The Comision Nacional del Mercado de Valores httpwwwcnmves Supranational (EU) Institutional Arrangements for the Regulationand Supervision of the Financial Sector 2000 International Dimension Bank for International Settlement httpwwwbisorg International Organization ofSecurities Commissions httpwwwioscoorg International Association of Insurance Supervisors httpwwwiaisorg Financial Stability Forum httpwwwfsforumorg
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 121
the inflexibility of tight surveillance against the need to encourage in-novation and growth The US Securities and Exchange Commission isworried about aggressive accounting by firms and biased reports bysecurities analysts in an equity environment that prizes steadily higherquarterly earnings41 Japanese regulators are preoccupied with opaqueinterconnections between portfolio institutions banks and nonfinancialfirms through the keiretsu system Canadian regulators reeling from high-profile scandals of managers intentionally misleading investors are strengtheningmarket discipline through legal penalties aimed at managers and directorsof offending firms
When panic strikes a securities regulator cannot do much As the 1987stock market crash and the LTCM debacle in the fall of 1998 both dem-onstrated steep stock and bond price declines can create systemic risksIf severe enough the wealth effect of falling securities values and thefear of widespread insolvency can depress real activity Flooding thesystem with liquidity is a central bankerrsquos solutionmdashsomething a securi-ties regulator cannot do42 But just as financial supervisors can changethe incentive structure to discourage bankers from making risky loans ingood times so securities regulators can pay more attention to incentiveson the demand side when capital markets are strong
Prudential Supervision and InnovationmdashA Footnote
In concluding this discussion of prudential supervision in the G-10 anadditional point is worth noting National regulators face a persistenttrade-off between emphasizing financial system safety and soundnesswhile encouraging innovationmdashin spite of the added risks innovationbrings to financial markets Former US Treasury Secretary Lawrence Summers(2000 3) has argued by analogy
The jet airplane made airplane air travel more comfortable more efficient andmore safe though the accidents were more spectacular and for a time morenumerous after the jet was invented In the same way modern global financialmarkets carry with them enormous potential for benefit even if some of theaccidents are that much more spectacular As the right public policy response
41 The problem is illustrated by the divergence since mid-1998 between reported earn-ings by the Standard amp Poorrsquos (SampP) 500 and the after-tax profits of all corporations inthe national accounts Generally these two series move closely with one another Be-tween mid-1998 and mid-1999 SampP 500 reported that earnings increased by more than20 percent while after-tax profits of all corporations increased by less than 5 percent(Chase Bank US Economic and Policy Research US Weekly Prospects Chase SecuritiesWeekly Newsletter 5 June 2000 5)
42 For example the US Securities and Exchange Commission had no direct role in calmingmarkets in the 1987 or 1998 panics
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122 WORLD CAPITAL MARKETS
to the jet was longer runways better air-traffic control and better training forpilots and not the discouragement of rapid travel so the right public policyresponse to financial innovation is to assure a safe framework so that the ben-efits can be realized not to stifle the change
Accepting Summersrsquos analogy for the international financial system better-informed supervisors and investors are a necessary part of the financialsystem framework Supervisors require more timely information on therisk profiles resulting from positions taken by financial institutions Theyalso need a better understanding of risk-management systems Snapshotsof an institutionrsquos risk profile and risk-management procedures are nolonger adequate In a world where huge bets are quickly made (andpossibly lostmdashas with Barings Bank in 1995 and LTCM in 1998) super-visors must focus on the soundness of banking systems for evaluatingand managing risk on a daily basis Some progress has been made inaddressing these issues US banking examiners are extending their in-formation requirements in banking examinations and increasing theirinvolvement in large complex institutions43 More awareness is alsorequired of the fact that they are national organizations in a world ofcross-border capital flows To a much greater extent they need a multi-national reach International supervision and coordination among super-visors are the subject of the next section
Our analysis suggests that G-10 supervisors have unfinished businessBank supervisors need to start yesterday securities regulators can waituntil tomorrow One G-10 member acting alone cannot correct the biasIn good times the lending business will simply migrate to other G-10banks In bad times financial problems will not stop at the national bor-der A way has to be found to establish common international standardsfor the key financial players in order to prevent crises and to agree onapproaches for managing them The path has already been laid out Inthe wake of the bank failures of the past 25 years bank supervisors havetried to establish such standards They have done this without creating anew global institution
The essence of the international framework is decentralizationmdashglobalrules and design standards without global institutions that are perceivedto intrude on national sovereignty The awkward jargon for this frame-work is vertical subsidiaritymdashldquothink internationally act nationallyrdquo Theinternational thinking is done by a committee of regulators that meets
International SupervisionA Decentralized Framework
43 These issues are discussed in Ferguson (1999) and Meyer (2000a)
Institute for International Economics | httpwwwiiecom
THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 123
regularly at the Bank for International Settlements in Basel The commit-tee establishes principles and standards that are interpreted implementedand enforced by national authorities44 In this section we describe thesesupervisory efforts and their weaknesses We present our recommenda-tions for addressing these weaknesses in the next chapter
Basel I
The Basel Capital Accord of 1988 (Basel I)45 drew the lesson from thefinancial crises of the mid-1970s that more adequate capital levels in in-ternational banks would help reduce the systemic risk of bank failureThe primary goal of Basel I was capital adequacy other standards wereput in place not so much for their own virtue as to defend the primarygoal
Capital adequacy requirements were designed to ensure that individualinstitutions have the ability to absorb losses particularly credit lossesAccordingly a backup system of scoring credit risk was devised thatrequired large amounts of bank capital for some types of loans smalleramounts for others and zero for a select list of preferred assets Report-ing requirements were designed to disclose problems and ensure that atroubled bank would take timely steps to restore its capital base in thewake of a loss The Basel I framework worked tolerably well in limitingthe call on the public purse in the G-10 countriesmdashwith the notable ex-ceptions of France and Japan The framework failed to moderate riskybank lending to emerging markets however
Basel I was not developed with emerging markets in mind The origi-nal idea behind it was to develop a common supervisory approach tocross-border banking operations It grew out of political pressure fromUS lawmakers who were determined to require international banks op-erating in the United States to meet US banking standards Toward thisgoal in 1983 Congress passed the International Lending Supervisory ActUS and British banking authorities subsequently agreed on a commontarget the adoption of strict common capital-adequacy standards In 1988other G-10 governments agreed to go along voluntary acceptance ofthe standards throughout much of the rest of the world followed46 Therationale for the capital targets was two-fold The first was to requirebanks to hold sufficient amounts of capital (8 percent of risk-adjusted
44 The international committee of financial authorities agreed on a common definitionof banksrsquo tier-one or ldquocorerdquo capital national authorities defined tier-two capital in theirown manner which permitted greater variations in national working definitions andpractices
45 International Convergence of Capital Measurement and Capital Standards (BIS 1988)was prepared by the Basel Committee on Banking Supervision
46 See Reineke (1998)
Institute for International Economics | httpwwwiiecom
124 WORLD CAPITAL MARKETS
assets) to cushion losses on those assets The second was to dull theirappetites for risk banks with large capital bases would have more tolose if they failed and therefore would take fewer risks
Rapid change in financial markets soon revealed flaws in the Basel IAccord In a complex world with numerous sources of risk it focusedheavily on credit risk but overlooked other risks in a bankrsquos portfolioand the correlation between returns on different asset classes The Baselformula required banks to maintain a fixed amount of capital againsteach of its asset classes But the formula did not distinguish the riskinessof the borrower within each class As a result one large loan to a low-risk corporate borrower such as General Electric would require the sameamount of capital as 10 smaller transactions with high-risk borrowers
The system was also biased toward short-term loans Loans maturingin less than a year required a 20 percent risk weight whereas those ma-turing after more than a year required a 100 percent risk weight Inter-bank lending was particularly favored For example loans to banks inOECD countries required less capital than loans to private firms in thesame countries creating the anomaly that interbank loans to South Ko-rean banks required less capital than loans to General Electric47 Thisanomaly encouraged banks to shed high-quality assets if the Basel rulesrequired the allocation of more capital than banks thought they needed
Another weakness was that financial innovators quickly circumventedthe Accord Because short-term loans required less provisioning than long-term loans banks responded by securitizing their long-term debt port-folios and lending short-term against the collateral of the newly createdasset This allowed banks to circumvent the capital requirements gearedto the terms of the underlying debt At the same time the Basel I Accordfailed to encourage risk mitigation techniques such as credit derivativescollateral guarantees and on-balance-sheet netting the flip side of fi-nancial innovation Because off-balance-sheet products were not coveredby the Accord another anomaly appeared when Barings Bank collapsedin 1995 Barings met capital adequacy standards but collapsed becauseits systems for managing risk failed traders were allowed to speculatein futures contracts that did not appear on the balance sheet
Basel II
Work to overhaul Basel I began in 1995 and produced consultativepapers issued in June 1999 and January 200148 These papers have been
47 South Korean banks have had notoriously weak balance sheets because the practiceof ldquodirected lendingrdquo left them with many poor loans (in making these loans the bankswere expected to follow government objectives rather than creditworthiness criteria)
48 Basel Committee on Banking Supervision (1999 2001)
Institute for International Economics | httpwwwiiecom
THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 125
the subject of extensive consultation and revision as a result the newAccord is expected to be introduced in 200449 The Basel II frameworkhas three parts (pillars) revisions to Basel I minimum-capital require-ments supervisory review criteria and greater emphasis on market dis-cipline Broadly Basel II aims to maintain the level of capital in the sys-tem but achieve better alignment of banksrsquo capital with their risk pro-files and keep up with financial innovation
To align capital requirements with market realities (the first pillar)Basel II concentrates on the 100 or so largest banksmdashthe type of playerslisted in table 21mdashand on the holding-company parents of banking groups50
Capital requirements will differentiate between an increased number ofcredit groups or ldquorisk bucketsrdquo including claims on governments otherbanks corporations mortgage-backed securities and other asset-backedsecurities
Basel II originally proposed to use external ratings to set capital chargesfor a number of these credit risks Many banks objected arguing thatthey assess credit risk better than Standard amp Poorrsquos Moodyrsquos or FitchIBCA51 Basel II thus proposes two approaches to rating a standard ap-proach using external ratings and an ldquoadvancedrdquo approach that allowsselected banks to use their own internal rating systems To encouragethe development of rigorous internal control systems based on these in-ternal rating systems Basel II also proposes to levy capital charges foroperational risk (the risk of direct or indirect loss resulting from inad-equate or failed internal processes people and systems or from exter-nal events)
Some critics of this proposal dismiss it as an abrogation of the prin-ciple of external independent monitoring and as ldquodangerously naiumlverdquo52
But regulators argue that the new capital charge on operational risk shouldoffset this concern It is also far from clear how cross-national compari-sons of rating and internal risk-assessment systems will be made (Engelen2000) The development by the European Union of its own capital rulescould well complicate the international resolution of these issues Publicassurances by EU officials in January 2001 however indicated that theirmain concerns are to create a level playing field and avoid regulatoryarbitrage (Hargreaves 2001) There is also the significant problem ofthe procyclical character of risk weights When a crisis hits losses are
49 See Berry (2000) for an update in an interview with William J McDonough chair ofthe Basel Committee on Banking Supervision
50 For obvious reasons these proposals are addressed to large banks and simpler capi-tal standards are allowed for small banks that focus on their domestic credit markets
51 See Ammer and Packer (2000) for an empirical critique of the success of rating agen-cies in distinguishing risk by sector and region
52 See Auerback (2001)
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126 WORLD CAPITAL MARKETS
incurred or accrued capital is lost and loan exposure must be reducedor securities sold to restore the requisite capital-adequacy ratios A morerisk-sensitive framework could amplify volatility
As the second pillar of Basel II supervisory review criteria are beingbeefed up to encourage supervisors to intervene earlier in potential problemsituations and to compel banks to align their capital positions with theirrisk profiles Bank supervisors will be authorized to require banks tohold capital in excess of minimum requirements if they have concernsabout general management overall strategy risk-management performanceor the macroeconomic environment Of course if one G-10 supervisorimposes higher capital requirements in isolation the same disparity willemerge that presaged Basel I Some banks will be disadvantaged in theinternational marketplace and will loudly complain that excessive super-vision is driving business to their competitors Hence close internationalcooperation among supervisors is critical
To implement the third pillar market discipline banks will be requiredto make fuller more timely disclosure of capital adequacy and the risksto which that capital is exposed A number of measures are being stud-ied that might help supervisors evaluate bank performance such as com-parisons of uninsured deposit interest rates subordinated debt yieldsand equity prices The idea is that these yields and prices might alertsupervisors to market perceptions of risk Of course market perceptionsare only as good as market information More direct and controversialways to reinforce market discipline would dramatically increase publicdisclosure of bank positions and risk management systems
Many questions are still outstanding about how to resolve the techni-cal details of capital requirements and whether the requirements willachieve their intended goal of better assessment and mitigation of therisks in banksrsquo portfolios There is no substitute for skilled supervisorsThe intricacies of effective design and implementation suggest that su-pervisors need to be highly competent technically knowledgeable aboutbanking portfolio characteristics and the factors that influence bank ex-posure to credit risk (Mishkin 2000) And they must be aided by vigilantshareholders market forces and transparency of information53
Standard setting at the global level is desirable but ultimately theeffectiveness of these efforts will be tested at the national level espe-cially in times of systemic financial distress Here the record of Basel Iwas not a bright shining success Japanese banking regulators havetraditionally allowed banks to include real estate and securities in theircapital base When the value of these assets plummeted in the early 1990sregulators allowed banks to continue valuing these depreciated (andoften bankrupt) assets at their old inflated levels Japanese authorities
53 Benedict Roth Complacency Towards Catastrophe Financial Times 23 January 2001
Institute for International Economics | httpwwwiiecom
THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 127
insisted until the mid-1990s that eroded capital bases could be rebuiltin a market-driven fashion They rightly foresaw that huge loan losseswould undermine public support for the ruling party and require a po-litically unpopular bailout
Japanese foot dragging on Basel I was the worst54 but not uniqueOther examples can be found of ldquopolitically mandated forbearancerdquo TheFederal Reserve Bank of New York held important hands during theLTCM crisis of 1998 Mexico is still resolving the banking crisis that eruptedin 1995 South Korea has not yet closed the insolvent banks that behavedso badly before the crisis of 1998 In the aftermath of a crisis nationalregulators cannot always be relied upon to discipline politically power-ful bankers55 One of the little-noticed consequences of these differingapproaches is that those banks with strong regulatory systems receivedan implicit ldquoexport subsidyrdquo for their services US banks which had notengaged extensively in emerging-market lending in the 1990s were bet-ter positioned than their German and Japanese counterparts to expandtheir international assets in the wake of the crises
Other Financial Forums
54 See Japanese Banks Fiddling while Marunouchi Burns The Economist 27 January2001 67-69
55 See Calomiris (1997)
The Basel model of vertical subsidiarity has already been extended toother financial regulatory bodies In 1993-94 the BIS established a Tri-partite Group of Banking Insurance and Securities Regulators In 1994-95 the BIS increased its cooperation with the International Organizationof Securities Commissions when the two organizations issued parallelpapers on guidelines for national regulators concerning risk managementand disclosure of derivative trades In 1996 a permanent Joint Forum onFinancial Conglomerates was established to examine supervisory issuesand develop working arrangements among the different functional super-visors of conglomerate institutions that offer combinations of bankingsecurities and insurance products Draft papers on the supervisionof conglomerates were released for comment in 1998 applying capital-adequacy principles to these groups and providing guidelines both forassessing the integrity and competence of top managers and for sharingassessments between regulators
In 1997 the Basel Committee on Banking Supervision extended itsreach beyond capital standards to broader aspects of banking supervi-sion with the publication of the Core Principles for Effective BankingSupervision In 1999 a wide range of regulatory and standard-settingbodies were gathered under the umbrella of the Financial Stability
Institute for International Economics | httpwwwiiecom
128 WORLD CAPITAL MARKETS
Forum (FSF) itself established under BIS aegis56 The FSF has alreadyissued recommendations for stepped-up supervision and transparencyas well as guidelines for best practices in a number of areas includingoffshore financial centers and highly leveraged institutions or hedge funds57
Conclusion
Although the structural weaknesses in emerging-market economies arewidely acknowledged to have been causal factors in international capi-tal-market volatility this chapter points to the role of large G-10 bankingorganizations as major suppliers of the most volatile instrument short-term debt We have examined evidence of the impact of public safetynets in the G-10 economiesmdashthe deposit insurance systems the pruden-tial supervisory systems and the lender-of-last-resort functions of centralbanksmdashon the incentive structures of these organizations
Although supervisors in most countries working nationally and to-gether in the BIS have made significant efforts to mimic market forcesin their prudential supervision the most sophisticated financial institu-tions find innovative ways to circumvent the rules New global regulatorybodies are not about to be created G-10 national bank regulators shouldthemselves address the short-term debt bias in the international financialsystem by changing incentive systems G-10 securities regulators shouldalso take steps to get ahead of the curve paying close attention to largeportfolio swings by institutional investors particularly in times of crisisIn short more needs to be done at national and international levels tochange the rules of the game That is the subject of the next chapter
56 The Financial Stability Forum includes banking securities insurance and accountingregulatory bodies the OECD on taxation corruption and corporate governance and theIMF
57 See Martin (2000)
Institute for International Economics | httpwwwiiecom
THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 81
Table 21 Worldrsquos largest 50 commercial banks by marketcapitalization October 2000 (billions of dollars)
Market capitalizatona Total Net Shareholderassets income equityb
Global Sept Oct National Dec Dec Decrank Banks 1999 2000 rankc 1999 1999 1999
Continental Europe
8 ING Bank 46 66 1 351 17 1412 UBS 58 55 2 614 39 2213 Creacutedit Suisse Group 50 54 3 452 33 2215 Deutsche Bank 36 48 4 843 26 2317 Banco Santander
Central Hispano 33 45 5 258 22 1719 BNP Paribas 43 6 702 17 22
Banque Nationalede Paris 26
Paribas 1621 ABN AMRO 29 34 7 460 26 1325 Banco Bilbao
Vizcaya Argentaria 25 28 8 240 22 1826 UniCredito Italiano 21 26 9 170 13 1030 Socieacuteteacute Geacuteneacuterale 19 22 10 408 24 1229 HypoVereinsbank 20 22d 11 505 04 1432 Dresdner Bank 21 21 12 398 11 1243 San Paolo IMI 16 17d 13 141 11 845 Fortis Bank 34 16 14 330 12 949 Commerzbank 17 14 15 374 09 1249 KBC Bank 13 14d 16 147 07 6
Total for Continental Europe 482 524d 6393 291 234
Japan
3 Mizuho Holdings Inc 115 1 51e
3 Dai-Ichi Kangyo Bankf 39 463 ndash38 203 Industrial Bank
of Japanf 32 390 ndash15 133 Fuji Bankf 42 489 ndash36 187 Sumitomo Sakura
(tentative) 68 2 56e
Sumitomo Bankg 47 464 ndash48 15Sakura Banki 31 414 ndash40 18
10 Bank of Tokyo Mitsubishi 72 56 3 664 ndash07 2311 UFJ Holdings Inc 55d 4 36e
Sanwa Bankh 39 425 ndash40 18Tokai Bankh 16 269 ndash24 13Toyo Trust amp Bankingh na 67 ndash13 5
40 Asahi Bank 20 18d 5 247 ndash21 1249 Mitsubishi Trust amp
Bankingi 16 14d 6 149 ndash14 750 Sumitomo Trust amp
Banking 11 10d 7 127 ndash12 6
Total for Japan 364 336e 6472 ndash481 260
(table continues mext page)
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82 WORLD CAPITAL MARKETS
Table 21 Worldrsquos largest 50 commercial banks by marketcapitalization October 2000 (billions of dollars) (continued )
Market capitalizatona Total Net Shareholderassets income equityb
Global Sept Oct National Dec Dec Decrank Banks 1999 2000 rankc 1999 1999 1999
United Kingdom
2 HSBC Holdings 97 122 1 569 54 379 Royal Bank of Scotland 19 58d 2 146 14 7
NatWestj 39 na na 292 na 1414 Lloyds TSB 68 52 3 285 41 1418 Barclays 44 44 4 402 28 1435 Abbey National 25 19 5 292 20 846 Standard Chartered 15 15d 6 88 06 646 Bank of Scotland 15 15d 7 116 10 6
Total for United Kingdom 322 324d 2191 173 106
United States
1 Citigroup 149 237 1 717 99 504 JP Morgan Chase amp Co 83 2 35e
Chase Manhattank 63 na na 406 54 24JP Morgank 20 na na 261 21 11
5 Bank of America 96 79 3 633 79 446 Wells Fargo amp Company 65 78 4 218 37 2216 Bank of New York
Company 25 46 5 75 17 520 Bank One 41 42 6 269 35 2022 Fleet Boston Financial 34 34 7 191 20 1523 MBNA 18 30 8 31 10 424 First Union 34 30 9 253 32 1727 Fifth Third Bancorp 17 24 10 42 07 427 Mellon Financial 17 24 11 48 10 433 State Street na 20 12 61 06 335 PNC Bank 16 19 13 75 13 635 Northern Trust na 19 14 29 04 235 Firstar 25 19 15 73 09 640 US Bancorp 22 18 16 82 15 846 SunTrust Banks 21 15 17 95 13 850 National City 16 13 18 87 14 650 Wachovia 16 11 19 67 10 650 KeyCorp 12 11 20 83 11 6
Total for United States 707 850 3796 517 271
Other
31 National Australia Bank 2 21 1 166 18 1234 Hang Seng Bank Ltd 20 20d 2 na na na35 Royal Bank of Canada 13 19 3 184 12 940 Commonwealth Bank
of Australia 14 18d 4 91 09 543 Toronto Dominion Bank 12 17 5 146 20 850 Westpac Banking Corp 12 13 6 92 10 650 Development Bank
of Singapore 12 13d 7 64 06 6
Total for other 105 121d 742 76 46
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 83
developing countries In turn the claims on developing countries repre-sent about 4 percent of the assets of G-10 and Spanish commercial banks
Portfolio Investors
Table 21 (continued )
Market capitalizatona Total Net Shareholderassets income equityb
Sept Oct National Dec Dec Dec1999 2000 rankc 1999 1999 1999
Total for largest 50 1980 2155 19594 58 917
Total for G-10 1900 2070 19182 53 888
na = not availablenot applicableG-10 = Group of Ten countries see note to table 11
a Market capitalization is defined as the number of ordinary shares currently in circulationmultiplied by the current share price Market capitalization as of October 2000 is presentedfor the banks that had a market capitalization higher than $11 billion as of September 1999b Shareholder equity is defined as the sum of issued common stock capital surplus or pre-mium various reserves and retained earnings Shareholder equity includes group equity at-tributable to consolidated minority interestsc Rankings within the country or regiond Estimates based on the available rates of change from September 1999 to October 2000The market capitalization and shareholder equity figures represent combined estimate for themerged bankse Total for the merged banksf Merged in September 2000g Merged in April 2001h Will merge in April 2002i Will merge with Nippon Trust and Tokyo Trust in October 2001j NatWest Bank merged with the Royal Bank of Scotland in March 2000k Announced a merger in September 2000
Sources Euromoney The Bank Atlas 2000 httpwwweuromoneycom American BankerThe Top 100 World Financial Companies Q3 1999 httpwwwamericanbankercom YahooFinance Company Profiles financeyahoocom Bloomberg Financials httpwwwbloombergcom
Three groups of financial institutions dominate the flow of portfolio capitalinvestment banks wealth managers and insurance companies Table 23lists nine large investment banks all based in New York with offices inLondon and other financial centers In 1998 these nine firms had a com-bined market capitalization in excess of $130 billion and controlled as-sets in excess of $18 trillion
Investment banks act as guardians to the securities markets Nearly allpublic and private shares bonds and asset-backed securities are broughtto market by an investment bank Fulfilling the same function they areexpanding the securities markets of emerging economies They also act asthe pilots of privatization mergers and takeoversmdashnow a core feature of
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84 WORLD CAPITAL MARKETS
Table 22 Total assets and external assets of all commercialbanks June 2000 (billions of dollars)
Claims onExternal assets developing countriesb
Share of Share ofTotal total assets total assets
Country assetsa Amount (percent) Amount (percent)
Austria 423 91 22 33 8Bahamas 316 244 77 61c 19Bahrain 100 92 92 46c 46Belgium 806 309 38 26 3Canada 720 98 14 31 4Denmark 244 58 24 6 2Finland 121 31 25 4 3France 2486 607 24 135 5Germany 4535 901 20 240 5Ireland 423 160 38 2 0Italy 1345 191 14 47 4Japan 8460 1199 14 258 3Luxembourg 821 495 60 124c 15Netherlands 1080 296 27 67 6Norway 157 14 9 3 3Singapore 574 405 70 202c 35Spain 889 124 14 57 6Sweden 348 67 19 12 2Switzerland 1632 709 43 177c 11United Kingdom 5802 1990 34 138 2United States 6223 889 14 144 2
Total for all BISreporting countries 37506 8968 24 1813 5
Total for G-10 34326 7378 21 1331 4
BIS = Bank for International SettlementsG-10 = Group of Ten countries see note to table 11
a Total assets are calculated as banking institutions (deposit institutions) reserve claims onthe public sector claims on the private sector (lines 20 21 22 from IFS) plus externalassets Figures are converted into US dollars using the market exchange rate at the end ofJune 2000b Developing countries are countries other than Andorra Australia Austria Belgium CanadaCyprus Denmark Finland France Germany Gibraltar Greece Iceland Ireland Italy JapanLiechtenstein Luxembourg Malta Netherlands New Zealand Norway Portugal Spain Swe-den Switzerland Turkey the United Kingdom the United States the Vatican City State andthe former Yugoslaviac These countries do not disclose their claims on developing countries Such claims arearbitrarily (and generously) estimated at half the external assets of commercial banks in Bahrainand Singapore and a quarter of the external assets of banks in the Bahamas Luxembourgand Switzerland
Sources IMF International Financial Statistics (IFS) November 2000 Bank for InternationalSettlements BIS Quarterly Review November 2000 httpwwwbisorg
Institute for International Economics | httpwwwiiecom
THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 85
global capitalism In addition to their underwriting role investment banksearn substantial profits from trading securities
Wealth-management firms are the second group of portfolio institu-tions They typically deal with the publicmdashindividuals and companiesthat want a trusted firm to manage their pensions and other funds Table24 lists 10 large wealth managers all based in the G-10 Together these10 firms control $64 trillion in assets and their own market capitalization
Table 23 Large investment banks 1998 (billions of dollars)
MarketRevenue Assets capitalizationa
Merrill Lynchb (United States) 36 300 25Morgan Stanley Dean Witterb (United States) 31 318 50c
Goldman Sachs (United States) 22d 217e 29c
Lehman Brothers Holdingsb (United States) 20 154 10c
Salomon Smith Barneyf (United States) 8 211 naCredit Suisse First Bostong (United States
Switzerland) 7 280 naPaine Webberh (United States) 7 54 6i
Bear Stearnsj (United States) 8 154 5i
Donaldson Lufkin amp Jenrettek (United States) 5 72 7i
Total 144 1760 132 plusTotal for G-10 144 1760 132 plus
na = not available (subsidiaries of large holding companies Citigroup and Creacutedit SuisseGroup respectively individual market capitalization is not available)G-10 = Group of Ten countries see note to table 11
a Market capitalization is calculated by multiplying the total number of shares by the shareprice at the companyrsquos fiscal year-endb Source Fortune Global 500 1999 Data shown are for the fiscal year ended on or before31 March 1999 Assets shown are those at the companyrsquos fiscal year-end httpwwwpathfindercomfortuneglobal500indexhtmlc Figures as of September 1999 are from American Banker httpwwwamericanbankercomBankRankingsd Source 1998 Goldman Sachs Annual Review Assets as of November 1998 httpwwwgscomaboutannual19984_fsindexhtmle Source Financial Times Company Financials Revenue as of 27 November 1998 httpwwwglobalarchiveftcomcbcb_searchhtmf Source 1998 Citigroup Annual Report 20 Revenue figures for year ending 31 December1998 Asset figures as of 31 December 1998 httpwwwcitigroupcomcitigroupfindatac1998ar2pdfg Source 19981999 Creacutedit Suisse Group Annual Report 23 httpwwwcsgchcsg_annual_report_98downloadcsg_ar98_p1_enpdfh Source 1998 Paine Webber Annual Report 34-35 httpwwwpainewebbercomannual98graphicsfininfoindexhtmi Individual figures are obtained from Yahoo The time for valuations is as follows BearStearns December 1999 Lehman Brothers November 1999 Paine Webber and DonaldsonLufkin amp Jenrette September 1999j Source 1999 Bear Stearns Annual Report 55-56 Figures are for fiscal year ending 30June 1998 httpwwwbearstearnscomcorporateinvestorindexhtmk Source 1999 Donaldson Lufkin and Jenrette Annual Report ldquoFinancial Highlightsrdquo httpwwwdljcompdfDLJ98_1pdf
Institute for International Economics | httpwwwiiecom
86 WORLD CAPITAL MARKETS
exceeds $260 billion For the most part wealth managers are long-termportfolio investors
Hedge funds represent a highly specialized investment vehicle that isnot widely available to the public Most hedge funds are leveraged theyemploy dynamic (and sometimes opportunistic) trading strategies involvingpositions in several different markets they adjust their investment port-folios frequently in anticipation of asset price movements or changes inyield differentials between related securities Hedge funds are opaque tomarket monitoring They are subject to little direct regulation and areunder few obligations to disclose information Hence the size of the in-dustry is difficult to measure
If they are measured by capital under management or by assets hedgefunds are small relative to established wealth managers As table 25shows the capital managed by 20 large hedge funds in late 1998 amountedto less than $50 billion Estimates vary widely but if all hedge funds arecounted their assets range from $100 to $300 billion Even the highestnumber is less than 5 percent of the combined assets of investment banksand traditional asset managers
The amount of leverage used by hedge funds depends on trading strate-gies that are in turn shaped by investor attitudes toward risk Leverage
Table 24 Large asset managers in 1998 (billions of dollars)
Total assets under Marketmanagementa capitalizationb
UBS (Switzerland) 1145 58c
Fidelity Investments (United States) 773 naKampo (Japan) 698 naCredit Suisse Group (Switzerland) 680 50c
AXA Group (France) 647 39c
Barclayrsquos Global Investors (United States) 616 44c
Merrill Lynch amp Co (United States) 501 25c
State Street Global Advisors (United States) 493 naCapital Group Cos (United States) 424 naZurich Financial Services (Switzerland) 415 45c
Total 6392 261 plusTotal for G-10 6392 261 plus
na = not available (usually a nonpublic company)G-10 = Group of Ten countries see note to table 11
a Figures are assets under management at fiscal year-end 1998b Market capitalization is calculated by multiplying the total number of shares by the shareprice at the companyrsquos fiscal year-endc Figures from American Banker httpwwwamericanbankercomBankRankings
Sources Institutional Investor 1999 httpwwwiimagazinecomresearchinterfacehtml US(II300) Asia (Asia200) and Europe (Euro100) Asset Management Rankings American BankerhttpwwwamericanbankercomBankRankings
Institute for International Economics | httpwwwiiecom
THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 87
is achieved using such instruments as repos (repurchase agreements)futures and forward contracts and other derivative products5 It is alsovery difficult to measure A Financial Stability Forum (FSF 2000b) studyof hedge funds noted thatmdashalthough there are problems with the waydata vendors report these positionsmdashestimates suggest most hedge fundsuse modest amounts of leverage averaging 21 but ranging to 41 insome FSF (2000b) further notes difficulties with evaluating the risk-adjusted performance of hedge funds because of their dynamic tradingstrategies
Table 25 Largest hedge funds according tocapitalization August 1998 (billions of dollars)
Fund Capital under management
Domestica
Tiger 51Moore Global Investment 40Highbridge Capital Corp 14Intercap 13Rosenberg Market Neutral 12Ellington Composite 11Hedged Taxable-Equivalent 10Quantitative LongShort 09Sr International Fund 09Perry Partners 08
OffshoreJaguar Fund NV 100Quantum Fund NV 60Quantum Industrial Fund 24Quota Fund NV 17Omega Overseas Partners 17Maverick Fund 17Zweig Dimenna International 16Quasar International Fund NV 15SBC Currency Portfolio 15Perry Partners International 13
Totalb 471
a Long Term Capital Management (LTCM) was in serious difficulty in August1998 and is omitted from the listb Estimates of hedge fund capital and the number of funds vary significantlyMARHedge estimated 1115 funds with $109 billion capital under managementat the end of 1997 Van Hedge Fund estimated 5500 funds with capital of $295billions at the same date
Source Adapted from Eichengreen (1999a)
5 Positions are established by posting margins rather than the face value of the position
Institute for International Economics | httpwwwiiecom
88 WORLD CAPITAL MARKETS
The positive role of hedge fundsmdashproviding diversification to inves-tors because their returns have low correlations with standard asset classesmdashis counterbalanced by some negative features Hedge funds and otherhighly leveraged institutions (HLIs) may take concentrated positions andengage in aggressive market practices that amount to ldquoganging uprdquo on asmall economy (such as Hong Kong)6 Under normal market conditionsHLI positions are not destabilizing but some of the aggressive practicesdocumented in 1998 are worrisome The FSF study group participantsagreed (2000b 112) that such practices raise important issues for marketintegrity but they could not agree that market manipulation was suffi-ciently widespread to be a serious concern for policymakers
Insurance companies are the third group of portfolio institutions Theseare divided into two categories property and casualty companies andlife and health insurance companies Ten large companies of each cat-egory are listed in table 26 In 1998 the 10 property and casualty insur-ance companies had $16 trillion in assets and more than $330 billion inmarket capitalization The 10 life insurance companies had $28 trillionin assets7 Combining both categories 100 percent of assets are controlledby insurance companies based in the G-10 and Spain In portfolio man-agement styles life insurance companies tend to hold longer-term assetswhereas property and casualty companies tend to hold shorter-term in-struments
Nonfinancial Multinational Enterprises
The last players are the nonfinancial multinational enterprises (MNEs)The worldrsquos 100 largest corporations measured by 1998 revenue are re-corded in tables 27 and 28 The 30 financial giants among the top 100are separately shown in table 27 Most of the firms appeared in previ-ous tables Together these 30 financial giants had revenues of $13 tril-lion and controlled assets of $113 trillion8
Table 28 lists the 70 top nonfinancial giants Their revenues in 1998were $40 trillion and their assets (at book value) measured $45 trillionMeasured by revenue or assets about 95 percent of the giants are basedin the G-10 These firms are responsible for a large share of the worldrsquos
6 See IMF (1999c) for a description of the ldquodouble playrdquo that hedge funds are accusedof using in an attempt to destabilize Hong Kong in August 1998
7 Many life insurance companies are owned by their policyholders and therefore donot have a market capitalization
8 By comparison the larger set of 96 financial firms listed in previous tables controlled$322 trillion in assets This is the total amount of assets recorded in tables 21 (50 com-mercial banks) 22 (9 investment banks) 24 (10 asset managers) and 26 (20 insurancecompanies) The largest hedge funds might add $300 billion to the total
Institute for International Economics | httpwwwiiecom
THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 89
Table 26 20 large insurance companies in 1998(billions of dollars)
Property and casualty insurance Marketcompanies Revenuea Assetsb capitalizationc
Allianz (Germany) 65 402 62d
Assicurazioni Generali (Italy) 48 178 30d
State Farm Insurance Cos (United States) 45 111 naZurich Financial Services (Switzerland) 39 215 45d
CGU (United Kingdom) 38 176 20d
Munich Re Group (Germany) 35 131 naAmerican International Group (United States) 33 194 135d
Allstate (United States) 26 88 20d
Royal amp Sun Alliance (United Kingdom) 25 76 11d
Loews (United States) 21 71 7e
Total 375 1642 330 plusTotal for G-10 375 1642 330 plus
MarketLife and health insurance Revenuea Assetsb capitalizationc
AXA (France) 79 452 39d
Nippon Life Insurance (Japan) 66 363 naING Group (Netherlands) 56 464 46d
Dai-ichi Mutual Life Insurance (Japan) 44 253 naSumitomo Life Insurance (Japan) 40 206 naTIAA-CREF (United States) 36 250 naPrudential Ins Co of America (United States) 34 279 naPrudential (United Kingdom) 34 197 30d
Meiji Life Insurance (Japan) 28 146 naMetropolitan Life Insurance (United States) 27 215 na
Total 444 2825 naTotal for G-10 444 2825 na
na = not available (usually an insurance company owned by its policyholders)G-10 = Group of Ten countries see note to table 11
a Data shown are for the fiscal year ended on or before 31 March 1999b Assets shown are those at the companyrsquos fiscal year-endc Market capitalization is calculated by multiplying the total number of shares by the shareprice at the companyrsquos fiscal year-endd Market capitalization data as of September 1999 from American Banker httpwwwamericanbankercome Individual companyrsquos market capitalization as of September 1999 from Yahoo yahoomarketguidecom
Sources Fortune Global 500 1999 httpwwwpathfindercomfortuneglobal500indexhtmlAmerican Banker httpwwwamericanbankercomRankingBanks1999 Yahoo Marketguideyahoomarketguidecom
Institute for International Economics | httpwwwiiecom
90 WORLD CAPITAL MARKETS
Table 27 Financial firms in the 100 largest companiesby revenue 1998 (billions of dollars)
Globalrank Company Revenuesa Assetsb Type
Continental Europe
15 AXA (France) 79 452 Insurance23 Allianz (Germany) 65 402 Insurance28 Ing Group (Netherlands) 56 464 Insurance37 Credit Suisse (Switzerland) 49 475 Banks commercial
and savings39 Assicurazioni Generali (Italy) 48 178 Insurance42 Deutsche Bank (Germany) 45 736 Banks commercial
and savings56 Zurich Financial Services (Switerland) 39 215 Insurance68 Munich Re Group (Germany) 35 131 Insurance72 ABN AMRO Holding (Netherlands) 34 507 Banks commercial
and savings77 Credit Agricole (France) 33 459 Banks commercial
and savings80 HypoVereinsbank (Germany) 32 541 Banks commercial
and savings84 Fortis (Belgium) 31 397 Banks commercial
and savings98 Socieacuteteacute Geacuteneacuterale (France) 30 450 Banks commercial
and savingsUnited Kingdom
47 HSBC Holdings 43 485 Banks commercialand savings
58 CGU 38 176 Insurance74 Prudential 34 197 Insurance
United States
16 Citigroup 76 669 Diversified financials35 Bank of America Corp 51 618 Banks commercial
and savings44 State Farm Insurance Cos 45 111 Insurance64 TIAA-CREF 36 250 Insurance67 Merrill Lynch 36 300 Securities71 Prudential Ins Co of America 34 279 Insurance76 American International Group 33 194 Insurance79 Chase Manhattan Corp 32 366 Banks commercial
and savings83 Fannie Mae 31 485 Diversified financials88 Morgan Stanley Dean Witter 31 318 Securities
Japan
21 Nippon Life Insurance 66 363 Insurance45 Dai-ichi Mutual Life Insurance 44 253 Insurance54 Sumitomo Life Insurance 40 206 Insurance91 Bank of Tokyo-Mitsubishi 31 664 Banks commercial
and savingsTotal 1279 11341Total for G-10 1279 11341
G-10 = Group of Ten countries see note to table 11
a Data shown are for the fiscal year ended on or before 31 March 1999b Assets shown are those at the companyrsquos fiscal year-end
Source Fortune Global 500 1999 httpwwwpathfindercomfortuneglobal500indexhtml
Institute for International Economics | httpwwwiiecom
THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 91
Tab
le 2
8N
on
fin
anci
al f
irm
s in
th
e 10
0 la
rges
t co
mp
anie
s b
y re
ven
ue
199
8 (b
illio
ns o
f do
llars
)
Glo
bal
Tra
nsn
atio
nal
ity
ran
k
Co
mp
any
Rev
enu
esa
Ass
etsb
ind
exc
Typ
e
Co
nti
nen
tal
Eu
rop
e
2D
aim
lerC
hrys
ler
(Ger
man
y)15
516
044
1M
otor
veh
icle
s an
d pa
rts
11R
oyal
Dut
chS
hell
Gro
up (
Net
herla
nds)
9411
058
9P
etro
leum
ref
inin
g17
Vol
ksw
agon
(G
erm
any)
7670
568
Mot
or v
ehic
les
and
part
s22
Sie
men
s (G
erm
any)
6667
521
Ele
ctro
nics
el
ectr
ical
equ
ipm
ent
32M
etro
(G
erm
any)
5222
n
a
Foo
d an
d dr
ug s
tore
s34
Fia
t (I
taly
)51
7640
8M
otor
veh
icle
s an
d pa
rts
36N
estle
(S
witz
erla
nd)
5041
932
Foo
d46
Veb
a G
roup
(G
erm
any)
4351
275
Tra
ding
49R
enau
lt (F
ranc
e)41
4545
7M
otor
veh
icle
s an
d pa
rts
53D
euts
che
Tel
ekom
(G
erm
any)
4093
n
a
Tel
ecom
mun
icat
ions
57R
oyal
Phi
lips
Ele
ctro
nics
(N
ethe
rland
s)38
3386
4E
lect
roni
cs
elec
tric
al e
quip
men
t59
Peu
geot
(F
ranc
e)38
4038
7M
otor
veh
icle
s an
d pa
rts
62E
lect
riciteacute
de
Fra
nce
(Fra
nce)
3711
3
na
Util
ities
ga
s an
d el
ectr
ic63
Rw
e G
roup
(G
erm
any)
3747
n
a
Util
ities
ga
s an
d el
ectr
ic65
BM
W (
Ger
man
y)36
3660
7M
otor
veh
icle
s an
d pa
rts
66E
lf A
quita
ine
(Fra
nce)
3643
576
Pet
role
um r
efin
ing
69V
iven
di (
Fra
nce)
3558
n
a
Eng
inee
ring
and
cons
truc
tion
70S
uez
Lyon
nais
e de
s E
aux
(Fra
nce)
3585
n
a
Ene
rgy
78E
NI
(Ita
ly)
3249
317
Pet
role
um r
efin
ing
86B
ayer
(G
erm
any)
3134
827
Che
mic
als
92A
BB
Ase
a B
row
n B
over
i (S
witz
erla
nd)
3132
957
Ele
ctro
nics
el
ectr
ical
equ
ipm
ent
93B
AS
F (
Ger
man
y)31
3159
5C
hem
ical
s95
Car
refo
ur (
Fra
nce)
3020
n
a
Foo
d an
d dr
ug s
tore
s
(tab
le c
ontin
ues
next
pag
e)
Institute for International Economics | httpwwwiiecom
92 WORLD CAPITAL MARKETS
Tab
le 2
8N
on
fin
anci
al f
irm
s in
th
e 10
0 la
rges
t co
mp
anie
s b
y re
ven
ue
199
8 (b
illio
ns o
f do
llars
) (c
ontin
ued
)
Glo
bal
Tra
nsn
atio
nal
ity
ran
k
Co
mp
any
Rev
enu
esa
Ass
etsb
ind
exc
Typ
e
Un
ited
Kin
gd
om
19B
P A
moc
o68
8559
2P
etro
leum
ref
inin
g43
Uni
leve
r45
3692
4F
ood
Un
ited
Sta
tes
1G
ener
al M
otor
s16
125
729
3M
otor
veh
icle
s an
d pa
rts
3F
ord
Mot
or14
423
835
2M
otor
veh
icle
s an
d pa
rts
4W
al-M
art
Sto
res
139
49
na
G
ener
al m
erch
andi
sers
8E
xxon
101
9365
9P
etro
leum
ref
inin
g9
Gen
eral
Ele
ctric
100
356
331
Ele
ctro
nics
el
ectr
ical
equ
ipm
ent
14In
tl B
usin
ess
Mac
hine
s82
8653
7C
ompu
ters
of
fice
equi
pmen
t25
US
Pos
tal
Ser
vice
6055
n
a
Mai
l pa
ckag
e a
nd f
reig
ht d
eliv
ery
27P
hilip
Mor
ris58
6051
1T
obac
co29
Boe
ing
5637
n
a
Aer
ospa
ce30
AT
ampT
5460
219
Tel
ecom
mun
icat
ions
40M
obil
4843
597
Pet
role
um r
efin
ing
41H
ewle
tt-P
acka
rd47
3451
1C
ompu
ters
of
fice
equi
pmen
t50
Sea
rs R
oebu
ck41
38
na
G
ener
al m
erch
andi
sers
55E
I d
u P
ont
de N
emou
rs39
40
na
C
hem
ical
s61
Pro
ctor
and
Gam
ble
3731
477
Soa
ps
cosm
etic
s75
Km
art
3414
n
a
Gen
eral
mer
chan
dise
rs81
Tex
aco
3229
453
Pet
role
um r
efin
ing
82B
ell
Atla
ntic
3255
n
a
Tel
ecom
mun
icat
ions
85E
nron
3129
n
a
Ene
rgy
87C
ompa
q C
ompu
ter
3123
n
a
Com
pute
rs
offic
e eq
uipm
ent
89D
ayto
n H
udso
n31
16
na
G
ener
al m
erch
andi
sers
94J
C
Pen
ney
3124
n
a
Gen
eral
mer
chan
dise
rs96
Hom
e D
epot
3013
n
a
Spe
cial
ty r
etai
lers
97Lu
cent
Tec
hnol
ogie
s30
27
na
E
lect
roni
cs
elec
tric
al e
quip
men
t10
0M
otor
ola
2929
n
a
Ele
ctro
nics
el
ectr
ical
equ
ipm
ent
Institute for International Economics | httpwwwiiecom
THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 93
Jap
an
5M
itsui
109
5635
8T
radi
ng6
Itoch
u10
957
333
Tra
ding
7M
itsub
ishi
107
7536
9T
radi
ng10
Toy
ota
Mot
or10
012
540
0M
otor
veh
icle
s an
d pa
rts
12M
arub
eni
9455
300
Tra
ding
13S
umito
mo
8946
259
Tra
ding
18N
ippo
n T
eleg
raph
amp T
elep
hone
7614
7
na
Tel
ecom
mun
icat
ions
20N
issh
o Iw
ai68
3938
8T
radi
ng24
Hita
chi
6282
214
Ele
ctro
nics
el
ectr
ical
equ
ipm
ent
26M
atsu
shita
Ele
ctric
Ind
ustr
ial
6067
332
Ele
ctro
nics
el
ectr
ical
equ
ipm
ent
31S
ony
5353
628
Ele
ctro
nics
el
ectr
ical
equ
ipm
ent
33N
issa
n M
otor
5158
511
Mot
or v
ehic
les
and
part
s38
Hon
da M
otor
4943
641
Mot
or v
ehic
les
and
part
s48
Tos
hiba
4151
252
Ele
ctro
nics
el
ectr
ical
equ
ipm
ent
51F
ujits
u41
4332
6C
ompu
ters
of
fice
equi
pmen
t52
Tok
yo E
lect
ric P
ower
4012
2
na
Util
ities
ga
s an
d el
ectr
ic60
NE
C37
42
na
E
lect
roni
cs
elec
tric
al e
quip
men
t90
Tom
en31
18
na
T
radi
ng99
Mits
ubis
hi E
lect
ric30
35
na
E
lect
roni
cs
elec
tric
al e
quip
men
t
Ch
ina
73S
inop
ec34
52
na
P
etro
leum
ref
inin
g
Tot
al (
aver
age
for
tran
snat
iona
lity
inde
x)3
988
447
949
0T
otal
for
G-1
0 (a
vera
ge f
or t
he i
ndex
)3
954
442
749
0
na
= n
ot a
vaila
ble
G-1
0 =
Gro
up o
f T
en c
ount
ries
see
not
e to
tab
le 1
1
a
Dat
a sh
own
are
for
the
fisca
l ye
ar e
nded
on
or b
efor
e 31
Mar
ch 1
999
b
Ass
ets
show
n ar
e th
ose
at t
he c
ompa
nyrsquos
fis
cal
year
-end
c
The
ind
ex o
f tr
ansn
atio
nalit
y is
cal
cula
ted
as t
he a
vera
ge o
f ra
tios
of f
orei
gn a
sset
s to
tot
al a
sset
s f
orei
gn s
ales
to
tota
l sa
les
and
for
eign
em
ploy
men
tto
tot
al e
mpl
oym
ent
as o
f 19
97 (
UN
CT
AD
)
Sou
rces
F
ortu
ne G
loba
l 50
0 1
999
http
w
ww
pat
hfin
der
com
fort
une
glob
al50
0in
dex
htm
l U
NC
TA
D (
1999
)
Institute for International Economics | httpwwwiiecom
94 WORLD CAPITAL MARKETS
foreign direct investment The ldquotransnationality indexrdquo (table 28) showsthat on average they conducted about half their business outside theirhome country9
Overview of the Players
Our review of the major players points to two major features First ahandful of big playersmdashfewer than 200 firms all toldmdashcontrol the ac-tion in international capital markets Their dominance will doubtless erodebut for now financial power is strikingly concentrated with them Sec-ond the big players are overwhelmingly based in the G-10 countriesplus Spain The responsibility to supervise them rests not in the IMFnor in Basel but squarely in Washington London Tokyo and the otherG-10 capitals At year-end 1999 the G-10 countries plus Spain accountedfor 84 percent of world banking assets 86 percent of world stock marketcapitalization and 76 percent of international debt securities (BIS 2000aWorld Bank 2000b)
International private capital flows are of three types bank loans anddeposits portfolio investment and foreign direct investment In cumula-tive total flows to emerging markets FDI was the biggest story in the1990s amounting to $954 billion (table 12) Portfolio flows were nextcumulatively amounting to somewhere between $612 billion (table 12)and $764 billion (table A1) Bank loans and deposits are the most com-plicated story
The Key Role of Banks
Banks are more important as an epicenter than as a wellspring Banksgenerate waves in the flow of capital to emerging markets rather than acontinuous steady stream According to data compiled by the Institute ofInternational Finance (table A1) net bank lending to emerging marketscumulated to $269 billion in the 1990s However deposits by emerging-market residents in G-10 banks more than offset G-10 bank lending tothese countries during the decade According to IMF data cumulativebank loans net of deposits amounted to a negative $135 billion (table 12)
In other words when loans and deposits are combined net bank ac-tivity that moves financial resources to emerging markets is small incomparison with portfolio investment and FDI But bank loans are thelubricant of any financial system Depending on circumstances bankscan be shock absorbers or shock propagators In recent decades with
9 The transnationality index is calculated as a simple average of the share of assetssales and employees outside the home country
Institute for International Economics | httpwwwiiecom
THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 95
respect to emerging markets banks have more often been propagatorsthan absorbers The average annual swing in bank lending to emergingmarkets was nearly $50 billionmdashby far the largest source of year-to-yearfluctuations in capital flows Both interbank loans between Europe Japanand Asia and sovereign Russian debt used as loan collateral played amajor role in the 1997-98 crisesmdashnot because banks are profligate playersbut because of the incentives they face and the instruments they useAccordingly our story begins with banks
Banks in the Modern Financial System
10 See Levine (2000) for a concise description of the role of banks in the financial system
11 The asymmetric information problem helps to explain why banks dominate the im-mature financial systems of emerging-market economies The general lack of informationon borrowers and undeveloped legal systems to enforce contracts hamper suppliers oflong-term financial instruments such as equities and bonds in evaluating risk and re-ward Banks are best suited in these circumstances to solve the asymmetric informationproblem by evaluating and monitoring private loans As more and better informationbecomes available capital markets develop and financial systems mature
As we noted in the previous paragraph the problem of financial volatil-ity in emerging-market economies is associated with bank lending Ifand when repayment problems arise cross-border private bank loansand bond placements are such that private creditors have no plausiblemeans of seizing assets from either private or sovereign borrowers Thusalthough international finance can nourish entrepreneurs and accelerategrowth a necessary complement may be a drastic creditor response inthe event of nonpaymentmdashto withhold fresh funds and force an eco-nomic crisis (Dooley 2000)
This argument is based on the characteristics of banks They are notldquobadrdquo per se They perform three essential functions in any financialsystem pooling the resources of disparate savers and channeling these re-sources into productive investment improving resource allocation throughtheir expertise in assessing and monitoring borrowers and facilitatingthe division of risk among numerous creditors10 But by their very na-ture banks are prone to two problems asymmetric information (the bor-rower knows more about the potential risk and return of its projectsthan the bank) and adverse selection (riskier borrowers will pay higherinterest rates and thus may constitute a disproportionate share of bankloan portfolios)11
Bank loans are illiquid fixed-price instruments They cannot easily beconverted to cash although they can be bundled into securities (knownas ldquosecuritizationrdquo) Once loan terms have been agreed on the only waya bank can adjust for shifting market conditions is by changing the quantityof its exposure When a borrower runs into trouble the bank can mix
Institute for International Economics | httpwwwiiecom
96 WORLD CAPITAL MARKETS
and match from two unpleasant menus It can roll over existing loansand extend new credit or it can call some part of existing loans andattempt to recover the principal It can also hedge by selling short otherclaims on the borrower These choices entail either an unwelcome exten-sion of the bankrsquos exposure or credit rationing against the borrower Whentrouble brews all banks encounter the same conditions in the aggregatethey prefer less exposure and ensuing credit restrictions lead to volatilebank lending
Innovation
12 Derivatives have no value of their own They ldquoderiverdquo their value from the value ofthe underlying asset They include swaps futures (contracts for future delivery at speci-fied prices) and options (which give one party the right but not the obligation to buyfrom or sell to a counterparty at an agreed price)
13 Maxfield (1998) analyzed available evidence of emerging-market investor objectivesmost of it before the crisis Analysis of portfolio equity flows is sensitive to the choice ofperiod with year-over-year data indicating that investors respond to country ldquofundamen-talsrdquo Other evidence suggests more ambiguity Ranking by ldquoinvestor impatiencerdquo ie thesearch for yield over value Tesar and Werner (1995) find short-term bank flows to be themost yield driven followed by portfolio investment FDI and long-term bank lending
14 Because market risk credit risk and country risk interact in complex ways newfinancial instruments have been created to help reduce negative interactions One is theldquototal return swaprdquo which has become an instrument of choice for hedge funds lookingfor high leverage Banks also use the total return swap to cover risks without increasingtheir capital requirements
Since the 1980s national and international banking systems have beentransformed by deregulation intensified competition and the informationand communications-technology revolutions The market environment isone of intense competition particularly in traditional banking activitiesThe innovations point away from traditional activities of plain vanilladeposit taking and loan making Three big themes are discernible Firstthe walls separating commercial banks investment banks portfolio man-agers and insurance firms are falling even if they are still distinct Sec-ond large banks are shifting toward securitizationmdashcreating securitiesout of everything from credit card debt to trade finance to disaster insur-ancemdashand earning fees in the process Third all large banks are shiftingtoward trading activity making markets and taking short-term stakes inbonds shares and derivatives12 These activities when successful satisfythe search for higher yields13
Many of the new financial instruments that banks trade are ldquooff bal-ance sheetrdquo This means that banks are not required to allocate capitalagainst them In swap contracts for example neither side pays cash at theoutset and therefore neither party has an asset in the traditional sense14
Futures and options contracts can be written with a relatively small initial
Institute for International Economics | httpwwwiiecom
THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 97
margin relative to the potential risk Credit derivatives limit credit risk bytransferring the potential loss associated with corporate loans and bondssovereign debt and other loan portfolios to counterparties15
Deregulation and innovation working in combination seem to havepushed banks into trading activity and leveraged plays but not into shareownershipmdasheven in jurisdictions that have no prohibition against equitystakes Among the G-10 banking systems the highest ratio of share own-ership to assets was only 5 percent in 1996 reached in Germany andJapan (Berlin 2000)16
The wave of innovation in financial instruments and the accompany-ing expansion of banking beyond its old boundaries is a two-edged swordOn one side it allows risk management far beyond what was tradition-ally possible Risk can now be shifted from firms that can ill afford lossesto those that can Banks can profitably act as intermediaries in shiftingrisk On the other side the innovation wave creates huge opportunitiesfor leveraged plays fostering a speculative search by banks themselvesfor high returns that in turn magnify their own risks17
15 Credit derivatives include total return swaps credit default swaps credit-linked notesand collateralized debt obligations They are the fastest-growing sector of the global de-rivatives market
16 Banks seem to specialize in lending even when they are allowed to mix finance andcommerce for reasons related both to how they are expected to behave with distressedfirms and to other intricacies of lender liability (Berlin 2000) Yet a recent cross-countrystudy found that restrictions on banking and commerce are associated with greater fi-nancial instability (Barth Caprio and Levine 2000)
17 Leverage is the magnification of the rate of return (positive or negative) on an in-vestment beyond the rate obtained by solely investing funds owned by the institution Itis often defined as the ratio of assets to equity Leverage is achieved by increasing thesize of an investment by borrowing or using derivative instruments such as futures oroptions These allow investors to earn a return on the notional amount underlying thecontract by committing a small portion of equity in the form of a margin deposit oroption premium payment
18 In a repo (repurchase agreement) one party (typically a trader) buys a bond andsells it to a dealer for cash with a promise to buy it back the next day at the same priceplus the overnight interest rate As long as the overnight interest rate is lower than theinterest accruing on the bond the trader earns some income on the bond The extremeform of these kinds of transactions was discovered at LTCM the failed US highly lever-aged institution which appears to have controlled more than $120 billion in assets froman investment of about $3 billion This leveraging was accomplished mostly through theuse of repos (Mayer 1999)
The potential for damage is illustrated in an extreme form by figure 21To precisely measure a firmrsquos leverage all positions must be known andrealistically valuedmdashwhich may be impossible to do Because many ac-tivitiesmdashsuch as repos18 and derivativesmdashdo not appear on the institutionrsquos
Leverage
Institute for International Economics | httpwwwiiecom
98W
OR
LD
CA
PIT
AL
MA
RK
ET
S
Figure 21 Hypothetical example of leverage
$1000 notional value of call option on equity in firms targeted for takeover
Repo FRN into cash and use cash to pay option premium
(repro is initially collateralized
Borrow $100 for margin purchase
$125 of US investment bank floating-rate notes (FRN) (secured by $25 equity in FRNs)
Repo off-the-run bond into cash and post margin
(repo is initially collateralizedSell (short) Borrow on-the-run bonds worth $20
$25 worth of off-the-run bonds (secured by $5 equity in bonds)
Exchange into $4
Cash $5 yen400 Japanese bank loans
$1 equity base
FRN = floating rate notesRepo = repurchase agreement
Source IMF (1998)
Institute for International Econom
ics | httpww
wiiecom
THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 99
balance sheet and because balance sheets are published quarterly at bestoutsiders have a difficult time assessing the extent of a firmrsquos leverage19
Leveraging by a single firm enhances its risk of default the widespreaduse of leverage in the financial system can magnify market adjustmentsespecially when they require ldquodeleveragingrdquomdashunwinding prior positionsRapid adjustments can cause credit to dry up and asset prices to plummetIn a mark-to-market environment falling asset prices trigger calls foradditional collateral that can ripple through markets
Risk Management
Because it is confronted with the widespread use of leverage and prolif-erating kinds of risk international finance is increasingly driven by riskevaluation and control20 Different institutions face various risk profilesand differing kinds of risk The most common risks can be quickly tickedoff Banks because of their traditional intermediary role of channelingthe resources from savers to borrowers face significant credit risk therisk of default or delay in the payment of principal and interest Theymust also manage market risk the risk that the prices of their liabilitiesmay change faster than their assets Market risk devastated US savingsand loan institutions in the late 1980s
Closely associated with market risk are interest-rate risk (unexpectedchanges in market interest rates that slash margins net income and theeconomic value of a bankrsquos equity) and foreign exchange risk (losses thatarise when assets denominated in an appreciating foreign currency areless than liabilities denominated in that currency) Banks make numer-ous loans to other banks around the world portfolio investors buy se-curities direct investors acquire fixed assets and all incur country risk(economic and political uncertainty in the host country) During the heightof the Asian crisis for example interbank loans to Japanese banksreflected the credit risk of lending to these banks the so-called Japanpremium
Substantial attention has been lavished on country risk analysis sincethe 1982 debt crisis in developing countries Yet in spite of this exper-tise the Asian crisis occurred in part because of a sudden upward reap-praisal of country risk after the Thai baht collapsed in April 1997 Banksand other financial institutions must also manage liquidity risk the riskthat market conditions will change unexpectedly depressing demand andprices of assets at the time they want to sell these assets And they mustmanage operational riskmdashfailures in control systems or people that cause
19 Another example of asymmetric information Both risk and leverage are difficult foroutsiders to assess without full timely disclosure
20 A longer discussion of these issues can be found in Managing Global Finance in IMF(1999c)
Institute for International Economics | httpwwwiiecom
100 WORLD CAPITAL MARKETS
financial loss or damage reputations Operational risk devastated BaringsBank in 1995
Financial institutions practice risk management to measure all theserisks the potential damage to their investment positions and ultimatelythe chance of becoming insolvent VAR (value at risk) risk models mea-sure subject to certain assumptions the amount of the firmrsquos capital thatis exposed in each period For example the VAR model might say thatin a 3-standard-deviation worst case (a case that is not supposed to hap-pen more than 1 percent of the time) the firm will loose 25 percent of itscapital during the next year
VAR models are widely used but like all models they have weak-nesses They rely on past values to estimate key variables in financialmarkets past values are not always good predictors of future risks More-over rising volatility and higher loss correlation among different assetclasses in a portfolio will cause all banks using these models to reducetheir exposures at the same time by switching to less volatile and lesscorrelated assets such as US Treasury bills (Persaud 2000)
Newer risk models entail stress testing and scenario analysis Scenarioanalysis envisages possible adverse changes one at a time that mightaffect the investment portfolio Stress testing estimates potential losseswhen several individual risk factors simultaneously move against thefirm but it too uses historical probabilities
Financial Volatility
21 For example derivative markets usually rely on underlying securities markets thatproduce continuous prices When these markets are interrupted financial shocks cantrigger a cascade of margin calls and sell orders that move prices very sharply
22 See IIF (1999a)
The combination of trading activity and modern risk management lie atthe root of financial volatility When risks increase banks must eitherraise more capital to cover the greater risk or reduce their exposure bycutting loan exposure by selling securities or by undertaking new de-rivative trades Raising more capital is time-consuming and in a crisisvery expensive because bank shares are depressed So banks look to theother alternatives If the bank can reduce lending it need not book aloss But most banks use the same VAR models and as indicated abovethese models will encourage them to reduce their outstanding loans atthe same time actually magnifying loan volatility
If banks attempt to reduce their exposure to risk by selling securitiesor undertaking new derivative trades they may trigger large priceshocks because of limited and shrinking market liquidity21 The liquid-ity problem is compounded when a small number of large institu-tions hold the same positions22 Take your pick loan volatility or price
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 101
volatility As two experts have observed (Folkerts-Landau and Garber1998)
[V]olatility even in one country will automatically generate an upward re-estimate of credit and market risk in a correlated country triggering automaticmargin calls and tightening of credit lines Thus apparently bizarre opera-tions that connect otherwise disconnected securities markets are not the re-sponses of panicked green screen traders arbitrarily driving economies from agood to a bad equilibrium Rather they work with relentless predictability andunder the seal of approval of supervisors in the main financial centers
23 See Ferguson (1999)
24 As Gerald Corrigan (1982) put the matter ldquoBanks are specialrdquo Corrigan (2000) reit-erated this view even after all the changes of the past two decades Unlike other institu-tions banks offer on-demand transactions are a backup liquidity source for other insti-tutions and serve as a ldquotransmission beltrdquo for monetary policy
These changes in the banking environment accentuate an existing anomalyThe anomaly is that banks even as they grow larger and increasinglyengage in more risky and complex transactions are perceived to enjoyimplicit and explicit public guarantees
The guarantees grow out of an incentive problem inherent in bankingasymmetric information which we mentioned above Depositors know lessabout a bankrsquos management and the quality of its balance sheet than doits managers and shareholders Thus in times of uncertainty or adver-sity bank depositorsmdashuncertain whether they will have access to theirdepositsmdashare prone to bank runs This prospect has in turn compelledgovernments to treat banks differently than other firms because a bankthat fails can disrupt the rest of the economy24
To prevent such crises governments have entered into quid pro quoarrangements with banks Governments provide them both with an im-plicit safety net in the form of an unstated promise by the central bankto act as a lender of last resort in a liquidity crisis and an explicit safetynet in the form of a public deposit insurance fund to reassure depositorsIn return the banks submit to closer government oversight and regu-lation of their activities than is usual for industries in the private sector
The ldquoinsurancerdquo provided by the public safety net contributes to an-other incentive problem moral hazard Banks acquire greater tastes forrisk and face less market discipline than other firms The explicit depositinsurance safety nets actually have or are perceived to have blanketcoverage that extends beyond the retail depositors (households and small
One of the lessons of the 1997-98 crisis must surely be that market par-ticipants and their regulatory supervisors relied too heavily on quantita-tive tools and insufficiently on judgment23
The Anomaly of Modern Banking
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102 WORLD CAPITAL MARKETS
businesses) for which they were originally intended The implicit centralbank safety nets extend in a crisis to nearly all depositors and banksThus banks are both viewed and behave as if they will be bailed out ifthey get into trouble
The existence of a public safety net raises a perennial question Dobanks have an unfair advantage over other financial institutions becauseof the subsidy provided by the safety net This question was at the heartof intensive study and debate in the United States leading up to thepassage in November 1999 of the Financial Services Modernization Act(also known as the Gramm-Leach-Bliley Act) The size of the gross sub-sidy is difficult to estimate despite determined research efforts Somesuggest it is well under 100 basis points and is at least partly offset bythe direct costs of deposit insurance premiums interest payments on bondsissued by the Financing Corporation25 reserve requirements regulatoryexpenses and operational costs associated with collecting deposits26 Con-versely Kwast and Passmore (2000) suggest that banks can expand theirscope far beyond the levels that other financial institutions could reachwith the same equity base but without the public safety net
A related concern in the US debate is whether allowing banks to ex-pand their activities into securities and insurance will ultimately extendthe safety net and add to the subsidy The Financial Services Moderniza-tion Act deals with this issue by maintaining a legal separation betweenbanks and the rest of the banking organization known as large com-plex banking organizations (LCBOs) They must engage in most securi-ties activities and insurance underwriting through separately capitalizedinvestment bank subsidiaries or holding company affiliates This act canbe said to have merely brought US banking laws closer to those of mostother industrial countries (Barth Brumbaugh and Wilcox 2000 BarthNolle and Rice 2000) If the fire wall is well-maintained and stoutly de-fended the safety net will neither expand in practice nor become a sourceof comfort to noncommercial bank subsidiaries of LCBOs
The quid pro quo exacted by governments to offset the subsidy iscloser public-sector monitoring of banksrsquo activities through prudentialsupervision The effectiveness of this closer official scrutinymdashand closermarket monitoringmdashare the subjects of the next section
25 The Financing Corporation was created by Congress in 1987 to sell bonds to raisefunds to help resolve the savings and loan crisis
26 See Levonian and Furlong (1995) Jones and Kolatch (1999) Shull and White (1998)and Whalen (1999a 1999b)
Are G-10 bank supervisors adequately responding In this section we firstassess the case for and compare the structures of prudential supervisory
Prudential Supervision
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 103
systems both within and among the G-10 economies plus Spain andconsider whether these offset the subsidy provided by the public safetynet Despite offsetting regulation and supervision implicit and explicitguarantees by G-10 governments to their banks are still a source of bank-ing instability in the emerging-market economies
National Systems for Prudential Supervision
Governments use prudential supervision to reduce the moral hazard andadverse selection created by their own safety nets Supervisors establishregulations and monitor compliance to limit risk taking and ensure thesafety and soundness of the banking system In a thoughtful analysis ofthe case for prudential supervision Frederic Mishkin (2000) identifiesthe main forms that supervision can take including the tasks of grantingbanking charters and licenses establishing capital requirements settingdeposit insurance premiums and defining disclosure requirements as wellas carrying out bank examinations Bank examiners gather informationfrom banks and evaluate whether they are following the regulatorsrsquo rulesin cases of weakness they are empowered to change banksrsquo behaviorand close them if necessary
Supervisors also may restrict competition define the activities in whichbanks may engage and restrict their asset holdings and separate banksand other financial (or nonfinancial) activities During the past two de-cades the barriers separating commercial banks investment banks in-surance firms and securities firms have been all but eliminated (tableB1) Deregulation has stimulated competitive forces that drive diversifi-cation and consolidation of the financial industry nowhere faster than inthe United States
The Financial Services Modernization Act of 1999 confirmed this trendIt eliminated restrictions dating back to the Glass Steagall Act of 1933which once prevented banking insurance and securities firms fromentering each otherrsquos businesses (Barth Brumbaugh and Wilcox 2000)Cross-pillar mergers among banks insurance and securities firms arewell under way to form giant financial holding companies The 1999merger between Citibank (banking) and Travelers (insurance) created themodel for megafinance and confirmed new challenges for supervisors
Mishkin (2000) notes the corresponding evolution in US supervisionfrom an emphasis on rules-based regulation (detailed rules for opera-tional behavior and the quality of line items in the balance sheet) to anapproach that stresses the soundness of bank management practices es-pecially risk management
Appendix B outlines the systems of financial supervision now in theplace in the G-10 countries plus Spain Some systems like the UK andCanadian approach are models of simplicitymdashorganized to keep pacewith the spreading reach of financial conglomerates Other systems like
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104 WORLD CAPITAL MARKETS
the US and French approaches show traces of the bureaucratic divisionsthat made sense in an era when banking securities and insurance weresharply separated
The US Model
27 See Meyer (1999a)
28 Canada has a similar degree of simplification with the exception that securities firmsare still regulated by provincial authorities
29 See Pratti and Schinasi (1999 67)
30 The agents are the bank regulators and the principals are the taxpayers Agents maypursue their own interests including bureaucratic survival and postgovernment employ-ment opportunities rather than the national interest in banking safety and soundness
The US model of financial regulation delineated in the Financial Ser-vices Modernization Act of 1999 blends functional and umbrella super-vision Bank and thrift regulators oversee depository institutions Newnonbank activities are subject to both functional regulation (eg by theSecurities and Exchange Commission and state insurance examiners) andumbrella supervision (of financial holding companies) by the FederalReserve27
The UK Model
Another supervisory model exists in the United Kingdom as well as inAustralia Canada and Switzerland28 In this model banking supervisionis separated from the monetary policy function The regulatory structureis considerably simplified by relying on a consolidated financial regula-tor separate from the central bank for both banking and nonbankingactivities The remaining question answered differently depending on thecountry is the extent to which the regulator relies on home-country sur-veillance of banks and conglomerates that have a local presence
Regulatory Models Compared
Appendix B provides more detail on the differences in these modelsGerman simplicity contrasts with French complexity In France the bankingcommission is chaired by the governor of the central bank and includesrepresentatives from the Treasury The commission supervises compli-ance with regulations but the central bank inspects banks on behalf ofthe commission29 In countries such as the United States and France withmultiple supervisors and crossover functions internal coordination is criticalAt the same time multiple agencies create regulatory competition Wheneach agency knows what the other is doing transparency within gov-ernment circles can help to limit principal-agent problems of regulation30
The discussion as to where in the public bureaucracy financial super-
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 105
vision should be placed goes back many years Peek Rosengren andTootell (1999) argue that a synergy exists between monetary policy andprudential supervision because information gained in the course of super-vision can increase the accuracy of macroeconomic forecasts A twist tothis argument is that the information on the state of financial institutionsavailable to the central bank as supervisor can facilitate its role as lenderof last resort Conversely there is the concern that a supervisory rolewill compromise the central bankrsquos independence of action with respectto its core mandatemdashmaintaining price stability As these arguments haveplayed out financial supervision has generally been shared between centralbanks and other regulators or placed entirely in the hands of an inde-pendent regulator However in Italy the Netherlands and Spain cen-tral banks are the sole banking supervisor
Goodhart (1995) examined the arguments and evidence for each modeland concluded that there were no overwhelming arguments or evidencefor one or the other31 Going forward a key problem for any financialsupervisory system is dealing with (and closing as necessary) weak banksIf both central banks and other regulators have this responsibility closecoordination between them is critical Another problem is large conglom-erate banks LCBOs Although they are less likely to fail because of thediversification of their assets and liabilities they are more likely to berescued They are also more likely to be multinational enterprises withinternational implications Goodhart observes that regulation of theseentities might be put in the hands of the central bank because it is lessamenable to political pressures In any event the complexity of LCBOoperations suggests that greater supervisory rigor is necessary
The US Congress was persuaded that broad oversight would help containthe moral hazard problem and accordingly gave the Federal Reservethe role of umbrella supervisor with the understanding that the Fed willscrutinize depository activity more intensely than nonbank financial ac-tivities Under this approach LCBOs such as Citigroup are subject tomuch closer monitoring than smaller and simpler institutions32 The USregulatory model requires enormous cooperation between the Fed otherbank supervisors and the functional regulators for insurance and securi-ties but it also benefits from regulatory competition
31 National systems of supervision are path dependent they are determined by the struc-ture of financial institutions and history in each country If Goodhart (1995) is right out-comes are not materially better or worse with one model of supervision rather than another
32 See Ferguson (1999)
Public Safety Nets
One of prudential supervisorsrsquo biggest challenges is to reduce moral hazardFor many years commercial banks engaged in communal self-insurance
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106 WORLD CAPITAL MARKETS
to deal with crises They formed voluntary groups that agreed to rescuetroubled members As financial markets evolved and competition inten-sified banks were no longer willing to play this role Private-sector in-surance is one alternative but moral hazard and adverse selection wouldappear to prevent it from happening Public safety nets have developedbecause of the low probability and high cost of potential bank runs Aclear trade-off is involved The effectiveness of insurance in preventingbank runs is greater the more comprehensive the coverage But the morecomprehensive the coverage the greater the moral hazardmdashbank man-agers bank directors investors and depositors all take on greater risksin the belief that the safety net will protect them against losses
All G-10 countries have compulsory public safety nets for banks (table29) Deposit insurance agencies are officially organized in Canada theNetherlands Sweden Switzerland and the United States organized bythe industry in France Germany Italy and the United Kingdom andjointly organized by the public and private sectors in Belgium Japanand Spain
How well do G-10 governments offset the subsidy provided by thepublic safety net This is a question on which there is substantial debateAs banking organizations have become more complex the challengesthat supervisors face have become more difficult One challenge is toalign the incentives facing bank managers and shareholders with thoseof depositors Another is the principal-agent problem in supervision Wehave discussed the incentive structures for financial institutions but wehave said little about the incentives for supervisors themselves and thedistortions they can generate in the financial system
In one of the many studies of the US savings and loan crisis of the1980s Kane (1989) documented both problems He described managersusing cosmetic approaches to disguise the magnitude of insolvency regulatorspracticing forbearance even though they knew of the deteriorating riskprofiles of the institutions for which they were responsible and legisla-tors increasing deposit insurance without regard for any offsetting changesin supervision A subsequent overhaul of the legislative framework forthe Federal Deposit Insurance Corporation (FDIC) known as the FDICImprovement Act of 1991 (FDICIA) aimed to introduce a clearer incen-tive structure for both regulators and regulated institutions
The changes introduced by this US legislation are worth discussionwith respect to the other G-10 countries as well First FDICIA created astronger signal to management and investors by targeting deposit insur-ance at small depositors only and by risk-weighting the deposit insur-ance premiums paid by banks to reflect their capital adequacy and bankexaminer ratings Among the G-10 countries rated in table 210 depositinsurance premiums vary considerablymdashbut it is not clear that the dif-ferences have much to do with risk-weighting Most G-10 countries em-ploy funding formulas based for example on the total domestic deposit
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Table 29 Deposit insurance schemes in the G-10 countries Explicit safety net
Coverage limit(dollar Foreign
equivalent currency Interbank Source Bankrsquos Contingency fundingDate Membership Co- at end of deposit deposit of premium from banks
Country established managementa insuranceb July 1998)c covered covered Fundingd funding costs or governments
United 1982 Compulsory Yes Larger of 90 No No Unfunded Banks only Callable (subject Parliament may increase Kingdom private percent co- to maximum the maximum payable
insurance to 03 percent of pound125 million advance 33000 total deposits) facility with Bank of
England
United 1934 Compulsory No 100000 Yes Yes Funded Banks and Up to 027 Borrowing up to $3 States official government percent total billion from US Treasury
domestic deposits
Japan 1971 Compulsory No 71000 but No No Funded Banks and 0084 percent of Borrowing up to yen500bn joint in full until government insured deposits from Bank of Japan
year 2000 subject to Ministry of Finance approval
Canada 1967 Compulsory No 40800 No Yes Funded Banks and 033 percent of Borrowing up to C$6 official government insured deposits billion authorized further
(maximum) borrowing subject to parliamentary approval
Germany 1966 Compulsory Yes 90 percent Yes No Funded Banks only 003 percent of Annual levy may be private coinsurance deposits doubled
to 22000
Italy 1987 Compulsory Yes 125000 Yes No Unfunded Banks and Callable Two options defer private government (maximum of payment or diminish
1 percent of compensation to be paid total deposits)
(table continues next page)
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Table 29 Deposit insurance schemes in the G-10 countries Explicit safety net (continued )
Coverage limit(dollar Foreign
equivalent currency Interbank Source Bankrsquos Contingency fundingDate Membership Co- at end of deposit deposit of premium from banks
Country established managementa insuranceb July 1998)c covered covered Fundingd funding costs or governments
Netherlands 1979 Compulsory No 22000 Yes No Unfunded Banks and On demand Government backing official government maximum of subject to parliamentary
5 percent of own approval funds
France 1980 Compulsory No 65400 No No Unfunded Banks only Callable (on Extra calls up to FFr1000 private demand calls million can be made in
up to FFr200 a 5-year period million)
Switzerland 1984 Voluntary No 19700 No No Unfunded Banks only Callable (on Underwritten by member official demand) banks
Sweden 1996 Compulsory No 31400 Yes No Funded Banks and 05 percent of Full emergency coverage official government deposits while replacing it with a
limited system after the emergency
Belgium 1974 Compulsory No 16600 No No Funded Banks and Callable 002 None insurance limited joint 22000 in government percent of to assets in fund
year 2000 deposits from clients
Spain 1977 Compulsory No 16439 Yes No Funded Banks and 02 percent of Government backing joint government deposits through the Banco de
(maximum) Espantildea subject to approval by royal decree
a Bank membership in the fund can be either compulsory or voluntary and the management of the fund can be official and official and private joint or privateb Coinsurance refers to the situation where depositors face a deductible against their insured fundsc Coverage limit refers to the explicit amount the authorities promise to insured Funded scheme means that it is funded ex ante unfunded otherwise
Sources Goodhart (1995) Demirguccedil-Kunt and Detragiache (2000) Demirguccedil-Kunt and Sabaci (2000)
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 109
base Explicit safety net protection also varies but only Canada focuseson the protected class33 All G-10 countries specify a limit on depositorprotection Under FDICIA the insurance fund is prohibited from pro-tecting uninsured depositors or creditors at a failed bank although adiscretionary system-wide override is provided for exceptional circum-stancesmdashbut with stringent requirements for consultation and account-ability Other G-10 countries allow for contingency funding from the publicpurse alongside unwritten lender-of-last-resort support Among large banksa significant and growing portion of deposit liabilities including foreigncurrency and interbank deposits are uninsuredmdashbut depositors assumethey will be protected in a crisis
FDICIA also made some significant qualitative changes to address theprincipal-agent problem by penalizing weak banks and rewarding strongbanks For example banks whose capital declined faced progressivelytougher regulatory sanctions that for example required them to elimi-nate dividends restrict their lending and change their managementsRegulators have also been forced to take prompt corrective action (toreduce the practice of regulatory forbearance in hopes that a bankrsquos for-tunes might improve)34 Unfortunately comparative qualitative assess-ments across the G-10 are difficult to make due to lack of information35
This discussion highlights the complexity of evaluating the extent towhich prudential supervision and market discipline reduce the moralhazard associated with G-10 safety nets Our argument is that publicsafety nets in the G-10 can be linked to banking instability in other coun-tries specifically in the emerging-market economies that have attractedG-10 cross-border bank lending This lending is a leading source of vola-tility in capital flows the large financial institutions many of which arecomplex banking organizations are based in and regulated by authori-ties in the G-10 economies These two features of the international finan-cial system are closely related although it is not possible to test thisrelationship econometrically
Two World Bank studies however indicate a basis for concern Onestudy is a cross-country econometric analysis of the relationship betweenbank stability and deposit insurance (Demirguccedil-Kunt and Detragiache2000) which found a negative relationship Their estimated model forbanking crises in a sample of 61 countries (both industrial and develop-ing) suggests that explicit deposit insurance raises the probability of acrisis by at least 30 percent36 Crises are especially likely in countries
33 Japanrsquos legislation says it does but recent experience shows this is not the case34 See Goldstein (1997) for a summary of the changes35 See Barth Nolle and Rice (2000) for a beginning in this area36 Demirguccedil-Kunt and and Detragiache (2000 table 1) report a logit coefficient of 0696with a standard error of 0397 (the coefficient is significant at the 8 percent threshold)This suggests that the ldquotruerdquo coefficient could well be as small as 030 (the reportedvalue minus the standard error)
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110 WORLD CAPITAL MARKETS
with immature financial supervisory systems (and not in the G-10) buttheir analysis does underscore the view that deposit insurance weakensmarket discipline37
An earlier World Bank analysis established similar results One wasthat market discipline is undermined by deposit insurance schemes an-other was that illiquid banks are forced to pay more for their funds un-less a generous deposit insurance scheme is in place (Demirguccedil-Kuntand Huizinga 1999) This econometric study also provides clear-cut evi-dence that depositor monitoring of banks declines with the existence ofdeposit insurance schemes At the heart of the problem is the questionof whether deposit insurance is accompanied by increased governmentmonitoring
This evidence and the weight of other arguments suggests that moralhazard is still an issue in the G-10 countries Consider the ongoing de-bate about instilling greater market discipline on risk taking by banksAt one extreme is the perennial proposal to do away with safety netsleaving markets to monitor the players and to force adjustments but toprotect small savers by creating ldquonarrow banksrdquo such as postal savingsystems that are allowed to invest these savings only in risk-free gov-ernment securities Whatever the merits of narrow banking this solutionis too extreme to be politically feasible
A moderate alternative is to force more disclosure by financial institu-tions to facilitate market monitoring But transparency has its own prob-lems Persaud (2000) argues that financial markets cannot reliably discernsustainable from unsustainable positions in the short term This uncer-tainty causes banks to ldquoherdrdquo behind market leaders to exploit theirsupposedly superior information ldquoThe more herding investors and bankersknow about what each other is up to the [more] unstable markets maybecomerdquo The implication is that greater transparency in the marketplaceby itself will not solve the problemmdashand in the short term more informa-tion may exacerbate herding Further supervisory steps (discussed in thenext chapter) are required
Yet another proposal is to promote private-sector involvement in bankmonitoring through market-based alternatives such as Calomirisrsquos sub-ordinated debt proposal (Calomiris 1997 Federal Reserve Board 1999)Banks could be required to issue and maintain a minimum amount of
37 Other findings in the Demirguccedil-Kunt and Detragiache (2000) study include thesepropositions The impact of deposit insurance on bank stability tends to be stronger themore extensive is the coverage offered to depositors when the scheme is funded andwhere the scheme is run by the government rather than by the private sector Con-versely deposit insurance is detrimental to bank stability where bank interest rates havebeen deregulated and where the institutional environment is weak Additional findingson deposit insurance are reported from a recent World Bank conference (8-9 June 2000httpwwwworldbankorgresearchinterestconfsupcomingdeposit_insurancehomehtm)Also see Smalhout (2001)
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 111
subordinated debt (eg uninsured certificates of deposit) to finance asmall fraction (such as 2 percent) of their total nonreserve assets Thesubordinated debt would be allowed to earn a set yield no more than 50basis points over the risk-free yield on government treasury bills Thisrule would supposedly force banks to operate in a safe manner Other-wise subordinated debt holders would redeem their uninsured certifi-cates of deposit and equity investors would sell their bank shares Despiteits practical problems the beauty of the subordinated debt requirementis that it enlists market incentives to push banks to avoid excessive port-folio risk38
The thrust of these proposals is very relevant to the arguments in ourstudy Even in the G-10 countries government monitoring by itself hasnot eliminated moral hazard among banks More work is needed to in-troduce market monitoring and to improve the incentive structures bothfor financial institutions and their supervisors We return to this issuewith our recommendations in the next chapter
38 In late 1996 Argentina began requiring its banks to finance 2 percent of total depos-its in the form of subordinated debt but without a maximum yield provision TheArgentine authorities expect that market discipline will act in concert with the publicsafety net One obvious problem with the subordinated debt proposal is that banks mayencourage some of their customers to buy the subordinated debt
Portfolio Institutions Tomorrowrsquos Problem
Before proceeding to the issues of international supervision we flag an-other potential problem for national regulators The big asset managersprofiled in tables 24 and 26 answer to diverse groups of pensionersshareholders and policyholders They allocate funds across a number ofcountries to diversify their risks They hold liquid assets that can be tradedand they have a higher proportion of long-term assets than banks Eco-nomic shocks can be absorbed through price changes and their effectsspread across time and markets Thus when conditions change in a par-ticular market they are more likely to ride out the storm than to flee Inother words they have less incentive than banks to pull their invest-ments in the face of adversity In the 1990s most large asset managersestablished a record of ldquoriding out the stormrdquo rather than ldquorunning withthe windrdquo although as we saw in chapter 1 instances of running withthe wind were detected in some portfolios As we write these insti-tutions have a good record overall in the emerging markets so whyworry
The Russian crisis and the near-collapse of LTCM previewed the dan-gers that may await future portfolio managers and G-10 financial minis-ters We have presented evidence indicating a systemic bias toward bank
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112 WORLD CAPITAL MARKETS
lending and debt finance to emerging markets and we have argued forsubstitution toward equity finance and direct investment39
That is not the end of the story We noted in the previous chapterthat institutional investors can become momentum investors selling in adownturn As more portfolio capital is invested in emerging marketssome players may adopt the high-risk high-leverage strategies of themost aggressive hedge funds Indeed the data in box 11 show that G-10portfolio investors held somewhat more long-term debt (more than $500billion) than equity (less than $400 billion) in emerging markets at theend of 1997 Long-term debt is an ideal vehicle for high-risk high-leveragestrategies These strategies practiced on a large scale could compound afuture crisis harming emerging markets A big enough crisis could inturn pressure G-10 central banks and finance ministers to arrange bail-out plans Instead of shrinking as a systemic financial problem moralhazard could increase
National securities regulators are the first line of defense against thisscenario They play a critical role in the safe evolution of capital mar-kets But regulators today are mandated to approve the issuance of newsecurities and to monitor the continuing disclosure of material informa-tion by issuers They are far less concerned with or empowered to monitorthe behavior of the increasingly large wealth-management firms that arethe major purchasers (and therefore resellers) of these securities
Within their mandates the goals of national securities regulators (table210 and appendix B) are similar to the concerns of bank regulators withsystem safety and soundness Their focus is also on the incentive sys-tems for management and boards of directors and on disclosure by cor-porations that issue marketable securities such as shares bonds andasset-backed securities 40 Issuers of securities possess greater knowledgeabout the quality of these assets than do the purchasers hence investorprotection is a key concern of regulators Moreover market disciplineworks best when markets know what is happening Well-functioning corpora-tions are key agents of wealth creation and social progress Underperform-ing corporations waste resources During recessions bad corporationsget into bad trouble often with severe social consequences Inadequateincentives for managers and inadequate accountability for boards andmanagers thus have negative externalities Regulators play a vital role inexposing weakness so that market disciplines come to bear sooner ratherthan later
Regulatory emphasis is constantly shifting as financial markets evolveand as the macroeconomic environment changes Regulators try to balance
39 See Rogoff (1999) Also see Berlin (2000) for a perspective on the limited role thatbanks play as share owners
40 See Habib and Ljungqvist (2000) for recent empirical analysis showing that corporateshare market values are higher when corporate executives have a larger ownership stake
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Table 210 Financial-sector regulation G-10 countries 2000
Financial institutions and their supervisors
Country and supervisory structure Retail banking Wholesale banking Securities Insurance
Financial conglomeratesFinancial Services Authority (FSA) = umbrella supervisor
United Kingdom FSA FSA FSA FSA
Treasury bull Commercial banks bull Investment funds (Securities and (Insurance Directorate(Securities and Investments Board) bull Unit trust groups Futures Authority) of the Treasury)
Bank of bull Building societies bull Pension funds England (Building Societies Commission) bull Merchant banks
bull Friendly societies bull Clearing houses bull Primary issuers bull Insurance FSA (Friendly Societies Commission) bull Venture capital of securities companies
bull Pensions and life insurance etc bull Stock exchanges bull Insurance brokers(Personal Investment Authority) bull Stockbrokers
Financial holding companiesFederal Reserve (FR) = umbrella supervisor
United States bull National banks(OCC) Securities and Regulated by
Treasury OCC bull State banks Federal Reserve Exchange Commission StatesMembers (FR)
OTS Nonmembers (FDIC) bull Investment banks bull Primary issuers of bull Insurance companies FR bull Cooperative banks (FDICFR) bull Finance companies securities bull Insurance brokers FDIC bull Insured industrial banks (FDIC) bull Stock exchanges
bull Thrift holding companies (OTS) bull Stockbrokers SEC bull Savings banks (OTSFDICFR) bull Investment advisors
bull Savings and loan associations bull Mutual funds(OTS) bull Public utility holding
bull Edge Act corporations (FR) companies
(table continues next page)
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Table 210 Financial-sector regulation G-10 countries 2000 (continued )
Financial institutions and their supervisors
Country and supervisory structure Retail banking Wholesale banking Securities Insurance
Financial holding companies Japan Financial Supervisory Authority (FSA) = umbrella supervisor
Prime FSA FSA FSA FSA ministerrsquos Ministry of office Finance (Securities and Exchange
Surveillance Commission) FRC Bureau of Financial bull City banks bull Investment banks bull Primary issuers of bull Insurance companies FSA Regulation bull Regional banks bull Asset managers securities bull Insurance brokers
bull Trust banks bull Stock exchanges SESC bull Long-term credit banks bull Stockbrokers
bull Pension funds
Financial holding companiesOffice of the Superintendent of Financial Institutions (OSFI) = umbrella supervisor
Canada Regulated by OSFI OSFI provinces OSFI
Department of Financebull Banks bull Cooperative credit bull Primary issuers of bull Insurance companies
(previously Office of the Inspector associations securities (previously Depart- OSFI General of the Banks) bull Fraternal benefit bull Stock exchanges ment of Insurance) Bank of bull Trust and loan companies society bull Stockbrokers bull Insurance brokers Canada bull Pension funds bull Asset managers
(previously Depart- CDIC ment of Insurance)
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115
Financial institutions and their supervisors
Country and supervisory structure Retail banking Wholesale banking Securities Insurance
Germany Financial holding groupsFederal Banking Supervisory Office (FBSO) = umbrella supervisor
Ministry of Finance FBSO BSO FSSO FISO
Bundesbankbull Universal banks bull Other financial bull Primary issuers of bull Insurance companies
Federal Banking bull Savings banks institutions (eg securities bull Insurance brokers Supervisory Office bull Securities banks management foreign bull Stock exchanges
currency dealings) bull Stockbrokers Federal Securities bull Financial enterprises bull Asset managers Supervisory Office (eg leasing bull Pension funds
organizations Federal Insurance credit card companies Supervisory Office investment advisors)
Italy Bank foundationsMinistry of Finance = umbrella supervisor
Ministry of Finance Bank of Italy Bank of Italy Consob ISVAP
Bank of Italy bull Commerical banks bull Asset managers bull Primary issuers of bull Insurance companies Consob bull Savings bank bull Open-end investment securities bull Insurance brokers
bull Securities banks companies (SICAVs) bull Stock exchangesbull Stockbrokers
ISVAP
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Table 210 Financial-sector regulation G-10 countries 2000 (continued )
Financial institutions and their supervisors
Country and supervisory structure Retail banking Wholesale banking Securities Insurance
The Netherlands Financial conglomeratesCouncil of Financial Supervisors = umbrella supervisor
Securities Board Securities Board Netherlandsche Netherlands Bank Netherlandsche Bank of the Netherlands Insurance Board Bank Insurance bull Credit institutions (universal banks bull Investment institutions bull Stock exchanges bull Insurance companies Board cooperative banks security credit (securities issuing bull Stockbrokers bull Insurance brokers
institutions mortgage banks) and tradingmdashprimary The Council of Financial and secondary Supervisors markets)
France Commission des Commission de Operations des Controcircle des
Banking and Banking Commission Bourse Assurances Financial Regulatory bull Ensuring that credit institutions (and investment firms since bull Primary issuers of bull Insurance companies Ministry for Committee the Financial Activity Modernization Act of 1996) comply securities bull Insurance brokers Economic with laws and regulations bull Stock exchanges Affairs and bull Execute instructions regarding all off-site monitoring and bull Stockbrokers Finance Credit on-site supervision Institutions and Banking and Financial Regulatory Committee Investment bull Formulates general regulations for credit institutions and investment firms Committee (capital adequacy requirements accounting rules etc) Bank of France Credit Institutions and Investment Committee Banking bull Authorizes and examines financial institutions except for those within the Commission competence of the Banking Commission
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117
Financial institutions and their supervisors
Country and supervisory structure Retail banking Wholesale banking Securities Insurance
Switzerland Large banking groupSwiss Federal Banking Commission (SFBC) = umbrella supervisor
Swiss National Bank Federal Office of
SFBC SFBC SFBC Private Insurance Swiss Federal Banking Commission bull Universal banks bull Investment banks bull Primary issuers of bull Insurance companies
bull Savings banks bull Asset management securities bull Insurance brokerscompanies bull Stock exchanges
Private audit Federal bull Investment funds bull Stockbrokers firms Office of bull Mortgage bond authorized by Private business SFBC Insurance
Sweden Financial holding company groupsFinancial Supervisory Authority = umbrella supervisor
Ministry of Finance Credit Market Securities Market Insurance Market
Credit Market Department Department Department Department
Financial bull Commercial banks bull Investment funds bull Primary issuers of bull Insurance companies Riksbank Supervisory bull Savings banks securities bull Insurance brokers Authority bull Friendly societies bull Stock exchanges
bull Stockbrokers
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Table 210 Financial-sector regulation G-10 countries 2000 (continued )
Financial institutions and their supervisors
Country and supervisory structure Retail banking Wholesale banking Securities Insurance
Belgium Bank holding companiesBanking and Finance Commission = umbrella supervisor
Bank of Belgium Banking Banking
Banking and Finance and Finance Insurance Controland Finance Commission Commission Commission Office
Banking and Insurance Finance Control bull Commercial banks bull Asset management bull Primary issuers of bull Insurance companies Commission Office bull Savings banks firms securities bull Insurance brokers
bull Securities banks bull Investment funds bull Stock exchanges bull Mortgage companiesbull Stockbrokers bull Pension funds
Securities Regulation Fund Securities Regulation Fund
bull Other investment firms and credit institutions(institutions participating in regulated off-exchangemarket in strips and Treasury certificates)
Bank holding companies Spain Banco de Espantildea = umbrella supervisor
Banco de Espantildea Comision Nacional del Mercado de Directorate General
Banco de Espantildea Valores (CNMV) Insurance
bull All credit institutions (commercial banks savings banks credit bull Primary issuers of (Ministry of Economy Ministry of cooperatives official credit institutions finance factoring and securities and Finance) Economy and CNMV leasing companies mortgage-loan companies etc) bull Stock exchanges bull Insurance companies Finance bull Interbank foreign exchange and book-entry public debt bull Stockbrokers bull Pension funds
markets bull Venture capital(companies and funds)
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119
Financial institutions and their supervisors
Country and supervisory structure Banking Securities Insurance
Banking Advisory High Level Securities Supervisors Committee (BAC) Committee (HLSS) Insurance Committee (IC)
Supranational (EU) bull Formulates standards for prudential bull Coordination of securities market bull Formulates standards forsupervision supervision prudential supervision
BACICHLSS Banking Supervision
Conglomerates Committee (BSC) Securities Contact Committee Regulation of prudential bull Systemic risk monitoring bull Regulation and implementation of supervision securities admission
International Association International International Organization of of Insurance Supervisors
Basel Committee Securities Commisison (IOSCO) (IAIS) Joint Forum Conglomerates Supervision bull Supervision and regulation best bull Supervision and regulation best bull Supervision and regulation amp regulation Best practices practices practices best practices
FSF Coordination across supervisors of various functions
Notes See appendix B for more information Boldface type indicates senior or oversight supervisor normal type indicates adjunct or front-line supervisorsolid line indicates direct responsbility to the senior-ranking authority dotted line indicates coordination in supervisory activities
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Table 210 Financial-sector regulation G-10 countries 2000 (continued )
Glossary of names United Kingdom FSA = Financial Services Authority United States FR = Federal Reserve OCC = Office of the Comptroller of theCurrency FDIC = Federal Deposit Insurance Corporation SEC = Securities and Exchange Commission OTS = Office of Thrift Supervision Japan FRC =Financial Reconstruction Commission FSA = Financial Services Agency SESC = Securities and Exchange Surveillance Commission Canada OSFI =Office of the Superintendent of Financial Institutions CDIC = Canada Deposit Insurance Corporation Germany FBSO = Federal Banking SupervisoryOffice FSSO = Federal Securities Supervisory Office FISO = Federal Insurance Supervisory Office BSO = Banking Supervisory Office Italy Consob =Commissione Nazionale per le Societa e la Borsa ISVAP = Instituto per la Vigilanza sulle assicurazioni private e di Interesse colletivo Switzerland SFBC= Swiss Federal Banking Commission Spain CNMV = The Comision Nacional del Mercado de Valores Supranational BAC = Banking Advisory CommitteeBSC = Banking Supervision Committee IC = Insurance Committee HLSS = High Level Securities Supervisors Committee International Dimension FSF =Financial Stability Forum IOSCO = International Organization of Securities Commission IAIS = International Association of Insurance Supervisors
Sources United Kingdom Bank of England httpwwwbankofenglandcouk Financial Services Authority httpwwwfsagovuk United States Board ofGovernors of Federal Reserve System httpwwwfederalreservegov Japan Bank of Japan httpwwwbojorjo Financial Reconstruction Commissionhttpwwwfsagojpfrcindexehtml Financial Services Agency httpwwwfsagojp Canada Bank of Canada httpwwwbank-banque-canadaca Office ofthe Superintendent of Financial Institutions httpwwwosfi-bsifgccaAndreEindexhtml Germany Deutsche Bundesbank httpwwwbundesbankde Fed-eral Banking Supervisory Office httpwwwbakredde Italy Banca drsquoitalia httpwwwbancaditaliait Commissione Nazionale per le Societa e la Borsahttpwwwconsobit Instituto per la Vigilanza sulle assicurazioni private e di Interesse colletivo httpwwwisvapit The Netherlands De NederlandscheBank httpwwwdnbnl France Banque de France httpwwwbanque-francefr Switzerland Schweizerische Nationalbank httpwwwsnbchindex3htmlSweden Sveriges Riksbank httpwwwriksbanksedefaultasp Belgium National Bank of Belgium httpwwwbnbbesgindexhtm Spain Banco de Espantildeahttpwwwbdees The Comision Nacional del Mercado de Valores httpwwwcnmves Supranational (EU) Institutional Arrangements for the Regulationand Supervision of the Financial Sector 2000 International Dimension Bank for International Settlement httpwwwbisorg International Organization ofSecurities Commissions httpwwwioscoorg International Association of Insurance Supervisors httpwwwiaisorg Financial Stability Forum httpwwwfsforumorg
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 121
the inflexibility of tight surveillance against the need to encourage in-novation and growth The US Securities and Exchange Commission isworried about aggressive accounting by firms and biased reports bysecurities analysts in an equity environment that prizes steadily higherquarterly earnings41 Japanese regulators are preoccupied with opaqueinterconnections between portfolio institutions banks and nonfinancialfirms through the keiretsu system Canadian regulators reeling from high-profile scandals of managers intentionally misleading investors are strengtheningmarket discipline through legal penalties aimed at managers and directorsof offending firms
When panic strikes a securities regulator cannot do much As the 1987stock market crash and the LTCM debacle in the fall of 1998 both dem-onstrated steep stock and bond price declines can create systemic risksIf severe enough the wealth effect of falling securities values and thefear of widespread insolvency can depress real activity Flooding thesystem with liquidity is a central bankerrsquos solutionmdashsomething a securi-ties regulator cannot do42 But just as financial supervisors can changethe incentive structure to discourage bankers from making risky loans ingood times so securities regulators can pay more attention to incentiveson the demand side when capital markets are strong
Prudential Supervision and InnovationmdashA Footnote
In concluding this discussion of prudential supervision in the G-10 anadditional point is worth noting National regulators face a persistenttrade-off between emphasizing financial system safety and soundnesswhile encouraging innovationmdashin spite of the added risks innovationbrings to financial markets Former US Treasury Secretary Lawrence Summers(2000 3) has argued by analogy
The jet airplane made airplane air travel more comfortable more efficient andmore safe though the accidents were more spectacular and for a time morenumerous after the jet was invented In the same way modern global financialmarkets carry with them enormous potential for benefit even if some of theaccidents are that much more spectacular As the right public policy response
41 The problem is illustrated by the divergence since mid-1998 between reported earn-ings by the Standard amp Poorrsquos (SampP) 500 and the after-tax profits of all corporations inthe national accounts Generally these two series move closely with one another Be-tween mid-1998 and mid-1999 SampP 500 reported that earnings increased by more than20 percent while after-tax profits of all corporations increased by less than 5 percent(Chase Bank US Economic and Policy Research US Weekly Prospects Chase SecuritiesWeekly Newsletter 5 June 2000 5)
42 For example the US Securities and Exchange Commission had no direct role in calmingmarkets in the 1987 or 1998 panics
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122 WORLD CAPITAL MARKETS
to the jet was longer runways better air-traffic control and better training forpilots and not the discouragement of rapid travel so the right public policyresponse to financial innovation is to assure a safe framework so that the ben-efits can be realized not to stifle the change
Accepting Summersrsquos analogy for the international financial system better-informed supervisors and investors are a necessary part of the financialsystem framework Supervisors require more timely information on therisk profiles resulting from positions taken by financial institutions Theyalso need a better understanding of risk-management systems Snapshotsof an institutionrsquos risk profile and risk-management procedures are nolonger adequate In a world where huge bets are quickly made (andpossibly lostmdashas with Barings Bank in 1995 and LTCM in 1998) super-visors must focus on the soundness of banking systems for evaluatingand managing risk on a daily basis Some progress has been made inaddressing these issues US banking examiners are extending their in-formation requirements in banking examinations and increasing theirinvolvement in large complex institutions43 More awareness is alsorequired of the fact that they are national organizations in a world ofcross-border capital flows To a much greater extent they need a multi-national reach International supervision and coordination among super-visors are the subject of the next section
Our analysis suggests that G-10 supervisors have unfinished businessBank supervisors need to start yesterday securities regulators can waituntil tomorrow One G-10 member acting alone cannot correct the biasIn good times the lending business will simply migrate to other G-10banks In bad times financial problems will not stop at the national bor-der A way has to be found to establish common international standardsfor the key financial players in order to prevent crises and to agree onapproaches for managing them The path has already been laid out Inthe wake of the bank failures of the past 25 years bank supervisors havetried to establish such standards They have done this without creating anew global institution
The essence of the international framework is decentralizationmdashglobalrules and design standards without global institutions that are perceivedto intrude on national sovereignty The awkward jargon for this frame-work is vertical subsidiaritymdashldquothink internationally act nationallyrdquo Theinternational thinking is done by a committee of regulators that meets
International SupervisionA Decentralized Framework
43 These issues are discussed in Ferguson (1999) and Meyer (2000a)
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 123
regularly at the Bank for International Settlements in Basel The commit-tee establishes principles and standards that are interpreted implementedand enforced by national authorities44 In this section we describe thesesupervisory efforts and their weaknesses We present our recommenda-tions for addressing these weaknesses in the next chapter
Basel I
The Basel Capital Accord of 1988 (Basel I)45 drew the lesson from thefinancial crises of the mid-1970s that more adequate capital levels in in-ternational banks would help reduce the systemic risk of bank failureThe primary goal of Basel I was capital adequacy other standards wereput in place not so much for their own virtue as to defend the primarygoal
Capital adequacy requirements were designed to ensure that individualinstitutions have the ability to absorb losses particularly credit lossesAccordingly a backup system of scoring credit risk was devised thatrequired large amounts of bank capital for some types of loans smalleramounts for others and zero for a select list of preferred assets Report-ing requirements were designed to disclose problems and ensure that atroubled bank would take timely steps to restore its capital base in thewake of a loss The Basel I framework worked tolerably well in limitingthe call on the public purse in the G-10 countriesmdashwith the notable ex-ceptions of France and Japan The framework failed to moderate riskybank lending to emerging markets however
Basel I was not developed with emerging markets in mind The origi-nal idea behind it was to develop a common supervisory approach tocross-border banking operations It grew out of political pressure fromUS lawmakers who were determined to require international banks op-erating in the United States to meet US banking standards Toward thisgoal in 1983 Congress passed the International Lending Supervisory ActUS and British banking authorities subsequently agreed on a commontarget the adoption of strict common capital-adequacy standards In 1988other G-10 governments agreed to go along voluntary acceptance ofthe standards throughout much of the rest of the world followed46 Therationale for the capital targets was two-fold The first was to requirebanks to hold sufficient amounts of capital (8 percent of risk-adjusted
44 The international committee of financial authorities agreed on a common definitionof banksrsquo tier-one or ldquocorerdquo capital national authorities defined tier-two capital in theirown manner which permitted greater variations in national working definitions andpractices
45 International Convergence of Capital Measurement and Capital Standards (BIS 1988)was prepared by the Basel Committee on Banking Supervision
46 See Reineke (1998)
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124 WORLD CAPITAL MARKETS
assets) to cushion losses on those assets The second was to dull theirappetites for risk banks with large capital bases would have more tolose if they failed and therefore would take fewer risks
Rapid change in financial markets soon revealed flaws in the Basel IAccord In a complex world with numerous sources of risk it focusedheavily on credit risk but overlooked other risks in a bankrsquos portfolioand the correlation between returns on different asset classes The Baselformula required banks to maintain a fixed amount of capital againsteach of its asset classes But the formula did not distinguish the riskinessof the borrower within each class As a result one large loan to a low-risk corporate borrower such as General Electric would require the sameamount of capital as 10 smaller transactions with high-risk borrowers
The system was also biased toward short-term loans Loans maturingin less than a year required a 20 percent risk weight whereas those ma-turing after more than a year required a 100 percent risk weight Inter-bank lending was particularly favored For example loans to banks inOECD countries required less capital than loans to private firms in thesame countries creating the anomaly that interbank loans to South Ko-rean banks required less capital than loans to General Electric47 Thisanomaly encouraged banks to shed high-quality assets if the Basel rulesrequired the allocation of more capital than banks thought they needed
Another weakness was that financial innovators quickly circumventedthe Accord Because short-term loans required less provisioning than long-term loans banks responded by securitizing their long-term debt port-folios and lending short-term against the collateral of the newly createdasset This allowed banks to circumvent the capital requirements gearedto the terms of the underlying debt At the same time the Basel I Accordfailed to encourage risk mitigation techniques such as credit derivativescollateral guarantees and on-balance-sheet netting the flip side of fi-nancial innovation Because off-balance-sheet products were not coveredby the Accord another anomaly appeared when Barings Bank collapsedin 1995 Barings met capital adequacy standards but collapsed becauseits systems for managing risk failed traders were allowed to speculatein futures contracts that did not appear on the balance sheet
Basel II
Work to overhaul Basel I began in 1995 and produced consultativepapers issued in June 1999 and January 200148 These papers have been
47 South Korean banks have had notoriously weak balance sheets because the practiceof ldquodirected lendingrdquo left them with many poor loans (in making these loans the bankswere expected to follow government objectives rather than creditworthiness criteria)
48 Basel Committee on Banking Supervision (1999 2001)
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 125
the subject of extensive consultation and revision as a result the newAccord is expected to be introduced in 200449 The Basel II frameworkhas three parts (pillars) revisions to Basel I minimum-capital require-ments supervisory review criteria and greater emphasis on market dis-cipline Broadly Basel II aims to maintain the level of capital in the sys-tem but achieve better alignment of banksrsquo capital with their risk pro-files and keep up with financial innovation
To align capital requirements with market realities (the first pillar)Basel II concentrates on the 100 or so largest banksmdashthe type of playerslisted in table 21mdashand on the holding-company parents of banking groups50
Capital requirements will differentiate between an increased number ofcredit groups or ldquorisk bucketsrdquo including claims on governments otherbanks corporations mortgage-backed securities and other asset-backedsecurities
Basel II originally proposed to use external ratings to set capital chargesfor a number of these credit risks Many banks objected arguing thatthey assess credit risk better than Standard amp Poorrsquos Moodyrsquos or FitchIBCA51 Basel II thus proposes two approaches to rating a standard ap-proach using external ratings and an ldquoadvancedrdquo approach that allowsselected banks to use their own internal rating systems To encouragethe development of rigorous internal control systems based on these in-ternal rating systems Basel II also proposes to levy capital charges foroperational risk (the risk of direct or indirect loss resulting from inad-equate or failed internal processes people and systems or from exter-nal events)
Some critics of this proposal dismiss it as an abrogation of the prin-ciple of external independent monitoring and as ldquodangerously naiumlverdquo52
But regulators argue that the new capital charge on operational risk shouldoffset this concern It is also far from clear how cross-national compari-sons of rating and internal risk-assessment systems will be made (Engelen2000) The development by the European Union of its own capital rulescould well complicate the international resolution of these issues Publicassurances by EU officials in January 2001 however indicated that theirmain concerns are to create a level playing field and avoid regulatoryarbitrage (Hargreaves 2001) There is also the significant problem ofthe procyclical character of risk weights When a crisis hits losses are
49 See Berry (2000) for an update in an interview with William J McDonough chair ofthe Basel Committee on Banking Supervision
50 For obvious reasons these proposals are addressed to large banks and simpler capi-tal standards are allowed for small banks that focus on their domestic credit markets
51 See Ammer and Packer (2000) for an empirical critique of the success of rating agen-cies in distinguishing risk by sector and region
52 See Auerback (2001)
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126 WORLD CAPITAL MARKETS
incurred or accrued capital is lost and loan exposure must be reducedor securities sold to restore the requisite capital-adequacy ratios A morerisk-sensitive framework could amplify volatility
As the second pillar of Basel II supervisory review criteria are beingbeefed up to encourage supervisors to intervene earlier in potential problemsituations and to compel banks to align their capital positions with theirrisk profiles Bank supervisors will be authorized to require banks tohold capital in excess of minimum requirements if they have concernsabout general management overall strategy risk-management performanceor the macroeconomic environment Of course if one G-10 supervisorimposes higher capital requirements in isolation the same disparity willemerge that presaged Basel I Some banks will be disadvantaged in theinternational marketplace and will loudly complain that excessive super-vision is driving business to their competitors Hence close internationalcooperation among supervisors is critical
To implement the third pillar market discipline banks will be requiredto make fuller more timely disclosure of capital adequacy and the risksto which that capital is exposed A number of measures are being stud-ied that might help supervisors evaluate bank performance such as com-parisons of uninsured deposit interest rates subordinated debt yieldsand equity prices The idea is that these yields and prices might alertsupervisors to market perceptions of risk Of course market perceptionsare only as good as market information More direct and controversialways to reinforce market discipline would dramatically increase publicdisclosure of bank positions and risk management systems
Many questions are still outstanding about how to resolve the techni-cal details of capital requirements and whether the requirements willachieve their intended goal of better assessment and mitigation of therisks in banksrsquo portfolios There is no substitute for skilled supervisorsThe intricacies of effective design and implementation suggest that su-pervisors need to be highly competent technically knowledgeable aboutbanking portfolio characteristics and the factors that influence bank ex-posure to credit risk (Mishkin 2000) And they must be aided by vigilantshareholders market forces and transparency of information53
Standard setting at the global level is desirable but ultimately theeffectiveness of these efforts will be tested at the national level espe-cially in times of systemic financial distress Here the record of Basel Iwas not a bright shining success Japanese banking regulators havetraditionally allowed banks to include real estate and securities in theircapital base When the value of these assets plummeted in the early 1990sregulators allowed banks to continue valuing these depreciated (andoften bankrupt) assets at their old inflated levels Japanese authorities
53 Benedict Roth Complacency Towards Catastrophe Financial Times 23 January 2001
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 127
insisted until the mid-1990s that eroded capital bases could be rebuiltin a market-driven fashion They rightly foresaw that huge loan losseswould undermine public support for the ruling party and require a po-litically unpopular bailout
Japanese foot dragging on Basel I was the worst54 but not uniqueOther examples can be found of ldquopolitically mandated forbearancerdquo TheFederal Reserve Bank of New York held important hands during theLTCM crisis of 1998 Mexico is still resolving the banking crisis that eruptedin 1995 South Korea has not yet closed the insolvent banks that behavedso badly before the crisis of 1998 In the aftermath of a crisis nationalregulators cannot always be relied upon to discipline politically power-ful bankers55 One of the little-noticed consequences of these differingapproaches is that those banks with strong regulatory systems receivedan implicit ldquoexport subsidyrdquo for their services US banks which had notengaged extensively in emerging-market lending in the 1990s were bet-ter positioned than their German and Japanese counterparts to expandtheir international assets in the wake of the crises
Other Financial Forums
54 See Japanese Banks Fiddling while Marunouchi Burns The Economist 27 January2001 67-69
55 See Calomiris (1997)
The Basel model of vertical subsidiarity has already been extended toother financial regulatory bodies In 1993-94 the BIS established a Tri-partite Group of Banking Insurance and Securities Regulators In 1994-95 the BIS increased its cooperation with the International Organizationof Securities Commissions when the two organizations issued parallelpapers on guidelines for national regulators concerning risk managementand disclosure of derivative trades In 1996 a permanent Joint Forum onFinancial Conglomerates was established to examine supervisory issuesand develop working arrangements among the different functional super-visors of conglomerate institutions that offer combinations of bankingsecurities and insurance products Draft papers on the supervisionof conglomerates were released for comment in 1998 applying capital-adequacy principles to these groups and providing guidelines both forassessing the integrity and competence of top managers and for sharingassessments between regulators
In 1997 the Basel Committee on Banking Supervision extended itsreach beyond capital standards to broader aspects of banking supervi-sion with the publication of the Core Principles for Effective BankingSupervision In 1999 a wide range of regulatory and standard-settingbodies were gathered under the umbrella of the Financial Stability
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128 WORLD CAPITAL MARKETS
Forum (FSF) itself established under BIS aegis56 The FSF has alreadyissued recommendations for stepped-up supervision and transparencyas well as guidelines for best practices in a number of areas includingoffshore financial centers and highly leveraged institutions or hedge funds57
Conclusion
Although the structural weaknesses in emerging-market economies arewidely acknowledged to have been causal factors in international capi-tal-market volatility this chapter points to the role of large G-10 bankingorganizations as major suppliers of the most volatile instrument short-term debt We have examined evidence of the impact of public safetynets in the G-10 economiesmdashthe deposit insurance systems the pruden-tial supervisory systems and the lender-of-last-resort functions of centralbanksmdashon the incentive structures of these organizations
Although supervisors in most countries working nationally and to-gether in the BIS have made significant efforts to mimic market forcesin their prudential supervision the most sophisticated financial institu-tions find innovative ways to circumvent the rules New global regulatorybodies are not about to be created G-10 national bank regulators shouldthemselves address the short-term debt bias in the international financialsystem by changing incentive systems G-10 securities regulators shouldalso take steps to get ahead of the curve paying close attention to largeportfolio swings by institutional investors particularly in times of crisisIn short more needs to be done at national and international levels tochange the rules of the game That is the subject of the next chapter
56 The Financial Stability Forum includes banking securities insurance and accountingregulatory bodies the OECD on taxation corruption and corporate governance and theIMF
57 See Martin (2000)
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82 WORLD CAPITAL MARKETS
Table 21 Worldrsquos largest 50 commercial banks by marketcapitalization October 2000 (billions of dollars) (continued )
Market capitalizatona Total Net Shareholderassets income equityb
Global Sept Oct National Dec Dec Decrank Banks 1999 2000 rankc 1999 1999 1999
United Kingdom
2 HSBC Holdings 97 122 1 569 54 379 Royal Bank of Scotland 19 58d 2 146 14 7
NatWestj 39 na na 292 na 1414 Lloyds TSB 68 52 3 285 41 1418 Barclays 44 44 4 402 28 1435 Abbey National 25 19 5 292 20 846 Standard Chartered 15 15d 6 88 06 646 Bank of Scotland 15 15d 7 116 10 6
Total for United Kingdom 322 324d 2191 173 106
United States
1 Citigroup 149 237 1 717 99 504 JP Morgan Chase amp Co 83 2 35e
Chase Manhattank 63 na na 406 54 24JP Morgank 20 na na 261 21 11
5 Bank of America 96 79 3 633 79 446 Wells Fargo amp Company 65 78 4 218 37 2216 Bank of New York
Company 25 46 5 75 17 520 Bank One 41 42 6 269 35 2022 Fleet Boston Financial 34 34 7 191 20 1523 MBNA 18 30 8 31 10 424 First Union 34 30 9 253 32 1727 Fifth Third Bancorp 17 24 10 42 07 427 Mellon Financial 17 24 11 48 10 433 State Street na 20 12 61 06 335 PNC Bank 16 19 13 75 13 635 Northern Trust na 19 14 29 04 235 Firstar 25 19 15 73 09 640 US Bancorp 22 18 16 82 15 846 SunTrust Banks 21 15 17 95 13 850 National City 16 13 18 87 14 650 Wachovia 16 11 19 67 10 650 KeyCorp 12 11 20 83 11 6
Total for United States 707 850 3796 517 271
Other
31 National Australia Bank 2 21 1 166 18 1234 Hang Seng Bank Ltd 20 20d 2 na na na35 Royal Bank of Canada 13 19 3 184 12 940 Commonwealth Bank
of Australia 14 18d 4 91 09 543 Toronto Dominion Bank 12 17 5 146 20 850 Westpac Banking Corp 12 13 6 92 10 650 Development Bank
of Singapore 12 13d 7 64 06 6
Total for other 105 121d 742 76 46
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 83
developing countries In turn the claims on developing countries repre-sent about 4 percent of the assets of G-10 and Spanish commercial banks
Portfolio Investors
Table 21 (continued )
Market capitalizatona Total Net Shareholderassets income equityb
Sept Oct National Dec Dec Dec1999 2000 rankc 1999 1999 1999
Total for largest 50 1980 2155 19594 58 917
Total for G-10 1900 2070 19182 53 888
na = not availablenot applicableG-10 = Group of Ten countries see note to table 11
a Market capitalization is defined as the number of ordinary shares currently in circulationmultiplied by the current share price Market capitalization as of October 2000 is presentedfor the banks that had a market capitalization higher than $11 billion as of September 1999b Shareholder equity is defined as the sum of issued common stock capital surplus or pre-mium various reserves and retained earnings Shareholder equity includes group equity at-tributable to consolidated minority interestsc Rankings within the country or regiond Estimates based on the available rates of change from September 1999 to October 2000The market capitalization and shareholder equity figures represent combined estimate for themerged bankse Total for the merged banksf Merged in September 2000g Merged in April 2001h Will merge in April 2002i Will merge with Nippon Trust and Tokyo Trust in October 2001j NatWest Bank merged with the Royal Bank of Scotland in March 2000k Announced a merger in September 2000
Sources Euromoney The Bank Atlas 2000 httpwwweuromoneycom American BankerThe Top 100 World Financial Companies Q3 1999 httpwwwamericanbankercom YahooFinance Company Profiles financeyahoocom Bloomberg Financials httpwwwbloombergcom
Three groups of financial institutions dominate the flow of portfolio capitalinvestment banks wealth managers and insurance companies Table 23lists nine large investment banks all based in New York with offices inLondon and other financial centers In 1998 these nine firms had a com-bined market capitalization in excess of $130 billion and controlled as-sets in excess of $18 trillion
Investment banks act as guardians to the securities markets Nearly allpublic and private shares bonds and asset-backed securities are broughtto market by an investment bank Fulfilling the same function they areexpanding the securities markets of emerging economies They also act asthe pilots of privatization mergers and takeoversmdashnow a core feature of
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84 WORLD CAPITAL MARKETS
Table 22 Total assets and external assets of all commercialbanks June 2000 (billions of dollars)
Claims onExternal assets developing countriesb
Share of Share ofTotal total assets total assets
Country assetsa Amount (percent) Amount (percent)
Austria 423 91 22 33 8Bahamas 316 244 77 61c 19Bahrain 100 92 92 46c 46Belgium 806 309 38 26 3Canada 720 98 14 31 4Denmark 244 58 24 6 2Finland 121 31 25 4 3France 2486 607 24 135 5Germany 4535 901 20 240 5Ireland 423 160 38 2 0Italy 1345 191 14 47 4Japan 8460 1199 14 258 3Luxembourg 821 495 60 124c 15Netherlands 1080 296 27 67 6Norway 157 14 9 3 3Singapore 574 405 70 202c 35Spain 889 124 14 57 6Sweden 348 67 19 12 2Switzerland 1632 709 43 177c 11United Kingdom 5802 1990 34 138 2United States 6223 889 14 144 2
Total for all BISreporting countries 37506 8968 24 1813 5
Total for G-10 34326 7378 21 1331 4
BIS = Bank for International SettlementsG-10 = Group of Ten countries see note to table 11
a Total assets are calculated as banking institutions (deposit institutions) reserve claims onthe public sector claims on the private sector (lines 20 21 22 from IFS) plus externalassets Figures are converted into US dollars using the market exchange rate at the end ofJune 2000b Developing countries are countries other than Andorra Australia Austria Belgium CanadaCyprus Denmark Finland France Germany Gibraltar Greece Iceland Ireland Italy JapanLiechtenstein Luxembourg Malta Netherlands New Zealand Norway Portugal Spain Swe-den Switzerland Turkey the United Kingdom the United States the Vatican City State andthe former Yugoslaviac These countries do not disclose their claims on developing countries Such claims arearbitrarily (and generously) estimated at half the external assets of commercial banks in Bahrainand Singapore and a quarter of the external assets of banks in the Bahamas Luxembourgand Switzerland
Sources IMF International Financial Statistics (IFS) November 2000 Bank for InternationalSettlements BIS Quarterly Review November 2000 httpwwwbisorg
Institute for International Economics | httpwwwiiecom
THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 85
global capitalism In addition to their underwriting role investment banksearn substantial profits from trading securities
Wealth-management firms are the second group of portfolio institu-tions They typically deal with the publicmdashindividuals and companiesthat want a trusted firm to manage their pensions and other funds Table24 lists 10 large wealth managers all based in the G-10 Together these10 firms control $64 trillion in assets and their own market capitalization
Table 23 Large investment banks 1998 (billions of dollars)
MarketRevenue Assets capitalizationa
Merrill Lynchb (United States) 36 300 25Morgan Stanley Dean Witterb (United States) 31 318 50c
Goldman Sachs (United States) 22d 217e 29c
Lehman Brothers Holdingsb (United States) 20 154 10c
Salomon Smith Barneyf (United States) 8 211 naCredit Suisse First Bostong (United States
Switzerland) 7 280 naPaine Webberh (United States) 7 54 6i
Bear Stearnsj (United States) 8 154 5i
Donaldson Lufkin amp Jenrettek (United States) 5 72 7i
Total 144 1760 132 plusTotal for G-10 144 1760 132 plus
na = not available (subsidiaries of large holding companies Citigroup and Creacutedit SuisseGroup respectively individual market capitalization is not available)G-10 = Group of Ten countries see note to table 11
a Market capitalization is calculated by multiplying the total number of shares by the shareprice at the companyrsquos fiscal year-endb Source Fortune Global 500 1999 Data shown are for the fiscal year ended on or before31 March 1999 Assets shown are those at the companyrsquos fiscal year-end httpwwwpathfindercomfortuneglobal500indexhtmlc Figures as of September 1999 are from American Banker httpwwwamericanbankercomBankRankingsd Source 1998 Goldman Sachs Annual Review Assets as of November 1998 httpwwwgscomaboutannual19984_fsindexhtmle Source Financial Times Company Financials Revenue as of 27 November 1998 httpwwwglobalarchiveftcomcbcb_searchhtmf Source 1998 Citigroup Annual Report 20 Revenue figures for year ending 31 December1998 Asset figures as of 31 December 1998 httpwwwcitigroupcomcitigroupfindatac1998ar2pdfg Source 19981999 Creacutedit Suisse Group Annual Report 23 httpwwwcsgchcsg_annual_report_98downloadcsg_ar98_p1_enpdfh Source 1998 Paine Webber Annual Report 34-35 httpwwwpainewebbercomannual98graphicsfininfoindexhtmi Individual figures are obtained from Yahoo The time for valuations is as follows BearStearns December 1999 Lehman Brothers November 1999 Paine Webber and DonaldsonLufkin amp Jenrette September 1999j Source 1999 Bear Stearns Annual Report 55-56 Figures are for fiscal year ending 30June 1998 httpwwwbearstearnscomcorporateinvestorindexhtmk Source 1999 Donaldson Lufkin and Jenrette Annual Report ldquoFinancial Highlightsrdquo httpwwwdljcompdfDLJ98_1pdf
Institute for International Economics | httpwwwiiecom
86 WORLD CAPITAL MARKETS
exceeds $260 billion For the most part wealth managers are long-termportfolio investors
Hedge funds represent a highly specialized investment vehicle that isnot widely available to the public Most hedge funds are leveraged theyemploy dynamic (and sometimes opportunistic) trading strategies involvingpositions in several different markets they adjust their investment port-folios frequently in anticipation of asset price movements or changes inyield differentials between related securities Hedge funds are opaque tomarket monitoring They are subject to little direct regulation and areunder few obligations to disclose information Hence the size of the in-dustry is difficult to measure
If they are measured by capital under management or by assets hedgefunds are small relative to established wealth managers As table 25shows the capital managed by 20 large hedge funds in late 1998 amountedto less than $50 billion Estimates vary widely but if all hedge funds arecounted their assets range from $100 to $300 billion Even the highestnumber is less than 5 percent of the combined assets of investment banksand traditional asset managers
The amount of leverage used by hedge funds depends on trading strate-gies that are in turn shaped by investor attitudes toward risk Leverage
Table 24 Large asset managers in 1998 (billions of dollars)
Total assets under Marketmanagementa capitalizationb
UBS (Switzerland) 1145 58c
Fidelity Investments (United States) 773 naKampo (Japan) 698 naCredit Suisse Group (Switzerland) 680 50c
AXA Group (France) 647 39c
Barclayrsquos Global Investors (United States) 616 44c
Merrill Lynch amp Co (United States) 501 25c
State Street Global Advisors (United States) 493 naCapital Group Cos (United States) 424 naZurich Financial Services (Switzerland) 415 45c
Total 6392 261 plusTotal for G-10 6392 261 plus
na = not available (usually a nonpublic company)G-10 = Group of Ten countries see note to table 11
a Figures are assets under management at fiscal year-end 1998b Market capitalization is calculated by multiplying the total number of shares by the shareprice at the companyrsquos fiscal year-endc Figures from American Banker httpwwwamericanbankercomBankRankings
Sources Institutional Investor 1999 httpwwwiimagazinecomresearchinterfacehtml US(II300) Asia (Asia200) and Europe (Euro100) Asset Management Rankings American BankerhttpwwwamericanbankercomBankRankings
Institute for International Economics | httpwwwiiecom
THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 87
is achieved using such instruments as repos (repurchase agreements)futures and forward contracts and other derivative products5 It is alsovery difficult to measure A Financial Stability Forum (FSF 2000b) studyof hedge funds noted thatmdashalthough there are problems with the waydata vendors report these positionsmdashestimates suggest most hedge fundsuse modest amounts of leverage averaging 21 but ranging to 41 insome FSF (2000b) further notes difficulties with evaluating the risk-adjusted performance of hedge funds because of their dynamic tradingstrategies
Table 25 Largest hedge funds according tocapitalization August 1998 (billions of dollars)
Fund Capital under management
Domestica
Tiger 51Moore Global Investment 40Highbridge Capital Corp 14Intercap 13Rosenberg Market Neutral 12Ellington Composite 11Hedged Taxable-Equivalent 10Quantitative LongShort 09Sr International Fund 09Perry Partners 08
OffshoreJaguar Fund NV 100Quantum Fund NV 60Quantum Industrial Fund 24Quota Fund NV 17Omega Overseas Partners 17Maverick Fund 17Zweig Dimenna International 16Quasar International Fund NV 15SBC Currency Portfolio 15Perry Partners International 13
Totalb 471
a Long Term Capital Management (LTCM) was in serious difficulty in August1998 and is omitted from the listb Estimates of hedge fund capital and the number of funds vary significantlyMARHedge estimated 1115 funds with $109 billion capital under managementat the end of 1997 Van Hedge Fund estimated 5500 funds with capital of $295billions at the same date
Source Adapted from Eichengreen (1999a)
5 Positions are established by posting margins rather than the face value of the position
Institute for International Economics | httpwwwiiecom
88 WORLD CAPITAL MARKETS
The positive role of hedge fundsmdashproviding diversification to inves-tors because their returns have low correlations with standard asset classesmdashis counterbalanced by some negative features Hedge funds and otherhighly leveraged institutions (HLIs) may take concentrated positions andengage in aggressive market practices that amount to ldquoganging uprdquo on asmall economy (such as Hong Kong)6 Under normal market conditionsHLI positions are not destabilizing but some of the aggressive practicesdocumented in 1998 are worrisome The FSF study group participantsagreed (2000b 112) that such practices raise important issues for marketintegrity but they could not agree that market manipulation was suffi-ciently widespread to be a serious concern for policymakers
Insurance companies are the third group of portfolio institutions Theseare divided into two categories property and casualty companies andlife and health insurance companies Ten large companies of each cat-egory are listed in table 26 In 1998 the 10 property and casualty insur-ance companies had $16 trillion in assets and more than $330 billion inmarket capitalization The 10 life insurance companies had $28 trillionin assets7 Combining both categories 100 percent of assets are controlledby insurance companies based in the G-10 and Spain In portfolio man-agement styles life insurance companies tend to hold longer-term assetswhereas property and casualty companies tend to hold shorter-term in-struments
Nonfinancial Multinational Enterprises
The last players are the nonfinancial multinational enterprises (MNEs)The worldrsquos 100 largest corporations measured by 1998 revenue are re-corded in tables 27 and 28 The 30 financial giants among the top 100are separately shown in table 27 Most of the firms appeared in previ-ous tables Together these 30 financial giants had revenues of $13 tril-lion and controlled assets of $113 trillion8
Table 28 lists the 70 top nonfinancial giants Their revenues in 1998were $40 trillion and their assets (at book value) measured $45 trillionMeasured by revenue or assets about 95 percent of the giants are basedin the G-10 These firms are responsible for a large share of the worldrsquos
6 See IMF (1999c) for a description of the ldquodouble playrdquo that hedge funds are accusedof using in an attempt to destabilize Hong Kong in August 1998
7 Many life insurance companies are owned by their policyholders and therefore donot have a market capitalization
8 By comparison the larger set of 96 financial firms listed in previous tables controlled$322 trillion in assets This is the total amount of assets recorded in tables 21 (50 com-mercial banks) 22 (9 investment banks) 24 (10 asset managers) and 26 (20 insurancecompanies) The largest hedge funds might add $300 billion to the total
Institute for International Economics | httpwwwiiecom
THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 89
Table 26 20 large insurance companies in 1998(billions of dollars)
Property and casualty insurance Marketcompanies Revenuea Assetsb capitalizationc
Allianz (Germany) 65 402 62d
Assicurazioni Generali (Italy) 48 178 30d
State Farm Insurance Cos (United States) 45 111 naZurich Financial Services (Switzerland) 39 215 45d
CGU (United Kingdom) 38 176 20d
Munich Re Group (Germany) 35 131 naAmerican International Group (United States) 33 194 135d
Allstate (United States) 26 88 20d
Royal amp Sun Alliance (United Kingdom) 25 76 11d
Loews (United States) 21 71 7e
Total 375 1642 330 plusTotal for G-10 375 1642 330 plus
MarketLife and health insurance Revenuea Assetsb capitalizationc
AXA (France) 79 452 39d
Nippon Life Insurance (Japan) 66 363 naING Group (Netherlands) 56 464 46d
Dai-ichi Mutual Life Insurance (Japan) 44 253 naSumitomo Life Insurance (Japan) 40 206 naTIAA-CREF (United States) 36 250 naPrudential Ins Co of America (United States) 34 279 naPrudential (United Kingdom) 34 197 30d
Meiji Life Insurance (Japan) 28 146 naMetropolitan Life Insurance (United States) 27 215 na
Total 444 2825 naTotal for G-10 444 2825 na
na = not available (usually an insurance company owned by its policyholders)G-10 = Group of Ten countries see note to table 11
a Data shown are for the fiscal year ended on or before 31 March 1999b Assets shown are those at the companyrsquos fiscal year-endc Market capitalization is calculated by multiplying the total number of shares by the shareprice at the companyrsquos fiscal year-endd Market capitalization data as of September 1999 from American Banker httpwwwamericanbankercome Individual companyrsquos market capitalization as of September 1999 from Yahoo yahoomarketguidecom
Sources Fortune Global 500 1999 httpwwwpathfindercomfortuneglobal500indexhtmlAmerican Banker httpwwwamericanbankercomRankingBanks1999 Yahoo Marketguideyahoomarketguidecom
Institute for International Economics | httpwwwiiecom
90 WORLD CAPITAL MARKETS
Table 27 Financial firms in the 100 largest companiesby revenue 1998 (billions of dollars)
Globalrank Company Revenuesa Assetsb Type
Continental Europe
15 AXA (France) 79 452 Insurance23 Allianz (Germany) 65 402 Insurance28 Ing Group (Netherlands) 56 464 Insurance37 Credit Suisse (Switzerland) 49 475 Banks commercial
and savings39 Assicurazioni Generali (Italy) 48 178 Insurance42 Deutsche Bank (Germany) 45 736 Banks commercial
and savings56 Zurich Financial Services (Switerland) 39 215 Insurance68 Munich Re Group (Germany) 35 131 Insurance72 ABN AMRO Holding (Netherlands) 34 507 Banks commercial
and savings77 Credit Agricole (France) 33 459 Banks commercial
and savings80 HypoVereinsbank (Germany) 32 541 Banks commercial
and savings84 Fortis (Belgium) 31 397 Banks commercial
and savings98 Socieacuteteacute Geacuteneacuterale (France) 30 450 Banks commercial
and savingsUnited Kingdom
47 HSBC Holdings 43 485 Banks commercialand savings
58 CGU 38 176 Insurance74 Prudential 34 197 Insurance
United States
16 Citigroup 76 669 Diversified financials35 Bank of America Corp 51 618 Banks commercial
and savings44 State Farm Insurance Cos 45 111 Insurance64 TIAA-CREF 36 250 Insurance67 Merrill Lynch 36 300 Securities71 Prudential Ins Co of America 34 279 Insurance76 American International Group 33 194 Insurance79 Chase Manhattan Corp 32 366 Banks commercial
and savings83 Fannie Mae 31 485 Diversified financials88 Morgan Stanley Dean Witter 31 318 Securities
Japan
21 Nippon Life Insurance 66 363 Insurance45 Dai-ichi Mutual Life Insurance 44 253 Insurance54 Sumitomo Life Insurance 40 206 Insurance91 Bank of Tokyo-Mitsubishi 31 664 Banks commercial
and savingsTotal 1279 11341Total for G-10 1279 11341
G-10 = Group of Ten countries see note to table 11
a Data shown are for the fiscal year ended on or before 31 March 1999b Assets shown are those at the companyrsquos fiscal year-end
Source Fortune Global 500 1999 httpwwwpathfindercomfortuneglobal500indexhtml
Institute for International Economics | httpwwwiiecom
THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 91
Tab
le 2
8N
on
fin
anci
al f
irm
s in
th
e 10
0 la
rges
t co
mp
anie
s b
y re
ven
ue
199
8 (b
illio
ns o
f do
llars
)
Glo
bal
Tra
nsn
atio
nal
ity
ran
k
Co
mp
any
Rev
enu
esa
Ass
etsb
ind
exc
Typ
e
Co
nti
nen
tal
Eu
rop
e
2D
aim
lerC
hrys
ler
(Ger
man
y)15
516
044
1M
otor
veh
icle
s an
d pa
rts
11R
oyal
Dut
chS
hell
Gro
up (
Net
herla
nds)
9411
058
9P
etro
leum
ref
inin
g17
Vol
ksw
agon
(G
erm
any)
7670
568
Mot
or v
ehic
les
and
part
s22
Sie
men
s (G
erm
any)
6667
521
Ele
ctro
nics
el
ectr
ical
equ
ipm
ent
32M
etro
(G
erm
any)
5222
n
a
Foo
d an
d dr
ug s
tore
s34
Fia
t (I
taly
)51
7640
8M
otor
veh
icle
s an
d pa
rts
36N
estle
(S
witz
erla
nd)
5041
932
Foo
d46
Veb
a G
roup
(G
erm
any)
4351
275
Tra
ding
49R
enau
lt (F
ranc
e)41
4545
7M
otor
veh
icle
s an
d pa
rts
53D
euts
che
Tel
ekom
(G
erm
any)
4093
n
a
Tel
ecom
mun
icat
ions
57R
oyal
Phi
lips
Ele
ctro
nics
(N
ethe
rland
s)38
3386
4E
lect
roni
cs
elec
tric
al e
quip
men
t59
Peu
geot
(F
ranc
e)38
4038
7M
otor
veh
icle
s an
d pa
rts
62E
lect
riciteacute
de
Fra
nce
(Fra
nce)
3711
3
na
Util
ities
ga
s an
d el
ectr
ic63
Rw
e G
roup
(G
erm
any)
3747
n
a
Util
ities
ga
s an
d el
ectr
ic65
BM
W (
Ger
man
y)36
3660
7M
otor
veh
icle
s an
d pa
rts
66E
lf A
quita
ine
(Fra
nce)
3643
576
Pet
role
um r
efin
ing
69V
iven
di (
Fra
nce)
3558
n
a
Eng
inee
ring
and
cons
truc
tion
70S
uez
Lyon
nais
e de
s E
aux
(Fra
nce)
3585
n
a
Ene
rgy
78E
NI
(Ita
ly)
3249
317
Pet
role
um r
efin
ing
86B
ayer
(G
erm
any)
3134
827
Che
mic
als
92A
BB
Ase
a B
row
n B
over
i (S
witz
erla
nd)
3132
957
Ele
ctro
nics
el
ectr
ical
equ
ipm
ent
93B
AS
F (
Ger
man
y)31
3159
5C
hem
ical
s95
Car
refo
ur (
Fra
nce)
3020
n
a
Foo
d an
d dr
ug s
tore
s
(tab
le c
ontin
ues
next
pag
e)
Institute for International Economics | httpwwwiiecom
92 WORLD CAPITAL MARKETS
Tab
le 2
8N
on
fin
anci
al f
irm
s in
th
e 10
0 la
rges
t co
mp
anie
s b
y re
ven
ue
199
8 (b
illio
ns o
f do
llars
) (c
ontin
ued
)
Glo
bal
Tra
nsn
atio
nal
ity
ran
k
Co
mp
any
Rev
enu
esa
Ass
etsb
ind
exc
Typ
e
Un
ited
Kin
gd
om
19B
P A
moc
o68
8559
2P
etro
leum
ref
inin
g43
Uni
leve
r45
3692
4F
ood
Un
ited
Sta
tes
1G
ener
al M
otor
s16
125
729
3M
otor
veh
icle
s an
d pa
rts
3F
ord
Mot
or14
423
835
2M
otor
veh
icle
s an
d pa
rts
4W
al-M
art
Sto
res
139
49
na
G
ener
al m
erch
andi
sers
8E
xxon
101
9365
9P
etro
leum
ref
inin
g9
Gen
eral
Ele
ctric
100
356
331
Ele
ctro
nics
el
ectr
ical
equ
ipm
ent
14In
tl B
usin
ess
Mac
hine
s82
8653
7C
ompu
ters
of
fice
equi
pmen
t25
US
Pos
tal
Ser
vice
6055
n
a
Mai
l pa
ckag
e a
nd f
reig
ht d
eliv
ery
27P
hilip
Mor
ris58
6051
1T
obac
co29
Boe
ing
5637
n
a
Aer
ospa
ce30
AT
ampT
5460
219
Tel
ecom
mun
icat
ions
40M
obil
4843
597
Pet
role
um r
efin
ing
41H
ewle
tt-P
acka
rd47
3451
1C
ompu
ters
of
fice
equi
pmen
t50
Sea
rs R
oebu
ck41
38
na
G
ener
al m
erch
andi
sers
55E
I d
u P
ont
de N
emou
rs39
40
na
C
hem
ical
s61
Pro
ctor
and
Gam
ble
3731
477
Soa
ps
cosm
etic
s75
Km
art
3414
n
a
Gen
eral
mer
chan
dise
rs81
Tex
aco
3229
453
Pet
role
um r
efin
ing
82B
ell
Atla
ntic
3255
n
a
Tel
ecom
mun
icat
ions
85E
nron
3129
n
a
Ene
rgy
87C
ompa
q C
ompu
ter
3123
n
a
Com
pute
rs
offic
e eq
uipm
ent
89D
ayto
n H
udso
n31
16
na
G
ener
al m
erch
andi
sers
94J
C
Pen
ney
3124
n
a
Gen
eral
mer
chan
dise
rs96
Hom
e D
epot
3013
n
a
Spe
cial
ty r
etai
lers
97Lu
cent
Tec
hnol
ogie
s30
27
na
E
lect
roni
cs
elec
tric
al e
quip
men
t10
0M
otor
ola
2929
n
a
Ele
ctro
nics
el
ectr
ical
equ
ipm
ent
Institute for International Economics | httpwwwiiecom
THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 93
Jap
an
5M
itsui
109
5635
8T
radi
ng6
Itoch
u10
957
333
Tra
ding
7M
itsub
ishi
107
7536
9T
radi
ng10
Toy
ota
Mot
or10
012
540
0M
otor
veh
icle
s an
d pa
rts
12M
arub
eni
9455
300
Tra
ding
13S
umito
mo
8946
259
Tra
ding
18N
ippo
n T
eleg
raph
amp T
elep
hone
7614
7
na
Tel
ecom
mun
icat
ions
20N
issh
o Iw
ai68
3938
8T
radi
ng24
Hita
chi
6282
214
Ele
ctro
nics
el
ectr
ical
equ
ipm
ent
26M
atsu
shita
Ele
ctric
Ind
ustr
ial
6067
332
Ele
ctro
nics
el
ectr
ical
equ
ipm
ent
31S
ony
5353
628
Ele
ctro
nics
el
ectr
ical
equ
ipm
ent
33N
issa
n M
otor
5158
511
Mot
or v
ehic
les
and
part
s38
Hon
da M
otor
4943
641
Mot
or v
ehic
les
and
part
s48
Tos
hiba
4151
252
Ele
ctro
nics
el
ectr
ical
equ
ipm
ent
51F
ujits
u41
4332
6C
ompu
ters
of
fice
equi
pmen
t52
Tok
yo E
lect
ric P
ower
4012
2
na
Util
ities
ga
s an
d el
ectr
ic60
NE
C37
42
na
E
lect
roni
cs
elec
tric
al e
quip
men
t90
Tom
en31
18
na
T
radi
ng99
Mits
ubis
hi E
lect
ric30
35
na
E
lect
roni
cs
elec
tric
al e
quip
men
t
Ch
ina
73S
inop
ec34
52
na
P
etro
leum
ref
inin
g
Tot
al (
aver
age
for
tran
snat
iona
lity
inde
x)3
988
447
949
0T
otal
for
G-1
0 (a
vera
ge f
or t
he i
ndex
)3
954
442
749
0
na
= n
ot a
vaila
ble
G-1
0 =
Gro
up o
f T
en c
ount
ries
see
not
e to
tab
le 1
1
a
Dat
a sh
own
are
for
the
fisca
l ye
ar e
nded
on
or b
efor
e 31
Mar
ch 1
999
b
Ass
ets
show
n ar
e th
ose
at t
he c
ompa
nyrsquos
fis
cal
year
-end
c
The
ind
ex o
f tr
ansn
atio
nalit
y is
cal
cula
ted
as t
he a
vera
ge o
f ra
tios
of f
orei
gn a
sset
s to
tot
al a
sset
s f
orei
gn s
ales
to
tota
l sa
les
and
for
eign
em
ploy
men
tto
tot
al e
mpl
oym
ent
as o
f 19
97 (
UN
CT
AD
)
Sou
rces
F
ortu
ne G
loba
l 50
0 1
999
http
w
ww
pat
hfin
der
com
fort
une
glob
al50
0in
dex
htm
l U
NC
TA
D (
1999
)
Institute for International Economics | httpwwwiiecom
94 WORLD CAPITAL MARKETS
foreign direct investment The ldquotransnationality indexrdquo (table 28) showsthat on average they conducted about half their business outside theirhome country9
Overview of the Players
Our review of the major players points to two major features First ahandful of big playersmdashfewer than 200 firms all toldmdashcontrol the ac-tion in international capital markets Their dominance will doubtless erodebut for now financial power is strikingly concentrated with them Sec-ond the big players are overwhelmingly based in the G-10 countriesplus Spain The responsibility to supervise them rests not in the IMFnor in Basel but squarely in Washington London Tokyo and the otherG-10 capitals At year-end 1999 the G-10 countries plus Spain accountedfor 84 percent of world banking assets 86 percent of world stock marketcapitalization and 76 percent of international debt securities (BIS 2000aWorld Bank 2000b)
International private capital flows are of three types bank loans anddeposits portfolio investment and foreign direct investment In cumula-tive total flows to emerging markets FDI was the biggest story in the1990s amounting to $954 billion (table 12) Portfolio flows were nextcumulatively amounting to somewhere between $612 billion (table 12)and $764 billion (table A1) Bank loans and deposits are the most com-plicated story
The Key Role of Banks
Banks are more important as an epicenter than as a wellspring Banksgenerate waves in the flow of capital to emerging markets rather than acontinuous steady stream According to data compiled by the Institute ofInternational Finance (table A1) net bank lending to emerging marketscumulated to $269 billion in the 1990s However deposits by emerging-market residents in G-10 banks more than offset G-10 bank lending tothese countries during the decade According to IMF data cumulativebank loans net of deposits amounted to a negative $135 billion (table 12)
In other words when loans and deposits are combined net bank ac-tivity that moves financial resources to emerging markets is small incomparison with portfolio investment and FDI But bank loans are thelubricant of any financial system Depending on circumstances bankscan be shock absorbers or shock propagators In recent decades with
9 The transnationality index is calculated as a simple average of the share of assetssales and employees outside the home country
Institute for International Economics | httpwwwiiecom
THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 95
respect to emerging markets banks have more often been propagatorsthan absorbers The average annual swing in bank lending to emergingmarkets was nearly $50 billionmdashby far the largest source of year-to-yearfluctuations in capital flows Both interbank loans between Europe Japanand Asia and sovereign Russian debt used as loan collateral played amajor role in the 1997-98 crisesmdashnot because banks are profligate playersbut because of the incentives they face and the instruments they useAccordingly our story begins with banks
Banks in the Modern Financial System
10 See Levine (2000) for a concise description of the role of banks in the financial system
11 The asymmetric information problem helps to explain why banks dominate the im-mature financial systems of emerging-market economies The general lack of informationon borrowers and undeveloped legal systems to enforce contracts hamper suppliers oflong-term financial instruments such as equities and bonds in evaluating risk and re-ward Banks are best suited in these circumstances to solve the asymmetric informationproblem by evaluating and monitoring private loans As more and better informationbecomes available capital markets develop and financial systems mature
As we noted in the previous paragraph the problem of financial volatil-ity in emerging-market economies is associated with bank lending Ifand when repayment problems arise cross-border private bank loansand bond placements are such that private creditors have no plausiblemeans of seizing assets from either private or sovereign borrowers Thusalthough international finance can nourish entrepreneurs and accelerategrowth a necessary complement may be a drastic creditor response inthe event of nonpaymentmdashto withhold fresh funds and force an eco-nomic crisis (Dooley 2000)
This argument is based on the characteristics of banks They are notldquobadrdquo per se They perform three essential functions in any financialsystem pooling the resources of disparate savers and channeling these re-sources into productive investment improving resource allocation throughtheir expertise in assessing and monitoring borrowers and facilitatingthe division of risk among numerous creditors10 But by their very na-ture banks are prone to two problems asymmetric information (the bor-rower knows more about the potential risk and return of its projectsthan the bank) and adverse selection (riskier borrowers will pay higherinterest rates and thus may constitute a disproportionate share of bankloan portfolios)11
Bank loans are illiquid fixed-price instruments They cannot easily beconverted to cash although they can be bundled into securities (knownas ldquosecuritizationrdquo) Once loan terms have been agreed on the only waya bank can adjust for shifting market conditions is by changing the quantityof its exposure When a borrower runs into trouble the bank can mix
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96 WORLD CAPITAL MARKETS
and match from two unpleasant menus It can roll over existing loansand extend new credit or it can call some part of existing loans andattempt to recover the principal It can also hedge by selling short otherclaims on the borrower These choices entail either an unwelcome exten-sion of the bankrsquos exposure or credit rationing against the borrower Whentrouble brews all banks encounter the same conditions in the aggregatethey prefer less exposure and ensuing credit restrictions lead to volatilebank lending
Innovation
12 Derivatives have no value of their own They ldquoderiverdquo their value from the value ofthe underlying asset They include swaps futures (contracts for future delivery at speci-fied prices) and options (which give one party the right but not the obligation to buyfrom or sell to a counterparty at an agreed price)
13 Maxfield (1998) analyzed available evidence of emerging-market investor objectivesmost of it before the crisis Analysis of portfolio equity flows is sensitive to the choice ofperiod with year-over-year data indicating that investors respond to country ldquofundamen-talsrdquo Other evidence suggests more ambiguity Ranking by ldquoinvestor impatiencerdquo ie thesearch for yield over value Tesar and Werner (1995) find short-term bank flows to be themost yield driven followed by portfolio investment FDI and long-term bank lending
14 Because market risk credit risk and country risk interact in complex ways newfinancial instruments have been created to help reduce negative interactions One is theldquototal return swaprdquo which has become an instrument of choice for hedge funds lookingfor high leverage Banks also use the total return swap to cover risks without increasingtheir capital requirements
Since the 1980s national and international banking systems have beentransformed by deregulation intensified competition and the informationand communications-technology revolutions The market environment isone of intense competition particularly in traditional banking activitiesThe innovations point away from traditional activities of plain vanilladeposit taking and loan making Three big themes are discernible Firstthe walls separating commercial banks investment banks portfolio man-agers and insurance firms are falling even if they are still distinct Sec-ond large banks are shifting toward securitizationmdashcreating securitiesout of everything from credit card debt to trade finance to disaster insur-ancemdashand earning fees in the process Third all large banks are shiftingtoward trading activity making markets and taking short-term stakes inbonds shares and derivatives12 These activities when successful satisfythe search for higher yields13
Many of the new financial instruments that banks trade are ldquooff bal-ance sheetrdquo This means that banks are not required to allocate capitalagainst them In swap contracts for example neither side pays cash at theoutset and therefore neither party has an asset in the traditional sense14
Futures and options contracts can be written with a relatively small initial
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 97
margin relative to the potential risk Credit derivatives limit credit risk bytransferring the potential loss associated with corporate loans and bondssovereign debt and other loan portfolios to counterparties15
Deregulation and innovation working in combination seem to havepushed banks into trading activity and leveraged plays but not into shareownershipmdasheven in jurisdictions that have no prohibition against equitystakes Among the G-10 banking systems the highest ratio of share own-ership to assets was only 5 percent in 1996 reached in Germany andJapan (Berlin 2000)16
The wave of innovation in financial instruments and the accompany-ing expansion of banking beyond its old boundaries is a two-edged swordOn one side it allows risk management far beyond what was tradition-ally possible Risk can now be shifted from firms that can ill afford lossesto those that can Banks can profitably act as intermediaries in shiftingrisk On the other side the innovation wave creates huge opportunitiesfor leveraged plays fostering a speculative search by banks themselvesfor high returns that in turn magnify their own risks17
15 Credit derivatives include total return swaps credit default swaps credit-linked notesand collateralized debt obligations They are the fastest-growing sector of the global de-rivatives market
16 Banks seem to specialize in lending even when they are allowed to mix finance andcommerce for reasons related both to how they are expected to behave with distressedfirms and to other intricacies of lender liability (Berlin 2000) Yet a recent cross-countrystudy found that restrictions on banking and commerce are associated with greater fi-nancial instability (Barth Caprio and Levine 2000)
17 Leverage is the magnification of the rate of return (positive or negative) on an in-vestment beyond the rate obtained by solely investing funds owned by the institution Itis often defined as the ratio of assets to equity Leverage is achieved by increasing thesize of an investment by borrowing or using derivative instruments such as futures oroptions These allow investors to earn a return on the notional amount underlying thecontract by committing a small portion of equity in the form of a margin deposit oroption premium payment
18 In a repo (repurchase agreement) one party (typically a trader) buys a bond andsells it to a dealer for cash with a promise to buy it back the next day at the same priceplus the overnight interest rate As long as the overnight interest rate is lower than theinterest accruing on the bond the trader earns some income on the bond The extremeform of these kinds of transactions was discovered at LTCM the failed US highly lever-aged institution which appears to have controlled more than $120 billion in assets froman investment of about $3 billion This leveraging was accomplished mostly through theuse of repos (Mayer 1999)
The potential for damage is illustrated in an extreme form by figure 21To precisely measure a firmrsquos leverage all positions must be known andrealistically valuedmdashwhich may be impossible to do Because many ac-tivitiesmdashsuch as repos18 and derivativesmdashdo not appear on the institutionrsquos
Leverage
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98W
OR
LD
CA
PIT
AL
MA
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ET
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Figure 21 Hypothetical example of leverage
$1000 notional value of call option on equity in firms targeted for takeover
Repo FRN into cash and use cash to pay option premium
(repro is initially collateralized
Borrow $100 for margin purchase
$125 of US investment bank floating-rate notes (FRN) (secured by $25 equity in FRNs)
Repo off-the-run bond into cash and post margin
(repo is initially collateralizedSell (short) Borrow on-the-run bonds worth $20
$25 worth of off-the-run bonds (secured by $5 equity in bonds)
Exchange into $4
Cash $5 yen400 Japanese bank loans
$1 equity base
FRN = floating rate notesRepo = repurchase agreement
Source IMF (1998)
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 99
balance sheet and because balance sheets are published quarterly at bestoutsiders have a difficult time assessing the extent of a firmrsquos leverage19
Leveraging by a single firm enhances its risk of default the widespreaduse of leverage in the financial system can magnify market adjustmentsespecially when they require ldquodeleveragingrdquomdashunwinding prior positionsRapid adjustments can cause credit to dry up and asset prices to plummetIn a mark-to-market environment falling asset prices trigger calls foradditional collateral that can ripple through markets
Risk Management
Because it is confronted with the widespread use of leverage and prolif-erating kinds of risk international finance is increasingly driven by riskevaluation and control20 Different institutions face various risk profilesand differing kinds of risk The most common risks can be quickly tickedoff Banks because of their traditional intermediary role of channelingthe resources from savers to borrowers face significant credit risk therisk of default or delay in the payment of principal and interest Theymust also manage market risk the risk that the prices of their liabilitiesmay change faster than their assets Market risk devastated US savingsand loan institutions in the late 1980s
Closely associated with market risk are interest-rate risk (unexpectedchanges in market interest rates that slash margins net income and theeconomic value of a bankrsquos equity) and foreign exchange risk (losses thatarise when assets denominated in an appreciating foreign currency areless than liabilities denominated in that currency) Banks make numer-ous loans to other banks around the world portfolio investors buy se-curities direct investors acquire fixed assets and all incur country risk(economic and political uncertainty in the host country) During the heightof the Asian crisis for example interbank loans to Japanese banksreflected the credit risk of lending to these banks the so-called Japanpremium
Substantial attention has been lavished on country risk analysis sincethe 1982 debt crisis in developing countries Yet in spite of this exper-tise the Asian crisis occurred in part because of a sudden upward reap-praisal of country risk after the Thai baht collapsed in April 1997 Banksand other financial institutions must also manage liquidity risk the riskthat market conditions will change unexpectedly depressing demand andprices of assets at the time they want to sell these assets And they mustmanage operational riskmdashfailures in control systems or people that cause
19 Another example of asymmetric information Both risk and leverage are difficult foroutsiders to assess without full timely disclosure
20 A longer discussion of these issues can be found in Managing Global Finance in IMF(1999c)
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100 WORLD CAPITAL MARKETS
financial loss or damage reputations Operational risk devastated BaringsBank in 1995
Financial institutions practice risk management to measure all theserisks the potential damage to their investment positions and ultimatelythe chance of becoming insolvent VAR (value at risk) risk models mea-sure subject to certain assumptions the amount of the firmrsquos capital thatis exposed in each period For example the VAR model might say thatin a 3-standard-deviation worst case (a case that is not supposed to hap-pen more than 1 percent of the time) the firm will loose 25 percent of itscapital during the next year
VAR models are widely used but like all models they have weak-nesses They rely on past values to estimate key variables in financialmarkets past values are not always good predictors of future risks More-over rising volatility and higher loss correlation among different assetclasses in a portfolio will cause all banks using these models to reducetheir exposures at the same time by switching to less volatile and lesscorrelated assets such as US Treasury bills (Persaud 2000)
Newer risk models entail stress testing and scenario analysis Scenarioanalysis envisages possible adverse changes one at a time that mightaffect the investment portfolio Stress testing estimates potential losseswhen several individual risk factors simultaneously move against thefirm but it too uses historical probabilities
Financial Volatility
21 For example derivative markets usually rely on underlying securities markets thatproduce continuous prices When these markets are interrupted financial shocks cantrigger a cascade of margin calls and sell orders that move prices very sharply
22 See IIF (1999a)
The combination of trading activity and modern risk management lie atthe root of financial volatility When risks increase banks must eitherraise more capital to cover the greater risk or reduce their exposure bycutting loan exposure by selling securities or by undertaking new de-rivative trades Raising more capital is time-consuming and in a crisisvery expensive because bank shares are depressed So banks look to theother alternatives If the bank can reduce lending it need not book aloss But most banks use the same VAR models and as indicated abovethese models will encourage them to reduce their outstanding loans atthe same time actually magnifying loan volatility
If banks attempt to reduce their exposure to risk by selling securitiesor undertaking new derivative trades they may trigger large priceshocks because of limited and shrinking market liquidity21 The liquid-ity problem is compounded when a small number of large institu-tions hold the same positions22 Take your pick loan volatility or price
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 101
volatility As two experts have observed (Folkerts-Landau and Garber1998)
[V]olatility even in one country will automatically generate an upward re-estimate of credit and market risk in a correlated country triggering automaticmargin calls and tightening of credit lines Thus apparently bizarre opera-tions that connect otherwise disconnected securities markets are not the re-sponses of panicked green screen traders arbitrarily driving economies from agood to a bad equilibrium Rather they work with relentless predictability andunder the seal of approval of supervisors in the main financial centers
23 See Ferguson (1999)
24 As Gerald Corrigan (1982) put the matter ldquoBanks are specialrdquo Corrigan (2000) reit-erated this view even after all the changes of the past two decades Unlike other institu-tions banks offer on-demand transactions are a backup liquidity source for other insti-tutions and serve as a ldquotransmission beltrdquo for monetary policy
These changes in the banking environment accentuate an existing anomalyThe anomaly is that banks even as they grow larger and increasinglyengage in more risky and complex transactions are perceived to enjoyimplicit and explicit public guarantees
The guarantees grow out of an incentive problem inherent in bankingasymmetric information which we mentioned above Depositors know lessabout a bankrsquos management and the quality of its balance sheet than doits managers and shareholders Thus in times of uncertainty or adver-sity bank depositorsmdashuncertain whether they will have access to theirdepositsmdashare prone to bank runs This prospect has in turn compelledgovernments to treat banks differently than other firms because a bankthat fails can disrupt the rest of the economy24
To prevent such crises governments have entered into quid pro quoarrangements with banks Governments provide them both with an im-plicit safety net in the form of an unstated promise by the central bankto act as a lender of last resort in a liquidity crisis and an explicit safetynet in the form of a public deposit insurance fund to reassure depositorsIn return the banks submit to closer government oversight and regu-lation of their activities than is usual for industries in the private sector
The ldquoinsurancerdquo provided by the public safety net contributes to an-other incentive problem moral hazard Banks acquire greater tastes forrisk and face less market discipline than other firms The explicit depositinsurance safety nets actually have or are perceived to have blanketcoverage that extends beyond the retail depositors (households and small
One of the lessons of the 1997-98 crisis must surely be that market par-ticipants and their regulatory supervisors relied too heavily on quantita-tive tools and insufficiently on judgment23
The Anomaly of Modern Banking
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102 WORLD CAPITAL MARKETS
businesses) for which they were originally intended The implicit centralbank safety nets extend in a crisis to nearly all depositors and banksThus banks are both viewed and behave as if they will be bailed out ifthey get into trouble
The existence of a public safety net raises a perennial question Dobanks have an unfair advantage over other financial institutions becauseof the subsidy provided by the safety net This question was at the heartof intensive study and debate in the United States leading up to thepassage in November 1999 of the Financial Services Modernization Act(also known as the Gramm-Leach-Bliley Act) The size of the gross sub-sidy is difficult to estimate despite determined research efforts Somesuggest it is well under 100 basis points and is at least partly offset bythe direct costs of deposit insurance premiums interest payments on bondsissued by the Financing Corporation25 reserve requirements regulatoryexpenses and operational costs associated with collecting deposits26 Con-versely Kwast and Passmore (2000) suggest that banks can expand theirscope far beyond the levels that other financial institutions could reachwith the same equity base but without the public safety net
A related concern in the US debate is whether allowing banks to ex-pand their activities into securities and insurance will ultimately extendthe safety net and add to the subsidy The Financial Services Moderniza-tion Act deals with this issue by maintaining a legal separation betweenbanks and the rest of the banking organization known as large com-plex banking organizations (LCBOs) They must engage in most securi-ties activities and insurance underwriting through separately capitalizedinvestment bank subsidiaries or holding company affiliates This act canbe said to have merely brought US banking laws closer to those of mostother industrial countries (Barth Brumbaugh and Wilcox 2000 BarthNolle and Rice 2000) If the fire wall is well-maintained and stoutly de-fended the safety net will neither expand in practice nor become a sourceof comfort to noncommercial bank subsidiaries of LCBOs
The quid pro quo exacted by governments to offset the subsidy iscloser public-sector monitoring of banksrsquo activities through prudentialsupervision The effectiveness of this closer official scrutinymdashand closermarket monitoringmdashare the subjects of the next section
25 The Financing Corporation was created by Congress in 1987 to sell bonds to raisefunds to help resolve the savings and loan crisis
26 See Levonian and Furlong (1995) Jones and Kolatch (1999) Shull and White (1998)and Whalen (1999a 1999b)
Are G-10 bank supervisors adequately responding In this section we firstassess the case for and compare the structures of prudential supervisory
Prudential Supervision
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 103
systems both within and among the G-10 economies plus Spain andconsider whether these offset the subsidy provided by the public safetynet Despite offsetting regulation and supervision implicit and explicitguarantees by G-10 governments to their banks are still a source of bank-ing instability in the emerging-market economies
National Systems for Prudential Supervision
Governments use prudential supervision to reduce the moral hazard andadverse selection created by their own safety nets Supervisors establishregulations and monitor compliance to limit risk taking and ensure thesafety and soundness of the banking system In a thoughtful analysis ofthe case for prudential supervision Frederic Mishkin (2000) identifiesthe main forms that supervision can take including the tasks of grantingbanking charters and licenses establishing capital requirements settingdeposit insurance premiums and defining disclosure requirements as wellas carrying out bank examinations Bank examiners gather informationfrom banks and evaluate whether they are following the regulatorsrsquo rulesin cases of weakness they are empowered to change banksrsquo behaviorand close them if necessary
Supervisors also may restrict competition define the activities in whichbanks may engage and restrict their asset holdings and separate banksand other financial (or nonfinancial) activities During the past two de-cades the barriers separating commercial banks investment banks in-surance firms and securities firms have been all but eliminated (tableB1) Deregulation has stimulated competitive forces that drive diversifi-cation and consolidation of the financial industry nowhere faster than inthe United States
The Financial Services Modernization Act of 1999 confirmed this trendIt eliminated restrictions dating back to the Glass Steagall Act of 1933which once prevented banking insurance and securities firms fromentering each otherrsquos businesses (Barth Brumbaugh and Wilcox 2000)Cross-pillar mergers among banks insurance and securities firms arewell under way to form giant financial holding companies The 1999merger between Citibank (banking) and Travelers (insurance) created themodel for megafinance and confirmed new challenges for supervisors
Mishkin (2000) notes the corresponding evolution in US supervisionfrom an emphasis on rules-based regulation (detailed rules for opera-tional behavior and the quality of line items in the balance sheet) to anapproach that stresses the soundness of bank management practices es-pecially risk management
Appendix B outlines the systems of financial supervision now in theplace in the G-10 countries plus Spain Some systems like the UK andCanadian approach are models of simplicitymdashorganized to keep pacewith the spreading reach of financial conglomerates Other systems like
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104 WORLD CAPITAL MARKETS
the US and French approaches show traces of the bureaucratic divisionsthat made sense in an era when banking securities and insurance weresharply separated
The US Model
27 See Meyer (1999a)
28 Canada has a similar degree of simplification with the exception that securities firmsare still regulated by provincial authorities
29 See Pratti and Schinasi (1999 67)
30 The agents are the bank regulators and the principals are the taxpayers Agents maypursue their own interests including bureaucratic survival and postgovernment employ-ment opportunities rather than the national interest in banking safety and soundness
The US model of financial regulation delineated in the Financial Ser-vices Modernization Act of 1999 blends functional and umbrella super-vision Bank and thrift regulators oversee depository institutions Newnonbank activities are subject to both functional regulation (eg by theSecurities and Exchange Commission and state insurance examiners) andumbrella supervision (of financial holding companies) by the FederalReserve27
The UK Model
Another supervisory model exists in the United Kingdom as well as inAustralia Canada and Switzerland28 In this model banking supervisionis separated from the monetary policy function The regulatory structureis considerably simplified by relying on a consolidated financial regula-tor separate from the central bank for both banking and nonbankingactivities The remaining question answered differently depending on thecountry is the extent to which the regulator relies on home-country sur-veillance of banks and conglomerates that have a local presence
Regulatory Models Compared
Appendix B provides more detail on the differences in these modelsGerman simplicity contrasts with French complexity In France the bankingcommission is chaired by the governor of the central bank and includesrepresentatives from the Treasury The commission supervises compli-ance with regulations but the central bank inspects banks on behalf ofthe commission29 In countries such as the United States and France withmultiple supervisors and crossover functions internal coordination is criticalAt the same time multiple agencies create regulatory competition Wheneach agency knows what the other is doing transparency within gov-ernment circles can help to limit principal-agent problems of regulation30
The discussion as to where in the public bureaucracy financial super-
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 105
vision should be placed goes back many years Peek Rosengren andTootell (1999) argue that a synergy exists between monetary policy andprudential supervision because information gained in the course of super-vision can increase the accuracy of macroeconomic forecasts A twist tothis argument is that the information on the state of financial institutionsavailable to the central bank as supervisor can facilitate its role as lenderof last resort Conversely there is the concern that a supervisory rolewill compromise the central bankrsquos independence of action with respectto its core mandatemdashmaintaining price stability As these arguments haveplayed out financial supervision has generally been shared between centralbanks and other regulators or placed entirely in the hands of an inde-pendent regulator However in Italy the Netherlands and Spain cen-tral banks are the sole banking supervisor
Goodhart (1995) examined the arguments and evidence for each modeland concluded that there were no overwhelming arguments or evidencefor one or the other31 Going forward a key problem for any financialsupervisory system is dealing with (and closing as necessary) weak banksIf both central banks and other regulators have this responsibility closecoordination between them is critical Another problem is large conglom-erate banks LCBOs Although they are less likely to fail because of thediversification of their assets and liabilities they are more likely to berescued They are also more likely to be multinational enterprises withinternational implications Goodhart observes that regulation of theseentities might be put in the hands of the central bank because it is lessamenable to political pressures In any event the complexity of LCBOoperations suggests that greater supervisory rigor is necessary
The US Congress was persuaded that broad oversight would help containthe moral hazard problem and accordingly gave the Federal Reservethe role of umbrella supervisor with the understanding that the Fed willscrutinize depository activity more intensely than nonbank financial ac-tivities Under this approach LCBOs such as Citigroup are subject tomuch closer monitoring than smaller and simpler institutions32 The USregulatory model requires enormous cooperation between the Fed otherbank supervisors and the functional regulators for insurance and securi-ties but it also benefits from regulatory competition
31 National systems of supervision are path dependent they are determined by the struc-ture of financial institutions and history in each country If Goodhart (1995) is right out-comes are not materially better or worse with one model of supervision rather than another
32 See Ferguson (1999)
Public Safety Nets
One of prudential supervisorsrsquo biggest challenges is to reduce moral hazardFor many years commercial banks engaged in communal self-insurance
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106 WORLD CAPITAL MARKETS
to deal with crises They formed voluntary groups that agreed to rescuetroubled members As financial markets evolved and competition inten-sified banks were no longer willing to play this role Private-sector in-surance is one alternative but moral hazard and adverse selection wouldappear to prevent it from happening Public safety nets have developedbecause of the low probability and high cost of potential bank runs Aclear trade-off is involved The effectiveness of insurance in preventingbank runs is greater the more comprehensive the coverage But the morecomprehensive the coverage the greater the moral hazardmdashbank man-agers bank directors investors and depositors all take on greater risksin the belief that the safety net will protect them against losses
All G-10 countries have compulsory public safety nets for banks (table29) Deposit insurance agencies are officially organized in Canada theNetherlands Sweden Switzerland and the United States organized bythe industry in France Germany Italy and the United Kingdom andjointly organized by the public and private sectors in Belgium Japanand Spain
How well do G-10 governments offset the subsidy provided by thepublic safety net This is a question on which there is substantial debateAs banking organizations have become more complex the challengesthat supervisors face have become more difficult One challenge is toalign the incentives facing bank managers and shareholders with thoseof depositors Another is the principal-agent problem in supervision Wehave discussed the incentive structures for financial institutions but wehave said little about the incentives for supervisors themselves and thedistortions they can generate in the financial system
In one of the many studies of the US savings and loan crisis of the1980s Kane (1989) documented both problems He described managersusing cosmetic approaches to disguise the magnitude of insolvency regulatorspracticing forbearance even though they knew of the deteriorating riskprofiles of the institutions for which they were responsible and legisla-tors increasing deposit insurance without regard for any offsetting changesin supervision A subsequent overhaul of the legislative framework forthe Federal Deposit Insurance Corporation (FDIC) known as the FDICImprovement Act of 1991 (FDICIA) aimed to introduce a clearer incen-tive structure for both regulators and regulated institutions
The changes introduced by this US legislation are worth discussionwith respect to the other G-10 countries as well First FDICIA created astronger signal to management and investors by targeting deposit insur-ance at small depositors only and by risk-weighting the deposit insur-ance premiums paid by banks to reflect their capital adequacy and bankexaminer ratings Among the G-10 countries rated in table 210 depositinsurance premiums vary considerablymdashbut it is not clear that the dif-ferences have much to do with risk-weighting Most G-10 countries em-ploy funding formulas based for example on the total domestic deposit
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TH
E P
LAY
ER
S T
HE
IR S
UP
ER
VIS
OR
S A
ND
MO
RA
L HA
ZA
RD
107
Table 29 Deposit insurance schemes in the G-10 countries Explicit safety net
Coverage limit(dollar Foreign
equivalent currency Interbank Source Bankrsquos Contingency fundingDate Membership Co- at end of deposit deposit of premium from banks
Country established managementa insuranceb July 1998)c covered covered Fundingd funding costs or governments
United 1982 Compulsory Yes Larger of 90 No No Unfunded Banks only Callable (subject Parliament may increase Kingdom private percent co- to maximum the maximum payable
insurance to 03 percent of pound125 million advance 33000 total deposits) facility with Bank of
England
United 1934 Compulsory No 100000 Yes Yes Funded Banks and Up to 027 Borrowing up to $3 States official government percent total billion from US Treasury
domestic deposits
Japan 1971 Compulsory No 71000 but No No Funded Banks and 0084 percent of Borrowing up to yen500bn joint in full until government insured deposits from Bank of Japan
year 2000 subject to Ministry of Finance approval
Canada 1967 Compulsory No 40800 No Yes Funded Banks and 033 percent of Borrowing up to C$6 official government insured deposits billion authorized further
(maximum) borrowing subject to parliamentary approval
Germany 1966 Compulsory Yes 90 percent Yes No Funded Banks only 003 percent of Annual levy may be private coinsurance deposits doubled
to 22000
Italy 1987 Compulsory Yes 125000 Yes No Unfunded Banks and Callable Two options defer private government (maximum of payment or diminish
1 percent of compensation to be paid total deposits)
(table continues next page)
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108W
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PIT
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MA
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ET
S
Table 29 Deposit insurance schemes in the G-10 countries Explicit safety net (continued )
Coverage limit(dollar Foreign
equivalent currency Interbank Source Bankrsquos Contingency fundingDate Membership Co- at end of deposit deposit of premium from banks
Country established managementa insuranceb July 1998)c covered covered Fundingd funding costs or governments
Netherlands 1979 Compulsory No 22000 Yes No Unfunded Banks and On demand Government backing official government maximum of subject to parliamentary
5 percent of own approval funds
France 1980 Compulsory No 65400 No No Unfunded Banks only Callable (on Extra calls up to FFr1000 private demand calls million can be made in
up to FFr200 a 5-year period million)
Switzerland 1984 Voluntary No 19700 No No Unfunded Banks only Callable (on Underwritten by member official demand) banks
Sweden 1996 Compulsory No 31400 Yes No Funded Banks and 05 percent of Full emergency coverage official government deposits while replacing it with a
limited system after the emergency
Belgium 1974 Compulsory No 16600 No No Funded Banks and Callable 002 None insurance limited joint 22000 in government percent of to assets in fund
year 2000 deposits from clients
Spain 1977 Compulsory No 16439 Yes No Funded Banks and 02 percent of Government backing joint government deposits through the Banco de
(maximum) Espantildea subject to approval by royal decree
a Bank membership in the fund can be either compulsory or voluntary and the management of the fund can be official and official and private joint or privateb Coinsurance refers to the situation where depositors face a deductible against their insured fundsc Coverage limit refers to the explicit amount the authorities promise to insured Funded scheme means that it is funded ex ante unfunded otherwise
Sources Goodhart (1995) Demirguccedil-Kunt and Detragiache (2000) Demirguccedil-Kunt and Sabaci (2000)
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 109
base Explicit safety net protection also varies but only Canada focuseson the protected class33 All G-10 countries specify a limit on depositorprotection Under FDICIA the insurance fund is prohibited from pro-tecting uninsured depositors or creditors at a failed bank although adiscretionary system-wide override is provided for exceptional circum-stancesmdashbut with stringent requirements for consultation and account-ability Other G-10 countries allow for contingency funding from the publicpurse alongside unwritten lender-of-last-resort support Among large banksa significant and growing portion of deposit liabilities including foreigncurrency and interbank deposits are uninsuredmdashbut depositors assumethey will be protected in a crisis
FDICIA also made some significant qualitative changes to address theprincipal-agent problem by penalizing weak banks and rewarding strongbanks For example banks whose capital declined faced progressivelytougher regulatory sanctions that for example required them to elimi-nate dividends restrict their lending and change their managementsRegulators have also been forced to take prompt corrective action (toreduce the practice of regulatory forbearance in hopes that a bankrsquos for-tunes might improve)34 Unfortunately comparative qualitative assess-ments across the G-10 are difficult to make due to lack of information35
This discussion highlights the complexity of evaluating the extent towhich prudential supervision and market discipline reduce the moralhazard associated with G-10 safety nets Our argument is that publicsafety nets in the G-10 can be linked to banking instability in other coun-tries specifically in the emerging-market economies that have attractedG-10 cross-border bank lending This lending is a leading source of vola-tility in capital flows the large financial institutions many of which arecomplex banking organizations are based in and regulated by authori-ties in the G-10 economies These two features of the international finan-cial system are closely related although it is not possible to test thisrelationship econometrically
Two World Bank studies however indicate a basis for concern Onestudy is a cross-country econometric analysis of the relationship betweenbank stability and deposit insurance (Demirguccedil-Kunt and Detragiache2000) which found a negative relationship Their estimated model forbanking crises in a sample of 61 countries (both industrial and develop-ing) suggests that explicit deposit insurance raises the probability of acrisis by at least 30 percent36 Crises are especially likely in countries
33 Japanrsquos legislation says it does but recent experience shows this is not the case34 See Goldstein (1997) for a summary of the changes35 See Barth Nolle and Rice (2000) for a beginning in this area36 Demirguccedil-Kunt and and Detragiache (2000 table 1) report a logit coefficient of 0696with a standard error of 0397 (the coefficient is significant at the 8 percent threshold)This suggests that the ldquotruerdquo coefficient could well be as small as 030 (the reportedvalue minus the standard error)
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110 WORLD CAPITAL MARKETS
with immature financial supervisory systems (and not in the G-10) buttheir analysis does underscore the view that deposit insurance weakensmarket discipline37
An earlier World Bank analysis established similar results One wasthat market discipline is undermined by deposit insurance schemes an-other was that illiquid banks are forced to pay more for their funds un-less a generous deposit insurance scheme is in place (Demirguccedil-Kuntand Huizinga 1999) This econometric study also provides clear-cut evi-dence that depositor monitoring of banks declines with the existence ofdeposit insurance schemes At the heart of the problem is the questionof whether deposit insurance is accompanied by increased governmentmonitoring
This evidence and the weight of other arguments suggests that moralhazard is still an issue in the G-10 countries Consider the ongoing de-bate about instilling greater market discipline on risk taking by banksAt one extreme is the perennial proposal to do away with safety netsleaving markets to monitor the players and to force adjustments but toprotect small savers by creating ldquonarrow banksrdquo such as postal savingsystems that are allowed to invest these savings only in risk-free gov-ernment securities Whatever the merits of narrow banking this solutionis too extreme to be politically feasible
A moderate alternative is to force more disclosure by financial institu-tions to facilitate market monitoring But transparency has its own prob-lems Persaud (2000) argues that financial markets cannot reliably discernsustainable from unsustainable positions in the short term This uncer-tainty causes banks to ldquoherdrdquo behind market leaders to exploit theirsupposedly superior information ldquoThe more herding investors and bankersknow about what each other is up to the [more] unstable markets maybecomerdquo The implication is that greater transparency in the marketplaceby itself will not solve the problemmdashand in the short term more informa-tion may exacerbate herding Further supervisory steps (discussed in thenext chapter) are required
Yet another proposal is to promote private-sector involvement in bankmonitoring through market-based alternatives such as Calomirisrsquos sub-ordinated debt proposal (Calomiris 1997 Federal Reserve Board 1999)Banks could be required to issue and maintain a minimum amount of
37 Other findings in the Demirguccedil-Kunt and Detragiache (2000) study include thesepropositions The impact of deposit insurance on bank stability tends to be stronger themore extensive is the coverage offered to depositors when the scheme is funded andwhere the scheme is run by the government rather than by the private sector Con-versely deposit insurance is detrimental to bank stability where bank interest rates havebeen deregulated and where the institutional environment is weak Additional findingson deposit insurance are reported from a recent World Bank conference (8-9 June 2000httpwwwworldbankorgresearchinterestconfsupcomingdeposit_insurancehomehtm)Also see Smalhout (2001)
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 111
subordinated debt (eg uninsured certificates of deposit) to finance asmall fraction (such as 2 percent) of their total nonreserve assets Thesubordinated debt would be allowed to earn a set yield no more than 50basis points over the risk-free yield on government treasury bills Thisrule would supposedly force banks to operate in a safe manner Other-wise subordinated debt holders would redeem their uninsured certifi-cates of deposit and equity investors would sell their bank shares Despiteits practical problems the beauty of the subordinated debt requirementis that it enlists market incentives to push banks to avoid excessive port-folio risk38
The thrust of these proposals is very relevant to the arguments in ourstudy Even in the G-10 countries government monitoring by itself hasnot eliminated moral hazard among banks More work is needed to in-troduce market monitoring and to improve the incentive structures bothfor financial institutions and their supervisors We return to this issuewith our recommendations in the next chapter
38 In late 1996 Argentina began requiring its banks to finance 2 percent of total depos-its in the form of subordinated debt but without a maximum yield provision TheArgentine authorities expect that market discipline will act in concert with the publicsafety net One obvious problem with the subordinated debt proposal is that banks mayencourage some of their customers to buy the subordinated debt
Portfolio Institutions Tomorrowrsquos Problem
Before proceeding to the issues of international supervision we flag an-other potential problem for national regulators The big asset managersprofiled in tables 24 and 26 answer to diverse groups of pensionersshareholders and policyholders They allocate funds across a number ofcountries to diversify their risks They hold liquid assets that can be tradedand they have a higher proportion of long-term assets than banks Eco-nomic shocks can be absorbed through price changes and their effectsspread across time and markets Thus when conditions change in a par-ticular market they are more likely to ride out the storm than to flee Inother words they have less incentive than banks to pull their invest-ments in the face of adversity In the 1990s most large asset managersestablished a record of ldquoriding out the stormrdquo rather than ldquorunning withthe windrdquo although as we saw in chapter 1 instances of running withthe wind were detected in some portfolios As we write these insti-tutions have a good record overall in the emerging markets so whyworry
The Russian crisis and the near-collapse of LTCM previewed the dan-gers that may await future portfolio managers and G-10 financial minis-ters We have presented evidence indicating a systemic bias toward bank
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112 WORLD CAPITAL MARKETS
lending and debt finance to emerging markets and we have argued forsubstitution toward equity finance and direct investment39
That is not the end of the story We noted in the previous chapterthat institutional investors can become momentum investors selling in adownturn As more portfolio capital is invested in emerging marketssome players may adopt the high-risk high-leverage strategies of themost aggressive hedge funds Indeed the data in box 11 show that G-10portfolio investors held somewhat more long-term debt (more than $500billion) than equity (less than $400 billion) in emerging markets at theend of 1997 Long-term debt is an ideal vehicle for high-risk high-leveragestrategies These strategies practiced on a large scale could compound afuture crisis harming emerging markets A big enough crisis could inturn pressure G-10 central banks and finance ministers to arrange bail-out plans Instead of shrinking as a systemic financial problem moralhazard could increase
National securities regulators are the first line of defense against thisscenario They play a critical role in the safe evolution of capital mar-kets But regulators today are mandated to approve the issuance of newsecurities and to monitor the continuing disclosure of material informa-tion by issuers They are far less concerned with or empowered to monitorthe behavior of the increasingly large wealth-management firms that arethe major purchasers (and therefore resellers) of these securities
Within their mandates the goals of national securities regulators (table210 and appendix B) are similar to the concerns of bank regulators withsystem safety and soundness Their focus is also on the incentive sys-tems for management and boards of directors and on disclosure by cor-porations that issue marketable securities such as shares bonds andasset-backed securities 40 Issuers of securities possess greater knowledgeabout the quality of these assets than do the purchasers hence investorprotection is a key concern of regulators Moreover market disciplineworks best when markets know what is happening Well-functioning corpora-tions are key agents of wealth creation and social progress Underperform-ing corporations waste resources During recessions bad corporationsget into bad trouble often with severe social consequences Inadequateincentives for managers and inadequate accountability for boards andmanagers thus have negative externalities Regulators play a vital role inexposing weakness so that market disciplines come to bear sooner ratherthan later
Regulatory emphasis is constantly shifting as financial markets evolveand as the macroeconomic environment changes Regulators try to balance
39 See Rogoff (1999) Also see Berlin (2000) for a perspective on the limited role thatbanks play as share owners
40 See Habib and Ljungqvist (2000) for recent empirical analysis showing that corporateshare market values are higher when corporate executives have a larger ownership stake
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Table 210 Financial-sector regulation G-10 countries 2000
Financial institutions and their supervisors
Country and supervisory structure Retail banking Wholesale banking Securities Insurance
Financial conglomeratesFinancial Services Authority (FSA) = umbrella supervisor
United Kingdom FSA FSA FSA FSA
Treasury bull Commercial banks bull Investment funds (Securities and (Insurance Directorate(Securities and Investments Board) bull Unit trust groups Futures Authority) of the Treasury)
Bank of bull Building societies bull Pension funds England (Building Societies Commission) bull Merchant banks
bull Friendly societies bull Clearing houses bull Primary issuers bull Insurance FSA (Friendly Societies Commission) bull Venture capital of securities companies
bull Pensions and life insurance etc bull Stock exchanges bull Insurance brokers(Personal Investment Authority) bull Stockbrokers
Financial holding companiesFederal Reserve (FR) = umbrella supervisor
United States bull National banks(OCC) Securities and Regulated by
Treasury OCC bull State banks Federal Reserve Exchange Commission StatesMembers (FR)
OTS Nonmembers (FDIC) bull Investment banks bull Primary issuers of bull Insurance companies FR bull Cooperative banks (FDICFR) bull Finance companies securities bull Insurance brokers FDIC bull Insured industrial banks (FDIC) bull Stock exchanges
bull Thrift holding companies (OTS) bull Stockbrokers SEC bull Savings banks (OTSFDICFR) bull Investment advisors
bull Savings and loan associations bull Mutual funds(OTS) bull Public utility holding
bull Edge Act corporations (FR) companies
(table continues next page)
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Table 210 Financial-sector regulation G-10 countries 2000 (continued )
Financial institutions and their supervisors
Country and supervisory structure Retail banking Wholesale banking Securities Insurance
Financial holding companies Japan Financial Supervisory Authority (FSA) = umbrella supervisor
Prime FSA FSA FSA FSA ministerrsquos Ministry of office Finance (Securities and Exchange
Surveillance Commission) FRC Bureau of Financial bull City banks bull Investment banks bull Primary issuers of bull Insurance companies FSA Regulation bull Regional banks bull Asset managers securities bull Insurance brokers
bull Trust banks bull Stock exchanges SESC bull Long-term credit banks bull Stockbrokers
bull Pension funds
Financial holding companiesOffice of the Superintendent of Financial Institutions (OSFI) = umbrella supervisor
Canada Regulated by OSFI OSFI provinces OSFI
Department of Financebull Banks bull Cooperative credit bull Primary issuers of bull Insurance companies
(previously Office of the Inspector associations securities (previously Depart- OSFI General of the Banks) bull Fraternal benefit bull Stock exchanges ment of Insurance) Bank of bull Trust and loan companies society bull Stockbrokers bull Insurance brokers Canada bull Pension funds bull Asset managers
(previously Depart- CDIC ment of Insurance)
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Financial institutions and their supervisors
Country and supervisory structure Retail banking Wholesale banking Securities Insurance
Germany Financial holding groupsFederal Banking Supervisory Office (FBSO) = umbrella supervisor
Ministry of Finance FBSO BSO FSSO FISO
Bundesbankbull Universal banks bull Other financial bull Primary issuers of bull Insurance companies
Federal Banking bull Savings banks institutions (eg securities bull Insurance brokers Supervisory Office bull Securities banks management foreign bull Stock exchanges
currency dealings) bull Stockbrokers Federal Securities bull Financial enterprises bull Asset managers Supervisory Office (eg leasing bull Pension funds
organizations Federal Insurance credit card companies Supervisory Office investment advisors)
Italy Bank foundationsMinistry of Finance = umbrella supervisor
Ministry of Finance Bank of Italy Bank of Italy Consob ISVAP
Bank of Italy bull Commerical banks bull Asset managers bull Primary issuers of bull Insurance companies Consob bull Savings bank bull Open-end investment securities bull Insurance brokers
bull Securities banks companies (SICAVs) bull Stock exchangesbull Stockbrokers
ISVAP
(table continues next page)
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Table 210 Financial-sector regulation G-10 countries 2000 (continued )
Financial institutions and their supervisors
Country and supervisory structure Retail banking Wholesale banking Securities Insurance
The Netherlands Financial conglomeratesCouncil of Financial Supervisors = umbrella supervisor
Securities Board Securities Board Netherlandsche Netherlands Bank Netherlandsche Bank of the Netherlands Insurance Board Bank Insurance bull Credit institutions (universal banks bull Investment institutions bull Stock exchanges bull Insurance companies Board cooperative banks security credit (securities issuing bull Stockbrokers bull Insurance brokers
institutions mortgage banks) and tradingmdashprimary The Council of Financial and secondary Supervisors markets)
France Commission des Commission de Operations des Controcircle des
Banking and Banking Commission Bourse Assurances Financial Regulatory bull Ensuring that credit institutions (and investment firms since bull Primary issuers of bull Insurance companies Ministry for Committee the Financial Activity Modernization Act of 1996) comply securities bull Insurance brokers Economic with laws and regulations bull Stock exchanges Affairs and bull Execute instructions regarding all off-site monitoring and bull Stockbrokers Finance Credit on-site supervision Institutions and Banking and Financial Regulatory Committee Investment bull Formulates general regulations for credit institutions and investment firms Committee (capital adequacy requirements accounting rules etc) Bank of France Credit Institutions and Investment Committee Banking bull Authorizes and examines financial institutions except for those within the Commission competence of the Banking Commission
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117
Financial institutions and their supervisors
Country and supervisory structure Retail banking Wholesale banking Securities Insurance
Switzerland Large banking groupSwiss Federal Banking Commission (SFBC) = umbrella supervisor
Swiss National Bank Federal Office of
SFBC SFBC SFBC Private Insurance Swiss Federal Banking Commission bull Universal banks bull Investment banks bull Primary issuers of bull Insurance companies
bull Savings banks bull Asset management securities bull Insurance brokerscompanies bull Stock exchanges
Private audit Federal bull Investment funds bull Stockbrokers firms Office of bull Mortgage bond authorized by Private business SFBC Insurance
Sweden Financial holding company groupsFinancial Supervisory Authority = umbrella supervisor
Ministry of Finance Credit Market Securities Market Insurance Market
Credit Market Department Department Department Department
Financial bull Commercial banks bull Investment funds bull Primary issuers of bull Insurance companies Riksbank Supervisory bull Savings banks securities bull Insurance brokers Authority bull Friendly societies bull Stock exchanges
bull Stockbrokers
(table continues next page)
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Table 210 Financial-sector regulation G-10 countries 2000 (continued )
Financial institutions and their supervisors
Country and supervisory structure Retail banking Wholesale banking Securities Insurance
Belgium Bank holding companiesBanking and Finance Commission = umbrella supervisor
Bank of Belgium Banking Banking
Banking and Finance and Finance Insurance Controland Finance Commission Commission Commission Office
Banking and Insurance Finance Control bull Commercial banks bull Asset management bull Primary issuers of bull Insurance companies Commission Office bull Savings banks firms securities bull Insurance brokers
bull Securities banks bull Investment funds bull Stock exchanges bull Mortgage companiesbull Stockbrokers bull Pension funds
Securities Regulation Fund Securities Regulation Fund
bull Other investment firms and credit institutions(institutions participating in regulated off-exchangemarket in strips and Treasury certificates)
Bank holding companies Spain Banco de Espantildea = umbrella supervisor
Banco de Espantildea Comision Nacional del Mercado de Directorate General
Banco de Espantildea Valores (CNMV) Insurance
bull All credit institutions (commercial banks savings banks credit bull Primary issuers of (Ministry of Economy Ministry of cooperatives official credit institutions finance factoring and securities and Finance) Economy and CNMV leasing companies mortgage-loan companies etc) bull Stock exchanges bull Insurance companies Finance bull Interbank foreign exchange and book-entry public debt bull Stockbrokers bull Pension funds
markets bull Venture capital(companies and funds)
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119
Financial institutions and their supervisors
Country and supervisory structure Banking Securities Insurance
Banking Advisory High Level Securities Supervisors Committee (BAC) Committee (HLSS) Insurance Committee (IC)
Supranational (EU) bull Formulates standards for prudential bull Coordination of securities market bull Formulates standards forsupervision supervision prudential supervision
BACICHLSS Banking Supervision
Conglomerates Committee (BSC) Securities Contact Committee Regulation of prudential bull Systemic risk monitoring bull Regulation and implementation of supervision securities admission
International Association International International Organization of of Insurance Supervisors
Basel Committee Securities Commisison (IOSCO) (IAIS) Joint Forum Conglomerates Supervision bull Supervision and regulation best bull Supervision and regulation best bull Supervision and regulation amp regulation Best practices practices practices best practices
FSF Coordination across supervisors of various functions
Notes See appendix B for more information Boldface type indicates senior or oversight supervisor normal type indicates adjunct or front-line supervisorsolid line indicates direct responsbility to the senior-ranking authority dotted line indicates coordination in supervisory activities
(table continues next page)
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Table 210 Financial-sector regulation G-10 countries 2000 (continued )
Glossary of names United Kingdom FSA = Financial Services Authority United States FR = Federal Reserve OCC = Office of the Comptroller of theCurrency FDIC = Federal Deposit Insurance Corporation SEC = Securities and Exchange Commission OTS = Office of Thrift Supervision Japan FRC =Financial Reconstruction Commission FSA = Financial Services Agency SESC = Securities and Exchange Surveillance Commission Canada OSFI =Office of the Superintendent of Financial Institutions CDIC = Canada Deposit Insurance Corporation Germany FBSO = Federal Banking SupervisoryOffice FSSO = Federal Securities Supervisory Office FISO = Federal Insurance Supervisory Office BSO = Banking Supervisory Office Italy Consob =Commissione Nazionale per le Societa e la Borsa ISVAP = Instituto per la Vigilanza sulle assicurazioni private e di Interesse colletivo Switzerland SFBC= Swiss Federal Banking Commission Spain CNMV = The Comision Nacional del Mercado de Valores Supranational BAC = Banking Advisory CommitteeBSC = Banking Supervision Committee IC = Insurance Committee HLSS = High Level Securities Supervisors Committee International Dimension FSF =Financial Stability Forum IOSCO = International Organization of Securities Commission IAIS = International Association of Insurance Supervisors
Sources United Kingdom Bank of England httpwwwbankofenglandcouk Financial Services Authority httpwwwfsagovuk United States Board ofGovernors of Federal Reserve System httpwwwfederalreservegov Japan Bank of Japan httpwwwbojorjo Financial Reconstruction Commissionhttpwwwfsagojpfrcindexehtml Financial Services Agency httpwwwfsagojp Canada Bank of Canada httpwwwbank-banque-canadaca Office ofthe Superintendent of Financial Institutions httpwwwosfi-bsifgccaAndreEindexhtml Germany Deutsche Bundesbank httpwwwbundesbankde Fed-eral Banking Supervisory Office httpwwwbakredde Italy Banca drsquoitalia httpwwwbancaditaliait Commissione Nazionale per le Societa e la Borsahttpwwwconsobit Instituto per la Vigilanza sulle assicurazioni private e di Interesse colletivo httpwwwisvapit The Netherlands De NederlandscheBank httpwwwdnbnl France Banque de France httpwwwbanque-francefr Switzerland Schweizerische Nationalbank httpwwwsnbchindex3htmlSweden Sveriges Riksbank httpwwwriksbanksedefaultasp Belgium National Bank of Belgium httpwwwbnbbesgindexhtm Spain Banco de Espantildeahttpwwwbdees The Comision Nacional del Mercado de Valores httpwwwcnmves Supranational (EU) Institutional Arrangements for the Regulationand Supervision of the Financial Sector 2000 International Dimension Bank for International Settlement httpwwwbisorg International Organization ofSecurities Commissions httpwwwioscoorg International Association of Insurance Supervisors httpwwwiaisorg Financial Stability Forum httpwwwfsforumorg
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 121
the inflexibility of tight surveillance against the need to encourage in-novation and growth The US Securities and Exchange Commission isworried about aggressive accounting by firms and biased reports bysecurities analysts in an equity environment that prizes steadily higherquarterly earnings41 Japanese regulators are preoccupied with opaqueinterconnections between portfolio institutions banks and nonfinancialfirms through the keiretsu system Canadian regulators reeling from high-profile scandals of managers intentionally misleading investors are strengtheningmarket discipline through legal penalties aimed at managers and directorsof offending firms
When panic strikes a securities regulator cannot do much As the 1987stock market crash and the LTCM debacle in the fall of 1998 both dem-onstrated steep stock and bond price declines can create systemic risksIf severe enough the wealth effect of falling securities values and thefear of widespread insolvency can depress real activity Flooding thesystem with liquidity is a central bankerrsquos solutionmdashsomething a securi-ties regulator cannot do42 But just as financial supervisors can changethe incentive structure to discourage bankers from making risky loans ingood times so securities regulators can pay more attention to incentiveson the demand side when capital markets are strong
Prudential Supervision and InnovationmdashA Footnote
In concluding this discussion of prudential supervision in the G-10 anadditional point is worth noting National regulators face a persistenttrade-off between emphasizing financial system safety and soundnesswhile encouraging innovationmdashin spite of the added risks innovationbrings to financial markets Former US Treasury Secretary Lawrence Summers(2000 3) has argued by analogy
The jet airplane made airplane air travel more comfortable more efficient andmore safe though the accidents were more spectacular and for a time morenumerous after the jet was invented In the same way modern global financialmarkets carry with them enormous potential for benefit even if some of theaccidents are that much more spectacular As the right public policy response
41 The problem is illustrated by the divergence since mid-1998 between reported earn-ings by the Standard amp Poorrsquos (SampP) 500 and the after-tax profits of all corporations inthe national accounts Generally these two series move closely with one another Be-tween mid-1998 and mid-1999 SampP 500 reported that earnings increased by more than20 percent while after-tax profits of all corporations increased by less than 5 percent(Chase Bank US Economic and Policy Research US Weekly Prospects Chase SecuritiesWeekly Newsletter 5 June 2000 5)
42 For example the US Securities and Exchange Commission had no direct role in calmingmarkets in the 1987 or 1998 panics
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122 WORLD CAPITAL MARKETS
to the jet was longer runways better air-traffic control and better training forpilots and not the discouragement of rapid travel so the right public policyresponse to financial innovation is to assure a safe framework so that the ben-efits can be realized not to stifle the change
Accepting Summersrsquos analogy for the international financial system better-informed supervisors and investors are a necessary part of the financialsystem framework Supervisors require more timely information on therisk profiles resulting from positions taken by financial institutions Theyalso need a better understanding of risk-management systems Snapshotsof an institutionrsquos risk profile and risk-management procedures are nolonger adequate In a world where huge bets are quickly made (andpossibly lostmdashas with Barings Bank in 1995 and LTCM in 1998) super-visors must focus on the soundness of banking systems for evaluatingand managing risk on a daily basis Some progress has been made inaddressing these issues US banking examiners are extending their in-formation requirements in banking examinations and increasing theirinvolvement in large complex institutions43 More awareness is alsorequired of the fact that they are national organizations in a world ofcross-border capital flows To a much greater extent they need a multi-national reach International supervision and coordination among super-visors are the subject of the next section
Our analysis suggests that G-10 supervisors have unfinished businessBank supervisors need to start yesterday securities regulators can waituntil tomorrow One G-10 member acting alone cannot correct the biasIn good times the lending business will simply migrate to other G-10banks In bad times financial problems will not stop at the national bor-der A way has to be found to establish common international standardsfor the key financial players in order to prevent crises and to agree onapproaches for managing them The path has already been laid out Inthe wake of the bank failures of the past 25 years bank supervisors havetried to establish such standards They have done this without creating anew global institution
The essence of the international framework is decentralizationmdashglobalrules and design standards without global institutions that are perceivedto intrude on national sovereignty The awkward jargon for this frame-work is vertical subsidiaritymdashldquothink internationally act nationallyrdquo Theinternational thinking is done by a committee of regulators that meets
International SupervisionA Decentralized Framework
43 These issues are discussed in Ferguson (1999) and Meyer (2000a)
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 123
regularly at the Bank for International Settlements in Basel The commit-tee establishes principles and standards that are interpreted implementedand enforced by national authorities44 In this section we describe thesesupervisory efforts and their weaknesses We present our recommenda-tions for addressing these weaknesses in the next chapter
Basel I
The Basel Capital Accord of 1988 (Basel I)45 drew the lesson from thefinancial crises of the mid-1970s that more adequate capital levels in in-ternational banks would help reduce the systemic risk of bank failureThe primary goal of Basel I was capital adequacy other standards wereput in place not so much for their own virtue as to defend the primarygoal
Capital adequacy requirements were designed to ensure that individualinstitutions have the ability to absorb losses particularly credit lossesAccordingly a backup system of scoring credit risk was devised thatrequired large amounts of bank capital for some types of loans smalleramounts for others and zero for a select list of preferred assets Report-ing requirements were designed to disclose problems and ensure that atroubled bank would take timely steps to restore its capital base in thewake of a loss The Basel I framework worked tolerably well in limitingthe call on the public purse in the G-10 countriesmdashwith the notable ex-ceptions of France and Japan The framework failed to moderate riskybank lending to emerging markets however
Basel I was not developed with emerging markets in mind The origi-nal idea behind it was to develop a common supervisory approach tocross-border banking operations It grew out of political pressure fromUS lawmakers who were determined to require international banks op-erating in the United States to meet US banking standards Toward thisgoal in 1983 Congress passed the International Lending Supervisory ActUS and British banking authorities subsequently agreed on a commontarget the adoption of strict common capital-adequacy standards In 1988other G-10 governments agreed to go along voluntary acceptance ofthe standards throughout much of the rest of the world followed46 Therationale for the capital targets was two-fold The first was to requirebanks to hold sufficient amounts of capital (8 percent of risk-adjusted
44 The international committee of financial authorities agreed on a common definitionof banksrsquo tier-one or ldquocorerdquo capital national authorities defined tier-two capital in theirown manner which permitted greater variations in national working definitions andpractices
45 International Convergence of Capital Measurement and Capital Standards (BIS 1988)was prepared by the Basel Committee on Banking Supervision
46 See Reineke (1998)
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124 WORLD CAPITAL MARKETS
assets) to cushion losses on those assets The second was to dull theirappetites for risk banks with large capital bases would have more tolose if they failed and therefore would take fewer risks
Rapid change in financial markets soon revealed flaws in the Basel IAccord In a complex world with numerous sources of risk it focusedheavily on credit risk but overlooked other risks in a bankrsquos portfolioand the correlation between returns on different asset classes The Baselformula required banks to maintain a fixed amount of capital againsteach of its asset classes But the formula did not distinguish the riskinessof the borrower within each class As a result one large loan to a low-risk corporate borrower such as General Electric would require the sameamount of capital as 10 smaller transactions with high-risk borrowers
The system was also biased toward short-term loans Loans maturingin less than a year required a 20 percent risk weight whereas those ma-turing after more than a year required a 100 percent risk weight Inter-bank lending was particularly favored For example loans to banks inOECD countries required less capital than loans to private firms in thesame countries creating the anomaly that interbank loans to South Ko-rean banks required less capital than loans to General Electric47 Thisanomaly encouraged banks to shed high-quality assets if the Basel rulesrequired the allocation of more capital than banks thought they needed
Another weakness was that financial innovators quickly circumventedthe Accord Because short-term loans required less provisioning than long-term loans banks responded by securitizing their long-term debt port-folios and lending short-term against the collateral of the newly createdasset This allowed banks to circumvent the capital requirements gearedto the terms of the underlying debt At the same time the Basel I Accordfailed to encourage risk mitigation techniques such as credit derivativescollateral guarantees and on-balance-sheet netting the flip side of fi-nancial innovation Because off-balance-sheet products were not coveredby the Accord another anomaly appeared when Barings Bank collapsedin 1995 Barings met capital adequacy standards but collapsed becauseits systems for managing risk failed traders were allowed to speculatein futures contracts that did not appear on the balance sheet
Basel II
Work to overhaul Basel I began in 1995 and produced consultativepapers issued in June 1999 and January 200148 These papers have been
47 South Korean banks have had notoriously weak balance sheets because the practiceof ldquodirected lendingrdquo left them with many poor loans (in making these loans the bankswere expected to follow government objectives rather than creditworthiness criteria)
48 Basel Committee on Banking Supervision (1999 2001)
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 125
the subject of extensive consultation and revision as a result the newAccord is expected to be introduced in 200449 The Basel II frameworkhas three parts (pillars) revisions to Basel I minimum-capital require-ments supervisory review criteria and greater emphasis on market dis-cipline Broadly Basel II aims to maintain the level of capital in the sys-tem but achieve better alignment of banksrsquo capital with their risk pro-files and keep up with financial innovation
To align capital requirements with market realities (the first pillar)Basel II concentrates on the 100 or so largest banksmdashthe type of playerslisted in table 21mdashand on the holding-company parents of banking groups50
Capital requirements will differentiate between an increased number ofcredit groups or ldquorisk bucketsrdquo including claims on governments otherbanks corporations mortgage-backed securities and other asset-backedsecurities
Basel II originally proposed to use external ratings to set capital chargesfor a number of these credit risks Many banks objected arguing thatthey assess credit risk better than Standard amp Poorrsquos Moodyrsquos or FitchIBCA51 Basel II thus proposes two approaches to rating a standard ap-proach using external ratings and an ldquoadvancedrdquo approach that allowsselected banks to use their own internal rating systems To encouragethe development of rigorous internal control systems based on these in-ternal rating systems Basel II also proposes to levy capital charges foroperational risk (the risk of direct or indirect loss resulting from inad-equate or failed internal processes people and systems or from exter-nal events)
Some critics of this proposal dismiss it as an abrogation of the prin-ciple of external independent monitoring and as ldquodangerously naiumlverdquo52
But regulators argue that the new capital charge on operational risk shouldoffset this concern It is also far from clear how cross-national compari-sons of rating and internal risk-assessment systems will be made (Engelen2000) The development by the European Union of its own capital rulescould well complicate the international resolution of these issues Publicassurances by EU officials in January 2001 however indicated that theirmain concerns are to create a level playing field and avoid regulatoryarbitrage (Hargreaves 2001) There is also the significant problem ofthe procyclical character of risk weights When a crisis hits losses are
49 See Berry (2000) for an update in an interview with William J McDonough chair ofthe Basel Committee on Banking Supervision
50 For obvious reasons these proposals are addressed to large banks and simpler capi-tal standards are allowed for small banks that focus on their domestic credit markets
51 See Ammer and Packer (2000) for an empirical critique of the success of rating agen-cies in distinguishing risk by sector and region
52 See Auerback (2001)
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126 WORLD CAPITAL MARKETS
incurred or accrued capital is lost and loan exposure must be reducedor securities sold to restore the requisite capital-adequacy ratios A morerisk-sensitive framework could amplify volatility
As the second pillar of Basel II supervisory review criteria are beingbeefed up to encourage supervisors to intervene earlier in potential problemsituations and to compel banks to align their capital positions with theirrisk profiles Bank supervisors will be authorized to require banks tohold capital in excess of minimum requirements if they have concernsabout general management overall strategy risk-management performanceor the macroeconomic environment Of course if one G-10 supervisorimposes higher capital requirements in isolation the same disparity willemerge that presaged Basel I Some banks will be disadvantaged in theinternational marketplace and will loudly complain that excessive super-vision is driving business to their competitors Hence close internationalcooperation among supervisors is critical
To implement the third pillar market discipline banks will be requiredto make fuller more timely disclosure of capital adequacy and the risksto which that capital is exposed A number of measures are being stud-ied that might help supervisors evaluate bank performance such as com-parisons of uninsured deposit interest rates subordinated debt yieldsand equity prices The idea is that these yields and prices might alertsupervisors to market perceptions of risk Of course market perceptionsare only as good as market information More direct and controversialways to reinforce market discipline would dramatically increase publicdisclosure of bank positions and risk management systems
Many questions are still outstanding about how to resolve the techni-cal details of capital requirements and whether the requirements willachieve their intended goal of better assessment and mitigation of therisks in banksrsquo portfolios There is no substitute for skilled supervisorsThe intricacies of effective design and implementation suggest that su-pervisors need to be highly competent technically knowledgeable aboutbanking portfolio characteristics and the factors that influence bank ex-posure to credit risk (Mishkin 2000) And they must be aided by vigilantshareholders market forces and transparency of information53
Standard setting at the global level is desirable but ultimately theeffectiveness of these efforts will be tested at the national level espe-cially in times of systemic financial distress Here the record of Basel Iwas not a bright shining success Japanese banking regulators havetraditionally allowed banks to include real estate and securities in theircapital base When the value of these assets plummeted in the early 1990sregulators allowed banks to continue valuing these depreciated (andoften bankrupt) assets at their old inflated levels Japanese authorities
53 Benedict Roth Complacency Towards Catastrophe Financial Times 23 January 2001
Institute for International Economics | httpwwwiiecom
THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 127
insisted until the mid-1990s that eroded capital bases could be rebuiltin a market-driven fashion They rightly foresaw that huge loan losseswould undermine public support for the ruling party and require a po-litically unpopular bailout
Japanese foot dragging on Basel I was the worst54 but not uniqueOther examples can be found of ldquopolitically mandated forbearancerdquo TheFederal Reserve Bank of New York held important hands during theLTCM crisis of 1998 Mexico is still resolving the banking crisis that eruptedin 1995 South Korea has not yet closed the insolvent banks that behavedso badly before the crisis of 1998 In the aftermath of a crisis nationalregulators cannot always be relied upon to discipline politically power-ful bankers55 One of the little-noticed consequences of these differingapproaches is that those banks with strong regulatory systems receivedan implicit ldquoexport subsidyrdquo for their services US banks which had notengaged extensively in emerging-market lending in the 1990s were bet-ter positioned than their German and Japanese counterparts to expandtheir international assets in the wake of the crises
Other Financial Forums
54 See Japanese Banks Fiddling while Marunouchi Burns The Economist 27 January2001 67-69
55 See Calomiris (1997)
The Basel model of vertical subsidiarity has already been extended toother financial regulatory bodies In 1993-94 the BIS established a Tri-partite Group of Banking Insurance and Securities Regulators In 1994-95 the BIS increased its cooperation with the International Organizationof Securities Commissions when the two organizations issued parallelpapers on guidelines for national regulators concerning risk managementand disclosure of derivative trades In 1996 a permanent Joint Forum onFinancial Conglomerates was established to examine supervisory issuesand develop working arrangements among the different functional super-visors of conglomerate institutions that offer combinations of bankingsecurities and insurance products Draft papers on the supervisionof conglomerates were released for comment in 1998 applying capital-adequacy principles to these groups and providing guidelines both forassessing the integrity and competence of top managers and for sharingassessments between regulators
In 1997 the Basel Committee on Banking Supervision extended itsreach beyond capital standards to broader aspects of banking supervi-sion with the publication of the Core Principles for Effective BankingSupervision In 1999 a wide range of regulatory and standard-settingbodies were gathered under the umbrella of the Financial Stability
Institute for International Economics | httpwwwiiecom
128 WORLD CAPITAL MARKETS
Forum (FSF) itself established under BIS aegis56 The FSF has alreadyissued recommendations for stepped-up supervision and transparencyas well as guidelines for best practices in a number of areas includingoffshore financial centers and highly leveraged institutions or hedge funds57
Conclusion
Although the structural weaknesses in emerging-market economies arewidely acknowledged to have been causal factors in international capi-tal-market volatility this chapter points to the role of large G-10 bankingorganizations as major suppliers of the most volatile instrument short-term debt We have examined evidence of the impact of public safetynets in the G-10 economiesmdashthe deposit insurance systems the pruden-tial supervisory systems and the lender-of-last-resort functions of centralbanksmdashon the incentive structures of these organizations
Although supervisors in most countries working nationally and to-gether in the BIS have made significant efforts to mimic market forcesin their prudential supervision the most sophisticated financial institu-tions find innovative ways to circumvent the rules New global regulatorybodies are not about to be created G-10 national bank regulators shouldthemselves address the short-term debt bias in the international financialsystem by changing incentive systems G-10 securities regulators shouldalso take steps to get ahead of the curve paying close attention to largeportfolio swings by institutional investors particularly in times of crisisIn short more needs to be done at national and international levels tochange the rules of the game That is the subject of the next chapter
56 The Financial Stability Forum includes banking securities insurance and accountingregulatory bodies the OECD on taxation corruption and corporate governance and theIMF
57 See Martin (2000)
Institute for International Economics | httpwwwiiecom
THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 83
developing countries In turn the claims on developing countries repre-sent about 4 percent of the assets of G-10 and Spanish commercial banks
Portfolio Investors
Table 21 (continued )
Market capitalizatona Total Net Shareholderassets income equityb
Sept Oct National Dec Dec Dec1999 2000 rankc 1999 1999 1999
Total for largest 50 1980 2155 19594 58 917
Total for G-10 1900 2070 19182 53 888
na = not availablenot applicableG-10 = Group of Ten countries see note to table 11
a Market capitalization is defined as the number of ordinary shares currently in circulationmultiplied by the current share price Market capitalization as of October 2000 is presentedfor the banks that had a market capitalization higher than $11 billion as of September 1999b Shareholder equity is defined as the sum of issued common stock capital surplus or pre-mium various reserves and retained earnings Shareholder equity includes group equity at-tributable to consolidated minority interestsc Rankings within the country or regiond Estimates based on the available rates of change from September 1999 to October 2000The market capitalization and shareholder equity figures represent combined estimate for themerged bankse Total for the merged banksf Merged in September 2000g Merged in April 2001h Will merge in April 2002i Will merge with Nippon Trust and Tokyo Trust in October 2001j NatWest Bank merged with the Royal Bank of Scotland in March 2000k Announced a merger in September 2000
Sources Euromoney The Bank Atlas 2000 httpwwweuromoneycom American BankerThe Top 100 World Financial Companies Q3 1999 httpwwwamericanbankercom YahooFinance Company Profiles financeyahoocom Bloomberg Financials httpwwwbloombergcom
Three groups of financial institutions dominate the flow of portfolio capitalinvestment banks wealth managers and insurance companies Table 23lists nine large investment banks all based in New York with offices inLondon and other financial centers In 1998 these nine firms had a com-bined market capitalization in excess of $130 billion and controlled as-sets in excess of $18 trillion
Investment banks act as guardians to the securities markets Nearly allpublic and private shares bonds and asset-backed securities are broughtto market by an investment bank Fulfilling the same function they areexpanding the securities markets of emerging economies They also act asthe pilots of privatization mergers and takeoversmdashnow a core feature of
Institute for International Economics | httpwwwiiecom
84 WORLD CAPITAL MARKETS
Table 22 Total assets and external assets of all commercialbanks June 2000 (billions of dollars)
Claims onExternal assets developing countriesb
Share of Share ofTotal total assets total assets
Country assetsa Amount (percent) Amount (percent)
Austria 423 91 22 33 8Bahamas 316 244 77 61c 19Bahrain 100 92 92 46c 46Belgium 806 309 38 26 3Canada 720 98 14 31 4Denmark 244 58 24 6 2Finland 121 31 25 4 3France 2486 607 24 135 5Germany 4535 901 20 240 5Ireland 423 160 38 2 0Italy 1345 191 14 47 4Japan 8460 1199 14 258 3Luxembourg 821 495 60 124c 15Netherlands 1080 296 27 67 6Norway 157 14 9 3 3Singapore 574 405 70 202c 35Spain 889 124 14 57 6Sweden 348 67 19 12 2Switzerland 1632 709 43 177c 11United Kingdom 5802 1990 34 138 2United States 6223 889 14 144 2
Total for all BISreporting countries 37506 8968 24 1813 5
Total for G-10 34326 7378 21 1331 4
BIS = Bank for International SettlementsG-10 = Group of Ten countries see note to table 11
a Total assets are calculated as banking institutions (deposit institutions) reserve claims onthe public sector claims on the private sector (lines 20 21 22 from IFS) plus externalassets Figures are converted into US dollars using the market exchange rate at the end ofJune 2000b Developing countries are countries other than Andorra Australia Austria Belgium CanadaCyprus Denmark Finland France Germany Gibraltar Greece Iceland Ireland Italy JapanLiechtenstein Luxembourg Malta Netherlands New Zealand Norway Portugal Spain Swe-den Switzerland Turkey the United Kingdom the United States the Vatican City State andthe former Yugoslaviac These countries do not disclose their claims on developing countries Such claims arearbitrarily (and generously) estimated at half the external assets of commercial banks in Bahrainand Singapore and a quarter of the external assets of banks in the Bahamas Luxembourgand Switzerland
Sources IMF International Financial Statistics (IFS) November 2000 Bank for InternationalSettlements BIS Quarterly Review November 2000 httpwwwbisorg
Institute for International Economics | httpwwwiiecom
THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 85
global capitalism In addition to their underwriting role investment banksearn substantial profits from trading securities
Wealth-management firms are the second group of portfolio institu-tions They typically deal with the publicmdashindividuals and companiesthat want a trusted firm to manage their pensions and other funds Table24 lists 10 large wealth managers all based in the G-10 Together these10 firms control $64 trillion in assets and their own market capitalization
Table 23 Large investment banks 1998 (billions of dollars)
MarketRevenue Assets capitalizationa
Merrill Lynchb (United States) 36 300 25Morgan Stanley Dean Witterb (United States) 31 318 50c
Goldman Sachs (United States) 22d 217e 29c
Lehman Brothers Holdingsb (United States) 20 154 10c
Salomon Smith Barneyf (United States) 8 211 naCredit Suisse First Bostong (United States
Switzerland) 7 280 naPaine Webberh (United States) 7 54 6i
Bear Stearnsj (United States) 8 154 5i
Donaldson Lufkin amp Jenrettek (United States) 5 72 7i
Total 144 1760 132 plusTotal for G-10 144 1760 132 plus
na = not available (subsidiaries of large holding companies Citigroup and Creacutedit SuisseGroup respectively individual market capitalization is not available)G-10 = Group of Ten countries see note to table 11
a Market capitalization is calculated by multiplying the total number of shares by the shareprice at the companyrsquos fiscal year-endb Source Fortune Global 500 1999 Data shown are for the fiscal year ended on or before31 March 1999 Assets shown are those at the companyrsquos fiscal year-end httpwwwpathfindercomfortuneglobal500indexhtmlc Figures as of September 1999 are from American Banker httpwwwamericanbankercomBankRankingsd Source 1998 Goldman Sachs Annual Review Assets as of November 1998 httpwwwgscomaboutannual19984_fsindexhtmle Source Financial Times Company Financials Revenue as of 27 November 1998 httpwwwglobalarchiveftcomcbcb_searchhtmf Source 1998 Citigroup Annual Report 20 Revenue figures for year ending 31 December1998 Asset figures as of 31 December 1998 httpwwwcitigroupcomcitigroupfindatac1998ar2pdfg Source 19981999 Creacutedit Suisse Group Annual Report 23 httpwwwcsgchcsg_annual_report_98downloadcsg_ar98_p1_enpdfh Source 1998 Paine Webber Annual Report 34-35 httpwwwpainewebbercomannual98graphicsfininfoindexhtmi Individual figures are obtained from Yahoo The time for valuations is as follows BearStearns December 1999 Lehman Brothers November 1999 Paine Webber and DonaldsonLufkin amp Jenrette September 1999j Source 1999 Bear Stearns Annual Report 55-56 Figures are for fiscal year ending 30June 1998 httpwwwbearstearnscomcorporateinvestorindexhtmk Source 1999 Donaldson Lufkin and Jenrette Annual Report ldquoFinancial Highlightsrdquo httpwwwdljcompdfDLJ98_1pdf
Institute for International Economics | httpwwwiiecom
86 WORLD CAPITAL MARKETS
exceeds $260 billion For the most part wealth managers are long-termportfolio investors
Hedge funds represent a highly specialized investment vehicle that isnot widely available to the public Most hedge funds are leveraged theyemploy dynamic (and sometimes opportunistic) trading strategies involvingpositions in several different markets they adjust their investment port-folios frequently in anticipation of asset price movements or changes inyield differentials between related securities Hedge funds are opaque tomarket monitoring They are subject to little direct regulation and areunder few obligations to disclose information Hence the size of the in-dustry is difficult to measure
If they are measured by capital under management or by assets hedgefunds are small relative to established wealth managers As table 25shows the capital managed by 20 large hedge funds in late 1998 amountedto less than $50 billion Estimates vary widely but if all hedge funds arecounted their assets range from $100 to $300 billion Even the highestnumber is less than 5 percent of the combined assets of investment banksand traditional asset managers
The amount of leverage used by hedge funds depends on trading strate-gies that are in turn shaped by investor attitudes toward risk Leverage
Table 24 Large asset managers in 1998 (billions of dollars)
Total assets under Marketmanagementa capitalizationb
UBS (Switzerland) 1145 58c
Fidelity Investments (United States) 773 naKampo (Japan) 698 naCredit Suisse Group (Switzerland) 680 50c
AXA Group (France) 647 39c
Barclayrsquos Global Investors (United States) 616 44c
Merrill Lynch amp Co (United States) 501 25c
State Street Global Advisors (United States) 493 naCapital Group Cos (United States) 424 naZurich Financial Services (Switzerland) 415 45c
Total 6392 261 plusTotal for G-10 6392 261 plus
na = not available (usually a nonpublic company)G-10 = Group of Ten countries see note to table 11
a Figures are assets under management at fiscal year-end 1998b Market capitalization is calculated by multiplying the total number of shares by the shareprice at the companyrsquos fiscal year-endc Figures from American Banker httpwwwamericanbankercomBankRankings
Sources Institutional Investor 1999 httpwwwiimagazinecomresearchinterfacehtml US(II300) Asia (Asia200) and Europe (Euro100) Asset Management Rankings American BankerhttpwwwamericanbankercomBankRankings
Institute for International Economics | httpwwwiiecom
THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 87
is achieved using such instruments as repos (repurchase agreements)futures and forward contracts and other derivative products5 It is alsovery difficult to measure A Financial Stability Forum (FSF 2000b) studyof hedge funds noted thatmdashalthough there are problems with the waydata vendors report these positionsmdashestimates suggest most hedge fundsuse modest amounts of leverage averaging 21 but ranging to 41 insome FSF (2000b) further notes difficulties with evaluating the risk-adjusted performance of hedge funds because of their dynamic tradingstrategies
Table 25 Largest hedge funds according tocapitalization August 1998 (billions of dollars)
Fund Capital under management
Domestica
Tiger 51Moore Global Investment 40Highbridge Capital Corp 14Intercap 13Rosenberg Market Neutral 12Ellington Composite 11Hedged Taxable-Equivalent 10Quantitative LongShort 09Sr International Fund 09Perry Partners 08
OffshoreJaguar Fund NV 100Quantum Fund NV 60Quantum Industrial Fund 24Quota Fund NV 17Omega Overseas Partners 17Maverick Fund 17Zweig Dimenna International 16Quasar International Fund NV 15SBC Currency Portfolio 15Perry Partners International 13
Totalb 471
a Long Term Capital Management (LTCM) was in serious difficulty in August1998 and is omitted from the listb Estimates of hedge fund capital and the number of funds vary significantlyMARHedge estimated 1115 funds with $109 billion capital under managementat the end of 1997 Van Hedge Fund estimated 5500 funds with capital of $295billions at the same date
Source Adapted from Eichengreen (1999a)
5 Positions are established by posting margins rather than the face value of the position
Institute for International Economics | httpwwwiiecom
88 WORLD CAPITAL MARKETS
The positive role of hedge fundsmdashproviding diversification to inves-tors because their returns have low correlations with standard asset classesmdashis counterbalanced by some negative features Hedge funds and otherhighly leveraged institutions (HLIs) may take concentrated positions andengage in aggressive market practices that amount to ldquoganging uprdquo on asmall economy (such as Hong Kong)6 Under normal market conditionsHLI positions are not destabilizing but some of the aggressive practicesdocumented in 1998 are worrisome The FSF study group participantsagreed (2000b 112) that such practices raise important issues for marketintegrity but they could not agree that market manipulation was suffi-ciently widespread to be a serious concern for policymakers
Insurance companies are the third group of portfolio institutions Theseare divided into two categories property and casualty companies andlife and health insurance companies Ten large companies of each cat-egory are listed in table 26 In 1998 the 10 property and casualty insur-ance companies had $16 trillion in assets and more than $330 billion inmarket capitalization The 10 life insurance companies had $28 trillionin assets7 Combining both categories 100 percent of assets are controlledby insurance companies based in the G-10 and Spain In portfolio man-agement styles life insurance companies tend to hold longer-term assetswhereas property and casualty companies tend to hold shorter-term in-struments
Nonfinancial Multinational Enterprises
The last players are the nonfinancial multinational enterprises (MNEs)The worldrsquos 100 largest corporations measured by 1998 revenue are re-corded in tables 27 and 28 The 30 financial giants among the top 100are separately shown in table 27 Most of the firms appeared in previ-ous tables Together these 30 financial giants had revenues of $13 tril-lion and controlled assets of $113 trillion8
Table 28 lists the 70 top nonfinancial giants Their revenues in 1998were $40 trillion and their assets (at book value) measured $45 trillionMeasured by revenue or assets about 95 percent of the giants are basedin the G-10 These firms are responsible for a large share of the worldrsquos
6 See IMF (1999c) for a description of the ldquodouble playrdquo that hedge funds are accusedof using in an attempt to destabilize Hong Kong in August 1998
7 Many life insurance companies are owned by their policyholders and therefore donot have a market capitalization
8 By comparison the larger set of 96 financial firms listed in previous tables controlled$322 trillion in assets This is the total amount of assets recorded in tables 21 (50 com-mercial banks) 22 (9 investment banks) 24 (10 asset managers) and 26 (20 insurancecompanies) The largest hedge funds might add $300 billion to the total
Institute for International Economics | httpwwwiiecom
THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 89
Table 26 20 large insurance companies in 1998(billions of dollars)
Property and casualty insurance Marketcompanies Revenuea Assetsb capitalizationc
Allianz (Germany) 65 402 62d
Assicurazioni Generali (Italy) 48 178 30d
State Farm Insurance Cos (United States) 45 111 naZurich Financial Services (Switzerland) 39 215 45d
CGU (United Kingdom) 38 176 20d
Munich Re Group (Germany) 35 131 naAmerican International Group (United States) 33 194 135d
Allstate (United States) 26 88 20d
Royal amp Sun Alliance (United Kingdom) 25 76 11d
Loews (United States) 21 71 7e
Total 375 1642 330 plusTotal for G-10 375 1642 330 plus
MarketLife and health insurance Revenuea Assetsb capitalizationc
AXA (France) 79 452 39d
Nippon Life Insurance (Japan) 66 363 naING Group (Netherlands) 56 464 46d
Dai-ichi Mutual Life Insurance (Japan) 44 253 naSumitomo Life Insurance (Japan) 40 206 naTIAA-CREF (United States) 36 250 naPrudential Ins Co of America (United States) 34 279 naPrudential (United Kingdom) 34 197 30d
Meiji Life Insurance (Japan) 28 146 naMetropolitan Life Insurance (United States) 27 215 na
Total 444 2825 naTotal for G-10 444 2825 na
na = not available (usually an insurance company owned by its policyholders)G-10 = Group of Ten countries see note to table 11
a Data shown are for the fiscal year ended on or before 31 March 1999b Assets shown are those at the companyrsquos fiscal year-endc Market capitalization is calculated by multiplying the total number of shares by the shareprice at the companyrsquos fiscal year-endd Market capitalization data as of September 1999 from American Banker httpwwwamericanbankercome Individual companyrsquos market capitalization as of September 1999 from Yahoo yahoomarketguidecom
Sources Fortune Global 500 1999 httpwwwpathfindercomfortuneglobal500indexhtmlAmerican Banker httpwwwamericanbankercomRankingBanks1999 Yahoo Marketguideyahoomarketguidecom
Institute for International Economics | httpwwwiiecom
90 WORLD CAPITAL MARKETS
Table 27 Financial firms in the 100 largest companiesby revenue 1998 (billions of dollars)
Globalrank Company Revenuesa Assetsb Type
Continental Europe
15 AXA (France) 79 452 Insurance23 Allianz (Germany) 65 402 Insurance28 Ing Group (Netherlands) 56 464 Insurance37 Credit Suisse (Switzerland) 49 475 Banks commercial
and savings39 Assicurazioni Generali (Italy) 48 178 Insurance42 Deutsche Bank (Germany) 45 736 Banks commercial
and savings56 Zurich Financial Services (Switerland) 39 215 Insurance68 Munich Re Group (Germany) 35 131 Insurance72 ABN AMRO Holding (Netherlands) 34 507 Banks commercial
and savings77 Credit Agricole (France) 33 459 Banks commercial
and savings80 HypoVereinsbank (Germany) 32 541 Banks commercial
and savings84 Fortis (Belgium) 31 397 Banks commercial
and savings98 Socieacuteteacute Geacuteneacuterale (France) 30 450 Banks commercial
and savingsUnited Kingdom
47 HSBC Holdings 43 485 Banks commercialand savings
58 CGU 38 176 Insurance74 Prudential 34 197 Insurance
United States
16 Citigroup 76 669 Diversified financials35 Bank of America Corp 51 618 Banks commercial
and savings44 State Farm Insurance Cos 45 111 Insurance64 TIAA-CREF 36 250 Insurance67 Merrill Lynch 36 300 Securities71 Prudential Ins Co of America 34 279 Insurance76 American International Group 33 194 Insurance79 Chase Manhattan Corp 32 366 Banks commercial
and savings83 Fannie Mae 31 485 Diversified financials88 Morgan Stanley Dean Witter 31 318 Securities
Japan
21 Nippon Life Insurance 66 363 Insurance45 Dai-ichi Mutual Life Insurance 44 253 Insurance54 Sumitomo Life Insurance 40 206 Insurance91 Bank of Tokyo-Mitsubishi 31 664 Banks commercial
and savingsTotal 1279 11341Total for G-10 1279 11341
G-10 = Group of Ten countries see note to table 11
a Data shown are for the fiscal year ended on or before 31 March 1999b Assets shown are those at the companyrsquos fiscal year-end
Source Fortune Global 500 1999 httpwwwpathfindercomfortuneglobal500indexhtml
Institute for International Economics | httpwwwiiecom
THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 91
Tab
le 2
8N
on
fin
anci
al f
irm
s in
th
e 10
0 la
rges
t co
mp
anie
s b
y re
ven
ue
199
8 (b
illio
ns o
f do
llars
)
Glo
bal
Tra
nsn
atio
nal
ity
ran
k
Co
mp
any
Rev
enu
esa
Ass
etsb
ind
exc
Typ
e
Co
nti
nen
tal
Eu
rop
e
2D
aim
lerC
hrys
ler
(Ger
man
y)15
516
044
1M
otor
veh
icle
s an
d pa
rts
11R
oyal
Dut
chS
hell
Gro
up (
Net
herla
nds)
9411
058
9P
etro
leum
ref
inin
g17
Vol
ksw
agon
(G
erm
any)
7670
568
Mot
or v
ehic
les
and
part
s22
Sie
men
s (G
erm
any)
6667
521
Ele
ctro
nics
el
ectr
ical
equ
ipm
ent
32M
etro
(G
erm
any)
5222
n
a
Foo
d an
d dr
ug s
tore
s34
Fia
t (I
taly
)51
7640
8M
otor
veh
icle
s an
d pa
rts
36N
estle
(S
witz
erla
nd)
5041
932
Foo
d46
Veb
a G
roup
(G
erm
any)
4351
275
Tra
ding
49R
enau
lt (F
ranc
e)41
4545
7M
otor
veh
icle
s an
d pa
rts
53D
euts
che
Tel
ekom
(G
erm
any)
4093
n
a
Tel
ecom
mun
icat
ions
57R
oyal
Phi
lips
Ele
ctro
nics
(N
ethe
rland
s)38
3386
4E
lect
roni
cs
elec
tric
al e
quip
men
t59
Peu
geot
(F
ranc
e)38
4038
7M
otor
veh
icle
s an
d pa
rts
62E
lect
riciteacute
de
Fra
nce
(Fra
nce)
3711
3
na
Util
ities
ga
s an
d el
ectr
ic63
Rw
e G
roup
(G
erm
any)
3747
n
a
Util
ities
ga
s an
d el
ectr
ic65
BM
W (
Ger
man
y)36
3660
7M
otor
veh
icle
s an
d pa
rts
66E
lf A
quita
ine
(Fra
nce)
3643
576
Pet
role
um r
efin
ing
69V
iven
di (
Fra
nce)
3558
n
a
Eng
inee
ring
and
cons
truc
tion
70S
uez
Lyon
nais
e de
s E
aux
(Fra
nce)
3585
n
a
Ene
rgy
78E
NI
(Ita
ly)
3249
317
Pet
role
um r
efin
ing
86B
ayer
(G
erm
any)
3134
827
Che
mic
als
92A
BB
Ase
a B
row
n B
over
i (S
witz
erla
nd)
3132
957
Ele
ctro
nics
el
ectr
ical
equ
ipm
ent
93B
AS
F (
Ger
man
y)31
3159
5C
hem
ical
s95
Car
refo
ur (
Fra
nce)
3020
n
a
Foo
d an
d dr
ug s
tore
s
(tab
le c
ontin
ues
next
pag
e)
Institute for International Economics | httpwwwiiecom
92 WORLD CAPITAL MARKETS
Tab
le 2
8N
on
fin
anci
al f
irm
s in
th
e 10
0 la
rges
t co
mp
anie
s b
y re
ven
ue
199
8 (b
illio
ns o
f do
llars
) (c
ontin
ued
)
Glo
bal
Tra
nsn
atio
nal
ity
ran
k
Co
mp
any
Rev
enu
esa
Ass
etsb
ind
exc
Typ
e
Un
ited
Kin
gd
om
19B
P A
moc
o68
8559
2P
etro
leum
ref
inin
g43
Uni
leve
r45
3692
4F
ood
Un
ited
Sta
tes
1G
ener
al M
otor
s16
125
729
3M
otor
veh
icle
s an
d pa
rts
3F
ord
Mot
or14
423
835
2M
otor
veh
icle
s an
d pa
rts
4W
al-M
art
Sto
res
139
49
na
G
ener
al m
erch
andi
sers
8E
xxon
101
9365
9P
etro
leum
ref
inin
g9
Gen
eral
Ele
ctric
100
356
331
Ele
ctro
nics
el
ectr
ical
equ
ipm
ent
14In
tl B
usin
ess
Mac
hine
s82
8653
7C
ompu
ters
of
fice
equi
pmen
t25
US
Pos
tal
Ser
vice
6055
n
a
Mai
l pa
ckag
e a
nd f
reig
ht d
eliv
ery
27P
hilip
Mor
ris58
6051
1T
obac
co29
Boe
ing
5637
n
a
Aer
ospa
ce30
AT
ampT
5460
219
Tel
ecom
mun
icat
ions
40M
obil
4843
597
Pet
role
um r
efin
ing
41H
ewle
tt-P
acka
rd47
3451
1C
ompu
ters
of
fice
equi
pmen
t50
Sea
rs R
oebu
ck41
38
na
G
ener
al m
erch
andi
sers
55E
I d
u P
ont
de N
emou
rs39
40
na
C
hem
ical
s61
Pro
ctor
and
Gam
ble
3731
477
Soa
ps
cosm
etic
s75
Km
art
3414
n
a
Gen
eral
mer
chan
dise
rs81
Tex
aco
3229
453
Pet
role
um r
efin
ing
82B
ell
Atla
ntic
3255
n
a
Tel
ecom
mun
icat
ions
85E
nron
3129
n
a
Ene
rgy
87C
ompa
q C
ompu
ter
3123
n
a
Com
pute
rs
offic
e eq
uipm
ent
89D
ayto
n H
udso
n31
16
na
G
ener
al m
erch
andi
sers
94J
C
Pen
ney
3124
n
a
Gen
eral
mer
chan
dise
rs96
Hom
e D
epot
3013
n
a
Spe
cial
ty r
etai
lers
97Lu
cent
Tec
hnol
ogie
s30
27
na
E
lect
roni
cs
elec
tric
al e
quip
men
t10
0M
otor
ola
2929
n
a
Ele
ctro
nics
el
ectr
ical
equ
ipm
ent
Institute for International Economics | httpwwwiiecom
THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 93
Jap
an
5M
itsui
109
5635
8T
radi
ng6
Itoch
u10
957
333
Tra
ding
7M
itsub
ishi
107
7536
9T
radi
ng10
Toy
ota
Mot
or10
012
540
0M
otor
veh
icle
s an
d pa
rts
12M
arub
eni
9455
300
Tra
ding
13S
umito
mo
8946
259
Tra
ding
18N
ippo
n T
eleg
raph
amp T
elep
hone
7614
7
na
Tel
ecom
mun
icat
ions
20N
issh
o Iw
ai68
3938
8T
radi
ng24
Hita
chi
6282
214
Ele
ctro
nics
el
ectr
ical
equ
ipm
ent
26M
atsu
shita
Ele
ctric
Ind
ustr
ial
6067
332
Ele
ctro
nics
el
ectr
ical
equ
ipm
ent
31S
ony
5353
628
Ele
ctro
nics
el
ectr
ical
equ
ipm
ent
33N
issa
n M
otor
5158
511
Mot
or v
ehic
les
and
part
s38
Hon
da M
otor
4943
641
Mot
or v
ehic
les
and
part
s48
Tos
hiba
4151
252
Ele
ctro
nics
el
ectr
ical
equ
ipm
ent
51F
ujits
u41
4332
6C
ompu
ters
of
fice
equi
pmen
t52
Tok
yo E
lect
ric P
ower
4012
2
na
Util
ities
ga
s an
d el
ectr
ic60
NE
C37
42
na
E
lect
roni
cs
elec
tric
al e
quip
men
t90
Tom
en31
18
na
T
radi
ng99
Mits
ubis
hi E
lect
ric30
35
na
E
lect
roni
cs
elec
tric
al e
quip
men
t
Ch
ina
73S
inop
ec34
52
na
P
etro
leum
ref
inin
g
Tot
al (
aver
age
for
tran
snat
iona
lity
inde
x)3
988
447
949
0T
otal
for
G-1
0 (a
vera
ge f
or t
he i
ndex
)3
954
442
749
0
na
= n
ot a
vaila
ble
G-1
0 =
Gro
up o
f T
en c
ount
ries
see
not
e to
tab
le 1
1
a
Dat
a sh
own
are
for
the
fisca
l ye
ar e
nded
on
or b
efor
e 31
Mar
ch 1
999
b
Ass
ets
show
n ar
e th
ose
at t
he c
ompa
nyrsquos
fis
cal
year
-end
c
The
ind
ex o
f tr
ansn
atio
nalit
y is
cal
cula
ted
as t
he a
vera
ge o
f ra
tios
of f
orei
gn a
sset
s to
tot
al a
sset
s f
orei
gn s
ales
to
tota
l sa
les
and
for
eign
em
ploy
men
tto
tot
al e
mpl
oym
ent
as o
f 19
97 (
UN
CT
AD
)
Sou
rces
F
ortu
ne G
loba
l 50
0 1
999
http
w
ww
pat
hfin
der
com
fort
une
glob
al50
0in
dex
htm
l U
NC
TA
D (
1999
)
Institute for International Economics | httpwwwiiecom
94 WORLD CAPITAL MARKETS
foreign direct investment The ldquotransnationality indexrdquo (table 28) showsthat on average they conducted about half their business outside theirhome country9
Overview of the Players
Our review of the major players points to two major features First ahandful of big playersmdashfewer than 200 firms all toldmdashcontrol the ac-tion in international capital markets Their dominance will doubtless erodebut for now financial power is strikingly concentrated with them Sec-ond the big players are overwhelmingly based in the G-10 countriesplus Spain The responsibility to supervise them rests not in the IMFnor in Basel but squarely in Washington London Tokyo and the otherG-10 capitals At year-end 1999 the G-10 countries plus Spain accountedfor 84 percent of world banking assets 86 percent of world stock marketcapitalization and 76 percent of international debt securities (BIS 2000aWorld Bank 2000b)
International private capital flows are of three types bank loans anddeposits portfolio investment and foreign direct investment In cumula-tive total flows to emerging markets FDI was the biggest story in the1990s amounting to $954 billion (table 12) Portfolio flows were nextcumulatively amounting to somewhere between $612 billion (table 12)and $764 billion (table A1) Bank loans and deposits are the most com-plicated story
The Key Role of Banks
Banks are more important as an epicenter than as a wellspring Banksgenerate waves in the flow of capital to emerging markets rather than acontinuous steady stream According to data compiled by the Institute ofInternational Finance (table A1) net bank lending to emerging marketscumulated to $269 billion in the 1990s However deposits by emerging-market residents in G-10 banks more than offset G-10 bank lending tothese countries during the decade According to IMF data cumulativebank loans net of deposits amounted to a negative $135 billion (table 12)
In other words when loans and deposits are combined net bank ac-tivity that moves financial resources to emerging markets is small incomparison with portfolio investment and FDI But bank loans are thelubricant of any financial system Depending on circumstances bankscan be shock absorbers or shock propagators In recent decades with
9 The transnationality index is calculated as a simple average of the share of assetssales and employees outside the home country
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 95
respect to emerging markets banks have more often been propagatorsthan absorbers The average annual swing in bank lending to emergingmarkets was nearly $50 billionmdashby far the largest source of year-to-yearfluctuations in capital flows Both interbank loans between Europe Japanand Asia and sovereign Russian debt used as loan collateral played amajor role in the 1997-98 crisesmdashnot because banks are profligate playersbut because of the incentives they face and the instruments they useAccordingly our story begins with banks
Banks in the Modern Financial System
10 See Levine (2000) for a concise description of the role of banks in the financial system
11 The asymmetric information problem helps to explain why banks dominate the im-mature financial systems of emerging-market economies The general lack of informationon borrowers and undeveloped legal systems to enforce contracts hamper suppliers oflong-term financial instruments such as equities and bonds in evaluating risk and re-ward Banks are best suited in these circumstances to solve the asymmetric informationproblem by evaluating and monitoring private loans As more and better informationbecomes available capital markets develop and financial systems mature
As we noted in the previous paragraph the problem of financial volatil-ity in emerging-market economies is associated with bank lending Ifand when repayment problems arise cross-border private bank loansand bond placements are such that private creditors have no plausiblemeans of seizing assets from either private or sovereign borrowers Thusalthough international finance can nourish entrepreneurs and accelerategrowth a necessary complement may be a drastic creditor response inthe event of nonpaymentmdashto withhold fresh funds and force an eco-nomic crisis (Dooley 2000)
This argument is based on the characteristics of banks They are notldquobadrdquo per se They perform three essential functions in any financialsystem pooling the resources of disparate savers and channeling these re-sources into productive investment improving resource allocation throughtheir expertise in assessing and monitoring borrowers and facilitatingthe division of risk among numerous creditors10 But by their very na-ture banks are prone to two problems asymmetric information (the bor-rower knows more about the potential risk and return of its projectsthan the bank) and adverse selection (riskier borrowers will pay higherinterest rates and thus may constitute a disproportionate share of bankloan portfolios)11
Bank loans are illiquid fixed-price instruments They cannot easily beconverted to cash although they can be bundled into securities (knownas ldquosecuritizationrdquo) Once loan terms have been agreed on the only waya bank can adjust for shifting market conditions is by changing the quantityof its exposure When a borrower runs into trouble the bank can mix
Institute for International Economics | httpwwwiiecom
96 WORLD CAPITAL MARKETS
and match from two unpleasant menus It can roll over existing loansand extend new credit or it can call some part of existing loans andattempt to recover the principal It can also hedge by selling short otherclaims on the borrower These choices entail either an unwelcome exten-sion of the bankrsquos exposure or credit rationing against the borrower Whentrouble brews all banks encounter the same conditions in the aggregatethey prefer less exposure and ensuing credit restrictions lead to volatilebank lending
Innovation
12 Derivatives have no value of their own They ldquoderiverdquo their value from the value ofthe underlying asset They include swaps futures (contracts for future delivery at speci-fied prices) and options (which give one party the right but not the obligation to buyfrom or sell to a counterparty at an agreed price)
13 Maxfield (1998) analyzed available evidence of emerging-market investor objectivesmost of it before the crisis Analysis of portfolio equity flows is sensitive to the choice ofperiod with year-over-year data indicating that investors respond to country ldquofundamen-talsrdquo Other evidence suggests more ambiguity Ranking by ldquoinvestor impatiencerdquo ie thesearch for yield over value Tesar and Werner (1995) find short-term bank flows to be themost yield driven followed by portfolio investment FDI and long-term bank lending
14 Because market risk credit risk and country risk interact in complex ways newfinancial instruments have been created to help reduce negative interactions One is theldquototal return swaprdquo which has become an instrument of choice for hedge funds lookingfor high leverage Banks also use the total return swap to cover risks without increasingtheir capital requirements
Since the 1980s national and international banking systems have beentransformed by deregulation intensified competition and the informationand communications-technology revolutions The market environment isone of intense competition particularly in traditional banking activitiesThe innovations point away from traditional activities of plain vanilladeposit taking and loan making Three big themes are discernible Firstthe walls separating commercial banks investment banks portfolio man-agers and insurance firms are falling even if they are still distinct Sec-ond large banks are shifting toward securitizationmdashcreating securitiesout of everything from credit card debt to trade finance to disaster insur-ancemdashand earning fees in the process Third all large banks are shiftingtoward trading activity making markets and taking short-term stakes inbonds shares and derivatives12 These activities when successful satisfythe search for higher yields13
Many of the new financial instruments that banks trade are ldquooff bal-ance sheetrdquo This means that banks are not required to allocate capitalagainst them In swap contracts for example neither side pays cash at theoutset and therefore neither party has an asset in the traditional sense14
Futures and options contracts can be written with a relatively small initial
Institute for International Economics | httpwwwiiecom
THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 97
margin relative to the potential risk Credit derivatives limit credit risk bytransferring the potential loss associated with corporate loans and bondssovereign debt and other loan portfolios to counterparties15
Deregulation and innovation working in combination seem to havepushed banks into trading activity and leveraged plays but not into shareownershipmdasheven in jurisdictions that have no prohibition against equitystakes Among the G-10 banking systems the highest ratio of share own-ership to assets was only 5 percent in 1996 reached in Germany andJapan (Berlin 2000)16
The wave of innovation in financial instruments and the accompany-ing expansion of banking beyond its old boundaries is a two-edged swordOn one side it allows risk management far beyond what was tradition-ally possible Risk can now be shifted from firms that can ill afford lossesto those that can Banks can profitably act as intermediaries in shiftingrisk On the other side the innovation wave creates huge opportunitiesfor leveraged plays fostering a speculative search by banks themselvesfor high returns that in turn magnify their own risks17
15 Credit derivatives include total return swaps credit default swaps credit-linked notesand collateralized debt obligations They are the fastest-growing sector of the global de-rivatives market
16 Banks seem to specialize in lending even when they are allowed to mix finance andcommerce for reasons related both to how they are expected to behave with distressedfirms and to other intricacies of lender liability (Berlin 2000) Yet a recent cross-countrystudy found that restrictions on banking and commerce are associated with greater fi-nancial instability (Barth Caprio and Levine 2000)
17 Leverage is the magnification of the rate of return (positive or negative) on an in-vestment beyond the rate obtained by solely investing funds owned by the institution Itis often defined as the ratio of assets to equity Leverage is achieved by increasing thesize of an investment by borrowing or using derivative instruments such as futures oroptions These allow investors to earn a return on the notional amount underlying thecontract by committing a small portion of equity in the form of a margin deposit oroption premium payment
18 In a repo (repurchase agreement) one party (typically a trader) buys a bond andsells it to a dealer for cash with a promise to buy it back the next day at the same priceplus the overnight interest rate As long as the overnight interest rate is lower than theinterest accruing on the bond the trader earns some income on the bond The extremeform of these kinds of transactions was discovered at LTCM the failed US highly lever-aged institution which appears to have controlled more than $120 billion in assets froman investment of about $3 billion This leveraging was accomplished mostly through theuse of repos (Mayer 1999)
The potential for damage is illustrated in an extreme form by figure 21To precisely measure a firmrsquos leverage all positions must be known andrealistically valuedmdashwhich may be impossible to do Because many ac-tivitiesmdashsuch as repos18 and derivativesmdashdo not appear on the institutionrsquos
Leverage
Institute for International Economics | httpwwwiiecom
98W
OR
LD
CA
PIT
AL
MA
RK
ET
S
Figure 21 Hypothetical example of leverage
$1000 notional value of call option on equity in firms targeted for takeover
Repo FRN into cash and use cash to pay option premium
(repro is initially collateralized
Borrow $100 for margin purchase
$125 of US investment bank floating-rate notes (FRN) (secured by $25 equity in FRNs)
Repo off-the-run bond into cash and post margin
(repo is initially collateralizedSell (short) Borrow on-the-run bonds worth $20
$25 worth of off-the-run bonds (secured by $5 equity in bonds)
Exchange into $4
Cash $5 yen400 Japanese bank loans
$1 equity base
FRN = floating rate notesRepo = repurchase agreement
Source IMF (1998)
Institute for International Econom
ics | httpww
wiiecom
THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 99
balance sheet and because balance sheets are published quarterly at bestoutsiders have a difficult time assessing the extent of a firmrsquos leverage19
Leveraging by a single firm enhances its risk of default the widespreaduse of leverage in the financial system can magnify market adjustmentsespecially when they require ldquodeleveragingrdquomdashunwinding prior positionsRapid adjustments can cause credit to dry up and asset prices to plummetIn a mark-to-market environment falling asset prices trigger calls foradditional collateral that can ripple through markets
Risk Management
Because it is confronted with the widespread use of leverage and prolif-erating kinds of risk international finance is increasingly driven by riskevaluation and control20 Different institutions face various risk profilesand differing kinds of risk The most common risks can be quickly tickedoff Banks because of their traditional intermediary role of channelingthe resources from savers to borrowers face significant credit risk therisk of default or delay in the payment of principal and interest Theymust also manage market risk the risk that the prices of their liabilitiesmay change faster than their assets Market risk devastated US savingsand loan institutions in the late 1980s
Closely associated with market risk are interest-rate risk (unexpectedchanges in market interest rates that slash margins net income and theeconomic value of a bankrsquos equity) and foreign exchange risk (losses thatarise when assets denominated in an appreciating foreign currency areless than liabilities denominated in that currency) Banks make numer-ous loans to other banks around the world portfolio investors buy se-curities direct investors acquire fixed assets and all incur country risk(economic and political uncertainty in the host country) During the heightof the Asian crisis for example interbank loans to Japanese banksreflected the credit risk of lending to these banks the so-called Japanpremium
Substantial attention has been lavished on country risk analysis sincethe 1982 debt crisis in developing countries Yet in spite of this exper-tise the Asian crisis occurred in part because of a sudden upward reap-praisal of country risk after the Thai baht collapsed in April 1997 Banksand other financial institutions must also manage liquidity risk the riskthat market conditions will change unexpectedly depressing demand andprices of assets at the time they want to sell these assets And they mustmanage operational riskmdashfailures in control systems or people that cause
19 Another example of asymmetric information Both risk and leverage are difficult foroutsiders to assess without full timely disclosure
20 A longer discussion of these issues can be found in Managing Global Finance in IMF(1999c)
Institute for International Economics | httpwwwiiecom
100 WORLD CAPITAL MARKETS
financial loss or damage reputations Operational risk devastated BaringsBank in 1995
Financial institutions practice risk management to measure all theserisks the potential damage to their investment positions and ultimatelythe chance of becoming insolvent VAR (value at risk) risk models mea-sure subject to certain assumptions the amount of the firmrsquos capital thatis exposed in each period For example the VAR model might say thatin a 3-standard-deviation worst case (a case that is not supposed to hap-pen more than 1 percent of the time) the firm will loose 25 percent of itscapital during the next year
VAR models are widely used but like all models they have weak-nesses They rely on past values to estimate key variables in financialmarkets past values are not always good predictors of future risks More-over rising volatility and higher loss correlation among different assetclasses in a portfolio will cause all banks using these models to reducetheir exposures at the same time by switching to less volatile and lesscorrelated assets such as US Treasury bills (Persaud 2000)
Newer risk models entail stress testing and scenario analysis Scenarioanalysis envisages possible adverse changes one at a time that mightaffect the investment portfolio Stress testing estimates potential losseswhen several individual risk factors simultaneously move against thefirm but it too uses historical probabilities
Financial Volatility
21 For example derivative markets usually rely on underlying securities markets thatproduce continuous prices When these markets are interrupted financial shocks cantrigger a cascade of margin calls and sell orders that move prices very sharply
22 See IIF (1999a)
The combination of trading activity and modern risk management lie atthe root of financial volatility When risks increase banks must eitherraise more capital to cover the greater risk or reduce their exposure bycutting loan exposure by selling securities or by undertaking new de-rivative trades Raising more capital is time-consuming and in a crisisvery expensive because bank shares are depressed So banks look to theother alternatives If the bank can reduce lending it need not book aloss But most banks use the same VAR models and as indicated abovethese models will encourage them to reduce their outstanding loans atthe same time actually magnifying loan volatility
If banks attempt to reduce their exposure to risk by selling securitiesor undertaking new derivative trades they may trigger large priceshocks because of limited and shrinking market liquidity21 The liquid-ity problem is compounded when a small number of large institu-tions hold the same positions22 Take your pick loan volatility or price
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 101
volatility As two experts have observed (Folkerts-Landau and Garber1998)
[V]olatility even in one country will automatically generate an upward re-estimate of credit and market risk in a correlated country triggering automaticmargin calls and tightening of credit lines Thus apparently bizarre opera-tions that connect otherwise disconnected securities markets are not the re-sponses of panicked green screen traders arbitrarily driving economies from agood to a bad equilibrium Rather they work with relentless predictability andunder the seal of approval of supervisors in the main financial centers
23 See Ferguson (1999)
24 As Gerald Corrigan (1982) put the matter ldquoBanks are specialrdquo Corrigan (2000) reit-erated this view even after all the changes of the past two decades Unlike other institu-tions banks offer on-demand transactions are a backup liquidity source for other insti-tutions and serve as a ldquotransmission beltrdquo for monetary policy
These changes in the banking environment accentuate an existing anomalyThe anomaly is that banks even as they grow larger and increasinglyengage in more risky and complex transactions are perceived to enjoyimplicit and explicit public guarantees
The guarantees grow out of an incentive problem inherent in bankingasymmetric information which we mentioned above Depositors know lessabout a bankrsquos management and the quality of its balance sheet than doits managers and shareholders Thus in times of uncertainty or adver-sity bank depositorsmdashuncertain whether they will have access to theirdepositsmdashare prone to bank runs This prospect has in turn compelledgovernments to treat banks differently than other firms because a bankthat fails can disrupt the rest of the economy24
To prevent such crises governments have entered into quid pro quoarrangements with banks Governments provide them both with an im-plicit safety net in the form of an unstated promise by the central bankto act as a lender of last resort in a liquidity crisis and an explicit safetynet in the form of a public deposit insurance fund to reassure depositorsIn return the banks submit to closer government oversight and regu-lation of their activities than is usual for industries in the private sector
The ldquoinsurancerdquo provided by the public safety net contributes to an-other incentive problem moral hazard Banks acquire greater tastes forrisk and face less market discipline than other firms The explicit depositinsurance safety nets actually have or are perceived to have blanketcoverage that extends beyond the retail depositors (households and small
One of the lessons of the 1997-98 crisis must surely be that market par-ticipants and their regulatory supervisors relied too heavily on quantita-tive tools and insufficiently on judgment23
The Anomaly of Modern Banking
Institute for International Economics | httpwwwiiecom
102 WORLD CAPITAL MARKETS
businesses) for which they were originally intended The implicit centralbank safety nets extend in a crisis to nearly all depositors and banksThus banks are both viewed and behave as if they will be bailed out ifthey get into trouble
The existence of a public safety net raises a perennial question Dobanks have an unfair advantage over other financial institutions becauseof the subsidy provided by the safety net This question was at the heartof intensive study and debate in the United States leading up to thepassage in November 1999 of the Financial Services Modernization Act(also known as the Gramm-Leach-Bliley Act) The size of the gross sub-sidy is difficult to estimate despite determined research efforts Somesuggest it is well under 100 basis points and is at least partly offset bythe direct costs of deposit insurance premiums interest payments on bondsissued by the Financing Corporation25 reserve requirements regulatoryexpenses and operational costs associated with collecting deposits26 Con-versely Kwast and Passmore (2000) suggest that banks can expand theirscope far beyond the levels that other financial institutions could reachwith the same equity base but without the public safety net
A related concern in the US debate is whether allowing banks to ex-pand their activities into securities and insurance will ultimately extendthe safety net and add to the subsidy The Financial Services Moderniza-tion Act deals with this issue by maintaining a legal separation betweenbanks and the rest of the banking organization known as large com-plex banking organizations (LCBOs) They must engage in most securi-ties activities and insurance underwriting through separately capitalizedinvestment bank subsidiaries or holding company affiliates This act canbe said to have merely brought US banking laws closer to those of mostother industrial countries (Barth Brumbaugh and Wilcox 2000 BarthNolle and Rice 2000) If the fire wall is well-maintained and stoutly de-fended the safety net will neither expand in practice nor become a sourceof comfort to noncommercial bank subsidiaries of LCBOs
The quid pro quo exacted by governments to offset the subsidy iscloser public-sector monitoring of banksrsquo activities through prudentialsupervision The effectiveness of this closer official scrutinymdashand closermarket monitoringmdashare the subjects of the next section
25 The Financing Corporation was created by Congress in 1987 to sell bonds to raisefunds to help resolve the savings and loan crisis
26 See Levonian and Furlong (1995) Jones and Kolatch (1999) Shull and White (1998)and Whalen (1999a 1999b)
Are G-10 bank supervisors adequately responding In this section we firstassess the case for and compare the structures of prudential supervisory
Prudential Supervision
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 103
systems both within and among the G-10 economies plus Spain andconsider whether these offset the subsidy provided by the public safetynet Despite offsetting regulation and supervision implicit and explicitguarantees by G-10 governments to their banks are still a source of bank-ing instability in the emerging-market economies
National Systems for Prudential Supervision
Governments use prudential supervision to reduce the moral hazard andadverse selection created by their own safety nets Supervisors establishregulations and monitor compliance to limit risk taking and ensure thesafety and soundness of the banking system In a thoughtful analysis ofthe case for prudential supervision Frederic Mishkin (2000) identifiesthe main forms that supervision can take including the tasks of grantingbanking charters and licenses establishing capital requirements settingdeposit insurance premiums and defining disclosure requirements as wellas carrying out bank examinations Bank examiners gather informationfrom banks and evaluate whether they are following the regulatorsrsquo rulesin cases of weakness they are empowered to change banksrsquo behaviorand close them if necessary
Supervisors also may restrict competition define the activities in whichbanks may engage and restrict their asset holdings and separate banksand other financial (or nonfinancial) activities During the past two de-cades the barriers separating commercial banks investment banks in-surance firms and securities firms have been all but eliminated (tableB1) Deregulation has stimulated competitive forces that drive diversifi-cation and consolidation of the financial industry nowhere faster than inthe United States
The Financial Services Modernization Act of 1999 confirmed this trendIt eliminated restrictions dating back to the Glass Steagall Act of 1933which once prevented banking insurance and securities firms fromentering each otherrsquos businesses (Barth Brumbaugh and Wilcox 2000)Cross-pillar mergers among banks insurance and securities firms arewell under way to form giant financial holding companies The 1999merger between Citibank (banking) and Travelers (insurance) created themodel for megafinance and confirmed new challenges for supervisors
Mishkin (2000) notes the corresponding evolution in US supervisionfrom an emphasis on rules-based regulation (detailed rules for opera-tional behavior and the quality of line items in the balance sheet) to anapproach that stresses the soundness of bank management practices es-pecially risk management
Appendix B outlines the systems of financial supervision now in theplace in the G-10 countries plus Spain Some systems like the UK andCanadian approach are models of simplicitymdashorganized to keep pacewith the spreading reach of financial conglomerates Other systems like
Institute for International Economics | httpwwwiiecom
104 WORLD CAPITAL MARKETS
the US and French approaches show traces of the bureaucratic divisionsthat made sense in an era when banking securities and insurance weresharply separated
The US Model
27 See Meyer (1999a)
28 Canada has a similar degree of simplification with the exception that securities firmsare still regulated by provincial authorities
29 See Pratti and Schinasi (1999 67)
30 The agents are the bank regulators and the principals are the taxpayers Agents maypursue their own interests including bureaucratic survival and postgovernment employ-ment opportunities rather than the national interest in banking safety and soundness
The US model of financial regulation delineated in the Financial Ser-vices Modernization Act of 1999 blends functional and umbrella super-vision Bank and thrift regulators oversee depository institutions Newnonbank activities are subject to both functional regulation (eg by theSecurities and Exchange Commission and state insurance examiners) andumbrella supervision (of financial holding companies) by the FederalReserve27
The UK Model
Another supervisory model exists in the United Kingdom as well as inAustralia Canada and Switzerland28 In this model banking supervisionis separated from the monetary policy function The regulatory structureis considerably simplified by relying on a consolidated financial regula-tor separate from the central bank for both banking and nonbankingactivities The remaining question answered differently depending on thecountry is the extent to which the regulator relies on home-country sur-veillance of banks and conglomerates that have a local presence
Regulatory Models Compared
Appendix B provides more detail on the differences in these modelsGerman simplicity contrasts with French complexity In France the bankingcommission is chaired by the governor of the central bank and includesrepresentatives from the Treasury The commission supervises compli-ance with regulations but the central bank inspects banks on behalf ofthe commission29 In countries such as the United States and France withmultiple supervisors and crossover functions internal coordination is criticalAt the same time multiple agencies create regulatory competition Wheneach agency knows what the other is doing transparency within gov-ernment circles can help to limit principal-agent problems of regulation30
The discussion as to where in the public bureaucracy financial super-
Institute for International Economics | httpwwwiiecom
THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 105
vision should be placed goes back many years Peek Rosengren andTootell (1999) argue that a synergy exists between monetary policy andprudential supervision because information gained in the course of super-vision can increase the accuracy of macroeconomic forecasts A twist tothis argument is that the information on the state of financial institutionsavailable to the central bank as supervisor can facilitate its role as lenderof last resort Conversely there is the concern that a supervisory rolewill compromise the central bankrsquos independence of action with respectto its core mandatemdashmaintaining price stability As these arguments haveplayed out financial supervision has generally been shared between centralbanks and other regulators or placed entirely in the hands of an inde-pendent regulator However in Italy the Netherlands and Spain cen-tral banks are the sole banking supervisor
Goodhart (1995) examined the arguments and evidence for each modeland concluded that there were no overwhelming arguments or evidencefor one or the other31 Going forward a key problem for any financialsupervisory system is dealing with (and closing as necessary) weak banksIf both central banks and other regulators have this responsibility closecoordination between them is critical Another problem is large conglom-erate banks LCBOs Although they are less likely to fail because of thediversification of their assets and liabilities they are more likely to berescued They are also more likely to be multinational enterprises withinternational implications Goodhart observes that regulation of theseentities might be put in the hands of the central bank because it is lessamenable to political pressures In any event the complexity of LCBOoperations suggests that greater supervisory rigor is necessary
The US Congress was persuaded that broad oversight would help containthe moral hazard problem and accordingly gave the Federal Reservethe role of umbrella supervisor with the understanding that the Fed willscrutinize depository activity more intensely than nonbank financial ac-tivities Under this approach LCBOs such as Citigroup are subject tomuch closer monitoring than smaller and simpler institutions32 The USregulatory model requires enormous cooperation between the Fed otherbank supervisors and the functional regulators for insurance and securi-ties but it also benefits from regulatory competition
31 National systems of supervision are path dependent they are determined by the struc-ture of financial institutions and history in each country If Goodhart (1995) is right out-comes are not materially better or worse with one model of supervision rather than another
32 See Ferguson (1999)
Public Safety Nets
One of prudential supervisorsrsquo biggest challenges is to reduce moral hazardFor many years commercial banks engaged in communal self-insurance
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106 WORLD CAPITAL MARKETS
to deal with crises They formed voluntary groups that agreed to rescuetroubled members As financial markets evolved and competition inten-sified banks were no longer willing to play this role Private-sector in-surance is one alternative but moral hazard and adverse selection wouldappear to prevent it from happening Public safety nets have developedbecause of the low probability and high cost of potential bank runs Aclear trade-off is involved The effectiveness of insurance in preventingbank runs is greater the more comprehensive the coverage But the morecomprehensive the coverage the greater the moral hazardmdashbank man-agers bank directors investors and depositors all take on greater risksin the belief that the safety net will protect them against losses
All G-10 countries have compulsory public safety nets for banks (table29) Deposit insurance agencies are officially organized in Canada theNetherlands Sweden Switzerland and the United States organized bythe industry in France Germany Italy and the United Kingdom andjointly organized by the public and private sectors in Belgium Japanand Spain
How well do G-10 governments offset the subsidy provided by thepublic safety net This is a question on which there is substantial debateAs banking organizations have become more complex the challengesthat supervisors face have become more difficult One challenge is toalign the incentives facing bank managers and shareholders with thoseof depositors Another is the principal-agent problem in supervision Wehave discussed the incentive structures for financial institutions but wehave said little about the incentives for supervisors themselves and thedistortions they can generate in the financial system
In one of the many studies of the US savings and loan crisis of the1980s Kane (1989) documented both problems He described managersusing cosmetic approaches to disguise the magnitude of insolvency regulatorspracticing forbearance even though they knew of the deteriorating riskprofiles of the institutions for which they were responsible and legisla-tors increasing deposit insurance without regard for any offsetting changesin supervision A subsequent overhaul of the legislative framework forthe Federal Deposit Insurance Corporation (FDIC) known as the FDICImprovement Act of 1991 (FDICIA) aimed to introduce a clearer incen-tive structure for both regulators and regulated institutions
The changes introduced by this US legislation are worth discussionwith respect to the other G-10 countries as well First FDICIA created astronger signal to management and investors by targeting deposit insur-ance at small depositors only and by risk-weighting the deposit insur-ance premiums paid by banks to reflect their capital adequacy and bankexaminer ratings Among the G-10 countries rated in table 210 depositinsurance premiums vary considerablymdashbut it is not clear that the dif-ferences have much to do with risk-weighting Most G-10 countries em-ploy funding formulas based for example on the total domestic deposit
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Table 29 Deposit insurance schemes in the G-10 countries Explicit safety net
Coverage limit(dollar Foreign
equivalent currency Interbank Source Bankrsquos Contingency fundingDate Membership Co- at end of deposit deposit of premium from banks
Country established managementa insuranceb July 1998)c covered covered Fundingd funding costs or governments
United 1982 Compulsory Yes Larger of 90 No No Unfunded Banks only Callable (subject Parliament may increase Kingdom private percent co- to maximum the maximum payable
insurance to 03 percent of pound125 million advance 33000 total deposits) facility with Bank of
England
United 1934 Compulsory No 100000 Yes Yes Funded Banks and Up to 027 Borrowing up to $3 States official government percent total billion from US Treasury
domestic deposits
Japan 1971 Compulsory No 71000 but No No Funded Banks and 0084 percent of Borrowing up to yen500bn joint in full until government insured deposits from Bank of Japan
year 2000 subject to Ministry of Finance approval
Canada 1967 Compulsory No 40800 No Yes Funded Banks and 033 percent of Borrowing up to C$6 official government insured deposits billion authorized further
(maximum) borrowing subject to parliamentary approval
Germany 1966 Compulsory Yes 90 percent Yes No Funded Banks only 003 percent of Annual levy may be private coinsurance deposits doubled
to 22000
Italy 1987 Compulsory Yes 125000 Yes No Unfunded Banks and Callable Two options defer private government (maximum of payment or diminish
1 percent of compensation to be paid total deposits)
(table continues next page)
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Table 29 Deposit insurance schemes in the G-10 countries Explicit safety net (continued )
Coverage limit(dollar Foreign
equivalent currency Interbank Source Bankrsquos Contingency fundingDate Membership Co- at end of deposit deposit of premium from banks
Country established managementa insuranceb July 1998)c covered covered Fundingd funding costs or governments
Netherlands 1979 Compulsory No 22000 Yes No Unfunded Banks and On demand Government backing official government maximum of subject to parliamentary
5 percent of own approval funds
France 1980 Compulsory No 65400 No No Unfunded Banks only Callable (on Extra calls up to FFr1000 private demand calls million can be made in
up to FFr200 a 5-year period million)
Switzerland 1984 Voluntary No 19700 No No Unfunded Banks only Callable (on Underwritten by member official demand) banks
Sweden 1996 Compulsory No 31400 Yes No Funded Banks and 05 percent of Full emergency coverage official government deposits while replacing it with a
limited system after the emergency
Belgium 1974 Compulsory No 16600 No No Funded Banks and Callable 002 None insurance limited joint 22000 in government percent of to assets in fund
year 2000 deposits from clients
Spain 1977 Compulsory No 16439 Yes No Funded Banks and 02 percent of Government backing joint government deposits through the Banco de
(maximum) Espantildea subject to approval by royal decree
a Bank membership in the fund can be either compulsory or voluntary and the management of the fund can be official and official and private joint or privateb Coinsurance refers to the situation where depositors face a deductible against their insured fundsc Coverage limit refers to the explicit amount the authorities promise to insured Funded scheme means that it is funded ex ante unfunded otherwise
Sources Goodhart (1995) Demirguccedil-Kunt and Detragiache (2000) Demirguccedil-Kunt and Sabaci (2000)
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 109
base Explicit safety net protection also varies but only Canada focuseson the protected class33 All G-10 countries specify a limit on depositorprotection Under FDICIA the insurance fund is prohibited from pro-tecting uninsured depositors or creditors at a failed bank although adiscretionary system-wide override is provided for exceptional circum-stancesmdashbut with stringent requirements for consultation and account-ability Other G-10 countries allow for contingency funding from the publicpurse alongside unwritten lender-of-last-resort support Among large banksa significant and growing portion of deposit liabilities including foreigncurrency and interbank deposits are uninsuredmdashbut depositors assumethey will be protected in a crisis
FDICIA also made some significant qualitative changes to address theprincipal-agent problem by penalizing weak banks and rewarding strongbanks For example banks whose capital declined faced progressivelytougher regulatory sanctions that for example required them to elimi-nate dividends restrict their lending and change their managementsRegulators have also been forced to take prompt corrective action (toreduce the practice of regulatory forbearance in hopes that a bankrsquos for-tunes might improve)34 Unfortunately comparative qualitative assess-ments across the G-10 are difficult to make due to lack of information35
This discussion highlights the complexity of evaluating the extent towhich prudential supervision and market discipline reduce the moralhazard associated with G-10 safety nets Our argument is that publicsafety nets in the G-10 can be linked to banking instability in other coun-tries specifically in the emerging-market economies that have attractedG-10 cross-border bank lending This lending is a leading source of vola-tility in capital flows the large financial institutions many of which arecomplex banking organizations are based in and regulated by authori-ties in the G-10 economies These two features of the international finan-cial system are closely related although it is not possible to test thisrelationship econometrically
Two World Bank studies however indicate a basis for concern Onestudy is a cross-country econometric analysis of the relationship betweenbank stability and deposit insurance (Demirguccedil-Kunt and Detragiache2000) which found a negative relationship Their estimated model forbanking crises in a sample of 61 countries (both industrial and develop-ing) suggests that explicit deposit insurance raises the probability of acrisis by at least 30 percent36 Crises are especially likely in countries
33 Japanrsquos legislation says it does but recent experience shows this is not the case34 See Goldstein (1997) for a summary of the changes35 See Barth Nolle and Rice (2000) for a beginning in this area36 Demirguccedil-Kunt and and Detragiache (2000 table 1) report a logit coefficient of 0696with a standard error of 0397 (the coefficient is significant at the 8 percent threshold)This suggests that the ldquotruerdquo coefficient could well be as small as 030 (the reportedvalue minus the standard error)
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110 WORLD CAPITAL MARKETS
with immature financial supervisory systems (and not in the G-10) buttheir analysis does underscore the view that deposit insurance weakensmarket discipline37
An earlier World Bank analysis established similar results One wasthat market discipline is undermined by deposit insurance schemes an-other was that illiquid banks are forced to pay more for their funds un-less a generous deposit insurance scheme is in place (Demirguccedil-Kuntand Huizinga 1999) This econometric study also provides clear-cut evi-dence that depositor monitoring of banks declines with the existence ofdeposit insurance schemes At the heart of the problem is the questionof whether deposit insurance is accompanied by increased governmentmonitoring
This evidence and the weight of other arguments suggests that moralhazard is still an issue in the G-10 countries Consider the ongoing de-bate about instilling greater market discipline on risk taking by banksAt one extreme is the perennial proposal to do away with safety netsleaving markets to monitor the players and to force adjustments but toprotect small savers by creating ldquonarrow banksrdquo such as postal savingsystems that are allowed to invest these savings only in risk-free gov-ernment securities Whatever the merits of narrow banking this solutionis too extreme to be politically feasible
A moderate alternative is to force more disclosure by financial institu-tions to facilitate market monitoring But transparency has its own prob-lems Persaud (2000) argues that financial markets cannot reliably discernsustainable from unsustainable positions in the short term This uncer-tainty causes banks to ldquoherdrdquo behind market leaders to exploit theirsupposedly superior information ldquoThe more herding investors and bankersknow about what each other is up to the [more] unstable markets maybecomerdquo The implication is that greater transparency in the marketplaceby itself will not solve the problemmdashand in the short term more informa-tion may exacerbate herding Further supervisory steps (discussed in thenext chapter) are required
Yet another proposal is to promote private-sector involvement in bankmonitoring through market-based alternatives such as Calomirisrsquos sub-ordinated debt proposal (Calomiris 1997 Federal Reserve Board 1999)Banks could be required to issue and maintain a minimum amount of
37 Other findings in the Demirguccedil-Kunt and Detragiache (2000) study include thesepropositions The impact of deposit insurance on bank stability tends to be stronger themore extensive is the coverage offered to depositors when the scheme is funded andwhere the scheme is run by the government rather than by the private sector Con-versely deposit insurance is detrimental to bank stability where bank interest rates havebeen deregulated and where the institutional environment is weak Additional findingson deposit insurance are reported from a recent World Bank conference (8-9 June 2000httpwwwworldbankorgresearchinterestconfsupcomingdeposit_insurancehomehtm)Also see Smalhout (2001)
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 111
subordinated debt (eg uninsured certificates of deposit) to finance asmall fraction (such as 2 percent) of their total nonreserve assets Thesubordinated debt would be allowed to earn a set yield no more than 50basis points over the risk-free yield on government treasury bills Thisrule would supposedly force banks to operate in a safe manner Other-wise subordinated debt holders would redeem their uninsured certifi-cates of deposit and equity investors would sell their bank shares Despiteits practical problems the beauty of the subordinated debt requirementis that it enlists market incentives to push banks to avoid excessive port-folio risk38
The thrust of these proposals is very relevant to the arguments in ourstudy Even in the G-10 countries government monitoring by itself hasnot eliminated moral hazard among banks More work is needed to in-troduce market monitoring and to improve the incentive structures bothfor financial institutions and their supervisors We return to this issuewith our recommendations in the next chapter
38 In late 1996 Argentina began requiring its banks to finance 2 percent of total depos-its in the form of subordinated debt but without a maximum yield provision TheArgentine authorities expect that market discipline will act in concert with the publicsafety net One obvious problem with the subordinated debt proposal is that banks mayencourage some of their customers to buy the subordinated debt
Portfolio Institutions Tomorrowrsquos Problem
Before proceeding to the issues of international supervision we flag an-other potential problem for national regulators The big asset managersprofiled in tables 24 and 26 answer to diverse groups of pensionersshareholders and policyholders They allocate funds across a number ofcountries to diversify their risks They hold liquid assets that can be tradedand they have a higher proportion of long-term assets than banks Eco-nomic shocks can be absorbed through price changes and their effectsspread across time and markets Thus when conditions change in a par-ticular market they are more likely to ride out the storm than to flee Inother words they have less incentive than banks to pull their invest-ments in the face of adversity In the 1990s most large asset managersestablished a record of ldquoriding out the stormrdquo rather than ldquorunning withthe windrdquo although as we saw in chapter 1 instances of running withthe wind were detected in some portfolios As we write these insti-tutions have a good record overall in the emerging markets so whyworry
The Russian crisis and the near-collapse of LTCM previewed the dan-gers that may await future portfolio managers and G-10 financial minis-ters We have presented evidence indicating a systemic bias toward bank
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112 WORLD CAPITAL MARKETS
lending and debt finance to emerging markets and we have argued forsubstitution toward equity finance and direct investment39
That is not the end of the story We noted in the previous chapterthat institutional investors can become momentum investors selling in adownturn As more portfolio capital is invested in emerging marketssome players may adopt the high-risk high-leverage strategies of themost aggressive hedge funds Indeed the data in box 11 show that G-10portfolio investors held somewhat more long-term debt (more than $500billion) than equity (less than $400 billion) in emerging markets at theend of 1997 Long-term debt is an ideal vehicle for high-risk high-leveragestrategies These strategies practiced on a large scale could compound afuture crisis harming emerging markets A big enough crisis could inturn pressure G-10 central banks and finance ministers to arrange bail-out plans Instead of shrinking as a systemic financial problem moralhazard could increase
National securities regulators are the first line of defense against thisscenario They play a critical role in the safe evolution of capital mar-kets But regulators today are mandated to approve the issuance of newsecurities and to monitor the continuing disclosure of material informa-tion by issuers They are far less concerned with or empowered to monitorthe behavior of the increasingly large wealth-management firms that arethe major purchasers (and therefore resellers) of these securities
Within their mandates the goals of national securities regulators (table210 and appendix B) are similar to the concerns of bank regulators withsystem safety and soundness Their focus is also on the incentive sys-tems for management and boards of directors and on disclosure by cor-porations that issue marketable securities such as shares bonds andasset-backed securities 40 Issuers of securities possess greater knowledgeabout the quality of these assets than do the purchasers hence investorprotection is a key concern of regulators Moreover market disciplineworks best when markets know what is happening Well-functioning corpora-tions are key agents of wealth creation and social progress Underperform-ing corporations waste resources During recessions bad corporationsget into bad trouble often with severe social consequences Inadequateincentives for managers and inadequate accountability for boards andmanagers thus have negative externalities Regulators play a vital role inexposing weakness so that market disciplines come to bear sooner ratherthan later
Regulatory emphasis is constantly shifting as financial markets evolveand as the macroeconomic environment changes Regulators try to balance
39 See Rogoff (1999) Also see Berlin (2000) for a perspective on the limited role thatbanks play as share owners
40 See Habib and Ljungqvist (2000) for recent empirical analysis showing that corporateshare market values are higher when corporate executives have a larger ownership stake
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Table 210 Financial-sector regulation G-10 countries 2000
Financial institutions and their supervisors
Country and supervisory structure Retail banking Wholesale banking Securities Insurance
Financial conglomeratesFinancial Services Authority (FSA) = umbrella supervisor
United Kingdom FSA FSA FSA FSA
Treasury bull Commercial banks bull Investment funds (Securities and (Insurance Directorate(Securities and Investments Board) bull Unit trust groups Futures Authority) of the Treasury)
Bank of bull Building societies bull Pension funds England (Building Societies Commission) bull Merchant banks
bull Friendly societies bull Clearing houses bull Primary issuers bull Insurance FSA (Friendly Societies Commission) bull Venture capital of securities companies
bull Pensions and life insurance etc bull Stock exchanges bull Insurance brokers(Personal Investment Authority) bull Stockbrokers
Financial holding companiesFederal Reserve (FR) = umbrella supervisor
United States bull National banks(OCC) Securities and Regulated by
Treasury OCC bull State banks Federal Reserve Exchange Commission StatesMembers (FR)
OTS Nonmembers (FDIC) bull Investment banks bull Primary issuers of bull Insurance companies FR bull Cooperative banks (FDICFR) bull Finance companies securities bull Insurance brokers FDIC bull Insured industrial banks (FDIC) bull Stock exchanges
bull Thrift holding companies (OTS) bull Stockbrokers SEC bull Savings banks (OTSFDICFR) bull Investment advisors
bull Savings and loan associations bull Mutual funds(OTS) bull Public utility holding
bull Edge Act corporations (FR) companies
(table continues next page)
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Table 210 Financial-sector regulation G-10 countries 2000 (continued )
Financial institutions and their supervisors
Country and supervisory structure Retail banking Wholesale banking Securities Insurance
Financial holding companies Japan Financial Supervisory Authority (FSA) = umbrella supervisor
Prime FSA FSA FSA FSA ministerrsquos Ministry of office Finance (Securities and Exchange
Surveillance Commission) FRC Bureau of Financial bull City banks bull Investment banks bull Primary issuers of bull Insurance companies FSA Regulation bull Regional banks bull Asset managers securities bull Insurance brokers
bull Trust banks bull Stock exchanges SESC bull Long-term credit banks bull Stockbrokers
bull Pension funds
Financial holding companiesOffice of the Superintendent of Financial Institutions (OSFI) = umbrella supervisor
Canada Regulated by OSFI OSFI provinces OSFI
Department of Financebull Banks bull Cooperative credit bull Primary issuers of bull Insurance companies
(previously Office of the Inspector associations securities (previously Depart- OSFI General of the Banks) bull Fraternal benefit bull Stock exchanges ment of Insurance) Bank of bull Trust and loan companies society bull Stockbrokers bull Insurance brokers Canada bull Pension funds bull Asset managers
(previously Depart- CDIC ment of Insurance)
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Financial institutions and their supervisors
Country and supervisory structure Retail banking Wholesale banking Securities Insurance
Germany Financial holding groupsFederal Banking Supervisory Office (FBSO) = umbrella supervisor
Ministry of Finance FBSO BSO FSSO FISO
Bundesbankbull Universal banks bull Other financial bull Primary issuers of bull Insurance companies
Federal Banking bull Savings banks institutions (eg securities bull Insurance brokers Supervisory Office bull Securities banks management foreign bull Stock exchanges
currency dealings) bull Stockbrokers Federal Securities bull Financial enterprises bull Asset managers Supervisory Office (eg leasing bull Pension funds
organizations Federal Insurance credit card companies Supervisory Office investment advisors)
Italy Bank foundationsMinistry of Finance = umbrella supervisor
Ministry of Finance Bank of Italy Bank of Italy Consob ISVAP
Bank of Italy bull Commerical banks bull Asset managers bull Primary issuers of bull Insurance companies Consob bull Savings bank bull Open-end investment securities bull Insurance brokers
bull Securities banks companies (SICAVs) bull Stock exchangesbull Stockbrokers
ISVAP
(table continues next page)
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Table 210 Financial-sector regulation G-10 countries 2000 (continued )
Financial institutions and their supervisors
Country and supervisory structure Retail banking Wholesale banking Securities Insurance
The Netherlands Financial conglomeratesCouncil of Financial Supervisors = umbrella supervisor
Securities Board Securities Board Netherlandsche Netherlands Bank Netherlandsche Bank of the Netherlands Insurance Board Bank Insurance bull Credit institutions (universal banks bull Investment institutions bull Stock exchanges bull Insurance companies Board cooperative banks security credit (securities issuing bull Stockbrokers bull Insurance brokers
institutions mortgage banks) and tradingmdashprimary The Council of Financial and secondary Supervisors markets)
France Commission des Commission de Operations des Controcircle des
Banking and Banking Commission Bourse Assurances Financial Regulatory bull Ensuring that credit institutions (and investment firms since bull Primary issuers of bull Insurance companies Ministry for Committee the Financial Activity Modernization Act of 1996) comply securities bull Insurance brokers Economic with laws and regulations bull Stock exchanges Affairs and bull Execute instructions regarding all off-site monitoring and bull Stockbrokers Finance Credit on-site supervision Institutions and Banking and Financial Regulatory Committee Investment bull Formulates general regulations for credit institutions and investment firms Committee (capital adequacy requirements accounting rules etc) Bank of France Credit Institutions and Investment Committee Banking bull Authorizes and examines financial institutions except for those within the Commission competence of the Banking Commission
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117
Financial institutions and their supervisors
Country and supervisory structure Retail banking Wholesale banking Securities Insurance
Switzerland Large banking groupSwiss Federal Banking Commission (SFBC) = umbrella supervisor
Swiss National Bank Federal Office of
SFBC SFBC SFBC Private Insurance Swiss Federal Banking Commission bull Universal banks bull Investment banks bull Primary issuers of bull Insurance companies
bull Savings banks bull Asset management securities bull Insurance brokerscompanies bull Stock exchanges
Private audit Federal bull Investment funds bull Stockbrokers firms Office of bull Mortgage bond authorized by Private business SFBC Insurance
Sweden Financial holding company groupsFinancial Supervisory Authority = umbrella supervisor
Ministry of Finance Credit Market Securities Market Insurance Market
Credit Market Department Department Department Department
Financial bull Commercial banks bull Investment funds bull Primary issuers of bull Insurance companies Riksbank Supervisory bull Savings banks securities bull Insurance brokers Authority bull Friendly societies bull Stock exchanges
bull Stockbrokers
(table continues next page)
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Table 210 Financial-sector regulation G-10 countries 2000 (continued )
Financial institutions and their supervisors
Country and supervisory structure Retail banking Wholesale banking Securities Insurance
Belgium Bank holding companiesBanking and Finance Commission = umbrella supervisor
Bank of Belgium Banking Banking
Banking and Finance and Finance Insurance Controland Finance Commission Commission Commission Office
Banking and Insurance Finance Control bull Commercial banks bull Asset management bull Primary issuers of bull Insurance companies Commission Office bull Savings banks firms securities bull Insurance brokers
bull Securities banks bull Investment funds bull Stock exchanges bull Mortgage companiesbull Stockbrokers bull Pension funds
Securities Regulation Fund Securities Regulation Fund
bull Other investment firms and credit institutions(institutions participating in regulated off-exchangemarket in strips and Treasury certificates)
Bank holding companies Spain Banco de Espantildea = umbrella supervisor
Banco de Espantildea Comision Nacional del Mercado de Directorate General
Banco de Espantildea Valores (CNMV) Insurance
bull All credit institutions (commercial banks savings banks credit bull Primary issuers of (Ministry of Economy Ministry of cooperatives official credit institutions finance factoring and securities and Finance) Economy and CNMV leasing companies mortgage-loan companies etc) bull Stock exchanges bull Insurance companies Finance bull Interbank foreign exchange and book-entry public debt bull Stockbrokers bull Pension funds
markets bull Venture capital(companies and funds)
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119
Financial institutions and their supervisors
Country and supervisory structure Banking Securities Insurance
Banking Advisory High Level Securities Supervisors Committee (BAC) Committee (HLSS) Insurance Committee (IC)
Supranational (EU) bull Formulates standards for prudential bull Coordination of securities market bull Formulates standards forsupervision supervision prudential supervision
BACICHLSS Banking Supervision
Conglomerates Committee (BSC) Securities Contact Committee Regulation of prudential bull Systemic risk monitoring bull Regulation and implementation of supervision securities admission
International Association International International Organization of of Insurance Supervisors
Basel Committee Securities Commisison (IOSCO) (IAIS) Joint Forum Conglomerates Supervision bull Supervision and regulation best bull Supervision and regulation best bull Supervision and regulation amp regulation Best practices practices practices best practices
FSF Coordination across supervisors of various functions
Notes See appendix B for more information Boldface type indicates senior or oversight supervisor normal type indicates adjunct or front-line supervisorsolid line indicates direct responsbility to the senior-ranking authority dotted line indicates coordination in supervisory activities
(table continues next page)
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Table 210 Financial-sector regulation G-10 countries 2000 (continued )
Glossary of names United Kingdom FSA = Financial Services Authority United States FR = Federal Reserve OCC = Office of the Comptroller of theCurrency FDIC = Federal Deposit Insurance Corporation SEC = Securities and Exchange Commission OTS = Office of Thrift Supervision Japan FRC =Financial Reconstruction Commission FSA = Financial Services Agency SESC = Securities and Exchange Surveillance Commission Canada OSFI =Office of the Superintendent of Financial Institutions CDIC = Canada Deposit Insurance Corporation Germany FBSO = Federal Banking SupervisoryOffice FSSO = Federal Securities Supervisory Office FISO = Federal Insurance Supervisory Office BSO = Banking Supervisory Office Italy Consob =Commissione Nazionale per le Societa e la Borsa ISVAP = Instituto per la Vigilanza sulle assicurazioni private e di Interesse colletivo Switzerland SFBC= Swiss Federal Banking Commission Spain CNMV = The Comision Nacional del Mercado de Valores Supranational BAC = Banking Advisory CommitteeBSC = Banking Supervision Committee IC = Insurance Committee HLSS = High Level Securities Supervisors Committee International Dimension FSF =Financial Stability Forum IOSCO = International Organization of Securities Commission IAIS = International Association of Insurance Supervisors
Sources United Kingdom Bank of England httpwwwbankofenglandcouk Financial Services Authority httpwwwfsagovuk United States Board ofGovernors of Federal Reserve System httpwwwfederalreservegov Japan Bank of Japan httpwwwbojorjo Financial Reconstruction Commissionhttpwwwfsagojpfrcindexehtml Financial Services Agency httpwwwfsagojp Canada Bank of Canada httpwwwbank-banque-canadaca Office ofthe Superintendent of Financial Institutions httpwwwosfi-bsifgccaAndreEindexhtml Germany Deutsche Bundesbank httpwwwbundesbankde Fed-eral Banking Supervisory Office httpwwwbakredde Italy Banca drsquoitalia httpwwwbancaditaliait Commissione Nazionale per le Societa e la Borsahttpwwwconsobit Instituto per la Vigilanza sulle assicurazioni private e di Interesse colletivo httpwwwisvapit The Netherlands De NederlandscheBank httpwwwdnbnl France Banque de France httpwwwbanque-francefr Switzerland Schweizerische Nationalbank httpwwwsnbchindex3htmlSweden Sveriges Riksbank httpwwwriksbanksedefaultasp Belgium National Bank of Belgium httpwwwbnbbesgindexhtm Spain Banco de Espantildeahttpwwwbdees The Comision Nacional del Mercado de Valores httpwwwcnmves Supranational (EU) Institutional Arrangements for the Regulationand Supervision of the Financial Sector 2000 International Dimension Bank for International Settlement httpwwwbisorg International Organization ofSecurities Commissions httpwwwioscoorg International Association of Insurance Supervisors httpwwwiaisorg Financial Stability Forum httpwwwfsforumorg
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 121
the inflexibility of tight surveillance against the need to encourage in-novation and growth The US Securities and Exchange Commission isworried about aggressive accounting by firms and biased reports bysecurities analysts in an equity environment that prizes steadily higherquarterly earnings41 Japanese regulators are preoccupied with opaqueinterconnections between portfolio institutions banks and nonfinancialfirms through the keiretsu system Canadian regulators reeling from high-profile scandals of managers intentionally misleading investors are strengtheningmarket discipline through legal penalties aimed at managers and directorsof offending firms
When panic strikes a securities regulator cannot do much As the 1987stock market crash and the LTCM debacle in the fall of 1998 both dem-onstrated steep stock and bond price declines can create systemic risksIf severe enough the wealth effect of falling securities values and thefear of widespread insolvency can depress real activity Flooding thesystem with liquidity is a central bankerrsquos solutionmdashsomething a securi-ties regulator cannot do42 But just as financial supervisors can changethe incentive structure to discourage bankers from making risky loans ingood times so securities regulators can pay more attention to incentiveson the demand side when capital markets are strong
Prudential Supervision and InnovationmdashA Footnote
In concluding this discussion of prudential supervision in the G-10 anadditional point is worth noting National regulators face a persistenttrade-off between emphasizing financial system safety and soundnesswhile encouraging innovationmdashin spite of the added risks innovationbrings to financial markets Former US Treasury Secretary Lawrence Summers(2000 3) has argued by analogy
The jet airplane made airplane air travel more comfortable more efficient andmore safe though the accidents were more spectacular and for a time morenumerous after the jet was invented In the same way modern global financialmarkets carry with them enormous potential for benefit even if some of theaccidents are that much more spectacular As the right public policy response
41 The problem is illustrated by the divergence since mid-1998 between reported earn-ings by the Standard amp Poorrsquos (SampP) 500 and the after-tax profits of all corporations inthe national accounts Generally these two series move closely with one another Be-tween mid-1998 and mid-1999 SampP 500 reported that earnings increased by more than20 percent while after-tax profits of all corporations increased by less than 5 percent(Chase Bank US Economic and Policy Research US Weekly Prospects Chase SecuritiesWeekly Newsletter 5 June 2000 5)
42 For example the US Securities and Exchange Commission had no direct role in calmingmarkets in the 1987 or 1998 panics
Institute for International Economics | httpwwwiiecom
122 WORLD CAPITAL MARKETS
to the jet was longer runways better air-traffic control and better training forpilots and not the discouragement of rapid travel so the right public policyresponse to financial innovation is to assure a safe framework so that the ben-efits can be realized not to stifle the change
Accepting Summersrsquos analogy for the international financial system better-informed supervisors and investors are a necessary part of the financialsystem framework Supervisors require more timely information on therisk profiles resulting from positions taken by financial institutions Theyalso need a better understanding of risk-management systems Snapshotsof an institutionrsquos risk profile and risk-management procedures are nolonger adequate In a world where huge bets are quickly made (andpossibly lostmdashas with Barings Bank in 1995 and LTCM in 1998) super-visors must focus on the soundness of banking systems for evaluatingand managing risk on a daily basis Some progress has been made inaddressing these issues US banking examiners are extending their in-formation requirements in banking examinations and increasing theirinvolvement in large complex institutions43 More awareness is alsorequired of the fact that they are national organizations in a world ofcross-border capital flows To a much greater extent they need a multi-national reach International supervision and coordination among super-visors are the subject of the next section
Our analysis suggests that G-10 supervisors have unfinished businessBank supervisors need to start yesterday securities regulators can waituntil tomorrow One G-10 member acting alone cannot correct the biasIn good times the lending business will simply migrate to other G-10banks In bad times financial problems will not stop at the national bor-der A way has to be found to establish common international standardsfor the key financial players in order to prevent crises and to agree onapproaches for managing them The path has already been laid out Inthe wake of the bank failures of the past 25 years bank supervisors havetried to establish such standards They have done this without creating anew global institution
The essence of the international framework is decentralizationmdashglobalrules and design standards without global institutions that are perceivedto intrude on national sovereignty The awkward jargon for this frame-work is vertical subsidiaritymdashldquothink internationally act nationallyrdquo Theinternational thinking is done by a committee of regulators that meets
International SupervisionA Decentralized Framework
43 These issues are discussed in Ferguson (1999) and Meyer (2000a)
Institute for International Economics | httpwwwiiecom
THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 123
regularly at the Bank for International Settlements in Basel The commit-tee establishes principles and standards that are interpreted implementedand enforced by national authorities44 In this section we describe thesesupervisory efforts and their weaknesses We present our recommenda-tions for addressing these weaknesses in the next chapter
Basel I
The Basel Capital Accord of 1988 (Basel I)45 drew the lesson from thefinancial crises of the mid-1970s that more adequate capital levels in in-ternational banks would help reduce the systemic risk of bank failureThe primary goal of Basel I was capital adequacy other standards wereput in place not so much for their own virtue as to defend the primarygoal
Capital adequacy requirements were designed to ensure that individualinstitutions have the ability to absorb losses particularly credit lossesAccordingly a backup system of scoring credit risk was devised thatrequired large amounts of bank capital for some types of loans smalleramounts for others and zero for a select list of preferred assets Report-ing requirements were designed to disclose problems and ensure that atroubled bank would take timely steps to restore its capital base in thewake of a loss The Basel I framework worked tolerably well in limitingthe call on the public purse in the G-10 countriesmdashwith the notable ex-ceptions of France and Japan The framework failed to moderate riskybank lending to emerging markets however
Basel I was not developed with emerging markets in mind The origi-nal idea behind it was to develop a common supervisory approach tocross-border banking operations It grew out of political pressure fromUS lawmakers who were determined to require international banks op-erating in the United States to meet US banking standards Toward thisgoal in 1983 Congress passed the International Lending Supervisory ActUS and British banking authorities subsequently agreed on a commontarget the adoption of strict common capital-adequacy standards In 1988other G-10 governments agreed to go along voluntary acceptance ofthe standards throughout much of the rest of the world followed46 Therationale for the capital targets was two-fold The first was to requirebanks to hold sufficient amounts of capital (8 percent of risk-adjusted
44 The international committee of financial authorities agreed on a common definitionof banksrsquo tier-one or ldquocorerdquo capital national authorities defined tier-two capital in theirown manner which permitted greater variations in national working definitions andpractices
45 International Convergence of Capital Measurement and Capital Standards (BIS 1988)was prepared by the Basel Committee on Banking Supervision
46 See Reineke (1998)
Institute for International Economics | httpwwwiiecom
124 WORLD CAPITAL MARKETS
assets) to cushion losses on those assets The second was to dull theirappetites for risk banks with large capital bases would have more tolose if they failed and therefore would take fewer risks
Rapid change in financial markets soon revealed flaws in the Basel IAccord In a complex world with numerous sources of risk it focusedheavily on credit risk but overlooked other risks in a bankrsquos portfolioand the correlation between returns on different asset classes The Baselformula required banks to maintain a fixed amount of capital againsteach of its asset classes But the formula did not distinguish the riskinessof the borrower within each class As a result one large loan to a low-risk corporate borrower such as General Electric would require the sameamount of capital as 10 smaller transactions with high-risk borrowers
The system was also biased toward short-term loans Loans maturingin less than a year required a 20 percent risk weight whereas those ma-turing after more than a year required a 100 percent risk weight Inter-bank lending was particularly favored For example loans to banks inOECD countries required less capital than loans to private firms in thesame countries creating the anomaly that interbank loans to South Ko-rean banks required less capital than loans to General Electric47 Thisanomaly encouraged banks to shed high-quality assets if the Basel rulesrequired the allocation of more capital than banks thought they needed
Another weakness was that financial innovators quickly circumventedthe Accord Because short-term loans required less provisioning than long-term loans banks responded by securitizing their long-term debt port-folios and lending short-term against the collateral of the newly createdasset This allowed banks to circumvent the capital requirements gearedto the terms of the underlying debt At the same time the Basel I Accordfailed to encourage risk mitigation techniques such as credit derivativescollateral guarantees and on-balance-sheet netting the flip side of fi-nancial innovation Because off-balance-sheet products were not coveredby the Accord another anomaly appeared when Barings Bank collapsedin 1995 Barings met capital adequacy standards but collapsed becauseits systems for managing risk failed traders were allowed to speculatein futures contracts that did not appear on the balance sheet
Basel II
Work to overhaul Basel I began in 1995 and produced consultativepapers issued in June 1999 and January 200148 These papers have been
47 South Korean banks have had notoriously weak balance sheets because the practiceof ldquodirected lendingrdquo left them with many poor loans (in making these loans the bankswere expected to follow government objectives rather than creditworthiness criteria)
48 Basel Committee on Banking Supervision (1999 2001)
Institute for International Economics | httpwwwiiecom
THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 125
the subject of extensive consultation and revision as a result the newAccord is expected to be introduced in 200449 The Basel II frameworkhas three parts (pillars) revisions to Basel I minimum-capital require-ments supervisory review criteria and greater emphasis on market dis-cipline Broadly Basel II aims to maintain the level of capital in the sys-tem but achieve better alignment of banksrsquo capital with their risk pro-files and keep up with financial innovation
To align capital requirements with market realities (the first pillar)Basel II concentrates on the 100 or so largest banksmdashthe type of playerslisted in table 21mdashand on the holding-company parents of banking groups50
Capital requirements will differentiate between an increased number ofcredit groups or ldquorisk bucketsrdquo including claims on governments otherbanks corporations mortgage-backed securities and other asset-backedsecurities
Basel II originally proposed to use external ratings to set capital chargesfor a number of these credit risks Many banks objected arguing thatthey assess credit risk better than Standard amp Poorrsquos Moodyrsquos or FitchIBCA51 Basel II thus proposes two approaches to rating a standard ap-proach using external ratings and an ldquoadvancedrdquo approach that allowsselected banks to use their own internal rating systems To encouragethe development of rigorous internal control systems based on these in-ternal rating systems Basel II also proposes to levy capital charges foroperational risk (the risk of direct or indirect loss resulting from inad-equate or failed internal processes people and systems or from exter-nal events)
Some critics of this proposal dismiss it as an abrogation of the prin-ciple of external independent monitoring and as ldquodangerously naiumlverdquo52
But regulators argue that the new capital charge on operational risk shouldoffset this concern It is also far from clear how cross-national compari-sons of rating and internal risk-assessment systems will be made (Engelen2000) The development by the European Union of its own capital rulescould well complicate the international resolution of these issues Publicassurances by EU officials in January 2001 however indicated that theirmain concerns are to create a level playing field and avoid regulatoryarbitrage (Hargreaves 2001) There is also the significant problem ofthe procyclical character of risk weights When a crisis hits losses are
49 See Berry (2000) for an update in an interview with William J McDonough chair ofthe Basel Committee on Banking Supervision
50 For obvious reasons these proposals are addressed to large banks and simpler capi-tal standards are allowed for small banks that focus on their domestic credit markets
51 See Ammer and Packer (2000) for an empirical critique of the success of rating agen-cies in distinguishing risk by sector and region
52 See Auerback (2001)
Institute for International Economics | httpwwwiiecom
126 WORLD CAPITAL MARKETS
incurred or accrued capital is lost and loan exposure must be reducedor securities sold to restore the requisite capital-adequacy ratios A morerisk-sensitive framework could amplify volatility
As the second pillar of Basel II supervisory review criteria are beingbeefed up to encourage supervisors to intervene earlier in potential problemsituations and to compel banks to align their capital positions with theirrisk profiles Bank supervisors will be authorized to require banks tohold capital in excess of minimum requirements if they have concernsabout general management overall strategy risk-management performanceor the macroeconomic environment Of course if one G-10 supervisorimposes higher capital requirements in isolation the same disparity willemerge that presaged Basel I Some banks will be disadvantaged in theinternational marketplace and will loudly complain that excessive super-vision is driving business to their competitors Hence close internationalcooperation among supervisors is critical
To implement the third pillar market discipline banks will be requiredto make fuller more timely disclosure of capital adequacy and the risksto which that capital is exposed A number of measures are being stud-ied that might help supervisors evaluate bank performance such as com-parisons of uninsured deposit interest rates subordinated debt yieldsand equity prices The idea is that these yields and prices might alertsupervisors to market perceptions of risk Of course market perceptionsare only as good as market information More direct and controversialways to reinforce market discipline would dramatically increase publicdisclosure of bank positions and risk management systems
Many questions are still outstanding about how to resolve the techni-cal details of capital requirements and whether the requirements willachieve their intended goal of better assessment and mitigation of therisks in banksrsquo portfolios There is no substitute for skilled supervisorsThe intricacies of effective design and implementation suggest that su-pervisors need to be highly competent technically knowledgeable aboutbanking portfolio characteristics and the factors that influence bank ex-posure to credit risk (Mishkin 2000) And they must be aided by vigilantshareholders market forces and transparency of information53
Standard setting at the global level is desirable but ultimately theeffectiveness of these efforts will be tested at the national level espe-cially in times of systemic financial distress Here the record of Basel Iwas not a bright shining success Japanese banking regulators havetraditionally allowed banks to include real estate and securities in theircapital base When the value of these assets plummeted in the early 1990sregulators allowed banks to continue valuing these depreciated (andoften bankrupt) assets at their old inflated levels Japanese authorities
53 Benedict Roth Complacency Towards Catastrophe Financial Times 23 January 2001
Institute for International Economics | httpwwwiiecom
THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 127
insisted until the mid-1990s that eroded capital bases could be rebuiltin a market-driven fashion They rightly foresaw that huge loan losseswould undermine public support for the ruling party and require a po-litically unpopular bailout
Japanese foot dragging on Basel I was the worst54 but not uniqueOther examples can be found of ldquopolitically mandated forbearancerdquo TheFederal Reserve Bank of New York held important hands during theLTCM crisis of 1998 Mexico is still resolving the banking crisis that eruptedin 1995 South Korea has not yet closed the insolvent banks that behavedso badly before the crisis of 1998 In the aftermath of a crisis nationalregulators cannot always be relied upon to discipline politically power-ful bankers55 One of the little-noticed consequences of these differingapproaches is that those banks with strong regulatory systems receivedan implicit ldquoexport subsidyrdquo for their services US banks which had notengaged extensively in emerging-market lending in the 1990s were bet-ter positioned than their German and Japanese counterparts to expandtheir international assets in the wake of the crises
Other Financial Forums
54 See Japanese Banks Fiddling while Marunouchi Burns The Economist 27 January2001 67-69
55 See Calomiris (1997)
The Basel model of vertical subsidiarity has already been extended toother financial regulatory bodies In 1993-94 the BIS established a Tri-partite Group of Banking Insurance and Securities Regulators In 1994-95 the BIS increased its cooperation with the International Organizationof Securities Commissions when the two organizations issued parallelpapers on guidelines for national regulators concerning risk managementand disclosure of derivative trades In 1996 a permanent Joint Forum onFinancial Conglomerates was established to examine supervisory issuesand develop working arrangements among the different functional super-visors of conglomerate institutions that offer combinations of bankingsecurities and insurance products Draft papers on the supervisionof conglomerates were released for comment in 1998 applying capital-adequacy principles to these groups and providing guidelines both forassessing the integrity and competence of top managers and for sharingassessments between regulators
In 1997 the Basel Committee on Banking Supervision extended itsreach beyond capital standards to broader aspects of banking supervi-sion with the publication of the Core Principles for Effective BankingSupervision In 1999 a wide range of regulatory and standard-settingbodies were gathered under the umbrella of the Financial Stability
Institute for International Economics | httpwwwiiecom
128 WORLD CAPITAL MARKETS
Forum (FSF) itself established under BIS aegis56 The FSF has alreadyissued recommendations for stepped-up supervision and transparencyas well as guidelines for best practices in a number of areas includingoffshore financial centers and highly leveraged institutions or hedge funds57
Conclusion
Although the structural weaknesses in emerging-market economies arewidely acknowledged to have been causal factors in international capi-tal-market volatility this chapter points to the role of large G-10 bankingorganizations as major suppliers of the most volatile instrument short-term debt We have examined evidence of the impact of public safetynets in the G-10 economiesmdashthe deposit insurance systems the pruden-tial supervisory systems and the lender-of-last-resort functions of centralbanksmdashon the incentive structures of these organizations
Although supervisors in most countries working nationally and to-gether in the BIS have made significant efforts to mimic market forcesin their prudential supervision the most sophisticated financial institu-tions find innovative ways to circumvent the rules New global regulatorybodies are not about to be created G-10 national bank regulators shouldthemselves address the short-term debt bias in the international financialsystem by changing incentive systems G-10 securities regulators shouldalso take steps to get ahead of the curve paying close attention to largeportfolio swings by institutional investors particularly in times of crisisIn short more needs to be done at national and international levels tochange the rules of the game That is the subject of the next chapter
56 The Financial Stability Forum includes banking securities insurance and accountingregulatory bodies the OECD on taxation corruption and corporate governance and theIMF
57 See Martin (2000)
Institute for International Economics | httpwwwiiecom
84 WORLD CAPITAL MARKETS
Table 22 Total assets and external assets of all commercialbanks June 2000 (billions of dollars)
Claims onExternal assets developing countriesb
Share of Share ofTotal total assets total assets
Country assetsa Amount (percent) Amount (percent)
Austria 423 91 22 33 8Bahamas 316 244 77 61c 19Bahrain 100 92 92 46c 46Belgium 806 309 38 26 3Canada 720 98 14 31 4Denmark 244 58 24 6 2Finland 121 31 25 4 3France 2486 607 24 135 5Germany 4535 901 20 240 5Ireland 423 160 38 2 0Italy 1345 191 14 47 4Japan 8460 1199 14 258 3Luxembourg 821 495 60 124c 15Netherlands 1080 296 27 67 6Norway 157 14 9 3 3Singapore 574 405 70 202c 35Spain 889 124 14 57 6Sweden 348 67 19 12 2Switzerland 1632 709 43 177c 11United Kingdom 5802 1990 34 138 2United States 6223 889 14 144 2
Total for all BISreporting countries 37506 8968 24 1813 5
Total for G-10 34326 7378 21 1331 4
BIS = Bank for International SettlementsG-10 = Group of Ten countries see note to table 11
a Total assets are calculated as banking institutions (deposit institutions) reserve claims onthe public sector claims on the private sector (lines 20 21 22 from IFS) plus externalassets Figures are converted into US dollars using the market exchange rate at the end ofJune 2000b Developing countries are countries other than Andorra Australia Austria Belgium CanadaCyprus Denmark Finland France Germany Gibraltar Greece Iceland Ireland Italy JapanLiechtenstein Luxembourg Malta Netherlands New Zealand Norway Portugal Spain Swe-den Switzerland Turkey the United Kingdom the United States the Vatican City State andthe former Yugoslaviac These countries do not disclose their claims on developing countries Such claims arearbitrarily (and generously) estimated at half the external assets of commercial banks in Bahrainand Singapore and a quarter of the external assets of banks in the Bahamas Luxembourgand Switzerland
Sources IMF International Financial Statistics (IFS) November 2000 Bank for InternationalSettlements BIS Quarterly Review November 2000 httpwwwbisorg
Institute for International Economics | httpwwwiiecom
THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 85
global capitalism In addition to their underwriting role investment banksearn substantial profits from trading securities
Wealth-management firms are the second group of portfolio institu-tions They typically deal with the publicmdashindividuals and companiesthat want a trusted firm to manage their pensions and other funds Table24 lists 10 large wealth managers all based in the G-10 Together these10 firms control $64 trillion in assets and their own market capitalization
Table 23 Large investment banks 1998 (billions of dollars)
MarketRevenue Assets capitalizationa
Merrill Lynchb (United States) 36 300 25Morgan Stanley Dean Witterb (United States) 31 318 50c
Goldman Sachs (United States) 22d 217e 29c
Lehman Brothers Holdingsb (United States) 20 154 10c
Salomon Smith Barneyf (United States) 8 211 naCredit Suisse First Bostong (United States
Switzerland) 7 280 naPaine Webberh (United States) 7 54 6i
Bear Stearnsj (United States) 8 154 5i
Donaldson Lufkin amp Jenrettek (United States) 5 72 7i
Total 144 1760 132 plusTotal for G-10 144 1760 132 plus
na = not available (subsidiaries of large holding companies Citigroup and Creacutedit SuisseGroup respectively individual market capitalization is not available)G-10 = Group of Ten countries see note to table 11
a Market capitalization is calculated by multiplying the total number of shares by the shareprice at the companyrsquos fiscal year-endb Source Fortune Global 500 1999 Data shown are for the fiscal year ended on or before31 March 1999 Assets shown are those at the companyrsquos fiscal year-end httpwwwpathfindercomfortuneglobal500indexhtmlc Figures as of September 1999 are from American Banker httpwwwamericanbankercomBankRankingsd Source 1998 Goldman Sachs Annual Review Assets as of November 1998 httpwwwgscomaboutannual19984_fsindexhtmle Source Financial Times Company Financials Revenue as of 27 November 1998 httpwwwglobalarchiveftcomcbcb_searchhtmf Source 1998 Citigroup Annual Report 20 Revenue figures for year ending 31 December1998 Asset figures as of 31 December 1998 httpwwwcitigroupcomcitigroupfindatac1998ar2pdfg Source 19981999 Creacutedit Suisse Group Annual Report 23 httpwwwcsgchcsg_annual_report_98downloadcsg_ar98_p1_enpdfh Source 1998 Paine Webber Annual Report 34-35 httpwwwpainewebbercomannual98graphicsfininfoindexhtmi Individual figures are obtained from Yahoo The time for valuations is as follows BearStearns December 1999 Lehman Brothers November 1999 Paine Webber and DonaldsonLufkin amp Jenrette September 1999j Source 1999 Bear Stearns Annual Report 55-56 Figures are for fiscal year ending 30June 1998 httpwwwbearstearnscomcorporateinvestorindexhtmk Source 1999 Donaldson Lufkin and Jenrette Annual Report ldquoFinancial Highlightsrdquo httpwwwdljcompdfDLJ98_1pdf
Institute for International Economics | httpwwwiiecom
86 WORLD CAPITAL MARKETS
exceeds $260 billion For the most part wealth managers are long-termportfolio investors
Hedge funds represent a highly specialized investment vehicle that isnot widely available to the public Most hedge funds are leveraged theyemploy dynamic (and sometimes opportunistic) trading strategies involvingpositions in several different markets they adjust their investment port-folios frequently in anticipation of asset price movements or changes inyield differentials between related securities Hedge funds are opaque tomarket monitoring They are subject to little direct regulation and areunder few obligations to disclose information Hence the size of the in-dustry is difficult to measure
If they are measured by capital under management or by assets hedgefunds are small relative to established wealth managers As table 25shows the capital managed by 20 large hedge funds in late 1998 amountedto less than $50 billion Estimates vary widely but if all hedge funds arecounted their assets range from $100 to $300 billion Even the highestnumber is less than 5 percent of the combined assets of investment banksand traditional asset managers
The amount of leverage used by hedge funds depends on trading strate-gies that are in turn shaped by investor attitudes toward risk Leverage
Table 24 Large asset managers in 1998 (billions of dollars)
Total assets under Marketmanagementa capitalizationb
UBS (Switzerland) 1145 58c
Fidelity Investments (United States) 773 naKampo (Japan) 698 naCredit Suisse Group (Switzerland) 680 50c
AXA Group (France) 647 39c
Barclayrsquos Global Investors (United States) 616 44c
Merrill Lynch amp Co (United States) 501 25c
State Street Global Advisors (United States) 493 naCapital Group Cos (United States) 424 naZurich Financial Services (Switzerland) 415 45c
Total 6392 261 plusTotal for G-10 6392 261 plus
na = not available (usually a nonpublic company)G-10 = Group of Ten countries see note to table 11
a Figures are assets under management at fiscal year-end 1998b Market capitalization is calculated by multiplying the total number of shares by the shareprice at the companyrsquos fiscal year-endc Figures from American Banker httpwwwamericanbankercomBankRankings
Sources Institutional Investor 1999 httpwwwiimagazinecomresearchinterfacehtml US(II300) Asia (Asia200) and Europe (Euro100) Asset Management Rankings American BankerhttpwwwamericanbankercomBankRankings
Institute for International Economics | httpwwwiiecom
THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 87
is achieved using such instruments as repos (repurchase agreements)futures and forward contracts and other derivative products5 It is alsovery difficult to measure A Financial Stability Forum (FSF 2000b) studyof hedge funds noted thatmdashalthough there are problems with the waydata vendors report these positionsmdashestimates suggest most hedge fundsuse modest amounts of leverage averaging 21 but ranging to 41 insome FSF (2000b) further notes difficulties with evaluating the risk-adjusted performance of hedge funds because of their dynamic tradingstrategies
Table 25 Largest hedge funds according tocapitalization August 1998 (billions of dollars)
Fund Capital under management
Domestica
Tiger 51Moore Global Investment 40Highbridge Capital Corp 14Intercap 13Rosenberg Market Neutral 12Ellington Composite 11Hedged Taxable-Equivalent 10Quantitative LongShort 09Sr International Fund 09Perry Partners 08
OffshoreJaguar Fund NV 100Quantum Fund NV 60Quantum Industrial Fund 24Quota Fund NV 17Omega Overseas Partners 17Maverick Fund 17Zweig Dimenna International 16Quasar International Fund NV 15SBC Currency Portfolio 15Perry Partners International 13
Totalb 471
a Long Term Capital Management (LTCM) was in serious difficulty in August1998 and is omitted from the listb Estimates of hedge fund capital and the number of funds vary significantlyMARHedge estimated 1115 funds with $109 billion capital under managementat the end of 1997 Van Hedge Fund estimated 5500 funds with capital of $295billions at the same date
Source Adapted from Eichengreen (1999a)
5 Positions are established by posting margins rather than the face value of the position
Institute for International Economics | httpwwwiiecom
88 WORLD CAPITAL MARKETS
The positive role of hedge fundsmdashproviding diversification to inves-tors because their returns have low correlations with standard asset classesmdashis counterbalanced by some negative features Hedge funds and otherhighly leveraged institutions (HLIs) may take concentrated positions andengage in aggressive market practices that amount to ldquoganging uprdquo on asmall economy (such as Hong Kong)6 Under normal market conditionsHLI positions are not destabilizing but some of the aggressive practicesdocumented in 1998 are worrisome The FSF study group participantsagreed (2000b 112) that such practices raise important issues for marketintegrity but they could not agree that market manipulation was suffi-ciently widespread to be a serious concern for policymakers
Insurance companies are the third group of portfolio institutions Theseare divided into two categories property and casualty companies andlife and health insurance companies Ten large companies of each cat-egory are listed in table 26 In 1998 the 10 property and casualty insur-ance companies had $16 trillion in assets and more than $330 billion inmarket capitalization The 10 life insurance companies had $28 trillionin assets7 Combining both categories 100 percent of assets are controlledby insurance companies based in the G-10 and Spain In portfolio man-agement styles life insurance companies tend to hold longer-term assetswhereas property and casualty companies tend to hold shorter-term in-struments
Nonfinancial Multinational Enterprises
The last players are the nonfinancial multinational enterprises (MNEs)The worldrsquos 100 largest corporations measured by 1998 revenue are re-corded in tables 27 and 28 The 30 financial giants among the top 100are separately shown in table 27 Most of the firms appeared in previ-ous tables Together these 30 financial giants had revenues of $13 tril-lion and controlled assets of $113 trillion8
Table 28 lists the 70 top nonfinancial giants Their revenues in 1998were $40 trillion and their assets (at book value) measured $45 trillionMeasured by revenue or assets about 95 percent of the giants are basedin the G-10 These firms are responsible for a large share of the worldrsquos
6 See IMF (1999c) for a description of the ldquodouble playrdquo that hedge funds are accusedof using in an attempt to destabilize Hong Kong in August 1998
7 Many life insurance companies are owned by their policyholders and therefore donot have a market capitalization
8 By comparison the larger set of 96 financial firms listed in previous tables controlled$322 trillion in assets This is the total amount of assets recorded in tables 21 (50 com-mercial banks) 22 (9 investment banks) 24 (10 asset managers) and 26 (20 insurancecompanies) The largest hedge funds might add $300 billion to the total
Institute for International Economics | httpwwwiiecom
THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 89
Table 26 20 large insurance companies in 1998(billions of dollars)
Property and casualty insurance Marketcompanies Revenuea Assetsb capitalizationc
Allianz (Germany) 65 402 62d
Assicurazioni Generali (Italy) 48 178 30d
State Farm Insurance Cos (United States) 45 111 naZurich Financial Services (Switzerland) 39 215 45d
CGU (United Kingdom) 38 176 20d
Munich Re Group (Germany) 35 131 naAmerican International Group (United States) 33 194 135d
Allstate (United States) 26 88 20d
Royal amp Sun Alliance (United Kingdom) 25 76 11d
Loews (United States) 21 71 7e
Total 375 1642 330 plusTotal for G-10 375 1642 330 plus
MarketLife and health insurance Revenuea Assetsb capitalizationc
AXA (France) 79 452 39d
Nippon Life Insurance (Japan) 66 363 naING Group (Netherlands) 56 464 46d
Dai-ichi Mutual Life Insurance (Japan) 44 253 naSumitomo Life Insurance (Japan) 40 206 naTIAA-CREF (United States) 36 250 naPrudential Ins Co of America (United States) 34 279 naPrudential (United Kingdom) 34 197 30d
Meiji Life Insurance (Japan) 28 146 naMetropolitan Life Insurance (United States) 27 215 na
Total 444 2825 naTotal for G-10 444 2825 na
na = not available (usually an insurance company owned by its policyholders)G-10 = Group of Ten countries see note to table 11
a Data shown are for the fiscal year ended on or before 31 March 1999b Assets shown are those at the companyrsquos fiscal year-endc Market capitalization is calculated by multiplying the total number of shares by the shareprice at the companyrsquos fiscal year-endd Market capitalization data as of September 1999 from American Banker httpwwwamericanbankercome Individual companyrsquos market capitalization as of September 1999 from Yahoo yahoomarketguidecom
Sources Fortune Global 500 1999 httpwwwpathfindercomfortuneglobal500indexhtmlAmerican Banker httpwwwamericanbankercomRankingBanks1999 Yahoo Marketguideyahoomarketguidecom
Institute for International Economics | httpwwwiiecom
90 WORLD CAPITAL MARKETS
Table 27 Financial firms in the 100 largest companiesby revenue 1998 (billions of dollars)
Globalrank Company Revenuesa Assetsb Type
Continental Europe
15 AXA (France) 79 452 Insurance23 Allianz (Germany) 65 402 Insurance28 Ing Group (Netherlands) 56 464 Insurance37 Credit Suisse (Switzerland) 49 475 Banks commercial
and savings39 Assicurazioni Generali (Italy) 48 178 Insurance42 Deutsche Bank (Germany) 45 736 Banks commercial
and savings56 Zurich Financial Services (Switerland) 39 215 Insurance68 Munich Re Group (Germany) 35 131 Insurance72 ABN AMRO Holding (Netherlands) 34 507 Banks commercial
and savings77 Credit Agricole (France) 33 459 Banks commercial
and savings80 HypoVereinsbank (Germany) 32 541 Banks commercial
and savings84 Fortis (Belgium) 31 397 Banks commercial
and savings98 Socieacuteteacute Geacuteneacuterale (France) 30 450 Banks commercial
and savingsUnited Kingdom
47 HSBC Holdings 43 485 Banks commercialand savings
58 CGU 38 176 Insurance74 Prudential 34 197 Insurance
United States
16 Citigroup 76 669 Diversified financials35 Bank of America Corp 51 618 Banks commercial
and savings44 State Farm Insurance Cos 45 111 Insurance64 TIAA-CREF 36 250 Insurance67 Merrill Lynch 36 300 Securities71 Prudential Ins Co of America 34 279 Insurance76 American International Group 33 194 Insurance79 Chase Manhattan Corp 32 366 Banks commercial
and savings83 Fannie Mae 31 485 Diversified financials88 Morgan Stanley Dean Witter 31 318 Securities
Japan
21 Nippon Life Insurance 66 363 Insurance45 Dai-ichi Mutual Life Insurance 44 253 Insurance54 Sumitomo Life Insurance 40 206 Insurance91 Bank of Tokyo-Mitsubishi 31 664 Banks commercial
and savingsTotal 1279 11341Total for G-10 1279 11341
G-10 = Group of Ten countries see note to table 11
a Data shown are for the fiscal year ended on or before 31 March 1999b Assets shown are those at the companyrsquos fiscal year-end
Source Fortune Global 500 1999 httpwwwpathfindercomfortuneglobal500indexhtml
Institute for International Economics | httpwwwiiecom
THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 91
Tab
le 2
8N
on
fin
anci
al f
irm
s in
th
e 10
0 la
rges
t co
mp
anie
s b
y re
ven
ue
199
8 (b
illio
ns o
f do
llars
)
Glo
bal
Tra
nsn
atio
nal
ity
ran
k
Co
mp
any
Rev
enu
esa
Ass
etsb
ind
exc
Typ
e
Co
nti
nen
tal
Eu
rop
e
2D
aim
lerC
hrys
ler
(Ger
man
y)15
516
044
1M
otor
veh
icle
s an
d pa
rts
11R
oyal
Dut
chS
hell
Gro
up (
Net
herla
nds)
9411
058
9P
etro
leum
ref
inin
g17
Vol
ksw
agon
(G
erm
any)
7670
568
Mot
or v
ehic
les
and
part
s22
Sie
men
s (G
erm
any)
6667
521
Ele
ctro
nics
el
ectr
ical
equ
ipm
ent
32M
etro
(G
erm
any)
5222
n
a
Foo
d an
d dr
ug s
tore
s34
Fia
t (I
taly
)51
7640
8M
otor
veh
icle
s an
d pa
rts
36N
estle
(S
witz
erla
nd)
5041
932
Foo
d46
Veb
a G
roup
(G
erm
any)
4351
275
Tra
ding
49R
enau
lt (F
ranc
e)41
4545
7M
otor
veh
icle
s an
d pa
rts
53D
euts
che
Tel
ekom
(G
erm
any)
4093
n
a
Tel
ecom
mun
icat
ions
57R
oyal
Phi
lips
Ele
ctro
nics
(N
ethe
rland
s)38
3386
4E
lect
roni
cs
elec
tric
al e
quip
men
t59
Peu
geot
(F
ranc
e)38
4038
7M
otor
veh
icle
s an
d pa
rts
62E
lect
riciteacute
de
Fra
nce
(Fra
nce)
3711
3
na
Util
ities
ga
s an
d el
ectr
ic63
Rw
e G
roup
(G
erm
any)
3747
n
a
Util
ities
ga
s an
d el
ectr
ic65
BM
W (
Ger
man
y)36
3660
7M
otor
veh
icle
s an
d pa
rts
66E
lf A
quita
ine
(Fra
nce)
3643
576
Pet
role
um r
efin
ing
69V
iven
di (
Fra
nce)
3558
n
a
Eng
inee
ring
and
cons
truc
tion
70S
uez
Lyon
nais
e de
s E
aux
(Fra
nce)
3585
n
a
Ene
rgy
78E
NI
(Ita
ly)
3249
317
Pet
role
um r
efin
ing
86B
ayer
(G
erm
any)
3134
827
Che
mic
als
92A
BB
Ase
a B
row
n B
over
i (S
witz
erla
nd)
3132
957
Ele
ctro
nics
el
ectr
ical
equ
ipm
ent
93B
AS
F (
Ger
man
y)31
3159
5C
hem
ical
s95
Car
refo
ur (
Fra
nce)
3020
n
a
Foo
d an
d dr
ug s
tore
s
(tab
le c
ontin
ues
next
pag
e)
Institute for International Economics | httpwwwiiecom
92 WORLD CAPITAL MARKETS
Tab
le 2
8N
on
fin
anci
al f
irm
s in
th
e 10
0 la
rges
t co
mp
anie
s b
y re
ven
ue
199
8 (b
illio
ns o
f do
llars
) (c
ontin
ued
)
Glo
bal
Tra
nsn
atio
nal
ity
ran
k
Co
mp
any
Rev
enu
esa
Ass
etsb
ind
exc
Typ
e
Un
ited
Kin
gd
om
19B
P A
moc
o68
8559
2P
etro
leum
ref
inin
g43
Uni
leve
r45
3692
4F
ood
Un
ited
Sta
tes
1G
ener
al M
otor
s16
125
729
3M
otor
veh
icle
s an
d pa
rts
3F
ord
Mot
or14
423
835
2M
otor
veh
icle
s an
d pa
rts
4W
al-M
art
Sto
res
139
49
na
G
ener
al m
erch
andi
sers
8E
xxon
101
9365
9P
etro
leum
ref
inin
g9
Gen
eral
Ele
ctric
100
356
331
Ele
ctro
nics
el
ectr
ical
equ
ipm
ent
14In
tl B
usin
ess
Mac
hine
s82
8653
7C
ompu
ters
of
fice
equi
pmen
t25
US
Pos
tal
Ser
vice
6055
n
a
Mai
l pa
ckag
e a
nd f
reig
ht d
eliv
ery
27P
hilip
Mor
ris58
6051
1T
obac
co29
Boe
ing
5637
n
a
Aer
ospa
ce30
AT
ampT
5460
219
Tel
ecom
mun
icat
ions
40M
obil
4843
597
Pet
role
um r
efin
ing
41H
ewle
tt-P
acka
rd47
3451
1C
ompu
ters
of
fice
equi
pmen
t50
Sea
rs R
oebu
ck41
38
na
G
ener
al m
erch
andi
sers
55E
I d
u P
ont
de N
emou
rs39
40
na
C
hem
ical
s61
Pro
ctor
and
Gam
ble
3731
477
Soa
ps
cosm
etic
s75
Km
art
3414
n
a
Gen
eral
mer
chan
dise
rs81
Tex
aco
3229
453
Pet
role
um r
efin
ing
82B
ell
Atla
ntic
3255
n
a
Tel
ecom
mun
icat
ions
85E
nron
3129
n
a
Ene
rgy
87C
ompa
q C
ompu
ter
3123
n
a
Com
pute
rs
offic
e eq
uipm
ent
89D
ayto
n H
udso
n31
16
na
G
ener
al m
erch
andi
sers
94J
C
Pen
ney
3124
n
a
Gen
eral
mer
chan
dise
rs96
Hom
e D
epot
3013
n
a
Spe
cial
ty r
etai
lers
97Lu
cent
Tec
hnol
ogie
s30
27
na
E
lect
roni
cs
elec
tric
al e
quip
men
t10
0M
otor
ola
2929
n
a
Ele
ctro
nics
el
ectr
ical
equ
ipm
ent
Institute for International Economics | httpwwwiiecom
THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 93
Jap
an
5M
itsui
109
5635
8T
radi
ng6
Itoch
u10
957
333
Tra
ding
7M
itsub
ishi
107
7536
9T
radi
ng10
Toy
ota
Mot
or10
012
540
0M
otor
veh
icle
s an
d pa
rts
12M
arub
eni
9455
300
Tra
ding
13S
umito
mo
8946
259
Tra
ding
18N
ippo
n T
eleg
raph
amp T
elep
hone
7614
7
na
Tel
ecom
mun
icat
ions
20N
issh
o Iw
ai68
3938
8T
radi
ng24
Hita
chi
6282
214
Ele
ctro
nics
el
ectr
ical
equ
ipm
ent
26M
atsu
shita
Ele
ctric
Ind
ustr
ial
6067
332
Ele
ctro
nics
el
ectr
ical
equ
ipm
ent
31S
ony
5353
628
Ele
ctro
nics
el
ectr
ical
equ
ipm
ent
33N
issa
n M
otor
5158
511
Mot
or v
ehic
les
and
part
s38
Hon
da M
otor
4943
641
Mot
or v
ehic
les
and
part
s48
Tos
hiba
4151
252
Ele
ctro
nics
el
ectr
ical
equ
ipm
ent
51F
ujits
u41
4332
6C
ompu
ters
of
fice
equi
pmen
t52
Tok
yo E
lect
ric P
ower
4012
2
na
Util
ities
ga
s an
d el
ectr
ic60
NE
C37
42
na
E
lect
roni
cs
elec
tric
al e
quip
men
t90
Tom
en31
18
na
T
radi
ng99
Mits
ubis
hi E
lect
ric30
35
na
E
lect
roni
cs
elec
tric
al e
quip
men
t
Ch
ina
73S
inop
ec34
52
na
P
etro
leum
ref
inin
g
Tot
al (
aver
age
for
tran
snat
iona
lity
inde
x)3
988
447
949
0T
otal
for
G-1
0 (a
vera
ge f
or t
he i
ndex
)3
954
442
749
0
na
= n
ot a
vaila
ble
G-1
0 =
Gro
up o
f T
en c
ount
ries
see
not
e to
tab
le 1
1
a
Dat
a sh
own
are
for
the
fisca
l ye
ar e
nded
on
or b
efor
e 31
Mar
ch 1
999
b
Ass
ets
show
n ar
e th
ose
at t
he c
ompa
nyrsquos
fis
cal
year
-end
c
The
ind
ex o
f tr
ansn
atio
nalit
y is
cal
cula
ted
as t
he a
vera
ge o
f ra
tios
of f
orei
gn a
sset
s to
tot
al a
sset
s f
orei
gn s
ales
to
tota
l sa
les
and
for
eign
em
ploy
men
tto
tot
al e
mpl
oym
ent
as o
f 19
97 (
UN
CT
AD
)
Sou
rces
F
ortu
ne G
loba
l 50
0 1
999
http
w
ww
pat
hfin
der
com
fort
une
glob
al50
0in
dex
htm
l U
NC
TA
D (
1999
)
Institute for International Economics | httpwwwiiecom
94 WORLD CAPITAL MARKETS
foreign direct investment The ldquotransnationality indexrdquo (table 28) showsthat on average they conducted about half their business outside theirhome country9
Overview of the Players
Our review of the major players points to two major features First ahandful of big playersmdashfewer than 200 firms all toldmdashcontrol the ac-tion in international capital markets Their dominance will doubtless erodebut for now financial power is strikingly concentrated with them Sec-ond the big players are overwhelmingly based in the G-10 countriesplus Spain The responsibility to supervise them rests not in the IMFnor in Basel but squarely in Washington London Tokyo and the otherG-10 capitals At year-end 1999 the G-10 countries plus Spain accountedfor 84 percent of world banking assets 86 percent of world stock marketcapitalization and 76 percent of international debt securities (BIS 2000aWorld Bank 2000b)
International private capital flows are of three types bank loans anddeposits portfolio investment and foreign direct investment In cumula-tive total flows to emerging markets FDI was the biggest story in the1990s amounting to $954 billion (table 12) Portfolio flows were nextcumulatively amounting to somewhere between $612 billion (table 12)and $764 billion (table A1) Bank loans and deposits are the most com-plicated story
The Key Role of Banks
Banks are more important as an epicenter than as a wellspring Banksgenerate waves in the flow of capital to emerging markets rather than acontinuous steady stream According to data compiled by the Institute ofInternational Finance (table A1) net bank lending to emerging marketscumulated to $269 billion in the 1990s However deposits by emerging-market residents in G-10 banks more than offset G-10 bank lending tothese countries during the decade According to IMF data cumulativebank loans net of deposits amounted to a negative $135 billion (table 12)
In other words when loans and deposits are combined net bank ac-tivity that moves financial resources to emerging markets is small incomparison with portfolio investment and FDI But bank loans are thelubricant of any financial system Depending on circumstances bankscan be shock absorbers or shock propagators In recent decades with
9 The transnationality index is calculated as a simple average of the share of assetssales and employees outside the home country
Institute for International Economics | httpwwwiiecom
THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 95
respect to emerging markets banks have more often been propagatorsthan absorbers The average annual swing in bank lending to emergingmarkets was nearly $50 billionmdashby far the largest source of year-to-yearfluctuations in capital flows Both interbank loans between Europe Japanand Asia and sovereign Russian debt used as loan collateral played amajor role in the 1997-98 crisesmdashnot because banks are profligate playersbut because of the incentives they face and the instruments they useAccordingly our story begins with banks
Banks in the Modern Financial System
10 See Levine (2000) for a concise description of the role of banks in the financial system
11 The asymmetric information problem helps to explain why banks dominate the im-mature financial systems of emerging-market economies The general lack of informationon borrowers and undeveloped legal systems to enforce contracts hamper suppliers oflong-term financial instruments such as equities and bonds in evaluating risk and re-ward Banks are best suited in these circumstances to solve the asymmetric informationproblem by evaluating and monitoring private loans As more and better informationbecomes available capital markets develop and financial systems mature
As we noted in the previous paragraph the problem of financial volatil-ity in emerging-market economies is associated with bank lending Ifand when repayment problems arise cross-border private bank loansand bond placements are such that private creditors have no plausiblemeans of seizing assets from either private or sovereign borrowers Thusalthough international finance can nourish entrepreneurs and accelerategrowth a necessary complement may be a drastic creditor response inthe event of nonpaymentmdashto withhold fresh funds and force an eco-nomic crisis (Dooley 2000)
This argument is based on the characteristics of banks They are notldquobadrdquo per se They perform three essential functions in any financialsystem pooling the resources of disparate savers and channeling these re-sources into productive investment improving resource allocation throughtheir expertise in assessing and monitoring borrowers and facilitatingthe division of risk among numerous creditors10 But by their very na-ture banks are prone to two problems asymmetric information (the bor-rower knows more about the potential risk and return of its projectsthan the bank) and adverse selection (riskier borrowers will pay higherinterest rates and thus may constitute a disproportionate share of bankloan portfolios)11
Bank loans are illiquid fixed-price instruments They cannot easily beconverted to cash although they can be bundled into securities (knownas ldquosecuritizationrdquo) Once loan terms have been agreed on the only waya bank can adjust for shifting market conditions is by changing the quantityof its exposure When a borrower runs into trouble the bank can mix
Institute for International Economics | httpwwwiiecom
96 WORLD CAPITAL MARKETS
and match from two unpleasant menus It can roll over existing loansand extend new credit or it can call some part of existing loans andattempt to recover the principal It can also hedge by selling short otherclaims on the borrower These choices entail either an unwelcome exten-sion of the bankrsquos exposure or credit rationing against the borrower Whentrouble brews all banks encounter the same conditions in the aggregatethey prefer less exposure and ensuing credit restrictions lead to volatilebank lending
Innovation
12 Derivatives have no value of their own They ldquoderiverdquo their value from the value ofthe underlying asset They include swaps futures (contracts for future delivery at speci-fied prices) and options (which give one party the right but not the obligation to buyfrom or sell to a counterparty at an agreed price)
13 Maxfield (1998) analyzed available evidence of emerging-market investor objectivesmost of it before the crisis Analysis of portfolio equity flows is sensitive to the choice ofperiod with year-over-year data indicating that investors respond to country ldquofundamen-talsrdquo Other evidence suggests more ambiguity Ranking by ldquoinvestor impatiencerdquo ie thesearch for yield over value Tesar and Werner (1995) find short-term bank flows to be themost yield driven followed by portfolio investment FDI and long-term bank lending
14 Because market risk credit risk and country risk interact in complex ways newfinancial instruments have been created to help reduce negative interactions One is theldquototal return swaprdquo which has become an instrument of choice for hedge funds lookingfor high leverage Banks also use the total return swap to cover risks without increasingtheir capital requirements
Since the 1980s national and international banking systems have beentransformed by deregulation intensified competition and the informationand communications-technology revolutions The market environment isone of intense competition particularly in traditional banking activitiesThe innovations point away from traditional activities of plain vanilladeposit taking and loan making Three big themes are discernible Firstthe walls separating commercial banks investment banks portfolio man-agers and insurance firms are falling even if they are still distinct Sec-ond large banks are shifting toward securitizationmdashcreating securitiesout of everything from credit card debt to trade finance to disaster insur-ancemdashand earning fees in the process Third all large banks are shiftingtoward trading activity making markets and taking short-term stakes inbonds shares and derivatives12 These activities when successful satisfythe search for higher yields13
Many of the new financial instruments that banks trade are ldquooff bal-ance sheetrdquo This means that banks are not required to allocate capitalagainst them In swap contracts for example neither side pays cash at theoutset and therefore neither party has an asset in the traditional sense14
Futures and options contracts can be written with a relatively small initial
Institute for International Economics | httpwwwiiecom
THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 97
margin relative to the potential risk Credit derivatives limit credit risk bytransferring the potential loss associated with corporate loans and bondssovereign debt and other loan portfolios to counterparties15
Deregulation and innovation working in combination seem to havepushed banks into trading activity and leveraged plays but not into shareownershipmdasheven in jurisdictions that have no prohibition against equitystakes Among the G-10 banking systems the highest ratio of share own-ership to assets was only 5 percent in 1996 reached in Germany andJapan (Berlin 2000)16
The wave of innovation in financial instruments and the accompany-ing expansion of banking beyond its old boundaries is a two-edged swordOn one side it allows risk management far beyond what was tradition-ally possible Risk can now be shifted from firms that can ill afford lossesto those that can Banks can profitably act as intermediaries in shiftingrisk On the other side the innovation wave creates huge opportunitiesfor leveraged plays fostering a speculative search by banks themselvesfor high returns that in turn magnify their own risks17
15 Credit derivatives include total return swaps credit default swaps credit-linked notesand collateralized debt obligations They are the fastest-growing sector of the global de-rivatives market
16 Banks seem to specialize in lending even when they are allowed to mix finance andcommerce for reasons related both to how they are expected to behave with distressedfirms and to other intricacies of lender liability (Berlin 2000) Yet a recent cross-countrystudy found that restrictions on banking and commerce are associated with greater fi-nancial instability (Barth Caprio and Levine 2000)
17 Leverage is the magnification of the rate of return (positive or negative) on an in-vestment beyond the rate obtained by solely investing funds owned by the institution Itis often defined as the ratio of assets to equity Leverage is achieved by increasing thesize of an investment by borrowing or using derivative instruments such as futures oroptions These allow investors to earn a return on the notional amount underlying thecontract by committing a small portion of equity in the form of a margin deposit oroption premium payment
18 In a repo (repurchase agreement) one party (typically a trader) buys a bond andsells it to a dealer for cash with a promise to buy it back the next day at the same priceplus the overnight interest rate As long as the overnight interest rate is lower than theinterest accruing on the bond the trader earns some income on the bond The extremeform of these kinds of transactions was discovered at LTCM the failed US highly lever-aged institution which appears to have controlled more than $120 billion in assets froman investment of about $3 billion This leveraging was accomplished mostly through theuse of repos (Mayer 1999)
The potential for damage is illustrated in an extreme form by figure 21To precisely measure a firmrsquos leverage all positions must be known andrealistically valuedmdashwhich may be impossible to do Because many ac-tivitiesmdashsuch as repos18 and derivativesmdashdo not appear on the institutionrsquos
Leverage
Institute for International Economics | httpwwwiiecom
98W
OR
LD
CA
PIT
AL
MA
RK
ET
S
Figure 21 Hypothetical example of leverage
$1000 notional value of call option on equity in firms targeted for takeover
Repo FRN into cash and use cash to pay option premium
(repro is initially collateralized
Borrow $100 for margin purchase
$125 of US investment bank floating-rate notes (FRN) (secured by $25 equity in FRNs)
Repo off-the-run bond into cash and post margin
(repo is initially collateralizedSell (short) Borrow on-the-run bonds worth $20
$25 worth of off-the-run bonds (secured by $5 equity in bonds)
Exchange into $4
Cash $5 yen400 Japanese bank loans
$1 equity base
FRN = floating rate notesRepo = repurchase agreement
Source IMF (1998)
Institute for International Econom
ics | httpww
wiiecom
THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 99
balance sheet and because balance sheets are published quarterly at bestoutsiders have a difficult time assessing the extent of a firmrsquos leverage19
Leveraging by a single firm enhances its risk of default the widespreaduse of leverage in the financial system can magnify market adjustmentsespecially when they require ldquodeleveragingrdquomdashunwinding prior positionsRapid adjustments can cause credit to dry up and asset prices to plummetIn a mark-to-market environment falling asset prices trigger calls foradditional collateral that can ripple through markets
Risk Management
Because it is confronted with the widespread use of leverage and prolif-erating kinds of risk international finance is increasingly driven by riskevaluation and control20 Different institutions face various risk profilesand differing kinds of risk The most common risks can be quickly tickedoff Banks because of their traditional intermediary role of channelingthe resources from savers to borrowers face significant credit risk therisk of default or delay in the payment of principal and interest Theymust also manage market risk the risk that the prices of their liabilitiesmay change faster than their assets Market risk devastated US savingsand loan institutions in the late 1980s
Closely associated with market risk are interest-rate risk (unexpectedchanges in market interest rates that slash margins net income and theeconomic value of a bankrsquos equity) and foreign exchange risk (losses thatarise when assets denominated in an appreciating foreign currency areless than liabilities denominated in that currency) Banks make numer-ous loans to other banks around the world portfolio investors buy se-curities direct investors acquire fixed assets and all incur country risk(economic and political uncertainty in the host country) During the heightof the Asian crisis for example interbank loans to Japanese banksreflected the credit risk of lending to these banks the so-called Japanpremium
Substantial attention has been lavished on country risk analysis sincethe 1982 debt crisis in developing countries Yet in spite of this exper-tise the Asian crisis occurred in part because of a sudden upward reap-praisal of country risk after the Thai baht collapsed in April 1997 Banksand other financial institutions must also manage liquidity risk the riskthat market conditions will change unexpectedly depressing demand andprices of assets at the time they want to sell these assets And they mustmanage operational riskmdashfailures in control systems or people that cause
19 Another example of asymmetric information Both risk and leverage are difficult foroutsiders to assess without full timely disclosure
20 A longer discussion of these issues can be found in Managing Global Finance in IMF(1999c)
Institute for International Economics | httpwwwiiecom
100 WORLD CAPITAL MARKETS
financial loss or damage reputations Operational risk devastated BaringsBank in 1995
Financial institutions practice risk management to measure all theserisks the potential damage to their investment positions and ultimatelythe chance of becoming insolvent VAR (value at risk) risk models mea-sure subject to certain assumptions the amount of the firmrsquos capital thatis exposed in each period For example the VAR model might say thatin a 3-standard-deviation worst case (a case that is not supposed to hap-pen more than 1 percent of the time) the firm will loose 25 percent of itscapital during the next year
VAR models are widely used but like all models they have weak-nesses They rely on past values to estimate key variables in financialmarkets past values are not always good predictors of future risks More-over rising volatility and higher loss correlation among different assetclasses in a portfolio will cause all banks using these models to reducetheir exposures at the same time by switching to less volatile and lesscorrelated assets such as US Treasury bills (Persaud 2000)
Newer risk models entail stress testing and scenario analysis Scenarioanalysis envisages possible adverse changes one at a time that mightaffect the investment portfolio Stress testing estimates potential losseswhen several individual risk factors simultaneously move against thefirm but it too uses historical probabilities
Financial Volatility
21 For example derivative markets usually rely on underlying securities markets thatproduce continuous prices When these markets are interrupted financial shocks cantrigger a cascade of margin calls and sell orders that move prices very sharply
22 See IIF (1999a)
The combination of trading activity and modern risk management lie atthe root of financial volatility When risks increase banks must eitherraise more capital to cover the greater risk or reduce their exposure bycutting loan exposure by selling securities or by undertaking new de-rivative trades Raising more capital is time-consuming and in a crisisvery expensive because bank shares are depressed So banks look to theother alternatives If the bank can reduce lending it need not book aloss But most banks use the same VAR models and as indicated abovethese models will encourage them to reduce their outstanding loans atthe same time actually magnifying loan volatility
If banks attempt to reduce their exposure to risk by selling securitiesor undertaking new derivative trades they may trigger large priceshocks because of limited and shrinking market liquidity21 The liquid-ity problem is compounded when a small number of large institu-tions hold the same positions22 Take your pick loan volatility or price
Institute for International Economics | httpwwwiiecom
THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 101
volatility As two experts have observed (Folkerts-Landau and Garber1998)
[V]olatility even in one country will automatically generate an upward re-estimate of credit and market risk in a correlated country triggering automaticmargin calls and tightening of credit lines Thus apparently bizarre opera-tions that connect otherwise disconnected securities markets are not the re-sponses of panicked green screen traders arbitrarily driving economies from agood to a bad equilibrium Rather they work with relentless predictability andunder the seal of approval of supervisors in the main financial centers
23 See Ferguson (1999)
24 As Gerald Corrigan (1982) put the matter ldquoBanks are specialrdquo Corrigan (2000) reit-erated this view even after all the changes of the past two decades Unlike other institu-tions banks offer on-demand transactions are a backup liquidity source for other insti-tutions and serve as a ldquotransmission beltrdquo for monetary policy
These changes in the banking environment accentuate an existing anomalyThe anomaly is that banks even as they grow larger and increasinglyengage in more risky and complex transactions are perceived to enjoyimplicit and explicit public guarantees
The guarantees grow out of an incentive problem inherent in bankingasymmetric information which we mentioned above Depositors know lessabout a bankrsquos management and the quality of its balance sheet than doits managers and shareholders Thus in times of uncertainty or adver-sity bank depositorsmdashuncertain whether they will have access to theirdepositsmdashare prone to bank runs This prospect has in turn compelledgovernments to treat banks differently than other firms because a bankthat fails can disrupt the rest of the economy24
To prevent such crises governments have entered into quid pro quoarrangements with banks Governments provide them both with an im-plicit safety net in the form of an unstated promise by the central bankto act as a lender of last resort in a liquidity crisis and an explicit safetynet in the form of a public deposit insurance fund to reassure depositorsIn return the banks submit to closer government oversight and regu-lation of their activities than is usual for industries in the private sector
The ldquoinsurancerdquo provided by the public safety net contributes to an-other incentive problem moral hazard Banks acquire greater tastes forrisk and face less market discipline than other firms The explicit depositinsurance safety nets actually have or are perceived to have blanketcoverage that extends beyond the retail depositors (households and small
One of the lessons of the 1997-98 crisis must surely be that market par-ticipants and their regulatory supervisors relied too heavily on quantita-tive tools and insufficiently on judgment23
The Anomaly of Modern Banking
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102 WORLD CAPITAL MARKETS
businesses) for which they were originally intended The implicit centralbank safety nets extend in a crisis to nearly all depositors and banksThus banks are both viewed and behave as if they will be bailed out ifthey get into trouble
The existence of a public safety net raises a perennial question Dobanks have an unfair advantage over other financial institutions becauseof the subsidy provided by the safety net This question was at the heartof intensive study and debate in the United States leading up to thepassage in November 1999 of the Financial Services Modernization Act(also known as the Gramm-Leach-Bliley Act) The size of the gross sub-sidy is difficult to estimate despite determined research efforts Somesuggest it is well under 100 basis points and is at least partly offset bythe direct costs of deposit insurance premiums interest payments on bondsissued by the Financing Corporation25 reserve requirements regulatoryexpenses and operational costs associated with collecting deposits26 Con-versely Kwast and Passmore (2000) suggest that banks can expand theirscope far beyond the levels that other financial institutions could reachwith the same equity base but without the public safety net
A related concern in the US debate is whether allowing banks to ex-pand their activities into securities and insurance will ultimately extendthe safety net and add to the subsidy The Financial Services Moderniza-tion Act deals with this issue by maintaining a legal separation betweenbanks and the rest of the banking organization known as large com-plex banking organizations (LCBOs) They must engage in most securi-ties activities and insurance underwriting through separately capitalizedinvestment bank subsidiaries or holding company affiliates This act canbe said to have merely brought US banking laws closer to those of mostother industrial countries (Barth Brumbaugh and Wilcox 2000 BarthNolle and Rice 2000) If the fire wall is well-maintained and stoutly de-fended the safety net will neither expand in practice nor become a sourceof comfort to noncommercial bank subsidiaries of LCBOs
The quid pro quo exacted by governments to offset the subsidy iscloser public-sector monitoring of banksrsquo activities through prudentialsupervision The effectiveness of this closer official scrutinymdashand closermarket monitoringmdashare the subjects of the next section
25 The Financing Corporation was created by Congress in 1987 to sell bonds to raisefunds to help resolve the savings and loan crisis
26 See Levonian and Furlong (1995) Jones and Kolatch (1999) Shull and White (1998)and Whalen (1999a 1999b)
Are G-10 bank supervisors adequately responding In this section we firstassess the case for and compare the structures of prudential supervisory
Prudential Supervision
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 103
systems both within and among the G-10 economies plus Spain andconsider whether these offset the subsidy provided by the public safetynet Despite offsetting regulation and supervision implicit and explicitguarantees by G-10 governments to their banks are still a source of bank-ing instability in the emerging-market economies
National Systems for Prudential Supervision
Governments use prudential supervision to reduce the moral hazard andadverse selection created by their own safety nets Supervisors establishregulations and monitor compliance to limit risk taking and ensure thesafety and soundness of the banking system In a thoughtful analysis ofthe case for prudential supervision Frederic Mishkin (2000) identifiesthe main forms that supervision can take including the tasks of grantingbanking charters and licenses establishing capital requirements settingdeposit insurance premiums and defining disclosure requirements as wellas carrying out bank examinations Bank examiners gather informationfrom banks and evaluate whether they are following the regulatorsrsquo rulesin cases of weakness they are empowered to change banksrsquo behaviorand close them if necessary
Supervisors also may restrict competition define the activities in whichbanks may engage and restrict their asset holdings and separate banksand other financial (or nonfinancial) activities During the past two de-cades the barriers separating commercial banks investment banks in-surance firms and securities firms have been all but eliminated (tableB1) Deregulation has stimulated competitive forces that drive diversifi-cation and consolidation of the financial industry nowhere faster than inthe United States
The Financial Services Modernization Act of 1999 confirmed this trendIt eliminated restrictions dating back to the Glass Steagall Act of 1933which once prevented banking insurance and securities firms fromentering each otherrsquos businesses (Barth Brumbaugh and Wilcox 2000)Cross-pillar mergers among banks insurance and securities firms arewell under way to form giant financial holding companies The 1999merger between Citibank (banking) and Travelers (insurance) created themodel for megafinance and confirmed new challenges for supervisors
Mishkin (2000) notes the corresponding evolution in US supervisionfrom an emphasis on rules-based regulation (detailed rules for opera-tional behavior and the quality of line items in the balance sheet) to anapproach that stresses the soundness of bank management practices es-pecially risk management
Appendix B outlines the systems of financial supervision now in theplace in the G-10 countries plus Spain Some systems like the UK andCanadian approach are models of simplicitymdashorganized to keep pacewith the spreading reach of financial conglomerates Other systems like
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104 WORLD CAPITAL MARKETS
the US and French approaches show traces of the bureaucratic divisionsthat made sense in an era when banking securities and insurance weresharply separated
The US Model
27 See Meyer (1999a)
28 Canada has a similar degree of simplification with the exception that securities firmsare still regulated by provincial authorities
29 See Pratti and Schinasi (1999 67)
30 The agents are the bank regulators and the principals are the taxpayers Agents maypursue their own interests including bureaucratic survival and postgovernment employ-ment opportunities rather than the national interest in banking safety and soundness
The US model of financial regulation delineated in the Financial Ser-vices Modernization Act of 1999 blends functional and umbrella super-vision Bank and thrift regulators oversee depository institutions Newnonbank activities are subject to both functional regulation (eg by theSecurities and Exchange Commission and state insurance examiners) andumbrella supervision (of financial holding companies) by the FederalReserve27
The UK Model
Another supervisory model exists in the United Kingdom as well as inAustralia Canada and Switzerland28 In this model banking supervisionis separated from the monetary policy function The regulatory structureis considerably simplified by relying on a consolidated financial regula-tor separate from the central bank for both banking and nonbankingactivities The remaining question answered differently depending on thecountry is the extent to which the regulator relies on home-country sur-veillance of banks and conglomerates that have a local presence
Regulatory Models Compared
Appendix B provides more detail on the differences in these modelsGerman simplicity contrasts with French complexity In France the bankingcommission is chaired by the governor of the central bank and includesrepresentatives from the Treasury The commission supervises compli-ance with regulations but the central bank inspects banks on behalf ofthe commission29 In countries such as the United States and France withmultiple supervisors and crossover functions internal coordination is criticalAt the same time multiple agencies create regulatory competition Wheneach agency knows what the other is doing transparency within gov-ernment circles can help to limit principal-agent problems of regulation30
The discussion as to where in the public bureaucracy financial super-
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 105
vision should be placed goes back many years Peek Rosengren andTootell (1999) argue that a synergy exists between monetary policy andprudential supervision because information gained in the course of super-vision can increase the accuracy of macroeconomic forecasts A twist tothis argument is that the information on the state of financial institutionsavailable to the central bank as supervisor can facilitate its role as lenderof last resort Conversely there is the concern that a supervisory rolewill compromise the central bankrsquos independence of action with respectto its core mandatemdashmaintaining price stability As these arguments haveplayed out financial supervision has generally been shared between centralbanks and other regulators or placed entirely in the hands of an inde-pendent regulator However in Italy the Netherlands and Spain cen-tral banks are the sole banking supervisor
Goodhart (1995) examined the arguments and evidence for each modeland concluded that there were no overwhelming arguments or evidencefor one or the other31 Going forward a key problem for any financialsupervisory system is dealing with (and closing as necessary) weak banksIf both central banks and other regulators have this responsibility closecoordination between them is critical Another problem is large conglom-erate banks LCBOs Although they are less likely to fail because of thediversification of their assets and liabilities they are more likely to berescued They are also more likely to be multinational enterprises withinternational implications Goodhart observes that regulation of theseentities might be put in the hands of the central bank because it is lessamenable to political pressures In any event the complexity of LCBOoperations suggests that greater supervisory rigor is necessary
The US Congress was persuaded that broad oversight would help containthe moral hazard problem and accordingly gave the Federal Reservethe role of umbrella supervisor with the understanding that the Fed willscrutinize depository activity more intensely than nonbank financial ac-tivities Under this approach LCBOs such as Citigroup are subject tomuch closer monitoring than smaller and simpler institutions32 The USregulatory model requires enormous cooperation between the Fed otherbank supervisors and the functional regulators for insurance and securi-ties but it also benefits from regulatory competition
31 National systems of supervision are path dependent they are determined by the struc-ture of financial institutions and history in each country If Goodhart (1995) is right out-comes are not materially better or worse with one model of supervision rather than another
32 See Ferguson (1999)
Public Safety Nets
One of prudential supervisorsrsquo biggest challenges is to reduce moral hazardFor many years commercial banks engaged in communal self-insurance
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106 WORLD CAPITAL MARKETS
to deal with crises They formed voluntary groups that agreed to rescuetroubled members As financial markets evolved and competition inten-sified banks were no longer willing to play this role Private-sector in-surance is one alternative but moral hazard and adverse selection wouldappear to prevent it from happening Public safety nets have developedbecause of the low probability and high cost of potential bank runs Aclear trade-off is involved The effectiveness of insurance in preventingbank runs is greater the more comprehensive the coverage But the morecomprehensive the coverage the greater the moral hazardmdashbank man-agers bank directors investors and depositors all take on greater risksin the belief that the safety net will protect them against losses
All G-10 countries have compulsory public safety nets for banks (table29) Deposit insurance agencies are officially organized in Canada theNetherlands Sweden Switzerland and the United States organized bythe industry in France Germany Italy and the United Kingdom andjointly organized by the public and private sectors in Belgium Japanand Spain
How well do G-10 governments offset the subsidy provided by thepublic safety net This is a question on which there is substantial debateAs banking organizations have become more complex the challengesthat supervisors face have become more difficult One challenge is toalign the incentives facing bank managers and shareholders with thoseof depositors Another is the principal-agent problem in supervision Wehave discussed the incentive structures for financial institutions but wehave said little about the incentives for supervisors themselves and thedistortions they can generate in the financial system
In one of the many studies of the US savings and loan crisis of the1980s Kane (1989) documented both problems He described managersusing cosmetic approaches to disguise the magnitude of insolvency regulatorspracticing forbearance even though they knew of the deteriorating riskprofiles of the institutions for which they were responsible and legisla-tors increasing deposit insurance without regard for any offsetting changesin supervision A subsequent overhaul of the legislative framework forthe Federal Deposit Insurance Corporation (FDIC) known as the FDICImprovement Act of 1991 (FDICIA) aimed to introduce a clearer incen-tive structure for both regulators and regulated institutions
The changes introduced by this US legislation are worth discussionwith respect to the other G-10 countries as well First FDICIA created astronger signal to management and investors by targeting deposit insur-ance at small depositors only and by risk-weighting the deposit insur-ance premiums paid by banks to reflect their capital adequacy and bankexaminer ratings Among the G-10 countries rated in table 210 depositinsurance premiums vary considerablymdashbut it is not clear that the dif-ferences have much to do with risk-weighting Most G-10 countries em-ploy funding formulas based for example on the total domestic deposit
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Table 29 Deposit insurance schemes in the G-10 countries Explicit safety net
Coverage limit(dollar Foreign
equivalent currency Interbank Source Bankrsquos Contingency fundingDate Membership Co- at end of deposit deposit of premium from banks
Country established managementa insuranceb July 1998)c covered covered Fundingd funding costs or governments
United 1982 Compulsory Yes Larger of 90 No No Unfunded Banks only Callable (subject Parliament may increase Kingdom private percent co- to maximum the maximum payable
insurance to 03 percent of pound125 million advance 33000 total deposits) facility with Bank of
England
United 1934 Compulsory No 100000 Yes Yes Funded Banks and Up to 027 Borrowing up to $3 States official government percent total billion from US Treasury
domestic deposits
Japan 1971 Compulsory No 71000 but No No Funded Banks and 0084 percent of Borrowing up to yen500bn joint in full until government insured deposits from Bank of Japan
year 2000 subject to Ministry of Finance approval
Canada 1967 Compulsory No 40800 No Yes Funded Banks and 033 percent of Borrowing up to C$6 official government insured deposits billion authorized further
(maximum) borrowing subject to parliamentary approval
Germany 1966 Compulsory Yes 90 percent Yes No Funded Banks only 003 percent of Annual levy may be private coinsurance deposits doubled
to 22000
Italy 1987 Compulsory Yes 125000 Yes No Unfunded Banks and Callable Two options defer private government (maximum of payment or diminish
1 percent of compensation to be paid total deposits)
(table continues next page)
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Table 29 Deposit insurance schemes in the G-10 countries Explicit safety net (continued )
Coverage limit(dollar Foreign
equivalent currency Interbank Source Bankrsquos Contingency fundingDate Membership Co- at end of deposit deposit of premium from banks
Country established managementa insuranceb July 1998)c covered covered Fundingd funding costs or governments
Netherlands 1979 Compulsory No 22000 Yes No Unfunded Banks and On demand Government backing official government maximum of subject to parliamentary
5 percent of own approval funds
France 1980 Compulsory No 65400 No No Unfunded Banks only Callable (on Extra calls up to FFr1000 private demand calls million can be made in
up to FFr200 a 5-year period million)
Switzerland 1984 Voluntary No 19700 No No Unfunded Banks only Callable (on Underwritten by member official demand) banks
Sweden 1996 Compulsory No 31400 Yes No Funded Banks and 05 percent of Full emergency coverage official government deposits while replacing it with a
limited system after the emergency
Belgium 1974 Compulsory No 16600 No No Funded Banks and Callable 002 None insurance limited joint 22000 in government percent of to assets in fund
year 2000 deposits from clients
Spain 1977 Compulsory No 16439 Yes No Funded Banks and 02 percent of Government backing joint government deposits through the Banco de
(maximum) Espantildea subject to approval by royal decree
a Bank membership in the fund can be either compulsory or voluntary and the management of the fund can be official and official and private joint or privateb Coinsurance refers to the situation where depositors face a deductible against their insured fundsc Coverage limit refers to the explicit amount the authorities promise to insured Funded scheme means that it is funded ex ante unfunded otherwise
Sources Goodhart (1995) Demirguccedil-Kunt and Detragiache (2000) Demirguccedil-Kunt and Sabaci (2000)
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 109
base Explicit safety net protection also varies but only Canada focuseson the protected class33 All G-10 countries specify a limit on depositorprotection Under FDICIA the insurance fund is prohibited from pro-tecting uninsured depositors or creditors at a failed bank although adiscretionary system-wide override is provided for exceptional circum-stancesmdashbut with stringent requirements for consultation and account-ability Other G-10 countries allow for contingency funding from the publicpurse alongside unwritten lender-of-last-resort support Among large banksa significant and growing portion of deposit liabilities including foreigncurrency and interbank deposits are uninsuredmdashbut depositors assumethey will be protected in a crisis
FDICIA also made some significant qualitative changes to address theprincipal-agent problem by penalizing weak banks and rewarding strongbanks For example banks whose capital declined faced progressivelytougher regulatory sanctions that for example required them to elimi-nate dividends restrict their lending and change their managementsRegulators have also been forced to take prompt corrective action (toreduce the practice of regulatory forbearance in hopes that a bankrsquos for-tunes might improve)34 Unfortunately comparative qualitative assess-ments across the G-10 are difficult to make due to lack of information35
This discussion highlights the complexity of evaluating the extent towhich prudential supervision and market discipline reduce the moralhazard associated with G-10 safety nets Our argument is that publicsafety nets in the G-10 can be linked to banking instability in other coun-tries specifically in the emerging-market economies that have attractedG-10 cross-border bank lending This lending is a leading source of vola-tility in capital flows the large financial institutions many of which arecomplex banking organizations are based in and regulated by authori-ties in the G-10 economies These two features of the international finan-cial system are closely related although it is not possible to test thisrelationship econometrically
Two World Bank studies however indicate a basis for concern Onestudy is a cross-country econometric analysis of the relationship betweenbank stability and deposit insurance (Demirguccedil-Kunt and Detragiache2000) which found a negative relationship Their estimated model forbanking crises in a sample of 61 countries (both industrial and develop-ing) suggests that explicit deposit insurance raises the probability of acrisis by at least 30 percent36 Crises are especially likely in countries
33 Japanrsquos legislation says it does but recent experience shows this is not the case34 See Goldstein (1997) for a summary of the changes35 See Barth Nolle and Rice (2000) for a beginning in this area36 Demirguccedil-Kunt and and Detragiache (2000 table 1) report a logit coefficient of 0696with a standard error of 0397 (the coefficient is significant at the 8 percent threshold)This suggests that the ldquotruerdquo coefficient could well be as small as 030 (the reportedvalue minus the standard error)
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110 WORLD CAPITAL MARKETS
with immature financial supervisory systems (and not in the G-10) buttheir analysis does underscore the view that deposit insurance weakensmarket discipline37
An earlier World Bank analysis established similar results One wasthat market discipline is undermined by deposit insurance schemes an-other was that illiquid banks are forced to pay more for their funds un-less a generous deposit insurance scheme is in place (Demirguccedil-Kuntand Huizinga 1999) This econometric study also provides clear-cut evi-dence that depositor monitoring of banks declines with the existence ofdeposit insurance schemes At the heart of the problem is the questionof whether deposit insurance is accompanied by increased governmentmonitoring
This evidence and the weight of other arguments suggests that moralhazard is still an issue in the G-10 countries Consider the ongoing de-bate about instilling greater market discipline on risk taking by banksAt one extreme is the perennial proposal to do away with safety netsleaving markets to monitor the players and to force adjustments but toprotect small savers by creating ldquonarrow banksrdquo such as postal savingsystems that are allowed to invest these savings only in risk-free gov-ernment securities Whatever the merits of narrow banking this solutionis too extreme to be politically feasible
A moderate alternative is to force more disclosure by financial institu-tions to facilitate market monitoring But transparency has its own prob-lems Persaud (2000) argues that financial markets cannot reliably discernsustainable from unsustainable positions in the short term This uncer-tainty causes banks to ldquoherdrdquo behind market leaders to exploit theirsupposedly superior information ldquoThe more herding investors and bankersknow about what each other is up to the [more] unstable markets maybecomerdquo The implication is that greater transparency in the marketplaceby itself will not solve the problemmdashand in the short term more informa-tion may exacerbate herding Further supervisory steps (discussed in thenext chapter) are required
Yet another proposal is to promote private-sector involvement in bankmonitoring through market-based alternatives such as Calomirisrsquos sub-ordinated debt proposal (Calomiris 1997 Federal Reserve Board 1999)Banks could be required to issue and maintain a minimum amount of
37 Other findings in the Demirguccedil-Kunt and Detragiache (2000) study include thesepropositions The impact of deposit insurance on bank stability tends to be stronger themore extensive is the coverage offered to depositors when the scheme is funded andwhere the scheme is run by the government rather than by the private sector Con-versely deposit insurance is detrimental to bank stability where bank interest rates havebeen deregulated and where the institutional environment is weak Additional findingson deposit insurance are reported from a recent World Bank conference (8-9 June 2000httpwwwworldbankorgresearchinterestconfsupcomingdeposit_insurancehomehtm)Also see Smalhout (2001)
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 111
subordinated debt (eg uninsured certificates of deposit) to finance asmall fraction (such as 2 percent) of their total nonreserve assets Thesubordinated debt would be allowed to earn a set yield no more than 50basis points over the risk-free yield on government treasury bills Thisrule would supposedly force banks to operate in a safe manner Other-wise subordinated debt holders would redeem their uninsured certifi-cates of deposit and equity investors would sell their bank shares Despiteits practical problems the beauty of the subordinated debt requirementis that it enlists market incentives to push banks to avoid excessive port-folio risk38
The thrust of these proposals is very relevant to the arguments in ourstudy Even in the G-10 countries government monitoring by itself hasnot eliminated moral hazard among banks More work is needed to in-troduce market monitoring and to improve the incentive structures bothfor financial institutions and their supervisors We return to this issuewith our recommendations in the next chapter
38 In late 1996 Argentina began requiring its banks to finance 2 percent of total depos-its in the form of subordinated debt but without a maximum yield provision TheArgentine authorities expect that market discipline will act in concert with the publicsafety net One obvious problem with the subordinated debt proposal is that banks mayencourage some of their customers to buy the subordinated debt
Portfolio Institutions Tomorrowrsquos Problem
Before proceeding to the issues of international supervision we flag an-other potential problem for national regulators The big asset managersprofiled in tables 24 and 26 answer to diverse groups of pensionersshareholders and policyholders They allocate funds across a number ofcountries to diversify their risks They hold liquid assets that can be tradedand they have a higher proportion of long-term assets than banks Eco-nomic shocks can be absorbed through price changes and their effectsspread across time and markets Thus when conditions change in a par-ticular market they are more likely to ride out the storm than to flee Inother words they have less incentive than banks to pull their invest-ments in the face of adversity In the 1990s most large asset managersestablished a record of ldquoriding out the stormrdquo rather than ldquorunning withthe windrdquo although as we saw in chapter 1 instances of running withthe wind were detected in some portfolios As we write these insti-tutions have a good record overall in the emerging markets so whyworry
The Russian crisis and the near-collapse of LTCM previewed the dan-gers that may await future portfolio managers and G-10 financial minis-ters We have presented evidence indicating a systemic bias toward bank
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112 WORLD CAPITAL MARKETS
lending and debt finance to emerging markets and we have argued forsubstitution toward equity finance and direct investment39
That is not the end of the story We noted in the previous chapterthat institutional investors can become momentum investors selling in adownturn As more portfolio capital is invested in emerging marketssome players may adopt the high-risk high-leverage strategies of themost aggressive hedge funds Indeed the data in box 11 show that G-10portfolio investors held somewhat more long-term debt (more than $500billion) than equity (less than $400 billion) in emerging markets at theend of 1997 Long-term debt is an ideal vehicle for high-risk high-leveragestrategies These strategies practiced on a large scale could compound afuture crisis harming emerging markets A big enough crisis could inturn pressure G-10 central banks and finance ministers to arrange bail-out plans Instead of shrinking as a systemic financial problem moralhazard could increase
National securities regulators are the first line of defense against thisscenario They play a critical role in the safe evolution of capital mar-kets But regulators today are mandated to approve the issuance of newsecurities and to monitor the continuing disclosure of material informa-tion by issuers They are far less concerned with or empowered to monitorthe behavior of the increasingly large wealth-management firms that arethe major purchasers (and therefore resellers) of these securities
Within their mandates the goals of national securities regulators (table210 and appendix B) are similar to the concerns of bank regulators withsystem safety and soundness Their focus is also on the incentive sys-tems for management and boards of directors and on disclosure by cor-porations that issue marketable securities such as shares bonds andasset-backed securities 40 Issuers of securities possess greater knowledgeabout the quality of these assets than do the purchasers hence investorprotection is a key concern of regulators Moreover market disciplineworks best when markets know what is happening Well-functioning corpora-tions are key agents of wealth creation and social progress Underperform-ing corporations waste resources During recessions bad corporationsget into bad trouble often with severe social consequences Inadequateincentives for managers and inadequate accountability for boards andmanagers thus have negative externalities Regulators play a vital role inexposing weakness so that market disciplines come to bear sooner ratherthan later
Regulatory emphasis is constantly shifting as financial markets evolveand as the macroeconomic environment changes Regulators try to balance
39 See Rogoff (1999) Also see Berlin (2000) for a perspective on the limited role thatbanks play as share owners
40 See Habib and Ljungqvist (2000) for recent empirical analysis showing that corporateshare market values are higher when corporate executives have a larger ownership stake
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Table 210 Financial-sector regulation G-10 countries 2000
Financial institutions and their supervisors
Country and supervisory structure Retail banking Wholesale banking Securities Insurance
Financial conglomeratesFinancial Services Authority (FSA) = umbrella supervisor
United Kingdom FSA FSA FSA FSA
Treasury bull Commercial banks bull Investment funds (Securities and (Insurance Directorate(Securities and Investments Board) bull Unit trust groups Futures Authority) of the Treasury)
Bank of bull Building societies bull Pension funds England (Building Societies Commission) bull Merchant banks
bull Friendly societies bull Clearing houses bull Primary issuers bull Insurance FSA (Friendly Societies Commission) bull Venture capital of securities companies
bull Pensions and life insurance etc bull Stock exchanges bull Insurance brokers(Personal Investment Authority) bull Stockbrokers
Financial holding companiesFederal Reserve (FR) = umbrella supervisor
United States bull National banks(OCC) Securities and Regulated by
Treasury OCC bull State banks Federal Reserve Exchange Commission StatesMembers (FR)
OTS Nonmembers (FDIC) bull Investment banks bull Primary issuers of bull Insurance companies FR bull Cooperative banks (FDICFR) bull Finance companies securities bull Insurance brokers FDIC bull Insured industrial banks (FDIC) bull Stock exchanges
bull Thrift holding companies (OTS) bull Stockbrokers SEC bull Savings banks (OTSFDICFR) bull Investment advisors
bull Savings and loan associations bull Mutual funds(OTS) bull Public utility holding
bull Edge Act corporations (FR) companies
(table continues next page)
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Table 210 Financial-sector regulation G-10 countries 2000 (continued )
Financial institutions and their supervisors
Country and supervisory structure Retail banking Wholesale banking Securities Insurance
Financial holding companies Japan Financial Supervisory Authority (FSA) = umbrella supervisor
Prime FSA FSA FSA FSA ministerrsquos Ministry of office Finance (Securities and Exchange
Surveillance Commission) FRC Bureau of Financial bull City banks bull Investment banks bull Primary issuers of bull Insurance companies FSA Regulation bull Regional banks bull Asset managers securities bull Insurance brokers
bull Trust banks bull Stock exchanges SESC bull Long-term credit banks bull Stockbrokers
bull Pension funds
Financial holding companiesOffice of the Superintendent of Financial Institutions (OSFI) = umbrella supervisor
Canada Regulated by OSFI OSFI provinces OSFI
Department of Financebull Banks bull Cooperative credit bull Primary issuers of bull Insurance companies
(previously Office of the Inspector associations securities (previously Depart- OSFI General of the Banks) bull Fraternal benefit bull Stock exchanges ment of Insurance) Bank of bull Trust and loan companies society bull Stockbrokers bull Insurance brokers Canada bull Pension funds bull Asset managers
(previously Depart- CDIC ment of Insurance)
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Financial institutions and their supervisors
Country and supervisory structure Retail banking Wholesale banking Securities Insurance
Germany Financial holding groupsFederal Banking Supervisory Office (FBSO) = umbrella supervisor
Ministry of Finance FBSO BSO FSSO FISO
Bundesbankbull Universal banks bull Other financial bull Primary issuers of bull Insurance companies
Federal Banking bull Savings banks institutions (eg securities bull Insurance brokers Supervisory Office bull Securities banks management foreign bull Stock exchanges
currency dealings) bull Stockbrokers Federal Securities bull Financial enterprises bull Asset managers Supervisory Office (eg leasing bull Pension funds
organizations Federal Insurance credit card companies Supervisory Office investment advisors)
Italy Bank foundationsMinistry of Finance = umbrella supervisor
Ministry of Finance Bank of Italy Bank of Italy Consob ISVAP
Bank of Italy bull Commerical banks bull Asset managers bull Primary issuers of bull Insurance companies Consob bull Savings bank bull Open-end investment securities bull Insurance brokers
bull Securities banks companies (SICAVs) bull Stock exchangesbull Stockbrokers
ISVAP
(table continues next page)
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Table 210 Financial-sector regulation G-10 countries 2000 (continued )
Financial institutions and their supervisors
Country and supervisory structure Retail banking Wholesale banking Securities Insurance
The Netherlands Financial conglomeratesCouncil of Financial Supervisors = umbrella supervisor
Securities Board Securities Board Netherlandsche Netherlands Bank Netherlandsche Bank of the Netherlands Insurance Board Bank Insurance bull Credit institutions (universal banks bull Investment institutions bull Stock exchanges bull Insurance companies Board cooperative banks security credit (securities issuing bull Stockbrokers bull Insurance brokers
institutions mortgage banks) and tradingmdashprimary The Council of Financial and secondary Supervisors markets)
France Commission des Commission de Operations des Controcircle des
Banking and Banking Commission Bourse Assurances Financial Regulatory bull Ensuring that credit institutions (and investment firms since bull Primary issuers of bull Insurance companies Ministry for Committee the Financial Activity Modernization Act of 1996) comply securities bull Insurance brokers Economic with laws and regulations bull Stock exchanges Affairs and bull Execute instructions regarding all off-site monitoring and bull Stockbrokers Finance Credit on-site supervision Institutions and Banking and Financial Regulatory Committee Investment bull Formulates general regulations for credit institutions and investment firms Committee (capital adequacy requirements accounting rules etc) Bank of France Credit Institutions and Investment Committee Banking bull Authorizes and examines financial institutions except for those within the Commission competence of the Banking Commission
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Financial institutions and their supervisors
Country and supervisory structure Retail banking Wholesale banking Securities Insurance
Switzerland Large banking groupSwiss Federal Banking Commission (SFBC) = umbrella supervisor
Swiss National Bank Federal Office of
SFBC SFBC SFBC Private Insurance Swiss Federal Banking Commission bull Universal banks bull Investment banks bull Primary issuers of bull Insurance companies
bull Savings banks bull Asset management securities bull Insurance brokerscompanies bull Stock exchanges
Private audit Federal bull Investment funds bull Stockbrokers firms Office of bull Mortgage bond authorized by Private business SFBC Insurance
Sweden Financial holding company groupsFinancial Supervisory Authority = umbrella supervisor
Ministry of Finance Credit Market Securities Market Insurance Market
Credit Market Department Department Department Department
Financial bull Commercial banks bull Investment funds bull Primary issuers of bull Insurance companies Riksbank Supervisory bull Savings banks securities bull Insurance brokers Authority bull Friendly societies bull Stock exchanges
bull Stockbrokers
(table continues next page)
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Table 210 Financial-sector regulation G-10 countries 2000 (continued )
Financial institutions and their supervisors
Country and supervisory structure Retail banking Wholesale banking Securities Insurance
Belgium Bank holding companiesBanking and Finance Commission = umbrella supervisor
Bank of Belgium Banking Banking
Banking and Finance and Finance Insurance Controland Finance Commission Commission Commission Office
Banking and Insurance Finance Control bull Commercial banks bull Asset management bull Primary issuers of bull Insurance companies Commission Office bull Savings banks firms securities bull Insurance brokers
bull Securities banks bull Investment funds bull Stock exchanges bull Mortgage companiesbull Stockbrokers bull Pension funds
Securities Regulation Fund Securities Regulation Fund
bull Other investment firms and credit institutions(institutions participating in regulated off-exchangemarket in strips and Treasury certificates)
Bank holding companies Spain Banco de Espantildea = umbrella supervisor
Banco de Espantildea Comision Nacional del Mercado de Directorate General
Banco de Espantildea Valores (CNMV) Insurance
bull All credit institutions (commercial banks savings banks credit bull Primary issuers of (Ministry of Economy Ministry of cooperatives official credit institutions finance factoring and securities and Finance) Economy and CNMV leasing companies mortgage-loan companies etc) bull Stock exchanges bull Insurance companies Finance bull Interbank foreign exchange and book-entry public debt bull Stockbrokers bull Pension funds
markets bull Venture capital(companies and funds)
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TH
E P
LAY
ER
S T
HE
IR S
UP
ER
VIS
OR
S A
ND
MO
RA
L HA
ZA
RD
119
Financial institutions and their supervisors
Country and supervisory structure Banking Securities Insurance
Banking Advisory High Level Securities Supervisors Committee (BAC) Committee (HLSS) Insurance Committee (IC)
Supranational (EU) bull Formulates standards for prudential bull Coordination of securities market bull Formulates standards forsupervision supervision prudential supervision
BACICHLSS Banking Supervision
Conglomerates Committee (BSC) Securities Contact Committee Regulation of prudential bull Systemic risk monitoring bull Regulation and implementation of supervision securities admission
International Association International International Organization of of Insurance Supervisors
Basel Committee Securities Commisison (IOSCO) (IAIS) Joint Forum Conglomerates Supervision bull Supervision and regulation best bull Supervision and regulation best bull Supervision and regulation amp regulation Best practices practices practices best practices
FSF Coordination across supervisors of various functions
Notes See appendix B for more information Boldface type indicates senior or oversight supervisor normal type indicates adjunct or front-line supervisorsolid line indicates direct responsbility to the senior-ranking authority dotted line indicates coordination in supervisory activities
(table continues next page)
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Table 210 Financial-sector regulation G-10 countries 2000 (continued )
Glossary of names United Kingdom FSA = Financial Services Authority United States FR = Federal Reserve OCC = Office of the Comptroller of theCurrency FDIC = Federal Deposit Insurance Corporation SEC = Securities and Exchange Commission OTS = Office of Thrift Supervision Japan FRC =Financial Reconstruction Commission FSA = Financial Services Agency SESC = Securities and Exchange Surveillance Commission Canada OSFI =Office of the Superintendent of Financial Institutions CDIC = Canada Deposit Insurance Corporation Germany FBSO = Federal Banking SupervisoryOffice FSSO = Federal Securities Supervisory Office FISO = Federal Insurance Supervisory Office BSO = Banking Supervisory Office Italy Consob =Commissione Nazionale per le Societa e la Borsa ISVAP = Instituto per la Vigilanza sulle assicurazioni private e di Interesse colletivo Switzerland SFBC= Swiss Federal Banking Commission Spain CNMV = The Comision Nacional del Mercado de Valores Supranational BAC = Banking Advisory CommitteeBSC = Banking Supervision Committee IC = Insurance Committee HLSS = High Level Securities Supervisors Committee International Dimension FSF =Financial Stability Forum IOSCO = International Organization of Securities Commission IAIS = International Association of Insurance Supervisors
Sources United Kingdom Bank of England httpwwwbankofenglandcouk Financial Services Authority httpwwwfsagovuk United States Board ofGovernors of Federal Reserve System httpwwwfederalreservegov Japan Bank of Japan httpwwwbojorjo Financial Reconstruction Commissionhttpwwwfsagojpfrcindexehtml Financial Services Agency httpwwwfsagojp Canada Bank of Canada httpwwwbank-banque-canadaca Office ofthe Superintendent of Financial Institutions httpwwwosfi-bsifgccaAndreEindexhtml Germany Deutsche Bundesbank httpwwwbundesbankde Fed-eral Banking Supervisory Office httpwwwbakredde Italy Banca drsquoitalia httpwwwbancaditaliait Commissione Nazionale per le Societa e la Borsahttpwwwconsobit Instituto per la Vigilanza sulle assicurazioni private e di Interesse colletivo httpwwwisvapit The Netherlands De NederlandscheBank httpwwwdnbnl France Banque de France httpwwwbanque-francefr Switzerland Schweizerische Nationalbank httpwwwsnbchindex3htmlSweden Sveriges Riksbank httpwwwriksbanksedefaultasp Belgium National Bank of Belgium httpwwwbnbbesgindexhtm Spain Banco de Espantildeahttpwwwbdees The Comision Nacional del Mercado de Valores httpwwwcnmves Supranational (EU) Institutional Arrangements for the Regulationand Supervision of the Financial Sector 2000 International Dimension Bank for International Settlement httpwwwbisorg International Organization ofSecurities Commissions httpwwwioscoorg International Association of Insurance Supervisors httpwwwiaisorg Financial Stability Forum httpwwwfsforumorg
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 121
the inflexibility of tight surveillance against the need to encourage in-novation and growth The US Securities and Exchange Commission isworried about aggressive accounting by firms and biased reports bysecurities analysts in an equity environment that prizes steadily higherquarterly earnings41 Japanese regulators are preoccupied with opaqueinterconnections between portfolio institutions banks and nonfinancialfirms through the keiretsu system Canadian regulators reeling from high-profile scandals of managers intentionally misleading investors are strengtheningmarket discipline through legal penalties aimed at managers and directorsof offending firms
When panic strikes a securities regulator cannot do much As the 1987stock market crash and the LTCM debacle in the fall of 1998 both dem-onstrated steep stock and bond price declines can create systemic risksIf severe enough the wealth effect of falling securities values and thefear of widespread insolvency can depress real activity Flooding thesystem with liquidity is a central bankerrsquos solutionmdashsomething a securi-ties regulator cannot do42 But just as financial supervisors can changethe incentive structure to discourage bankers from making risky loans ingood times so securities regulators can pay more attention to incentiveson the demand side when capital markets are strong
Prudential Supervision and InnovationmdashA Footnote
In concluding this discussion of prudential supervision in the G-10 anadditional point is worth noting National regulators face a persistenttrade-off between emphasizing financial system safety and soundnesswhile encouraging innovationmdashin spite of the added risks innovationbrings to financial markets Former US Treasury Secretary Lawrence Summers(2000 3) has argued by analogy
The jet airplane made airplane air travel more comfortable more efficient andmore safe though the accidents were more spectacular and for a time morenumerous after the jet was invented In the same way modern global financialmarkets carry with them enormous potential for benefit even if some of theaccidents are that much more spectacular As the right public policy response
41 The problem is illustrated by the divergence since mid-1998 between reported earn-ings by the Standard amp Poorrsquos (SampP) 500 and the after-tax profits of all corporations inthe national accounts Generally these two series move closely with one another Be-tween mid-1998 and mid-1999 SampP 500 reported that earnings increased by more than20 percent while after-tax profits of all corporations increased by less than 5 percent(Chase Bank US Economic and Policy Research US Weekly Prospects Chase SecuritiesWeekly Newsletter 5 June 2000 5)
42 For example the US Securities and Exchange Commission had no direct role in calmingmarkets in the 1987 or 1998 panics
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122 WORLD CAPITAL MARKETS
to the jet was longer runways better air-traffic control and better training forpilots and not the discouragement of rapid travel so the right public policyresponse to financial innovation is to assure a safe framework so that the ben-efits can be realized not to stifle the change
Accepting Summersrsquos analogy for the international financial system better-informed supervisors and investors are a necessary part of the financialsystem framework Supervisors require more timely information on therisk profiles resulting from positions taken by financial institutions Theyalso need a better understanding of risk-management systems Snapshotsof an institutionrsquos risk profile and risk-management procedures are nolonger adequate In a world where huge bets are quickly made (andpossibly lostmdashas with Barings Bank in 1995 and LTCM in 1998) super-visors must focus on the soundness of banking systems for evaluatingand managing risk on a daily basis Some progress has been made inaddressing these issues US banking examiners are extending their in-formation requirements in banking examinations and increasing theirinvolvement in large complex institutions43 More awareness is alsorequired of the fact that they are national organizations in a world ofcross-border capital flows To a much greater extent they need a multi-national reach International supervision and coordination among super-visors are the subject of the next section
Our analysis suggests that G-10 supervisors have unfinished businessBank supervisors need to start yesterday securities regulators can waituntil tomorrow One G-10 member acting alone cannot correct the biasIn good times the lending business will simply migrate to other G-10banks In bad times financial problems will not stop at the national bor-der A way has to be found to establish common international standardsfor the key financial players in order to prevent crises and to agree onapproaches for managing them The path has already been laid out Inthe wake of the bank failures of the past 25 years bank supervisors havetried to establish such standards They have done this without creating anew global institution
The essence of the international framework is decentralizationmdashglobalrules and design standards without global institutions that are perceivedto intrude on national sovereignty The awkward jargon for this frame-work is vertical subsidiaritymdashldquothink internationally act nationallyrdquo Theinternational thinking is done by a committee of regulators that meets
International SupervisionA Decentralized Framework
43 These issues are discussed in Ferguson (1999) and Meyer (2000a)
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 123
regularly at the Bank for International Settlements in Basel The commit-tee establishes principles and standards that are interpreted implementedand enforced by national authorities44 In this section we describe thesesupervisory efforts and their weaknesses We present our recommenda-tions for addressing these weaknesses in the next chapter
Basel I
The Basel Capital Accord of 1988 (Basel I)45 drew the lesson from thefinancial crises of the mid-1970s that more adequate capital levels in in-ternational banks would help reduce the systemic risk of bank failureThe primary goal of Basel I was capital adequacy other standards wereput in place not so much for their own virtue as to defend the primarygoal
Capital adequacy requirements were designed to ensure that individualinstitutions have the ability to absorb losses particularly credit lossesAccordingly a backup system of scoring credit risk was devised thatrequired large amounts of bank capital for some types of loans smalleramounts for others and zero for a select list of preferred assets Report-ing requirements were designed to disclose problems and ensure that atroubled bank would take timely steps to restore its capital base in thewake of a loss The Basel I framework worked tolerably well in limitingthe call on the public purse in the G-10 countriesmdashwith the notable ex-ceptions of France and Japan The framework failed to moderate riskybank lending to emerging markets however
Basel I was not developed with emerging markets in mind The origi-nal idea behind it was to develop a common supervisory approach tocross-border banking operations It grew out of political pressure fromUS lawmakers who were determined to require international banks op-erating in the United States to meet US banking standards Toward thisgoal in 1983 Congress passed the International Lending Supervisory ActUS and British banking authorities subsequently agreed on a commontarget the adoption of strict common capital-adequacy standards In 1988other G-10 governments agreed to go along voluntary acceptance ofthe standards throughout much of the rest of the world followed46 Therationale for the capital targets was two-fold The first was to requirebanks to hold sufficient amounts of capital (8 percent of risk-adjusted
44 The international committee of financial authorities agreed on a common definitionof banksrsquo tier-one or ldquocorerdquo capital national authorities defined tier-two capital in theirown manner which permitted greater variations in national working definitions andpractices
45 International Convergence of Capital Measurement and Capital Standards (BIS 1988)was prepared by the Basel Committee on Banking Supervision
46 See Reineke (1998)
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124 WORLD CAPITAL MARKETS
assets) to cushion losses on those assets The second was to dull theirappetites for risk banks with large capital bases would have more tolose if they failed and therefore would take fewer risks
Rapid change in financial markets soon revealed flaws in the Basel IAccord In a complex world with numerous sources of risk it focusedheavily on credit risk but overlooked other risks in a bankrsquos portfolioand the correlation between returns on different asset classes The Baselformula required banks to maintain a fixed amount of capital againsteach of its asset classes But the formula did not distinguish the riskinessof the borrower within each class As a result one large loan to a low-risk corporate borrower such as General Electric would require the sameamount of capital as 10 smaller transactions with high-risk borrowers
The system was also biased toward short-term loans Loans maturingin less than a year required a 20 percent risk weight whereas those ma-turing after more than a year required a 100 percent risk weight Inter-bank lending was particularly favored For example loans to banks inOECD countries required less capital than loans to private firms in thesame countries creating the anomaly that interbank loans to South Ko-rean banks required less capital than loans to General Electric47 Thisanomaly encouraged banks to shed high-quality assets if the Basel rulesrequired the allocation of more capital than banks thought they needed
Another weakness was that financial innovators quickly circumventedthe Accord Because short-term loans required less provisioning than long-term loans banks responded by securitizing their long-term debt port-folios and lending short-term against the collateral of the newly createdasset This allowed banks to circumvent the capital requirements gearedto the terms of the underlying debt At the same time the Basel I Accordfailed to encourage risk mitigation techniques such as credit derivativescollateral guarantees and on-balance-sheet netting the flip side of fi-nancial innovation Because off-balance-sheet products were not coveredby the Accord another anomaly appeared when Barings Bank collapsedin 1995 Barings met capital adequacy standards but collapsed becauseits systems for managing risk failed traders were allowed to speculatein futures contracts that did not appear on the balance sheet
Basel II
Work to overhaul Basel I began in 1995 and produced consultativepapers issued in June 1999 and January 200148 These papers have been
47 South Korean banks have had notoriously weak balance sheets because the practiceof ldquodirected lendingrdquo left them with many poor loans (in making these loans the bankswere expected to follow government objectives rather than creditworthiness criteria)
48 Basel Committee on Banking Supervision (1999 2001)
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 125
the subject of extensive consultation and revision as a result the newAccord is expected to be introduced in 200449 The Basel II frameworkhas three parts (pillars) revisions to Basel I minimum-capital require-ments supervisory review criteria and greater emphasis on market dis-cipline Broadly Basel II aims to maintain the level of capital in the sys-tem but achieve better alignment of banksrsquo capital with their risk pro-files and keep up with financial innovation
To align capital requirements with market realities (the first pillar)Basel II concentrates on the 100 or so largest banksmdashthe type of playerslisted in table 21mdashand on the holding-company parents of banking groups50
Capital requirements will differentiate between an increased number ofcredit groups or ldquorisk bucketsrdquo including claims on governments otherbanks corporations mortgage-backed securities and other asset-backedsecurities
Basel II originally proposed to use external ratings to set capital chargesfor a number of these credit risks Many banks objected arguing thatthey assess credit risk better than Standard amp Poorrsquos Moodyrsquos or FitchIBCA51 Basel II thus proposes two approaches to rating a standard ap-proach using external ratings and an ldquoadvancedrdquo approach that allowsselected banks to use their own internal rating systems To encouragethe development of rigorous internal control systems based on these in-ternal rating systems Basel II also proposes to levy capital charges foroperational risk (the risk of direct or indirect loss resulting from inad-equate or failed internal processes people and systems or from exter-nal events)
Some critics of this proposal dismiss it as an abrogation of the prin-ciple of external independent monitoring and as ldquodangerously naiumlverdquo52
But regulators argue that the new capital charge on operational risk shouldoffset this concern It is also far from clear how cross-national compari-sons of rating and internal risk-assessment systems will be made (Engelen2000) The development by the European Union of its own capital rulescould well complicate the international resolution of these issues Publicassurances by EU officials in January 2001 however indicated that theirmain concerns are to create a level playing field and avoid regulatoryarbitrage (Hargreaves 2001) There is also the significant problem ofthe procyclical character of risk weights When a crisis hits losses are
49 See Berry (2000) for an update in an interview with William J McDonough chair ofthe Basel Committee on Banking Supervision
50 For obvious reasons these proposals are addressed to large banks and simpler capi-tal standards are allowed for small banks that focus on their domestic credit markets
51 See Ammer and Packer (2000) for an empirical critique of the success of rating agen-cies in distinguishing risk by sector and region
52 See Auerback (2001)
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126 WORLD CAPITAL MARKETS
incurred or accrued capital is lost and loan exposure must be reducedor securities sold to restore the requisite capital-adequacy ratios A morerisk-sensitive framework could amplify volatility
As the second pillar of Basel II supervisory review criteria are beingbeefed up to encourage supervisors to intervene earlier in potential problemsituations and to compel banks to align their capital positions with theirrisk profiles Bank supervisors will be authorized to require banks tohold capital in excess of minimum requirements if they have concernsabout general management overall strategy risk-management performanceor the macroeconomic environment Of course if one G-10 supervisorimposes higher capital requirements in isolation the same disparity willemerge that presaged Basel I Some banks will be disadvantaged in theinternational marketplace and will loudly complain that excessive super-vision is driving business to their competitors Hence close internationalcooperation among supervisors is critical
To implement the third pillar market discipline banks will be requiredto make fuller more timely disclosure of capital adequacy and the risksto which that capital is exposed A number of measures are being stud-ied that might help supervisors evaluate bank performance such as com-parisons of uninsured deposit interest rates subordinated debt yieldsand equity prices The idea is that these yields and prices might alertsupervisors to market perceptions of risk Of course market perceptionsare only as good as market information More direct and controversialways to reinforce market discipline would dramatically increase publicdisclosure of bank positions and risk management systems
Many questions are still outstanding about how to resolve the techni-cal details of capital requirements and whether the requirements willachieve their intended goal of better assessment and mitigation of therisks in banksrsquo portfolios There is no substitute for skilled supervisorsThe intricacies of effective design and implementation suggest that su-pervisors need to be highly competent technically knowledgeable aboutbanking portfolio characteristics and the factors that influence bank ex-posure to credit risk (Mishkin 2000) And they must be aided by vigilantshareholders market forces and transparency of information53
Standard setting at the global level is desirable but ultimately theeffectiveness of these efforts will be tested at the national level espe-cially in times of systemic financial distress Here the record of Basel Iwas not a bright shining success Japanese banking regulators havetraditionally allowed banks to include real estate and securities in theircapital base When the value of these assets plummeted in the early 1990sregulators allowed banks to continue valuing these depreciated (andoften bankrupt) assets at their old inflated levels Japanese authorities
53 Benedict Roth Complacency Towards Catastrophe Financial Times 23 January 2001
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 127
insisted until the mid-1990s that eroded capital bases could be rebuiltin a market-driven fashion They rightly foresaw that huge loan losseswould undermine public support for the ruling party and require a po-litically unpopular bailout
Japanese foot dragging on Basel I was the worst54 but not uniqueOther examples can be found of ldquopolitically mandated forbearancerdquo TheFederal Reserve Bank of New York held important hands during theLTCM crisis of 1998 Mexico is still resolving the banking crisis that eruptedin 1995 South Korea has not yet closed the insolvent banks that behavedso badly before the crisis of 1998 In the aftermath of a crisis nationalregulators cannot always be relied upon to discipline politically power-ful bankers55 One of the little-noticed consequences of these differingapproaches is that those banks with strong regulatory systems receivedan implicit ldquoexport subsidyrdquo for their services US banks which had notengaged extensively in emerging-market lending in the 1990s were bet-ter positioned than their German and Japanese counterparts to expandtheir international assets in the wake of the crises
Other Financial Forums
54 See Japanese Banks Fiddling while Marunouchi Burns The Economist 27 January2001 67-69
55 See Calomiris (1997)
The Basel model of vertical subsidiarity has already been extended toother financial regulatory bodies In 1993-94 the BIS established a Tri-partite Group of Banking Insurance and Securities Regulators In 1994-95 the BIS increased its cooperation with the International Organizationof Securities Commissions when the two organizations issued parallelpapers on guidelines for national regulators concerning risk managementand disclosure of derivative trades In 1996 a permanent Joint Forum onFinancial Conglomerates was established to examine supervisory issuesand develop working arrangements among the different functional super-visors of conglomerate institutions that offer combinations of bankingsecurities and insurance products Draft papers on the supervisionof conglomerates were released for comment in 1998 applying capital-adequacy principles to these groups and providing guidelines both forassessing the integrity and competence of top managers and for sharingassessments between regulators
In 1997 the Basel Committee on Banking Supervision extended itsreach beyond capital standards to broader aspects of banking supervi-sion with the publication of the Core Principles for Effective BankingSupervision In 1999 a wide range of regulatory and standard-settingbodies were gathered under the umbrella of the Financial Stability
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128 WORLD CAPITAL MARKETS
Forum (FSF) itself established under BIS aegis56 The FSF has alreadyissued recommendations for stepped-up supervision and transparencyas well as guidelines for best practices in a number of areas includingoffshore financial centers and highly leveraged institutions or hedge funds57
Conclusion
Although the structural weaknesses in emerging-market economies arewidely acknowledged to have been causal factors in international capi-tal-market volatility this chapter points to the role of large G-10 bankingorganizations as major suppliers of the most volatile instrument short-term debt We have examined evidence of the impact of public safetynets in the G-10 economiesmdashthe deposit insurance systems the pruden-tial supervisory systems and the lender-of-last-resort functions of centralbanksmdashon the incentive structures of these organizations
Although supervisors in most countries working nationally and to-gether in the BIS have made significant efforts to mimic market forcesin their prudential supervision the most sophisticated financial institu-tions find innovative ways to circumvent the rules New global regulatorybodies are not about to be created G-10 national bank regulators shouldthemselves address the short-term debt bias in the international financialsystem by changing incentive systems G-10 securities regulators shouldalso take steps to get ahead of the curve paying close attention to largeportfolio swings by institutional investors particularly in times of crisisIn short more needs to be done at national and international levels tochange the rules of the game That is the subject of the next chapter
56 The Financial Stability Forum includes banking securities insurance and accountingregulatory bodies the OECD on taxation corruption and corporate governance and theIMF
57 See Martin (2000)
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 85
global capitalism In addition to their underwriting role investment banksearn substantial profits from trading securities
Wealth-management firms are the second group of portfolio institu-tions They typically deal with the publicmdashindividuals and companiesthat want a trusted firm to manage their pensions and other funds Table24 lists 10 large wealth managers all based in the G-10 Together these10 firms control $64 trillion in assets and their own market capitalization
Table 23 Large investment banks 1998 (billions of dollars)
MarketRevenue Assets capitalizationa
Merrill Lynchb (United States) 36 300 25Morgan Stanley Dean Witterb (United States) 31 318 50c
Goldman Sachs (United States) 22d 217e 29c
Lehman Brothers Holdingsb (United States) 20 154 10c
Salomon Smith Barneyf (United States) 8 211 naCredit Suisse First Bostong (United States
Switzerland) 7 280 naPaine Webberh (United States) 7 54 6i
Bear Stearnsj (United States) 8 154 5i
Donaldson Lufkin amp Jenrettek (United States) 5 72 7i
Total 144 1760 132 plusTotal for G-10 144 1760 132 plus
na = not available (subsidiaries of large holding companies Citigroup and Creacutedit SuisseGroup respectively individual market capitalization is not available)G-10 = Group of Ten countries see note to table 11
a Market capitalization is calculated by multiplying the total number of shares by the shareprice at the companyrsquos fiscal year-endb Source Fortune Global 500 1999 Data shown are for the fiscal year ended on or before31 March 1999 Assets shown are those at the companyrsquos fiscal year-end httpwwwpathfindercomfortuneglobal500indexhtmlc Figures as of September 1999 are from American Banker httpwwwamericanbankercomBankRankingsd Source 1998 Goldman Sachs Annual Review Assets as of November 1998 httpwwwgscomaboutannual19984_fsindexhtmle Source Financial Times Company Financials Revenue as of 27 November 1998 httpwwwglobalarchiveftcomcbcb_searchhtmf Source 1998 Citigroup Annual Report 20 Revenue figures for year ending 31 December1998 Asset figures as of 31 December 1998 httpwwwcitigroupcomcitigroupfindatac1998ar2pdfg Source 19981999 Creacutedit Suisse Group Annual Report 23 httpwwwcsgchcsg_annual_report_98downloadcsg_ar98_p1_enpdfh Source 1998 Paine Webber Annual Report 34-35 httpwwwpainewebbercomannual98graphicsfininfoindexhtmi Individual figures are obtained from Yahoo The time for valuations is as follows BearStearns December 1999 Lehman Brothers November 1999 Paine Webber and DonaldsonLufkin amp Jenrette September 1999j Source 1999 Bear Stearns Annual Report 55-56 Figures are for fiscal year ending 30June 1998 httpwwwbearstearnscomcorporateinvestorindexhtmk Source 1999 Donaldson Lufkin and Jenrette Annual Report ldquoFinancial Highlightsrdquo httpwwwdljcompdfDLJ98_1pdf
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86 WORLD CAPITAL MARKETS
exceeds $260 billion For the most part wealth managers are long-termportfolio investors
Hedge funds represent a highly specialized investment vehicle that isnot widely available to the public Most hedge funds are leveraged theyemploy dynamic (and sometimes opportunistic) trading strategies involvingpositions in several different markets they adjust their investment port-folios frequently in anticipation of asset price movements or changes inyield differentials between related securities Hedge funds are opaque tomarket monitoring They are subject to little direct regulation and areunder few obligations to disclose information Hence the size of the in-dustry is difficult to measure
If they are measured by capital under management or by assets hedgefunds are small relative to established wealth managers As table 25shows the capital managed by 20 large hedge funds in late 1998 amountedto less than $50 billion Estimates vary widely but if all hedge funds arecounted their assets range from $100 to $300 billion Even the highestnumber is less than 5 percent of the combined assets of investment banksand traditional asset managers
The amount of leverage used by hedge funds depends on trading strate-gies that are in turn shaped by investor attitudes toward risk Leverage
Table 24 Large asset managers in 1998 (billions of dollars)
Total assets under Marketmanagementa capitalizationb
UBS (Switzerland) 1145 58c
Fidelity Investments (United States) 773 naKampo (Japan) 698 naCredit Suisse Group (Switzerland) 680 50c
AXA Group (France) 647 39c
Barclayrsquos Global Investors (United States) 616 44c
Merrill Lynch amp Co (United States) 501 25c
State Street Global Advisors (United States) 493 naCapital Group Cos (United States) 424 naZurich Financial Services (Switzerland) 415 45c
Total 6392 261 plusTotal for G-10 6392 261 plus
na = not available (usually a nonpublic company)G-10 = Group of Ten countries see note to table 11
a Figures are assets under management at fiscal year-end 1998b Market capitalization is calculated by multiplying the total number of shares by the shareprice at the companyrsquos fiscal year-endc Figures from American Banker httpwwwamericanbankercomBankRankings
Sources Institutional Investor 1999 httpwwwiimagazinecomresearchinterfacehtml US(II300) Asia (Asia200) and Europe (Euro100) Asset Management Rankings American BankerhttpwwwamericanbankercomBankRankings
Institute for International Economics | httpwwwiiecom
THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 87
is achieved using such instruments as repos (repurchase agreements)futures and forward contracts and other derivative products5 It is alsovery difficult to measure A Financial Stability Forum (FSF 2000b) studyof hedge funds noted thatmdashalthough there are problems with the waydata vendors report these positionsmdashestimates suggest most hedge fundsuse modest amounts of leverage averaging 21 but ranging to 41 insome FSF (2000b) further notes difficulties with evaluating the risk-adjusted performance of hedge funds because of their dynamic tradingstrategies
Table 25 Largest hedge funds according tocapitalization August 1998 (billions of dollars)
Fund Capital under management
Domestica
Tiger 51Moore Global Investment 40Highbridge Capital Corp 14Intercap 13Rosenberg Market Neutral 12Ellington Composite 11Hedged Taxable-Equivalent 10Quantitative LongShort 09Sr International Fund 09Perry Partners 08
OffshoreJaguar Fund NV 100Quantum Fund NV 60Quantum Industrial Fund 24Quota Fund NV 17Omega Overseas Partners 17Maverick Fund 17Zweig Dimenna International 16Quasar International Fund NV 15SBC Currency Portfolio 15Perry Partners International 13
Totalb 471
a Long Term Capital Management (LTCM) was in serious difficulty in August1998 and is omitted from the listb Estimates of hedge fund capital and the number of funds vary significantlyMARHedge estimated 1115 funds with $109 billion capital under managementat the end of 1997 Van Hedge Fund estimated 5500 funds with capital of $295billions at the same date
Source Adapted from Eichengreen (1999a)
5 Positions are established by posting margins rather than the face value of the position
Institute for International Economics | httpwwwiiecom
88 WORLD CAPITAL MARKETS
The positive role of hedge fundsmdashproviding diversification to inves-tors because their returns have low correlations with standard asset classesmdashis counterbalanced by some negative features Hedge funds and otherhighly leveraged institutions (HLIs) may take concentrated positions andengage in aggressive market practices that amount to ldquoganging uprdquo on asmall economy (such as Hong Kong)6 Under normal market conditionsHLI positions are not destabilizing but some of the aggressive practicesdocumented in 1998 are worrisome The FSF study group participantsagreed (2000b 112) that such practices raise important issues for marketintegrity but they could not agree that market manipulation was suffi-ciently widespread to be a serious concern for policymakers
Insurance companies are the third group of portfolio institutions Theseare divided into two categories property and casualty companies andlife and health insurance companies Ten large companies of each cat-egory are listed in table 26 In 1998 the 10 property and casualty insur-ance companies had $16 trillion in assets and more than $330 billion inmarket capitalization The 10 life insurance companies had $28 trillionin assets7 Combining both categories 100 percent of assets are controlledby insurance companies based in the G-10 and Spain In portfolio man-agement styles life insurance companies tend to hold longer-term assetswhereas property and casualty companies tend to hold shorter-term in-struments
Nonfinancial Multinational Enterprises
The last players are the nonfinancial multinational enterprises (MNEs)The worldrsquos 100 largest corporations measured by 1998 revenue are re-corded in tables 27 and 28 The 30 financial giants among the top 100are separately shown in table 27 Most of the firms appeared in previ-ous tables Together these 30 financial giants had revenues of $13 tril-lion and controlled assets of $113 trillion8
Table 28 lists the 70 top nonfinancial giants Their revenues in 1998were $40 trillion and their assets (at book value) measured $45 trillionMeasured by revenue or assets about 95 percent of the giants are basedin the G-10 These firms are responsible for a large share of the worldrsquos
6 See IMF (1999c) for a description of the ldquodouble playrdquo that hedge funds are accusedof using in an attempt to destabilize Hong Kong in August 1998
7 Many life insurance companies are owned by their policyholders and therefore donot have a market capitalization
8 By comparison the larger set of 96 financial firms listed in previous tables controlled$322 trillion in assets This is the total amount of assets recorded in tables 21 (50 com-mercial banks) 22 (9 investment banks) 24 (10 asset managers) and 26 (20 insurancecompanies) The largest hedge funds might add $300 billion to the total
Institute for International Economics | httpwwwiiecom
THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 89
Table 26 20 large insurance companies in 1998(billions of dollars)
Property and casualty insurance Marketcompanies Revenuea Assetsb capitalizationc
Allianz (Germany) 65 402 62d
Assicurazioni Generali (Italy) 48 178 30d
State Farm Insurance Cos (United States) 45 111 naZurich Financial Services (Switzerland) 39 215 45d
CGU (United Kingdom) 38 176 20d
Munich Re Group (Germany) 35 131 naAmerican International Group (United States) 33 194 135d
Allstate (United States) 26 88 20d
Royal amp Sun Alliance (United Kingdom) 25 76 11d
Loews (United States) 21 71 7e
Total 375 1642 330 plusTotal for G-10 375 1642 330 plus
MarketLife and health insurance Revenuea Assetsb capitalizationc
AXA (France) 79 452 39d
Nippon Life Insurance (Japan) 66 363 naING Group (Netherlands) 56 464 46d
Dai-ichi Mutual Life Insurance (Japan) 44 253 naSumitomo Life Insurance (Japan) 40 206 naTIAA-CREF (United States) 36 250 naPrudential Ins Co of America (United States) 34 279 naPrudential (United Kingdom) 34 197 30d
Meiji Life Insurance (Japan) 28 146 naMetropolitan Life Insurance (United States) 27 215 na
Total 444 2825 naTotal for G-10 444 2825 na
na = not available (usually an insurance company owned by its policyholders)G-10 = Group of Ten countries see note to table 11
a Data shown are for the fiscal year ended on or before 31 March 1999b Assets shown are those at the companyrsquos fiscal year-endc Market capitalization is calculated by multiplying the total number of shares by the shareprice at the companyrsquos fiscal year-endd Market capitalization data as of September 1999 from American Banker httpwwwamericanbankercome Individual companyrsquos market capitalization as of September 1999 from Yahoo yahoomarketguidecom
Sources Fortune Global 500 1999 httpwwwpathfindercomfortuneglobal500indexhtmlAmerican Banker httpwwwamericanbankercomRankingBanks1999 Yahoo Marketguideyahoomarketguidecom
Institute for International Economics | httpwwwiiecom
90 WORLD CAPITAL MARKETS
Table 27 Financial firms in the 100 largest companiesby revenue 1998 (billions of dollars)
Globalrank Company Revenuesa Assetsb Type
Continental Europe
15 AXA (France) 79 452 Insurance23 Allianz (Germany) 65 402 Insurance28 Ing Group (Netherlands) 56 464 Insurance37 Credit Suisse (Switzerland) 49 475 Banks commercial
and savings39 Assicurazioni Generali (Italy) 48 178 Insurance42 Deutsche Bank (Germany) 45 736 Banks commercial
and savings56 Zurich Financial Services (Switerland) 39 215 Insurance68 Munich Re Group (Germany) 35 131 Insurance72 ABN AMRO Holding (Netherlands) 34 507 Banks commercial
and savings77 Credit Agricole (France) 33 459 Banks commercial
and savings80 HypoVereinsbank (Germany) 32 541 Banks commercial
and savings84 Fortis (Belgium) 31 397 Banks commercial
and savings98 Socieacuteteacute Geacuteneacuterale (France) 30 450 Banks commercial
and savingsUnited Kingdom
47 HSBC Holdings 43 485 Banks commercialand savings
58 CGU 38 176 Insurance74 Prudential 34 197 Insurance
United States
16 Citigroup 76 669 Diversified financials35 Bank of America Corp 51 618 Banks commercial
and savings44 State Farm Insurance Cos 45 111 Insurance64 TIAA-CREF 36 250 Insurance67 Merrill Lynch 36 300 Securities71 Prudential Ins Co of America 34 279 Insurance76 American International Group 33 194 Insurance79 Chase Manhattan Corp 32 366 Banks commercial
and savings83 Fannie Mae 31 485 Diversified financials88 Morgan Stanley Dean Witter 31 318 Securities
Japan
21 Nippon Life Insurance 66 363 Insurance45 Dai-ichi Mutual Life Insurance 44 253 Insurance54 Sumitomo Life Insurance 40 206 Insurance91 Bank of Tokyo-Mitsubishi 31 664 Banks commercial
and savingsTotal 1279 11341Total for G-10 1279 11341
G-10 = Group of Ten countries see note to table 11
a Data shown are for the fiscal year ended on or before 31 March 1999b Assets shown are those at the companyrsquos fiscal year-end
Source Fortune Global 500 1999 httpwwwpathfindercomfortuneglobal500indexhtml
Institute for International Economics | httpwwwiiecom
THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 91
Tab
le 2
8N
on
fin
anci
al f
irm
s in
th
e 10
0 la
rges
t co
mp
anie
s b
y re
ven
ue
199
8 (b
illio
ns o
f do
llars
)
Glo
bal
Tra
nsn
atio
nal
ity
ran
k
Co
mp
any
Rev
enu
esa
Ass
etsb
ind
exc
Typ
e
Co
nti
nen
tal
Eu
rop
e
2D
aim
lerC
hrys
ler
(Ger
man
y)15
516
044
1M
otor
veh
icle
s an
d pa
rts
11R
oyal
Dut
chS
hell
Gro
up (
Net
herla
nds)
9411
058
9P
etro
leum
ref
inin
g17
Vol
ksw
agon
(G
erm
any)
7670
568
Mot
or v
ehic
les
and
part
s22
Sie
men
s (G
erm
any)
6667
521
Ele
ctro
nics
el
ectr
ical
equ
ipm
ent
32M
etro
(G
erm
any)
5222
n
a
Foo
d an
d dr
ug s
tore
s34
Fia
t (I
taly
)51
7640
8M
otor
veh
icle
s an
d pa
rts
36N
estle
(S
witz
erla
nd)
5041
932
Foo
d46
Veb
a G
roup
(G
erm
any)
4351
275
Tra
ding
49R
enau
lt (F
ranc
e)41
4545
7M
otor
veh
icle
s an
d pa
rts
53D
euts
che
Tel
ekom
(G
erm
any)
4093
n
a
Tel
ecom
mun
icat
ions
57R
oyal
Phi
lips
Ele
ctro
nics
(N
ethe
rland
s)38
3386
4E
lect
roni
cs
elec
tric
al e
quip
men
t59
Peu
geot
(F
ranc
e)38
4038
7M
otor
veh
icle
s an
d pa
rts
62E
lect
riciteacute
de
Fra
nce
(Fra
nce)
3711
3
na
Util
ities
ga
s an
d el
ectr
ic63
Rw
e G
roup
(G
erm
any)
3747
n
a
Util
ities
ga
s an
d el
ectr
ic65
BM
W (
Ger
man
y)36
3660
7M
otor
veh
icle
s an
d pa
rts
66E
lf A
quita
ine
(Fra
nce)
3643
576
Pet
role
um r
efin
ing
69V
iven
di (
Fra
nce)
3558
n
a
Eng
inee
ring
and
cons
truc
tion
70S
uez
Lyon
nais
e de
s E
aux
(Fra
nce)
3585
n
a
Ene
rgy
78E
NI
(Ita
ly)
3249
317
Pet
role
um r
efin
ing
86B
ayer
(G
erm
any)
3134
827
Che
mic
als
92A
BB
Ase
a B
row
n B
over
i (S
witz
erla
nd)
3132
957
Ele
ctro
nics
el
ectr
ical
equ
ipm
ent
93B
AS
F (
Ger
man
y)31
3159
5C
hem
ical
s95
Car
refo
ur (
Fra
nce)
3020
n
a
Foo
d an
d dr
ug s
tore
s
(tab
le c
ontin
ues
next
pag
e)
Institute for International Economics | httpwwwiiecom
92 WORLD CAPITAL MARKETS
Tab
le 2
8N
on
fin
anci
al f
irm
s in
th
e 10
0 la
rges
t co
mp
anie
s b
y re
ven
ue
199
8 (b
illio
ns o
f do
llars
) (c
ontin
ued
)
Glo
bal
Tra
nsn
atio
nal
ity
ran
k
Co
mp
any
Rev
enu
esa
Ass
etsb
ind
exc
Typ
e
Un
ited
Kin
gd
om
19B
P A
moc
o68
8559
2P
etro
leum
ref
inin
g43
Uni
leve
r45
3692
4F
ood
Un
ited
Sta
tes
1G
ener
al M
otor
s16
125
729
3M
otor
veh
icle
s an
d pa
rts
3F
ord
Mot
or14
423
835
2M
otor
veh
icle
s an
d pa
rts
4W
al-M
art
Sto
res
139
49
na
G
ener
al m
erch
andi
sers
8E
xxon
101
9365
9P
etro
leum
ref
inin
g9
Gen
eral
Ele
ctric
100
356
331
Ele
ctro
nics
el
ectr
ical
equ
ipm
ent
14In
tl B
usin
ess
Mac
hine
s82
8653
7C
ompu
ters
of
fice
equi
pmen
t25
US
Pos
tal
Ser
vice
6055
n
a
Mai
l pa
ckag
e a
nd f
reig
ht d
eliv
ery
27P
hilip
Mor
ris58
6051
1T
obac
co29
Boe
ing
5637
n
a
Aer
ospa
ce30
AT
ampT
5460
219
Tel
ecom
mun
icat
ions
40M
obil
4843
597
Pet
role
um r
efin
ing
41H
ewle
tt-P
acka
rd47
3451
1C
ompu
ters
of
fice
equi
pmen
t50
Sea
rs R
oebu
ck41
38
na
G
ener
al m
erch
andi
sers
55E
I d
u P
ont
de N
emou
rs39
40
na
C
hem
ical
s61
Pro
ctor
and
Gam
ble
3731
477
Soa
ps
cosm
etic
s75
Km
art
3414
n
a
Gen
eral
mer
chan
dise
rs81
Tex
aco
3229
453
Pet
role
um r
efin
ing
82B
ell
Atla
ntic
3255
n
a
Tel
ecom
mun
icat
ions
85E
nron
3129
n
a
Ene
rgy
87C
ompa
q C
ompu
ter
3123
n
a
Com
pute
rs
offic
e eq
uipm
ent
89D
ayto
n H
udso
n31
16
na
G
ener
al m
erch
andi
sers
94J
C
Pen
ney
3124
n
a
Gen
eral
mer
chan
dise
rs96
Hom
e D
epot
3013
n
a
Spe
cial
ty r
etai
lers
97Lu
cent
Tec
hnol
ogie
s30
27
na
E
lect
roni
cs
elec
tric
al e
quip
men
t10
0M
otor
ola
2929
n
a
Ele
ctro
nics
el
ectr
ical
equ
ipm
ent
Institute for International Economics | httpwwwiiecom
THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 93
Jap
an
5M
itsui
109
5635
8T
radi
ng6
Itoch
u10
957
333
Tra
ding
7M
itsub
ishi
107
7536
9T
radi
ng10
Toy
ota
Mot
or10
012
540
0M
otor
veh
icle
s an
d pa
rts
12M
arub
eni
9455
300
Tra
ding
13S
umito
mo
8946
259
Tra
ding
18N
ippo
n T
eleg
raph
amp T
elep
hone
7614
7
na
Tel
ecom
mun
icat
ions
20N
issh
o Iw
ai68
3938
8T
radi
ng24
Hita
chi
6282
214
Ele
ctro
nics
el
ectr
ical
equ
ipm
ent
26M
atsu
shita
Ele
ctric
Ind
ustr
ial
6067
332
Ele
ctro
nics
el
ectr
ical
equ
ipm
ent
31S
ony
5353
628
Ele
ctro
nics
el
ectr
ical
equ
ipm
ent
33N
issa
n M
otor
5158
511
Mot
or v
ehic
les
and
part
s38
Hon
da M
otor
4943
641
Mot
or v
ehic
les
and
part
s48
Tos
hiba
4151
252
Ele
ctro
nics
el
ectr
ical
equ
ipm
ent
51F
ujits
u41
4332
6C
ompu
ters
of
fice
equi
pmen
t52
Tok
yo E
lect
ric P
ower
4012
2
na
Util
ities
ga
s an
d el
ectr
ic60
NE
C37
42
na
E
lect
roni
cs
elec
tric
al e
quip
men
t90
Tom
en31
18
na
T
radi
ng99
Mits
ubis
hi E
lect
ric30
35
na
E
lect
roni
cs
elec
tric
al e
quip
men
t
Ch
ina
73S
inop
ec34
52
na
P
etro
leum
ref
inin
g
Tot
al (
aver
age
for
tran
snat
iona
lity
inde
x)3
988
447
949
0T
otal
for
G-1
0 (a
vera
ge f
or t
he i
ndex
)3
954
442
749
0
na
= n
ot a
vaila
ble
G-1
0 =
Gro
up o
f T
en c
ount
ries
see
not
e to
tab
le 1
1
a
Dat
a sh
own
are
for
the
fisca
l ye
ar e
nded
on
or b
efor
e 31
Mar
ch 1
999
b
Ass
ets
show
n ar
e th
ose
at t
he c
ompa
nyrsquos
fis
cal
year
-end
c
The
ind
ex o
f tr
ansn
atio
nalit
y is
cal
cula
ted
as t
he a
vera
ge o
f ra
tios
of f
orei
gn a
sset
s to
tot
al a
sset
s f
orei
gn s
ales
to
tota
l sa
les
and
for
eign
em
ploy
men
tto
tot
al e
mpl
oym
ent
as o
f 19
97 (
UN
CT
AD
)
Sou
rces
F
ortu
ne G
loba
l 50
0 1
999
http
w
ww
pat
hfin
der
com
fort
une
glob
al50
0in
dex
htm
l U
NC
TA
D (
1999
)
Institute for International Economics | httpwwwiiecom
94 WORLD CAPITAL MARKETS
foreign direct investment The ldquotransnationality indexrdquo (table 28) showsthat on average they conducted about half their business outside theirhome country9
Overview of the Players
Our review of the major players points to two major features First ahandful of big playersmdashfewer than 200 firms all toldmdashcontrol the ac-tion in international capital markets Their dominance will doubtless erodebut for now financial power is strikingly concentrated with them Sec-ond the big players are overwhelmingly based in the G-10 countriesplus Spain The responsibility to supervise them rests not in the IMFnor in Basel but squarely in Washington London Tokyo and the otherG-10 capitals At year-end 1999 the G-10 countries plus Spain accountedfor 84 percent of world banking assets 86 percent of world stock marketcapitalization and 76 percent of international debt securities (BIS 2000aWorld Bank 2000b)
International private capital flows are of three types bank loans anddeposits portfolio investment and foreign direct investment In cumula-tive total flows to emerging markets FDI was the biggest story in the1990s amounting to $954 billion (table 12) Portfolio flows were nextcumulatively amounting to somewhere between $612 billion (table 12)and $764 billion (table A1) Bank loans and deposits are the most com-plicated story
The Key Role of Banks
Banks are more important as an epicenter than as a wellspring Banksgenerate waves in the flow of capital to emerging markets rather than acontinuous steady stream According to data compiled by the Institute ofInternational Finance (table A1) net bank lending to emerging marketscumulated to $269 billion in the 1990s However deposits by emerging-market residents in G-10 banks more than offset G-10 bank lending tothese countries during the decade According to IMF data cumulativebank loans net of deposits amounted to a negative $135 billion (table 12)
In other words when loans and deposits are combined net bank ac-tivity that moves financial resources to emerging markets is small incomparison with portfolio investment and FDI But bank loans are thelubricant of any financial system Depending on circumstances bankscan be shock absorbers or shock propagators In recent decades with
9 The transnationality index is calculated as a simple average of the share of assetssales and employees outside the home country
Institute for International Economics | httpwwwiiecom
THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 95
respect to emerging markets banks have more often been propagatorsthan absorbers The average annual swing in bank lending to emergingmarkets was nearly $50 billionmdashby far the largest source of year-to-yearfluctuations in capital flows Both interbank loans between Europe Japanand Asia and sovereign Russian debt used as loan collateral played amajor role in the 1997-98 crisesmdashnot because banks are profligate playersbut because of the incentives they face and the instruments they useAccordingly our story begins with banks
Banks in the Modern Financial System
10 See Levine (2000) for a concise description of the role of banks in the financial system
11 The asymmetric information problem helps to explain why banks dominate the im-mature financial systems of emerging-market economies The general lack of informationon borrowers and undeveloped legal systems to enforce contracts hamper suppliers oflong-term financial instruments such as equities and bonds in evaluating risk and re-ward Banks are best suited in these circumstances to solve the asymmetric informationproblem by evaluating and monitoring private loans As more and better informationbecomes available capital markets develop and financial systems mature
As we noted in the previous paragraph the problem of financial volatil-ity in emerging-market economies is associated with bank lending Ifand when repayment problems arise cross-border private bank loansand bond placements are such that private creditors have no plausiblemeans of seizing assets from either private or sovereign borrowers Thusalthough international finance can nourish entrepreneurs and accelerategrowth a necessary complement may be a drastic creditor response inthe event of nonpaymentmdashto withhold fresh funds and force an eco-nomic crisis (Dooley 2000)
This argument is based on the characteristics of banks They are notldquobadrdquo per se They perform three essential functions in any financialsystem pooling the resources of disparate savers and channeling these re-sources into productive investment improving resource allocation throughtheir expertise in assessing and monitoring borrowers and facilitatingthe division of risk among numerous creditors10 But by their very na-ture banks are prone to two problems asymmetric information (the bor-rower knows more about the potential risk and return of its projectsthan the bank) and adverse selection (riskier borrowers will pay higherinterest rates and thus may constitute a disproportionate share of bankloan portfolios)11
Bank loans are illiquid fixed-price instruments They cannot easily beconverted to cash although they can be bundled into securities (knownas ldquosecuritizationrdquo) Once loan terms have been agreed on the only waya bank can adjust for shifting market conditions is by changing the quantityof its exposure When a borrower runs into trouble the bank can mix
Institute for International Economics | httpwwwiiecom
96 WORLD CAPITAL MARKETS
and match from two unpleasant menus It can roll over existing loansand extend new credit or it can call some part of existing loans andattempt to recover the principal It can also hedge by selling short otherclaims on the borrower These choices entail either an unwelcome exten-sion of the bankrsquos exposure or credit rationing against the borrower Whentrouble brews all banks encounter the same conditions in the aggregatethey prefer less exposure and ensuing credit restrictions lead to volatilebank lending
Innovation
12 Derivatives have no value of their own They ldquoderiverdquo their value from the value ofthe underlying asset They include swaps futures (contracts for future delivery at speci-fied prices) and options (which give one party the right but not the obligation to buyfrom or sell to a counterparty at an agreed price)
13 Maxfield (1998) analyzed available evidence of emerging-market investor objectivesmost of it before the crisis Analysis of portfolio equity flows is sensitive to the choice ofperiod with year-over-year data indicating that investors respond to country ldquofundamen-talsrdquo Other evidence suggests more ambiguity Ranking by ldquoinvestor impatiencerdquo ie thesearch for yield over value Tesar and Werner (1995) find short-term bank flows to be themost yield driven followed by portfolio investment FDI and long-term bank lending
14 Because market risk credit risk and country risk interact in complex ways newfinancial instruments have been created to help reduce negative interactions One is theldquototal return swaprdquo which has become an instrument of choice for hedge funds lookingfor high leverage Banks also use the total return swap to cover risks without increasingtheir capital requirements
Since the 1980s national and international banking systems have beentransformed by deregulation intensified competition and the informationand communications-technology revolutions The market environment isone of intense competition particularly in traditional banking activitiesThe innovations point away from traditional activities of plain vanilladeposit taking and loan making Three big themes are discernible Firstthe walls separating commercial banks investment banks portfolio man-agers and insurance firms are falling even if they are still distinct Sec-ond large banks are shifting toward securitizationmdashcreating securitiesout of everything from credit card debt to trade finance to disaster insur-ancemdashand earning fees in the process Third all large banks are shiftingtoward trading activity making markets and taking short-term stakes inbonds shares and derivatives12 These activities when successful satisfythe search for higher yields13
Many of the new financial instruments that banks trade are ldquooff bal-ance sheetrdquo This means that banks are not required to allocate capitalagainst them In swap contracts for example neither side pays cash at theoutset and therefore neither party has an asset in the traditional sense14
Futures and options contracts can be written with a relatively small initial
Institute for International Economics | httpwwwiiecom
THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 97
margin relative to the potential risk Credit derivatives limit credit risk bytransferring the potential loss associated with corporate loans and bondssovereign debt and other loan portfolios to counterparties15
Deregulation and innovation working in combination seem to havepushed banks into trading activity and leveraged plays but not into shareownershipmdasheven in jurisdictions that have no prohibition against equitystakes Among the G-10 banking systems the highest ratio of share own-ership to assets was only 5 percent in 1996 reached in Germany andJapan (Berlin 2000)16
The wave of innovation in financial instruments and the accompany-ing expansion of banking beyond its old boundaries is a two-edged swordOn one side it allows risk management far beyond what was tradition-ally possible Risk can now be shifted from firms that can ill afford lossesto those that can Banks can profitably act as intermediaries in shiftingrisk On the other side the innovation wave creates huge opportunitiesfor leveraged plays fostering a speculative search by banks themselvesfor high returns that in turn magnify their own risks17
15 Credit derivatives include total return swaps credit default swaps credit-linked notesand collateralized debt obligations They are the fastest-growing sector of the global de-rivatives market
16 Banks seem to specialize in lending even when they are allowed to mix finance andcommerce for reasons related both to how they are expected to behave with distressedfirms and to other intricacies of lender liability (Berlin 2000) Yet a recent cross-countrystudy found that restrictions on banking and commerce are associated with greater fi-nancial instability (Barth Caprio and Levine 2000)
17 Leverage is the magnification of the rate of return (positive or negative) on an in-vestment beyond the rate obtained by solely investing funds owned by the institution Itis often defined as the ratio of assets to equity Leverage is achieved by increasing thesize of an investment by borrowing or using derivative instruments such as futures oroptions These allow investors to earn a return on the notional amount underlying thecontract by committing a small portion of equity in the form of a margin deposit oroption premium payment
18 In a repo (repurchase agreement) one party (typically a trader) buys a bond andsells it to a dealer for cash with a promise to buy it back the next day at the same priceplus the overnight interest rate As long as the overnight interest rate is lower than theinterest accruing on the bond the trader earns some income on the bond The extremeform of these kinds of transactions was discovered at LTCM the failed US highly lever-aged institution which appears to have controlled more than $120 billion in assets froman investment of about $3 billion This leveraging was accomplished mostly through theuse of repos (Mayer 1999)
The potential for damage is illustrated in an extreme form by figure 21To precisely measure a firmrsquos leverage all positions must be known andrealistically valuedmdashwhich may be impossible to do Because many ac-tivitiesmdashsuch as repos18 and derivativesmdashdo not appear on the institutionrsquos
Leverage
Institute for International Economics | httpwwwiiecom
98W
OR
LD
CA
PIT
AL
MA
RK
ET
S
Figure 21 Hypothetical example of leverage
$1000 notional value of call option on equity in firms targeted for takeover
Repo FRN into cash and use cash to pay option premium
(repro is initially collateralized
Borrow $100 for margin purchase
$125 of US investment bank floating-rate notes (FRN) (secured by $25 equity in FRNs)
Repo off-the-run bond into cash and post margin
(repo is initially collateralizedSell (short) Borrow on-the-run bonds worth $20
$25 worth of off-the-run bonds (secured by $5 equity in bonds)
Exchange into $4
Cash $5 yen400 Japanese bank loans
$1 equity base
FRN = floating rate notesRepo = repurchase agreement
Source IMF (1998)
Institute for International Econom
ics | httpww
wiiecom
THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 99
balance sheet and because balance sheets are published quarterly at bestoutsiders have a difficult time assessing the extent of a firmrsquos leverage19
Leveraging by a single firm enhances its risk of default the widespreaduse of leverage in the financial system can magnify market adjustmentsespecially when they require ldquodeleveragingrdquomdashunwinding prior positionsRapid adjustments can cause credit to dry up and asset prices to plummetIn a mark-to-market environment falling asset prices trigger calls foradditional collateral that can ripple through markets
Risk Management
Because it is confronted with the widespread use of leverage and prolif-erating kinds of risk international finance is increasingly driven by riskevaluation and control20 Different institutions face various risk profilesand differing kinds of risk The most common risks can be quickly tickedoff Banks because of their traditional intermediary role of channelingthe resources from savers to borrowers face significant credit risk therisk of default or delay in the payment of principal and interest Theymust also manage market risk the risk that the prices of their liabilitiesmay change faster than their assets Market risk devastated US savingsand loan institutions in the late 1980s
Closely associated with market risk are interest-rate risk (unexpectedchanges in market interest rates that slash margins net income and theeconomic value of a bankrsquos equity) and foreign exchange risk (losses thatarise when assets denominated in an appreciating foreign currency areless than liabilities denominated in that currency) Banks make numer-ous loans to other banks around the world portfolio investors buy se-curities direct investors acquire fixed assets and all incur country risk(economic and political uncertainty in the host country) During the heightof the Asian crisis for example interbank loans to Japanese banksreflected the credit risk of lending to these banks the so-called Japanpremium
Substantial attention has been lavished on country risk analysis sincethe 1982 debt crisis in developing countries Yet in spite of this exper-tise the Asian crisis occurred in part because of a sudden upward reap-praisal of country risk after the Thai baht collapsed in April 1997 Banksand other financial institutions must also manage liquidity risk the riskthat market conditions will change unexpectedly depressing demand andprices of assets at the time they want to sell these assets And they mustmanage operational riskmdashfailures in control systems or people that cause
19 Another example of asymmetric information Both risk and leverage are difficult foroutsiders to assess without full timely disclosure
20 A longer discussion of these issues can be found in Managing Global Finance in IMF(1999c)
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100 WORLD CAPITAL MARKETS
financial loss or damage reputations Operational risk devastated BaringsBank in 1995
Financial institutions practice risk management to measure all theserisks the potential damage to their investment positions and ultimatelythe chance of becoming insolvent VAR (value at risk) risk models mea-sure subject to certain assumptions the amount of the firmrsquos capital thatis exposed in each period For example the VAR model might say thatin a 3-standard-deviation worst case (a case that is not supposed to hap-pen more than 1 percent of the time) the firm will loose 25 percent of itscapital during the next year
VAR models are widely used but like all models they have weak-nesses They rely on past values to estimate key variables in financialmarkets past values are not always good predictors of future risks More-over rising volatility and higher loss correlation among different assetclasses in a portfolio will cause all banks using these models to reducetheir exposures at the same time by switching to less volatile and lesscorrelated assets such as US Treasury bills (Persaud 2000)
Newer risk models entail stress testing and scenario analysis Scenarioanalysis envisages possible adverse changes one at a time that mightaffect the investment portfolio Stress testing estimates potential losseswhen several individual risk factors simultaneously move against thefirm but it too uses historical probabilities
Financial Volatility
21 For example derivative markets usually rely on underlying securities markets thatproduce continuous prices When these markets are interrupted financial shocks cantrigger a cascade of margin calls and sell orders that move prices very sharply
22 See IIF (1999a)
The combination of trading activity and modern risk management lie atthe root of financial volatility When risks increase banks must eitherraise more capital to cover the greater risk or reduce their exposure bycutting loan exposure by selling securities or by undertaking new de-rivative trades Raising more capital is time-consuming and in a crisisvery expensive because bank shares are depressed So banks look to theother alternatives If the bank can reduce lending it need not book aloss But most banks use the same VAR models and as indicated abovethese models will encourage them to reduce their outstanding loans atthe same time actually magnifying loan volatility
If banks attempt to reduce their exposure to risk by selling securitiesor undertaking new derivative trades they may trigger large priceshocks because of limited and shrinking market liquidity21 The liquid-ity problem is compounded when a small number of large institu-tions hold the same positions22 Take your pick loan volatility or price
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 101
volatility As two experts have observed (Folkerts-Landau and Garber1998)
[V]olatility even in one country will automatically generate an upward re-estimate of credit and market risk in a correlated country triggering automaticmargin calls and tightening of credit lines Thus apparently bizarre opera-tions that connect otherwise disconnected securities markets are not the re-sponses of panicked green screen traders arbitrarily driving economies from agood to a bad equilibrium Rather they work with relentless predictability andunder the seal of approval of supervisors in the main financial centers
23 See Ferguson (1999)
24 As Gerald Corrigan (1982) put the matter ldquoBanks are specialrdquo Corrigan (2000) reit-erated this view even after all the changes of the past two decades Unlike other institu-tions banks offer on-demand transactions are a backup liquidity source for other insti-tutions and serve as a ldquotransmission beltrdquo for monetary policy
These changes in the banking environment accentuate an existing anomalyThe anomaly is that banks even as they grow larger and increasinglyengage in more risky and complex transactions are perceived to enjoyimplicit and explicit public guarantees
The guarantees grow out of an incentive problem inherent in bankingasymmetric information which we mentioned above Depositors know lessabout a bankrsquos management and the quality of its balance sheet than doits managers and shareholders Thus in times of uncertainty or adver-sity bank depositorsmdashuncertain whether they will have access to theirdepositsmdashare prone to bank runs This prospect has in turn compelledgovernments to treat banks differently than other firms because a bankthat fails can disrupt the rest of the economy24
To prevent such crises governments have entered into quid pro quoarrangements with banks Governments provide them both with an im-plicit safety net in the form of an unstated promise by the central bankto act as a lender of last resort in a liquidity crisis and an explicit safetynet in the form of a public deposit insurance fund to reassure depositorsIn return the banks submit to closer government oversight and regu-lation of their activities than is usual for industries in the private sector
The ldquoinsurancerdquo provided by the public safety net contributes to an-other incentive problem moral hazard Banks acquire greater tastes forrisk and face less market discipline than other firms The explicit depositinsurance safety nets actually have or are perceived to have blanketcoverage that extends beyond the retail depositors (households and small
One of the lessons of the 1997-98 crisis must surely be that market par-ticipants and their regulatory supervisors relied too heavily on quantita-tive tools and insufficiently on judgment23
The Anomaly of Modern Banking
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102 WORLD CAPITAL MARKETS
businesses) for which they were originally intended The implicit centralbank safety nets extend in a crisis to nearly all depositors and banksThus banks are both viewed and behave as if they will be bailed out ifthey get into trouble
The existence of a public safety net raises a perennial question Dobanks have an unfair advantage over other financial institutions becauseof the subsidy provided by the safety net This question was at the heartof intensive study and debate in the United States leading up to thepassage in November 1999 of the Financial Services Modernization Act(also known as the Gramm-Leach-Bliley Act) The size of the gross sub-sidy is difficult to estimate despite determined research efforts Somesuggest it is well under 100 basis points and is at least partly offset bythe direct costs of deposit insurance premiums interest payments on bondsissued by the Financing Corporation25 reserve requirements regulatoryexpenses and operational costs associated with collecting deposits26 Con-versely Kwast and Passmore (2000) suggest that banks can expand theirscope far beyond the levels that other financial institutions could reachwith the same equity base but without the public safety net
A related concern in the US debate is whether allowing banks to ex-pand their activities into securities and insurance will ultimately extendthe safety net and add to the subsidy The Financial Services Moderniza-tion Act deals with this issue by maintaining a legal separation betweenbanks and the rest of the banking organization known as large com-plex banking organizations (LCBOs) They must engage in most securi-ties activities and insurance underwriting through separately capitalizedinvestment bank subsidiaries or holding company affiliates This act canbe said to have merely brought US banking laws closer to those of mostother industrial countries (Barth Brumbaugh and Wilcox 2000 BarthNolle and Rice 2000) If the fire wall is well-maintained and stoutly de-fended the safety net will neither expand in practice nor become a sourceof comfort to noncommercial bank subsidiaries of LCBOs
The quid pro quo exacted by governments to offset the subsidy iscloser public-sector monitoring of banksrsquo activities through prudentialsupervision The effectiveness of this closer official scrutinymdashand closermarket monitoringmdashare the subjects of the next section
25 The Financing Corporation was created by Congress in 1987 to sell bonds to raisefunds to help resolve the savings and loan crisis
26 See Levonian and Furlong (1995) Jones and Kolatch (1999) Shull and White (1998)and Whalen (1999a 1999b)
Are G-10 bank supervisors adequately responding In this section we firstassess the case for and compare the structures of prudential supervisory
Prudential Supervision
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 103
systems both within and among the G-10 economies plus Spain andconsider whether these offset the subsidy provided by the public safetynet Despite offsetting regulation and supervision implicit and explicitguarantees by G-10 governments to their banks are still a source of bank-ing instability in the emerging-market economies
National Systems for Prudential Supervision
Governments use prudential supervision to reduce the moral hazard andadverse selection created by their own safety nets Supervisors establishregulations and monitor compliance to limit risk taking and ensure thesafety and soundness of the banking system In a thoughtful analysis ofthe case for prudential supervision Frederic Mishkin (2000) identifiesthe main forms that supervision can take including the tasks of grantingbanking charters and licenses establishing capital requirements settingdeposit insurance premiums and defining disclosure requirements as wellas carrying out bank examinations Bank examiners gather informationfrom banks and evaluate whether they are following the regulatorsrsquo rulesin cases of weakness they are empowered to change banksrsquo behaviorand close them if necessary
Supervisors also may restrict competition define the activities in whichbanks may engage and restrict their asset holdings and separate banksand other financial (or nonfinancial) activities During the past two de-cades the barriers separating commercial banks investment banks in-surance firms and securities firms have been all but eliminated (tableB1) Deregulation has stimulated competitive forces that drive diversifi-cation and consolidation of the financial industry nowhere faster than inthe United States
The Financial Services Modernization Act of 1999 confirmed this trendIt eliminated restrictions dating back to the Glass Steagall Act of 1933which once prevented banking insurance and securities firms fromentering each otherrsquos businesses (Barth Brumbaugh and Wilcox 2000)Cross-pillar mergers among banks insurance and securities firms arewell under way to form giant financial holding companies The 1999merger between Citibank (banking) and Travelers (insurance) created themodel for megafinance and confirmed new challenges for supervisors
Mishkin (2000) notes the corresponding evolution in US supervisionfrom an emphasis on rules-based regulation (detailed rules for opera-tional behavior and the quality of line items in the balance sheet) to anapproach that stresses the soundness of bank management practices es-pecially risk management
Appendix B outlines the systems of financial supervision now in theplace in the G-10 countries plus Spain Some systems like the UK andCanadian approach are models of simplicitymdashorganized to keep pacewith the spreading reach of financial conglomerates Other systems like
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104 WORLD CAPITAL MARKETS
the US and French approaches show traces of the bureaucratic divisionsthat made sense in an era when banking securities and insurance weresharply separated
The US Model
27 See Meyer (1999a)
28 Canada has a similar degree of simplification with the exception that securities firmsare still regulated by provincial authorities
29 See Pratti and Schinasi (1999 67)
30 The agents are the bank regulators and the principals are the taxpayers Agents maypursue their own interests including bureaucratic survival and postgovernment employ-ment opportunities rather than the national interest in banking safety and soundness
The US model of financial regulation delineated in the Financial Ser-vices Modernization Act of 1999 blends functional and umbrella super-vision Bank and thrift regulators oversee depository institutions Newnonbank activities are subject to both functional regulation (eg by theSecurities and Exchange Commission and state insurance examiners) andumbrella supervision (of financial holding companies) by the FederalReserve27
The UK Model
Another supervisory model exists in the United Kingdom as well as inAustralia Canada and Switzerland28 In this model banking supervisionis separated from the monetary policy function The regulatory structureis considerably simplified by relying on a consolidated financial regula-tor separate from the central bank for both banking and nonbankingactivities The remaining question answered differently depending on thecountry is the extent to which the regulator relies on home-country sur-veillance of banks and conglomerates that have a local presence
Regulatory Models Compared
Appendix B provides more detail on the differences in these modelsGerman simplicity contrasts with French complexity In France the bankingcommission is chaired by the governor of the central bank and includesrepresentatives from the Treasury The commission supervises compli-ance with regulations but the central bank inspects banks on behalf ofthe commission29 In countries such as the United States and France withmultiple supervisors and crossover functions internal coordination is criticalAt the same time multiple agencies create regulatory competition Wheneach agency knows what the other is doing transparency within gov-ernment circles can help to limit principal-agent problems of regulation30
The discussion as to where in the public bureaucracy financial super-
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 105
vision should be placed goes back many years Peek Rosengren andTootell (1999) argue that a synergy exists between monetary policy andprudential supervision because information gained in the course of super-vision can increase the accuracy of macroeconomic forecasts A twist tothis argument is that the information on the state of financial institutionsavailable to the central bank as supervisor can facilitate its role as lenderof last resort Conversely there is the concern that a supervisory rolewill compromise the central bankrsquos independence of action with respectto its core mandatemdashmaintaining price stability As these arguments haveplayed out financial supervision has generally been shared between centralbanks and other regulators or placed entirely in the hands of an inde-pendent regulator However in Italy the Netherlands and Spain cen-tral banks are the sole banking supervisor
Goodhart (1995) examined the arguments and evidence for each modeland concluded that there were no overwhelming arguments or evidencefor one or the other31 Going forward a key problem for any financialsupervisory system is dealing with (and closing as necessary) weak banksIf both central banks and other regulators have this responsibility closecoordination between them is critical Another problem is large conglom-erate banks LCBOs Although they are less likely to fail because of thediversification of their assets and liabilities they are more likely to berescued They are also more likely to be multinational enterprises withinternational implications Goodhart observes that regulation of theseentities might be put in the hands of the central bank because it is lessamenable to political pressures In any event the complexity of LCBOoperations suggests that greater supervisory rigor is necessary
The US Congress was persuaded that broad oversight would help containthe moral hazard problem and accordingly gave the Federal Reservethe role of umbrella supervisor with the understanding that the Fed willscrutinize depository activity more intensely than nonbank financial ac-tivities Under this approach LCBOs such as Citigroup are subject tomuch closer monitoring than smaller and simpler institutions32 The USregulatory model requires enormous cooperation between the Fed otherbank supervisors and the functional regulators for insurance and securi-ties but it also benefits from regulatory competition
31 National systems of supervision are path dependent they are determined by the struc-ture of financial institutions and history in each country If Goodhart (1995) is right out-comes are not materially better or worse with one model of supervision rather than another
32 See Ferguson (1999)
Public Safety Nets
One of prudential supervisorsrsquo biggest challenges is to reduce moral hazardFor many years commercial banks engaged in communal self-insurance
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106 WORLD CAPITAL MARKETS
to deal with crises They formed voluntary groups that agreed to rescuetroubled members As financial markets evolved and competition inten-sified banks were no longer willing to play this role Private-sector in-surance is one alternative but moral hazard and adverse selection wouldappear to prevent it from happening Public safety nets have developedbecause of the low probability and high cost of potential bank runs Aclear trade-off is involved The effectiveness of insurance in preventingbank runs is greater the more comprehensive the coverage But the morecomprehensive the coverage the greater the moral hazardmdashbank man-agers bank directors investors and depositors all take on greater risksin the belief that the safety net will protect them against losses
All G-10 countries have compulsory public safety nets for banks (table29) Deposit insurance agencies are officially organized in Canada theNetherlands Sweden Switzerland and the United States organized bythe industry in France Germany Italy and the United Kingdom andjointly organized by the public and private sectors in Belgium Japanand Spain
How well do G-10 governments offset the subsidy provided by thepublic safety net This is a question on which there is substantial debateAs banking organizations have become more complex the challengesthat supervisors face have become more difficult One challenge is toalign the incentives facing bank managers and shareholders with thoseof depositors Another is the principal-agent problem in supervision Wehave discussed the incentive structures for financial institutions but wehave said little about the incentives for supervisors themselves and thedistortions they can generate in the financial system
In one of the many studies of the US savings and loan crisis of the1980s Kane (1989) documented both problems He described managersusing cosmetic approaches to disguise the magnitude of insolvency regulatorspracticing forbearance even though they knew of the deteriorating riskprofiles of the institutions for which they were responsible and legisla-tors increasing deposit insurance without regard for any offsetting changesin supervision A subsequent overhaul of the legislative framework forthe Federal Deposit Insurance Corporation (FDIC) known as the FDICImprovement Act of 1991 (FDICIA) aimed to introduce a clearer incen-tive structure for both regulators and regulated institutions
The changes introduced by this US legislation are worth discussionwith respect to the other G-10 countries as well First FDICIA created astronger signal to management and investors by targeting deposit insur-ance at small depositors only and by risk-weighting the deposit insur-ance premiums paid by banks to reflect their capital adequacy and bankexaminer ratings Among the G-10 countries rated in table 210 depositinsurance premiums vary considerablymdashbut it is not clear that the dif-ferences have much to do with risk-weighting Most G-10 countries em-ploy funding formulas based for example on the total domestic deposit
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E P
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Table 29 Deposit insurance schemes in the G-10 countries Explicit safety net
Coverage limit(dollar Foreign
equivalent currency Interbank Source Bankrsquos Contingency fundingDate Membership Co- at end of deposit deposit of premium from banks
Country established managementa insuranceb July 1998)c covered covered Fundingd funding costs or governments
United 1982 Compulsory Yes Larger of 90 No No Unfunded Banks only Callable (subject Parliament may increase Kingdom private percent co- to maximum the maximum payable
insurance to 03 percent of pound125 million advance 33000 total deposits) facility with Bank of
England
United 1934 Compulsory No 100000 Yes Yes Funded Banks and Up to 027 Borrowing up to $3 States official government percent total billion from US Treasury
domestic deposits
Japan 1971 Compulsory No 71000 but No No Funded Banks and 0084 percent of Borrowing up to yen500bn joint in full until government insured deposits from Bank of Japan
year 2000 subject to Ministry of Finance approval
Canada 1967 Compulsory No 40800 No Yes Funded Banks and 033 percent of Borrowing up to C$6 official government insured deposits billion authorized further
(maximum) borrowing subject to parliamentary approval
Germany 1966 Compulsory Yes 90 percent Yes No Funded Banks only 003 percent of Annual levy may be private coinsurance deposits doubled
to 22000
Italy 1987 Compulsory Yes 125000 Yes No Unfunded Banks and Callable Two options defer private government (maximum of payment or diminish
1 percent of compensation to be paid total deposits)
(table continues next page)
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108W
OR
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CA
PIT
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MA
RK
ET
S
Table 29 Deposit insurance schemes in the G-10 countries Explicit safety net (continued )
Coverage limit(dollar Foreign
equivalent currency Interbank Source Bankrsquos Contingency fundingDate Membership Co- at end of deposit deposit of premium from banks
Country established managementa insuranceb July 1998)c covered covered Fundingd funding costs or governments
Netherlands 1979 Compulsory No 22000 Yes No Unfunded Banks and On demand Government backing official government maximum of subject to parliamentary
5 percent of own approval funds
France 1980 Compulsory No 65400 No No Unfunded Banks only Callable (on Extra calls up to FFr1000 private demand calls million can be made in
up to FFr200 a 5-year period million)
Switzerland 1984 Voluntary No 19700 No No Unfunded Banks only Callable (on Underwritten by member official demand) banks
Sweden 1996 Compulsory No 31400 Yes No Funded Banks and 05 percent of Full emergency coverage official government deposits while replacing it with a
limited system after the emergency
Belgium 1974 Compulsory No 16600 No No Funded Banks and Callable 002 None insurance limited joint 22000 in government percent of to assets in fund
year 2000 deposits from clients
Spain 1977 Compulsory No 16439 Yes No Funded Banks and 02 percent of Government backing joint government deposits through the Banco de
(maximum) Espantildea subject to approval by royal decree
a Bank membership in the fund can be either compulsory or voluntary and the management of the fund can be official and official and private joint or privateb Coinsurance refers to the situation where depositors face a deductible against their insured fundsc Coverage limit refers to the explicit amount the authorities promise to insured Funded scheme means that it is funded ex ante unfunded otherwise
Sources Goodhart (1995) Demirguccedil-Kunt and Detragiache (2000) Demirguccedil-Kunt and Sabaci (2000)
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 109
base Explicit safety net protection also varies but only Canada focuseson the protected class33 All G-10 countries specify a limit on depositorprotection Under FDICIA the insurance fund is prohibited from pro-tecting uninsured depositors or creditors at a failed bank although adiscretionary system-wide override is provided for exceptional circum-stancesmdashbut with stringent requirements for consultation and account-ability Other G-10 countries allow for contingency funding from the publicpurse alongside unwritten lender-of-last-resort support Among large banksa significant and growing portion of deposit liabilities including foreigncurrency and interbank deposits are uninsuredmdashbut depositors assumethey will be protected in a crisis
FDICIA also made some significant qualitative changes to address theprincipal-agent problem by penalizing weak banks and rewarding strongbanks For example banks whose capital declined faced progressivelytougher regulatory sanctions that for example required them to elimi-nate dividends restrict their lending and change their managementsRegulators have also been forced to take prompt corrective action (toreduce the practice of regulatory forbearance in hopes that a bankrsquos for-tunes might improve)34 Unfortunately comparative qualitative assess-ments across the G-10 are difficult to make due to lack of information35
This discussion highlights the complexity of evaluating the extent towhich prudential supervision and market discipline reduce the moralhazard associated with G-10 safety nets Our argument is that publicsafety nets in the G-10 can be linked to banking instability in other coun-tries specifically in the emerging-market economies that have attractedG-10 cross-border bank lending This lending is a leading source of vola-tility in capital flows the large financial institutions many of which arecomplex banking organizations are based in and regulated by authori-ties in the G-10 economies These two features of the international finan-cial system are closely related although it is not possible to test thisrelationship econometrically
Two World Bank studies however indicate a basis for concern Onestudy is a cross-country econometric analysis of the relationship betweenbank stability and deposit insurance (Demirguccedil-Kunt and Detragiache2000) which found a negative relationship Their estimated model forbanking crises in a sample of 61 countries (both industrial and develop-ing) suggests that explicit deposit insurance raises the probability of acrisis by at least 30 percent36 Crises are especially likely in countries
33 Japanrsquos legislation says it does but recent experience shows this is not the case34 See Goldstein (1997) for a summary of the changes35 See Barth Nolle and Rice (2000) for a beginning in this area36 Demirguccedil-Kunt and and Detragiache (2000 table 1) report a logit coefficient of 0696with a standard error of 0397 (the coefficient is significant at the 8 percent threshold)This suggests that the ldquotruerdquo coefficient could well be as small as 030 (the reportedvalue minus the standard error)
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110 WORLD CAPITAL MARKETS
with immature financial supervisory systems (and not in the G-10) buttheir analysis does underscore the view that deposit insurance weakensmarket discipline37
An earlier World Bank analysis established similar results One wasthat market discipline is undermined by deposit insurance schemes an-other was that illiquid banks are forced to pay more for their funds un-less a generous deposit insurance scheme is in place (Demirguccedil-Kuntand Huizinga 1999) This econometric study also provides clear-cut evi-dence that depositor monitoring of banks declines with the existence ofdeposit insurance schemes At the heart of the problem is the questionof whether deposit insurance is accompanied by increased governmentmonitoring
This evidence and the weight of other arguments suggests that moralhazard is still an issue in the G-10 countries Consider the ongoing de-bate about instilling greater market discipline on risk taking by banksAt one extreme is the perennial proposal to do away with safety netsleaving markets to monitor the players and to force adjustments but toprotect small savers by creating ldquonarrow banksrdquo such as postal savingsystems that are allowed to invest these savings only in risk-free gov-ernment securities Whatever the merits of narrow banking this solutionis too extreme to be politically feasible
A moderate alternative is to force more disclosure by financial institu-tions to facilitate market monitoring But transparency has its own prob-lems Persaud (2000) argues that financial markets cannot reliably discernsustainable from unsustainable positions in the short term This uncer-tainty causes banks to ldquoherdrdquo behind market leaders to exploit theirsupposedly superior information ldquoThe more herding investors and bankersknow about what each other is up to the [more] unstable markets maybecomerdquo The implication is that greater transparency in the marketplaceby itself will not solve the problemmdashand in the short term more informa-tion may exacerbate herding Further supervisory steps (discussed in thenext chapter) are required
Yet another proposal is to promote private-sector involvement in bankmonitoring through market-based alternatives such as Calomirisrsquos sub-ordinated debt proposal (Calomiris 1997 Federal Reserve Board 1999)Banks could be required to issue and maintain a minimum amount of
37 Other findings in the Demirguccedil-Kunt and Detragiache (2000) study include thesepropositions The impact of deposit insurance on bank stability tends to be stronger themore extensive is the coverage offered to depositors when the scheme is funded andwhere the scheme is run by the government rather than by the private sector Con-versely deposit insurance is detrimental to bank stability where bank interest rates havebeen deregulated and where the institutional environment is weak Additional findingson deposit insurance are reported from a recent World Bank conference (8-9 June 2000httpwwwworldbankorgresearchinterestconfsupcomingdeposit_insurancehomehtm)Also see Smalhout (2001)
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 111
subordinated debt (eg uninsured certificates of deposit) to finance asmall fraction (such as 2 percent) of their total nonreserve assets Thesubordinated debt would be allowed to earn a set yield no more than 50basis points over the risk-free yield on government treasury bills Thisrule would supposedly force banks to operate in a safe manner Other-wise subordinated debt holders would redeem their uninsured certifi-cates of deposit and equity investors would sell their bank shares Despiteits practical problems the beauty of the subordinated debt requirementis that it enlists market incentives to push banks to avoid excessive port-folio risk38
The thrust of these proposals is very relevant to the arguments in ourstudy Even in the G-10 countries government monitoring by itself hasnot eliminated moral hazard among banks More work is needed to in-troduce market monitoring and to improve the incentive structures bothfor financial institutions and their supervisors We return to this issuewith our recommendations in the next chapter
38 In late 1996 Argentina began requiring its banks to finance 2 percent of total depos-its in the form of subordinated debt but without a maximum yield provision TheArgentine authorities expect that market discipline will act in concert with the publicsafety net One obvious problem with the subordinated debt proposal is that banks mayencourage some of their customers to buy the subordinated debt
Portfolio Institutions Tomorrowrsquos Problem
Before proceeding to the issues of international supervision we flag an-other potential problem for national regulators The big asset managersprofiled in tables 24 and 26 answer to diverse groups of pensionersshareholders and policyholders They allocate funds across a number ofcountries to diversify their risks They hold liquid assets that can be tradedand they have a higher proportion of long-term assets than banks Eco-nomic shocks can be absorbed through price changes and their effectsspread across time and markets Thus when conditions change in a par-ticular market they are more likely to ride out the storm than to flee Inother words they have less incentive than banks to pull their invest-ments in the face of adversity In the 1990s most large asset managersestablished a record of ldquoriding out the stormrdquo rather than ldquorunning withthe windrdquo although as we saw in chapter 1 instances of running withthe wind were detected in some portfolios As we write these insti-tutions have a good record overall in the emerging markets so whyworry
The Russian crisis and the near-collapse of LTCM previewed the dan-gers that may await future portfolio managers and G-10 financial minis-ters We have presented evidence indicating a systemic bias toward bank
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112 WORLD CAPITAL MARKETS
lending and debt finance to emerging markets and we have argued forsubstitution toward equity finance and direct investment39
That is not the end of the story We noted in the previous chapterthat institutional investors can become momentum investors selling in adownturn As more portfolio capital is invested in emerging marketssome players may adopt the high-risk high-leverage strategies of themost aggressive hedge funds Indeed the data in box 11 show that G-10portfolio investors held somewhat more long-term debt (more than $500billion) than equity (less than $400 billion) in emerging markets at theend of 1997 Long-term debt is an ideal vehicle for high-risk high-leveragestrategies These strategies practiced on a large scale could compound afuture crisis harming emerging markets A big enough crisis could inturn pressure G-10 central banks and finance ministers to arrange bail-out plans Instead of shrinking as a systemic financial problem moralhazard could increase
National securities regulators are the first line of defense against thisscenario They play a critical role in the safe evolution of capital mar-kets But regulators today are mandated to approve the issuance of newsecurities and to monitor the continuing disclosure of material informa-tion by issuers They are far less concerned with or empowered to monitorthe behavior of the increasingly large wealth-management firms that arethe major purchasers (and therefore resellers) of these securities
Within their mandates the goals of national securities regulators (table210 and appendix B) are similar to the concerns of bank regulators withsystem safety and soundness Their focus is also on the incentive sys-tems for management and boards of directors and on disclosure by cor-porations that issue marketable securities such as shares bonds andasset-backed securities 40 Issuers of securities possess greater knowledgeabout the quality of these assets than do the purchasers hence investorprotection is a key concern of regulators Moreover market disciplineworks best when markets know what is happening Well-functioning corpora-tions are key agents of wealth creation and social progress Underperform-ing corporations waste resources During recessions bad corporationsget into bad trouble often with severe social consequences Inadequateincentives for managers and inadequate accountability for boards andmanagers thus have negative externalities Regulators play a vital role inexposing weakness so that market disciplines come to bear sooner ratherthan later
Regulatory emphasis is constantly shifting as financial markets evolveand as the macroeconomic environment changes Regulators try to balance
39 See Rogoff (1999) Also see Berlin (2000) for a perspective on the limited role thatbanks play as share owners
40 See Habib and Ljungqvist (2000) for recent empirical analysis showing that corporateshare market values are higher when corporate executives have a larger ownership stake
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E P
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113
Table 210 Financial-sector regulation G-10 countries 2000
Financial institutions and their supervisors
Country and supervisory structure Retail banking Wholesale banking Securities Insurance
Financial conglomeratesFinancial Services Authority (FSA) = umbrella supervisor
United Kingdom FSA FSA FSA FSA
Treasury bull Commercial banks bull Investment funds (Securities and (Insurance Directorate(Securities and Investments Board) bull Unit trust groups Futures Authority) of the Treasury)
Bank of bull Building societies bull Pension funds England (Building Societies Commission) bull Merchant banks
bull Friendly societies bull Clearing houses bull Primary issuers bull Insurance FSA (Friendly Societies Commission) bull Venture capital of securities companies
bull Pensions and life insurance etc bull Stock exchanges bull Insurance brokers(Personal Investment Authority) bull Stockbrokers
Financial holding companiesFederal Reserve (FR) = umbrella supervisor
United States bull National banks(OCC) Securities and Regulated by
Treasury OCC bull State banks Federal Reserve Exchange Commission StatesMembers (FR)
OTS Nonmembers (FDIC) bull Investment banks bull Primary issuers of bull Insurance companies FR bull Cooperative banks (FDICFR) bull Finance companies securities bull Insurance brokers FDIC bull Insured industrial banks (FDIC) bull Stock exchanges
bull Thrift holding companies (OTS) bull Stockbrokers SEC bull Savings banks (OTSFDICFR) bull Investment advisors
bull Savings and loan associations bull Mutual funds(OTS) bull Public utility holding
bull Edge Act corporations (FR) companies
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Table 210 Financial-sector regulation G-10 countries 2000 (continued )
Financial institutions and their supervisors
Country and supervisory structure Retail banking Wholesale banking Securities Insurance
Financial holding companies Japan Financial Supervisory Authority (FSA) = umbrella supervisor
Prime FSA FSA FSA FSA ministerrsquos Ministry of office Finance (Securities and Exchange
Surveillance Commission) FRC Bureau of Financial bull City banks bull Investment banks bull Primary issuers of bull Insurance companies FSA Regulation bull Regional banks bull Asset managers securities bull Insurance brokers
bull Trust banks bull Stock exchanges SESC bull Long-term credit banks bull Stockbrokers
bull Pension funds
Financial holding companiesOffice of the Superintendent of Financial Institutions (OSFI) = umbrella supervisor
Canada Regulated by OSFI OSFI provinces OSFI
Department of Financebull Banks bull Cooperative credit bull Primary issuers of bull Insurance companies
(previously Office of the Inspector associations securities (previously Depart- OSFI General of the Banks) bull Fraternal benefit bull Stock exchanges ment of Insurance) Bank of bull Trust and loan companies society bull Stockbrokers bull Insurance brokers Canada bull Pension funds bull Asset managers
(previously Depart- CDIC ment of Insurance)
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Financial institutions and their supervisors
Country and supervisory structure Retail banking Wholesale banking Securities Insurance
Germany Financial holding groupsFederal Banking Supervisory Office (FBSO) = umbrella supervisor
Ministry of Finance FBSO BSO FSSO FISO
Bundesbankbull Universal banks bull Other financial bull Primary issuers of bull Insurance companies
Federal Banking bull Savings banks institutions (eg securities bull Insurance brokers Supervisory Office bull Securities banks management foreign bull Stock exchanges
currency dealings) bull Stockbrokers Federal Securities bull Financial enterprises bull Asset managers Supervisory Office (eg leasing bull Pension funds
organizations Federal Insurance credit card companies Supervisory Office investment advisors)
Italy Bank foundationsMinistry of Finance = umbrella supervisor
Ministry of Finance Bank of Italy Bank of Italy Consob ISVAP
Bank of Italy bull Commerical banks bull Asset managers bull Primary issuers of bull Insurance companies Consob bull Savings bank bull Open-end investment securities bull Insurance brokers
bull Securities banks companies (SICAVs) bull Stock exchangesbull Stockbrokers
ISVAP
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Table 210 Financial-sector regulation G-10 countries 2000 (continued )
Financial institutions and their supervisors
Country and supervisory structure Retail banking Wholesale banking Securities Insurance
The Netherlands Financial conglomeratesCouncil of Financial Supervisors = umbrella supervisor
Securities Board Securities Board Netherlandsche Netherlands Bank Netherlandsche Bank of the Netherlands Insurance Board Bank Insurance bull Credit institutions (universal banks bull Investment institutions bull Stock exchanges bull Insurance companies Board cooperative banks security credit (securities issuing bull Stockbrokers bull Insurance brokers
institutions mortgage banks) and tradingmdashprimary The Council of Financial and secondary Supervisors markets)
France Commission des Commission de Operations des Controcircle des
Banking and Banking Commission Bourse Assurances Financial Regulatory bull Ensuring that credit institutions (and investment firms since bull Primary issuers of bull Insurance companies Ministry for Committee the Financial Activity Modernization Act of 1996) comply securities bull Insurance brokers Economic with laws and regulations bull Stock exchanges Affairs and bull Execute instructions regarding all off-site monitoring and bull Stockbrokers Finance Credit on-site supervision Institutions and Banking and Financial Regulatory Committee Investment bull Formulates general regulations for credit institutions and investment firms Committee (capital adequacy requirements accounting rules etc) Bank of France Credit Institutions and Investment Committee Banking bull Authorizes and examines financial institutions except for those within the Commission competence of the Banking Commission
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117
Financial institutions and their supervisors
Country and supervisory structure Retail banking Wholesale banking Securities Insurance
Switzerland Large banking groupSwiss Federal Banking Commission (SFBC) = umbrella supervisor
Swiss National Bank Federal Office of
SFBC SFBC SFBC Private Insurance Swiss Federal Banking Commission bull Universal banks bull Investment banks bull Primary issuers of bull Insurance companies
bull Savings banks bull Asset management securities bull Insurance brokerscompanies bull Stock exchanges
Private audit Federal bull Investment funds bull Stockbrokers firms Office of bull Mortgage bond authorized by Private business SFBC Insurance
Sweden Financial holding company groupsFinancial Supervisory Authority = umbrella supervisor
Ministry of Finance Credit Market Securities Market Insurance Market
Credit Market Department Department Department Department
Financial bull Commercial banks bull Investment funds bull Primary issuers of bull Insurance companies Riksbank Supervisory bull Savings banks securities bull Insurance brokers Authority bull Friendly societies bull Stock exchanges
bull Stockbrokers
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Table 210 Financial-sector regulation G-10 countries 2000 (continued )
Financial institutions and their supervisors
Country and supervisory structure Retail banking Wholesale banking Securities Insurance
Belgium Bank holding companiesBanking and Finance Commission = umbrella supervisor
Bank of Belgium Banking Banking
Banking and Finance and Finance Insurance Controland Finance Commission Commission Commission Office
Banking and Insurance Finance Control bull Commercial banks bull Asset management bull Primary issuers of bull Insurance companies Commission Office bull Savings banks firms securities bull Insurance brokers
bull Securities banks bull Investment funds bull Stock exchanges bull Mortgage companiesbull Stockbrokers bull Pension funds
Securities Regulation Fund Securities Regulation Fund
bull Other investment firms and credit institutions(institutions participating in regulated off-exchangemarket in strips and Treasury certificates)
Bank holding companies Spain Banco de Espantildea = umbrella supervisor
Banco de Espantildea Comision Nacional del Mercado de Directorate General
Banco de Espantildea Valores (CNMV) Insurance
bull All credit institutions (commercial banks savings banks credit bull Primary issuers of (Ministry of Economy Ministry of cooperatives official credit institutions finance factoring and securities and Finance) Economy and CNMV leasing companies mortgage-loan companies etc) bull Stock exchanges bull Insurance companies Finance bull Interbank foreign exchange and book-entry public debt bull Stockbrokers bull Pension funds
markets bull Venture capital(companies and funds)
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119
Financial institutions and their supervisors
Country and supervisory structure Banking Securities Insurance
Banking Advisory High Level Securities Supervisors Committee (BAC) Committee (HLSS) Insurance Committee (IC)
Supranational (EU) bull Formulates standards for prudential bull Coordination of securities market bull Formulates standards forsupervision supervision prudential supervision
BACICHLSS Banking Supervision
Conglomerates Committee (BSC) Securities Contact Committee Regulation of prudential bull Systemic risk monitoring bull Regulation and implementation of supervision securities admission
International Association International International Organization of of Insurance Supervisors
Basel Committee Securities Commisison (IOSCO) (IAIS) Joint Forum Conglomerates Supervision bull Supervision and regulation best bull Supervision and regulation best bull Supervision and regulation amp regulation Best practices practices practices best practices
FSF Coordination across supervisors of various functions
Notes See appendix B for more information Boldface type indicates senior or oversight supervisor normal type indicates adjunct or front-line supervisorsolid line indicates direct responsbility to the senior-ranking authority dotted line indicates coordination in supervisory activities
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Table 210 Financial-sector regulation G-10 countries 2000 (continued )
Glossary of names United Kingdom FSA = Financial Services Authority United States FR = Federal Reserve OCC = Office of the Comptroller of theCurrency FDIC = Federal Deposit Insurance Corporation SEC = Securities and Exchange Commission OTS = Office of Thrift Supervision Japan FRC =Financial Reconstruction Commission FSA = Financial Services Agency SESC = Securities and Exchange Surveillance Commission Canada OSFI =Office of the Superintendent of Financial Institutions CDIC = Canada Deposit Insurance Corporation Germany FBSO = Federal Banking SupervisoryOffice FSSO = Federal Securities Supervisory Office FISO = Federal Insurance Supervisory Office BSO = Banking Supervisory Office Italy Consob =Commissione Nazionale per le Societa e la Borsa ISVAP = Instituto per la Vigilanza sulle assicurazioni private e di Interesse colletivo Switzerland SFBC= Swiss Federal Banking Commission Spain CNMV = The Comision Nacional del Mercado de Valores Supranational BAC = Banking Advisory CommitteeBSC = Banking Supervision Committee IC = Insurance Committee HLSS = High Level Securities Supervisors Committee International Dimension FSF =Financial Stability Forum IOSCO = International Organization of Securities Commission IAIS = International Association of Insurance Supervisors
Sources United Kingdom Bank of England httpwwwbankofenglandcouk Financial Services Authority httpwwwfsagovuk United States Board ofGovernors of Federal Reserve System httpwwwfederalreservegov Japan Bank of Japan httpwwwbojorjo Financial Reconstruction Commissionhttpwwwfsagojpfrcindexehtml Financial Services Agency httpwwwfsagojp Canada Bank of Canada httpwwwbank-banque-canadaca Office ofthe Superintendent of Financial Institutions httpwwwosfi-bsifgccaAndreEindexhtml Germany Deutsche Bundesbank httpwwwbundesbankde Fed-eral Banking Supervisory Office httpwwwbakredde Italy Banca drsquoitalia httpwwwbancaditaliait Commissione Nazionale per le Societa e la Borsahttpwwwconsobit Instituto per la Vigilanza sulle assicurazioni private e di Interesse colletivo httpwwwisvapit The Netherlands De NederlandscheBank httpwwwdnbnl France Banque de France httpwwwbanque-francefr Switzerland Schweizerische Nationalbank httpwwwsnbchindex3htmlSweden Sveriges Riksbank httpwwwriksbanksedefaultasp Belgium National Bank of Belgium httpwwwbnbbesgindexhtm Spain Banco de Espantildeahttpwwwbdees The Comision Nacional del Mercado de Valores httpwwwcnmves Supranational (EU) Institutional Arrangements for the Regulationand Supervision of the Financial Sector 2000 International Dimension Bank for International Settlement httpwwwbisorg International Organization ofSecurities Commissions httpwwwioscoorg International Association of Insurance Supervisors httpwwwiaisorg Financial Stability Forum httpwwwfsforumorg
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 121
the inflexibility of tight surveillance against the need to encourage in-novation and growth The US Securities and Exchange Commission isworried about aggressive accounting by firms and biased reports bysecurities analysts in an equity environment that prizes steadily higherquarterly earnings41 Japanese regulators are preoccupied with opaqueinterconnections between portfolio institutions banks and nonfinancialfirms through the keiretsu system Canadian regulators reeling from high-profile scandals of managers intentionally misleading investors are strengtheningmarket discipline through legal penalties aimed at managers and directorsof offending firms
When panic strikes a securities regulator cannot do much As the 1987stock market crash and the LTCM debacle in the fall of 1998 both dem-onstrated steep stock and bond price declines can create systemic risksIf severe enough the wealth effect of falling securities values and thefear of widespread insolvency can depress real activity Flooding thesystem with liquidity is a central bankerrsquos solutionmdashsomething a securi-ties regulator cannot do42 But just as financial supervisors can changethe incentive structure to discourage bankers from making risky loans ingood times so securities regulators can pay more attention to incentiveson the demand side when capital markets are strong
Prudential Supervision and InnovationmdashA Footnote
In concluding this discussion of prudential supervision in the G-10 anadditional point is worth noting National regulators face a persistenttrade-off between emphasizing financial system safety and soundnesswhile encouraging innovationmdashin spite of the added risks innovationbrings to financial markets Former US Treasury Secretary Lawrence Summers(2000 3) has argued by analogy
The jet airplane made airplane air travel more comfortable more efficient andmore safe though the accidents were more spectacular and for a time morenumerous after the jet was invented In the same way modern global financialmarkets carry with them enormous potential for benefit even if some of theaccidents are that much more spectacular As the right public policy response
41 The problem is illustrated by the divergence since mid-1998 between reported earn-ings by the Standard amp Poorrsquos (SampP) 500 and the after-tax profits of all corporations inthe national accounts Generally these two series move closely with one another Be-tween mid-1998 and mid-1999 SampP 500 reported that earnings increased by more than20 percent while after-tax profits of all corporations increased by less than 5 percent(Chase Bank US Economic and Policy Research US Weekly Prospects Chase SecuritiesWeekly Newsletter 5 June 2000 5)
42 For example the US Securities and Exchange Commission had no direct role in calmingmarkets in the 1987 or 1998 panics
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122 WORLD CAPITAL MARKETS
to the jet was longer runways better air-traffic control and better training forpilots and not the discouragement of rapid travel so the right public policyresponse to financial innovation is to assure a safe framework so that the ben-efits can be realized not to stifle the change
Accepting Summersrsquos analogy for the international financial system better-informed supervisors and investors are a necessary part of the financialsystem framework Supervisors require more timely information on therisk profiles resulting from positions taken by financial institutions Theyalso need a better understanding of risk-management systems Snapshotsof an institutionrsquos risk profile and risk-management procedures are nolonger adequate In a world where huge bets are quickly made (andpossibly lostmdashas with Barings Bank in 1995 and LTCM in 1998) super-visors must focus on the soundness of banking systems for evaluatingand managing risk on a daily basis Some progress has been made inaddressing these issues US banking examiners are extending their in-formation requirements in banking examinations and increasing theirinvolvement in large complex institutions43 More awareness is alsorequired of the fact that they are national organizations in a world ofcross-border capital flows To a much greater extent they need a multi-national reach International supervision and coordination among super-visors are the subject of the next section
Our analysis suggests that G-10 supervisors have unfinished businessBank supervisors need to start yesterday securities regulators can waituntil tomorrow One G-10 member acting alone cannot correct the biasIn good times the lending business will simply migrate to other G-10banks In bad times financial problems will not stop at the national bor-der A way has to be found to establish common international standardsfor the key financial players in order to prevent crises and to agree onapproaches for managing them The path has already been laid out Inthe wake of the bank failures of the past 25 years bank supervisors havetried to establish such standards They have done this without creating anew global institution
The essence of the international framework is decentralizationmdashglobalrules and design standards without global institutions that are perceivedto intrude on national sovereignty The awkward jargon for this frame-work is vertical subsidiaritymdashldquothink internationally act nationallyrdquo Theinternational thinking is done by a committee of regulators that meets
International SupervisionA Decentralized Framework
43 These issues are discussed in Ferguson (1999) and Meyer (2000a)
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 123
regularly at the Bank for International Settlements in Basel The commit-tee establishes principles and standards that are interpreted implementedand enforced by national authorities44 In this section we describe thesesupervisory efforts and their weaknesses We present our recommenda-tions for addressing these weaknesses in the next chapter
Basel I
The Basel Capital Accord of 1988 (Basel I)45 drew the lesson from thefinancial crises of the mid-1970s that more adequate capital levels in in-ternational banks would help reduce the systemic risk of bank failureThe primary goal of Basel I was capital adequacy other standards wereput in place not so much for their own virtue as to defend the primarygoal
Capital adequacy requirements were designed to ensure that individualinstitutions have the ability to absorb losses particularly credit lossesAccordingly a backup system of scoring credit risk was devised thatrequired large amounts of bank capital for some types of loans smalleramounts for others and zero for a select list of preferred assets Report-ing requirements were designed to disclose problems and ensure that atroubled bank would take timely steps to restore its capital base in thewake of a loss The Basel I framework worked tolerably well in limitingthe call on the public purse in the G-10 countriesmdashwith the notable ex-ceptions of France and Japan The framework failed to moderate riskybank lending to emerging markets however
Basel I was not developed with emerging markets in mind The origi-nal idea behind it was to develop a common supervisory approach tocross-border banking operations It grew out of political pressure fromUS lawmakers who were determined to require international banks op-erating in the United States to meet US banking standards Toward thisgoal in 1983 Congress passed the International Lending Supervisory ActUS and British banking authorities subsequently agreed on a commontarget the adoption of strict common capital-adequacy standards In 1988other G-10 governments agreed to go along voluntary acceptance ofthe standards throughout much of the rest of the world followed46 Therationale for the capital targets was two-fold The first was to requirebanks to hold sufficient amounts of capital (8 percent of risk-adjusted
44 The international committee of financial authorities agreed on a common definitionof banksrsquo tier-one or ldquocorerdquo capital national authorities defined tier-two capital in theirown manner which permitted greater variations in national working definitions andpractices
45 International Convergence of Capital Measurement and Capital Standards (BIS 1988)was prepared by the Basel Committee on Banking Supervision
46 See Reineke (1998)
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124 WORLD CAPITAL MARKETS
assets) to cushion losses on those assets The second was to dull theirappetites for risk banks with large capital bases would have more tolose if they failed and therefore would take fewer risks
Rapid change in financial markets soon revealed flaws in the Basel IAccord In a complex world with numerous sources of risk it focusedheavily on credit risk but overlooked other risks in a bankrsquos portfolioand the correlation between returns on different asset classes The Baselformula required banks to maintain a fixed amount of capital againsteach of its asset classes But the formula did not distinguish the riskinessof the borrower within each class As a result one large loan to a low-risk corporate borrower such as General Electric would require the sameamount of capital as 10 smaller transactions with high-risk borrowers
The system was also biased toward short-term loans Loans maturingin less than a year required a 20 percent risk weight whereas those ma-turing after more than a year required a 100 percent risk weight Inter-bank lending was particularly favored For example loans to banks inOECD countries required less capital than loans to private firms in thesame countries creating the anomaly that interbank loans to South Ko-rean banks required less capital than loans to General Electric47 Thisanomaly encouraged banks to shed high-quality assets if the Basel rulesrequired the allocation of more capital than banks thought they needed
Another weakness was that financial innovators quickly circumventedthe Accord Because short-term loans required less provisioning than long-term loans banks responded by securitizing their long-term debt port-folios and lending short-term against the collateral of the newly createdasset This allowed banks to circumvent the capital requirements gearedto the terms of the underlying debt At the same time the Basel I Accordfailed to encourage risk mitigation techniques such as credit derivativescollateral guarantees and on-balance-sheet netting the flip side of fi-nancial innovation Because off-balance-sheet products were not coveredby the Accord another anomaly appeared when Barings Bank collapsedin 1995 Barings met capital adequacy standards but collapsed becauseits systems for managing risk failed traders were allowed to speculatein futures contracts that did not appear on the balance sheet
Basel II
Work to overhaul Basel I began in 1995 and produced consultativepapers issued in June 1999 and January 200148 These papers have been
47 South Korean banks have had notoriously weak balance sheets because the practiceof ldquodirected lendingrdquo left them with many poor loans (in making these loans the bankswere expected to follow government objectives rather than creditworthiness criteria)
48 Basel Committee on Banking Supervision (1999 2001)
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 125
the subject of extensive consultation and revision as a result the newAccord is expected to be introduced in 200449 The Basel II frameworkhas three parts (pillars) revisions to Basel I minimum-capital require-ments supervisory review criteria and greater emphasis on market dis-cipline Broadly Basel II aims to maintain the level of capital in the sys-tem but achieve better alignment of banksrsquo capital with their risk pro-files and keep up with financial innovation
To align capital requirements with market realities (the first pillar)Basel II concentrates on the 100 or so largest banksmdashthe type of playerslisted in table 21mdashand on the holding-company parents of banking groups50
Capital requirements will differentiate between an increased number ofcredit groups or ldquorisk bucketsrdquo including claims on governments otherbanks corporations mortgage-backed securities and other asset-backedsecurities
Basel II originally proposed to use external ratings to set capital chargesfor a number of these credit risks Many banks objected arguing thatthey assess credit risk better than Standard amp Poorrsquos Moodyrsquos or FitchIBCA51 Basel II thus proposes two approaches to rating a standard ap-proach using external ratings and an ldquoadvancedrdquo approach that allowsselected banks to use their own internal rating systems To encouragethe development of rigorous internal control systems based on these in-ternal rating systems Basel II also proposes to levy capital charges foroperational risk (the risk of direct or indirect loss resulting from inad-equate or failed internal processes people and systems or from exter-nal events)
Some critics of this proposal dismiss it as an abrogation of the prin-ciple of external independent monitoring and as ldquodangerously naiumlverdquo52
But regulators argue that the new capital charge on operational risk shouldoffset this concern It is also far from clear how cross-national compari-sons of rating and internal risk-assessment systems will be made (Engelen2000) The development by the European Union of its own capital rulescould well complicate the international resolution of these issues Publicassurances by EU officials in January 2001 however indicated that theirmain concerns are to create a level playing field and avoid regulatoryarbitrage (Hargreaves 2001) There is also the significant problem ofthe procyclical character of risk weights When a crisis hits losses are
49 See Berry (2000) for an update in an interview with William J McDonough chair ofthe Basel Committee on Banking Supervision
50 For obvious reasons these proposals are addressed to large banks and simpler capi-tal standards are allowed for small banks that focus on their domestic credit markets
51 See Ammer and Packer (2000) for an empirical critique of the success of rating agen-cies in distinguishing risk by sector and region
52 See Auerback (2001)
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126 WORLD CAPITAL MARKETS
incurred or accrued capital is lost and loan exposure must be reducedor securities sold to restore the requisite capital-adequacy ratios A morerisk-sensitive framework could amplify volatility
As the second pillar of Basel II supervisory review criteria are beingbeefed up to encourage supervisors to intervene earlier in potential problemsituations and to compel banks to align their capital positions with theirrisk profiles Bank supervisors will be authorized to require banks tohold capital in excess of minimum requirements if they have concernsabout general management overall strategy risk-management performanceor the macroeconomic environment Of course if one G-10 supervisorimposes higher capital requirements in isolation the same disparity willemerge that presaged Basel I Some banks will be disadvantaged in theinternational marketplace and will loudly complain that excessive super-vision is driving business to their competitors Hence close internationalcooperation among supervisors is critical
To implement the third pillar market discipline banks will be requiredto make fuller more timely disclosure of capital adequacy and the risksto which that capital is exposed A number of measures are being stud-ied that might help supervisors evaluate bank performance such as com-parisons of uninsured deposit interest rates subordinated debt yieldsand equity prices The idea is that these yields and prices might alertsupervisors to market perceptions of risk Of course market perceptionsare only as good as market information More direct and controversialways to reinforce market discipline would dramatically increase publicdisclosure of bank positions and risk management systems
Many questions are still outstanding about how to resolve the techni-cal details of capital requirements and whether the requirements willachieve their intended goal of better assessment and mitigation of therisks in banksrsquo portfolios There is no substitute for skilled supervisorsThe intricacies of effective design and implementation suggest that su-pervisors need to be highly competent technically knowledgeable aboutbanking portfolio characteristics and the factors that influence bank ex-posure to credit risk (Mishkin 2000) And they must be aided by vigilantshareholders market forces and transparency of information53
Standard setting at the global level is desirable but ultimately theeffectiveness of these efforts will be tested at the national level espe-cially in times of systemic financial distress Here the record of Basel Iwas not a bright shining success Japanese banking regulators havetraditionally allowed banks to include real estate and securities in theircapital base When the value of these assets plummeted in the early 1990sregulators allowed banks to continue valuing these depreciated (andoften bankrupt) assets at their old inflated levels Japanese authorities
53 Benedict Roth Complacency Towards Catastrophe Financial Times 23 January 2001
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 127
insisted until the mid-1990s that eroded capital bases could be rebuiltin a market-driven fashion They rightly foresaw that huge loan losseswould undermine public support for the ruling party and require a po-litically unpopular bailout
Japanese foot dragging on Basel I was the worst54 but not uniqueOther examples can be found of ldquopolitically mandated forbearancerdquo TheFederal Reserve Bank of New York held important hands during theLTCM crisis of 1998 Mexico is still resolving the banking crisis that eruptedin 1995 South Korea has not yet closed the insolvent banks that behavedso badly before the crisis of 1998 In the aftermath of a crisis nationalregulators cannot always be relied upon to discipline politically power-ful bankers55 One of the little-noticed consequences of these differingapproaches is that those banks with strong regulatory systems receivedan implicit ldquoexport subsidyrdquo for their services US banks which had notengaged extensively in emerging-market lending in the 1990s were bet-ter positioned than their German and Japanese counterparts to expandtheir international assets in the wake of the crises
Other Financial Forums
54 See Japanese Banks Fiddling while Marunouchi Burns The Economist 27 January2001 67-69
55 See Calomiris (1997)
The Basel model of vertical subsidiarity has already been extended toother financial regulatory bodies In 1993-94 the BIS established a Tri-partite Group of Banking Insurance and Securities Regulators In 1994-95 the BIS increased its cooperation with the International Organizationof Securities Commissions when the two organizations issued parallelpapers on guidelines for national regulators concerning risk managementand disclosure of derivative trades In 1996 a permanent Joint Forum onFinancial Conglomerates was established to examine supervisory issuesand develop working arrangements among the different functional super-visors of conglomerate institutions that offer combinations of bankingsecurities and insurance products Draft papers on the supervisionof conglomerates were released for comment in 1998 applying capital-adequacy principles to these groups and providing guidelines both forassessing the integrity and competence of top managers and for sharingassessments between regulators
In 1997 the Basel Committee on Banking Supervision extended itsreach beyond capital standards to broader aspects of banking supervi-sion with the publication of the Core Principles for Effective BankingSupervision In 1999 a wide range of regulatory and standard-settingbodies were gathered under the umbrella of the Financial Stability
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128 WORLD CAPITAL MARKETS
Forum (FSF) itself established under BIS aegis56 The FSF has alreadyissued recommendations for stepped-up supervision and transparencyas well as guidelines for best practices in a number of areas includingoffshore financial centers and highly leveraged institutions or hedge funds57
Conclusion
Although the structural weaknesses in emerging-market economies arewidely acknowledged to have been causal factors in international capi-tal-market volatility this chapter points to the role of large G-10 bankingorganizations as major suppliers of the most volatile instrument short-term debt We have examined evidence of the impact of public safetynets in the G-10 economiesmdashthe deposit insurance systems the pruden-tial supervisory systems and the lender-of-last-resort functions of centralbanksmdashon the incentive structures of these organizations
Although supervisors in most countries working nationally and to-gether in the BIS have made significant efforts to mimic market forcesin their prudential supervision the most sophisticated financial institu-tions find innovative ways to circumvent the rules New global regulatorybodies are not about to be created G-10 national bank regulators shouldthemselves address the short-term debt bias in the international financialsystem by changing incentive systems G-10 securities regulators shouldalso take steps to get ahead of the curve paying close attention to largeportfolio swings by institutional investors particularly in times of crisisIn short more needs to be done at national and international levels tochange the rules of the game That is the subject of the next chapter
56 The Financial Stability Forum includes banking securities insurance and accountingregulatory bodies the OECD on taxation corruption and corporate governance and theIMF
57 See Martin (2000)
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86 WORLD CAPITAL MARKETS
exceeds $260 billion For the most part wealth managers are long-termportfolio investors
Hedge funds represent a highly specialized investment vehicle that isnot widely available to the public Most hedge funds are leveraged theyemploy dynamic (and sometimes opportunistic) trading strategies involvingpositions in several different markets they adjust their investment port-folios frequently in anticipation of asset price movements or changes inyield differentials between related securities Hedge funds are opaque tomarket monitoring They are subject to little direct regulation and areunder few obligations to disclose information Hence the size of the in-dustry is difficult to measure
If they are measured by capital under management or by assets hedgefunds are small relative to established wealth managers As table 25shows the capital managed by 20 large hedge funds in late 1998 amountedto less than $50 billion Estimates vary widely but if all hedge funds arecounted their assets range from $100 to $300 billion Even the highestnumber is less than 5 percent of the combined assets of investment banksand traditional asset managers
The amount of leverage used by hedge funds depends on trading strate-gies that are in turn shaped by investor attitudes toward risk Leverage
Table 24 Large asset managers in 1998 (billions of dollars)
Total assets under Marketmanagementa capitalizationb
UBS (Switzerland) 1145 58c
Fidelity Investments (United States) 773 naKampo (Japan) 698 naCredit Suisse Group (Switzerland) 680 50c
AXA Group (France) 647 39c
Barclayrsquos Global Investors (United States) 616 44c
Merrill Lynch amp Co (United States) 501 25c
State Street Global Advisors (United States) 493 naCapital Group Cos (United States) 424 naZurich Financial Services (Switzerland) 415 45c
Total 6392 261 plusTotal for G-10 6392 261 plus
na = not available (usually a nonpublic company)G-10 = Group of Ten countries see note to table 11
a Figures are assets under management at fiscal year-end 1998b Market capitalization is calculated by multiplying the total number of shares by the shareprice at the companyrsquos fiscal year-endc Figures from American Banker httpwwwamericanbankercomBankRankings
Sources Institutional Investor 1999 httpwwwiimagazinecomresearchinterfacehtml US(II300) Asia (Asia200) and Europe (Euro100) Asset Management Rankings American BankerhttpwwwamericanbankercomBankRankings
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 87
is achieved using such instruments as repos (repurchase agreements)futures and forward contracts and other derivative products5 It is alsovery difficult to measure A Financial Stability Forum (FSF 2000b) studyof hedge funds noted thatmdashalthough there are problems with the waydata vendors report these positionsmdashestimates suggest most hedge fundsuse modest amounts of leverage averaging 21 but ranging to 41 insome FSF (2000b) further notes difficulties with evaluating the risk-adjusted performance of hedge funds because of their dynamic tradingstrategies
Table 25 Largest hedge funds according tocapitalization August 1998 (billions of dollars)
Fund Capital under management
Domestica
Tiger 51Moore Global Investment 40Highbridge Capital Corp 14Intercap 13Rosenberg Market Neutral 12Ellington Composite 11Hedged Taxable-Equivalent 10Quantitative LongShort 09Sr International Fund 09Perry Partners 08
OffshoreJaguar Fund NV 100Quantum Fund NV 60Quantum Industrial Fund 24Quota Fund NV 17Omega Overseas Partners 17Maverick Fund 17Zweig Dimenna International 16Quasar International Fund NV 15SBC Currency Portfolio 15Perry Partners International 13
Totalb 471
a Long Term Capital Management (LTCM) was in serious difficulty in August1998 and is omitted from the listb Estimates of hedge fund capital and the number of funds vary significantlyMARHedge estimated 1115 funds with $109 billion capital under managementat the end of 1997 Van Hedge Fund estimated 5500 funds with capital of $295billions at the same date
Source Adapted from Eichengreen (1999a)
5 Positions are established by posting margins rather than the face value of the position
Institute for International Economics | httpwwwiiecom
88 WORLD CAPITAL MARKETS
The positive role of hedge fundsmdashproviding diversification to inves-tors because their returns have low correlations with standard asset classesmdashis counterbalanced by some negative features Hedge funds and otherhighly leveraged institutions (HLIs) may take concentrated positions andengage in aggressive market practices that amount to ldquoganging uprdquo on asmall economy (such as Hong Kong)6 Under normal market conditionsHLI positions are not destabilizing but some of the aggressive practicesdocumented in 1998 are worrisome The FSF study group participantsagreed (2000b 112) that such practices raise important issues for marketintegrity but they could not agree that market manipulation was suffi-ciently widespread to be a serious concern for policymakers
Insurance companies are the third group of portfolio institutions Theseare divided into two categories property and casualty companies andlife and health insurance companies Ten large companies of each cat-egory are listed in table 26 In 1998 the 10 property and casualty insur-ance companies had $16 trillion in assets and more than $330 billion inmarket capitalization The 10 life insurance companies had $28 trillionin assets7 Combining both categories 100 percent of assets are controlledby insurance companies based in the G-10 and Spain In portfolio man-agement styles life insurance companies tend to hold longer-term assetswhereas property and casualty companies tend to hold shorter-term in-struments
Nonfinancial Multinational Enterprises
The last players are the nonfinancial multinational enterprises (MNEs)The worldrsquos 100 largest corporations measured by 1998 revenue are re-corded in tables 27 and 28 The 30 financial giants among the top 100are separately shown in table 27 Most of the firms appeared in previ-ous tables Together these 30 financial giants had revenues of $13 tril-lion and controlled assets of $113 trillion8
Table 28 lists the 70 top nonfinancial giants Their revenues in 1998were $40 trillion and their assets (at book value) measured $45 trillionMeasured by revenue or assets about 95 percent of the giants are basedin the G-10 These firms are responsible for a large share of the worldrsquos
6 See IMF (1999c) for a description of the ldquodouble playrdquo that hedge funds are accusedof using in an attempt to destabilize Hong Kong in August 1998
7 Many life insurance companies are owned by their policyholders and therefore donot have a market capitalization
8 By comparison the larger set of 96 financial firms listed in previous tables controlled$322 trillion in assets This is the total amount of assets recorded in tables 21 (50 com-mercial banks) 22 (9 investment banks) 24 (10 asset managers) and 26 (20 insurancecompanies) The largest hedge funds might add $300 billion to the total
Institute for International Economics | httpwwwiiecom
THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 89
Table 26 20 large insurance companies in 1998(billions of dollars)
Property and casualty insurance Marketcompanies Revenuea Assetsb capitalizationc
Allianz (Germany) 65 402 62d
Assicurazioni Generali (Italy) 48 178 30d
State Farm Insurance Cos (United States) 45 111 naZurich Financial Services (Switzerland) 39 215 45d
CGU (United Kingdom) 38 176 20d
Munich Re Group (Germany) 35 131 naAmerican International Group (United States) 33 194 135d
Allstate (United States) 26 88 20d
Royal amp Sun Alliance (United Kingdom) 25 76 11d
Loews (United States) 21 71 7e
Total 375 1642 330 plusTotal for G-10 375 1642 330 plus
MarketLife and health insurance Revenuea Assetsb capitalizationc
AXA (France) 79 452 39d
Nippon Life Insurance (Japan) 66 363 naING Group (Netherlands) 56 464 46d
Dai-ichi Mutual Life Insurance (Japan) 44 253 naSumitomo Life Insurance (Japan) 40 206 naTIAA-CREF (United States) 36 250 naPrudential Ins Co of America (United States) 34 279 naPrudential (United Kingdom) 34 197 30d
Meiji Life Insurance (Japan) 28 146 naMetropolitan Life Insurance (United States) 27 215 na
Total 444 2825 naTotal for G-10 444 2825 na
na = not available (usually an insurance company owned by its policyholders)G-10 = Group of Ten countries see note to table 11
a Data shown are for the fiscal year ended on or before 31 March 1999b Assets shown are those at the companyrsquos fiscal year-endc Market capitalization is calculated by multiplying the total number of shares by the shareprice at the companyrsquos fiscal year-endd Market capitalization data as of September 1999 from American Banker httpwwwamericanbankercome Individual companyrsquos market capitalization as of September 1999 from Yahoo yahoomarketguidecom
Sources Fortune Global 500 1999 httpwwwpathfindercomfortuneglobal500indexhtmlAmerican Banker httpwwwamericanbankercomRankingBanks1999 Yahoo Marketguideyahoomarketguidecom
Institute for International Economics | httpwwwiiecom
90 WORLD CAPITAL MARKETS
Table 27 Financial firms in the 100 largest companiesby revenue 1998 (billions of dollars)
Globalrank Company Revenuesa Assetsb Type
Continental Europe
15 AXA (France) 79 452 Insurance23 Allianz (Germany) 65 402 Insurance28 Ing Group (Netherlands) 56 464 Insurance37 Credit Suisse (Switzerland) 49 475 Banks commercial
and savings39 Assicurazioni Generali (Italy) 48 178 Insurance42 Deutsche Bank (Germany) 45 736 Banks commercial
and savings56 Zurich Financial Services (Switerland) 39 215 Insurance68 Munich Re Group (Germany) 35 131 Insurance72 ABN AMRO Holding (Netherlands) 34 507 Banks commercial
and savings77 Credit Agricole (France) 33 459 Banks commercial
and savings80 HypoVereinsbank (Germany) 32 541 Banks commercial
and savings84 Fortis (Belgium) 31 397 Banks commercial
and savings98 Socieacuteteacute Geacuteneacuterale (France) 30 450 Banks commercial
and savingsUnited Kingdom
47 HSBC Holdings 43 485 Banks commercialand savings
58 CGU 38 176 Insurance74 Prudential 34 197 Insurance
United States
16 Citigroup 76 669 Diversified financials35 Bank of America Corp 51 618 Banks commercial
and savings44 State Farm Insurance Cos 45 111 Insurance64 TIAA-CREF 36 250 Insurance67 Merrill Lynch 36 300 Securities71 Prudential Ins Co of America 34 279 Insurance76 American International Group 33 194 Insurance79 Chase Manhattan Corp 32 366 Banks commercial
and savings83 Fannie Mae 31 485 Diversified financials88 Morgan Stanley Dean Witter 31 318 Securities
Japan
21 Nippon Life Insurance 66 363 Insurance45 Dai-ichi Mutual Life Insurance 44 253 Insurance54 Sumitomo Life Insurance 40 206 Insurance91 Bank of Tokyo-Mitsubishi 31 664 Banks commercial
and savingsTotal 1279 11341Total for G-10 1279 11341
G-10 = Group of Ten countries see note to table 11
a Data shown are for the fiscal year ended on or before 31 March 1999b Assets shown are those at the companyrsquos fiscal year-end
Source Fortune Global 500 1999 httpwwwpathfindercomfortuneglobal500indexhtml
Institute for International Economics | httpwwwiiecom
THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 91
Tab
le 2
8N
on
fin
anci
al f
irm
s in
th
e 10
0 la
rges
t co
mp
anie
s b
y re
ven
ue
199
8 (b
illio
ns o
f do
llars
)
Glo
bal
Tra
nsn
atio
nal
ity
ran
k
Co
mp
any
Rev
enu
esa
Ass
etsb
ind
exc
Typ
e
Co
nti
nen
tal
Eu
rop
e
2D
aim
lerC
hrys
ler
(Ger
man
y)15
516
044
1M
otor
veh
icle
s an
d pa
rts
11R
oyal
Dut
chS
hell
Gro
up (
Net
herla
nds)
9411
058
9P
etro
leum
ref
inin
g17
Vol
ksw
agon
(G
erm
any)
7670
568
Mot
or v
ehic
les
and
part
s22
Sie
men
s (G
erm
any)
6667
521
Ele
ctro
nics
el
ectr
ical
equ
ipm
ent
32M
etro
(G
erm
any)
5222
n
a
Foo
d an
d dr
ug s
tore
s34
Fia
t (I
taly
)51
7640
8M
otor
veh
icle
s an
d pa
rts
36N
estle
(S
witz
erla
nd)
5041
932
Foo
d46
Veb
a G
roup
(G
erm
any)
4351
275
Tra
ding
49R
enau
lt (F
ranc
e)41
4545
7M
otor
veh
icle
s an
d pa
rts
53D
euts
che
Tel
ekom
(G
erm
any)
4093
n
a
Tel
ecom
mun
icat
ions
57R
oyal
Phi
lips
Ele
ctro
nics
(N
ethe
rland
s)38
3386
4E
lect
roni
cs
elec
tric
al e
quip
men
t59
Peu
geot
(F
ranc
e)38
4038
7M
otor
veh
icle
s an
d pa
rts
62E
lect
riciteacute
de
Fra
nce
(Fra
nce)
3711
3
na
Util
ities
ga
s an
d el
ectr
ic63
Rw
e G
roup
(G
erm
any)
3747
n
a
Util
ities
ga
s an
d el
ectr
ic65
BM
W (
Ger
man
y)36
3660
7M
otor
veh
icle
s an
d pa
rts
66E
lf A
quita
ine
(Fra
nce)
3643
576
Pet
role
um r
efin
ing
69V
iven
di (
Fra
nce)
3558
n
a
Eng
inee
ring
and
cons
truc
tion
70S
uez
Lyon
nais
e de
s E
aux
(Fra
nce)
3585
n
a
Ene
rgy
78E
NI
(Ita
ly)
3249
317
Pet
role
um r
efin
ing
86B
ayer
(G
erm
any)
3134
827
Che
mic
als
92A
BB
Ase
a B
row
n B
over
i (S
witz
erla
nd)
3132
957
Ele
ctro
nics
el
ectr
ical
equ
ipm
ent
93B
AS
F (
Ger
man
y)31
3159
5C
hem
ical
s95
Car
refo
ur (
Fra
nce)
3020
n
a
Foo
d an
d dr
ug s
tore
s
(tab
le c
ontin
ues
next
pag
e)
Institute for International Economics | httpwwwiiecom
92 WORLD CAPITAL MARKETS
Tab
le 2
8N
on
fin
anci
al f
irm
s in
th
e 10
0 la
rges
t co
mp
anie
s b
y re
ven
ue
199
8 (b
illio
ns o
f do
llars
) (c
ontin
ued
)
Glo
bal
Tra
nsn
atio
nal
ity
ran
k
Co
mp
any
Rev
enu
esa
Ass
etsb
ind
exc
Typ
e
Un
ited
Kin
gd
om
19B
P A
moc
o68
8559
2P
etro
leum
ref
inin
g43
Uni
leve
r45
3692
4F
ood
Un
ited
Sta
tes
1G
ener
al M
otor
s16
125
729
3M
otor
veh
icle
s an
d pa
rts
3F
ord
Mot
or14
423
835
2M
otor
veh
icle
s an
d pa
rts
4W
al-M
art
Sto
res
139
49
na
G
ener
al m
erch
andi
sers
8E
xxon
101
9365
9P
etro
leum
ref
inin
g9
Gen
eral
Ele
ctric
100
356
331
Ele
ctro
nics
el
ectr
ical
equ
ipm
ent
14In
tl B
usin
ess
Mac
hine
s82
8653
7C
ompu
ters
of
fice
equi
pmen
t25
US
Pos
tal
Ser
vice
6055
n
a
Mai
l pa
ckag
e a
nd f
reig
ht d
eliv
ery
27P
hilip
Mor
ris58
6051
1T
obac
co29
Boe
ing
5637
n
a
Aer
ospa
ce30
AT
ampT
5460
219
Tel
ecom
mun
icat
ions
40M
obil
4843
597
Pet
role
um r
efin
ing
41H
ewle
tt-P
acka
rd47
3451
1C
ompu
ters
of
fice
equi
pmen
t50
Sea
rs R
oebu
ck41
38
na
G
ener
al m
erch
andi
sers
55E
I d
u P
ont
de N
emou
rs39
40
na
C
hem
ical
s61
Pro
ctor
and
Gam
ble
3731
477
Soa
ps
cosm
etic
s75
Km
art
3414
n
a
Gen
eral
mer
chan
dise
rs81
Tex
aco
3229
453
Pet
role
um r
efin
ing
82B
ell
Atla
ntic
3255
n
a
Tel
ecom
mun
icat
ions
85E
nron
3129
n
a
Ene
rgy
87C
ompa
q C
ompu
ter
3123
n
a
Com
pute
rs
offic
e eq
uipm
ent
89D
ayto
n H
udso
n31
16
na
G
ener
al m
erch
andi
sers
94J
C
Pen
ney
3124
n
a
Gen
eral
mer
chan
dise
rs96
Hom
e D
epot
3013
n
a
Spe
cial
ty r
etai
lers
97Lu
cent
Tec
hnol
ogie
s30
27
na
E
lect
roni
cs
elec
tric
al e
quip
men
t10
0M
otor
ola
2929
n
a
Ele
ctro
nics
el
ectr
ical
equ
ipm
ent
Institute for International Economics | httpwwwiiecom
THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 93
Jap
an
5M
itsui
109
5635
8T
radi
ng6
Itoch
u10
957
333
Tra
ding
7M
itsub
ishi
107
7536
9T
radi
ng10
Toy
ota
Mot
or10
012
540
0M
otor
veh
icle
s an
d pa
rts
12M
arub
eni
9455
300
Tra
ding
13S
umito
mo
8946
259
Tra
ding
18N
ippo
n T
eleg
raph
amp T
elep
hone
7614
7
na
Tel
ecom
mun
icat
ions
20N
issh
o Iw
ai68
3938
8T
radi
ng24
Hita
chi
6282
214
Ele
ctro
nics
el
ectr
ical
equ
ipm
ent
26M
atsu
shita
Ele
ctric
Ind
ustr
ial
6067
332
Ele
ctro
nics
el
ectr
ical
equ
ipm
ent
31S
ony
5353
628
Ele
ctro
nics
el
ectr
ical
equ
ipm
ent
33N
issa
n M
otor
5158
511
Mot
or v
ehic
les
and
part
s38
Hon
da M
otor
4943
641
Mot
or v
ehic
les
and
part
s48
Tos
hiba
4151
252
Ele
ctro
nics
el
ectr
ical
equ
ipm
ent
51F
ujits
u41
4332
6C
ompu
ters
of
fice
equi
pmen
t52
Tok
yo E
lect
ric P
ower
4012
2
na
Util
ities
ga
s an
d el
ectr
ic60
NE
C37
42
na
E
lect
roni
cs
elec
tric
al e
quip
men
t90
Tom
en31
18
na
T
radi
ng99
Mits
ubis
hi E
lect
ric30
35
na
E
lect
roni
cs
elec
tric
al e
quip
men
t
Ch
ina
73S
inop
ec34
52
na
P
etro
leum
ref
inin
g
Tot
al (
aver
age
for
tran
snat
iona
lity
inde
x)3
988
447
949
0T
otal
for
G-1
0 (a
vera
ge f
or t
he i
ndex
)3
954
442
749
0
na
= n
ot a
vaila
ble
G-1
0 =
Gro
up o
f T
en c
ount
ries
see
not
e to
tab
le 1
1
a
Dat
a sh
own
are
for
the
fisca
l ye
ar e
nded
on
or b
efor
e 31
Mar
ch 1
999
b
Ass
ets
show
n ar
e th
ose
at t
he c
ompa
nyrsquos
fis
cal
year
-end
c
The
ind
ex o
f tr
ansn
atio
nalit
y is
cal
cula
ted
as t
he a
vera
ge o
f ra
tios
of f
orei
gn a
sset
s to
tot
al a
sset
s f
orei
gn s
ales
to
tota
l sa
les
and
for
eign
em
ploy
men
tto
tot
al e
mpl
oym
ent
as o
f 19
97 (
UN
CT
AD
)
Sou
rces
F
ortu
ne G
loba
l 50
0 1
999
http
w
ww
pat
hfin
der
com
fort
une
glob
al50
0in
dex
htm
l U
NC
TA
D (
1999
)
Institute for International Economics | httpwwwiiecom
94 WORLD CAPITAL MARKETS
foreign direct investment The ldquotransnationality indexrdquo (table 28) showsthat on average they conducted about half their business outside theirhome country9
Overview of the Players
Our review of the major players points to two major features First ahandful of big playersmdashfewer than 200 firms all toldmdashcontrol the ac-tion in international capital markets Their dominance will doubtless erodebut for now financial power is strikingly concentrated with them Sec-ond the big players are overwhelmingly based in the G-10 countriesplus Spain The responsibility to supervise them rests not in the IMFnor in Basel but squarely in Washington London Tokyo and the otherG-10 capitals At year-end 1999 the G-10 countries plus Spain accountedfor 84 percent of world banking assets 86 percent of world stock marketcapitalization and 76 percent of international debt securities (BIS 2000aWorld Bank 2000b)
International private capital flows are of three types bank loans anddeposits portfolio investment and foreign direct investment In cumula-tive total flows to emerging markets FDI was the biggest story in the1990s amounting to $954 billion (table 12) Portfolio flows were nextcumulatively amounting to somewhere between $612 billion (table 12)and $764 billion (table A1) Bank loans and deposits are the most com-plicated story
The Key Role of Banks
Banks are more important as an epicenter than as a wellspring Banksgenerate waves in the flow of capital to emerging markets rather than acontinuous steady stream According to data compiled by the Institute ofInternational Finance (table A1) net bank lending to emerging marketscumulated to $269 billion in the 1990s However deposits by emerging-market residents in G-10 banks more than offset G-10 bank lending tothese countries during the decade According to IMF data cumulativebank loans net of deposits amounted to a negative $135 billion (table 12)
In other words when loans and deposits are combined net bank ac-tivity that moves financial resources to emerging markets is small incomparison with portfolio investment and FDI But bank loans are thelubricant of any financial system Depending on circumstances bankscan be shock absorbers or shock propagators In recent decades with
9 The transnationality index is calculated as a simple average of the share of assetssales and employees outside the home country
Institute for International Economics | httpwwwiiecom
THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 95
respect to emerging markets banks have more often been propagatorsthan absorbers The average annual swing in bank lending to emergingmarkets was nearly $50 billionmdashby far the largest source of year-to-yearfluctuations in capital flows Both interbank loans between Europe Japanand Asia and sovereign Russian debt used as loan collateral played amajor role in the 1997-98 crisesmdashnot because banks are profligate playersbut because of the incentives they face and the instruments they useAccordingly our story begins with banks
Banks in the Modern Financial System
10 See Levine (2000) for a concise description of the role of banks in the financial system
11 The asymmetric information problem helps to explain why banks dominate the im-mature financial systems of emerging-market economies The general lack of informationon borrowers and undeveloped legal systems to enforce contracts hamper suppliers oflong-term financial instruments such as equities and bonds in evaluating risk and re-ward Banks are best suited in these circumstances to solve the asymmetric informationproblem by evaluating and monitoring private loans As more and better informationbecomes available capital markets develop and financial systems mature
As we noted in the previous paragraph the problem of financial volatil-ity in emerging-market economies is associated with bank lending Ifand when repayment problems arise cross-border private bank loansand bond placements are such that private creditors have no plausiblemeans of seizing assets from either private or sovereign borrowers Thusalthough international finance can nourish entrepreneurs and accelerategrowth a necessary complement may be a drastic creditor response inthe event of nonpaymentmdashto withhold fresh funds and force an eco-nomic crisis (Dooley 2000)
This argument is based on the characteristics of banks They are notldquobadrdquo per se They perform three essential functions in any financialsystem pooling the resources of disparate savers and channeling these re-sources into productive investment improving resource allocation throughtheir expertise in assessing and monitoring borrowers and facilitatingthe division of risk among numerous creditors10 But by their very na-ture banks are prone to two problems asymmetric information (the bor-rower knows more about the potential risk and return of its projectsthan the bank) and adverse selection (riskier borrowers will pay higherinterest rates and thus may constitute a disproportionate share of bankloan portfolios)11
Bank loans are illiquid fixed-price instruments They cannot easily beconverted to cash although they can be bundled into securities (knownas ldquosecuritizationrdquo) Once loan terms have been agreed on the only waya bank can adjust for shifting market conditions is by changing the quantityof its exposure When a borrower runs into trouble the bank can mix
Institute for International Economics | httpwwwiiecom
96 WORLD CAPITAL MARKETS
and match from two unpleasant menus It can roll over existing loansand extend new credit or it can call some part of existing loans andattempt to recover the principal It can also hedge by selling short otherclaims on the borrower These choices entail either an unwelcome exten-sion of the bankrsquos exposure or credit rationing against the borrower Whentrouble brews all banks encounter the same conditions in the aggregatethey prefer less exposure and ensuing credit restrictions lead to volatilebank lending
Innovation
12 Derivatives have no value of their own They ldquoderiverdquo their value from the value ofthe underlying asset They include swaps futures (contracts for future delivery at speci-fied prices) and options (which give one party the right but not the obligation to buyfrom or sell to a counterparty at an agreed price)
13 Maxfield (1998) analyzed available evidence of emerging-market investor objectivesmost of it before the crisis Analysis of portfolio equity flows is sensitive to the choice ofperiod with year-over-year data indicating that investors respond to country ldquofundamen-talsrdquo Other evidence suggests more ambiguity Ranking by ldquoinvestor impatiencerdquo ie thesearch for yield over value Tesar and Werner (1995) find short-term bank flows to be themost yield driven followed by portfolio investment FDI and long-term bank lending
14 Because market risk credit risk and country risk interact in complex ways newfinancial instruments have been created to help reduce negative interactions One is theldquototal return swaprdquo which has become an instrument of choice for hedge funds lookingfor high leverage Banks also use the total return swap to cover risks without increasingtheir capital requirements
Since the 1980s national and international banking systems have beentransformed by deregulation intensified competition and the informationand communications-technology revolutions The market environment isone of intense competition particularly in traditional banking activitiesThe innovations point away from traditional activities of plain vanilladeposit taking and loan making Three big themes are discernible Firstthe walls separating commercial banks investment banks portfolio man-agers and insurance firms are falling even if they are still distinct Sec-ond large banks are shifting toward securitizationmdashcreating securitiesout of everything from credit card debt to trade finance to disaster insur-ancemdashand earning fees in the process Third all large banks are shiftingtoward trading activity making markets and taking short-term stakes inbonds shares and derivatives12 These activities when successful satisfythe search for higher yields13
Many of the new financial instruments that banks trade are ldquooff bal-ance sheetrdquo This means that banks are not required to allocate capitalagainst them In swap contracts for example neither side pays cash at theoutset and therefore neither party has an asset in the traditional sense14
Futures and options contracts can be written with a relatively small initial
Institute for International Economics | httpwwwiiecom
THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 97
margin relative to the potential risk Credit derivatives limit credit risk bytransferring the potential loss associated with corporate loans and bondssovereign debt and other loan portfolios to counterparties15
Deregulation and innovation working in combination seem to havepushed banks into trading activity and leveraged plays but not into shareownershipmdasheven in jurisdictions that have no prohibition against equitystakes Among the G-10 banking systems the highest ratio of share own-ership to assets was only 5 percent in 1996 reached in Germany andJapan (Berlin 2000)16
The wave of innovation in financial instruments and the accompany-ing expansion of banking beyond its old boundaries is a two-edged swordOn one side it allows risk management far beyond what was tradition-ally possible Risk can now be shifted from firms that can ill afford lossesto those that can Banks can profitably act as intermediaries in shiftingrisk On the other side the innovation wave creates huge opportunitiesfor leveraged plays fostering a speculative search by banks themselvesfor high returns that in turn magnify their own risks17
15 Credit derivatives include total return swaps credit default swaps credit-linked notesand collateralized debt obligations They are the fastest-growing sector of the global de-rivatives market
16 Banks seem to specialize in lending even when they are allowed to mix finance andcommerce for reasons related both to how they are expected to behave with distressedfirms and to other intricacies of lender liability (Berlin 2000) Yet a recent cross-countrystudy found that restrictions on banking and commerce are associated with greater fi-nancial instability (Barth Caprio and Levine 2000)
17 Leverage is the magnification of the rate of return (positive or negative) on an in-vestment beyond the rate obtained by solely investing funds owned by the institution Itis often defined as the ratio of assets to equity Leverage is achieved by increasing thesize of an investment by borrowing or using derivative instruments such as futures oroptions These allow investors to earn a return on the notional amount underlying thecontract by committing a small portion of equity in the form of a margin deposit oroption premium payment
18 In a repo (repurchase agreement) one party (typically a trader) buys a bond andsells it to a dealer for cash with a promise to buy it back the next day at the same priceplus the overnight interest rate As long as the overnight interest rate is lower than theinterest accruing on the bond the trader earns some income on the bond The extremeform of these kinds of transactions was discovered at LTCM the failed US highly lever-aged institution which appears to have controlled more than $120 billion in assets froman investment of about $3 billion This leveraging was accomplished mostly through theuse of repos (Mayer 1999)
The potential for damage is illustrated in an extreme form by figure 21To precisely measure a firmrsquos leverage all positions must be known andrealistically valuedmdashwhich may be impossible to do Because many ac-tivitiesmdashsuch as repos18 and derivativesmdashdo not appear on the institutionrsquos
Leverage
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98W
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PIT
AL
MA
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ET
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Figure 21 Hypothetical example of leverage
$1000 notional value of call option on equity in firms targeted for takeover
Repo FRN into cash and use cash to pay option premium
(repro is initially collateralized
Borrow $100 for margin purchase
$125 of US investment bank floating-rate notes (FRN) (secured by $25 equity in FRNs)
Repo off-the-run bond into cash and post margin
(repo is initially collateralizedSell (short) Borrow on-the-run bonds worth $20
$25 worth of off-the-run bonds (secured by $5 equity in bonds)
Exchange into $4
Cash $5 yen400 Japanese bank loans
$1 equity base
FRN = floating rate notesRepo = repurchase agreement
Source IMF (1998)
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 99
balance sheet and because balance sheets are published quarterly at bestoutsiders have a difficult time assessing the extent of a firmrsquos leverage19
Leveraging by a single firm enhances its risk of default the widespreaduse of leverage in the financial system can magnify market adjustmentsespecially when they require ldquodeleveragingrdquomdashunwinding prior positionsRapid adjustments can cause credit to dry up and asset prices to plummetIn a mark-to-market environment falling asset prices trigger calls foradditional collateral that can ripple through markets
Risk Management
Because it is confronted with the widespread use of leverage and prolif-erating kinds of risk international finance is increasingly driven by riskevaluation and control20 Different institutions face various risk profilesand differing kinds of risk The most common risks can be quickly tickedoff Banks because of their traditional intermediary role of channelingthe resources from savers to borrowers face significant credit risk therisk of default or delay in the payment of principal and interest Theymust also manage market risk the risk that the prices of their liabilitiesmay change faster than their assets Market risk devastated US savingsand loan institutions in the late 1980s
Closely associated with market risk are interest-rate risk (unexpectedchanges in market interest rates that slash margins net income and theeconomic value of a bankrsquos equity) and foreign exchange risk (losses thatarise when assets denominated in an appreciating foreign currency areless than liabilities denominated in that currency) Banks make numer-ous loans to other banks around the world portfolio investors buy se-curities direct investors acquire fixed assets and all incur country risk(economic and political uncertainty in the host country) During the heightof the Asian crisis for example interbank loans to Japanese banksreflected the credit risk of lending to these banks the so-called Japanpremium
Substantial attention has been lavished on country risk analysis sincethe 1982 debt crisis in developing countries Yet in spite of this exper-tise the Asian crisis occurred in part because of a sudden upward reap-praisal of country risk after the Thai baht collapsed in April 1997 Banksand other financial institutions must also manage liquidity risk the riskthat market conditions will change unexpectedly depressing demand andprices of assets at the time they want to sell these assets And they mustmanage operational riskmdashfailures in control systems or people that cause
19 Another example of asymmetric information Both risk and leverage are difficult foroutsiders to assess without full timely disclosure
20 A longer discussion of these issues can be found in Managing Global Finance in IMF(1999c)
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100 WORLD CAPITAL MARKETS
financial loss or damage reputations Operational risk devastated BaringsBank in 1995
Financial institutions practice risk management to measure all theserisks the potential damage to their investment positions and ultimatelythe chance of becoming insolvent VAR (value at risk) risk models mea-sure subject to certain assumptions the amount of the firmrsquos capital thatis exposed in each period For example the VAR model might say thatin a 3-standard-deviation worst case (a case that is not supposed to hap-pen more than 1 percent of the time) the firm will loose 25 percent of itscapital during the next year
VAR models are widely used but like all models they have weak-nesses They rely on past values to estimate key variables in financialmarkets past values are not always good predictors of future risks More-over rising volatility and higher loss correlation among different assetclasses in a portfolio will cause all banks using these models to reducetheir exposures at the same time by switching to less volatile and lesscorrelated assets such as US Treasury bills (Persaud 2000)
Newer risk models entail stress testing and scenario analysis Scenarioanalysis envisages possible adverse changes one at a time that mightaffect the investment portfolio Stress testing estimates potential losseswhen several individual risk factors simultaneously move against thefirm but it too uses historical probabilities
Financial Volatility
21 For example derivative markets usually rely on underlying securities markets thatproduce continuous prices When these markets are interrupted financial shocks cantrigger a cascade of margin calls and sell orders that move prices very sharply
22 See IIF (1999a)
The combination of trading activity and modern risk management lie atthe root of financial volatility When risks increase banks must eitherraise more capital to cover the greater risk or reduce their exposure bycutting loan exposure by selling securities or by undertaking new de-rivative trades Raising more capital is time-consuming and in a crisisvery expensive because bank shares are depressed So banks look to theother alternatives If the bank can reduce lending it need not book aloss But most banks use the same VAR models and as indicated abovethese models will encourage them to reduce their outstanding loans atthe same time actually magnifying loan volatility
If banks attempt to reduce their exposure to risk by selling securitiesor undertaking new derivative trades they may trigger large priceshocks because of limited and shrinking market liquidity21 The liquid-ity problem is compounded when a small number of large institu-tions hold the same positions22 Take your pick loan volatility or price
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 101
volatility As two experts have observed (Folkerts-Landau and Garber1998)
[V]olatility even in one country will automatically generate an upward re-estimate of credit and market risk in a correlated country triggering automaticmargin calls and tightening of credit lines Thus apparently bizarre opera-tions that connect otherwise disconnected securities markets are not the re-sponses of panicked green screen traders arbitrarily driving economies from agood to a bad equilibrium Rather they work with relentless predictability andunder the seal of approval of supervisors in the main financial centers
23 See Ferguson (1999)
24 As Gerald Corrigan (1982) put the matter ldquoBanks are specialrdquo Corrigan (2000) reit-erated this view even after all the changes of the past two decades Unlike other institu-tions banks offer on-demand transactions are a backup liquidity source for other insti-tutions and serve as a ldquotransmission beltrdquo for monetary policy
These changes in the banking environment accentuate an existing anomalyThe anomaly is that banks even as they grow larger and increasinglyengage in more risky and complex transactions are perceived to enjoyimplicit and explicit public guarantees
The guarantees grow out of an incentive problem inherent in bankingasymmetric information which we mentioned above Depositors know lessabout a bankrsquos management and the quality of its balance sheet than doits managers and shareholders Thus in times of uncertainty or adver-sity bank depositorsmdashuncertain whether they will have access to theirdepositsmdashare prone to bank runs This prospect has in turn compelledgovernments to treat banks differently than other firms because a bankthat fails can disrupt the rest of the economy24
To prevent such crises governments have entered into quid pro quoarrangements with banks Governments provide them both with an im-plicit safety net in the form of an unstated promise by the central bankto act as a lender of last resort in a liquidity crisis and an explicit safetynet in the form of a public deposit insurance fund to reassure depositorsIn return the banks submit to closer government oversight and regu-lation of their activities than is usual for industries in the private sector
The ldquoinsurancerdquo provided by the public safety net contributes to an-other incentive problem moral hazard Banks acquire greater tastes forrisk and face less market discipline than other firms The explicit depositinsurance safety nets actually have or are perceived to have blanketcoverage that extends beyond the retail depositors (households and small
One of the lessons of the 1997-98 crisis must surely be that market par-ticipants and their regulatory supervisors relied too heavily on quantita-tive tools and insufficiently on judgment23
The Anomaly of Modern Banking
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102 WORLD CAPITAL MARKETS
businesses) for which they were originally intended The implicit centralbank safety nets extend in a crisis to nearly all depositors and banksThus banks are both viewed and behave as if they will be bailed out ifthey get into trouble
The existence of a public safety net raises a perennial question Dobanks have an unfair advantage over other financial institutions becauseof the subsidy provided by the safety net This question was at the heartof intensive study and debate in the United States leading up to thepassage in November 1999 of the Financial Services Modernization Act(also known as the Gramm-Leach-Bliley Act) The size of the gross sub-sidy is difficult to estimate despite determined research efforts Somesuggest it is well under 100 basis points and is at least partly offset bythe direct costs of deposit insurance premiums interest payments on bondsissued by the Financing Corporation25 reserve requirements regulatoryexpenses and operational costs associated with collecting deposits26 Con-versely Kwast and Passmore (2000) suggest that banks can expand theirscope far beyond the levels that other financial institutions could reachwith the same equity base but without the public safety net
A related concern in the US debate is whether allowing banks to ex-pand their activities into securities and insurance will ultimately extendthe safety net and add to the subsidy The Financial Services Moderniza-tion Act deals with this issue by maintaining a legal separation betweenbanks and the rest of the banking organization known as large com-plex banking organizations (LCBOs) They must engage in most securi-ties activities and insurance underwriting through separately capitalizedinvestment bank subsidiaries or holding company affiliates This act canbe said to have merely brought US banking laws closer to those of mostother industrial countries (Barth Brumbaugh and Wilcox 2000 BarthNolle and Rice 2000) If the fire wall is well-maintained and stoutly de-fended the safety net will neither expand in practice nor become a sourceof comfort to noncommercial bank subsidiaries of LCBOs
The quid pro quo exacted by governments to offset the subsidy iscloser public-sector monitoring of banksrsquo activities through prudentialsupervision The effectiveness of this closer official scrutinymdashand closermarket monitoringmdashare the subjects of the next section
25 The Financing Corporation was created by Congress in 1987 to sell bonds to raisefunds to help resolve the savings and loan crisis
26 See Levonian and Furlong (1995) Jones and Kolatch (1999) Shull and White (1998)and Whalen (1999a 1999b)
Are G-10 bank supervisors adequately responding In this section we firstassess the case for and compare the structures of prudential supervisory
Prudential Supervision
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 103
systems both within and among the G-10 economies plus Spain andconsider whether these offset the subsidy provided by the public safetynet Despite offsetting regulation and supervision implicit and explicitguarantees by G-10 governments to their banks are still a source of bank-ing instability in the emerging-market economies
National Systems for Prudential Supervision
Governments use prudential supervision to reduce the moral hazard andadverse selection created by their own safety nets Supervisors establishregulations and monitor compliance to limit risk taking and ensure thesafety and soundness of the banking system In a thoughtful analysis ofthe case for prudential supervision Frederic Mishkin (2000) identifiesthe main forms that supervision can take including the tasks of grantingbanking charters and licenses establishing capital requirements settingdeposit insurance premiums and defining disclosure requirements as wellas carrying out bank examinations Bank examiners gather informationfrom banks and evaluate whether they are following the regulatorsrsquo rulesin cases of weakness they are empowered to change banksrsquo behaviorand close them if necessary
Supervisors also may restrict competition define the activities in whichbanks may engage and restrict their asset holdings and separate banksand other financial (or nonfinancial) activities During the past two de-cades the barriers separating commercial banks investment banks in-surance firms and securities firms have been all but eliminated (tableB1) Deregulation has stimulated competitive forces that drive diversifi-cation and consolidation of the financial industry nowhere faster than inthe United States
The Financial Services Modernization Act of 1999 confirmed this trendIt eliminated restrictions dating back to the Glass Steagall Act of 1933which once prevented banking insurance and securities firms fromentering each otherrsquos businesses (Barth Brumbaugh and Wilcox 2000)Cross-pillar mergers among banks insurance and securities firms arewell under way to form giant financial holding companies The 1999merger between Citibank (banking) and Travelers (insurance) created themodel for megafinance and confirmed new challenges for supervisors
Mishkin (2000) notes the corresponding evolution in US supervisionfrom an emphasis on rules-based regulation (detailed rules for opera-tional behavior and the quality of line items in the balance sheet) to anapproach that stresses the soundness of bank management practices es-pecially risk management
Appendix B outlines the systems of financial supervision now in theplace in the G-10 countries plus Spain Some systems like the UK andCanadian approach are models of simplicitymdashorganized to keep pacewith the spreading reach of financial conglomerates Other systems like
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104 WORLD CAPITAL MARKETS
the US and French approaches show traces of the bureaucratic divisionsthat made sense in an era when banking securities and insurance weresharply separated
The US Model
27 See Meyer (1999a)
28 Canada has a similar degree of simplification with the exception that securities firmsare still regulated by provincial authorities
29 See Pratti and Schinasi (1999 67)
30 The agents are the bank regulators and the principals are the taxpayers Agents maypursue their own interests including bureaucratic survival and postgovernment employ-ment opportunities rather than the national interest in banking safety and soundness
The US model of financial regulation delineated in the Financial Ser-vices Modernization Act of 1999 blends functional and umbrella super-vision Bank and thrift regulators oversee depository institutions Newnonbank activities are subject to both functional regulation (eg by theSecurities and Exchange Commission and state insurance examiners) andumbrella supervision (of financial holding companies) by the FederalReserve27
The UK Model
Another supervisory model exists in the United Kingdom as well as inAustralia Canada and Switzerland28 In this model banking supervisionis separated from the monetary policy function The regulatory structureis considerably simplified by relying on a consolidated financial regula-tor separate from the central bank for both banking and nonbankingactivities The remaining question answered differently depending on thecountry is the extent to which the regulator relies on home-country sur-veillance of banks and conglomerates that have a local presence
Regulatory Models Compared
Appendix B provides more detail on the differences in these modelsGerman simplicity contrasts with French complexity In France the bankingcommission is chaired by the governor of the central bank and includesrepresentatives from the Treasury The commission supervises compli-ance with regulations but the central bank inspects banks on behalf ofthe commission29 In countries such as the United States and France withmultiple supervisors and crossover functions internal coordination is criticalAt the same time multiple agencies create regulatory competition Wheneach agency knows what the other is doing transparency within gov-ernment circles can help to limit principal-agent problems of regulation30
The discussion as to where in the public bureaucracy financial super-
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 105
vision should be placed goes back many years Peek Rosengren andTootell (1999) argue that a synergy exists between monetary policy andprudential supervision because information gained in the course of super-vision can increase the accuracy of macroeconomic forecasts A twist tothis argument is that the information on the state of financial institutionsavailable to the central bank as supervisor can facilitate its role as lenderof last resort Conversely there is the concern that a supervisory rolewill compromise the central bankrsquos independence of action with respectto its core mandatemdashmaintaining price stability As these arguments haveplayed out financial supervision has generally been shared between centralbanks and other regulators or placed entirely in the hands of an inde-pendent regulator However in Italy the Netherlands and Spain cen-tral banks are the sole banking supervisor
Goodhart (1995) examined the arguments and evidence for each modeland concluded that there were no overwhelming arguments or evidencefor one or the other31 Going forward a key problem for any financialsupervisory system is dealing with (and closing as necessary) weak banksIf both central banks and other regulators have this responsibility closecoordination between them is critical Another problem is large conglom-erate banks LCBOs Although they are less likely to fail because of thediversification of their assets and liabilities they are more likely to berescued They are also more likely to be multinational enterprises withinternational implications Goodhart observes that regulation of theseentities might be put in the hands of the central bank because it is lessamenable to political pressures In any event the complexity of LCBOoperations suggests that greater supervisory rigor is necessary
The US Congress was persuaded that broad oversight would help containthe moral hazard problem and accordingly gave the Federal Reservethe role of umbrella supervisor with the understanding that the Fed willscrutinize depository activity more intensely than nonbank financial ac-tivities Under this approach LCBOs such as Citigroup are subject tomuch closer monitoring than smaller and simpler institutions32 The USregulatory model requires enormous cooperation between the Fed otherbank supervisors and the functional regulators for insurance and securi-ties but it also benefits from regulatory competition
31 National systems of supervision are path dependent they are determined by the struc-ture of financial institutions and history in each country If Goodhart (1995) is right out-comes are not materially better or worse with one model of supervision rather than another
32 See Ferguson (1999)
Public Safety Nets
One of prudential supervisorsrsquo biggest challenges is to reduce moral hazardFor many years commercial banks engaged in communal self-insurance
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106 WORLD CAPITAL MARKETS
to deal with crises They formed voluntary groups that agreed to rescuetroubled members As financial markets evolved and competition inten-sified banks were no longer willing to play this role Private-sector in-surance is one alternative but moral hazard and adverse selection wouldappear to prevent it from happening Public safety nets have developedbecause of the low probability and high cost of potential bank runs Aclear trade-off is involved The effectiveness of insurance in preventingbank runs is greater the more comprehensive the coverage But the morecomprehensive the coverage the greater the moral hazardmdashbank man-agers bank directors investors and depositors all take on greater risksin the belief that the safety net will protect them against losses
All G-10 countries have compulsory public safety nets for banks (table29) Deposit insurance agencies are officially organized in Canada theNetherlands Sweden Switzerland and the United States organized bythe industry in France Germany Italy and the United Kingdom andjointly organized by the public and private sectors in Belgium Japanand Spain
How well do G-10 governments offset the subsidy provided by thepublic safety net This is a question on which there is substantial debateAs banking organizations have become more complex the challengesthat supervisors face have become more difficult One challenge is toalign the incentives facing bank managers and shareholders with thoseof depositors Another is the principal-agent problem in supervision Wehave discussed the incentive structures for financial institutions but wehave said little about the incentives for supervisors themselves and thedistortions they can generate in the financial system
In one of the many studies of the US savings and loan crisis of the1980s Kane (1989) documented both problems He described managersusing cosmetic approaches to disguise the magnitude of insolvency regulatorspracticing forbearance even though they knew of the deteriorating riskprofiles of the institutions for which they were responsible and legisla-tors increasing deposit insurance without regard for any offsetting changesin supervision A subsequent overhaul of the legislative framework forthe Federal Deposit Insurance Corporation (FDIC) known as the FDICImprovement Act of 1991 (FDICIA) aimed to introduce a clearer incen-tive structure for both regulators and regulated institutions
The changes introduced by this US legislation are worth discussionwith respect to the other G-10 countries as well First FDICIA created astronger signal to management and investors by targeting deposit insur-ance at small depositors only and by risk-weighting the deposit insur-ance premiums paid by banks to reflect their capital adequacy and bankexaminer ratings Among the G-10 countries rated in table 210 depositinsurance premiums vary considerablymdashbut it is not clear that the dif-ferences have much to do with risk-weighting Most G-10 countries em-ploy funding formulas based for example on the total domestic deposit
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TH
E P
LAY
ER
S T
HE
IR S
UP
ER
VIS
OR
S A
ND
MO
RA
L HA
ZA
RD
107
Table 29 Deposit insurance schemes in the G-10 countries Explicit safety net
Coverage limit(dollar Foreign
equivalent currency Interbank Source Bankrsquos Contingency fundingDate Membership Co- at end of deposit deposit of premium from banks
Country established managementa insuranceb July 1998)c covered covered Fundingd funding costs or governments
United 1982 Compulsory Yes Larger of 90 No No Unfunded Banks only Callable (subject Parliament may increase Kingdom private percent co- to maximum the maximum payable
insurance to 03 percent of pound125 million advance 33000 total deposits) facility with Bank of
England
United 1934 Compulsory No 100000 Yes Yes Funded Banks and Up to 027 Borrowing up to $3 States official government percent total billion from US Treasury
domestic deposits
Japan 1971 Compulsory No 71000 but No No Funded Banks and 0084 percent of Borrowing up to yen500bn joint in full until government insured deposits from Bank of Japan
year 2000 subject to Ministry of Finance approval
Canada 1967 Compulsory No 40800 No Yes Funded Banks and 033 percent of Borrowing up to C$6 official government insured deposits billion authorized further
(maximum) borrowing subject to parliamentary approval
Germany 1966 Compulsory Yes 90 percent Yes No Funded Banks only 003 percent of Annual levy may be private coinsurance deposits doubled
to 22000
Italy 1987 Compulsory Yes 125000 Yes No Unfunded Banks and Callable Two options defer private government (maximum of payment or diminish
1 percent of compensation to be paid total deposits)
(table continues next page)
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108W
OR
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CA
PIT
AL
MA
RK
ET
S
Table 29 Deposit insurance schemes in the G-10 countries Explicit safety net (continued )
Coverage limit(dollar Foreign
equivalent currency Interbank Source Bankrsquos Contingency fundingDate Membership Co- at end of deposit deposit of premium from banks
Country established managementa insuranceb July 1998)c covered covered Fundingd funding costs or governments
Netherlands 1979 Compulsory No 22000 Yes No Unfunded Banks and On demand Government backing official government maximum of subject to parliamentary
5 percent of own approval funds
France 1980 Compulsory No 65400 No No Unfunded Banks only Callable (on Extra calls up to FFr1000 private demand calls million can be made in
up to FFr200 a 5-year period million)
Switzerland 1984 Voluntary No 19700 No No Unfunded Banks only Callable (on Underwritten by member official demand) banks
Sweden 1996 Compulsory No 31400 Yes No Funded Banks and 05 percent of Full emergency coverage official government deposits while replacing it with a
limited system after the emergency
Belgium 1974 Compulsory No 16600 No No Funded Banks and Callable 002 None insurance limited joint 22000 in government percent of to assets in fund
year 2000 deposits from clients
Spain 1977 Compulsory No 16439 Yes No Funded Banks and 02 percent of Government backing joint government deposits through the Banco de
(maximum) Espantildea subject to approval by royal decree
a Bank membership in the fund can be either compulsory or voluntary and the management of the fund can be official and official and private joint or privateb Coinsurance refers to the situation where depositors face a deductible against their insured fundsc Coverage limit refers to the explicit amount the authorities promise to insured Funded scheme means that it is funded ex ante unfunded otherwise
Sources Goodhart (1995) Demirguccedil-Kunt and Detragiache (2000) Demirguccedil-Kunt and Sabaci (2000)
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 109
base Explicit safety net protection also varies but only Canada focuseson the protected class33 All G-10 countries specify a limit on depositorprotection Under FDICIA the insurance fund is prohibited from pro-tecting uninsured depositors or creditors at a failed bank although adiscretionary system-wide override is provided for exceptional circum-stancesmdashbut with stringent requirements for consultation and account-ability Other G-10 countries allow for contingency funding from the publicpurse alongside unwritten lender-of-last-resort support Among large banksa significant and growing portion of deposit liabilities including foreigncurrency and interbank deposits are uninsuredmdashbut depositors assumethey will be protected in a crisis
FDICIA also made some significant qualitative changes to address theprincipal-agent problem by penalizing weak banks and rewarding strongbanks For example banks whose capital declined faced progressivelytougher regulatory sanctions that for example required them to elimi-nate dividends restrict their lending and change their managementsRegulators have also been forced to take prompt corrective action (toreduce the practice of regulatory forbearance in hopes that a bankrsquos for-tunes might improve)34 Unfortunately comparative qualitative assess-ments across the G-10 are difficult to make due to lack of information35
This discussion highlights the complexity of evaluating the extent towhich prudential supervision and market discipline reduce the moralhazard associated with G-10 safety nets Our argument is that publicsafety nets in the G-10 can be linked to banking instability in other coun-tries specifically in the emerging-market economies that have attractedG-10 cross-border bank lending This lending is a leading source of vola-tility in capital flows the large financial institutions many of which arecomplex banking organizations are based in and regulated by authori-ties in the G-10 economies These two features of the international finan-cial system are closely related although it is not possible to test thisrelationship econometrically
Two World Bank studies however indicate a basis for concern Onestudy is a cross-country econometric analysis of the relationship betweenbank stability and deposit insurance (Demirguccedil-Kunt and Detragiache2000) which found a negative relationship Their estimated model forbanking crises in a sample of 61 countries (both industrial and develop-ing) suggests that explicit deposit insurance raises the probability of acrisis by at least 30 percent36 Crises are especially likely in countries
33 Japanrsquos legislation says it does but recent experience shows this is not the case34 See Goldstein (1997) for a summary of the changes35 See Barth Nolle and Rice (2000) for a beginning in this area36 Demirguccedil-Kunt and and Detragiache (2000 table 1) report a logit coefficient of 0696with a standard error of 0397 (the coefficient is significant at the 8 percent threshold)This suggests that the ldquotruerdquo coefficient could well be as small as 030 (the reportedvalue minus the standard error)
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110 WORLD CAPITAL MARKETS
with immature financial supervisory systems (and not in the G-10) buttheir analysis does underscore the view that deposit insurance weakensmarket discipline37
An earlier World Bank analysis established similar results One wasthat market discipline is undermined by deposit insurance schemes an-other was that illiquid banks are forced to pay more for their funds un-less a generous deposit insurance scheme is in place (Demirguccedil-Kuntand Huizinga 1999) This econometric study also provides clear-cut evi-dence that depositor monitoring of banks declines with the existence ofdeposit insurance schemes At the heart of the problem is the questionof whether deposit insurance is accompanied by increased governmentmonitoring
This evidence and the weight of other arguments suggests that moralhazard is still an issue in the G-10 countries Consider the ongoing de-bate about instilling greater market discipline on risk taking by banksAt one extreme is the perennial proposal to do away with safety netsleaving markets to monitor the players and to force adjustments but toprotect small savers by creating ldquonarrow banksrdquo such as postal savingsystems that are allowed to invest these savings only in risk-free gov-ernment securities Whatever the merits of narrow banking this solutionis too extreme to be politically feasible
A moderate alternative is to force more disclosure by financial institu-tions to facilitate market monitoring But transparency has its own prob-lems Persaud (2000) argues that financial markets cannot reliably discernsustainable from unsustainable positions in the short term This uncer-tainty causes banks to ldquoherdrdquo behind market leaders to exploit theirsupposedly superior information ldquoThe more herding investors and bankersknow about what each other is up to the [more] unstable markets maybecomerdquo The implication is that greater transparency in the marketplaceby itself will not solve the problemmdashand in the short term more informa-tion may exacerbate herding Further supervisory steps (discussed in thenext chapter) are required
Yet another proposal is to promote private-sector involvement in bankmonitoring through market-based alternatives such as Calomirisrsquos sub-ordinated debt proposal (Calomiris 1997 Federal Reserve Board 1999)Banks could be required to issue and maintain a minimum amount of
37 Other findings in the Demirguccedil-Kunt and Detragiache (2000) study include thesepropositions The impact of deposit insurance on bank stability tends to be stronger themore extensive is the coverage offered to depositors when the scheme is funded andwhere the scheme is run by the government rather than by the private sector Con-versely deposit insurance is detrimental to bank stability where bank interest rates havebeen deregulated and where the institutional environment is weak Additional findingson deposit insurance are reported from a recent World Bank conference (8-9 June 2000httpwwwworldbankorgresearchinterestconfsupcomingdeposit_insurancehomehtm)Also see Smalhout (2001)
Institute for International Economics | httpwwwiiecom
THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 111
subordinated debt (eg uninsured certificates of deposit) to finance asmall fraction (such as 2 percent) of their total nonreserve assets Thesubordinated debt would be allowed to earn a set yield no more than 50basis points over the risk-free yield on government treasury bills Thisrule would supposedly force banks to operate in a safe manner Other-wise subordinated debt holders would redeem their uninsured certifi-cates of deposit and equity investors would sell their bank shares Despiteits practical problems the beauty of the subordinated debt requirementis that it enlists market incentives to push banks to avoid excessive port-folio risk38
The thrust of these proposals is very relevant to the arguments in ourstudy Even in the G-10 countries government monitoring by itself hasnot eliminated moral hazard among banks More work is needed to in-troduce market monitoring and to improve the incentive structures bothfor financial institutions and their supervisors We return to this issuewith our recommendations in the next chapter
38 In late 1996 Argentina began requiring its banks to finance 2 percent of total depos-its in the form of subordinated debt but without a maximum yield provision TheArgentine authorities expect that market discipline will act in concert with the publicsafety net One obvious problem with the subordinated debt proposal is that banks mayencourage some of their customers to buy the subordinated debt
Portfolio Institutions Tomorrowrsquos Problem
Before proceeding to the issues of international supervision we flag an-other potential problem for national regulators The big asset managersprofiled in tables 24 and 26 answer to diverse groups of pensionersshareholders and policyholders They allocate funds across a number ofcountries to diversify their risks They hold liquid assets that can be tradedand they have a higher proportion of long-term assets than banks Eco-nomic shocks can be absorbed through price changes and their effectsspread across time and markets Thus when conditions change in a par-ticular market they are more likely to ride out the storm than to flee Inother words they have less incentive than banks to pull their invest-ments in the face of adversity In the 1990s most large asset managersestablished a record of ldquoriding out the stormrdquo rather than ldquorunning withthe windrdquo although as we saw in chapter 1 instances of running withthe wind were detected in some portfolios As we write these insti-tutions have a good record overall in the emerging markets so whyworry
The Russian crisis and the near-collapse of LTCM previewed the dan-gers that may await future portfolio managers and G-10 financial minis-ters We have presented evidence indicating a systemic bias toward bank
Institute for International Economics | httpwwwiiecom
112 WORLD CAPITAL MARKETS
lending and debt finance to emerging markets and we have argued forsubstitution toward equity finance and direct investment39
That is not the end of the story We noted in the previous chapterthat institutional investors can become momentum investors selling in adownturn As more portfolio capital is invested in emerging marketssome players may adopt the high-risk high-leverage strategies of themost aggressive hedge funds Indeed the data in box 11 show that G-10portfolio investors held somewhat more long-term debt (more than $500billion) than equity (less than $400 billion) in emerging markets at theend of 1997 Long-term debt is an ideal vehicle for high-risk high-leveragestrategies These strategies practiced on a large scale could compound afuture crisis harming emerging markets A big enough crisis could inturn pressure G-10 central banks and finance ministers to arrange bail-out plans Instead of shrinking as a systemic financial problem moralhazard could increase
National securities regulators are the first line of defense against thisscenario They play a critical role in the safe evolution of capital mar-kets But regulators today are mandated to approve the issuance of newsecurities and to monitor the continuing disclosure of material informa-tion by issuers They are far less concerned with or empowered to monitorthe behavior of the increasingly large wealth-management firms that arethe major purchasers (and therefore resellers) of these securities
Within their mandates the goals of national securities regulators (table210 and appendix B) are similar to the concerns of bank regulators withsystem safety and soundness Their focus is also on the incentive sys-tems for management and boards of directors and on disclosure by cor-porations that issue marketable securities such as shares bonds andasset-backed securities 40 Issuers of securities possess greater knowledgeabout the quality of these assets than do the purchasers hence investorprotection is a key concern of regulators Moreover market disciplineworks best when markets know what is happening Well-functioning corpora-tions are key agents of wealth creation and social progress Underperform-ing corporations waste resources During recessions bad corporationsget into bad trouble often with severe social consequences Inadequateincentives for managers and inadequate accountability for boards andmanagers thus have negative externalities Regulators play a vital role inexposing weakness so that market disciplines come to bear sooner ratherthan later
Regulatory emphasis is constantly shifting as financial markets evolveand as the macroeconomic environment changes Regulators try to balance
39 See Rogoff (1999) Also see Berlin (2000) for a perspective on the limited role thatbanks play as share owners
40 See Habib and Ljungqvist (2000) for recent empirical analysis showing that corporateshare market values are higher when corporate executives have a larger ownership stake
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Table 210 Financial-sector regulation G-10 countries 2000
Financial institutions and their supervisors
Country and supervisory structure Retail banking Wholesale banking Securities Insurance
Financial conglomeratesFinancial Services Authority (FSA) = umbrella supervisor
United Kingdom FSA FSA FSA FSA
Treasury bull Commercial banks bull Investment funds (Securities and (Insurance Directorate(Securities and Investments Board) bull Unit trust groups Futures Authority) of the Treasury)
Bank of bull Building societies bull Pension funds England (Building Societies Commission) bull Merchant banks
bull Friendly societies bull Clearing houses bull Primary issuers bull Insurance FSA (Friendly Societies Commission) bull Venture capital of securities companies
bull Pensions and life insurance etc bull Stock exchanges bull Insurance brokers(Personal Investment Authority) bull Stockbrokers
Financial holding companiesFederal Reserve (FR) = umbrella supervisor
United States bull National banks(OCC) Securities and Regulated by
Treasury OCC bull State banks Federal Reserve Exchange Commission StatesMembers (FR)
OTS Nonmembers (FDIC) bull Investment banks bull Primary issuers of bull Insurance companies FR bull Cooperative banks (FDICFR) bull Finance companies securities bull Insurance brokers FDIC bull Insured industrial banks (FDIC) bull Stock exchanges
bull Thrift holding companies (OTS) bull Stockbrokers SEC bull Savings banks (OTSFDICFR) bull Investment advisors
bull Savings and loan associations bull Mutual funds(OTS) bull Public utility holding
bull Edge Act corporations (FR) companies
(table continues next page)
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Table 210 Financial-sector regulation G-10 countries 2000 (continued )
Financial institutions and their supervisors
Country and supervisory structure Retail banking Wholesale banking Securities Insurance
Financial holding companies Japan Financial Supervisory Authority (FSA) = umbrella supervisor
Prime FSA FSA FSA FSA ministerrsquos Ministry of office Finance (Securities and Exchange
Surveillance Commission) FRC Bureau of Financial bull City banks bull Investment banks bull Primary issuers of bull Insurance companies FSA Regulation bull Regional banks bull Asset managers securities bull Insurance brokers
bull Trust banks bull Stock exchanges SESC bull Long-term credit banks bull Stockbrokers
bull Pension funds
Financial holding companiesOffice of the Superintendent of Financial Institutions (OSFI) = umbrella supervisor
Canada Regulated by OSFI OSFI provinces OSFI
Department of Financebull Banks bull Cooperative credit bull Primary issuers of bull Insurance companies
(previously Office of the Inspector associations securities (previously Depart- OSFI General of the Banks) bull Fraternal benefit bull Stock exchanges ment of Insurance) Bank of bull Trust and loan companies society bull Stockbrokers bull Insurance brokers Canada bull Pension funds bull Asset managers
(previously Depart- CDIC ment of Insurance)
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Financial institutions and their supervisors
Country and supervisory structure Retail banking Wholesale banking Securities Insurance
Germany Financial holding groupsFederal Banking Supervisory Office (FBSO) = umbrella supervisor
Ministry of Finance FBSO BSO FSSO FISO
Bundesbankbull Universal banks bull Other financial bull Primary issuers of bull Insurance companies
Federal Banking bull Savings banks institutions (eg securities bull Insurance brokers Supervisory Office bull Securities banks management foreign bull Stock exchanges
currency dealings) bull Stockbrokers Federal Securities bull Financial enterprises bull Asset managers Supervisory Office (eg leasing bull Pension funds
organizations Federal Insurance credit card companies Supervisory Office investment advisors)
Italy Bank foundationsMinistry of Finance = umbrella supervisor
Ministry of Finance Bank of Italy Bank of Italy Consob ISVAP
Bank of Italy bull Commerical banks bull Asset managers bull Primary issuers of bull Insurance companies Consob bull Savings bank bull Open-end investment securities bull Insurance brokers
bull Securities banks companies (SICAVs) bull Stock exchangesbull Stockbrokers
ISVAP
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Table 210 Financial-sector regulation G-10 countries 2000 (continued )
Financial institutions and their supervisors
Country and supervisory structure Retail banking Wholesale banking Securities Insurance
The Netherlands Financial conglomeratesCouncil of Financial Supervisors = umbrella supervisor
Securities Board Securities Board Netherlandsche Netherlands Bank Netherlandsche Bank of the Netherlands Insurance Board Bank Insurance bull Credit institutions (universal banks bull Investment institutions bull Stock exchanges bull Insurance companies Board cooperative banks security credit (securities issuing bull Stockbrokers bull Insurance brokers
institutions mortgage banks) and tradingmdashprimary The Council of Financial and secondary Supervisors markets)
France Commission des Commission de Operations des Controcircle des
Banking and Banking Commission Bourse Assurances Financial Regulatory bull Ensuring that credit institutions (and investment firms since bull Primary issuers of bull Insurance companies Ministry for Committee the Financial Activity Modernization Act of 1996) comply securities bull Insurance brokers Economic with laws and regulations bull Stock exchanges Affairs and bull Execute instructions regarding all off-site monitoring and bull Stockbrokers Finance Credit on-site supervision Institutions and Banking and Financial Regulatory Committee Investment bull Formulates general regulations for credit institutions and investment firms Committee (capital adequacy requirements accounting rules etc) Bank of France Credit Institutions and Investment Committee Banking bull Authorizes and examines financial institutions except for those within the Commission competence of the Banking Commission
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117
Financial institutions and their supervisors
Country and supervisory structure Retail banking Wholesale banking Securities Insurance
Switzerland Large banking groupSwiss Federal Banking Commission (SFBC) = umbrella supervisor
Swiss National Bank Federal Office of
SFBC SFBC SFBC Private Insurance Swiss Federal Banking Commission bull Universal banks bull Investment banks bull Primary issuers of bull Insurance companies
bull Savings banks bull Asset management securities bull Insurance brokerscompanies bull Stock exchanges
Private audit Federal bull Investment funds bull Stockbrokers firms Office of bull Mortgage bond authorized by Private business SFBC Insurance
Sweden Financial holding company groupsFinancial Supervisory Authority = umbrella supervisor
Ministry of Finance Credit Market Securities Market Insurance Market
Credit Market Department Department Department Department
Financial bull Commercial banks bull Investment funds bull Primary issuers of bull Insurance companies Riksbank Supervisory bull Savings banks securities bull Insurance brokers Authority bull Friendly societies bull Stock exchanges
bull Stockbrokers
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Table 210 Financial-sector regulation G-10 countries 2000 (continued )
Financial institutions and their supervisors
Country and supervisory structure Retail banking Wholesale banking Securities Insurance
Belgium Bank holding companiesBanking and Finance Commission = umbrella supervisor
Bank of Belgium Banking Banking
Banking and Finance and Finance Insurance Controland Finance Commission Commission Commission Office
Banking and Insurance Finance Control bull Commercial banks bull Asset management bull Primary issuers of bull Insurance companies Commission Office bull Savings banks firms securities bull Insurance brokers
bull Securities banks bull Investment funds bull Stock exchanges bull Mortgage companiesbull Stockbrokers bull Pension funds
Securities Regulation Fund Securities Regulation Fund
bull Other investment firms and credit institutions(institutions participating in regulated off-exchangemarket in strips and Treasury certificates)
Bank holding companies Spain Banco de Espantildea = umbrella supervisor
Banco de Espantildea Comision Nacional del Mercado de Directorate General
Banco de Espantildea Valores (CNMV) Insurance
bull All credit institutions (commercial banks savings banks credit bull Primary issuers of (Ministry of Economy Ministry of cooperatives official credit institutions finance factoring and securities and Finance) Economy and CNMV leasing companies mortgage-loan companies etc) bull Stock exchanges bull Insurance companies Finance bull Interbank foreign exchange and book-entry public debt bull Stockbrokers bull Pension funds
markets bull Venture capital(companies and funds)
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119
Financial institutions and their supervisors
Country and supervisory structure Banking Securities Insurance
Banking Advisory High Level Securities Supervisors Committee (BAC) Committee (HLSS) Insurance Committee (IC)
Supranational (EU) bull Formulates standards for prudential bull Coordination of securities market bull Formulates standards forsupervision supervision prudential supervision
BACICHLSS Banking Supervision
Conglomerates Committee (BSC) Securities Contact Committee Regulation of prudential bull Systemic risk monitoring bull Regulation and implementation of supervision securities admission
International Association International International Organization of of Insurance Supervisors
Basel Committee Securities Commisison (IOSCO) (IAIS) Joint Forum Conglomerates Supervision bull Supervision and regulation best bull Supervision and regulation best bull Supervision and regulation amp regulation Best practices practices practices best practices
FSF Coordination across supervisors of various functions
Notes See appendix B for more information Boldface type indicates senior or oversight supervisor normal type indicates adjunct or front-line supervisorsolid line indicates direct responsbility to the senior-ranking authority dotted line indicates coordination in supervisory activities
(table continues next page)
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Table 210 Financial-sector regulation G-10 countries 2000 (continued )
Glossary of names United Kingdom FSA = Financial Services Authority United States FR = Federal Reserve OCC = Office of the Comptroller of theCurrency FDIC = Federal Deposit Insurance Corporation SEC = Securities and Exchange Commission OTS = Office of Thrift Supervision Japan FRC =Financial Reconstruction Commission FSA = Financial Services Agency SESC = Securities and Exchange Surveillance Commission Canada OSFI =Office of the Superintendent of Financial Institutions CDIC = Canada Deposit Insurance Corporation Germany FBSO = Federal Banking SupervisoryOffice FSSO = Federal Securities Supervisory Office FISO = Federal Insurance Supervisory Office BSO = Banking Supervisory Office Italy Consob =Commissione Nazionale per le Societa e la Borsa ISVAP = Instituto per la Vigilanza sulle assicurazioni private e di Interesse colletivo Switzerland SFBC= Swiss Federal Banking Commission Spain CNMV = The Comision Nacional del Mercado de Valores Supranational BAC = Banking Advisory CommitteeBSC = Banking Supervision Committee IC = Insurance Committee HLSS = High Level Securities Supervisors Committee International Dimension FSF =Financial Stability Forum IOSCO = International Organization of Securities Commission IAIS = International Association of Insurance Supervisors
Sources United Kingdom Bank of England httpwwwbankofenglandcouk Financial Services Authority httpwwwfsagovuk United States Board ofGovernors of Federal Reserve System httpwwwfederalreservegov Japan Bank of Japan httpwwwbojorjo Financial Reconstruction Commissionhttpwwwfsagojpfrcindexehtml Financial Services Agency httpwwwfsagojp Canada Bank of Canada httpwwwbank-banque-canadaca Office ofthe Superintendent of Financial Institutions httpwwwosfi-bsifgccaAndreEindexhtml Germany Deutsche Bundesbank httpwwwbundesbankde Fed-eral Banking Supervisory Office httpwwwbakredde Italy Banca drsquoitalia httpwwwbancaditaliait Commissione Nazionale per le Societa e la Borsahttpwwwconsobit Instituto per la Vigilanza sulle assicurazioni private e di Interesse colletivo httpwwwisvapit The Netherlands De NederlandscheBank httpwwwdnbnl France Banque de France httpwwwbanque-francefr Switzerland Schweizerische Nationalbank httpwwwsnbchindex3htmlSweden Sveriges Riksbank httpwwwriksbanksedefaultasp Belgium National Bank of Belgium httpwwwbnbbesgindexhtm Spain Banco de Espantildeahttpwwwbdees The Comision Nacional del Mercado de Valores httpwwwcnmves Supranational (EU) Institutional Arrangements for the Regulationand Supervision of the Financial Sector 2000 International Dimension Bank for International Settlement httpwwwbisorg International Organization ofSecurities Commissions httpwwwioscoorg International Association of Insurance Supervisors httpwwwiaisorg Financial Stability Forum httpwwwfsforumorg
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 121
the inflexibility of tight surveillance against the need to encourage in-novation and growth The US Securities and Exchange Commission isworried about aggressive accounting by firms and biased reports bysecurities analysts in an equity environment that prizes steadily higherquarterly earnings41 Japanese regulators are preoccupied with opaqueinterconnections between portfolio institutions banks and nonfinancialfirms through the keiretsu system Canadian regulators reeling from high-profile scandals of managers intentionally misleading investors are strengtheningmarket discipline through legal penalties aimed at managers and directorsof offending firms
When panic strikes a securities regulator cannot do much As the 1987stock market crash and the LTCM debacle in the fall of 1998 both dem-onstrated steep stock and bond price declines can create systemic risksIf severe enough the wealth effect of falling securities values and thefear of widespread insolvency can depress real activity Flooding thesystem with liquidity is a central bankerrsquos solutionmdashsomething a securi-ties regulator cannot do42 But just as financial supervisors can changethe incentive structure to discourage bankers from making risky loans ingood times so securities regulators can pay more attention to incentiveson the demand side when capital markets are strong
Prudential Supervision and InnovationmdashA Footnote
In concluding this discussion of prudential supervision in the G-10 anadditional point is worth noting National regulators face a persistenttrade-off between emphasizing financial system safety and soundnesswhile encouraging innovationmdashin spite of the added risks innovationbrings to financial markets Former US Treasury Secretary Lawrence Summers(2000 3) has argued by analogy
The jet airplane made airplane air travel more comfortable more efficient andmore safe though the accidents were more spectacular and for a time morenumerous after the jet was invented In the same way modern global financialmarkets carry with them enormous potential for benefit even if some of theaccidents are that much more spectacular As the right public policy response
41 The problem is illustrated by the divergence since mid-1998 between reported earn-ings by the Standard amp Poorrsquos (SampP) 500 and the after-tax profits of all corporations inthe national accounts Generally these two series move closely with one another Be-tween mid-1998 and mid-1999 SampP 500 reported that earnings increased by more than20 percent while after-tax profits of all corporations increased by less than 5 percent(Chase Bank US Economic and Policy Research US Weekly Prospects Chase SecuritiesWeekly Newsletter 5 June 2000 5)
42 For example the US Securities and Exchange Commission had no direct role in calmingmarkets in the 1987 or 1998 panics
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122 WORLD CAPITAL MARKETS
to the jet was longer runways better air-traffic control and better training forpilots and not the discouragement of rapid travel so the right public policyresponse to financial innovation is to assure a safe framework so that the ben-efits can be realized not to stifle the change
Accepting Summersrsquos analogy for the international financial system better-informed supervisors and investors are a necessary part of the financialsystem framework Supervisors require more timely information on therisk profiles resulting from positions taken by financial institutions Theyalso need a better understanding of risk-management systems Snapshotsof an institutionrsquos risk profile and risk-management procedures are nolonger adequate In a world where huge bets are quickly made (andpossibly lostmdashas with Barings Bank in 1995 and LTCM in 1998) super-visors must focus on the soundness of banking systems for evaluatingand managing risk on a daily basis Some progress has been made inaddressing these issues US banking examiners are extending their in-formation requirements in banking examinations and increasing theirinvolvement in large complex institutions43 More awareness is alsorequired of the fact that they are national organizations in a world ofcross-border capital flows To a much greater extent they need a multi-national reach International supervision and coordination among super-visors are the subject of the next section
Our analysis suggests that G-10 supervisors have unfinished businessBank supervisors need to start yesterday securities regulators can waituntil tomorrow One G-10 member acting alone cannot correct the biasIn good times the lending business will simply migrate to other G-10banks In bad times financial problems will not stop at the national bor-der A way has to be found to establish common international standardsfor the key financial players in order to prevent crises and to agree onapproaches for managing them The path has already been laid out Inthe wake of the bank failures of the past 25 years bank supervisors havetried to establish such standards They have done this without creating anew global institution
The essence of the international framework is decentralizationmdashglobalrules and design standards without global institutions that are perceivedto intrude on national sovereignty The awkward jargon for this frame-work is vertical subsidiaritymdashldquothink internationally act nationallyrdquo Theinternational thinking is done by a committee of regulators that meets
International SupervisionA Decentralized Framework
43 These issues are discussed in Ferguson (1999) and Meyer (2000a)
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 123
regularly at the Bank for International Settlements in Basel The commit-tee establishes principles and standards that are interpreted implementedand enforced by national authorities44 In this section we describe thesesupervisory efforts and their weaknesses We present our recommenda-tions for addressing these weaknesses in the next chapter
Basel I
The Basel Capital Accord of 1988 (Basel I)45 drew the lesson from thefinancial crises of the mid-1970s that more adequate capital levels in in-ternational banks would help reduce the systemic risk of bank failureThe primary goal of Basel I was capital adequacy other standards wereput in place not so much for their own virtue as to defend the primarygoal
Capital adequacy requirements were designed to ensure that individualinstitutions have the ability to absorb losses particularly credit lossesAccordingly a backup system of scoring credit risk was devised thatrequired large amounts of bank capital for some types of loans smalleramounts for others and zero for a select list of preferred assets Report-ing requirements were designed to disclose problems and ensure that atroubled bank would take timely steps to restore its capital base in thewake of a loss The Basel I framework worked tolerably well in limitingthe call on the public purse in the G-10 countriesmdashwith the notable ex-ceptions of France and Japan The framework failed to moderate riskybank lending to emerging markets however
Basel I was not developed with emerging markets in mind The origi-nal idea behind it was to develop a common supervisory approach tocross-border banking operations It grew out of political pressure fromUS lawmakers who were determined to require international banks op-erating in the United States to meet US banking standards Toward thisgoal in 1983 Congress passed the International Lending Supervisory ActUS and British banking authorities subsequently agreed on a commontarget the adoption of strict common capital-adequacy standards In 1988other G-10 governments agreed to go along voluntary acceptance ofthe standards throughout much of the rest of the world followed46 Therationale for the capital targets was two-fold The first was to requirebanks to hold sufficient amounts of capital (8 percent of risk-adjusted
44 The international committee of financial authorities agreed on a common definitionof banksrsquo tier-one or ldquocorerdquo capital national authorities defined tier-two capital in theirown manner which permitted greater variations in national working definitions andpractices
45 International Convergence of Capital Measurement and Capital Standards (BIS 1988)was prepared by the Basel Committee on Banking Supervision
46 See Reineke (1998)
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124 WORLD CAPITAL MARKETS
assets) to cushion losses on those assets The second was to dull theirappetites for risk banks with large capital bases would have more tolose if they failed and therefore would take fewer risks
Rapid change in financial markets soon revealed flaws in the Basel IAccord In a complex world with numerous sources of risk it focusedheavily on credit risk but overlooked other risks in a bankrsquos portfolioand the correlation between returns on different asset classes The Baselformula required banks to maintain a fixed amount of capital againsteach of its asset classes But the formula did not distinguish the riskinessof the borrower within each class As a result one large loan to a low-risk corporate borrower such as General Electric would require the sameamount of capital as 10 smaller transactions with high-risk borrowers
The system was also biased toward short-term loans Loans maturingin less than a year required a 20 percent risk weight whereas those ma-turing after more than a year required a 100 percent risk weight Inter-bank lending was particularly favored For example loans to banks inOECD countries required less capital than loans to private firms in thesame countries creating the anomaly that interbank loans to South Ko-rean banks required less capital than loans to General Electric47 Thisanomaly encouraged banks to shed high-quality assets if the Basel rulesrequired the allocation of more capital than banks thought they needed
Another weakness was that financial innovators quickly circumventedthe Accord Because short-term loans required less provisioning than long-term loans banks responded by securitizing their long-term debt port-folios and lending short-term against the collateral of the newly createdasset This allowed banks to circumvent the capital requirements gearedto the terms of the underlying debt At the same time the Basel I Accordfailed to encourage risk mitigation techniques such as credit derivativescollateral guarantees and on-balance-sheet netting the flip side of fi-nancial innovation Because off-balance-sheet products were not coveredby the Accord another anomaly appeared when Barings Bank collapsedin 1995 Barings met capital adequacy standards but collapsed becauseits systems for managing risk failed traders were allowed to speculatein futures contracts that did not appear on the balance sheet
Basel II
Work to overhaul Basel I began in 1995 and produced consultativepapers issued in June 1999 and January 200148 These papers have been
47 South Korean banks have had notoriously weak balance sheets because the practiceof ldquodirected lendingrdquo left them with many poor loans (in making these loans the bankswere expected to follow government objectives rather than creditworthiness criteria)
48 Basel Committee on Banking Supervision (1999 2001)
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 125
the subject of extensive consultation and revision as a result the newAccord is expected to be introduced in 200449 The Basel II frameworkhas three parts (pillars) revisions to Basel I minimum-capital require-ments supervisory review criteria and greater emphasis on market dis-cipline Broadly Basel II aims to maintain the level of capital in the sys-tem but achieve better alignment of banksrsquo capital with their risk pro-files and keep up with financial innovation
To align capital requirements with market realities (the first pillar)Basel II concentrates on the 100 or so largest banksmdashthe type of playerslisted in table 21mdashand on the holding-company parents of banking groups50
Capital requirements will differentiate between an increased number ofcredit groups or ldquorisk bucketsrdquo including claims on governments otherbanks corporations mortgage-backed securities and other asset-backedsecurities
Basel II originally proposed to use external ratings to set capital chargesfor a number of these credit risks Many banks objected arguing thatthey assess credit risk better than Standard amp Poorrsquos Moodyrsquos or FitchIBCA51 Basel II thus proposes two approaches to rating a standard ap-proach using external ratings and an ldquoadvancedrdquo approach that allowsselected banks to use their own internal rating systems To encouragethe development of rigorous internal control systems based on these in-ternal rating systems Basel II also proposes to levy capital charges foroperational risk (the risk of direct or indirect loss resulting from inad-equate or failed internal processes people and systems or from exter-nal events)
Some critics of this proposal dismiss it as an abrogation of the prin-ciple of external independent monitoring and as ldquodangerously naiumlverdquo52
But regulators argue that the new capital charge on operational risk shouldoffset this concern It is also far from clear how cross-national compari-sons of rating and internal risk-assessment systems will be made (Engelen2000) The development by the European Union of its own capital rulescould well complicate the international resolution of these issues Publicassurances by EU officials in January 2001 however indicated that theirmain concerns are to create a level playing field and avoid regulatoryarbitrage (Hargreaves 2001) There is also the significant problem ofthe procyclical character of risk weights When a crisis hits losses are
49 See Berry (2000) for an update in an interview with William J McDonough chair ofthe Basel Committee on Banking Supervision
50 For obvious reasons these proposals are addressed to large banks and simpler capi-tal standards are allowed for small banks that focus on their domestic credit markets
51 See Ammer and Packer (2000) for an empirical critique of the success of rating agen-cies in distinguishing risk by sector and region
52 See Auerback (2001)
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126 WORLD CAPITAL MARKETS
incurred or accrued capital is lost and loan exposure must be reducedor securities sold to restore the requisite capital-adequacy ratios A morerisk-sensitive framework could amplify volatility
As the second pillar of Basel II supervisory review criteria are beingbeefed up to encourage supervisors to intervene earlier in potential problemsituations and to compel banks to align their capital positions with theirrisk profiles Bank supervisors will be authorized to require banks tohold capital in excess of minimum requirements if they have concernsabout general management overall strategy risk-management performanceor the macroeconomic environment Of course if one G-10 supervisorimposes higher capital requirements in isolation the same disparity willemerge that presaged Basel I Some banks will be disadvantaged in theinternational marketplace and will loudly complain that excessive super-vision is driving business to their competitors Hence close internationalcooperation among supervisors is critical
To implement the third pillar market discipline banks will be requiredto make fuller more timely disclosure of capital adequacy and the risksto which that capital is exposed A number of measures are being stud-ied that might help supervisors evaluate bank performance such as com-parisons of uninsured deposit interest rates subordinated debt yieldsand equity prices The idea is that these yields and prices might alertsupervisors to market perceptions of risk Of course market perceptionsare only as good as market information More direct and controversialways to reinforce market discipline would dramatically increase publicdisclosure of bank positions and risk management systems
Many questions are still outstanding about how to resolve the techni-cal details of capital requirements and whether the requirements willachieve their intended goal of better assessment and mitigation of therisks in banksrsquo portfolios There is no substitute for skilled supervisorsThe intricacies of effective design and implementation suggest that su-pervisors need to be highly competent technically knowledgeable aboutbanking portfolio characteristics and the factors that influence bank ex-posure to credit risk (Mishkin 2000) And they must be aided by vigilantshareholders market forces and transparency of information53
Standard setting at the global level is desirable but ultimately theeffectiveness of these efforts will be tested at the national level espe-cially in times of systemic financial distress Here the record of Basel Iwas not a bright shining success Japanese banking regulators havetraditionally allowed banks to include real estate and securities in theircapital base When the value of these assets plummeted in the early 1990sregulators allowed banks to continue valuing these depreciated (andoften bankrupt) assets at their old inflated levels Japanese authorities
53 Benedict Roth Complacency Towards Catastrophe Financial Times 23 January 2001
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 127
insisted until the mid-1990s that eroded capital bases could be rebuiltin a market-driven fashion They rightly foresaw that huge loan losseswould undermine public support for the ruling party and require a po-litically unpopular bailout
Japanese foot dragging on Basel I was the worst54 but not uniqueOther examples can be found of ldquopolitically mandated forbearancerdquo TheFederal Reserve Bank of New York held important hands during theLTCM crisis of 1998 Mexico is still resolving the banking crisis that eruptedin 1995 South Korea has not yet closed the insolvent banks that behavedso badly before the crisis of 1998 In the aftermath of a crisis nationalregulators cannot always be relied upon to discipline politically power-ful bankers55 One of the little-noticed consequences of these differingapproaches is that those banks with strong regulatory systems receivedan implicit ldquoexport subsidyrdquo for their services US banks which had notengaged extensively in emerging-market lending in the 1990s were bet-ter positioned than their German and Japanese counterparts to expandtheir international assets in the wake of the crises
Other Financial Forums
54 See Japanese Banks Fiddling while Marunouchi Burns The Economist 27 January2001 67-69
55 See Calomiris (1997)
The Basel model of vertical subsidiarity has already been extended toother financial regulatory bodies In 1993-94 the BIS established a Tri-partite Group of Banking Insurance and Securities Regulators In 1994-95 the BIS increased its cooperation with the International Organizationof Securities Commissions when the two organizations issued parallelpapers on guidelines for national regulators concerning risk managementand disclosure of derivative trades In 1996 a permanent Joint Forum onFinancial Conglomerates was established to examine supervisory issuesand develop working arrangements among the different functional super-visors of conglomerate institutions that offer combinations of bankingsecurities and insurance products Draft papers on the supervisionof conglomerates were released for comment in 1998 applying capital-adequacy principles to these groups and providing guidelines both forassessing the integrity and competence of top managers and for sharingassessments between regulators
In 1997 the Basel Committee on Banking Supervision extended itsreach beyond capital standards to broader aspects of banking supervi-sion with the publication of the Core Principles for Effective BankingSupervision In 1999 a wide range of regulatory and standard-settingbodies were gathered under the umbrella of the Financial Stability
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128 WORLD CAPITAL MARKETS
Forum (FSF) itself established under BIS aegis56 The FSF has alreadyissued recommendations for stepped-up supervision and transparencyas well as guidelines for best practices in a number of areas includingoffshore financial centers and highly leveraged institutions or hedge funds57
Conclusion
Although the structural weaknesses in emerging-market economies arewidely acknowledged to have been causal factors in international capi-tal-market volatility this chapter points to the role of large G-10 bankingorganizations as major suppliers of the most volatile instrument short-term debt We have examined evidence of the impact of public safetynets in the G-10 economiesmdashthe deposit insurance systems the pruden-tial supervisory systems and the lender-of-last-resort functions of centralbanksmdashon the incentive structures of these organizations
Although supervisors in most countries working nationally and to-gether in the BIS have made significant efforts to mimic market forcesin their prudential supervision the most sophisticated financial institu-tions find innovative ways to circumvent the rules New global regulatorybodies are not about to be created G-10 national bank regulators shouldthemselves address the short-term debt bias in the international financialsystem by changing incentive systems G-10 securities regulators shouldalso take steps to get ahead of the curve paying close attention to largeportfolio swings by institutional investors particularly in times of crisisIn short more needs to be done at national and international levels tochange the rules of the game That is the subject of the next chapter
56 The Financial Stability Forum includes banking securities insurance and accountingregulatory bodies the OECD on taxation corruption and corporate governance and theIMF
57 See Martin (2000)
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 87
is achieved using such instruments as repos (repurchase agreements)futures and forward contracts and other derivative products5 It is alsovery difficult to measure A Financial Stability Forum (FSF 2000b) studyof hedge funds noted thatmdashalthough there are problems with the waydata vendors report these positionsmdashestimates suggest most hedge fundsuse modest amounts of leverage averaging 21 but ranging to 41 insome FSF (2000b) further notes difficulties with evaluating the risk-adjusted performance of hedge funds because of their dynamic tradingstrategies
Table 25 Largest hedge funds according tocapitalization August 1998 (billions of dollars)
Fund Capital under management
Domestica
Tiger 51Moore Global Investment 40Highbridge Capital Corp 14Intercap 13Rosenberg Market Neutral 12Ellington Composite 11Hedged Taxable-Equivalent 10Quantitative LongShort 09Sr International Fund 09Perry Partners 08
OffshoreJaguar Fund NV 100Quantum Fund NV 60Quantum Industrial Fund 24Quota Fund NV 17Omega Overseas Partners 17Maverick Fund 17Zweig Dimenna International 16Quasar International Fund NV 15SBC Currency Portfolio 15Perry Partners International 13
Totalb 471
a Long Term Capital Management (LTCM) was in serious difficulty in August1998 and is omitted from the listb Estimates of hedge fund capital and the number of funds vary significantlyMARHedge estimated 1115 funds with $109 billion capital under managementat the end of 1997 Van Hedge Fund estimated 5500 funds with capital of $295billions at the same date
Source Adapted from Eichengreen (1999a)
5 Positions are established by posting margins rather than the face value of the position
Institute for International Economics | httpwwwiiecom
88 WORLD CAPITAL MARKETS
The positive role of hedge fundsmdashproviding diversification to inves-tors because their returns have low correlations with standard asset classesmdashis counterbalanced by some negative features Hedge funds and otherhighly leveraged institutions (HLIs) may take concentrated positions andengage in aggressive market practices that amount to ldquoganging uprdquo on asmall economy (such as Hong Kong)6 Under normal market conditionsHLI positions are not destabilizing but some of the aggressive practicesdocumented in 1998 are worrisome The FSF study group participantsagreed (2000b 112) that such practices raise important issues for marketintegrity but they could not agree that market manipulation was suffi-ciently widespread to be a serious concern for policymakers
Insurance companies are the third group of portfolio institutions Theseare divided into two categories property and casualty companies andlife and health insurance companies Ten large companies of each cat-egory are listed in table 26 In 1998 the 10 property and casualty insur-ance companies had $16 trillion in assets and more than $330 billion inmarket capitalization The 10 life insurance companies had $28 trillionin assets7 Combining both categories 100 percent of assets are controlledby insurance companies based in the G-10 and Spain In portfolio man-agement styles life insurance companies tend to hold longer-term assetswhereas property and casualty companies tend to hold shorter-term in-struments
Nonfinancial Multinational Enterprises
The last players are the nonfinancial multinational enterprises (MNEs)The worldrsquos 100 largest corporations measured by 1998 revenue are re-corded in tables 27 and 28 The 30 financial giants among the top 100are separately shown in table 27 Most of the firms appeared in previ-ous tables Together these 30 financial giants had revenues of $13 tril-lion and controlled assets of $113 trillion8
Table 28 lists the 70 top nonfinancial giants Their revenues in 1998were $40 trillion and their assets (at book value) measured $45 trillionMeasured by revenue or assets about 95 percent of the giants are basedin the G-10 These firms are responsible for a large share of the worldrsquos
6 See IMF (1999c) for a description of the ldquodouble playrdquo that hedge funds are accusedof using in an attempt to destabilize Hong Kong in August 1998
7 Many life insurance companies are owned by their policyholders and therefore donot have a market capitalization
8 By comparison the larger set of 96 financial firms listed in previous tables controlled$322 trillion in assets This is the total amount of assets recorded in tables 21 (50 com-mercial banks) 22 (9 investment banks) 24 (10 asset managers) and 26 (20 insurancecompanies) The largest hedge funds might add $300 billion to the total
Institute for International Economics | httpwwwiiecom
THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 89
Table 26 20 large insurance companies in 1998(billions of dollars)
Property and casualty insurance Marketcompanies Revenuea Assetsb capitalizationc
Allianz (Germany) 65 402 62d
Assicurazioni Generali (Italy) 48 178 30d
State Farm Insurance Cos (United States) 45 111 naZurich Financial Services (Switzerland) 39 215 45d
CGU (United Kingdom) 38 176 20d
Munich Re Group (Germany) 35 131 naAmerican International Group (United States) 33 194 135d
Allstate (United States) 26 88 20d
Royal amp Sun Alliance (United Kingdom) 25 76 11d
Loews (United States) 21 71 7e
Total 375 1642 330 plusTotal for G-10 375 1642 330 plus
MarketLife and health insurance Revenuea Assetsb capitalizationc
AXA (France) 79 452 39d
Nippon Life Insurance (Japan) 66 363 naING Group (Netherlands) 56 464 46d
Dai-ichi Mutual Life Insurance (Japan) 44 253 naSumitomo Life Insurance (Japan) 40 206 naTIAA-CREF (United States) 36 250 naPrudential Ins Co of America (United States) 34 279 naPrudential (United Kingdom) 34 197 30d
Meiji Life Insurance (Japan) 28 146 naMetropolitan Life Insurance (United States) 27 215 na
Total 444 2825 naTotal for G-10 444 2825 na
na = not available (usually an insurance company owned by its policyholders)G-10 = Group of Ten countries see note to table 11
a Data shown are for the fiscal year ended on or before 31 March 1999b Assets shown are those at the companyrsquos fiscal year-endc Market capitalization is calculated by multiplying the total number of shares by the shareprice at the companyrsquos fiscal year-endd Market capitalization data as of September 1999 from American Banker httpwwwamericanbankercome Individual companyrsquos market capitalization as of September 1999 from Yahoo yahoomarketguidecom
Sources Fortune Global 500 1999 httpwwwpathfindercomfortuneglobal500indexhtmlAmerican Banker httpwwwamericanbankercomRankingBanks1999 Yahoo Marketguideyahoomarketguidecom
Institute for International Economics | httpwwwiiecom
90 WORLD CAPITAL MARKETS
Table 27 Financial firms in the 100 largest companiesby revenue 1998 (billions of dollars)
Globalrank Company Revenuesa Assetsb Type
Continental Europe
15 AXA (France) 79 452 Insurance23 Allianz (Germany) 65 402 Insurance28 Ing Group (Netherlands) 56 464 Insurance37 Credit Suisse (Switzerland) 49 475 Banks commercial
and savings39 Assicurazioni Generali (Italy) 48 178 Insurance42 Deutsche Bank (Germany) 45 736 Banks commercial
and savings56 Zurich Financial Services (Switerland) 39 215 Insurance68 Munich Re Group (Germany) 35 131 Insurance72 ABN AMRO Holding (Netherlands) 34 507 Banks commercial
and savings77 Credit Agricole (France) 33 459 Banks commercial
and savings80 HypoVereinsbank (Germany) 32 541 Banks commercial
and savings84 Fortis (Belgium) 31 397 Banks commercial
and savings98 Socieacuteteacute Geacuteneacuterale (France) 30 450 Banks commercial
and savingsUnited Kingdom
47 HSBC Holdings 43 485 Banks commercialand savings
58 CGU 38 176 Insurance74 Prudential 34 197 Insurance
United States
16 Citigroup 76 669 Diversified financials35 Bank of America Corp 51 618 Banks commercial
and savings44 State Farm Insurance Cos 45 111 Insurance64 TIAA-CREF 36 250 Insurance67 Merrill Lynch 36 300 Securities71 Prudential Ins Co of America 34 279 Insurance76 American International Group 33 194 Insurance79 Chase Manhattan Corp 32 366 Banks commercial
and savings83 Fannie Mae 31 485 Diversified financials88 Morgan Stanley Dean Witter 31 318 Securities
Japan
21 Nippon Life Insurance 66 363 Insurance45 Dai-ichi Mutual Life Insurance 44 253 Insurance54 Sumitomo Life Insurance 40 206 Insurance91 Bank of Tokyo-Mitsubishi 31 664 Banks commercial
and savingsTotal 1279 11341Total for G-10 1279 11341
G-10 = Group of Ten countries see note to table 11
a Data shown are for the fiscal year ended on or before 31 March 1999b Assets shown are those at the companyrsquos fiscal year-end
Source Fortune Global 500 1999 httpwwwpathfindercomfortuneglobal500indexhtml
Institute for International Economics | httpwwwiiecom
THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 91
Tab
le 2
8N
on
fin
anci
al f
irm
s in
th
e 10
0 la
rges
t co
mp
anie
s b
y re
ven
ue
199
8 (b
illio
ns o
f do
llars
)
Glo
bal
Tra
nsn
atio
nal
ity
ran
k
Co
mp
any
Rev
enu
esa
Ass
etsb
ind
exc
Typ
e
Co
nti
nen
tal
Eu
rop
e
2D
aim
lerC
hrys
ler
(Ger
man
y)15
516
044
1M
otor
veh
icle
s an
d pa
rts
11R
oyal
Dut
chS
hell
Gro
up (
Net
herla
nds)
9411
058
9P
etro
leum
ref
inin
g17
Vol
ksw
agon
(G
erm
any)
7670
568
Mot
or v
ehic
les
and
part
s22
Sie
men
s (G
erm
any)
6667
521
Ele
ctro
nics
el
ectr
ical
equ
ipm
ent
32M
etro
(G
erm
any)
5222
n
a
Foo
d an
d dr
ug s
tore
s34
Fia
t (I
taly
)51
7640
8M
otor
veh
icle
s an
d pa
rts
36N
estle
(S
witz
erla
nd)
5041
932
Foo
d46
Veb
a G
roup
(G
erm
any)
4351
275
Tra
ding
49R
enau
lt (F
ranc
e)41
4545
7M
otor
veh
icle
s an
d pa
rts
53D
euts
che
Tel
ekom
(G
erm
any)
4093
n
a
Tel
ecom
mun
icat
ions
57R
oyal
Phi
lips
Ele
ctro
nics
(N
ethe
rland
s)38
3386
4E
lect
roni
cs
elec
tric
al e
quip
men
t59
Peu
geot
(F
ranc
e)38
4038
7M
otor
veh
icle
s an
d pa
rts
62E
lect
riciteacute
de
Fra
nce
(Fra
nce)
3711
3
na
Util
ities
ga
s an
d el
ectr
ic63
Rw
e G
roup
(G
erm
any)
3747
n
a
Util
ities
ga
s an
d el
ectr
ic65
BM
W (
Ger
man
y)36
3660
7M
otor
veh
icle
s an
d pa
rts
66E
lf A
quita
ine
(Fra
nce)
3643
576
Pet
role
um r
efin
ing
69V
iven
di (
Fra
nce)
3558
n
a
Eng
inee
ring
and
cons
truc
tion
70S
uez
Lyon
nais
e de
s E
aux
(Fra
nce)
3585
n
a
Ene
rgy
78E
NI
(Ita
ly)
3249
317
Pet
role
um r
efin
ing
86B
ayer
(G
erm
any)
3134
827
Che
mic
als
92A
BB
Ase
a B
row
n B
over
i (S
witz
erla
nd)
3132
957
Ele
ctro
nics
el
ectr
ical
equ
ipm
ent
93B
AS
F (
Ger
man
y)31
3159
5C
hem
ical
s95
Car
refo
ur (
Fra
nce)
3020
n
a
Foo
d an
d dr
ug s
tore
s
(tab
le c
ontin
ues
next
pag
e)
Institute for International Economics | httpwwwiiecom
92 WORLD CAPITAL MARKETS
Tab
le 2
8N
on
fin
anci
al f
irm
s in
th
e 10
0 la
rges
t co
mp
anie
s b
y re
ven
ue
199
8 (b
illio
ns o
f do
llars
) (c
ontin
ued
)
Glo
bal
Tra
nsn
atio
nal
ity
ran
k
Co
mp
any
Rev
enu
esa
Ass
etsb
ind
exc
Typ
e
Un
ited
Kin
gd
om
19B
P A
moc
o68
8559
2P
etro
leum
ref
inin
g43
Uni
leve
r45
3692
4F
ood
Un
ited
Sta
tes
1G
ener
al M
otor
s16
125
729
3M
otor
veh
icle
s an
d pa
rts
3F
ord
Mot
or14
423
835
2M
otor
veh
icle
s an
d pa
rts
4W
al-M
art
Sto
res
139
49
na
G
ener
al m
erch
andi
sers
8E
xxon
101
9365
9P
etro
leum
ref
inin
g9
Gen
eral
Ele
ctric
100
356
331
Ele
ctro
nics
el
ectr
ical
equ
ipm
ent
14In
tl B
usin
ess
Mac
hine
s82
8653
7C
ompu
ters
of
fice
equi
pmen
t25
US
Pos
tal
Ser
vice
6055
n
a
Mai
l pa
ckag
e a
nd f
reig
ht d
eliv
ery
27P
hilip
Mor
ris58
6051
1T
obac
co29
Boe
ing
5637
n
a
Aer
ospa
ce30
AT
ampT
5460
219
Tel
ecom
mun
icat
ions
40M
obil
4843
597
Pet
role
um r
efin
ing
41H
ewle
tt-P
acka
rd47
3451
1C
ompu
ters
of
fice
equi
pmen
t50
Sea
rs R
oebu
ck41
38
na
G
ener
al m
erch
andi
sers
55E
I d
u P
ont
de N
emou
rs39
40
na
C
hem
ical
s61
Pro
ctor
and
Gam
ble
3731
477
Soa
ps
cosm
etic
s75
Km
art
3414
n
a
Gen
eral
mer
chan
dise
rs81
Tex
aco
3229
453
Pet
role
um r
efin
ing
82B
ell
Atla
ntic
3255
n
a
Tel
ecom
mun
icat
ions
85E
nron
3129
n
a
Ene
rgy
87C
ompa
q C
ompu
ter
3123
n
a
Com
pute
rs
offic
e eq
uipm
ent
89D
ayto
n H
udso
n31
16
na
G
ener
al m
erch
andi
sers
94J
C
Pen
ney
3124
n
a
Gen
eral
mer
chan
dise
rs96
Hom
e D
epot
3013
n
a
Spe
cial
ty r
etai
lers
97Lu
cent
Tec
hnol
ogie
s30
27
na
E
lect
roni
cs
elec
tric
al e
quip
men
t10
0M
otor
ola
2929
n
a
Ele
ctro
nics
el
ectr
ical
equ
ipm
ent
Institute for International Economics | httpwwwiiecom
THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 93
Jap
an
5M
itsui
109
5635
8T
radi
ng6
Itoch
u10
957
333
Tra
ding
7M
itsub
ishi
107
7536
9T
radi
ng10
Toy
ota
Mot
or10
012
540
0M
otor
veh
icle
s an
d pa
rts
12M
arub
eni
9455
300
Tra
ding
13S
umito
mo
8946
259
Tra
ding
18N
ippo
n T
eleg
raph
amp T
elep
hone
7614
7
na
Tel
ecom
mun
icat
ions
20N
issh
o Iw
ai68
3938
8T
radi
ng24
Hita
chi
6282
214
Ele
ctro
nics
el
ectr
ical
equ
ipm
ent
26M
atsu
shita
Ele
ctric
Ind
ustr
ial
6067
332
Ele
ctro
nics
el
ectr
ical
equ
ipm
ent
31S
ony
5353
628
Ele
ctro
nics
el
ectr
ical
equ
ipm
ent
33N
issa
n M
otor
5158
511
Mot
or v
ehic
les
and
part
s38
Hon
da M
otor
4943
641
Mot
or v
ehic
les
and
part
s48
Tos
hiba
4151
252
Ele
ctro
nics
el
ectr
ical
equ
ipm
ent
51F
ujits
u41
4332
6C
ompu
ters
of
fice
equi
pmen
t52
Tok
yo E
lect
ric P
ower
4012
2
na
Util
ities
ga
s an
d el
ectr
ic60
NE
C37
42
na
E
lect
roni
cs
elec
tric
al e
quip
men
t90
Tom
en31
18
na
T
radi
ng99
Mits
ubis
hi E
lect
ric30
35
na
E
lect
roni
cs
elec
tric
al e
quip
men
t
Ch
ina
73S
inop
ec34
52
na
P
etro
leum
ref
inin
g
Tot
al (
aver
age
for
tran
snat
iona
lity
inde
x)3
988
447
949
0T
otal
for
G-1
0 (a
vera
ge f
or t
he i
ndex
)3
954
442
749
0
na
= n
ot a
vaila
ble
G-1
0 =
Gro
up o
f T
en c
ount
ries
see
not
e to
tab
le 1
1
a
Dat
a sh
own
are
for
the
fisca
l ye
ar e
nded
on
or b
efor
e 31
Mar
ch 1
999
b
Ass
ets
show
n ar
e th
ose
at t
he c
ompa
nyrsquos
fis
cal
year
-end
c
The
ind
ex o
f tr
ansn
atio
nalit
y is
cal
cula
ted
as t
he a
vera
ge o
f ra
tios
of f
orei
gn a
sset
s to
tot
al a
sset
s f
orei
gn s
ales
to
tota
l sa
les
and
for
eign
em
ploy
men
tto
tot
al e
mpl
oym
ent
as o
f 19
97 (
UN
CT
AD
)
Sou
rces
F
ortu
ne G
loba
l 50
0 1
999
http
w
ww
pat
hfin
der
com
fort
une
glob
al50
0in
dex
htm
l U
NC
TA
D (
1999
)
Institute for International Economics | httpwwwiiecom
94 WORLD CAPITAL MARKETS
foreign direct investment The ldquotransnationality indexrdquo (table 28) showsthat on average they conducted about half their business outside theirhome country9
Overview of the Players
Our review of the major players points to two major features First ahandful of big playersmdashfewer than 200 firms all toldmdashcontrol the ac-tion in international capital markets Their dominance will doubtless erodebut for now financial power is strikingly concentrated with them Sec-ond the big players are overwhelmingly based in the G-10 countriesplus Spain The responsibility to supervise them rests not in the IMFnor in Basel but squarely in Washington London Tokyo and the otherG-10 capitals At year-end 1999 the G-10 countries plus Spain accountedfor 84 percent of world banking assets 86 percent of world stock marketcapitalization and 76 percent of international debt securities (BIS 2000aWorld Bank 2000b)
International private capital flows are of three types bank loans anddeposits portfolio investment and foreign direct investment In cumula-tive total flows to emerging markets FDI was the biggest story in the1990s amounting to $954 billion (table 12) Portfolio flows were nextcumulatively amounting to somewhere between $612 billion (table 12)and $764 billion (table A1) Bank loans and deposits are the most com-plicated story
The Key Role of Banks
Banks are more important as an epicenter than as a wellspring Banksgenerate waves in the flow of capital to emerging markets rather than acontinuous steady stream According to data compiled by the Institute ofInternational Finance (table A1) net bank lending to emerging marketscumulated to $269 billion in the 1990s However deposits by emerging-market residents in G-10 banks more than offset G-10 bank lending tothese countries during the decade According to IMF data cumulativebank loans net of deposits amounted to a negative $135 billion (table 12)
In other words when loans and deposits are combined net bank ac-tivity that moves financial resources to emerging markets is small incomparison with portfolio investment and FDI But bank loans are thelubricant of any financial system Depending on circumstances bankscan be shock absorbers or shock propagators In recent decades with
9 The transnationality index is calculated as a simple average of the share of assetssales and employees outside the home country
Institute for International Economics | httpwwwiiecom
THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 95
respect to emerging markets banks have more often been propagatorsthan absorbers The average annual swing in bank lending to emergingmarkets was nearly $50 billionmdashby far the largest source of year-to-yearfluctuations in capital flows Both interbank loans between Europe Japanand Asia and sovereign Russian debt used as loan collateral played amajor role in the 1997-98 crisesmdashnot because banks are profligate playersbut because of the incentives they face and the instruments they useAccordingly our story begins with banks
Banks in the Modern Financial System
10 See Levine (2000) for a concise description of the role of banks in the financial system
11 The asymmetric information problem helps to explain why banks dominate the im-mature financial systems of emerging-market economies The general lack of informationon borrowers and undeveloped legal systems to enforce contracts hamper suppliers oflong-term financial instruments such as equities and bonds in evaluating risk and re-ward Banks are best suited in these circumstances to solve the asymmetric informationproblem by evaluating and monitoring private loans As more and better informationbecomes available capital markets develop and financial systems mature
As we noted in the previous paragraph the problem of financial volatil-ity in emerging-market economies is associated with bank lending Ifand when repayment problems arise cross-border private bank loansand bond placements are such that private creditors have no plausiblemeans of seizing assets from either private or sovereign borrowers Thusalthough international finance can nourish entrepreneurs and accelerategrowth a necessary complement may be a drastic creditor response inthe event of nonpaymentmdashto withhold fresh funds and force an eco-nomic crisis (Dooley 2000)
This argument is based on the characteristics of banks They are notldquobadrdquo per se They perform three essential functions in any financialsystem pooling the resources of disparate savers and channeling these re-sources into productive investment improving resource allocation throughtheir expertise in assessing and monitoring borrowers and facilitatingthe division of risk among numerous creditors10 But by their very na-ture banks are prone to two problems asymmetric information (the bor-rower knows more about the potential risk and return of its projectsthan the bank) and adverse selection (riskier borrowers will pay higherinterest rates and thus may constitute a disproportionate share of bankloan portfolios)11
Bank loans are illiquid fixed-price instruments They cannot easily beconverted to cash although they can be bundled into securities (knownas ldquosecuritizationrdquo) Once loan terms have been agreed on the only waya bank can adjust for shifting market conditions is by changing the quantityof its exposure When a borrower runs into trouble the bank can mix
Institute for International Economics | httpwwwiiecom
96 WORLD CAPITAL MARKETS
and match from two unpleasant menus It can roll over existing loansand extend new credit or it can call some part of existing loans andattempt to recover the principal It can also hedge by selling short otherclaims on the borrower These choices entail either an unwelcome exten-sion of the bankrsquos exposure or credit rationing against the borrower Whentrouble brews all banks encounter the same conditions in the aggregatethey prefer less exposure and ensuing credit restrictions lead to volatilebank lending
Innovation
12 Derivatives have no value of their own They ldquoderiverdquo their value from the value ofthe underlying asset They include swaps futures (contracts for future delivery at speci-fied prices) and options (which give one party the right but not the obligation to buyfrom or sell to a counterparty at an agreed price)
13 Maxfield (1998) analyzed available evidence of emerging-market investor objectivesmost of it before the crisis Analysis of portfolio equity flows is sensitive to the choice ofperiod with year-over-year data indicating that investors respond to country ldquofundamen-talsrdquo Other evidence suggests more ambiguity Ranking by ldquoinvestor impatiencerdquo ie thesearch for yield over value Tesar and Werner (1995) find short-term bank flows to be themost yield driven followed by portfolio investment FDI and long-term bank lending
14 Because market risk credit risk and country risk interact in complex ways newfinancial instruments have been created to help reduce negative interactions One is theldquototal return swaprdquo which has become an instrument of choice for hedge funds lookingfor high leverage Banks also use the total return swap to cover risks without increasingtheir capital requirements
Since the 1980s national and international banking systems have beentransformed by deregulation intensified competition and the informationand communications-technology revolutions The market environment isone of intense competition particularly in traditional banking activitiesThe innovations point away from traditional activities of plain vanilladeposit taking and loan making Three big themes are discernible Firstthe walls separating commercial banks investment banks portfolio man-agers and insurance firms are falling even if they are still distinct Sec-ond large banks are shifting toward securitizationmdashcreating securitiesout of everything from credit card debt to trade finance to disaster insur-ancemdashand earning fees in the process Third all large banks are shiftingtoward trading activity making markets and taking short-term stakes inbonds shares and derivatives12 These activities when successful satisfythe search for higher yields13
Many of the new financial instruments that banks trade are ldquooff bal-ance sheetrdquo This means that banks are not required to allocate capitalagainst them In swap contracts for example neither side pays cash at theoutset and therefore neither party has an asset in the traditional sense14
Futures and options contracts can be written with a relatively small initial
Institute for International Economics | httpwwwiiecom
THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 97
margin relative to the potential risk Credit derivatives limit credit risk bytransferring the potential loss associated with corporate loans and bondssovereign debt and other loan portfolios to counterparties15
Deregulation and innovation working in combination seem to havepushed banks into trading activity and leveraged plays but not into shareownershipmdasheven in jurisdictions that have no prohibition against equitystakes Among the G-10 banking systems the highest ratio of share own-ership to assets was only 5 percent in 1996 reached in Germany andJapan (Berlin 2000)16
The wave of innovation in financial instruments and the accompany-ing expansion of banking beyond its old boundaries is a two-edged swordOn one side it allows risk management far beyond what was tradition-ally possible Risk can now be shifted from firms that can ill afford lossesto those that can Banks can profitably act as intermediaries in shiftingrisk On the other side the innovation wave creates huge opportunitiesfor leveraged plays fostering a speculative search by banks themselvesfor high returns that in turn magnify their own risks17
15 Credit derivatives include total return swaps credit default swaps credit-linked notesand collateralized debt obligations They are the fastest-growing sector of the global de-rivatives market
16 Banks seem to specialize in lending even when they are allowed to mix finance andcommerce for reasons related both to how they are expected to behave with distressedfirms and to other intricacies of lender liability (Berlin 2000) Yet a recent cross-countrystudy found that restrictions on banking and commerce are associated with greater fi-nancial instability (Barth Caprio and Levine 2000)
17 Leverage is the magnification of the rate of return (positive or negative) on an in-vestment beyond the rate obtained by solely investing funds owned by the institution Itis often defined as the ratio of assets to equity Leverage is achieved by increasing thesize of an investment by borrowing or using derivative instruments such as futures oroptions These allow investors to earn a return on the notional amount underlying thecontract by committing a small portion of equity in the form of a margin deposit oroption premium payment
18 In a repo (repurchase agreement) one party (typically a trader) buys a bond andsells it to a dealer for cash with a promise to buy it back the next day at the same priceplus the overnight interest rate As long as the overnight interest rate is lower than theinterest accruing on the bond the trader earns some income on the bond The extremeform of these kinds of transactions was discovered at LTCM the failed US highly lever-aged institution which appears to have controlled more than $120 billion in assets froman investment of about $3 billion This leveraging was accomplished mostly through theuse of repos (Mayer 1999)
The potential for damage is illustrated in an extreme form by figure 21To precisely measure a firmrsquos leverage all positions must be known andrealistically valuedmdashwhich may be impossible to do Because many ac-tivitiesmdashsuch as repos18 and derivativesmdashdo not appear on the institutionrsquos
Leverage
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98W
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PIT
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MA
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ET
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Figure 21 Hypothetical example of leverage
$1000 notional value of call option on equity in firms targeted for takeover
Repo FRN into cash and use cash to pay option premium
(repro is initially collateralized
Borrow $100 for margin purchase
$125 of US investment bank floating-rate notes (FRN) (secured by $25 equity in FRNs)
Repo off-the-run bond into cash and post margin
(repo is initially collateralizedSell (short) Borrow on-the-run bonds worth $20
$25 worth of off-the-run bonds (secured by $5 equity in bonds)
Exchange into $4
Cash $5 yen400 Japanese bank loans
$1 equity base
FRN = floating rate notesRepo = repurchase agreement
Source IMF (1998)
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 99
balance sheet and because balance sheets are published quarterly at bestoutsiders have a difficult time assessing the extent of a firmrsquos leverage19
Leveraging by a single firm enhances its risk of default the widespreaduse of leverage in the financial system can magnify market adjustmentsespecially when they require ldquodeleveragingrdquomdashunwinding prior positionsRapid adjustments can cause credit to dry up and asset prices to plummetIn a mark-to-market environment falling asset prices trigger calls foradditional collateral that can ripple through markets
Risk Management
Because it is confronted with the widespread use of leverage and prolif-erating kinds of risk international finance is increasingly driven by riskevaluation and control20 Different institutions face various risk profilesand differing kinds of risk The most common risks can be quickly tickedoff Banks because of their traditional intermediary role of channelingthe resources from savers to borrowers face significant credit risk therisk of default or delay in the payment of principal and interest Theymust also manage market risk the risk that the prices of their liabilitiesmay change faster than their assets Market risk devastated US savingsand loan institutions in the late 1980s
Closely associated with market risk are interest-rate risk (unexpectedchanges in market interest rates that slash margins net income and theeconomic value of a bankrsquos equity) and foreign exchange risk (losses thatarise when assets denominated in an appreciating foreign currency areless than liabilities denominated in that currency) Banks make numer-ous loans to other banks around the world portfolio investors buy se-curities direct investors acquire fixed assets and all incur country risk(economic and political uncertainty in the host country) During the heightof the Asian crisis for example interbank loans to Japanese banksreflected the credit risk of lending to these banks the so-called Japanpremium
Substantial attention has been lavished on country risk analysis sincethe 1982 debt crisis in developing countries Yet in spite of this exper-tise the Asian crisis occurred in part because of a sudden upward reap-praisal of country risk after the Thai baht collapsed in April 1997 Banksand other financial institutions must also manage liquidity risk the riskthat market conditions will change unexpectedly depressing demand andprices of assets at the time they want to sell these assets And they mustmanage operational riskmdashfailures in control systems or people that cause
19 Another example of asymmetric information Both risk and leverage are difficult foroutsiders to assess without full timely disclosure
20 A longer discussion of these issues can be found in Managing Global Finance in IMF(1999c)
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100 WORLD CAPITAL MARKETS
financial loss or damage reputations Operational risk devastated BaringsBank in 1995
Financial institutions practice risk management to measure all theserisks the potential damage to their investment positions and ultimatelythe chance of becoming insolvent VAR (value at risk) risk models mea-sure subject to certain assumptions the amount of the firmrsquos capital thatis exposed in each period For example the VAR model might say thatin a 3-standard-deviation worst case (a case that is not supposed to hap-pen more than 1 percent of the time) the firm will loose 25 percent of itscapital during the next year
VAR models are widely used but like all models they have weak-nesses They rely on past values to estimate key variables in financialmarkets past values are not always good predictors of future risks More-over rising volatility and higher loss correlation among different assetclasses in a portfolio will cause all banks using these models to reducetheir exposures at the same time by switching to less volatile and lesscorrelated assets such as US Treasury bills (Persaud 2000)
Newer risk models entail stress testing and scenario analysis Scenarioanalysis envisages possible adverse changes one at a time that mightaffect the investment portfolio Stress testing estimates potential losseswhen several individual risk factors simultaneously move against thefirm but it too uses historical probabilities
Financial Volatility
21 For example derivative markets usually rely on underlying securities markets thatproduce continuous prices When these markets are interrupted financial shocks cantrigger a cascade of margin calls and sell orders that move prices very sharply
22 See IIF (1999a)
The combination of trading activity and modern risk management lie atthe root of financial volatility When risks increase banks must eitherraise more capital to cover the greater risk or reduce their exposure bycutting loan exposure by selling securities or by undertaking new de-rivative trades Raising more capital is time-consuming and in a crisisvery expensive because bank shares are depressed So banks look to theother alternatives If the bank can reduce lending it need not book aloss But most banks use the same VAR models and as indicated abovethese models will encourage them to reduce their outstanding loans atthe same time actually magnifying loan volatility
If banks attempt to reduce their exposure to risk by selling securitiesor undertaking new derivative trades they may trigger large priceshocks because of limited and shrinking market liquidity21 The liquid-ity problem is compounded when a small number of large institu-tions hold the same positions22 Take your pick loan volatility or price
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 101
volatility As two experts have observed (Folkerts-Landau and Garber1998)
[V]olatility even in one country will automatically generate an upward re-estimate of credit and market risk in a correlated country triggering automaticmargin calls and tightening of credit lines Thus apparently bizarre opera-tions that connect otherwise disconnected securities markets are not the re-sponses of panicked green screen traders arbitrarily driving economies from agood to a bad equilibrium Rather they work with relentless predictability andunder the seal of approval of supervisors in the main financial centers
23 See Ferguson (1999)
24 As Gerald Corrigan (1982) put the matter ldquoBanks are specialrdquo Corrigan (2000) reit-erated this view even after all the changes of the past two decades Unlike other institu-tions banks offer on-demand transactions are a backup liquidity source for other insti-tutions and serve as a ldquotransmission beltrdquo for monetary policy
These changes in the banking environment accentuate an existing anomalyThe anomaly is that banks even as they grow larger and increasinglyengage in more risky and complex transactions are perceived to enjoyimplicit and explicit public guarantees
The guarantees grow out of an incentive problem inherent in bankingasymmetric information which we mentioned above Depositors know lessabout a bankrsquos management and the quality of its balance sheet than doits managers and shareholders Thus in times of uncertainty or adver-sity bank depositorsmdashuncertain whether they will have access to theirdepositsmdashare prone to bank runs This prospect has in turn compelledgovernments to treat banks differently than other firms because a bankthat fails can disrupt the rest of the economy24
To prevent such crises governments have entered into quid pro quoarrangements with banks Governments provide them both with an im-plicit safety net in the form of an unstated promise by the central bankto act as a lender of last resort in a liquidity crisis and an explicit safetynet in the form of a public deposit insurance fund to reassure depositorsIn return the banks submit to closer government oversight and regu-lation of their activities than is usual for industries in the private sector
The ldquoinsurancerdquo provided by the public safety net contributes to an-other incentive problem moral hazard Banks acquire greater tastes forrisk and face less market discipline than other firms The explicit depositinsurance safety nets actually have or are perceived to have blanketcoverage that extends beyond the retail depositors (households and small
One of the lessons of the 1997-98 crisis must surely be that market par-ticipants and their regulatory supervisors relied too heavily on quantita-tive tools and insufficiently on judgment23
The Anomaly of Modern Banking
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102 WORLD CAPITAL MARKETS
businesses) for which they were originally intended The implicit centralbank safety nets extend in a crisis to nearly all depositors and banksThus banks are both viewed and behave as if they will be bailed out ifthey get into trouble
The existence of a public safety net raises a perennial question Dobanks have an unfair advantage over other financial institutions becauseof the subsidy provided by the safety net This question was at the heartof intensive study and debate in the United States leading up to thepassage in November 1999 of the Financial Services Modernization Act(also known as the Gramm-Leach-Bliley Act) The size of the gross sub-sidy is difficult to estimate despite determined research efforts Somesuggest it is well under 100 basis points and is at least partly offset bythe direct costs of deposit insurance premiums interest payments on bondsissued by the Financing Corporation25 reserve requirements regulatoryexpenses and operational costs associated with collecting deposits26 Con-versely Kwast and Passmore (2000) suggest that banks can expand theirscope far beyond the levels that other financial institutions could reachwith the same equity base but without the public safety net
A related concern in the US debate is whether allowing banks to ex-pand their activities into securities and insurance will ultimately extendthe safety net and add to the subsidy The Financial Services Moderniza-tion Act deals with this issue by maintaining a legal separation betweenbanks and the rest of the banking organization known as large com-plex banking organizations (LCBOs) They must engage in most securi-ties activities and insurance underwriting through separately capitalizedinvestment bank subsidiaries or holding company affiliates This act canbe said to have merely brought US banking laws closer to those of mostother industrial countries (Barth Brumbaugh and Wilcox 2000 BarthNolle and Rice 2000) If the fire wall is well-maintained and stoutly de-fended the safety net will neither expand in practice nor become a sourceof comfort to noncommercial bank subsidiaries of LCBOs
The quid pro quo exacted by governments to offset the subsidy iscloser public-sector monitoring of banksrsquo activities through prudentialsupervision The effectiveness of this closer official scrutinymdashand closermarket monitoringmdashare the subjects of the next section
25 The Financing Corporation was created by Congress in 1987 to sell bonds to raisefunds to help resolve the savings and loan crisis
26 See Levonian and Furlong (1995) Jones and Kolatch (1999) Shull and White (1998)and Whalen (1999a 1999b)
Are G-10 bank supervisors adequately responding In this section we firstassess the case for and compare the structures of prudential supervisory
Prudential Supervision
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 103
systems both within and among the G-10 economies plus Spain andconsider whether these offset the subsidy provided by the public safetynet Despite offsetting regulation and supervision implicit and explicitguarantees by G-10 governments to their banks are still a source of bank-ing instability in the emerging-market economies
National Systems for Prudential Supervision
Governments use prudential supervision to reduce the moral hazard andadverse selection created by their own safety nets Supervisors establishregulations and monitor compliance to limit risk taking and ensure thesafety and soundness of the banking system In a thoughtful analysis ofthe case for prudential supervision Frederic Mishkin (2000) identifiesthe main forms that supervision can take including the tasks of grantingbanking charters and licenses establishing capital requirements settingdeposit insurance premiums and defining disclosure requirements as wellas carrying out bank examinations Bank examiners gather informationfrom banks and evaluate whether they are following the regulatorsrsquo rulesin cases of weakness they are empowered to change banksrsquo behaviorand close them if necessary
Supervisors also may restrict competition define the activities in whichbanks may engage and restrict their asset holdings and separate banksand other financial (or nonfinancial) activities During the past two de-cades the barriers separating commercial banks investment banks in-surance firms and securities firms have been all but eliminated (tableB1) Deregulation has stimulated competitive forces that drive diversifi-cation and consolidation of the financial industry nowhere faster than inthe United States
The Financial Services Modernization Act of 1999 confirmed this trendIt eliminated restrictions dating back to the Glass Steagall Act of 1933which once prevented banking insurance and securities firms fromentering each otherrsquos businesses (Barth Brumbaugh and Wilcox 2000)Cross-pillar mergers among banks insurance and securities firms arewell under way to form giant financial holding companies The 1999merger between Citibank (banking) and Travelers (insurance) created themodel for megafinance and confirmed new challenges for supervisors
Mishkin (2000) notes the corresponding evolution in US supervisionfrom an emphasis on rules-based regulation (detailed rules for opera-tional behavior and the quality of line items in the balance sheet) to anapproach that stresses the soundness of bank management practices es-pecially risk management
Appendix B outlines the systems of financial supervision now in theplace in the G-10 countries plus Spain Some systems like the UK andCanadian approach are models of simplicitymdashorganized to keep pacewith the spreading reach of financial conglomerates Other systems like
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104 WORLD CAPITAL MARKETS
the US and French approaches show traces of the bureaucratic divisionsthat made sense in an era when banking securities and insurance weresharply separated
The US Model
27 See Meyer (1999a)
28 Canada has a similar degree of simplification with the exception that securities firmsare still regulated by provincial authorities
29 See Pratti and Schinasi (1999 67)
30 The agents are the bank regulators and the principals are the taxpayers Agents maypursue their own interests including bureaucratic survival and postgovernment employ-ment opportunities rather than the national interest in banking safety and soundness
The US model of financial regulation delineated in the Financial Ser-vices Modernization Act of 1999 blends functional and umbrella super-vision Bank and thrift regulators oversee depository institutions Newnonbank activities are subject to both functional regulation (eg by theSecurities and Exchange Commission and state insurance examiners) andumbrella supervision (of financial holding companies) by the FederalReserve27
The UK Model
Another supervisory model exists in the United Kingdom as well as inAustralia Canada and Switzerland28 In this model banking supervisionis separated from the monetary policy function The regulatory structureis considerably simplified by relying on a consolidated financial regula-tor separate from the central bank for both banking and nonbankingactivities The remaining question answered differently depending on thecountry is the extent to which the regulator relies on home-country sur-veillance of banks and conglomerates that have a local presence
Regulatory Models Compared
Appendix B provides more detail on the differences in these modelsGerman simplicity contrasts with French complexity In France the bankingcommission is chaired by the governor of the central bank and includesrepresentatives from the Treasury The commission supervises compli-ance with regulations but the central bank inspects banks on behalf ofthe commission29 In countries such as the United States and France withmultiple supervisors and crossover functions internal coordination is criticalAt the same time multiple agencies create regulatory competition Wheneach agency knows what the other is doing transparency within gov-ernment circles can help to limit principal-agent problems of regulation30
The discussion as to where in the public bureaucracy financial super-
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 105
vision should be placed goes back many years Peek Rosengren andTootell (1999) argue that a synergy exists between monetary policy andprudential supervision because information gained in the course of super-vision can increase the accuracy of macroeconomic forecasts A twist tothis argument is that the information on the state of financial institutionsavailable to the central bank as supervisor can facilitate its role as lenderof last resort Conversely there is the concern that a supervisory rolewill compromise the central bankrsquos independence of action with respectto its core mandatemdashmaintaining price stability As these arguments haveplayed out financial supervision has generally been shared between centralbanks and other regulators or placed entirely in the hands of an inde-pendent regulator However in Italy the Netherlands and Spain cen-tral banks are the sole banking supervisor
Goodhart (1995) examined the arguments and evidence for each modeland concluded that there were no overwhelming arguments or evidencefor one or the other31 Going forward a key problem for any financialsupervisory system is dealing with (and closing as necessary) weak banksIf both central banks and other regulators have this responsibility closecoordination between them is critical Another problem is large conglom-erate banks LCBOs Although they are less likely to fail because of thediversification of their assets and liabilities they are more likely to berescued They are also more likely to be multinational enterprises withinternational implications Goodhart observes that regulation of theseentities might be put in the hands of the central bank because it is lessamenable to political pressures In any event the complexity of LCBOoperations suggests that greater supervisory rigor is necessary
The US Congress was persuaded that broad oversight would help containthe moral hazard problem and accordingly gave the Federal Reservethe role of umbrella supervisor with the understanding that the Fed willscrutinize depository activity more intensely than nonbank financial ac-tivities Under this approach LCBOs such as Citigroup are subject tomuch closer monitoring than smaller and simpler institutions32 The USregulatory model requires enormous cooperation between the Fed otherbank supervisors and the functional regulators for insurance and securi-ties but it also benefits from regulatory competition
31 National systems of supervision are path dependent they are determined by the struc-ture of financial institutions and history in each country If Goodhart (1995) is right out-comes are not materially better or worse with one model of supervision rather than another
32 See Ferguson (1999)
Public Safety Nets
One of prudential supervisorsrsquo biggest challenges is to reduce moral hazardFor many years commercial banks engaged in communal self-insurance
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106 WORLD CAPITAL MARKETS
to deal with crises They formed voluntary groups that agreed to rescuetroubled members As financial markets evolved and competition inten-sified banks were no longer willing to play this role Private-sector in-surance is one alternative but moral hazard and adverse selection wouldappear to prevent it from happening Public safety nets have developedbecause of the low probability and high cost of potential bank runs Aclear trade-off is involved The effectiveness of insurance in preventingbank runs is greater the more comprehensive the coverage But the morecomprehensive the coverage the greater the moral hazardmdashbank man-agers bank directors investors and depositors all take on greater risksin the belief that the safety net will protect them against losses
All G-10 countries have compulsory public safety nets for banks (table29) Deposit insurance agencies are officially organized in Canada theNetherlands Sweden Switzerland and the United States organized bythe industry in France Germany Italy and the United Kingdom andjointly organized by the public and private sectors in Belgium Japanand Spain
How well do G-10 governments offset the subsidy provided by thepublic safety net This is a question on which there is substantial debateAs banking organizations have become more complex the challengesthat supervisors face have become more difficult One challenge is toalign the incentives facing bank managers and shareholders with thoseof depositors Another is the principal-agent problem in supervision Wehave discussed the incentive structures for financial institutions but wehave said little about the incentives for supervisors themselves and thedistortions they can generate in the financial system
In one of the many studies of the US savings and loan crisis of the1980s Kane (1989) documented both problems He described managersusing cosmetic approaches to disguise the magnitude of insolvency regulatorspracticing forbearance even though they knew of the deteriorating riskprofiles of the institutions for which they were responsible and legisla-tors increasing deposit insurance without regard for any offsetting changesin supervision A subsequent overhaul of the legislative framework forthe Federal Deposit Insurance Corporation (FDIC) known as the FDICImprovement Act of 1991 (FDICIA) aimed to introduce a clearer incen-tive structure for both regulators and regulated institutions
The changes introduced by this US legislation are worth discussionwith respect to the other G-10 countries as well First FDICIA created astronger signal to management and investors by targeting deposit insur-ance at small depositors only and by risk-weighting the deposit insur-ance premiums paid by banks to reflect their capital adequacy and bankexaminer ratings Among the G-10 countries rated in table 210 depositinsurance premiums vary considerablymdashbut it is not clear that the dif-ferences have much to do with risk-weighting Most G-10 countries em-ploy funding formulas based for example on the total domestic deposit
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TH
E P
LAY
ER
S T
HE
IR S
UP
ER
VIS
OR
S A
ND
MO
RA
L HA
ZA
RD
107
Table 29 Deposit insurance schemes in the G-10 countries Explicit safety net
Coverage limit(dollar Foreign
equivalent currency Interbank Source Bankrsquos Contingency fundingDate Membership Co- at end of deposit deposit of premium from banks
Country established managementa insuranceb July 1998)c covered covered Fundingd funding costs or governments
United 1982 Compulsory Yes Larger of 90 No No Unfunded Banks only Callable (subject Parliament may increase Kingdom private percent co- to maximum the maximum payable
insurance to 03 percent of pound125 million advance 33000 total deposits) facility with Bank of
England
United 1934 Compulsory No 100000 Yes Yes Funded Banks and Up to 027 Borrowing up to $3 States official government percent total billion from US Treasury
domestic deposits
Japan 1971 Compulsory No 71000 but No No Funded Banks and 0084 percent of Borrowing up to yen500bn joint in full until government insured deposits from Bank of Japan
year 2000 subject to Ministry of Finance approval
Canada 1967 Compulsory No 40800 No Yes Funded Banks and 033 percent of Borrowing up to C$6 official government insured deposits billion authorized further
(maximum) borrowing subject to parliamentary approval
Germany 1966 Compulsory Yes 90 percent Yes No Funded Banks only 003 percent of Annual levy may be private coinsurance deposits doubled
to 22000
Italy 1987 Compulsory Yes 125000 Yes No Unfunded Banks and Callable Two options defer private government (maximum of payment or diminish
1 percent of compensation to be paid total deposits)
(table continues next page)
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108W
OR
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CA
PIT
AL
MA
RK
ET
S
Table 29 Deposit insurance schemes in the G-10 countries Explicit safety net (continued )
Coverage limit(dollar Foreign
equivalent currency Interbank Source Bankrsquos Contingency fundingDate Membership Co- at end of deposit deposit of premium from banks
Country established managementa insuranceb July 1998)c covered covered Fundingd funding costs or governments
Netherlands 1979 Compulsory No 22000 Yes No Unfunded Banks and On demand Government backing official government maximum of subject to parliamentary
5 percent of own approval funds
France 1980 Compulsory No 65400 No No Unfunded Banks only Callable (on Extra calls up to FFr1000 private demand calls million can be made in
up to FFr200 a 5-year period million)
Switzerland 1984 Voluntary No 19700 No No Unfunded Banks only Callable (on Underwritten by member official demand) banks
Sweden 1996 Compulsory No 31400 Yes No Funded Banks and 05 percent of Full emergency coverage official government deposits while replacing it with a
limited system after the emergency
Belgium 1974 Compulsory No 16600 No No Funded Banks and Callable 002 None insurance limited joint 22000 in government percent of to assets in fund
year 2000 deposits from clients
Spain 1977 Compulsory No 16439 Yes No Funded Banks and 02 percent of Government backing joint government deposits through the Banco de
(maximum) Espantildea subject to approval by royal decree
a Bank membership in the fund can be either compulsory or voluntary and the management of the fund can be official and official and private joint or privateb Coinsurance refers to the situation where depositors face a deductible against their insured fundsc Coverage limit refers to the explicit amount the authorities promise to insured Funded scheme means that it is funded ex ante unfunded otherwise
Sources Goodhart (1995) Demirguccedil-Kunt and Detragiache (2000) Demirguccedil-Kunt and Sabaci (2000)
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 109
base Explicit safety net protection also varies but only Canada focuseson the protected class33 All G-10 countries specify a limit on depositorprotection Under FDICIA the insurance fund is prohibited from pro-tecting uninsured depositors or creditors at a failed bank although adiscretionary system-wide override is provided for exceptional circum-stancesmdashbut with stringent requirements for consultation and account-ability Other G-10 countries allow for contingency funding from the publicpurse alongside unwritten lender-of-last-resort support Among large banksa significant and growing portion of deposit liabilities including foreigncurrency and interbank deposits are uninsuredmdashbut depositors assumethey will be protected in a crisis
FDICIA also made some significant qualitative changes to address theprincipal-agent problem by penalizing weak banks and rewarding strongbanks For example banks whose capital declined faced progressivelytougher regulatory sanctions that for example required them to elimi-nate dividends restrict their lending and change their managementsRegulators have also been forced to take prompt corrective action (toreduce the practice of regulatory forbearance in hopes that a bankrsquos for-tunes might improve)34 Unfortunately comparative qualitative assess-ments across the G-10 are difficult to make due to lack of information35
This discussion highlights the complexity of evaluating the extent towhich prudential supervision and market discipline reduce the moralhazard associated with G-10 safety nets Our argument is that publicsafety nets in the G-10 can be linked to banking instability in other coun-tries specifically in the emerging-market economies that have attractedG-10 cross-border bank lending This lending is a leading source of vola-tility in capital flows the large financial institutions many of which arecomplex banking organizations are based in and regulated by authori-ties in the G-10 economies These two features of the international finan-cial system are closely related although it is not possible to test thisrelationship econometrically
Two World Bank studies however indicate a basis for concern Onestudy is a cross-country econometric analysis of the relationship betweenbank stability and deposit insurance (Demirguccedil-Kunt and Detragiache2000) which found a negative relationship Their estimated model forbanking crises in a sample of 61 countries (both industrial and develop-ing) suggests that explicit deposit insurance raises the probability of acrisis by at least 30 percent36 Crises are especially likely in countries
33 Japanrsquos legislation says it does but recent experience shows this is not the case34 See Goldstein (1997) for a summary of the changes35 See Barth Nolle and Rice (2000) for a beginning in this area36 Demirguccedil-Kunt and and Detragiache (2000 table 1) report a logit coefficient of 0696with a standard error of 0397 (the coefficient is significant at the 8 percent threshold)This suggests that the ldquotruerdquo coefficient could well be as small as 030 (the reportedvalue minus the standard error)
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110 WORLD CAPITAL MARKETS
with immature financial supervisory systems (and not in the G-10) buttheir analysis does underscore the view that deposit insurance weakensmarket discipline37
An earlier World Bank analysis established similar results One wasthat market discipline is undermined by deposit insurance schemes an-other was that illiquid banks are forced to pay more for their funds un-less a generous deposit insurance scheme is in place (Demirguccedil-Kuntand Huizinga 1999) This econometric study also provides clear-cut evi-dence that depositor monitoring of banks declines with the existence ofdeposit insurance schemes At the heart of the problem is the questionof whether deposit insurance is accompanied by increased governmentmonitoring
This evidence and the weight of other arguments suggests that moralhazard is still an issue in the G-10 countries Consider the ongoing de-bate about instilling greater market discipline on risk taking by banksAt one extreme is the perennial proposal to do away with safety netsleaving markets to monitor the players and to force adjustments but toprotect small savers by creating ldquonarrow banksrdquo such as postal savingsystems that are allowed to invest these savings only in risk-free gov-ernment securities Whatever the merits of narrow banking this solutionis too extreme to be politically feasible
A moderate alternative is to force more disclosure by financial institu-tions to facilitate market monitoring But transparency has its own prob-lems Persaud (2000) argues that financial markets cannot reliably discernsustainable from unsustainable positions in the short term This uncer-tainty causes banks to ldquoherdrdquo behind market leaders to exploit theirsupposedly superior information ldquoThe more herding investors and bankersknow about what each other is up to the [more] unstable markets maybecomerdquo The implication is that greater transparency in the marketplaceby itself will not solve the problemmdashand in the short term more informa-tion may exacerbate herding Further supervisory steps (discussed in thenext chapter) are required
Yet another proposal is to promote private-sector involvement in bankmonitoring through market-based alternatives such as Calomirisrsquos sub-ordinated debt proposal (Calomiris 1997 Federal Reserve Board 1999)Banks could be required to issue and maintain a minimum amount of
37 Other findings in the Demirguccedil-Kunt and Detragiache (2000) study include thesepropositions The impact of deposit insurance on bank stability tends to be stronger themore extensive is the coverage offered to depositors when the scheme is funded andwhere the scheme is run by the government rather than by the private sector Con-versely deposit insurance is detrimental to bank stability where bank interest rates havebeen deregulated and where the institutional environment is weak Additional findingson deposit insurance are reported from a recent World Bank conference (8-9 June 2000httpwwwworldbankorgresearchinterestconfsupcomingdeposit_insurancehomehtm)Also see Smalhout (2001)
Institute for International Economics | httpwwwiiecom
THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 111
subordinated debt (eg uninsured certificates of deposit) to finance asmall fraction (such as 2 percent) of their total nonreserve assets Thesubordinated debt would be allowed to earn a set yield no more than 50basis points over the risk-free yield on government treasury bills Thisrule would supposedly force banks to operate in a safe manner Other-wise subordinated debt holders would redeem their uninsured certifi-cates of deposit and equity investors would sell their bank shares Despiteits practical problems the beauty of the subordinated debt requirementis that it enlists market incentives to push banks to avoid excessive port-folio risk38
The thrust of these proposals is very relevant to the arguments in ourstudy Even in the G-10 countries government monitoring by itself hasnot eliminated moral hazard among banks More work is needed to in-troduce market monitoring and to improve the incentive structures bothfor financial institutions and their supervisors We return to this issuewith our recommendations in the next chapter
38 In late 1996 Argentina began requiring its banks to finance 2 percent of total depos-its in the form of subordinated debt but without a maximum yield provision TheArgentine authorities expect that market discipline will act in concert with the publicsafety net One obvious problem with the subordinated debt proposal is that banks mayencourage some of their customers to buy the subordinated debt
Portfolio Institutions Tomorrowrsquos Problem
Before proceeding to the issues of international supervision we flag an-other potential problem for national regulators The big asset managersprofiled in tables 24 and 26 answer to diverse groups of pensionersshareholders and policyholders They allocate funds across a number ofcountries to diversify their risks They hold liquid assets that can be tradedand they have a higher proportion of long-term assets than banks Eco-nomic shocks can be absorbed through price changes and their effectsspread across time and markets Thus when conditions change in a par-ticular market they are more likely to ride out the storm than to flee Inother words they have less incentive than banks to pull their invest-ments in the face of adversity In the 1990s most large asset managersestablished a record of ldquoriding out the stormrdquo rather than ldquorunning withthe windrdquo although as we saw in chapter 1 instances of running withthe wind were detected in some portfolios As we write these insti-tutions have a good record overall in the emerging markets so whyworry
The Russian crisis and the near-collapse of LTCM previewed the dan-gers that may await future portfolio managers and G-10 financial minis-ters We have presented evidence indicating a systemic bias toward bank
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112 WORLD CAPITAL MARKETS
lending and debt finance to emerging markets and we have argued forsubstitution toward equity finance and direct investment39
That is not the end of the story We noted in the previous chapterthat institutional investors can become momentum investors selling in adownturn As more portfolio capital is invested in emerging marketssome players may adopt the high-risk high-leverage strategies of themost aggressive hedge funds Indeed the data in box 11 show that G-10portfolio investors held somewhat more long-term debt (more than $500billion) than equity (less than $400 billion) in emerging markets at theend of 1997 Long-term debt is an ideal vehicle for high-risk high-leveragestrategies These strategies practiced on a large scale could compound afuture crisis harming emerging markets A big enough crisis could inturn pressure G-10 central banks and finance ministers to arrange bail-out plans Instead of shrinking as a systemic financial problem moralhazard could increase
National securities regulators are the first line of defense against thisscenario They play a critical role in the safe evolution of capital mar-kets But regulators today are mandated to approve the issuance of newsecurities and to monitor the continuing disclosure of material informa-tion by issuers They are far less concerned with or empowered to monitorthe behavior of the increasingly large wealth-management firms that arethe major purchasers (and therefore resellers) of these securities
Within their mandates the goals of national securities regulators (table210 and appendix B) are similar to the concerns of bank regulators withsystem safety and soundness Their focus is also on the incentive sys-tems for management and boards of directors and on disclosure by cor-porations that issue marketable securities such as shares bonds andasset-backed securities 40 Issuers of securities possess greater knowledgeabout the quality of these assets than do the purchasers hence investorprotection is a key concern of regulators Moreover market disciplineworks best when markets know what is happening Well-functioning corpora-tions are key agents of wealth creation and social progress Underperform-ing corporations waste resources During recessions bad corporationsget into bad trouble often with severe social consequences Inadequateincentives for managers and inadequate accountability for boards andmanagers thus have negative externalities Regulators play a vital role inexposing weakness so that market disciplines come to bear sooner ratherthan later
Regulatory emphasis is constantly shifting as financial markets evolveand as the macroeconomic environment changes Regulators try to balance
39 See Rogoff (1999) Also see Berlin (2000) for a perspective on the limited role thatbanks play as share owners
40 See Habib and Ljungqvist (2000) for recent empirical analysis showing that corporateshare market values are higher when corporate executives have a larger ownership stake
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Table 210 Financial-sector regulation G-10 countries 2000
Financial institutions and their supervisors
Country and supervisory structure Retail banking Wholesale banking Securities Insurance
Financial conglomeratesFinancial Services Authority (FSA) = umbrella supervisor
United Kingdom FSA FSA FSA FSA
Treasury bull Commercial banks bull Investment funds (Securities and (Insurance Directorate(Securities and Investments Board) bull Unit trust groups Futures Authority) of the Treasury)
Bank of bull Building societies bull Pension funds England (Building Societies Commission) bull Merchant banks
bull Friendly societies bull Clearing houses bull Primary issuers bull Insurance FSA (Friendly Societies Commission) bull Venture capital of securities companies
bull Pensions and life insurance etc bull Stock exchanges bull Insurance brokers(Personal Investment Authority) bull Stockbrokers
Financial holding companiesFederal Reserve (FR) = umbrella supervisor
United States bull National banks(OCC) Securities and Regulated by
Treasury OCC bull State banks Federal Reserve Exchange Commission StatesMembers (FR)
OTS Nonmembers (FDIC) bull Investment banks bull Primary issuers of bull Insurance companies FR bull Cooperative banks (FDICFR) bull Finance companies securities bull Insurance brokers FDIC bull Insured industrial banks (FDIC) bull Stock exchanges
bull Thrift holding companies (OTS) bull Stockbrokers SEC bull Savings banks (OTSFDICFR) bull Investment advisors
bull Savings and loan associations bull Mutual funds(OTS) bull Public utility holding
bull Edge Act corporations (FR) companies
(table continues next page)
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Table 210 Financial-sector regulation G-10 countries 2000 (continued )
Financial institutions and their supervisors
Country and supervisory structure Retail banking Wholesale banking Securities Insurance
Financial holding companies Japan Financial Supervisory Authority (FSA) = umbrella supervisor
Prime FSA FSA FSA FSA ministerrsquos Ministry of office Finance (Securities and Exchange
Surveillance Commission) FRC Bureau of Financial bull City banks bull Investment banks bull Primary issuers of bull Insurance companies FSA Regulation bull Regional banks bull Asset managers securities bull Insurance brokers
bull Trust banks bull Stock exchanges SESC bull Long-term credit banks bull Stockbrokers
bull Pension funds
Financial holding companiesOffice of the Superintendent of Financial Institutions (OSFI) = umbrella supervisor
Canada Regulated by OSFI OSFI provinces OSFI
Department of Financebull Banks bull Cooperative credit bull Primary issuers of bull Insurance companies
(previously Office of the Inspector associations securities (previously Depart- OSFI General of the Banks) bull Fraternal benefit bull Stock exchanges ment of Insurance) Bank of bull Trust and loan companies society bull Stockbrokers bull Insurance brokers Canada bull Pension funds bull Asset managers
(previously Depart- CDIC ment of Insurance)
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Financial institutions and their supervisors
Country and supervisory structure Retail banking Wholesale banking Securities Insurance
Germany Financial holding groupsFederal Banking Supervisory Office (FBSO) = umbrella supervisor
Ministry of Finance FBSO BSO FSSO FISO
Bundesbankbull Universal banks bull Other financial bull Primary issuers of bull Insurance companies
Federal Banking bull Savings banks institutions (eg securities bull Insurance brokers Supervisory Office bull Securities banks management foreign bull Stock exchanges
currency dealings) bull Stockbrokers Federal Securities bull Financial enterprises bull Asset managers Supervisory Office (eg leasing bull Pension funds
organizations Federal Insurance credit card companies Supervisory Office investment advisors)
Italy Bank foundationsMinistry of Finance = umbrella supervisor
Ministry of Finance Bank of Italy Bank of Italy Consob ISVAP
Bank of Italy bull Commerical banks bull Asset managers bull Primary issuers of bull Insurance companies Consob bull Savings bank bull Open-end investment securities bull Insurance brokers
bull Securities banks companies (SICAVs) bull Stock exchangesbull Stockbrokers
ISVAP
(table continues next page)
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Table 210 Financial-sector regulation G-10 countries 2000 (continued )
Financial institutions and their supervisors
Country and supervisory structure Retail banking Wholesale banking Securities Insurance
The Netherlands Financial conglomeratesCouncil of Financial Supervisors = umbrella supervisor
Securities Board Securities Board Netherlandsche Netherlands Bank Netherlandsche Bank of the Netherlands Insurance Board Bank Insurance bull Credit institutions (universal banks bull Investment institutions bull Stock exchanges bull Insurance companies Board cooperative banks security credit (securities issuing bull Stockbrokers bull Insurance brokers
institutions mortgage banks) and tradingmdashprimary The Council of Financial and secondary Supervisors markets)
France Commission des Commission de Operations des Controcircle des
Banking and Banking Commission Bourse Assurances Financial Regulatory bull Ensuring that credit institutions (and investment firms since bull Primary issuers of bull Insurance companies Ministry for Committee the Financial Activity Modernization Act of 1996) comply securities bull Insurance brokers Economic with laws and regulations bull Stock exchanges Affairs and bull Execute instructions regarding all off-site monitoring and bull Stockbrokers Finance Credit on-site supervision Institutions and Banking and Financial Regulatory Committee Investment bull Formulates general regulations for credit institutions and investment firms Committee (capital adequacy requirements accounting rules etc) Bank of France Credit Institutions and Investment Committee Banking bull Authorizes and examines financial institutions except for those within the Commission competence of the Banking Commission
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117
Financial institutions and their supervisors
Country and supervisory structure Retail banking Wholesale banking Securities Insurance
Switzerland Large banking groupSwiss Federal Banking Commission (SFBC) = umbrella supervisor
Swiss National Bank Federal Office of
SFBC SFBC SFBC Private Insurance Swiss Federal Banking Commission bull Universal banks bull Investment banks bull Primary issuers of bull Insurance companies
bull Savings banks bull Asset management securities bull Insurance brokerscompanies bull Stock exchanges
Private audit Federal bull Investment funds bull Stockbrokers firms Office of bull Mortgage bond authorized by Private business SFBC Insurance
Sweden Financial holding company groupsFinancial Supervisory Authority = umbrella supervisor
Ministry of Finance Credit Market Securities Market Insurance Market
Credit Market Department Department Department Department
Financial bull Commercial banks bull Investment funds bull Primary issuers of bull Insurance companies Riksbank Supervisory bull Savings banks securities bull Insurance brokers Authority bull Friendly societies bull Stock exchanges
bull Stockbrokers
(table continues next page)
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Table 210 Financial-sector regulation G-10 countries 2000 (continued )
Financial institutions and their supervisors
Country and supervisory structure Retail banking Wholesale banking Securities Insurance
Belgium Bank holding companiesBanking and Finance Commission = umbrella supervisor
Bank of Belgium Banking Banking
Banking and Finance and Finance Insurance Controland Finance Commission Commission Commission Office
Banking and Insurance Finance Control bull Commercial banks bull Asset management bull Primary issuers of bull Insurance companies Commission Office bull Savings banks firms securities bull Insurance brokers
bull Securities banks bull Investment funds bull Stock exchanges bull Mortgage companiesbull Stockbrokers bull Pension funds
Securities Regulation Fund Securities Regulation Fund
bull Other investment firms and credit institutions(institutions participating in regulated off-exchangemarket in strips and Treasury certificates)
Bank holding companies Spain Banco de Espantildea = umbrella supervisor
Banco de Espantildea Comision Nacional del Mercado de Directorate General
Banco de Espantildea Valores (CNMV) Insurance
bull All credit institutions (commercial banks savings banks credit bull Primary issuers of (Ministry of Economy Ministry of cooperatives official credit institutions finance factoring and securities and Finance) Economy and CNMV leasing companies mortgage-loan companies etc) bull Stock exchanges bull Insurance companies Finance bull Interbank foreign exchange and book-entry public debt bull Stockbrokers bull Pension funds
markets bull Venture capital(companies and funds)
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119
Financial institutions and their supervisors
Country and supervisory structure Banking Securities Insurance
Banking Advisory High Level Securities Supervisors Committee (BAC) Committee (HLSS) Insurance Committee (IC)
Supranational (EU) bull Formulates standards for prudential bull Coordination of securities market bull Formulates standards forsupervision supervision prudential supervision
BACICHLSS Banking Supervision
Conglomerates Committee (BSC) Securities Contact Committee Regulation of prudential bull Systemic risk monitoring bull Regulation and implementation of supervision securities admission
International Association International International Organization of of Insurance Supervisors
Basel Committee Securities Commisison (IOSCO) (IAIS) Joint Forum Conglomerates Supervision bull Supervision and regulation best bull Supervision and regulation best bull Supervision and regulation amp regulation Best practices practices practices best practices
FSF Coordination across supervisors of various functions
Notes See appendix B for more information Boldface type indicates senior or oversight supervisor normal type indicates adjunct or front-line supervisorsolid line indicates direct responsbility to the senior-ranking authority dotted line indicates coordination in supervisory activities
(table continues next page)
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Table 210 Financial-sector regulation G-10 countries 2000 (continued )
Glossary of names United Kingdom FSA = Financial Services Authority United States FR = Federal Reserve OCC = Office of the Comptroller of theCurrency FDIC = Federal Deposit Insurance Corporation SEC = Securities and Exchange Commission OTS = Office of Thrift Supervision Japan FRC =Financial Reconstruction Commission FSA = Financial Services Agency SESC = Securities and Exchange Surveillance Commission Canada OSFI =Office of the Superintendent of Financial Institutions CDIC = Canada Deposit Insurance Corporation Germany FBSO = Federal Banking SupervisoryOffice FSSO = Federal Securities Supervisory Office FISO = Federal Insurance Supervisory Office BSO = Banking Supervisory Office Italy Consob =Commissione Nazionale per le Societa e la Borsa ISVAP = Instituto per la Vigilanza sulle assicurazioni private e di Interesse colletivo Switzerland SFBC= Swiss Federal Banking Commission Spain CNMV = The Comision Nacional del Mercado de Valores Supranational BAC = Banking Advisory CommitteeBSC = Banking Supervision Committee IC = Insurance Committee HLSS = High Level Securities Supervisors Committee International Dimension FSF =Financial Stability Forum IOSCO = International Organization of Securities Commission IAIS = International Association of Insurance Supervisors
Sources United Kingdom Bank of England httpwwwbankofenglandcouk Financial Services Authority httpwwwfsagovuk United States Board ofGovernors of Federal Reserve System httpwwwfederalreservegov Japan Bank of Japan httpwwwbojorjo Financial Reconstruction Commissionhttpwwwfsagojpfrcindexehtml Financial Services Agency httpwwwfsagojp Canada Bank of Canada httpwwwbank-banque-canadaca Office ofthe Superintendent of Financial Institutions httpwwwosfi-bsifgccaAndreEindexhtml Germany Deutsche Bundesbank httpwwwbundesbankde Fed-eral Banking Supervisory Office httpwwwbakredde Italy Banca drsquoitalia httpwwwbancaditaliait Commissione Nazionale per le Societa e la Borsahttpwwwconsobit Instituto per la Vigilanza sulle assicurazioni private e di Interesse colletivo httpwwwisvapit The Netherlands De NederlandscheBank httpwwwdnbnl France Banque de France httpwwwbanque-francefr Switzerland Schweizerische Nationalbank httpwwwsnbchindex3htmlSweden Sveriges Riksbank httpwwwriksbanksedefaultasp Belgium National Bank of Belgium httpwwwbnbbesgindexhtm Spain Banco de Espantildeahttpwwwbdees The Comision Nacional del Mercado de Valores httpwwwcnmves Supranational (EU) Institutional Arrangements for the Regulationand Supervision of the Financial Sector 2000 International Dimension Bank for International Settlement httpwwwbisorg International Organization ofSecurities Commissions httpwwwioscoorg International Association of Insurance Supervisors httpwwwiaisorg Financial Stability Forum httpwwwfsforumorg
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 121
the inflexibility of tight surveillance against the need to encourage in-novation and growth The US Securities and Exchange Commission isworried about aggressive accounting by firms and biased reports bysecurities analysts in an equity environment that prizes steadily higherquarterly earnings41 Japanese regulators are preoccupied with opaqueinterconnections between portfolio institutions banks and nonfinancialfirms through the keiretsu system Canadian regulators reeling from high-profile scandals of managers intentionally misleading investors are strengtheningmarket discipline through legal penalties aimed at managers and directorsof offending firms
When panic strikes a securities regulator cannot do much As the 1987stock market crash and the LTCM debacle in the fall of 1998 both dem-onstrated steep stock and bond price declines can create systemic risksIf severe enough the wealth effect of falling securities values and thefear of widespread insolvency can depress real activity Flooding thesystem with liquidity is a central bankerrsquos solutionmdashsomething a securi-ties regulator cannot do42 But just as financial supervisors can changethe incentive structure to discourage bankers from making risky loans ingood times so securities regulators can pay more attention to incentiveson the demand side when capital markets are strong
Prudential Supervision and InnovationmdashA Footnote
In concluding this discussion of prudential supervision in the G-10 anadditional point is worth noting National regulators face a persistenttrade-off between emphasizing financial system safety and soundnesswhile encouraging innovationmdashin spite of the added risks innovationbrings to financial markets Former US Treasury Secretary Lawrence Summers(2000 3) has argued by analogy
The jet airplane made airplane air travel more comfortable more efficient andmore safe though the accidents were more spectacular and for a time morenumerous after the jet was invented In the same way modern global financialmarkets carry with them enormous potential for benefit even if some of theaccidents are that much more spectacular As the right public policy response
41 The problem is illustrated by the divergence since mid-1998 between reported earn-ings by the Standard amp Poorrsquos (SampP) 500 and the after-tax profits of all corporations inthe national accounts Generally these two series move closely with one another Be-tween mid-1998 and mid-1999 SampP 500 reported that earnings increased by more than20 percent while after-tax profits of all corporations increased by less than 5 percent(Chase Bank US Economic and Policy Research US Weekly Prospects Chase SecuritiesWeekly Newsletter 5 June 2000 5)
42 For example the US Securities and Exchange Commission had no direct role in calmingmarkets in the 1987 or 1998 panics
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122 WORLD CAPITAL MARKETS
to the jet was longer runways better air-traffic control and better training forpilots and not the discouragement of rapid travel so the right public policyresponse to financial innovation is to assure a safe framework so that the ben-efits can be realized not to stifle the change
Accepting Summersrsquos analogy for the international financial system better-informed supervisors and investors are a necessary part of the financialsystem framework Supervisors require more timely information on therisk profiles resulting from positions taken by financial institutions Theyalso need a better understanding of risk-management systems Snapshotsof an institutionrsquos risk profile and risk-management procedures are nolonger adequate In a world where huge bets are quickly made (andpossibly lostmdashas with Barings Bank in 1995 and LTCM in 1998) super-visors must focus on the soundness of banking systems for evaluatingand managing risk on a daily basis Some progress has been made inaddressing these issues US banking examiners are extending their in-formation requirements in banking examinations and increasing theirinvolvement in large complex institutions43 More awareness is alsorequired of the fact that they are national organizations in a world ofcross-border capital flows To a much greater extent they need a multi-national reach International supervision and coordination among super-visors are the subject of the next section
Our analysis suggests that G-10 supervisors have unfinished businessBank supervisors need to start yesterday securities regulators can waituntil tomorrow One G-10 member acting alone cannot correct the biasIn good times the lending business will simply migrate to other G-10banks In bad times financial problems will not stop at the national bor-der A way has to be found to establish common international standardsfor the key financial players in order to prevent crises and to agree onapproaches for managing them The path has already been laid out Inthe wake of the bank failures of the past 25 years bank supervisors havetried to establish such standards They have done this without creating anew global institution
The essence of the international framework is decentralizationmdashglobalrules and design standards without global institutions that are perceivedto intrude on national sovereignty The awkward jargon for this frame-work is vertical subsidiaritymdashldquothink internationally act nationallyrdquo Theinternational thinking is done by a committee of regulators that meets
International SupervisionA Decentralized Framework
43 These issues are discussed in Ferguson (1999) and Meyer (2000a)
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 123
regularly at the Bank for International Settlements in Basel The commit-tee establishes principles and standards that are interpreted implementedand enforced by national authorities44 In this section we describe thesesupervisory efforts and their weaknesses We present our recommenda-tions for addressing these weaknesses in the next chapter
Basel I
The Basel Capital Accord of 1988 (Basel I)45 drew the lesson from thefinancial crises of the mid-1970s that more adequate capital levels in in-ternational banks would help reduce the systemic risk of bank failureThe primary goal of Basel I was capital adequacy other standards wereput in place not so much for their own virtue as to defend the primarygoal
Capital adequacy requirements were designed to ensure that individualinstitutions have the ability to absorb losses particularly credit lossesAccordingly a backup system of scoring credit risk was devised thatrequired large amounts of bank capital for some types of loans smalleramounts for others and zero for a select list of preferred assets Report-ing requirements were designed to disclose problems and ensure that atroubled bank would take timely steps to restore its capital base in thewake of a loss The Basel I framework worked tolerably well in limitingthe call on the public purse in the G-10 countriesmdashwith the notable ex-ceptions of France and Japan The framework failed to moderate riskybank lending to emerging markets however
Basel I was not developed with emerging markets in mind The origi-nal idea behind it was to develop a common supervisory approach tocross-border banking operations It grew out of political pressure fromUS lawmakers who were determined to require international banks op-erating in the United States to meet US banking standards Toward thisgoal in 1983 Congress passed the International Lending Supervisory ActUS and British banking authorities subsequently agreed on a commontarget the adoption of strict common capital-adequacy standards In 1988other G-10 governments agreed to go along voluntary acceptance ofthe standards throughout much of the rest of the world followed46 Therationale for the capital targets was two-fold The first was to requirebanks to hold sufficient amounts of capital (8 percent of risk-adjusted
44 The international committee of financial authorities agreed on a common definitionof banksrsquo tier-one or ldquocorerdquo capital national authorities defined tier-two capital in theirown manner which permitted greater variations in national working definitions andpractices
45 International Convergence of Capital Measurement and Capital Standards (BIS 1988)was prepared by the Basel Committee on Banking Supervision
46 See Reineke (1998)
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124 WORLD CAPITAL MARKETS
assets) to cushion losses on those assets The second was to dull theirappetites for risk banks with large capital bases would have more tolose if they failed and therefore would take fewer risks
Rapid change in financial markets soon revealed flaws in the Basel IAccord In a complex world with numerous sources of risk it focusedheavily on credit risk but overlooked other risks in a bankrsquos portfolioand the correlation between returns on different asset classes The Baselformula required banks to maintain a fixed amount of capital againsteach of its asset classes But the formula did not distinguish the riskinessof the borrower within each class As a result one large loan to a low-risk corporate borrower such as General Electric would require the sameamount of capital as 10 smaller transactions with high-risk borrowers
The system was also biased toward short-term loans Loans maturingin less than a year required a 20 percent risk weight whereas those ma-turing after more than a year required a 100 percent risk weight Inter-bank lending was particularly favored For example loans to banks inOECD countries required less capital than loans to private firms in thesame countries creating the anomaly that interbank loans to South Ko-rean banks required less capital than loans to General Electric47 Thisanomaly encouraged banks to shed high-quality assets if the Basel rulesrequired the allocation of more capital than banks thought they needed
Another weakness was that financial innovators quickly circumventedthe Accord Because short-term loans required less provisioning than long-term loans banks responded by securitizing their long-term debt port-folios and lending short-term against the collateral of the newly createdasset This allowed banks to circumvent the capital requirements gearedto the terms of the underlying debt At the same time the Basel I Accordfailed to encourage risk mitigation techniques such as credit derivativescollateral guarantees and on-balance-sheet netting the flip side of fi-nancial innovation Because off-balance-sheet products were not coveredby the Accord another anomaly appeared when Barings Bank collapsedin 1995 Barings met capital adequacy standards but collapsed becauseits systems for managing risk failed traders were allowed to speculatein futures contracts that did not appear on the balance sheet
Basel II
Work to overhaul Basel I began in 1995 and produced consultativepapers issued in June 1999 and January 200148 These papers have been
47 South Korean banks have had notoriously weak balance sheets because the practiceof ldquodirected lendingrdquo left them with many poor loans (in making these loans the bankswere expected to follow government objectives rather than creditworthiness criteria)
48 Basel Committee on Banking Supervision (1999 2001)
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 125
the subject of extensive consultation and revision as a result the newAccord is expected to be introduced in 200449 The Basel II frameworkhas three parts (pillars) revisions to Basel I minimum-capital require-ments supervisory review criteria and greater emphasis on market dis-cipline Broadly Basel II aims to maintain the level of capital in the sys-tem but achieve better alignment of banksrsquo capital with their risk pro-files and keep up with financial innovation
To align capital requirements with market realities (the first pillar)Basel II concentrates on the 100 or so largest banksmdashthe type of playerslisted in table 21mdashand on the holding-company parents of banking groups50
Capital requirements will differentiate between an increased number ofcredit groups or ldquorisk bucketsrdquo including claims on governments otherbanks corporations mortgage-backed securities and other asset-backedsecurities
Basel II originally proposed to use external ratings to set capital chargesfor a number of these credit risks Many banks objected arguing thatthey assess credit risk better than Standard amp Poorrsquos Moodyrsquos or FitchIBCA51 Basel II thus proposes two approaches to rating a standard ap-proach using external ratings and an ldquoadvancedrdquo approach that allowsselected banks to use their own internal rating systems To encouragethe development of rigorous internal control systems based on these in-ternal rating systems Basel II also proposes to levy capital charges foroperational risk (the risk of direct or indirect loss resulting from inad-equate or failed internal processes people and systems or from exter-nal events)
Some critics of this proposal dismiss it as an abrogation of the prin-ciple of external independent monitoring and as ldquodangerously naiumlverdquo52
But regulators argue that the new capital charge on operational risk shouldoffset this concern It is also far from clear how cross-national compari-sons of rating and internal risk-assessment systems will be made (Engelen2000) The development by the European Union of its own capital rulescould well complicate the international resolution of these issues Publicassurances by EU officials in January 2001 however indicated that theirmain concerns are to create a level playing field and avoid regulatoryarbitrage (Hargreaves 2001) There is also the significant problem ofthe procyclical character of risk weights When a crisis hits losses are
49 See Berry (2000) for an update in an interview with William J McDonough chair ofthe Basel Committee on Banking Supervision
50 For obvious reasons these proposals are addressed to large banks and simpler capi-tal standards are allowed for small banks that focus on their domestic credit markets
51 See Ammer and Packer (2000) for an empirical critique of the success of rating agen-cies in distinguishing risk by sector and region
52 See Auerback (2001)
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126 WORLD CAPITAL MARKETS
incurred or accrued capital is lost and loan exposure must be reducedor securities sold to restore the requisite capital-adequacy ratios A morerisk-sensitive framework could amplify volatility
As the second pillar of Basel II supervisory review criteria are beingbeefed up to encourage supervisors to intervene earlier in potential problemsituations and to compel banks to align their capital positions with theirrisk profiles Bank supervisors will be authorized to require banks tohold capital in excess of minimum requirements if they have concernsabout general management overall strategy risk-management performanceor the macroeconomic environment Of course if one G-10 supervisorimposes higher capital requirements in isolation the same disparity willemerge that presaged Basel I Some banks will be disadvantaged in theinternational marketplace and will loudly complain that excessive super-vision is driving business to their competitors Hence close internationalcooperation among supervisors is critical
To implement the third pillar market discipline banks will be requiredto make fuller more timely disclosure of capital adequacy and the risksto which that capital is exposed A number of measures are being stud-ied that might help supervisors evaluate bank performance such as com-parisons of uninsured deposit interest rates subordinated debt yieldsand equity prices The idea is that these yields and prices might alertsupervisors to market perceptions of risk Of course market perceptionsare only as good as market information More direct and controversialways to reinforce market discipline would dramatically increase publicdisclosure of bank positions and risk management systems
Many questions are still outstanding about how to resolve the techni-cal details of capital requirements and whether the requirements willachieve their intended goal of better assessment and mitigation of therisks in banksrsquo portfolios There is no substitute for skilled supervisorsThe intricacies of effective design and implementation suggest that su-pervisors need to be highly competent technically knowledgeable aboutbanking portfolio characteristics and the factors that influence bank ex-posure to credit risk (Mishkin 2000) And they must be aided by vigilantshareholders market forces and transparency of information53
Standard setting at the global level is desirable but ultimately theeffectiveness of these efforts will be tested at the national level espe-cially in times of systemic financial distress Here the record of Basel Iwas not a bright shining success Japanese banking regulators havetraditionally allowed banks to include real estate and securities in theircapital base When the value of these assets plummeted in the early 1990sregulators allowed banks to continue valuing these depreciated (andoften bankrupt) assets at their old inflated levels Japanese authorities
53 Benedict Roth Complacency Towards Catastrophe Financial Times 23 January 2001
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 127
insisted until the mid-1990s that eroded capital bases could be rebuiltin a market-driven fashion They rightly foresaw that huge loan losseswould undermine public support for the ruling party and require a po-litically unpopular bailout
Japanese foot dragging on Basel I was the worst54 but not uniqueOther examples can be found of ldquopolitically mandated forbearancerdquo TheFederal Reserve Bank of New York held important hands during theLTCM crisis of 1998 Mexico is still resolving the banking crisis that eruptedin 1995 South Korea has not yet closed the insolvent banks that behavedso badly before the crisis of 1998 In the aftermath of a crisis nationalregulators cannot always be relied upon to discipline politically power-ful bankers55 One of the little-noticed consequences of these differingapproaches is that those banks with strong regulatory systems receivedan implicit ldquoexport subsidyrdquo for their services US banks which had notengaged extensively in emerging-market lending in the 1990s were bet-ter positioned than their German and Japanese counterparts to expandtheir international assets in the wake of the crises
Other Financial Forums
54 See Japanese Banks Fiddling while Marunouchi Burns The Economist 27 January2001 67-69
55 See Calomiris (1997)
The Basel model of vertical subsidiarity has already been extended toother financial regulatory bodies In 1993-94 the BIS established a Tri-partite Group of Banking Insurance and Securities Regulators In 1994-95 the BIS increased its cooperation with the International Organizationof Securities Commissions when the two organizations issued parallelpapers on guidelines for national regulators concerning risk managementand disclosure of derivative trades In 1996 a permanent Joint Forum onFinancial Conglomerates was established to examine supervisory issuesand develop working arrangements among the different functional super-visors of conglomerate institutions that offer combinations of bankingsecurities and insurance products Draft papers on the supervisionof conglomerates were released for comment in 1998 applying capital-adequacy principles to these groups and providing guidelines both forassessing the integrity and competence of top managers and for sharingassessments between regulators
In 1997 the Basel Committee on Banking Supervision extended itsreach beyond capital standards to broader aspects of banking supervi-sion with the publication of the Core Principles for Effective BankingSupervision In 1999 a wide range of regulatory and standard-settingbodies were gathered under the umbrella of the Financial Stability
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128 WORLD CAPITAL MARKETS
Forum (FSF) itself established under BIS aegis56 The FSF has alreadyissued recommendations for stepped-up supervision and transparencyas well as guidelines for best practices in a number of areas includingoffshore financial centers and highly leveraged institutions or hedge funds57
Conclusion
Although the structural weaknesses in emerging-market economies arewidely acknowledged to have been causal factors in international capi-tal-market volatility this chapter points to the role of large G-10 bankingorganizations as major suppliers of the most volatile instrument short-term debt We have examined evidence of the impact of public safetynets in the G-10 economiesmdashthe deposit insurance systems the pruden-tial supervisory systems and the lender-of-last-resort functions of centralbanksmdashon the incentive structures of these organizations
Although supervisors in most countries working nationally and to-gether in the BIS have made significant efforts to mimic market forcesin their prudential supervision the most sophisticated financial institu-tions find innovative ways to circumvent the rules New global regulatorybodies are not about to be created G-10 national bank regulators shouldthemselves address the short-term debt bias in the international financialsystem by changing incentive systems G-10 securities regulators shouldalso take steps to get ahead of the curve paying close attention to largeportfolio swings by institutional investors particularly in times of crisisIn short more needs to be done at national and international levels tochange the rules of the game That is the subject of the next chapter
56 The Financial Stability Forum includes banking securities insurance and accountingregulatory bodies the OECD on taxation corruption and corporate governance and theIMF
57 See Martin (2000)
Institute for International Economics | httpwwwiiecom
88 WORLD CAPITAL MARKETS
The positive role of hedge fundsmdashproviding diversification to inves-tors because their returns have low correlations with standard asset classesmdashis counterbalanced by some negative features Hedge funds and otherhighly leveraged institutions (HLIs) may take concentrated positions andengage in aggressive market practices that amount to ldquoganging uprdquo on asmall economy (such as Hong Kong)6 Under normal market conditionsHLI positions are not destabilizing but some of the aggressive practicesdocumented in 1998 are worrisome The FSF study group participantsagreed (2000b 112) that such practices raise important issues for marketintegrity but they could not agree that market manipulation was suffi-ciently widespread to be a serious concern for policymakers
Insurance companies are the third group of portfolio institutions Theseare divided into two categories property and casualty companies andlife and health insurance companies Ten large companies of each cat-egory are listed in table 26 In 1998 the 10 property and casualty insur-ance companies had $16 trillion in assets and more than $330 billion inmarket capitalization The 10 life insurance companies had $28 trillionin assets7 Combining both categories 100 percent of assets are controlledby insurance companies based in the G-10 and Spain In portfolio man-agement styles life insurance companies tend to hold longer-term assetswhereas property and casualty companies tend to hold shorter-term in-struments
Nonfinancial Multinational Enterprises
The last players are the nonfinancial multinational enterprises (MNEs)The worldrsquos 100 largest corporations measured by 1998 revenue are re-corded in tables 27 and 28 The 30 financial giants among the top 100are separately shown in table 27 Most of the firms appeared in previ-ous tables Together these 30 financial giants had revenues of $13 tril-lion and controlled assets of $113 trillion8
Table 28 lists the 70 top nonfinancial giants Their revenues in 1998were $40 trillion and their assets (at book value) measured $45 trillionMeasured by revenue or assets about 95 percent of the giants are basedin the G-10 These firms are responsible for a large share of the worldrsquos
6 See IMF (1999c) for a description of the ldquodouble playrdquo that hedge funds are accusedof using in an attempt to destabilize Hong Kong in August 1998
7 Many life insurance companies are owned by their policyholders and therefore donot have a market capitalization
8 By comparison the larger set of 96 financial firms listed in previous tables controlled$322 trillion in assets This is the total amount of assets recorded in tables 21 (50 com-mercial banks) 22 (9 investment banks) 24 (10 asset managers) and 26 (20 insurancecompanies) The largest hedge funds might add $300 billion to the total
Institute for International Economics | httpwwwiiecom
THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 89
Table 26 20 large insurance companies in 1998(billions of dollars)
Property and casualty insurance Marketcompanies Revenuea Assetsb capitalizationc
Allianz (Germany) 65 402 62d
Assicurazioni Generali (Italy) 48 178 30d
State Farm Insurance Cos (United States) 45 111 naZurich Financial Services (Switzerland) 39 215 45d
CGU (United Kingdom) 38 176 20d
Munich Re Group (Germany) 35 131 naAmerican International Group (United States) 33 194 135d
Allstate (United States) 26 88 20d
Royal amp Sun Alliance (United Kingdom) 25 76 11d
Loews (United States) 21 71 7e
Total 375 1642 330 plusTotal for G-10 375 1642 330 plus
MarketLife and health insurance Revenuea Assetsb capitalizationc
AXA (France) 79 452 39d
Nippon Life Insurance (Japan) 66 363 naING Group (Netherlands) 56 464 46d
Dai-ichi Mutual Life Insurance (Japan) 44 253 naSumitomo Life Insurance (Japan) 40 206 naTIAA-CREF (United States) 36 250 naPrudential Ins Co of America (United States) 34 279 naPrudential (United Kingdom) 34 197 30d
Meiji Life Insurance (Japan) 28 146 naMetropolitan Life Insurance (United States) 27 215 na
Total 444 2825 naTotal for G-10 444 2825 na
na = not available (usually an insurance company owned by its policyholders)G-10 = Group of Ten countries see note to table 11
a Data shown are for the fiscal year ended on or before 31 March 1999b Assets shown are those at the companyrsquos fiscal year-endc Market capitalization is calculated by multiplying the total number of shares by the shareprice at the companyrsquos fiscal year-endd Market capitalization data as of September 1999 from American Banker httpwwwamericanbankercome Individual companyrsquos market capitalization as of September 1999 from Yahoo yahoomarketguidecom
Sources Fortune Global 500 1999 httpwwwpathfindercomfortuneglobal500indexhtmlAmerican Banker httpwwwamericanbankercomRankingBanks1999 Yahoo Marketguideyahoomarketguidecom
Institute for International Economics | httpwwwiiecom
90 WORLD CAPITAL MARKETS
Table 27 Financial firms in the 100 largest companiesby revenue 1998 (billions of dollars)
Globalrank Company Revenuesa Assetsb Type
Continental Europe
15 AXA (France) 79 452 Insurance23 Allianz (Germany) 65 402 Insurance28 Ing Group (Netherlands) 56 464 Insurance37 Credit Suisse (Switzerland) 49 475 Banks commercial
and savings39 Assicurazioni Generali (Italy) 48 178 Insurance42 Deutsche Bank (Germany) 45 736 Banks commercial
and savings56 Zurich Financial Services (Switerland) 39 215 Insurance68 Munich Re Group (Germany) 35 131 Insurance72 ABN AMRO Holding (Netherlands) 34 507 Banks commercial
and savings77 Credit Agricole (France) 33 459 Banks commercial
and savings80 HypoVereinsbank (Germany) 32 541 Banks commercial
and savings84 Fortis (Belgium) 31 397 Banks commercial
and savings98 Socieacuteteacute Geacuteneacuterale (France) 30 450 Banks commercial
and savingsUnited Kingdom
47 HSBC Holdings 43 485 Banks commercialand savings
58 CGU 38 176 Insurance74 Prudential 34 197 Insurance
United States
16 Citigroup 76 669 Diversified financials35 Bank of America Corp 51 618 Banks commercial
and savings44 State Farm Insurance Cos 45 111 Insurance64 TIAA-CREF 36 250 Insurance67 Merrill Lynch 36 300 Securities71 Prudential Ins Co of America 34 279 Insurance76 American International Group 33 194 Insurance79 Chase Manhattan Corp 32 366 Banks commercial
and savings83 Fannie Mae 31 485 Diversified financials88 Morgan Stanley Dean Witter 31 318 Securities
Japan
21 Nippon Life Insurance 66 363 Insurance45 Dai-ichi Mutual Life Insurance 44 253 Insurance54 Sumitomo Life Insurance 40 206 Insurance91 Bank of Tokyo-Mitsubishi 31 664 Banks commercial
and savingsTotal 1279 11341Total for G-10 1279 11341
G-10 = Group of Ten countries see note to table 11
a Data shown are for the fiscal year ended on or before 31 March 1999b Assets shown are those at the companyrsquos fiscal year-end
Source Fortune Global 500 1999 httpwwwpathfindercomfortuneglobal500indexhtml
Institute for International Economics | httpwwwiiecom
THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 91
Tab
le 2
8N
on
fin
anci
al f
irm
s in
th
e 10
0 la
rges
t co
mp
anie
s b
y re
ven
ue
199
8 (b
illio
ns o
f do
llars
)
Glo
bal
Tra
nsn
atio
nal
ity
ran
k
Co
mp
any
Rev
enu
esa
Ass
etsb
ind
exc
Typ
e
Co
nti
nen
tal
Eu
rop
e
2D
aim
lerC
hrys
ler
(Ger
man
y)15
516
044
1M
otor
veh
icle
s an
d pa
rts
11R
oyal
Dut
chS
hell
Gro
up (
Net
herla
nds)
9411
058
9P
etro
leum
ref
inin
g17
Vol
ksw
agon
(G
erm
any)
7670
568
Mot
or v
ehic
les
and
part
s22
Sie
men
s (G
erm
any)
6667
521
Ele
ctro
nics
el
ectr
ical
equ
ipm
ent
32M
etro
(G
erm
any)
5222
n
a
Foo
d an
d dr
ug s
tore
s34
Fia
t (I
taly
)51
7640
8M
otor
veh
icle
s an
d pa
rts
36N
estle
(S
witz
erla
nd)
5041
932
Foo
d46
Veb
a G
roup
(G
erm
any)
4351
275
Tra
ding
49R
enau
lt (F
ranc
e)41
4545
7M
otor
veh
icle
s an
d pa
rts
53D
euts
che
Tel
ekom
(G
erm
any)
4093
n
a
Tel
ecom
mun
icat
ions
57R
oyal
Phi
lips
Ele
ctro
nics
(N
ethe
rland
s)38
3386
4E
lect
roni
cs
elec
tric
al e
quip
men
t59
Peu
geot
(F
ranc
e)38
4038
7M
otor
veh
icle
s an
d pa
rts
62E
lect
riciteacute
de
Fra
nce
(Fra
nce)
3711
3
na
Util
ities
ga
s an
d el
ectr
ic63
Rw
e G
roup
(G
erm
any)
3747
n
a
Util
ities
ga
s an
d el
ectr
ic65
BM
W (
Ger
man
y)36
3660
7M
otor
veh
icle
s an
d pa
rts
66E
lf A
quita
ine
(Fra
nce)
3643
576
Pet
role
um r
efin
ing
69V
iven
di (
Fra
nce)
3558
n
a
Eng
inee
ring
and
cons
truc
tion
70S
uez
Lyon
nais
e de
s E
aux
(Fra
nce)
3585
n
a
Ene
rgy
78E
NI
(Ita
ly)
3249
317
Pet
role
um r
efin
ing
86B
ayer
(G
erm
any)
3134
827
Che
mic
als
92A
BB
Ase
a B
row
n B
over
i (S
witz
erla
nd)
3132
957
Ele
ctro
nics
el
ectr
ical
equ
ipm
ent
93B
AS
F (
Ger
man
y)31
3159
5C
hem
ical
s95
Car
refo
ur (
Fra
nce)
3020
n
a
Foo
d an
d dr
ug s
tore
s
(tab
le c
ontin
ues
next
pag
e)
Institute for International Economics | httpwwwiiecom
92 WORLD CAPITAL MARKETS
Tab
le 2
8N
on
fin
anci
al f
irm
s in
th
e 10
0 la
rges
t co
mp
anie
s b
y re
ven
ue
199
8 (b
illio
ns o
f do
llars
) (c
ontin
ued
)
Glo
bal
Tra
nsn
atio
nal
ity
ran
k
Co
mp
any
Rev
enu
esa
Ass
etsb
ind
exc
Typ
e
Un
ited
Kin
gd
om
19B
P A
moc
o68
8559
2P
etro
leum
ref
inin
g43
Uni
leve
r45
3692
4F
ood
Un
ited
Sta
tes
1G
ener
al M
otor
s16
125
729
3M
otor
veh
icle
s an
d pa
rts
3F
ord
Mot
or14
423
835
2M
otor
veh
icle
s an
d pa
rts
4W
al-M
art
Sto
res
139
49
na
G
ener
al m
erch
andi
sers
8E
xxon
101
9365
9P
etro
leum
ref
inin
g9
Gen
eral
Ele
ctric
100
356
331
Ele
ctro
nics
el
ectr
ical
equ
ipm
ent
14In
tl B
usin
ess
Mac
hine
s82
8653
7C
ompu
ters
of
fice
equi
pmen
t25
US
Pos
tal
Ser
vice
6055
n
a
Mai
l pa
ckag
e a
nd f
reig
ht d
eliv
ery
27P
hilip
Mor
ris58
6051
1T
obac
co29
Boe
ing
5637
n
a
Aer
ospa
ce30
AT
ampT
5460
219
Tel
ecom
mun
icat
ions
40M
obil
4843
597
Pet
role
um r
efin
ing
41H
ewle
tt-P
acka
rd47
3451
1C
ompu
ters
of
fice
equi
pmen
t50
Sea
rs R
oebu
ck41
38
na
G
ener
al m
erch
andi
sers
55E
I d
u P
ont
de N
emou
rs39
40
na
C
hem
ical
s61
Pro
ctor
and
Gam
ble
3731
477
Soa
ps
cosm
etic
s75
Km
art
3414
n
a
Gen
eral
mer
chan
dise
rs81
Tex
aco
3229
453
Pet
role
um r
efin
ing
82B
ell
Atla
ntic
3255
n
a
Tel
ecom
mun
icat
ions
85E
nron
3129
n
a
Ene
rgy
87C
ompa
q C
ompu
ter
3123
n
a
Com
pute
rs
offic
e eq
uipm
ent
89D
ayto
n H
udso
n31
16
na
G
ener
al m
erch
andi
sers
94J
C
Pen
ney
3124
n
a
Gen
eral
mer
chan
dise
rs96
Hom
e D
epot
3013
n
a
Spe
cial
ty r
etai
lers
97Lu
cent
Tec
hnol
ogie
s30
27
na
E
lect
roni
cs
elec
tric
al e
quip
men
t10
0M
otor
ola
2929
n
a
Ele
ctro
nics
el
ectr
ical
equ
ipm
ent
Institute for International Economics | httpwwwiiecom
THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 93
Jap
an
5M
itsui
109
5635
8T
radi
ng6
Itoch
u10
957
333
Tra
ding
7M
itsub
ishi
107
7536
9T
radi
ng10
Toy
ota
Mot
or10
012
540
0M
otor
veh
icle
s an
d pa
rts
12M
arub
eni
9455
300
Tra
ding
13S
umito
mo
8946
259
Tra
ding
18N
ippo
n T
eleg
raph
amp T
elep
hone
7614
7
na
Tel
ecom
mun
icat
ions
20N
issh
o Iw
ai68
3938
8T
radi
ng24
Hita
chi
6282
214
Ele
ctro
nics
el
ectr
ical
equ
ipm
ent
26M
atsu
shita
Ele
ctric
Ind
ustr
ial
6067
332
Ele
ctro
nics
el
ectr
ical
equ
ipm
ent
31S
ony
5353
628
Ele
ctro
nics
el
ectr
ical
equ
ipm
ent
33N
issa
n M
otor
5158
511
Mot
or v
ehic
les
and
part
s38
Hon
da M
otor
4943
641
Mot
or v
ehic
les
and
part
s48
Tos
hiba
4151
252
Ele
ctro
nics
el
ectr
ical
equ
ipm
ent
51F
ujits
u41
4332
6C
ompu
ters
of
fice
equi
pmen
t52
Tok
yo E
lect
ric P
ower
4012
2
na
Util
ities
ga
s an
d el
ectr
ic60
NE
C37
42
na
E
lect
roni
cs
elec
tric
al e
quip
men
t90
Tom
en31
18
na
T
radi
ng99
Mits
ubis
hi E
lect
ric30
35
na
E
lect
roni
cs
elec
tric
al e
quip
men
t
Ch
ina
73S
inop
ec34
52
na
P
etro
leum
ref
inin
g
Tot
al (
aver
age
for
tran
snat
iona
lity
inde
x)3
988
447
949
0T
otal
for
G-1
0 (a
vera
ge f
or t
he i
ndex
)3
954
442
749
0
na
= n
ot a
vaila
ble
G-1
0 =
Gro
up o
f T
en c
ount
ries
see
not
e to
tab
le 1
1
a
Dat
a sh
own
are
for
the
fisca
l ye
ar e
nded
on
or b
efor
e 31
Mar
ch 1
999
b
Ass
ets
show
n ar
e th
ose
at t
he c
ompa
nyrsquos
fis
cal
year
-end
c
The
ind
ex o
f tr
ansn
atio
nalit
y is
cal
cula
ted
as t
he a
vera
ge o
f ra
tios
of f
orei
gn a
sset
s to
tot
al a
sset
s f
orei
gn s
ales
to
tota
l sa
les
and
for
eign
em
ploy
men
tto
tot
al e
mpl
oym
ent
as o
f 19
97 (
UN
CT
AD
)
Sou
rces
F
ortu
ne G
loba
l 50
0 1
999
http
w
ww
pat
hfin
der
com
fort
une
glob
al50
0in
dex
htm
l U
NC
TA
D (
1999
)
Institute for International Economics | httpwwwiiecom
94 WORLD CAPITAL MARKETS
foreign direct investment The ldquotransnationality indexrdquo (table 28) showsthat on average they conducted about half their business outside theirhome country9
Overview of the Players
Our review of the major players points to two major features First ahandful of big playersmdashfewer than 200 firms all toldmdashcontrol the ac-tion in international capital markets Their dominance will doubtless erodebut for now financial power is strikingly concentrated with them Sec-ond the big players are overwhelmingly based in the G-10 countriesplus Spain The responsibility to supervise them rests not in the IMFnor in Basel but squarely in Washington London Tokyo and the otherG-10 capitals At year-end 1999 the G-10 countries plus Spain accountedfor 84 percent of world banking assets 86 percent of world stock marketcapitalization and 76 percent of international debt securities (BIS 2000aWorld Bank 2000b)
International private capital flows are of three types bank loans anddeposits portfolio investment and foreign direct investment In cumula-tive total flows to emerging markets FDI was the biggest story in the1990s amounting to $954 billion (table 12) Portfolio flows were nextcumulatively amounting to somewhere between $612 billion (table 12)and $764 billion (table A1) Bank loans and deposits are the most com-plicated story
The Key Role of Banks
Banks are more important as an epicenter than as a wellspring Banksgenerate waves in the flow of capital to emerging markets rather than acontinuous steady stream According to data compiled by the Institute ofInternational Finance (table A1) net bank lending to emerging marketscumulated to $269 billion in the 1990s However deposits by emerging-market residents in G-10 banks more than offset G-10 bank lending tothese countries during the decade According to IMF data cumulativebank loans net of deposits amounted to a negative $135 billion (table 12)
In other words when loans and deposits are combined net bank ac-tivity that moves financial resources to emerging markets is small incomparison with portfolio investment and FDI But bank loans are thelubricant of any financial system Depending on circumstances bankscan be shock absorbers or shock propagators In recent decades with
9 The transnationality index is calculated as a simple average of the share of assetssales and employees outside the home country
Institute for International Economics | httpwwwiiecom
THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 95
respect to emerging markets banks have more often been propagatorsthan absorbers The average annual swing in bank lending to emergingmarkets was nearly $50 billionmdashby far the largest source of year-to-yearfluctuations in capital flows Both interbank loans between Europe Japanand Asia and sovereign Russian debt used as loan collateral played amajor role in the 1997-98 crisesmdashnot because banks are profligate playersbut because of the incentives they face and the instruments they useAccordingly our story begins with banks
Banks in the Modern Financial System
10 See Levine (2000) for a concise description of the role of banks in the financial system
11 The asymmetric information problem helps to explain why banks dominate the im-mature financial systems of emerging-market economies The general lack of informationon borrowers and undeveloped legal systems to enforce contracts hamper suppliers oflong-term financial instruments such as equities and bonds in evaluating risk and re-ward Banks are best suited in these circumstances to solve the asymmetric informationproblem by evaluating and monitoring private loans As more and better informationbecomes available capital markets develop and financial systems mature
As we noted in the previous paragraph the problem of financial volatil-ity in emerging-market economies is associated with bank lending Ifand when repayment problems arise cross-border private bank loansand bond placements are such that private creditors have no plausiblemeans of seizing assets from either private or sovereign borrowers Thusalthough international finance can nourish entrepreneurs and accelerategrowth a necessary complement may be a drastic creditor response inthe event of nonpaymentmdashto withhold fresh funds and force an eco-nomic crisis (Dooley 2000)
This argument is based on the characteristics of banks They are notldquobadrdquo per se They perform three essential functions in any financialsystem pooling the resources of disparate savers and channeling these re-sources into productive investment improving resource allocation throughtheir expertise in assessing and monitoring borrowers and facilitatingthe division of risk among numerous creditors10 But by their very na-ture banks are prone to two problems asymmetric information (the bor-rower knows more about the potential risk and return of its projectsthan the bank) and adverse selection (riskier borrowers will pay higherinterest rates and thus may constitute a disproportionate share of bankloan portfolios)11
Bank loans are illiquid fixed-price instruments They cannot easily beconverted to cash although they can be bundled into securities (knownas ldquosecuritizationrdquo) Once loan terms have been agreed on the only waya bank can adjust for shifting market conditions is by changing the quantityof its exposure When a borrower runs into trouble the bank can mix
Institute for International Economics | httpwwwiiecom
96 WORLD CAPITAL MARKETS
and match from two unpleasant menus It can roll over existing loansand extend new credit or it can call some part of existing loans andattempt to recover the principal It can also hedge by selling short otherclaims on the borrower These choices entail either an unwelcome exten-sion of the bankrsquos exposure or credit rationing against the borrower Whentrouble brews all banks encounter the same conditions in the aggregatethey prefer less exposure and ensuing credit restrictions lead to volatilebank lending
Innovation
12 Derivatives have no value of their own They ldquoderiverdquo their value from the value ofthe underlying asset They include swaps futures (contracts for future delivery at speci-fied prices) and options (which give one party the right but not the obligation to buyfrom or sell to a counterparty at an agreed price)
13 Maxfield (1998) analyzed available evidence of emerging-market investor objectivesmost of it before the crisis Analysis of portfolio equity flows is sensitive to the choice ofperiod with year-over-year data indicating that investors respond to country ldquofundamen-talsrdquo Other evidence suggests more ambiguity Ranking by ldquoinvestor impatiencerdquo ie thesearch for yield over value Tesar and Werner (1995) find short-term bank flows to be themost yield driven followed by portfolio investment FDI and long-term bank lending
14 Because market risk credit risk and country risk interact in complex ways newfinancial instruments have been created to help reduce negative interactions One is theldquototal return swaprdquo which has become an instrument of choice for hedge funds lookingfor high leverage Banks also use the total return swap to cover risks without increasingtheir capital requirements
Since the 1980s national and international banking systems have beentransformed by deregulation intensified competition and the informationand communications-technology revolutions The market environment isone of intense competition particularly in traditional banking activitiesThe innovations point away from traditional activities of plain vanilladeposit taking and loan making Three big themes are discernible Firstthe walls separating commercial banks investment banks portfolio man-agers and insurance firms are falling even if they are still distinct Sec-ond large banks are shifting toward securitizationmdashcreating securitiesout of everything from credit card debt to trade finance to disaster insur-ancemdashand earning fees in the process Third all large banks are shiftingtoward trading activity making markets and taking short-term stakes inbonds shares and derivatives12 These activities when successful satisfythe search for higher yields13
Many of the new financial instruments that banks trade are ldquooff bal-ance sheetrdquo This means that banks are not required to allocate capitalagainst them In swap contracts for example neither side pays cash at theoutset and therefore neither party has an asset in the traditional sense14
Futures and options contracts can be written with a relatively small initial
Institute for International Economics | httpwwwiiecom
THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 97
margin relative to the potential risk Credit derivatives limit credit risk bytransferring the potential loss associated with corporate loans and bondssovereign debt and other loan portfolios to counterparties15
Deregulation and innovation working in combination seem to havepushed banks into trading activity and leveraged plays but not into shareownershipmdasheven in jurisdictions that have no prohibition against equitystakes Among the G-10 banking systems the highest ratio of share own-ership to assets was only 5 percent in 1996 reached in Germany andJapan (Berlin 2000)16
The wave of innovation in financial instruments and the accompany-ing expansion of banking beyond its old boundaries is a two-edged swordOn one side it allows risk management far beyond what was tradition-ally possible Risk can now be shifted from firms that can ill afford lossesto those that can Banks can profitably act as intermediaries in shiftingrisk On the other side the innovation wave creates huge opportunitiesfor leveraged plays fostering a speculative search by banks themselvesfor high returns that in turn magnify their own risks17
15 Credit derivatives include total return swaps credit default swaps credit-linked notesand collateralized debt obligations They are the fastest-growing sector of the global de-rivatives market
16 Banks seem to specialize in lending even when they are allowed to mix finance andcommerce for reasons related both to how they are expected to behave with distressedfirms and to other intricacies of lender liability (Berlin 2000) Yet a recent cross-countrystudy found that restrictions on banking and commerce are associated with greater fi-nancial instability (Barth Caprio and Levine 2000)
17 Leverage is the magnification of the rate of return (positive or negative) on an in-vestment beyond the rate obtained by solely investing funds owned by the institution Itis often defined as the ratio of assets to equity Leverage is achieved by increasing thesize of an investment by borrowing or using derivative instruments such as futures oroptions These allow investors to earn a return on the notional amount underlying thecontract by committing a small portion of equity in the form of a margin deposit oroption premium payment
18 In a repo (repurchase agreement) one party (typically a trader) buys a bond andsells it to a dealer for cash with a promise to buy it back the next day at the same priceplus the overnight interest rate As long as the overnight interest rate is lower than theinterest accruing on the bond the trader earns some income on the bond The extremeform of these kinds of transactions was discovered at LTCM the failed US highly lever-aged institution which appears to have controlled more than $120 billion in assets froman investment of about $3 billion This leveraging was accomplished mostly through theuse of repos (Mayer 1999)
The potential for damage is illustrated in an extreme form by figure 21To precisely measure a firmrsquos leverage all positions must be known andrealistically valuedmdashwhich may be impossible to do Because many ac-tivitiesmdashsuch as repos18 and derivativesmdashdo not appear on the institutionrsquos
Leverage
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98W
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MA
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ET
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Figure 21 Hypothetical example of leverage
$1000 notional value of call option on equity in firms targeted for takeover
Repo FRN into cash and use cash to pay option premium
(repro is initially collateralized
Borrow $100 for margin purchase
$125 of US investment bank floating-rate notes (FRN) (secured by $25 equity in FRNs)
Repo off-the-run bond into cash and post margin
(repo is initially collateralizedSell (short) Borrow on-the-run bonds worth $20
$25 worth of off-the-run bonds (secured by $5 equity in bonds)
Exchange into $4
Cash $5 yen400 Japanese bank loans
$1 equity base
FRN = floating rate notesRepo = repurchase agreement
Source IMF (1998)
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 99
balance sheet and because balance sheets are published quarterly at bestoutsiders have a difficult time assessing the extent of a firmrsquos leverage19
Leveraging by a single firm enhances its risk of default the widespreaduse of leverage in the financial system can magnify market adjustmentsespecially when they require ldquodeleveragingrdquomdashunwinding prior positionsRapid adjustments can cause credit to dry up and asset prices to plummetIn a mark-to-market environment falling asset prices trigger calls foradditional collateral that can ripple through markets
Risk Management
Because it is confronted with the widespread use of leverage and prolif-erating kinds of risk international finance is increasingly driven by riskevaluation and control20 Different institutions face various risk profilesand differing kinds of risk The most common risks can be quickly tickedoff Banks because of their traditional intermediary role of channelingthe resources from savers to borrowers face significant credit risk therisk of default or delay in the payment of principal and interest Theymust also manage market risk the risk that the prices of their liabilitiesmay change faster than their assets Market risk devastated US savingsand loan institutions in the late 1980s
Closely associated with market risk are interest-rate risk (unexpectedchanges in market interest rates that slash margins net income and theeconomic value of a bankrsquos equity) and foreign exchange risk (losses thatarise when assets denominated in an appreciating foreign currency areless than liabilities denominated in that currency) Banks make numer-ous loans to other banks around the world portfolio investors buy se-curities direct investors acquire fixed assets and all incur country risk(economic and political uncertainty in the host country) During the heightof the Asian crisis for example interbank loans to Japanese banksreflected the credit risk of lending to these banks the so-called Japanpremium
Substantial attention has been lavished on country risk analysis sincethe 1982 debt crisis in developing countries Yet in spite of this exper-tise the Asian crisis occurred in part because of a sudden upward reap-praisal of country risk after the Thai baht collapsed in April 1997 Banksand other financial institutions must also manage liquidity risk the riskthat market conditions will change unexpectedly depressing demand andprices of assets at the time they want to sell these assets And they mustmanage operational riskmdashfailures in control systems or people that cause
19 Another example of asymmetric information Both risk and leverage are difficult foroutsiders to assess without full timely disclosure
20 A longer discussion of these issues can be found in Managing Global Finance in IMF(1999c)
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100 WORLD CAPITAL MARKETS
financial loss or damage reputations Operational risk devastated BaringsBank in 1995
Financial institutions practice risk management to measure all theserisks the potential damage to their investment positions and ultimatelythe chance of becoming insolvent VAR (value at risk) risk models mea-sure subject to certain assumptions the amount of the firmrsquos capital thatis exposed in each period For example the VAR model might say thatin a 3-standard-deviation worst case (a case that is not supposed to hap-pen more than 1 percent of the time) the firm will loose 25 percent of itscapital during the next year
VAR models are widely used but like all models they have weak-nesses They rely on past values to estimate key variables in financialmarkets past values are not always good predictors of future risks More-over rising volatility and higher loss correlation among different assetclasses in a portfolio will cause all banks using these models to reducetheir exposures at the same time by switching to less volatile and lesscorrelated assets such as US Treasury bills (Persaud 2000)
Newer risk models entail stress testing and scenario analysis Scenarioanalysis envisages possible adverse changes one at a time that mightaffect the investment portfolio Stress testing estimates potential losseswhen several individual risk factors simultaneously move against thefirm but it too uses historical probabilities
Financial Volatility
21 For example derivative markets usually rely on underlying securities markets thatproduce continuous prices When these markets are interrupted financial shocks cantrigger a cascade of margin calls and sell orders that move prices very sharply
22 See IIF (1999a)
The combination of trading activity and modern risk management lie atthe root of financial volatility When risks increase banks must eitherraise more capital to cover the greater risk or reduce their exposure bycutting loan exposure by selling securities or by undertaking new de-rivative trades Raising more capital is time-consuming and in a crisisvery expensive because bank shares are depressed So banks look to theother alternatives If the bank can reduce lending it need not book aloss But most banks use the same VAR models and as indicated abovethese models will encourage them to reduce their outstanding loans atthe same time actually magnifying loan volatility
If banks attempt to reduce their exposure to risk by selling securitiesor undertaking new derivative trades they may trigger large priceshocks because of limited and shrinking market liquidity21 The liquid-ity problem is compounded when a small number of large institu-tions hold the same positions22 Take your pick loan volatility or price
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 101
volatility As two experts have observed (Folkerts-Landau and Garber1998)
[V]olatility even in one country will automatically generate an upward re-estimate of credit and market risk in a correlated country triggering automaticmargin calls and tightening of credit lines Thus apparently bizarre opera-tions that connect otherwise disconnected securities markets are not the re-sponses of panicked green screen traders arbitrarily driving economies from agood to a bad equilibrium Rather they work with relentless predictability andunder the seal of approval of supervisors in the main financial centers
23 See Ferguson (1999)
24 As Gerald Corrigan (1982) put the matter ldquoBanks are specialrdquo Corrigan (2000) reit-erated this view even after all the changes of the past two decades Unlike other institu-tions banks offer on-demand transactions are a backup liquidity source for other insti-tutions and serve as a ldquotransmission beltrdquo for monetary policy
These changes in the banking environment accentuate an existing anomalyThe anomaly is that banks even as they grow larger and increasinglyengage in more risky and complex transactions are perceived to enjoyimplicit and explicit public guarantees
The guarantees grow out of an incentive problem inherent in bankingasymmetric information which we mentioned above Depositors know lessabout a bankrsquos management and the quality of its balance sheet than doits managers and shareholders Thus in times of uncertainty or adver-sity bank depositorsmdashuncertain whether they will have access to theirdepositsmdashare prone to bank runs This prospect has in turn compelledgovernments to treat banks differently than other firms because a bankthat fails can disrupt the rest of the economy24
To prevent such crises governments have entered into quid pro quoarrangements with banks Governments provide them both with an im-plicit safety net in the form of an unstated promise by the central bankto act as a lender of last resort in a liquidity crisis and an explicit safetynet in the form of a public deposit insurance fund to reassure depositorsIn return the banks submit to closer government oversight and regu-lation of their activities than is usual for industries in the private sector
The ldquoinsurancerdquo provided by the public safety net contributes to an-other incentive problem moral hazard Banks acquire greater tastes forrisk and face less market discipline than other firms The explicit depositinsurance safety nets actually have or are perceived to have blanketcoverage that extends beyond the retail depositors (households and small
One of the lessons of the 1997-98 crisis must surely be that market par-ticipants and their regulatory supervisors relied too heavily on quantita-tive tools and insufficiently on judgment23
The Anomaly of Modern Banking
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102 WORLD CAPITAL MARKETS
businesses) for which they were originally intended The implicit centralbank safety nets extend in a crisis to nearly all depositors and banksThus banks are both viewed and behave as if they will be bailed out ifthey get into trouble
The existence of a public safety net raises a perennial question Dobanks have an unfair advantage over other financial institutions becauseof the subsidy provided by the safety net This question was at the heartof intensive study and debate in the United States leading up to thepassage in November 1999 of the Financial Services Modernization Act(also known as the Gramm-Leach-Bliley Act) The size of the gross sub-sidy is difficult to estimate despite determined research efforts Somesuggest it is well under 100 basis points and is at least partly offset bythe direct costs of deposit insurance premiums interest payments on bondsissued by the Financing Corporation25 reserve requirements regulatoryexpenses and operational costs associated with collecting deposits26 Con-versely Kwast and Passmore (2000) suggest that banks can expand theirscope far beyond the levels that other financial institutions could reachwith the same equity base but without the public safety net
A related concern in the US debate is whether allowing banks to ex-pand their activities into securities and insurance will ultimately extendthe safety net and add to the subsidy The Financial Services Moderniza-tion Act deals with this issue by maintaining a legal separation betweenbanks and the rest of the banking organization known as large com-plex banking organizations (LCBOs) They must engage in most securi-ties activities and insurance underwriting through separately capitalizedinvestment bank subsidiaries or holding company affiliates This act canbe said to have merely brought US banking laws closer to those of mostother industrial countries (Barth Brumbaugh and Wilcox 2000 BarthNolle and Rice 2000) If the fire wall is well-maintained and stoutly de-fended the safety net will neither expand in practice nor become a sourceof comfort to noncommercial bank subsidiaries of LCBOs
The quid pro quo exacted by governments to offset the subsidy iscloser public-sector monitoring of banksrsquo activities through prudentialsupervision The effectiveness of this closer official scrutinymdashand closermarket monitoringmdashare the subjects of the next section
25 The Financing Corporation was created by Congress in 1987 to sell bonds to raisefunds to help resolve the savings and loan crisis
26 See Levonian and Furlong (1995) Jones and Kolatch (1999) Shull and White (1998)and Whalen (1999a 1999b)
Are G-10 bank supervisors adequately responding In this section we firstassess the case for and compare the structures of prudential supervisory
Prudential Supervision
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 103
systems both within and among the G-10 economies plus Spain andconsider whether these offset the subsidy provided by the public safetynet Despite offsetting regulation and supervision implicit and explicitguarantees by G-10 governments to their banks are still a source of bank-ing instability in the emerging-market economies
National Systems for Prudential Supervision
Governments use prudential supervision to reduce the moral hazard andadverse selection created by their own safety nets Supervisors establishregulations and monitor compliance to limit risk taking and ensure thesafety and soundness of the banking system In a thoughtful analysis ofthe case for prudential supervision Frederic Mishkin (2000) identifiesthe main forms that supervision can take including the tasks of grantingbanking charters and licenses establishing capital requirements settingdeposit insurance premiums and defining disclosure requirements as wellas carrying out bank examinations Bank examiners gather informationfrom banks and evaluate whether they are following the regulatorsrsquo rulesin cases of weakness they are empowered to change banksrsquo behaviorand close them if necessary
Supervisors also may restrict competition define the activities in whichbanks may engage and restrict their asset holdings and separate banksand other financial (or nonfinancial) activities During the past two de-cades the barriers separating commercial banks investment banks in-surance firms and securities firms have been all but eliminated (tableB1) Deregulation has stimulated competitive forces that drive diversifi-cation and consolidation of the financial industry nowhere faster than inthe United States
The Financial Services Modernization Act of 1999 confirmed this trendIt eliminated restrictions dating back to the Glass Steagall Act of 1933which once prevented banking insurance and securities firms fromentering each otherrsquos businesses (Barth Brumbaugh and Wilcox 2000)Cross-pillar mergers among banks insurance and securities firms arewell under way to form giant financial holding companies The 1999merger between Citibank (banking) and Travelers (insurance) created themodel for megafinance and confirmed new challenges for supervisors
Mishkin (2000) notes the corresponding evolution in US supervisionfrom an emphasis on rules-based regulation (detailed rules for opera-tional behavior and the quality of line items in the balance sheet) to anapproach that stresses the soundness of bank management practices es-pecially risk management
Appendix B outlines the systems of financial supervision now in theplace in the G-10 countries plus Spain Some systems like the UK andCanadian approach are models of simplicitymdashorganized to keep pacewith the spreading reach of financial conglomerates Other systems like
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104 WORLD CAPITAL MARKETS
the US and French approaches show traces of the bureaucratic divisionsthat made sense in an era when banking securities and insurance weresharply separated
The US Model
27 See Meyer (1999a)
28 Canada has a similar degree of simplification with the exception that securities firmsare still regulated by provincial authorities
29 See Pratti and Schinasi (1999 67)
30 The agents are the bank regulators and the principals are the taxpayers Agents maypursue their own interests including bureaucratic survival and postgovernment employ-ment opportunities rather than the national interest in banking safety and soundness
The US model of financial regulation delineated in the Financial Ser-vices Modernization Act of 1999 blends functional and umbrella super-vision Bank and thrift regulators oversee depository institutions Newnonbank activities are subject to both functional regulation (eg by theSecurities and Exchange Commission and state insurance examiners) andumbrella supervision (of financial holding companies) by the FederalReserve27
The UK Model
Another supervisory model exists in the United Kingdom as well as inAustralia Canada and Switzerland28 In this model banking supervisionis separated from the monetary policy function The regulatory structureis considerably simplified by relying on a consolidated financial regula-tor separate from the central bank for both banking and nonbankingactivities The remaining question answered differently depending on thecountry is the extent to which the regulator relies on home-country sur-veillance of banks and conglomerates that have a local presence
Regulatory Models Compared
Appendix B provides more detail on the differences in these modelsGerman simplicity contrasts with French complexity In France the bankingcommission is chaired by the governor of the central bank and includesrepresentatives from the Treasury The commission supervises compli-ance with regulations but the central bank inspects banks on behalf ofthe commission29 In countries such as the United States and France withmultiple supervisors and crossover functions internal coordination is criticalAt the same time multiple agencies create regulatory competition Wheneach agency knows what the other is doing transparency within gov-ernment circles can help to limit principal-agent problems of regulation30
The discussion as to where in the public bureaucracy financial super-
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 105
vision should be placed goes back many years Peek Rosengren andTootell (1999) argue that a synergy exists between monetary policy andprudential supervision because information gained in the course of super-vision can increase the accuracy of macroeconomic forecasts A twist tothis argument is that the information on the state of financial institutionsavailable to the central bank as supervisor can facilitate its role as lenderof last resort Conversely there is the concern that a supervisory rolewill compromise the central bankrsquos independence of action with respectto its core mandatemdashmaintaining price stability As these arguments haveplayed out financial supervision has generally been shared between centralbanks and other regulators or placed entirely in the hands of an inde-pendent regulator However in Italy the Netherlands and Spain cen-tral banks are the sole banking supervisor
Goodhart (1995) examined the arguments and evidence for each modeland concluded that there were no overwhelming arguments or evidencefor one or the other31 Going forward a key problem for any financialsupervisory system is dealing with (and closing as necessary) weak banksIf both central banks and other regulators have this responsibility closecoordination between them is critical Another problem is large conglom-erate banks LCBOs Although they are less likely to fail because of thediversification of their assets and liabilities they are more likely to berescued They are also more likely to be multinational enterprises withinternational implications Goodhart observes that regulation of theseentities might be put in the hands of the central bank because it is lessamenable to political pressures In any event the complexity of LCBOoperations suggests that greater supervisory rigor is necessary
The US Congress was persuaded that broad oversight would help containthe moral hazard problem and accordingly gave the Federal Reservethe role of umbrella supervisor with the understanding that the Fed willscrutinize depository activity more intensely than nonbank financial ac-tivities Under this approach LCBOs such as Citigroup are subject tomuch closer monitoring than smaller and simpler institutions32 The USregulatory model requires enormous cooperation between the Fed otherbank supervisors and the functional regulators for insurance and securi-ties but it also benefits from regulatory competition
31 National systems of supervision are path dependent they are determined by the struc-ture of financial institutions and history in each country If Goodhart (1995) is right out-comes are not materially better or worse with one model of supervision rather than another
32 See Ferguson (1999)
Public Safety Nets
One of prudential supervisorsrsquo biggest challenges is to reduce moral hazardFor many years commercial banks engaged in communal self-insurance
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106 WORLD CAPITAL MARKETS
to deal with crises They formed voluntary groups that agreed to rescuetroubled members As financial markets evolved and competition inten-sified banks were no longer willing to play this role Private-sector in-surance is one alternative but moral hazard and adverse selection wouldappear to prevent it from happening Public safety nets have developedbecause of the low probability and high cost of potential bank runs Aclear trade-off is involved The effectiveness of insurance in preventingbank runs is greater the more comprehensive the coverage But the morecomprehensive the coverage the greater the moral hazardmdashbank man-agers bank directors investors and depositors all take on greater risksin the belief that the safety net will protect them against losses
All G-10 countries have compulsory public safety nets for banks (table29) Deposit insurance agencies are officially organized in Canada theNetherlands Sweden Switzerland and the United States organized bythe industry in France Germany Italy and the United Kingdom andjointly organized by the public and private sectors in Belgium Japanand Spain
How well do G-10 governments offset the subsidy provided by thepublic safety net This is a question on which there is substantial debateAs banking organizations have become more complex the challengesthat supervisors face have become more difficult One challenge is toalign the incentives facing bank managers and shareholders with thoseof depositors Another is the principal-agent problem in supervision Wehave discussed the incentive structures for financial institutions but wehave said little about the incentives for supervisors themselves and thedistortions they can generate in the financial system
In one of the many studies of the US savings and loan crisis of the1980s Kane (1989) documented both problems He described managersusing cosmetic approaches to disguise the magnitude of insolvency regulatorspracticing forbearance even though they knew of the deteriorating riskprofiles of the institutions for which they were responsible and legisla-tors increasing deposit insurance without regard for any offsetting changesin supervision A subsequent overhaul of the legislative framework forthe Federal Deposit Insurance Corporation (FDIC) known as the FDICImprovement Act of 1991 (FDICIA) aimed to introduce a clearer incen-tive structure for both regulators and regulated institutions
The changes introduced by this US legislation are worth discussionwith respect to the other G-10 countries as well First FDICIA created astronger signal to management and investors by targeting deposit insur-ance at small depositors only and by risk-weighting the deposit insur-ance premiums paid by banks to reflect their capital adequacy and bankexaminer ratings Among the G-10 countries rated in table 210 depositinsurance premiums vary considerablymdashbut it is not clear that the dif-ferences have much to do with risk-weighting Most G-10 countries em-ploy funding formulas based for example on the total domestic deposit
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TH
E P
LAY
ER
S T
HE
IR S
UP
ER
VIS
OR
S A
ND
MO
RA
L HA
ZA
RD
107
Table 29 Deposit insurance schemes in the G-10 countries Explicit safety net
Coverage limit(dollar Foreign
equivalent currency Interbank Source Bankrsquos Contingency fundingDate Membership Co- at end of deposit deposit of premium from banks
Country established managementa insuranceb July 1998)c covered covered Fundingd funding costs or governments
United 1982 Compulsory Yes Larger of 90 No No Unfunded Banks only Callable (subject Parliament may increase Kingdom private percent co- to maximum the maximum payable
insurance to 03 percent of pound125 million advance 33000 total deposits) facility with Bank of
England
United 1934 Compulsory No 100000 Yes Yes Funded Banks and Up to 027 Borrowing up to $3 States official government percent total billion from US Treasury
domestic deposits
Japan 1971 Compulsory No 71000 but No No Funded Banks and 0084 percent of Borrowing up to yen500bn joint in full until government insured deposits from Bank of Japan
year 2000 subject to Ministry of Finance approval
Canada 1967 Compulsory No 40800 No Yes Funded Banks and 033 percent of Borrowing up to C$6 official government insured deposits billion authorized further
(maximum) borrowing subject to parliamentary approval
Germany 1966 Compulsory Yes 90 percent Yes No Funded Banks only 003 percent of Annual levy may be private coinsurance deposits doubled
to 22000
Italy 1987 Compulsory Yes 125000 Yes No Unfunded Banks and Callable Two options defer private government (maximum of payment or diminish
1 percent of compensation to be paid total deposits)
(table continues next page)
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108W
OR
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CA
PIT
AL
MA
RK
ET
S
Table 29 Deposit insurance schemes in the G-10 countries Explicit safety net (continued )
Coverage limit(dollar Foreign
equivalent currency Interbank Source Bankrsquos Contingency fundingDate Membership Co- at end of deposit deposit of premium from banks
Country established managementa insuranceb July 1998)c covered covered Fundingd funding costs or governments
Netherlands 1979 Compulsory No 22000 Yes No Unfunded Banks and On demand Government backing official government maximum of subject to parliamentary
5 percent of own approval funds
France 1980 Compulsory No 65400 No No Unfunded Banks only Callable (on Extra calls up to FFr1000 private demand calls million can be made in
up to FFr200 a 5-year period million)
Switzerland 1984 Voluntary No 19700 No No Unfunded Banks only Callable (on Underwritten by member official demand) banks
Sweden 1996 Compulsory No 31400 Yes No Funded Banks and 05 percent of Full emergency coverage official government deposits while replacing it with a
limited system after the emergency
Belgium 1974 Compulsory No 16600 No No Funded Banks and Callable 002 None insurance limited joint 22000 in government percent of to assets in fund
year 2000 deposits from clients
Spain 1977 Compulsory No 16439 Yes No Funded Banks and 02 percent of Government backing joint government deposits through the Banco de
(maximum) Espantildea subject to approval by royal decree
a Bank membership in the fund can be either compulsory or voluntary and the management of the fund can be official and official and private joint or privateb Coinsurance refers to the situation where depositors face a deductible against their insured fundsc Coverage limit refers to the explicit amount the authorities promise to insured Funded scheme means that it is funded ex ante unfunded otherwise
Sources Goodhart (1995) Demirguccedil-Kunt and Detragiache (2000) Demirguccedil-Kunt and Sabaci (2000)
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 109
base Explicit safety net protection also varies but only Canada focuseson the protected class33 All G-10 countries specify a limit on depositorprotection Under FDICIA the insurance fund is prohibited from pro-tecting uninsured depositors or creditors at a failed bank although adiscretionary system-wide override is provided for exceptional circum-stancesmdashbut with stringent requirements for consultation and account-ability Other G-10 countries allow for contingency funding from the publicpurse alongside unwritten lender-of-last-resort support Among large banksa significant and growing portion of deposit liabilities including foreigncurrency and interbank deposits are uninsuredmdashbut depositors assumethey will be protected in a crisis
FDICIA also made some significant qualitative changes to address theprincipal-agent problem by penalizing weak banks and rewarding strongbanks For example banks whose capital declined faced progressivelytougher regulatory sanctions that for example required them to elimi-nate dividends restrict their lending and change their managementsRegulators have also been forced to take prompt corrective action (toreduce the practice of regulatory forbearance in hopes that a bankrsquos for-tunes might improve)34 Unfortunately comparative qualitative assess-ments across the G-10 are difficult to make due to lack of information35
This discussion highlights the complexity of evaluating the extent towhich prudential supervision and market discipline reduce the moralhazard associated with G-10 safety nets Our argument is that publicsafety nets in the G-10 can be linked to banking instability in other coun-tries specifically in the emerging-market economies that have attractedG-10 cross-border bank lending This lending is a leading source of vola-tility in capital flows the large financial institutions many of which arecomplex banking organizations are based in and regulated by authori-ties in the G-10 economies These two features of the international finan-cial system are closely related although it is not possible to test thisrelationship econometrically
Two World Bank studies however indicate a basis for concern Onestudy is a cross-country econometric analysis of the relationship betweenbank stability and deposit insurance (Demirguccedil-Kunt and Detragiache2000) which found a negative relationship Their estimated model forbanking crises in a sample of 61 countries (both industrial and develop-ing) suggests that explicit deposit insurance raises the probability of acrisis by at least 30 percent36 Crises are especially likely in countries
33 Japanrsquos legislation says it does but recent experience shows this is not the case34 See Goldstein (1997) for a summary of the changes35 See Barth Nolle and Rice (2000) for a beginning in this area36 Demirguccedil-Kunt and and Detragiache (2000 table 1) report a logit coefficient of 0696with a standard error of 0397 (the coefficient is significant at the 8 percent threshold)This suggests that the ldquotruerdquo coefficient could well be as small as 030 (the reportedvalue minus the standard error)
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110 WORLD CAPITAL MARKETS
with immature financial supervisory systems (and not in the G-10) buttheir analysis does underscore the view that deposit insurance weakensmarket discipline37
An earlier World Bank analysis established similar results One wasthat market discipline is undermined by deposit insurance schemes an-other was that illiquid banks are forced to pay more for their funds un-less a generous deposit insurance scheme is in place (Demirguccedil-Kuntand Huizinga 1999) This econometric study also provides clear-cut evi-dence that depositor monitoring of banks declines with the existence ofdeposit insurance schemes At the heart of the problem is the questionof whether deposit insurance is accompanied by increased governmentmonitoring
This evidence and the weight of other arguments suggests that moralhazard is still an issue in the G-10 countries Consider the ongoing de-bate about instilling greater market discipline on risk taking by banksAt one extreme is the perennial proposal to do away with safety netsleaving markets to monitor the players and to force adjustments but toprotect small savers by creating ldquonarrow banksrdquo such as postal savingsystems that are allowed to invest these savings only in risk-free gov-ernment securities Whatever the merits of narrow banking this solutionis too extreme to be politically feasible
A moderate alternative is to force more disclosure by financial institu-tions to facilitate market monitoring But transparency has its own prob-lems Persaud (2000) argues that financial markets cannot reliably discernsustainable from unsustainable positions in the short term This uncer-tainty causes banks to ldquoherdrdquo behind market leaders to exploit theirsupposedly superior information ldquoThe more herding investors and bankersknow about what each other is up to the [more] unstable markets maybecomerdquo The implication is that greater transparency in the marketplaceby itself will not solve the problemmdashand in the short term more informa-tion may exacerbate herding Further supervisory steps (discussed in thenext chapter) are required
Yet another proposal is to promote private-sector involvement in bankmonitoring through market-based alternatives such as Calomirisrsquos sub-ordinated debt proposal (Calomiris 1997 Federal Reserve Board 1999)Banks could be required to issue and maintain a minimum amount of
37 Other findings in the Demirguccedil-Kunt and Detragiache (2000) study include thesepropositions The impact of deposit insurance on bank stability tends to be stronger themore extensive is the coverage offered to depositors when the scheme is funded andwhere the scheme is run by the government rather than by the private sector Con-versely deposit insurance is detrimental to bank stability where bank interest rates havebeen deregulated and where the institutional environment is weak Additional findingson deposit insurance are reported from a recent World Bank conference (8-9 June 2000httpwwwworldbankorgresearchinterestconfsupcomingdeposit_insurancehomehtm)Also see Smalhout (2001)
Institute for International Economics | httpwwwiiecom
THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 111
subordinated debt (eg uninsured certificates of deposit) to finance asmall fraction (such as 2 percent) of their total nonreserve assets Thesubordinated debt would be allowed to earn a set yield no more than 50basis points over the risk-free yield on government treasury bills Thisrule would supposedly force banks to operate in a safe manner Other-wise subordinated debt holders would redeem their uninsured certifi-cates of deposit and equity investors would sell their bank shares Despiteits practical problems the beauty of the subordinated debt requirementis that it enlists market incentives to push banks to avoid excessive port-folio risk38
The thrust of these proposals is very relevant to the arguments in ourstudy Even in the G-10 countries government monitoring by itself hasnot eliminated moral hazard among banks More work is needed to in-troduce market monitoring and to improve the incentive structures bothfor financial institutions and their supervisors We return to this issuewith our recommendations in the next chapter
38 In late 1996 Argentina began requiring its banks to finance 2 percent of total depos-its in the form of subordinated debt but without a maximum yield provision TheArgentine authorities expect that market discipline will act in concert with the publicsafety net One obvious problem with the subordinated debt proposal is that banks mayencourage some of their customers to buy the subordinated debt
Portfolio Institutions Tomorrowrsquos Problem
Before proceeding to the issues of international supervision we flag an-other potential problem for national regulators The big asset managersprofiled in tables 24 and 26 answer to diverse groups of pensionersshareholders and policyholders They allocate funds across a number ofcountries to diversify their risks They hold liquid assets that can be tradedand they have a higher proportion of long-term assets than banks Eco-nomic shocks can be absorbed through price changes and their effectsspread across time and markets Thus when conditions change in a par-ticular market they are more likely to ride out the storm than to flee Inother words they have less incentive than banks to pull their invest-ments in the face of adversity In the 1990s most large asset managersestablished a record of ldquoriding out the stormrdquo rather than ldquorunning withthe windrdquo although as we saw in chapter 1 instances of running withthe wind were detected in some portfolios As we write these insti-tutions have a good record overall in the emerging markets so whyworry
The Russian crisis and the near-collapse of LTCM previewed the dan-gers that may await future portfolio managers and G-10 financial minis-ters We have presented evidence indicating a systemic bias toward bank
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112 WORLD CAPITAL MARKETS
lending and debt finance to emerging markets and we have argued forsubstitution toward equity finance and direct investment39
That is not the end of the story We noted in the previous chapterthat institutional investors can become momentum investors selling in adownturn As more portfolio capital is invested in emerging marketssome players may adopt the high-risk high-leverage strategies of themost aggressive hedge funds Indeed the data in box 11 show that G-10portfolio investors held somewhat more long-term debt (more than $500billion) than equity (less than $400 billion) in emerging markets at theend of 1997 Long-term debt is an ideal vehicle for high-risk high-leveragestrategies These strategies practiced on a large scale could compound afuture crisis harming emerging markets A big enough crisis could inturn pressure G-10 central banks and finance ministers to arrange bail-out plans Instead of shrinking as a systemic financial problem moralhazard could increase
National securities regulators are the first line of defense against thisscenario They play a critical role in the safe evolution of capital mar-kets But regulators today are mandated to approve the issuance of newsecurities and to monitor the continuing disclosure of material informa-tion by issuers They are far less concerned with or empowered to monitorthe behavior of the increasingly large wealth-management firms that arethe major purchasers (and therefore resellers) of these securities
Within their mandates the goals of national securities regulators (table210 and appendix B) are similar to the concerns of bank regulators withsystem safety and soundness Their focus is also on the incentive sys-tems for management and boards of directors and on disclosure by cor-porations that issue marketable securities such as shares bonds andasset-backed securities 40 Issuers of securities possess greater knowledgeabout the quality of these assets than do the purchasers hence investorprotection is a key concern of regulators Moreover market disciplineworks best when markets know what is happening Well-functioning corpora-tions are key agents of wealth creation and social progress Underperform-ing corporations waste resources During recessions bad corporationsget into bad trouble often with severe social consequences Inadequateincentives for managers and inadequate accountability for boards andmanagers thus have negative externalities Regulators play a vital role inexposing weakness so that market disciplines come to bear sooner ratherthan later
Regulatory emphasis is constantly shifting as financial markets evolveand as the macroeconomic environment changes Regulators try to balance
39 See Rogoff (1999) Also see Berlin (2000) for a perspective on the limited role thatbanks play as share owners
40 See Habib and Ljungqvist (2000) for recent empirical analysis showing that corporateshare market values are higher when corporate executives have a larger ownership stake
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Table 210 Financial-sector regulation G-10 countries 2000
Financial institutions and their supervisors
Country and supervisory structure Retail banking Wholesale banking Securities Insurance
Financial conglomeratesFinancial Services Authority (FSA) = umbrella supervisor
United Kingdom FSA FSA FSA FSA
Treasury bull Commercial banks bull Investment funds (Securities and (Insurance Directorate(Securities and Investments Board) bull Unit trust groups Futures Authority) of the Treasury)
Bank of bull Building societies bull Pension funds England (Building Societies Commission) bull Merchant banks
bull Friendly societies bull Clearing houses bull Primary issuers bull Insurance FSA (Friendly Societies Commission) bull Venture capital of securities companies
bull Pensions and life insurance etc bull Stock exchanges bull Insurance brokers(Personal Investment Authority) bull Stockbrokers
Financial holding companiesFederal Reserve (FR) = umbrella supervisor
United States bull National banks(OCC) Securities and Regulated by
Treasury OCC bull State banks Federal Reserve Exchange Commission StatesMembers (FR)
OTS Nonmembers (FDIC) bull Investment banks bull Primary issuers of bull Insurance companies FR bull Cooperative banks (FDICFR) bull Finance companies securities bull Insurance brokers FDIC bull Insured industrial banks (FDIC) bull Stock exchanges
bull Thrift holding companies (OTS) bull Stockbrokers SEC bull Savings banks (OTSFDICFR) bull Investment advisors
bull Savings and loan associations bull Mutual funds(OTS) bull Public utility holding
bull Edge Act corporations (FR) companies
(table continues next page)
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Table 210 Financial-sector regulation G-10 countries 2000 (continued )
Financial institutions and their supervisors
Country and supervisory structure Retail banking Wholesale banking Securities Insurance
Financial holding companies Japan Financial Supervisory Authority (FSA) = umbrella supervisor
Prime FSA FSA FSA FSA ministerrsquos Ministry of office Finance (Securities and Exchange
Surveillance Commission) FRC Bureau of Financial bull City banks bull Investment banks bull Primary issuers of bull Insurance companies FSA Regulation bull Regional banks bull Asset managers securities bull Insurance brokers
bull Trust banks bull Stock exchanges SESC bull Long-term credit banks bull Stockbrokers
bull Pension funds
Financial holding companiesOffice of the Superintendent of Financial Institutions (OSFI) = umbrella supervisor
Canada Regulated by OSFI OSFI provinces OSFI
Department of Financebull Banks bull Cooperative credit bull Primary issuers of bull Insurance companies
(previously Office of the Inspector associations securities (previously Depart- OSFI General of the Banks) bull Fraternal benefit bull Stock exchanges ment of Insurance) Bank of bull Trust and loan companies society bull Stockbrokers bull Insurance brokers Canada bull Pension funds bull Asset managers
(previously Depart- CDIC ment of Insurance)
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Financial institutions and their supervisors
Country and supervisory structure Retail banking Wholesale banking Securities Insurance
Germany Financial holding groupsFederal Banking Supervisory Office (FBSO) = umbrella supervisor
Ministry of Finance FBSO BSO FSSO FISO
Bundesbankbull Universal banks bull Other financial bull Primary issuers of bull Insurance companies
Federal Banking bull Savings banks institutions (eg securities bull Insurance brokers Supervisory Office bull Securities banks management foreign bull Stock exchanges
currency dealings) bull Stockbrokers Federal Securities bull Financial enterprises bull Asset managers Supervisory Office (eg leasing bull Pension funds
organizations Federal Insurance credit card companies Supervisory Office investment advisors)
Italy Bank foundationsMinistry of Finance = umbrella supervisor
Ministry of Finance Bank of Italy Bank of Italy Consob ISVAP
Bank of Italy bull Commerical banks bull Asset managers bull Primary issuers of bull Insurance companies Consob bull Savings bank bull Open-end investment securities bull Insurance brokers
bull Securities banks companies (SICAVs) bull Stock exchangesbull Stockbrokers
ISVAP
(table continues next page)
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Table 210 Financial-sector regulation G-10 countries 2000 (continued )
Financial institutions and their supervisors
Country and supervisory structure Retail banking Wholesale banking Securities Insurance
The Netherlands Financial conglomeratesCouncil of Financial Supervisors = umbrella supervisor
Securities Board Securities Board Netherlandsche Netherlands Bank Netherlandsche Bank of the Netherlands Insurance Board Bank Insurance bull Credit institutions (universal banks bull Investment institutions bull Stock exchanges bull Insurance companies Board cooperative banks security credit (securities issuing bull Stockbrokers bull Insurance brokers
institutions mortgage banks) and tradingmdashprimary The Council of Financial and secondary Supervisors markets)
France Commission des Commission de Operations des Controcircle des
Banking and Banking Commission Bourse Assurances Financial Regulatory bull Ensuring that credit institutions (and investment firms since bull Primary issuers of bull Insurance companies Ministry for Committee the Financial Activity Modernization Act of 1996) comply securities bull Insurance brokers Economic with laws and regulations bull Stock exchanges Affairs and bull Execute instructions regarding all off-site monitoring and bull Stockbrokers Finance Credit on-site supervision Institutions and Banking and Financial Regulatory Committee Investment bull Formulates general regulations for credit institutions and investment firms Committee (capital adequacy requirements accounting rules etc) Bank of France Credit Institutions and Investment Committee Banking bull Authorizes and examines financial institutions except for those within the Commission competence of the Banking Commission
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117
Financial institutions and their supervisors
Country and supervisory structure Retail banking Wholesale banking Securities Insurance
Switzerland Large banking groupSwiss Federal Banking Commission (SFBC) = umbrella supervisor
Swiss National Bank Federal Office of
SFBC SFBC SFBC Private Insurance Swiss Federal Banking Commission bull Universal banks bull Investment banks bull Primary issuers of bull Insurance companies
bull Savings banks bull Asset management securities bull Insurance brokerscompanies bull Stock exchanges
Private audit Federal bull Investment funds bull Stockbrokers firms Office of bull Mortgage bond authorized by Private business SFBC Insurance
Sweden Financial holding company groupsFinancial Supervisory Authority = umbrella supervisor
Ministry of Finance Credit Market Securities Market Insurance Market
Credit Market Department Department Department Department
Financial bull Commercial banks bull Investment funds bull Primary issuers of bull Insurance companies Riksbank Supervisory bull Savings banks securities bull Insurance brokers Authority bull Friendly societies bull Stock exchanges
bull Stockbrokers
(table continues next page)
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Table 210 Financial-sector regulation G-10 countries 2000 (continued )
Financial institutions and their supervisors
Country and supervisory structure Retail banking Wholesale banking Securities Insurance
Belgium Bank holding companiesBanking and Finance Commission = umbrella supervisor
Bank of Belgium Banking Banking
Banking and Finance and Finance Insurance Controland Finance Commission Commission Commission Office
Banking and Insurance Finance Control bull Commercial banks bull Asset management bull Primary issuers of bull Insurance companies Commission Office bull Savings banks firms securities bull Insurance brokers
bull Securities banks bull Investment funds bull Stock exchanges bull Mortgage companiesbull Stockbrokers bull Pension funds
Securities Regulation Fund Securities Regulation Fund
bull Other investment firms and credit institutions(institutions participating in regulated off-exchangemarket in strips and Treasury certificates)
Bank holding companies Spain Banco de Espantildea = umbrella supervisor
Banco de Espantildea Comision Nacional del Mercado de Directorate General
Banco de Espantildea Valores (CNMV) Insurance
bull All credit institutions (commercial banks savings banks credit bull Primary issuers of (Ministry of Economy Ministry of cooperatives official credit institutions finance factoring and securities and Finance) Economy and CNMV leasing companies mortgage-loan companies etc) bull Stock exchanges bull Insurance companies Finance bull Interbank foreign exchange and book-entry public debt bull Stockbrokers bull Pension funds
markets bull Venture capital(companies and funds)
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119
Financial institutions and their supervisors
Country and supervisory structure Banking Securities Insurance
Banking Advisory High Level Securities Supervisors Committee (BAC) Committee (HLSS) Insurance Committee (IC)
Supranational (EU) bull Formulates standards for prudential bull Coordination of securities market bull Formulates standards forsupervision supervision prudential supervision
BACICHLSS Banking Supervision
Conglomerates Committee (BSC) Securities Contact Committee Regulation of prudential bull Systemic risk monitoring bull Regulation and implementation of supervision securities admission
International Association International International Organization of of Insurance Supervisors
Basel Committee Securities Commisison (IOSCO) (IAIS) Joint Forum Conglomerates Supervision bull Supervision and regulation best bull Supervision and regulation best bull Supervision and regulation amp regulation Best practices practices practices best practices
FSF Coordination across supervisors of various functions
Notes See appendix B for more information Boldface type indicates senior or oversight supervisor normal type indicates adjunct or front-line supervisorsolid line indicates direct responsbility to the senior-ranking authority dotted line indicates coordination in supervisory activities
(table continues next page)
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Table 210 Financial-sector regulation G-10 countries 2000 (continued )
Glossary of names United Kingdom FSA = Financial Services Authority United States FR = Federal Reserve OCC = Office of the Comptroller of theCurrency FDIC = Federal Deposit Insurance Corporation SEC = Securities and Exchange Commission OTS = Office of Thrift Supervision Japan FRC =Financial Reconstruction Commission FSA = Financial Services Agency SESC = Securities and Exchange Surveillance Commission Canada OSFI =Office of the Superintendent of Financial Institutions CDIC = Canada Deposit Insurance Corporation Germany FBSO = Federal Banking SupervisoryOffice FSSO = Federal Securities Supervisory Office FISO = Federal Insurance Supervisory Office BSO = Banking Supervisory Office Italy Consob =Commissione Nazionale per le Societa e la Borsa ISVAP = Instituto per la Vigilanza sulle assicurazioni private e di Interesse colletivo Switzerland SFBC= Swiss Federal Banking Commission Spain CNMV = The Comision Nacional del Mercado de Valores Supranational BAC = Banking Advisory CommitteeBSC = Banking Supervision Committee IC = Insurance Committee HLSS = High Level Securities Supervisors Committee International Dimension FSF =Financial Stability Forum IOSCO = International Organization of Securities Commission IAIS = International Association of Insurance Supervisors
Sources United Kingdom Bank of England httpwwwbankofenglandcouk Financial Services Authority httpwwwfsagovuk United States Board ofGovernors of Federal Reserve System httpwwwfederalreservegov Japan Bank of Japan httpwwwbojorjo Financial Reconstruction Commissionhttpwwwfsagojpfrcindexehtml Financial Services Agency httpwwwfsagojp Canada Bank of Canada httpwwwbank-banque-canadaca Office ofthe Superintendent of Financial Institutions httpwwwosfi-bsifgccaAndreEindexhtml Germany Deutsche Bundesbank httpwwwbundesbankde Fed-eral Banking Supervisory Office httpwwwbakredde Italy Banca drsquoitalia httpwwwbancaditaliait Commissione Nazionale per le Societa e la Borsahttpwwwconsobit Instituto per la Vigilanza sulle assicurazioni private e di Interesse colletivo httpwwwisvapit The Netherlands De NederlandscheBank httpwwwdnbnl France Banque de France httpwwwbanque-francefr Switzerland Schweizerische Nationalbank httpwwwsnbchindex3htmlSweden Sveriges Riksbank httpwwwriksbanksedefaultasp Belgium National Bank of Belgium httpwwwbnbbesgindexhtm Spain Banco de Espantildeahttpwwwbdees The Comision Nacional del Mercado de Valores httpwwwcnmves Supranational (EU) Institutional Arrangements for the Regulationand Supervision of the Financial Sector 2000 International Dimension Bank for International Settlement httpwwwbisorg International Organization ofSecurities Commissions httpwwwioscoorg International Association of Insurance Supervisors httpwwwiaisorg Financial Stability Forum httpwwwfsforumorg
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 121
the inflexibility of tight surveillance against the need to encourage in-novation and growth The US Securities and Exchange Commission isworried about aggressive accounting by firms and biased reports bysecurities analysts in an equity environment that prizes steadily higherquarterly earnings41 Japanese regulators are preoccupied with opaqueinterconnections between portfolio institutions banks and nonfinancialfirms through the keiretsu system Canadian regulators reeling from high-profile scandals of managers intentionally misleading investors are strengtheningmarket discipline through legal penalties aimed at managers and directorsof offending firms
When panic strikes a securities regulator cannot do much As the 1987stock market crash and the LTCM debacle in the fall of 1998 both dem-onstrated steep stock and bond price declines can create systemic risksIf severe enough the wealth effect of falling securities values and thefear of widespread insolvency can depress real activity Flooding thesystem with liquidity is a central bankerrsquos solutionmdashsomething a securi-ties regulator cannot do42 But just as financial supervisors can changethe incentive structure to discourage bankers from making risky loans ingood times so securities regulators can pay more attention to incentiveson the demand side when capital markets are strong
Prudential Supervision and InnovationmdashA Footnote
In concluding this discussion of prudential supervision in the G-10 anadditional point is worth noting National regulators face a persistenttrade-off between emphasizing financial system safety and soundnesswhile encouraging innovationmdashin spite of the added risks innovationbrings to financial markets Former US Treasury Secretary Lawrence Summers(2000 3) has argued by analogy
The jet airplane made airplane air travel more comfortable more efficient andmore safe though the accidents were more spectacular and for a time morenumerous after the jet was invented In the same way modern global financialmarkets carry with them enormous potential for benefit even if some of theaccidents are that much more spectacular As the right public policy response
41 The problem is illustrated by the divergence since mid-1998 between reported earn-ings by the Standard amp Poorrsquos (SampP) 500 and the after-tax profits of all corporations inthe national accounts Generally these two series move closely with one another Be-tween mid-1998 and mid-1999 SampP 500 reported that earnings increased by more than20 percent while after-tax profits of all corporations increased by less than 5 percent(Chase Bank US Economic and Policy Research US Weekly Prospects Chase SecuritiesWeekly Newsletter 5 June 2000 5)
42 For example the US Securities and Exchange Commission had no direct role in calmingmarkets in the 1987 or 1998 panics
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122 WORLD CAPITAL MARKETS
to the jet was longer runways better air-traffic control and better training forpilots and not the discouragement of rapid travel so the right public policyresponse to financial innovation is to assure a safe framework so that the ben-efits can be realized not to stifle the change
Accepting Summersrsquos analogy for the international financial system better-informed supervisors and investors are a necessary part of the financialsystem framework Supervisors require more timely information on therisk profiles resulting from positions taken by financial institutions Theyalso need a better understanding of risk-management systems Snapshotsof an institutionrsquos risk profile and risk-management procedures are nolonger adequate In a world where huge bets are quickly made (andpossibly lostmdashas with Barings Bank in 1995 and LTCM in 1998) super-visors must focus on the soundness of banking systems for evaluatingand managing risk on a daily basis Some progress has been made inaddressing these issues US banking examiners are extending their in-formation requirements in banking examinations and increasing theirinvolvement in large complex institutions43 More awareness is alsorequired of the fact that they are national organizations in a world ofcross-border capital flows To a much greater extent they need a multi-national reach International supervision and coordination among super-visors are the subject of the next section
Our analysis suggests that G-10 supervisors have unfinished businessBank supervisors need to start yesterday securities regulators can waituntil tomorrow One G-10 member acting alone cannot correct the biasIn good times the lending business will simply migrate to other G-10banks In bad times financial problems will not stop at the national bor-der A way has to be found to establish common international standardsfor the key financial players in order to prevent crises and to agree onapproaches for managing them The path has already been laid out Inthe wake of the bank failures of the past 25 years bank supervisors havetried to establish such standards They have done this without creating anew global institution
The essence of the international framework is decentralizationmdashglobalrules and design standards without global institutions that are perceivedto intrude on national sovereignty The awkward jargon for this frame-work is vertical subsidiaritymdashldquothink internationally act nationallyrdquo Theinternational thinking is done by a committee of regulators that meets
International SupervisionA Decentralized Framework
43 These issues are discussed in Ferguson (1999) and Meyer (2000a)
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 123
regularly at the Bank for International Settlements in Basel The commit-tee establishes principles and standards that are interpreted implementedand enforced by national authorities44 In this section we describe thesesupervisory efforts and their weaknesses We present our recommenda-tions for addressing these weaknesses in the next chapter
Basel I
The Basel Capital Accord of 1988 (Basel I)45 drew the lesson from thefinancial crises of the mid-1970s that more adequate capital levels in in-ternational banks would help reduce the systemic risk of bank failureThe primary goal of Basel I was capital adequacy other standards wereput in place not so much for their own virtue as to defend the primarygoal
Capital adequacy requirements were designed to ensure that individualinstitutions have the ability to absorb losses particularly credit lossesAccordingly a backup system of scoring credit risk was devised thatrequired large amounts of bank capital for some types of loans smalleramounts for others and zero for a select list of preferred assets Report-ing requirements were designed to disclose problems and ensure that atroubled bank would take timely steps to restore its capital base in thewake of a loss The Basel I framework worked tolerably well in limitingthe call on the public purse in the G-10 countriesmdashwith the notable ex-ceptions of France and Japan The framework failed to moderate riskybank lending to emerging markets however
Basel I was not developed with emerging markets in mind The origi-nal idea behind it was to develop a common supervisory approach tocross-border banking operations It grew out of political pressure fromUS lawmakers who were determined to require international banks op-erating in the United States to meet US banking standards Toward thisgoal in 1983 Congress passed the International Lending Supervisory ActUS and British banking authorities subsequently agreed on a commontarget the adoption of strict common capital-adequacy standards In 1988other G-10 governments agreed to go along voluntary acceptance ofthe standards throughout much of the rest of the world followed46 Therationale for the capital targets was two-fold The first was to requirebanks to hold sufficient amounts of capital (8 percent of risk-adjusted
44 The international committee of financial authorities agreed on a common definitionof banksrsquo tier-one or ldquocorerdquo capital national authorities defined tier-two capital in theirown manner which permitted greater variations in national working definitions andpractices
45 International Convergence of Capital Measurement and Capital Standards (BIS 1988)was prepared by the Basel Committee on Banking Supervision
46 See Reineke (1998)
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124 WORLD CAPITAL MARKETS
assets) to cushion losses on those assets The second was to dull theirappetites for risk banks with large capital bases would have more tolose if they failed and therefore would take fewer risks
Rapid change in financial markets soon revealed flaws in the Basel IAccord In a complex world with numerous sources of risk it focusedheavily on credit risk but overlooked other risks in a bankrsquos portfolioand the correlation between returns on different asset classes The Baselformula required banks to maintain a fixed amount of capital againsteach of its asset classes But the formula did not distinguish the riskinessof the borrower within each class As a result one large loan to a low-risk corporate borrower such as General Electric would require the sameamount of capital as 10 smaller transactions with high-risk borrowers
The system was also biased toward short-term loans Loans maturingin less than a year required a 20 percent risk weight whereas those ma-turing after more than a year required a 100 percent risk weight Inter-bank lending was particularly favored For example loans to banks inOECD countries required less capital than loans to private firms in thesame countries creating the anomaly that interbank loans to South Ko-rean banks required less capital than loans to General Electric47 Thisanomaly encouraged banks to shed high-quality assets if the Basel rulesrequired the allocation of more capital than banks thought they needed
Another weakness was that financial innovators quickly circumventedthe Accord Because short-term loans required less provisioning than long-term loans banks responded by securitizing their long-term debt port-folios and lending short-term against the collateral of the newly createdasset This allowed banks to circumvent the capital requirements gearedto the terms of the underlying debt At the same time the Basel I Accordfailed to encourage risk mitigation techniques such as credit derivativescollateral guarantees and on-balance-sheet netting the flip side of fi-nancial innovation Because off-balance-sheet products were not coveredby the Accord another anomaly appeared when Barings Bank collapsedin 1995 Barings met capital adequacy standards but collapsed becauseits systems for managing risk failed traders were allowed to speculatein futures contracts that did not appear on the balance sheet
Basel II
Work to overhaul Basel I began in 1995 and produced consultativepapers issued in June 1999 and January 200148 These papers have been
47 South Korean banks have had notoriously weak balance sheets because the practiceof ldquodirected lendingrdquo left them with many poor loans (in making these loans the bankswere expected to follow government objectives rather than creditworthiness criteria)
48 Basel Committee on Banking Supervision (1999 2001)
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 125
the subject of extensive consultation and revision as a result the newAccord is expected to be introduced in 200449 The Basel II frameworkhas three parts (pillars) revisions to Basel I minimum-capital require-ments supervisory review criteria and greater emphasis on market dis-cipline Broadly Basel II aims to maintain the level of capital in the sys-tem but achieve better alignment of banksrsquo capital with their risk pro-files and keep up with financial innovation
To align capital requirements with market realities (the first pillar)Basel II concentrates on the 100 or so largest banksmdashthe type of playerslisted in table 21mdashand on the holding-company parents of banking groups50
Capital requirements will differentiate between an increased number ofcredit groups or ldquorisk bucketsrdquo including claims on governments otherbanks corporations mortgage-backed securities and other asset-backedsecurities
Basel II originally proposed to use external ratings to set capital chargesfor a number of these credit risks Many banks objected arguing thatthey assess credit risk better than Standard amp Poorrsquos Moodyrsquos or FitchIBCA51 Basel II thus proposes two approaches to rating a standard ap-proach using external ratings and an ldquoadvancedrdquo approach that allowsselected banks to use their own internal rating systems To encouragethe development of rigorous internal control systems based on these in-ternal rating systems Basel II also proposes to levy capital charges foroperational risk (the risk of direct or indirect loss resulting from inad-equate or failed internal processes people and systems or from exter-nal events)
Some critics of this proposal dismiss it as an abrogation of the prin-ciple of external independent monitoring and as ldquodangerously naiumlverdquo52
But regulators argue that the new capital charge on operational risk shouldoffset this concern It is also far from clear how cross-national compari-sons of rating and internal risk-assessment systems will be made (Engelen2000) The development by the European Union of its own capital rulescould well complicate the international resolution of these issues Publicassurances by EU officials in January 2001 however indicated that theirmain concerns are to create a level playing field and avoid regulatoryarbitrage (Hargreaves 2001) There is also the significant problem ofthe procyclical character of risk weights When a crisis hits losses are
49 See Berry (2000) for an update in an interview with William J McDonough chair ofthe Basel Committee on Banking Supervision
50 For obvious reasons these proposals are addressed to large banks and simpler capi-tal standards are allowed for small banks that focus on their domestic credit markets
51 See Ammer and Packer (2000) for an empirical critique of the success of rating agen-cies in distinguishing risk by sector and region
52 See Auerback (2001)
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126 WORLD CAPITAL MARKETS
incurred or accrued capital is lost and loan exposure must be reducedor securities sold to restore the requisite capital-adequacy ratios A morerisk-sensitive framework could amplify volatility
As the second pillar of Basel II supervisory review criteria are beingbeefed up to encourage supervisors to intervene earlier in potential problemsituations and to compel banks to align their capital positions with theirrisk profiles Bank supervisors will be authorized to require banks tohold capital in excess of minimum requirements if they have concernsabout general management overall strategy risk-management performanceor the macroeconomic environment Of course if one G-10 supervisorimposes higher capital requirements in isolation the same disparity willemerge that presaged Basel I Some banks will be disadvantaged in theinternational marketplace and will loudly complain that excessive super-vision is driving business to their competitors Hence close internationalcooperation among supervisors is critical
To implement the third pillar market discipline banks will be requiredto make fuller more timely disclosure of capital adequacy and the risksto which that capital is exposed A number of measures are being stud-ied that might help supervisors evaluate bank performance such as com-parisons of uninsured deposit interest rates subordinated debt yieldsand equity prices The idea is that these yields and prices might alertsupervisors to market perceptions of risk Of course market perceptionsare only as good as market information More direct and controversialways to reinforce market discipline would dramatically increase publicdisclosure of bank positions and risk management systems
Many questions are still outstanding about how to resolve the techni-cal details of capital requirements and whether the requirements willachieve their intended goal of better assessment and mitigation of therisks in banksrsquo portfolios There is no substitute for skilled supervisorsThe intricacies of effective design and implementation suggest that su-pervisors need to be highly competent technically knowledgeable aboutbanking portfolio characteristics and the factors that influence bank ex-posure to credit risk (Mishkin 2000) And they must be aided by vigilantshareholders market forces and transparency of information53
Standard setting at the global level is desirable but ultimately theeffectiveness of these efforts will be tested at the national level espe-cially in times of systemic financial distress Here the record of Basel Iwas not a bright shining success Japanese banking regulators havetraditionally allowed banks to include real estate and securities in theircapital base When the value of these assets plummeted in the early 1990sregulators allowed banks to continue valuing these depreciated (andoften bankrupt) assets at their old inflated levels Japanese authorities
53 Benedict Roth Complacency Towards Catastrophe Financial Times 23 January 2001
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 127
insisted until the mid-1990s that eroded capital bases could be rebuiltin a market-driven fashion They rightly foresaw that huge loan losseswould undermine public support for the ruling party and require a po-litically unpopular bailout
Japanese foot dragging on Basel I was the worst54 but not uniqueOther examples can be found of ldquopolitically mandated forbearancerdquo TheFederal Reserve Bank of New York held important hands during theLTCM crisis of 1998 Mexico is still resolving the banking crisis that eruptedin 1995 South Korea has not yet closed the insolvent banks that behavedso badly before the crisis of 1998 In the aftermath of a crisis nationalregulators cannot always be relied upon to discipline politically power-ful bankers55 One of the little-noticed consequences of these differingapproaches is that those banks with strong regulatory systems receivedan implicit ldquoexport subsidyrdquo for their services US banks which had notengaged extensively in emerging-market lending in the 1990s were bet-ter positioned than their German and Japanese counterparts to expandtheir international assets in the wake of the crises
Other Financial Forums
54 See Japanese Banks Fiddling while Marunouchi Burns The Economist 27 January2001 67-69
55 See Calomiris (1997)
The Basel model of vertical subsidiarity has already been extended toother financial regulatory bodies In 1993-94 the BIS established a Tri-partite Group of Banking Insurance and Securities Regulators In 1994-95 the BIS increased its cooperation with the International Organizationof Securities Commissions when the two organizations issued parallelpapers on guidelines for national regulators concerning risk managementand disclosure of derivative trades In 1996 a permanent Joint Forum onFinancial Conglomerates was established to examine supervisory issuesand develop working arrangements among the different functional super-visors of conglomerate institutions that offer combinations of bankingsecurities and insurance products Draft papers on the supervisionof conglomerates were released for comment in 1998 applying capital-adequacy principles to these groups and providing guidelines both forassessing the integrity and competence of top managers and for sharingassessments between regulators
In 1997 the Basel Committee on Banking Supervision extended itsreach beyond capital standards to broader aspects of banking supervi-sion with the publication of the Core Principles for Effective BankingSupervision In 1999 a wide range of regulatory and standard-settingbodies were gathered under the umbrella of the Financial Stability
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128 WORLD CAPITAL MARKETS
Forum (FSF) itself established under BIS aegis56 The FSF has alreadyissued recommendations for stepped-up supervision and transparencyas well as guidelines for best practices in a number of areas includingoffshore financial centers and highly leveraged institutions or hedge funds57
Conclusion
Although the structural weaknesses in emerging-market economies arewidely acknowledged to have been causal factors in international capi-tal-market volatility this chapter points to the role of large G-10 bankingorganizations as major suppliers of the most volatile instrument short-term debt We have examined evidence of the impact of public safetynets in the G-10 economiesmdashthe deposit insurance systems the pruden-tial supervisory systems and the lender-of-last-resort functions of centralbanksmdashon the incentive structures of these organizations
Although supervisors in most countries working nationally and to-gether in the BIS have made significant efforts to mimic market forcesin their prudential supervision the most sophisticated financial institu-tions find innovative ways to circumvent the rules New global regulatorybodies are not about to be created G-10 national bank regulators shouldthemselves address the short-term debt bias in the international financialsystem by changing incentive systems G-10 securities regulators shouldalso take steps to get ahead of the curve paying close attention to largeportfolio swings by institutional investors particularly in times of crisisIn short more needs to be done at national and international levels tochange the rules of the game That is the subject of the next chapter
56 The Financial Stability Forum includes banking securities insurance and accountingregulatory bodies the OECD on taxation corruption and corporate governance and theIMF
57 See Martin (2000)
Institute for International Economics | httpwwwiiecom
THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 89
Table 26 20 large insurance companies in 1998(billions of dollars)
Property and casualty insurance Marketcompanies Revenuea Assetsb capitalizationc
Allianz (Germany) 65 402 62d
Assicurazioni Generali (Italy) 48 178 30d
State Farm Insurance Cos (United States) 45 111 naZurich Financial Services (Switzerland) 39 215 45d
CGU (United Kingdom) 38 176 20d
Munich Re Group (Germany) 35 131 naAmerican International Group (United States) 33 194 135d
Allstate (United States) 26 88 20d
Royal amp Sun Alliance (United Kingdom) 25 76 11d
Loews (United States) 21 71 7e
Total 375 1642 330 plusTotal for G-10 375 1642 330 plus
MarketLife and health insurance Revenuea Assetsb capitalizationc
AXA (France) 79 452 39d
Nippon Life Insurance (Japan) 66 363 naING Group (Netherlands) 56 464 46d
Dai-ichi Mutual Life Insurance (Japan) 44 253 naSumitomo Life Insurance (Japan) 40 206 naTIAA-CREF (United States) 36 250 naPrudential Ins Co of America (United States) 34 279 naPrudential (United Kingdom) 34 197 30d
Meiji Life Insurance (Japan) 28 146 naMetropolitan Life Insurance (United States) 27 215 na
Total 444 2825 naTotal for G-10 444 2825 na
na = not available (usually an insurance company owned by its policyholders)G-10 = Group of Ten countries see note to table 11
a Data shown are for the fiscal year ended on or before 31 March 1999b Assets shown are those at the companyrsquos fiscal year-endc Market capitalization is calculated by multiplying the total number of shares by the shareprice at the companyrsquos fiscal year-endd Market capitalization data as of September 1999 from American Banker httpwwwamericanbankercome Individual companyrsquos market capitalization as of September 1999 from Yahoo yahoomarketguidecom
Sources Fortune Global 500 1999 httpwwwpathfindercomfortuneglobal500indexhtmlAmerican Banker httpwwwamericanbankercomRankingBanks1999 Yahoo Marketguideyahoomarketguidecom
Institute for International Economics | httpwwwiiecom
90 WORLD CAPITAL MARKETS
Table 27 Financial firms in the 100 largest companiesby revenue 1998 (billions of dollars)
Globalrank Company Revenuesa Assetsb Type
Continental Europe
15 AXA (France) 79 452 Insurance23 Allianz (Germany) 65 402 Insurance28 Ing Group (Netherlands) 56 464 Insurance37 Credit Suisse (Switzerland) 49 475 Banks commercial
and savings39 Assicurazioni Generali (Italy) 48 178 Insurance42 Deutsche Bank (Germany) 45 736 Banks commercial
and savings56 Zurich Financial Services (Switerland) 39 215 Insurance68 Munich Re Group (Germany) 35 131 Insurance72 ABN AMRO Holding (Netherlands) 34 507 Banks commercial
and savings77 Credit Agricole (France) 33 459 Banks commercial
and savings80 HypoVereinsbank (Germany) 32 541 Banks commercial
and savings84 Fortis (Belgium) 31 397 Banks commercial
and savings98 Socieacuteteacute Geacuteneacuterale (France) 30 450 Banks commercial
and savingsUnited Kingdom
47 HSBC Holdings 43 485 Banks commercialand savings
58 CGU 38 176 Insurance74 Prudential 34 197 Insurance
United States
16 Citigroup 76 669 Diversified financials35 Bank of America Corp 51 618 Banks commercial
and savings44 State Farm Insurance Cos 45 111 Insurance64 TIAA-CREF 36 250 Insurance67 Merrill Lynch 36 300 Securities71 Prudential Ins Co of America 34 279 Insurance76 American International Group 33 194 Insurance79 Chase Manhattan Corp 32 366 Banks commercial
and savings83 Fannie Mae 31 485 Diversified financials88 Morgan Stanley Dean Witter 31 318 Securities
Japan
21 Nippon Life Insurance 66 363 Insurance45 Dai-ichi Mutual Life Insurance 44 253 Insurance54 Sumitomo Life Insurance 40 206 Insurance91 Bank of Tokyo-Mitsubishi 31 664 Banks commercial
and savingsTotal 1279 11341Total for G-10 1279 11341
G-10 = Group of Ten countries see note to table 11
a Data shown are for the fiscal year ended on or before 31 March 1999b Assets shown are those at the companyrsquos fiscal year-end
Source Fortune Global 500 1999 httpwwwpathfindercomfortuneglobal500indexhtml
Institute for International Economics | httpwwwiiecom
THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 91
Tab
le 2
8N
on
fin
anci
al f
irm
s in
th
e 10
0 la
rges
t co
mp
anie
s b
y re
ven
ue
199
8 (b
illio
ns o
f do
llars
)
Glo
bal
Tra
nsn
atio
nal
ity
ran
k
Co
mp
any
Rev
enu
esa
Ass
etsb
ind
exc
Typ
e
Co
nti
nen
tal
Eu
rop
e
2D
aim
lerC
hrys
ler
(Ger
man
y)15
516
044
1M
otor
veh
icle
s an
d pa
rts
11R
oyal
Dut
chS
hell
Gro
up (
Net
herla
nds)
9411
058
9P
etro
leum
ref
inin
g17
Vol
ksw
agon
(G
erm
any)
7670
568
Mot
or v
ehic
les
and
part
s22
Sie
men
s (G
erm
any)
6667
521
Ele
ctro
nics
el
ectr
ical
equ
ipm
ent
32M
etro
(G
erm
any)
5222
n
a
Foo
d an
d dr
ug s
tore
s34
Fia
t (I
taly
)51
7640
8M
otor
veh
icle
s an
d pa
rts
36N
estle
(S
witz
erla
nd)
5041
932
Foo
d46
Veb
a G
roup
(G
erm
any)
4351
275
Tra
ding
49R
enau
lt (F
ranc
e)41
4545
7M
otor
veh
icle
s an
d pa
rts
53D
euts
che
Tel
ekom
(G
erm
any)
4093
n
a
Tel
ecom
mun
icat
ions
57R
oyal
Phi
lips
Ele
ctro
nics
(N
ethe
rland
s)38
3386
4E
lect
roni
cs
elec
tric
al e
quip
men
t59
Peu
geot
(F
ranc
e)38
4038
7M
otor
veh
icle
s an
d pa
rts
62E
lect
riciteacute
de
Fra
nce
(Fra
nce)
3711
3
na
Util
ities
ga
s an
d el
ectr
ic63
Rw
e G
roup
(G
erm
any)
3747
n
a
Util
ities
ga
s an
d el
ectr
ic65
BM
W (
Ger
man
y)36
3660
7M
otor
veh
icle
s an
d pa
rts
66E
lf A
quita
ine
(Fra
nce)
3643
576
Pet
role
um r
efin
ing
69V
iven
di (
Fra
nce)
3558
n
a
Eng
inee
ring
and
cons
truc
tion
70S
uez
Lyon
nais
e de
s E
aux
(Fra
nce)
3585
n
a
Ene
rgy
78E
NI
(Ita
ly)
3249
317
Pet
role
um r
efin
ing
86B
ayer
(G
erm
any)
3134
827
Che
mic
als
92A
BB
Ase
a B
row
n B
over
i (S
witz
erla
nd)
3132
957
Ele
ctro
nics
el
ectr
ical
equ
ipm
ent
93B
AS
F (
Ger
man
y)31
3159
5C
hem
ical
s95
Car
refo
ur (
Fra
nce)
3020
n
a
Foo
d an
d dr
ug s
tore
s
(tab
le c
ontin
ues
next
pag
e)
Institute for International Economics | httpwwwiiecom
92 WORLD CAPITAL MARKETS
Tab
le 2
8N
on
fin
anci
al f
irm
s in
th
e 10
0 la
rges
t co
mp
anie
s b
y re
ven
ue
199
8 (b
illio
ns o
f do
llars
) (c
ontin
ued
)
Glo
bal
Tra
nsn
atio
nal
ity
ran
k
Co
mp
any
Rev
enu
esa
Ass
etsb
ind
exc
Typ
e
Un
ited
Kin
gd
om
19B
P A
moc
o68
8559
2P
etro
leum
ref
inin
g43
Uni
leve
r45
3692
4F
ood
Un
ited
Sta
tes
1G
ener
al M
otor
s16
125
729
3M
otor
veh
icle
s an
d pa
rts
3F
ord
Mot
or14
423
835
2M
otor
veh
icle
s an
d pa
rts
4W
al-M
art
Sto
res
139
49
na
G
ener
al m
erch
andi
sers
8E
xxon
101
9365
9P
etro
leum
ref
inin
g9
Gen
eral
Ele
ctric
100
356
331
Ele
ctro
nics
el
ectr
ical
equ
ipm
ent
14In
tl B
usin
ess
Mac
hine
s82
8653
7C
ompu
ters
of
fice
equi
pmen
t25
US
Pos
tal
Ser
vice
6055
n
a
Mai
l pa
ckag
e a
nd f
reig
ht d
eliv
ery
27P
hilip
Mor
ris58
6051
1T
obac
co29
Boe
ing
5637
n
a
Aer
ospa
ce30
AT
ampT
5460
219
Tel
ecom
mun
icat
ions
40M
obil
4843
597
Pet
role
um r
efin
ing
41H
ewle
tt-P
acka
rd47
3451
1C
ompu
ters
of
fice
equi
pmen
t50
Sea
rs R
oebu
ck41
38
na
G
ener
al m
erch
andi
sers
55E
I d
u P
ont
de N
emou
rs39
40
na
C
hem
ical
s61
Pro
ctor
and
Gam
ble
3731
477
Soa
ps
cosm
etic
s75
Km
art
3414
n
a
Gen
eral
mer
chan
dise
rs81
Tex
aco
3229
453
Pet
role
um r
efin
ing
82B
ell
Atla
ntic
3255
n
a
Tel
ecom
mun
icat
ions
85E
nron
3129
n
a
Ene
rgy
87C
ompa
q C
ompu
ter
3123
n
a
Com
pute
rs
offic
e eq
uipm
ent
89D
ayto
n H
udso
n31
16
na
G
ener
al m
erch
andi
sers
94J
C
Pen
ney
3124
n
a
Gen
eral
mer
chan
dise
rs96
Hom
e D
epot
3013
n
a
Spe
cial
ty r
etai
lers
97Lu
cent
Tec
hnol
ogie
s30
27
na
E
lect
roni
cs
elec
tric
al e
quip
men
t10
0M
otor
ola
2929
n
a
Ele
ctro
nics
el
ectr
ical
equ
ipm
ent
Institute for International Economics | httpwwwiiecom
THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 93
Jap
an
5M
itsui
109
5635
8T
radi
ng6
Itoch
u10
957
333
Tra
ding
7M
itsub
ishi
107
7536
9T
radi
ng10
Toy
ota
Mot
or10
012
540
0M
otor
veh
icle
s an
d pa
rts
12M
arub
eni
9455
300
Tra
ding
13S
umito
mo
8946
259
Tra
ding
18N
ippo
n T
eleg
raph
amp T
elep
hone
7614
7
na
Tel
ecom
mun
icat
ions
20N
issh
o Iw
ai68
3938
8T
radi
ng24
Hita
chi
6282
214
Ele
ctro
nics
el
ectr
ical
equ
ipm
ent
26M
atsu
shita
Ele
ctric
Ind
ustr
ial
6067
332
Ele
ctro
nics
el
ectr
ical
equ
ipm
ent
31S
ony
5353
628
Ele
ctro
nics
el
ectr
ical
equ
ipm
ent
33N
issa
n M
otor
5158
511
Mot
or v
ehic
les
and
part
s38
Hon
da M
otor
4943
641
Mot
or v
ehic
les
and
part
s48
Tos
hiba
4151
252
Ele
ctro
nics
el
ectr
ical
equ
ipm
ent
51F
ujits
u41
4332
6C
ompu
ters
of
fice
equi
pmen
t52
Tok
yo E
lect
ric P
ower
4012
2
na
Util
ities
ga
s an
d el
ectr
ic60
NE
C37
42
na
E
lect
roni
cs
elec
tric
al e
quip
men
t90
Tom
en31
18
na
T
radi
ng99
Mits
ubis
hi E
lect
ric30
35
na
E
lect
roni
cs
elec
tric
al e
quip
men
t
Ch
ina
73S
inop
ec34
52
na
P
etro
leum
ref
inin
g
Tot
al (
aver
age
for
tran
snat
iona
lity
inde
x)3
988
447
949
0T
otal
for
G-1
0 (a
vera
ge f
or t
he i
ndex
)3
954
442
749
0
na
= n
ot a
vaila
ble
G-1
0 =
Gro
up o
f T
en c
ount
ries
see
not
e to
tab
le 1
1
a
Dat
a sh
own
are
for
the
fisca
l ye
ar e
nded
on
or b
efor
e 31
Mar
ch 1
999
b
Ass
ets
show
n ar
e th
ose
at t
he c
ompa
nyrsquos
fis
cal
year
-end
c
The
ind
ex o
f tr
ansn
atio
nalit
y is
cal
cula
ted
as t
he a
vera
ge o
f ra
tios
of f
orei
gn a
sset
s to
tot
al a
sset
s f
orei
gn s
ales
to
tota
l sa
les
and
for
eign
em
ploy
men
tto
tot
al e
mpl
oym
ent
as o
f 19
97 (
UN
CT
AD
)
Sou
rces
F
ortu
ne G
loba
l 50
0 1
999
http
w
ww
pat
hfin
der
com
fort
une
glob
al50
0in
dex
htm
l U
NC
TA
D (
1999
)
Institute for International Economics | httpwwwiiecom
94 WORLD CAPITAL MARKETS
foreign direct investment The ldquotransnationality indexrdquo (table 28) showsthat on average they conducted about half their business outside theirhome country9
Overview of the Players
Our review of the major players points to two major features First ahandful of big playersmdashfewer than 200 firms all toldmdashcontrol the ac-tion in international capital markets Their dominance will doubtless erodebut for now financial power is strikingly concentrated with them Sec-ond the big players are overwhelmingly based in the G-10 countriesplus Spain The responsibility to supervise them rests not in the IMFnor in Basel but squarely in Washington London Tokyo and the otherG-10 capitals At year-end 1999 the G-10 countries plus Spain accountedfor 84 percent of world banking assets 86 percent of world stock marketcapitalization and 76 percent of international debt securities (BIS 2000aWorld Bank 2000b)
International private capital flows are of three types bank loans anddeposits portfolio investment and foreign direct investment In cumula-tive total flows to emerging markets FDI was the biggest story in the1990s amounting to $954 billion (table 12) Portfolio flows were nextcumulatively amounting to somewhere between $612 billion (table 12)and $764 billion (table A1) Bank loans and deposits are the most com-plicated story
The Key Role of Banks
Banks are more important as an epicenter than as a wellspring Banksgenerate waves in the flow of capital to emerging markets rather than acontinuous steady stream According to data compiled by the Institute ofInternational Finance (table A1) net bank lending to emerging marketscumulated to $269 billion in the 1990s However deposits by emerging-market residents in G-10 banks more than offset G-10 bank lending tothese countries during the decade According to IMF data cumulativebank loans net of deposits amounted to a negative $135 billion (table 12)
In other words when loans and deposits are combined net bank ac-tivity that moves financial resources to emerging markets is small incomparison with portfolio investment and FDI But bank loans are thelubricant of any financial system Depending on circumstances bankscan be shock absorbers or shock propagators In recent decades with
9 The transnationality index is calculated as a simple average of the share of assetssales and employees outside the home country
Institute for International Economics | httpwwwiiecom
THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 95
respect to emerging markets banks have more often been propagatorsthan absorbers The average annual swing in bank lending to emergingmarkets was nearly $50 billionmdashby far the largest source of year-to-yearfluctuations in capital flows Both interbank loans between Europe Japanand Asia and sovereign Russian debt used as loan collateral played amajor role in the 1997-98 crisesmdashnot because banks are profligate playersbut because of the incentives they face and the instruments they useAccordingly our story begins with banks
Banks in the Modern Financial System
10 See Levine (2000) for a concise description of the role of banks in the financial system
11 The asymmetric information problem helps to explain why banks dominate the im-mature financial systems of emerging-market economies The general lack of informationon borrowers and undeveloped legal systems to enforce contracts hamper suppliers oflong-term financial instruments such as equities and bonds in evaluating risk and re-ward Banks are best suited in these circumstances to solve the asymmetric informationproblem by evaluating and monitoring private loans As more and better informationbecomes available capital markets develop and financial systems mature
As we noted in the previous paragraph the problem of financial volatil-ity in emerging-market economies is associated with bank lending Ifand when repayment problems arise cross-border private bank loansand bond placements are such that private creditors have no plausiblemeans of seizing assets from either private or sovereign borrowers Thusalthough international finance can nourish entrepreneurs and accelerategrowth a necessary complement may be a drastic creditor response inthe event of nonpaymentmdashto withhold fresh funds and force an eco-nomic crisis (Dooley 2000)
This argument is based on the characteristics of banks They are notldquobadrdquo per se They perform three essential functions in any financialsystem pooling the resources of disparate savers and channeling these re-sources into productive investment improving resource allocation throughtheir expertise in assessing and monitoring borrowers and facilitatingthe division of risk among numerous creditors10 But by their very na-ture banks are prone to two problems asymmetric information (the bor-rower knows more about the potential risk and return of its projectsthan the bank) and adverse selection (riskier borrowers will pay higherinterest rates and thus may constitute a disproportionate share of bankloan portfolios)11
Bank loans are illiquid fixed-price instruments They cannot easily beconverted to cash although they can be bundled into securities (knownas ldquosecuritizationrdquo) Once loan terms have been agreed on the only waya bank can adjust for shifting market conditions is by changing the quantityof its exposure When a borrower runs into trouble the bank can mix
Institute for International Economics | httpwwwiiecom
96 WORLD CAPITAL MARKETS
and match from two unpleasant menus It can roll over existing loansand extend new credit or it can call some part of existing loans andattempt to recover the principal It can also hedge by selling short otherclaims on the borrower These choices entail either an unwelcome exten-sion of the bankrsquos exposure or credit rationing against the borrower Whentrouble brews all banks encounter the same conditions in the aggregatethey prefer less exposure and ensuing credit restrictions lead to volatilebank lending
Innovation
12 Derivatives have no value of their own They ldquoderiverdquo their value from the value ofthe underlying asset They include swaps futures (contracts for future delivery at speci-fied prices) and options (which give one party the right but not the obligation to buyfrom or sell to a counterparty at an agreed price)
13 Maxfield (1998) analyzed available evidence of emerging-market investor objectivesmost of it before the crisis Analysis of portfolio equity flows is sensitive to the choice ofperiod with year-over-year data indicating that investors respond to country ldquofundamen-talsrdquo Other evidence suggests more ambiguity Ranking by ldquoinvestor impatiencerdquo ie thesearch for yield over value Tesar and Werner (1995) find short-term bank flows to be themost yield driven followed by portfolio investment FDI and long-term bank lending
14 Because market risk credit risk and country risk interact in complex ways newfinancial instruments have been created to help reduce negative interactions One is theldquototal return swaprdquo which has become an instrument of choice for hedge funds lookingfor high leverage Banks also use the total return swap to cover risks without increasingtheir capital requirements
Since the 1980s national and international banking systems have beentransformed by deregulation intensified competition and the informationand communications-technology revolutions The market environment isone of intense competition particularly in traditional banking activitiesThe innovations point away from traditional activities of plain vanilladeposit taking and loan making Three big themes are discernible Firstthe walls separating commercial banks investment banks portfolio man-agers and insurance firms are falling even if they are still distinct Sec-ond large banks are shifting toward securitizationmdashcreating securitiesout of everything from credit card debt to trade finance to disaster insur-ancemdashand earning fees in the process Third all large banks are shiftingtoward trading activity making markets and taking short-term stakes inbonds shares and derivatives12 These activities when successful satisfythe search for higher yields13
Many of the new financial instruments that banks trade are ldquooff bal-ance sheetrdquo This means that banks are not required to allocate capitalagainst them In swap contracts for example neither side pays cash at theoutset and therefore neither party has an asset in the traditional sense14
Futures and options contracts can be written with a relatively small initial
Institute for International Economics | httpwwwiiecom
THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 97
margin relative to the potential risk Credit derivatives limit credit risk bytransferring the potential loss associated with corporate loans and bondssovereign debt and other loan portfolios to counterparties15
Deregulation and innovation working in combination seem to havepushed banks into trading activity and leveraged plays but not into shareownershipmdasheven in jurisdictions that have no prohibition against equitystakes Among the G-10 banking systems the highest ratio of share own-ership to assets was only 5 percent in 1996 reached in Germany andJapan (Berlin 2000)16
The wave of innovation in financial instruments and the accompany-ing expansion of banking beyond its old boundaries is a two-edged swordOn one side it allows risk management far beyond what was tradition-ally possible Risk can now be shifted from firms that can ill afford lossesto those that can Banks can profitably act as intermediaries in shiftingrisk On the other side the innovation wave creates huge opportunitiesfor leveraged plays fostering a speculative search by banks themselvesfor high returns that in turn magnify their own risks17
15 Credit derivatives include total return swaps credit default swaps credit-linked notesand collateralized debt obligations They are the fastest-growing sector of the global de-rivatives market
16 Banks seem to specialize in lending even when they are allowed to mix finance andcommerce for reasons related both to how they are expected to behave with distressedfirms and to other intricacies of lender liability (Berlin 2000) Yet a recent cross-countrystudy found that restrictions on banking and commerce are associated with greater fi-nancial instability (Barth Caprio and Levine 2000)
17 Leverage is the magnification of the rate of return (positive or negative) on an in-vestment beyond the rate obtained by solely investing funds owned by the institution Itis often defined as the ratio of assets to equity Leverage is achieved by increasing thesize of an investment by borrowing or using derivative instruments such as futures oroptions These allow investors to earn a return on the notional amount underlying thecontract by committing a small portion of equity in the form of a margin deposit oroption premium payment
18 In a repo (repurchase agreement) one party (typically a trader) buys a bond andsells it to a dealer for cash with a promise to buy it back the next day at the same priceplus the overnight interest rate As long as the overnight interest rate is lower than theinterest accruing on the bond the trader earns some income on the bond The extremeform of these kinds of transactions was discovered at LTCM the failed US highly lever-aged institution which appears to have controlled more than $120 billion in assets froman investment of about $3 billion This leveraging was accomplished mostly through theuse of repos (Mayer 1999)
The potential for damage is illustrated in an extreme form by figure 21To precisely measure a firmrsquos leverage all positions must be known andrealistically valuedmdashwhich may be impossible to do Because many ac-tivitiesmdashsuch as repos18 and derivativesmdashdo not appear on the institutionrsquos
Leverage
Institute for International Economics | httpwwwiiecom
98W
OR
LD
CA
PIT
AL
MA
RK
ET
S
Figure 21 Hypothetical example of leverage
$1000 notional value of call option on equity in firms targeted for takeover
Repo FRN into cash and use cash to pay option premium
(repro is initially collateralized
Borrow $100 for margin purchase
$125 of US investment bank floating-rate notes (FRN) (secured by $25 equity in FRNs)
Repo off-the-run bond into cash and post margin
(repo is initially collateralizedSell (short) Borrow on-the-run bonds worth $20
$25 worth of off-the-run bonds (secured by $5 equity in bonds)
Exchange into $4
Cash $5 yen400 Japanese bank loans
$1 equity base
FRN = floating rate notesRepo = repurchase agreement
Source IMF (1998)
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 99
balance sheet and because balance sheets are published quarterly at bestoutsiders have a difficult time assessing the extent of a firmrsquos leverage19
Leveraging by a single firm enhances its risk of default the widespreaduse of leverage in the financial system can magnify market adjustmentsespecially when they require ldquodeleveragingrdquomdashunwinding prior positionsRapid adjustments can cause credit to dry up and asset prices to plummetIn a mark-to-market environment falling asset prices trigger calls foradditional collateral that can ripple through markets
Risk Management
Because it is confronted with the widespread use of leverage and prolif-erating kinds of risk international finance is increasingly driven by riskevaluation and control20 Different institutions face various risk profilesand differing kinds of risk The most common risks can be quickly tickedoff Banks because of their traditional intermediary role of channelingthe resources from savers to borrowers face significant credit risk therisk of default or delay in the payment of principal and interest Theymust also manage market risk the risk that the prices of their liabilitiesmay change faster than their assets Market risk devastated US savingsand loan institutions in the late 1980s
Closely associated with market risk are interest-rate risk (unexpectedchanges in market interest rates that slash margins net income and theeconomic value of a bankrsquos equity) and foreign exchange risk (losses thatarise when assets denominated in an appreciating foreign currency areless than liabilities denominated in that currency) Banks make numer-ous loans to other banks around the world portfolio investors buy se-curities direct investors acquire fixed assets and all incur country risk(economic and political uncertainty in the host country) During the heightof the Asian crisis for example interbank loans to Japanese banksreflected the credit risk of lending to these banks the so-called Japanpremium
Substantial attention has been lavished on country risk analysis sincethe 1982 debt crisis in developing countries Yet in spite of this exper-tise the Asian crisis occurred in part because of a sudden upward reap-praisal of country risk after the Thai baht collapsed in April 1997 Banksand other financial institutions must also manage liquidity risk the riskthat market conditions will change unexpectedly depressing demand andprices of assets at the time they want to sell these assets And they mustmanage operational riskmdashfailures in control systems or people that cause
19 Another example of asymmetric information Both risk and leverage are difficult foroutsiders to assess without full timely disclosure
20 A longer discussion of these issues can be found in Managing Global Finance in IMF(1999c)
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100 WORLD CAPITAL MARKETS
financial loss or damage reputations Operational risk devastated BaringsBank in 1995
Financial institutions practice risk management to measure all theserisks the potential damage to their investment positions and ultimatelythe chance of becoming insolvent VAR (value at risk) risk models mea-sure subject to certain assumptions the amount of the firmrsquos capital thatis exposed in each period For example the VAR model might say thatin a 3-standard-deviation worst case (a case that is not supposed to hap-pen more than 1 percent of the time) the firm will loose 25 percent of itscapital during the next year
VAR models are widely used but like all models they have weak-nesses They rely on past values to estimate key variables in financialmarkets past values are not always good predictors of future risks More-over rising volatility and higher loss correlation among different assetclasses in a portfolio will cause all banks using these models to reducetheir exposures at the same time by switching to less volatile and lesscorrelated assets such as US Treasury bills (Persaud 2000)
Newer risk models entail stress testing and scenario analysis Scenarioanalysis envisages possible adverse changes one at a time that mightaffect the investment portfolio Stress testing estimates potential losseswhen several individual risk factors simultaneously move against thefirm but it too uses historical probabilities
Financial Volatility
21 For example derivative markets usually rely on underlying securities markets thatproduce continuous prices When these markets are interrupted financial shocks cantrigger a cascade of margin calls and sell orders that move prices very sharply
22 See IIF (1999a)
The combination of trading activity and modern risk management lie atthe root of financial volatility When risks increase banks must eitherraise more capital to cover the greater risk or reduce their exposure bycutting loan exposure by selling securities or by undertaking new de-rivative trades Raising more capital is time-consuming and in a crisisvery expensive because bank shares are depressed So banks look to theother alternatives If the bank can reduce lending it need not book aloss But most banks use the same VAR models and as indicated abovethese models will encourage them to reduce their outstanding loans atthe same time actually magnifying loan volatility
If banks attempt to reduce their exposure to risk by selling securitiesor undertaking new derivative trades they may trigger large priceshocks because of limited and shrinking market liquidity21 The liquid-ity problem is compounded when a small number of large institu-tions hold the same positions22 Take your pick loan volatility or price
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 101
volatility As two experts have observed (Folkerts-Landau and Garber1998)
[V]olatility even in one country will automatically generate an upward re-estimate of credit and market risk in a correlated country triggering automaticmargin calls and tightening of credit lines Thus apparently bizarre opera-tions that connect otherwise disconnected securities markets are not the re-sponses of panicked green screen traders arbitrarily driving economies from agood to a bad equilibrium Rather they work with relentless predictability andunder the seal of approval of supervisors in the main financial centers
23 See Ferguson (1999)
24 As Gerald Corrigan (1982) put the matter ldquoBanks are specialrdquo Corrigan (2000) reit-erated this view even after all the changes of the past two decades Unlike other institu-tions banks offer on-demand transactions are a backup liquidity source for other insti-tutions and serve as a ldquotransmission beltrdquo for monetary policy
These changes in the banking environment accentuate an existing anomalyThe anomaly is that banks even as they grow larger and increasinglyengage in more risky and complex transactions are perceived to enjoyimplicit and explicit public guarantees
The guarantees grow out of an incentive problem inherent in bankingasymmetric information which we mentioned above Depositors know lessabout a bankrsquos management and the quality of its balance sheet than doits managers and shareholders Thus in times of uncertainty or adver-sity bank depositorsmdashuncertain whether they will have access to theirdepositsmdashare prone to bank runs This prospect has in turn compelledgovernments to treat banks differently than other firms because a bankthat fails can disrupt the rest of the economy24
To prevent such crises governments have entered into quid pro quoarrangements with banks Governments provide them both with an im-plicit safety net in the form of an unstated promise by the central bankto act as a lender of last resort in a liquidity crisis and an explicit safetynet in the form of a public deposit insurance fund to reassure depositorsIn return the banks submit to closer government oversight and regu-lation of their activities than is usual for industries in the private sector
The ldquoinsurancerdquo provided by the public safety net contributes to an-other incentive problem moral hazard Banks acquire greater tastes forrisk and face less market discipline than other firms The explicit depositinsurance safety nets actually have or are perceived to have blanketcoverage that extends beyond the retail depositors (households and small
One of the lessons of the 1997-98 crisis must surely be that market par-ticipants and their regulatory supervisors relied too heavily on quantita-tive tools and insufficiently on judgment23
The Anomaly of Modern Banking
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102 WORLD CAPITAL MARKETS
businesses) for which they were originally intended The implicit centralbank safety nets extend in a crisis to nearly all depositors and banksThus banks are both viewed and behave as if they will be bailed out ifthey get into trouble
The existence of a public safety net raises a perennial question Dobanks have an unfair advantage over other financial institutions becauseof the subsidy provided by the safety net This question was at the heartof intensive study and debate in the United States leading up to thepassage in November 1999 of the Financial Services Modernization Act(also known as the Gramm-Leach-Bliley Act) The size of the gross sub-sidy is difficult to estimate despite determined research efforts Somesuggest it is well under 100 basis points and is at least partly offset bythe direct costs of deposit insurance premiums interest payments on bondsissued by the Financing Corporation25 reserve requirements regulatoryexpenses and operational costs associated with collecting deposits26 Con-versely Kwast and Passmore (2000) suggest that banks can expand theirscope far beyond the levels that other financial institutions could reachwith the same equity base but without the public safety net
A related concern in the US debate is whether allowing banks to ex-pand their activities into securities and insurance will ultimately extendthe safety net and add to the subsidy The Financial Services Moderniza-tion Act deals with this issue by maintaining a legal separation betweenbanks and the rest of the banking organization known as large com-plex banking organizations (LCBOs) They must engage in most securi-ties activities and insurance underwriting through separately capitalizedinvestment bank subsidiaries or holding company affiliates This act canbe said to have merely brought US banking laws closer to those of mostother industrial countries (Barth Brumbaugh and Wilcox 2000 BarthNolle and Rice 2000) If the fire wall is well-maintained and stoutly de-fended the safety net will neither expand in practice nor become a sourceof comfort to noncommercial bank subsidiaries of LCBOs
The quid pro quo exacted by governments to offset the subsidy iscloser public-sector monitoring of banksrsquo activities through prudentialsupervision The effectiveness of this closer official scrutinymdashand closermarket monitoringmdashare the subjects of the next section
25 The Financing Corporation was created by Congress in 1987 to sell bonds to raisefunds to help resolve the savings and loan crisis
26 See Levonian and Furlong (1995) Jones and Kolatch (1999) Shull and White (1998)and Whalen (1999a 1999b)
Are G-10 bank supervisors adequately responding In this section we firstassess the case for and compare the structures of prudential supervisory
Prudential Supervision
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 103
systems both within and among the G-10 economies plus Spain andconsider whether these offset the subsidy provided by the public safetynet Despite offsetting regulation and supervision implicit and explicitguarantees by G-10 governments to their banks are still a source of bank-ing instability in the emerging-market economies
National Systems for Prudential Supervision
Governments use prudential supervision to reduce the moral hazard andadverse selection created by their own safety nets Supervisors establishregulations and monitor compliance to limit risk taking and ensure thesafety and soundness of the banking system In a thoughtful analysis ofthe case for prudential supervision Frederic Mishkin (2000) identifiesthe main forms that supervision can take including the tasks of grantingbanking charters and licenses establishing capital requirements settingdeposit insurance premiums and defining disclosure requirements as wellas carrying out bank examinations Bank examiners gather informationfrom banks and evaluate whether they are following the regulatorsrsquo rulesin cases of weakness they are empowered to change banksrsquo behaviorand close them if necessary
Supervisors also may restrict competition define the activities in whichbanks may engage and restrict their asset holdings and separate banksand other financial (or nonfinancial) activities During the past two de-cades the barriers separating commercial banks investment banks in-surance firms and securities firms have been all but eliminated (tableB1) Deregulation has stimulated competitive forces that drive diversifi-cation and consolidation of the financial industry nowhere faster than inthe United States
The Financial Services Modernization Act of 1999 confirmed this trendIt eliminated restrictions dating back to the Glass Steagall Act of 1933which once prevented banking insurance and securities firms fromentering each otherrsquos businesses (Barth Brumbaugh and Wilcox 2000)Cross-pillar mergers among banks insurance and securities firms arewell under way to form giant financial holding companies The 1999merger between Citibank (banking) and Travelers (insurance) created themodel for megafinance and confirmed new challenges for supervisors
Mishkin (2000) notes the corresponding evolution in US supervisionfrom an emphasis on rules-based regulation (detailed rules for opera-tional behavior and the quality of line items in the balance sheet) to anapproach that stresses the soundness of bank management practices es-pecially risk management
Appendix B outlines the systems of financial supervision now in theplace in the G-10 countries plus Spain Some systems like the UK andCanadian approach are models of simplicitymdashorganized to keep pacewith the spreading reach of financial conglomerates Other systems like
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104 WORLD CAPITAL MARKETS
the US and French approaches show traces of the bureaucratic divisionsthat made sense in an era when banking securities and insurance weresharply separated
The US Model
27 See Meyer (1999a)
28 Canada has a similar degree of simplification with the exception that securities firmsare still regulated by provincial authorities
29 See Pratti and Schinasi (1999 67)
30 The agents are the bank regulators and the principals are the taxpayers Agents maypursue their own interests including bureaucratic survival and postgovernment employ-ment opportunities rather than the national interest in banking safety and soundness
The US model of financial regulation delineated in the Financial Ser-vices Modernization Act of 1999 blends functional and umbrella super-vision Bank and thrift regulators oversee depository institutions Newnonbank activities are subject to both functional regulation (eg by theSecurities and Exchange Commission and state insurance examiners) andumbrella supervision (of financial holding companies) by the FederalReserve27
The UK Model
Another supervisory model exists in the United Kingdom as well as inAustralia Canada and Switzerland28 In this model banking supervisionis separated from the monetary policy function The regulatory structureis considerably simplified by relying on a consolidated financial regula-tor separate from the central bank for both banking and nonbankingactivities The remaining question answered differently depending on thecountry is the extent to which the regulator relies on home-country sur-veillance of banks and conglomerates that have a local presence
Regulatory Models Compared
Appendix B provides more detail on the differences in these modelsGerman simplicity contrasts with French complexity In France the bankingcommission is chaired by the governor of the central bank and includesrepresentatives from the Treasury The commission supervises compli-ance with regulations but the central bank inspects banks on behalf ofthe commission29 In countries such as the United States and France withmultiple supervisors and crossover functions internal coordination is criticalAt the same time multiple agencies create regulatory competition Wheneach agency knows what the other is doing transparency within gov-ernment circles can help to limit principal-agent problems of regulation30
The discussion as to where in the public bureaucracy financial super-
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 105
vision should be placed goes back many years Peek Rosengren andTootell (1999) argue that a synergy exists between monetary policy andprudential supervision because information gained in the course of super-vision can increase the accuracy of macroeconomic forecasts A twist tothis argument is that the information on the state of financial institutionsavailable to the central bank as supervisor can facilitate its role as lenderof last resort Conversely there is the concern that a supervisory rolewill compromise the central bankrsquos independence of action with respectto its core mandatemdashmaintaining price stability As these arguments haveplayed out financial supervision has generally been shared between centralbanks and other regulators or placed entirely in the hands of an inde-pendent regulator However in Italy the Netherlands and Spain cen-tral banks are the sole banking supervisor
Goodhart (1995) examined the arguments and evidence for each modeland concluded that there were no overwhelming arguments or evidencefor one or the other31 Going forward a key problem for any financialsupervisory system is dealing with (and closing as necessary) weak banksIf both central banks and other regulators have this responsibility closecoordination between them is critical Another problem is large conglom-erate banks LCBOs Although they are less likely to fail because of thediversification of their assets and liabilities they are more likely to berescued They are also more likely to be multinational enterprises withinternational implications Goodhart observes that regulation of theseentities might be put in the hands of the central bank because it is lessamenable to political pressures In any event the complexity of LCBOoperations suggests that greater supervisory rigor is necessary
The US Congress was persuaded that broad oversight would help containthe moral hazard problem and accordingly gave the Federal Reservethe role of umbrella supervisor with the understanding that the Fed willscrutinize depository activity more intensely than nonbank financial ac-tivities Under this approach LCBOs such as Citigroup are subject tomuch closer monitoring than smaller and simpler institutions32 The USregulatory model requires enormous cooperation between the Fed otherbank supervisors and the functional regulators for insurance and securi-ties but it also benefits from regulatory competition
31 National systems of supervision are path dependent they are determined by the struc-ture of financial institutions and history in each country If Goodhart (1995) is right out-comes are not materially better or worse with one model of supervision rather than another
32 See Ferguson (1999)
Public Safety Nets
One of prudential supervisorsrsquo biggest challenges is to reduce moral hazardFor many years commercial banks engaged in communal self-insurance
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106 WORLD CAPITAL MARKETS
to deal with crises They formed voluntary groups that agreed to rescuetroubled members As financial markets evolved and competition inten-sified banks were no longer willing to play this role Private-sector in-surance is one alternative but moral hazard and adverse selection wouldappear to prevent it from happening Public safety nets have developedbecause of the low probability and high cost of potential bank runs Aclear trade-off is involved The effectiveness of insurance in preventingbank runs is greater the more comprehensive the coverage But the morecomprehensive the coverage the greater the moral hazardmdashbank man-agers bank directors investors and depositors all take on greater risksin the belief that the safety net will protect them against losses
All G-10 countries have compulsory public safety nets for banks (table29) Deposit insurance agencies are officially organized in Canada theNetherlands Sweden Switzerland and the United States organized bythe industry in France Germany Italy and the United Kingdom andjointly organized by the public and private sectors in Belgium Japanand Spain
How well do G-10 governments offset the subsidy provided by thepublic safety net This is a question on which there is substantial debateAs banking organizations have become more complex the challengesthat supervisors face have become more difficult One challenge is toalign the incentives facing bank managers and shareholders with thoseof depositors Another is the principal-agent problem in supervision Wehave discussed the incentive structures for financial institutions but wehave said little about the incentives for supervisors themselves and thedistortions they can generate in the financial system
In one of the many studies of the US savings and loan crisis of the1980s Kane (1989) documented both problems He described managersusing cosmetic approaches to disguise the magnitude of insolvency regulatorspracticing forbearance even though they knew of the deteriorating riskprofiles of the institutions for which they were responsible and legisla-tors increasing deposit insurance without regard for any offsetting changesin supervision A subsequent overhaul of the legislative framework forthe Federal Deposit Insurance Corporation (FDIC) known as the FDICImprovement Act of 1991 (FDICIA) aimed to introduce a clearer incen-tive structure for both regulators and regulated institutions
The changes introduced by this US legislation are worth discussionwith respect to the other G-10 countries as well First FDICIA created astronger signal to management and investors by targeting deposit insur-ance at small depositors only and by risk-weighting the deposit insur-ance premiums paid by banks to reflect their capital adequacy and bankexaminer ratings Among the G-10 countries rated in table 210 depositinsurance premiums vary considerablymdashbut it is not clear that the dif-ferences have much to do with risk-weighting Most G-10 countries em-ploy funding formulas based for example on the total domestic deposit
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TH
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107
Table 29 Deposit insurance schemes in the G-10 countries Explicit safety net
Coverage limit(dollar Foreign
equivalent currency Interbank Source Bankrsquos Contingency fundingDate Membership Co- at end of deposit deposit of premium from banks
Country established managementa insuranceb July 1998)c covered covered Fundingd funding costs or governments
United 1982 Compulsory Yes Larger of 90 No No Unfunded Banks only Callable (subject Parliament may increase Kingdom private percent co- to maximum the maximum payable
insurance to 03 percent of pound125 million advance 33000 total deposits) facility with Bank of
England
United 1934 Compulsory No 100000 Yes Yes Funded Banks and Up to 027 Borrowing up to $3 States official government percent total billion from US Treasury
domestic deposits
Japan 1971 Compulsory No 71000 but No No Funded Banks and 0084 percent of Borrowing up to yen500bn joint in full until government insured deposits from Bank of Japan
year 2000 subject to Ministry of Finance approval
Canada 1967 Compulsory No 40800 No Yes Funded Banks and 033 percent of Borrowing up to C$6 official government insured deposits billion authorized further
(maximum) borrowing subject to parliamentary approval
Germany 1966 Compulsory Yes 90 percent Yes No Funded Banks only 003 percent of Annual levy may be private coinsurance deposits doubled
to 22000
Italy 1987 Compulsory Yes 125000 Yes No Unfunded Banks and Callable Two options defer private government (maximum of payment or diminish
1 percent of compensation to be paid total deposits)
(table continues next page)
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108W
OR
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CA
PIT
AL
MA
RK
ET
S
Table 29 Deposit insurance schemes in the G-10 countries Explicit safety net (continued )
Coverage limit(dollar Foreign
equivalent currency Interbank Source Bankrsquos Contingency fundingDate Membership Co- at end of deposit deposit of premium from banks
Country established managementa insuranceb July 1998)c covered covered Fundingd funding costs or governments
Netherlands 1979 Compulsory No 22000 Yes No Unfunded Banks and On demand Government backing official government maximum of subject to parliamentary
5 percent of own approval funds
France 1980 Compulsory No 65400 No No Unfunded Banks only Callable (on Extra calls up to FFr1000 private demand calls million can be made in
up to FFr200 a 5-year period million)
Switzerland 1984 Voluntary No 19700 No No Unfunded Banks only Callable (on Underwritten by member official demand) banks
Sweden 1996 Compulsory No 31400 Yes No Funded Banks and 05 percent of Full emergency coverage official government deposits while replacing it with a
limited system after the emergency
Belgium 1974 Compulsory No 16600 No No Funded Banks and Callable 002 None insurance limited joint 22000 in government percent of to assets in fund
year 2000 deposits from clients
Spain 1977 Compulsory No 16439 Yes No Funded Banks and 02 percent of Government backing joint government deposits through the Banco de
(maximum) Espantildea subject to approval by royal decree
a Bank membership in the fund can be either compulsory or voluntary and the management of the fund can be official and official and private joint or privateb Coinsurance refers to the situation where depositors face a deductible against their insured fundsc Coverage limit refers to the explicit amount the authorities promise to insured Funded scheme means that it is funded ex ante unfunded otherwise
Sources Goodhart (1995) Demirguccedil-Kunt and Detragiache (2000) Demirguccedil-Kunt and Sabaci (2000)
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 109
base Explicit safety net protection also varies but only Canada focuseson the protected class33 All G-10 countries specify a limit on depositorprotection Under FDICIA the insurance fund is prohibited from pro-tecting uninsured depositors or creditors at a failed bank although adiscretionary system-wide override is provided for exceptional circum-stancesmdashbut with stringent requirements for consultation and account-ability Other G-10 countries allow for contingency funding from the publicpurse alongside unwritten lender-of-last-resort support Among large banksa significant and growing portion of deposit liabilities including foreigncurrency and interbank deposits are uninsuredmdashbut depositors assumethey will be protected in a crisis
FDICIA also made some significant qualitative changes to address theprincipal-agent problem by penalizing weak banks and rewarding strongbanks For example banks whose capital declined faced progressivelytougher regulatory sanctions that for example required them to elimi-nate dividends restrict their lending and change their managementsRegulators have also been forced to take prompt corrective action (toreduce the practice of regulatory forbearance in hopes that a bankrsquos for-tunes might improve)34 Unfortunately comparative qualitative assess-ments across the G-10 are difficult to make due to lack of information35
This discussion highlights the complexity of evaluating the extent towhich prudential supervision and market discipline reduce the moralhazard associated with G-10 safety nets Our argument is that publicsafety nets in the G-10 can be linked to banking instability in other coun-tries specifically in the emerging-market economies that have attractedG-10 cross-border bank lending This lending is a leading source of vola-tility in capital flows the large financial institutions many of which arecomplex banking organizations are based in and regulated by authori-ties in the G-10 economies These two features of the international finan-cial system are closely related although it is not possible to test thisrelationship econometrically
Two World Bank studies however indicate a basis for concern Onestudy is a cross-country econometric analysis of the relationship betweenbank stability and deposit insurance (Demirguccedil-Kunt and Detragiache2000) which found a negative relationship Their estimated model forbanking crises in a sample of 61 countries (both industrial and develop-ing) suggests that explicit deposit insurance raises the probability of acrisis by at least 30 percent36 Crises are especially likely in countries
33 Japanrsquos legislation says it does but recent experience shows this is not the case34 See Goldstein (1997) for a summary of the changes35 See Barth Nolle and Rice (2000) for a beginning in this area36 Demirguccedil-Kunt and and Detragiache (2000 table 1) report a logit coefficient of 0696with a standard error of 0397 (the coefficient is significant at the 8 percent threshold)This suggests that the ldquotruerdquo coefficient could well be as small as 030 (the reportedvalue minus the standard error)
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110 WORLD CAPITAL MARKETS
with immature financial supervisory systems (and not in the G-10) buttheir analysis does underscore the view that deposit insurance weakensmarket discipline37
An earlier World Bank analysis established similar results One wasthat market discipline is undermined by deposit insurance schemes an-other was that illiquid banks are forced to pay more for their funds un-less a generous deposit insurance scheme is in place (Demirguccedil-Kuntand Huizinga 1999) This econometric study also provides clear-cut evi-dence that depositor monitoring of banks declines with the existence ofdeposit insurance schemes At the heart of the problem is the questionof whether deposit insurance is accompanied by increased governmentmonitoring
This evidence and the weight of other arguments suggests that moralhazard is still an issue in the G-10 countries Consider the ongoing de-bate about instilling greater market discipline on risk taking by banksAt one extreme is the perennial proposal to do away with safety netsleaving markets to monitor the players and to force adjustments but toprotect small savers by creating ldquonarrow banksrdquo such as postal savingsystems that are allowed to invest these savings only in risk-free gov-ernment securities Whatever the merits of narrow banking this solutionis too extreme to be politically feasible
A moderate alternative is to force more disclosure by financial institu-tions to facilitate market monitoring But transparency has its own prob-lems Persaud (2000) argues that financial markets cannot reliably discernsustainable from unsustainable positions in the short term This uncer-tainty causes banks to ldquoherdrdquo behind market leaders to exploit theirsupposedly superior information ldquoThe more herding investors and bankersknow about what each other is up to the [more] unstable markets maybecomerdquo The implication is that greater transparency in the marketplaceby itself will not solve the problemmdashand in the short term more informa-tion may exacerbate herding Further supervisory steps (discussed in thenext chapter) are required
Yet another proposal is to promote private-sector involvement in bankmonitoring through market-based alternatives such as Calomirisrsquos sub-ordinated debt proposal (Calomiris 1997 Federal Reserve Board 1999)Banks could be required to issue and maintain a minimum amount of
37 Other findings in the Demirguccedil-Kunt and Detragiache (2000) study include thesepropositions The impact of deposit insurance on bank stability tends to be stronger themore extensive is the coverage offered to depositors when the scheme is funded andwhere the scheme is run by the government rather than by the private sector Con-versely deposit insurance is detrimental to bank stability where bank interest rates havebeen deregulated and where the institutional environment is weak Additional findingson deposit insurance are reported from a recent World Bank conference (8-9 June 2000httpwwwworldbankorgresearchinterestconfsupcomingdeposit_insurancehomehtm)Also see Smalhout (2001)
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 111
subordinated debt (eg uninsured certificates of deposit) to finance asmall fraction (such as 2 percent) of their total nonreserve assets Thesubordinated debt would be allowed to earn a set yield no more than 50basis points over the risk-free yield on government treasury bills Thisrule would supposedly force banks to operate in a safe manner Other-wise subordinated debt holders would redeem their uninsured certifi-cates of deposit and equity investors would sell their bank shares Despiteits practical problems the beauty of the subordinated debt requirementis that it enlists market incentives to push banks to avoid excessive port-folio risk38
The thrust of these proposals is very relevant to the arguments in ourstudy Even in the G-10 countries government monitoring by itself hasnot eliminated moral hazard among banks More work is needed to in-troduce market monitoring and to improve the incentive structures bothfor financial institutions and their supervisors We return to this issuewith our recommendations in the next chapter
38 In late 1996 Argentina began requiring its banks to finance 2 percent of total depos-its in the form of subordinated debt but without a maximum yield provision TheArgentine authorities expect that market discipline will act in concert with the publicsafety net One obvious problem with the subordinated debt proposal is that banks mayencourage some of their customers to buy the subordinated debt
Portfolio Institutions Tomorrowrsquos Problem
Before proceeding to the issues of international supervision we flag an-other potential problem for national regulators The big asset managersprofiled in tables 24 and 26 answer to diverse groups of pensionersshareholders and policyholders They allocate funds across a number ofcountries to diversify their risks They hold liquid assets that can be tradedand they have a higher proportion of long-term assets than banks Eco-nomic shocks can be absorbed through price changes and their effectsspread across time and markets Thus when conditions change in a par-ticular market they are more likely to ride out the storm than to flee Inother words they have less incentive than banks to pull their invest-ments in the face of adversity In the 1990s most large asset managersestablished a record of ldquoriding out the stormrdquo rather than ldquorunning withthe windrdquo although as we saw in chapter 1 instances of running withthe wind were detected in some portfolios As we write these insti-tutions have a good record overall in the emerging markets so whyworry
The Russian crisis and the near-collapse of LTCM previewed the dan-gers that may await future portfolio managers and G-10 financial minis-ters We have presented evidence indicating a systemic bias toward bank
Institute for International Economics | httpwwwiiecom
112 WORLD CAPITAL MARKETS
lending and debt finance to emerging markets and we have argued forsubstitution toward equity finance and direct investment39
That is not the end of the story We noted in the previous chapterthat institutional investors can become momentum investors selling in adownturn As more portfolio capital is invested in emerging marketssome players may adopt the high-risk high-leverage strategies of themost aggressive hedge funds Indeed the data in box 11 show that G-10portfolio investors held somewhat more long-term debt (more than $500billion) than equity (less than $400 billion) in emerging markets at theend of 1997 Long-term debt is an ideal vehicle for high-risk high-leveragestrategies These strategies practiced on a large scale could compound afuture crisis harming emerging markets A big enough crisis could inturn pressure G-10 central banks and finance ministers to arrange bail-out plans Instead of shrinking as a systemic financial problem moralhazard could increase
National securities regulators are the first line of defense against thisscenario They play a critical role in the safe evolution of capital mar-kets But regulators today are mandated to approve the issuance of newsecurities and to monitor the continuing disclosure of material informa-tion by issuers They are far less concerned with or empowered to monitorthe behavior of the increasingly large wealth-management firms that arethe major purchasers (and therefore resellers) of these securities
Within their mandates the goals of national securities regulators (table210 and appendix B) are similar to the concerns of bank regulators withsystem safety and soundness Their focus is also on the incentive sys-tems for management and boards of directors and on disclosure by cor-porations that issue marketable securities such as shares bonds andasset-backed securities 40 Issuers of securities possess greater knowledgeabout the quality of these assets than do the purchasers hence investorprotection is a key concern of regulators Moreover market disciplineworks best when markets know what is happening Well-functioning corpora-tions are key agents of wealth creation and social progress Underperform-ing corporations waste resources During recessions bad corporationsget into bad trouble often with severe social consequences Inadequateincentives for managers and inadequate accountability for boards andmanagers thus have negative externalities Regulators play a vital role inexposing weakness so that market disciplines come to bear sooner ratherthan later
Regulatory emphasis is constantly shifting as financial markets evolveand as the macroeconomic environment changes Regulators try to balance
39 See Rogoff (1999) Also see Berlin (2000) for a perspective on the limited role thatbanks play as share owners
40 See Habib and Ljungqvist (2000) for recent empirical analysis showing that corporateshare market values are higher when corporate executives have a larger ownership stake
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E P
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OR
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ND
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113
Table 210 Financial-sector regulation G-10 countries 2000
Financial institutions and their supervisors
Country and supervisory structure Retail banking Wholesale banking Securities Insurance
Financial conglomeratesFinancial Services Authority (FSA) = umbrella supervisor
United Kingdom FSA FSA FSA FSA
Treasury bull Commercial banks bull Investment funds (Securities and (Insurance Directorate(Securities and Investments Board) bull Unit trust groups Futures Authority) of the Treasury)
Bank of bull Building societies bull Pension funds England (Building Societies Commission) bull Merchant banks
bull Friendly societies bull Clearing houses bull Primary issuers bull Insurance FSA (Friendly Societies Commission) bull Venture capital of securities companies
bull Pensions and life insurance etc bull Stock exchanges bull Insurance brokers(Personal Investment Authority) bull Stockbrokers
Financial holding companiesFederal Reserve (FR) = umbrella supervisor
United States bull National banks(OCC) Securities and Regulated by
Treasury OCC bull State banks Federal Reserve Exchange Commission StatesMembers (FR)
OTS Nonmembers (FDIC) bull Investment banks bull Primary issuers of bull Insurance companies FR bull Cooperative banks (FDICFR) bull Finance companies securities bull Insurance brokers FDIC bull Insured industrial banks (FDIC) bull Stock exchanges
bull Thrift holding companies (OTS) bull Stockbrokers SEC bull Savings banks (OTSFDICFR) bull Investment advisors
bull Savings and loan associations bull Mutual funds(OTS) bull Public utility holding
bull Edge Act corporations (FR) companies
(table continues next page)
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Table 210 Financial-sector regulation G-10 countries 2000 (continued )
Financial institutions and their supervisors
Country and supervisory structure Retail banking Wholesale banking Securities Insurance
Financial holding companies Japan Financial Supervisory Authority (FSA) = umbrella supervisor
Prime FSA FSA FSA FSA ministerrsquos Ministry of office Finance (Securities and Exchange
Surveillance Commission) FRC Bureau of Financial bull City banks bull Investment banks bull Primary issuers of bull Insurance companies FSA Regulation bull Regional banks bull Asset managers securities bull Insurance brokers
bull Trust banks bull Stock exchanges SESC bull Long-term credit banks bull Stockbrokers
bull Pension funds
Financial holding companiesOffice of the Superintendent of Financial Institutions (OSFI) = umbrella supervisor
Canada Regulated by OSFI OSFI provinces OSFI
Department of Financebull Banks bull Cooperative credit bull Primary issuers of bull Insurance companies
(previously Office of the Inspector associations securities (previously Depart- OSFI General of the Banks) bull Fraternal benefit bull Stock exchanges ment of Insurance) Bank of bull Trust and loan companies society bull Stockbrokers bull Insurance brokers Canada bull Pension funds bull Asset managers
(previously Depart- CDIC ment of Insurance)
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Financial institutions and their supervisors
Country and supervisory structure Retail banking Wholesale banking Securities Insurance
Germany Financial holding groupsFederal Banking Supervisory Office (FBSO) = umbrella supervisor
Ministry of Finance FBSO BSO FSSO FISO
Bundesbankbull Universal banks bull Other financial bull Primary issuers of bull Insurance companies
Federal Banking bull Savings banks institutions (eg securities bull Insurance brokers Supervisory Office bull Securities banks management foreign bull Stock exchanges
currency dealings) bull Stockbrokers Federal Securities bull Financial enterprises bull Asset managers Supervisory Office (eg leasing bull Pension funds
organizations Federal Insurance credit card companies Supervisory Office investment advisors)
Italy Bank foundationsMinistry of Finance = umbrella supervisor
Ministry of Finance Bank of Italy Bank of Italy Consob ISVAP
Bank of Italy bull Commerical banks bull Asset managers bull Primary issuers of bull Insurance companies Consob bull Savings bank bull Open-end investment securities bull Insurance brokers
bull Securities banks companies (SICAVs) bull Stock exchangesbull Stockbrokers
ISVAP
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Table 210 Financial-sector regulation G-10 countries 2000 (continued )
Financial institutions and their supervisors
Country and supervisory structure Retail banking Wholesale banking Securities Insurance
The Netherlands Financial conglomeratesCouncil of Financial Supervisors = umbrella supervisor
Securities Board Securities Board Netherlandsche Netherlands Bank Netherlandsche Bank of the Netherlands Insurance Board Bank Insurance bull Credit institutions (universal banks bull Investment institutions bull Stock exchanges bull Insurance companies Board cooperative banks security credit (securities issuing bull Stockbrokers bull Insurance brokers
institutions mortgage banks) and tradingmdashprimary The Council of Financial and secondary Supervisors markets)
France Commission des Commission de Operations des Controcircle des
Banking and Banking Commission Bourse Assurances Financial Regulatory bull Ensuring that credit institutions (and investment firms since bull Primary issuers of bull Insurance companies Ministry for Committee the Financial Activity Modernization Act of 1996) comply securities bull Insurance brokers Economic with laws and regulations bull Stock exchanges Affairs and bull Execute instructions regarding all off-site monitoring and bull Stockbrokers Finance Credit on-site supervision Institutions and Banking and Financial Regulatory Committee Investment bull Formulates general regulations for credit institutions and investment firms Committee (capital adequacy requirements accounting rules etc) Bank of France Credit Institutions and Investment Committee Banking bull Authorizes and examines financial institutions except for those within the Commission competence of the Banking Commission
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117
Financial institutions and their supervisors
Country and supervisory structure Retail banking Wholesale banking Securities Insurance
Switzerland Large banking groupSwiss Federal Banking Commission (SFBC) = umbrella supervisor
Swiss National Bank Federal Office of
SFBC SFBC SFBC Private Insurance Swiss Federal Banking Commission bull Universal banks bull Investment banks bull Primary issuers of bull Insurance companies
bull Savings banks bull Asset management securities bull Insurance brokerscompanies bull Stock exchanges
Private audit Federal bull Investment funds bull Stockbrokers firms Office of bull Mortgage bond authorized by Private business SFBC Insurance
Sweden Financial holding company groupsFinancial Supervisory Authority = umbrella supervisor
Ministry of Finance Credit Market Securities Market Insurance Market
Credit Market Department Department Department Department
Financial bull Commercial banks bull Investment funds bull Primary issuers of bull Insurance companies Riksbank Supervisory bull Savings banks securities bull Insurance brokers Authority bull Friendly societies bull Stock exchanges
bull Stockbrokers
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Table 210 Financial-sector regulation G-10 countries 2000 (continued )
Financial institutions and their supervisors
Country and supervisory structure Retail banking Wholesale banking Securities Insurance
Belgium Bank holding companiesBanking and Finance Commission = umbrella supervisor
Bank of Belgium Banking Banking
Banking and Finance and Finance Insurance Controland Finance Commission Commission Commission Office
Banking and Insurance Finance Control bull Commercial banks bull Asset management bull Primary issuers of bull Insurance companies Commission Office bull Savings banks firms securities bull Insurance brokers
bull Securities banks bull Investment funds bull Stock exchanges bull Mortgage companiesbull Stockbrokers bull Pension funds
Securities Regulation Fund Securities Regulation Fund
bull Other investment firms and credit institutions(institutions participating in regulated off-exchangemarket in strips and Treasury certificates)
Bank holding companies Spain Banco de Espantildea = umbrella supervisor
Banco de Espantildea Comision Nacional del Mercado de Directorate General
Banco de Espantildea Valores (CNMV) Insurance
bull All credit institutions (commercial banks savings banks credit bull Primary issuers of (Ministry of Economy Ministry of cooperatives official credit institutions finance factoring and securities and Finance) Economy and CNMV leasing companies mortgage-loan companies etc) bull Stock exchanges bull Insurance companies Finance bull Interbank foreign exchange and book-entry public debt bull Stockbrokers bull Pension funds
markets bull Venture capital(companies and funds)
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119
Financial institutions and their supervisors
Country and supervisory structure Banking Securities Insurance
Banking Advisory High Level Securities Supervisors Committee (BAC) Committee (HLSS) Insurance Committee (IC)
Supranational (EU) bull Formulates standards for prudential bull Coordination of securities market bull Formulates standards forsupervision supervision prudential supervision
BACICHLSS Banking Supervision
Conglomerates Committee (BSC) Securities Contact Committee Regulation of prudential bull Systemic risk monitoring bull Regulation and implementation of supervision securities admission
International Association International International Organization of of Insurance Supervisors
Basel Committee Securities Commisison (IOSCO) (IAIS) Joint Forum Conglomerates Supervision bull Supervision and regulation best bull Supervision and regulation best bull Supervision and regulation amp regulation Best practices practices practices best practices
FSF Coordination across supervisors of various functions
Notes See appendix B for more information Boldface type indicates senior or oversight supervisor normal type indicates adjunct or front-line supervisorsolid line indicates direct responsbility to the senior-ranking authority dotted line indicates coordination in supervisory activities
(table continues next page)
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Table 210 Financial-sector regulation G-10 countries 2000 (continued )
Glossary of names United Kingdom FSA = Financial Services Authority United States FR = Federal Reserve OCC = Office of the Comptroller of theCurrency FDIC = Federal Deposit Insurance Corporation SEC = Securities and Exchange Commission OTS = Office of Thrift Supervision Japan FRC =Financial Reconstruction Commission FSA = Financial Services Agency SESC = Securities and Exchange Surveillance Commission Canada OSFI =Office of the Superintendent of Financial Institutions CDIC = Canada Deposit Insurance Corporation Germany FBSO = Federal Banking SupervisoryOffice FSSO = Federal Securities Supervisory Office FISO = Federal Insurance Supervisory Office BSO = Banking Supervisory Office Italy Consob =Commissione Nazionale per le Societa e la Borsa ISVAP = Instituto per la Vigilanza sulle assicurazioni private e di Interesse colletivo Switzerland SFBC= Swiss Federal Banking Commission Spain CNMV = The Comision Nacional del Mercado de Valores Supranational BAC = Banking Advisory CommitteeBSC = Banking Supervision Committee IC = Insurance Committee HLSS = High Level Securities Supervisors Committee International Dimension FSF =Financial Stability Forum IOSCO = International Organization of Securities Commission IAIS = International Association of Insurance Supervisors
Sources United Kingdom Bank of England httpwwwbankofenglandcouk Financial Services Authority httpwwwfsagovuk United States Board ofGovernors of Federal Reserve System httpwwwfederalreservegov Japan Bank of Japan httpwwwbojorjo Financial Reconstruction Commissionhttpwwwfsagojpfrcindexehtml Financial Services Agency httpwwwfsagojp Canada Bank of Canada httpwwwbank-banque-canadaca Office ofthe Superintendent of Financial Institutions httpwwwosfi-bsifgccaAndreEindexhtml Germany Deutsche Bundesbank httpwwwbundesbankde Fed-eral Banking Supervisory Office httpwwwbakredde Italy Banca drsquoitalia httpwwwbancaditaliait Commissione Nazionale per le Societa e la Borsahttpwwwconsobit Instituto per la Vigilanza sulle assicurazioni private e di Interesse colletivo httpwwwisvapit The Netherlands De NederlandscheBank httpwwwdnbnl France Banque de France httpwwwbanque-francefr Switzerland Schweizerische Nationalbank httpwwwsnbchindex3htmlSweden Sveriges Riksbank httpwwwriksbanksedefaultasp Belgium National Bank of Belgium httpwwwbnbbesgindexhtm Spain Banco de Espantildeahttpwwwbdees The Comision Nacional del Mercado de Valores httpwwwcnmves Supranational (EU) Institutional Arrangements for the Regulationand Supervision of the Financial Sector 2000 International Dimension Bank for International Settlement httpwwwbisorg International Organization ofSecurities Commissions httpwwwioscoorg International Association of Insurance Supervisors httpwwwiaisorg Financial Stability Forum httpwwwfsforumorg
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 121
the inflexibility of tight surveillance against the need to encourage in-novation and growth The US Securities and Exchange Commission isworried about aggressive accounting by firms and biased reports bysecurities analysts in an equity environment that prizes steadily higherquarterly earnings41 Japanese regulators are preoccupied with opaqueinterconnections between portfolio institutions banks and nonfinancialfirms through the keiretsu system Canadian regulators reeling from high-profile scandals of managers intentionally misleading investors are strengtheningmarket discipline through legal penalties aimed at managers and directorsof offending firms
When panic strikes a securities regulator cannot do much As the 1987stock market crash and the LTCM debacle in the fall of 1998 both dem-onstrated steep stock and bond price declines can create systemic risksIf severe enough the wealth effect of falling securities values and thefear of widespread insolvency can depress real activity Flooding thesystem with liquidity is a central bankerrsquos solutionmdashsomething a securi-ties regulator cannot do42 But just as financial supervisors can changethe incentive structure to discourage bankers from making risky loans ingood times so securities regulators can pay more attention to incentiveson the demand side when capital markets are strong
Prudential Supervision and InnovationmdashA Footnote
In concluding this discussion of prudential supervision in the G-10 anadditional point is worth noting National regulators face a persistenttrade-off between emphasizing financial system safety and soundnesswhile encouraging innovationmdashin spite of the added risks innovationbrings to financial markets Former US Treasury Secretary Lawrence Summers(2000 3) has argued by analogy
The jet airplane made airplane air travel more comfortable more efficient andmore safe though the accidents were more spectacular and for a time morenumerous after the jet was invented In the same way modern global financialmarkets carry with them enormous potential for benefit even if some of theaccidents are that much more spectacular As the right public policy response
41 The problem is illustrated by the divergence since mid-1998 between reported earn-ings by the Standard amp Poorrsquos (SampP) 500 and the after-tax profits of all corporations inthe national accounts Generally these two series move closely with one another Be-tween mid-1998 and mid-1999 SampP 500 reported that earnings increased by more than20 percent while after-tax profits of all corporations increased by less than 5 percent(Chase Bank US Economic and Policy Research US Weekly Prospects Chase SecuritiesWeekly Newsletter 5 June 2000 5)
42 For example the US Securities and Exchange Commission had no direct role in calmingmarkets in the 1987 or 1998 panics
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122 WORLD CAPITAL MARKETS
to the jet was longer runways better air-traffic control and better training forpilots and not the discouragement of rapid travel so the right public policyresponse to financial innovation is to assure a safe framework so that the ben-efits can be realized not to stifle the change
Accepting Summersrsquos analogy for the international financial system better-informed supervisors and investors are a necessary part of the financialsystem framework Supervisors require more timely information on therisk profiles resulting from positions taken by financial institutions Theyalso need a better understanding of risk-management systems Snapshotsof an institutionrsquos risk profile and risk-management procedures are nolonger adequate In a world where huge bets are quickly made (andpossibly lostmdashas with Barings Bank in 1995 and LTCM in 1998) super-visors must focus on the soundness of banking systems for evaluatingand managing risk on a daily basis Some progress has been made inaddressing these issues US banking examiners are extending their in-formation requirements in banking examinations and increasing theirinvolvement in large complex institutions43 More awareness is alsorequired of the fact that they are national organizations in a world ofcross-border capital flows To a much greater extent they need a multi-national reach International supervision and coordination among super-visors are the subject of the next section
Our analysis suggests that G-10 supervisors have unfinished businessBank supervisors need to start yesterday securities regulators can waituntil tomorrow One G-10 member acting alone cannot correct the biasIn good times the lending business will simply migrate to other G-10banks In bad times financial problems will not stop at the national bor-der A way has to be found to establish common international standardsfor the key financial players in order to prevent crises and to agree onapproaches for managing them The path has already been laid out Inthe wake of the bank failures of the past 25 years bank supervisors havetried to establish such standards They have done this without creating anew global institution
The essence of the international framework is decentralizationmdashglobalrules and design standards without global institutions that are perceivedto intrude on national sovereignty The awkward jargon for this frame-work is vertical subsidiaritymdashldquothink internationally act nationallyrdquo Theinternational thinking is done by a committee of regulators that meets
International SupervisionA Decentralized Framework
43 These issues are discussed in Ferguson (1999) and Meyer (2000a)
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 123
regularly at the Bank for International Settlements in Basel The commit-tee establishes principles and standards that are interpreted implementedand enforced by national authorities44 In this section we describe thesesupervisory efforts and their weaknesses We present our recommenda-tions for addressing these weaknesses in the next chapter
Basel I
The Basel Capital Accord of 1988 (Basel I)45 drew the lesson from thefinancial crises of the mid-1970s that more adequate capital levels in in-ternational banks would help reduce the systemic risk of bank failureThe primary goal of Basel I was capital adequacy other standards wereput in place not so much for their own virtue as to defend the primarygoal
Capital adequacy requirements were designed to ensure that individualinstitutions have the ability to absorb losses particularly credit lossesAccordingly a backup system of scoring credit risk was devised thatrequired large amounts of bank capital for some types of loans smalleramounts for others and zero for a select list of preferred assets Report-ing requirements were designed to disclose problems and ensure that atroubled bank would take timely steps to restore its capital base in thewake of a loss The Basel I framework worked tolerably well in limitingthe call on the public purse in the G-10 countriesmdashwith the notable ex-ceptions of France and Japan The framework failed to moderate riskybank lending to emerging markets however
Basel I was not developed with emerging markets in mind The origi-nal idea behind it was to develop a common supervisory approach tocross-border banking operations It grew out of political pressure fromUS lawmakers who were determined to require international banks op-erating in the United States to meet US banking standards Toward thisgoal in 1983 Congress passed the International Lending Supervisory ActUS and British banking authorities subsequently agreed on a commontarget the adoption of strict common capital-adequacy standards In 1988other G-10 governments agreed to go along voluntary acceptance ofthe standards throughout much of the rest of the world followed46 Therationale for the capital targets was two-fold The first was to requirebanks to hold sufficient amounts of capital (8 percent of risk-adjusted
44 The international committee of financial authorities agreed on a common definitionof banksrsquo tier-one or ldquocorerdquo capital national authorities defined tier-two capital in theirown manner which permitted greater variations in national working definitions andpractices
45 International Convergence of Capital Measurement and Capital Standards (BIS 1988)was prepared by the Basel Committee on Banking Supervision
46 See Reineke (1998)
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124 WORLD CAPITAL MARKETS
assets) to cushion losses on those assets The second was to dull theirappetites for risk banks with large capital bases would have more tolose if they failed and therefore would take fewer risks
Rapid change in financial markets soon revealed flaws in the Basel IAccord In a complex world with numerous sources of risk it focusedheavily on credit risk but overlooked other risks in a bankrsquos portfolioand the correlation between returns on different asset classes The Baselformula required banks to maintain a fixed amount of capital againsteach of its asset classes But the formula did not distinguish the riskinessof the borrower within each class As a result one large loan to a low-risk corporate borrower such as General Electric would require the sameamount of capital as 10 smaller transactions with high-risk borrowers
The system was also biased toward short-term loans Loans maturingin less than a year required a 20 percent risk weight whereas those ma-turing after more than a year required a 100 percent risk weight Inter-bank lending was particularly favored For example loans to banks inOECD countries required less capital than loans to private firms in thesame countries creating the anomaly that interbank loans to South Ko-rean banks required less capital than loans to General Electric47 Thisanomaly encouraged banks to shed high-quality assets if the Basel rulesrequired the allocation of more capital than banks thought they needed
Another weakness was that financial innovators quickly circumventedthe Accord Because short-term loans required less provisioning than long-term loans banks responded by securitizing their long-term debt port-folios and lending short-term against the collateral of the newly createdasset This allowed banks to circumvent the capital requirements gearedto the terms of the underlying debt At the same time the Basel I Accordfailed to encourage risk mitigation techniques such as credit derivativescollateral guarantees and on-balance-sheet netting the flip side of fi-nancial innovation Because off-balance-sheet products were not coveredby the Accord another anomaly appeared when Barings Bank collapsedin 1995 Barings met capital adequacy standards but collapsed becauseits systems for managing risk failed traders were allowed to speculatein futures contracts that did not appear on the balance sheet
Basel II
Work to overhaul Basel I began in 1995 and produced consultativepapers issued in June 1999 and January 200148 These papers have been
47 South Korean banks have had notoriously weak balance sheets because the practiceof ldquodirected lendingrdquo left them with many poor loans (in making these loans the bankswere expected to follow government objectives rather than creditworthiness criteria)
48 Basel Committee on Banking Supervision (1999 2001)
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 125
the subject of extensive consultation and revision as a result the newAccord is expected to be introduced in 200449 The Basel II frameworkhas three parts (pillars) revisions to Basel I minimum-capital require-ments supervisory review criteria and greater emphasis on market dis-cipline Broadly Basel II aims to maintain the level of capital in the sys-tem but achieve better alignment of banksrsquo capital with their risk pro-files and keep up with financial innovation
To align capital requirements with market realities (the first pillar)Basel II concentrates on the 100 or so largest banksmdashthe type of playerslisted in table 21mdashand on the holding-company parents of banking groups50
Capital requirements will differentiate between an increased number ofcredit groups or ldquorisk bucketsrdquo including claims on governments otherbanks corporations mortgage-backed securities and other asset-backedsecurities
Basel II originally proposed to use external ratings to set capital chargesfor a number of these credit risks Many banks objected arguing thatthey assess credit risk better than Standard amp Poorrsquos Moodyrsquos or FitchIBCA51 Basel II thus proposes two approaches to rating a standard ap-proach using external ratings and an ldquoadvancedrdquo approach that allowsselected banks to use their own internal rating systems To encouragethe development of rigorous internal control systems based on these in-ternal rating systems Basel II also proposes to levy capital charges foroperational risk (the risk of direct or indirect loss resulting from inad-equate or failed internal processes people and systems or from exter-nal events)
Some critics of this proposal dismiss it as an abrogation of the prin-ciple of external independent monitoring and as ldquodangerously naiumlverdquo52
But regulators argue that the new capital charge on operational risk shouldoffset this concern It is also far from clear how cross-national compari-sons of rating and internal risk-assessment systems will be made (Engelen2000) The development by the European Union of its own capital rulescould well complicate the international resolution of these issues Publicassurances by EU officials in January 2001 however indicated that theirmain concerns are to create a level playing field and avoid regulatoryarbitrage (Hargreaves 2001) There is also the significant problem ofthe procyclical character of risk weights When a crisis hits losses are
49 See Berry (2000) for an update in an interview with William J McDonough chair ofthe Basel Committee on Banking Supervision
50 For obvious reasons these proposals are addressed to large banks and simpler capi-tal standards are allowed for small banks that focus on their domestic credit markets
51 See Ammer and Packer (2000) for an empirical critique of the success of rating agen-cies in distinguishing risk by sector and region
52 See Auerback (2001)
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126 WORLD CAPITAL MARKETS
incurred or accrued capital is lost and loan exposure must be reducedor securities sold to restore the requisite capital-adequacy ratios A morerisk-sensitive framework could amplify volatility
As the second pillar of Basel II supervisory review criteria are beingbeefed up to encourage supervisors to intervene earlier in potential problemsituations and to compel banks to align their capital positions with theirrisk profiles Bank supervisors will be authorized to require banks tohold capital in excess of minimum requirements if they have concernsabout general management overall strategy risk-management performanceor the macroeconomic environment Of course if one G-10 supervisorimposes higher capital requirements in isolation the same disparity willemerge that presaged Basel I Some banks will be disadvantaged in theinternational marketplace and will loudly complain that excessive super-vision is driving business to their competitors Hence close internationalcooperation among supervisors is critical
To implement the third pillar market discipline banks will be requiredto make fuller more timely disclosure of capital adequacy and the risksto which that capital is exposed A number of measures are being stud-ied that might help supervisors evaluate bank performance such as com-parisons of uninsured deposit interest rates subordinated debt yieldsand equity prices The idea is that these yields and prices might alertsupervisors to market perceptions of risk Of course market perceptionsare only as good as market information More direct and controversialways to reinforce market discipline would dramatically increase publicdisclosure of bank positions and risk management systems
Many questions are still outstanding about how to resolve the techni-cal details of capital requirements and whether the requirements willachieve their intended goal of better assessment and mitigation of therisks in banksrsquo portfolios There is no substitute for skilled supervisorsThe intricacies of effective design and implementation suggest that su-pervisors need to be highly competent technically knowledgeable aboutbanking portfolio characteristics and the factors that influence bank ex-posure to credit risk (Mishkin 2000) And they must be aided by vigilantshareholders market forces and transparency of information53
Standard setting at the global level is desirable but ultimately theeffectiveness of these efforts will be tested at the national level espe-cially in times of systemic financial distress Here the record of Basel Iwas not a bright shining success Japanese banking regulators havetraditionally allowed banks to include real estate and securities in theircapital base When the value of these assets plummeted in the early 1990sregulators allowed banks to continue valuing these depreciated (andoften bankrupt) assets at their old inflated levels Japanese authorities
53 Benedict Roth Complacency Towards Catastrophe Financial Times 23 January 2001
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 127
insisted until the mid-1990s that eroded capital bases could be rebuiltin a market-driven fashion They rightly foresaw that huge loan losseswould undermine public support for the ruling party and require a po-litically unpopular bailout
Japanese foot dragging on Basel I was the worst54 but not uniqueOther examples can be found of ldquopolitically mandated forbearancerdquo TheFederal Reserve Bank of New York held important hands during theLTCM crisis of 1998 Mexico is still resolving the banking crisis that eruptedin 1995 South Korea has not yet closed the insolvent banks that behavedso badly before the crisis of 1998 In the aftermath of a crisis nationalregulators cannot always be relied upon to discipline politically power-ful bankers55 One of the little-noticed consequences of these differingapproaches is that those banks with strong regulatory systems receivedan implicit ldquoexport subsidyrdquo for their services US banks which had notengaged extensively in emerging-market lending in the 1990s were bet-ter positioned than their German and Japanese counterparts to expandtheir international assets in the wake of the crises
Other Financial Forums
54 See Japanese Banks Fiddling while Marunouchi Burns The Economist 27 January2001 67-69
55 See Calomiris (1997)
The Basel model of vertical subsidiarity has already been extended toother financial regulatory bodies In 1993-94 the BIS established a Tri-partite Group of Banking Insurance and Securities Regulators In 1994-95 the BIS increased its cooperation with the International Organizationof Securities Commissions when the two organizations issued parallelpapers on guidelines for national regulators concerning risk managementand disclosure of derivative trades In 1996 a permanent Joint Forum onFinancial Conglomerates was established to examine supervisory issuesand develop working arrangements among the different functional super-visors of conglomerate institutions that offer combinations of bankingsecurities and insurance products Draft papers on the supervisionof conglomerates were released for comment in 1998 applying capital-adequacy principles to these groups and providing guidelines both forassessing the integrity and competence of top managers and for sharingassessments between regulators
In 1997 the Basel Committee on Banking Supervision extended itsreach beyond capital standards to broader aspects of banking supervi-sion with the publication of the Core Principles for Effective BankingSupervision In 1999 a wide range of regulatory and standard-settingbodies were gathered under the umbrella of the Financial Stability
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128 WORLD CAPITAL MARKETS
Forum (FSF) itself established under BIS aegis56 The FSF has alreadyissued recommendations for stepped-up supervision and transparencyas well as guidelines for best practices in a number of areas includingoffshore financial centers and highly leveraged institutions or hedge funds57
Conclusion
Although the structural weaknesses in emerging-market economies arewidely acknowledged to have been causal factors in international capi-tal-market volatility this chapter points to the role of large G-10 bankingorganizations as major suppliers of the most volatile instrument short-term debt We have examined evidence of the impact of public safetynets in the G-10 economiesmdashthe deposit insurance systems the pruden-tial supervisory systems and the lender-of-last-resort functions of centralbanksmdashon the incentive structures of these organizations
Although supervisors in most countries working nationally and to-gether in the BIS have made significant efforts to mimic market forcesin their prudential supervision the most sophisticated financial institu-tions find innovative ways to circumvent the rules New global regulatorybodies are not about to be created G-10 national bank regulators shouldthemselves address the short-term debt bias in the international financialsystem by changing incentive systems G-10 securities regulators shouldalso take steps to get ahead of the curve paying close attention to largeportfolio swings by institutional investors particularly in times of crisisIn short more needs to be done at national and international levels tochange the rules of the game That is the subject of the next chapter
56 The Financial Stability Forum includes banking securities insurance and accountingregulatory bodies the OECD on taxation corruption and corporate governance and theIMF
57 See Martin (2000)
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90 WORLD CAPITAL MARKETS
Table 27 Financial firms in the 100 largest companiesby revenue 1998 (billions of dollars)
Globalrank Company Revenuesa Assetsb Type
Continental Europe
15 AXA (France) 79 452 Insurance23 Allianz (Germany) 65 402 Insurance28 Ing Group (Netherlands) 56 464 Insurance37 Credit Suisse (Switzerland) 49 475 Banks commercial
and savings39 Assicurazioni Generali (Italy) 48 178 Insurance42 Deutsche Bank (Germany) 45 736 Banks commercial
and savings56 Zurich Financial Services (Switerland) 39 215 Insurance68 Munich Re Group (Germany) 35 131 Insurance72 ABN AMRO Holding (Netherlands) 34 507 Banks commercial
and savings77 Credit Agricole (France) 33 459 Banks commercial
and savings80 HypoVereinsbank (Germany) 32 541 Banks commercial
and savings84 Fortis (Belgium) 31 397 Banks commercial
and savings98 Socieacuteteacute Geacuteneacuterale (France) 30 450 Banks commercial
and savingsUnited Kingdom
47 HSBC Holdings 43 485 Banks commercialand savings
58 CGU 38 176 Insurance74 Prudential 34 197 Insurance
United States
16 Citigroup 76 669 Diversified financials35 Bank of America Corp 51 618 Banks commercial
and savings44 State Farm Insurance Cos 45 111 Insurance64 TIAA-CREF 36 250 Insurance67 Merrill Lynch 36 300 Securities71 Prudential Ins Co of America 34 279 Insurance76 American International Group 33 194 Insurance79 Chase Manhattan Corp 32 366 Banks commercial
and savings83 Fannie Mae 31 485 Diversified financials88 Morgan Stanley Dean Witter 31 318 Securities
Japan
21 Nippon Life Insurance 66 363 Insurance45 Dai-ichi Mutual Life Insurance 44 253 Insurance54 Sumitomo Life Insurance 40 206 Insurance91 Bank of Tokyo-Mitsubishi 31 664 Banks commercial
and savingsTotal 1279 11341Total for G-10 1279 11341
G-10 = Group of Ten countries see note to table 11
a Data shown are for the fiscal year ended on or before 31 March 1999b Assets shown are those at the companyrsquos fiscal year-end
Source Fortune Global 500 1999 httpwwwpathfindercomfortuneglobal500indexhtml
Institute for International Economics | httpwwwiiecom
THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 91
Tab
le 2
8N
on
fin
anci
al f
irm
s in
th
e 10
0 la
rges
t co
mp
anie
s b
y re
ven
ue
199
8 (b
illio
ns o
f do
llars
)
Glo
bal
Tra
nsn
atio
nal
ity
ran
k
Co
mp
any
Rev
enu
esa
Ass
etsb
ind
exc
Typ
e
Co
nti
nen
tal
Eu
rop
e
2D
aim
lerC
hrys
ler
(Ger
man
y)15
516
044
1M
otor
veh
icle
s an
d pa
rts
11R
oyal
Dut
chS
hell
Gro
up (
Net
herla
nds)
9411
058
9P
etro
leum
ref
inin
g17
Vol
ksw
agon
(G
erm
any)
7670
568
Mot
or v
ehic
les
and
part
s22
Sie
men
s (G
erm
any)
6667
521
Ele
ctro
nics
el
ectr
ical
equ
ipm
ent
32M
etro
(G
erm
any)
5222
n
a
Foo
d an
d dr
ug s
tore
s34
Fia
t (I
taly
)51
7640
8M
otor
veh
icle
s an
d pa
rts
36N
estle
(S
witz
erla
nd)
5041
932
Foo
d46
Veb
a G
roup
(G
erm
any)
4351
275
Tra
ding
49R
enau
lt (F
ranc
e)41
4545
7M
otor
veh
icle
s an
d pa
rts
53D
euts
che
Tel
ekom
(G
erm
any)
4093
n
a
Tel
ecom
mun
icat
ions
57R
oyal
Phi
lips
Ele
ctro
nics
(N
ethe
rland
s)38
3386
4E
lect
roni
cs
elec
tric
al e
quip
men
t59
Peu
geot
(F
ranc
e)38
4038
7M
otor
veh
icle
s an
d pa
rts
62E
lect
riciteacute
de
Fra
nce
(Fra
nce)
3711
3
na
Util
ities
ga
s an
d el
ectr
ic63
Rw
e G
roup
(G
erm
any)
3747
n
a
Util
ities
ga
s an
d el
ectr
ic65
BM
W (
Ger
man
y)36
3660
7M
otor
veh
icle
s an
d pa
rts
66E
lf A
quita
ine
(Fra
nce)
3643
576
Pet
role
um r
efin
ing
69V
iven
di (
Fra
nce)
3558
n
a
Eng
inee
ring
and
cons
truc
tion
70S
uez
Lyon
nais
e de
s E
aux
(Fra
nce)
3585
n
a
Ene
rgy
78E
NI
(Ita
ly)
3249
317
Pet
role
um r
efin
ing
86B
ayer
(G
erm
any)
3134
827
Che
mic
als
92A
BB
Ase
a B
row
n B
over
i (S
witz
erla
nd)
3132
957
Ele
ctro
nics
el
ectr
ical
equ
ipm
ent
93B
AS
F (
Ger
man
y)31
3159
5C
hem
ical
s95
Car
refo
ur (
Fra
nce)
3020
n
a
Foo
d an
d dr
ug s
tore
s
(tab
le c
ontin
ues
next
pag
e)
Institute for International Economics | httpwwwiiecom
92 WORLD CAPITAL MARKETS
Tab
le 2
8N
on
fin
anci
al f
irm
s in
th
e 10
0 la
rges
t co
mp
anie
s b
y re
ven
ue
199
8 (b
illio
ns o
f do
llars
) (c
ontin
ued
)
Glo
bal
Tra
nsn
atio
nal
ity
ran
k
Co
mp
any
Rev
enu
esa
Ass
etsb
ind
exc
Typ
e
Un
ited
Kin
gd
om
19B
P A
moc
o68
8559
2P
etro
leum
ref
inin
g43
Uni
leve
r45
3692
4F
ood
Un
ited
Sta
tes
1G
ener
al M
otor
s16
125
729
3M
otor
veh
icle
s an
d pa
rts
3F
ord
Mot
or14
423
835
2M
otor
veh
icle
s an
d pa
rts
4W
al-M
art
Sto
res
139
49
na
G
ener
al m
erch
andi
sers
8E
xxon
101
9365
9P
etro
leum
ref
inin
g9
Gen
eral
Ele
ctric
100
356
331
Ele
ctro
nics
el
ectr
ical
equ
ipm
ent
14In
tl B
usin
ess
Mac
hine
s82
8653
7C
ompu
ters
of
fice
equi
pmen
t25
US
Pos
tal
Ser
vice
6055
n
a
Mai
l pa
ckag
e a
nd f
reig
ht d
eliv
ery
27P
hilip
Mor
ris58
6051
1T
obac
co29
Boe
ing
5637
n
a
Aer
ospa
ce30
AT
ampT
5460
219
Tel
ecom
mun
icat
ions
40M
obil
4843
597
Pet
role
um r
efin
ing
41H
ewle
tt-P
acka
rd47
3451
1C
ompu
ters
of
fice
equi
pmen
t50
Sea
rs R
oebu
ck41
38
na
G
ener
al m
erch
andi
sers
55E
I d
u P
ont
de N
emou
rs39
40
na
C
hem
ical
s61
Pro
ctor
and
Gam
ble
3731
477
Soa
ps
cosm
etic
s75
Km
art
3414
n
a
Gen
eral
mer
chan
dise
rs81
Tex
aco
3229
453
Pet
role
um r
efin
ing
82B
ell
Atla
ntic
3255
n
a
Tel
ecom
mun
icat
ions
85E
nron
3129
n
a
Ene
rgy
87C
ompa
q C
ompu
ter
3123
n
a
Com
pute
rs
offic
e eq
uipm
ent
89D
ayto
n H
udso
n31
16
na
G
ener
al m
erch
andi
sers
94J
C
Pen
ney
3124
n
a
Gen
eral
mer
chan
dise
rs96
Hom
e D
epot
3013
n
a
Spe
cial
ty r
etai
lers
97Lu
cent
Tec
hnol
ogie
s30
27
na
E
lect
roni
cs
elec
tric
al e
quip
men
t10
0M
otor
ola
2929
n
a
Ele
ctro
nics
el
ectr
ical
equ
ipm
ent
Institute for International Economics | httpwwwiiecom
THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 93
Jap
an
5M
itsui
109
5635
8T
radi
ng6
Itoch
u10
957
333
Tra
ding
7M
itsub
ishi
107
7536
9T
radi
ng10
Toy
ota
Mot
or10
012
540
0M
otor
veh
icle
s an
d pa
rts
12M
arub
eni
9455
300
Tra
ding
13S
umito
mo
8946
259
Tra
ding
18N
ippo
n T
eleg
raph
amp T
elep
hone
7614
7
na
Tel
ecom
mun
icat
ions
20N
issh
o Iw
ai68
3938
8T
radi
ng24
Hita
chi
6282
214
Ele
ctro
nics
el
ectr
ical
equ
ipm
ent
26M
atsu
shita
Ele
ctric
Ind
ustr
ial
6067
332
Ele
ctro
nics
el
ectr
ical
equ
ipm
ent
31S
ony
5353
628
Ele
ctro
nics
el
ectr
ical
equ
ipm
ent
33N
issa
n M
otor
5158
511
Mot
or v
ehic
les
and
part
s38
Hon
da M
otor
4943
641
Mot
or v
ehic
les
and
part
s48
Tos
hiba
4151
252
Ele
ctro
nics
el
ectr
ical
equ
ipm
ent
51F
ujits
u41
4332
6C
ompu
ters
of
fice
equi
pmen
t52
Tok
yo E
lect
ric P
ower
4012
2
na
Util
ities
ga
s an
d el
ectr
ic60
NE
C37
42
na
E
lect
roni
cs
elec
tric
al e
quip
men
t90
Tom
en31
18
na
T
radi
ng99
Mits
ubis
hi E
lect
ric30
35
na
E
lect
roni
cs
elec
tric
al e
quip
men
t
Ch
ina
73S
inop
ec34
52
na
P
etro
leum
ref
inin
g
Tot
al (
aver
age
for
tran
snat
iona
lity
inde
x)3
988
447
949
0T
otal
for
G-1
0 (a
vera
ge f
or t
he i
ndex
)3
954
442
749
0
na
= n
ot a
vaila
ble
G-1
0 =
Gro
up o
f T
en c
ount
ries
see
not
e to
tab
le 1
1
a
Dat
a sh
own
are
for
the
fisca
l ye
ar e
nded
on
or b
efor
e 31
Mar
ch 1
999
b
Ass
ets
show
n ar
e th
ose
at t
he c
ompa
nyrsquos
fis
cal
year
-end
c
The
ind
ex o
f tr
ansn
atio
nalit
y is
cal
cula
ted
as t
he a
vera
ge o
f ra
tios
of f
orei
gn a
sset
s to
tot
al a
sset
s f
orei
gn s
ales
to
tota
l sa
les
and
for
eign
em
ploy
men
tto
tot
al e
mpl
oym
ent
as o
f 19
97 (
UN
CT
AD
)
Sou
rces
F
ortu
ne G
loba
l 50
0 1
999
http
w
ww
pat
hfin
der
com
fort
une
glob
al50
0in
dex
htm
l U
NC
TA
D (
1999
)
Institute for International Economics | httpwwwiiecom
94 WORLD CAPITAL MARKETS
foreign direct investment The ldquotransnationality indexrdquo (table 28) showsthat on average they conducted about half their business outside theirhome country9
Overview of the Players
Our review of the major players points to two major features First ahandful of big playersmdashfewer than 200 firms all toldmdashcontrol the ac-tion in international capital markets Their dominance will doubtless erodebut for now financial power is strikingly concentrated with them Sec-ond the big players are overwhelmingly based in the G-10 countriesplus Spain The responsibility to supervise them rests not in the IMFnor in Basel but squarely in Washington London Tokyo and the otherG-10 capitals At year-end 1999 the G-10 countries plus Spain accountedfor 84 percent of world banking assets 86 percent of world stock marketcapitalization and 76 percent of international debt securities (BIS 2000aWorld Bank 2000b)
International private capital flows are of three types bank loans anddeposits portfolio investment and foreign direct investment In cumula-tive total flows to emerging markets FDI was the biggest story in the1990s amounting to $954 billion (table 12) Portfolio flows were nextcumulatively amounting to somewhere between $612 billion (table 12)and $764 billion (table A1) Bank loans and deposits are the most com-plicated story
The Key Role of Banks
Banks are more important as an epicenter than as a wellspring Banksgenerate waves in the flow of capital to emerging markets rather than acontinuous steady stream According to data compiled by the Institute ofInternational Finance (table A1) net bank lending to emerging marketscumulated to $269 billion in the 1990s However deposits by emerging-market residents in G-10 banks more than offset G-10 bank lending tothese countries during the decade According to IMF data cumulativebank loans net of deposits amounted to a negative $135 billion (table 12)
In other words when loans and deposits are combined net bank ac-tivity that moves financial resources to emerging markets is small incomparison with portfolio investment and FDI But bank loans are thelubricant of any financial system Depending on circumstances bankscan be shock absorbers or shock propagators In recent decades with
9 The transnationality index is calculated as a simple average of the share of assetssales and employees outside the home country
Institute for International Economics | httpwwwiiecom
THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 95
respect to emerging markets banks have more often been propagatorsthan absorbers The average annual swing in bank lending to emergingmarkets was nearly $50 billionmdashby far the largest source of year-to-yearfluctuations in capital flows Both interbank loans between Europe Japanand Asia and sovereign Russian debt used as loan collateral played amajor role in the 1997-98 crisesmdashnot because banks are profligate playersbut because of the incentives they face and the instruments they useAccordingly our story begins with banks
Banks in the Modern Financial System
10 See Levine (2000) for a concise description of the role of banks in the financial system
11 The asymmetric information problem helps to explain why banks dominate the im-mature financial systems of emerging-market economies The general lack of informationon borrowers and undeveloped legal systems to enforce contracts hamper suppliers oflong-term financial instruments such as equities and bonds in evaluating risk and re-ward Banks are best suited in these circumstances to solve the asymmetric informationproblem by evaluating and monitoring private loans As more and better informationbecomes available capital markets develop and financial systems mature
As we noted in the previous paragraph the problem of financial volatil-ity in emerging-market economies is associated with bank lending Ifand when repayment problems arise cross-border private bank loansand bond placements are such that private creditors have no plausiblemeans of seizing assets from either private or sovereign borrowers Thusalthough international finance can nourish entrepreneurs and accelerategrowth a necessary complement may be a drastic creditor response inthe event of nonpaymentmdashto withhold fresh funds and force an eco-nomic crisis (Dooley 2000)
This argument is based on the characteristics of banks They are notldquobadrdquo per se They perform three essential functions in any financialsystem pooling the resources of disparate savers and channeling these re-sources into productive investment improving resource allocation throughtheir expertise in assessing and monitoring borrowers and facilitatingthe division of risk among numerous creditors10 But by their very na-ture banks are prone to two problems asymmetric information (the bor-rower knows more about the potential risk and return of its projectsthan the bank) and adverse selection (riskier borrowers will pay higherinterest rates and thus may constitute a disproportionate share of bankloan portfolios)11
Bank loans are illiquid fixed-price instruments They cannot easily beconverted to cash although they can be bundled into securities (knownas ldquosecuritizationrdquo) Once loan terms have been agreed on the only waya bank can adjust for shifting market conditions is by changing the quantityof its exposure When a borrower runs into trouble the bank can mix
Institute for International Economics | httpwwwiiecom
96 WORLD CAPITAL MARKETS
and match from two unpleasant menus It can roll over existing loansand extend new credit or it can call some part of existing loans andattempt to recover the principal It can also hedge by selling short otherclaims on the borrower These choices entail either an unwelcome exten-sion of the bankrsquos exposure or credit rationing against the borrower Whentrouble brews all banks encounter the same conditions in the aggregatethey prefer less exposure and ensuing credit restrictions lead to volatilebank lending
Innovation
12 Derivatives have no value of their own They ldquoderiverdquo their value from the value ofthe underlying asset They include swaps futures (contracts for future delivery at speci-fied prices) and options (which give one party the right but not the obligation to buyfrom or sell to a counterparty at an agreed price)
13 Maxfield (1998) analyzed available evidence of emerging-market investor objectivesmost of it before the crisis Analysis of portfolio equity flows is sensitive to the choice ofperiod with year-over-year data indicating that investors respond to country ldquofundamen-talsrdquo Other evidence suggests more ambiguity Ranking by ldquoinvestor impatiencerdquo ie thesearch for yield over value Tesar and Werner (1995) find short-term bank flows to be themost yield driven followed by portfolio investment FDI and long-term bank lending
14 Because market risk credit risk and country risk interact in complex ways newfinancial instruments have been created to help reduce negative interactions One is theldquototal return swaprdquo which has become an instrument of choice for hedge funds lookingfor high leverage Banks also use the total return swap to cover risks without increasingtheir capital requirements
Since the 1980s national and international banking systems have beentransformed by deregulation intensified competition and the informationand communications-technology revolutions The market environment isone of intense competition particularly in traditional banking activitiesThe innovations point away from traditional activities of plain vanilladeposit taking and loan making Three big themes are discernible Firstthe walls separating commercial banks investment banks portfolio man-agers and insurance firms are falling even if they are still distinct Sec-ond large banks are shifting toward securitizationmdashcreating securitiesout of everything from credit card debt to trade finance to disaster insur-ancemdashand earning fees in the process Third all large banks are shiftingtoward trading activity making markets and taking short-term stakes inbonds shares and derivatives12 These activities when successful satisfythe search for higher yields13
Many of the new financial instruments that banks trade are ldquooff bal-ance sheetrdquo This means that banks are not required to allocate capitalagainst them In swap contracts for example neither side pays cash at theoutset and therefore neither party has an asset in the traditional sense14
Futures and options contracts can be written with a relatively small initial
Institute for International Economics | httpwwwiiecom
THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 97
margin relative to the potential risk Credit derivatives limit credit risk bytransferring the potential loss associated with corporate loans and bondssovereign debt and other loan portfolios to counterparties15
Deregulation and innovation working in combination seem to havepushed banks into trading activity and leveraged plays but not into shareownershipmdasheven in jurisdictions that have no prohibition against equitystakes Among the G-10 banking systems the highest ratio of share own-ership to assets was only 5 percent in 1996 reached in Germany andJapan (Berlin 2000)16
The wave of innovation in financial instruments and the accompany-ing expansion of banking beyond its old boundaries is a two-edged swordOn one side it allows risk management far beyond what was tradition-ally possible Risk can now be shifted from firms that can ill afford lossesto those that can Banks can profitably act as intermediaries in shiftingrisk On the other side the innovation wave creates huge opportunitiesfor leveraged plays fostering a speculative search by banks themselvesfor high returns that in turn magnify their own risks17
15 Credit derivatives include total return swaps credit default swaps credit-linked notesand collateralized debt obligations They are the fastest-growing sector of the global de-rivatives market
16 Banks seem to specialize in lending even when they are allowed to mix finance andcommerce for reasons related both to how they are expected to behave with distressedfirms and to other intricacies of lender liability (Berlin 2000) Yet a recent cross-countrystudy found that restrictions on banking and commerce are associated with greater fi-nancial instability (Barth Caprio and Levine 2000)
17 Leverage is the magnification of the rate of return (positive or negative) on an in-vestment beyond the rate obtained by solely investing funds owned by the institution Itis often defined as the ratio of assets to equity Leverage is achieved by increasing thesize of an investment by borrowing or using derivative instruments such as futures oroptions These allow investors to earn a return on the notional amount underlying thecontract by committing a small portion of equity in the form of a margin deposit oroption premium payment
18 In a repo (repurchase agreement) one party (typically a trader) buys a bond andsells it to a dealer for cash with a promise to buy it back the next day at the same priceplus the overnight interest rate As long as the overnight interest rate is lower than theinterest accruing on the bond the trader earns some income on the bond The extremeform of these kinds of transactions was discovered at LTCM the failed US highly lever-aged institution which appears to have controlled more than $120 billion in assets froman investment of about $3 billion This leveraging was accomplished mostly through theuse of repos (Mayer 1999)
The potential for damage is illustrated in an extreme form by figure 21To precisely measure a firmrsquos leverage all positions must be known andrealistically valuedmdashwhich may be impossible to do Because many ac-tivitiesmdashsuch as repos18 and derivativesmdashdo not appear on the institutionrsquos
Leverage
Institute for International Economics | httpwwwiiecom
98W
OR
LD
CA
PIT
AL
MA
RK
ET
S
Figure 21 Hypothetical example of leverage
$1000 notional value of call option on equity in firms targeted for takeover
Repo FRN into cash and use cash to pay option premium
(repro is initially collateralized
Borrow $100 for margin purchase
$125 of US investment bank floating-rate notes (FRN) (secured by $25 equity in FRNs)
Repo off-the-run bond into cash and post margin
(repo is initially collateralizedSell (short) Borrow on-the-run bonds worth $20
$25 worth of off-the-run bonds (secured by $5 equity in bonds)
Exchange into $4
Cash $5 yen400 Japanese bank loans
$1 equity base
FRN = floating rate notesRepo = repurchase agreement
Source IMF (1998)
Institute for International Econom
ics | httpww
wiiecom
THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 99
balance sheet and because balance sheets are published quarterly at bestoutsiders have a difficult time assessing the extent of a firmrsquos leverage19
Leveraging by a single firm enhances its risk of default the widespreaduse of leverage in the financial system can magnify market adjustmentsespecially when they require ldquodeleveragingrdquomdashunwinding prior positionsRapid adjustments can cause credit to dry up and asset prices to plummetIn a mark-to-market environment falling asset prices trigger calls foradditional collateral that can ripple through markets
Risk Management
Because it is confronted with the widespread use of leverage and prolif-erating kinds of risk international finance is increasingly driven by riskevaluation and control20 Different institutions face various risk profilesand differing kinds of risk The most common risks can be quickly tickedoff Banks because of their traditional intermediary role of channelingthe resources from savers to borrowers face significant credit risk therisk of default or delay in the payment of principal and interest Theymust also manage market risk the risk that the prices of their liabilitiesmay change faster than their assets Market risk devastated US savingsand loan institutions in the late 1980s
Closely associated with market risk are interest-rate risk (unexpectedchanges in market interest rates that slash margins net income and theeconomic value of a bankrsquos equity) and foreign exchange risk (losses thatarise when assets denominated in an appreciating foreign currency areless than liabilities denominated in that currency) Banks make numer-ous loans to other banks around the world portfolio investors buy se-curities direct investors acquire fixed assets and all incur country risk(economic and political uncertainty in the host country) During the heightof the Asian crisis for example interbank loans to Japanese banksreflected the credit risk of lending to these banks the so-called Japanpremium
Substantial attention has been lavished on country risk analysis sincethe 1982 debt crisis in developing countries Yet in spite of this exper-tise the Asian crisis occurred in part because of a sudden upward reap-praisal of country risk after the Thai baht collapsed in April 1997 Banksand other financial institutions must also manage liquidity risk the riskthat market conditions will change unexpectedly depressing demand andprices of assets at the time they want to sell these assets And they mustmanage operational riskmdashfailures in control systems or people that cause
19 Another example of asymmetric information Both risk and leverage are difficult foroutsiders to assess without full timely disclosure
20 A longer discussion of these issues can be found in Managing Global Finance in IMF(1999c)
Institute for International Economics | httpwwwiiecom
100 WORLD CAPITAL MARKETS
financial loss or damage reputations Operational risk devastated BaringsBank in 1995
Financial institutions practice risk management to measure all theserisks the potential damage to their investment positions and ultimatelythe chance of becoming insolvent VAR (value at risk) risk models mea-sure subject to certain assumptions the amount of the firmrsquos capital thatis exposed in each period For example the VAR model might say thatin a 3-standard-deviation worst case (a case that is not supposed to hap-pen more than 1 percent of the time) the firm will loose 25 percent of itscapital during the next year
VAR models are widely used but like all models they have weak-nesses They rely on past values to estimate key variables in financialmarkets past values are not always good predictors of future risks More-over rising volatility and higher loss correlation among different assetclasses in a portfolio will cause all banks using these models to reducetheir exposures at the same time by switching to less volatile and lesscorrelated assets such as US Treasury bills (Persaud 2000)
Newer risk models entail stress testing and scenario analysis Scenarioanalysis envisages possible adverse changes one at a time that mightaffect the investment portfolio Stress testing estimates potential losseswhen several individual risk factors simultaneously move against thefirm but it too uses historical probabilities
Financial Volatility
21 For example derivative markets usually rely on underlying securities markets thatproduce continuous prices When these markets are interrupted financial shocks cantrigger a cascade of margin calls and sell orders that move prices very sharply
22 See IIF (1999a)
The combination of trading activity and modern risk management lie atthe root of financial volatility When risks increase banks must eitherraise more capital to cover the greater risk or reduce their exposure bycutting loan exposure by selling securities or by undertaking new de-rivative trades Raising more capital is time-consuming and in a crisisvery expensive because bank shares are depressed So banks look to theother alternatives If the bank can reduce lending it need not book aloss But most banks use the same VAR models and as indicated abovethese models will encourage them to reduce their outstanding loans atthe same time actually magnifying loan volatility
If banks attempt to reduce their exposure to risk by selling securitiesor undertaking new derivative trades they may trigger large priceshocks because of limited and shrinking market liquidity21 The liquid-ity problem is compounded when a small number of large institu-tions hold the same positions22 Take your pick loan volatility or price
Institute for International Economics | httpwwwiiecom
THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 101
volatility As two experts have observed (Folkerts-Landau and Garber1998)
[V]olatility even in one country will automatically generate an upward re-estimate of credit and market risk in a correlated country triggering automaticmargin calls and tightening of credit lines Thus apparently bizarre opera-tions that connect otherwise disconnected securities markets are not the re-sponses of panicked green screen traders arbitrarily driving economies from agood to a bad equilibrium Rather they work with relentless predictability andunder the seal of approval of supervisors in the main financial centers
23 See Ferguson (1999)
24 As Gerald Corrigan (1982) put the matter ldquoBanks are specialrdquo Corrigan (2000) reit-erated this view even after all the changes of the past two decades Unlike other institu-tions banks offer on-demand transactions are a backup liquidity source for other insti-tutions and serve as a ldquotransmission beltrdquo for monetary policy
These changes in the banking environment accentuate an existing anomalyThe anomaly is that banks even as they grow larger and increasinglyengage in more risky and complex transactions are perceived to enjoyimplicit and explicit public guarantees
The guarantees grow out of an incentive problem inherent in bankingasymmetric information which we mentioned above Depositors know lessabout a bankrsquos management and the quality of its balance sheet than doits managers and shareholders Thus in times of uncertainty or adver-sity bank depositorsmdashuncertain whether they will have access to theirdepositsmdashare prone to bank runs This prospect has in turn compelledgovernments to treat banks differently than other firms because a bankthat fails can disrupt the rest of the economy24
To prevent such crises governments have entered into quid pro quoarrangements with banks Governments provide them both with an im-plicit safety net in the form of an unstated promise by the central bankto act as a lender of last resort in a liquidity crisis and an explicit safetynet in the form of a public deposit insurance fund to reassure depositorsIn return the banks submit to closer government oversight and regu-lation of their activities than is usual for industries in the private sector
The ldquoinsurancerdquo provided by the public safety net contributes to an-other incentive problem moral hazard Banks acquire greater tastes forrisk and face less market discipline than other firms The explicit depositinsurance safety nets actually have or are perceived to have blanketcoverage that extends beyond the retail depositors (households and small
One of the lessons of the 1997-98 crisis must surely be that market par-ticipants and their regulatory supervisors relied too heavily on quantita-tive tools and insufficiently on judgment23
The Anomaly of Modern Banking
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102 WORLD CAPITAL MARKETS
businesses) for which they were originally intended The implicit centralbank safety nets extend in a crisis to nearly all depositors and banksThus banks are both viewed and behave as if they will be bailed out ifthey get into trouble
The existence of a public safety net raises a perennial question Dobanks have an unfair advantage over other financial institutions becauseof the subsidy provided by the safety net This question was at the heartof intensive study and debate in the United States leading up to thepassage in November 1999 of the Financial Services Modernization Act(also known as the Gramm-Leach-Bliley Act) The size of the gross sub-sidy is difficult to estimate despite determined research efforts Somesuggest it is well under 100 basis points and is at least partly offset bythe direct costs of deposit insurance premiums interest payments on bondsissued by the Financing Corporation25 reserve requirements regulatoryexpenses and operational costs associated with collecting deposits26 Con-versely Kwast and Passmore (2000) suggest that banks can expand theirscope far beyond the levels that other financial institutions could reachwith the same equity base but without the public safety net
A related concern in the US debate is whether allowing banks to ex-pand their activities into securities and insurance will ultimately extendthe safety net and add to the subsidy The Financial Services Moderniza-tion Act deals with this issue by maintaining a legal separation betweenbanks and the rest of the banking organization known as large com-plex banking organizations (LCBOs) They must engage in most securi-ties activities and insurance underwriting through separately capitalizedinvestment bank subsidiaries or holding company affiliates This act canbe said to have merely brought US banking laws closer to those of mostother industrial countries (Barth Brumbaugh and Wilcox 2000 BarthNolle and Rice 2000) If the fire wall is well-maintained and stoutly de-fended the safety net will neither expand in practice nor become a sourceof comfort to noncommercial bank subsidiaries of LCBOs
The quid pro quo exacted by governments to offset the subsidy iscloser public-sector monitoring of banksrsquo activities through prudentialsupervision The effectiveness of this closer official scrutinymdashand closermarket monitoringmdashare the subjects of the next section
25 The Financing Corporation was created by Congress in 1987 to sell bonds to raisefunds to help resolve the savings and loan crisis
26 See Levonian and Furlong (1995) Jones and Kolatch (1999) Shull and White (1998)and Whalen (1999a 1999b)
Are G-10 bank supervisors adequately responding In this section we firstassess the case for and compare the structures of prudential supervisory
Prudential Supervision
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 103
systems both within and among the G-10 economies plus Spain andconsider whether these offset the subsidy provided by the public safetynet Despite offsetting regulation and supervision implicit and explicitguarantees by G-10 governments to their banks are still a source of bank-ing instability in the emerging-market economies
National Systems for Prudential Supervision
Governments use prudential supervision to reduce the moral hazard andadverse selection created by their own safety nets Supervisors establishregulations and monitor compliance to limit risk taking and ensure thesafety and soundness of the banking system In a thoughtful analysis ofthe case for prudential supervision Frederic Mishkin (2000) identifiesthe main forms that supervision can take including the tasks of grantingbanking charters and licenses establishing capital requirements settingdeposit insurance premiums and defining disclosure requirements as wellas carrying out bank examinations Bank examiners gather informationfrom banks and evaluate whether they are following the regulatorsrsquo rulesin cases of weakness they are empowered to change banksrsquo behaviorand close them if necessary
Supervisors also may restrict competition define the activities in whichbanks may engage and restrict their asset holdings and separate banksand other financial (or nonfinancial) activities During the past two de-cades the barriers separating commercial banks investment banks in-surance firms and securities firms have been all but eliminated (tableB1) Deregulation has stimulated competitive forces that drive diversifi-cation and consolidation of the financial industry nowhere faster than inthe United States
The Financial Services Modernization Act of 1999 confirmed this trendIt eliminated restrictions dating back to the Glass Steagall Act of 1933which once prevented banking insurance and securities firms fromentering each otherrsquos businesses (Barth Brumbaugh and Wilcox 2000)Cross-pillar mergers among banks insurance and securities firms arewell under way to form giant financial holding companies The 1999merger between Citibank (banking) and Travelers (insurance) created themodel for megafinance and confirmed new challenges for supervisors
Mishkin (2000) notes the corresponding evolution in US supervisionfrom an emphasis on rules-based regulation (detailed rules for opera-tional behavior and the quality of line items in the balance sheet) to anapproach that stresses the soundness of bank management practices es-pecially risk management
Appendix B outlines the systems of financial supervision now in theplace in the G-10 countries plus Spain Some systems like the UK andCanadian approach are models of simplicitymdashorganized to keep pacewith the spreading reach of financial conglomerates Other systems like
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104 WORLD CAPITAL MARKETS
the US and French approaches show traces of the bureaucratic divisionsthat made sense in an era when banking securities and insurance weresharply separated
The US Model
27 See Meyer (1999a)
28 Canada has a similar degree of simplification with the exception that securities firmsare still regulated by provincial authorities
29 See Pratti and Schinasi (1999 67)
30 The agents are the bank regulators and the principals are the taxpayers Agents maypursue their own interests including bureaucratic survival and postgovernment employ-ment opportunities rather than the national interest in banking safety and soundness
The US model of financial regulation delineated in the Financial Ser-vices Modernization Act of 1999 blends functional and umbrella super-vision Bank and thrift regulators oversee depository institutions Newnonbank activities are subject to both functional regulation (eg by theSecurities and Exchange Commission and state insurance examiners) andumbrella supervision (of financial holding companies) by the FederalReserve27
The UK Model
Another supervisory model exists in the United Kingdom as well as inAustralia Canada and Switzerland28 In this model banking supervisionis separated from the monetary policy function The regulatory structureis considerably simplified by relying on a consolidated financial regula-tor separate from the central bank for both banking and nonbankingactivities The remaining question answered differently depending on thecountry is the extent to which the regulator relies on home-country sur-veillance of banks and conglomerates that have a local presence
Regulatory Models Compared
Appendix B provides more detail on the differences in these modelsGerman simplicity contrasts with French complexity In France the bankingcommission is chaired by the governor of the central bank and includesrepresentatives from the Treasury The commission supervises compli-ance with regulations but the central bank inspects banks on behalf ofthe commission29 In countries such as the United States and France withmultiple supervisors and crossover functions internal coordination is criticalAt the same time multiple agencies create regulatory competition Wheneach agency knows what the other is doing transparency within gov-ernment circles can help to limit principal-agent problems of regulation30
The discussion as to where in the public bureaucracy financial super-
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 105
vision should be placed goes back many years Peek Rosengren andTootell (1999) argue that a synergy exists between monetary policy andprudential supervision because information gained in the course of super-vision can increase the accuracy of macroeconomic forecasts A twist tothis argument is that the information on the state of financial institutionsavailable to the central bank as supervisor can facilitate its role as lenderof last resort Conversely there is the concern that a supervisory rolewill compromise the central bankrsquos independence of action with respectto its core mandatemdashmaintaining price stability As these arguments haveplayed out financial supervision has generally been shared between centralbanks and other regulators or placed entirely in the hands of an inde-pendent regulator However in Italy the Netherlands and Spain cen-tral banks are the sole banking supervisor
Goodhart (1995) examined the arguments and evidence for each modeland concluded that there were no overwhelming arguments or evidencefor one or the other31 Going forward a key problem for any financialsupervisory system is dealing with (and closing as necessary) weak banksIf both central banks and other regulators have this responsibility closecoordination between them is critical Another problem is large conglom-erate banks LCBOs Although they are less likely to fail because of thediversification of their assets and liabilities they are more likely to berescued They are also more likely to be multinational enterprises withinternational implications Goodhart observes that regulation of theseentities might be put in the hands of the central bank because it is lessamenable to political pressures In any event the complexity of LCBOoperations suggests that greater supervisory rigor is necessary
The US Congress was persuaded that broad oversight would help containthe moral hazard problem and accordingly gave the Federal Reservethe role of umbrella supervisor with the understanding that the Fed willscrutinize depository activity more intensely than nonbank financial ac-tivities Under this approach LCBOs such as Citigroup are subject tomuch closer monitoring than smaller and simpler institutions32 The USregulatory model requires enormous cooperation between the Fed otherbank supervisors and the functional regulators for insurance and securi-ties but it also benefits from regulatory competition
31 National systems of supervision are path dependent they are determined by the struc-ture of financial institutions and history in each country If Goodhart (1995) is right out-comes are not materially better or worse with one model of supervision rather than another
32 See Ferguson (1999)
Public Safety Nets
One of prudential supervisorsrsquo biggest challenges is to reduce moral hazardFor many years commercial banks engaged in communal self-insurance
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106 WORLD CAPITAL MARKETS
to deal with crises They formed voluntary groups that agreed to rescuetroubled members As financial markets evolved and competition inten-sified banks were no longer willing to play this role Private-sector in-surance is one alternative but moral hazard and adverse selection wouldappear to prevent it from happening Public safety nets have developedbecause of the low probability and high cost of potential bank runs Aclear trade-off is involved The effectiveness of insurance in preventingbank runs is greater the more comprehensive the coverage But the morecomprehensive the coverage the greater the moral hazardmdashbank man-agers bank directors investors and depositors all take on greater risksin the belief that the safety net will protect them against losses
All G-10 countries have compulsory public safety nets for banks (table29) Deposit insurance agencies are officially organized in Canada theNetherlands Sweden Switzerland and the United States organized bythe industry in France Germany Italy and the United Kingdom andjointly organized by the public and private sectors in Belgium Japanand Spain
How well do G-10 governments offset the subsidy provided by thepublic safety net This is a question on which there is substantial debateAs banking organizations have become more complex the challengesthat supervisors face have become more difficult One challenge is toalign the incentives facing bank managers and shareholders with thoseof depositors Another is the principal-agent problem in supervision Wehave discussed the incentive structures for financial institutions but wehave said little about the incentives for supervisors themselves and thedistortions they can generate in the financial system
In one of the many studies of the US savings and loan crisis of the1980s Kane (1989) documented both problems He described managersusing cosmetic approaches to disguise the magnitude of insolvency regulatorspracticing forbearance even though they knew of the deteriorating riskprofiles of the institutions for which they were responsible and legisla-tors increasing deposit insurance without regard for any offsetting changesin supervision A subsequent overhaul of the legislative framework forthe Federal Deposit Insurance Corporation (FDIC) known as the FDICImprovement Act of 1991 (FDICIA) aimed to introduce a clearer incen-tive structure for both regulators and regulated institutions
The changes introduced by this US legislation are worth discussionwith respect to the other G-10 countries as well First FDICIA created astronger signal to management and investors by targeting deposit insur-ance at small depositors only and by risk-weighting the deposit insur-ance premiums paid by banks to reflect their capital adequacy and bankexaminer ratings Among the G-10 countries rated in table 210 depositinsurance premiums vary considerablymdashbut it is not clear that the dif-ferences have much to do with risk-weighting Most G-10 countries em-ploy funding formulas based for example on the total domestic deposit
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Table 29 Deposit insurance schemes in the G-10 countries Explicit safety net
Coverage limit(dollar Foreign
equivalent currency Interbank Source Bankrsquos Contingency fundingDate Membership Co- at end of deposit deposit of premium from banks
Country established managementa insuranceb July 1998)c covered covered Fundingd funding costs or governments
United 1982 Compulsory Yes Larger of 90 No No Unfunded Banks only Callable (subject Parliament may increase Kingdom private percent co- to maximum the maximum payable
insurance to 03 percent of pound125 million advance 33000 total deposits) facility with Bank of
England
United 1934 Compulsory No 100000 Yes Yes Funded Banks and Up to 027 Borrowing up to $3 States official government percent total billion from US Treasury
domestic deposits
Japan 1971 Compulsory No 71000 but No No Funded Banks and 0084 percent of Borrowing up to yen500bn joint in full until government insured deposits from Bank of Japan
year 2000 subject to Ministry of Finance approval
Canada 1967 Compulsory No 40800 No Yes Funded Banks and 033 percent of Borrowing up to C$6 official government insured deposits billion authorized further
(maximum) borrowing subject to parliamentary approval
Germany 1966 Compulsory Yes 90 percent Yes No Funded Banks only 003 percent of Annual levy may be private coinsurance deposits doubled
to 22000
Italy 1987 Compulsory Yes 125000 Yes No Unfunded Banks and Callable Two options defer private government (maximum of payment or diminish
1 percent of compensation to be paid total deposits)
(table continues next page)
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Table 29 Deposit insurance schemes in the G-10 countries Explicit safety net (continued )
Coverage limit(dollar Foreign
equivalent currency Interbank Source Bankrsquos Contingency fundingDate Membership Co- at end of deposit deposit of premium from banks
Country established managementa insuranceb July 1998)c covered covered Fundingd funding costs or governments
Netherlands 1979 Compulsory No 22000 Yes No Unfunded Banks and On demand Government backing official government maximum of subject to parliamentary
5 percent of own approval funds
France 1980 Compulsory No 65400 No No Unfunded Banks only Callable (on Extra calls up to FFr1000 private demand calls million can be made in
up to FFr200 a 5-year period million)
Switzerland 1984 Voluntary No 19700 No No Unfunded Banks only Callable (on Underwritten by member official demand) banks
Sweden 1996 Compulsory No 31400 Yes No Funded Banks and 05 percent of Full emergency coverage official government deposits while replacing it with a
limited system after the emergency
Belgium 1974 Compulsory No 16600 No No Funded Banks and Callable 002 None insurance limited joint 22000 in government percent of to assets in fund
year 2000 deposits from clients
Spain 1977 Compulsory No 16439 Yes No Funded Banks and 02 percent of Government backing joint government deposits through the Banco de
(maximum) Espantildea subject to approval by royal decree
a Bank membership in the fund can be either compulsory or voluntary and the management of the fund can be official and official and private joint or privateb Coinsurance refers to the situation where depositors face a deductible against their insured fundsc Coverage limit refers to the explicit amount the authorities promise to insured Funded scheme means that it is funded ex ante unfunded otherwise
Sources Goodhart (1995) Demirguccedil-Kunt and Detragiache (2000) Demirguccedil-Kunt and Sabaci (2000)
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 109
base Explicit safety net protection also varies but only Canada focuseson the protected class33 All G-10 countries specify a limit on depositorprotection Under FDICIA the insurance fund is prohibited from pro-tecting uninsured depositors or creditors at a failed bank although adiscretionary system-wide override is provided for exceptional circum-stancesmdashbut with stringent requirements for consultation and account-ability Other G-10 countries allow for contingency funding from the publicpurse alongside unwritten lender-of-last-resort support Among large banksa significant and growing portion of deposit liabilities including foreigncurrency and interbank deposits are uninsuredmdashbut depositors assumethey will be protected in a crisis
FDICIA also made some significant qualitative changes to address theprincipal-agent problem by penalizing weak banks and rewarding strongbanks For example banks whose capital declined faced progressivelytougher regulatory sanctions that for example required them to elimi-nate dividends restrict their lending and change their managementsRegulators have also been forced to take prompt corrective action (toreduce the practice of regulatory forbearance in hopes that a bankrsquos for-tunes might improve)34 Unfortunately comparative qualitative assess-ments across the G-10 are difficult to make due to lack of information35
This discussion highlights the complexity of evaluating the extent towhich prudential supervision and market discipline reduce the moralhazard associated with G-10 safety nets Our argument is that publicsafety nets in the G-10 can be linked to banking instability in other coun-tries specifically in the emerging-market economies that have attractedG-10 cross-border bank lending This lending is a leading source of vola-tility in capital flows the large financial institutions many of which arecomplex banking organizations are based in and regulated by authori-ties in the G-10 economies These two features of the international finan-cial system are closely related although it is not possible to test thisrelationship econometrically
Two World Bank studies however indicate a basis for concern Onestudy is a cross-country econometric analysis of the relationship betweenbank stability and deposit insurance (Demirguccedil-Kunt and Detragiache2000) which found a negative relationship Their estimated model forbanking crises in a sample of 61 countries (both industrial and develop-ing) suggests that explicit deposit insurance raises the probability of acrisis by at least 30 percent36 Crises are especially likely in countries
33 Japanrsquos legislation says it does but recent experience shows this is not the case34 See Goldstein (1997) for a summary of the changes35 See Barth Nolle and Rice (2000) for a beginning in this area36 Demirguccedil-Kunt and and Detragiache (2000 table 1) report a logit coefficient of 0696with a standard error of 0397 (the coefficient is significant at the 8 percent threshold)This suggests that the ldquotruerdquo coefficient could well be as small as 030 (the reportedvalue minus the standard error)
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110 WORLD CAPITAL MARKETS
with immature financial supervisory systems (and not in the G-10) buttheir analysis does underscore the view that deposit insurance weakensmarket discipline37
An earlier World Bank analysis established similar results One wasthat market discipline is undermined by deposit insurance schemes an-other was that illiquid banks are forced to pay more for their funds un-less a generous deposit insurance scheme is in place (Demirguccedil-Kuntand Huizinga 1999) This econometric study also provides clear-cut evi-dence that depositor monitoring of banks declines with the existence ofdeposit insurance schemes At the heart of the problem is the questionof whether deposit insurance is accompanied by increased governmentmonitoring
This evidence and the weight of other arguments suggests that moralhazard is still an issue in the G-10 countries Consider the ongoing de-bate about instilling greater market discipline on risk taking by banksAt one extreme is the perennial proposal to do away with safety netsleaving markets to monitor the players and to force adjustments but toprotect small savers by creating ldquonarrow banksrdquo such as postal savingsystems that are allowed to invest these savings only in risk-free gov-ernment securities Whatever the merits of narrow banking this solutionis too extreme to be politically feasible
A moderate alternative is to force more disclosure by financial institu-tions to facilitate market monitoring But transparency has its own prob-lems Persaud (2000) argues that financial markets cannot reliably discernsustainable from unsustainable positions in the short term This uncer-tainty causes banks to ldquoherdrdquo behind market leaders to exploit theirsupposedly superior information ldquoThe more herding investors and bankersknow about what each other is up to the [more] unstable markets maybecomerdquo The implication is that greater transparency in the marketplaceby itself will not solve the problemmdashand in the short term more informa-tion may exacerbate herding Further supervisory steps (discussed in thenext chapter) are required
Yet another proposal is to promote private-sector involvement in bankmonitoring through market-based alternatives such as Calomirisrsquos sub-ordinated debt proposal (Calomiris 1997 Federal Reserve Board 1999)Banks could be required to issue and maintain a minimum amount of
37 Other findings in the Demirguccedil-Kunt and Detragiache (2000) study include thesepropositions The impact of deposit insurance on bank stability tends to be stronger themore extensive is the coverage offered to depositors when the scheme is funded andwhere the scheme is run by the government rather than by the private sector Con-versely deposit insurance is detrimental to bank stability where bank interest rates havebeen deregulated and where the institutional environment is weak Additional findingson deposit insurance are reported from a recent World Bank conference (8-9 June 2000httpwwwworldbankorgresearchinterestconfsupcomingdeposit_insurancehomehtm)Also see Smalhout (2001)
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 111
subordinated debt (eg uninsured certificates of deposit) to finance asmall fraction (such as 2 percent) of their total nonreserve assets Thesubordinated debt would be allowed to earn a set yield no more than 50basis points over the risk-free yield on government treasury bills Thisrule would supposedly force banks to operate in a safe manner Other-wise subordinated debt holders would redeem their uninsured certifi-cates of deposit and equity investors would sell their bank shares Despiteits practical problems the beauty of the subordinated debt requirementis that it enlists market incentives to push banks to avoid excessive port-folio risk38
The thrust of these proposals is very relevant to the arguments in ourstudy Even in the G-10 countries government monitoring by itself hasnot eliminated moral hazard among banks More work is needed to in-troduce market monitoring and to improve the incentive structures bothfor financial institutions and their supervisors We return to this issuewith our recommendations in the next chapter
38 In late 1996 Argentina began requiring its banks to finance 2 percent of total depos-its in the form of subordinated debt but without a maximum yield provision TheArgentine authorities expect that market discipline will act in concert with the publicsafety net One obvious problem with the subordinated debt proposal is that banks mayencourage some of their customers to buy the subordinated debt
Portfolio Institutions Tomorrowrsquos Problem
Before proceeding to the issues of international supervision we flag an-other potential problem for national regulators The big asset managersprofiled in tables 24 and 26 answer to diverse groups of pensionersshareholders and policyholders They allocate funds across a number ofcountries to diversify their risks They hold liquid assets that can be tradedand they have a higher proportion of long-term assets than banks Eco-nomic shocks can be absorbed through price changes and their effectsspread across time and markets Thus when conditions change in a par-ticular market they are more likely to ride out the storm than to flee Inother words they have less incentive than banks to pull their invest-ments in the face of adversity In the 1990s most large asset managersestablished a record of ldquoriding out the stormrdquo rather than ldquorunning withthe windrdquo although as we saw in chapter 1 instances of running withthe wind were detected in some portfolios As we write these insti-tutions have a good record overall in the emerging markets so whyworry
The Russian crisis and the near-collapse of LTCM previewed the dan-gers that may await future portfolio managers and G-10 financial minis-ters We have presented evidence indicating a systemic bias toward bank
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112 WORLD CAPITAL MARKETS
lending and debt finance to emerging markets and we have argued forsubstitution toward equity finance and direct investment39
That is not the end of the story We noted in the previous chapterthat institutional investors can become momentum investors selling in adownturn As more portfolio capital is invested in emerging marketssome players may adopt the high-risk high-leverage strategies of themost aggressive hedge funds Indeed the data in box 11 show that G-10portfolio investors held somewhat more long-term debt (more than $500billion) than equity (less than $400 billion) in emerging markets at theend of 1997 Long-term debt is an ideal vehicle for high-risk high-leveragestrategies These strategies practiced on a large scale could compound afuture crisis harming emerging markets A big enough crisis could inturn pressure G-10 central banks and finance ministers to arrange bail-out plans Instead of shrinking as a systemic financial problem moralhazard could increase
National securities regulators are the first line of defense against thisscenario They play a critical role in the safe evolution of capital mar-kets But regulators today are mandated to approve the issuance of newsecurities and to monitor the continuing disclosure of material informa-tion by issuers They are far less concerned with or empowered to monitorthe behavior of the increasingly large wealth-management firms that arethe major purchasers (and therefore resellers) of these securities
Within their mandates the goals of national securities regulators (table210 and appendix B) are similar to the concerns of bank regulators withsystem safety and soundness Their focus is also on the incentive sys-tems for management and boards of directors and on disclosure by cor-porations that issue marketable securities such as shares bonds andasset-backed securities 40 Issuers of securities possess greater knowledgeabout the quality of these assets than do the purchasers hence investorprotection is a key concern of regulators Moreover market disciplineworks best when markets know what is happening Well-functioning corpora-tions are key agents of wealth creation and social progress Underperform-ing corporations waste resources During recessions bad corporationsget into bad trouble often with severe social consequences Inadequateincentives for managers and inadequate accountability for boards andmanagers thus have negative externalities Regulators play a vital role inexposing weakness so that market disciplines come to bear sooner ratherthan later
Regulatory emphasis is constantly shifting as financial markets evolveand as the macroeconomic environment changes Regulators try to balance
39 See Rogoff (1999) Also see Berlin (2000) for a perspective on the limited role thatbanks play as share owners
40 See Habib and Ljungqvist (2000) for recent empirical analysis showing that corporateshare market values are higher when corporate executives have a larger ownership stake
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Table 210 Financial-sector regulation G-10 countries 2000
Financial institutions and their supervisors
Country and supervisory structure Retail banking Wholesale banking Securities Insurance
Financial conglomeratesFinancial Services Authority (FSA) = umbrella supervisor
United Kingdom FSA FSA FSA FSA
Treasury bull Commercial banks bull Investment funds (Securities and (Insurance Directorate(Securities and Investments Board) bull Unit trust groups Futures Authority) of the Treasury)
Bank of bull Building societies bull Pension funds England (Building Societies Commission) bull Merchant banks
bull Friendly societies bull Clearing houses bull Primary issuers bull Insurance FSA (Friendly Societies Commission) bull Venture capital of securities companies
bull Pensions and life insurance etc bull Stock exchanges bull Insurance brokers(Personal Investment Authority) bull Stockbrokers
Financial holding companiesFederal Reserve (FR) = umbrella supervisor
United States bull National banks(OCC) Securities and Regulated by
Treasury OCC bull State banks Federal Reserve Exchange Commission StatesMembers (FR)
OTS Nonmembers (FDIC) bull Investment banks bull Primary issuers of bull Insurance companies FR bull Cooperative banks (FDICFR) bull Finance companies securities bull Insurance brokers FDIC bull Insured industrial banks (FDIC) bull Stock exchanges
bull Thrift holding companies (OTS) bull Stockbrokers SEC bull Savings banks (OTSFDICFR) bull Investment advisors
bull Savings and loan associations bull Mutual funds(OTS) bull Public utility holding
bull Edge Act corporations (FR) companies
(table continues next page)
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Table 210 Financial-sector regulation G-10 countries 2000 (continued )
Financial institutions and their supervisors
Country and supervisory structure Retail banking Wholesale banking Securities Insurance
Financial holding companies Japan Financial Supervisory Authority (FSA) = umbrella supervisor
Prime FSA FSA FSA FSA ministerrsquos Ministry of office Finance (Securities and Exchange
Surveillance Commission) FRC Bureau of Financial bull City banks bull Investment banks bull Primary issuers of bull Insurance companies FSA Regulation bull Regional banks bull Asset managers securities bull Insurance brokers
bull Trust banks bull Stock exchanges SESC bull Long-term credit banks bull Stockbrokers
bull Pension funds
Financial holding companiesOffice of the Superintendent of Financial Institutions (OSFI) = umbrella supervisor
Canada Regulated by OSFI OSFI provinces OSFI
Department of Financebull Banks bull Cooperative credit bull Primary issuers of bull Insurance companies
(previously Office of the Inspector associations securities (previously Depart- OSFI General of the Banks) bull Fraternal benefit bull Stock exchanges ment of Insurance) Bank of bull Trust and loan companies society bull Stockbrokers bull Insurance brokers Canada bull Pension funds bull Asset managers
(previously Depart- CDIC ment of Insurance)
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Financial institutions and their supervisors
Country and supervisory structure Retail banking Wholesale banking Securities Insurance
Germany Financial holding groupsFederal Banking Supervisory Office (FBSO) = umbrella supervisor
Ministry of Finance FBSO BSO FSSO FISO
Bundesbankbull Universal banks bull Other financial bull Primary issuers of bull Insurance companies
Federal Banking bull Savings banks institutions (eg securities bull Insurance brokers Supervisory Office bull Securities banks management foreign bull Stock exchanges
currency dealings) bull Stockbrokers Federal Securities bull Financial enterprises bull Asset managers Supervisory Office (eg leasing bull Pension funds
organizations Federal Insurance credit card companies Supervisory Office investment advisors)
Italy Bank foundationsMinistry of Finance = umbrella supervisor
Ministry of Finance Bank of Italy Bank of Italy Consob ISVAP
Bank of Italy bull Commerical banks bull Asset managers bull Primary issuers of bull Insurance companies Consob bull Savings bank bull Open-end investment securities bull Insurance brokers
bull Securities banks companies (SICAVs) bull Stock exchangesbull Stockbrokers
ISVAP
(table continues next page)
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Table 210 Financial-sector regulation G-10 countries 2000 (continued )
Financial institutions and their supervisors
Country and supervisory structure Retail banking Wholesale banking Securities Insurance
The Netherlands Financial conglomeratesCouncil of Financial Supervisors = umbrella supervisor
Securities Board Securities Board Netherlandsche Netherlands Bank Netherlandsche Bank of the Netherlands Insurance Board Bank Insurance bull Credit institutions (universal banks bull Investment institutions bull Stock exchanges bull Insurance companies Board cooperative banks security credit (securities issuing bull Stockbrokers bull Insurance brokers
institutions mortgage banks) and tradingmdashprimary The Council of Financial and secondary Supervisors markets)
France Commission des Commission de Operations des Controcircle des
Banking and Banking Commission Bourse Assurances Financial Regulatory bull Ensuring that credit institutions (and investment firms since bull Primary issuers of bull Insurance companies Ministry for Committee the Financial Activity Modernization Act of 1996) comply securities bull Insurance brokers Economic with laws and regulations bull Stock exchanges Affairs and bull Execute instructions regarding all off-site monitoring and bull Stockbrokers Finance Credit on-site supervision Institutions and Banking and Financial Regulatory Committee Investment bull Formulates general regulations for credit institutions and investment firms Committee (capital adequacy requirements accounting rules etc) Bank of France Credit Institutions and Investment Committee Banking bull Authorizes and examines financial institutions except for those within the Commission competence of the Banking Commission
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Financial institutions and their supervisors
Country and supervisory structure Retail banking Wholesale banking Securities Insurance
Switzerland Large banking groupSwiss Federal Banking Commission (SFBC) = umbrella supervisor
Swiss National Bank Federal Office of
SFBC SFBC SFBC Private Insurance Swiss Federal Banking Commission bull Universal banks bull Investment banks bull Primary issuers of bull Insurance companies
bull Savings banks bull Asset management securities bull Insurance brokerscompanies bull Stock exchanges
Private audit Federal bull Investment funds bull Stockbrokers firms Office of bull Mortgage bond authorized by Private business SFBC Insurance
Sweden Financial holding company groupsFinancial Supervisory Authority = umbrella supervisor
Ministry of Finance Credit Market Securities Market Insurance Market
Credit Market Department Department Department Department
Financial bull Commercial banks bull Investment funds bull Primary issuers of bull Insurance companies Riksbank Supervisory bull Savings banks securities bull Insurance brokers Authority bull Friendly societies bull Stock exchanges
bull Stockbrokers
(table continues next page)
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118W
OR
LD
CA
PIT
AL
MA
RK
ET
S
Table 210 Financial-sector regulation G-10 countries 2000 (continued )
Financial institutions and their supervisors
Country and supervisory structure Retail banking Wholesale banking Securities Insurance
Belgium Bank holding companiesBanking and Finance Commission = umbrella supervisor
Bank of Belgium Banking Banking
Banking and Finance and Finance Insurance Controland Finance Commission Commission Commission Office
Banking and Insurance Finance Control bull Commercial banks bull Asset management bull Primary issuers of bull Insurance companies Commission Office bull Savings banks firms securities bull Insurance brokers
bull Securities banks bull Investment funds bull Stock exchanges bull Mortgage companiesbull Stockbrokers bull Pension funds
Securities Regulation Fund Securities Regulation Fund
bull Other investment firms and credit institutions(institutions participating in regulated off-exchangemarket in strips and Treasury certificates)
Bank holding companies Spain Banco de Espantildea = umbrella supervisor
Banco de Espantildea Comision Nacional del Mercado de Directorate General
Banco de Espantildea Valores (CNMV) Insurance
bull All credit institutions (commercial banks savings banks credit bull Primary issuers of (Ministry of Economy Ministry of cooperatives official credit institutions finance factoring and securities and Finance) Economy and CNMV leasing companies mortgage-loan companies etc) bull Stock exchanges bull Insurance companies Finance bull Interbank foreign exchange and book-entry public debt bull Stockbrokers bull Pension funds
markets bull Venture capital(companies and funds)
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ics | httpww
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TH
E P
LAY
ER
S T
HE
IR S
UP
ER
VIS
OR
S A
ND
MO
RA
L HA
ZA
RD
119
Financial institutions and their supervisors
Country and supervisory structure Banking Securities Insurance
Banking Advisory High Level Securities Supervisors Committee (BAC) Committee (HLSS) Insurance Committee (IC)
Supranational (EU) bull Formulates standards for prudential bull Coordination of securities market bull Formulates standards forsupervision supervision prudential supervision
BACICHLSS Banking Supervision
Conglomerates Committee (BSC) Securities Contact Committee Regulation of prudential bull Systemic risk monitoring bull Regulation and implementation of supervision securities admission
International Association International International Organization of of Insurance Supervisors
Basel Committee Securities Commisison (IOSCO) (IAIS) Joint Forum Conglomerates Supervision bull Supervision and regulation best bull Supervision and regulation best bull Supervision and regulation amp regulation Best practices practices practices best practices
FSF Coordination across supervisors of various functions
Notes See appendix B for more information Boldface type indicates senior or oversight supervisor normal type indicates adjunct or front-line supervisorsolid line indicates direct responsbility to the senior-ranking authority dotted line indicates coordination in supervisory activities
(table continues next page)
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120W
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ET
S
Table 210 Financial-sector regulation G-10 countries 2000 (continued )
Glossary of names United Kingdom FSA = Financial Services Authority United States FR = Federal Reserve OCC = Office of the Comptroller of theCurrency FDIC = Federal Deposit Insurance Corporation SEC = Securities and Exchange Commission OTS = Office of Thrift Supervision Japan FRC =Financial Reconstruction Commission FSA = Financial Services Agency SESC = Securities and Exchange Surveillance Commission Canada OSFI =Office of the Superintendent of Financial Institutions CDIC = Canada Deposit Insurance Corporation Germany FBSO = Federal Banking SupervisoryOffice FSSO = Federal Securities Supervisory Office FISO = Federal Insurance Supervisory Office BSO = Banking Supervisory Office Italy Consob =Commissione Nazionale per le Societa e la Borsa ISVAP = Instituto per la Vigilanza sulle assicurazioni private e di Interesse colletivo Switzerland SFBC= Swiss Federal Banking Commission Spain CNMV = The Comision Nacional del Mercado de Valores Supranational BAC = Banking Advisory CommitteeBSC = Banking Supervision Committee IC = Insurance Committee HLSS = High Level Securities Supervisors Committee International Dimension FSF =Financial Stability Forum IOSCO = International Organization of Securities Commission IAIS = International Association of Insurance Supervisors
Sources United Kingdom Bank of England httpwwwbankofenglandcouk Financial Services Authority httpwwwfsagovuk United States Board ofGovernors of Federal Reserve System httpwwwfederalreservegov Japan Bank of Japan httpwwwbojorjo Financial Reconstruction Commissionhttpwwwfsagojpfrcindexehtml Financial Services Agency httpwwwfsagojp Canada Bank of Canada httpwwwbank-banque-canadaca Office ofthe Superintendent of Financial Institutions httpwwwosfi-bsifgccaAndreEindexhtml Germany Deutsche Bundesbank httpwwwbundesbankde Fed-eral Banking Supervisory Office httpwwwbakredde Italy Banca drsquoitalia httpwwwbancaditaliait Commissione Nazionale per le Societa e la Borsahttpwwwconsobit Instituto per la Vigilanza sulle assicurazioni private e di Interesse colletivo httpwwwisvapit The Netherlands De NederlandscheBank httpwwwdnbnl France Banque de France httpwwwbanque-francefr Switzerland Schweizerische Nationalbank httpwwwsnbchindex3htmlSweden Sveriges Riksbank httpwwwriksbanksedefaultasp Belgium National Bank of Belgium httpwwwbnbbesgindexhtm Spain Banco de Espantildeahttpwwwbdees The Comision Nacional del Mercado de Valores httpwwwcnmves Supranational (EU) Institutional Arrangements for the Regulationand Supervision of the Financial Sector 2000 International Dimension Bank for International Settlement httpwwwbisorg International Organization ofSecurities Commissions httpwwwioscoorg International Association of Insurance Supervisors httpwwwiaisorg Financial Stability Forum httpwwwfsforumorg
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 121
the inflexibility of tight surveillance against the need to encourage in-novation and growth The US Securities and Exchange Commission isworried about aggressive accounting by firms and biased reports bysecurities analysts in an equity environment that prizes steadily higherquarterly earnings41 Japanese regulators are preoccupied with opaqueinterconnections between portfolio institutions banks and nonfinancialfirms through the keiretsu system Canadian regulators reeling from high-profile scandals of managers intentionally misleading investors are strengtheningmarket discipline through legal penalties aimed at managers and directorsof offending firms
When panic strikes a securities regulator cannot do much As the 1987stock market crash and the LTCM debacle in the fall of 1998 both dem-onstrated steep stock and bond price declines can create systemic risksIf severe enough the wealth effect of falling securities values and thefear of widespread insolvency can depress real activity Flooding thesystem with liquidity is a central bankerrsquos solutionmdashsomething a securi-ties regulator cannot do42 But just as financial supervisors can changethe incentive structure to discourage bankers from making risky loans ingood times so securities regulators can pay more attention to incentiveson the demand side when capital markets are strong
Prudential Supervision and InnovationmdashA Footnote
In concluding this discussion of prudential supervision in the G-10 anadditional point is worth noting National regulators face a persistenttrade-off between emphasizing financial system safety and soundnesswhile encouraging innovationmdashin spite of the added risks innovationbrings to financial markets Former US Treasury Secretary Lawrence Summers(2000 3) has argued by analogy
The jet airplane made airplane air travel more comfortable more efficient andmore safe though the accidents were more spectacular and for a time morenumerous after the jet was invented In the same way modern global financialmarkets carry with them enormous potential for benefit even if some of theaccidents are that much more spectacular As the right public policy response
41 The problem is illustrated by the divergence since mid-1998 between reported earn-ings by the Standard amp Poorrsquos (SampP) 500 and the after-tax profits of all corporations inthe national accounts Generally these two series move closely with one another Be-tween mid-1998 and mid-1999 SampP 500 reported that earnings increased by more than20 percent while after-tax profits of all corporations increased by less than 5 percent(Chase Bank US Economic and Policy Research US Weekly Prospects Chase SecuritiesWeekly Newsletter 5 June 2000 5)
42 For example the US Securities and Exchange Commission had no direct role in calmingmarkets in the 1987 or 1998 panics
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122 WORLD CAPITAL MARKETS
to the jet was longer runways better air-traffic control and better training forpilots and not the discouragement of rapid travel so the right public policyresponse to financial innovation is to assure a safe framework so that the ben-efits can be realized not to stifle the change
Accepting Summersrsquos analogy for the international financial system better-informed supervisors and investors are a necessary part of the financialsystem framework Supervisors require more timely information on therisk profiles resulting from positions taken by financial institutions Theyalso need a better understanding of risk-management systems Snapshotsof an institutionrsquos risk profile and risk-management procedures are nolonger adequate In a world where huge bets are quickly made (andpossibly lostmdashas with Barings Bank in 1995 and LTCM in 1998) super-visors must focus on the soundness of banking systems for evaluatingand managing risk on a daily basis Some progress has been made inaddressing these issues US banking examiners are extending their in-formation requirements in banking examinations and increasing theirinvolvement in large complex institutions43 More awareness is alsorequired of the fact that they are national organizations in a world ofcross-border capital flows To a much greater extent they need a multi-national reach International supervision and coordination among super-visors are the subject of the next section
Our analysis suggests that G-10 supervisors have unfinished businessBank supervisors need to start yesterday securities regulators can waituntil tomorrow One G-10 member acting alone cannot correct the biasIn good times the lending business will simply migrate to other G-10banks In bad times financial problems will not stop at the national bor-der A way has to be found to establish common international standardsfor the key financial players in order to prevent crises and to agree onapproaches for managing them The path has already been laid out Inthe wake of the bank failures of the past 25 years bank supervisors havetried to establish such standards They have done this without creating anew global institution
The essence of the international framework is decentralizationmdashglobalrules and design standards without global institutions that are perceivedto intrude on national sovereignty The awkward jargon for this frame-work is vertical subsidiaritymdashldquothink internationally act nationallyrdquo Theinternational thinking is done by a committee of regulators that meets
International SupervisionA Decentralized Framework
43 These issues are discussed in Ferguson (1999) and Meyer (2000a)
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 123
regularly at the Bank for International Settlements in Basel The commit-tee establishes principles and standards that are interpreted implementedand enforced by national authorities44 In this section we describe thesesupervisory efforts and their weaknesses We present our recommenda-tions for addressing these weaknesses in the next chapter
Basel I
The Basel Capital Accord of 1988 (Basel I)45 drew the lesson from thefinancial crises of the mid-1970s that more adequate capital levels in in-ternational banks would help reduce the systemic risk of bank failureThe primary goal of Basel I was capital adequacy other standards wereput in place not so much for their own virtue as to defend the primarygoal
Capital adequacy requirements were designed to ensure that individualinstitutions have the ability to absorb losses particularly credit lossesAccordingly a backup system of scoring credit risk was devised thatrequired large amounts of bank capital for some types of loans smalleramounts for others and zero for a select list of preferred assets Report-ing requirements were designed to disclose problems and ensure that atroubled bank would take timely steps to restore its capital base in thewake of a loss The Basel I framework worked tolerably well in limitingthe call on the public purse in the G-10 countriesmdashwith the notable ex-ceptions of France and Japan The framework failed to moderate riskybank lending to emerging markets however
Basel I was not developed with emerging markets in mind The origi-nal idea behind it was to develop a common supervisory approach tocross-border banking operations It grew out of political pressure fromUS lawmakers who were determined to require international banks op-erating in the United States to meet US banking standards Toward thisgoal in 1983 Congress passed the International Lending Supervisory ActUS and British banking authorities subsequently agreed on a commontarget the adoption of strict common capital-adequacy standards In 1988other G-10 governments agreed to go along voluntary acceptance ofthe standards throughout much of the rest of the world followed46 Therationale for the capital targets was two-fold The first was to requirebanks to hold sufficient amounts of capital (8 percent of risk-adjusted
44 The international committee of financial authorities agreed on a common definitionof banksrsquo tier-one or ldquocorerdquo capital national authorities defined tier-two capital in theirown manner which permitted greater variations in national working definitions andpractices
45 International Convergence of Capital Measurement and Capital Standards (BIS 1988)was prepared by the Basel Committee on Banking Supervision
46 See Reineke (1998)
Institute for International Economics | httpwwwiiecom
124 WORLD CAPITAL MARKETS
assets) to cushion losses on those assets The second was to dull theirappetites for risk banks with large capital bases would have more tolose if they failed and therefore would take fewer risks
Rapid change in financial markets soon revealed flaws in the Basel IAccord In a complex world with numerous sources of risk it focusedheavily on credit risk but overlooked other risks in a bankrsquos portfolioand the correlation between returns on different asset classes The Baselformula required banks to maintain a fixed amount of capital againsteach of its asset classes But the formula did not distinguish the riskinessof the borrower within each class As a result one large loan to a low-risk corporate borrower such as General Electric would require the sameamount of capital as 10 smaller transactions with high-risk borrowers
The system was also biased toward short-term loans Loans maturingin less than a year required a 20 percent risk weight whereas those ma-turing after more than a year required a 100 percent risk weight Inter-bank lending was particularly favored For example loans to banks inOECD countries required less capital than loans to private firms in thesame countries creating the anomaly that interbank loans to South Ko-rean banks required less capital than loans to General Electric47 Thisanomaly encouraged banks to shed high-quality assets if the Basel rulesrequired the allocation of more capital than banks thought they needed
Another weakness was that financial innovators quickly circumventedthe Accord Because short-term loans required less provisioning than long-term loans banks responded by securitizing their long-term debt port-folios and lending short-term against the collateral of the newly createdasset This allowed banks to circumvent the capital requirements gearedto the terms of the underlying debt At the same time the Basel I Accordfailed to encourage risk mitigation techniques such as credit derivativescollateral guarantees and on-balance-sheet netting the flip side of fi-nancial innovation Because off-balance-sheet products were not coveredby the Accord another anomaly appeared when Barings Bank collapsedin 1995 Barings met capital adequacy standards but collapsed becauseits systems for managing risk failed traders were allowed to speculatein futures contracts that did not appear on the balance sheet
Basel II
Work to overhaul Basel I began in 1995 and produced consultativepapers issued in June 1999 and January 200148 These papers have been
47 South Korean banks have had notoriously weak balance sheets because the practiceof ldquodirected lendingrdquo left them with many poor loans (in making these loans the bankswere expected to follow government objectives rather than creditworthiness criteria)
48 Basel Committee on Banking Supervision (1999 2001)
Institute for International Economics | httpwwwiiecom
THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 125
the subject of extensive consultation and revision as a result the newAccord is expected to be introduced in 200449 The Basel II frameworkhas three parts (pillars) revisions to Basel I minimum-capital require-ments supervisory review criteria and greater emphasis on market dis-cipline Broadly Basel II aims to maintain the level of capital in the sys-tem but achieve better alignment of banksrsquo capital with their risk pro-files and keep up with financial innovation
To align capital requirements with market realities (the first pillar)Basel II concentrates on the 100 or so largest banksmdashthe type of playerslisted in table 21mdashand on the holding-company parents of banking groups50
Capital requirements will differentiate between an increased number ofcredit groups or ldquorisk bucketsrdquo including claims on governments otherbanks corporations mortgage-backed securities and other asset-backedsecurities
Basel II originally proposed to use external ratings to set capital chargesfor a number of these credit risks Many banks objected arguing thatthey assess credit risk better than Standard amp Poorrsquos Moodyrsquos or FitchIBCA51 Basel II thus proposes two approaches to rating a standard ap-proach using external ratings and an ldquoadvancedrdquo approach that allowsselected banks to use their own internal rating systems To encouragethe development of rigorous internal control systems based on these in-ternal rating systems Basel II also proposes to levy capital charges foroperational risk (the risk of direct or indirect loss resulting from inad-equate or failed internal processes people and systems or from exter-nal events)
Some critics of this proposal dismiss it as an abrogation of the prin-ciple of external independent monitoring and as ldquodangerously naiumlverdquo52
But regulators argue that the new capital charge on operational risk shouldoffset this concern It is also far from clear how cross-national compari-sons of rating and internal risk-assessment systems will be made (Engelen2000) The development by the European Union of its own capital rulescould well complicate the international resolution of these issues Publicassurances by EU officials in January 2001 however indicated that theirmain concerns are to create a level playing field and avoid regulatoryarbitrage (Hargreaves 2001) There is also the significant problem ofthe procyclical character of risk weights When a crisis hits losses are
49 See Berry (2000) for an update in an interview with William J McDonough chair ofthe Basel Committee on Banking Supervision
50 For obvious reasons these proposals are addressed to large banks and simpler capi-tal standards are allowed for small banks that focus on their domestic credit markets
51 See Ammer and Packer (2000) for an empirical critique of the success of rating agen-cies in distinguishing risk by sector and region
52 See Auerback (2001)
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126 WORLD CAPITAL MARKETS
incurred or accrued capital is lost and loan exposure must be reducedor securities sold to restore the requisite capital-adequacy ratios A morerisk-sensitive framework could amplify volatility
As the second pillar of Basel II supervisory review criteria are beingbeefed up to encourage supervisors to intervene earlier in potential problemsituations and to compel banks to align their capital positions with theirrisk profiles Bank supervisors will be authorized to require banks tohold capital in excess of minimum requirements if they have concernsabout general management overall strategy risk-management performanceor the macroeconomic environment Of course if one G-10 supervisorimposes higher capital requirements in isolation the same disparity willemerge that presaged Basel I Some banks will be disadvantaged in theinternational marketplace and will loudly complain that excessive super-vision is driving business to their competitors Hence close internationalcooperation among supervisors is critical
To implement the third pillar market discipline banks will be requiredto make fuller more timely disclosure of capital adequacy and the risksto which that capital is exposed A number of measures are being stud-ied that might help supervisors evaluate bank performance such as com-parisons of uninsured deposit interest rates subordinated debt yieldsand equity prices The idea is that these yields and prices might alertsupervisors to market perceptions of risk Of course market perceptionsare only as good as market information More direct and controversialways to reinforce market discipline would dramatically increase publicdisclosure of bank positions and risk management systems
Many questions are still outstanding about how to resolve the techni-cal details of capital requirements and whether the requirements willachieve their intended goal of better assessment and mitigation of therisks in banksrsquo portfolios There is no substitute for skilled supervisorsThe intricacies of effective design and implementation suggest that su-pervisors need to be highly competent technically knowledgeable aboutbanking portfolio characteristics and the factors that influence bank ex-posure to credit risk (Mishkin 2000) And they must be aided by vigilantshareholders market forces and transparency of information53
Standard setting at the global level is desirable but ultimately theeffectiveness of these efforts will be tested at the national level espe-cially in times of systemic financial distress Here the record of Basel Iwas not a bright shining success Japanese banking regulators havetraditionally allowed banks to include real estate and securities in theircapital base When the value of these assets plummeted in the early 1990sregulators allowed banks to continue valuing these depreciated (andoften bankrupt) assets at their old inflated levels Japanese authorities
53 Benedict Roth Complacency Towards Catastrophe Financial Times 23 January 2001
Institute for International Economics | httpwwwiiecom
THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 127
insisted until the mid-1990s that eroded capital bases could be rebuiltin a market-driven fashion They rightly foresaw that huge loan losseswould undermine public support for the ruling party and require a po-litically unpopular bailout
Japanese foot dragging on Basel I was the worst54 but not uniqueOther examples can be found of ldquopolitically mandated forbearancerdquo TheFederal Reserve Bank of New York held important hands during theLTCM crisis of 1998 Mexico is still resolving the banking crisis that eruptedin 1995 South Korea has not yet closed the insolvent banks that behavedso badly before the crisis of 1998 In the aftermath of a crisis nationalregulators cannot always be relied upon to discipline politically power-ful bankers55 One of the little-noticed consequences of these differingapproaches is that those banks with strong regulatory systems receivedan implicit ldquoexport subsidyrdquo for their services US banks which had notengaged extensively in emerging-market lending in the 1990s were bet-ter positioned than their German and Japanese counterparts to expandtheir international assets in the wake of the crises
Other Financial Forums
54 See Japanese Banks Fiddling while Marunouchi Burns The Economist 27 January2001 67-69
55 See Calomiris (1997)
The Basel model of vertical subsidiarity has already been extended toother financial regulatory bodies In 1993-94 the BIS established a Tri-partite Group of Banking Insurance and Securities Regulators In 1994-95 the BIS increased its cooperation with the International Organizationof Securities Commissions when the two organizations issued parallelpapers on guidelines for national regulators concerning risk managementand disclosure of derivative trades In 1996 a permanent Joint Forum onFinancial Conglomerates was established to examine supervisory issuesand develop working arrangements among the different functional super-visors of conglomerate institutions that offer combinations of bankingsecurities and insurance products Draft papers on the supervisionof conglomerates were released for comment in 1998 applying capital-adequacy principles to these groups and providing guidelines both forassessing the integrity and competence of top managers and for sharingassessments between regulators
In 1997 the Basel Committee on Banking Supervision extended itsreach beyond capital standards to broader aspects of banking supervi-sion with the publication of the Core Principles for Effective BankingSupervision In 1999 a wide range of regulatory and standard-settingbodies were gathered under the umbrella of the Financial Stability
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128 WORLD CAPITAL MARKETS
Forum (FSF) itself established under BIS aegis56 The FSF has alreadyissued recommendations for stepped-up supervision and transparencyas well as guidelines for best practices in a number of areas includingoffshore financial centers and highly leveraged institutions or hedge funds57
Conclusion
Although the structural weaknesses in emerging-market economies arewidely acknowledged to have been causal factors in international capi-tal-market volatility this chapter points to the role of large G-10 bankingorganizations as major suppliers of the most volatile instrument short-term debt We have examined evidence of the impact of public safetynets in the G-10 economiesmdashthe deposit insurance systems the pruden-tial supervisory systems and the lender-of-last-resort functions of centralbanksmdashon the incentive structures of these organizations
Although supervisors in most countries working nationally and to-gether in the BIS have made significant efforts to mimic market forcesin their prudential supervision the most sophisticated financial institu-tions find innovative ways to circumvent the rules New global regulatorybodies are not about to be created G-10 national bank regulators shouldthemselves address the short-term debt bias in the international financialsystem by changing incentive systems G-10 securities regulators shouldalso take steps to get ahead of the curve paying close attention to largeportfolio swings by institutional investors particularly in times of crisisIn short more needs to be done at national and international levels tochange the rules of the game That is the subject of the next chapter
56 The Financial Stability Forum includes banking securities insurance and accountingregulatory bodies the OECD on taxation corruption and corporate governance and theIMF
57 See Martin (2000)
Institute for International Economics | httpwwwiiecom
THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 91
Tab
le 2
8N
on
fin
anci
al f
irm
s in
th
e 10
0 la
rges
t co
mp
anie
s b
y re
ven
ue
199
8 (b
illio
ns o
f do
llars
)
Glo
bal
Tra
nsn
atio
nal
ity
ran
k
Co
mp
any
Rev
enu
esa
Ass
etsb
ind
exc
Typ
e
Co
nti
nen
tal
Eu
rop
e
2D
aim
lerC
hrys
ler
(Ger
man
y)15
516
044
1M
otor
veh
icle
s an
d pa
rts
11R
oyal
Dut
chS
hell
Gro
up (
Net
herla
nds)
9411
058
9P
etro
leum
ref
inin
g17
Vol
ksw
agon
(G
erm
any)
7670
568
Mot
or v
ehic
les
and
part
s22
Sie
men
s (G
erm
any)
6667
521
Ele
ctro
nics
el
ectr
ical
equ
ipm
ent
32M
etro
(G
erm
any)
5222
n
a
Foo
d an
d dr
ug s
tore
s34
Fia
t (I
taly
)51
7640
8M
otor
veh
icle
s an
d pa
rts
36N
estle
(S
witz
erla
nd)
5041
932
Foo
d46
Veb
a G
roup
(G
erm
any)
4351
275
Tra
ding
49R
enau
lt (F
ranc
e)41
4545
7M
otor
veh
icle
s an
d pa
rts
53D
euts
che
Tel
ekom
(G
erm
any)
4093
n
a
Tel
ecom
mun
icat
ions
57R
oyal
Phi
lips
Ele
ctro
nics
(N
ethe
rland
s)38
3386
4E
lect
roni
cs
elec
tric
al e
quip
men
t59
Peu
geot
(F
ranc
e)38
4038
7M
otor
veh
icle
s an
d pa
rts
62E
lect
riciteacute
de
Fra
nce
(Fra
nce)
3711
3
na
Util
ities
ga
s an
d el
ectr
ic63
Rw
e G
roup
(G
erm
any)
3747
n
a
Util
ities
ga
s an
d el
ectr
ic65
BM
W (
Ger
man
y)36
3660
7M
otor
veh
icle
s an
d pa
rts
66E
lf A
quita
ine
(Fra
nce)
3643
576
Pet
role
um r
efin
ing
69V
iven
di (
Fra
nce)
3558
n
a
Eng
inee
ring
and
cons
truc
tion
70S
uez
Lyon
nais
e de
s E
aux
(Fra
nce)
3585
n
a
Ene
rgy
78E
NI
(Ita
ly)
3249
317
Pet
role
um r
efin
ing
86B
ayer
(G
erm
any)
3134
827
Che
mic
als
92A
BB
Ase
a B
row
n B
over
i (S
witz
erla
nd)
3132
957
Ele
ctro
nics
el
ectr
ical
equ
ipm
ent
93B
AS
F (
Ger
man
y)31
3159
5C
hem
ical
s95
Car
refo
ur (
Fra
nce)
3020
n
a
Foo
d an
d dr
ug s
tore
s
(tab
le c
ontin
ues
next
pag
e)
Institute for International Economics | httpwwwiiecom
92 WORLD CAPITAL MARKETS
Tab
le 2
8N
on
fin
anci
al f
irm
s in
th
e 10
0 la
rges
t co
mp
anie
s b
y re
ven
ue
199
8 (b
illio
ns o
f do
llars
) (c
ontin
ued
)
Glo
bal
Tra
nsn
atio
nal
ity
ran
k
Co
mp
any
Rev
enu
esa
Ass
etsb
ind
exc
Typ
e
Un
ited
Kin
gd
om
19B
P A
moc
o68
8559
2P
etro
leum
ref
inin
g43
Uni
leve
r45
3692
4F
ood
Un
ited
Sta
tes
1G
ener
al M
otor
s16
125
729
3M
otor
veh
icle
s an
d pa
rts
3F
ord
Mot
or14
423
835
2M
otor
veh
icle
s an
d pa
rts
4W
al-M
art
Sto
res
139
49
na
G
ener
al m
erch
andi
sers
8E
xxon
101
9365
9P
etro
leum
ref
inin
g9
Gen
eral
Ele
ctric
100
356
331
Ele
ctro
nics
el
ectr
ical
equ
ipm
ent
14In
tl B
usin
ess
Mac
hine
s82
8653
7C
ompu
ters
of
fice
equi
pmen
t25
US
Pos
tal
Ser
vice
6055
n
a
Mai
l pa
ckag
e a
nd f
reig
ht d
eliv
ery
27P
hilip
Mor
ris58
6051
1T
obac
co29
Boe
ing
5637
n
a
Aer
ospa
ce30
AT
ampT
5460
219
Tel
ecom
mun
icat
ions
40M
obil
4843
597
Pet
role
um r
efin
ing
41H
ewle
tt-P
acka
rd47
3451
1C
ompu
ters
of
fice
equi
pmen
t50
Sea
rs R
oebu
ck41
38
na
G
ener
al m
erch
andi
sers
55E
I d
u P
ont
de N
emou
rs39
40
na
C
hem
ical
s61
Pro
ctor
and
Gam
ble
3731
477
Soa
ps
cosm
etic
s75
Km
art
3414
n
a
Gen
eral
mer
chan
dise
rs81
Tex
aco
3229
453
Pet
role
um r
efin
ing
82B
ell
Atla
ntic
3255
n
a
Tel
ecom
mun
icat
ions
85E
nron
3129
n
a
Ene
rgy
87C
ompa
q C
ompu
ter
3123
n
a
Com
pute
rs
offic
e eq
uipm
ent
89D
ayto
n H
udso
n31
16
na
G
ener
al m
erch
andi
sers
94J
C
Pen
ney
3124
n
a
Gen
eral
mer
chan
dise
rs96
Hom
e D
epot
3013
n
a
Spe
cial
ty r
etai
lers
97Lu
cent
Tec
hnol
ogie
s30
27
na
E
lect
roni
cs
elec
tric
al e
quip
men
t10
0M
otor
ola
2929
n
a
Ele
ctro
nics
el
ectr
ical
equ
ipm
ent
Institute for International Economics | httpwwwiiecom
THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 93
Jap
an
5M
itsui
109
5635
8T
radi
ng6
Itoch
u10
957
333
Tra
ding
7M
itsub
ishi
107
7536
9T
radi
ng10
Toy
ota
Mot
or10
012
540
0M
otor
veh
icle
s an
d pa
rts
12M
arub
eni
9455
300
Tra
ding
13S
umito
mo
8946
259
Tra
ding
18N
ippo
n T
eleg
raph
amp T
elep
hone
7614
7
na
Tel
ecom
mun
icat
ions
20N
issh
o Iw
ai68
3938
8T
radi
ng24
Hita
chi
6282
214
Ele
ctro
nics
el
ectr
ical
equ
ipm
ent
26M
atsu
shita
Ele
ctric
Ind
ustr
ial
6067
332
Ele
ctro
nics
el
ectr
ical
equ
ipm
ent
31S
ony
5353
628
Ele
ctro
nics
el
ectr
ical
equ
ipm
ent
33N
issa
n M
otor
5158
511
Mot
or v
ehic
les
and
part
s38
Hon
da M
otor
4943
641
Mot
or v
ehic
les
and
part
s48
Tos
hiba
4151
252
Ele
ctro
nics
el
ectr
ical
equ
ipm
ent
51F
ujits
u41
4332
6C
ompu
ters
of
fice
equi
pmen
t52
Tok
yo E
lect
ric P
ower
4012
2
na
Util
ities
ga
s an
d el
ectr
ic60
NE
C37
42
na
E
lect
roni
cs
elec
tric
al e
quip
men
t90
Tom
en31
18
na
T
radi
ng99
Mits
ubis
hi E
lect
ric30
35
na
E
lect
roni
cs
elec
tric
al e
quip
men
t
Ch
ina
73S
inop
ec34
52
na
P
etro
leum
ref
inin
g
Tot
al (
aver
age
for
tran
snat
iona
lity
inde
x)3
988
447
949
0T
otal
for
G-1
0 (a
vera
ge f
or t
he i
ndex
)3
954
442
749
0
na
= n
ot a
vaila
ble
G-1
0 =
Gro
up o
f T
en c
ount
ries
see
not
e to
tab
le 1
1
a
Dat
a sh
own
are
for
the
fisca
l ye
ar e
nded
on
or b
efor
e 31
Mar
ch 1
999
b
Ass
ets
show
n ar
e th
ose
at t
he c
ompa
nyrsquos
fis
cal
year
-end
c
The
ind
ex o
f tr
ansn
atio
nalit
y is
cal
cula
ted
as t
he a
vera
ge o
f ra
tios
of f
orei
gn a
sset
s to
tot
al a
sset
s f
orei
gn s
ales
to
tota
l sa
les
and
for
eign
em
ploy
men
tto
tot
al e
mpl
oym
ent
as o
f 19
97 (
UN
CT
AD
)
Sou
rces
F
ortu
ne G
loba
l 50
0 1
999
http
w
ww
pat
hfin
der
com
fort
une
glob
al50
0in
dex
htm
l U
NC
TA
D (
1999
)
Institute for International Economics | httpwwwiiecom
94 WORLD CAPITAL MARKETS
foreign direct investment The ldquotransnationality indexrdquo (table 28) showsthat on average they conducted about half their business outside theirhome country9
Overview of the Players
Our review of the major players points to two major features First ahandful of big playersmdashfewer than 200 firms all toldmdashcontrol the ac-tion in international capital markets Their dominance will doubtless erodebut for now financial power is strikingly concentrated with them Sec-ond the big players are overwhelmingly based in the G-10 countriesplus Spain The responsibility to supervise them rests not in the IMFnor in Basel but squarely in Washington London Tokyo and the otherG-10 capitals At year-end 1999 the G-10 countries plus Spain accountedfor 84 percent of world banking assets 86 percent of world stock marketcapitalization and 76 percent of international debt securities (BIS 2000aWorld Bank 2000b)
International private capital flows are of three types bank loans anddeposits portfolio investment and foreign direct investment In cumula-tive total flows to emerging markets FDI was the biggest story in the1990s amounting to $954 billion (table 12) Portfolio flows were nextcumulatively amounting to somewhere between $612 billion (table 12)and $764 billion (table A1) Bank loans and deposits are the most com-plicated story
The Key Role of Banks
Banks are more important as an epicenter than as a wellspring Banksgenerate waves in the flow of capital to emerging markets rather than acontinuous steady stream According to data compiled by the Institute ofInternational Finance (table A1) net bank lending to emerging marketscumulated to $269 billion in the 1990s However deposits by emerging-market residents in G-10 banks more than offset G-10 bank lending tothese countries during the decade According to IMF data cumulativebank loans net of deposits amounted to a negative $135 billion (table 12)
In other words when loans and deposits are combined net bank ac-tivity that moves financial resources to emerging markets is small incomparison with portfolio investment and FDI But bank loans are thelubricant of any financial system Depending on circumstances bankscan be shock absorbers or shock propagators In recent decades with
9 The transnationality index is calculated as a simple average of the share of assetssales and employees outside the home country
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 95
respect to emerging markets banks have more often been propagatorsthan absorbers The average annual swing in bank lending to emergingmarkets was nearly $50 billionmdashby far the largest source of year-to-yearfluctuations in capital flows Both interbank loans between Europe Japanand Asia and sovereign Russian debt used as loan collateral played amajor role in the 1997-98 crisesmdashnot because banks are profligate playersbut because of the incentives they face and the instruments they useAccordingly our story begins with banks
Banks in the Modern Financial System
10 See Levine (2000) for a concise description of the role of banks in the financial system
11 The asymmetric information problem helps to explain why banks dominate the im-mature financial systems of emerging-market economies The general lack of informationon borrowers and undeveloped legal systems to enforce contracts hamper suppliers oflong-term financial instruments such as equities and bonds in evaluating risk and re-ward Banks are best suited in these circumstances to solve the asymmetric informationproblem by evaluating and monitoring private loans As more and better informationbecomes available capital markets develop and financial systems mature
As we noted in the previous paragraph the problem of financial volatil-ity in emerging-market economies is associated with bank lending Ifand when repayment problems arise cross-border private bank loansand bond placements are such that private creditors have no plausiblemeans of seizing assets from either private or sovereign borrowers Thusalthough international finance can nourish entrepreneurs and accelerategrowth a necessary complement may be a drastic creditor response inthe event of nonpaymentmdashto withhold fresh funds and force an eco-nomic crisis (Dooley 2000)
This argument is based on the characteristics of banks They are notldquobadrdquo per se They perform three essential functions in any financialsystem pooling the resources of disparate savers and channeling these re-sources into productive investment improving resource allocation throughtheir expertise in assessing and monitoring borrowers and facilitatingthe division of risk among numerous creditors10 But by their very na-ture banks are prone to two problems asymmetric information (the bor-rower knows more about the potential risk and return of its projectsthan the bank) and adverse selection (riskier borrowers will pay higherinterest rates and thus may constitute a disproportionate share of bankloan portfolios)11
Bank loans are illiquid fixed-price instruments They cannot easily beconverted to cash although they can be bundled into securities (knownas ldquosecuritizationrdquo) Once loan terms have been agreed on the only waya bank can adjust for shifting market conditions is by changing the quantityof its exposure When a borrower runs into trouble the bank can mix
Institute for International Economics | httpwwwiiecom
96 WORLD CAPITAL MARKETS
and match from two unpleasant menus It can roll over existing loansand extend new credit or it can call some part of existing loans andattempt to recover the principal It can also hedge by selling short otherclaims on the borrower These choices entail either an unwelcome exten-sion of the bankrsquos exposure or credit rationing against the borrower Whentrouble brews all banks encounter the same conditions in the aggregatethey prefer less exposure and ensuing credit restrictions lead to volatilebank lending
Innovation
12 Derivatives have no value of their own They ldquoderiverdquo their value from the value ofthe underlying asset They include swaps futures (contracts for future delivery at speci-fied prices) and options (which give one party the right but not the obligation to buyfrom or sell to a counterparty at an agreed price)
13 Maxfield (1998) analyzed available evidence of emerging-market investor objectivesmost of it before the crisis Analysis of portfolio equity flows is sensitive to the choice ofperiod with year-over-year data indicating that investors respond to country ldquofundamen-talsrdquo Other evidence suggests more ambiguity Ranking by ldquoinvestor impatiencerdquo ie thesearch for yield over value Tesar and Werner (1995) find short-term bank flows to be themost yield driven followed by portfolio investment FDI and long-term bank lending
14 Because market risk credit risk and country risk interact in complex ways newfinancial instruments have been created to help reduce negative interactions One is theldquototal return swaprdquo which has become an instrument of choice for hedge funds lookingfor high leverage Banks also use the total return swap to cover risks without increasingtheir capital requirements
Since the 1980s national and international banking systems have beentransformed by deregulation intensified competition and the informationand communications-technology revolutions The market environment isone of intense competition particularly in traditional banking activitiesThe innovations point away from traditional activities of plain vanilladeposit taking and loan making Three big themes are discernible Firstthe walls separating commercial banks investment banks portfolio man-agers and insurance firms are falling even if they are still distinct Sec-ond large banks are shifting toward securitizationmdashcreating securitiesout of everything from credit card debt to trade finance to disaster insur-ancemdashand earning fees in the process Third all large banks are shiftingtoward trading activity making markets and taking short-term stakes inbonds shares and derivatives12 These activities when successful satisfythe search for higher yields13
Many of the new financial instruments that banks trade are ldquooff bal-ance sheetrdquo This means that banks are not required to allocate capitalagainst them In swap contracts for example neither side pays cash at theoutset and therefore neither party has an asset in the traditional sense14
Futures and options contracts can be written with a relatively small initial
Institute for International Economics | httpwwwiiecom
THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 97
margin relative to the potential risk Credit derivatives limit credit risk bytransferring the potential loss associated with corporate loans and bondssovereign debt and other loan portfolios to counterparties15
Deregulation and innovation working in combination seem to havepushed banks into trading activity and leveraged plays but not into shareownershipmdasheven in jurisdictions that have no prohibition against equitystakes Among the G-10 banking systems the highest ratio of share own-ership to assets was only 5 percent in 1996 reached in Germany andJapan (Berlin 2000)16
The wave of innovation in financial instruments and the accompany-ing expansion of banking beyond its old boundaries is a two-edged swordOn one side it allows risk management far beyond what was tradition-ally possible Risk can now be shifted from firms that can ill afford lossesto those that can Banks can profitably act as intermediaries in shiftingrisk On the other side the innovation wave creates huge opportunitiesfor leveraged plays fostering a speculative search by banks themselvesfor high returns that in turn magnify their own risks17
15 Credit derivatives include total return swaps credit default swaps credit-linked notesand collateralized debt obligations They are the fastest-growing sector of the global de-rivatives market
16 Banks seem to specialize in lending even when they are allowed to mix finance andcommerce for reasons related both to how they are expected to behave with distressedfirms and to other intricacies of lender liability (Berlin 2000) Yet a recent cross-countrystudy found that restrictions on banking and commerce are associated with greater fi-nancial instability (Barth Caprio and Levine 2000)
17 Leverage is the magnification of the rate of return (positive or negative) on an in-vestment beyond the rate obtained by solely investing funds owned by the institution Itis often defined as the ratio of assets to equity Leverage is achieved by increasing thesize of an investment by borrowing or using derivative instruments such as futures oroptions These allow investors to earn a return on the notional amount underlying thecontract by committing a small portion of equity in the form of a margin deposit oroption premium payment
18 In a repo (repurchase agreement) one party (typically a trader) buys a bond andsells it to a dealer for cash with a promise to buy it back the next day at the same priceplus the overnight interest rate As long as the overnight interest rate is lower than theinterest accruing on the bond the trader earns some income on the bond The extremeform of these kinds of transactions was discovered at LTCM the failed US highly lever-aged institution which appears to have controlled more than $120 billion in assets froman investment of about $3 billion This leveraging was accomplished mostly through theuse of repos (Mayer 1999)
The potential for damage is illustrated in an extreme form by figure 21To precisely measure a firmrsquos leverage all positions must be known andrealistically valuedmdashwhich may be impossible to do Because many ac-tivitiesmdashsuch as repos18 and derivativesmdashdo not appear on the institutionrsquos
Leverage
Institute for International Economics | httpwwwiiecom
98W
OR
LD
CA
PIT
AL
MA
RK
ET
S
Figure 21 Hypothetical example of leverage
$1000 notional value of call option on equity in firms targeted for takeover
Repo FRN into cash and use cash to pay option premium
(repro is initially collateralized
Borrow $100 for margin purchase
$125 of US investment bank floating-rate notes (FRN) (secured by $25 equity in FRNs)
Repo off-the-run bond into cash and post margin
(repo is initially collateralizedSell (short) Borrow on-the-run bonds worth $20
$25 worth of off-the-run bonds (secured by $5 equity in bonds)
Exchange into $4
Cash $5 yen400 Japanese bank loans
$1 equity base
FRN = floating rate notesRepo = repurchase agreement
Source IMF (1998)
Institute for International Econom
ics | httpww
wiiecom
THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 99
balance sheet and because balance sheets are published quarterly at bestoutsiders have a difficult time assessing the extent of a firmrsquos leverage19
Leveraging by a single firm enhances its risk of default the widespreaduse of leverage in the financial system can magnify market adjustmentsespecially when they require ldquodeleveragingrdquomdashunwinding prior positionsRapid adjustments can cause credit to dry up and asset prices to plummetIn a mark-to-market environment falling asset prices trigger calls foradditional collateral that can ripple through markets
Risk Management
Because it is confronted with the widespread use of leverage and prolif-erating kinds of risk international finance is increasingly driven by riskevaluation and control20 Different institutions face various risk profilesand differing kinds of risk The most common risks can be quickly tickedoff Banks because of their traditional intermediary role of channelingthe resources from savers to borrowers face significant credit risk therisk of default or delay in the payment of principal and interest Theymust also manage market risk the risk that the prices of their liabilitiesmay change faster than their assets Market risk devastated US savingsand loan institutions in the late 1980s
Closely associated with market risk are interest-rate risk (unexpectedchanges in market interest rates that slash margins net income and theeconomic value of a bankrsquos equity) and foreign exchange risk (losses thatarise when assets denominated in an appreciating foreign currency areless than liabilities denominated in that currency) Banks make numer-ous loans to other banks around the world portfolio investors buy se-curities direct investors acquire fixed assets and all incur country risk(economic and political uncertainty in the host country) During the heightof the Asian crisis for example interbank loans to Japanese banksreflected the credit risk of lending to these banks the so-called Japanpremium
Substantial attention has been lavished on country risk analysis sincethe 1982 debt crisis in developing countries Yet in spite of this exper-tise the Asian crisis occurred in part because of a sudden upward reap-praisal of country risk after the Thai baht collapsed in April 1997 Banksand other financial institutions must also manage liquidity risk the riskthat market conditions will change unexpectedly depressing demand andprices of assets at the time they want to sell these assets And they mustmanage operational riskmdashfailures in control systems or people that cause
19 Another example of asymmetric information Both risk and leverage are difficult foroutsiders to assess without full timely disclosure
20 A longer discussion of these issues can be found in Managing Global Finance in IMF(1999c)
Institute for International Economics | httpwwwiiecom
100 WORLD CAPITAL MARKETS
financial loss or damage reputations Operational risk devastated BaringsBank in 1995
Financial institutions practice risk management to measure all theserisks the potential damage to their investment positions and ultimatelythe chance of becoming insolvent VAR (value at risk) risk models mea-sure subject to certain assumptions the amount of the firmrsquos capital thatis exposed in each period For example the VAR model might say thatin a 3-standard-deviation worst case (a case that is not supposed to hap-pen more than 1 percent of the time) the firm will loose 25 percent of itscapital during the next year
VAR models are widely used but like all models they have weak-nesses They rely on past values to estimate key variables in financialmarkets past values are not always good predictors of future risks More-over rising volatility and higher loss correlation among different assetclasses in a portfolio will cause all banks using these models to reducetheir exposures at the same time by switching to less volatile and lesscorrelated assets such as US Treasury bills (Persaud 2000)
Newer risk models entail stress testing and scenario analysis Scenarioanalysis envisages possible adverse changes one at a time that mightaffect the investment portfolio Stress testing estimates potential losseswhen several individual risk factors simultaneously move against thefirm but it too uses historical probabilities
Financial Volatility
21 For example derivative markets usually rely on underlying securities markets thatproduce continuous prices When these markets are interrupted financial shocks cantrigger a cascade of margin calls and sell orders that move prices very sharply
22 See IIF (1999a)
The combination of trading activity and modern risk management lie atthe root of financial volatility When risks increase banks must eitherraise more capital to cover the greater risk or reduce their exposure bycutting loan exposure by selling securities or by undertaking new de-rivative trades Raising more capital is time-consuming and in a crisisvery expensive because bank shares are depressed So banks look to theother alternatives If the bank can reduce lending it need not book aloss But most banks use the same VAR models and as indicated abovethese models will encourage them to reduce their outstanding loans atthe same time actually magnifying loan volatility
If banks attempt to reduce their exposure to risk by selling securitiesor undertaking new derivative trades they may trigger large priceshocks because of limited and shrinking market liquidity21 The liquid-ity problem is compounded when a small number of large institu-tions hold the same positions22 Take your pick loan volatility or price
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 101
volatility As two experts have observed (Folkerts-Landau and Garber1998)
[V]olatility even in one country will automatically generate an upward re-estimate of credit and market risk in a correlated country triggering automaticmargin calls and tightening of credit lines Thus apparently bizarre opera-tions that connect otherwise disconnected securities markets are not the re-sponses of panicked green screen traders arbitrarily driving economies from agood to a bad equilibrium Rather they work with relentless predictability andunder the seal of approval of supervisors in the main financial centers
23 See Ferguson (1999)
24 As Gerald Corrigan (1982) put the matter ldquoBanks are specialrdquo Corrigan (2000) reit-erated this view even after all the changes of the past two decades Unlike other institu-tions banks offer on-demand transactions are a backup liquidity source for other insti-tutions and serve as a ldquotransmission beltrdquo for monetary policy
These changes in the banking environment accentuate an existing anomalyThe anomaly is that banks even as they grow larger and increasinglyengage in more risky and complex transactions are perceived to enjoyimplicit and explicit public guarantees
The guarantees grow out of an incentive problem inherent in bankingasymmetric information which we mentioned above Depositors know lessabout a bankrsquos management and the quality of its balance sheet than doits managers and shareholders Thus in times of uncertainty or adver-sity bank depositorsmdashuncertain whether they will have access to theirdepositsmdashare prone to bank runs This prospect has in turn compelledgovernments to treat banks differently than other firms because a bankthat fails can disrupt the rest of the economy24
To prevent such crises governments have entered into quid pro quoarrangements with banks Governments provide them both with an im-plicit safety net in the form of an unstated promise by the central bankto act as a lender of last resort in a liquidity crisis and an explicit safetynet in the form of a public deposit insurance fund to reassure depositorsIn return the banks submit to closer government oversight and regu-lation of their activities than is usual for industries in the private sector
The ldquoinsurancerdquo provided by the public safety net contributes to an-other incentive problem moral hazard Banks acquire greater tastes forrisk and face less market discipline than other firms The explicit depositinsurance safety nets actually have or are perceived to have blanketcoverage that extends beyond the retail depositors (households and small
One of the lessons of the 1997-98 crisis must surely be that market par-ticipants and their regulatory supervisors relied too heavily on quantita-tive tools and insufficiently on judgment23
The Anomaly of Modern Banking
Institute for International Economics | httpwwwiiecom
102 WORLD CAPITAL MARKETS
businesses) for which they were originally intended The implicit centralbank safety nets extend in a crisis to nearly all depositors and banksThus banks are both viewed and behave as if they will be bailed out ifthey get into trouble
The existence of a public safety net raises a perennial question Dobanks have an unfair advantage over other financial institutions becauseof the subsidy provided by the safety net This question was at the heartof intensive study and debate in the United States leading up to thepassage in November 1999 of the Financial Services Modernization Act(also known as the Gramm-Leach-Bliley Act) The size of the gross sub-sidy is difficult to estimate despite determined research efforts Somesuggest it is well under 100 basis points and is at least partly offset bythe direct costs of deposit insurance premiums interest payments on bondsissued by the Financing Corporation25 reserve requirements regulatoryexpenses and operational costs associated with collecting deposits26 Con-versely Kwast and Passmore (2000) suggest that banks can expand theirscope far beyond the levels that other financial institutions could reachwith the same equity base but without the public safety net
A related concern in the US debate is whether allowing banks to ex-pand their activities into securities and insurance will ultimately extendthe safety net and add to the subsidy The Financial Services Moderniza-tion Act deals with this issue by maintaining a legal separation betweenbanks and the rest of the banking organization known as large com-plex banking organizations (LCBOs) They must engage in most securi-ties activities and insurance underwriting through separately capitalizedinvestment bank subsidiaries or holding company affiliates This act canbe said to have merely brought US banking laws closer to those of mostother industrial countries (Barth Brumbaugh and Wilcox 2000 BarthNolle and Rice 2000) If the fire wall is well-maintained and stoutly de-fended the safety net will neither expand in practice nor become a sourceof comfort to noncommercial bank subsidiaries of LCBOs
The quid pro quo exacted by governments to offset the subsidy iscloser public-sector monitoring of banksrsquo activities through prudentialsupervision The effectiveness of this closer official scrutinymdashand closermarket monitoringmdashare the subjects of the next section
25 The Financing Corporation was created by Congress in 1987 to sell bonds to raisefunds to help resolve the savings and loan crisis
26 See Levonian and Furlong (1995) Jones and Kolatch (1999) Shull and White (1998)and Whalen (1999a 1999b)
Are G-10 bank supervisors adequately responding In this section we firstassess the case for and compare the structures of prudential supervisory
Prudential Supervision
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 103
systems both within and among the G-10 economies plus Spain andconsider whether these offset the subsidy provided by the public safetynet Despite offsetting regulation and supervision implicit and explicitguarantees by G-10 governments to their banks are still a source of bank-ing instability in the emerging-market economies
National Systems for Prudential Supervision
Governments use prudential supervision to reduce the moral hazard andadverse selection created by their own safety nets Supervisors establishregulations and monitor compliance to limit risk taking and ensure thesafety and soundness of the banking system In a thoughtful analysis ofthe case for prudential supervision Frederic Mishkin (2000) identifiesthe main forms that supervision can take including the tasks of grantingbanking charters and licenses establishing capital requirements settingdeposit insurance premiums and defining disclosure requirements as wellas carrying out bank examinations Bank examiners gather informationfrom banks and evaluate whether they are following the regulatorsrsquo rulesin cases of weakness they are empowered to change banksrsquo behaviorand close them if necessary
Supervisors also may restrict competition define the activities in whichbanks may engage and restrict their asset holdings and separate banksand other financial (or nonfinancial) activities During the past two de-cades the barriers separating commercial banks investment banks in-surance firms and securities firms have been all but eliminated (tableB1) Deregulation has stimulated competitive forces that drive diversifi-cation and consolidation of the financial industry nowhere faster than inthe United States
The Financial Services Modernization Act of 1999 confirmed this trendIt eliminated restrictions dating back to the Glass Steagall Act of 1933which once prevented banking insurance and securities firms fromentering each otherrsquos businesses (Barth Brumbaugh and Wilcox 2000)Cross-pillar mergers among banks insurance and securities firms arewell under way to form giant financial holding companies The 1999merger between Citibank (banking) and Travelers (insurance) created themodel for megafinance and confirmed new challenges for supervisors
Mishkin (2000) notes the corresponding evolution in US supervisionfrom an emphasis on rules-based regulation (detailed rules for opera-tional behavior and the quality of line items in the balance sheet) to anapproach that stresses the soundness of bank management practices es-pecially risk management
Appendix B outlines the systems of financial supervision now in theplace in the G-10 countries plus Spain Some systems like the UK andCanadian approach are models of simplicitymdashorganized to keep pacewith the spreading reach of financial conglomerates Other systems like
Institute for International Economics | httpwwwiiecom
104 WORLD CAPITAL MARKETS
the US and French approaches show traces of the bureaucratic divisionsthat made sense in an era when banking securities and insurance weresharply separated
The US Model
27 See Meyer (1999a)
28 Canada has a similar degree of simplification with the exception that securities firmsare still regulated by provincial authorities
29 See Pratti and Schinasi (1999 67)
30 The agents are the bank regulators and the principals are the taxpayers Agents maypursue their own interests including bureaucratic survival and postgovernment employ-ment opportunities rather than the national interest in banking safety and soundness
The US model of financial regulation delineated in the Financial Ser-vices Modernization Act of 1999 blends functional and umbrella super-vision Bank and thrift regulators oversee depository institutions Newnonbank activities are subject to both functional regulation (eg by theSecurities and Exchange Commission and state insurance examiners) andumbrella supervision (of financial holding companies) by the FederalReserve27
The UK Model
Another supervisory model exists in the United Kingdom as well as inAustralia Canada and Switzerland28 In this model banking supervisionis separated from the monetary policy function The regulatory structureis considerably simplified by relying on a consolidated financial regula-tor separate from the central bank for both banking and nonbankingactivities The remaining question answered differently depending on thecountry is the extent to which the regulator relies on home-country sur-veillance of banks and conglomerates that have a local presence
Regulatory Models Compared
Appendix B provides more detail on the differences in these modelsGerman simplicity contrasts with French complexity In France the bankingcommission is chaired by the governor of the central bank and includesrepresentatives from the Treasury The commission supervises compli-ance with regulations but the central bank inspects banks on behalf ofthe commission29 In countries such as the United States and France withmultiple supervisors and crossover functions internal coordination is criticalAt the same time multiple agencies create regulatory competition Wheneach agency knows what the other is doing transparency within gov-ernment circles can help to limit principal-agent problems of regulation30
The discussion as to where in the public bureaucracy financial super-
Institute for International Economics | httpwwwiiecom
THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 105
vision should be placed goes back many years Peek Rosengren andTootell (1999) argue that a synergy exists between monetary policy andprudential supervision because information gained in the course of super-vision can increase the accuracy of macroeconomic forecasts A twist tothis argument is that the information on the state of financial institutionsavailable to the central bank as supervisor can facilitate its role as lenderof last resort Conversely there is the concern that a supervisory rolewill compromise the central bankrsquos independence of action with respectto its core mandatemdashmaintaining price stability As these arguments haveplayed out financial supervision has generally been shared between centralbanks and other regulators or placed entirely in the hands of an inde-pendent regulator However in Italy the Netherlands and Spain cen-tral banks are the sole banking supervisor
Goodhart (1995) examined the arguments and evidence for each modeland concluded that there were no overwhelming arguments or evidencefor one or the other31 Going forward a key problem for any financialsupervisory system is dealing with (and closing as necessary) weak banksIf both central banks and other regulators have this responsibility closecoordination between them is critical Another problem is large conglom-erate banks LCBOs Although they are less likely to fail because of thediversification of their assets and liabilities they are more likely to berescued They are also more likely to be multinational enterprises withinternational implications Goodhart observes that regulation of theseentities might be put in the hands of the central bank because it is lessamenable to political pressures In any event the complexity of LCBOoperations suggests that greater supervisory rigor is necessary
The US Congress was persuaded that broad oversight would help containthe moral hazard problem and accordingly gave the Federal Reservethe role of umbrella supervisor with the understanding that the Fed willscrutinize depository activity more intensely than nonbank financial ac-tivities Under this approach LCBOs such as Citigroup are subject tomuch closer monitoring than smaller and simpler institutions32 The USregulatory model requires enormous cooperation between the Fed otherbank supervisors and the functional regulators for insurance and securi-ties but it also benefits from regulatory competition
31 National systems of supervision are path dependent they are determined by the struc-ture of financial institutions and history in each country If Goodhart (1995) is right out-comes are not materially better or worse with one model of supervision rather than another
32 See Ferguson (1999)
Public Safety Nets
One of prudential supervisorsrsquo biggest challenges is to reduce moral hazardFor many years commercial banks engaged in communal self-insurance
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106 WORLD CAPITAL MARKETS
to deal with crises They formed voluntary groups that agreed to rescuetroubled members As financial markets evolved and competition inten-sified banks were no longer willing to play this role Private-sector in-surance is one alternative but moral hazard and adverse selection wouldappear to prevent it from happening Public safety nets have developedbecause of the low probability and high cost of potential bank runs Aclear trade-off is involved The effectiveness of insurance in preventingbank runs is greater the more comprehensive the coverage But the morecomprehensive the coverage the greater the moral hazardmdashbank man-agers bank directors investors and depositors all take on greater risksin the belief that the safety net will protect them against losses
All G-10 countries have compulsory public safety nets for banks (table29) Deposit insurance agencies are officially organized in Canada theNetherlands Sweden Switzerland and the United States organized bythe industry in France Germany Italy and the United Kingdom andjointly organized by the public and private sectors in Belgium Japanand Spain
How well do G-10 governments offset the subsidy provided by thepublic safety net This is a question on which there is substantial debateAs banking organizations have become more complex the challengesthat supervisors face have become more difficult One challenge is toalign the incentives facing bank managers and shareholders with thoseof depositors Another is the principal-agent problem in supervision Wehave discussed the incentive structures for financial institutions but wehave said little about the incentives for supervisors themselves and thedistortions they can generate in the financial system
In one of the many studies of the US savings and loan crisis of the1980s Kane (1989) documented both problems He described managersusing cosmetic approaches to disguise the magnitude of insolvency regulatorspracticing forbearance even though they knew of the deteriorating riskprofiles of the institutions for which they were responsible and legisla-tors increasing deposit insurance without regard for any offsetting changesin supervision A subsequent overhaul of the legislative framework forthe Federal Deposit Insurance Corporation (FDIC) known as the FDICImprovement Act of 1991 (FDICIA) aimed to introduce a clearer incen-tive structure for both regulators and regulated institutions
The changes introduced by this US legislation are worth discussionwith respect to the other G-10 countries as well First FDICIA created astronger signal to management and investors by targeting deposit insur-ance at small depositors only and by risk-weighting the deposit insur-ance premiums paid by banks to reflect their capital adequacy and bankexaminer ratings Among the G-10 countries rated in table 210 depositinsurance premiums vary considerablymdashbut it is not clear that the dif-ferences have much to do with risk-weighting Most G-10 countries em-ploy funding formulas based for example on the total domestic deposit
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Table 29 Deposit insurance schemes in the G-10 countries Explicit safety net
Coverage limit(dollar Foreign
equivalent currency Interbank Source Bankrsquos Contingency fundingDate Membership Co- at end of deposit deposit of premium from banks
Country established managementa insuranceb July 1998)c covered covered Fundingd funding costs or governments
United 1982 Compulsory Yes Larger of 90 No No Unfunded Banks only Callable (subject Parliament may increase Kingdom private percent co- to maximum the maximum payable
insurance to 03 percent of pound125 million advance 33000 total deposits) facility with Bank of
England
United 1934 Compulsory No 100000 Yes Yes Funded Banks and Up to 027 Borrowing up to $3 States official government percent total billion from US Treasury
domestic deposits
Japan 1971 Compulsory No 71000 but No No Funded Banks and 0084 percent of Borrowing up to yen500bn joint in full until government insured deposits from Bank of Japan
year 2000 subject to Ministry of Finance approval
Canada 1967 Compulsory No 40800 No Yes Funded Banks and 033 percent of Borrowing up to C$6 official government insured deposits billion authorized further
(maximum) borrowing subject to parliamentary approval
Germany 1966 Compulsory Yes 90 percent Yes No Funded Banks only 003 percent of Annual levy may be private coinsurance deposits doubled
to 22000
Italy 1987 Compulsory Yes 125000 Yes No Unfunded Banks and Callable Two options defer private government (maximum of payment or diminish
1 percent of compensation to be paid total deposits)
(table continues next page)
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Table 29 Deposit insurance schemes in the G-10 countries Explicit safety net (continued )
Coverage limit(dollar Foreign
equivalent currency Interbank Source Bankrsquos Contingency fundingDate Membership Co- at end of deposit deposit of premium from banks
Country established managementa insuranceb July 1998)c covered covered Fundingd funding costs or governments
Netherlands 1979 Compulsory No 22000 Yes No Unfunded Banks and On demand Government backing official government maximum of subject to parliamentary
5 percent of own approval funds
France 1980 Compulsory No 65400 No No Unfunded Banks only Callable (on Extra calls up to FFr1000 private demand calls million can be made in
up to FFr200 a 5-year period million)
Switzerland 1984 Voluntary No 19700 No No Unfunded Banks only Callable (on Underwritten by member official demand) banks
Sweden 1996 Compulsory No 31400 Yes No Funded Banks and 05 percent of Full emergency coverage official government deposits while replacing it with a
limited system after the emergency
Belgium 1974 Compulsory No 16600 No No Funded Banks and Callable 002 None insurance limited joint 22000 in government percent of to assets in fund
year 2000 deposits from clients
Spain 1977 Compulsory No 16439 Yes No Funded Banks and 02 percent of Government backing joint government deposits through the Banco de
(maximum) Espantildea subject to approval by royal decree
a Bank membership in the fund can be either compulsory or voluntary and the management of the fund can be official and official and private joint or privateb Coinsurance refers to the situation where depositors face a deductible against their insured fundsc Coverage limit refers to the explicit amount the authorities promise to insured Funded scheme means that it is funded ex ante unfunded otherwise
Sources Goodhart (1995) Demirguccedil-Kunt and Detragiache (2000) Demirguccedil-Kunt and Sabaci (2000)
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 109
base Explicit safety net protection also varies but only Canada focuseson the protected class33 All G-10 countries specify a limit on depositorprotection Under FDICIA the insurance fund is prohibited from pro-tecting uninsured depositors or creditors at a failed bank although adiscretionary system-wide override is provided for exceptional circum-stancesmdashbut with stringent requirements for consultation and account-ability Other G-10 countries allow for contingency funding from the publicpurse alongside unwritten lender-of-last-resort support Among large banksa significant and growing portion of deposit liabilities including foreigncurrency and interbank deposits are uninsuredmdashbut depositors assumethey will be protected in a crisis
FDICIA also made some significant qualitative changes to address theprincipal-agent problem by penalizing weak banks and rewarding strongbanks For example banks whose capital declined faced progressivelytougher regulatory sanctions that for example required them to elimi-nate dividends restrict their lending and change their managementsRegulators have also been forced to take prompt corrective action (toreduce the practice of regulatory forbearance in hopes that a bankrsquos for-tunes might improve)34 Unfortunately comparative qualitative assess-ments across the G-10 are difficult to make due to lack of information35
This discussion highlights the complexity of evaluating the extent towhich prudential supervision and market discipline reduce the moralhazard associated with G-10 safety nets Our argument is that publicsafety nets in the G-10 can be linked to banking instability in other coun-tries specifically in the emerging-market economies that have attractedG-10 cross-border bank lending This lending is a leading source of vola-tility in capital flows the large financial institutions many of which arecomplex banking organizations are based in and regulated by authori-ties in the G-10 economies These two features of the international finan-cial system are closely related although it is not possible to test thisrelationship econometrically
Two World Bank studies however indicate a basis for concern Onestudy is a cross-country econometric analysis of the relationship betweenbank stability and deposit insurance (Demirguccedil-Kunt and Detragiache2000) which found a negative relationship Their estimated model forbanking crises in a sample of 61 countries (both industrial and develop-ing) suggests that explicit deposit insurance raises the probability of acrisis by at least 30 percent36 Crises are especially likely in countries
33 Japanrsquos legislation says it does but recent experience shows this is not the case34 See Goldstein (1997) for a summary of the changes35 See Barth Nolle and Rice (2000) for a beginning in this area36 Demirguccedil-Kunt and and Detragiache (2000 table 1) report a logit coefficient of 0696with a standard error of 0397 (the coefficient is significant at the 8 percent threshold)This suggests that the ldquotruerdquo coefficient could well be as small as 030 (the reportedvalue minus the standard error)
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110 WORLD CAPITAL MARKETS
with immature financial supervisory systems (and not in the G-10) buttheir analysis does underscore the view that deposit insurance weakensmarket discipline37
An earlier World Bank analysis established similar results One wasthat market discipline is undermined by deposit insurance schemes an-other was that illiquid banks are forced to pay more for their funds un-less a generous deposit insurance scheme is in place (Demirguccedil-Kuntand Huizinga 1999) This econometric study also provides clear-cut evi-dence that depositor monitoring of banks declines with the existence ofdeposit insurance schemes At the heart of the problem is the questionof whether deposit insurance is accompanied by increased governmentmonitoring
This evidence and the weight of other arguments suggests that moralhazard is still an issue in the G-10 countries Consider the ongoing de-bate about instilling greater market discipline on risk taking by banksAt one extreme is the perennial proposal to do away with safety netsleaving markets to monitor the players and to force adjustments but toprotect small savers by creating ldquonarrow banksrdquo such as postal savingsystems that are allowed to invest these savings only in risk-free gov-ernment securities Whatever the merits of narrow banking this solutionis too extreme to be politically feasible
A moderate alternative is to force more disclosure by financial institu-tions to facilitate market monitoring But transparency has its own prob-lems Persaud (2000) argues that financial markets cannot reliably discernsustainable from unsustainable positions in the short term This uncer-tainty causes banks to ldquoherdrdquo behind market leaders to exploit theirsupposedly superior information ldquoThe more herding investors and bankersknow about what each other is up to the [more] unstable markets maybecomerdquo The implication is that greater transparency in the marketplaceby itself will not solve the problemmdashand in the short term more informa-tion may exacerbate herding Further supervisory steps (discussed in thenext chapter) are required
Yet another proposal is to promote private-sector involvement in bankmonitoring through market-based alternatives such as Calomirisrsquos sub-ordinated debt proposal (Calomiris 1997 Federal Reserve Board 1999)Banks could be required to issue and maintain a minimum amount of
37 Other findings in the Demirguccedil-Kunt and Detragiache (2000) study include thesepropositions The impact of deposit insurance on bank stability tends to be stronger themore extensive is the coverage offered to depositors when the scheme is funded andwhere the scheme is run by the government rather than by the private sector Con-versely deposit insurance is detrimental to bank stability where bank interest rates havebeen deregulated and where the institutional environment is weak Additional findingson deposit insurance are reported from a recent World Bank conference (8-9 June 2000httpwwwworldbankorgresearchinterestconfsupcomingdeposit_insurancehomehtm)Also see Smalhout (2001)
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 111
subordinated debt (eg uninsured certificates of deposit) to finance asmall fraction (such as 2 percent) of their total nonreserve assets Thesubordinated debt would be allowed to earn a set yield no more than 50basis points over the risk-free yield on government treasury bills Thisrule would supposedly force banks to operate in a safe manner Other-wise subordinated debt holders would redeem their uninsured certifi-cates of deposit and equity investors would sell their bank shares Despiteits practical problems the beauty of the subordinated debt requirementis that it enlists market incentives to push banks to avoid excessive port-folio risk38
The thrust of these proposals is very relevant to the arguments in ourstudy Even in the G-10 countries government monitoring by itself hasnot eliminated moral hazard among banks More work is needed to in-troduce market monitoring and to improve the incentive structures bothfor financial institutions and their supervisors We return to this issuewith our recommendations in the next chapter
38 In late 1996 Argentina began requiring its banks to finance 2 percent of total depos-its in the form of subordinated debt but without a maximum yield provision TheArgentine authorities expect that market discipline will act in concert with the publicsafety net One obvious problem with the subordinated debt proposal is that banks mayencourage some of their customers to buy the subordinated debt
Portfolio Institutions Tomorrowrsquos Problem
Before proceeding to the issues of international supervision we flag an-other potential problem for national regulators The big asset managersprofiled in tables 24 and 26 answer to diverse groups of pensionersshareholders and policyholders They allocate funds across a number ofcountries to diversify their risks They hold liquid assets that can be tradedand they have a higher proportion of long-term assets than banks Eco-nomic shocks can be absorbed through price changes and their effectsspread across time and markets Thus when conditions change in a par-ticular market they are more likely to ride out the storm than to flee Inother words they have less incentive than banks to pull their invest-ments in the face of adversity In the 1990s most large asset managersestablished a record of ldquoriding out the stormrdquo rather than ldquorunning withthe windrdquo although as we saw in chapter 1 instances of running withthe wind were detected in some portfolios As we write these insti-tutions have a good record overall in the emerging markets so whyworry
The Russian crisis and the near-collapse of LTCM previewed the dan-gers that may await future portfolio managers and G-10 financial minis-ters We have presented evidence indicating a systemic bias toward bank
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112 WORLD CAPITAL MARKETS
lending and debt finance to emerging markets and we have argued forsubstitution toward equity finance and direct investment39
That is not the end of the story We noted in the previous chapterthat institutional investors can become momentum investors selling in adownturn As more portfolio capital is invested in emerging marketssome players may adopt the high-risk high-leverage strategies of themost aggressive hedge funds Indeed the data in box 11 show that G-10portfolio investors held somewhat more long-term debt (more than $500billion) than equity (less than $400 billion) in emerging markets at theend of 1997 Long-term debt is an ideal vehicle for high-risk high-leveragestrategies These strategies practiced on a large scale could compound afuture crisis harming emerging markets A big enough crisis could inturn pressure G-10 central banks and finance ministers to arrange bail-out plans Instead of shrinking as a systemic financial problem moralhazard could increase
National securities regulators are the first line of defense against thisscenario They play a critical role in the safe evolution of capital mar-kets But regulators today are mandated to approve the issuance of newsecurities and to monitor the continuing disclosure of material informa-tion by issuers They are far less concerned with or empowered to monitorthe behavior of the increasingly large wealth-management firms that arethe major purchasers (and therefore resellers) of these securities
Within their mandates the goals of national securities regulators (table210 and appendix B) are similar to the concerns of bank regulators withsystem safety and soundness Their focus is also on the incentive sys-tems for management and boards of directors and on disclosure by cor-porations that issue marketable securities such as shares bonds andasset-backed securities 40 Issuers of securities possess greater knowledgeabout the quality of these assets than do the purchasers hence investorprotection is a key concern of regulators Moreover market disciplineworks best when markets know what is happening Well-functioning corpora-tions are key agents of wealth creation and social progress Underperform-ing corporations waste resources During recessions bad corporationsget into bad trouble often with severe social consequences Inadequateincentives for managers and inadequate accountability for boards andmanagers thus have negative externalities Regulators play a vital role inexposing weakness so that market disciplines come to bear sooner ratherthan later
Regulatory emphasis is constantly shifting as financial markets evolveand as the macroeconomic environment changes Regulators try to balance
39 See Rogoff (1999) Also see Berlin (2000) for a perspective on the limited role thatbanks play as share owners
40 See Habib and Ljungqvist (2000) for recent empirical analysis showing that corporateshare market values are higher when corporate executives have a larger ownership stake
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Table 210 Financial-sector regulation G-10 countries 2000
Financial institutions and their supervisors
Country and supervisory structure Retail banking Wholesale banking Securities Insurance
Financial conglomeratesFinancial Services Authority (FSA) = umbrella supervisor
United Kingdom FSA FSA FSA FSA
Treasury bull Commercial banks bull Investment funds (Securities and (Insurance Directorate(Securities and Investments Board) bull Unit trust groups Futures Authority) of the Treasury)
Bank of bull Building societies bull Pension funds England (Building Societies Commission) bull Merchant banks
bull Friendly societies bull Clearing houses bull Primary issuers bull Insurance FSA (Friendly Societies Commission) bull Venture capital of securities companies
bull Pensions and life insurance etc bull Stock exchanges bull Insurance brokers(Personal Investment Authority) bull Stockbrokers
Financial holding companiesFederal Reserve (FR) = umbrella supervisor
United States bull National banks(OCC) Securities and Regulated by
Treasury OCC bull State banks Federal Reserve Exchange Commission StatesMembers (FR)
OTS Nonmembers (FDIC) bull Investment banks bull Primary issuers of bull Insurance companies FR bull Cooperative banks (FDICFR) bull Finance companies securities bull Insurance brokers FDIC bull Insured industrial banks (FDIC) bull Stock exchanges
bull Thrift holding companies (OTS) bull Stockbrokers SEC bull Savings banks (OTSFDICFR) bull Investment advisors
bull Savings and loan associations bull Mutual funds(OTS) bull Public utility holding
bull Edge Act corporations (FR) companies
(table continues next page)
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Table 210 Financial-sector regulation G-10 countries 2000 (continued )
Financial institutions and their supervisors
Country and supervisory structure Retail banking Wholesale banking Securities Insurance
Financial holding companies Japan Financial Supervisory Authority (FSA) = umbrella supervisor
Prime FSA FSA FSA FSA ministerrsquos Ministry of office Finance (Securities and Exchange
Surveillance Commission) FRC Bureau of Financial bull City banks bull Investment banks bull Primary issuers of bull Insurance companies FSA Regulation bull Regional banks bull Asset managers securities bull Insurance brokers
bull Trust banks bull Stock exchanges SESC bull Long-term credit banks bull Stockbrokers
bull Pension funds
Financial holding companiesOffice of the Superintendent of Financial Institutions (OSFI) = umbrella supervisor
Canada Regulated by OSFI OSFI provinces OSFI
Department of Financebull Banks bull Cooperative credit bull Primary issuers of bull Insurance companies
(previously Office of the Inspector associations securities (previously Depart- OSFI General of the Banks) bull Fraternal benefit bull Stock exchanges ment of Insurance) Bank of bull Trust and loan companies society bull Stockbrokers bull Insurance brokers Canada bull Pension funds bull Asset managers
(previously Depart- CDIC ment of Insurance)
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Financial institutions and their supervisors
Country and supervisory structure Retail banking Wholesale banking Securities Insurance
Germany Financial holding groupsFederal Banking Supervisory Office (FBSO) = umbrella supervisor
Ministry of Finance FBSO BSO FSSO FISO
Bundesbankbull Universal banks bull Other financial bull Primary issuers of bull Insurance companies
Federal Banking bull Savings banks institutions (eg securities bull Insurance brokers Supervisory Office bull Securities banks management foreign bull Stock exchanges
currency dealings) bull Stockbrokers Federal Securities bull Financial enterprises bull Asset managers Supervisory Office (eg leasing bull Pension funds
organizations Federal Insurance credit card companies Supervisory Office investment advisors)
Italy Bank foundationsMinistry of Finance = umbrella supervisor
Ministry of Finance Bank of Italy Bank of Italy Consob ISVAP
Bank of Italy bull Commerical banks bull Asset managers bull Primary issuers of bull Insurance companies Consob bull Savings bank bull Open-end investment securities bull Insurance brokers
bull Securities banks companies (SICAVs) bull Stock exchangesbull Stockbrokers
ISVAP
(table continues next page)
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Table 210 Financial-sector regulation G-10 countries 2000 (continued )
Financial institutions and their supervisors
Country and supervisory structure Retail banking Wholesale banking Securities Insurance
The Netherlands Financial conglomeratesCouncil of Financial Supervisors = umbrella supervisor
Securities Board Securities Board Netherlandsche Netherlands Bank Netherlandsche Bank of the Netherlands Insurance Board Bank Insurance bull Credit institutions (universal banks bull Investment institutions bull Stock exchanges bull Insurance companies Board cooperative banks security credit (securities issuing bull Stockbrokers bull Insurance brokers
institutions mortgage banks) and tradingmdashprimary The Council of Financial and secondary Supervisors markets)
France Commission des Commission de Operations des Controcircle des
Banking and Banking Commission Bourse Assurances Financial Regulatory bull Ensuring that credit institutions (and investment firms since bull Primary issuers of bull Insurance companies Ministry for Committee the Financial Activity Modernization Act of 1996) comply securities bull Insurance brokers Economic with laws and regulations bull Stock exchanges Affairs and bull Execute instructions regarding all off-site monitoring and bull Stockbrokers Finance Credit on-site supervision Institutions and Banking and Financial Regulatory Committee Investment bull Formulates general regulations for credit institutions and investment firms Committee (capital adequacy requirements accounting rules etc) Bank of France Credit Institutions and Investment Committee Banking bull Authorizes and examines financial institutions except for those within the Commission competence of the Banking Commission
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117
Financial institutions and their supervisors
Country and supervisory structure Retail banking Wholesale banking Securities Insurance
Switzerland Large banking groupSwiss Federal Banking Commission (SFBC) = umbrella supervisor
Swiss National Bank Federal Office of
SFBC SFBC SFBC Private Insurance Swiss Federal Banking Commission bull Universal banks bull Investment banks bull Primary issuers of bull Insurance companies
bull Savings banks bull Asset management securities bull Insurance brokerscompanies bull Stock exchanges
Private audit Federal bull Investment funds bull Stockbrokers firms Office of bull Mortgage bond authorized by Private business SFBC Insurance
Sweden Financial holding company groupsFinancial Supervisory Authority = umbrella supervisor
Ministry of Finance Credit Market Securities Market Insurance Market
Credit Market Department Department Department Department
Financial bull Commercial banks bull Investment funds bull Primary issuers of bull Insurance companies Riksbank Supervisory bull Savings banks securities bull Insurance brokers Authority bull Friendly societies bull Stock exchanges
bull Stockbrokers
(table continues next page)
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Table 210 Financial-sector regulation G-10 countries 2000 (continued )
Financial institutions and their supervisors
Country and supervisory structure Retail banking Wholesale banking Securities Insurance
Belgium Bank holding companiesBanking and Finance Commission = umbrella supervisor
Bank of Belgium Banking Banking
Banking and Finance and Finance Insurance Controland Finance Commission Commission Commission Office
Banking and Insurance Finance Control bull Commercial banks bull Asset management bull Primary issuers of bull Insurance companies Commission Office bull Savings banks firms securities bull Insurance brokers
bull Securities banks bull Investment funds bull Stock exchanges bull Mortgage companiesbull Stockbrokers bull Pension funds
Securities Regulation Fund Securities Regulation Fund
bull Other investment firms and credit institutions(institutions participating in regulated off-exchangemarket in strips and Treasury certificates)
Bank holding companies Spain Banco de Espantildea = umbrella supervisor
Banco de Espantildea Comision Nacional del Mercado de Directorate General
Banco de Espantildea Valores (CNMV) Insurance
bull All credit institutions (commercial banks savings banks credit bull Primary issuers of (Ministry of Economy Ministry of cooperatives official credit institutions finance factoring and securities and Finance) Economy and CNMV leasing companies mortgage-loan companies etc) bull Stock exchanges bull Insurance companies Finance bull Interbank foreign exchange and book-entry public debt bull Stockbrokers bull Pension funds
markets bull Venture capital(companies and funds)
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119
Financial institutions and their supervisors
Country and supervisory structure Banking Securities Insurance
Banking Advisory High Level Securities Supervisors Committee (BAC) Committee (HLSS) Insurance Committee (IC)
Supranational (EU) bull Formulates standards for prudential bull Coordination of securities market bull Formulates standards forsupervision supervision prudential supervision
BACICHLSS Banking Supervision
Conglomerates Committee (BSC) Securities Contact Committee Regulation of prudential bull Systemic risk monitoring bull Regulation and implementation of supervision securities admission
International Association International International Organization of of Insurance Supervisors
Basel Committee Securities Commisison (IOSCO) (IAIS) Joint Forum Conglomerates Supervision bull Supervision and regulation best bull Supervision and regulation best bull Supervision and regulation amp regulation Best practices practices practices best practices
FSF Coordination across supervisors of various functions
Notes See appendix B for more information Boldface type indicates senior or oversight supervisor normal type indicates adjunct or front-line supervisorsolid line indicates direct responsbility to the senior-ranking authority dotted line indicates coordination in supervisory activities
(table continues next page)
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Table 210 Financial-sector regulation G-10 countries 2000 (continued )
Glossary of names United Kingdom FSA = Financial Services Authority United States FR = Federal Reserve OCC = Office of the Comptroller of theCurrency FDIC = Federal Deposit Insurance Corporation SEC = Securities and Exchange Commission OTS = Office of Thrift Supervision Japan FRC =Financial Reconstruction Commission FSA = Financial Services Agency SESC = Securities and Exchange Surveillance Commission Canada OSFI =Office of the Superintendent of Financial Institutions CDIC = Canada Deposit Insurance Corporation Germany FBSO = Federal Banking SupervisoryOffice FSSO = Federal Securities Supervisory Office FISO = Federal Insurance Supervisory Office BSO = Banking Supervisory Office Italy Consob =Commissione Nazionale per le Societa e la Borsa ISVAP = Instituto per la Vigilanza sulle assicurazioni private e di Interesse colletivo Switzerland SFBC= Swiss Federal Banking Commission Spain CNMV = The Comision Nacional del Mercado de Valores Supranational BAC = Banking Advisory CommitteeBSC = Banking Supervision Committee IC = Insurance Committee HLSS = High Level Securities Supervisors Committee International Dimension FSF =Financial Stability Forum IOSCO = International Organization of Securities Commission IAIS = International Association of Insurance Supervisors
Sources United Kingdom Bank of England httpwwwbankofenglandcouk Financial Services Authority httpwwwfsagovuk United States Board ofGovernors of Federal Reserve System httpwwwfederalreservegov Japan Bank of Japan httpwwwbojorjo Financial Reconstruction Commissionhttpwwwfsagojpfrcindexehtml Financial Services Agency httpwwwfsagojp Canada Bank of Canada httpwwwbank-banque-canadaca Office ofthe Superintendent of Financial Institutions httpwwwosfi-bsifgccaAndreEindexhtml Germany Deutsche Bundesbank httpwwwbundesbankde Fed-eral Banking Supervisory Office httpwwwbakredde Italy Banca drsquoitalia httpwwwbancaditaliait Commissione Nazionale per le Societa e la Borsahttpwwwconsobit Instituto per la Vigilanza sulle assicurazioni private e di Interesse colletivo httpwwwisvapit The Netherlands De NederlandscheBank httpwwwdnbnl France Banque de France httpwwwbanque-francefr Switzerland Schweizerische Nationalbank httpwwwsnbchindex3htmlSweden Sveriges Riksbank httpwwwriksbanksedefaultasp Belgium National Bank of Belgium httpwwwbnbbesgindexhtm Spain Banco de Espantildeahttpwwwbdees The Comision Nacional del Mercado de Valores httpwwwcnmves Supranational (EU) Institutional Arrangements for the Regulationand Supervision of the Financial Sector 2000 International Dimension Bank for International Settlement httpwwwbisorg International Organization ofSecurities Commissions httpwwwioscoorg International Association of Insurance Supervisors httpwwwiaisorg Financial Stability Forum httpwwwfsforumorg
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 121
the inflexibility of tight surveillance against the need to encourage in-novation and growth The US Securities and Exchange Commission isworried about aggressive accounting by firms and biased reports bysecurities analysts in an equity environment that prizes steadily higherquarterly earnings41 Japanese regulators are preoccupied with opaqueinterconnections between portfolio institutions banks and nonfinancialfirms through the keiretsu system Canadian regulators reeling from high-profile scandals of managers intentionally misleading investors are strengtheningmarket discipline through legal penalties aimed at managers and directorsof offending firms
When panic strikes a securities regulator cannot do much As the 1987stock market crash and the LTCM debacle in the fall of 1998 both dem-onstrated steep stock and bond price declines can create systemic risksIf severe enough the wealth effect of falling securities values and thefear of widespread insolvency can depress real activity Flooding thesystem with liquidity is a central bankerrsquos solutionmdashsomething a securi-ties regulator cannot do42 But just as financial supervisors can changethe incentive structure to discourage bankers from making risky loans ingood times so securities regulators can pay more attention to incentiveson the demand side when capital markets are strong
Prudential Supervision and InnovationmdashA Footnote
In concluding this discussion of prudential supervision in the G-10 anadditional point is worth noting National regulators face a persistenttrade-off between emphasizing financial system safety and soundnesswhile encouraging innovationmdashin spite of the added risks innovationbrings to financial markets Former US Treasury Secretary Lawrence Summers(2000 3) has argued by analogy
The jet airplane made airplane air travel more comfortable more efficient andmore safe though the accidents were more spectacular and for a time morenumerous after the jet was invented In the same way modern global financialmarkets carry with them enormous potential for benefit even if some of theaccidents are that much more spectacular As the right public policy response
41 The problem is illustrated by the divergence since mid-1998 between reported earn-ings by the Standard amp Poorrsquos (SampP) 500 and the after-tax profits of all corporations inthe national accounts Generally these two series move closely with one another Be-tween mid-1998 and mid-1999 SampP 500 reported that earnings increased by more than20 percent while after-tax profits of all corporations increased by less than 5 percent(Chase Bank US Economic and Policy Research US Weekly Prospects Chase SecuritiesWeekly Newsletter 5 June 2000 5)
42 For example the US Securities and Exchange Commission had no direct role in calmingmarkets in the 1987 or 1998 panics
Institute for International Economics | httpwwwiiecom
122 WORLD CAPITAL MARKETS
to the jet was longer runways better air-traffic control and better training forpilots and not the discouragement of rapid travel so the right public policyresponse to financial innovation is to assure a safe framework so that the ben-efits can be realized not to stifle the change
Accepting Summersrsquos analogy for the international financial system better-informed supervisors and investors are a necessary part of the financialsystem framework Supervisors require more timely information on therisk profiles resulting from positions taken by financial institutions Theyalso need a better understanding of risk-management systems Snapshotsof an institutionrsquos risk profile and risk-management procedures are nolonger adequate In a world where huge bets are quickly made (andpossibly lostmdashas with Barings Bank in 1995 and LTCM in 1998) super-visors must focus on the soundness of banking systems for evaluatingand managing risk on a daily basis Some progress has been made inaddressing these issues US banking examiners are extending their in-formation requirements in banking examinations and increasing theirinvolvement in large complex institutions43 More awareness is alsorequired of the fact that they are national organizations in a world ofcross-border capital flows To a much greater extent they need a multi-national reach International supervision and coordination among super-visors are the subject of the next section
Our analysis suggests that G-10 supervisors have unfinished businessBank supervisors need to start yesterday securities regulators can waituntil tomorrow One G-10 member acting alone cannot correct the biasIn good times the lending business will simply migrate to other G-10banks In bad times financial problems will not stop at the national bor-der A way has to be found to establish common international standardsfor the key financial players in order to prevent crises and to agree onapproaches for managing them The path has already been laid out Inthe wake of the bank failures of the past 25 years bank supervisors havetried to establish such standards They have done this without creating anew global institution
The essence of the international framework is decentralizationmdashglobalrules and design standards without global institutions that are perceivedto intrude on national sovereignty The awkward jargon for this frame-work is vertical subsidiaritymdashldquothink internationally act nationallyrdquo Theinternational thinking is done by a committee of regulators that meets
International SupervisionA Decentralized Framework
43 These issues are discussed in Ferguson (1999) and Meyer (2000a)
Institute for International Economics | httpwwwiiecom
THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 123
regularly at the Bank for International Settlements in Basel The commit-tee establishes principles and standards that are interpreted implementedand enforced by national authorities44 In this section we describe thesesupervisory efforts and their weaknesses We present our recommenda-tions for addressing these weaknesses in the next chapter
Basel I
The Basel Capital Accord of 1988 (Basel I)45 drew the lesson from thefinancial crises of the mid-1970s that more adequate capital levels in in-ternational banks would help reduce the systemic risk of bank failureThe primary goal of Basel I was capital adequacy other standards wereput in place not so much for their own virtue as to defend the primarygoal
Capital adequacy requirements were designed to ensure that individualinstitutions have the ability to absorb losses particularly credit lossesAccordingly a backup system of scoring credit risk was devised thatrequired large amounts of bank capital for some types of loans smalleramounts for others and zero for a select list of preferred assets Report-ing requirements were designed to disclose problems and ensure that atroubled bank would take timely steps to restore its capital base in thewake of a loss The Basel I framework worked tolerably well in limitingthe call on the public purse in the G-10 countriesmdashwith the notable ex-ceptions of France and Japan The framework failed to moderate riskybank lending to emerging markets however
Basel I was not developed with emerging markets in mind The origi-nal idea behind it was to develop a common supervisory approach tocross-border banking operations It grew out of political pressure fromUS lawmakers who were determined to require international banks op-erating in the United States to meet US banking standards Toward thisgoal in 1983 Congress passed the International Lending Supervisory ActUS and British banking authorities subsequently agreed on a commontarget the adoption of strict common capital-adequacy standards In 1988other G-10 governments agreed to go along voluntary acceptance ofthe standards throughout much of the rest of the world followed46 Therationale for the capital targets was two-fold The first was to requirebanks to hold sufficient amounts of capital (8 percent of risk-adjusted
44 The international committee of financial authorities agreed on a common definitionof banksrsquo tier-one or ldquocorerdquo capital national authorities defined tier-two capital in theirown manner which permitted greater variations in national working definitions andpractices
45 International Convergence of Capital Measurement and Capital Standards (BIS 1988)was prepared by the Basel Committee on Banking Supervision
46 See Reineke (1998)
Institute for International Economics | httpwwwiiecom
124 WORLD CAPITAL MARKETS
assets) to cushion losses on those assets The second was to dull theirappetites for risk banks with large capital bases would have more tolose if they failed and therefore would take fewer risks
Rapid change in financial markets soon revealed flaws in the Basel IAccord In a complex world with numerous sources of risk it focusedheavily on credit risk but overlooked other risks in a bankrsquos portfolioand the correlation between returns on different asset classes The Baselformula required banks to maintain a fixed amount of capital againsteach of its asset classes But the formula did not distinguish the riskinessof the borrower within each class As a result one large loan to a low-risk corporate borrower such as General Electric would require the sameamount of capital as 10 smaller transactions with high-risk borrowers
The system was also biased toward short-term loans Loans maturingin less than a year required a 20 percent risk weight whereas those ma-turing after more than a year required a 100 percent risk weight Inter-bank lending was particularly favored For example loans to banks inOECD countries required less capital than loans to private firms in thesame countries creating the anomaly that interbank loans to South Ko-rean banks required less capital than loans to General Electric47 Thisanomaly encouraged banks to shed high-quality assets if the Basel rulesrequired the allocation of more capital than banks thought they needed
Another weakness was that financial innovators quickly circumventedthe Accord Because short-term loans required less provisioning than long-term loans banks responded by securitizing their long-term debt port-folios and lending short-term against the collateral of the newly createdasset This allowed banks to circumvent the capital requirements gearedto the terms of the underlying debt At the same time the Basel I Accordfailed to encourage risk mitigation techniques such as credit derivativescollateral guarantees and on-balance-sheet netting the flip side of fi-nancial innovation Because off-balance-sheet products were not coveredby the Accord another anomaly appeared when Barings Bank collapsedin 1995 Barings met capital adequacy standards but collapsed becauseits systems for managing risk failed traders were allowed to speculatein futures contracts that did not appear on the balance sheet
Basel II
Work to overhaul Basel I began in 1995 and produced consultativepapers issued in June 1999 and January 200148 These papers have been
47 South Korean banks have had notoriously weak balance sheets because the practiceof ldquodirected lendingrdquo left them with many poor loans (in making these loans the bankswere expected to follow government objectives rather than creditworthiness criteria)
48 Basel Committee on Banking Supervision (1999 2001)
Institute for International Economics | httpwwwiiecom
THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 125
the subject of extensive consultation and revision as a result the newAccord is expected to be introduced in 200449 The Basel II frameworkhas three parts (pillars) revisions to Basel I minimum-capital require-ments supervisory review criteria and greater emphasis on market dis-cipline Broadly Basel II aims to maintain the level of capital in the sys-tem but achieve better alignment of banksrsquo capital with their risk pro-files and keep up with financial innovation
To align capital requirements with market realities (the first pillar)Basel II concentrates on the 100 or so largest banksmdashthe type of playerslisted in table 21mdashand on the holding-company parents of banking groups50
Capital requirements will differentiate between an increased number ofcredit groups or ldquorisk bucketsrdquo including claims on governments otherbanks corporations mortgage-backed securities and other asset-backedsecurities
Basel II originally proposed to use external ratings to set capital chargesfor a number of these credit risks Many banks objected arguing thatthey assess credit risk better than Standard amp Poorrsquos Moodyrsquos or FitchIBCA51 Basel II thus proposes two approaches to rating a standard ap-proach using external ratings and an ldquoadvancedrdquo approach that allowsselected banks to use their own internal rating systems To encouragethe development of rigorous internal control systems based on these in-ternal rating systems Basel II also proposes to levy capital charges foroperational risk (the risk of direct or indirect loss resulting from inad-equate or failed internal processes people and systems or from exter-nal events)
Some critics of this proposal dismiss it as an abrogation of the prin-ciple of external independent monitoring and as ldquodangerously naiumlverdquo52
But regulators argue that the new capital charge on operational risk shouldoffset this concern It is also far from clear how cross-national compari-sons of rating and internal risk-assessment systems will be made (Engelen2000) The development by the European Union of its own capital rulescould well complicate the international resolution of these issues Publicassurances by EU officials in January 2001 however indicated that theirmain concerns are to create a level playing field and avoid regulatoryarbitrage (Hargreaves 2001) There is also the significant problem ofthe procyclical character of risk weights When a crisis hits losses are
49 See Berry (2000) for an update in an interview with William J McDonough chair ofthe Basel Committee on Banking Supervision
50 For obvious reasons these proposals are addressed to large banks and simpler capi-tal standards are allowed for small banks that focus on their domestic credit markets
51 See Ammer and Packer (2000) for an empirical critique of the success of rating agen-cies in distinguishing risk by sector and region
52 See Auerback (2001)
Institute for International Economics | httpwwwiiecom
126 WORLD CAPITAL MARKETS
incurred or accrued capital is lost and loan exposure must be reducedor securities sold to restore the requisite capital-adequacy ratios A morerisk-sensitive framework could amplify volatility
As the second pillar of Basel II supervisory review criteria are beingbeefed up to encourage supervisors to intervene earlier in potential problemsituations and to compel banks to align their capital positions with theirrisk profiles Bank supervisors will be authorized to require banks tohold capital in excess of minimum requirements if they have concernsabout general management overall strategy risk-management performanceor the macroeconomic environment Of course if one G-10 supervisorimposes higher capital requirements in isolation the same disparity willemerge that presaged Basel I Some banks will be disadvantaged in theinternational marketplace and will loudly complain that excessive super-vision is driving business to their competitors Hence close internationalcooperation among supervisors is critical
To implement the third pillar market discipline banks will be requiredto make fuller more timely disclosure of capital adequacy and the risksto which that capital is exposed A number of measures are being stud-ied that might help supervisors evaluate bank performance such as com-parisons of uninsured deposit interest rates subordinated debt yieldsand equity prices The idea is that these yields and prices might alertsupervisors to market perceptions of risk Of course market perceptionsare only as good as market information More direct and controversialways to reinforce market discipline would dramatically increase publicdisclosure of bank positions and risk management systems
Many questions are still outstanding about how to resolve the techni-cal details of capital requirements and whether the requirements willachieve their intended goal of better assessment and mitigation of therisks in banksrsquo portfolios There is no substitute for skilled supervisorsThe intricacies of effective design and implementation suggest that su-pervisors need to be highly competent technically knowledgeable aboutbanking portfolio characteristics and the factors that influence bank ex-posure to credit risk (Mishkin 2000) And they must be aided by vigilantshareholders market forces and transparency of information53
Standard setting at the global level is desirable but ultimately theeffectiveness of these efforts will be tested at the national level espe-cially in times of systemic financial distress Here the record of Basel Iwas not a bright shining success Japanese banking regulators havetraditionally allowed banks to include real estate and securities in theircapital base When the value of these assets plummeted in the early 1990sregulators allowed banks to continue valuing these depreciated (andoften bankrupt) assets at their old inflated levels Japanese authorities
53 Benedict Roth Complacency Towards Catastrophe Financial Times 23 January 2001
Institute for International Economics | httpwwwiiecom
THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 127
insisted until the mid-1990s that eroded capital bases could be rebuiltin a market-driven fashion They rightly foresaw that huge loan losseswould undermine public support for the ruling party and require a po-litically unpopular bailout
Japanese foot dragging on Basel I was the worst54 but not uniqueOther examples can be found of ldquopolitically mandated forbearancerdquo TheFederal Reserve Bank of New York held important hands during theLTCM crisis of 1998 Mexico is still resolving the banking crisis that eruptedin 1995 South Korea has not yet closed the insolvent banks that behavedso badly before the crisis of 1998 In the aftermath of a crisis nationalregulators cannot always be relied upon to discipline politically power-ful bankers55 One of the little-noticed consequences of these differingapproaches is that those banks with strong regulatory systems receivedan implicit ldquoexport subsidyrdquo for their services US banks which had notengaged extensively in emerging-market lending in the 1990s were bet-ter positioned than their German and Japanese counterparts to expandtheir international assets in the wake of the crises
Other Financial Forums
54 See Japanese Banks Fiddling while Marunouchi Burns The Economist 27 January2001 67-69
55 See Calomiris (1997)
The Basel model of vertical subsidiarity has already been extended toother financial regulatory bodies In 1993-94 the BIS established a Tri-partite Group of Banking Insurance and Securities Regulators In 1994-95 the BIS increased its cooperation with the International Organizationof Securities Commissions when the two organizations issued parallelpapers on guidelines for national regulators concerning risk managementand disclosure of derivative trades In 1996 a permanent Joint Forum onFinancial Conglomerates was established to examine supervisory issuesand develop working arrangements among the different functional super-visors of conglomerate institutions that offer combinations of bankingsecurities and insurance products Draft papers on the supervisionof conglomerates were released for comment in 1998 applying capital-adequacy principles to these groups and providing guidelines both forassessing the integrity and competence of top managers and for sharingassessments between regulators
In 1997 the Basel Committee on Banking Supervision extended itsreach beyond capital standards to broader aspects of banking supervi-sion with the publication of the Core Principles for Effective BankingSupervision In 1999 a wide range of regulatory and standard-settingbodies were gathered under the umbrella of the Financial Stability
Institute for International Economics | httpwwwiiecom
128 WORLD CAPITAL MARKETS
Forum (FSF) itself established under BIS aegis56 The FSF has alreadyissued recommendations for stepped-up supervision and transparencyas well as guidelines for best practices in a number of areas includingoffshore financial centers and highly leveraged institutions or hedge funds57
Conclusion
Although the structural weaknesses in emerging-market economies arewidely acknowledged to have been causal factors in international capi-tal-market volatility this chapter points to the role of large G-10 bankingorganizations as major suppliers of the most volatile instrument short-term debt We have examined evidence of the impact of public safetynets in the G-10 economiesmdashthe deposit insurance systems the pruden-tial supervisory systems and the lender-of-last-resort functions of centralbanksmdashon the incentive structures of these organizations
Although supervisors in most countries working nationally and to-gether in the BIS have made significant efforts to mimic market forcesin their prudential supervision the most sophisticated financial institu-tions find innovative ways to circumvent the rules New global regulatorybodies are not about to be created G-10 national bank regulators shouldthemselves address the short-term debt bias in the international financialsystem by changing incentive systems G-10 securities regulators shouldalso take steps to get ahead of the curve paying close attention to largeportfolio swings by institutional investors particularly in times of crisisIn short more needs to be done at national and international levels tochange the rules of the game That is the subject of the next chapter
56 The Financial Stability Forum includes banking securities insurance and accountingregulatory bodies the OECD on taxation corruption and corporate governance and theIMF
57 See Martin (2000)
Institute for International Economics | httpwwwiiecom
92 WORLD CAPITAL MARKETS
Tab
le 2
8N
on
fin
anci
al f
irm
s in
th
e 10
0 la
rges
t co
mp
anie
s b
y re
ven
ue
199
8 (b
illio
ns o
f do
llars
) (c
ontin
ued
)
Glo
bal
Tra
nsn
atio
nal
ity
ran
k
Co
mp
any
Rev
enu
esa
Ass
etsb
ind
exc
Typ
e
Un
ited
Kin
gd
om
19B
P A
moc
o68
8559
2P
etro
leum
ref
inin
g43
Uni
leve
r45
3692
4F
ood
Un
ited
Sta
tes
1G
ener
al M
otor
s16
125
729
3M
otor
veh
icle
s an
d pa
rts
3F
ord
Mot
or14
423
835
2M
otor
veh
icle
s an
d pa
rts
4W
al-M
art
Sto
res
139
49
na
G
ener
al m
erch
andi
sers
8E
xxon
101
9365
9P
etro
leum
ref
inin
g9
Gen
eral
Ele
ctric
100
356
331
Ele
ctro
nics
el
ectr
ical
equ
ipm
ent
14In
tl B
usin
ess
Mac
hine
s82
8653
7C
ompu
ters
of
fice
equi
pmen
t25
US
Pos
tal
Ser
vice
6055
n
a
Mai
l pa
ckag
e a
nd f
reig
ht d
eliv
ery
27P
hilip
Mor
ris58
6051
1T
obac
co29
Boe
ing
5637
n
a
Aer
ospa
ce30
AT
ampT
5460
219
Tel
ecom
mun
icat
ions
40M
obil
4843
597
Pet
role
um r
efin
ing
41H
ewle
tt-P
acka
rd47
3451
1C
ompu
ters
of
fice
equi
pmen
t50
Sea
rs R
oebu
ck41
38
na
G
ener
al m
erch
andi
sers
55E
I d
u P
ont
de N
emou
rs39
40
na
C
hem
ical
s61
Pro
ctor
and
Gam
ble
3731
477
Soa
ps
cosm
etic
s75
Km
art
3414
n
a
Gen
eral
mer
chan
dise
rs81
Tex
aco
3229
453
Pet
role
um r
efin
ing
82B
ell
Atla
ntic
3255
n
a
Tel
ecom
mun
icat
ions
85E
nron
3129
n
a
Ene
rgy
87C
ompa
q C
ompu
ter
3123
n
a
Com
pute
rs
offic
e eq
uipm
ent
89D
ayto
n H
udso
n31
16
na
G
ener
al m
erch
andi
sers
94J
C
Pen
ney
3124
n
a
Gen
eral
mer
chan
dise
rs96
Hom
e D
epot
3013
n
a
Spe
cial
ty r
etai
lers
97Lu
cent
Tec
hnol
ogie
s30
27
na
E
lect
roni
cs
elec
tric
al e
quip
men
t10
0M
otor
ola
2929
n
a
Ele
ctro
nics
el
ectr
ical
equ
ipm
ent
Institute for International Economics | httpwwwiiecom
THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 93
Jap
an
5M
itsui
109
5635
8T
radi
ng6
Itoch
u10
957
333
Tra
ding
7M
itsub
ishi
107
7536
9T
radi
ng10
Toy
ota
Mot
or10
012
540
0M
otor
veh
icle
s an
d pa
rts
12M
arub
eni
9455
300
Tra
ding
13S
umito
mo
8946
259
Tra
ding
18N
ippo
n T
eleg
raph
amp T
elep
hone
7614
7
na
Tel
ecom
mun
icat
ions
20N
issh
o Iw
ai68
3938
8T
radi
ng24
Hita
chi
6282
214
Ele
ctro
nics
el
ectr
ical
equ
ipm
ent
26M
atsu
shita
Ele
ctric
Ind
ustr
ial
6067
332
Ele
ctro
nics
el
ectr
ical
equ
ipm
ent
31S
ony
5353
628
Ele
ctro
nics
el
ectr
ical
equ
ipm
ent
33N
issa
n M
otor
5158
511
Mot
or v
ehic
les
and
part
s38
Hon
da M
otor
4943
641
Mot
or v
ehic
les
and
part
s48
Tos
hiba
4151
252
Ele
ctro
nics
el
ectr
ical
equ
ipm
ent
51F
ujits
u41
4332
6C
ompu
ters
of
fice
equi
pmen
t52
Tok
yo E
lect
ric P
ower
4012
2
na
Util
ities
ga
s an
d el
ectr
ic60
NE
C37
42
na
E
lect
roni
cs
elec
tric
al e
quip
men
t90
Tom
en31
18
na
T
radi
ng99
Mits
ubis
hi E
lect
ric30
35
na
E
lect
roni
cs
elec
tric
al e
quip
men
t
Ch
ina
73S
inop
ec34
52
na
P
etro
leum
ref
inin
g
Tot
al (
aver
age
for
tran
snat
iona
lity
inde
x)3
988
447
949
0T
otal
for
G-1
0 (a
vera
ge f
or t
he i
ndex
)3
954
442
749
0
na
= n
ot a
vaila
ble
G-1
0 =
Gro
up o
f T
en c
ount
ries
see
not
e to
tab
le 1
1
a
Dat
a sh
own
are
for
the
fisca
l ye
ar e
nded
on
or b
efor
e 31
Mar
ch 1
999
b
Ass
ets
show
n ar
e th
ose
at t
he c
ompa
nyrsquos
fis
cal
year
-end
c
The
ind
ex o
f tr
ansn
atio
nalit
y is
cal
cula
ted
as t
he a
vera
ge o
f ra
tios
of f
orei
gn a
sset
s to
tot
al a
sset
s f
orei
gn s
ales
to
tota
l sa
les
and
for
eign
em
ploy
men
tto
tot
al e
mpl
oym
ent
as o
f 19
97 (
UN
CT
AD
)
Sou
rces
F
ortu
ne G
loba
l 50
0 1
999
http
w
ww
pat
hfin
der
com
fort
une
glob
al50
0in
dex
htm
l U
NC
TA
D (
1999
)
Institute for International Economics | httpwwwiiecom
94 WORLD CAPITAL MARKETS
foreign direct investment The ldquotransnationality indexrdquo (table 28) showsthat on average they conducted about half their business outside theirhome country9
Overview of the Players
Our review of the major players points to two major features First ahandful of big playersmdashfewer than 200 firms all toldmdashcontrol the ac-tion in international capital markets Their dominance will doubtless erodebut for now financial power is strikingly concentrated with them Sec-ond the big players are overwhelmingly based in the G-10 countriesplus Spain The responsibility to supervise them rests not in the IMFnor in Basel but squarely in Washington London Tokyo and the otherG-10 capitals At year-end 1999 the G-10 countries plus Spain accountedfor 84 percent of world banking assets 86 percent of world stock marketcapitalization and 76 percent of international debt securities (BIS 2000aWorld Bank 2000b)
International private capital flows are of three types bank loans anddeposits portfolio investment and foreign direct investment In cumula-tive total flows to emerging markets FDI was the biggest story in the1990s amounting to $954 billion (table 12) Portfolio flows were nextcumulatively amounting to somewhere between $612 billion (table 12)and $764 billion (table A1) Bank loans and deposits are the most com-plicated story
The Key Role of Banks
Banks are more important as an epicenter than as a wellspring Banksgenerate waves in the flow of capital to emerging markets rather than acontinuous steady stream According to data compiled by the Institute ofInternational Finance (table A1) net bank lending to emerging marketscumulated to $269 billion in the 1990s However deposits by emerging-market residents in G-10 banks more than offset G-10 bank lending tothese countries during the decade According to IMF data cumulativebank loans net of deposits amounted to a negative $135 billion (table 12)
In other words when loans and deposits are combined net bank ac-tivity that moves financial resources to emerging markets is small incomparison with portfolio investment and FDI But bank loans are thelubricant of any financial system Depending on circumstances bankscan be shock absorbers or shock propagators In recent decades with
9 The transnationality index is calculated as a simple average of the share of assetssales and employees outside the home country
Institute for International Economics | httpwwwiiecom
THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 95
respect to emerging markets banks have more often been propagatorsthan absorbers The average annual swing in bank lending to emergingmarkets was nearly $50 billionmdashby far the largest source of year-to-yearfluctuations in capital flows Both interbank loans between Europe Japanand Asia and sovereign Russian debt used as loan collateral played amajor role in the 1997-98 crisesmdashnot because banks are profligate playersbut because of the incentives they face and the instruments they useAccordingly our story begins with banks
Banks in the Modern Financial System
10 See Levine (2000) for a concise description of the role of banks in the financial system
11 The asymmetric information problem helps to explain why banks dominate the im-mature financial systems of emerging-market economies The general lack of informationon borrowers and undeveloped legal systems to enforce contracts hamper suppliers oflong-term financial instruments such as equities and bonds in evaluating risk and re-ward Banks are best suited in these circumstances to solve the asymmetric informationproblem by evaluating and monitoring private loans As more and better informationbecomes available capital markets develop and financial systems mature
As we noted in the previous paragraph the problem of financial volatil-ity in emerging-market economies is associated with bank lending Ifand when repayment problems arise cross-border private bank loansand bond placements are such that private creditors have no plausiblemeans of seizing assets from either private or sovereign borrowers Thusalthough international finance can nourish entrepreneurs and accelerategrowth a necessary complement may be a drastic creditor response inthe event of nonpaymentmdashto withhold fresh funds and force an eco-nomic crisis (Dooley 2000)
This argument is based on the characteristics of banks They are notldquobadrdquo per se They perform three essential functions in any financialsystem pooling the resources of disparate savers and channeling these re-sources into productive investment improving resource allocation throughtheir expertise in assessing and monitoring borrowers and facilitatingthe division of risk among numerous creditors10 But by their very na-ture banks are prone to two problems asymmetric information (the bor-rower knows more about the potential risk and return of its projectsthan the bank) and adverse selection (riskier borrowers will pay higherinterest rates and thus may constitute a disproportionate share of bankloan portfolios)11
Bank loans are illiquid fixed-price instruments They cannot easily beconverted to cash although they can be bundled into securities (knownas ldquosecuritizationrdquo) Once loan terms have been agreed on the only waya bank can adjust for shifting market conditions is by changing the quantityof its exposure When a borrower runs into trouble the bank can mix
Institute for International Economics | httpwwwiiecom
96 WORLD CAPITAL MARKETS
and match from two unpleasant menus It can roll over existing loansand extend new credit or it can call some part of existing loans andattempt to recover the principal It can also hedge by selling short otherclaims on the borrower These choices entail either an unwelcome exten-sion of the bankrsquos exposure or credit rationing against the borrower Whentrouble brews all banks encounter the same conditions in the aggregatethey prefer less exposure and ensuing credit restrictions lead to volatilebank lending
Innovation
12 Derivatives have no value of their own They ldquoderiverdquo their value from the value ofthe underlying asset They include swaps futures (contracts for future delivery at speci-fied prices) and options (which give one party the right but not the obligation to buyfrom or sell to a counterparty at an agreed price)
13 Maxfield (1998) analyzed available evidence of emerging-market investor objectivesmost of it before the crisis Analysis of portfolio equity flows is sensitive to the choice ofperiod with year-over-year data indicating that investors respond to country ldquofundamen-talsrdquo Other evidence suggests more ambiguity Ranking by ldquoinvestor impatiencerdquo ie thesearch for yield over value Tesar and Werner (1995) find short-term bank flows to be themost yield driven followed by portfolio investment FDI and long-term bank lending
14 Because market risk credit risk and country risk interact in complex ways newfinancial instruments have been created to help reduce negative interactions One is theldquototal return swaprdquo which has become an instrument of choice for hedge funds lookingfor high leverage Banks also use the total return swap to cover risks without increasingtheir capital requirements
Since the 1980s national and international banking systems have beentransformed by deregulation intensified competition and the informationand communications-technology revolutions The market environment isone of intense competition particularly in traditional banking activitiesThe innovations point away from traditional activities of plain vanilladeposit taking and loan making Three big themes are discernible Firstthe walls separating commercial banks investment banks portfolio man-agers and insurance firms are falling even if they are still distinct Sec-ond large banks are shifting toward securitizationmdashcreating securitiesout of everything from credit card debt to trade finance to disaster insur-ancemdashand earning fees in the process Third all large banks are shiftingtoward trading activity making markets and taking short-term stakes inbonds shares and derivatives12 These activities when successful satisfythe search for higher yields13
Many of the new financial instruments that banks trade are ldquooff bal-ance sheetrdquo This means that banks are not required to allocate capitalagainst them In swap contracts for example neither side pays cash at theoutset and therefore neither party has an asset in the traditional sense14
Futures and options contracts can be written with a relatively small initial
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 97
margin relative to the potential risk Credit derivatives limit credit risk bytransferring the potential loss associated with corporate loans and bondssovereign debt and other loan portfolios to counterparties15
Deregulation and innovation working in combination seem to havepushed banks into trading activity and leveraged plays but not into shareownershipmdasheven in jurisdictions that have no prohibition against equitystakes Among the G-10 banking systems the highest ratio of share own-ership to assets was only 5 percent in 1996 reached in Germany andJapan (Berlin 2000)16
The wave of innovation in financial instruments and the accompany-ing expansion of banking beyond its old boundaries is a two-edged swordOn one side it allows risk management far beyond what was tradition-ally possible Risk can now be shifted from firms that can ill afford lossesto those that can Banks can profitably act as intermediaries in shiftingrisk On the other side the innovation wave creates huge opportunitiesfor leveraged plays fostering a speculative search by banks themselvesfor high returns that in turn magnify their own risks17
15 Credit derivatives include total return swaps credit default swaps credit-linked notesand collateralized debt obligations They are the fastest-growing sector of the global de-rivatives market
16 Banks seem to specialize in lending even when they are allowed to mix finance andcommerce for reasons related both to how they are expected to behave with distressedfirms and to other intricacies of lender liability (Berlin 2000) Yet a recent cross-countrystudy found that restrictions on banking and commerce are associated with greater fi-nancial instability (Barth Caprio and Levine 2000)
17 Leverage is the magnification of the rate of return (positive or negative) on an in-vestment beyond the rate obtained by solely investing funds owned by the institution Itis often defined as the ratio of assets to equity Leverage is achieved by increasing thesize of an investment by borrowing or using derivative instruments such as futures oroptions These allow investors to earn a return on the notional amount underlying thecontract by committing a small portion of equity in the form of a margin deposit oroption premium payment
18 In a repo (repurchase agreement) one party (typically a trader) buys a bond andsells it to a dealer for cash with a promise to buy it back the next day at the same priceplus the overnight interest rate As long as the overnight interest rate is lower than theinterest accruing on the bond the trader earns some income on the bond The extremeform of these kinds of transactions was discovered at LTCM the failed US highly lever-aged institution which appears to have controlled more than $120 billion in assets froman investment of about $3 billion This leveraging was accomplished mostly through theuse of repos (Mayer 1999)
The potential for damage is illustrated in an extreme form by figure 21To precisely measure a firmrsquos leverage all positions must be known andrealistically valuedmdashwhich may be impossible to do Because many ac-tivitiesmdashsuch as repos18 and derivativesmdashdo not appear on the institutionrsquos
Leverage
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98W
OR
LD
CA
PIT
AL
MA
RK
ET
S
Figure 21 Hypothetical example of leverage
$1000 notional value of call option on equity in firms targeted for takeover
Repo FRN into cash and use cash to pay option premium
(repro is initially collateralized
Borrow $100 for margin purchase
$125 of US investment bank floating-rate notes (FRN) (secured by $25 equity in FRNs)
Repo off-the-run bond into cash and post margin
(repo is initially collateralizedSell (short) Borrow on-the-run bonds worth $20
$25 worth of off-the-run bonds (secured by $5 equity in bonds)
Exchange into $4
Cash $5 yen400 Japanese bank loans
$1 equity base
FRN = floating rate notesRepo = repurchase agreement
Source IMF (1998)
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wiiecom
THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 99
balance sheet and because balance sheets are published quarterly at bestoutsiders have a difficult time assessing the extent of a firmrsquos leverage19
Leveraging by a single firm enhances its risk of default the widespreaduse of leverage in the financial system can magnify market adjustmentsespecially when they require ldquodeleveragingrdquomdashunwinding prior positionsRapid adjustments can cause credit to dry up and asset prices to plummetIn a mark-to-market environment falling asset prices trigger calls foradditional collateral that can ripple through markets
Risk Management
Because it is confronted with the widespread use of leverage and prolif-erating kinds of risk international finance is increasingly driven by riskevaluation and control20 Different institutions face various risk profilesand differing kinds of risk The most common risks can be quickly tickedoff Banks because of their traditional intermediary role of channelingthe resources from savers to borrowers face significant credit risk therisk of default or delay in the payment of principal and interest Theymust also manage market risk the risk that the prices of their liabilitiesmay change faster than their assets Market risk devastated US savingsand loan institutions in the late 1980s
Closely associated with market risk are interest-rate risk (unexpectedchanges in market interest rates that slash margins net income and theeconomic value of a bankrsquos equity) and foreign exchange risk (losses thatarise when assets denominated in an appreciating foreign currency areless than liabilities denominated in that currency) Banks make numer-ous loans to other banks around the world portfolio investors buy se-curities direct investors acquire fixed assets and all incur country risk(economic and political uncertainty in the host country) During the heightof the Asian crisis for example interbank loans to Japanese banksreflected the credit risk of lending to these banks the so-called Japanpremium
Substantial attention has been lavished on country risk analysis sincethe 1982 debt crisis in developing countries Yet in spite of this exper-tise the Asian crisis occurred in part because of a sudden upward reap-praisal of country risk after the Thai baht collapsed in April 1997 Banksand other financial institutions must also manage liquidity risk the riskthat market conditions will change unexpectedly depressing demand andprices of assets at the time they want to sell these assets And they mustmanage operational riskmdashfailures in control systems or people that cause
19 Another example of asymmetric information Both risk and leverage are difficult foroutsiders to assess without full timely disclosure
20 A longer discussion of these issues can be found in Managing Global Finance in IMF(1999c)
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100 WORLD CAPITAL MARKETS
financial loss or damage reputations Operational risk devastated BaringsBank in 1995
Financial institutions practice risk management to measure all theserisks the potential damage to their investment positions and ultimatelythe chance of becoming insolvent VAR (value at risk) risk models mea-sure subject to certain assumptions the amount of the firmrsquos capital thatis exposed in each period For example the VAR model might say thatin a 3-standard-deviation worst case (a case that is not supposed to hap-pen more than 1 percent of the time) the firm will loose 25 percent of itscapital during the next year
VAR models are widely used but like all models they have weak-nesses They rely on past values to estimate key variables in financialmarkets past values are not always good predictors of future risks More-over rising volatility and higher loss correlation among different assetclasses in a portfolio will cause all banks using these models to reducetheir exposures at the same time by switching to less volatile and lesscorrelated assets such as US Treasury bills (Persaud 2000)
Newer risk models entail stress testing and scenario analysis Scenarioanalysis envisages possible adverse changes one at a time that mightaffect the investment portfolio Stress testing estimates potential losseswhen several individual risk factors simultaneously move against thefirm but it too uses historical probabilities
Financial Volatility
21 For example derivative markets usually rely on underlying securities markets thatproduce continuous prices When these markets are interrupted financial shocks cantrigger a cascade of margin calls and sell orders that move prices very sharply
22 See IIF (1999a)
The combination of trading activity and modern risk management lie atthe root of financial volatility When risks increase banks must eitherraise more capital to cover the greater risk or reduce their exposure bycutting loan exposure by selling securities or by undertaking new de-rivative trades Raising more capital is time-consuming and in a crisisvery expensive because bank shares are depressed So banks look to theother alternatives If the bank can reduce lending it need not book aloss But most banks use the same VAR models and as indicated abovethese models will encourage them to reduce their outstanding loans atthe same time actually magnifying loan volatility
If banks attempt to reduce their exposure to risk by selling securitiesor undertaking new derivative trades they may trigger large priceshocks because of limited and shrinking market liquidity21 The liquid-ity problem is compounded when a small number of large institu-tions hold the same positions22 Take your pick loan volatility or price
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 101
volatility As two experts have observed (Folkerts-Landau and Garber1998)
[V]olatility even in one country will automatically generate an upward re-estimate of credit and market risk in a correlated country triggering automaticmargin calls and tightening of credit lines Thus apparently bizarre opera-tions that connect otherwise disconnected securities markets are not the re-sponses of panicked green screen traders arbitrarily driving economies from agood to a bad equilibrium Rather they work with relentless predictability andunder the seal of approval of supervisors in the main financial centers
23 See Ferguson (1999)
24 As Gerald Corrigan (1982) put the matter ldquoBanks are specialrdquo Corrigan (2000) reit-erated this view even after all the changes of the past two decades Unlike other institu-tions banks offer on-demand transactions are a backup liquidity source for other insti-tutions and serve as a ldquotransmission beltrdquo for monetary policy
These changes in the banking environment accentuate an existing anomalyThe anomaly is that banks even as they grow larger and increasinglyengage in more risky and complex transactions are perceived to enjoyimplicit and explicit public guarantees
The guarantees grow out of an incentive problem inherent in bankingasymmetric information which we mentioned above Depositors know lessabout a bankrsquos management and the quality of its balance sheet than doits managers and shareholders Thus in times of uncertainty or adver-sity bank depositorsmdashuncertain whether they will have access to theirdepositsmdashare prone to bank runs This prospect has in turn compelledgovernments to treat banks differently than other firms because a bankthat fails can disrupt the rest of the economy24
To prevent such crises governments have entered into quid pro quoarrangements with banks Governments provide them both with an im-plicit safety net in the form of an unstated promise by the central bankto act as a lender of last resort in a liquidity crisis and an explicit safetynet in the form of a public deposit insurance fund to reassure depositorsIn return the banks submit to closer government oversight and regu-lation of their activities than is usual for industries in the private sector
The ldquoinsurancerdquo provided by the public safety net contributes to an-other incentive problem moral hazard Banks acquire greater tastes forrisk and face less market discipline than other firms The explicit depositinsurance safety nets actually have or are perceived to have blanketcoverage that extends beyond the retail depositors (households and small
One of the lessons of the 1997-98 crisis must surely be that market par-ticipants and their regulatory supervisors relied too heavily on quantita-tive tools and insufficiently on judgment23
The Anomaly of Modern Banking
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102 WORLD CAPITAL MARKETS
businesses) for which they were originally intended The implicit centralbank safety nets extend in a crisis to nearly all depositors and banksThus banks are both viewed and behave as if they will be bailed out ifthey get into trouble
The existence of a public safety net raises a perennial question Dobanks have an unfair advantage over other financial institutions becauseof the subsidy provided by the safety net This question was at the heartof intensive study and debate in the United States leading up to thepassage in November 1999 of the Financial Services Modernization Act(also known as the Gramm-Leach-Bliley Act) The size of the gross sub-sidy is difficult to estimate despite determined research efforts Somesuggest it is well under 100 basis points and is at least partly offset bythe direct costs of deposit insurance premiums interest payments on bondsissued by the Financing Corporation25 reserve requirements regulatoryexpenses and operational costs associated with collecting deposits26 Con-versely Kwast and Passmore (2000) suggest that banks can expand theirscope far beyond the levels that other financial institutions could reachwith the same equity base but without the public safety net
A related concern in the US debate is whether allowing banks to ex-pand their activities into securities and insurance will ultimately extendthe safety net and add to the subsidy The Financial Services Moderniza-tion Act deals with this issue by maintaining a legal separation betweenbanks and the rest of the banking organization known as large com-plex banking organizations (LCBOs) They must engage in most securi-ties activities and insurance underwriting through separately capitalizedinvestment bank subsidiaries or holding company affiliates This act canbe said to have merely brought US banking laws closer to those of mostother industrial countries (Barth Brumbaugh and Wilcox 2000 BarthNolle and Rice 2000) If the fire wall is well-maintained and stoutly de-fended the safety net will neither expand in practice nor become a sourceof comfort to noncommercial bank subsidiaries of LCBOs
The quid pro quo exacted by governments to offset the subsidy iscloser public-sector monitoring of banksrsquo activities through prudentialsupervision The effectiveness of this closer official scrutinymdashand closermarket monitoringmdashare the subjects of the next section
25 The Financing Corporation was created by Congress in 1987 to sell bonds to raisefunds to help resolve the savings and loan crisis
26 See Levonian and Furlong (1995) Jones and Kolatch (1999) Shull and White (1998)and Whalen (1999a 1999b)
Are G-10 bank supervisors adequately responding In this section we firstassess the case for and compare the structures of prudential supervisory
Prudential Supervision
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 103
systems both within and among the G-10 economies plus Spain andconsider whether these offset the subsidy provided by the public safetynet Despite offsetting regulation and supervision implicit and explicitguarantees by G-10 governments to their banks are still a source of bank-ing instability in the emerging-market economies
National Systems for Prudential Supervision
Governments use prudential supervision to reduce the moral hazard andadverse selection created by their own safety nets Supervisors establishregulations and monitor compliance to limit risk taking and ensure thesafety and soundness of the banking system In a thoughtful analysis ofthe case for prudential supervision Frederic Mishkin (2000) identifiesthe main forms that supervision can take including the tasks of grantingbanking charters and licenses establishing capital requirements settingdeposit insurance premiums and defining disclosure requirements as wellas carrying out bank examinations Bank examiners gather informationfrom banks and evaluate whether they are following the regulatorsrsquo rulesin cases of weakness they are empowered to change banksrsquo behaviorand close them if necessary
Supervisors also may restrict competition define the activities in whichbanks may engage and restrict their asset holdings and separate banksand other financial (or nonfinancial) activities During the past two de-cades the barriers separating commercial banks investment banks in-surance firms and securities firms have been all but eliminated (tableB1) Deregulation has stimulated competitive forces that drive diversifi-cation and consolidation of the financial industry nowhere faster than inthe United States
The Financial Services Modernization Act of 1999 confirmed this trendIt eliminated restrictions dating back to the Glass Steagall Act of 1933which once prevented banking insurance and securities firms fromentering each otherrsquos businesses (Barth Brumbaugh and Wilcox 2000)Cross-pillar mergers among banks insurance and securities firms arewell under way to form giant financial holding companies The 1999merger between Citibank (banking) and Travelers (insurance) created themodel for megafinance and confirmed new challenges for supervisors
Mishkin (2000) notes the corresponding evolution in US supervisionfrom an emphasis on rules-based regulation (detailed rules for opera-tional behavior and the quality of line items in the balance sheet) to anapproach that stresses the soundness of bank management practices es-pecially risk management
Appendix B outlines the systems of financial supervision now in theplace in the G-10 countries plus Spain Some systems like the UK andCanadian approach are models of simplicitymdashorganized to keep pacewith the spreading reach of financial conglomerates Other systems like
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104 WORLD CAPITAL MARKETS
the US and French approaches show traces of the bureaucratic divisionsthat made sense in an era when banking securities and insurance weresharply separated
The US Model
27 See Meyer (1999a)
28 Canada has a similar degree of simplification with the exception that securities firmsare still regulated by provincial authorities
29 See Pratti and Schinasi (1999 67)
30 The agents are the bank regulators and the principals are the taxpayers Agents maypursue their own interests including bureaucratic survival and postgovernment employ-ment opportunities rather than the national interest in banking safety and soundness
The US model of financial regulation delineated in the Financial Ser-vices Modernization Act of 1999 blends functional and umbrella super-vision Bank and thrift regulators oversee depository institutions Newnonbank activities are subject to both functional regulation (eg by theSecurities and Exchange Commission and state insurance examiners) andumbrella supervision (of financial holding companies) by the FederalReserve27
The UK Model
Another supervisory model exists in the United Kingdom as well as inAustralia Canada and Switzerland28 In this model banking supervisionis separated from the monetary policy function The regulatory structureis considerably simplified by relying on a consolidated financial regula-tor separate from the central bank for both banking and nonbankingactivities The remaining question answered differently depending on thecountry is the extent to which the regulator relies on home-country sur-veillance of banks and conglomerates that have a local presence
Regulatory Models Compared
Appendix B provides more detail on the differences in these modelsGerman simplicity contrasts with French complexity In France the bankingcommission is chaired by the governor of the central bank and includesrepresentatives from the Treasury The commission supervises compli-ance with regulations but the central bank inspects banks on behalf ofthe commission29 In countries such as the United States and France withmultiple supervisors and crossover functions internal coordination is criticalAt the same time multiple agencies create regulatory competition Wheneach agency knows what the other is doing transparency within gov-ernment circles can help to limit principal-agent problems of regulation30
The discussion as to where in the public bureaucracy financial super-
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 105
vision should be placed goes back many years Peek Rosengren andTootell (1999) argue that a synergy exists between monetary policy andprudential supervision because information gained in the course of super-vision can increase the accuracy of macroeconomic forecasts A twist tothis argument is that the information on the state of financial institutionsavailable to the central bank as supervisor can facilitate its role as lenderof last resort Conversely there is the concern that a supervisory rolewill compromise the central bankrsquos independence of action with respectto its core mandatemdashmaintaining price stability As these arguments haveplayed out financial supervision has generally been shared between centralbanks and other regulators or placed entirely in the hands of an inde-pendent regulator However in Italy the Netherlands and Spain cen-tral banks are the sole banking supervisor
Goodhart (1995) examined the arguments and evidence for each modeland concluded that there were no overwhelming arguments or evidencefor one or the other31 Going forward a key problem for any financialsupervisory system is dealing with (and closing as necessary) weak banksIf both central banks and other regulators have this responsibility closecoordination between them is critical Another problem is large conglom-erate banks LCBOs Although they are less likely to fail because of thediversification of their assets and liabilities they are more likely to berescued They are also more likely to be multinational enterprises withinternational implications Goodhart observes that regulation of theseentities might be put in the hands of the central bank because it is lessamenable to political pressures In any event the complexity of LCBOoperations suggests that greater supervisory rigor is necessary
The US Congress was persuaded that broad oversight would help containthe moral hazard problem and accordingly gave the Federal Reservethe role of umbrella supervisor with the understanding that the Fed willscrutinize depository activity more intensely than nonbank financial ac-tivities Under this approach LCBOs such as Citigroup are subject tomuch closer monitoring than smaller and simpler institutions32 The USregulatory model requires enormous cooperation between the Fed otherbank supervisors and the functional regulators for insurance and securi-ties but it also benefits from regulatory competition
31 National systems of supervision are path dependent they are determined by the struc-ture of financial institutions and history in each country If Goodhart (1995) is right out-comes are not materially better or worse with one model of supervision rather than another
32 See Ferguson (1999)
Public Safety Nets
One of prudential supervisorsrsquo biggest challenges is to reduce moral hazardFor many years commercial banks engaged in communal self-insurance
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106 WORLD CAPITAL MARKETS
to deal with crises They formed voluntary groups that agreed to rescuetroubled members As financial markets evolved and competition inten-sified banks were no longer willing to play this role Private-sector in-surance is one alternative but moral hazard and adverse selection wouldappear to prevent it from happening Public safety nets have developedbecause of the low probability and high cost of potential bank runs Aclear trade-off is involved The effectiveness of insurance in preventingbank runs is greater the more comprehensive the coverage But the morecomprehensive the coverage the greater the moral hazardmdashbank man-agers bank directors investors and depositors all take on greater risksin the belief that the safety net will protect them against losses
All G-10 countries have compulsory public safety nets for banks (table29) Deposit insurance agencies are officially organized in Canada theNetherlands Sweden Switzerland and the United States organized bythe industry in France Germany Italy and the United Kingdom andjointly organized by the public and private sectors in Belgium Japanand Spain
How well do G-10 governments offset the subsidy provided by thepublic safety net This is a question on which there is substantial debateAs banking organizations have become more complex the challengesthat supervisors face have become more difficult One challenge is toalign the incentives facing bank managers and shareholders with thoseof depositors Another is the principal-agent problem in supervision Wehave discussed the incentive structures for financial institutions but wehave said little about the incentives for supervisors themselves and thedistortions they can generate in the financial system
In one of the many studies of the US savings and loan crisis of the1980s Kane (1989) documented both problems He described managersusing cosmetic approaches to disguise the magnitude of insolvency regulatorspracticing forbearance even though they knew of the deteriorating riskprofiles of the institutions for which they were responsible and legisla-tors increasing deposit insurance without regard for any offsetting changesin supervision A subsequent overhaul of the legislative framework forthe Federal Deposit Insurance Corporation (FDIC) known as the FDICImprovement Act of 1991 (FDICIA) aimed to introduce a clearer incen-tive structure for both regulators and regulated institutions
The changes introduced by this US legislation are worth discussionwith respect to the other G-10 countries as well First FDICIA created astronger signal to management and investors by targeting deposit insur-ance at small depositors only and by risk-weighting the deposit insur-ance premiums paid by banks to reflect their capital adequacy and bankexaminer ratings Among the G-10 countries rated in table 210 depositinsurance premiums vary considerablymdashbut it is not clear that the dif-ferences have much to do with risk-weighting Most G-10 countries em-ploy funding formulas based for example on the total domestic deposit
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TH
E P
LAY
ER
S T
HE
IR S
UP
ER
VIS
OR
S A
ND
MO
RA
L HA
ZA
RD
107
Table 29 Deposit insurance schemes in the G-10 countries Explicit safety net
Coverage limit(dollar Foreign
equivalent currency Interbank Source Bankrsquos Contingency fundingDate Membership Co- at end of deposit deposit of premium from banks
Country established managementa insuranceb July 1998)c covered covered Fundingd funding costs or governments
United 1982 Compulsory Yes Larger of 90 No No Unfunded Banks only Callable (subject Parliament may increase Kingdom private percent co- to maximum the maximum payable
insurance to 03 percent of pound125 million advance 33000 total deposits) facility with Bank of
England
United 1934 Compulsory No 100000 Yes Yes Funded Banks and Up to 027 Borrowing up to $3 States official government percent total billion from US Treasury
domestic deposits
Japan 1971 Compulsory No 71000 but No No Funded Banks and 0084 percent of Borrowing up to yen500bn joint in full until government insured deposits from Bank of Japan
year 2000 subject to Ministry of Finance approval
Canada 1967 Compulsory No 40800 No Yes Funded Banks and 033 percent of Borrowing up to C$6 official government insured deposits billion authorized further
(maximum) borrowing subject to parliamentary approval
Germany 1966 Compulsory Yes 90 percent Yes No Funded Banks only 003 percent of Annual levy may be private coinsurance deposits doubled
to 22000
Italy 1987 Compulsory Yes 125000 Yes No Unfunded Banks and Callable Two options defer private government (maximum of payment or diminish
1 percent of compensation to be paid total deposits)
(table continues next page)
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108W
OR
LD
CA
PIT
AL
MA
RK
ET
S
Table 29 Deposit insurance schemes in the G-10 countries Explicit safety net (continued )
Coverage limit(dollar Foreign
equivalent currency Interbank Source Bankrsquos Contingency fundingDate Membership Co- at end of deposit deposit of premium from banks
Country established managementa insuranceb July 1998)c covered covered Fundingd funding costs or governments
Netherlands 1979 Compulsory No 22000 Yes No Unfunded Banks and On demand Government backing official government maximum of subject to parliamentary
5 percent of own approval funds
France 1980 Compulsory No 65400 No No Unfunded Banks only Callable (on Extra calls up to FFr1000 private demand calls million can be made in
up to FFr200 a 5-year period million)
Switzerland 1984 Voluntary No 19700 No No Unfunded Banks only Callable (on Underwritten by member official demand) banks
Sweden 1996 Compulsory No 31400 Yes No Funded Banks and 05 percent of Full emergency coverage official government deposits while replacing it with a
limited system after the emergency
Belgium 1974 Compulsory No 16600 No No Funded Banks and Callable 002 None insurance limited joint 22000 in government percent of to assets in fund
year 2000 deposits from clients
Spain 1977 Compulsory No 16439 Yes No Funded Banks and 02 percent of Government backing joint government deposits through the Banco de
(maximum) Espantildea subject to approval by royal decree
a Bank membership in the fund can be either compulsory or voluntary and the management of the fund can be official and official and private joint or privateb Coinsurance refers to the situation where depositors face a deductible against their insured fundsc Coverage limit refers to the explicit amount the authorities promise to insured Funded scheme means that it is funded ex ante unfunded otherwise
Sources Goodhart (1995) Demirguccedil-Kunt and Detragiache (2000) Demirguccedil-Kunt and Sabaci (2000)
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ics | httpww
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 109
base Explicit safety net protection also varies but only Canada focuseson the protected class33 All G-10 countries specify a limit on depositorprotection Under FDICIA the insurance fund is prohibited from pro-tecting uninsured depositors or creditors at a failed bank although adiscretionary system-wide override is provided for exceptional circum-stancesmdashbut with stringent requirements for consultation and account-ability Other G-10 countries allow for contingency funding from the publicpurse alongside unwritten lender-of-last-resort support Among large banksa significant and growing portion of deposit liabilities including foreigncurrency and interbank deposits are uninsuredmdashbut depositors assumethey will be protected in a crisis
FDICIA also made some significant qualitative changes to address theprincipal-agent problem by penalizing weak banks and rewarding strongbanks For example banks whose capital declined faced progressivelytougher regulatory sanctions that for example required them to elimi-nate dividends restrict their lending and change their managementsRegulators have also been forced to take prompt corrective action (toreduce the practice of regulatory forbearance in hopes that a bankrsquos for-tunes might improve)34 Unfortunately comparative qualitative assess-ments across the G-10 are difficult to make due to lack of information35
This discussion highlights the complexity of evaluating the extent towhich prudential supervision and market discipline reduce the moralhazard associated with G-10 safety nets Our argument is that publicsafety nets in the G-10 can be linked to banking instability in other coun-tries specifically in the emerging-market economies that have attractedG-10 cross-border bank lending This lending is a leading source of vola-tility in capital flows the large financial institutions many of which arecomplex banking organizations are based in and regulated by authori-ties in the G-10 economies These two features of the international finan-cial system are closely related although it is not possible to test thisrelationship econometrically
Two World Bank studies however indicate a basis for concern Onestudy is a cross-country econometric analysis of the relationship betweenbank stability and deposit insurance (Demirguccedil-Kunt and Detragiache2000) which found a negative relationship Their estimated model forbanking crises in a sample of 61 countries (both industrial and develop-ing) suggests that explicit deposit insurance raises the probability of acrisis by at least 30 percent36 Crises are especially likely in countries
33 Japanrsquos legislation says it does but recent experience shows this is not the case34 See Goldstein (1997) for a summary of the changes35 See Barth Nolle and Rice (2000) for a beginning in this area36 Demirguccedil-Kunt and and Detragiache (2000 table 1) report a logit coefficient of 0696with a standard error of 0397 (the coefficient is significant at the 8 percent threshold)This suggests that the ldquotruerdquo coefficient could well be as small as 030 (the reportedvalue minus the standard error)
Institute for International Economics | httpwwwiiecom
110 WORLD CAPITAL MARKETS
with immature financial supervisory systems (and not in the G-10) buttheir analysis does underscore the view that deposit insurance weakensmarket discipline37
An earlier World Bank analysis established similar results One wasthat market discipline is undermined by deposit insurance schemes an-other was that illiquid banks are forced to pay more for their funds un-less a generous deposit insurance scheme is in place (Demirguccedil-Kuntand Huizinga 1999) This econometric study also provides clear-cut evi-dence that depositor monitoring of banks declines with the existence ofdeposit insurance schemes At the heart of the problem is the questionof whether deposit insurance is accompanied by increased governmentmonitoring
This evidence and the weight of other arguments suggests that moralhazard is still an issue in the G-10 countries Consider the ongoing de-bate about instilling greater market discipline on risk taking by banksAt one extreme is the perennial proposal to do away with safety netsleaving markets to monitor the players and to force adjustments but toprotect small savers by creating ldquonarrow banksrdquo such as postal savingsystems that are allowed to invest these savings only in risk-free gov-ernment securities Whatever the merits of narrow banking this solutionis too extreme to be politically feasible
A moderate alternative is to force more disclosure by financial institu-tions to facilitate market monitoring But transparency has its own prob-lems Persaud (2000) argues that financial markets cannot reliably discernsustainable from unsustainable positions in the short term This uncer-tainty causes banks to ldquoherdrdquo behind market leaders to exploit theirsupposedly superior information ldquoThe more herding investors and bankersknow about what each other is up to the [more] unstable markets maybecomerdquo The implication is that greater transparency in the marketplaceby itself will not solve the problemmdashand in the short term more informa-tion may exacerbate herding Further supervisory steps (discussed in thenext chapter) are required
Yet another proposal is to promote private-sector involvement in bankmonitoring through market-based alternatives such as Calomirisrsquos sub-ordinated debt proposal (Calomiris 1997 Federal Reserve Board 1999)Banks could be required to issue and maintain a minimum amount of
37 Other findings in the Demirguccedil-Kunt and Detragiache (2000) study include thesepropositions The impact of deposit insurance on bank stability tends to be stronger themore extensive is the coverage offered to depositors when the scheme is funded andwhere the scheme is run by the government rather than by the private sector Con-versely deposit insurance is detrimental to bank stability where bank interest rates havebeen deregulated and where the institutional environment is weak Additional findingson deposit insurance are reported from a recent World Bank conference (8-9 June 2000httpwwwworldbankorgresearchinterestconfsupcomingdeposit_insurancehomehtm)Also see Smalhout (2001)
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 111
subordinated debt (eg uninsured certificates of deposit) to finance asmall fraction (such as 2 percent) of their total nonreserve assets Thesubordinated debt would be allowed to earn a set yield no more than 50basis points over the risk-free yield on government treasury bills Thisrule would supposedly force banks to operate in a safe manner Other-wise subordinated debt holders would redeem their uninsured certifi-cates of deposit and equity investors would sell their bank shares Despiteits practical problems the beauty of the subordinated debt requirementis that it enlists market incentives to push banks to avoid excessive port-folio risk38
The thrust of these proposals is very relevant to the arguments in ourstudy Even in the G-10 countries government monitoring by itself hasnot eliminated moral hazard among banks More work is needed to in-troduce market monitoring and to improve the incentive structures bothfor financial institutions and their supervisors We return to this issuewith our recommendations in the next chapter
38 In late 1996 Argentina began requiring its banks to finance 2 percent of total depos-its in the form of subordinated debt but without a maximum yield provision TheArgentine authorities expect that market discipline will act in concert with the publicsafety net One obvious problem with the subordinated debt proposal is that banks mayencourage some of their customers to buy the subordinated debt
Portfolio Institutions Tomorrowrsquos Problem
Before proceeding to the issues of international supervision we flag an-other potential problem for national regulators The big asset managersprofiled in tables 24 and 26 answer to diverse groups of pensionersshareholders and policyholders They allocate funds across a number ofcountries to diversify their risks They hold liquid assets that can be tradedand they have a higher proportion of long-term assets than banks Eco-nomic shocks can be absorbed through price changes and their effectsspread across time and markets Thus when conditions change in a par-ticular market they are more likely to ride out the storm than to flee Inother words they have less incentive than banks to pull their invest-ments in the face of adversity In the 1990s most large asset managersestablished a record of ldquoriding out the stormrdquo rather than ldquorunning withthe windrdquo although as we saw in chapter 1 instances of running withthe wind were detected in some portfolios As we write these insti-tutions have a good record overall in the emerging markets so whyworry
The Russian crisis and the near-collapse of LTCM previewed the dan-gers that may await future portfolio managers and G-10 financial minis-ters We have presented evidence indicating a systemic bias toward bank
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112 WORLD CAPITAL MARKETS
lending and debt finance to emerging markets and we have argued forsubstitution toward equity finance and direct investment39
That is not the end of the story We noted in the previous chapterthat institutional investors can become momentum investors selling in adownturn As more portfolio capital is invested in emerging marketssome players may adopt the high-risk high-leverage strategies of themost aggressive hedge funds Indeed the data in box 11 show that G-10portfolio investors held somewhat more long-term debt (more than $500billion) than equity (less than $400 billion) in emerging markets at theend of 1997 Long-term debt is an ideal vehicle for high-risk high-leveragestrategies These strategies practiced on a large scale could compound afuture crisis harming emerging markets A big enough crisis could inturn pressure G-10 central banks and finance ministers to arrange bail-out plans Instead of shrinking as a systemic financial problem moralhazard could increase
National securities regulators are the first line of defense against thisscenario They play a critical role in the safe evolution of capital mar-kets But regulators today are mandated to approve the issuance of newsecurities and to monitor the continuing disclosure of material informa-tion by issuers They are far less concerned with or empowered to monitorthe behavior of the increasingly large wealth-management firms that arethe major purchasers (and therefore resellers) of these securities
Within their mandates the goals of national securities regulators (table210 and appendix B) are similar to the concerns of bank regulators withsystem safety and soundness Their focus is also on the incentive sys-tems for management and boards of directors and on disclosure by cor-porations that issue marketable securities such as shares bonds andasset-backed securities 40 Issuers of securities possess greater knowledgeabout the quality of these assets than do the purchasers hence investorprotection is a key concern of regulators Moreover market disciplineworks best when markets know what is happening Well-functioning corpora-tions are key agents of wealth creation and social progress Underperform-ing corporations waste resources During recessions bad corporationsget into bad trouble often with severe social consequences Inadequateincentives for managers and inadequate accountability for boards andmanagers thus have negative externalities Regulators play a vital role inexposing weakness so that market disciplines come to bear sooner ratherthan later
Regulatory emphasis is constantly shifting as financial markets evolveand as the macroeconomic environment changes Regulators try to balance
39 See Rogoff (1999) Also see Berlin (2000) for a perspective on the limited role thatbanks play as share owners
40 See Habib and Ljungqvist (2000) for recent empirical analysis showing that corporateshare market values are higher when corporate executives have a larger ownership stake
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Table 210 Financial-sector regulation G-10 countries 2000
Financial institutions and their supervisors
Country and supervisory structure Retail banking Wholesale banking Securities Insurance
Financial conglomeratesFinancial Services Authority (FSA) = umbrella supervisor
United Kingdom FSA FSA FSA FSA
Treasury bull Commercial banks bull Investment funds (Securities and (Insurance Directorate(Securities and Investments Board) bull Unit trust groups Futures Authority) of the Treasury)
Bank of bull Building societies bull Pension funds England (Building Societies Commission) bull Merchant banks
bull Friendly societies bull Clearing houses bull Primary issuers bull Insurance FSA (Friendly Societies Commission) bull Venture capital of securities companies
bull Pensions and life insurance etc bull Stock exchanges bull Insurance brokers(Personal Investment Authority) bull Stockbrokers
Financial holding companiesFederal Reserve (FR) = umbrella supervisor
United States bull National banks(OCC) Securities and Regulated by
Treasury OCC bull State banks Federal Reserve Exchange Commission StatesMembers (FR)
OTS Nonmembers (FDIC) bull Investment banks bull Primary issuers of bull Insurance companies FR bull Cooperative banks (FDICFR) bull Finance companies securities bull Insurance brokers FDIC bull Insured industrial banks (FDIC) bull Stock exchanges
bull Thrift holding companies (OTS) bull Stockbrokers SEC bull Savings banks (OTSFDICFR) bull Investment advisors
bull Savings and loan associations bull Mutual funds(OTS) bull Public utility holding
bull Edge Act corporations (FR) companies
(table continues next page)
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Table 210 Financial-sector regulation G-10 countries 2000 (continued )
Financial institutions and their supervisors
Country and supervisory structure Retail banking Wholesale banking Securities Insurance
Financial holding companies Japan Financial Supervisory Authority (FSA) = umbrella supervisor
Prime FSA FSA FSA FSA ministerrsquos Ministry of office Finance (Securities and Exchange
Surveillance Commission) FRC Bureau of Financial bull City banks bull Investment banks bull Primary issuers of bull Insurance companies FSA Regulation bull Regional banks bull Asset managers securities bull Insurance brokers
bull Trust banks bull Stock exchanges SESC bull Long-term credit banks bull Stockbrokers
bull Pension funds
Financial holding companiesOffice of the Superintendent of Financial Institutions (OSFI) = umbrella supervisor
Canada Regulated by OSFI OSFI provinces OSFI
Department of Financebull Banks bull Cooperative credit bull Primary issuers of bull Insurance companies
(previously Office of the Inspector associations securities (previously Depart- OSFI General of the Banks) bull Fraternal benefit bull Stock exchanges ment of Insurance) Bank of bull Trust and loan companies society bull Stockbrokers bull Insurance brokers Canada bull Pension funds bull Asset managers
(previously Depart- CDIC ment of Insurance)
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Financial institutions and their supervisors
Country and supervisory structure Retail banking Wholesale banking Securities Insurance
Germany Financial holding groupsFederal Banking Supervisory Office (FBSO) = umbrella supervisor
Ministry of Finance FBSO BSO FSSO FISO
Bundesbankbull Universal banks bull Other financial bull Primary issuers of bull Insurance companies
Federal Banking bull Savings banks institutions (eg securities bull Insurance brokers Supervisory Office bull Securities banks management foreign bull Stock exchanges
currency dealings) bull Stockbrokers Federal Securities bull Financial enterprises bull Asset managers Supervisory Office (eg leasing bull Pension funds
organizations Federal Insurance credit card companies Supervisory Office investment advisors)
Italy Bank foundationsMinistry of Finance = umbrella supervisor
Ministry of Finance Bank of Italy Bank of Italy Consob ISVAP
Bank of Italy bull Commerical banks bull Asset managers bull Primary issuers of bull Insurance companies Consob bull Savings bank bull Open-end investment securities bull Insurance brokers
bull Securities banks companies (SICAVs) bull Stock exchangesbull Stockbrokers
ISVAP
(table continues next page)
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Table 210 Financial-sector regulation G-10 countries 2000 (continued )
Financial institutions and their supervisors
Country and supervisory structure Retail banking Wholesale banking Securities Insurance
The Netherlands Financial conglomeratesCouncil of Financial Supervisors = umbrella supervisor
Securities Board Securities Board Netherlandsche Netherlands Bank Netherlandsche Bank of the Netherlands Insurance Board Bank Insurance bull Credit institutions (universal banks bull Investment institutions bull Stock exchanges bull Insurance companies Board cooperative banks security credit (securities issuing bull Stockbrokers bull Insurance brokers
institutions mortgage banks) and tradingmdashprimary The Council of Financial and secondary Supervisors markets)
France Commission des Commission de Operations des Controcircle des
Banking and Banking Commission Bourse Assurances Financial Regulatory bull Ensuring that credit institutions (and investment firms since bull Primary issuers of bull Insurance companies Ministry for Committee the Financial Activity Modernization Act of 1996) comply securities bull Insurance brokers Economic with laws and regulations bull Stock exchanges Affairs and bull Execute instructions regarding all off-site monitoring and bull Stockbrokers Finance Credit on-site supervision Institutions and Banking and Financial Regulatory Committee Investment bull Formulates general regulations for credit institutions and investment firms Committee (capital adequacy requirements accounting rules etc) Bank of France Credit Institutions and Investment Committee Banking bull Authorizes and examines financial institutions except for those within the Commission competence of the Banking Commission
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117
Financial institutions and their supervisors
Country and supervisory structure Retail banking Wholesale banking Securities Insurance
Switzerland Large banking groupSwiss Federal Banking Commission (SFBC) = umbrella supervisor
Swiss National Bank Federal Office of
SFBC SFBC SFBC Private Insurance Swiss Federal Banking Commission bull Universal banks bull Investment banks bull Primary issuers of bull Insurance companies
bull Savings banks bull Asset management securities bull Insurance brokerscompanies bull Stock exchanges
Private audit Federal bull Investment funds bull Stockbrokers firms Office of bull Mortgage bond authorized by Private business SFBC Insurance
Sweden Financial holding company groupsFinancial Supervisory Authority = umbrella supervisor
Ministry of Finance Credit Market Securities Market Insurance Market
Credit Market Department Department Department Department
Financial bull Commercial banks bull Investment funds bull Primary issuers of bull Insurance companies Riksbank Supervisory bull Savings banks securities bull Insurance brokers Authority bull Friendly societies bull Stock exchanges
bull Stockbrokers
(table continues next page)
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Table 210 Financial-sector regulation G-10 countries 2000 (continued )
Financial institutions and their supervisors
Country and supervisory structure Retail banking Wholesale banking Securities Insurance
Belgium Bank holding companiesBanking and Finance Commission = umbrella supervisor
Bank of Belgium Banking Banking
Banking and Finance and Finance Insurance Controland Finance Commission Commission Commission Office
Banking and Insurance Finance Control bull Commercial banks bull Asset management bull Primary issuers of bull Insurance companies Commission Office bull Savings banks firms securities bull Insurance brokers
bull Securities banks bull Investment funds bull Stock exchanges bull Mortgage companiesbull Stockbrokers bull Pension funds
Securities Regulation Fund Securities Regulation Fund
bull Other investment firms and credit institutions(institutions participating in regulated off-exchangemarket in strips and Treasury certificates)
Bank holding companies Spain Banco de Espantildea = umbrella supervisor
Banco de Espantildea Comision Nacional del Mercado de Directorate General
Banco de Espantildea Valores (CNMV) Insurance
bull All credit institutions (commercial banks savings banks credit bull Primary issuers of (Ministry of Economy Ministry of cooperatives official credit institutions finance factoring and securities and Finance) Economy and CNMV leasing companies mortgage-loan companies etc) bull Stock exchanges bull Insurance companies Finance bull Interbank foreign exchange and book-entry public debt bull Stockbrokers bull Pension funds
markets bull Venture capital(companies and funds)
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119
Financial institutions and their supervisors
Country and supervisory structure Banking Securities Insurance
Banking Advisory High Level Securities Supervisors Committee (BAC) Committee (HLSS) Insurance Committee (IC)
Supranational (EU) bull Formulates standards for prudential bull Coordination of securities market bull Formulates standards forsupervision supervision prudential supervision
BACICHLSS Banking Supervision
Conglomerates Committee (BSC) Securities Contact Committee Regulation of prudential bull Systemic risk monitoring bull Regulation and implementation of supervision securities admission
International Association International International Organization of of Insurance Supervisors
Basel Committee Securities Commisison (IOSCO) (IAIS) Joint Forum Conglomerates Supervision bull Supervision and regulation best bull Supervision and regulation best bull Supervision and regulation amp regulation Best practices practices practices best practices
FSF Coordination across supervisors of various functions
Notes See appendix B for more information Boldface type indicates senior or oversight supervisor normal type indicates adjunct or front-line supervisorsolid line indicates direct responsbility to the senior-ranking authority dotted line indicates coordination in supervisory activities
(table continues next page)
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Table 210 Financial-sector regulation G-10 countries 2000 (continued )
Glossary of names United Kingdom FSA = Financial Services Authority United States FR = Federal Reserve OCC = Office of the Comptroller of theCurrency FDIC = Federal Deposit Insurance Corporation SEC = Securities and Exchange Commission OTS = Office of Thrift Supervision Japan FRC =Financial Reconstruction Commission FSA = Financial Services Agency SESC = Securities and Exchange Surveillance Commission Canada OSFI =Office of the Superintendent of Financial Institutions CDIC = Canada Deposit Insurance Corporation Germany FBSO = Federal Banking SupervisoryOffice FSSO = Federal Securities Supervisory Office FISO = Federal Insurance Supervisory Office BSO = Banking Supervisory Office Italy Consob =Commissione Nazionale per le Societa e la Borsa ISVAP = Instituto per la Vigilanza sulle assicurazioni private e di Interesse colletivo Switzerland SFBC= Swiss Federal Banking Commission Spain CNMV = The Comision Nacional del Mercado de Valores Supranational BAC = Banking Advisory CommitteeBSC = Banking Supervision Committee IC = Insurance Committee HLSS = High Level Securities Supervisors Committee International Dimension FSF =Financial Stability Forum IOSCO = International Organization of Securities Commission IAIS = International Association of Insurance Supervisors
Sources United Kingdom Bank of England httpwwwbankofenglandcouk Financial Services Authority httpwwwfsagovuk United States Board ofGovernors of Federal Reserve System httpwwwfederalreservegov Japan Bank of Japan httpwwwbojorjo Financial Reconstruction Commissionhttpwwwfsagojpfrcindexehtml Financial Services Agency httpwwwfsagojp Canada Bank of Canada httpwwwbank-banque-canadaca Office ofthe Superintendent of Financial Institutions httpwwwosfi-bsifgccaAndreEindexhtml Germany Deutsche Bundesbank httpwwwbundesbankde Fed-eral Banking Supervisory Office httpwwwbakredde Italy Banca drsquoitalia httpwwwbancaditaliait Commissione Nazionale per le Societa e la Borsahttpwwwconsobit Instituto per la Vigilanza sulle assicurazioni private e di Interesse colletivo httpwwwisvapit The Netherlands De NederlandscheBank httpwwwdnbnl France Banque de France httpwwwbanque-francefr Switzerland Schweizerische Nationalbank httpwwwsnbchindex3htmlSweden Sveriges Riksbank httpwwwriksbanksedefaultasp Belgium National Bank of Belgium httpwwwbnbbesgindexhtm Spain Banco de Espantildeahttpwwwbdees The Comision Nacional del Mercado de Valores httpwwwcnmves Supranational (EU) Institutional Arrangements for the Regulationand Supervision of the Financial Sector 2000 International Dimension Bank for International Settlement httpwwwbisorg International Organization ofSecurities Commissions httpwwwioscoorg International Association of Insurance Supervisors httpwwwiaisorg Financial Stability Forum httpwwwfsforumorg
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 121
the inflexibility of tight surveillance against the need to encourage in-novation and growth The US Securities and Exchange Commission isworried about aggressive accounting by firms and biased reports bysecurities analysts in an equity environment that prizes steadily higherquarterly earnings41 Japanese regulators are preoccupied with opaqueinterconnections between portfolio institutions banks and nonfinancialfirms through the keiretsu system Canadian regulators reeling from high-profile scandals of managers intentionally misleading investors are strengtheningmarket discipline through legal penalties aimed at managers and directorsof offending firms
When panic strikes a securities regulator cannot do much As the 1987stock market crash and the LTCM debacle in the fall of 1998 both dem-onstrated steep stock and bond price declines can create systemic risksIf severe enough the wealth effect of falling securities values and thefear of widespread insolvency can depress real activity Flooding thesystem with liquidity is a central bankerrsquos solutionmdashsomething a securi-ties regulator cannot do42 But just as financial supervisors can changethe incentive structure to discourage bankers from making risky loans ingood times so securities regulators can pay more attention to incentiveson the demand side when capital markets are strong
Prudential Supervision and InnovationmdashA Footnote
In concluding this discussion of prudential supervision in the G-10 anadditional point is worth noting National regulators face a persistenttrade-off between emphasizing financial system safety and soundnesswhile encouraging innovationmdashin spite of the added risks innovationbrings to financial markets Former US Treasury Secretary Lawrence Summers(2000 3) has argued by analogy
The jet airplane made airplane air travel more comfortable more efficient andmore safe though the accidents were more spectacular and for a time morenumerous after the jet was invented In the same way modern global financialmarkets carry with them enormous potential for benefit even if some of theaccidents are that much more spectacular As the right public policy response
41 The problem is illustrated by the divergence since mid-1998 between reported earn-ings by the Standard amp Poorrsquos (SampP) 500 and the after-tax profits of all corporations inthe national accounts Generally these two series move closely with one another Be-tween mid-1998 and mid-1999 SampP 500 reported that earnings increased by more than20 percent while after-tax profits of all corporations increased by less than 5 percent(Chase Bank US Economic and Policy Research US Weekly Prospects Chase SecuritiesWeekly Newsletter 5 June 2000 5)
42 For example the US Securities and Exchange Commission had no direct role in calmingmarkets in the 1987 or 1998 panics
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122 WORLD CAPITAL MARKETS
to the jet was longer runways better air-traffic control and better training forpilots and not the discouragement of rapid travel so the right public policyresponse to financial innovation is to assure a safe framework so that the ben-efits can be realized not to stifle the change
Accepting Summersrsquos analogy for the international financial system better-informed supervisors and investors are a necessary part of the financialsystem framework Supervisors require more timely information on therisk profiles resulting from positions taken by financial institutions Theyalso need a better understanding of risk-management systems Snapshotsof an institutionrsquos risk profile and risk-management procedures are nolonger adequate In a world where huge bets are quickly made (andpossibly lostmdashas with Barings Bank in 1995 and LTCM in 1998) super-visors must focus on the soundness of banking systems for evaluatingand managing risk on a daily basis Some progress has been made inaddressing these issues US banking examiners are extending their in-formation requirements in banking examinations and increasing theirinvolvement in large complex institutions43 More awareness is alsorequired of the fact that they are national organizations in a world ofcross-border capital flows To a much greater extent they need a multi-national reach International supervision and coordination among super-visors are the subject of the next section
Our analysis suggests that G-10 supervisors have unfinished businessBank supervisors need to start yesterday securities regulators can waituntil tomorrow One G-10 member acting alone cannot correct the biasIn good times the lending business will simply migrate to other G-10banks In bad times financial problems will not stop at the national bor-der A way has to be found to establish common international standardsfor the key financial players in order to prevent crises and to agree onapproaches for managing them The path has already been laid out Inthe wake of the bank failures of the past 25 years bank supervisors havetried to establish such standards They have done this without creating anew global institution
The essence of the international framework is decentralizationmdashglobalrules and design standards without global institutions that are perceivedto intrude on national sovereignty The awkward jargon for this frame-work is vertical subsidiaritymdashldquothink internationally act nationallyrdquo Theinternational thinking is done by a committee of regulators that meets
International SupervisionA Decentralized Framework
43 These issues are discussed in Ferguson (1999) and Meyer (2000a)
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 123
regularly at the Bank for International Settlements in Basel The commit-tee establishes principles and standards that are interpreted implementedand enforced by national authorities44 In this section we describe thesesupervisory efforts and their weaknesses We present our recommenda-tions for addressing these weaknesses in the next chapter
Basel I
The Basel Capital Accord of 1988 (Basel I)45 drew the lesson from thefinancial crises of the mid-1970s that more adequate capital levels in in-ternational banks would help reduce the systemic risk of bank failureThe primary goal of Basel I was capital adequacy other standards wereput in place not so much for their own virtue as to defend the primarygoal
Capital adequacy requirements were designed to ensure that individualinstitutions have the ability to absorb losses particularly credit lossesAccordingly a backup system of scoring credit risk was devised thatrequired large amounts of bank capital for some types of loans smalleramounts for others and zero for a select list of preferred assets Report-ing requirements were designed to disclose problems and ensure that atroubled bank would take timely steps to restore its capital base in thewake of a loss The Basel I framework worked tolerably well in limitingthe call on the public purse in the G-10 countriesmdashwith the notable ex-ceptions of France and Japan The framework failed to moderate riskybank lending to emerging markets however
Basel I was not developed with emerging markets in mind The origi-nal idea behind it was to develop a common supervisory approach tocross-border banking operations It grew out of political pressure fromUS lawmakers who were determined to require international banks op-erating in the United States to meet US banking standards Toward thisgoal in 1983 Congress passed the International Lending Supervisory ActUS and British banking authorities subsequently agreed on a commontarget the adoption of strict common capital-adequacy standards In 1988other G-10 governments agreed to go along voluntary acceptance ofthe standards throughout much of the rest of the world followed46 Therationale for the capital targets was two-fold The first was to requirebanks to hold sufficient amounts of capital (8 percent of risk-adjusted
44 The international committee of financial authorities agreed on a common definitionof banksrsquo tier-one or ldquocorerdquo capital national authorities defined tier-two capital in theirown manner which permitted greater variations in national working definitions andpractices
45 International Convergence of Capital Measurement and Capital Standards (BIS 1988)was prepared by the Basel Committee on Banking Supervision
46 See Reineke (1998)
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124 WORLD CAPITAL MARKETS
assets) to cushion losses on those assets The second was to dull theirappetites for risk banks with large capital bases would have more tolose if they failed and therefore would take fewer risks
Rapid change in financial markets soon revealed flaws in the Basel IAccord In a complex world with numerous sources of risk it focusedheavily on credit risk but overlooked other risks in a bankrsquos portfolioand the correlation between returns on different asset classes The Baselformula required banks to maintain a fixed amount of capital againsteach of its asset classes But the formula did not distinguish the riskinessof the borrower within each class As a result one large loan to a low-risk corporate borrower such as General Electric would require the sameamount of capital as 10 smaller transactions with high-risk borrowers
The system was also biased toward short-term loans Loans maturingin less than a year required a 20 percent risk weight whereas those ma-turing after more than a year required a 100 percent risk weight Inter-bank lending was particularly favored For example loans to banks inOECD countries required less capital than loans to private firms in thesame countries creating the anomaly that interbank loans to South Ko-rean banks required less capital than loans to General Electric47 Thisanomaly encouraged banks to shed high-quality assets if the Basel rulesrequired the allocation of more capital than banks thought they needed
Another weakness was that financial innovators quickly circumventedthe Accord Because short-term loans required less provisioning than long-term loans banks responded by securitizing their long-term debt port-folios and lending short-term against the collateral of the newly createdasset This allowed banks to circumvent the capital requirements gearedto the terms of the underlying debt At the same time the Basel I Accordfailed to encourage risk mitigation techniques such as credit derivativescollateral guarantees and on-balance-sheet netting the flip side of fi-nancial innovation Because off-balance-sheet products were not coveredby the Accord another anomaly appeared when Barings Bank collapsedin 1995 Barings met capital adequacy standards but collapsed becauseits systems for managing risk failed traders were allowed to speculatein futures contracts that did not appear on the balance sheet
Basel II
Work to overhaul Basel I began in 1995 and produced consultativepapers issued in June 1999 and January 200148 These papers have been
47 South Korean banks have had notoriously weak balance sheets because the practiceof ldquodirected lendingrdquo left them with many poor loans (in making these loans the bankswere expected to follow government objectives rather than creditworthiness criteria)
48 Basel Committee on Banking Supervision (1999 2001)
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 125
the subject of extensive consultation and revision as a result the newAccord is expected to be introduced in 200449 The Basel II frameworkhas three parts (pillars) revisions to Basel I minimum-capital require-ments supervisory review criteria and greater emphasis on market dis-cipline Broadly Basel II aims to maintain the level of capital in the sys-tem but achieve better alignment of banksrsquo capital with their risk pro-files and keep up with financial innovation
To align capital requirements with market realities (the first pillar)Basel II concentrates on the 100 or so largest banksmdashthe type of playerslisted in table 21mdashand on the holding-company parents of banking groups50
Capital requirements will differentiate between an increased number ofcredit groups or ldquorisk bucketsrdquo including claims on governments otherbanks corporations mortgage-backed securities and other asset-backedsecurities
Basel II originally proposed to use external ratings to set capital chargesfor a number of these credit risks Many banks objected arguing thatthey assess credit risk better than Standard amp Poorrsquos Moodyrsquos or FitchIBCA51 Basel II thus proposes two approaches to rating a standard ap-proach using external ratings and an ldquoadvancedrdquo approach that allowsselected banks to use their own internal rating systems To encouragethe development of rigorous internal control systems based on these in-ternal rating systems Basel II also proposes to levy capital charges foroperational risk (the risk of direct or indirect loss resulting from inad-equate or failed internal processes people and systems or from exter-nal events)
Some critics of this proposal dismiss it as an abrogation of the prin-ciple of external independent monitoring and as ldquodangerously naiumlverdquo52
But regulators argue that the new capital charge on operational risk shouldoffset this concern It is also far from clear how cross-national compari-sons of rating and internal risk-assessment systems will be made (Engelen2000) The development by the European Union of its own capital rulescould well complicate the international resolution of these issues Publicassurances by EU officials in January 2001 however indicated that theirmain concerns are to create a level playing field and avoid regulatoryarbitrage (Hargreaves 2001) There is also the significant problem ofthe procyclical character of risk weights When a crisis hits losses are
49 See Berry (2000) for an update in an interview with William J McDonough chair ofthe Basel Committee on Banking Supervision
50 For obvious reasons these proposals are addressed to large banks and simpler capi-tal standards are allowed for small banks that focus on their domestic credit markets
51 See Ammer and Packer (2000) for an empirical critique of the success of rating agen-cies in distinguishing risk by sector and region
52 See Auerback (2001)
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126 WORLD CAPITAL MARKETS
incurred or accrued capital is lost and loan exposure must be reducedor securities sold to restore the requisite capital-adequacy ratios A morerisk-sensitive framework could amplify volatility
As the second pillar of Basel II supervisory review criteria are beingbeefed up to encourage supervisors to intervene earlier in potential problemsituations and to compel banks to align their capital positions with theirrisk profiles Bank supervisors will be authorized to require banks tohold capital in excess of minimum requirements if they have concernsabout general management overall strategy risk-management performanceor the macroeconomic environment Of course if one G-10 supervisorimposes higher capital requirements in isolation the same disparity willemerge that presaged Basel I Some banks will be disadvantaged in theinternational marketplace and will loudly complain that excessive super-vision is driving business to their competitors Hence close internationalcooperation among supervisors is critical
To implement the third pillar market discipline banks will be requiredto make fuller more timely disclosure of capital adequacy and the risksto which that capital is exposed A number of measures are being stud-ied that might help supervisors evaluate bank performance such as com-parisons of uninsured deposit interest rates subordinated debt yieldsand equity prices The idea is that these yields and prices might alertsupervisors to market perceptions of risk Of course market perceptionsare only as good as market information More direct and controversialways to reinforce market discipline would dramatically increase publicdisclosure of bank positions and risk management systems
Many questions are still outstanding about how to resolve the techni-cal details of capital requirements and whether the requirements willachieve their intended goal of better assessment and mitigation of therisks in banksrsquo portfolios There is no substitute for skilled supervisorsThe intricacies of effective design and implementation suggest that su-pervisors need to be highly competent technically knowledgeable aboutbanking portfolio characteristics and the factors that influence bank ex-posure to credit risk (Mishkin 2000) And they must be aided by vigilantshareholders market forces and transparency of information53
Standard setting at the global level is desirable but ultimately theeffectiveness of these efforts will be tested at the national level espe-cially in times of systemic financial distress Here the record of Basel Iwas not a bright shining success Japanese banking regulators havetraditionally allowed banks to include real estate and securities in theircapital base When the value of these assets plummeted in the early 1990sregulators allowed banks to continue valuing these depreciated (andoften bankrupt) assets at their old inflated levels Japanese authorities
53 Benedict Roth Complacency Towards Catastrophe Financial Times 23 January 2001
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 127
insisted until the mid-1990s that eroded capital bases could be rebuiltin a market-driven fashion They rightly foresaw that huge loan losseswould undermine public support for the ruling party and require a po-litically unpopular bailout
Japanese foot dragging on Basel I was the worst54 but not uniqueOther examples can be found of ldquopolitically mandated forbearancerdquo TheFederal Reserve Bank of New York held important hands during theLTCM crisis of 1998 Mexico is still resolving the banking crisis that eruptedin 1995 South Korea has not yet closed the insolvent banks that behavedso badly before the crisis of 1998 In the aftermath of a crisis nationalregulators cannot always be relied upon to discipline politically power-ful bankers55 One of the little-noticed consequences of these differingapproaches is that those banks with strong regulatory systems receivedan implicit ldquoexport subsidyrdquo for their services US banks which had notengaged extensively in emerging-market lending in the 1990s were bet-ter positioned than their German and Japanese counterparts to expandtheir international assets in the wake of the crises
Other Financial Forums
54 See Japanese Banks Fiddling while Marunouchi Burns The Economist 27 January2001 67-69
55 See Calomiris (1997)
The Basel model of vertical subsidiarity has already been extended toother financial regulatory bodies In 1993-94 the BIS established a Tri-partite Group of Banking Insurance and Securities Regulators In 1994-95 the BIS increased its cooperation with the International Organizationof Securities Commissions when the two organizations issued parallelpapers on guidelines for national regulators concerning risk managementand disclosure of derivative trades In 1996 a permanent Joint Forum onFinancial Conglomerates was established to examine supervisory issuesand develop working arrangements among the different functional super-visors of conglomerate institutions that offer combinations of bankingsecurities and insurance products Draft papers on the supervisionof conglomerates were released for comment in 1998 applying capital-adequacy principles to these groups and providing guidelines both forassessing the integrity and competence of top managers and for sharingassessments between regulators
In 1997 the Basel Committee on Banking Supervision extended itsreach beyond capital standards to broader aspects of banking supervi-sion with the publication of the Core Principles for Effective BankingSupervision In 1999 a wide range of regulatory and standard-settingbodies were gathered under the umbrella of the Financial Stability
Institute for International Economics | httpwwwiiecom
128 WORLD CAPITAL MARKETS
Forum (FSF) itself established under BIS aegis56 The FSF has alreadyissued recommendations for stepped-up supervision and transparencyas well as guidelines for best practices in a number of areas includingoffshore financial centers and highly leveraged institutions or hedge funds57
Conclusion
Although the structural weaknesses in emerging-market economies arewidely acknowledged to have been causal factors in international capi-tal-market volatility this chapter points to the role of large G-10 bankingorganizations as major suppliers of the most volatile instrument short-term debt We have examined evidence of the impact of public safetynets in the G-10 economiesmdashthe deposit insurance systems the pruden-tial supervisory systems and the lender-of-last-resort functions of centralbanksmdashon the incentive structures of these organizations
Although supervisors in most countries working nationally and to-gether in the BIS have made significant efforts to mimic market forcesin their prudential supervision the most sophisticated financial institu-tions find innovative ways to circumvent the rules New global regulatorybodies are not about to be created G-10 national bank regulators shouldthemselves address the short-term debt bias in the international financialsystem by changing incentive systems G-10 securities regulators shouldalso take steps to get ahead of the curve paying close attention to largeportfolio swings by institutional investors particularly in times of crisisIn short more needs to be done at national and international levels tochange the rules of the game That is the subject of the next chapter
56 The Financial Stability Forum includes banking securities insurance and accountingregulatory bodies the OECD on taxation corruption and corporate governance and theIMF
57 See Martin (2000)
Institute for International Economics | httpwwwiiecom
THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 93
Jap
an
5M
itsui
109
5635
8T
radi
ng6
Itoch
u10
957
333
Tra
ding
7M
itsub
ishi
107
7536
9T
radi
ng10
Toy
ota
Mot
or10
012
540
0M
otor
veh
icle
s an
d pa
rts
12M
arub
eni
9455
300
Tra
ding
13S
umito
mo
8946
259
Tra
ding
18N
ippo
n T
eleg
raph
amp T
elep
hone
7614
7
na
Tel
ecom
mun
icat
ions
20N
issh
o Iw
ai68
3938
8T
radi
ng24
Hita
chi
6282
214
Ele
ctro
nics
el
ectr
ical
equ
ipm
ent
26M
atsu
shita
Ele
ctric
Ind
ustr
ial
6067
332
Ele
ctro
nics
el
ectr
ical
equ
ipm
ent
31S
ony
5353
628
Ele
ctro
nics
el
ectr
ical
equ
ipm
ent
33N
issa
n M
otor
5158
511
Mot
or v
ehic
les
and
part
s38
Hon
da M
otor
4943
641
Mot
or v
ehic
les
and
part
s48
Tos
hiba
4151
252
Ele
ctro
nics
el
ectr
ical
equ
ipm
ent
51F
ujits
u41
4332
6C
ompu
ters
of
fice
equi
pmen
t52
Tok
yo E
lect
ric P
ower
4012
2
na
Util
ities
ga
s an
d el
ectr
ic60
NE
C37
42
na
E
lect
roni
cs
elec
tric
al e
quip
men
t90
Tom
en31
18
na
T
radi
ng99
Mits
ubis
hi E
lect
ric30
35
na
E
lect
roni
cs
elec
tric
al e
quip
men
t
Ch
ina
73S
inop
ec34
52
na
P
etro
leum
ref
inin
g
Tot
al (
aver
age
for
tran
snat
iona
lity
inde
x)3
988
447
949
0T
otal
for
G-1
0 (a
vera
ge f
or t
he i
ndex
)3
954
442
749
0
na
= n
ot a
vaila
ble
G-1
0 =
Gro
up o
f T
en c
ount
ries
see
not
e to
tab
le 1
1
a
Dat
a sh
own
are
for
the
fisca
l ye
ar e
nded
on
or b
efor
e 31
Mar
ch 1
999
b
Ass
ets
show
n ar
e th
ose
at t
he c
ompa
nyrsquos
fis
cal
year
-end
c
The
ind
ex o
f tr
ansn
atio
nalit
y is
cal
cula
ted
as t
he a
vera
ge o
f ra
tios
of f
orei
gn a
sset
s to
tot
al a
sset
s f
orei
gn s
ales
to
tota
l sa
les
and
for
eign
em
ploy
men
tto
tot
al e
mpl
oym
ent
as o
f 19
97 (
UN
CT
AD
)
Sou
rces
F
ortu
ne G
loba
l 50
0 1
999
http
w
ww
pat
hfin
der
com
fort
une
glob
al50
0in
dex
htm
l U
NC
TA
D (
1999
)
Institute for International Economics | httpwwwiiecom
94 WORLD CAPITAL MARKETS
foreign direct investment The ldquotransnationality indexrdquo (table 28) showsthat on average they conducted about half their business outside theirhome country9
Overview of the Players
Our review of the major players points to two major features First ahandful of big playersmdashfewer than 200 firms all toldmdashcontrol the ac-tion in international capital markets Their dominance will doubtless erodebut for now financial power is strikingly concentrated with them Sec-ond the big players are overwhelmingly based in the G-10 countriesplus Spain The responsibility to supervise them rests not in the IMFnor in Basel but squarely in Washington London Tokyo and the otherG-10 capitals At year-end 1999 the G-10 countries plus Spain accountedfor 84 percent of world banking assets 86 percent of world stock marketcapitalization and 76 percent of international debt securities (BIS 2000aWorld Bank 2000b)
International private capital flows are of three types bank loans anddeposits portfolio investment and foreign direct investment In cumula-tive total flows to emerging markets FDI was the biggest story in the1990s amounting to $954 billion (table 12) Portfolio flows were nextcumulatively amounting to somewhere between $612 billion (table 12)and $764 billion (table A1) Bank loans and deposits are the most com-plicated story
The Key Role of Banks
Banks are more important as an epicenter than as a wellspring Banksgenerate waves in the flow of capital to emerging markets rather than acontinuous steady stream According to data compiled by the Institute ofInternational Finance (table A1) net bank lending to emerging marketscumulated to $269 billion in the 1990s However deposits by emerging-market residents in G-10 banks more than offset G-10 bank lending tothese countries during the decade According to IMF data cumulativebank loans net of deposits amounted to a negative $135 billion (table 12)
In other words when loans and deposits are combined net bank ac-tivity that moves financial resources to emerging markets is small incomparison with portfolio investment and FDI But bank loans are thelubricant of any financial system Depending on circumstances bankscan be shock absorbers or shock propagators In recent decades with
9 The transnationality index is calculated as a simple average of the share of assetssales and employees outside the home country
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 95
respect to emerging markets banks have more often been propagatorsthan absorbers The average annual swing in bank lending to emergingmarkets was nearly $50 billionmdashby far the largest source of year-to-yearfluctuations in capital flows Both interbank loans between Europe Japanand Asia and sovereign Russian debt used as loan collateral played amajor role in the 1997-98 crisesmdashnot because banks are profligate playersbut because of the incentives they face and the instruments they useAccordingly our story begins with banks
Banks in the Modern Financial System
10 See Levine (2000) for a concise description of the role of banks in the financial system
11 The asymmetric information problem helps to explain why banks dominate the im-mature financial systems of emerging-market economies The general lack of informationon borrowers and undeveloped legal systems to enforce contracts hamper suppliers oflong-term financial instruments such as equities and bonds in evaluating risk and re-ward Banks are best suited in these circumstances to solve the asymmetric informationproblem by evaluating and monitoring private loans As more and better informationbecomes available capital markets develop and financial systems mature
As we noted in the previous paragraph the problem of financial volatil-ity in emerging-market economies is associated with bank lending Ifand when repayment problems arise cross-border private bank loansand bond placements are such that private creditors have no plausiblemeans of seizing assets from either private or sovereign borrowers Thusalthough international finance can nourish entrepreneurs and accelerategrowth a necessary complement may be a drastic creditor response inthe event of nonpaymentmdashto withhold fresh funds and force an eco-nomic crisis (Dooley 2000)
This argument is based on the characteristics of banks They are notldquobadrdquo per se They perform three essential functions in any financialsystem pooling the resources of disparate savers and channeling these re-sources into productive investment improving resource allocation throughtheir expertise in assessing and monitoring borrowers and facilitatingthe division of risk among numerous creditors10 But by their very na-ture banks are prone to two problems asymmetric information (the bor-rower knows more about the potential risk and return of its projectsthan the bank) and adverse selection (riskier borrowers will pay higherinterest rates and thus may constitute a disproportionate share of bankloan portfolios)11
Bank loans are illiquid fixed-price instruments They cannot easily beconverted to cash although they can be bundled into securities (knownas ldquosecuritizationrdquo) Once loan terms have been agreed on the only waya bank can adjust for shifting market conditions is by changing the quantityof its exposure When a borrower runs into trouble the bank can mix
Institute for International Economics | httpwwwiiecom
96 WORLD CAPITAL MARKETS
and match from two unpleasant menus It can roll over existing loansand extend new credit or it can call some part of existing loans andattempt to recover the principal It can also hedge by selling short otherclaims on the borrower These choices entail either an unwelcome exten-sion of the bankrsquos exposure or credit rationing against the borrower Whentrouble brews all banks encounter the same conditions in the aggregatethey prefer less exposure and ensuing credit restrictions lead to volatilebank lending
Innovation
12 Derivatives have no value of their own They ldquoderiverdquo their value from the value ofthe underlying asset They include swaps futures (contracts for future delivery at speci-fied prices) and options (which give one party the right but not the obligation to buyfrom or sell to a counterparty at an agreed price)
13 Maxfield (1998) analyzed available evidence of emerging-market investor objectivesmost of it before the crisis Analysis of portfolio equity flows is sensitive to the choice ofperiod with year-over-year data indicating that investors respond to country ldquofundamen-talsrdquo Other evidence suggests more ambiguity Ranking by ldquoinvestor impatiencerdquo ie thesearch for yield over value Tesar and Werner (1995) find short-term bank flows to be themost yield driven followed by portfolio investment FDI and long-term bank lending
14 Because market risk credit risk and country risk interact in complex ways newfinancial instruments have been created to help reduce negative interactions One is theldquototal return swaprdquo which has become an instrument of choice for hedge funds lookingfor high leverage Banks also use the total return swap to cover risks without increasingtheir capital requirements
Since the 1980s national and international banking systems have beentransformed by deregulation intensified competition and the informationand communications-technology revolutions The market environment isone of intense competition particularly in traditional banking activitiesThe innovations point away from traditional activities of plain vanilladeposit taking and loan making Three big themes are discernible Firstthe walls separating commercial banks investment banks portfolio man-agers and insurance firms are falling even if they are still distinct Sec-ond large banks are shifting toward securitizationmdashcreating securitiesout of everything from credit card debt to trade finance to disaster insur-ancemdashand earning fees in the process Third all large banks are shiftingtoward trading activity making markets and taking short-term stakes inbonds shares and derivatives12 These activities when successful satisfythe search for higher yields13
Many of the new financial instruments that banks trade are ldquooff bal-ance sheetrdquo This means that banks are not required to allocate capitalagainst them In swap contracts for example neither side pays cash at theoutset and therefore neither party has an asset in the traditional sense14
Futures and options contracts can be written with a relatively small initial
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 97
margin relative to the potential risk Credit derivatives limit credit risk bytransferring the potential loss associated with corporate loans and bondssovereign debt and other loan portfolios to counterparties15
Deregulation and innovation working in combination seem to havepushed banks into trading activity and leveraged plays but not into shareownershipmdasheven in jurisdictions that have no prohibition against equitystakes Among the G-10 banking systems the highest ratio of share own-ership to assets was only 5 percent in 1996 reached in Germany andJapan (Berlin 2000)16
The wave of innovation in financial instruments and the accompany-ing expansion of banking beyond its old boundaries is a two-edged swordOn one side it allows risk management far beyond what was tradition-ally possible Risk can now be shifted from firms that can ill afford lossesto those that can Banks can profitably act as intermediaries in shiftingrisk On the other side the innovation wave creates huge opportunitiesfor leveraged plays fostering a speculative search by banks themselvesfor high returns that in turn magnify their own risks17
15 Credit derivatives include total return swaps credit default swaps credit-linked notesand collateralized debt obligations They are the fastest-growing sector of the global de-rivatives market
16 Banks seem to specialize in lending even when they are allowed to mix finance andcommerce for reasons related both to how they are expected to behave with distressedfirms and to other intricacies of lender liability (Berlin 2000) Yet a recent cross-countrystudy found that restrictions on banking and commerce are associated with greater fi-nancial instability (Barth Caprio and Levine 2000)
17 Leverage is the magnification of the rate of return (positive or negative) on an in-vestment beyond the rate obtained by solely investing funds owned by the institution Itis often defined as the ratio of assets to equity Leverage is achieved by increasing thesize of an investment by borrowing or using derivative instruments such as futures oroptions These allow investors to earn a return on the notional amount underlying thecontract by committing a small portion of equity in the form of a margin deposit oroption premium payment
18 In a repo (repurchase agreement) one party (typically a trader) buys a bond andsells it to a dealer for cash with a promise to buy it back the next day at the same priceplus the overnight interest rate As long as the overnight interest rate is lower than theinterest accruing on the bond the trader earns some income on the bond The extremeform of these kinds of transactions was discovered at LTCM the failed US highly lever-aged institution which appears to have controlled more than $120 billion in assets froman investment of about $3 billion This leveraging was accomplished mostly through theuse of repos (Mayer 1999)
The potential for damage is illustrated in an extreme form by figure 21To precisely measure a firmrsquos leverage all positions must be known andrealistically valuedmdashwhich may be impossible to do Because many ac-tivitiesmdashsuch as repos18 and derivativesmdashdo not appear on the institutionrsquos
Leverage
Institute for International Economics | httpwwwiiecom
98W
OR
LD
CA
PIT
AL
MA
RK
ET
S
Figure 21 Hypothetical example of leverage
$1000 notional value of call option on equity in firms targeted for takeover
Repo FRN into cash and use cash to pay option premium
(repro is initially collateralized
Borrow $100 for margin purchase
$125 of US investment bank floating-rate notes (FRN) (secured by $25 equity in FRNs)
Repo off-the-run bond into cash and post margin
(repo is initially collateralizedSell (short) Borrow on-the-run bonds worth $20
$25 worth of off-the-run bonds (secured by $5 equity in bonds)
Exchange into $4
Cash $5 yen400 Japanese bank loans
$1 equity base
FRN = floating rate notesRepo = repurchase agreement
Source IMF (1998)
Institute for International Econom
ics | httpww
wiiecom
THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 99
balance sheet and because balance sheets are published quarterly at bestoutsiders have a difficult time assessing the extent of a firmrsquos leverage19
Leveraging by a single firm enhances its risk of default the widespreaduse of leverage in the financial system can magnify market adjustmentsespecially when they require ldquodeleveragingrdquomdashunwinding prior positionsRapid adjustments can cause credit to dry up and asset prices to plummetIn a mark-to-market environment falling asset prices trigger calls foradditional collateral that can ripple through markets
Risk Management
Because it is confronted with the widespread use of leverage and prolif-erating kinds of risk international finance is increasingly driven by riskevaluation and control20 Different institutions face various risk profilesand differing kinds of risk The most common risks can be quickly tickedoff Banks because of their traditional intermediary role of channelingthe resources from savers to borrowers face significant credit risk therisk of default or delay in the payment of principal and interest Theymust also manage market risk the risk that the prices of their liabilitiesmay change faster than their assets Market risk devastated US savingsand loan institutions in the late 1980s
Closely associated with market risk are interest-rate risk (unexpectedchanges in market interest rates that slash margins net income and theeconomic value of a bankrsquos equity) and foreign exchange risk (losses thatarise when assets denominated in an appreciating foreign currency areless than liabilities denominated in that currency) Banks make numer-ous loans to other banks around the world portfolio investors buy se-curities direct investors acquire fixed assets and all incur country risk(economic and political uncertainty in the host country) During the heightof the Asian crisis for example interbank loans to Japanese banksreflected the credit risk of lending to these banks the so-called Japanpremium
Substantial attention has been lavished on country risk analysis sincethe 1982 debt crisis in developing countries Yet in spite of this exper-tise the Asian crisis occurred in part because of a sudden upward reap-praisal of country risk after the Thai baht collapsed in April 1997 Banksand other financial institutions must also manage liquidity risk the riskthat market conditions will change unexpectedly depressing demand andprices of assets at the time they want to sell these assets And they mustmanage operational riskmdashfailures in control systems or people that cause
19 Another example of asymmetric information Both risk and leverage are difficult foroutsiders to assess without full timely disclosure
20 A longer discussion of these issues can be found in Managing Global Finance in IMF(1999c)
Institute for International Economics | httpwwwiiecom
100 WORLD CAPITAL MARKETS
financial loss or damage reputations Operational risk devastated BaringsBank in 1995
Financial institutions practice risk management to measure all theserisks the potential damage to their investment positions and ultimatelythe chance of becoming insolvent VAR (value at risk) risk models mea-sure subject to certain assumptions the amount of the firmrsquos capital thatis exposed in each period For example the VAR model might say thatin a 3-standard-deviation worst case (a case that is not supposed to hap-pen more than 1 percent of the time) the firm will loose 25 percent of itscapital during the next year
VAR models are widely used but like all models they have weak-nesses They rely on past values to estimate key variables in financialmarkets past values are not always good predictors of future risks More-over rising volatility and higher loss correlation among different assetclasses in a portfolio will cause all banks using these models to reducetheir exposures at the same time by switching to less volatile and lesscorrelated assets such as US Treasury bills (Persaud 2000)
Newer risk models entail stress testing and scenario analysis Scenarioanalysis envisages possible adverse changes one at a time that mightaffect the investment portfolio Stress testing estimates potential losseswhen several individual risk factors simultaneously move against thefirm but it too uses historical probabilities
Financial Volatility
21 For example derivative markets usually rely on underlying securities markets thatproduce continuous prices When these markets are interrupted financial shocks cantrigger a cascade of margin calls and sell orders that move prices very sharply
22 See IIF (1999a)
The combination of trading activity and modern risk management lie atthe root of financial volatility When risks increase banks must eitherraise more capital to cover the greater risk or reduce their exposure bycutting loan exposure by selling securities or by undertaking new de-rivative trades Raising more capital is time-consuming and in a crisisvery expensive because bank shares are depressed So banks look to theother alternatives If the bank can reduce lending it need not book aloss But most banks use the same VAR models and as indicated abovethese models will encourage them to reduce their outstanding loans atthe same time actually magnifying loan volatility
If banks attempt to reduce their exposure to risk by selling securitiesor undertaking new derivative trades they may trigger large priceshocks because of limited and shrinking market liquidity21 The liquid-ity problem is compounded when a small number of large institu-tions hold the same positions22 Take your pick loan volatility or price
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 101
volatility As two experts have observed (Folkerts-Landau and Garber1998)
[V]olatility even in one country will automatically generate an upward re-estimate of credit and market risk in a correlated country triggering automaticmargin calls and tightening of credit lines Thus apparently bizarre opera-tions that connect otherwise disconnected securities markets are not the re-sponses of panicked green screen traders arbitrarily driving economies from agood to a bad equilibrium Rather they work with relentless predictability andunder the seal of approval of supervisors in the main financial centers
23 See Ferguson (1999)
24 As Gerald Corrigan (1982) put the matter ldquoBanks are specialrdquo Corrigan (2000) reit-erated this view even after all the changes of the past two decades Unlike other institu-tions banks offer on-demand transactions are a backup liquidity source for other insti-tutions and serve as a ldquotransmission beltrdquo for monetary policy
These changes in the banking environment accentuate an existing anomalyThe anomaly is that banks even as they grow larger and increasinglyengage in more risky and complex transactions are perceived to enjoyimplicit and explicit public guarantees
The guarantees grow out of an incentive problem inherent in bankingasymmetric information which we mentioned above Depositors know lessabout a bankrsquos management and the quality of its balance sheet than doits managers and shareholders Thus in times of uncertainty or adver-sity bank depositorsmdashuncertain whether they will have access to theirdepositsmdashare prone to bank runs This prospect has in turn compelledgovernments to treat banks differently than other firms because a bankthat fails can disrupt the rest of the economy24
To prevent such crises governments have entered into quid pro quoarrangements with banks Governments provide them both with an im-plicit safety net in the form of an unstated promise by the central bankto act as a lender of last resort in a liquidity crisis and an explicit safetynet in the form of a public deposit insurance fund to reassure depositorsIn return the banks submit to closer government oversight and regu-lation of their activities than is usual for industries in the private sector
The ldquoinsurancerdquo provided by the public safety net contributes to an-other incentive problem moral hazard Banks acquire greater tastes forrisk and face less market discipline than other firms The explicit depositinsurance safety nets actually have or are perceived to have blanketcoverage that extends beyond the retail depositors (households and small
One of the lessons of the 1997-98 crisis must surely be that market par-ticipants and their regulatory supervisors relied too heavily on quantita-tive tools and insufficiently on judgment23
The Anomaly of Modern Banking
Institute for International Economics | httpwwwiiecom
102 WORLD CAPITAL MARKETS
businesses) for which they were originally intended The implicit centralbank safety nets extend in a crisis to nearly all depositors and banksThus banks are both viewed and behave as if they will be bailed out ifthey get into trouble
The existence of a public safety net raises a perennial question Dobanks have an unfair advantage over other financial institutions becauseof the subsidy provided by the safety net This question was at the heartof intensive study and debate in the United States leading up to thepassage in November 1999 of the Financial Services Modernization Act(also known as the Gramm-Leach-Bliley Act) The size of the gross sub-sidy is difficult to estimate despite determined research efforts Somesuggest it is well under 100 basis points and is at least partly offset bythe direct costs of deposit insurance premiums interest payments on bondsissued by the Financing Corporation25 reserve requirements regulatoryexpenses and operational costs associated with collecting deposits26 Con-versely Kwast and Passmore (2000) suggest that banks can expand theirscope far beyond the levels that other financial institutions could reachwith the same equity base but without the public safety net
A related concern in the US debate is whether allowing banks to ex-pand their activities into securities and insurance will ultimately extendthe safety net and add to the subsidy The Financial Services Moderniza-tion Act deals with this issue by maintaining a legal separation betweenbanks and the rest of the banking organization known as large com-plex banking organizations (LCBOs) They must engage in most securi-ties activities and insurance underwriting through separately capitalizedinvestment bank subsidiaries or holding company affiliates This act canbe said to have merely brought US banking laws closer to those of mostother industrial countries (Barth Brumbaugh and Wilcox 2000 BarthNolle and Rice 2000) If the fire wall is well-maintained and stoutly de-fended the safety net will neither expand in practice nor become a sourceof comfort to noncommercial bank subsidiaries of LCBOs
The quid pro quo exacted by governments to offset the subsidy iscloser public-sector monitoring of banksrsquo activities through prudentialsupervision The effectiveness of this closer official scrutinymdashand closermarket monitoringmdashare the subjects of the next section
25 The Financing Corporation was created by Congress in 1987 to sell bonds to raisefunds to help resolve the savings and loan crisis
26 See Levonian and Furlong (1995) Jones and Kolatch (1999) Shull and White (1998)and Whalen (1999a 1999b)
Are G-10 bank supervisors adequately responding In this section we firstassess the case for and compare the structures of prudential supervisory
Prudential Supervision
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 103
systems both within and among the G-10 economies plus Spain andconsider whether these offset the subsidy provided by the public safetynet Despite offsetting regulation and supervision implicit and explicitguarantees by G-10 governments to their banks are still a source of bank-ing instability in the emerging-market economies
National Systems for Prudential Supervision
Governments use prudential supervision to reduce the moral hazard andadverse selection created by their own safety nets Supervisors establishregulations and monitor compliance to limit risk taking and ensure thesafety and soundness of the banking system In a thoughtful analysis ofthe case for prudential supervision Frederic Mishkin (2000) identifiesthe main forms that supervision can take including the tasks of grantingbanking charters and licenses establishing capital requirements settingdeposit insurance premiums and defining disclosure requirements as wellas carrying out bank examinations Bank examiners gather informationfrom banks and evaluate whether they are following the regulatorsrsquo rulesin cases of weakness they are empowered to change banksrsquo behaviorand close them if necessary
Supervisors also may restrict competition define the activities in whichbanks may engage and restrict their asset holdings and separate banksand other financial (or nonfinancial) activities During the past two de-cades the barriers separating commercial banks investment banks in-surance firms and securities firms have been all but eliminated (tableB1) Deregulation has stimulated competitive forces that drive diversifi-cation and consolidation of the financial industry nowhere faster than inthe United States
The Financial Services Modernization Act of 1999 confirmed this trendIt eliminated restrictions dating back to the Glass Steagall Act of 1933which once prevented banking insurance and securities firms fromentering each otherrsquos businesses (Barth Brumbaugh and Wilcox 2000)Cross-pillar mergers among banks insurance and securities firms arewell under way to form giant financial holding companies The 1999merger between Citibank (banking) and Travelers (insurance) created themodel for megafinance and confirmed new challenges for supervisors
Mishkin (2000) notes the corresponding evolution in US supervisionfrom an emphasis on rules-based regulation (detailed rules for opera-tional behavior and the quality of line items in the balance sheet) to anapproach that stresses the soundness of bank management practices es-pecially risk management
Appendix B outlines the systems of financial supervision now in theplace in the G-10 countries plus Spain Some systems like the UK andCanadian approach are models of simplicitymdashorganized to keep pacewith the spreading reach of financial conglomerates Other systems like
Institute for International Economics | httpwwwiiecom
104 WORLD CAPITAL MARKETS
the US and French approaches show traces of the bureaucratic divisionsthat made sense in an era when banking securities and insurance weresharply separated
The US Model
27 See Meyer (1999a)
28 Canada has a similar degree of simplification with the exception that securities firmsare still regulated by provincial authorities
29 See Pratti and Schinasi (1999 67)
30 The agents are the bank regulators and the principals are the taxpayers Agents maypursue their own interests including bureaucratic survival and postgovernment employ-ment opportunities rather than the national interest in banking safety and soundness
The US model of financial regulation delineated in the Financial Ser-vices Modernization Act of 1999 blends functional and umbrella super-vision Bank and thrift regulators oversee depository institutions Newnonbank activities are subject to both functional regulation (eg by theSecurities and Exchange Commission and state insurance examiners) andumbrella supervision (of financial holding companies) by the FederalReserve27
The UK Model
Another supervisory model exists in the United Kingdom as well as inAustralia Canada and Switzerland28 In this model banking supervisionis separated from the monetary policy function The regulatory structureis considerably simplified by relying on a consolidated financial regula-tor separate from the central bank for both banking and nonbankingactivities The remaining question answered differently depending on thecountry is the extent to which the regulator relies on home-country sur-veillance of banks and conglomerates that have a local presence
Regulatory Models Compared
Appendix B provides more detail on the differences in these modelsGerman simplicity contrasts with French complexity In France the bankingcommission is chaired by the governor of the central bank and includesrepresentatives from the Treasury The commission supervises compli-ance with regulations but the central bank inspects banks on behalf ofthe commission29 In countries such as the United States and France withmultiple supervisors and crossover functions internal coordination is criticalAt the same time multiple agencies create regulatory competition Wheneach agency knows what the other is doing transparency within gov-ernment circles can help to limit principal-agent problems of regulation30
The discussion as to where in the public bureaucracy financial super-
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 105
vision should be placed goes back many years Peek Rosengren andTootell (1999) argue that a synergy exists between monetary policy andprudential supervision because information gained in the course of super-vision can increase the accuracy of macroeconomic forecasts A twist tothis argument is that the information on the state of financial institutionsavailable to the central bank as supervisor can facilitate its role as lenderof last resort Conversely there is the concern that a supervisory rolewill compromise the central bankrsquos independence of action with respectto its core mandatemdashmaintaining price stability As these arguments haveplayed out financial supervision has generally been shared between centralbanks and other regulators or placed entirely in the hands of an inde-pendent regulator However in Italy the Netherlands and Spain cen-tral banks are the sole banking supervisor
Goodhart (1995) examined the arguments and evidence for each modeland concluded that there were no overwhelming arguments or evidencefor one or the other31 Going forward a key problem for any financialsupervisory system is dealing with (and closing as necessary) weak banksIf both central banks and other regulators have this responsibility closecoordination between them is critical Another problem is large conglom-erate banks LCBOs Although they are less likely to fail because of thediversification of their assets and liabilities they are more likely to berescued They are also more likely to be multinational enterprises withinternational implications Goodhart observes that regulation of theseentities might be put in the hands of the central bank because it is lessamenable to political pressures In any event the complexity of LCBOoperations suggests that greater supervisory rigor is necessary
The US Congress was persuaded that broad oversight would help containthe moral hazard problem and accordingly gave the Federal Reservethe role of umbrella supervisor with the understanding that the Fed willscrutinize depository activity more intensely than nonbank financial ac-tivities Under this approach LCBOs such as Citigroup are subject tomuch closer monitoring than smaller and simpler institutions32 The USregulatory model requires enormous cooperation between the Fed otherbank supervisors and the functional regulators for insurance and securi-ties but it also benefits from regulatory competition
31 National systems of supervision are path dependent they are determined by the struc-ture of financial institutions and history in each country If Goodhart (1995) is right out-comes are not materially better or worse with one model of supervision rather than another
32 See Ferguson (1999)
Public Safety Nets
One of prudential supervisorsrsquo biggest challenges is to reduce moral hazardFor many years commercial banks engaged in communal self-insurance
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106 WORLD CAPITAL MARKETS
to deal with crises They formed voluntary groups that agreed to rescuetroubled members As financial markets evolved and competition inten-sified banks were no longer willing to play this role Private-sector in-surance is one alternative but moral hazard and adverse selection wouldappear to prevent it from happening Public safety nets have developedbecause of the low probability and high cost of potential bank runs Aclear trade-off is involved The effectiveness of insurance in preventingbank runs is greater the more comprehensive the coverage But the morecomprehensive the coverage the greater the moral hazardmdashbank man-agers bank directors investors and depositors all take on greater risksin the belief that the safety net will protect them against losses
All G-10 countries have compulsory public safety nets for banks (table29) Deposit insurance agencies are officially organized in Canada theNetherlands Sweden Switzerland and the United States organized bythe industry in France Germany Italy and the United Kingdom andjointly organized by the public and private sectors in Belgium Japanand Spain
How well do G-10 governments offset the subsidy provided by thepublic safety net This is a question on which there is substantial debateAs banking organizations have become more complex the challengesthat supervisors face have become more difficult One challenge is toalign the incentives facing bank managers and shareholders with thoseof depositors Another is the principal-agent problem in supervision Wehave discussed the incentive structures for financial institutions but wehave said little about the incentives for supervisors themselves and thedistortions they can generate in the financial system
In one of the many studies of the US savings and loan crisis of the1980s Kane (1989) documented both problems He described managersusing cosmetic approaches to disguise the magnitude of insolvency regulatorspracticing forbearance even though they knew of the deteriorating riskprofiles of the institutions for which they were responsible and legisla-tors increasing deposit insurance without regard for any offsetting changesin supervision A subsequent overhaul of the legislative framework forthe Federal Deposit Insurance Corporation (FDIC) known as the FDICImprovement Act of 1991 (FDICIA) aimed to introduce a clearer incen-tive structure for both regulators and regulated institutions
The changes introduced by this US legislation are worth discussionwith respect to the other G-10 countries as well First FDICIA created astronger signal to management and investors by targeting deposit insur-ance at small depositors only and by risk-weighting the deposit insur-ance premiums paid by banks to reflect their capital adequacy and bankexaminer ratings Among the G-10 countries rated in table 210 depositinsurance premiums vary considerablymdashbut it is not clear that the dif-ferences have much to do with risk-weighting Most G-10 countries em-ploy funding formulas based for example on the total domestic deposit
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Table 29 Deposit insurance schemes in the G-10 countries Explicit safety net
Coverage limit(dollar Foreign
equivalent currency Interbank Source Bankrsquos Contingency fundingDate Membership Co- at end of deposit deposit of premium from banks
Country established managementa insuranceb July 1998)c covered covered Fundingd funding costs or governments
United 1982 Compulsory Yes Larger of 90 No No Unfunded Banks only Callable (subject Parliament may increase Kingdom private percent co- to maximum the maximum payable
insurance to 03 percent of pound125 million advance 33000 total deposits) facility with Bank of
England
United 1934 Compulsory No 100000 Yes Yes Funded Banks and Up to 027 Borrowing up to $3 States official government percent total billion from US Treasury
domestic deposits
Japan 1971 Compulsory No 71000 but No No Funded Banks and 0084 percent of Borrowing up to yen500bn joint in full until government insured deposits from Bank of Japan
year 2000 subject to Ministry of Finance approval
Canada 1967 Compulsory No 40800 No Yes Funded Banks and 033 percent of Borrowing up to C$6 official government insured deposits billion authorized further
(maximum) borrowing subject to parliamentary approval
Germany 1966 Compulsory Yes 90 percent Yes No Funded Banks only 003 percent of Annual levy may be private coinsurance deposits doubled
to 22000
Italy 1987 Compulsory Yes 125000 Yes No Unfunded Banks and Callable Two options defer private government (maximum of payment or diminish
1 percent of compensation to be paid total deposits)
(table continues next page)
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Table 29 Deposit insurance schemes in the G-10 countries Explicit safety net (continued )
Coverage limit(dollar Foreign
equivalent currency Interbank Source Bankrsquos Contingency fundingDate Membership Co- at end of deposit deposit of premium from banks
Country established managementa insuranceb July 1998)c covered covered Fundingd funding costs or governments
Netherlands 1979 Compulsory No 22000 Yes No Unfunded Banks and On demand Government backing official government maximum of subject to parliamentary
5 percent of own approval funds
France 1980 Compulsory No 65400 No No Unfunded Banks only Callable (on Extra calls up to FFr1000 private demand calls million can be made in
up to FFr200 a 5-year period million)
Switzerland 1984 Voluntary No 19700 No No Unfunded Banks only Callable (on Underwritten by member official demand) banks
Sweden 1996 Compulsory No 31400 Yes No Funded Banks and 05 percent of Full emergency coverage official government deposits while replacing it with a
limited system after the emergency
Belgium 1974 Compulsory No 16600 No No Funded Banks and Callable 002 None insurance limited joint 22000 in government percent of to assets in fund
year 2000 deposits from clients
Spain 1977 Compulsory No 16439 Yes No Funded Banks and 02 percent of Government backing joint government deposits through the Banco de
(maximum) Espantildea subject to approval by royal decree
a Bank membership in the fund can be either compulsory or voluntary and the management of the fund can be official and official and private joint or privateb Coinsurance refers to the situation where depositors face a deductible against their insured fundsc Coverage limit refers to the explicit amount the authorities promise to insured Funded scheme means that it is funded ex ante unfunded otherwise
Sources Goodhart (1995) Demirguccedil-Kunt and Detragiache (2000) Demirguccedil-Kunt and Sabaci (2000)
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 109
base Explicit safety net protection also varies but only Canada focuseson the protected class33 All G-10 countries specify a limit on depositorprotection Under FDICIA the insurance fund is prohibited from pro-tecting uninsured depositors or creditors at a failed bank although adiscretionary system-wide override is provided for exceptional circum-stancesmdashbut with stringent requirements for consultation and account-ability Other G-10 countries allow for contingency funding from the publicpurse alongside unwritten lender-of-last-resort support Among large banksa significant and growing portion of deposit liabilities including foreigncurrency and interbank deposits are uninsuredmdashbut depositors assumethey will be protected in a crisis
FDICIA also made some significant qualitative changes to address theprincipal-agent problem by penalizing weak banks and rewarding strongbanks For example banks whose capital declined faced progressivelytougher regulatory sanctions that for example required them to elimi-nate dividends restrict their lending and change their managementsRegulators have also been forced to take prompt corrective action (toreduce the practice of regulatory forbearance in hopes that a bankrsquos for-tunes might improve)34 Unfortunately comparative qualitative assess-ments across the G-10 are difficult to make due to lack of information35
This discussion highlights the complexity of evaluating the extent towhich prudential supervision and market discipline reduce the moralhazard associated with G-10 safety nets Our argument is that publicsafety nets in the G-10 can be linked to banking instability in other coun-tries specifically in the emerging-market economies that have attractedG-10 cross-border bank lending This lending is a leading source of vola-tility in capital flows the large financial institutions many of which arecomplex banking organizations are based in and regulated by authori-ties in the G-10 economies These two features of the international finan-cial system are closely related although it is not possible to test thisrelationship econometrically
Two World Bank studies however indicate a basis for concern Onestudy is a cross-country econometric analysis of the relationship betweenbank stability and deposit insurance (Demirguccedil-Kunt and Detragiache2000) which found a negative relationship Their estimated model forbanking crises in a sample of 61 countries (both industrial and develop-ing) suggests that explicit deposit insurance raises the probability of acrisis by at least 30 percent36 Crises are especially likely in countries
33 Japanrsquos legislation says it does but recent experience shows this is not the case34 See Goldstein (1997) for a summary of the changes35 See Barth Nolle and Rice (2000) for a beginning in this area36 Demirguccedil-Kunt and and Detragiache (2000 table 1) report a logit coefficient of 0696with a standard error of 0397 (the coefficient is significant at the 8 percent threshold)This suggests that the ldquotruerdquo coefficient could well be as small as 030 (the reportedvalue minus the standard error)
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110 WORLD CAPITAL MARKETS
with immature financial supervisory systems (and not in the G-10) buttheir analysis does underscore the view that deposit insurance weakensmarket discipline37
An earlier World Bank analysis established similar results One wasthat market discipline is undermined by deposit insurance schemes an-other was that illiquid banks are forced to pay more for their funds un-less a generous deposit insurance scheme is in place (Demirguccedil-Kuntand Huizinga 1999) This econometric study also provides clear-cut evi-dence that depositor monitoring of banks declines with the existence ofdeposit insurance schemes At the heart of the problem is the questionof whether deposit insurance is accompanied by increased governmentmonitoring
This evidence and the weight of other arguments suggests that moralhazard is still an issue in the G-10 countries Consider the ongoing de-bate about instilling greater market discipline on risk taking by banksAt one extreme is the perennial proposal to do away with safety netsleaving markets to monitor the players and to force adjustments but toprotect small savers by creating ldquonarrow banksrdquo such as postal savingsystems that are allowed to invest these savings only in risk-free gov-ernment securities Whatever the merits of narrow banking this solutionis too extreme to be politically feasible
A moderate alternative is to force more disclosure by financial institu-tions to facilitate market monitoring But transparency has its own prob-lems Persaud (2000) argues that financial markets cannot reliably discernsustainable from unsustainable positions in the short term This uncer-tainty causes banks to ldquoherdrdquo behind market leaders to exploit theirsupposedly superior information ldquoThe more herding investors and bankersknow about what each other is up to the [more] unstable markets maybecomerdquo The implication is that greater transparency in the marketplaceby itself will not solve the problemmdashand in the short term more informa-tion may exacerbate herding Further supervisory steps (discussed in thenext chapter) are required
Yet another proposal is to promote private-sector involvement in bankmonitoring through market-based alternatives such as Calomirisrsquos sub-ordinated debt proposal (Calomiris 1997 Federal Reserve Board 1999)Banks could be required to issue and maintain a minimum amount of
37 Other findings in the Demirguccedil-Kunt and Detragiache (2000) study include thesepropositions The impact of deposit insurance on bank stability tends to be stronger themore extensive is the coverage offered to depositors when the scheme is funded andwhere the scheme is run by the government rather than by the private sector Con-versely deposit insurance is detrimental to bank stability where bank interest rates havebeen deregulated and where the institutional environment is weak Additional findingson deposit insurance are reported from a recent World Bank conference (8-9 June 2000httpwwwworldbankorgresearchinterestconfsupcomingdeposit_insurancehomehtm)Also see Smalhout (2001)
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 111
subordinated debt (eg uninsured certificates of deposit) to finance asmall fraction (such as 2 percent) of their total nonreserve assets Thesubordinated debt would be allowed to earn a set yield no more than 50basis points over the risk-free yield on government treasury bills Thisrule would supposedly force banks to operate in a safe manner Other-wise subordinated debt holders would redeem their uninsured certifi-cates of deposit and equity investors would sell their bank shares Despiteits practical problems the beauty of the subordinated debt requirementis that it enlists market incentives to push banks to avoid excessive port-folio risk38
The thrust of these proposals is very relevant to the arguments in ourstudy Even in the G-10 countries government monitoring by itself hasnot eliminated moral hazard among banks More work is needed to in-troduce market monitoring and to improve the incentive structures bothfor financial institutions and their supervisors We return to this issuewith our recommendations in the next chapter
38 In late 1996 Argentina began requiring its banks to finance 2 percent of total depos-its in the form of subordinated debt but without a maximum yield provision TheArgentine authorities expect that market discipline will act in concert with the publicsafety net One obvious problem with the subordinated debt proposal is that banks mayencourage some of their customers to buy the subordinated debt
Portfolio Institutions Tomorrowrsquos Problem
Before proceeding to the issues of international supervision we flag an-other potential problem for national regulators The big asset managersprofiled in tables 24 and 26 answer to diverse groups of pensionersshareholders and policyholders They allocate funds across a number ofcountries to diversify their risks They hold liquid assets that can be tradedand they have a higher proportion of long-term assets than banks Eco-nomic shocks can be absorbed through price changes and their effectsspread across time and markets Thus when conditions change in a par-ticular market they are more likely to ride out the storm than to flee Inother words they have less incentive than banks to pull their invest-ments in the face of adversity In the 1990s most large asset managersestablished a record of ldquoriding out the stormrdquo rather than ldquorunning withthe windrdquo although as we saw in chapter 1 instances of running withthe wind were detected in some portfolios As we write these insti-tutions have a good record overall in the emerging markets so whyworry
The Russian crisis and the near-collapse of LTCM previewed the dan-gers that may await future portfolio managers and G-10 financial minis-ters We have presented evidence indicating a systemic bias toward bank
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112 WORLD CAPITAL MARKETS
lending and debt finance to emerging markets and we have argued forsubstitution toward equity finance and direct investment39
That is not the end of the story We noted in the previous chapterthat institutional investors can become momentum investors selling in adownturn As more portfolio capital is invested in emerging marketssome players may adopt the high-risk high-leverage strategies of themost aggressive hedge funds Indeed the data in box 11 show that G-10portfolio investors held somewhat more long-term debt (more than $500billion) than equity (less than $400 billion) in emerging markets at theend of 1997 Long-term debt is an ideal vehicle for high-risk high-leveragestrategies These strategies practiced on a large scale could compound afuture crisis harming emerging markets A big enough crisis could inturn pressure G-10 central banks and finance ministers to arrange bail-out plans Instead of shrinking as a systemic financial problem moralhazard could increase
National securities regulators are the first line of defense against thisscenario They play a critical role in the safe evolution of capital mar-kets But regulators today are mandated to approve the issuance of newsecurities and to monitor the continuing disclosure of material informa-tion by issuers They are far less concerned with or empowered to monitorthe behavior of the increasingly large wealth-management firms that arethe major purchasers (and therefore resellers) of these securities
Within their mandates the goals of national securities regulators (table210 and appendix B) are similar to the concerns of bank regulators withsystem safety and soundness Their focus is also on the incentive sys-tems for management and boards of directors and on disclosure by cor-porations that issue marketable securities such as shares bonds andasset-backed securities 40 Issuers of securities possess greater knowledgeabout the quality of these assets than do the purchasers hence investorprotection is a key concern of regulators Moreover market disciplineworks best when markets know what is happening Well-functioning corpora-tions are key agents of wealth creation and social progress Underperform-ing corporations waste resources During recessions bad corporationsget into bad trouble often with severe social consequences Inadequateincentives for managers and inadequate accountability for boards andmanagers thus have negative externalities Regulators play a vital role inexposing weakness so that market disciplines come to bear sooner ratherthan later
Regulatory emphasis is constantly shifting as financial markets evolveand as the macroeconomic environment changes Regulators try to balance
39 See Rogoff (1999) Also see Berlin (2000) for a perspective on the limited role thatbanks play as share owners
40 See Habib and Ljungqvist (2000) for recent empirical analysis showing that corporateshare market values are higher when corporate executives have a larger ownership stake
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Table 210 Financial-sector regulation G-10 countries 2000
Financial institutions and their supervisors
Country and supervisory structure Retail banking Wholesale banking Securities Insurance
Financial conglomeratesFinancial Services Authority (FSA) = umbrella supervisor
United Kingdom FSA FSA FSA FSA
Treasury bull Commercial banks bull Investment funds (Securities and (Insurance Directorate(Securities and Investments Board) bull Unit trust groups Futures Authority) of the Treasury)
Bank of bull Building societies bull Pension funds England (Building Societies Commission) bull Merchant banks
bull Friendly societies bull Clearing houses bull Primary issuers bull Insurance FSA (Friendly Societies Commission) bull Venture capital of securities companies
bull Pensions and life insurance etc bull Stock exchanges bull Insurance brokers(Personal Investment Authority) bull Stockbrokers
Financial holding companiesFederal Reserve (FR) = umbrella supervisor
United States bull National banks(OCC) Securities and Regulated by
Treasury OCC bull State banks Federal Reserve Exchange Commission StatesMembers (FR)
OTS Nonmembers (FDIC) bull Investment banks bull Primary issuers of bull Insurance companies FR bull Cooperative banks (FDICFR) bull Finance companies securities bull Insurance brokers FDIC bull Insured industrial banks (FDIC) bull Stock exchanges
bull Thrift holding companies (OTS) bull Stockbrokers SEC bull Savings banks (OTSFDICFR) bull Investment advisors
bull Savings and loan associations bull Mutual funds(OTS) bull Public utility holding
bull Edge Act corporations (FR) companies
(table continues next page)
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Table 210 Financial-sector regulation G-10 countries 2000 (continued )
Financial institutions and their supervisors
Country and supervisory structure Retail banking Wholesale banking Securities Insurance
Financial holding companies Japan Financial Supervisory Authority (FSA) = umbrella supervisor
Prime FSA FSA FSA FSA ministerrsquos Ministry of office Finance (Securities and Exchange
Surveillance Commission) FRC Bureau of Financial bull City banks bull Investment banks bull Primary issuers of bull Insurance companies FSA Regulation bull Regional banks bull Asset managers securities bull Insurance brokers
bull Trust banks bull Stock exchanges SESC bull Long-term credit banks bull Stockbrokers
bull Pension funds
Financial holding companiesOffice of the Superintendent of Financial Institutions (OSFI) = umbrella supervisor
Canada Regulated by OSFI OSFI provinces OSFI
Department of Financebull Banks bull Cooperative credit bull Primary issuers of bull Insurance companies
(previously Office of the Inspector associations securities (previously Depart- OSFI General of the Banks) bull Fraternal benefit bull Stock exchanges ment of Insurance) Bank of bull Trust and loan companies society bull Stockbrokers bull Insurance brokers Canada bull Pension funds bull Asset managers
(previously Depart- CDIC ment of Insurance)
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Financial institutions and their supervisors
Country and supervisory structure Retail banking Wholesale banking Securities Insurance
Germany Financial holding groupsFederal Banking Supervisory Office (FBSO) = umbrella supervisor
Ministry of Finance FBSO BSO FSSO FISO
Bundesbankbull Universal banks bull Other financial bull Primary issuers of bull Insurance companies
Federal Banking bull Savings banks institutions (eg securities bull Insurance brokers Supervisory Office bull Securities banks management foreign bull Stock exchanges
currency dealings) bull Stockbrokers Federal Securities bull Financial enterprises bull Asset managers Supervisory Office (eg leasing bull Pension funds
organizations Federal Insurance credit card companies Supervisory Office investment advisors)
Italy Bank foundationsMinistry of Finance = umbrella supervisor
Ministry of Finance Bank of Italy Bank of Italy Consob ISVAP
Bank of Italy bull Commerical banks bull Asset managers bull Primary issuers of bull Insurance companies Consob bull Savings bank bull Open-end investment securities bull Insurance brokers
bull Securities banks companies (SICAVs) bull Stock exchangesbull Stockbrokers
ISVAP
(table continues next page)
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Table 210 Financial-sector regulation G-10 countries 2000 (continued )
Financial institutions and their supervisors
Country and supervisory structure Retail banking Wholesale banking Securities Insurance
The Netherlands Financial conglomeratesCouncil of Financial Supervisors = umbrella supervisor
Securities Board Securities Board Netherlandsche Netherlands Bank Netherlandsche Bank of the Netherlands Insurance Board Bank Insurance bull Credit institutions (universal banks bull Investment institutions bull Stock exchanges bull Insurance companies Board cooperative banks security credit (securities issuing bull Stockbrokers bull Insurance brokers
institutions mortgage banks) and tradingmdashprimary The Council of Financial and secondary Supervisors markets)
France Commission des Commission de Operations des Controcircle des
Banking and Banking Commission Bourse Assurances Financial Regulatory bull Ensuring that credit institutions (and investment firms since bull Primary issuers of bull Insurance companies Ministry for Committee the Financial Activity Modernization Act of 1996) comply securities bull Insurance brokers Economic with laws and regulations bull Stock exchanges Affairs and bull Execute instructions regarding all off-site monitoring and bull Stockbrokers Finance Credit on-site supervision Institutions and Banking and Financial Regulatory Committee Investment bull Formulates general regulations for credit institutions and investment firms Committee (capital adequacy requirements accounting rules etc) Bank of France Credit Institutions and Investment Committee Banking bull Authorizes and examines financial institutions except for those within the Commission competence of the Banking Commission
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117
Financial institutions and their supervisors
Country and supervisory structure Retail banking Wholesale banking Securities Insurance
Switzerland Large banking groupSwiss Federal Banking Commission (SFBC) = umbrella supervisor
Swiss National Bank Federal Office of
SFBC SFBC SFBC Private Insurance Swiss Federal Banking Commission bull Universal banks bull Investment banks bull Primary issuers of bull Insurance companies
bull Savings banks bull Asset management securities bull Insurance brokerscompanies bull Stock exchanges
Private audit Federal bull Investment funds bull Stockbrokers firms Office of bull Mortgage bond authorized by Private business SFBC Insurance
Sweden Financial holding company groupsFinancial Supervisory Authority = umbrella supervisor
Ministry of Finance Credit Market Securities Market Insurance Market
Credit Market Department Department Department Department
Financial bull Commercial banks bull Investment funds bull Primary issuers of bull Insurance companies Riksbank Supervisory bull Savings banks securities bull Insurance brokers Authority bull Friendly societies bull Stock exchanges
bull Stockbrokers
(table continues next page)
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Table 210 Financial-sector regulation G-10 countries 2000 (continued )
Financial institutions and their supervisors
Country and supervisory structure Retail banking Wholesale banking Securities Insurance
Belgium Bank holding companiesBanking and Finance Commission = umbrella supervisor
Bank of Belgium Banking Banking
Banking and Finance and Finance Insurance Controland Finance Commission Commission Commission Office
Banking and Insurance Finance Control bull Commercial banks bull Asset management bull Primary issuers of bull Insurance companies Commission Office bull Savings banks firms securities bull Insurance brokers
bull Securities banks bull Investment funds bull Stock exchanges bull Mortgage companiesbull Stockbrokers bull Pension funds
Securities Regulation Fund Securities Regulation Fund
bull Other investment firms and credit institutions(institutions participating in regulated off-exchangemarket in strips and Treasury certificates)
Bank holding companies Spain Banco de Espantildea = umbrella supervisor
Banco de Espantildea Comision Nacional del Mercado de Directorate General
Banco de Espantildea Valores (CNMV) Insurance
bull All credit institutions (commercial banks savings banks credit bull Primary issuers of (Ministry of Economy Ministry of cooperatives official credit institutions finance factoring and securities and Finance) Economy and CNMV leasing companies mortgage-loan companies etc) bull Stock exchanges bull Insurance companies Finance bull Interbank foreign exchange and book-entry public debt bull Stockbrokers bull Pension funds
markets bull Venture capital(companies and funds)
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119
Financial institutions and their supervisors
Country and supervisory structure Banking Securities Insurance
Banking Advisory High Level Securities Supervisors Committee (BAC) Committee (HLSS) Insurance Committee (IC)
Supranational (EU) bull Formulates standards for prudential bull Coordination of securities market bull Formulates standards forsupervision supervision prudential supervision
BACICHLSS Banking Supervision
Conglomerates Committee (BSC) Securities Contact Committee Regulation of prudential bull Systemic risk monitoring bull Regulation and implementation of supervision securities admission
International Association International International Organization of of Insurance Supervisors
Basel Committee Securities Commisison (IOSCO) (IAIS) Joint Forum Conglomerates Supervision bull Supervision and regulation best bull Supervision and regulation best bull Supervision and regulation amp regulation Best practices practices practices best practices
FSF Coordination across supervisors of various functions
Notes See appendix B for more information Boldface type indicates senior or oversight supervisor normal type indicates adjunct or front-line supervisorsolid line indicates direct responsbility to the senior-ranking authority dotted line indicates coordination in supervisory activities
(table continues next page)
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Table 210 Financial-sector regulation G-10 countries 2000 (continued )
Glossary of names United Kingdom FSA = Financial Services Authority United States FR = Federal Reserve OCC = Office of the Comptroller of theCurrency FDIC = Federal Deposit Insurance Corporation SEC = Securities and Exchange Commission OTS = Office of Thrift Supervision Japan FRC =Financial Reconstruction Commission FSA = Financial Services Agency SESC = Securities and Exchange Surveillance Commission Canada OSFI =Office of the Superintendent of Financial Institutions CDIC = Canada Deposit Insurance Corporation Germany FBSO = Federal Banking SupervisoryOffice FSSO = Federal Securities Supervisory Office FISO = Federal Insurance Supervisory Office BSO = Banking Supervisory Office Italy Consob =Commissione Nazionale per le Societa e la Borsa ISVAP = Instituto per la Vigilanza sulle assicurazioni private e di Interesse colletivo Switzerland SFBC= Swiss Federal Banking Commission Spain CNMV = The Comision Nacional del Mercado de Valores Supranational BAC = Banking Advisory CommitteeBSC = Banking Supervision Committee IC = Insurance Committee HLSS = High Level Securities Supervisors Committee International Dimension FSF =Financial Stability Forum IOSCO = International Organization of Securities Commission IAIS = International Association of Insurance Supervisors
Sources United Kingdom Bank of England httpwwwbankofenglandcouk Financial Services Authority httpwwwfsagovuk United States Board ofGovernors of Federal Reserve System httpwwwfederalreservegov Japan Bank of Japan httpwwwbojorjo Financial Reconstruction Commissionhttpwwwfsagojpfrcindexehtml Financial Services Agency httpwwwfsagojp Canada Bank of Canada httpwwwbank-banque-canadaca Office ofthe Superintendent of Financial Institutions httpwwwosfi-bsifgccaAndreEindexhtml Germany Deutsche Bundesbank httpwwwbundesbankde Fed-eral Banking Supervisory Office httpwwwbakredde Italy Banca drsquoitalia httpwwwbancaditaliait Commissione Nazionale per le Societa e la Borsahttpwwwconsobit Instituto per la Vigilanza sulle assicurazioni private e di Interesse colletivo httpwwwisvapit The Netherlands De NederlandscheBank httpwwwdnbnl France Banque de France httpwwwbanque-francefr Switzerland Schweizerische Nationalbank httpwwwsnbchindex3htmlSweden Sveriges Riksbank httpwwwriksbanksedefaultasp Belgium National Bank of Belgium httpwwwbnbbesgindexhtm Spain Banco de Espantildeahttpwwwbdees The Comision Nacional del Mercado de Valores httpwwwcnmves Supranational (EU) Institutional Arrangements for the Regulationand Supervision of the Financial Sector 2000 International Dimension Bank for International Settlement httpwwwbisorg International Organization ofSecurities Commissions httpwwwioscoorg International Association of Insurance Supervisors httpwwwiaisorg Financial Stability Forum httpwwwfsforumorg
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 121
the inflexibility of tight surveillance against the need to encourage in-novation and growth The US Securities and Exchange Commission isworried about aggressive accounting by firms and biased reports bysecurities analysts in an equity environment that prizes steadily higherquarterly earnings41 Japanese regulators are preoccupied with opaqueinterconnections between portfolio institutions banks and nonfinancialfirms through the keiretsu system Canadian regulators reeling from high-profile scandals of managers intentionally misleading investors are strengtheningmarket discipline through legal penalties aimed at managers and directorsof offending firms
When panic strikes a securities regulator cannot do much As the 1987stock market crash and the LTCM debacle in the fall of 1998 both dem-onstrated steep stock and bond price declines can create systemic risksIf severe enough the wealth effect of falling securities values and thefear of widespread insolvency can depress real activity Flooding thesystem with liquidity is a central bankerrsquos solutionmdashsomething a securi-ties regulator cannot do42 But just as financial supervisors can changethe incentive structure to discourage bankers from making risky loans ingood times so securities regulators can pay more attention to incentiveson the demand side when capital markets are strong
Prudential Supervision and InnovationmdashA Footnote
In concluding this discussion of prudential supervision in the G-10 anadditional point is worth noting National regulators face a persistenttrade-off between emphasizing financial system safety and soundnesswhile encouraging innovationmdashin spite of the added risks innovationbrings to financial markets Former US Treasury Secretary Lawrence Summers(2000 3) has argued by analogy
The jet airplane made airplane air travel more comfortable more efficient andmore safe though the accidents were more spectacular and for a time morenumerous after the jet was invented In the same way modern global financialmarkets carry with them enormous potential for benefit even if some of theaccidents are that much more spectacular As the right public policy response
41 The problem is illustrated by the divergence since mid-1998 between reported earn-ings by the Standard amp Poorrsquos (SampP) 500 and the after-tax profits of all corporations inthe national accounts Generally these two series move closely with one another Be-tween mid-1998 and mid-1999 SampP 500 reported that earnings increased by more than20 percent while after-tax profits of all corporations increased by less than 5 percent(Chase Bank US Economic and Policy Research US Weekly Prospects Chase SecuritiesWeekly Newsletter 5 June 2000 5)
42 For example the US Securities and Exchange Commission had no direct role in calmingmarkets in the 1987 or 1998 panics
Institute for International Economics | httpwwwiiecom
122 WORLD CAPITAL MARKETS
to the jet was longer runways better air-traffic control and better training forpilots and not the discouragement of rapid travel so the right public policyresponse to financial innovation is to assure a safe framework so that the ben-efits can be realized not to stifle the change
Accepting Summersrsquos analogy for the international financial system better-informed supervisors and investors are a necessary part of the financialsystem framework Supervisors require more timely information on therisk profiles resulting from positions taken by financial institutions Theyalso need a better understanding of risk-management systems Snapshotsof an institutionrsquos risk profile and risk-management procedures are nolonger adequate In a world where huge bets are quickly made (andpossibly lostmdashas with Barings Bank in 1995 and LTCM in 1998) super-visors must focus on the soundness of banking systems for evaluatingand managing risk on a daily basis Some progress has been made inaddressing these issues US banking examiners are extending their in-formation requirements in banking examinations and increasing theirinvolvement in large complex institutions43 More awareness is alsorequired of the fact that they are national organizations in a world ofcross-border capital flows To a much greater extent they need a multi-national reach International supervision and coordination among super-visors are the subject of the next section
Our analysis suggests that G-10 supervisors have unfinished businessBank supervisors need to start yesterday securities regulators can waituntil tomorrow One G-10 member acting alone cannot correct the biasIn good times the lending business will simply migrate to other G-10banks In bad times financial problems will not stop at the national bor-der A way has to be found to establish common international standardsfor the key financial players in order to prevent crises and to agree onapproaches for managing them The path has already been laid out Inthe wake of the bank failures of the past 25 years bank supervisors havetried to establish such standards They have done this without creating anew global institution
The essence of the international framework is decentralizationmdashglobalrules and design standards without global institutions that are perceivedto intrude on national sovereignty The awkward jargon for this frame-work is vertical subsidiaritymdashldquothink internationally act nationallyrdquo Theinternational thinking is done by a committee of regulators that meets
International SupervisionA Decentralized Framework
43 These issues are discussed in Ferguson (1999) and Meyer (2000a)
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 123
regularly at the Bank for International Settlements in Basel The commit-tee establishes principles and standards that are interpreted implementedand enforced by national authorities44 In this section we describe thesesupervisory efforts and their weaknesses We present our recommenda-tions for addressing these weaknesses in the next chapter
Basel I
The Basel Capital Accord of 1988 (Basel I)45 drew the lesson from thefinancial crises of the mid-1970s that more adequate capital levels in in-ternational banks would help reduce the systemic risk of bank failureThe primary goal of Basel I was capital adequacy other standards wereput in place not so much for their own virtue as to defend the primarygoal
Capital adequacy requirements were designed to ensure that individualinstitutions have the ability to absorb losses particularly credit lossesAccordingly a backup system of scoring credit risk was devised thatrequired large amounts of bank capital for some types of loans smalleramounts for others and zero for a select list of preferred assets Report-ing requirements were designed to disclose problems and ensure that atroubled bank would take timely steps to restore its capital base in thewake of a loss The Basel I framework worked tolerably well in limitingthe call on the public purse in the G-10 countriesmdashwith the notable ex-ceptions of France and Japan The framework failed to moderate riskybank lending to emerging markets however
Basel I was not developed with emerging markets in mind The origi-nal idea behind it was to develop a common supervisory approach tocross-border banking operations It grew out of political pressure fromUS lawmakers who were determined to require international banks op-erating in the United States to meet US banking standards Toward thisgoal in 1983 Congress passed the International Lending Supervisory ActUS and British banking authorities subsequently agreed on a commontarget the adoption of strict common capital-adequacy standards In 1988other G-10 governments agreed to go along voluntary acceptance ofthe standards throughout much of the rest of the world followed46 Therationale for the capital targets was two-fold The first was to requirebanks to hold sufficient amounts of capital (8 percent of risk-adjusted
44 The international committee of financial authorities agreed on a common definitionof banksrsquo tier-one or ldquocorerdquo capital national authorities defined tier-two capital in theirown manner which permitted greater variations in national working definitions andpractices
45 International Convergence of Capital Measurement and Capital Standards (BIS 1988)was prepared by the Basel Committee on Banking Supervision
46 See Reineke (1998)
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124 WORLD CAPITAL MARKETS
assets) to cushion losses on those assets The second was to dull theirappetites for risk banks with large capital bases would have more tolose if they failed and therefore would take fewer risks
Rapid change in financial markets soon revealed flaws in the Basel IAccord In a complex world with numerous sources of risk it focusedheavily on credit risk but overlooked other risks in a bankrsquos portfolioand the correlation between returns on different asset classes The Baselformula required banks to maintain a fixed amount of capital againsteach of its asset classes But the formula did not distinguish the riskinessof the borrower within each class As a result one large loan to a low-risk corporate borrower such as General Electric would require the sameamount of capital as 10 smaller transactions with high-risk borrowers
The system was also biased toward short-term loans Loans maturingin less than a year required a 20 percent risk weight whereas those ma-turing after more than a year required a 100 percent risk weight Inter-bank lending was particularly favored For example loans to banks inOECD countries required less capital than loans to private firms in thesame countries creating the anomaly that interbank loans to South Ko-rean banks required less capital than loans to General Electric47 Thisanomaly encouraged banks to shed high-quality assets if the Basel rulesrequired the allocation of more capital than banks thought they needed
Another weakness was that financial innovators quickly circumventedthe Accord Because short-term loans required less provisioning than long-term loans banks responded by securitizing their long-term debt port-folios and lending short-term against the collateral of the newly createdasset This allowed banks to circumvent the capital requirements gearedto the terms of the underlying debt At the same time the Basel I Accordfailed to encourage risk mitigation techniques such as credit derivativescollateral guarantees and on-balance-sheet netting the flip side of fi-nancial innovation Because off-balance-sheet products were not coveredby the Accord another anomaly appeared when Barings Bank collapsedin 1995 Barings met capital adequacy standards but collapsed becauseits systems for managing risk failed traders were allowed to speculatein futures contracts that did not appear on the balance sheet
Basel II
Work to overhaul Basel I began in 1995 and produced consultativepapers issued in June 1999 and January 200148 These papers have been
47 South Korean banks have had notoriously weak balance sheets because the practiceof ldquodirected lendingrdquo left them with many poor loans (in making these loans the bankswere expected to follow government objectives rather than creditworthiness criteria)
48 Basel Committee on Banking Supervision (1999 2001)
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 125
the subject of extensive consultation and revision as a result the newAccord is expected to be introduced in 200449 The Basel II frameworkhas three parts (pillars) revisions to Basel I minimum-capital require-ments supervisory review criteria and greater emphasis on market dis-cipline Broadly Basel II aims to maintain the level of capital in the sys-tem but achieve better alignment of banksrsquo capital with their risk pro-files and keep up with financial innovation
To align capital requirements with market realities (the first pillar)Basel II concentrates on the 100 or so largest banksmdashthe type of playerslisted in table 21mdashand on the holding-company parents of banking groups50
Capital requirements will differentiate between an increased number ofcredit groups or ldquorisk bucketsrdquo including claims on governments otherbanks corporations mortgage-backed securities and other asset-backedsecurities
Basel II originally proposed to use external ratings to set capital chargesfor a number of these credit risks Many banks objected arguing thatthey assess credit risk better than Standard amp Poorrsquos Moodyrsquos or FitchIBCA51 Basel II thus proposes two approaches to rating a standard ap-proach using external ratings and an ldquoadvancedrdquo approach that allowsselected banks to use their own internal rating systems To encouragethe development of rigorous internal control systems based on these in-ternal rating systems Basel II also proposes to levy capital charges foroperational risk (the risk of direct or indirect loss resulting from inad-equate or failed internal processes people and systems or from exter-nal events)
Some critics of this proposal dismiss it as an abrogation of the prin-ciple of external independent monitoring and as ldquodangerously naiumlverdquo52
But regulators argue that the new capital charge on operational risk shouldoffset this concern It is also far from clear how cross-national compari-sons of rating and internal risk-assessment systems will be made (Engelen2000) The development by the European Union of its own capital rulescould well complicate the international resolution of these issues Publicassurances by EU officials in January 2001 however indicated that theirmain concerns are to create a level playing field and avoid regulatoryarbitrage (Hargreaves 2001) There is also the significant problem ofthe procyclical character of risk weights When a crisis hits losses are
49 See Berry (2000) for an update in an interview with William J McDonough chair ofthe Basel Committee on Banking Supervision
50 For obvious reasons these proposals are addressed to large banks and simpler capi-tal standards are allowed for small banks that focus on their domestic credit markets
51 See Ammer and Packer (2000) for an empirical critique of the success of rating agen-cies in distinguishing risk by sector and region
52 See Auerback (2001)
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126 WORLD CAPITAL MARKETS
incurred or accrued capital is lost and loan exposure must be reducedor securities sold to restore the requisite capital-adequacy ratios A morerisk-sensitive framework could amplify volatility
As the second pillar of Basel II supervisory review criteria are beingbeefed up to encourage supervisors to intervene earlier in potential problemsituations and to compel banks to align their capital positions with theirrisk profiles Bank supervisors will be authorized to require banks tohold capital in excess of minimum requirements if they have concernsabout general management overall strategy risk-management performanceor the macroeconomic environment Of course if one G-10 supervisorimposes higher capital requirements in isolation the same disparity willemerge that presaged Basel I Some banks will be disadvantaged in theinternational marketplace and will loudly complain that excessive super-vision is driving business to their competitors Hence close internationalcooperation among supervisors is critical
To implement the third pillar market discipline banks will be requiredto make fuller more timely disclosure of capital adequacy and the risksto which that capital is exposed A number of measures are being stud-ied that might help supervisors evaluate bank performance such as com-parisons of uninsured deposit interest rates subordinated debt yieldsand equity prices The idea is that these yields and prices might alertsupervisors to market perceptions of risk Of course market perceptionsare only as good as market information More direct and controversialways to reinforce market discipline would dramatically increase publicdisclosure of bank positions and risk management systems
Many questions are still outstanding about how to resolve the techni-cal details of capital requirements and whether the requirements willachieve their intended goal of better assessment and mitigation of therisks in banksrsquo portfolios There is no substitute for skilled supervisorsThe intricacies of effective design and implementation suggest that su-pervisors need to be highly competent technically knowledgeable aboutbanking portfolio characteristics and the factors that influence bank ex-posure to credit risk (Mishkin 2000) And they must be aided by vigilantshareholders market forces and transparency of information53
Standard setting at the global level is desirable but ultimately theeffectiveness of these efforts will be tested at the national level espe-cially in times of systemic financial distress Here the record of Basel Iwas not a bright shining success Japanese banking regulators havetraditionally allowed banks to include real estate and securities in theircapital base When the value of these assets plummeted in the early 1990sregulators allowed banks to continue valuing these depreciated (andoften bankrupt) assets at their old inflated levels Japanese authorities
53 Benedict Roth Complacency Towards Catastrophe Financial Times 23 January 2001
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 127
insisted until the mid-1990s that eroded capital bases could be rebuiltin a market-driven fashion They rightly foresaw that huge loan losseswould undermine public support for the ruling party and require a po-litically unpopular bailout
Japanese foot dragging on Basel I was the worst54 but not uniqueOther examples can be found of ldquopolitically mandated forbearancerdquo TheFederal Reserve Bank of New York held important hands during theLTCM crisis of 1998 Mexico is still resolving the banking crisis that eruptedin 1995 South Korea has not yet closed the insolvent banks that behavedso badly before the crisis of 1998 In the aftermath of a crisis nationalregulators cannot always be relied upon to discipline politically power-ful bankers55 One of the little-noticed consequences of these differingapproaches is that those banks with strong regulatory systems receivedan implicit ldquoexport subsidyrdquo for their services US banks which had notengaged extensively in emerging-market lending in the 1990s were bet-ter positioned than their German and Japanese counterparts to expandtheir international assets in the wake of the crises
Other Financial Forums
54 See Japanese Banks Fiddling while Marunouchi Burns The Economist 27 January2001 67-69
55 See Calomiris (1997)
The Basel model of vertical subsidiarity has already been extended toother financial regulatory bodies In 1993-94 the BIS established a Tri-partite Group of Banking Insurance and Securities Regulators In 1994-95 the BIS increased its cooperation with the International Organizationof Securities Commissions when the two organizations issued parallelpapers on guidelines for national regulators concerning risk managementand disclosure of derivative trades In 1996 a permanent Joint Forum onFinancial Conglomerates was established to examine supervisory issuesand develop working arrangements among the different functional super-visors of conglomerate institutions that offer combinations of bankingsecurities and insurance products Draft papers on the supervisionof conglomerates were released for comment in 1998 applying capital-adequacy principles to these groups and providing guidelines both forassessing the integrity and competence of top managers and for sharingassessments between regulators
In 1997 the Basel Committee on Banking Supervision extended itsreach beyond capital standards to broader aspects of banking supervi-sion with the publication of the Core Principles for Effective BankingSupervision In 1999 a wide range of regulatory and standard-settingbodies were gathered under the umbrella of the Financial Stability
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128 WORLD CAPITAL MARKETS
Forum (FSF) itself established under BIS aegis56 The FSF has alreadyissued recommendations for stepped-up supervision and transparencyas well as guidelines for best practices in a number of areas includingoffshore financial centers and highly leveraged institutions or hedge funds57
Conclusion
Although the structural weaknesses in emerging-market economies arewidely acknowledged to have been causal factors in international capi-tal-market volatility this chapter points to the role of large G-10 bankingorganizations as major suppliers of the most volatile instrument short-term debt We have examined evidence of the impact of public safetynets in the G-10 economiesmdashthe deposit insurance systems the pruden-tial supervisory systems and the lender-of-last-resort functions of centralbanksmdashon the incentive structures of these organizations
Although supervisors in most countries working nationally and to-gether in the BIS have made significant efforts to mimic market forcesin their prudential supervision the most sophisticated financial institu-tions find innovative ways to circumvent the rules New global regulatorybodies are not about to be created G-10 national bank regulators shouldthemselves address the short-term debt bias in the international financialsystem by changing incentive systems G-10 securities regulators shouldalso take steps to get ahead of the curve paying close attention to largeportfolio swings by institutional investors particularly in times of crisisIn short more needs to be done at national and international levels tochange the rules of the game That is the subject of the next chapter
56 The Financial Stability Forum includes banking securities insurance and accountingregulatory bodies the OECD on taxation corruption and corporate governance and theIMF
57 See Martin (2000)
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94 WORLD CAPITAL MARKETS
foreign direct investment The ldquotransnationality indexrdquo (table 28) showsthat on average they conducted about half their business outside theirhome country9
Overview of the Players
Our review of the major players points to two major features First ahandful of big playersmdashfewer than 200 firms all toldmdashcontrol the ac-tion in international capital markets Their dominance will doubtless erodebut for now financial power is strikingly concentrated with them Sec-ond the big players are overwhelmingly based in the G-10 countriesplus Spain The responsibility to supervise them rests not in the IMFnor in Basel but squarely in Washington London Tokyo and the otherG-10 capitals At year-end 1999 the G-10 countries plus Spain accountedfor 84 percent of world banking assets 86 percent of world stock marketcapitalization and 76 percent of international debt securities (BIS 2000aWorld Bank 2000b)
International private capital flows are of three types bank loans anddeposits portfolio investment and foreign direct investment In cumula-tive total flows to emerging markets FDI was the biggest story in the1990s amounting to $954 billion (table 12) Portfolio flows were nextcumulatively amounting to somewhere between $612 billion (table 12)and $764 billion (table A1) Bank loans and deposits are the most com-plicated story
The Key Role of Banks
Banks are more important as an epicenter than as a wellspring Banksgenerate waves in the flow of capital to emerging markets rather than acontinuous steady stream According to data compiled by the Institute ofInternational Finance (table A1) net bank lending to emerging marketscumulated to $269 billion in the 1990s However deposits by emerging-market residents in G-10 banks more than offset G-10 bank lending tothese countries during the decade According to IMF data cumulativebank loans net of deposits amounted to a negative $135 billion (table 12)
In other words when loans and deposits are combined net bank ac-tivity that moves financial resources to emerging markets is small incomparison with portfolio investment and FDI But bank loans are thelubricant of any financial system Depending on circumstances bankscan be shock absorbers or shock propagators In recent decades with
9 The transnationality index is calculated as a simple average of the share of assetssales and employees outside the home country
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 95
respect to emerging markets banks have more often been propagatorsthan absorbers The average annual swing in bank lending to emergingmarkets was nearly $50 billionmdashby far the largest source of year-to-yearfluctuations in capital flows Both interbank loans between Europe Japanand Asia and sovereign Russian debt used as loan collateral played amajor role in the 1997-98 crisesmdashnot because banks are profligate playersbut because of the incentives they face and the instruments they useAccordingly our story begins with banks
Banks in the Modern Financial System
10 See Levine (2000) for a concise description of the role of banks in the financial system
11 The asymmetric information problem helps to explain why banks dominate the im-mature financial systems of emerging-market economies The general lack of informationon borrowers and undeveloped legal systems to enforce contracts hamper suppliers oflong-term financial instruments such as equities and bonds in evaluating risk and re-ward Banks are best suited in these circumstances to solve the asymmetric informationproblem by evaluating and monitoring private loans As more and better informationbecomes available capital markets develop and financial systems mature
As we noted in the previous paragraph the problem of financial volatil-ity in emerging-market economies is associated with bank lending Ifand when repayment problems arise cross-border private bank loansand bond placements are such that private creditors have no plausiblemeans of seizing assets from either private or sovereign borrowers Thusalthough international finance can nourish entrepreneurs and accelerategrowth a necessary complement may be a drastic creditor response inthe event of nonpaymentmdashto withhold fresh funds and force an eco-nomic crisis (Dooley 2000)
This argument is based on the characteristics of banks They are notldquobadrdquo per se They perform three essential functions in any financialsystem pooling the resources of disparate savers and channeling these re-sources into productive investment improving resource allocation throughtheir expertise in assessing and monitoring borrowers and facilitatingthe division of risk among numerous creditors10 But by their very na-ture banks are prone to two problems asymmetric information (the bor-rower knows more about the potential risk and return of its projectsthan the bank) and adverse selection (riskier borrowers will pay higherinterest rates and thus may constitute a disproportionate share of bankloan portfolios)11
Bank loans are illiquid fixed-price instruments They cannot easily beconverted to cash although they can be bundled into securities (knownas ldquosecuritizationrdquo) Once loan terms have been agreed on the only waya bank can adjust for shifting market conditions is by changing the quantityof its exposure When a borrower runs into trouble the bank can mix
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96 WORLD CAPITAL MARKETS
and match from two unpleasant menus It can roll over existing loansand extend new credit or it can call some part of existing loans andattempt to recover the principal It can also hedge by selling short otherclaims on the borrower These choices entail either an unwelcome exten-sion of the bankrsquos exposure or credit rationing against the borrower Whentrouble brews all banks encounter the same conditions in the aggregatethey prefer less exposure and ensuing credit restrictions lead to volatilebank lending
Innovation
12 Derivatives have no value of their own They ldquoderiverdquo their value from the value ofthe underlying asset They include swaps futures (contracts for future delivery at speci-fied prices) and options (which give one party the right but not the obligation to buyfrom or sell to a counterparty at an agreed price)
13 Maxfield (1998) analyzed available evidence of emerging-market investor objectivesmost of it before the crisis Analysis of portfolio equity flows is sensitive to the choice ofperiod with year-over-year data indicating that investors respond to country ldquofundamen-talsrdquo Other evidence suggests more ambiguity Ranking by ldquoinvestor impatiencerdquo ie thesearch for yield over value Tesar and Werner (1995) find short-term bank flows to be themost yield driven followed by portfolio investment FDI and long-term bank lending
14 Because market risk credit risk and country risk interact in complex ways newfinancial instruments have been created to help reduce negative interactions One is theldquototal return swaprdquo which has become an instrument of choice for hedge funds lookingfor high leverage Banks also use the total return swap to cover risks without increasingtheir capital requirements
Since the 1980s national and international banking systems have beentransformed by deregulation intensified competition and the informationand communications-technology revolutions The market environment isone of intense competition particularly in traditional banking activitiesThe innovations point away from traditional activities of plain vanilladeposit taking and loan making Three big themes are discernible Firstthe walls separating commercial banks investment banks portfolio man-agers and insurance firms are falling even if they are still distinct Sec-ond large banks are shifting toward securitizationmdashcreating securitiesout of everything from credit card debt to trade finance to disaster insur-ancemdashand earning fees in the process Third all large banks are shiftingtoward trading activity making markets and taking short-term stakes inbonds shares and derivatives12 These activities when successful satisfythe search for higher yields13
Many of the new financial instruments that banks trade are ldquooff bal-ance sheetrdquo This means that banks are not required to allocate capitalagainst them In swap contracts for example neither side pays cash at theoutset and therefore neither party has an asset in the traditional sense14
Futures and options contracts can be written with a relatively small initial
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 97
margin relative to the potential risk Credit derivatives limit credit risk bytransferring the potential loss associated with corporate loans and bondssovereign debt and other loan portfolios to counterparties15
Deregulation and innovation working in combination seem to havepushed banks into trading activity and leveraged plays but not into shareownershipmdasheven in jurisdictions that have no prohibition against equitystakes Among the G-10 banking systems the highest ratio of share own-ership to assets was only 5 percent in 1996 reached in Germany andJapan (Berlin 2000)16
The wave of innovation in financial instruments and the accompany-ing expansion of banking beyond its old boundaries is a two-edged swordOn one side it allows risk management far beyond what was tradition-ally possible Risk can now be shifted from firms that can ill afford lossesto those that can Banks can profitably act as intermediaries in shiftingrisk On the other side the innovation wave creates huge opportunitiesfor leveraged plays fostering a speculative search by banks themselvesfor high returns that in turn magnify their own risks17
15 Credit derivatives include total return swaps credit default swaps credit-linked notesand collateralized debt obligations They are the fastest-growing sector of the global de-rivatives market
16 Banks seem to specialize in lending even when they are allowed to mix finance andcommerce for reasons related both to how they are expected to behave with distressedfirms and to other intricacies of lender liability (Berlin 2000) Yet a recent cross-countrystudy found that restrictions on banking and commerce are associated with greater fi-nancial instability (Barth Caprio and Levine 2000)
17 Leverage is the magnification of the rate of return (positive or negative) on an in-vestment beyond the rate obtained by solely investing funds owned by the institution Itis often defined as the ratio of assets to equity Leverage is achieved by increasing thesize of an investment by borrowing or using derivative instruments such as futures oroptions These allow investors to earn a return on the notional amount underlying thecontract by committing a small portion of equity in the form of a margin deposit oroption premium payment
18 In a repo (repurchase agreement) one party (typically a trader) buys a bond andsells it to a dealer for cash with a promise to buy it back the next day at the same priceplus the overnight interest rate As long as the overnight interest rate is lower than theinterest accruing on the bond the trader earns some income on the bond The extremeform of these kinds of transactions was discovered at LTCM the failed US highly lever-aged institution which appears to have controlled more than $120 billion in assets froman investment of about $3 billion This leveraging was accomplished mostly through theuse of repos (Mayer 1999)
The potential for damage is illustrated in an extreme form by figure 21To precisely measure a firmrsquos leverage all positions must be known andrealistically valuedmdashwhich may be impossible to do Because many ac-tivitiesmdashsuch as repos18 and derivativesmdashdo not appear on the institutionrsquos
Leverage
Institute for International Economics | httpwwwiiecom
98W
OR
LD
CA
PIT
AL
MA
RK
ET
S
Figure 21 Hypothetical example of leverage
$1000 notional value of call option on equity in firms targeted for takeover
Repo FRN into cash and use cash to pay option premium
(repro is initially collateralized
Borrow $100 for margin purchase
$125 of US investment bank floating-rate notes (FRN) (secured by $25 equity in FRNs)
Repo off-the-run bond into cash and post margin
(repo is initially collateralizedSell (short) Borrow on-the-run bonds worth $20
$25 worth of off-the-run bonds (secured by $5 equity in bonds)
Exchange into $4
Cash $5 yen400 Japanese bank loans
$1 equity base
FRN = floating rate notesRepo = repurchase agreement
Source IMF (1998)
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ics | httpww
wiiecom
THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 99
balance sheet and because balance sheets are published quarterly at bestoutsiders have a difficult time assessing the extent of a firmrsquos leverage19
Leveraging by a single firm enhances its risk of default the widespreaduse of leverage in the financial system can magnify market adjustmentsespecially when they require ldquodeleveragingrdquomdashunwinding prior positionsRapid adjustments can cause credit to dry up and asset prices to plummetIn a mark-to-market environment falling asset prices trigger calls foradditional collateral that can ripple through markets
Risk Management
Because it is confronted with the widespread use of leverage and prolif-erating kinds of risk international finance is increasingly driven by riskevaluation and control20 Different institutions face various risk profilesand differing kinds of risk The most common risks can be quickly tickedoff Banks because of their traditional intermediary role of channelingthe resources from savers to borrowers face significant credit risk therisk of default or delay in the payment of principal and interest Theymust also manage market risk the risk that the prices of their liabilitiesmay change faster than their assets Market risk devastated US savingsand loan institutions in the late 1980s
Closely associated with market risk are interest-rate risk (unexpectedchanges in market interest rates that slash margins net income and theeconomic value of a bankrsquos equity) and foreign exchange risk (losses thatarise when assets denominated in an appreciating foreign currency areless than liabilities denominated in that currency) Banks make numer-ous loans to other banks around the world portfolio investors buy se-curities direct investors acquire fixed assets and all incur country risk(economic and political uncertainty in the host country) During the heightof the Asian crisis for example interbank loans to Japanese banksreflected the credit risk of lending to these banks the so-called Japanpremium
Substantial attention has been lavished on country risk analysis sincethe 1982 debt crisis in developing countries Yet in spite of this exper-tise the Asian crisis occurred in part because of a sudden upward reap-praisal of country risk after the Thai baht collapsed in April 1997 Banksand other financial institutions must also manage liquidity risk the riskthat market conditions will change unexpectedly depressing demand andprices of assets at the time they want to sell these assets And they mustmanage operational riskmdashfailures in control systems or people that cause
19 Another example of asymmetric information Both risk and leverage are difficult foroutsiders to assess without full timely disclosure
20 A longer discussion of these issues can be found in Managing Global Finance in IMF(1999c)
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100 WORLD CAPITAL MARKETS
financial loss or damage reputations Operational risk devastated BaringsBank in 1995
Financial institutions practice risk management to measure all theserisks the potential damage to their investment positions and ultimatelythe chance of becoming insolvent VAR (value at risk) risk models mea-sure subject to certain assumptions the amount of the firmrsquos capital thatis exposed in each period For example the VAR model might say thatin a 3-standard-deviation worst case (a case that is not supposed to hap-pen more than 1 percent of the time) the firm will loose 25 percent of itscapital during the next year
VAR models are widely used but like all models they have weak-nesses They rely on past values to estimate key variables in financialmarkets past values are not always good predictors of future risks More-over rising volatility and higher loss correlation among different assetclasses in a portfolio will cause all banks using these models to reducetheir exposures at the same time by switching to less volatile and lesscorrelated assets such as US Treasury bills (Persaud 2000)
Newer risk models entail stress testing and scenario analysis Scenarioanalysis envisages possible adverse changes one at a time that mightaffect the investment portfolio Stress testing estimates potential losseswhen several individual risk factors simultaneously move against thefirm but it too uses historical probabilities
Financial Volatility
21 For example derivative markets usually rely on underlying securities markets thatproduce continuous prices When these markets are interrupted financial shocks cantrigger a cascade of margin calls and sell orders that move prices very sharply
22 See IIF (1999a)
The combination of trading activity and modern risk management lie atthe root of financial volatility When risks increase banks must eitherraise more capital to cover the greater risk or reduce their exposure bycutting loan exposure by selling securities or by undertaking new de-rivative trades Raising more capital is time-consuming and in a crisisvery expensive because bank shares are depressed So banks look to theother alternatives If the bank can reduce lending it need not book aloss But most banks use the same VAR models and as indicated abovethese models will encourage them to reduce their outstanding loans atthe same time actually magnifying loan volatility
If banks attempt to reduce their exposure to risk by selling securitiesor undertaking new derivative trades they may trigger large priceshocks because of limited and shrinking market liquidity21 The liquid-ity problem is compounded when a small number of large institu-tions hold the same positions22 Take your pick loan volatility or price
Institute for International Economics | httpwwwiiecom
THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 101
volatility As two experts have observed (Folkerts-Landau and Garber1998)
[V]olatility even in one country will automatically generate an upward re-estimate of credit and market risk in a correlated country triggering automaticmargin calls and tightening of credit lines Thus apparently bizarre opera-tions that connect otherwise disconnected securities markets are not the re-sponses of panicked green screen traders arbitrarily driving economies from agood to a bad equilibrium Rather they work with relentless predictability andunder the seal of approval of supervisors in the main financial centers
23 See Ferguson (1999)
24 As Gerald Corrigan (1982) put the matter ldquoBanks are specialrdquo Corrigan (2000) reit-erated this view even after all the changes of the past two decades Unlike other institu-tions banks offer on-demand transactions are a backup liquidity source for other insti-tutions and serve as a ldquotransmission beltrdquo for monetary policy
These changes in the banking environment accentuate an existing anomalyThe anomaly is that banks even as they grow larger and increasinglyengage in more risky and complex transactions are perceived to enjoyimplicit and explicit public guarantees
The guarantees grow out of an incentive problem inherent in bankingasymmetric information which we mentioned above Depositors know lessabout a bankrsquos management and the quality of its balance sheet than doits managers and shareholders Thus in times of uncertainty or adver-sity bank depositorsmdashuncertain whether they will have access to theirdepositsmdashare prone to bank runs This prospect has in turn compelledgovernments to treat banks differently than other firms because a bankthat fails can disrupt the rest of the economy24
To prevent such crises governments have entered into quid pro quoarrangements with banks Governments provide them both with an im-plicit safety net in the form of an unstated promise by the central bankto act as a lender of last resort in a liquidity crisis and an explicit safetynet in the form of a public deposit insurance fund to reassure depositorsIn return the banks submit to closer government oversight and regu-lation of their activities than is usual for industries in the private sector
The ldquoinsurancerdquo provided by the public safety net contributes to an-other incentive problem moral hazard Banks acquire greater tastes forrisk and face less market discipline than other firms The explicit depositinsurance safety nets actually have or are perceived to have blanketcoverage that extends beyond the retail depositors (households and small
One of the lessons of the 1997-98 crisis must surely be that market par-ticipants and their regulatory supervisors relied too heavily on quantita-tive tools and insufficiently on judgment23
The Anomaly of Modern Banking
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102 WORLD CAPITAL MARKETS
businesses) for which they were originally intended The implicit centralbank safety nets extend in a crisis to nearly all depositors and banksThus banks are both viewed and behave as if they will be bailed out ifthey get into trouble
The existence of a public safety net raises a perennial question Dobanks have an unfair advantage over other financial institutions becauseof the subsidy provided by the safety net This question was at the heartof intensive study and debate in the United States leading up to thepassage in November 1999 of the Financial Services Modernization Act(also known as the Gramm-Leach-Bliley Act) The size of the gross sub-sidy is difficult to estimate despite determined research efforts Somesuggest it is well under 100 basis points and is at least partly offset bythe direct costs of deposit insurance premiums interest payments on bondsissued by the Financing Corporation25 reserve requirements regulatoryexpenses and operational costs associated with collecting deposits26 Con-versely Kwast and Passmore (2000) suggest that banks can expand theirscope far beyond the levels that other financial institutions could reachwith the same equity base but without the public safety net
A related concern in the US debate is whether allowing banks to ex-pand their activities into securities and insurance will ultimately extendthe safety net and add to the subsidy The Financial Services Moderniza-tion Act deals with this issue by maintaining a legal separation betweenbanks and the rest of the banking organization known as large com-plex banking organizations (LCBOs) They must engage in most securi-ties activities and insurance underwriting through separately capitalizedinvestment bank subsidiaries or holding company affiliates This act canbe said to have merely brought US banking laws closer to those of mostother industrial countries (Barth Brumbaugh and Wilcox 2000 BarthNolle and Rice 2000) If the fire wall is well-maintained and stoutly de-fended the safety net will neither expand in practice nor become a sourceof comfort to noncommercial bank subsidiaries of LCBOs
The quid pro quo exacted by governments to offset the subsidy iscloser public-sector monitoring of banksrsquo activities through prudentialsupervision The effectiveness of this closer official scrutinymdashand closermarket monitoringmdashare the subjects of the next section
25 The Financing Corporation was created by Congress in 1987 to sell bonds to raisefunds to help resolve the savings and loan crisis
26 See Levonian and Furlong (1995) Jones and Kolatch (1999) Shull and White (1998)and Whalen (1999a 1999b)
Are G-10 bank supervisors adequately responding In this section we firstassess the case for and compare the structures of prudential supervisory
Prudential Supervision
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 103
systems both within and among the G-10 economies plus Spain andconsider whether these offset the subsidy provided by the public safetynet Despite offsetting regulation and supervision implicit and explicitguarantees by G-10 governments to their banks are still a source of bank-ing instability in the emerging-market economies
National Systems for Prudential Supervision
Governments use prudential supervision to reduce the moral hazard andadverse selection created by their own safety nets Supervisors establishregulations and monitor compliance to limit risk taking and ensure thesafety and soundness of the banking system In a thoughtful analysis ofthe case for prudential supervision Frederic Mishkin (2000) identifiesthe main forms that supervision can take including the tasks of grantingbanking charters and licenses establishing capital requirements settingdeposit insurance premiums and defining disclosure requirements as wellas carrying out bank examinations Bank examiners gather informationfrom banks and evaluate whether they are following the regulatorsrsquo rulesin cases of weakness they are empowered to change banksrsquo behaviorand close them if necessary
Supervisors also may restrict competition define the activities in whichbanks may engage and restrict their asset holdings and separate banksand other financial (or nonfinancial) activities During the past two de-cades the barriers separating commercial banks investment banks in-surance firms and securities firms have been all but eliminated (tableB1) Deregulation has stimulated competitive forces that drive diversifi-cation and consolidation of the financial industry nowhere faster than inthe United States
The Financial Services Modernization Act of 1999 confirmed this trendIt eliminated restrictions dating back to the Glass Steagall Act of 1933which once prevented banking insurance and securities firms fromentering each otherrsquos businesses (Barth Brumbaugh and Wilcox 2000)Cross-pillar mergers among banks insurance and securities firms arewell under way to form giant financial holding companies The 1999merger between Citibank (banking) and Travelers (insurance) created themodel for megafinance and confirmed new challenges for supervisors
Mishkin (2000) notes the corresponding evolution in US supervisionfrom an emphasis on rules-based regulation (detailed rules for opera-tional behavior and the quality of line items in the balance sheet) to anapproach that stresses the soundness of bank management practices es-pecially risk management
Appendix B outlines the systems of financial supervision now in theplace in the G-10 countries plus Spain Some systems like the UK andCanadian approach are models of simplicitymdashorganized to keep pacewith the spreading reach of financial conglomerates Other systems like
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104 WORLD CAPITAL MARKETS
the US and French approaches show traces of the bureaucratic divisionsthat made sense in an era when banking securities and insurance weresharply separated
The US Model
27 See Meyer (1999a)
28 Canada has a similar degree of simplification with the exception that securities firmsare still regulated by provincial authorities
29 See Pratti and Schinasi (1999 67)
30 The agents are the bank regulators and the principals are the taxpayers Agents maypursue their own interests including bureaucratic survival and postgovernment employ-ment opportunities rather than the national interest in banking safety and soundness
The US model of financial regulation delineated in the Financial Ser-vices Modernization Act of 1999 blends functional and umbrella super-vision Bank and thrift regulators oversee depository institutions Newnonbank activities are subject to both functional regulation (eg by theSecurities and Exchange Commission and state insurance examiners) andumbrella supervision (of financial holding companies) by the FederalReserve27
The UK Model
Another supervisory model exists in the United Kingdom as well as inAustralia Canada and Switzerland28 In this model banking supervisionis separated from the monetary policy function The regulatory structureis considerably simplified by relying on a consolidated financial regula-tor separate from the central bank for both banking and nonbankingactivities The remaining question answered differently depending on thecountry is the extent to which the regulator relies on home-country sur-veillance of banks and conglomerates that have a local presence
Regulatory Models Compared
Appendix B provides more detail on the differences in these modelsGerman simplicity contrasts with French complexity In France the bankingcommission is chaired by the governor of the central bank and includesrepresentatives from the Treasury The commission supervises compli-ance with regulations but the central bank inspects banks on behalf ofthe commission29 In countries such as the United States and France withmultiple supervisors and crossover functions internal coordination is criticalAt the same time multiple agencies create regulatory competition Wheneach agency knows what the other is doing transparency within gov-ernment circles can help to limit principal-agent problems of regulation30
The discussion as to where in the public bureaucracy financial super-
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 105
vision should be placed goes back many years Peek Rosengren andTootell (1999) argue that a synergy exists between monetary policy andprudential supervision because information gained in the course of super-vision can increase the accuracy of macroeconomic forecasts A twist tothis argument is that the information on the state of financial institutionsavailable to the central bank as supervisor can facilitate its role as lenderof last resort Conversely there is the concern that a supervisory rolewill compromise the central bankrsquos independence of action with respectto its core mandatemdashmaintaining price stability As these arguments haveplayed out financial supervision has generally been shared between centralbanks and other regulators or placed entirely in the hands of an inde-pendent regulator However in Italy the Netherlands and Spain cen-tral banks are the sole banking supervisor
Goodhart (1995) examined the arguments and evidence for each modeland concluded that there were no overwhelming arguments or evidencefor one or the other31 Going forward a key problem for any financialsupervisory system is dealing with (and closing as necessary) weak banksIf both central banks and other regulators have this responsibility closecoordination between them is critical Another problem is large conglom-erate banks LCBOs Although they are less likely to fail because of thediversification of their assets and liabilities they are more likely to berescued They are also more likely to be multinational enterprises withinternational implications Goodhart observes that regulation of theseentities might be put in the hands of the central bank because it is lessamenable to political pressures In any event the complexity of LCBOoperations suggests that greater supervisory rigor is necessary
The US Congress was persuaded that broad oversight would help containthe moral hazard problem and accordingly gave the Federal Reservethe role of umbrella supervisor with the understanding that the Fed willscrutinize depository activity more intensely than nonbank financial ac-tivities Under this approach LCBOs such as Citigroup are subject tomuch closer monitoring than smaller and simpler institutions32 The USregulatory model requires enormous cooperation between the Fed otherbank supervisors and the functional regulators for insurance and securi-ties but it also benefits from regulatory competition
31 National systems of supervision are path dependent they are determined by the struc-ture of financial institutions and history in each country If Goodhart (1995) is right out-comes are not materially better or worse with one model of supervision rather than another
32 See Ferguson (1999)
Public Safety Nets
One of prudential supervisorsrsquo biggest challenges is to reduce moral hazardFor many years commercial banks engaged in communal self-insurance
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106 WORLD CAPITAL MARKETS
to deal with crises They formed voluntary groups that agreed to rescuetroubled members As financial markets evolved and competition inten-sified banks were no longer willing to play this role Private-sector in-surance is one alternative but moral hazard and adverse selection wouldappear to prevent it from happening Public safety nets have developedbecause of the low probability and high cost of potential bank runs Aclear trade-off is involved The effectiveness of insurance in preventingbank runs is greater the more comprehensive the coverage But the morecomprehensive the coverage the greater the moral hazardmdashbank man-agers bank directors investors and depositors all take on greater risksin the belief that the safety net will protect them against losses
All G-10 countries have compulsory public safety nets for banks (table29) Deposit insurance agencies are officially organized in Canada theNetherlands Sweden Switzerland and the United States organized bythe industry in France Germany Italy and the United Kingdom andjointly organized by the public and private sectors in Belgium Japanand Spain
How well do G-10 governments offset the subsidy provided by thepublic safety net This is a question on which there is substantial debateAs banking organizations have become more complex the challengesthat supervisors face have become more difficult One challenge is toalign the incentives facing bank managers and shareholders with thoseof depositors Another is the principal-agent problem in supervision Wehave discussed the incentive structures for financial institutions but wehave said little about the incentives for supervisors themselves and thedistortions they can generate in the financial system
In one of the many studies of the US savings and loan crisis of the1980s Kane (1989) documented both problems He described managersusing cosmetic approaches to disguise the magnitude of insolvency regulatorspracticing forbearance even though they knew of the deteriorating riskprofiles of the institutions for which they were responsible and legisla-tors increasing deposit insurance without regard for any offsetting changesin supervision A subsequent overhaul of the legislative framework forthe Federal Deposit Insurance Corporation (FDIC) known as the FDICImprovement Act of 1991 (FDICIA) aimed to introduce a clearer incen-tive structure for both regulators and regulated institutions
The changes introduced by this US legislation are worth discussionwith respect to the other G-10 countries as well First FDICIA created astronger signal to management and investors by targeting deposit insur-ance at small depositors only and by risk-weighting the deposit insur-ance premiums paid by banks to reflect their capital adequacy and bankexaminer ratings Among the G-10 countries rated in table 210 depositinsurance premiums vary considerablymdashbut it is not clear that the dif-ferences have much to do with risk-weighting Most G-10 countries em-ploy funding formulas based for example on the total domestic deposit
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Table 29 Deposit insurance schemes in the G-10 countries Explicit safety net
Coverage limit(dollar Foreign
equivalent currency Interbank Source Bankrsquos Contingency fundingDate Membership Co- at end of deposit deposit of premium from banks
Country established managementa insuranceb July 1998)c covered covered Fundingd funding costs or governments
United 1982 Compulsory Yes Larger of 90 No No Unfunded Banks only Callable (subject Parliament may increase Kingdom private percent co- to maximum the maximum payable
insurance to 03 percent of pound125 million advance 33000 total deposits) facility with Bank of
England
United 1934 Compulsory No 100000 Yes Yes Funded Banks and Up to 027 Borrowing up to $3 States official government percent total billion from US Treasury
domestic deposits
Japan 1971 Compulsory No 71000 but No No Funded Banks and 0084 percent of Borrowing up to yen500bn joint in full until government insured deposits from Bank of Japan
year 2000 subject to Ministry of Finance approval
Canada 1967 Compulsory No 40800 No Yes Funded Banks and 033 percent of Borrowing up to C$6 official government insured deposits billion authorized further
(maximum) borrowing subject to parliamentary approval
Germany 1966 Compulsory Yes 90 percent Yes No Funded Banks only 003 percent of Annual levy may be private coinsurance deposits doubled
to 22000
Italy 1987 Compulsory Yes 125000 Yes No Unfunded Banks and Callable Two options defer private government (maximum of payment or diminish
1 percent of compensation to be paid total deposits)
(table continues next page)
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Table 29 Deposit insurance schemes in the G-10 countries Explicit safety net (continued )
Coverage limit(dollar Foreign
equivalent currency Interbank Source Bankrsquos Contingency fundingDate Membership Co- at end of deposit deposit of premium from banks
Country established managementa insuranceb July 1998)c covered covered Fundingd funding costs or governments
Netherlands 1979 Compulsory No 22000 Yes No Unfunded Banks and On demand Government backing official government maximum of subject to parliamentary
5 percent of own approval funds
France 1980 Compulsory No 65400 No No Unfunded Banks only Callable (on Extra calls up to FFr1000 private demand calls million can be made in
up to FFr200 a 5-year period million)
Switzerland 1984 Voluntary No 19700 No No Unfunded Banks only Callable (on Underwritten by member official demand) banks
Sweden 1996 Compulsory No 31400 Yes No Funded Banks and 05 percent of Full emergency coverage official government deposits while replacing it with a
limited system after the emergency
Belgium 1974 Compulsory No 16600 No No Funded Banks and Callable 002 None insurance limited joint 22000 in government percent of to assets in fund
year 2000 deposits from clients
Spain 1977 Compulsory No 16439 Yes No Funded Banks and 02 percent of Government backing joint government deposits through the Banco de
(maximum) Espantildea subject to approval by royal decree
a Bank membership in the fund can be either compulsory or voluntary and the management of the fund can be official and official and private joint or privateb Coinsurance refers to the situation where depositors face a deductible against their insured fundsc Coverage limit refers to the explicit amount the authorities promise to insured Funded scheme means that it is funded ex ante unfunded otherwise
Sources Goodhart (1995) Demirguccedil-Kunt and Detragiache (2000) Demirguccedil-Kunt and Sabaci (2000)
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 109
base Explicit safety net protection also varies but only Canada focuseson the protected class33 All G-10 countries specify a limit on depositorprotection Under FDICIA the insurance fund is prohibited from pro-tecting uninsured depositors or creditors at a failed bank although adiscretionary system-wide override is provided for exceptional circum-stancesmdashbut with stringent requirements for consultation and account-ability Other G-10 countries allow for contingency funding from the publicpurse alongside unwritten lender-of-last-resort support Among large banksa significant and growing portion of deposit liabilities including foreigncurrency and interbank deposits are uninsuredmdashbut depositors assumethey will be protected in a crisis
FDICIA also made some significant qualitative changes to address theprincipal-agent problem by penalizing weak banks and rewarding strongbanks For example banks whose capital declined faced progressivelytougher regulatory sanctions that for example required them to elimi-nate dividends restrict their lending and change their managementsRegulators have also been forced to take prompt corrective action (toreduce the practice of regulatory forbearance in hopes that a bankrsquos for-tunes might improve)34 Unfortunately comparative qualitative assess-ments across the G-10 are difficult to make due to lack of information35
This discussion highlights the complexity of evaluating the extent towhich prudential supervision and market discipline reduce the moralhazard associated with G-10 safety nets Our argument is that publicsafety nets in the G-10 can be linked to banking instability in other coun-tries specifically in the emerging-market economies that have attractedG-10 cross-border bank lending This lending is a leading source of vola-tility in capital flows the large financial institutions many of which arecomplex banking organizations are based in and regulated by authori-ties in the G-10 economies These two features of the international finan-cial system are closely related although it is not possible to test thisrelationship econometrically
Two World Bank studies however indicate a basis for concern Onestudy is a cross-country econometric analysis of the relationship betweenbank stability and deposit insurance (Demirguccedil-Kunt and Detragiache2000) which found a negative relationship Their estimated model forbanking crises in a sample of 61 countries (both industrial and develop-ing) suggests that explicit deposit insurance raises the probability of acrisis by at least 30 percent36 Crises are especially likely in countries
33 Japanrsquos legislation says it does but recent experience shows this is not the case34 See Goldstein (1997) for a summary of the changes35 See Barth Nolle and Rice (2000) for a beginning in this area36 Demirguccedil-Kunt and and Detragiache (2000 table 1) report a logit coefficient of 0696with a standard error of 0397 (the coefficient is significant at the 8 percent threshold)This suggests that the ldquotruerdquo coefficient could well be as small as 030 (the reportedvalue minus the standard error)
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110 WORLD CAPITAL MARKETS
with immature financial supervisory systems (and not in the G-10) buttheir analysis does underscore the view that deposit insurance weakensmarket discipline37
An earlier World Bank analysis established similar results One wasthat market discipline is undermined by deposit insurance schemes an-other was that illiquid banks are forced to pay more for their funds un-less a generous deposit insurance scheme is in place (Demirguccedil-Kuntand Huizinga 1999) This econometric study also provides clear-cut evi-dence that depositor monitoring of banks declines with the existence ofdeposit insurance schemes At the heart of the problem is the questionof whether deposit insurance is accompanied by increased governmentmonitoring
This evidence and the weight of other arguments suggests that moralhazard is still an issue in the G-10 countries Consider the ongoing de-bate about instilling greater market discipline on risk taking by banksAt one extreme is the perennial proposal to do away with safety netsleaving markets to monitor the players and to force adjustments but toprotect small savers by creating ldquonarrow banksrdquo such as postal savingsystems that are allowed to invest these savings only in risk-free gov-ernment securities Whatever the merits of narrow banking this solutionis too extreme to be politically feasible
A moderate alternative is to force more disclosure by financial institu-tions to facilitate market monitoring But transparency has its own prob-lems Persaud (2000) argues that financial markets cannot reliably discernsustainable from unsustainable positions in the short term This uncer-tainty causes banks to ldquoherdrdquo behind market leaders to exploit theirsupposedly superior information ldquoThe more herding investors and bankersknow about what each other is up to the [more] unstable markets maybecomerdquo The implication is that greater transparency in the marketplaceby itself will not solve the problemmdashand in the short term more informa-tion may exacerbate herding Further supervisory steps (discussed in thenext chapter) are required
Yet another proposal is to promote private-sector involvement in bankmonitoring through market-based alternatives such as Calomirisrsquos sub-ordinated debt proposal (Calomiris 1997 Federal Reserve Board 1999)Banks could be required to issue and maintain a minimum amount of
37 Other findings in the Demirguccedil-Kunt and Detragiache (2000) study include thesepropositions The impact of deposit insurance on bank stability tends to be stronger themore extensive is the coverage offered to depositors when the scheme is funded andwhere the scheme is run by the government rather than by the private sector Con-versely deposit insurance is detrimental to bank stability where bank interest rates havebeen deregulated and where the institutional environment is weak Additional findingson deposit insurance are reported from a recent World Bank conference (8-9 June 2000httpwwwworldbankorgresearchinterestconfsupcomingdeposit_insurancehomehtm)Also see Smalhout (2001)
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 111
subordinated debt (eg uninsured certificates of deposit) to finance asmall fraction (such as 2 percent) of their total nonreserve assets Thesubordinated debt would be allowed to earn a set yield no more than 50basis points over the risk-free yield on government treasury bills Thisrule would supposedly force banks to operate in a safe manner Other-wise subordinated debt holders would redeem their uninsured certifi-cates of deposit and equity investors would sell their bank shares Despiteits practical problems the beauty of the subordinated debt requirementis that it enlists market incentives to push banks to avoid excessive port-folio risk38
The thrust of these proposals is very relevant to the arguments in ourstudy Even in the G-10 countries government monitoring by itself hasnot eliminated moral hazard among banks More work is needed to in-troduce market monitoring and to improve the incentive structures bothfor financial institutions and their supervisors We return to this issuewith our recommendations in the next chapter
38 In late 1996 Argentina began requiring its banks to finance 2 percent of total depos-its in the form of subordinated debt but without a maximum yield provision TheArgentine authorities expect that market discipline will act in concert with the publicsafety net One obvious problem with the subordinated debt proposal is that banks mayencourage some of their customers to buy the subordinated debt
Portfolio Institutions Tomorrowrsquos Problem
Before proceeding to the issues of international supervision we flag an-other potential problem for national regulators The big asset managersprofiled in tables 24 and 26 answer to diverse groups of pensionersshareholders and policyholders They allocate funds across a number ofcountries to diversify their risks They hold liquid assets that can be tradedand they have a higher proportion of long-term assets than banks Eco-nomic shocks can be absorbed through price changes and their effectsspread across time and markets Thus when conditions change in a par-ticular market they are more likely to ride out the storm than to flee Inother words they have less incentive than banks to pull their invest-ments in the face of adversity In the 1990s most large asset managersestablished a record of ldquoriding out the stormrdquo rather than ldquorunning withthe windrdquo although as we saw in chapter 1 instances of running withthe wind were detected in some portfolios As we write these insti-tutions have a good record overall in the emerging markets so whyworry
The Russian crisis and the near-collapse of LTCM previewed the dan-gers that may await future portfolio managers and G-10 financial minis-ters We have presented evidence indicating a systemic bias toward bank
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112 WORLD CAPITAL MARKETS
lending and debt finance to emerging markets and we have argued forsubstitution toward equity finance and direct investment39
That is not the end of the story We noted in the previous chapterthat institutional investors can become momentum investors selling in adownturn As more portfolio capital is invested in emerging marketssome players may adopt the high-risk high-leverage strategies of themost aggressive hedge funds Indeed the data in box 11 show that G-10portfolio investors held somewhat more long-term debt (more than $500billion) than equity (less than $400 billion) in emerging markets at theend of 1997 Long-term debt is an ideal vehicle for high-risk high-leveragestrategies These strategies practiced on a large scale could compound afuture crisis harming emerging markets A big enough crisis could inturn pressure G-10 central banks and finance ministers to arrange bail-out plans Instead of shrinking as a systemic financial problem moralhazard could increase
National securities regulators are the first line of defense against thisscenario They play a critical role in the safe evolution of capital mar-kets But regulators today are mandated to approve the issuance of newsecurities and to monitor the continuing disclosure of material informa-tion by issuers They are far less concerned with or empowered to monitorthe behavior of the increasingly large wealth-management firms that arethe major purchasers (and therefore resellers) of these securities
Within their mandates the goals of national securities regulators (table210 and appendix B) are similar to the concerns of bank regulators withsystem safety and soundness Their focus is also on the incentive sys-tems for management and boards of directors and on disclosure by cor-porations that issue marketable securities such as shares bonds andasset-backed securities 40 Issuers of securities possess greater knowledgeabout the quality of these assets than do the purchasers hence investorprotection is a key concern of regulators Moreover market disciplineworks best when markets know what is happening Well-functioning corpora-tions are key agents of wealth creation and social progress Underperform-ing corporations waste resources During recessions bad corporationsget into bad trouble often with severe social consequences Inadequateincentives for managers and inadequate accountability for boards andmanagers thus have negative externalities Regulators play a vital role inexposing weakness so that market disciplines come to bear sooner ratherthan later
Regulatory emphasis is constantly shifting as financial markets evolveand as the macroeconomic environment changes Regulators try to balance
39 See Rogoff (1999) Also see Berlin (2000) for a perspective on the limited role thatbanks play as share owners
40 See Habib and Ljungqvist (2000) for recent empirical analysis showing that corporateshare market values are higher when corporate executives have a larger ownership stake
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Table 210 Financial-sector regulation G-10 countries 2000
Financial institutions and their supervisors
Country and supervisory structure Retail banking Wholesale banking Securities Insurance
Financial conglomeratesFinancial Services Authority (FSA) = umbrella supervisor
United Kingdom FSA FSA FSA FSA
Treasury bull Commercial banks bull Investment funds (Securities and (Insurance Directorate(Securities and Investments Board) bull Unit trust groups Futures Authority) of the Treasury)
Bank of bull Building societies bull Pension funds England (Building Societies Commission) bull Merchant banks
bull Friendly societies bull Clearing houses bull Primary issuers bull Insurance FSA (Friendly Societies Commission) bull Venture capital of securities companies
bull Pensions and life insurance etc bull Stock exchanges bull Insurance brokers(Personal Investment Authority) bull Stockbrokers
Financial holding companiesFederal Reserve (FR) = umbrella supervisor
United States bull National banks(OCC) Securities and Regulated by
Treasury OCC bull State banks Federal Reserve Exchange Commission StatesMembers (FR)
OTS Nonmembers (FDIC) bull Investment banks bull Primary issuers of bull Insurance companies FR bull Cooperative banks (FDICFR) bull Finance companies securities bull Insurance brokers FDIC bull Insured industrial banks (FDIC) bull Stock exchanges
bull Thrift holding companies (OTS) bull Stockbrokers SEC bull Savings banks (OTSFDICFR) bull Investment advisors
bull Savings and loan associations bull Mutual funds(OTS) bull Public utility holding
bull Edge Act corporations (FR) companies
(table continues next page)
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Table 210 Financial-sector regulation G-10 countries 2000 (continued )
Financial institutions and their supervisors
Country and supervisory structure Retail banking Wholesale banking Securities Insurance
Financial holding companies Japan Financial Supervisory Authority (FSA) = umbrella supervisor
Prime FSA FSA FSA FSA ministerrsquos Ministry of office Finance (Securities and Exchange
Surveillance Commission) FRC Bureau of Financial bull City banks bull Investment banks bull Primary issuers of bull Insurance companies FSA Regulation bull Regional banks bull Asset managers securities bull Insurance brokers
bull Trust banks bull Stock exchanges SESC bull Long-term credit banks bull Stockbrokers
bull Pension funds
Financial holding companiesOffice of the Superintendent of Financial Institutions (OSFI) = umbrella supervisor
Canada Regulated by OSFI OSFI provinces OSFI
Department of Financebull Banks bull Cooperative credit bull Primary issuers of bull Insurance companies
(previously Office of the Inspector associations securities (previously Depart- OSFI General of the Banks) bull Fraternal benefit bull Stock exchanges ment of Insurance) Bank of bull Trust and loan companies society bull Stockbrokers bull Insurance brokers Canada bull Pension funds bull Asset managers
(previously Depart- CDIC ment of Insurance)
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Financial institutions and their supervisors
Country and supervisory structure Retail banking Wholesale banking Securities Insurance
Germany Financial holding groupsFederal Banking Supervisory Office (FBSO) = umbrella supervisor
Ministry of Finance FBSO BSO FSSO FISO
Bundesbankbull Universal banks bull Other financial bull Primary issuers of bull Insurance companies
Federal Banking bull Savings banks institutions (eg securities bull Insurance brokers Supervisory Office bull Securities banks management foreign bull Stock exchanges
currency dealings) bull Stockbrokers Federal Securities bull Financial enterprises bull Asset managers Supervisory Office (eg leasing bull Pension funds
organizations Federal Insurance credit card companies Supervisory Office investment advisors)
Italy Bank foundationsMinistry of Finance = umbrella supervisor
Ministry of Finance Bank of Italy Bank of Italy Consob ISVAP
Bank of Italy bull Commerical banks bull Asset managers bull Primary issuers of bull Insurance companies Consob bull Savings bank bull Open-end investment securities bull Insurance brokers
bull Securities banks companies (SICAVs) bull Stock exchangesbull Stockbrokers
ISVAP
(table continues next page)
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Table 210 Financial-sector regulation G-10 countries 2000 (continued )
Financial institutions and their supervisors
Country and supervisory structure Retail banking Wholesale banking Securities Insurance
The Netherlands Financial conglomeratesCouncil of Financial Supervisors = umbrella supervisor
Securities Board Securities Board Netherlandsche Netherlands Bank Netherlandsche Bank of the Netherlands Insurance Board Bank Insurance bull Credit institutions (universal banks bull Investment institutions bull Stock exchanges bull Insurance companies Board cooperative banks security credit (securities issuing bull Stockbrokers bull Insurance brokers
institutions mortgage banks) and tradingmdashprimary The Council of Financial and secondary Supervisors markets)
France Commission des Commission de Operations des Controcircle des
Banking and Banking Commission Bourse Assurances Financial Regulatory bull Ensuring that credit institutions (and investment firms since bull Primary issuers of bull Insurance companies Ministry for Committee the Financial Activity Modernization Act of 1996) comply securities bull Insurance brokers Economic with laws and regulations bull Stock exchanges Affairs and bull Execute instructions regarding all off-site monitoring and bull Stockbrokers Finance Credit on-site supervision Institutions and Banking and Financial Regulatory Committee Investment bull Formulates general regulations for credit institutions and investment firms Committee (capital adequacy requirements accounting rules etc) Bank of France Credit Institutions and Investment Committee Banking bull Authorizes and examines financial institutions except for those within the Commission competence of the Banking Commission
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Financial institutions and their supervisors
Country and supervisory structure Retail banking Wholesale banking Securities Insurance
Switzerland Large banking groupSwiss Federal Banking Commission (SFBC) = umbrella supervisor
Swiss National Bank Federal Office of
SFBC SFBC SFBC Private Insurance Swiss Federal Banking Commission bull Universal banks bull Investment banks bull Primary issuers of bull Insurance companies
bull Savings banks bull Asset management securities bull Insurance brokerscompanies bull Stock exchanges
Private audit Federal bull Investment funds bull Stockbrokers firms Office of bull Mortgage bond authorized by Private business SFBC Insurance
Sweden Financial holding company groupsFinancial Supervisory Authority = umbrella supervisor
Ministry of Finance Credit Market Securities Market Insurance Market
Credit Market Department Department Department Department
Financial bull Commercial banks bull Investment funds bull Primary issuers of bull Insurance companies Riksbank Supervisory bull Savings banks securities bull Insurance brokers Authority bull Friendly societies bull Stock exchanges
bull Stockbrokers
(table continues next page)
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Table 210 Financial-sector regulation G-10 countries 2000 (continued )
Financial institutions and their supervisors
Country and supervisory structure Retail banking Wholesale banking Securities Insurance
Belgium Bank holding companiesBanking and Finance Commission = umbrella supervisor
Bank of Belgium Banking Banking
Banking and Finance and Finance Insurance Controland Finance Commission Commission Commission Office
Banking and Insurance Finance Control bull Commercial banks bull Asset management bull Primary issuers of bull Insurance companies Commission Office bull Savings banks firms securities bull Insurance brokers
bull Securities banks bull Investment funds bull Stock exchanges bull Mortgage companiesbull Stockbrokers bull Pension funds
Securities Regulation Fund Securities Regulation Fund
bull Other investment firms and credit institutions(institutions participating in regulated off-exchangemarket in strips and Treasury certificates)
Bank holding companies Spain Banco de Espantildea = umbrella supervisor
Banco de Espantildea Comision Nacional del Mercado de Directorate General
Banco de Espantildea Valores (CNMV) Insurance
bull All credit institutions (commercial banks savings banks credit bull Primary issuers of (Ministry of Economy Ministry of cooperatives official credit institutions finance factoring and securities and Finance) Economy and CNMV leasing companies mortgage-loan companies etc) bull Stock exchanges bull Insurance companies Finance bull Interbank foreign exchange and book-entry public debt bull Stockbrokers bull Pension funds
markets bull Venture capital(companies and funds)
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TH
E P
LAY
ER
S T
HE
IR S
UP
ER
VIS
OR
S A
ND
MO
RA
L HA
ZA
RD
119
Financial institutions and their supervisors
Country and supervisory structure Banking Securities Insurance
Banking Advisory High Level Securities Supervisors Committee (BAC) Committee (HLSS) Insurance Committee (IC)
Supranational (EU) bull Formulates standards for prudential bull Coordination of securities market bull Formulates standards forsupervision supervision prudential supervision
BACICHLSS Banking Supervision
Conglomerates Committee (BSC) Securities Contact Committee Regulation of prudential bull Systemic risk monitoring bull Regulation and implementation of supervision securities admission
International Association International International Organization of of Insurance Supervisors
Basel Committee Securities Commisison (IOSCO) (IAIS) Joint Forum Conglomerates Supervision bull Supervision and regulation best bull Supervision and regulation best bull Supervision and regulation amp regulation Best practices practices practices best practices
FSF Coordination across supervisors of various functions
Notes See appendix B for more information Boldface type indicates senior or oversight supervisor normal type indicates adjunct or front-line supervisorsolid line indicates direct responsbility to the senior-ranking authority dotted line indicates coordination in supervisory activities
(table continues next page)
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Table 210 Financial-sector regulation G-10 countries 2000 (continued )
Glossary of names United Kingdom FSA = Financial Services Authority United States FR = Federal Reserve OCC = Office of the Comptroller of theCurrency FDIC = Federal Deposit Insurance Corporation SEC = Securities and Exchange Commission OTS = Office of Thrift Supervision Japan FRC =Financial Reconstruction Commission FSA = Financial Services Agency SESC = Securities and Exchange Surveillance Commission Canada OSFI =Office of the Superintendent of Financial Institutions CDIC = Canada Deposit Insurance Corporation Germany FBSO = Federal Banking SupervisoryOffice FSSO = Federal Securities Supervisory Office FISO = Federal Insurance Supervisory Office BSO = Banking Supervisory Office Italy Consob =Commissione Nazionale per le Societa e la Borsa ISVAP = Instituto per la Vigilanza sulle assicurazioni private e di Interesse colletivo Switzerland SFBC= Swiss Federal Banking Commission Spain CNMV = The Comision Nacional del Mercado de Valores Supranational BAC = Banking Advisory CommitteeBSC = Banking Supervision Committee IC = Insurance Committee HLSS = High Level Securities Supervisors Committee International Dimension FSF =Financial Stability Forum IOSCO = International Organization of Securities Commission IAIS = International Association of Insurance Supervisors
Sources United Kingdom Bank of England httpwwwbankofenglandcouk Financial Services Authority httpwwwfsagovuk United States Board ofGovernors of Federal Reserve System httpwwwfederalreservegov Japan Bank of Japan httpwwwbojorjo Financial Reconstruction Commissionhttpwwwfsagojpfrcindexehtml Financial Services Agency httpwwwfsagojp Canada Bank of Canada httpwwwbank-banque-canadaca Office ofthe Superintendent of Financial Institutions httpwwwosfi-bsifgccaAndreEindexhtml Germany Deutsche Bundesbank httpwwwbundesbankde Fed-eral Banking Supervisory Office httpwwwbakredde Italy Banca drsquoitalia httpwwwbancaditaliait Commissione Nazionale per le Societa e la Borsahttpwwwconsobit Instituto per la Vigilanza sulle assicurazioni private e di Interesse colletivo httpwwwisvapit The Netherlands De NederlandscheBank httpwwwdnbnl France Banque de France httpwwwbanque-francefr Switzerland Schweizerische Nationalbank httpwwwsnbchindex3htmlSweden Sveriges Riksbank httpwwwriksbanksedefaultasp Belgium National Bank of Belgium httpwwwbnbbesgindexhtm Spain Banco de Espantildeahttpwwwbdees The Comision Nacional del Mercado de Valores httpwwwcnmves Supranational (EU) Institutional Arrangements for the Regulationand Supervision of the Financial Sector 2000 International Dimension Bank for International Settlement httpwwwbisorg International Organization ofSecurities Commissions httpwwwioscoorg International Association of Insurance Supervisors httpwwwiaisorg Financial Stability Forum httpwwwfsforumorg
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 121
the inflexibility of tight surveillance against the need to encourage in-novation and growth The US Securities and Exchange Commission isworried about aggressive accounting by firms and biased reports bysecurities analysts in an equity environment that prizes steadily higherquarterly earnings41 Japanese regulators are preoccupied with opaqueinterconnections between portfolio institutions banks and nonfinancialfirms through the keiretsu system Canadian regulators reeling from high-profile scandals of managers intentionally misleading investors are strengtheningmarket discipline through legal penalties aimed at managers and directorsof offending firms
When panic strikes a securities regulator cannot do much As the 1987stock market crash and the LTCM debacle in the fall of 1998 both dem-onstrated steep stock and bond price declines can create systemic risksIf severe enough the wealth effect of falling securities values and thefear of widespread insolvency can depress real activity Flooding thesystem with liquidity is a central bankerrsquos solutionmdashsomething a securi-ties regulator cannot do42 But just as financial supervisors can changethe incentive structure to discourage bankers from making risky loans ingood times so securities regulators can pay more attention to incentiveson the demand side when capital markets are strong
Prudential Supervision and InnovationmdashA Footnote
In concluding this discussion of prudential supervision in the G-10 anadditional point is worth noting National regulators face a persistenttrade-off between emphasizing financial system safety and soundnesswhile encouraging innovationmdashin spite of the added risks innovationbrings to financial markets Former US Treasury Secretary Lawrence Summers(2000 3) has argued by analogy
The jet airplane made airplane air travel more comfortable more efficient andmore safe though the accidents were more spectacular and for a time morenumerous after the jet was invented In the same way modern global financialmarkets carry with them enormous potential for benefit even if some of theaccidents are that much more spectacular As the right public policy response
41 The problem is illustrated by the divergence since mid-1998 between reported earn-ings by the Standard amp Poorrsquos (SampP) 500 and the after-tax profits of all corporations inthe national accounts Generally these two series move closely with one another Be-tween mid-1998 and mid-1999 SampP 500 reported that earnings increased by more than20 percent while after-tax profits of all corporations increased by less than 5 percent(Chase Bank US Economic and Policy Research US Weekly Prospects Chase SecuritiesWeekly Newsletter 5 June 2000 5)
42 For example the US Securities and Exchange Commission had no direct role in calmingmarkets in the 1987 or 1998 panics
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122 WORLD CAPITAL MARKETS
to the jet was longer runways better air-traffic control and better training forpilots and not the discouragement of rapid travel so the right public policyresponse to financial innovation is to assure a safe framework so that the ben-efits can be realized not to stifle the change
Accepting Summersrsquos analogy for the international financial system better-informed supervisors and investors are a necessary part of the financialsystem framework Supervisors require more timely information on therisk profiles resulting from positions taken by financial institutions Theyalso need a better understanding of risk-management systems Snapshotsof an institutionrsquos risk profile and risk-management procedures are nolonger adequate In a world where huge bets are quickly made (andpossibly lostmdashas with Barings Bank in 1995 and LTCM in 1998) super-visors must focus on the soundness of banking systems for evaluatingand managing risk on a daily basis Some progress has been made inaddressing these issues US banking examiners are extending their in-formation requirements in banking examinations and increasing theirinvolvement in large complex institutions43 More awareness is alsorequired of the fact that they are national organizations in a world ofcross-border capital flows To a much greater extent they need a multi-national reach International supervision and coordination among super-visors are the subject of the next section
Our analysis suggests that G-10 supervisors have unfinished businessBank supervisors need to start yesterday securities regulators can waituntil tomorrow One G-10 member acting alone cannot correct the biasIn good times the lending business will simply migrate to other G-10banks In bad times financial problems will not stop at the national bor-der A way has to be found to establish common international standardsfor the key financial players in order to prevent crises and to agree onapproaches for managing them The path has already been laid out Inthe wake of the bank failures of the past 25 years bank supervisors havetried to establish such standards They have done this without creating anew global institution
The essence of the international framework is decentralizationmdashglobalrules and design standards without global institutions that are perceivedto intrude on national sovereignty The awkward jargon for this frame-work is vertical subsidiaritymdashldquothink internationally act nationallyrdquo Theinternational thinking is done by a committee of regulators that meets
International SupervisionA Decentralized Framework
43 These issues are discussed in Ferguson (1999) and Meyer (2000a)
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 123
regularly at the Bank for International Settlements in Basel The commit-tee establishes principles and standards that are interpreted implementedand enforced by national authorities44 In this section we describe thesesupervisory efforts and their weaknesses We present our recommenda-tions for addressing these weaknesses in the next chapter
Basel I
The Basel Capital Accord of 1988 (Basel I)45 drew the lesson from thefinancial crises of the mid-1970s that more adequate capital levels in in-ternational banks would help reduce the systemic risk of bank failureThe primary goal of Basel I was capital adequacy other standards wereput in place not so much for their own virtue as to defend the primarygoal
Capital adequacy requirements were designed to ensure that individualinstitutions have the ability to absorb losses particularly credit lossesAccordingly a backup system of scoring credit risk was devised thatrequired large amounts of bank capital for some types of loans smalleramounts for others and zero for a select list of preferred assets Report-ing requirements were designed to disclose problems and ensure that atroubled bank would take timely steps to restore its capital base in thewake of a loss The Basel I framework worked tolerably well in limitingthe call on the public purse in the G-10 countriesmdashwith the notable ex-ceptions of France and Japan The framework failed to moderate riskybank lending to emerging markets however
Basel I was not developed with emerging markets in mind The origi-nal idea behind it was to develop a common supervisory approach tocross-border banking operations It grew out of political pressure fromUS lawmakers who were determined to require international banks op-erating in the United States to meet US banking standards Toward thisgoal in 1983 Congress passed the International Lending Supervisory ActUS and British banking authorities subsequently agreed on a commontarget the adoption of strict common capital-adequacy standards In 1988other G-10 governments agreed to go along voluntary acceptance ofthe standards throughout much of the rest of the world followed46 Therationale for the capital targets was two-fold The first was to requirebanks to hold sufficient amounts of capital (8 percent of risk-adjusted
44 The international committee of financial authorities agreed on a common definitionof banksrsquo tier-one or ldquocorerdquo capital national authorities defined tier-two capital in theirown manner which permitted greater variations in national working definitions andpractices
45 International Convergence of Capital Measurement and Capital Standards (BIS 1988)was prepared by the Basel Committee on Banking Supervision
46 See Reineke (1998)
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124 WORLD CAPITAL MARKETS
assets) to cushion losses on those assets The second was to dull theirappetites for risk banks with large capital bases would have more tolose if they failed and therefore would take fewer risks
Rapid change in financial markets soon revealed flaws in the Basel IAccord In a complex world with numerous sources of risk it focusedheavily on credit risk but overlooked other risks in a bankrsquos portfolioand the correlation between returns on different asset classes The Baselformula required banks to maintain a fixed amount of capital againsteach of its asset classes But the formula did not distinguish the riskinessof the borrower within each class As a result one large loan to a low-risk corporate borrower such as General Electric would require the sameamount of capital as 10 smaller transactions with high-risk borrowers
The system was also biased toward short-term loans Loans maturingin less than a year required a 20 percent risk weight whereas those ma-turing after more than a year required a 100 percent risk weight Inter-bank lending was particularly favored For example loans to banks inOECD countries required less capital than loans to private firms in thesame countries creating the anomaly that interbank loans to South Ko-rean banks required less capital than loans to General Electric47 Thisanomaly encouraged banks to shed high-quality assets if the Basel rulesrequired the allocation of more capital than banks thought they needed
Another weakness was that financial innovators quickly circumventedthe Accord Because short-term loans required less provisioning than long-term loans banks responded by securitizing their long-term debt port-folios and lending short-term against the collateral of the newly createdasset This allowed banks to circumvent the capital requirements gearedto the terms of the underlying debt At the same time the Basel I Accordfailed to encourage risk mitigation techniques such as credit derivativescollateral guarantees and on-balance-sheet netting the flip side of fi-nancial innovation Because off-balance-sheet products were not coveredby the Accord another anomaly appeared when Barings Bank collapsedin 1995 Barings met capital adequacy standards but collapsed becauseits systems for managing risk failed traders were allowed to speculatein futures contracts that did not appear on the balance sheet
Basel II
Work to overhaul Basel I began in 1995 and produced consultativepapers issued in June 1999 and January 200148 These papers have been
47 South Korean banks have had notoriously weak balance sheets because the practiceof ldquodirected lendingrdquo left them with many poor loans (in making these loans the bankswere expected to follow government objectives rather than creditworthiness criteria)
48 Basel Committee on Banking Supervision (1999 2001)
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 125
the subject of extensive consultation and revision as a result the newAccord is expected to be introduced in 200449 The Basel II frameworkhas three parts (pillars) revisions to Basel I minimum-capital require-ments supervisory review criteria and greater emphasis on market dis-cipline Broadly Basel II aims to maintain the level of capital in the sys-tem but achieve better alignment of banksrsquo capital with their risk pro-files and keep up with financial innovation
To align capital requirements with market realities (the first pillar)Basel II concentrates on the 100 or so largest banksmdashthe type of playerslisted in table 21mdashand on the holding-company parents of banking groups50
Capital requirements will differentiate between an increased number ofcredit groups or ldquorisk bucketsrdquo including claims on governments otherbanks corporations mortgage-backed securities and other asset-backedsecurities
Basel II originally proposed to use external ratings to set capital chargesfor a number of these credit risks Many banks objected arguing thatthey assess credit risk better than Standard amp Poorrsquos Moodyrsquos or FitchIBCA51 Basel II thus proposes two approaches to rating a standard ap-proach using external ratings and an ldquoadvancedrdquo approach that allowsselected banks to use their own internal rating systems To encouragethe development of rigorous internal control systems based on these in-ternal rating systems Basel II also proposes to levy capital charges foroperational risk (the risk of direct or indirect loss resulting from inad-equate or failed internal processes people and systems or from exter-nal events)
Some critics of this proposal dismiss it as an abrogation of the prin-ciple of external independent monitoring and as ldquodangerously naiumlverdquo52
But regulators argue that the new capital charge on operational risk shouldoffset this concern It is also far from clear how cross-national compari-sons of rating and internal risk-assessment systems will be made (Engelen2000) The development by the European Union of its own capital rulescould well complicate the international resolution of these issues Publicassurances by EU officials in January 2001 however indicated that theirmain concerns are to create a level playing field and avoid regulatoryarbitrage (Hargreaves 2001) There is also the significant problem ofthe procyclical character of risk weights When a crisis hits losses are
49 See Berry (2000) for an update in an interview with William J McDonough chair ofthe Basel Committee on Banking Supervision
50 For obvious reasons these proposals are addressed to large banks and simpler capi-tal standards are allowed for small banks that focus on their domestic credit markets
51 See Ammer and Packer (2000) for an empirical critique of the success of rating agen-cies in distinguishing risk by sector and region
52 See Auerback (2001)
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126 WORLD CAPITAL MARKETS
incurred or accrued capital is lost and loan exposure must be reducedor securities sold to restore the requisite capital-adequacy ratios A morerisk-sensitive framework could amplify volatility
As the second pillar of Basel II supervisory review criteria are beingbeefed up to encourage supervisors to intervene earlier in potential problemsituations and to compel banks to align their capital positions with theirrisk profiles Bank supervisors will be authorized to require banks tohold capital in excess of minimum requirements if they have concernsabout general management overall strategy risk-management performanceor the macroeconomic environment Of course if one G-10 supervisorimposes higher capital requirements in isolation the same disparity willemerge that presaged Basel I Some banks will be disadvantaged in theinternational marketplace and will loudly complain that excessive super-vision is driving business to their competitors Hence close internationalcooperation among supervisors is critical
To implement the third pillar market discipline banks will be requiredto make fuller more timely disclosure of capital adequacy and the risksto which that capital is exposed A number of measures are being stud-ied that might help supervisors evaluate bank performance such as com-parisons of uninsured deposit interest rates subordinated debt yieldsand equity prices The idea is that these yields and prices might alertsupervisors to market perceptions of risk Of course market perceptionsare only as good as market information More direct and controversialways to reinforce market discipline would dramatically increase publicdisclosure of bank positions and risk management systems
Many questions are still outstanding about how to resolve the techni-cal details of capital requirements and whether the requirements willachieve their intended goal of better assessment and mitigation of therisks in banksrsquo portfolios There is no substitute for skilled supervisorsThe intricacies of effective design and implementation suggest that su-pervisors need to be highly competent technically knowledgeable aboutbanking portfolio characteristics and the factors that influence bank ex-posure to credit risk (Mishkin 2000) And they must be aided by vigilantshareholders market forces and transparency of information53
Standard setting at the global level is desirable but ultimately theeffectiveness of these efforts will be tested at the national level espe-cially in times of systemic financial distress Here the record of Basel Iwas not a bright shining success Japanese banking regulators havetraditionally allowed banks to include real estate and securities in theircapital base When the value of these assets plummeted in the early 1990sregulators allowed banks to continue valuing these depreciated (andoften bankrupt) assets at their old inflated levels Japanese authorities
53 Benedict Roth Complacency Towards Catastrophe Financial Times 23 January 2001
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 127
insisted until the mid-1990s that eroded capital bases could be rebuiltin a market-driven fashion They rightly foresaw that huge loan losseswould undermine public support for the ruling party and require a po-litically unpopular bailout
Japanese foot dragging on Basel I was the worst54 but not uniqueOther examples can be found of ldquopolitically mandated forbearancerdquo TheFederal Reserve Bank of New York held important hands during theLTCM crisis of 1998 Mexico is still resolving the banking crisis that eruptedin 1995 South Korea has not yet closed the insolvent banks that behavedso badly before the crisis of 1998 In the aftermath of a crisis nationalregulators cannot always be relied upon to discipline politically power-ful bankers55 One of the little-noticed consequences of these differingapproaches is that those banks with strong regulatory systems receivedan implicit ldquoexport subsidyrdquo for their services US banks which had notengaged extensively in emerging-market lending in the 1990s were bet-ter positioned than their German and Japanese counterparts to expandtheir international assets in the wake of the crises
Other Financial Forums
54 See Japanese Banks Fiddling while Marunouchi Burns The Economist 27 January2001 67-69
55 See Calomiris (1997)
The Basel model of vertical subsidiarity has already been extended toother financial regulatory bodies In 1993-94 the BIS established a Tri-partite Group of Banking Insurance and Securities Regulators In 1994-95 the BIS increased its cooperation with the International Organizationof Securities Commissions when the two organizations issued parallelpapers on guidelines for national regulators concerning risk managementand disclosure of derivative trades In 1996 a permanent Joint Forum onFinancial Conglomerates was established to examine supervisory issuesand develop working arrangements among the different functional super-visors of conglomerate institutions that offer combinations of bankingsecurities and insurance products Draft papers on the supervisionof conglomerates were released for comment in 1998 applying capital-adequacy principles to these groups and providing guidelines both forassessing the integrity and competence of top managers and for sharingassessments between regulators
In 1997 the Basel Committee on Banking Supervision extended itsreach beyond capital standards to broader aspects of banking supervi-sion with the publication of the Core Principles for Effective BankingSupervision In 1999 a wide range of regulatory and standard-settingbodies were gathered under the umbrella of the Financial Stability
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128 WORLD CAPITAL MARKETS
Forum (FSF) itself established under BIS aegis56 The FSF has alreadyissued recommendations for stepped-up supervision and transparencyas well as guidelines for best practices in a number of areas includingoffshore financial centers and highly leveraged institutions or hedge funds57
Conclusion
Although the structural weaknesses in emerging-market economies arewidely acknowledged to have been causal factors in international capi-tal-market volatility this chapter points to the role of large G-10 bankingorganizations as major suppliers of the most volatile instrument short-term debt We have examined evidence of the impact of public safetynets in the G-10 economiesmdashthe deposit insurance systems the pruden-tial supervisory systems and the lender-of-last-resort functions of centralbanksmdashon the incentive structures of these organizations
Although supervisors in most countries working nationally and to-gether in the BIS have made significant efforts to mimic market forcesin their prudential supervision the most sophisticated financial institu-tions find innovative ways to circumvent the rules New global regulatorybodies are not about to be created G-10 national bank regulators shouldthemselves address the short-term debt bias in the international financialsystem by changing incentive systems G-10 securities regulators shouldalso take steps to get ahead of the curve paying close attention to largeportfolio swings by institutional investors particularly in times of crisisIn short more needs to be done at national and international levels tochange the rules of the game That is the subject of the next chapter
56 The Financial Stability Forum includes banking securities insurance and accountingregulatory bodies the OECD on taxation corruption and corporate governance and theIMF
57 See Martin (2000)
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 95
respect to emerging markets banks have more often been propagatorsthan absorbers The average annual swing in bank lending to emergingmarkets was nearly $50 billionmdashby far the largest source of year-to-yearfluctuations in capital flows Both interbank loans between Europe Japanand Asia and sovereign Russian debt used as loan collateral played amajor role in the 1997-98 crisesmdashnot because banks are profligate playersbut because of the incentives they face and the instruments they useAccordingly our story begins with banks
Banks in the Modern Financial System
10 See Levine (2000) for a concise description of the role of banks in the financial system
11 The asymmetric information problem helps to explain why banks dominate the im-mature financial systems of emerging-market economies The general lack of informationon borrowers and undeveloped legal systems to enforce contracts hamper suppliers oflong-term financial instruments such as equities and bonds in evaluating risk and re-ward Banks are best suited in these circumstances to solve the asymmetric informationproblem by evaluating and monitoring private loans As more and better informationbecomes available capital markets develop and financial systems mature
As we noted in the previous paragraph the problem of financial volatil-ity in emerging-market economies is associated with bank lending Ifand when repayment problems arise cross-border private bank loansand bond placements are such that private creditors have no plausiblemeans of seizing assets from either private or sovereign borrowers Thusalthough international finance can nourish entrepreneurs and accelerategrowth a necessary complement may be a drastic creditor response inthe event of nonpaymentmdashto withhold fresh funds and force an eco-nomic crisis (Dooley 2000)
This argument is based on the characteristics of banks They are notldquobadrdquo per se They perform three essential functions in any financialsystem pooling the resources of disparate savers and channeling these re-sources into productive investment improving resource allocation throughtheir expertise in assessing and monitoring borrowers and facilitatingthe division of risk among numerous creditors10 But by their very na-ture banks are prone to two problems asymmetric information (the bor-rower knows more about the potential risk and return of its projectsthan the bank) and adverse selection (riskier borrowers will pay higherinterest rates and thus may constitute a disproportionate share of bankloan portfolios)11
Bank loans are illiquid fixed-price instruments They cannot easily beconverted to cash although they can be bundled into securities (knownas ldquosecuritizationrdquo) Once loan terms have been agreed on the only waya bank can adjust for shifting market conditions is by changing the quantityof its exposure When a borrower runs into trouble the bank can mix
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96 WORLD CAPITAL MARKETS
and match from two unpleasant menus It can roll over existing loansand extend new credit or it can call some part of existing loans andattempt to recover the principal It can also hedge by selling short otherclaims on the borrower These choices entail either an unwelcome exten-sion of the bankrsquos exposure or credit rationing against the borrower Whentrouble brews all banks encounter the same conditions in the aggregatethey prefer less exposure and ensuing credit restrictions lead to volatilebank lending
Innovation
12 Derivatives have no value of their own They ldquoderiverdquo their value from the value ofthe underlying asset They include swaps futures (contracts for future delivery at speci-fied prices) and options (which give one party the right but not the obligation to buyfrom or sell to a counterparty at an agreed price)
13 Maxfield (1998) analyzed available evidence of emerging-market investor objectivesmost of it before the crisis Analysis of portfolio equity flows is sensitive to the choice ofperiod with year-over-year data indicating that investors respond to country ldquofundamen-talsrdquo Other evidence suggests more ambiguity Ranking by ldquoinvestor impatiencerdquo ie thesearch for yield over value Tesar and Werner (1995) find short-term bank flows to be themost yield driven followed by portfolio investment FDI and long-term bank lending
14 Because market risk credit risk and country risk interact in complex ways newfinancial instruments have been created to help reduce negative interactions One is theldquototal return swaprdquo which has become an instrument of choice for hedge funds lookingfor high leverage Banks also use the total return swap to cover risks without increasingtheir capital requirements
Since the 1980s national and international banking systems have beentransformed by deregulation intensified competition and the informationand communications-technology revolutions The market environment isone of intense competition particularly in traditional banking activitiesThe innovations point away from traditional activities of plain vanilladeposit taking and loan making Three big themes are discernible Firstthe walls separating commercial banks investment banks portfolio man-agers and insurance firms are falling even if they are still distinct Sec-ond large banks are shifting toward securitizationmdashcreating securitiesout of everything from credit card debt to trade finance to disaster insur-ancemdashand earning fees in the process Third all large banks are shiftingtoward trading activity making markets and taking short-term stakes inbonds shares and derivatives12 These activities when successful satisfythe search for higher yields13
Many of the new financial instruments that banks trade are ldquooff bal-ance sheetrdquo This means that banks are not required to allocate capitalagainst them In swap contracts for example neither side pays cash at theoutset and therefore neither party has an asset in the traditional sense14
Futures and options contracts can be written with a relatively small initial
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 97
margin relative to the potential risk Credit derivatives limit credit risk bytransferring the potential loss associated with corporate loans and bondssovereign debt and other loan portfolios to counterparties15
Deregulation and innovation working in combination seem to havepushed banks into trading activity and leveraged plays but not into shareownershipmdasheven in jurisdictions that have no prohibition against equitystakes Among the G-10 banking systems the highest ratio of share own-ership to assets was only 5 percent in 1996 reached in Germany andJapan (Berlin 2000)16
The wave of innovation in financial instruments and the accompany-ing expansion of banking beyond its old boundaries is a two-edged swordOn one side it allows risk management far beyond what was tradition-ally possible Risk can now be shifted from firms that can ill afford lossesto those that can Banks can profitably act as intermediaries in shiftingrisk On the other side the innovation wave creates huge opportunitiesfor leveraged plays fostering a speculative search by banks themselvesfor high returns that in turn magnify their own risks17
15 Credit derivatives include total return swaps credit default swaps credit-linked notesand collateralized debt obligations They are the fastest-growing sector of the global de-rivatives market
16 Banks seem to specialize in lending even when they are allowed to mix finance andcommerce for reasons related both to how they are expected to behave with distressedfirms and to other intricacies of lender liability (Berlin 2000) Yet a recent cross-countrystudy found that restrictions on banking and commerce are associated with greater fi-nancial instability (Barth Caprio and Levine 2000)
17 Leverage is the magnification of the rate of return (positive or negative) on an in-vestment beyond the rate obtained by solely investing funds owned by the institution Itis often defined as the ratio of assets to equity Leverage is achieved by increasing thesize of an investment by borrowing or using derivative instruments such as futures oroptions These allow investors to earn a return on the notional amount underlying thecontract by committing a small portion of equity in the form of a margin deposit oroption premium payment
18 In a repo (repurchase agreement) one party (typically a trader) buys a bond andsells it to a dealer for cash with a promise to buy it back the next day at the same priceplus the overnight interest rate As long as the overnight interest rate is lower than theinterest accruing on the bond the trader earns some income on the bond The extremeform of these kinds of transactions was discovered at LTCM the failed US highly lever-aged institution which appears to have controlled more than $120 billion in assets froman investment of about $3 billion This leveraging was accomplished mostly through theuse of repos (Mayer 1999)
The potential for damage is illustrated in an extreme form by figure 21To precisely measure a firmrsquos leverage all positions must be known andrealistically valuedmdashwhich may be impossible to do Because many ac-tivitiesmdashsuch as repos18 and derivativesmdashdo not appear on the institutionrsquos
Leverage
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MA
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Figure 21 Hypothetical example of leverage
$1000 notional value of call option on equity in firms targeted for takeover
Repo FRN into cash and use cash to pay option premium
(repro is initially collateralized
Borrow $100 for margin purchase
$125 of US investment bank floating-rate notes (FRN) (secured by $25 equity in FRNs)
Repo off-the-run bond into cash and post margin
(repo is initially collateralizedSell (short) Borrow on-the-run bonds worth $20
$25 worth of off-the-run bonds (secured by $5 equity in bonds)
Exchange into $4
Cash $5 yen400 Japanese bank loans
$1 equity base
FRN = floating rate notesRepo = repurchase agreement
Source IMF (1998)
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 99
balance sheet and because balance sheets are published quarterly at bestoutsiders have a difficult time assessing the extent of a firmrsquos leverage19
Leveraging by a single firm enhances its risk of default the widespreaduse of leverage in the financial system can magnify market adjustmentsespecially when they require ldquodeleveragingrdquomdashunwinding prior positionsRapid adjustments can cause credit to dry up and asset prices to plummetIn a mark-to-market environment falling asset prices trigger calls foradditional collateral that can ripple through markets
Risk Management
Because it is confronted with the widespread use of leverage and prolif-erating kinds of risk international finance is increasingly driven by riskevaluation and control20 Different institutions face various risk profilesand differing kinds of risk The most common risks can be quickly tickedoff Banks because of their traditional intermediary role of channelingthe resources from savers to borrowers face significant credit risk therisk of default or delay in the payment of principal and interest Theymust also manage market risk the risk that the prices of their liabilitiesmay change faster than their assets Market risk devastated US savingsand loan institutions in the late 1980s
Closely associated with market risk are interest-rate risk (unexpectedchanges in market interest rates that slash margins net income and theeconomic value of a bankrsquos equity) and foreign exchange risk (losses thatarise when assets denominated in an appreciating foreign currency areless than liabilities denominated in that currency) Banks make numer-ous loans to other banks around the world portfolio investors buy se-curities direct investors acquire fixed assets and all incur country risk(economic and political uncertainty in the host country) During the heightof the Asian crisis for example interbank loans to Japanese banksreflected the credit risk of lending to these banks the so-called Japanpremium
Substantial attention has been lavished on country risk analysis sincethe 1982 debt crisis in developing countries Yet in spite of this exper-tise the Asian crisis occurred in part because of a sudden upward reap-praisal of country risk after the Thai baht collapsed in April 1997 Banksand other financial institutions must also manage liquidity risk the riskthat market conditions will change unexpectedly depressing demand andprices of assets at the time they want to sell these assets And they mustmanage operational riskmdashfailures in control systems or people that cause
19 Another example of asymmetric information Both risk and leverage are difficult foroutsiders to assess without full timely disclosure
20 A longer discussion of these issues can be found in Managing Global Finance in IMF(1999c)
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100 WORLD CAPITAL MARKETS
financial loss or damage reputations Operational risk devastated BaringsBank in 1995
Financial institutions practice risk management to measure all theserisks the potential damage to their investment positions and ultimatelythe chance of becoming insolvent VAR (value at risk) risk models mea-sure subject to certain assumptions the amount of the firmrsquos capital thatis exposed in each period For example the VAR model might say thatin a 3-standard-deviation worst case (a case that is not supposed to hap-pen more than 1 percent of the time) the firm will loose 25 percent of itscapital during the next year
VAR models are widely used but like all models they have weak-nesses They rely on past values to estimate key variables in financialmarkets past values are not always good predictors of future risks More-over rising volatility and higher loss correlation among different assetclasses in a portfolio will cause all banks using these models to reducetheir exposures at the same time by switching to less volatile and lesscorrelated assets such as US Treasury bills (Persaud 2000)
Newer risk models entail stress testing and scenario analysis Scenarioanalysis envisages possible adverse changes one at a time that mightaffect the investment portfolio Stress testing estimates potential losseswhen several individual risk factors simultaneously move against thefirm but it too uses historical probabilities
Financial Volatility
21 For example derivative markets usually rely on underlying securities markets thatproduce continuous prices When these markets are interrupted financial shocks cantrigger a cascade of margin calls and sell orders that move prices very sharply
22 See IIF (1999a)
The combination of trading activity and modern risk management lie atthe root of financial volatility When risks increase banks must eitherraise more capital to cover the greater risk or reduce their exposure bycutting loan exposure by selling securities or by undertaking new de-rivative trades Raising more capital is time-consuming and in a crisisvery expensive because bank shares are depressed So banks look to theother alternatives If the bank can reduce lending it need not book aloss But most banks use the same VAR models and as indicated abovethese models will encourage them to reduce their outstanding loans atthe same time actually magnifying loan volatility
If banks attempt to reduce their exposure to risk by selling securitiesor undertaking new derivative trades they may trigger large priceshocks because of limited and shrinking market liquidity21 The liquid-ity problem is compounded when a small number of large institu-tions hold the same positions22 Take your pick loan volatility or price
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 101
volatility As two experts have observed (Folkerts-Landau and Garber1998)
[V]olatility even in one country will automatically generate an upward re-estimate of credit and market risk in a correlated country triggering automaticmargin calls and tightening of credit lines Thus apparently bizarre opera-tions that connect otherwise disconnected securities markets are not the re-sponses of panicked green screen traders arbitrarily driving economies from agood to a bad equilibrium Rather they work with relentless predictability andunder the seal of approval of supervisors in the main financial centers
23 See Ferguson (1999)
24 As Gerald Corrigan (1982) put the matter ldquoBanks are specialrdquo Corrigan (2000) reit-erated this view even after all the changes of the past two decades Unlike other institu-tions banks offer on-demand transactions are a backup liquidity source for other insti-tutions and serve as a ldquotransmission beltrdquo for monetary policy
These changes in the banking environment accentuate an existing anomalyThe anomaly is that banks even as they grow larger and increasinglyengage in more risky and complex transactions are perceived to enjoyimplicit and explicit public guarantees
The guarantees grow out of an incentive problem inherent in bankingasymmetric information which we mentioned above Depositors know lessabout a bankrsquos management and the quality of its balance sheet than doits managers and shareholders Thus in times of uncertainty or adver-sity bank depositorsmdashuncertain whether they will have access to theirdepositsmdashare prone to bank runs This prospect has in turn compelledgovernments to treat banks differently than other firms because a bankthat fails can disrupt the rest of the economy24
To prevent such crises governments have entered into quid pro quoarrangements with banks Governments provide them both with an im-plicit safety net in the form of an unstated promise by the central bankto act as a lender of last resort in a liquidity crisis and an explicit safetynet in the form of a public deposit insurance fund to reassure depositorsIn return the banks submit to closer government oversight and regu-lation of their activities than is usual for industries in the private sector
The ldquoinsurancerdquo provided by the public safety net contributes to an-other incentive problem moral hazard Banks acquire greater tastes forrisk and face less market discipline than other firms The explicit depositinsurance safety nets actually have or are perceived to have blanketcoverage that extends beyond the retail depositors (households and small
One of the lessons of the 1997-98 crisis must surely be that market par-ticipants and their regulatory supervisors relied too heavily on quantita-tive tools and insufficiently on judgment23
The Anomaly of Modern Banking
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102 WORLD CAPITAL MARKETS
businesses) for which they were originally intended The implicit centralbank safety nets extend in a crisis to nearly all depositors and banksThus banks are both viewed and behave as if they will be bailed out ifthey get into trouble
The existence of a public safety net raises a perennial question Dobanks have an unfair advantage over other financial institutions becauseof the subsidy provided by the safety net This question was at the heartof intensive study and debate in the United States leading up to thepassage in November 1999 of the Financial Services Modernization Act(also known as the Gramm-Leach-Bliley Act) The size of the gross sub-sidy is difficult to estimate despite determined research efforts Somesuggest it is well under 100 basis points and is at least partly offset bythe direct costs of deposit insurance premiums interest payments on bondsissued by the Financing Corporation25 reserve requirements regulatoryexpenses and operational costs associated with collecting deposits26 Con-versely Kwast and Passmore (2000) suggest that banks can expand theirscope far beyond the levels that other financial institutions could reachwith the same equity base but without the public safety net
A related concern in the US debate is whether allowing banks to ex-pand their activities into securities and insurance will ultimately extendthe safety net and add to the subsidy The Financial Services Moderniza-tion Act deals with this issue by maintaining a legal separation betweenbanks and the rest of the banking organization known as large com-plex banking organizations (LCBOs) They must engage in most securi-ties activities and insurance underwriting through separately capitalizedinvestment bank subsidiaries or holding company affiliates This act canbe said to have merely brought US banking laws closer to those of mostother industrial countries (Barth Brumbaugh and Wilcox 2000 BarthNolle and Rice 2000) If the fire wall is well-maintained and stoutly de-fended the safety net will neither expand in practice nor become a sourceof comfort to noncommercial bank subsidiaries of LCBOs
The quid pro quo exacted by governments to offset the subsidy iscloser public-sector monitoring of banksrsquo activities through prudentialsupervision The effectiveness of this closer official scrutinymdashand closermarket monitoringmdashare the subjects of the next section
25 The Financing Corporation was created by Congress in 1987 to sell bonds to raisefunds to help resolve the savings and loan crisis
26 See Levonian and Furlong (1995) Jones and Kolatch (1999) Shull and White (1998)and Whalen (1999a 1999b)
Are G-10 bank supervisors adequately responding In this section we firstassess the case for and compare the structures of prudential supervisory
Prudential Supervision
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 103
systems both within and among the G-10 economies plus Spain andconsider whether these offset the subsidy provided by the public safetynet Despite offsetting regulation and supervision implicit and explicitguarantees by G-10 governments to their banks are still a source of bank-ing instability in the emerging-market economies
National Systems for Prudential Supervision
Governments use prudential supervision to reduce the moral hazard andadverse selection created by their own safety nets Supervisors establishregulations and monitor compliance to limit risk taking and ensure thesafety and soundness of the banking system In a thoughtful analysis ofthe case for prudential supervision Frederic Mishkin (2000) identifiesthe main forms that supervision can take including the tasks of grantingbanking charters and licenses establishing capital requirements settingdeposit insurance premiums and defining disclosure requirements as wellas carrying out bank examinations Bank examiners gather informationfrom banks and evaluate whether they are following the regulatorsrsquo rulesin cases of weakness they are empowered to change banksrsquo behaviorand close them if necessary
Supervisors also may restrict competition define the activities in whichbanks may engage and restrict their asset holdings and separate banksand other financial (or nonfinancial) activities During the past two de-cades the barriers separating commercial banks investment banks in-surance firms and securities firms have been all but eliminated (tableB1) Deregulation has stimulated competitive forces that drive diversifi-cation and consolidation of the financial industry nowhere faster than inthe United States
The Financial Services Modernization Act of 1999 confirmed this trendIt eliminated restrictions dating back to the Glass Steagall Act of 1933which once prevented banking insurance and securities firms fromentering each otherrsquos businesses (Barth Brumbaugh and Wilcox 2000)Cross-pillar mergers among banks insurance and securities firms arewell under way to form giant financial holding companies The 1999merger between Citibank (banking) and Travelers (insurance) created themodel for megafinance and confirmed new challenges for supervisors
Mishkin (2000) notes the corresponding evolution in US supervisionfrom an emphasis on rules-based regulation (detailed rules for opera-tional behavior and the quality of line items in the balance sheet) to anapproach that stresses the soundness of bank management practices es-pecially risk management
Appendix B outlines the systems of financial supervision now in theplace in the G-10 countries plus Spain Some systems like the UK andCanadian approach are models of simplicitymdashorganized to keep pacewith the spreading reach of financial conglomerates Other systems like
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104 WORLD CAPITAL MARKETS
the US and French approaches show traces of the bureaucratic divisionsthat made sense in an era when banking securities and insurance weresharply separated
The US Model
27 See Meyer (1999a)
28 Canada has a similar degree of simplification with the exception that securities firmsare still regulated by provincial authorities
29 See Pratti and Schinasi (1999 67)
30 The agents are the bank regulators and the principals are the taxpayers Agents maypursue their own interests including bureaucratic survival and postgovernment employ-ment opportunities rather than the national interest in banking safety and soundness
The US model of financial regulation delineated in the Financial Ser-vices Modernization Act of 1999 blends functional and umbrella super-vision Bank and thrift regulators oversee depository institutions Newnonbank activities are subject to both functional regulation (eg by theSecurities and Exchange Commission and state insurance examiners) andumbrella supervision (of financial holding companies) by the FederalReserve27
The UK Model
Another supervisory model exists in the United Kingdom as well as inAustralia Canada and Switzerland28 In this model banking supervisionis separated from the monetary policy function The regulatory structureis considerably simplified by relying on a consolidated financial regula-tor separate from the central bank for both banking and nonbankingactivities The remaining question answered differently depending on thecountry is the extent to which the regulator relies on home-country sur-veillance of banks and conglomerates that have a local presence
Regulatory Models Compared
Appendix B provides more detail on the differences in these modelsGerman simplicity contrasts with French complexity In France the bankingcommission is chaired by the governor of the central bank and includesrepresentatives from the Treasury The commission supervises compli-ance with regulations but the central bank inspects banks on behalf ofthe commission29 In countries such as the United States and France withmultiple supervisors and crossover functions internal coordination is criticalAt the same time multiple agencies create regulatory competition Wheneach agency knows what the other is doing transparency within gov-ernment circles can help to limit principal-agent problems of regulation30
The discussion as to where in the public bureaucracy financial super-
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 105
vision should be placed goes back many years Peek Rosengren andTootell (1999) argue that a synergy exists between monetary policy andprudential supervision because information gained in the course of super-vision can increase the accuracy of macroeconomic forecasts A twist tothis argument is that the information on the state of financial institutionsavailable to the central bank as supervisor can facilitate its role as lenderof last resort Conversely there is the concern that a supervisory rolewill compromise the central bankrsquos independence of action with respectto its core mandatemdashmaintaining price stability As these arguments haveplayed out financial supervision has generally been shared between centralbanks and other regulators or placed entirely in the hands of an inde-pendent regulator However in Italy the Netherlands and Spain cen-tral banks are the sole banking supervisor
Goodhart (1995) examined the arguments and evidence for each modeland concluded that there were no overwhelming arguments or evidencefor one or the other31 Going forward a key problem for any financialsupervisory system is dealing with (and closing as necessary) weak banksIf both central banks and other regulators have this responsibility closecoordination between them is critical Another problem is large conglom-erate banks LCBOs Although they are less likely to fail because of thediversification of their assets and liabilities they are more likely to berescued They are also more likely to be multinational enterprises withinternational implications Goodhart observes that regulation of theseentities might be put in the hands of the central bank because it is lessamenable to political pressures In any event the complexity of LCBOoperations suggests that greater supervisory rigor is necessary
The US Congress was persuaded that broad oversight would help containthe moral hazard problem and accordingly gave the Federal Reservethe role of umbrella supervisor with the understanding that the Fed willscrutinize depository activity more intensely than nonbank financial ac-tivities Under this approach LCBOs such as Citigroup are subject tomuch closer monitoring than smaller and simpler institutions32 The USregulatory model requires enormous cooperation between the Fed otherbank supervisors and the functional regulators for insurance and securi-ties but it also benefits from regulatory competition
31 National systems of supervision are path dependent they are determined by the struc-ture of financial institutions and history in each country If Goodhart (1995) is right out-comes are not materially better or worse with one model of supervision rather than another
32 See Ferguson (1999)
Public Safety Nets
One of prudential supervisorsrsquo biggest challenges is to reduce moral hazardFor many years commercial banks engaged in communal self-insurance
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106 WORLD CAPITAL MARKETS
to deal with crises They formed voluntary groups that agreed to rescuetroubled members As financial markets evolved and competition inten-sified banks were no longer willing to play this role Private-sector in-surance is one alternative but moral hazard and adverse selection wouldappear to prevent it from happening Public safety nets have developedbecause of the low probability and high cost of potential bank runs Aclear trade-off is involved The effectiveness of insurance in preventingbank runs is greater the more comprehensive the coverage But the morecomprehensive the coverage the greater the moral hazardmdashbank man-agers bank directors investors and depositors all take on greater risksin the belief that the safety net will protect them against losses
All G-10 countries have compulsory public safety nets for banks (table29) Deposit insurance agencies are officially organized in Canada theNetherlands Sweden Switzerland and the United States organized bythe industry in France Germany Italy and the United Kingdom andjointly organized by the public and private sectors in Belgium Japanand Spain
How well do G-10 governments offset the subsidy provided by thepublic safety net This is a question on which there is substantial debateAs banking organizations have become more complex the challengesthat supervisors face have become more difficult One challenge is toalign the incentives facing bank managers and shareholders with thoseof depositors Another is the principal-agent problem in supervision Wehave discussed the incentive structures for financial institutions but wehave said little about the incentives for supervisors themselves and thedistortions they can generate in the financial system
In one of the many studies of the US savings and loan crisis of the1980s Kane (1989) documented both problems He described managersusing cosmetic approaches to disguise the magnitude of insolvency regulatorspracticing forbearance even though they knew of the deteriorating riskprofiles of the institutions for which they were responsible and legisla-tors increasing deposit insurance without regard for any offsetting changesin supervision A subsequent overhaul of the legislative framework forthe Federal Deposit Insurance Corporation (FDIC) known as the FDICImprovement Act of 1991 (FDICIA) aimed to introduce a clearer incen-tive structure for both regulators and regulated institutions
The changes introduced by this US legislation are worth discussionwith respect to the other G-10 countries as well First FDICIA created astronger signal to management and investors by targeting deposit insur-ance at small depositors only and by risk-weighting the deposit insur-ance premiums paid by banks to reflect their capital adequacy and bankexaminer ratings Among the G-10 countries rated in table 210 depositinsurance premiums vary considerablymdashbut it is not clear that the dif-ferences have much to do with risk-weighting Most G-10 countries em-ploy funding formulas based for example on the total domestic deposit
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E P
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Table 29 Deposit insurance schemes in the G-10 countries Explicit safety net
Coverage limit(dollar Foreign
equivalent currency Interbank Source Bankrsquos Contingency fundingDate Membership Co- at end of deposit deposit of premium from banks
Country established managementa insuranceb July 1998)c covered covered Fundingd funding costs or governments
United 1982 Compulsory Yes Larger of 90 No No Unfunded Banks only Callable (subject Parliament may increase Kingdom private percent co- to maximum the maximum payable
insurance to 03 percent of pound125 million advance 33000 total deposits) facility with Bank of
England
United 1934 Compulsory No 100000 Yes Yes Funded Banks and Up to 027 Borrowing up to $3 States official government percent total billion from US Treasury
domestic deposits
Japan 1971 Compulsory No 71000 but No No Funded Banks and 0084 percent of Borrowing up to yen500bn joint in full until government insured deposits from Bank of Japan
year 2000 subject to Ministry of Finance approval
Canada 1967 Compulsory No 40800 No Yes Funded Banks and 033 percent of Borrowing up to C$6 official government insured deposits billion authorized further
(maximum) borrowing subject to parliamentary approval
Germany 1966 Compulsory Yes 90 percent Yes No Funded Banks only 003 percent of Annual levy may be private coinsurance deposits doubled
to 22000
Italy 1987 Compulsory Yes 125000 Yes No Unfunded Banks and Callable Two options defer private government (maximum of payment or diminish
1 percent of compensation to be paid total deposits)
(table continues next page)
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108W
OR
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CA
PIT
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MA
RK
ET
S
Table 29 Deposit insurance schemes in the G-10 countries Explicit safety net (continued )
Coverage limit(dollar Foreign
equivalent currency Interbank Source Bankrsquos Contingency fundingDate Membership Co- at end of deposit deposit of premium from banks
Country established managementa insuranceb July 1998)c covered covered Fundingd funding costs or governments
Netherlands 1979 Compulsory No 22000 Yes No Unfunded Banks and On demand Government backing official government maximum of subject to parliamentary
5 percent of own approval funds
France 1980 Compulsory No 65400 No No Unfunded Banks only Callable (on Extra calls up to FFr1000 private demand calls million can be made in
up to FFr200 a 5-year period million)
Switzerland 1984 Voluntary No 19700 No No Unfunded Banks only Callable (on Underwritten by member official demand) banks
Sweden 1996 Compulsory No 31400 Yes No Funded Banks and 05 percent of Full emergency coverage official government deposits while replacing it with a
limited system after the emergency
Belgium 1974 Compulsory No 16600 No No Funded Banks and Callable 002 None insurance limited joint 22000 in government percent of to assets in fund
year 2000 deposits from clients
Spain 1977 Compulsory No 16439 Yes No Funded Banks and 02 percent of Government backing joint government deposits through the Banco de
(maximum) Espantildea subject to approval by royal decree
a Bank membership in the fund can be either compulsory or voluntary and the management of the fund can be official and official and private joint or privateb Coinsurance refers to the situation where depositors face a deductible against their insured fundsc Coverage limit refers to the explicit amount the authorities promise to insured Funded scheme means that it is funded ex ante unfunded otherwise
Sources Goodhart (1995) Demirguccedil-Kunt and Detragiache (2000) Demirguccedil-Kunt and Sabaci (2000)
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 109
base Explicit safety net protection also varies but only Canada focuseson the protected class33 All G-10 countries specify a limit on depositorprotection Under FDICIA the insurance fund is prohibited from pro-tecting uninsured depositors or creditors at a failed bank although adiscretionary system-wide override is provided for exceptional circum-stancesmdashbut with stringent requirements for consultation and account-ability Other G-10 countries allow for contingency funding from the publicpurse alongside unwritten lender-of-last-resort support Among large banksa significant and growing portion of deposit liabilities including foreigncurrency and interbank deposits are uninsuredmdashbut depositors assumethey will be protected in a crisis
FDICIA also made some significant qualitative changes to address theprincipal-agent problem by penalizing weak banks and rewarding strongbanks For example banks whose capital declined faced progressivelytougher regulatory sanctions that for example required them to elimi-nate dividends restrict their lending and change their managementsRegulators have also been forced to take prompt corrective action (toreduce the practice of regulatory forbearance in hopes that a bankrsquos for-tunes might improve)34 Unfortunately comparative qualitative assess-ments across the G-10 are difficult to make due to lack of information35
This discussion highlights the complexity of evaluating the extent towhich prudential supervision and market discipline reduce the moralhazard associated with G-10 safety nets Our argument is that publicsafety nets in the G-10 can be linked to banking instability in other coun-tries specifically in the emerging-market economies that have attractedG-10 cross-border bank lending This lending is a leading source of vola-tility in capital flows the large financial institutions many of which arecomplex banking organizations are based in and regulated by authori-ties in the G-10 economies These two features of the international finan-cial system are closely related although it is not possible to test thisrelationship econometrically
Two World Bank studies however indicate a basis for concern Onestudy is a cross-country econometric analysis of the relationship betweenbank stability and deposit insurance (Demirguccedil-Kunt and Detragiache2000) which found a negative relationship Their estimated model forbanking crises in a sample of 61 countries (both industrial and develop-ing) suggests that explicit deposit insurance raises the probability of acrisis by at least 30 percent36 Crises are especially likely in countries
33 Japanrsquos legislation says it does but recent experience shows this is not the case34 See Goldstein (1997) for a summary of the changes35 See Barth Nolle and Rice (2000) for a beginning in this area36 Demirguccedil-Kunt and and Detragiache (2000 table 1) report a logit coefficient of 0696with a standard error of 0397 (the coefficient is significant at the 8 percent threshold)This suggests that the ldquotruerdquo coefficient could well be as small as 030 (the reportedvalue minus the standard error)
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110 WORLD CAPITAL MARKETS
with immature financial supervisory systems (and not in the G-10) buttheir analysis does underscore the view that deposit insurance weakensmarket discipline37
An earlier World Bank analysis established similar results One wasthat market discipline is undermined by deposit insurance schemes an-other was that illiquid banks are forced to pay more for their funds un-less a generous deposit insurance scheme is in place (Demirguccedil-Kuntand Huizinga 1999) This econometric study also provides clear-cut evi-dence that depositor monitoring of banks declines with the existence ofdeposit insurance schemes At the heart of the problem is the questionof whether deposit insurance is accompanied by increased governmentmonitoring
This evidence and the weight of other arguments suggests that moralhazard is still an issue in the G-10 countries Consider the ongoing de-bate about instilling greater market discipline on risk taking by banksAt one extreme is the perennial proposal to do away with safety netsleaving markets to monitor the players and to force adjustments but toprotect small savers by creating ldquonarrow banksrdquo such as postal savingsystems that are allowed to invest these savings only in risk-free gov-ernment securities Whatever the merits of narrow banking this solutionis too extreme to be politically feasible
A moderate alternative is to force more disclosure by financial institu-tions to facilitate market monitoring But transparency has its own prob-lems Persaud (2000) argues that financial markets cannot reliably discernsustainable from unsustainable positions in the short term This uncer-tainty causes banks to ldquoherdrdquo behind market leaders to exploit theirsupposedly superior information ldquoThe more herding investors and bankersknow about what each other is up to the [more] unstable markets maybecomerdquo The implication is that greater transparency in the marketplaceby itself will not solve the problemmdashand in the short term more informa-tion may exacerbate herding Further supervisory steps (discussed in thenext chapter) are required
Yet another proposal is to promote private-sector involvement in bankmonitoring through market-based alternatives such as Calomirisrsquos sub-ordinated debt proposal (Calomiris 1997 Federal Reserve Board 1999)Banks could be required to issue and maintain a minimum amount of
37 Other findings in the Demirguccedil-Kunt and Detragiache (2000) study include thesepropositions The impact of deposit insurance on bank stability tends to be stronger themore extensive is the coverage offered to depositors when the scheme is funded andwhere the scheme is run by the government rather than by the private sector Con-versely deposit insurance is detrimental to bank stability where bank interest rates havebeen deregulated and where the institutional environment is weak Additional findingson deposit insurance are reported from a recent World Bank conference (8-9 June 2000httpwwwworldbankorgresearchinterestconfsupcomingdeposit_insurancehomehtm)Also see Smalhout (2001)
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 111
subordinated debt (eg uninsured certificates of deposit) to finance asmall fraction (such as 2 percent) of their total nonreserve assets Thesubordinated debt would be allowed to earn a set yield no more than 50basis points over the risk-free yield on government treasury bills Thisrule would supposedly force banks to operate in a safe manner Other-wise subordinated debt holders would redeem their uninsured certifi-cates of deposit and equity investors would sell their bank shares Despiteits practical problems the beauty of the subordinated debt requirementis that it enlists market incentives to push banks to avoid excessive port-folio risk38
The thrust of these proposals is very relevant to the arguments in ourstudy Even in the G-10 countries government monitoring by itself hasnot eliminated moral hazard among banks More work is needed to in-troduce market monitoring and to improve the incentive structures bothfor financial institutions and their supervisors We return to this issuewith our recommendations in the next chapter
38 In late 1996 Argentina began requiring its banks to finance 2 percent of total depos-its in the form of subordinated debt but without a maximum yield provision TheArgentine authorities expect that market discipline will act in concert with the publicsafety net One obvious problem with the subordinated debt proposal is that banks mayencourage some of their customers to buy the subordinated debt
Portfolio Institutions Tomorrowrsquos Problem
Before proceeding to the issues of international supervision we flag an-other potential problem for national regulators The big asset managersprofiled in tables 24 and 26 answer to diverse groups of pensionersshareholders and policyholders They allocate funds across a number ofcountries to diversify their risks They hold liquid assets that can be tradedand they have a higher proportion of long-term assets than banks Eco-nomic shocks can be absorbed through price changes and their effectsspread across time and markets Thus when conditions change in a par-ticular market they are more likely to ride out the storm than to flee Inother words they have less incentive than banks to pull their invest-ments in the face of adversity In the 1990s most large asset managersestablished a record of ldquoriding out the stormrdquo rather than ldquorunning withthe windrdquo although as we saw in chapter 1 instances of running withthe wind were detected in some portfolios As we write these insti-tutions have a good record overall in the emerging markets so whyworry
The Russian crisis and the near-collapse of LTCM previewed the dan-gers that may await future portfolio managers and G-10 financial minis-ters We have presented evidence indicating a systemic bias toward bank
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112 WORLD CAPITAL MARKETS
lending and debt finance to emerging markets and we have argued forsubstitution toward equity finance and direct investment39
That is not the end of the story We noted in the previous chapterthat institutional investors can become momentum investors selling in adownturn As more portfolio capital is invested in emerging marketssome players may adopt the high-risk high-leverage strategies of themost aggressive hedge funds Indeed the data in box 11 show that G-10portfolio investors held somewhat more long-term debt (more than $500billion) than equity (less than $400 billion) in emerging markets at theend of 1997 Long-term debt is an ideal vehicle for high-risk high-leveragestrategies These strategies practiced on a large scale could compound afuture crisis harming emerging markets A big enough crisis could inturn pressure G-10 central banks and finance ministers to arrange bail-out plans Instead of shrinking as a systemic financial problem moralhazard could increase
National securities regulators are the first line of defense against thisscenario They play a critical role in the safe evolution of capital mar-kets But regulators today are mandated to approve the issuance of newsecurities and to monitor the continuing disclosure of material informa-tion by issuers They are far less concerned with or empowered to monitorthe behavior of the increasingly large wealth-management firms that arethe major purchasers (and therefore resellers) of these securities
Within their mandates the goals of national securities regulators (table210 and appendix B) are similar to the concerns of bank regulators withsystem safety and soundness Their focus is also on the incentive sys-tems for management and boards of directors and on disclosure by cor-porations that issue marketable securities such as shares bonds andasset-backed securities 40 Issuers of securities possess greater knowledgeabout the quality of these assets than do the purchasers hence investorprotection is a key concern of regulators Moreover market disciplineworks best when markets know what is happening Well-functioning corpora-tions are key agents of wealth creation and social progress Underperform-ing corporations waste resources During recessions bad corporationsget into bad trouble often with severe social consequences Inadequateincentives for managers and inadequate accountability for boards andmanagers thus have negative externalities Regulators play a vital role inexposing weakness so that market disciplines come to bear sooner ratherthan later
Regulatory emphasis is constantly shifting as financial markets evolveand as the macroeconomic environment changes Regulators try to balance
39 See Rogoff (1999) Also see Berlin (2000) for a perspective on the limited role thatbanks play as share owners
40 See Habib and Ljungqvist (2000) for recent empirical analysis showing that corporateshare market values are higher when corporate executives have a larger ownership stake
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E P
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113
Table 210 Financial-sector regulation G-10 countries 2000
Financial institutions and their supervisors
Country and supervisory structure Retail banking Wholesale banking Securities Insurance
Financial conglomeratesFinancial Services Authority (FSA) = umbrella supervisor
United Kingdom FSA FSA FSA FSA
Treasury bull Commercial banks bull Investment funds (Securities and (Insurance Directorate(Securities and Investments Board) bull Unit trust groups Futures Authority) of the Treasury)
Bank of bull Building societies bull Pension funds England (Building Societies Commission) bull Merchant banks
bull Friendly societies bull Clearing houses bull Primary issuers bull Insurance FSA (Friendly Societies Commission) bull Venture capital of securities companies
bull Pensions and life insurance etc bull Stock exchanges bull Insurance brokers(Personal Investment Authority) bull Stockbrokers
Financial holding companiesFederal Reserve (FR) = umbrella supervisor
United States bull National banks(OCC) Securities and Regulated by
Treasury OCC bull State banks Federal Reserve Exchange Commission StatesMembers (FR)
OTS Nonmembers (FDIC) bull Investment banks bull Primary issuers of bull Insurance companies FR bull Cooperative banks (FDICFR) bull Finance companies securities bull Insurance brokers FDIC bull Insured industrial banks (FDIC) bull Stock exchanges
bull Thrift holding companies (OTS) bull Stockbrokers SEC bull Savings banks (OTSFDICFR) bull Investment advisors
bull Savings and loan associations bull Mutual funds(OTS) bull Public utility holding
bull Edge Act corporations (FR) companies
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Table 210 Financial-sector regulation G-10 countries 2000 (continued )
Financial institutions and their supervisors
Country and supervisory structure Retail banking Wholesale banking Securities Insurance
Financial holding companies Japan Financial Supervisory Authority (FSA) = umbrella supervisor
Prime FSA FSA FSA FSA ministerrsquos Ministry of office Finance (Securities and Exchange
Surveillance Commission) FRC Bureau of Financial bull City banks bull Investment banks bull Primary issuers of bull Insurance companies FSA Regulation bull Regional banks bull Asset managers securities bull Insurance brokers
bull Trust banks bull Stock exchanges SESC bull Long-term credit banks bull Stockbrokers
bull Pension funds
Financial holding companiesOffice of the Superintendent of Financial Institutions (OSFI) = umbrella supervisor
Canada Regulated by OSFI OSFI provinces OSFI
Department of Financebull Banks bull Cooperative credit bull Primary issuers of bull Insurance companies
(previously Office of the Inspector associations securities (previously Depart- OSFI General of the Banks) bull Fraternal benefit bull Stock exchanges ment of Insurance) Bank of bull Trust and loan companies society bull Stockbrokers bull Insurance brokers Canada bull Pension funds bull Asset managers
(previously Depart- CDIC ment of Insurance)
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Financial institutions and their supervisors
Country and supervisory structure Retail banking Wholesale banking Securities Insurance
Germany Financial holding groupsFederal Banking Supervisory Office (FBSO) = umbrella supervisor
Ministry of Finance FBSO BSO FSSO FISO
Bundesbankbull Universal banks bull Other financial bull Primary issuers of bull Insurance companies
Federal Banking bull Savings banks institutions (eg securities bull Insurance brokers Supervisory Office bull Securities banks management foreign bull Stock exchanges
currency dealings) bull Stockbrokers Federal Securities bull Financial enterprises bull Asset managers Supervisory Office (eg leasing bull Pension funds
organizations Federal Insurance credit card companies Supervisory Office investment advisors)
Italy Bank foundationsMinistry of Finance = umbrella supervisor
Ministry of Finance Bank of Italy Bank of Italy Consob ISVAP
Bank of Italy bull Commerical banks bull Asset managers bull Primary issuers of bull Insurance companies Consob bull Savings bank bull Open-end investment securities bull Insurance brokers
bull Securities banks companies (SICAVs) bull Stock exchangesbull Stockbrokers
ISVAP
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Table 210 Financial-sector regulation G-10 countries 2000 (continued )
Financial institutions and their supervisors
Country and supervisory structure Retail banking Wholesale banking Securities Insurance
The Netherlands Financial conglomeratesCouncil of Financial Supervisors = umbrella supervisor
Securities Board Securities Board Netherlandsche Netherlands Bank Netherlandsche Bank of the Netherlands Insurance Board Bank Insurance bull Credit institutions (universal banks bull Investment institutions bull Stock exchanges bull Insurance companies Board cooperative banks security credit (securities issuing bull Stockbrokers bull Insurance brokers
institutions mortgage banks) and tradingmdashprimary The Council of Financial and secondary Supervisors markets)
France Commission des Commission de Operations des Controcircle des
Banking and Banking Commission Bourse Assurances Financial Regulatory bull Ensuring that credit institutions (and investment firms since bull Primary issuers of bull Insurance companies Ministry for Committee the Financial Activity Modernization Act of 1996) comply securities bull Insurance brokers Economic with laws and regulations bull Stock exchanges Affairs and bull Execute instructions regarding all off-site monitoring and bull Stockbrokers Finance Credit on-site supervision Institutions and Banking and Financial Regulatory Committee Investment bull Formulates general regulations for credit institutions and investment firms Committee (capital adequacy requirements accounting rules etc) Bank of France Credit Institutions and Investment Committee Banking bull Authorizes and examines financial institutions except for those within the Commission competence of the Banking Commission
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117
Financial institutions and their supervisors
Country and supervisory structure Retail banking Wholesale banking Securities Insurance
Switzerland Large banking groupSwiss Federal Banking Commission (SFBC) = umbrella supervisor
Swiss National Bank Federal Office of
SFBC SFBC SFBC Private Insurance Swiss Federal Banking Commission bull Universal banks bull Investment banks bull Primary issuers of bull Insurance companies
bull Savings banks bull Asset management securities bull Insurance brokerscompanies bull Stock exchanges
Private audit Federal bull Investment funds bull Stockbrokers firms Office of bull Mortgage bond authorized by Private business SFBC Insurance
Sweden Financial holding company groupsFinancial Supervisory Authority = umbrella supervisor
Ministry of Finance Credit Market Securities Market Insurance Market
Credit Market Department Department Department Department
Financial bull Commercial banks bull Investment funds bull Primary issuers of bull Insurance companies Riksbank Supervisory bull Savings banks securities bull Insurance brokers Authority bull Friendly societies bull Stock exchanges
bull Stockbrokers
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Table 210 Financial-sector regulation G-10 countries 2000 (continued )
Financial institutions and their supervisors
Country and supervisory structure Retail banking Wholesale banking Securities Insurance
Belgium Bank holding companiesBanking and Finance Commission = umbrella supervisor
Bank of Belgium Banking Banking
Banking and Finance and Finance Insurance Controland Finance Commission Commission Commission Office
Banking and Insurance Finance Control bull Commercial banks bull Asset management bull Primary issuers of bull Insurance companies Commission Office bull Savings banks firms securities bull Insurance brokers
bull Securities banks bull Investment funds bull Stock exchanges bull Mortgage companiesbull Stockbrokers bull Pension funds
Securities Regulation Fund Securities Regulation Fund
bull Other investment firms and credit institutions(institutions participating in regulated off-exchangemarket in strips and Treasury certificates)
Bank holding companies Spain Banco de Espantildea = umbrella supervisor
Banco de Espantildea Comision Nacional del Mercado de Directorate General
Banco de Espantildea Valores (CNMV) Insurance
bull All credit institutions (commercial banks savings banks credit bull Primary issuers of (Ministry of Economy Ministry of cooperatives official credit institutions finance factoring and securities and Finance) Economy and CNMV leasing companies mortgage-loan companies etc) bull Stock exchanges bull Insurance companies Finance bull Interbank foreign exchange and book-entry public debt bull Stockbrokers bull Pension funds
markets bull Venture capital(companies and funds)
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119
Financial institutions and their supervisors
Country and supervisory structure Banking Securities Insurance
Banking Advisory High Level Securities Supervisors Committee (BAC) Committee (HLSS) Insurance Committee (IC)
Supranational (EU) bull Formulates standards for prudential bull Coordination of securities market bull Formulates standards forsupervision supervision prudential supervision
BACICHLSS Banking Supervision
Conglomerates Committee (BSC) Securities Contact Committee Regulation of prudential bull Systemic risk monitoring bull Regulation and implementation of supervision securities admission
International Association International International Organization of of Insurance Supervisors
Basel Committee Securities Commisison (IOSCO) (IAIS) Joint Forum Conglomerates Supervision bull Supervision and regulation best bull Supervision and regulation best bull Supervision and regulation amp regulation Best practices practices practices best practices
FSF Coordination across supervisors of various functions
Notes See appendix B for more information Boldface type indicates senior or oversight supervisor normal type indicates adjunct or front-line supervisorsolid line indicates direct responsbility to the senior-ranking authority dotted line indicates coordination in supervisory activities
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Table 210 Financial-sector regulation G-10 countries 2000 (continued )
Glossary of names United Kingdom FSA = Financial Services Authority United States FR = Federal Reserve OCC = Office of the Comptroller of theCurrency FDIC = Federal Deposit Insurance Corporation SEC = Securities and Exchange Commission OTS = Office of Thrift Supervision Japan FRC =Financial Reconstruction Commission FSA = Financial Services Agency SESC = Securities and Exchange Surveillance Commission Canada OSFI =Office of the Superintendent of Financial Institutions CDIC = Canada Deposit Insurance Corporation Germany FBSO = Federal Banking SupervisoryOffice FSSO = Federal Securities Supervisory Office FISO = Federal Insurance Supervisory Office BSO = Banking Supervisory Office Italy Consob =Commissione Nazionale per le Societa e la Borsa ISVAP = Instituto per la Vigilanza sulle assicurazioni private e di Interesse colletivo Switzerland SFBC= Swiss Federal Banking Commission Spain CNMV = The Comision Nacional del Mercado de Valores Supranational BAC = Banking Advisory CommitteeBSC = Banking Supervision Committee IC = Insurance Committee HLSS = High Level Securities Supervisors Committee International Dimension FSF =Financial Stability Forum IOSCO = International Organization of Securities Commission IAIS = International Association of Insurance Supervisors
Sources United Kingdom Bank of England httpwwwbankofenglandcouk Financial Services Authority httpwwwfsagovuk United States Board ofGovernors of Federal Reserve System httpwwwfederalreservegov Japan Bank of Japan httpwwwbojorjo Financial Reconstruction Commissionhttpwwwfsagojpfrcindexehtml Financial Services Agency httpwwwfsagojp Canada Bank of Canada httpwwwbank-banque-canadaca Office ofthe Superintendent of Financial Institutions httpwwwosfi-bsifgccaAndreEindexhtml Germany Deutsche Bundesbank httpwwwbundesbankde Fed-eral Banking Supervisory Office httpwwwbakredde Italy Banca drsquoitalia httpwwwbancaditaliait Commissione Nazionale per le Societa e la Borsahttpwwwconsobit Instituto per la Vigilanza sulle assicurazioni private e di Interesse colletivo httpwwwisvapit The Netherlands De NederlandscheBank httpwwwdnbnl France Banque de France httpwwwbanque-francefr Switzerland Schweizerische Nationalbank httpwwwsnbchindex3htmlSweden Sveriges Riksbank httpwwwriksbanksedefaultasp Belgium National Bank of Belgium httpwwwbnbbesgindexhtm Spain Banco de Espantildeahttpwwwbdees The Comision Nacional del Mercado de Valores httpwwwcnmves Supranational (EU) Institutional Arrangements for the Regulationand Supervision of the Financial Sector 2000 International Dimension Bank for International Settlement httpwwwbisorg International Organization ofSecurities Commissions httpwwwioscoorg International Association of Insurance Supervisors httpwwwiaisorg Financial Stability Forum httpwwwfsforumorg
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 121
the inflexibility of tight surveillance against the need to encourage in-novation and growth The US Securities and Exchange Commission isworried about aggressive accounting by firms and biased reports bysecurities analysts in an equity environment that prizes steadily higherquarterly earnings41 Japanese regulators are preoccupied with opaqueinterconnections between portfolio institutions banks and nonfinancialfirms through the keiretsu system Canadian regulators reeling from high-profile scandals of managers intentionally misleading investors are strengtheningmarket discipline through legal penalties aimed at managers and directorsof offending firms
When panic strikes a securities regulator cannot do much As the 1987stock market crash and the LTCM debacle in the fall of 1998 both dem-onstrated steep stock and bond price declines can create systemic risksIf severe enough the wealth effect of falling securities values and thefear of widespread insolvency can depress real activity Flooding thesystem with liquidity is a central bankerrsquos solutionmdashsomething a securi-ties regulator cannot do42 But just as financial supervisors can changethe incentive structure to discourage bankers from making risky loans ingood times so securities regulators can pay more attention to incentiveson the demand side when capital markets are strong
Prudential Supervision and InnovationmdashA Footnote
In concluding this discussion of prudential supervision in the G-10 anadditional point is worth noting National regulators face a persistenttrade-off between emphasizing financial system safety and soundnesswhile encouraging innovationmdashin spite of the added risks innovationbrings to financial markets Former US Treasury Secretary Lawrence Summers(2000 3) has argued by analogy
The jet airplane made airplane air travel more comfortable more efficient andmore safe though the accidents were more spectacular and for a time morenumerous after the jet was invented In the same way modern global financialmarkets carry with them enormous potential for benefit even if some of theaccidents are that much more spectacular As the right public policy response
41 The problem is illustrated by the divergence since mid-1998 between reported earn-ings by the Standard amp Poorrsquos (SampP) 500 and the after-tax profits of all corporations inthe national accounts Generally these two series move closely with one another Be-tween mid-1998 and mid-1999 SampP 500 reported that earnings increased by more than20 percent while after-tax profits of all corporations increased by less than 5 percent(Chase Bank US Economic and Policy Research US Weekly Prospects Chase SecuritiesWeekly Newsletter 5 June 2000 5)
42 For example the US Securities and Exchange Commission had no direct role in calmingmarkets in the 1987 or 1998 panics
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122 WORLD CAPITAL MARKETS
to the jet was longer runways better air-traffic control and better training forpilots and not the discouragement of rapid travel so the right public policyresponse to financial innovation is to assure a safe framework so that the ben-efits can be realized not to stifle the change
Accepting Summersrsquos analogy for the international financial system better-informed supervisors and investors are a necessary part of the financialsystem framework Supervisors require more timely information on therisk profiles resulting from positions taken by financial institutions Theyalso need a better understanding of risk-management systems Snapshotsof an institutionrsquos risk profile and risk-management procedures are nolonger adequate In a world where huge bets are quickly made (andpossibly lostmdashas with Barings Bank in 1995 and LTCM in 1998) super-visors must focus on the soundness of banking systems for evaluatingand managing risk on a daily basis Some progress has been made inaddressing these issues US banking examiners are extending their in-formation requirements in banking examinations and increasing theirinvolvement in large complex institutions43 More awareness is alsorequired of the fact that they are national organizations in a world ofcross-border capital flows To a much greater extent they need a multi-national reach International supervision and coordination among super-visors are the subject of the next section
Our analysis suggests that G-10 supervisors have unfinished businessBank supervisors need to start yesterday securities regulators can waituntil tomorrow One G-10 member acting alone cannot correct the biasIn good times the lending business will simply migrate to other G-10banks In bad times financial problems will not stop at the national bor-der A way has to be found to establish common international standardsfor the key financial players in order to prevent crises and to agree onapproaches for managing them The path has already been laid out Inthe wake of the bank failures of the past 25 years bank supervisors havetried to establish such standards They have done this without creating anew global institution
The essence of the international framework is decentralizationmdashglobalrules and design standards without global institutions that are perceivedto intrude on national sovereignty The awkward jargon for this frame-work is vertical subsidiaritymdashldquothink internationally act nationallyrdquo Theinternational thinking is done by a committee of regulators that meets
International SupervisionA Decentralized Framework
43 These issues are discussed in Ferguson (1999) and Meyer (2000a)
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 123
regularly at the Bank for International Settlements in Basel The commit-tee establishes principles and standards that are interpreted implementedand enforced by national authorities44 In this section we describe thesesupervisory efforts and their weaknesses We present our recommenda-tions for addressing these weaknesses in the next chapter
Basel I
The Basel Capital Accord of 1988 (Basel I)45 drew the lesson from thefinancial crises of the mid-1970s that more adequate capital levels in in-ternational banks would help reduce the systemic risk of bank failureThe primary goal of Basel I was capital adequacy other standards wereput in place not so much for their own virtue as to defend the primarygoal
Capital adequacy requirements were designed to ensure that individualinstitutions have the ability to absorb losses particularly credit lossesAccordingly a backup system of scoring credit risk was devised thatrequired large amounts of bank capital for some types of loans smalleramounts for others and zero for a select list of preferred assets Report-ing requirements were designed to disclose problems and ensure that atroubled bank would take timely steps to restore its capital base in thewake of a loss The Basel I framework worked tolerably well in limitingthe call on the public purse in the G-10 countriesmdashwith the notable ex-ceptions of France and Japan The framework failed to moderate riskybank lending to emerging markets however
Basel I was not developed with emerging markets in mind The origi-nal idea behind it was to develop a common supervisory approach tocross-border banking operations It grew out of political pressure fromUS lawmakers who were determined to require international banks op-erating in the United States to meet US banking standards Toward thisgoal in 1983 Congress passed the International Lending Supervisory ActUS and British banking authorities subsequently agreed on a commontarget the adoption of strict common capital-adequacy standards In 1988other G-10 governments agreed to go along voluntary acceptance ofthe standards throughout much of the rest of the world followed46 Therationale for the capital targets was two-fold The first was to requirebanks to hold sufficient amounts of capital (8 percent of risk-adjusted
44 The international committee of financial authorities agreed on a common definitionof banksrsquo tier-one or ldquocorerdquo capital national authorities defined tier-two capital in theirown manner which permitted greater variations in national working definitions andpractices
45 International Convergence of Capital Measurement and Capital Standards (BIS 1988)was prepared by the Basel Committee on Banking Supervision
46 See Reineke (1998)
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124 WORLD CAPITAL MARKETS
assets) to cushion losses on those assets The second was to dull theirappetites for risk banks with large capital bases would have more tolose if they failed and therefore would take fewer risks
Rapid change in financial markets soon revealed flaws in the Basel IAccord In a complex world with numerous sources of risk it focusedheavily on credit risk but overlooked other risks in a bankrsquos portfolioand the correlation between returns on different asset classes The Baselformula required banks to maintain a fixed amount of capital againsteach of its asset classes But the formula did not distinguish the riskinessof the borrower within each class As a result one large loan to a low-risk corporate borrower such as General Electric would require the sameamount of capital as 10 smaller transactions with high-risk borrowers
The system was also biased toward short-term loans Loans maturingin less than a year required a 20 percent risk weight whereas those ma-turing after more than a year required a 100 percent risk weight Inter-bank lending was particularly favored For example loans to banks inOECD countries required less capital than loans to private firms in thesame countries creating the anomaly that interbank loans to South Ko-rean banks required less capital than loans to General Electric47 Thisanomaly encouraged banks to shed high-quality assets if the Basel rulesrequired the allocation of more capital than banks thought they needed
Another weakness was that financial innovators quickly circumventedthe Accord Because short-term loans required less provisioning than long-term loans banks responded by securitizing their long-term debt port-folios and lending short-term against the collateral of the newly createdasset This allowed banks to circumvent the capital requirements gearedto the terms of the underlying debt At the same time the Basel I Accordfailed to encourage risk mitigation techniques such as credit derivativescollateral guarantees and on-balance-sheet netting the flip side of fi-nancial innovation Because off-balance-sheet products were not coveredby the Accord another anomaly appeared when Barings Bank collapsedin 1995 Barings met capital adequacy standards but collapsed becauseits systems for managing risk failed traders were allowed to speculatein futures contracts that did not appear on the balance sheet
Basel II
Work to overhaul Basel I began in 1995 and produced consultativepapers issued in June 1999 and January 200148 These papers have been
47 South Korean banks have had notoriously weak balance sheets because the practiceof ldquodirected lendingrdquo left them with many poor loans (in making these loans the bankswere expected to follow government objectives rather than creditworthiness criteria)
48 Basel Committee on Banking Supervision (1999 2001)
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 125
the subject of extensive consultation and revision as a result the newAccord is expected to be introduced in 200449 The Basel II frameworkhas three parts (pillars) revisions to Basel I minimum-capital require-ments supervisory review criteria and greater emphasis on market dis-cipline Broadly Basel II aims to maintain the level of capital in the sys-tem but achieve better alignment of banksrsquo capital with their risk pro-files and keep up with financial innovation
To align capital requirements with market realities (the first pillar)Basel II concentrates on the 100 or so largest banksmdashthe type of playerslisted in table 21mdashand on the holding-company parents of banking groups50
Capital requirements will differentiate between an increased number ofcredit groups or ldquorisk bucketsrdquo including claims on governments otherbanks corporations mortgage-backed securities and other asset-backedsecurities
Basel II originally proposed to use external ratings to set capital chargesfor a number of these credit risks Many banks objected arguing thatthey assess credit risk better than Standard amp Poorrsquos Moodyrsquos or FitchIBCA51 Basel II thus proposes two approaches to rating a standard ap-proach using external ratings and an ldquoadvancedrdquo approach that allowsselected banks to use their own internal rating systems To encouragethe development of rigorous internal control systems based on these in-ternal rating systems Basel II also proposes to levy capital charges foroperational risk (the risk of direct or indirect loss resulting from inad-equate or failed internal processes people and systems or from exter-nal events)
Some critics of this proposal dismiss it as an abrogation of the prin-ciple of external independent monitoring and as ldquodangerously naiumlverdquo52
But regulators argue that the new capital charge on operational risk shouldoffset this concern It is also far from clear how cross-national compari-sons of rating and internal risk-assessment systems will be made (Engelen2000) The development by the European Union of its own capital rulescould well complicate the international resolution of these issues Publicassurances by EU officials in January 2001 however indicated that theirmain concerns are to create a level playing field and avoid regulatoryarbitrage (Hargreaves 2001) There is also the significant problem ofthe procyclical character of risk weights When a crisis hits losses are
49 See Berry (2000) for an update in an interview with William J McDonough chair ofthe Basel Committee on Banking Supervision
50 For obvious reasons these proposals are addressed to large banks and simpler capi-tal standards are allowed for small banks that focus on their domestic credit markets
51 See Ammer and Packer (2000) for an empirical critique of the success of rating agen-cies in distinguishing risk by sector and region
52 See Auerback (2001)
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126 WORLD CAPITAL MARKETS
incurred or accrued capital is lost and loan exposure must be reducedor securities sold to restore the requisite capital-adequacy ratios A morerisk-sensitive framework could amplify volatility
As the second pillar of Basel II supervisory review criteria are beingbeefed up to encourage supervisors to intervene earlier in potential problemsituations and to compel banks to align their capital positions with theirrisk profiles Bank supervisors will be authorized to require banks tohold capital in excess of minimum requirements if they have concernsabout general management overall strategy risk-management performanceor the macroeconomic environment Of course if one G-10 supervisorimposes higher capital requirements in isolation the same disparity willemerge that presaged Basel I Some banks will be disadvantaged in theinternational marketplace and will loudly complain that excessive super-vision is driving business to their competitors Hence close internationalcooperation among supervisors is critical
To implement the third pillar market discipline banks will be requiredto make fuller more timely disclosure of capital adequacy and the risksto which that capital is exposed A number of measures are being stud-ied that might help supervisors evaluate bank performance such as com-parisons of uninsured deposit interest rates subordinated debt yieldsand equity prices The idea is that these yields and prices might alertsupervisors to market perceptions of risk Of course market perceptionsare only as good as market information More direct and controversialways to reinforce market discipline would dramatically increase publicdisclosure of bank positions and risk management systems
Many questions are still outstanding about how to resolve the techni-cal details of capital requirements and whether the requirements willachieve their intended goal of better assessment and mitigation of therisks in banksrsquo portfolios There is no substitute for skilled supervisorsThe intricacies of effective design and implementation suggest that su-pervisors need to be highly competent technically knowledgeable aboutbanking portfolio characteristics and the factors that influence bank ex-posure to credit risk (Mishkin 2000) And they must be aided by vigilantshareholders market forces and transparency of information53
Standard setting at the global level is desirable but ultimately theeffectiveness of these efforts will be tested at the national level espe-cially in times of systemic financial distress Here the record of Basel Iwas not a bright shining success Japanese banking regulators havetraditionally allowed banks to include real estate and securities in theircapital base When the value of these assets plummeted in the early 1990sregulators allowed banks to continue valuing these depreciated (andoften bankrupt) assets at their old inflated levels Japanese authorities
53 Benedict Roth Complacency Towards Catastrophe Financial Times 23 January 2001
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 127
insisted until the mid-1990s that eroded capital bases could be rebuiltin a market-driven fashion They rightly foresaw that huge loan losseswould undermine public support for the ruling party and require a po-litically unpopular bailout
Japanese foot dragging on Basel I was the worst54 but not uniqueOther examples can be found of ldquopolitically mandated forbearancerdquo TheFederal Reserve Bank of New York held important hands during theLTCM crisis of 1998 Mexico is still resolving the banking crisis that eruptedin 1995 South Korea has not yet closed the insolvent banks that behavedso badly before the crisis of 1998 In the aftermath of a crisis nationalregulators cannot always be relied upon to discipline politically power-ful bankers55 One of the little-noticed consequences of these differingapproaches is that those banks with strong regulatory systems receivedan implicit ldquoexport subsidyrdquo for their services US banks which had notengaged extensively in emerging-market lending in the 1990s were bet-ter positioned than their German and Japanese counterparts to expandtheir international assets in the wake of the crises
Other Financial Forums
54 See Japanese Banks Fiddling while Marunouchi Burns The Economist 27 January2001 67-69
55 See Calomiris (1997)
The Basel model of vertical subsidiarity has already been extended toother financial regulatory bodies In 1993-94 the BIS established a Tri-partite Group of Banking Insurance and Securities Regulators In 1994-95 the BIS increased its cooperation with the International Organizationof Securities Commissions when the two organizations issued parallelpapers on guidelines for national regulators concerning risk managementand disclosure of derivative trades In 1996 a permanent Joint Forum onFinancial Conglomerates was established to examine supervisory issuesand develop working arrangements among the different functional super-visors of conglomerate institutions that offer combinations of bankingsecurities and insurance products Draft papers on the supervisionof conglomerates were released for comment in 1998 applying capital-adequacy principles to these groups and providing guidelines both forassessing the integrity and competence of top managers and for sharingassessments between regulators
In 1997 the Basel Committee on Banking Supervision extended itsreach beyond capital standards to broader aspects of banking supervi-sion with the publication of the Core Principles for Effective BankingSupervision In 1999 a wide range of regulatory and standard-settingbodies were gathered under the umbrella of the Financial Stability
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128 WORLD CAPITAL MARKETS
Forum (FSF) itself established under BIS aegis56 The FSF has alreadyissued recommendations for stepped-up supervision and transparencyas well as guidelines for best practices in a number of areas includingoffshore financial centers and highly leveraged institutions or hedge funds57
Conclusion
Although the structural weaknesses in emerging-market economies arewidely acknowledged to have been causal factors in international capi-tal-market volatility this chapter points to the role of large G-10 bankingorganizations as major suppliers of the most volatile instrument short-term debt We have examined evidence of the impact of public safetynets in the G-10 economiesmdashthe deposit insurance systems the pruden-tial supervisory systems and the lender-of-last-resort functions of centralbanksmdashon the incentive structures of these organizations
Although supervisors in most countries working nationally and to-gether in the BIS have made significant efforts to mimic market forcesin their prudential supervision the most sophisticated financial institu-tions find innovative ways to circumvent the rules New global regulatorybodies are not about to be created G-10 national bank regulators shouldthemselves address the short-term debt bias in the international financialsystem by changing incentive systems G-10 securities regulators shouldalso take steps to get ahead of the curve paying close attention to largeportfolio swings by institutional investors particularly in times of crisisIn short more needs to be done at national and international levels tochange the rules of the game That is the subject of the next chapter
56 The Financial Stability Forum includes banking securities insurance and accountingregulatory bodies the OECD on taxation corruption and corporate governance and theIMF
57 See Martin (2000)
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96 WORLD CAPITAL MARKETS
and match from two unpleasant menus It can roll over existing loansand extend new credit or it can call some part of existing loans andattempt to recover the principal It can also hedge by selling short otherclaims on the borrower These choices entail either an unwelcome exten-sion of the bankrsquos exposure or credit rationing against the borrower Whentrouble brews all banks encounter the same conditions in the aggregatethey prefer less exposure and ensuing credit restrictions lead to volatilebank lending
Innovation
12 Derivatives have no value of their own They ldquoderiverdquo their value from the value ofthe underlying asset They include swaps futures (contracts for future delivery at speci-fied prices) and options (which give one party the right but not the obligation to buyfrom or sell to a counterparty at an agreed price)
13 Maxfield (1998) analyzed available evidence of emerging-market investor objectivesmost of it before the crisis Analysis of portfolio equity flows is sensitive to the choice ofperiod with year-over-year data indicating that investors respond to country ldquofundamen-talsrdquo Other evidence suggests more ambiguity Ranking by ldquoinvestor impatiencerdquo ie thesearch for yield over value Tesar and Werner (1995) find short-term bank flows to be themost yield driven followed by portfolio investment FDI and long-term bank lending
14 Because market risk credit risk and country risk interact in complex ways newfinancial instruments have been created to help reduce negative interactions One is theldquototal return swaprdquo which has become an instrument of choice for hedge funds lookingfor high leverage Banks also use the total return swap to cover risks without increasingtheir capital requirements
Since the 1980s national and international banking systems have beentransformed by deregulation intensified competition and the informationand communications-technology revolutions The market environment isone of intense competition particularly in traditional banking activitiesThe innovations point away from traditional activities of plain vanilladeposit taking and loan making Three big themes are discernible Firstthe walls separating commercial banks investment banks portfolio man-agers and insurance firms are falling even if they are still distinct Sec-ond large banks are shifting toward securitizationmdashcreating securitiesout of everything from credit card debt to trade finance to disaster insur-ancemdashand earning fees in the process Third all large banks are shiftingtoward trading activity making markets and taking short-term stakes inbonds shares and derivatives12 These activities when successful satisfythe search for higher yields13
Many of the new financial instruments that banks trade are ldquooff bal-ance sheetrdquo This means that banks are not required to allocate capitalagainst them In swap contracts for example neither side pays cash at theoutset and therefore neither party has an asset in the traditional sense14
Futures and options contracts can be written with a relatively small initial
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 97
margin relative to the potential risk Credit derivatives limit credit risk bytransferring the potential loss associated with corporate loans and bondssovereign debt and other loan portfolios to counterparties15
Deregulation and innovation working in combination seem to havepushed banks into trading activity and leveraged plays but not into shareownershipmdasheven in jurisdictions that have no prohibition against equitystakes Among the G-10 banking systems the highest ratio of share own-ership to assets was only 5 percent in 1996 reached in Germany andJapan (Berlin 2000)16
The wave of innovation in financial instruments and the accompany-ing expansion of banking beyond its old boundaries is a two-edged swordOn one side it allows risk management far beyond what was tradition-ally possible Risk can now be shifted from firms that can ill afford lossesto those that can Banks can profitably act as intermediaries in shiftingrisk On the other side the innovation wave creates huge opportunitiesfor leveraged plays fostering a speculative search by banks themselvesfor high returns that in turn magnify their own risks17
15 Credit derivatives include total return swaps credit default swaps credit-linked notesand collateralized debt obligations They are the fastest-growing sector of the global de-rivatives market
16 Banks seem to specialize in lending even when they are allowed to mix finance andcommerce for reasons related both to how they are expected to behave with distressedfirms and to other intricacies of lender liability (Berlin 2000) Yet a recent cross-countrystudy found that restrictions on banking and commerce are associated with greater fi-nancial instability (Barth Caprio and Levine 2000)
17 Leverage is the magnification of the rate of return (positive or negative) on an in-vestment beyond the rate obtained by solely investing funds owned by the institution Itis often defined as the ratio of assets to equity Leverage is achieved by increasing thesize of an investment by borrowing or using derivative instruments such as futures oroptions These allow investors to earn a return on the notional amount underlying thecontract by committing a small portion of equity in the form of a margin deposit oroption premium payment
18 In a repo (repurchase agreement) one party (typically a trader) buys a bond andsells it to a dealer for cash with a promise to buy it back the next day at the same priceplus the overnight interest rate As long as the overnight interest rate is lower than theinterest accruing on the bond the trader earns some income on the bond The extremeform of these kinds of transactions was discovered at LTCM the failed US highly lever-aged institution which appears to have controlled more than $120 billion in assets froman investment of about $3 billion This leveraging was accomplished mostly through theuse of repos (Mayer 1999)
The potential for damage is illustrated in an extreme form by figure 21To precisely measure a firmrsquos leverage all positions must be known andrealistically valuedmdashwhich may be impossible to do Because many ac-tivitiesmdashsuch as repos18 and derivativesmdashdo not appear on the institutionrsquos
Leverage
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98W
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PIT
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MA
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ET
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Figure 21 Hypothetical example of leverage
$1000 notional value of call option on equity in firms targeted for takeover
Repo FRN into cash and use cash to pay option premium
(repro is initially collateralized
Borrow $100 for margin purchase
$125 of US investment bank floating-rate notes (FRN) (secured by $25 equity in FRNs)
Repo off-the-run bond into cash and post margin
(repo is initially collateralizedSell (short) Borrow on-the-run bonds worth $20
$25 worth of off-the-run bonds (secured by $5 equity in bonds)
Exchange into $4
Cash $5 yen400 Japanese bank loans
$1 equity base
FRN = floating rate notesRepo = repurchase agreement
Source IMF (1998)
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 99
balance sheet and because balance sheets are published quarterly at bestoutsiders have a difficult time assessing the extent of a firmrsquos leverage19
Leveraging by a single firm enhances its risk of default the widespreaduse of leverage in the financial system can magnify market adjustmentsespecially when they require ldquodeleveragingrdquomdashunwinding prior positionsRapid adjustments can cause credit to dry up and asset prices to plummetIn a mark-to-market environment falling asset prices trigger calls foradditional collateral that can ripple through markets
Risk Management
Because it is confronted with the widespread use of leverage and prolif-erating kinds of risk international finance is increasingly driven by riskevaluation and control20 Different institutions face various risk profilesand differing kinds of risk The most common risks can be quickly tickedoff Banks because of their traditional intermediary role of channelingthe resources from savers to borrowers face significant credit risk therisk of default or delay in the payment of principal and interest Theymust also manage market risk the risk that the prices of their liabilitiesmay change faster than their assets Market risk devastated US savingsand loan institutions in the late 1980s
Closely associated with market risk are interest-rate risk (unexpectedchanges in market interest rates that slash margins net income and theeconomic value of a bankrsquos equity) and foreign exchange risk (losses thatarise when assets denominated in an appreciating foreign currency areless than liabilities denominated in that currency) Banks make numer-ous loans to other banks around the world portfolio investors buy se-curities direct investors acquire fixed assets and all incur country risk(economic and political uncertainty in the host country) During the heightof the Asian crisis for example interbank loans to Japanese banksreflected the credit risk of lending to these banks the so-called Japanpremium
Substantial attention has been lavished on country risk analysis sincethe 1982 debt crisis in developing countries Yet in spite of this exper-tise the Asian crisis occurred in part because of a sudden upward reap-praisal of country risk after the Thai baht collapsed in April 1997 Banksand other financial institutions must also manage liquidity risk the riskthat market conditions will change unexpectedly depressing demand andprices of assets at the time they want to sell these assets And they mustmanage operational riskmdashfailures in control systems or people that cause
19 Another example of asymmetric information Both risk and leverage are difficult foroutsiders to assess without full timely disclosure
20 A longer discussion of these issues can be found in Managing Global Finance in IMF(1999c)
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100 WORLD CAPITAL MARKETS
financial loss or damage reputations Operational risk devastated BaringsBank in 1995
Financial institutions practice risk management to measure all theserisks the potential damage to their investment positions and ultimatelythe chance of becoming insolvent VAR (value at risk) risk models mea-sure subject to certain assumptions the amount of the firmrsquos capital thatis exposed in each period For example the VAR model might say thatin a 3-standard-deviation worst case (a case that is not supposed to hap-pen more than 1 percent of the time) the firm will loose 25 percent of itscapital during the next year
VAR models are widely used but like all models they have weak-nesses They rely on past values to estimate key variables in financialmarkets past values are not always good predictors of future risks More-over rising volatility and higher loss correlation among different assetclasses in a portfolio will cause all banks using these models to reducetheir exposures at the same time by switching to less volatile and lesscorrelated assets such as US Treasury bills (Persaud 2000)
Newer risk models entail stress testing and scenario analysis Scenarioanalysis envisages possible adverse changes one at a time that mightaffect the investment portfolio Stress testing estimates potential losseswhen several individual risk factors simultaneously move against thefirm but it too uses historical probabilities
Financial Volatility
21 For example derivative markets usually rely on underlying securities markets thatproduce continuous prices When these markets are interrupted financial shocks cantrigger a cascade of margin calls and sell orders that move prices very sharply
22 See IIF (1999a)
The combination of trading activity and modern risk management lie atthe root of financial volatility When risks increase banks must eitherraise more capital to cover the greater risk or reduce their exposure bycutting loan exposure by selling securities or by undertaking new de-rivative trades Raising more capital is time-consuming and in a crisisvery expensive because bank shares are depressed So banks look to theother alternatives If the bank can reduce lending it need not book aloss But most banks use the same VAR models and as indicated abovethese models will encourage them to reduce their outstanding loans atthe same time actually magnifying loan volatility
If banks attempt to reduce their exposure to risk by selling securitiesor undertaking new derivative trades they may trigger large priceshocks because of limited and shrinking market liquidity21 The liquid-ity problem is compounded when a small number of large institu-tions hold the same positions22 Take your pick loan volatility or price
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 101
volatility As two experts have observed (Folkerts-Landau and Garber1998)
[V]olatility even in one country will automatically generate an upward re-estimate of credit and market risk in a correlated country triggering automaticmargin calls and tightening of credit lines Thus apparently bizarre opera-tions that connect otherwise disconnected securities markets are not the re-sponses of panicked green screen traders arbitrarily driving economies from agood to a bad equilibrium Rather they work with relentless predictability andunder the seal of approval of supervisors in the main financial centers
23 See Ferguson (1999)
24 As Gerald Corrigan (1982) put the matter ldquoBanks are specialrdquo Corrigan (2000) reit-erated this view even after all the changes of the past two decades Unlike other institu-tions banks offer on-demand transactions are a backup liquidity source for other insti-tutions and serve as a ldquotransmission beltrdquo for monetary policy
These changes in the banking environment accentuate an existing anomalyThe anomaly is that banks even as they grow larger and increasinglyengage in more risky and complex transactions are perceived to enjoyimplicit and explicit public guarantees
The guarantees grow out of an incentive problem inherent in bankingasymmetric information which we mentioned above Depositors know lessabout a bankrsquos management and the quality of its balance sheet than doits managers and shareholders Thus in times of uncertainty or adver-sity bank depositorsmdashuncertain whether they will have access to theirdepositsmdashare prone to bank runs This prospect has in turn compelledgovernments to treat banks differently than other firms because a bankthat fails can disrupt the rest of the economy24
To prevent such crises governments have entered into quid pro quoarrangements with banks Governments provide them both with an im-plicit safety net in the form of an unstated promise by the central bankto act as a lender of last resort in a liquidity crisis and an explicit safetynet in the form of a public deposit insurance fund to reassure depositorsIn return the banks submit to closer government oversight and regu-lation of their activities than is usual for industries in the private sector
The ldquoinsurancerdquo provided by the public safety net contributes to an-other incentive problem moral hazard Banks acquire greater tastes forrisk and face less market discipline than other firms The explicit depositinsurance safety nets actually have or are perceived to have blanketcoverage that extends beyond the retail depositors (households and small
One of the lessons of the 1997-98 crisis must surely be that market par-ticipants and their regulatory supervisors relied too heavily on quantita-tive tools and insufficiently on judgment23
The Anomaly of Modern Banking
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102 WORLD CAPITAL MARKETS
businesses) for which they were originally intended The implicit centralbank safety nets extend in a crisis to nearly all depositors and banksThus banks are both viewed and behave as if they will be bailed out ifthey get into trouble
The existence of a public safety net raises a perennial question Dobanks have an unfair advantage over other financial institutions becauseof the subsidy provided by the safety net This question was at the heartof intensive study and debate in the United States leading up to thepassage in November 1999 of the Financial Services Modernization Act(also known as the Gramm-Leach-Bliley Act) The size of the gross sub-sidy is difficult to estimate despite determined research efforts Somesuggest it is well under 100 basis points and is at least partly offset bythe direct costs of deposit insurance premiums interest payments on bondsissued by the Financing Corporation25 reserve requirements regulatoryexpenses and operational costs associated with collecting deposits26 Con-versely Kwast and Passmore (2000) suggest that banks can expand theirscope far beyond the levels that other financial institutions could reachwith the same equity base but without the public safety net
A related concern in the US debate is whether allowing banks to ex-pand their activities into securities and insurance will ultimately extendthe safety net and add to the subsidy The Financial Services Moderniza-tion Act deals with this issue by maintaining a legal separation betweenbanks and the rest of the banking organization known as large com-plex banking organizations (LCBOs) They must engage in most securi-ties activities and insurance underwriting through separately capitalizedinvestment bank subsidiaries or holding company affiliates This act canbe said to have merely brought US banking laws closer to those of mostother industrial countries (Barth Brumbaugh and Wilcox 2000 BarthNolle and Rice 2000) If the fire wall is well-maintained and stoutly de-fended the safety net will neither expand in practice nor become a sourceof comfort to noncommercial bank subsidiaries of LCBOs
The quid pro quo exacted by governments to offset the subsidy iscloser public-sector monitoring of banksrsquo activities through prudentialsupervision The effectiveness of this closer official scrutinymdashand closermarket monitoringmdashare the subjects of the next section
25 The Financing Corporation was created by Congress in 1987 to sell bonds to raisefunds to help resolve the savings and loan crisis
26 See Levonian and Furlong (1995) Jones and Kolatch (1999) Shull and White (1998)and Whalen (1999a 1999b)
Are G-10 bank supervisors adequately responding In this section we firstassess the case for and compare the structures of prudential supervisory
Prudential Supervision
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 103
systems both within and among the G-10 economies plus Spain andconsider whether these offset the subsidy provided by the public safetynet Despite offsetting regulation and supervision implicit and explicitguarantees by G-10 governments to their banks are still a source of bank-ing instability in the emerging-market economies
National Systems for Prudential Supervision
Governments use prudential supervision to reduce the moral hazard andadverse selection created by their own safety nets Supervisors establishregulations and monitor compliance to limit risk taking and ensure thesafety and soundness of the banking system In a thoughtful analysis ofthe case for prudential supervision Frederic Mishkin (2000) identifiesthe main forms that supervision can take including the tasks of grantingbanking charters and licenses establishing capital requirements settingdeposit insurance premiums and defining disclosure requirements as wellas carrying out bank examinations Bank examiners gather informationfrom banks and evaluate whether they are following the regulatorsrsquo rulesin cases of weakness they are empowered to change banksrsquo behaviorand close them if necessary
Supervisors also may restrict competition define the activities in whichbanks may engage and restrict their asset holdings and separate banksand other financial (or nonfinancial) activities During the past two de-cades the barriers separating commercial banks investment banks in-surance firms and securities firms have been all but eliminated (tableB1) Deregulation has stimulated competitive forces that drive diversifi-cation and consolidation of the financial industry nowhere faster than inthe United States
The Financial Services Modernization Act of 1999 confirmed this trendIt eliminated restrictions dating back to the Glass Steagall Act of 1933which once prevented banking insurance and securities firms fromentering each otherrsquos businesses (Barth Brumbaugh and Wilcox 2000)Cross-pillar mergers among banks insurance and securities firms arewell under way to form giant financial holding companies The 1999merger between Citibank (banking) and Travelers (insurance) created themodel for megafinance and confirmed new challenges for supervisors
Mishkin (2000) notes the corresponding evolution in US supervisionfrom an emphasis on rules-based regulation (detailed rules for opera-tional behavior and the quality of line items in the balance sheet) to anapproach that stresses the soundness of bank management practices es-pecially risk management
Appendix B outlines the systems of financial supervision now in theplace in the G-10 countries plus Spain Some systems like the UK andCanadian approach are models of simplicitymdashorganized to keep pacewith the spreading reach of financial conglomerates Other systems like
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104 WORLD CAPITAL MARKETS
the US and French approaches show traces of the bureaucratic divisionsthat made sense in an era when banking securities and insurance weresharply separated
The US Model
27 See Meyer (1999a)
28 Canada has a similar degree of simplification with the exception that securities firmsare still regulated by provincial authorities
29 See Pratti and Schinasi (1999 67)
30 The agents are the bank regulators and the principals are the taxpayers Agents maypursue their own interests including bureaucratic survival and postgovernment employ-ment opportunities rather than the national interest in banking safety and soundness
The US model of financial regulation delineated in the Financial Ser-vices Modernization Act of 1999 blends functional and umbrella super-vision Bank and thrift regulators oversee depository institutions Newnonbank activities are subject to both functional regulation (eg by theSecurities and Exchange Commission and state insurance examiners) andumbrella supervision (of financial holding companies) by the FederalReserve27
The UK Model
Another supervisory model exists in the United Kingdom as well as inAustralia Canada and Switzerland28 In this model banking supervisionis separated from the monetary policy function The regulatory structureis considerably simplified by relying on a consolidated financial regula-tor separate from the central bank for both banking and nonbankingactivities The remaining question answered differently depending on thecountry is the extent to which the regulator relies on home-country sur-veillance of banks and conglomerates that have a local presence
Regulatory Models Compared
Appendix B provides more detail on the differences in these modelsGerman simplicity contrasts with French complexity In France the bankingcommission is chaired by the governor of the central bank and includesrepresentatives from the Treasury The commission supervises compli-ance with regulations but the central bank inspects banks on behalf ofthe commission29 In countries such as the United States and France withmultiple supervisors and crossover functions internal coordination is criticalAt the same time multiple agencies create regulatory competition Wheneach agency knows what the other is doing transparency within gov-ernment circles can help to limit principal-agent problems of regulation30
The discussion as to where in the public bureaucracy financial super-
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 105
vision should be placed goes back many years Peek Rosengren andTootell (1999) argue that a synergy exists between monetary policy andprudential supervision because information gained in the course of super-vision can increase the accuracy of macroeconomic forecasts A twist tothis argument is that the information on the state of financial institutionsavailable to the central bank as supervisor can facilitate its role as lenderof last resort Conversely there is the concern that a supervisory rolewill compromise the central bankrsquos independence of action with respectto its core mandatemdashmaintaining price stability As these arguments haveplayed out financial supervision has generally been shared between centralbanks and other regulators or placed entirely in the hands of an inde-pendent regulator However in Italy the Netherlands and Spain cen-tral banks are the sole banking supervisor
Goodhart (1995) examined the arguments and evidence for each modeland concluded that there were no overwhelming arguments or evidencefor one or the other31 Going forward a key problem for any financialsupervisory system is dealing with (and closing as necessary) weak banksIf both central banks and other regulators have this responsibility closecoordination between them is critical Another problem is large conglom-erate banks LCBOs Although they are less likely to fail because of thediversification of their assets and liabilities they are more likely to berescued They are also more likely to be multinational enterprises withinternational implications Goodhart observes that regulation of theseentities might be put in the hands of the central bank because it is lessamenable to political pressures In any event the complexity of LCBOoperations suggests that greater supervisory rigor is necessary
The US Congress was persuaded that broad oversight would help containthe moral hazard problem and accordingly gave the Federal Reservethe role of umbrella supervisor with the understanding that the Fed willscrutinize depository activity more intensely than nonbank financial ac-tivities Under this approach LCBOs such as Citigroup are subject tomuch closer monitoring than smaller and simpler institutions32 The USregulatory model requires enormous cooperation between the Fed otherbank supervisors and the functional regulators for insurance and securi-ties but it also benefits from regulatory competition
31 National systems of supervision are path dependent they are determined by the struc-ture of financial institutions and history in each country If Goodhart (1995) is right out-comes are not materially better or worse with one model of supervision rather than another
32 See Ferguson (1999)
Public Safety Nets
One of prudential supervisorsrsquo biggest challenges is to reduce moral hazardFor many years commercial banks engaged in communal self-insurance
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106 WORLD CAPITAL MARKETS
to deal with crises They formed voluntary groups that agreed to rescuetroubled members As financial markets evolved and competition inten-sified banks were no longer willing to play this role Private-sector in-surance is one alternative but moral hazard and adverse selection wouldappear to prevent it from happening Public safety nets have developedbecause of the low probability and high cost of potential bank runs Aclear trade-off is involved The effectiveness of insurance in preventingbank runs is greater the more comprehensive the coverage But the morecomprehensive the coverage the greater the moral hazardmdashbank man-agers bank directors investors and depositors all take on greater risksin the belief that the safety net will protect them against losses
All G-10 countries have compulsory public safety nets for banks (table29) Deposit insurance agencies are officially organized in Canada theNetherlands Sweden Switzerland and the United States organized bythe industry in France Germany Italy and the United Kingdom andjointly organized by the public and private sectors in Belgium Japanand Spain
How well do G-10 governments offset the subsidy provided by thepublic safety net This is a question on which there is substantial debateAs banking organizations have become more complex the challengesthat supervisors face have become more difficult One challenge is toalign the incentives facing bank managers and shareholders with thoseof depositors Another is the principal-agent problem in supervision Wehave discussed the incentive structures for financial institutions but wehave said little about the incentives for supervisors themselves and thedistortions they can generate in the financial system
In one of the many studies of the US savings and loan crisis of the1980s Kane (1989) documented both problems He described managersusing cosmetic approaches to disguise the magnitude of insolvency regulatorspracticing forbearance even though they knew of the deteriorating riskprofiles of the institutions for which they were responsible and legisla-tors increasing deposit insurance without regard for any offsetting changesin supervision A subsequent overhaul of the legislative framework forthe Federal Deposit Insurance Corporation (FDIC) known as the FDICImprovement Act of 1991 (FDICIA) aimed to introduce a clearer incen-tive structure for both regulators and regulated institutions
The changes introduced by this US legislation are worth discussionwith respect to the other G-10 countries as well First FDICIA created astronger signal to management and investors by targeting deposit insur-ance at small depositors only and by risk-weighting the deposit insur-ance premiums paid by banks to reflect their capital adequacy and bankexaminer ratings Among the G-10 countries rated in table 210 depositinsurance premiums vary considerablymdashbut it is not clear that the dif-ferences have much to do with risk-weighting Most G-10 countries em-ploy funding formulas based for example on the total domestic deposit
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TH
E P
LAY
ER
S T
HE
IR S
UP
ER
VIS
OR
S A
ND
MO
RA
L HA
ZA
RD
107
Table 29 Deposit insurance schemes in the G-10 countries Explicit safety net
Coverage limit(dollar Foreign
equivalent currency Interbank Source Bankrsquos Contingency fundingDate Membership Co- at end of deposit deposit of premium from banks
Country established managementa insuranceb July 1998)c covered covered Fundingd funding costs or governments
United 1982 Compulsory Yes Larger of 90 No No Unfunded Banks only Callable (subject Parliament may increase Kingdom private percent co- to maximum the maximum payable
insurance to 03 percent of pound125 million advance 33000 total deposits) facility with Bank of
England
United 1934 Compulsory No 100000 Yes Yes Funded Banks and Up to 027 Borrowing up to $3 States official government percent total billion from US Treasury
domestic deposits
Japan 1971 Compulsory No 71000 but No No Funded Banks and 0084 percent of Borrowing up to yen500bn joint in full until government insured deposits from Bank of Japan
year 2000 subject to Ministry of Finance approval
Canada 1967 Compulsory No 40800 No Yes Funded Banks and 033 percent of Borrowing up to C$6 official government insured deposits billion authorized further
(maximum) borrowing subject to parliamentary approval
Germany 1966 Compulsory Yes 90 percent Yes No Funded Banks only 003 percent of Annual levy may be private coinsurance deposits doubled
to 22000
Italy 1987 Compulsory Yes 125000 Yes No Unfunded Banks and Callable Two options defer private government (maximum of payment or diminish
1 percent of compensation to be paid total deposits)
(table continues next page)
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108W
OR
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CA
PIT
AL
MA
RK
ET
S
Table 29 Deposit insurance schemes in the G-10 countries Explicit safety net (continued )
Coverage limit(dollar Foreign
equivalent currency Interbank Source Bankrsquos Contingency fundingDate Membership Co- at end of deposit deposit of premium from banks
Country established managementa insuranceb July 1998)c covered covered Fundingd funding costs or governments
Netherlands 1979 Compulsory No 22000 Yes No Unfunded Banks and On demand Government backing official government maximum of subject to parliamentary
5 percent of own approval funds
France 1980 Compulsory No 65400 No No Unfunded Banks only Callable (on Extra calls up to FFr1000 private demand calls million can be made in
up to FFr200 a 5-year period million)
Switzerland 1984 Voluntary No 19700 No No Unfunded Banks only Callable (on Underwritten by member official demand) banks
Sweden 1996 Compulsory No 31400 Yes No Funded Banks and 05 percent of Full emergency coverage official government deposits while replacing it with a
limited system after the emergency
Belgium 1974 Compulsory No 16600 No No Funded Banks and Callable 002 None insurance limited joint 22000 in government percent of to assets in fund
year 2000 deposits from clients
Spain 1977 Compulsory No 16439 Yes No Funded Banks and 02 percent of Government backing joint government deposits through the Banco de
(maximum) Espantildea subject to approval by royal decree
a Bank membership in the fund can be either compulsory or voluntary and the management of the fund can be official and official and private joint or privateb Coinsurance refers to the situation where depositors face a deductible against their insured fundsc Coverage limit refers to the explicit amount the authorities promise to insured Funded scheme means that it is funded ex ante unfunded otherwise
Sources Goodhart (1995) Demirguccedil-Kunt and Detragiache (2000) Demirguccedil-Kunt and Sabaci (2000)
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 109
base Explicit safety net protection also varies but only Canada focuseson the protected class33 All G-10 countries specify a limit on depositorprotection Under FDICIA the insurance fund is prohibited from pro-tecting uninsured depositors or creditors at a failed bank although adiscretionary system-wide override is provided for exceptional circum-stancesmdashbut with stringent requirements for consultation and account-ability Other G-10 countries allow for contingency funding from the publicpurse alongside unwritten lender-of-last-resort support Among large banksa significant and growing portion of deposit liabilities including foreigncurrency and interbank deposits are uninsuredmdashbut depositors assumethey will be protected in a crisis
FDICIA also made some significant qualitative changes to address theprincipal-agent problem by penalizing weak banks and rewarding strongbanks For example banks whose capital declined faced progressivelytougher regulatory sanctions that for example required them to elimi-nate dividends restrict their lending and change their managementsRegulators have also been forced to take prompt corrective action (toreduce the practice of regulatory forbearance in hopes that a bankrsquos for-tunes might improve)34 Unfortunately comparative qualitative assess-ments across the G-10 are difficult to make due to lack of information35
This discussion highlights the complexity of evaluating the extent towhich prudential supervision and market discipline reduce the moralhazard associated with G-10 safety nets Our argument is that publicsafety nets in the G-10 can be linked to banking instability in other coun-tries specifically in the emerging-market economies that have attractedG-10 cross-border bank lending This lending is a leading source of vola-tility in capital flows the large financial institutions many of which arecomplex banking organizations are based in and regulated by authori-ties in the G-10 economies These two features of the international finan-cial system are closely related although it is not possible to test thisrelationship econometrically
Two World Bank studies however indicate a basis for concern Onestudy is a cross-country econometric analysis of the relationship betweenbank stability and deposit insurance (Demirguccedil-Kunt and Detragiache2000) which found a negative relationship Their estimated model forbanking crises in a sample of 61 countries (both industrial and develop-ing) suggests that explicit deposit insurance raises the probability of acrisis by at least 30 percent36 Crises are especially likely in countries
33 Japanrsquos legislation says it does but recent experience shows this is not the case34 See Goldstein (1997) for a summary of the changes35 See Barth Nolle and Rice (2000) for a beginning in this area36 Demirguccedil-Kunt and and Detragiache (2000 table 1) report a logit coefficient of 0696with a standard error of 0397 (the coefficient is significant at the 8 percent threshold)This suggests that the ldquotruerdquo coefficient could well be as small as 030 (the reportedvalue minus the standard error)
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110 WORLD CAPITAL MARKETS
with immature financial supervisory systems (and not in the G-10) buttheir analysis does underscore the view that deposit insurance weakensmarket discipline37
An earlier World Bank analysis established similar results One wasthat market discipline is undermined by deposit insurance schemes an-other was that illiquid banks are forced to pay more for their funds un-less a generous deposit insurance scheme is in place (Demirguccedil-Kuntand Huizinga 1999) This econometric study also provides clear-cut evi-dence that depositor monitoring of banks declines with the existence ofdeposit insurance schemes At the heart of the problem is the questionof whether deposit insurance is accompanied by increased governmentmonitoring
This evidence and the weight of other arguments suggests that moralhazard is still an issue in the G-10 countries Consider the ongoing de-bate about instilling greater market discipline on risk taking by banksAt one extreme is the perennial proposal to do away with safety netsleaving markets to monitor the players and to force adjustments but toprotect small savers by creating ldquonarrow banksrdquo such as postal savingsystems that are allowed to invest these savings only in risk-free gov-ernment securities Whatever the merits of narrow banking this solutionis too extreme to be politically feasible
A moderate alternative is to force more disclosure by financial institu-tions to facilitate market monitoring But transparency has its own prob-lems Persaud (2000) argues that financial markets cannot reliably discernsustainable from unsustainable positions in the short term This uncer-tainty causes banks to ldquoherdrdquo behind market leaders to exploit theirsupposedly superior information ldquoThe more herding investors and bankersknow about what each other is up to the [more] unstable markets maybecomerdquo The implication is that greater transparency in the marketplaceby itself will not solve the problemmdashand in the short term more informa-tion may exacerbate herding Further supervisory steps (discussed in thenext chapter) are required
Yet another proposal is to promote private-sector involvement in bankmonitoring through market-based alternatives such as Calomirisrsquos sub-ordinated debt proposal (Calomiris 1997 Federal Reserve Board 1999)Banks could be required to issue and maintain a minimum amount of
37 Other findings in the Demirguccedil-Kunt and Detragiache (2000) study include thesepropositions The impact of deposit insurance on bank stability tends to be stronger themore extensive is the coverage offered to depositors when the scheme is funded andwhere the scheme is run by the government rather than by the private sector Con-versely deposit insurance is detrimental to bank stability where bank interest rates havebeen deregulated and where the institutional environment is weak Additional findingson deposit insurance are reported from a recent World Bank conference (8-9 June 2000httpwwwworldbankorgresearchinterestconfsupcomingdeposit_insurancehomehtm)Also see Smalhout (2001)
Institute for International Economics | httpwwwiiecom
THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 111
subordinated debt (eg uninsured certificates of deposit) to finance asmall fraction (such as 2 percent) of their total nonreserve assets Thesubordinated debt would be allowed to earn a set yield no more than 50basis points over the risk-free yield on government treasury bills Thisrule would supposedly force banks to operate in a safe manner Other-wise subordinated debt holders would redeem their uninsured certifi-cates of deposit and equity investors would sell their bank shares Despiteits practical problems the beauty of the subordinated debt requirementis that it enlists market incentives to push banks to avoid excessive port-folio risk38
The thrust of these proposals is very relevant to the arguments in ourstudy Even in the G-10 countries government monitoring by itself hasnot eliminated moral hazard among banks More work is needed to in-troduce market monitoring and to improve the incentive structures bothfor financial institutions and their supervisors We return to this issuewith our recommendations in the next chapter
38 In late 1996 Argentina began requiring its banks to finance 2 percent of total depos-its in the form of subordinated debt but without a maximum yield provision TheArgentine authorities expect that market discipline will act in concert with the publicsafety net One obvious problem with the subordinated debt proposal is that banks mayencourage some of their customers to buy the subordinated debt
Portfolio Institutions Tomorrowrsquos Problem
Before proceeding to the issues of international supervision we flag an-other potential problem for national regulators The big asset managersprofiled in tables 24 and 26 answer to diverse groups of pensionersshareholders and policyholders They allocate funds across a number ofcountries to diversify their risks They hold liquid assets that can be tradedand they have a higher proportion of long-term assets than banks Eco-nomic shocks can be absorbed through price changes and their effectsspread across time and markets Thus when conditions change in a par-ticular market they are more likely to ride out the storm than to flee Inother words they have less incentive than banks to pull their invest-ments in the face of adversity In the 1990s most large asset managersestablished a record of ldquoriding out the stormrdquo rather than ldquorunning withthe windrdquo although as we saw in chapter 1 instances of running withthe wind were detected in some portfolios As we write these insti-tutions have a good record overall in the emerging markets so whyworry
The Russian crisis and the near-collapse of LTCM previewed the dan-gers that may await future portfolio managers and G-10 financial minis-ters We have presented evidence indicating a systemic bias toward bank
Institute for International Economics | httpwwwiiecom
112 WORLD CAPITAL MARKETS
lending and debt finance to emerging markets and we have argued forsubstitution toward equity finance and direct investment39
That is not the end of the story We noted in the previous chapterthat institutional investors can become momentum investors selling in adownturn As more portfolio capital is invested in emerging marketssome players may adopt the high-risk high-leverage strategies of themost aggressive hedge funds Indeed the data in box 11 show that G-10portfolio investors held somewhat more long-term debt (more than $500billion) than equity (less than $400 billion) in emerging markets at theend of 1997 Long-term debt is an ideal vehicle for high-risk high-leveragestrategies These strategies practiced on a large scale could compound afuture crisis harming emerging markets A big enough crisis could inturn pressure G-10 central banks and finance ministers to arrange bail-out plans Instead of shrinking as a systemic financial problem moralhazard could increase
National securities regulators are the first line of defense against thisscenario They play a critical role in the safe evolution of capital mar-kets But regulators today are mandated to approve the issuance of newsecurities and to monitor the continuing disclosure of material informa-tion by issuers They are far less concerned with or empowered to monitorthe behavior of the increasingly large wealth-management firms that arethe major purchasers (and therefore resellers) of these securities
Within their mandates the goals of national securities regulators (table210 and appendix B) are similar to the concerns of bank regulators withsystem safety and soundness Their focus is also on the incentive sys-tems for management and boards of directors and on disclosure by cor-porations that issue marketable securities such as shares bonds andasset-backed securities 40 Issuers of securities possess greater knowledgeabout the quality of these assets than do the purchasers hence investorprotection is a key concern of regulators Moreover market disciplineworks best when markets know what is happening Well-functioning corpora-tions are key agents of wealth creation and social progress Underperform-ing corporations waste resources During recessions bad corporationsget into bad trouble often with severe social consequences Inadequateincentives for managers and inadequate accountability for boards andmanagers thus have negative externalities Regulators play a vital role inexposing weakness so that market disciplines come to bear sooner ratherthan later
Regulatory emphasis is constantly shifting as financial markets evolveand as the macroeconomic environment changes Regulators try to balance
39 See Rogoff (1999) Also see Berlin (2000) for a perspective on the limited role thatbanks play as share owners
40 See Habib and Ljungqvist (2000) for recent empirical analysis showing that corporateshare market values are higher when corporate executives have a larger ownership stake
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Table 210 Financial-sector regulation G-10 countries 2000
Financial institutions and their supervisors
Country and supervisory structure Retail banking Wholesale banking Securities Insurance
Financial conglomeratesFinancial Services Authority (FSA) = umbrella supervisor
United Kingdom FSA FSA FSA FSA
Treasury bull Commercial banks bull Investment funds (Securities and (Insurance Directorate(Securities and Investments Board) bull Unit trust groups Futures Authority) of the Treasury)
Bank of bull Building societies bull Pension funds England (Building Societies Commission) bull Merchant banks
bull Friendly societies bull Clearing houses bull Primary issuers bull Insurance FSA (Friendly Societies Commission) bull Venture capital of securities companies
bull Pensions and life insurance etc bull Stock exchanges bull Insurance brokers(Personal Investment Authority) bull Stockbrokers
Financial holding companiesFederal Reserve (FR) = umbrella supervisor
United States bull National banks(OCC) Securities and Regulated by
Treasury OCC bull State banks Federal Reserve Exchange Commission StatesMembers (FR)
OTS Nonmembers (FDIC) bull Investment banks bull Primary issuers of bull Insurance companies FR bull Cooperative banks (FDICFR) bull Finance companies securities bull Insurance brokers FDIC bull Insured industrial banks (FDIC) bull Stock exchanges
bull Thrift holding companies (OTS) bull Stockbrokers SEC bull Savings banks (OTSFDICFR) bull Investment advisors
bull Savings and loan associations bull Mutual funds(OTS) bull Public utility holding
bull Edge Act corporations (FR) companies
(table continues next page)
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Table 210 Financial-sector regulation G-10 countries 2000 (continued )
Financial institutions and their supervisors
Country and supervisory structure Retail banking Wholesale banking Securities Insurance
Financial holding companies Japan Financial Supervisory Authority (FSA) = umbrella supervisor
Prime FSA FSA FSA FSA ministerrsquos Ministry of office Finance (Securities and Exchange
Surveillance Commission) FRC Bureau of Financial bull City banks bull Investment banks bull Primary issuers of bull Insurance companies FSA Regulation bull Regional banks bull Asset managers securities bull Insurance brokers
bull Trust banks bull Stock exchanges SESC bull Long-term credit banks bull Stockbrokers
bull Pension funds
Financial holding companiesOffice of the Superintendent of Financial Institutions (OSFI) = umbrella supervisor
Canada Regulated by OSFI OSFI provinces OSFI
Department of Financebull Banks bull Cooperative credit bull Primary issuers of bull Insurance companies
(previously Office of the Inspector associations securities (previously Depart- OSFI General of the Banks) bull Fraternal benefit bull Stock exchanges ment of Insurance) Bank of bull Trust and loan companies society bull Stockbrokers bull Insurance brokers Canada bull Pension funds bull Asset managers
(previously Depart- CDIC ment of Insurance)
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Financial institutions and their supervisors
Country and supervisory structure Retail banking Wholesale banking Securities Insurance
Germany Financial holding groupsFederal Banking Supervisory Office (FBSO) = umbrella supervisor
Ministry of Finance FBSO BSO FSSO FISO
Bundesbankbull Universal banks bull Other financial bull Primary issuers of bull Insurance companies
Federal Banking bull Savings banks institutions (eg securities bull Insurance brokers Supervisory Office bull Securities banks management foreign bull Stock exchanges
currency dealings) bull Stockbrokers Federal Securities bull Financial enterprises bull Asset managers Supervisory Office (eg leasing bull Pension funds
organizations Federal Insurance credit card companies Supervisory Office investment advisors)
Italy Bank foundationsMinistry of Finance = umbrella supervisor
Ministry of Finance Bank of Italy Bank of Italy Consob ISVAP
Bank of Italy bull Commerical banks bull Asset managers bull Primary issuers of bull Insurance companies Consob bull Savings bank bull Open-end investment securities bull Insurance brokers
bull Securities banks companies (SICAVs) bull Stock exchangesbull Stockbrokers
ISVAP
(table continues next page)
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Table 210 Financial-sector regulation G-10 countries 2000 (continued )
Financial institutions and their supervisors
Country and supervisory structure Retail banking Wholesale banking Securities Insurance
The Netherlands Financial conglomeratesCouncil of Financial Supervisors = umbrella supervisor
Securities Board Securities Board Netherlandsche Netherlands Bank Netherlandsche Bank of the Netherlands Insurance Board Bank Insurance bull Credit institutions (universal banks bull Investment institutions bull Stock exchanges bull Insurance companies Board cooperative banks security credit (securities issuing bull Stockbrokers bull Insurance brokers
institutions mortgage banks) and tradingmdashprimary The Council of Financial and secondary Supervisors markets)
France Commission des Commission de Operations des Controcircle des
Banking and Banking Commission Bourse Assurances Financial Regulatory bull Ensuring that credit institutions (and investment firms since bull Primary issuers of bull Insurance companies Ministry for Committee the Financial Activity Modernization Act of 1996) comply securities bull Insurance brokers Economic with laws and regulations bull Stock exchanges Affairs and bull Execute instructions regarding all off-site monitoring and bull Stockbrokers Finance Credit on-site supervision Institutions and Banking and Financial Regulatory Committee Investment bull Formulates general regulations for credit institutions and investment firms Committee (capital adequacy requirements accounting rules etc) Bank of France Credit Institutions and Investment Committee Banking bull Authorizes and examines financial institutions except for those within the Commission competence of the Banking Commission
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117
Financial institutions and their supervisors
Country and supervisory structure Retail banking Wholesale banking Securities Insurance
Switzerland Large banking groupSwiss Federal Banking Commission (SFBC) = umbrella supervisor
Swiss National Bank Federal Office of
SFBC SFBC SFBC Private Insurance Swiss Federal Banking Commission bull Universal banks bull Investment banks bull Primary issuers of bull Insurance companies
bull Savings banks bull Asset management securities bull Insurance brokerscompanies bull Stock exchanges
Private audit Federal bull Investment funds bull Stockbrokers firms Office of bull Mortgage bond authorized by Private business SFBC Insurance
Sweden Financial holding company groupsFinancial Supervisory Authority = umbrella supervisor
Ministry of Finance Credit Market Securities Market Insurance Market
Credit Market Department Department Department Department
Financial bull Commercial banks bull Investment funds bull Primary issuers of bull Insurance companies Riksbank Supervisory bull Savings banks securities bull Insurance brokers Authority bull Friendly societies bull Stock exchanges
bull Stockbrokers
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Table 210 Financial-sector regulation G-10 countries 2000 (continued )
Financial institutions and their supervisors
Country and supervisory structure Retail banking Wholesale banking Securities Insurance
Belgium Bank holding companiesBanking and Finance Commission = umbrella supervisor
Bank of Belgium Banking Banking
Banking and Finance and Finance Insurance Controland Finance Commission Commission Commission Office
Banking and Insurance Finance Control bull Commercial banks bull Asset management bull Primary issuers of bull Insurance companies Commission Office bull Savings banks firms securities bull Insurance brokers
bull Securities banks bull Investment funds bull Stock exchanges bull Mortgage companiesbull Stockbrokers bull Pension funds
Securities Regulation Fund Securities Regulation Fund
bull Other investment firms and credit institutions(institutions participating in regulated off-exchangemarket in strips and Treasury certificates)
Bank holding companies Spain Banco de Espantildea = umbrella supervisor
Banco de Espantildea Comision Nacional del Mercado de Directorate General
Banco de Espantildea Valores (CNMV) Insurance
bull All credit institutions (commercial banks savings banks credit bull Primary issuers of (Ministry of Economy Ministry of cooperatives official credit institutions finance factoring and securities and Finance) Economy and CNMV leasing companies mortgage-loan companies etc) bull Stock exchanges bull Insurance companies Finance bull Interbank foreign exchange and book-entry public debt bull Stockbrokers bull Pension funds
markets bull Venture capital(companies and funds)
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119
Financial institutions and their supervisors
Country and supervisory structure Banking Securities Insurance
Banking Advisory High Level Securities Supervisors Committee (BAC) Committee (HLSS) Insurance Committee (IC)
Supranational (EU) bull Formulates standards for prudential bull Coordination of securities market bull Formulates standards forsupervision supervision prudential supervision
BACICHLSS Banking Supervision
Conglomerates Committee (BSC) Securities Contact Committee Regulation of prudential bull Systemic risk monitoring bull Regulation and implementation of supervision securities admission
International Association International International Organization of of Insurance Supervisors
Basel Committee Securities Commisison (IOSCO) (IAIS) Joint Forum Conglomerates Supervision bull Supervision and regulation best bull Supervision and regulation best bull Supervision and regulation amp regulation Best practices practices practices best practices
FSF Coordination across supervisors of various functions
Notes See appendix B for more information Boldface type indicates senior or oversight supervisor normal type indicates adjunct or front-line supervisorsolid line indicates direct responsbility to the senior-ranking authority dotted line indicates coordination in supervisory activities
(table continues next page)
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Table 210 Financial-sector regulation G-10 countries 2000 (continued )
Glossary of names United Kingdom FSA = Financial Services Authority United States FR = Federal Reserve OCC = Office of the Comptroller of theCurrency FDIC = Federal Deposit Insurance Corporation SEC = Securities and Exchange Commission OTS = Office of Thrift Supervision Japan FRC =Financial Reconstruction Commission FSA = Financial Services Agency SESC = Securities and Exchange Surveillance Commission Canada OSFI =Office of the Superintendent of Financial Institutions CDIC = Canada Deposit Insurance Corporation Germany FBSO = Federal Banking SupervisoryOffice FSSO = Federal Securities Supervisory Office FISO = Federal Insurance Supervisory Office BSO = Banking Supervisory Office Italy Consob =Commissione Nazionale per le Societa e la Borsa ISVAP = Instituto per la Vigilanza sulle assicurazioni private e di Interesse colletivo Switzerland SFBC= Swiss Federal Banking Commission Spain CNMV = The Comision Nacional del Mercado de Valores Supranational BAC = Banking Advisory CommitteeBSC = Banking Supervision Committee IC = Insurance Committee HLSS = High Level Securities Supervisors Committee International Dimension FSF =Financial Stability Forum IOSCO = International Organization of Securities Commission IAIS = International Association of Insurance Supervisors
Sources United Kingdom Bank of England httpwwwbankofenglandcouk Financial Services Authority httpwwwfsagovuk United States Board ofGovernors of Federal Reserve System httpwwwfederalreservegov Japan Bank of Japan httpwwwbojorjo Financial Reconstruction Commissionhttpwwwfsagojpfrcindexehtml Financial Services Agency httpwwwfsagojp Canada Bank of Canada httpwwwbank-banque-canadaca Office ofthe Superintendent of Financial Institutions httpwwwosfi-bsifgccaAndreEindexhtml Germany Deutsche Bundesbank httpwwwbundesbankde Fed-eral Banking Supervisory Office httpwwwbakredde Italy Banca drsquoitalia httpwwwbancaditaliait Commissione Nazionale per le Societa e la Borsahttpwwwconsobit Instituto per la Vigilanza sulle assicurazioni private e di Interesse colletivo httpwwwisvapit The Netherlands De NederlandscheBank httpwwwdnbnl France Banque de France httpwwwbanque-francefr Switzerland Schweizerische Nationalbank httpwwwsnbchindex3htmlSweden Sveriges Riksbank httpwwwriksbanksedefaultasp Belgium National Bank of Belgium httpwwwbnbbesgindexhtm Spain Banco de Espantildeahttpwwwbdees The Comision Nacional del Mercado de Valores httpwwwcnmves Supranational (EU) Institutional Arrangements for the Regulationand Supervision of the Financial Sector 2000 International Dimension Bank for International Settlement httpwwwbisorg International Organization ofSecurities Commissions httpwwwioscoorg International Association of Insurance Supervisors httpwwwiaisorg Financial Stability Forum httpwwwfsforumorg
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 121
the inflexibility of tight surveillance against the need to encourage in-novation and growth The US Securities and Exchange Commission isworried about aggressive accounting by firms and biased reports bysecurities analysts in an equity environment that prizes steadily higherquarterly earnings41 Japanese regulators are preoccupied with opaqueinterconnections between portfolio institutions banks and nonfinancialfirms through the keiretsu system Canadian regulators reeling from high-profile scandals of managers intentionally misleading investors are strengtheningmarket discipline through legal penalties aimed at managers and directorsof offending firms
When panic strikes a securities regulator cannot do much As the 1987stock market crash and the LTCM debacle in the fall of 1998 both dem-onstrated steep stock and bond price declines can create systemic risksIf severe enough the wealth effect of falling securities values and thefear of widespread insolvency can depress real activity Flooding thesystem with liquidity is a central bankerrsquos solutionmdashsomething a securi-ties regulator cannot do42 But just as financial supervisors can changethe incentive structure to discourage bankers from making risky loans ingood times so securities regulators can pay more attention to incentiveson the demand side when capital markets are strong
Prudential Supervision and InnovationmdashA Footnote
In concluding this discussion of prudential supervision in the G-10 anadditional point is worth noting National regulators face a persistenttrade-off between emphasizing financial system safety and soundnesswhile encouraging innovationmdashin spite of the added risks innovationbrings to financial markets Former US Treasury Secretary Lawrence Summers(2000 3) has argued by analogy
The jet airplane made airplane air travel more comfortable more efficient andmore safe though the accidents were more spectacular and for a time morenumerous after the jet was invented In the same way modern global financialmarkets carry with them enormous potential for benefit even if some of theaccidents are that much more spectacular As the right public policy response
41 The problem is illustrated by the divergence since mid-1998 between reported earn-ings by the Standard amp Poorrsquos (SampP) 500 and the after-tax profits of all corporations inthe national accounts Generally these two series move closely with one another Be-tween mid-1998 and mid-1999 SampP 500 reported that earnings increased by more than20 percent while after-tax profits of all corporations increased by less than 5 percent(Chase Bank US Economic and Policy Research US Weekly Prospects Chase SecuritiesWeekly Newsletter 5 June 2000 5)
42 For example the US Securities and Exchange Commission had no direct role in calmingmarkets in the 1987 or 1998 panics
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122 WORLD CAPITAL MARKETS
to the jet was longer runways better air-traffic control and better training forpilots and not the discouragement of rapid travel so the right public policyresponse to financial innovation is to assure a safe framework so that the ben-efits can be realized not to stifle the change
Accepting Summersrsquos analogy for the international financial system better-informed supervisors and investors are a necessary part of the financialsystem framework Supervisors require more timely information on therisk profiles resulting from positions taken by financial institutions Theyalso need a better understanding of risk-management systems Snapshotsof an institutionrsquos risk profile and risk-management procedures are nolonger adequate In a world where huge bets are quickly made (andpossibly lostmdashas with Barings Bank in 1995 and LTCM in 1998) super-visors must focus on the soundness of banking systems for evaluatingand managing risk on a daily basis Some progress has been made inaddressing these issues US banking examiners are extending their in-formation requirements in banking examinations and increasing theirinvolvement in large complex institutions43 More awareness is alsorequired of the fact that they are national organizations in a world ofcross-border capital flows To a much greater extent they need a multi-national reach International supervision and coordination among super-visors are the subject of the next section
Our analysis suggests that G-10 supervisors have unfinished businessBank supervisors need to start yesterday securities regulators can waituntil tomorrow One G-10 member acting alone cannot correct the biasIn good times the lending business will simply migrate to other G-10banks In bad times financial problems will not stop at the national bor-der A way has to be found to establish common international standardsfor the key financial players in order to prevent crises and to agree onapproaches for managing them The path has already been laid out Inthe wake of the bank failures of the past 25 years bank supervisors havetried to establish such standards They have done this without creating anew global institution
The essence of the international framework is decentralizationmdashglobalrules and design standards without global institutions that are perceivedto intrude on national sovereignty The awkward jargon for this frame-work is vertical subsidiaritymdashldquothink internationally act nationallyrdquo Theinternational thinking is done by a committee of regulators that meets
International SupervisionA Decentralized Framework
43 These issues are discussed in Ferguson (1999) and Meyer (2000a)
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 123
regularly at the Bank for International Settlements in Basel The commit-tee establishes principles and standards that are interpreted implementedand enforced by national authorities44 In this section we describe thesesupervisory efforts and their weaknesses We present our recommenda-tions for addressing these weaknesses in the next chapter
Basel I
The Basel Capital Accord of 1988 (Basel I)45 drew the lesson from thefinancial crises of the mid-1970s that more adequate capital levels in in-ternational banks would help reduce the systemic risk of bank failureThe primary goal of Basel I was capital adequacy other standards wereput in place not so much for their own virtue as to defend the primarygoal
Capital adequacy requirements were designed to ensure that individualinstitutions have the ability to absorb losses particularly credit lossesAccordingly a backup system of scoring credit risk was devised thatrequired large amounts of bank capital for some types of loans smalleramounts for others and zero for a select list of preferred assets Report-ing requirements were designed to disclose problems and ensure that atroubled bank would take timely steps to restore its capital base in thewake of a loss The Basel I framework worked tolerably well in limitingthe call on the public purse in the G-10 countriesmdashwith the notable ex-ceptions of France and Japan The framework failed to moderate riskybank lending to emerging markets however
Basel I was not developed with emerging markets in mind The origi-nal idea behind it was to develop a common supervisory approach tocross-border banking operations It grew out of political pressure fromUS lawmakers who were determined to require international banks op-erating in the United States to meet US banking standards Toward thisgoal in 1983 Congress passed the International Lending Supervisory ActUS and British banking authorities subsequently agreed on a commontarget the adoption of strict common capital-adequacy standards In 1988other G-10 governments agreed to go along voluntary acceptance ofthe standards throughout much of the rest of the world followed46 Therationale for the capital targets was two-fold The first was to requirebanks to hold sufficient amounts of capital (8 percent of risk-adjusted
44 The international committee of financial authorities agreed on a common definitionof banksrsquo tier-one or ldquocorerdquo capital national authorities defined tier-two capital in theirown manner which permitted greater variations in national working definitions andpractices
45 International Convergence of Capital Measurement and Capital Standards (BIS 1988)was prepared by the Basel Committee on Banking Supervision
46 See Reineke (1998)
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124 WORLD CAPITAL MARKETS
assets) to cushion losses on those assets The second was to dull theirappetites for risk banks with large capital bases would have more tolose if they failed and therefore would take fewer risks
Rapid change in financial markets soon revealed flaws in the Basel IAccord In a complex world with numerous sources of risk it focusedheavily on credit risk but overlooked other risks in a bankrsquos portfolioand the correlation between returns on different asset classes The Baselformula required banks to maintain a fixed amount of capital againsteach of its asset classes But the formula did not distinguish the riskinessof the borrower within each class As a result one large loan to a low-risk corporate borrower such as General Electric would require the sameamount of capital as 10 smaller transactions with high-risk borrowers
The system was also biased toward short-term loans Loans maturingin less than a year required a 20 percent risk weight whereas those ma-turing after more than a year required a 100 percent risk weight Inter-bank lending was particularly favored For example loans to banks inOECD countries required less capital than loans to private firms in thesame countries creating the anomaly that interbank loans to South Ko-rean banks required less capital than loans to General Electric47 Thisanomaly encouraged banks to shed high-quality assets if the Basel rulesrequired the allocation of more capital than banks thought they needed
Another weakness was that financial innovators quickly circumventedthe Accord Because short-term loans required less provisioning than long-term loans banks responded by securitizing their long-term debt port-folios and lending short-term against the collateral of the newly createdasset This allowed banks to circumvent the capital requirements gearedto the terms of the underlying debt At the same time the Basel I Accordfailed to encourage risk mitigation techniques such as credit derivativescollateral guarantees and on-balance-sheet netting the flip side of fi-nancial innovation Because off-balance-sheet products were not coveredby the Accord another anomaly appeared when Barings Bank collapsedin 1995 Barings met capital adequacy standards but collapsed becauseits systems for managing risk failed traders were allowed to speculatein futures contracts that did not appear on the balance sheet
Basel II
Work to overhaul Basel I began in 1995 and produced consultativepapers issued in June 1999 and January 200148 These papers have been
47 South Korean banks have had notoriously weak balance sheets because the practiceof ldquodirected lendingrdquo left them with many poor loans (in making these loans the bankswere expected to follow government objectives rather than creditworthiness criteria)
48 Basel Committee on Banking Supervision (1999 2001)
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 125
the subject of extensive consultation and revision as a result the newAccord is expected to be introduced in 200449 The Basel II frameworkhas three parts (pillars) revisions to Basel I minimum-capital require-ments supervisory review criteria and greater emphasis on market dis-cipline Broadly Basel II aims to maintain the level of capital in the sys-tem but achieve better alignment of banksrsquo capital with their risk pro-files and keep up with financial innovation
To align capital requirements with market realities (the first pillar)Basel II concentrates on the 100 or so largest banksmdashthe type of playerslisted in table 21mdashand on the holding-company parents of banking groups50
Capital requirements will differentiate between an increased number ofcredit groups or ldquorisk bucketsrdquo including claims on governments otherbanks corporations mortgage-backed securities and other asset-backedsecurities
Basel II originally proposed to use external ratings to set capital chargesfor a number of these credit risks Many banks objected arguing thatthey assess credit risk better than Standard amp Poorrsquos Moodyrsquos or FitchIBCA51 Basel II thus proposes two approaches to rating a standard ap-proach using external ratings and an ldquoadvancedrdquo approach that allowsselected banks to use their own internal rating systems To encouragethe development of rigorous internal control systems based on these in-ternal rating systems Basel II also proposes to levy capital charges foroperational risk (the risk of direct or indirect loss resulting from inad-equate or failed internal processes people and systems or from exter-nal events)
Some critics of this proposal dismiss it as an abrogation of the prin-ciple of external independent monitoring and as ldquodangerously naiumlverdquo52
But regulators argue that the new capital charge on operational risk shouldoffset this concern It is also far from clear how cross-national compari-sons of rating and internal risk-assessment systems will be made (Engelen2000) The development by the European Union of its own capital rulescould well complicate the international resolution of these issues Publicassurances by EU officials in January 2001 however indicated that theirmain concerns are to create a level playing field and avoid regulatoryarbitrage (Hargreaves 2001) There is also the significant problem ofthe procyclical character of risk weights When a crisis hits losses are
49 See Berry (2000) for an update in an interview with William J McDonough chair ofthe Basel Committee on Banking Supervision
50 For obvious reasons these proposals are addressed to large banks and simpler capi-tal standards are allowed for small banks that focus on their domestic credit markets
51 See Ammer and Packer (2000) for an empirical critique of the success of rating agen-cies in distinguishing risk by sector and region
52 See Auerback (2001)
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126 WORLD CAPITAL MARKETS
incurred or accrued capital is lost and loan exposure must be reducedor securities sold to restore the requisite capital-adequacy ratios A morerisk-sensitive framework could amplify volatility
As the second pillar of Basel II supervisory review criteria are beingbeefed up to encourage supervisors to intervene earlier in potential problemsituations and to compel banks to align their capital positions with theirrisk profiles Bank supervisors will be authorized to require banks tohold capital in excess of minimum requirements if they have concernsabout general management overall strategy risk-management performanceor the macroeconomic environment Of course if one G-10 supervisorimposes higher capital requirements in isolation the same disparity willemerge that presaged Basel I Some banks will be disadvantaged in theinternational marketplace and will loudly complain that excessive super-vision is driving business to their competitors Hence close internationalcooperation among supervisors is critical
To implement the third pillar market discipline banks will be requiredto make fuller more timely disclosure of capital adequacy and the risksto which that capital is exposed A number of measures are being stud-ied that might help supervisors evaluate bank performance such as com-parisons of uninsured deposit interest rates subordinated debt yieldsand equity prices The idea is that these yields and prices might alertsupervisors to market perceptions of risk Of course market perceptionsare only as good as market information More direct and controversialways to reinforce market discipline would dramatically increase publicdisclosure of bank positions and risk management systems
Many questions are still outstanding about how to resolve the techni-cal details of capital requirements and whether the requirements willachieve their intended goal of better assessment and mitigation of therisks in banksrsquo portfolios There is no substitute for skilled supervisorsThe intricacies of effective design and implementation suggest that su-pervisors need to be highly competent technically knowledgeable aboutbanking portfolio characteristics and the factors that influence bank ex-posure to credit risk (Mishkin 2000) And they must be aided by vigilantshareholders market forces and transparency of information53
Standard setting at the global level is desirable but ultimately theeffectiveness of these efforts will be tested at the national level espe-cially in times of systemic financial distress Here the record of Basel Iwas not a bright shining success Japanese banking regulators havetraditionally allowed banks to include real estate and securities in theircapital base When the value of these assets plummeted in the early 1990sregulators allowed banks to continue valuing these depreciated (andoften bankrupt) assets at their old inflated levels Japanese authorities
53 Benedict Roth Complacency Towards Catastrophe Financial Times 23 January 2001
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 127
insisted until the mid-1990s that eroded capital bases could be rebuiltin a market-driven fashion They rightly foresaw that huge loan losseswould undermine public support for the ruling party and require a po-litically unpopular bailout
Japanese foot dragging on Basel I was the worst54 but not uniqueOther examples can be found of ldquopolitically mandated forbearancerdquo TheFederal Reserve Bank of New York held important hands during theLTCM crisis of 1998 Mexico is still resolving the banking crisis that eruptedin 1995 South Korea has not yet closed the insolvent banks that behavedso badly before the crisis of 1998 In the aftermath of a crisis nationalregulators cannot always be relied upon to discipline politically power-ful bankers55 One of the little-noticed consequences of these differingapproaches is that those banks with strong regulatory systems receivedan implicit ldquoexport subsidyrdquo for their services US banks which had notengaged extensively in emerging-market lending in the 1990s were bet-ter positioned than their German and Japanese counterparts to expandtheir international assets in the wake of the crises
Other Financial Forums
54 See Japanese Banks Fiddling while Marunouchi Burns The Economist 27 January2001 67-69
55 See Calomiris (1997)
The Basel model of vertical subsidiarity has already been extended toother financial regulatory bodies In 1993-94 the BIS established a Tri-partite Group of Banking Insurance and Securities Regulators In 1994-95 the BIS increased its cooperation with the International Organizationof Securities Commissions when the two organizations issued parallelpapers on guidelines for national regulators concerning risk managementand disclosure of derivative trades In 1996 a permanent Joint Forum onFinancial Conglomerates was established to examine supervisory issuesand develop working arrangements among the different functional super-visors of conglomerate institutions that offer combinations of bankingsecurities and insurance products Draft papers on the supervisionof conglomerates were released for comment in 1998 applying capital-adequacy principles to these groups and providing guidelines both forassessing the integrity and competence of top managers and for sharingassessments between regulators
In 1997 the Basel Committee on Banking Supervision extended itsreach beyond capital standards to broader aspects of banking supervi-sion with the publication of the Core Principles for Effective BankingSupervision In 1999 a wide range of regulatory and standard-settingbodies were gathered under the umbrella of the Financial Stability
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128 WORLD CAPITAL MARKETS
Forum (FSF) itself established under BIS aegis56 The FSF has alreadyissued recommendations for stepped-up supervision and transparencyas well as guidelines for best practices in a number of areas includingoffshore financial centers and highly leveraged institutions or hedge funds57
Conclusion
Although the structural weaknesses in emerging-market economies arewidely acknowledged to have been causal factors in international capi-tal-market volatility this chapter points to the role of large G-10 bankingorganizations as major suppliers of the most volatile instrument short-term debt We have examined evidence of the impact of public safetynets in the G-10 economiesmdashthe deposit insurance systems the pruden-tial supervisory systems and the lender-of-last-resort functions of centralbanksmdashon the incentive structures of these organizations
Although supervisors in most countries working nationally and to-gether in the BIS have made significant efforts to mimic market forcesin their prudential supervision the most sophisticated financial institu-tions find innovative ways to circumvent the rules New global regulatorybodies are not about to be created G-10 national bank regulators shouldthemselves address the short-term debt bias in the international financialsystem by changing incentive systems G-10 securities regulators shouldalso take steps to get ahead of the curve paying close attention to largeportfolio swings by institutional investors particularly in times of crisisIn short more needs to be done at national and international levels tochange the rules of the game That is the subject of the next chapter
56 The Financial Stability Forum includes banking securities insurance and accountingregulatory bodies the OECD on taxation corruption and corporate governance and theIMF
57 See Martin (2000)
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 97
margin relative to the potential risk Credit derivatives limit credit risk bytransferring the potential loss associated with corporate loans and bondssovereign debt and other loan portfolios to counterparties15
Deregulation and innovation working in combination seem to havepushed banks into trading activity and leveraged plays but not into shareownershipmdasheven in jurisdictions that have no prohibition against equitystakes Among the G-10 banking systems the highest ratio of share own-ership to assets was only 5 percent in 1996 reached in Germany andJapan (Berlin 2000)16
The wave of innovation in financial instruments and the accompany-ing expansion of banking beyond its old boundaries is a two-edged swordOn one side it allows risk management far beyond what was tradition-ally possible Risk can now be shifted from firms that can ill afford lossesto those that can Banks can profitably act as intermediaries in shiftingrisk On the other side the innovation wave creates huge opportunitiesfor leveraged plays fostering a speculative search by banks themselvesfor high returns that in turn magnify their own risks17
15 Credit derivatives include total return swaps credit default swaps credit-linked notesand collateralized debt obligations They are the fastest-growing sector of the global de-rivatives market
16 Banks seem to specialize in lending even when they are allowed to mix finance andcommerce for reasons related both to how they are expected to behave with distressedfirms and to other intricacies of lender liability (Berlin 2000) Yet a recent cross-countrystudy found that restrictions on banking and commerce are associated with greater fi-nancial instability (Barth Caprio and Levine 2000)
17 Leverage is the magnification of the rate of return (positive or negative) on an in-vestment beyond the rate obtained by solely investing funds owned by the institution Itis often defined as the ratio of assets to equity Leverage is achieved by increasing thesize of an investment by borrowing or using derivative instruments such as futures oroptions These allow investors to earn a return on the notional amount underlying thecontract by committing a small portion of equity in the form of a margin deposit oroption premium payment
18 In a repo (repurchase agreement) one party (typically a trader) buys a bond andsells it to a dealer for cash with a promise to buy it back the next day at the same priceplus the overnight interest rate As long as the overnight interest rate is lower than theinterest accruing on the bond the trader earns some income on the bond The extremeform of these kinds of transactions was discovered at LTCM the failed US highly lever-aged institution which appears to have controlled more than $120 billion in assets froman investment of about $3 billion This leveraging was accomplished mostly through theuse of repos (Mayer 1999)
The potential for damage is illustrated in an extreme form by figure 21To precisely measure a firmrsquos leverage all positions must be known andrealistically valuedmdashwhich may be impossible to do Because many ac-tivitiesmdashsuch as repos18 and derivativesmdashdo not appear on the institutionrsquos
Leverage
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98W
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MA
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ET
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Figure 21 Hypothetical example of leverage
$1000 notional value of call option on equity in firms targeted for takeover
Repo FRN into cash and use cash to pay option premium
(repro is initially collateralized
Borrow $100 for margin purchase
$125 of US investment bank floating-rate notes (FRN) (secured by $25 equity in FRNs)
Repo off-the-run bond into cash and post margin
(repo is initially collateralizedSell (short) Borrow on-the-run bonds worth $20
$25 worth of off-the-run bonds (secured by $5 equity in bonds)
Exchange into $4
Cash $5 yen400 Japanese bank loans
$1 equity base
FRN = floating rate notesRepo = repurchase agreement
Source IMF (1998)
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 99
balance sheet and because balance sheets are published quarterly at bestoutsiders have a difficult time assessing the extent of a firmrsquos leverage19
Leveraging by a single firm enhances its risk of default the widespreaduse of leverage in the financial system can magnify market adjustmentsespecially when they require ldquodeleveragingrdquomdashunwinding prior positionsRapid adjustments can cause credit to dry up and asset prices to plummetIn a mark-to-market environment falling asset prices trigger calls foradditional collateral that can ripple through markets
Risk Management
Because it is confronted with the widespread use of leverage and prolif-erating kinds of risk international finance is increasingly driven by riskevaluation and control20 Different institutions face various risk profilesand differing kinds of risk The most common risks can be quickly tickedoff Banks because of their traditional intermediary role of channelingthe resources from savers to borrowers face significant credit risk therisk of default or delay in the payment of principal and interest Theymust also manage market risk the risk that the prices of their liabilitiesmay change faster than their assets Market risk devastated US savingsand loan institutions in the late 1980s
Closely associated with market risk are interest-rate risk (unexpectedchanges in market interest rates that slash margins net income and theeconomic value of a bankrsquos equity) and foreign exchange risk (losses thatarise when assets denominated in an appreciating foreign currency areless than liabilities denominated in that currency) Banks make numer-ous loans to other banks around the world portfolio investors buy se-curities direct investors acquire fixed assets and all incur country risk(economic and political uncertainty in the host country) During the heightof the Asian crisis for example interbank loans to Japanese banksreflected the credit risk of lending to these banks the so-called Japanpremium
Substantial attention has been lavished on country risk analysis sincethe 1982 debt crisis in developing countries Yet in spite of this exper-tise the Asian crisis occurred in part because of a sudden upward reap-praisal of country risk after the Thai baht collapsed in April 1997 Banksand other financial institutions must also manage liquidity risk the riskthat market conditions will change unexpectedly depressing demand andprices of assets at the time they want to sell these assets And they mustmanage operational riskmdashfailures in control systems or people that cause
19 Another example of asymmetric information Both risk and leverage are difficult foroutsiders to assess without full timely disclosure
20 A longer discussion of these issues can be found in Managing Global Finance in IMF(1999c)
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100 WORLD CAPITAL MARKETS
financial loss or damage reputations Operational risk devastated BaringsBank in 1995
Financial institutions practice risk management to measure all theserisks the potential damage to their investment positions and ultimatelythe chance of becoming insolvent VAR (value at risk) risk models mea-sure subject to certain assumptions the amount of the firmrsquos capital thatis exposed in each period For example the VAR model might say thatin a 3-standard-deviation worst case (a case that is not supposed to hap-pen more than 1 percent of the time) the firm will loose 25 percent of itscapital during the next year
VAR models are widely used but like all models they have weak-nesses They rely on past values to estimate key variables in financialmarkets past values are not always good predictors of future risks More-over rising volatility and higher loss correlation among different assetclasses in a portfolio will cause all banks using these models to reducetheir exposures at the same time by switching to less volatile and lesscorrelated assets such as US Treasury bills (Persaud 2000)
Newer risk models entail stress testing and scenario analysis Scenarioanalysis envisages possible adverse changes one at a time that mightaffect the investment portfolio Stress testing estimates potential losseswhen several individual risk factors simultaneously move against thefirm but it too uses historical probabilities
Financial Volatility
21 For example derivative markets usually rely on underlying securities markets thatproduce continuous prices When these markets are interrupted financial shocks cantrigger a cascade of margin calls and sell orders that move prices very sharply
22 See IIF (1999a)
The combination of trading activity and modern risk management lie atthe root of financial volatility When risks increase banks must eitherraise more capital to cover the greater risk or reduce their exposure bycutting loan exposure by selling securities or by undertaking new de-rivative trades Raising more capital is time-consuming and in a crisisvery expensive because bank shares are depressed So banks look to theother alternatives If the bank can reduce lending it need not book aloss But most banks use the same VAR models and as indicated abovethese models will encourage them to reduce their outstanding loans atthe same time actually magnifying loan volatility
If banks attempt to reduce their exposure to risk by selling securitiesor undertaking new derivative trades they may trigger large priceshocks because of limited and shrinking market liquidity21 The liquid-ity problem is compounded when a small number of large institu-tions hold the same positions22 Take your pick loan volatility or price
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 101
volatility As two experts have observed (Folkerts-Landau and Garber1998)
[V]olatility even in one country will automatically generate an upward re-estimate of credit and market risk in a correlated country triggering automaticmargin calls and tightening of credit lines Thus apparently bizarre opera-tions that connect otherwise disconnected securities markets are not the re-sponses of panicked green screen traders arbitrarily driving economies from agood to a bad equilibrium Rather they work with relentless predictability andunder the seal of approval of supervisors in the main financial centers
23 See Ferguson (1999)
24 As Gerald Corrigan (1982) put the matter ldquoBanks are specialrdquo Corrigan (2000) reit-erated this view even after all the changes of the past two decades Unlike other institu-tions banks offer on-demand transactions are a backup liquidity source for other insti-tutions and serve as a ldquotransmission beltrdquo for monetary policy
These changes in the banking environment accentuate an existing anomalyThe anomaly is that banks even as they grow larger and increasinglyengage in more risky and complex transactions are perceived to enjoyimplicit and explicit public guarantees
The guarantees grow out of an incentive problem inherent in bankingasymmetric information which we mentioned above Depositors know lessabout a bankrsquos management and the quality of its balance sheet than doits managers and shareholders Thus in times of uncertainty or adver-sity bank depositorsmdashuncertain whether they will have access to theirdepositsmdashare prone to bank runs This prospect has in turn compelledgovernments to treat banks differently than other firms because a bankthat fails can disrupt the rest of the economy24
To prevent such crises governments have entered into quid pro quoarrangements with banks Governments provide them both with an im-plicit safety net in the form of an unstated promise by the central bankto act as a lender of last resort in a liquidity crisis and an explicit safetynet in the form of a public deposit insurance fund to reassure depositorsIn return the banks submit to closer government oversight and regu-lation of their activities than is usual for industries in the private sector
The ldquoinsurancerdquo provided by the public safety net contributes to an-other incentive problem moral hazard Banks acquire greater tastes forrisk and face less market discipline than other firms The explicit depositinsurance safety nets actually have or are perceived to have blanketcoverage that extends beyond the retail depositors (households and small
One of the lessons of the 1997-98 crisis must surely be that market par-ticipants and their regulatory supervisors relied too heavily on quantita-tive tools and insufficiently on judgment23
The Anomaly of Modern Banking
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102 WORLD CAPITAL MARKETS
businesses) for which they were originally intended The implicit centralbank safety nets extend in a crisis to nearly all depositors and banksThus banks are both viewed and behave as if they will be bailed out ifthey get into trouble
The existence of a public safety net raises a perennial question Dobanks have an unfair advantage over other financial institutions becauseof the subsidy provided by the safety net This question was at the heartof intensive study and debate in the United States leading up to thepassage in November 1999 of the Financial Services Modernization Act(also known as the Gramm-Leach-Bliley Act) The size of the gross sub-sidy is difficult to estimate despite determined research efforts Somesuggest it is well under 100 basis points and is at least partly offset bythe direct costs of deposit insurance premiums interest payments on bondsissued by the Financing Corporation25 reserve requirements regulatoryexpenses and operational costs associated with collecting deposits26 Con-versely Kwast and Passmore (2000) suggest that banks can expand theirscope far beyond the levels that other financial institutions could reachwith the same equity base but without the public safety net
A related concern in the US debate is whether allowing banks to ex-pand their activities into securities and insurance will ultimately extendthe safety net and add to the subsidy The Financial Services Moderniza-tion Act deals with this issue by maintaining a legal separation betweenbanks and the rest of the banking organization known as large com-plex banking organizations (LCBOs) They must engage in most securi-ties activities and insurance underwriting through separately capitalizedinvestment bank subsidiaries or holding company affiliates This act canbe said to have merely brought US banking laws closer to those of mostother industrial countries (Barth Brumbaugh and Wilcox 2000 BarthNolle and Rice 2000) If the fire wall is well-maintained and stoutly de-fended the safety net will neither expand in practice nor become a sourceof comfort to noncommercial bank subsidiaries of LCBOs
The quid pro quo exacted by governments to offset the subsidy iscloser public-sector monitoring of banksrsquo activities through prudentialsupervision The effectiveness of this closer official scrutinymdashand closermarket monitoringmdashare the subjects of the next section
25 The Financing Corporation was created by Congress in 1987 to sell bonds to raisefunds to help resolve the savings and loan crisis
26 See Levonian and Furlong (1995) Jones and Kolatch (1999) Shull and White (1998)and Whalen (1999a 1999b)
Are G-10 bank supervisors adequately responding In this section we firstassess the case for and compare the structures of prudential supervisory
Prudential Supervision
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 103
systems both within and among the G-10 economies plus Spain andconsider whether these offset the subsidy provided by the public safetynet Despite offsetting regulation and supervision implicit and explicitguarantees by G-10 governments to their banks are still a source of bank-ing instability in the emerging-market economies
National Systems for Prudential Supervision
Governments use prudential supervision to reduce the moral hazard andadverse selection created by their own safety nets Supervisors establishregulations and monitor compliance to limit risk taking and ensure thesafety and soundness of the banking system In a thoughtful analysis ofthe case for prudential supervision Frederic Mishkin (2000) identifiesthe main forms that supervision can take including the tasks of grantingbanking charters and licenses establishing capital requirements settingdeposit insurance premiums and defining disclosure requirements as wellas carrying out bank examinations Bank examiners gather informationfrom banks and evaluate whether they are following the regulatorsrsquo rulesin cases of weakness they are empowered to change banksrsquo behaviorand close them if necessary
Supervisors also may restrict competition define the activities in whichbanks may engage and restrict their asset holdings and separate banksand other financial (or nonfinancial) activities During the past two de-cades the barriers separating commercial banks investment banks in-surance firms and securities firms have been all but eliminated (tableB1) Deregulation has stimulated competitive forces that drive diversifi-cation and consolidation of the financial industry nowhere faster than inthe United States
The Financial Services Modernization Act of 1999 confirmed this trendIt eliminated restrictions dating back to the Glass Steagall Act of 1933which once prevented banking insurance and securities firms fromentering each otherrsquos businesses (Barth Brumbaugh and Wilcox 2000)Cross-pillar mergers among banks insurance and securities firms arewell under way to form giant financial holding companies The 1999merger between Citibank (banking) and Travelers (insurance) created themodel for megafinance and confirmed new challenges for supervisors
Mishkin (2000) notes the corresponding evolution in US supervisionfrom an emphasis on rules-based regulation (detailed rules for opera-tional behavior and the quality of line items in the balance sheet) to anapproach that stresses the soundness of bank management practices es-pecially risk management
Appendix B outlines the systems of financial supervision now in theplace in the G-10 countries plus Spain Some systems like the UK andCanadian approach are models of simplicitymdashorganized to keep pacewith the spreading reach of financial conglomerates Other systems like
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104 WORLD CAPITAL MARKETS
the US and French approaches show traces of the bureaucratic divisionsthat made sense in an era when banking securities and insurance weresharply separated
The US Model
27 See Meyer (1999a)
28 Canada has a similar degree of simplification with the exception that securities firmsare still regulated by provincial authorities
29 See Pratti and Schinasi (1999 67)
30 The agents are the bank regulators and the principals are the taxpayers Agents maypursue their own interests including bureaucratic survival and postgovernment employ-ment opportunities rather than the national interest in banking safety and soundness
The US model of financial regulation delineated in the Financial Ser-vices Modernization Act of 1999 blends functional and umbrella super-vision Bank and thrift regulators oversee depository institutions Newnonbank activities are subject to both functional regulation (eg by theSecurities and Exchange Commission and state insurance examiners) andumbrella supervision (of financial holding companies) by the FederalReserve27
The UK Model
Another supervisory model exists in the United Kingdom as well as inAustralia Canada and Switzerland28 In this model banking supervisionis separated from the monetary policy function The regulatory structureis considerably simplified by relying on a consolidated financial regula-tor separate from the central bank for both banking and nonbankingactivities The remaining question answered differently depending on thecountry is the extent to which the regulator relies on home-country sur-veillance of banks and conglomerates that have a local presence
Regulatory Models Compared
Appendix B provides more detail on the differences in these modelsGerman simplicity contrasts with French complexity In France the bankingcommission is chaired by the governor of the central bank and includesrepresentatives from the Treasury The commission supervises compli-ance with regulations but the central bank inspects banks on behalf ofthe commission29 In countries such as the United States and France withmultiple supervisors and crossover functions internal coordination is criticalAt the same time multiple agencies create regulatory competition Wheneach agency knows what the other is doing transparency within gov-ernment circles can help to limit principal-agent problems of regulation30
The discussion as to where in the public bureaucracy financial super-
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 105
vision should be placed goes back many years Peek Rosengren andTootell (1999) argue that a synergy exists between monetary policy andprudential supervision because information gained in the course of super-vision can increase the accuracy of macroeconomic forecasts A twist tothis argument is that the information on the state of financial institutionsavailable to the central bank as supervisor can facilitate its role as lenderof last resort Conversely there is the concern that a supervisory rolewill compromise the central bankrsquos independence of action with respectto its core mandatemdashmaintaining price stability As these arguments haveplayed out financial supervision has generally been shared between centralbanks and other regulators or placed entirely in the hands of an inde-pendent regulator However in Italy the Netherlands and Spain cen-tral banks are the sole banking supervisor
Goodhart (1995) examined the arguments and evidence for each modeland concluded that there were no overwhelming arguments or evidencefor one or the other31 Going forward a key problem for any financialsupervisory system is dealing with (and closing as necessary) weak banksIf both central banks and other regulators have this responsibility closecoordination between them is critical Another problem is large conglom-erate banks LCBOs Although they are less likely to fail because of thediversification of their assets and liabilities they are more likely to berescued They are also more likely to be multinational enterprises withinternational implications Goodhart observes that regulation of theseentities might be put in the hands of the central bank because it is lessamenable to political pressures In any event the complexity of LCBOoperations suggests that greater supervisory rigor is necessary
The US Congress was persuaded that broad oversight would help containthe moral hazard problem and accordingly gave the Federal Reservethe role of umbrella supervisor with the understanding that the Fed willscrutinize depository activity more intensely than nonbank financial ac-tivities Under this approach LCBOs such as Citigroup are subject tomuch closer monitoring than smaller and simpler institutions32 The USregulatory model requires enormous cooperation between the Fed otherbank supervisors and the functional regulators for insurance and securi-ties but it also benefits from regulatory competition
31 National systems of supervision are path dependent they are determined by the struc-ture of financial institutions and history in each country If Goodhart (1995) is right out-comes are not materially better or worse with one model of supervision rather than another
32 See Ferguson (1999)
Public Safety Nets
One of prudential supervisorsrsquo biggest challenges is to reduce moral hazardFor many years commercial banks engaged in communal self-insurance
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106 WORLD CAPITAL MARKETS
to deal with crises They formed voluntary groups that agreed to rescuetroubled members As financial markets evolved and competition inten-sified banks were no longer willing to play this role Private-sector in-surance is one alternative but moral hazard and adverse selection wouldappear to prevent it from happening Public safety nets have developedbecause of the low probability and high cost of potential bank runs Aclear trade-off is involved The effectiveness of insurance in preventingbank runs is greater the more comprehensive the coverage But the morecomprehensive the coverage the greater the moral hazardmdashbank man-agers bank directors investors and depositors all take on greater risksin the belief that the safety net will protect them against losses
All G-10 countries have compulsory public safety nets for banks (table29) Deposit insurance agencies are officially organized in Canada theNetherlands Sweden Switzerland and the United States organized bythe industry in France Germany Italy and the United Kingdom andjointly organized by the public and private sectors in Belgium Japanand Spain
How well do G-10 governments offset the subsidy provided by thepublic safety net This is a question on which there is substantial debateAs banking organizations have become more complex the challengesthat supervisors face have become more difficult One challenge is toalign the incentives facing bank managers and shareholders with thoseof depositors Another is the principal-agent problem in supervision Wehave discussed the incentive structures for financial institutions but wehave said little about the incentives for supervisors themselves and thedistortions they can generate in the financial system
In one of the many studies of the US savings and loan crisis of the1980s Kane (1989) documented both problems He described managersusing cosmetic approaches to disguise the magnitude of insolvency regulatorspracticing forbearance even though they knew of the deteriorating riskprofiles of the institutions for which they were responsible and legisla-tors increasing deposit insurance without regard for any offsetting changesin supervision A subsequent overhaul of the legislative framework forthe Federal Deposit Insurance Corporation (FDIC) known as the FDICImprovement Act of 1991 (FDICIA) aimed to introduce a clearer incen-tive structure for both regulators and regulated institutions
The changes introduced by this US legislation are worth discussionwith respect to the other G-10 countries as well First FDICIA created astronger signal to management and investors by targeting deposit insur-ance at small depositors only and by risk-weighting the deposit insur-ance premiums paid by banks to reflect their capital adequacy and bankexaminer ratings Among the G-10 countries rated in table 210 depositinsurance premiums vary considerablymdashbut it is not clear that the dif-ferences have much to do with risk-weighting Most G-10 countries em-ploy funding formulas based for example on the total domestic deposit
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TH
E P
LAY
ER
S T
HE
IR S
UP
ER
VIS
OR
S A
ND
MO
RA
L HA
ZA
RD
107
Table 29 Deposit insurance schemes in the G-10 countries Explicit safety net
Coverage limit(dollar Foreign
equivalent currency Interbank Source Bankrsquos Contingency fundingDate Membership Co- at end of deposit deposit of premium from banks
Country established managementa insuranceb July 1998)c covered covered Fundingd funding costs or governments
United 1982 Compulsory Yes Larger of 90 No No Unfunded Banks only Callable (subject Parliament may increase Kingdom private percent co- to maximum the maximum payable
insurance to 03 percent of pound125 million advance 33000 total deposits) facility with Bank of
England
United 1934 Compulsory No 100000 Yes Yes Funded Banks and Up to 027 Borrowing up to $3 States official government percent total billion from US Treasury
domestic deposits
Japan 1971 Compulsory No 71000 but No No Funded Banks and 0084 percent of Borrowing up to yen500bn joint in full until government insured deposits from Bank of Japan
year 2000 subject to Ministry of Finance approval
Canada 1967 Compulsory No 40800 No Yes Funded Banks and 033 percent of Borrowing up to C$6 official government insured deposits billion authorized further
(maximum) borrowing subject to parliamentary approval
Germany 1966 Compulsory Yes 90 percent Yes No Funded Banks only 003 percent of Annual levy may be private coinsurance deposits doubled
to 22000
Italy 1987 Compulsory Yes 125000 Yes No Unfunded Banks and Callable Two options defer private government (maximum of payment or diminish
1 percent of compensation to be paid total deposits)
(table continues next page)
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108W
OR
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CA
PIT
AL
MA
RK
ET
S
Table 29 Deposit insurance schemes in the G-10 countries Explicit safety net (continued )
Coverage limit(dollar Foreign
equivalent currency Interbank Source Bankrsquos Contingency fundingDate Membership Co- at end of deposit deposit of premium from banks
Country established managementa insuranceb July 1998)c covered covered Fundingd funding costs or governments
Netherlands 1979 Compulsory No 22000 Yes No Unfunded Banks and On demand Government backing official government maximum of subject to parliamentary
5 percent of own approval funds
France 1980 Compulsory No 65400 No No Unfunded Banks only Callable (on Extra calls up to FFr1000 private demand calls million can be made in
up to FFr200 a 5-year period million)
Switzerland 1984 Voluntary No 19700 No No Unfunded Banks only Callable (on Underwritten by member official demand) banks
Sweden 1996 Compulsory No 31400 Yes No Funded Banks and 05 percent of Full emergency coverage official government deposits while replacing it with a
limited system after the emergency
Belgium 1974 Compulsory No 16600 No No Funded Banks and Callable 002 None insurance limited joint 22000 in government percent of to assets in fund
year 2000 deposits from clients
Spain 1977 Compulsory No 16439 Yes No Funded Banks and 02 percent of Government backing joint government deposits through the Banco de
(maximum) Espantildea subject to approval by royal decree
a Bank membership in the fund can be either compulsory or voluntary and the management of the fund can be official and official and private joint or privateb Coinsurance refers to the situation where depositors face a deductible against their insured fundsc Coverage limit refers to the explicit amount the authorities promise to insured Funded scheme means that it is funded ex ante unfunded otherwise
Sources Goodhart (1995) Demirguccedil-Kunt and Detragiache (2000) Demirguccedil-Kunt and Sabaci (2000)
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 109
base Explicit safety net protection also varies but only Canada focuseson the protected class33 All G-10 countries specify a limit on depositorprotection Under FDICIA the insurance fund is prohibited from pro-tecting uninsured depositors or creditors at a failed bank although adiscretionary system-wide override is provided for exceptional circum-stancesmdashbut with stringent requirements for consultation and account-ability Other G-10 countries allow for contingency funding from the publicpurse alongside unwritten lender-of-last-resort support Among large banksa significant and growing portion of deposit liabilities including foreigncurrency and interbank deposits are uninsuredmdashbut depositors assumethey will be protected in a crisis
FDICIA also made some significant qualitative changes to address theprincipal-agent problem by penalizing weak banks and rewarding strongbanks For example banks whose capital declined faced progressivelytougher regulatory sanctions that for example required them to elimi-nate dividends restrict their lending and change their managementsRegulators have also been forced to take prompt corrective action (toreduce the practice of regulatory forbearance in hopes that a bankrsquos for-tunes might improve)34 Unfortunately comparative qualitative assess-ments across the G-10 are difficult to make due to lack of information35
This discussion highlights the complexity of evaluating the extent towhich prudential supervision and market discipline reduce the moralhazard associated with G-10 safety nets Our argument is that publicsafety nets in the G-10 can be linked to banking instability in other coun-tries specifically in the emerging-market economies that have attractedG-10 cross-border bank lending This lending is a leading source of vola-tility in capital flows the large financial institutions many of which arecomplex banking organizations are based in and regulated by authori-ties in the G-10 economies These two features of the international finan-cial system are closely related although it is not possible to test thisrelationship econometrically
Two World Bank studies however indicate a basis for concern Onestudy is a cross-country econometric analysis of the relationship betweenbank stability and deposit insurance (Demirguccedil-Kunt and Detragiache2000) which found a negative relationship Their estimated model forbanking crises in a sample of 61 countries (both industrial and develop-ing) suggests that explicit deposit insurance raises the probability of acrisis by at least 30 percent36 Crises are especially likely in countries
33 Japanrsquos legislation says it does but recent experience shows this is not the case34 See Goldstein (1997) for a summary of the changes35 See Barth Nolle and Rice (2000) for a beginning in this area36 Demirguccedil-Kunt and and Detragiache (2000 table 1) report a logit coefficient of 0696with a standard error of 0397 (the coefficient is significant at the 8 percent threshold)This suggests that the ldquotruerdquo coefficient could well be as small as 030 (the reportedvalue minus the standard error)
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110 WORLD CAPITAL MARKETS
with immature financial supervisory systems (and not in the G-10) buttheir analysis does underscore the view that deposit insurance weakensmarket discipline37
An earlier World Bank analysis established similar results One wasthat market discipline is undermined by deposit insurance schemes an-other was that illiquid banks are forced to pay more for their funds un-less a generous deposit insurance scheme is in place (Demirguccedil-Kuntand Huizinga 1999) This econometric study also provides clear-cut evi-dence that depositor monitoring of banks declines with the existence ofdeposit insurance schemes At the heart of the problem is the questionof whether deposit insurance is accompanied by increased governmentmonitoring
This evidence and the weight of other arguments suggests that moralhazard is still an issue in the G-10 countries Consider the ongoing de-bate about instilling greater market discipline on risk taking by banksAt one extreme is the perennial proposal to do away with safety netsleaving markets to monitor the players and to force adjustments but toprotect small savers by creating ldquonarrow banksrdquo such as postal savingsystems that are allowed to invest these savings only in risk-free gov-ernment securities Whatever the merits of narrow banking this solutionis too extreme to be politically feasible
A moderate alternative is to force more disclosure by financial institu-tions to facilitate market monitoring But transparency has its own prob-lems Persaud (2000) argues that financial markets cannot reliably discernsustainable from unsustainable positions in the short term This uncer-tainty causes banks to ldquoherdrdquo behind market leaders to exploit theirsupposedly superior information ldquoThe more herding investors and bankersknow about what each other is up to the [more] unstable markets maybecomerdquo The implication is that greater transparency in the marketplaceby itself will not solve the problemmdashand in the short term more informa-tion may exacerbate herding Further supervisory steps (discussed in thenext chapter) are required
Yet another proposal is to promote private-sector involvement in bankmonitoring through market-based alternatives such as Calomirisrsquos sub-ordinated debt proposal (Calomiris 1997 Federal Reserve Board 1999)Banks could be required to issue and maintain a minimum amount of
37 Other findings in the Demirguccedil-Kunt and Detragiache (2000) study include thesepropositions The impact of deposit insurance on bank stability tends to be stronger themore extensive is the coverage offered to depositors when the scheme is funded andwhere the scheme is run by the government rather than by the private sector Con-versely deposit insurance is detrimental to bank stability where bank interest rates havebeen deregulated and where the institutional environment is weak Additional findingson deposit insurance are reported from a recent World Bank conference (8-9 June 2000httpwwwworldbankorgresearchinterestconfsupcomingdeposit_insurancehomehtm)Also see Smalhout (2001)
Institute for International Economics | httpwwwiiecom
THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 111
subordinated debt (eg uninsured certificates of deposit) to finance asmall fraction (such as 2 percent) of their total nonreserve assets Thesubordinated debt would be allowed to earn a set yield no more than 50basis points over the risk-free yield on government treasury bills Thisrule would supposedly force banks to operate in a safe manner Other-wise subordinated debt holders would redeem their uninsured certifi-cates of deposit and equity investors would sell their bank shares Despiteits practical problems the beauty of the subordinated debt requirementis that it enlists market incentives to push banks to avoid excessive port-folio risk38
The thrust of these proposals is very relevant to the arguments in ourstudy Even in the G-10 countries government monitoring by itself hasnot eliminated moral hazard among banks More work is needed to in-troduce market monitoring and to improve the incentive structures bothfor financial institutions and their supervisors We return to this issuewith our recommendations in the next chapter
38 In late 1996 Argentina began requiring its banks to finance 2 percent of total depos-its in the form of subordinated debt but without a maximum yield provision TheArgentine authorities expect that market discipline will act in concert with the publicsafety net One obvious problem with the subordinated debt proposal is that banks mayencourage some of their customers to buy the subordinated debt
Portfolio Institutions Tomorrowrsquos Problem
Before proceeding to the issues of international supervision we flag an-other potential problem for national regulators The big asset managersprofiled in tables 24 and 26 answer to diverse groups of pensionersshareholders and policyholders They allocate funds across a number ofcountries to diversify their risks They hold liquid assets that can be tradedand they have a higher proportion of long-term assets than banks Eco-nomic shocks can be absorbed through price changes and their effectsspread across time and markets Thus when conditions change in a par-ticular market they are more likely to ride out the storm than to flee Inother words they have less incentive than banks to pull their invest-ments in the face of adversity In the 1990s most large asset managersestablished a record of ldquoriding out the stormrdquo rather than ldquorunning withthe windrdquo although as we saw in chapter 1 instances of running withthe wind were detected in some portfolios As we write these insti-tutions have a good record overall in the emerging markets so whyworry
The Russian crisis and the near-collapse of LTCM previewed the dan-gers that may await future portfolio managers and G-10 financial minis-ters We have presented evidence indicating a systemic bias toward bank
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112 WORLD CAPITAL MARKETS
lending and debt finance to emerging markets and we have argued forsubstitution toward equity finance and direct investment39
That is not the end of the story We noted in the previous chapterthat institutional investors can become momentum investors selling in adownturn As more portfolio capital is invested in emerging marketssome players may adopt the high-risk high-leverage strategies of themost aggressive hedge funds Indeed the data in box 11 show that G-10portfolio investors held somewhat more long-term debt (more than $500billion) than equity (less than $400 billion) in emerging markets at theend of 1997 Long-term debt is an ideal vehicle for high-risk high-leveragestrategies These strategies practiced on a large scale could compound afuture crisis harming emerging markets A big enough crisis could inturn pressure G-10 central banks and finance ministers to arrange bail-out plans Instead of shrinking as a systemic financial problem moralhazard could increase
National securities regulators are the first line of defense against thisscenario They play a critical role in the safe evolution of capital mar-kets But regulators today are mandated to approve the issuance of newsecurities and to monitor the continuing disclosure of material informa-tion by issuers They are far less concerned with or empowered to monitorthe behavior of the increasingly large wealth-management firms that arethe major purchasers (and therefore resellers) of these securities
Within their mandates the goals of national securities regulators (table210 and appendix B) are similar to the concerns of bank regulators withsystem safety and soundness Their focus is also on the incentive sys-tems for management and boards of directors and on disclosure by cor-porations that issue marketable securities such as shares bonds andasset-backed securities 40 Issuers of securities possess greater knowledgeabout the quality of these assets than do the purchasers hence investorprotection is a key concern of regulators Moreover market disciplineworks best when markets know what is happening Well-functioning corpora-tions are key agents of wealth creation and social progress Underperform-ing corporations waste resources During recessions bad corporationsget into bad trouble often with severe social consequences Inadequateincentives for managers and inadequate accountability for boards andmanagers thus have negative externalities Regulators play a vital role inexposing weakness so that market disciplines come to bear sooner ratherthan later
Regulatory emphasis is constantly shifting as financial markets evolveand as the macroeconomic environment changes Regulators try to balance
39 See Rogoff (1999) Also see Berlin (2000) for a perspective on the limited role thatbanks play as share owners
40 See Habib and Ljungqvist (2000) for recent empirical analysis showing that corporateshare market values are higher when corporate executives have a larger ownership stake
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Table 210 Financial-sector regulation G-10 countries 2000
Financial institutions and their supervisors
Country and supervisory structure Retail banking Wholesale banking Securities Insurance
Financial conglomeratesFinancial Services Authority (FSA) = umbrella supervisor
United Kingdom FSA FSA FSA FSA
Treasury bull Commercial banks bull Investment funds (Securities and (Insurance Directorate(Securities and Investments Board) bull Unit trust groups Futures Authority) of the Treasury)
Bank of bull Building societies bull Pension funds England (Building Societies Commission) bull Merchant banks
bull Friendly societies bull Clearing houses bull Primary issuers bull Insurance FSA (Friendly Societies Commission) bull Venture capital of securities companies
bull Pensions and life insurance etc bull Stock exchanges bull Insurance brokers(Personal Investment Authority) bull Stockbrokers
Financial holding companiesFederal Reserve (FR) = umbrella supervisor
United States bull National banks(OCC) Securities and Regulated by
Treasury OCC bull State banks Federal Reserve Exchange Commission StatesMembers (FR)
OTS Nonmembers (FDIC) bull Investment banks bull Primary issuers of bull Insurance companies FR bull Cooperative banks (FDICFR) bull Finance companies securities bull Insurance brokers FDIC bull Insured industrial banks (FDIC) bull Stock exchanges
bull Thrift holding companies (OTS) bull Stockbrokers SEC bull Savings banks (OTSFDICFR) bull Investment advisors
bull Savings and loan associations bull Mutual funds(OTS) bull Public utility holding
bull Edge Act corporations (FR) companies
(table continues next page)
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Table 210 Financial-sector regulation G-10 countries 2000 (continued )
Financial institutions and their supervisors
Country and supervisory structure Retail banking Wholesale banking Securities Insurance
Financial holding companies Japan Financial Supervisory Authority (FSA) = umbrella supervisor
Prime FSA FSA FSA FSA ministerrsquos Ministry of office Finance (Securities and Exchange
Surveillance Commission) FRC Bureau of Financial bull City banks bull Investment banks bull Primary issuers of bull Insurance companies FSA Regulation bull Regional banks bull Asset managers securities bull Insurance brokers
bull Trust banks bull Stock exchanges SESC bull Long-term credit banks bull Stockbrokers
bull Pension funds
Financial holding companiesOffice of the Superintendent of Financial Institutions (OSFI) = umbrella supervisor
Canada Regulated by OSFI OSFI provinces OSFI
Department of Financebull Banks bull Cooperative credit bull Primary issuers of bull Insurance companies
(previously Office of the Inspector associations securities (previously Depart- OSFI General of the Banks) bull Fraternal benefit bull Stock exchanges ment of Insurance) Bank of bull Trust and loan companies society bull Stockbrokers bull Insurance brokers Canada bull Pension funds bull Asset managers
(previously Depart- CDIC ment of Insurance)
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Financial institutions and their supervisors
Country and supervisory structure Retail banking Wholesale banking Securities Insurance
Germany Financial holding groupsFederal Banking Supervisory Office (FBSO) = umbrella supervisor
Ministry of Finance FBSO BSO FSSO FISO
Bundesbankbull Universal banks bull Other financial bull Primary issuers of bull Insurance companies
Federal Banking bull Savings banks institutions (eg securities bull Insurance brokers Supervisory Office bull Securities banks management foreign bull Stock exchanges
currency dealings) bull Stockbrokers Federal Securities bull Financial enterprises bull Asset managers Supervisory Office (eg leasing bull Pension funds
organizations Federal Insurance credit card companies Supervisory Office investment advisors)
Italy Bank foundationsMinistry of Finance = umbrella supervisor
Ministry of Finance Bank of Italy Bank of Italy Consob ISVAP
Bank of Italy bull Commerical banks bull Asset managers bull Primary issuers of bull Insurance companies Consob bull Savings bank bull Open-end investment securities bull Insurance brokers
bull Securities banks companies (SICAVs) bull Stock exchangesbull Stockbrokers
ISVAP
(table continues next page)
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Table 210 Financial-sector regulation G-10 countries 2000 (continued )
Financial institutions and their supervisors
Country and supervisory structure Retail banking Wholesale banking Securities Insurance
The Netherlands Financial conglomeratesCouncil of Financial Supervisors = umbrella supervisor
Securities Board Securities Board Netherlandsche Netherlands Bank Netherlandsche Bank of the Netherlands Insurance Board Bank Insurance bull Credit institutions (universal banks bull Investment institutions bull Stock exchanges bull Insurance companies Board cooperative banks security credit (securities issuing bull Stockbrokers bull Insurance brokers
institutions mortgage banks) and tradingmdashprimary The Council of Financial and secondary Supervisors markets)
France Commission des Commission de Operations des Controcircle des
Banking and Banking Commission Bourse Assurances Financial Regulatory bull Ensuring that credit institutions (and investment firms since bull Primary issuers of bull Insurance companies Ministry for Committee the Financial Activity Modernization Act of 1996) comply securities bull Insurance brokers Economic with laws and regulations bull Stock exchanges Affairs and bull Execute instructions regarding all off-site monitoring and bull Stockbrokers Finance Credit on-site supervision Institutions and Banking and Financial Regulatory Committee Investment bull Formulates general regulations for credit institutions and investment firms Committee (capital adequacy requirements accounting rules etc) Bank of France Credit Institutions and Investment Committee Banking bull Authorizes and examines financial institutions except for those within the Commission competence of the Banking Commission
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117
Financial institutions and their supervisors
Country and supervisory structure Retail banking Wholesale banking Securities Insurance
Switzerland Large banking groupSwiss Federal Banking Commission (SFBC) = umbrella supervisor
Swiss National Bank Federal Office of
SFBC SFBC SFBC Private Insurance Swiss Federal Banking Commission bull Universal banks bull Investment banks bull Primary issuers of bull Insurance companies
bull Savings banks bull Asset management securities bull Insurance brokerscompanies bull Stock exchanges
Private audit Federal bull Investment funds bull Stockbrokers firms Office of bull Mortgage bond authorized by Private business SFBC Insurance
Sweden Financial holding company groupsFinancial Supervisory Authority = umbrella supervisor
Ministry of Finance Credit Market Securities Market Insurance Market
Credit Market Department Department Department Department
Financial bull Commercial banks bull Investment funds bull Primary issuers of bull Insurance companies Riksbank Supervisory bull Savings banks securities bull Insurance brokers Authority bull Friendly societies bull Stock exchanges
bull Stockbrokers
(table continues next page)
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Table 210 Financial-sector regulation G-10 countries 2000 (continued )
Financial institutions and their supervisors
Country and supervisory structure Retail banking Wholesale banking Securities Insurance
Belgium Bank holding companiesBanking and Finance Commission = umbrella supervisor
Bank of Belgium Banking Banking
Banking and Finance and Finance Insurance Controland Finance Commission Commission Commission Office
Banking and Insurance Finance Control bull Commercial banks bull Asset management bull Primary issuers of bull Insurance companies Commission Office bull Savings banks firms securities bull Insurance brokers
bull Securities banks bull Investment funds bull Stock exchanges bull Mortgage companiesbull Stockbrokers bull Pension funds
Securities Regulation Fund Securities Regulation Fund
bull Other investment firms and credit institutions(institutions participating in regulated off-exchangemarket in strips and Treasury certificates)
Bank holding companies Spain Banco de Espantildea = umbrella supervisor
Banco de Espantildea Comision Nacional del Mercado de Directorate General
Banco de Espantildea Valores (CNMV) Insurance
bull All credit institutions (commercial banks savings banks credit bull Primary issuers of (Ministry of Economy Ministry of cooperatives official credit institutions finance factoring and securities and Finance) Economy and CNMV leasing companies mortgage-loan companies etc) bull Stock exchanges bull Insurance companies Finance bull Interbank foreign exchange and book-entry public debt bull Stockbrokers bull Pension funds
markets bull Venture capital(companies and funds)
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119
Financial institutions and their supervisors
Country and supervisory structure Banking Securities Insurance
Banking Advisory High Level Securities Supervisors Committee (BAC) Committee (HLSS) Insurance Committee (IC)
Supranational (EU) bull Formulates standards for prudential bull Coordination of securities market bull Formulates standards forsupervision supervision prudential supervision
BACICHLSS Banking Supervision
Conglomerates Committee (BSC) Securities Contact Committee Regulation of prudential bull Systemic risk monitoring bull Regulation and implementation of supervision securities admission
International Association International International Organization of of Insurance Supervisors
Basel Committee Securities Commisison (IOSCO) (IAIS) Joint Forum Conglomerates Supervision bull Supervision and regulation best bull Supervision and regulation best bull Supervision and regulation amp regulation Best practices practices practices best practices
FSF Coordination across supervisors of various functions
Notes See appendix B for more information Boldface type indicates senior or oversight supervisor normal type indicates adjunct or front-line supervisorsolid line indicates direct responsbility to the senior-ranking authority dotted line indicates coordination in supervisory activities
(table continues next page)
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Table 210 Financial-sector regulation G-10 countries 2000 (continued )
Glossary of names United Kingdom FSA = Financial Services Authority United States FR = Federal Reserve OCC = Office of the Comptroller of theCurrency FDIC = Federal Deposit Insurance Corporation SEC = Securities and Exchange Commission OTS = Office of Thrift Supervision Japan FRC =Financial Reconstruction Commission FSA = Financial Services Agency SESC = Securities and Exchange Surveillance Commission Canada OSFI =Office of the Superintendent of Financial Institutions CDIC = Canada Deposit Insurance Corporation Germany FBSO = Federal Banking SupervisoryOffice FSSO = Federal Securities Supervisory Office FISO = Federal Insurance Supervisory Office BSO = Banking Supervisory Office Italy Consob =Commissione Nazionale per le Societa e la Borsa ISVAP = Instituto per la Vigilanza sulle assicurazioni private e di Interesse colletivo Switzerland SFBC= Swiss Federal Banking Commission Spain CNMV = The Comision Nacional del Mercado de Valores Supranational BAC = Banking Advisory CommitteeBSC = Banking Supervision Committee IC = Insurance Committee HLSS = High Level Securities Supervisors Committee International Dimension FSF =Financial Stability Forum IOSCO = International Organization of Securities Commission IAIS = International Association of Insurance Supervisors
Sources United Kingdom Bank of England httpwwwbankofenglandcouk Financial Services Authority httpwwwfsagovuk United States Board ofGovernors of Federal Reserve System httpwwwfederalreservegov Japan Bank of Japan httpwwwbojorjo Financial Reconstruction Commissionhttpwwwfsagojpfrcindexehtml Financial Services Agency httpwwwfsagojp Canada Bank of Canada httpwwwbank-banque-canadaca Office ofthe Superintendent of Financial Institutions httpwwwosfi-bsifgccaAndreEindexhtml Germany Deutsche Bundesbank httpwwwbundesbankde Fed-eral Banking Supervisory Office httpwwwbakredde Italy Banca drsquoitalia httpwwwbancaditaliait Commissione Nazionale per le Societa e la Borsahttpwwwconsobit Instituto per la Vigilanza sulle assicurazioni private e di Interesse colletivo httpwwwisvapit The Netherlands De NederlandscheBank httpwwwdnbnl France Banque de France httpwwwbanque-francefr Switzerland Schweizerische Nationalbank httpwwwsnbchindex3htmlSweden Sveriges Riksbank httpwwwriksbanksedefaultasp Belgium National Bank of Belgium httpwwwbnbbesgindexhtm Spain Banco de Espantildeahttpwwwbdees The Comision Nacional del Mercado de Valores httpwwwcnmves Supranational (EU) Institutional Arrangements for the Regulationand Supervision of the Financial Sector 2000 International Dimension Bank for International Settlement httpwwwbisorg International Organization ofSecurities Commissions httpwwwioscoorg International Association of Insurance Supervisors httpwwwiaisorg Financial Stability Forum httpwwwfsforumorg
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 121
the inflexibility of tight surveillance against the need to encourage in-novation and growth The US Securities and Exchange Commission isworried about aggressive accounting by firms and biased reports bysecurities analysts in an equity environment that prizes steadily higherquarterly earnings41 Japanese regulators are preoccupied with opaqueinterconnections between portfolio institutions banks and nonfinancialfirms through the keiretsu system Canadian regulators reeling from high-profile scandals of managers intentionally misleading investors are strengtheningmarket discipline through legal penalties aimed at managers and directorsof offending firms
When panic strikes a securities regulator cannot do much As the 1987stock market crash and the LTCM debacle in the fall of 1998 both dem-onstrated steep stock and bond price declines can create systemic risksIf severe enough the wealth effect of falling securities values and thefear of widespread insolvency can depress real activity Flooding thesystem with liquidity is a central bankerrsquos solutionmdashsomething a securi-ties regulator cannot do42 But just as financial supervisors can changethe incentive structure to discourage bankers from making risky loans ingood times so securities regulators can pay more attention to incentiveson the demand side when capital markets are strong
Prudential Supervision and InnovationmdashA Footnote
In concluding this discussion of prudential supervision in the G-10 anadditional point is worth noting National regulators face a persistenttrade-off between emphasizing financial system safety and soundnesswhile encouraging innovationmdashin spite of the added risks innovationbrings to financial markets Former US Treasury Secretary Lawrence Summers(2000 3) has argued by analogy
The jet airplane made airplane air travel more comfortable more efficient andmore safe though the accidents were more spectacular and for a time morenumerous after the jet was invented In the same way modern global financialmarkets carry with them enormous potential for benefit even if some of theaccidents are that much more spectacular As the right public policy response
41 The problem is illustrated by the divergence since mid-1998 between reported earn-ings by the Standard amp Poorrsquos (SampP) 500 and the after-tax profits of all corporations inthe national accounts Generally these two series move closely with one another Be-tween mid-1998 and mid-1999 SampP 500 reported that earnings increased by more than20 percent while after-tax profits of all corporations increased by less than 5 percent(Chase Bank US Economic and Policy Research US Weekly Prospects Chase SecuritiesWeekly Newsletter 5 June 2000 5)
42 For example the US Securities and Exchange Commission had no direct role in calmingmarkets in the 1987 or 1998 panics
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122 WORLD CAPITAL MARKETS
to the jet was longer runways better air-traffic control and better training forpilots and not the discouragement of rapid travel so the right public policyresponse to financial innovation is to assure a safe framework so that the ben-efits can be realized not to stifle the change
Accepting Summersrsquos analogy for the international financial system better-informed supervisors and investors are a necessary part of the financialsystem framework Supervisors require more timely information on therisk profiles resulting from positions taken by financial institutions Theyalso need a better understanding of risk-management systems Snapshotsof an institutionrsquos risk profile and risk-management procedures are nolonger adequate In a world where huge bets are quickly made (andpossibly lostmdashas with Barings Bank in 1995 and LTCM in 1998) super-visors must focus on the soundness of banking systems for evaluatingand managing risk on a daily basis Some progress has been made inaddressing these issues US banking examiners are extending their in-formation requirements in banking examinations and increasing theirinvolvement in large complex institutions43 More awareness is alsorequired of the fact that they are national organizations in a world ofcross-border capital flows To a much greater extent they need a multi-national reach International supervision and coordination among super-visors are the subject of the next section
Our analysis suggests that G-10 supervisors have unfinished businessBank supervisors need to start yesterday securities regulators can waituntil tomorrow One G-10 member acting alone cannot correct the biasIn good times the lending business will simply migrate to other G-10banks In bad times financial problems will not stop at the national bor-der A way has to be found to establish common international standardsfor the key financial players in order to prevent crises and to agree onapproaches for managing them The path has already been laid out Inthe wake of the bank failures of the past 25 years bank supervisors havetried to establish such standards They have done this without creating anew global institution
The essence of the international framework is decentralizationmdashglobalrules and design standards without global institutions that are perceivedto intrude on national sovereignty The awkward jargon for this frame-work is vertical subsidiaritymdashldquothink internationally act nationallyrdquo Theinternational thinking is done by a committee of regulators that meets
International SupervisionA Decentralized Framework
43 These issues are discussed in Ferguson (1999) and Meyer (2000a)
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 123
regularly at the Bank for International Settlements in Basel The commit-tee establishes principles and standards that are interpreted implementedand enforced by national authorities44 In this section we describe thesesupervisory efforts and their weaknesses We present our recommenda-tions for addressing these weaknesses in the next chapter
Basel I
The Basel Capital Accord of 1988 (Basel I)45 drew the lesson from thefinancial crises of the mid-1970s that more adequate capital levels in in-ternational banks would help reduce the systemic risk of bank failureThe primary goal of Basel I was capital adequacy other standards wereput in place not so much for their own virtue as to defend the primarygoal
Capital adequacy requirements were designed to ensure that individualinstitutions have the ability to absorb losses particularly credit lossesAccordingly a backup system of scoring credit risk was devised thatrequired large amounts of bank capital for some types of loans smalleramounts for others and zero for a select list of preferred assets Report-ing requirements were designed to disclose problems and ensure that atroubled bank would take timely steps to restore its capital base in thewake of a loss The Basel I framework worked tolerably well in limitingthe call on the public purse in the G-10 countriesmdashwith the notable ex-ceptions of France and Japan The framework failed to moderate riskybank lending to emerging markets however
Basel I was not developed with emerging markets in mind The origi-nal idea behind it was to develop a common supervisory approach tocross-border banking operations It grew out of political pressure fromUS lawmakers who were determined to require international banks op-erating in the United States to meet US banking standards Toward thisgoal in 1983 Congress passed the International Lending Supervisory ActUS and British banking authorities subsequently agreed on a commontarget the adoption of strict common capital-adequacy standards In 1988other G-10 governments agreed to go along voluntary acceptance ofthe standards throughout much of the rest of the world followed46 Therationale for the capital targets was two-fold The first was to requirebanks to hold sufficient amounts of capital (8 percent of risk-adjusted
44 The international committee of financial authorities agreed on a common definitionof banksrsquo tier-one or ldquocorerdquo capital national authorities defined tier-two capital in theirown manner which permitted greater variations in national working definitions andpractices
45 International Convergence of Capital Measurement and Capital Standards (BIS 1988)was prepared by the Basel Committee on Banking Supervision
46 See Reineke (1998)
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124 WORLD CAPITAL MARKETS
assets) to cushion losses on those assets The second was to dull theirappetites for risk banks with large capital bases would have more tolose if they failed and therefore would take fewer risks
Rapid change in financial markets soon revealed flaws in the Basel IAccord In a complex world with numerous sources of risk it focusedheavily on credit risk but overlooked other risks in a bankrsquos portfolioand the correlation between returns on different asset classes The Baselformula required banks to maintain a fixed amount of capital againsteach of its asset classes But the formula did not distinguish the riskinessof the borrower within each class As a result one large loan to a low-risk corporate borrower such as General Electric would require the sameamount of capital as 10 smaller transactions with high-risk borrowers
The system was also biased toward short-term loans Loans maturingin less than a year required a 20 percent risk weight whereas those ma-turing after more than a year required a 100 percent risk weight Inter-bank lending was particularly favored For example loans to banks inOECD countries required less capital than loans to private firms in thesame countries creating the anomaly that interbank loans to South Ko-rean banks required less capital than loans to General Electric47 Thisanomaly encouraged banks to shed high-quality assets if the Basel rulesrequired the allocation of more capital than banks thought they needed
Another weakness was that financial innovators quickly circumventedthe Accord Because short-term loans required less provisioning than long-term loans banks responded by securitizing their long-term debt port-folios and lending short-term against the collateral of the newly createdasset This allowed banks to circumvent the capital requirements gearedto the terms of the underlying debt At the same time the Basel I Accordfailed to encourage risk mitigation techniques such as credit derivativescollateral guarantees and on-balance-sheet netting the flip side of fi-nancial innovation Because off-balance-sheet products were not coveredby the Accord another anomaly appeared when Barings Bank collapsedin 1995 Barings met capital adequacy standards but collapsed becauseits systems for managing risk failed traders were allowed to speculatein futures contracts that did not appear on the balance sheet
Basel II
Work to overhaul Basel I began in 1995 and produced consultativepapers issued in June 1999 and January 200148 These papers have been
47 South Korean banks have had notoriously weak balance sheets because the practiceof ldquodirected lendingrdquo left them with many poor loans (in making these loans the bankswere expected to follow government objectives rather than creditworthiness criteria)
48 Basel Committee on Banking Supervision (1999 2001)
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 125
the subject of extensive consultation and revision as a result the newAccord is expected to be introduced in 200449 The Basel II frameworkhas three parts (pillars) revisions to Basel I minimum-capital require-ments supervisory review criteria and greater emphasis on market dis-cipline Broadly Basel II aims to maintain the level of capital in the sys-tem but achieve better alignment of banksrsquo capital with their risk pro-files and keep up with financial innovation
To align capital requirements with market realities (the first pillar)Basel II concentrates on the 100 or so largest banksmdashthe type of playerslisted in table 21mdashand on the holding-company parents of banking groups50
Capital requirements will differentiate between an increased number ofcredit groups or ldquorisk bucketsrdquo including claims on governments otherbanks corporations mortgage-backed securities and other asset-backedsecurities
Basel II originally proposed to use external ratings to set capital chargesfor a number of these credit risks Many banks objected arguing thatthey assess credit risk better than Standard amp Poorrsquos Moodyrsquos or FitchIBCA51 Basel II thus proposes two approaches to rating a standard ap-proach using external ratings and an ldquoadvancedrdquo approach that allowsselected banks to use their own internal rating systems To encouragethe development of rigorous internal control systems based on these in-ternal rating systems Basel II also proposes to levy capital charges foroperational risk (the risk of direct or indirect loss resulting from inad-equate or failed internal processes people and systems or from exter-nal events)
Some critics of this proposal dismiss it as an abrogation of the prin-ciple of external independent monitoring and as ldquodangerously naiumlverdquo52
But regulators argue that the new capital charge on operational risk shouldoffset this concern It is also far from clear how cross-national compari-sons of rating and internal risk-assessment systems will be made (Engelen2000) The development by the European Union of its own capital rulescould well complicate the international resolution of these issues Publicassurances by EU officials in January 2001 however indicated that theirmain concerns are to create a level playing field and avoid regulatoryarbitrage (Hargreaves 2001) There is also the significant problem ofthe procyclical character of risk weights When a crisis hits losses are
49 See Berry (2000) for an update in an interview with William J McDonough chair ofthe Basel Committee on Banking Supervision
50 For obvious reasons these proposals are addressed to large banks and simpler capi-tal standards are allowed for small banks that focus on their domestic credit markets
51 See Ammer and Packer (2000) for an empirical critique of the success of rating agen-cies in distinguishing risk by sector and region
52 See Auerback (2001)
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126 WORLD CAPITAL MARKETS
incurred or accrued capital is lost and loan exposure must be reducedor securities sold to restore the requisite capital-adequacy ratios A morerisk-sensitive framework could amplify volatility
As the second pillar of Basel II supervisory review criteria are beingbeefed up to encourage supervisors to intervene earlier in potential problemsituations and to compel banks to align their capital positions with theirrisk profiles Bank supervisors will be authorized to require banks tohold capital in excess of minimum requirements if they have concernsabout general management overall strategy risk-management performanceor the macroeconomic environment Of course if one G-10 supervisorimposes higher capital requirements in isolation the same disparity willemerge that presaged Basel I Some banks will be disadvantaged in theinternational marketplace and will loudly complain that excessive super-vision is driving business to their competitors Hence close internationalcooperation among supervisors is critical
To implement the third pillar market discipline banks will be requiredto make fuller more timely disclosure of capital adequacy and the risksto which that capital is exposed A number of measures are being stud-ied that might help supervisors evaluate bank performance such as com-parisons of uninsured deposit interest rates subordinated debt yieldsand equity prices The idea is that these yields and prices might alertsupervisors to market perceptions of risk Of course market perceptionsare only as good as market information More direct and controversialways to reinforce market discipline would dramatically increase publicdisclosure of bank positions and risk management systems
Many questions are still outstanding about how to resolve the techni-cal details of capital requirements and whether the requirements willachieve their intended goal of better assessment and mitigation of therisks in banksrsquo portfolios There is no substitute for skilled supervisorsThe intricacies of effective design and implementation suggest that su-pervisors need to be highly competent technically knowledgeable aboutbanking portfolio characteristics and the factors that influence bank ex-posure to credit risk (Mishkin 2000) And they must be aided by vigilantshareholders market forces and transparency of information53
Standard setting at the global level is desirable but ultimately theeffectiveness of these efforts will be tested at the national level espe-cially in times of systemic financial distress Here the record of Basel Iwas not a bright shining success Japanese banking regulators havetraditionally allowed banks to include real estate and securities in theircapital base When the value of these assets plummeted in the early 1990sregulators allowed banks to continue valuing these depreciated (andoften bankrupt) assets at their old inflated levels Japanese authorities
53 Benedict Roth Complacency Towards Catastrophe Financial Times 23 January 2001
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 127
insisted until the mid-1990s that eroded capital bases could be rebuiltin a market-driven fashion They rightly foresaw that huge loan losseswould undermine public support for the ruling party and require a po-litically unpopular bailout
Japanese foot dragging on Basel I was the worst54 but not uniqueOther examples can be found of ldquopolitically mandated forbearancerdquo TheFederal Reserve Bank of New York held important hands during theLTCM crisis of 1998 Mexico is still resolving the banking crisis that eruptedin 1995 South Korea has not yet closed the insolvent banks that behavedso badly before the crisis of 1998 In the aftermath of a crisis nationalregulators cannot always be relied upon to discipline politically power-ful bankers55 One of the little-noticed consequences of these differingapproaches is that those banks with strong regulatory systems receivedan implicit ldquoexport subsidyrdquo for their services US banks which had notengaged extensively in emerging-market lending in the 1990s were bet-ter positioned than their German and Japanese counterparts to expandtheir international assets in the wake of the crises
Other Financial Forums
54 See Japanese Banks Fiddling while Marunouchi Burns The Economist 27 January2001 67-69
55 See Calomiris (1997)
The Basel model of vertical subsidiarity has already been extended toother financial regulatory bodies In 1993-94 the BIS established a Tri-partite Group of Banking Insurance and Securities Regulators In 1994-95 the BIS increased its cooperation with the International Organizationof Securities Commissions when the two organizations issued parallelpapers on guidelines for national regulators concerning risk managementand disclosure of derivative trades In 1996 a permanent Joint Forum onFinancial Conglomerates was established to examine supervisory issuesand develop working arrangements among the different functional super-visors of conglomerate institutions that offer combinations of bankingsecurities and insurance products Draft papers on the supervisionof conglomerates were released for comment in 1998 applying capital-adequacy principles to these groups and providing guidelines both forassessing the integrity and competence of top managers and for sharingassessments between regulators
In 1997 the Basel Committee on Banking Supervision extended itsreach beyond capital standards to broader aspects of banking supervi-sion with the publication of the Core Principles for Effective BankingSupervision In 1999 a wide range of regulatory and standard-settingbodies were gathered under the umbrella of the Financial Stability
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128 WORLD CAPITAL MARKETS
Forum (FSF) itself established under BIS aegis56 The FSF has alreadyissued recommendations for stepped-up supervision and transparencyas well as guidelines for best practices in a number of areas includingoffshore financial centers and highly leveraged institutions or hedge funds57
Conclusion
Although the structural weaknesses in emerging-market economies arewidely acknowledged to have been causal factors in international capi-tal-market volatility this chapter points to the role of large G-10 bankingorganizations as major suppliers of the most volatile instrument short-term debt We have examined evidence of the impact of public safetynets in the G-10 economiesmdashthe deposit insurance systems the pruden-tial supervisory systems and the lender-of-last-resort functions of centralbanksmdashon the incentive structures of these organizations
Although supervisors in most countries working nationally and to-gether in the BIS have made significant efforts to mimic market forcesin their prudential supervision the most sophisticated financial institu-tions find innovative ways to circumvent the rules New global regulatorybodies are not about to be created G-10 national bank regulators shouldthemselves address the short-term debt bias in the international financialsystem by changing incentive systems G-10 securities regulators shouldalso take steps to get ahead of the curve paying close attention to largeportfolio swings by institutional investors particularly in times of crisisIn short more needs to be done at national and international levels tochange the rules of the game That is the subject of the next chapter
56 The Financial Stability Forum includes banking securities insurance and accountingregulatory bodies the OECD on taxation corruption and corporate governance and theIMF
57 See Martin (2000)
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98W
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ET
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Figure 21 Hypothetical example of leverage
$1000 notional value of call option on equity in firms targeted for takeover
Repo FRN into cash and use cash to pay option premium
(repro is initially collateralized
Borrow $100 for margin purchase
$125 of US investment bank floating-rate notes (FRN) (secured by $25 equity in FRNs)
Repo off-the-run bond into cash and post margin
(repo is initially collateralizedSell (short) Borrow on-the-run bonds worth $20
$25 worth of off-the-run bonds (secured by $5 equity in bonds)
Exchange into $4
Cash $5 yen400 Japanese bank loans
$1 equity base
FRN = floating rate notesRepo = repurchase agreement
Source IMF (1998)
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wiiecom
THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 99
balance sheet and because balance sheets are published quarterly at bestoutsiders have a difficult time assessing the extent of a firmrsquos leverage19
Leveraging by a single firm enhances its risk of default the widespreaduse of leverage in the financial system can magnify market adjustmentsespecially when they require ldquodeleveragingrdquomdashunwinding prior positionsRapid adjustments can cause credit to dry up and asset prices to plummetIn a mark-to-market environment falling asset prices trigger calls foradditional collateral that can ripple through markets
Risk Management
Because it is confronted with the widespread use of leverage and prolif-erating kinds of risk international finance is increasingly driven by riskevaluation and control20 Different institutions face various risk profilesand differing kinds of risk The most common risks can be quickly tickedoff Banks because of their traditional intermediary role of channelingthe resources from savers to borrowers face significant credit risk therisk of default or delay in the payment of principal and interest Theymust also manage market risk the risk that the prices of their liabilitiesmay change faster than their assets Market risk devastated US savingsand loan institutions in the late 1980s
Closely associated with market risk are interest-rate risk (unexpectedchanges in market interest rates that slash margins net income and theeconomic value of a bankrsquos equity) and foreign exchange risk (losses thatarise when assets denominated in an appreciating foreign currency areless than liabilities denominated in that currency) Banks make numer-ous loans to other banks around the world portfolio investors buy se-curities direct investors acquire fixed assets and all incur country risk(economic and political uncertainty in the host country) During the heightof the Asian crisis for example interbank loans to Japanese banksreflected the credit risk of lending to these banks the so-called Japanpremium
Substantial attention has been lavished on country risk analysis sincethe 1982 debt crisis in developing countries Yet in spite of this exper-tise the Asian crisis occurred in part because of a sudden upward reap-praisal of country risk after the Thai baht collapsed in April 1997 Banksand other financial institutions must also manage liquidity risk the riskthat market conditions will change unexpectedly depressing demand andprices of assets at the time they want to sell these assets And they mustmanage operational riskmdashfailures in control systems or people that cause
19 Another example of asymmetric information Both risk and leverage are difficult foroutsiders to assess without full timely disclosure
20 A longer discussion of these issues can be found in Managing Global Finance in IMF(1999c)
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100 WORLD CAPITAL MARKETS
financial loss or damage reputations Operational risk devastated BaringsBank in 1995
Financial institutions practice risk management to measure all theserisks the potential damage to their investment positions and ultimatelythe chance of becoming insolvent VAR (value at risk) risk models mea-sure subject to certain assumptions the amount of the firmrsquos capital thatis exposed in each period For example the VAR model might say thatin a 3-standard-deviation worst case (a case that is not supposed to hap-pen more than 1 percent of the time) the firm will loose 25 percent of itscapital during the next year
VAR models are widely used but like all models they have weak-nesses They rely on past values to estimate key variables in financialmarkets past values are not always good predictors of future risks More-over rising volatility and higher loss correlation among different assetclasses in a portfolio will cause all banks using these models to reducetheir exposures at the same time by switching to less volatile and lesscorrelated assets such as US Treasury bills (Persaud 2000)
Newer risk models entail stress testing and scenario analysis Scenarioanalysis envisages possible adverse changes one at a time that mightaffect the investment portfolio Stress testing estimates potential losseswhen several individual risk factors simultaneously move against thefirm but it too uses historical probabilities
Financial Volatility
21 For example derivative markets usually rely on underlying securities markets thatproduce continuous prices When these markets are interrupted financial shocks cantrigger a cascade of margin calls and sell orders that move prices very sharply
22 See IIF (1999a)
The combination of trading activity and modern risk management lie atthe root of financial volatility When risks increase banks must eitherraise more capital to cover the greater risk or reduce their exposure bycutting loan exposure by selling securities or by undertaking new de-rivative trades Raising more capital is time-consuming and in a crisisvery expensive because bank shares are depressed So banks look to theother alternatives If the bank can reduce lending it need not book aloss But most banks use the same VAR models and as indicated abovethese models will encourage them to reduce their outstanding loans atthe same time actually magnifying loan volatility
If banks attempt to reduce their exposure to risk by selling securitiesor undertaking new derivative trades they may trigger large priceshocks because of limited and shrinking market liquidity21 The liquid-ity problem is compounded when a small number of large institu-tions hold the same positions22 Take your pick loan volatility or price
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 101
volatility As two experts have observed (Folkerts-Landau and Garber1998)
[V]olatility even in one country will automatically generate an upward re-estimate of credit and market risk in a correlated country triggering automaticmargin calls and tightening of credit lines Thus apparently bizarre opera-tions that connect otherwise disconnected securities markets are not the re-sponses of panicked green screen traders arbitrarily driving economies from agood to a bad equilibrium Rather they work with relentless predictability andunder the seal of approval of supervisors in the main financial centers
23 See Ferguson (1999)
24 As Gerald Corrigan (1982) put the matter ldquoBanks are specialrdquo Corrigan (2000) reit-erated this view even after all the changes of the past two decades Unlike other institu-tions banks offer on-demand transactions are a backup liquidity source for other insti-tutions and serve as a ldquotransmission beltrdquo for monetary policy
These changes in the banking environment accentuate an existing anomalyThe anomaly is that banks even as they grow larger and increasinglyengage in more risky and complex transactions are perceived to enjoyimplicit and explicit public guarantees
The guarantees grow out of an incentive problem inherent in bankingasymmetric information which we mentioned above Depositors know lessabout a bankrsquos management and the quality of its balance sheet than doits managers and shareholders Thus in times of uncertainty or adver-sity bank depositorsmdashuncertain whether they will have access to theirdepositsmdashare prone to bank runs This prospect has in turn compelledgovernments to treat banks differently than other firms because a bankthat fails can disrupt the rest of the economy24
To prevent such crises governments have entered into quid pro quoarrangements with banks Governments provide them both with an im-plicit safety net in the form of an unstated promise by the central bankto act as a lender of last resort in a liquidity crisis and an explicit safetynet in the form of a public deposit insurance fund to reassure depositorsIn return the banks submit to closer government oversight and regu-lation of their activities than is usual for industries in the private sector
The ldquoinsurancerdquo provided by the public safety net contributes to an-other incentive problem moral hazard Banks acquire greater tastes forrisk and face less market discipline than other firms The explicit depositinsurance safety nets actually have or are perceived to have blanketcoverage that extends beyond the retail depositors (households and small
One of the lessons of the 1997-98 crisis must surely be that market par-ticipants and their regulatory supervisors relied too heavily on quantita-tive tools and insufficiently on judgment23
The Anomaly of Modern Banking
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102 WORLD CAPITAL MARKETS
businesses) for which they were originally intended The implicit centralbank safety nets extend in a crisis to nearly all depositors and banksThus banks are both viewed and behave as if they will be bailed out ifthey get into trouble
The existence of a public safety net raises a perennial question Dobanks have an unfair advantage over other financial institutions becauseof the subsidy provided by the safety net This question was at the heartof intensive study and debate in the United States leading up to thepassage in November 1999 of the Financial Services Modernization Act(also known as the Gramm-Leach-Bliley Act) The size of the gross sub-sidy is difficult to estimate despite determined research efforts Somesuggest it is well under 100 basis points and is at least partly offset bythe direct costs of deposit insurance premiums interest payments on bondsissued by the Financing Corporation25 reserve requirements regulatoryexpenses and operational costs associated with collecting deposits26 Con-versely Kwast and Passmore (2000) suggest that banks can expand theirscope far beyond the levels that other financial institutions could reachwith the same equity base but without the public safety net
A related concern in the US debate is whether allowing banks to ex-pand their activities into securities and insurance will ultimately extendthe safety net and add to the subsidy The Financial Services Moderniza-tion Act deals with this issue by maintaining a legal separation betweenbanks and the rest of the banking organization known as large com-plex banking organizations (LCBOs) They must engage in most securi-ties activities and insurance underwriting through separately capitalizedinvestment bank subsidiaries or holding company affiliates This act canbe said to have merely brought US banking laws closer to those of mostother industrial countries (Barth Brumbaugh and Wilcox 2000 BarthNolle and Rice 2000) If the fire wall is well-maintained and stoutly de-fended the safety net will neither expand in practice nor become a sourceof comfort to noncommercial bank subsidiaries of LCBOs
The quid pro quo exacted by governments to offset the subsidy iscloser public-sector monitoring of banksrsquo activities through prudentialsupervision The effectiveness of this closer official scrutinymdashand closermarket monitoringmdashare the subjects of the next section
25 The Financing Corporation was created by Congress in 1987 to sell bonds to raisefunds to help resolve the savings and loan crisis
26 See Levonian and Furlong (1995) Jones and Kolatch (1999) Shull and White (1998)and Whalen (1999a 1999b)
Are G-10 bank supervisors adequately responding In this section we firstassess the case for and compare the structures of prudential supervisory
Prudential Supervision
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 103
systems both within and among the G-10 economies plus Spain andconsider whether these offset the subsidy provided by the public safetynet Despite offsetting regulation and supervision implicit and explicitguarantees by G-10 governments to their banks are still a source of bank-ing instability in the emerging-market economies
National Systems for Prudential Supervision
Governments use prudential supervision to reduce the moral hazard andadverse selection created by their own safety nets Supervisors establishregulations and monitor compliance to limit risk taking and ensure thesafety and soundness of the banking system In a thoughtful analysis ofthe case for prudential supervision Frederic Mishkin (2000) identifiesthe main forms that supervision can take including the tasks of grantingbanking charters and licenses establishing capital requirements settingdeposit insurance premiums and defining disclosure requirements as wellas carrying out bank examinations Bank examiners gather informationfrom banks and evaluate whether they are following the regulatorsrsquo rulesin cases of weakness they are empowered to change banksrsquo behaviorand close them if necessary
Supervisors also may restrict competition define the activities in whichbanks may engage and restrict their asset holdings and separate banksand other financial (or nonfinancial) activities During the past two de-cades the barriers separating commercial banks investment banks in-surance firms and securities firms have been all but eliminated (tableB1) Deregulation has stimulated competitive forces that drive diversifi-cation and consolidation of the financial industry nowhere faster than inthe United States
The Financial Services Modernization Act of 1999 confirmed this trendIt eliminated restrictions dating back to the Glass Steagall Act of 1933which once prevented banking insurance and securities firms fromentering each otherrsquos businesses (Barth Brumbaugh and Wilcox 2000)Cross-pillar mergers among banks insurance and securities firms arewell under way to form giant financial holding companies The 1999merger between Citibank (banking) and Travelers (insurance) created themodel for megafinance and confirmed new challenges for supervisors
Mishkin (2000) notes the corresponding evolution in US supervisionfrom an emphasis on rules-based regulation (detailed rules for opera-tional behavior and the quality of line items in the balance sheet) to anapproach that stresses the soundness of bank management practices es-pecially risk management
Appendix B outlines the systems of financial supervision now in theplace in the G-10 countries plus Spain Some systems like the UK andCanadian approach are models of simplicitymdashorganized to keep pacewith the spreading reach of financial conglomerates Other systems like
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104 WORLD CAPITAL MARKETS
the US and French approaches show traces of the bureaucratic divisionsthat made sense in an era when banking securities and insurance weresharply separated
The US Model
27 See Meyer (1999a)
28 Canada has a similar degree of simplification with the exception that securities firmsare still regulated by provincial authorities
29 See Pratti and Schinasi (1999 67)
30 The agents are the bank regulators and the principals are the taxpayers Agents maypursue their own interests including bureaucratic survival and postgovernment employ-ment opportunities rather than the national interest in banking safety and soundness
The US model of financial regulation delineated in the Financial Ser-vices Modernization Act of 1999 blends functional and umbrella super-vision Bank and thrift regulators oversee depository institutions Newnonbank activities are subject to both functional regulation (eg by theSecurities and Exchange Commission and state insurance examiners) andumbrella supervision (of financial holding companies) by the FederalReserve27
The UK Model
Another supervisory model exists in the United Kingdom as well as inAustralia Canada and Switzerland28 In this model banking supervisionis separated from the monetary policy function The regulatory structureis considerably simplified by relying on a consolidated financial regula-tor separate from the central bank for both banking and nonbankingactivities The remaining question answered differently depending on thecountry is the extent to which the regulator relies on home-country sur-veillance of banks and conglomerates that have a local presence
Regulatory Models Compared
Appendix B provides more detail on the differences in these modelsGerman simplicity contrasts with French complexity In France the bankingcommission is chaired by the governor of the central bank and includesrepresentatives from the Treasury The commission supervises compli-ance with regulations but the central bank inspects banks on behalf ofthe commission29 In countries such as the United States and France withmultiple supervisors and crossover functions internal coordination is criticalAt the same time multiple agencies create regulatory competition Wheneach agency knows what the other is doing transparency within gov-ernment circles can help to limit principal-agent problems of regulation30
The discussion as to where in the public bureaucracy financial super-
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 105
vision should be placed goes back many years Peek Rosengren andTootell (1999) argue that a synergy exists between monetary policy andprudential supervision because information gained in the course of super-vision can increase the accuracy of macroeconomic forecasts A twist tothis argument is that the information on the state of financial institutionsavailable to the central bank as supervisor can facilitate its role as lenderof last resort Conversely there is the concern that a supervisory rolewill compromise the central bankrsquos independence of action with respectto its core mandatemdashmaintaining price stability As these arguments haveplayed out financial supervision has generally been shared between centralbanks and other regulators or placed entirely in the hands of an inde-pendent regulator However in Italy the Netherlands and Spain cen-tral banks are the sole banking supervisor
Goodhart (1995) examined the arguments and evidence for each modeland concluded that there were no overwhelming arguments or evidencefor one or the other31 Going forward a key problem for any financialsupervisory system is dealing with (and closing as necessary) weak banksIf both central banks and other regulators have this responsibility closecoordination between them is critical Another problem is large conglom-erate banks LCBOs Although they are less likely to fail because of thediversification of their assets and liabilities they are more likely to berescued They are also more likely to be multinational enterprises withinternational implications Goodhart observes that regulation of theseentities might be put in the hands of the central bank because it is lessamenable to political pressures In any event the complexity of LCBOoperations suggests that greater supervisory rigor is necessary
The US Congress was persuaded that broad oversight would help containthe moral hazard problem and accordingly gave the Federal Reservethe role of umbrella supervisor with the understanding that the Fed willscrutinize depository activity more intensely than nonbank financial ac-tivities Under this approach LCBOs such as Citigroup are subject tomuch closer monitoring than smaller and simpler institutions32 The USregulatory model requires enormous cooperation between the Fed otherbank supervisors and the functional regulators for insurance and securi-ties but it also benefits from regulatory competition
31 National systems of supervision are path dependent they are determined by the struc-ture of financial institutions and history in each country If Goodhart (1995) is right out-comes are not materially better or worse with one model of supervision rather than another
32 See Ferguson (1999)
Public Safety Nets
One of prudential supervisorsrsquo biggest challenges is to reduce moral hazardFor many years commercial banks engaged in communal self-insurance
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106 WORLD CAPITAL MARKETS
to deal with crises They formed voluntary groups that agreed to rescuetroubled members As financial markets evolved and competition inten-sified banks were no longer willing to play this role Private-sector in-surance is one alternative but moral hazard and adverse selection wouldappear to prevent it from happening Public safety nets have developedbecause of the low probability and high cost of potential bank runs Aclear trade-off is involved The effectiveness of insurance in preventingbank runs is greater the more comprehensive the coverage But the morecomprehensive the coverage the greater the moral hazardmdashbank man-agers bank directors investors and depositors all take on greater risksin the belief that the safety net will protect them against losses
All G-10 countries have compulsory public safety nets for banks (table29) Deposit insurance agencies are officially organized in Canada theNetherlands Sweden Switzerland and the United States organized bythe industry in France Germany Italy and the United Kingdom andjointly organized by the public and private sectors in Belgium Japanand Spain
How well do G-10 governments offset the subsidy provided by thepublic safety net This is a question on which there is substantial debateAs banking organizations have become more complex the challengesthat supervisors face have become more difficult One challenge is toalign the incentives facing bank managers and shareholders with thoseof depositors Another is the principal-agent problem in supervision Wehave discussed the incentive structures for financial institutions but wehave said little about the incentives for supervisors themselves and thedistortions they can generate in the financial system
In one of the many studies of the US savings and loan crisis of the1980s Kane (1989) documented both problems He described managersusing cosmetic approaches to disguise the magnitude of insolvency regulatorspracticing forbearance even though they knew of the deteriorating riskprofiles of the institutions for which they were responsible and legisla-tors increasing deposit insurance without regard for any offsetting changesin supervision A subsequent overhaul of the legislative framework forthe Federal Deposit Insurance Corporation (FDIC) known as the FDICImprovement Act of 1991 (FDICIA) aimed to introduce a clearer incen-tive structure for both regulators and regulated institutions
The changes introduced by this US legislation are worth discussionwith respect to the other G-10 countries as well First FDICIA created astronger signal to management and investors by targeting deposit insur-ance at small depositors only and by risk-weighting the deposit insur-ance premiums paid by banks to reflect their capital adequacy and bankexaminer ratings Among the G-10 countries rated in table 210 depositinsurance premiums vary considerablymdashbut it is not clear that the dif-ferences have much to do with risk-weighting Most G-10 countries em-ploy funding formulas based for example on the total domestic deposit
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TH
E P
LAY
ER
S T
HE
IR S
UP
ER
VIS
OR
S A
ND
MO
RA
L HA
ZA
RD
107
Table 29 Deposit insurance schemes in the G-10 countries Explicit safety net
Coverage limit(dollar Foreign
equivalent currency Interbank Source Bankrsquos Contingency fundingDate Membership Co- at end of deposit deposit of premium from banks
Country established managementa insuranceb July 1998)c covered covered Fundingd funding costs or governments
United 1982 Compulsory Yes Larger of 90 No No Unfunded Banks only Callable (subject Parliament may increase Kingdom private percent co- to maximum the maximum payable
insurance to 03 percent of pound125 million advance 33000 total deposits) facility with Bank of
England
United 1934 Compulsory No 100000 Yes Yes Funded Banks and Up to 027 Borrowing up to $3 States official government percent total billion from US Treasury
domestic deposits
Japan 1971 Compulsory No 71000 but No No Funded Banks and 0084 percent of Borrowing up to yen500bn joint in full until government insured deposits from Bank of Japan
year 2000 subject to Ministry of Finance approval
Canada 1967 Compulsory No 40800 No Yes Funded Banks and 033 percent of Borrowing up to C$6 official government insured deposits billion authorized further
(maximum) borrowing subject to parliamentary approval
Germany 1966 Compulsory Yes 90 percent Yes No Funded Banks only 003 percent of Annual levy may be private coinsurance deposits doubled
to 22000
Italy 1987 Compulsory Yes 125000 Yes No Unfunded Banks and Callable Two options defer private government (maximum of payment or diminish
1 percent of compensation to be paid total deposits)
(table continues next page)
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108W
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CA
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MA
RK
ET
S
Table 29 Deposit insurance schemes in the G-10 countries Explicit safety net (continued )
Coverage limit(dollar Foreign
equivalent currency Interbank Source Bankrsquos Contingency fundingDate Membership Co- at end of deposit deposit of premium from banks
Country established managementa insuranceb July 1998)c covered covered Fundingd funding costs or governments
Netherlands 1979 Compulsory No 22000 Yes No Unfunded Banks and On demand Government backing official government maximum of subject to parliamentary
5 percent of own approval funds
France 1980 Compulsory No 65400 No No Unfunded Banks only Callable (on Extra calls up to FFr1000 private demand calls million can be made in
up to FFr200 a 5-year period million)
Switzerland 1984 Voluntary No 19700 No No Unfunded Banks only Callable (on Underwritten by member official demand) banks
Sweden 1996 Compulsory No 31400 Yes No Funded Banks and 05 percent of Full emergency coverage official government deposits while replacing it with a
limited system after the emergency
Belgium 1974 Compulsory No 16600 No No Funded Banks and Callable 002 None insurance limited joint 22000 in government percent of to assets in fund
year 2000 deposits from clients
Spain 1977 Compulsory No 16439 Yes No Funded Banks and 02 percent of Government backing joint government deposits through the Banco de
(maximum) Espantildea subject to approval by royal decree
a Bank membership in the fund can be either compulsory or voluntary and the management of the fund can be official and official and private joint or privateb Coinsurance refers to the situation where depositors face a deductible against their insured fundsc Coverage limit refers to the explicit amount the authorities promise to insured Funded scheme means that it is funded ex ante unfunded otherwise
Sources Goodhart (1995) Demirguccedil-Kunt and Detragiache (2000) Demirguccedil-Kunt and Sabaci (2000)
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 109
base Explicit safety net protection also varies but only Canada focuseson the protected class33 All G-10 countries specify a limit on depositorprotection Under FDICIA the insurance fund is prohibited from pro-tecting uninsured depositors or creditors at a failed bank although adiscretionary system-wide override is provided for exceptional circum-stancesmdashbut with stringent requirements for consultation and account-ability Other G-10 countries allow for contingency funding from the publicpurse alongside unwritten lender-of-last-resort support Among large banksa significant and growing portion of deposit liabilities including foreigncurrency and interbank deposits are uninsuredmdashbut depositors assumethey will be protected in a crisis
FDICIA also made some significant qualitative changes to address theprincipal-agent problem by penalizing weak banks and rewarding strongbanks For example banks whose capital declined faced progressivelytougher regulatory sanctions that for example required them to elimi-nate dividends restrict their lending and change their managementsRegulators have also been forced to take prompt corrective action (toreduce the practice of regulatory forbearance in hopes that a bankrsquos for-tunes might improve)34 Unfortunately comparative qualitative assess-ments across the G-10 are difficult to make due to lack of information35
This discussion highlights the complexity of evaluating the extent towhich prudential supervision and market discipline reduce the moralhazard associated with G-10 safety nets Our argument is that publicsafety nets in the G-10 can be linked to banking instability in other coun-tries specifically in the emerging-market economies that have attractedG-10 cross-border bank lending This lending is a leading source of vola-tility in capital flows the large financial institutions many of which arecomplex banking organizations are based in and regulated by authori-ties in the G-10 economies These two features of the international finan-cial system are closely related although it is not possible to test thisrelationship econometrically
Two World Bank studies however indicate a basis for concern Onestudy is a cross-country econometric analysis of the relationship betweenbank stability and deposit insurance (Demirguccedil-Kunt and Detragiache2000) which found a negative relationship Their estimated model forbanking crises in a sample of 61 countries (both industrial and develop-ing) suggests that explicit deposit insurance raises the probability of acrisis by at least 30 percent36 Crises are especially likely in countries
33 Japanrsquos legislation says it does but recent experience shows this is not the case34 See Goldstein (1997) for a summary of the changes35 See Barth Nolle and Rice (2000) for a beginning in this area36 Demirguccedil-Kunt and and Detragiache (2000 table 1) report a logit coefficient of 0696with a standard error of 0397 (the coefficient is significant at the 8 percent threshold)This suggests that the ldquotruerdquo coefficient could well be as small as 030 (the reportedvalue minus the standard error)
Institute for International Economics | httpwwwiiecom
110 WORLD CAPITAL MARKETS
with immature financial supervisory systems (and not in the G-10) buttheir analysis does underscore the view that deposit insurance weakensmarket discipline37
An earlier World Bank analysis established similar results One wasthat market discipline is undermined by deposit insurance schemes an-other was that illiquid banks are forced to pay more for their funds un-less a generous deposit insurance scheme is in place (Demirguccedil-Kuntand Huizinga 1999) This econometric study also provides clear-cut evi-dence that depositor monitoring of banks declines with the existence ofdeposit insurance schemes At the heart of the problem is the questionof whether deposit insurance is accompanied by increased governmentmonitoring
This evidence and the weight of other arguments suggests that moralhazard is still an issue in the G-10 countries Consider the ongoing de-bate about instilling greater market discipline on risk taking by banksAt one extreme is the perennial proposal to do away with safety netsleaving markets to monitor the players and to force adjustments but toprotect small savers by creating ldquonarrow banksrdquo such as postal savingsystems that are allowed to invest these savings only in risk-free gov-ernment securities Whatever the merits of narrow banking this solutionis too extreme to be politically feasible
A moderate alternative is to force more disclosure by financial institu-tions to facilitate market monitoring But transparency has its own prob-lems Persaud (2000) argues that financial markets cannot reliably discernsustainable from unsustainable positions in the short term This uncer-tainty causes banks to ldquoherdrdquo behind market leaders to exploit theirsupposedly superior information ldquoThe more herding investors and bankersknow about what each other is up to the [more] unstable markets maybecomerdquo The implication is that greater transparency in the marketplaceby itself will not solve the problemmdashand in the short term more informa-tion may exacerbate herding Further supervisory steps (discussed in thenext chapter) are required
Yet another proposal is to promote private-sector involvement in bankmonitoring through market-based alternatives such as Calomirisrsquos sub-ordinated debt proposal (Calomiris 1997 Federal Reserve Board 1999)Banks could be required to issue and maintain a minimum amount of
37 Other findings in the Demirguccedil-Kunt and Detragiache (2000) study include thesepropositions The impact of deposit insurance on bank stability tends to be stronger themore extensive is the coverage offered to depositors when the scheme is funded andwhere the scheme is run by the government rather than by the private sector Con-versely deposit insurance is detrimental to bank stability where bank interest rates havebeen deregulated and where the institutional environment is weak Additional findingson deposit insurance are reported from a recent World Bank conference (8-9 June 2000httpwwwworldbankorgresearchinterestconfsupcomingdeposit_insurancehomehtm)Also see Smalhout (2001)
Institute for International Economics | httpwwwiiecom
THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 111
subordinated debt (eg uninsured certificates of deposit) to finance asmall fraction (such as 2 percent) of their total nonreserve assets Thesubordinated debt would be allowed to earn a set yield no more than 50basis points over the risk-free yield on government treasury bills Thisrule would supposedly force banks to operate in a safe manner Other-wise subordinated debt holders would redeem their uninsured certifi-cates of deposit and equity investors would sell their bank shares Despiteits practical problems the beauty of the subordinated debt requirementis that it enlists market incentives to push banks to avoid excessive port-folio risk38
The thrust of these proposals is very relevant to the arguments in ourstudy Even in the G-10 countries government monitoring by itself hasnot eliminated moral hazard among banks More work is needed to in-troduce market monitoring and to improve the incentive structures bothfor financial institutions and their supervisors We return to this issuewith our recommendations in the next chapter
38 In late 1996 Argentina began requiring its banks to finance 2 percent of total depos-its in the form of subordinated debt but without a maximum yield provision TheArgentine authorities expect that market discipline will act in concert with the publicsafety net One obvious problem with the subordinated debt proposal is that banks mayencourage some of their customers to buy the subordinated debt
Portfolio Institutions Tomorrowrsquos Problem
Before proceeding to the issues of international supervision we flag an-other potential problem for national regulators The big asset managersprofiled in tables 24 and 26 answer to diverse groups of pensionersshareholders and policyholders They allocate funds across a number ofcountries to diversify their risks They hold liquid assets that can be tradedand they have a higher proportion of long-term assets than banks Eco-nomic shocks can be absorbed through price changes and their effectsspread across time and markets Thus when conditions change in a par-ticular market they are more likely to ride out the storm than to flee Inother words they have less incentive than banks to pull their invest-ments in the face of adversity In the 1990s most large asset managersestablished a record of ldquoriding out the stormrdquo rather than ldquorunning withthe windrdquo although as we saw in chapter 1 instances of running withthe wind were detected in some portfolios As we write these insti-tutions have a good record overall in the emerging markets so whyworry
The Russian crisis and the near-collapse of LTCM previewed the dan-gers that may await future portfolio managers and G-10 financial minis-ters We have presented evidence indicating a systemic bias toward bank
Institute for International Economics | httpwwwiiecom
112 WORLD CAPITAL MARKETS
lending and debt finance to emerging markets and we have argued forsubstitution toward equity finance and direct investment39
That is not the end of the story We noted in the previous chapterthat institutional investors can become momentum investors selling in adownturn As more portfolio capital is invested in emerging marketssome players may adopt the high-risk high-leverage strategies of themost aggressive hedge funds Indeed the data in box 11 show that G-10portfolio investors held somewhat more long-term debt (more than $500billion) than equity (less than $400 billion) in emerging markets at theend of 1997 Long-term debt is an ideal vehicle for high-risk high-leveragestrategies These strategies practiced on a large scale could compound afuture crisis harming emerging markets A big enough crisis could inturn pressure G-10 central banks and finance ministers to arrange bail-out plans Instead of shrinking as a systemic financial problem moralhazard could increase
National securities regulators are the first line of defense against thisscenario They play a critical role in the safe evolution of capital mar-kets But regulators today are mandated to approve the issuance of newsecurities and to monitor the continuing disclosure of material informa-tion by issuers They are far less concerned with or empowered to monitorthe behavior of the increasingly large wealth-management firms that arethe major purchasers (and therefore resellers) of these securities
Within their mandates the goals of national securities regulators (table210 and appendix B) are similar to the concerns of bank regulators withsystem safety and soundness Their focus is also on the incentive sys-tems for management and boards of directors and on disclosure by cor-porations that issue marketable securities such as shares bonds andasset-backed securities 40 Issuers of securities possess greater knowledgeabout the quality of these assets than do the purchasers hence investorprotection is a key concern of regulators Moreover market disciplineworks best when markets know what is happening Well-functioning corpora-tions are key agents of wealth creation and social progress Underperform-ing corporations waste resources During recessions bad corporationsget into bad trouble often with severe social consequences Inadequateincentives for managers and inadequate accountability for boards andmanagers thus have negative externalities Regulators play a vital role inexposing weakness so that market disciplines come to bear sooner ratherthan later
Regulatory emphasis is constantly shifting as financial markets evolveand as the macroeconomic environment changes Regulators try to balance
39 See Rogoff (1999) Also see Berlin (2000) for a perspective on the limited role thatbanks play as share owners
40 See Habib and Ljungqvist (2000) for recent empirical analysis showing that corporateshare market values are higher when corporate executives have a larger ownership stake
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Table 210 Financial-sector regulation G-10 countries 2000
Financial institutions and their supervisors
Country and supervisory structure Retail banking Wholesale banking Securities Insurance
Financial conglomeratesFinancial Services Authority (FSA) = umbrella supervisor
United Kingdom FSA FSA FSA FSA
Treasury bull Commercial banks bull Investment funds (Securities and (Insurance Directorate(Securities and Investments Board) bull Unit trust groups Futures Authority) of the Treasury)
Bank of bull Building societies bull Pension funds England (Building Societies Commission) bull Merchant banks
bull Friendly societies bull Clearing houses bull Primary issuers bull Insurance FSA (Friendly Societies Commission) bull Venture capital of securities companies
bull Pensions and life insurance etc bull Stock exchanges bull Insurance brokers(Personal Investment Authority) bull Stockbrokers
Financial holding companiesFederal Reserve (FR) = umbrella supervisor
United States bull National banks(OCC) Securities and Regulated by
Treasury OCC bull State banks Federal Reserve Exchange Commission StatesMembers (FR)
OTS Nonmembers (FDIC) bull Investment banks bull Primary issuers of bull Insurance companies FR bull Cooperative banks (FDICFR) bull Finance companies securities bull Insurance brokers FDIC bull Insured industrial banks (FDIC) bull Stock exchanges
bull Thrift holding companies (OTS) bull Stockbrokers SEC bull Savings banks (OTSFDICFR) bull Investment advisors
bull Savings and loan associations bull Mutual funds(OTS) bull Public utility holding
bull Edge Act corporations (FR) companies
(table continues next page)
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Table 210 Financial-sector regulation G-10 countries 2000 (continued )
Financial institutions and their supervisors
Country and supervisory structure Retail banking Wholesale banking Securities Insurance
Financial holding companies Japan Financial Supervisory Authority (FSA) = umbrella supervisor
Prime FSA FSA FSA FSA ministerrsquos Ministry of office Finance (Securities and Exchange
Surveillance Commission) FRC Bureau of Financial bull City banks bull Investment banks bull Primary issuers of bull Insurance companies FSA Regulation bull Regional banks bull Asset managers securities bull Insurance brokers
bull Trust banks bull Stock exchanges SESC bull Long-term credit banks bull Stockbrokers
bull Pension funds
Financial holding companiesOffice of the Superintendent of Financial Institutions (OSFI) = umbrella supervisor
Canada Regulated by OSFI OSFI provinces OSFI
Department of Financebull Banks bull Cooperative credit bull Primary issuers of bull Insurance companies
(previously Office of the Inspector associations securities (previously Depart- OSFI General of the Banks) bull Fraternal benefit bull Stock exchanges ment of Insurance) Bank of bull Trust and loan companies society bull Stockbrokers bull Insurance brokers Canada bull Pension funds bull Asset managers
(previously Depart- CDIC ment of Insurance)
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Financial institutions and their supervisors
Country and supervisory structure Retail banking Wholesale banking Securities Insurance
Germany Financial holding groupsFederal Banking Supervisory Office (FBSO) = umbrella supervisor
Ministry of Finance FBSO BSO FSSO FISO
Bundesbankbull Universal banks bull Other financial bull Primary issuers of bull Insurance companies
Federal Banking bull Savings banks institutions (eg securities bull Insurance brokers Supervisory Office bull Securities banks management foreign bull Stock exchanges
currency dealings) bull Stockbrokers Federal Securities bull Financial enterprises bull Asset managers Supervisory Office (eg leasing bull Pension funds
organizations Federal Insurance credit card companies Supervisory Office investment advisors)
Italy Bank foundationsMinistry of Finance = umbrella supervisor
Ministry of Finance Bank of Italy Bank of Italy Consob ISVAP
Bank of Italy bull Commerical banks bull Asset managers bull Primary issuers of bull Insurance companies Consob bull Savings bank bull Open-end investment securities bull Insurance brokers
bull Securities banks companies (SICAVs) bull Stock exchangesbull Stockbrokers
ISVAP
(table continues next page)
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Table 210 Financial-sector regulation G-10 countries 2000 (continued )
Financial institutions and their supervisors
Country and supervisory structure Retail banking Wholesale banking Securities Insurance
The Netherlands Financial conglomeratesCouncil of Financial Supervisors = umbrella supervisor
Securities Board Securities Board Netherlandsche Netherlands Bank Netherlandsche Bank of the Netherlands Insurance Board Bank Insurance bull Credit institutions (universal banks bull Investment institutions bull Stock exchanges bull Insurance companies Board cooperative banks security credit (securities issuing bull Stockbrokers bull Insurance brokers
institutions mortgage banks) and tradingmdashprimary The Council of Financial and secondary Supervisors markets)
France Commission des Commission de Operations des Controcircle des
Banking and Banking Commission Bourse Assurances Financial Regulatory bull Ensuring that credit institutions (and investment firms since bull Primary issuers of bull Insurance companies Ministry for Committee the Financial Activity Modernization Act of 1996) comply securities bull Insurance brokers Economic with laws and regulations bull Stock exchanges Affairs and bull Execute instructions regarding all off-site monitoring and bull Stockbrokers Finance Credit on-site supervision Institutions and Banking and Financial Regulatory Committee Investment bull Formulates general regulations for credit institutions and investment firms Committee (capital adequacy requirements accounting rules etc) Bank of France Credit Institutions and Investment Committee Banking bull Authorizes and examines financial institutions except for those within the Commission competence of the Banking Commission
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117
Financial institutions and their supervisors
Country and supervisory structure Retail banking Wholesale banking Securities Insurance
Switzerland Large banking groupSwiss Federal Banking Commission (SFBC) = umbrella supervisor
Swiss National Bank Federal Office of
SFBC SFBC SFBC Private Insurance Swiss Federal Banking Commission bull Universal banks bull Investment banks bull Primary issuers of bull Insurance companies
bull Savings banks bull Asset management securities bull Insurance brokerscompanies bull Stock exchanges
Private audit Federal bull Investment funds bull Stockbrokers firms Office of bull Mortgage bond authorized by Private business SFBC Insurance
Sweden Financial holding company groupsFinancial Supervisory Authority = umbrella supervisor
Ministry of Finance Credit Market Securities Market Insurance Market
Credit Market Department Department Department Department
Financial bull Commercial banks bull Investment funds bull Primary issuers of bull Insurance companies Riksbank Supervisory bull Savings banks securities bull Insurance brokers Authority bull Friendly societies bull Stock exchanges
bull Stockbrokers
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Table 210 Financial-sector regulation G-10 countries 2000 (continued )
Financial institutions and their supervisors
Country and supervisory structure Retail banking Wholesale banking Securities Insurance
Belgium Bank holding companiesBanking and Finance Commission = umbrella supervisor
Bank of Belgium Banking Banking
Banking and Finance and Finance Insurance Controland Finance Commission Commission Commission Office
Banking and Insurance Finance Control bull Commercial banks bull Asset management bull Primary issuers of bull Insurance companies Commission Office bull Savings banks firms securities bull Insurance brokers
bull Securities banks bull Investment funds bull Stock exchanges bull Mortgage companiesbull Stockbrokers bull Pension funds
Securities Regulation Fund Securities Regulation Fund
bull Other investment firms and credit institutions(institutions participating in regulated off-exchangemarket in strips and Treasury certificates)
Bank holding companies Spain Banco de Espantildea = umbrella supervisor
Banco de Espantildea Comision Nacional del Mercado de Directorate General
Banco de Espantildea Valores (CNMV) Insurance
bull All credit institutions (commercial banks savings banks credit bull Primary issuers of (Ministry of Economy Ministry of cooperatives official credit institutions finance factoring and securities and Finance) Economy and CNMV leasing companies mortgage-loan companies etc) bull Stock exchanges bull Insurance companies Finance bull Interbank foreign exchange and book-entry public debt bull Stockbrokers bull Pension funds
markets bull Venture capital(companies and funds)
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119
Financial institutions and their supervisors
Country and supervisory structure Banking Securities Insurance
Banking Advisory High Level Securities Supervisors Committee (BAC) Committee (HLSS) Insurance Committee (IC)
Supranational (EU) bull Formulates standards for prudential bull Coordination of securities market bull Formulates standards forsupervision supervision prudential supervision
BACICHLSS Banking Supervision
Conglomerates Committee (BSC) Securities Contact Committee Regulation of prudential bull Systemic risk monitoring bull Regulation and implementation of supervision securities admission
International Association International International Organization of of Insurance Supervisors
Basel Committee Securities Commisison (IOSCO) (IAIS) Joint Forum Conglomerates Supervision bull Supervision and regulation best bull Supervision and regulation best bull Supervision and regulation amp regulation Best practices practices practices best practices
FSF Coordination across supervisors of various functions
Notes See appendix B for more information Boldface type indicates senior or oversight supervisor normal type indicates adjunct or front-line supervisorsolid line indicates direct responsbility to the senior-ranking authority dotted line indicates coordination in supervisory activities
(table continues next page)
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Table 210 Financial-sector regulation G-10 countries 2000 (continued )
Glossary of names United Kingdom FSA = Financial Services Authority United States FR = Federal Reserve OCC = Office of the Comptroller of theCurrency FDIC = Federal Deposit Insurance Corporation SEC = Securities and Exchange Commission OTS = Office of Thrift Supervision Japan FRC =Financial Reconstruction Commission FSA = Financial Services Agency SESC = Securities and Exchange Surveillance Commission Canada OSFI =Office of the Superintendent of Financial Institutions CDIC = Canada Deposit Insurance Corporation Germany FBSO = Federal Banking SupervisoryOffice FSSO = Federal Securities Supervisory Office FISO = Federal Insurance Supervisory Office BSO = Banking Supervisory Office Italy Consob =Commissione Nazionale per le Societa e la Borsa ISVAP = Instituto per la Vigilanza sulle assicurazioni private e di Interesse colletivo Switzerland SFBC= Swiss Federal Banking Commission Spain CNMV = The Comision Nacional del Mercado de Valores Supranational BAC = Banking Advisory CommitteeBSC = Banking Supervision Committee IC = Insurance Committee HLSS = High Level Securities Supervisors Committee International Dimension FSF =Financial Stability Forum IOSCO = International Organization of Securities Commission IAIS = International Association of Insurance Supervisors
Sources United Kingdom Bank of England httpwwwbankofenglandcouk Financial Services Authority httpwwwfsagovuk United States Board ofGovernors of Federal Reserve System httpwwwfederalreservegov Japan Bank of Japan httpwwwbojorjo Financial Reconstruction Commissionhttpwwwfsagojpfrcindexehtml Financial Services Agency httpwwwfsagojp Canada Bank of Canada httpwwwbank-banque-canadaca Office ofthe Superintendent of Financial Institutions httpwwwosfi-bsifgccaAndreEindexhtml Germany Deutsche Bundesbank httpwwwbundesbankde Fed-eral Banking Supervisory Office httpwwwbakredde Italy Banca drsquoitalia httpwwwbancaditaliait Commissione Nazionale per le Societa e la Borsahttpwwwconsobit Instituto per la Vigilanza sulle assicurazioni private e di Interesse colletivo httpwwwisvapit The Netherlands De NederlandscheBank httpwwwdnbnl France Banque de France httpwwwbanque-francefr Switzerland Schweizerische Nationalbank httpwwwsnbchindex3htmlSweden Sveriges Riksbank httpwwwriksbanksedefaultasp Belgium National Bank of Belgium httpwwwbnbbesgindexhtm Spain Banco de Espantildeahttpwwwbdees The Comision Nacional del Mercado de Valores httpwwwcnmves Supranational (EU) Institutional Arrangements for the Regulationand Supervision of the Financial Sector 2000 International Dimension Bank for International Settlement httpwwwbisorg International Organization ofSecurities Commissions httpwwwioscoorg International Association of Insurance Supervisors httpwwwiaisorg Financial Stability Forum httpwwwfsforumorg
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 121
the inflexibility of tight surveillance against the need to encourage in-novation and growth The US Securities and Exchange Commission isworried about aggressive accounting by firms and biased reports bysecurities analysts in an equity environment that prizes steadily higherquarterly earnings41 Japanese regulators are preoccupied with opaqueinterconnections between portfolio institutions banks and nonfinancialfirms through the keiretsu system Canadian regulators reeling from high-profile scandals of managers intentionally misleading investors are strengtheningmarket discipline through legal penalties aimed at managers and directorsof offending firms
When panic strikes a securities regulator cannot do much As the 1987stock market crash and the LTCM debacle in the fall of 1998 both dem-onstrated steep stock and bond price declines can create systemic risksIf severe enough the wealth effect of falling securities values and thefear of widespread insolvency can depress real activity Flooding thesystem with liquidity is a central bankerrsquos solutionmdashsomething a securi-ties regulator cannot do42 But just as financial supervisors can changethe incentive structure to discourage bankers from making risky loans ingood times so securities regulators can pay more attention to incentiveson the demand side when capital markets are strong
Prudential Supervision and InnovationmdashA Footnote
In concluding this discussion of prudential supervision in the G-10 anadditional point is worth noting National regulators face a persistenttrade-off between emphasizing financial system safety and soundnesswhile encouraging innovationmdashin spite of the added risks innovationbrings to financial markets Former US Treasury Secretary Lawrence Summers(2000 3) has argued by analogy
The jet airplane made airplane air travel more comfortable more efficient andmore safe though the accidents were more spectacular and for a time morenumerous after the jet was invented In the same way modern global financialmarkets carry with them enormous potential for benefit even if some of theaccidents are that much more spectacular As the right public policy response
41 The problem is illustrated by the divergence since mid-1998 between reported earn-ings by the Standard amp Poorrsquos (SampP) 500 and the after-tax profits of all corporations inthe national accounts Generally these two series move closely with one another Be-tween mid-1998 and mid-1999 SampP 500 reported that earnings increased by more than20 percent while after-tax profits of all corporations increased by less than 5 percent(Chase Bank US Economic and Policy Research US Weekly Prospects Chase SecuritiesWeekly Newsletter 5 June 2000 5)
42 For example the US Securities and Exchange Commission had no direct role in calmingmarkets in the 1987 or 1998 panics
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122 WORLD CAPITAL MARKETS
to the jet was longer runways better air-traffic control and better training forpilots and not the discouragement of rapid travel so the right public policyresponse to financial innovation is to assure a safe framework so that the ben-efits can be realized not to stifle the change
Accepting Summersrsquos analogy for the international financial system better-informed supervisors and investors are a necessary part of the financialsystem framework Supervisors require more timely information on therisk profiles resulting from positions taken by financial institutions Theyalso need a better understanding of risk-management systems Snapshotsof an institutionrsquos risk profile and risk-management procedures are nolonger adequate In a world where huge bets are quickly made (andpossibly lostmdashas with Barings Bank in 1995 and LTCM in 1998) super-visors must focus on the soundness of banking systems for evaluatingand managing risk on a daily basis Some progress has been made inaddressing these issues US banking examiners are extending their in-formation requirements in banking examinations and increasing theirinvolvement in large complex institutions43 More awareness is alsorequired of the fact that they are national organizations in a world ofcross-border capital flows To a much greater extent they need a multi-national reach International supervision and coordination among super-visors are the subject of the next section
Our analysis suggests that G-10 supervisors have unfinished businessBank supervisors need to start yesterday securities regulators can waituntil tomorrow One G-10 member acting alone cannot correct the biasIn good times the lending business will simply migrate to other G-10banks In bad times financial problems will not stop at the national bor-der A way has to be found to establish common international standardsfor the key financial players in order to prevent crises and to agree onapproaches for managing them The path has already been laid out Inthe wake of the bank failures of the past 25 years bank supervisors havetried to establish such standards They have done this without creating anew global institution
The essence of the international framework is decentralizationmdashglobalrules and design standards without global institutions that are perceivedto intrude on national sovereignty The awkward jargon for this frame-work is vertical subsidiaritymdashldquothink internationally act nationallyrdquo Theinternational thinking is done by a committee of regulators that meets
International SupervisionA Decentralized Framework
43 These issues are discussed in Ferguson (1999) and Meyer (2000a)
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 123
regularly at the Bank for International Settlements in Basel The commit-tee establishes principles and standards that are interpreted implementedand enforced by national authorities44 In this section we describe thesesupervisory efforts and their weaknesses We present our recommenda-tions for addressing these weaknesses in the next chapter
Basel I
The Basel Capital Accord of 1988 (Basel I)45 drew the lesson from thefinancial crises of the mid-1970s that more adequate capital levels in in-ternational banks would help reduce the systemic risk of bank failureThe primary goal of Basel I was capital adequacy other standards wereput in place not so much for their own virtue as to defend the primarygoal
Capital adequacy requirements were designed to ensure that individualinstitutions have the ability to absorb losses particularly credit lossesAccordingly a backup system of scoring credit risk was devised thatrequired large amounts of bank capital for some types of loans smalleramounts for others and zero for a select list of preferred assets Report-ing requirements were designed to disclose problems and ensure that atroubled bank would take timely steps to restore its capital base in thewake of a loss The Basel I framework worked tolerably well in limitingthe call on the public purse in the G-10 countriesmdashwith the notable ex-ceptions of France and Japan The framework failed to moderate riskybank lending to emerging markets however
Basel I was not developed with emerging markets in mind The origi-nal idea behind it was to develop a common supervisory approach tocross-border banking operations It grew out of political pressure fromUS lawmakers who were determined to require international banks op-erating in the United States to meet US banking standards Toward thisgoal in 1983 Congress passed the International Lending Supervisory ActUS and British banking authorities subsequently agreed on a commontarget the adoption of strict common capital-adequacy standards In 1988other G-10 governments agreed to go along voluntary acceptance ofthe standards throughout much of the rest of the world followed46 Therationale for the capital targets was two-fold The first was to requirebanks to hold sufficient amounts of capital (8 percent of risk-adjusted
44 The international committee of financial authorities agreed on a common definitionof banksrsquo tier-one or ldquocorerdquo capital national authorities defined tier-two capital in theirown manner which permitted greater variations in national working definitions andpractices
45 International Convergence of Capital Measurement and Capital Standards (BIS 1988)was prepared by the Basel Committee on Banking Supervision
46 See Reineke (1998)
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124 WORLD CAPITAL MARKETS
assets) to cushion losses on those assets The second was to dull theirappetites for risk banks with large capital bases would have more tolose if they failed and therefore would take fewer risks
Rapid change in financial markets soon revealed flaws in the Basel IAccord In a complex world with numerous sources of risk it focusedheavily on credit risk but overlooked other risks in a bankrsquos portfolioand the correlation between returns on different asset classes The Baselformula required banks to maintain a fixed amount of capital againsteach of its asset classes But the formula did not distinguish the riskinessof the borrower within each class As a result one large loan to a low-risk corporate borrower such as General Electric would require the sameamount of capital as 10 smaller transactions with high-risk borrowers
The system was also biased toward short-term loans Loans maturingin less than a year required a 20 percent risk weight whereas those ma-turing after more than a year required a 100 percent risk weight Inter-bank lending was particularly favored For example loans to banks inOECD countries required less capital than loans to private firms in thesame countries creating the anomaly that interbank loans to South Ko-rean banks required less capital than loans to General Electric47 Thisanomaly encouraged banks to shed high-quality assets if the Basel rulesrequired the allocation of more capital than banks thought they needed
Another weakness was that financial innovators quickly circumventedthe Accord Because short-term loans required less provisioning than long-term loans banks responded by securitizing their long-term debt port-folios and lending short-term against the collateral of the newly createdasset This allowed banks to circumvent the capital requirements gearedto the terms of the underlying debt At the same time the Basel I Accordfailed to encourage risk mitigation techniques such as credit derivativescollateral guarantees and on-balance-sheet netting the flip side of fi-nancial innovation Because off-balance-sheet products were not coveredby the Accord another anomaly appeared when Barings Bank collapsedin 1995 Barings met capital adequacy standards but collapsed becauseits systems for managing risk failed traders were allowed to speculatein futures contracts that did not appear on the balance sheet
Basel II
Work to overhaul Basel I began in 1995 and produced consultativepapers issued in June 1999 and January 200148 These papers have been
47 South Korean banks have had notoriously weak balance sheets because the practiceof ldquodirected lendingrdquo left them with many poor loans (in making these loans the bankswere expected to follow government objectives rather than creditworthiness criteria)
48 Basel Committee on Banking Supervision (1999 2001)
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 125
the subject of extensive consultation and revision as a result the newAccord is expected to be introduced in 200449 The Basel II frameworkhas three parts (pillars) revisions to Basel I minimum-capital require-ments supervisory review criteria and greater emphasis on market dis-cipline Broadly Basel II aims to maintain the level of capital in the sys-tem but achieve better alignment of banksrsquo capital with their risk pro-files and keep up with financial innovation
To align capital requirements with market realities (the first pillar)Basel II concentrates on the 100 or so largest banksmdashthe type of playerslisted in table 21mdashand on the holding-company parents of banking groups50
Capital requirements will differentiate between an increased number ofcredit groups or ldquorisk bucketsrdquo including claims on governments otherbanks corporations mortgage-backed securities and other asset-backedsecurities
Basel II originally proposed to use external ratings to set capital chargesfor a number of these credit risks Many banks objected arguing thatthey assess credit risk better than Standard amp Poorrsquos Moodyrsquos or FitchIBCA51 Basel II thus proposes two approaches to rating a standard ap-proach using external ratings and an ldquoadvancedrdquo approach that allowsselected banks to use their own internal rating systems To encouragethe development of rigorous internal control systems based on these in-ternal rating systems Basel II also proposes to levy capital charges foroperational risk (the risk of direct or indirect loss resulting from inad-equate or failed internal processes people and systems or from exter-nal events)
Some critics of this proposal dismiss it as an abrogation of the prin-ciple of external independent monitoring and as ldquodangerously naiumlverdquo52
But regulators argue that the new capital charge on operational risk shouldoffset this concern It is also far from clear how cross-national compari-sons of rating and internal risk-assessment systems will be made (Engelen2000) The development by the European Union of its own capital rulescould well complicate the international resolution of these issues Publicassurances by EU officials in January 2001 however indicated that theirmain concerns are to create a level playing field and avoid regulatoryarbitrage (Hargreaves 2001) There is also the significant problem ofthe procyclical character of risk weights When a crisis hits losses are
49 See Berry (2000) for an update in an interview with William J McDonough chair ofthe Basel Committee on Banking Supervision
50 For obvious reasons these proposals are addressed to large banks and simpler capi-tal standards are allowed for small banks that focus on their domestic credit markets
51 See Ammer and Packer (2000) for an empirical critique of the success of rating agen-cies in distinguishing risk by sector and region
52 See Auerback (2001)
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126 WORLD CAPITAL MARKETS
incurred or accrued capital is lost and loan exposure must be reducedor securities sold to restore the requisite capital-adequacy ratios A morerisk-sensitive framework could amplify volatility
As the second pillar of Basel II supervisory review criteria are beingbeefed up to encourage supervisors to intervene earlier in potential problemsituations and to compel banks to align their capital positions with theirrisk profiles Bank supervisors will be authorized to require banks tohold capital in excess of minimum requirements if they have concernsabout general management overall strategy risk-management performanceor the macroeconomic environment Of course if one G-10 supervisorimposes higher capital requirements in isolation the same disparity willemerge that presaged Basel I Some banks will be disadvantaged in theinternational marketplace and will loudly complain that excessive super-vision is driving business to their competitors Hence close internationalcooperation among supervisors is critical
To implement the third pillar market discipline banks will be requiredto make fuller more timely disclosure of capital adequacy and the risksto which that capital is exposed A number of measures are being stud-ied that might help supervisors evaluate bank performance such as com-parisons of uninsured deposit interest rates subordinated debt yieldsand equity prices The idea is that these yields and prices might alertsupervisors to market perceptions of risk Of course market perceptionsare only as good as market information More direct and controversialways to reinforce market discipline would dramatically increase publicdisclosure of bank positions and risk management systems
Many questions are still outstanding about how to resolve the techni-cal details of capital requirements and whether the requirements willachieve their intended goal of better assessment and mitigation of therisks in banksrsquo portfolios There is no substitute for skilled supervisorsThe intricacies of effective design and implementation suggest that su-pervisors need to be highly competent technically knowledgeable aboutbanking portfolio characteristics and the factors that influence bank ex-posure to credit risk (Mishkin 2000) And they must be aided by vigilantshareholders market forces and transparency of information53
Standard setting at the global level is desirable but ultimately theeffectiveness of these efforts will be tested at the national level espe-cially in times of systemic financial distress Here the record of Basel Iwas not a bright shining success Japanese banking regulators havetraditionally allowed banks to include real estate and securities in theircapital base When the value of these assets plummeted in the early 1990sregulators allowed banks to continue valuing these depreciated (andoften bankrupt) assets at their old inflated levels Japanese authorities
53 Benedict Roth Complacency Towards Catastrophe Financial Times 23 January 2001
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 127
insisted until the mid-1990s that eroded capital bases could be rebuiltin a market-driven fashion They rightly foresaw that huge loan losseswould undermine public support for the ruling party and require a po-litically unpopular bailout
Japanese foot dragging on Basel I was the worst54 but not uniqueOther examples can be found of ldquopolitically mandated forbearancerdquo TheFederal Reserve Bank of New York held important hands during theLTCM crisis of 1998 Mexico is still resolving the banking crisis that eruptedin 1995 South Korea has not yet closed the insolvent banks that behavedso badly before the crisis of 1998 In the aftermath of a crisis nationalregulators cannot always be relied upon to discipline politically power-ful bankers55 One of the little-noticed consequences of these differingapproaches is that those banks with strong regulatory systems receivedan implicit ldquoexport subsidyrdquo for their services US banks which had notengaged extensively in emerging-market lending in the 1990s were bet-ter positioned than their German and Japanese counterparts to expandtheir international assets in the wake of the crises
Other Financial Forums
54 See Japanese Banks Fiddling while Marunouchi Burns The Economist 27 January2001 67-69
55 See Calomiris (1997)
The Basel model of vertical subsidiarity has already been extended toother financial regulatory bodies In 1993-94 the BIS established a Tri-partite Group of Banking Insurance and Securities Regulators In 1994-95 the BIS increased its cooperation with the International Organizationof Securities Commissions when the two organizations issued parallelpapers on guidelines for national regulators concerning risk managementand disclosure of derivative trades In 1996 a permanent Joint Forum onFinancial Conglomerates was established to examine supervisory issuesand develop working arrangements among the different functional super-visors of conglomerate institutions that offer combinations of bankingsecurities and insurance products Draft papers on the supervisionof conglomerates were released for comment in 1998 applying capital-adequacy principles to these groups and providing guidelines both forassessing the integrity and competence of top managers and for sharingassessments between regulators
In 1997 the Basel Committee on Banking Supervision extended itsreach beyond capital standards to broader aspects of banking supervi-sion with the publication of the Core Principles for Effective BankingSupervision In 1999 a wide range of regulatory and standard-settingbodies were gathered under the umbrella of the Financial Stability
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128 WORLD CAPITAL MARKETS
Forum (FSF) itself established under BIS aegis56 The FSF has alreadyissued recommendations for stepped-up supervision and transparencyas well as guidelines for best practices in a number of areas includingoffshore financial centers and highly leveraged institutions or hedge funds57
Conclusion
Although the structural weaknesses in emerging-market economies arewidely acknowledged to have been causal factors in international capi-tal-market volatility this chapter points to the role of large G-10 bankingorganizations as major suppliers of the most volatile instrument short-term debt We have examined evidence of the impact of public safetynets in the G-10 economiesmdashthe deposit insurance systems the pruden-tial supervisory systems and the lender-of-last-resort functions of centralbanksmdashon the incentive structures of these organizations
Although supervisors in most countries working nationally and to-gether in the BIS have made significant efforts to mimic market forcesin their prudential supervision the most sophisticated financial institu-tions find innovative ways to circumvent the rules New global regulatorybodies are not about to be created G-10 national bank regulators shouldthemselves address the short-term debt bias in the international financialsystem by changing incentive systems G-10 securities regulators shouldalso take steps to get ahead of the curve paying close attention to largeportfolio swings by institutional investors particularly in times of crisisIn short more needs to be done at national and international levels tochange the rules of the game That is the subject of the next chapter
56 The Financial Stability Forum includes banking securities insurance and accountingregulatory bodies the OECD on taxation corruption and corporate governance and theIMF
57 See Martin (2000)
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 99
balance sheet and because balance sheets are published quarterly at bestoutsiders have a difficult time assessing the extent of a firmrsquos leverage19
Leveraging by a single firm enhances its risk of default the widespreaduse of leverage in the financial system can magnify market adjustmentsespecially when they require ldquodeleveragingrdquomdashunwinding prior positionsRapid adjustments can cause credit to dry up and asset prices to plummetIn a mark-to-market environment falling asset prices trigger calls foradditional collateral that can ripple through markets
Risk Management
Because it is confronted with the widespread use of leverage and prolif-erating kinds of risk international finance is increasingly driven by riskevaluation and control20 Different institutions face various risk profilesand differing kinds of risk The most common risks can be quickly tickedoff Banks because of their traditional intermediary role of channelingthe resources from savers to borrowers face significant credit risk therisk of default or delay in the payment of principal and interest Theymust also manage market risk the risk that the prices of their liabilitiesmay change faster than their assets Market risk devastated US savingsand loan institutions in the late 1980s
Closely associated with market risk are interest-rate risk (unexpectedchanges in market interest rates that slash margins net income and theeconomic value of a bankrsquos equity) and foreign exchange risk (losses thatarise when assets denominated in an appreciating foreign currency areless than liabilities denominated in that currency) Banks make numer-ous loans to other banks around the world portfolio investors buy se-curities direct investors acquire fixed assets and all incur country risk(economic and political uncertainty in the host country) During the heightof the Asian crisis for example interbank loans to Japanese banksreflected the credit risk of lending to these banks the so-called Japanpremium
Substantial attention has been lavished on country risk analysis sincethe 1982 debt crisis in developing countries Yet in spite of this exper-tise the Asian crisis occurred in part because of a sudden upward reap-praisal of country risk after the Thai baht collapsed in April 1997 Banksand other financial institutions must also manage liquidity risk the riskthat market conditions will change unexpectedly depressing demand andprices of assets at the time they want to sell these assets And they mustmanage operational riskmdashfailures in control systems or people that cause
19 Another example of asymmetric information Both risk and leverage are difficult foroutsiders to assess without full timely disclosure
20 A longer discussion of these issues can be found in Managing Global Finance in IMF(1999c)
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100 WORLD CAPITAL MARKETS
financial loss or damage reputations Operational risk devastated BaringsBank in 1995
Financial institutions practice risk management to measure all theserisks the potential damage to their investment positions and ultimatelythe chance of becoming insolvent VAR (value at risk) risk models mea-sure subject to certain assumptions the amount of the firmrsquos capital thatis exposed in each period For example the VAR model might say thatin a 3-standard-deviation worst case (a case that is not supposed to hap-pen more than 1 percent of the time) the firm will loose 25 percent of itscapital during the next year
VAR models are widely used but like all models they have weak-nesses They rely on past values to estimate key variables in financialmarkets past values are not always good predictors of future risks More-over rising volatility and higher loss correlation among different assetclasses in a portfolio will cause all banks using these models to reducetheir exposures at the same time by switching to less volatile and lesscorrelated assets such as US Treasury bills (Persaud 2000)
Newer risk models entail stress testing and scenario analysis Scenarioanalysis envisages possible adverse changes one at a time that mightaffect the investment portfolio Stress testing estimates potential losseswhen several individual risk factors simultaneously move against thefirm but it too uses historical probabilities
Financial Volatility
21 For example derivative markets usually rely on underlying securities markets thatproduce continuous prices When these markets are interrupted financial shocks cantrigger a cascade of margin calls and sell orders that move prices very sharply
22 See IIF (1999a)
The combination of trading activity and modern risk management lie atthe root of financial volatility When risks increase banks must eitherraise more capital to cover the greater risk or reduce their exposure bycutting loan exposure by selling securities or by undertaking new de-rivative trades Raising more capital is time-consuming and in a crisisvery expensive because bank shares are depressed So banks look to theother alternatives If the bank can reduce lending it need not book aloss But most banks use the same VAR models and as indicated abovethese models will encourage them to reduce their outstanding loans atthe same time actually magnifying loan volatility
If banks attempt to reduce their exposure to risk by selling securitiesor undertaking new derivative trades they may trigger large priceshocks because of limited and shrinking market liquidity21 The liquid-ity problem is compounded when a small number of large institu-tions hold the same positions22 Take your pick loan volatility or price
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 101
volatility As two experts have observed (Folkerts-Landau and Garber1998)
[V]olatility even in one country will automatically generate an upward re-estimate of credit and market risk in a correlated country triggering automaticmargin calls and tightening of credit lines Thus apparently bizarre opera-tions that connect otherwise disconnected securities markets are not the re-sponses of panicked green screen traders arbitrarily driving economies from agood to a bad equilibrium Rather they work with relentless predictability andunder the seal of approval of supervisors in the main financial centers
23 See Ferguson (1999)
24 As Gerald Corrigan (1982) put the matter ldquoBanks are specialrdquo Corrigan (2000) reit-erated this view even after all the changes of the past two decades Unlike other institu-tions banks offer on-demand transactions are a backup liquidity source for other insti-tutions and serve as a ldquotransmission beltrdquo for monetary policy
These changes in the banking environment accentuate an existing anomalyThe anomaly is that banks even as they grow larger and increasinglyengage in more risky and complex transactions are perceived to enjoyimplicit and explicit public guarantees
The guarantees grow out of an incentive problem inherent in bankingasymmetric information which we mentioned above Depositors know lessabout a bankrsquos management and the quality of its balance sheet than doits managers and shareholders Thus in times of uncertainty or adver-sity bank depositorsmdashuncertain whether they will have access to theirdepositsmdashare prone to bank runs This prospect has in turn compelledgovernments to treat banks differently than other firms because a bankthat fails can disrupt the rest of the economy24
To prevent such crises governments have entered into quid pro quoarrangements with banks Governments provide them both with an im-plicit safety net in the form of an unstated promise by the central bankto act as a lender of last resort in a liquidity crisis and an explicit safetynet in the form of a public deposit insurance fund to reassure depositorsIn return the banks submit to closer government oversight and regu-lation of their activities than is usual for industries in the private sector
The ldquoinsurancerdquo provided by the public safety net contributes to an-other incentive problem moral hazard Banks acquire greater tastes forrisk and face less market discipline than other firms The explicit depositinsurance safety nets actually have or are perceived to have blanketcoverage that extends beyond the retail depositors (households and small
One of the lessons of the 1997-98 crisis must surely be that market par-ticipants and their regulatory supervisors relied too heavily on quantita-tive tools and insufficiently on judgment23
The Anomaly of Modern Banking
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102 WORLD CAPITAL MARKETS
businesses) for which they were originally intended The implicit centralbank safety nets extend in a crisis to nearly all depositors and banksThus banks are both viewed and behave as if they will be bailed out ifthey get into trouble
The existence of a public safety net raises a perennial question Dobanks have an unfair advantage over other financial institutions becauseof the subsidy provided by the safety net This question was at the heartof intensive study and debate in the United States leading up to thepassage in November 1999 of the Financial Services Modernization Act(also known as the Gramm-Leach-Bliley Act) The size of the gross sub-sidy is difficult to estimate despite determined research efforts Somesuggest it is well under 100 basis points and is at least partly offset bythe direct costs of deposit insurance premiums interest payments on bondsissued by the Financing Corporation25 reserve requirements regulatoryexpenses and operational costs associated with collecting deposits26 Con-versely Kwast and Passmore (2000) suggest that banks can expand theirscope far beyond the levels that other financial institutions could reachwith the same equity base but without the public safety net
A related concern in the US debate is whether allowing banks to ex-pand their activities into securities and insurance will ultimately extendthe safety net and add to the subsidy The Financial Services Moderniza-tion Act deals with this issue by maintaining a legal separation betweenbanks and the rest of the banking organization known as large com-plex banking organizations (LCBOs) They must engage in most securi-ties activities and insurance underwriting through separately capitalizedinvestment bank subsidiaries or holding company affiliates This act canbe said to have merely brought US banking laws closer to those of mostother industrial countries (Barth Brumbaugh and Wilcox 2000 BarthNolle and Rice 2000) If the fire wall is well-maintained and stoutly de-fended the safety net will neither expand in practice nor become a sourceof comfort to noncommercial bank subsidiaries of LCBOs
The quid pro quo exacted by governments to offset the subsidy iscloser public-sector monitoring of banksrsquo activities through prudentialsupervision The effectiveness of this closer official scrutinymdashand closermarket monitoringmdashare the subjects of the next section
25 The Financing Corporation was created by Congress in 1987 to sell bonds to raisefunds to help resolve the savings and loan crisis
26 See Levonian and Furlong (1995) Jones and Kolatch (1999) Shull and White (1998)and Whalen (1999a 1999b)
Are G-10 bank supervisors adequately responding In this section we firstassess the case for and compare the structures of prudential supervisory
Prudential Supervision
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 103
systems both within and among the G-10 economies plus Spain andconsider whether these offset the subsidy provided by the public safetynet Despite offsetting regulation and supervision implicit and explicitguarantees by G-10 governments to their banks are still a source of bank-ing instability in the emerging-market economies
National Systems for Prudential Supervision
Governments use prudential supervision to reduce the moral hazard andadverse selection created by their own safety nets Supervisors establishregulations and monitor compliance to limit risk taking and ensure thesafety and soundness of the banking system In a thoughtful analysis ofthe case for prudential supervision Frederic Mishkin (2000) identifiesthe main forms that supervision can take including the tasks of grantingbanking charters and licenses establishing capital requirements settingdeposit insurance premiums and defining disclosure requirements as wellas carrying out bank examinations Bank examiners gather informationfrom banks and evaluate whether they are following the regulatorsrsquo rulesin cases of weakness they are empowered to change banksrsquo behaviorand close them if necessary
Supervisors also may restrict competition define the activities in whichbanks may engage and restrict their asset holdings and separate banksand other financial (or nonfinancial) activities During the past two de-cades the barriers separating commercial banks investment banks in-surance firms and securities firms have been all but eliminated (tableB1) Deregulation has stimulated competitive forces that drive diversifi-cation and consolidation of the financial industry nowhere faster than inthe United States
The Financial Services Modernization Act of 1999 confirmed this trendIt eliminated restrictions dating back to the Glass Steagall Act of 1933which once prevented banking insurance and securities firms fromentering each otherrsquos businesses (Barth Brumbaugh and Wilcox 2000)Cross-pillar mergers among banks insurance and securities firms arewell under way to form giant financial holding companies The 1999merger between Citibank (banking) and Travelers (insurance) created themodel for megafinance and confirmed new challenges for supervisors
Mishkin (2000) notes the corresponding evolution in US supervisionfrom an emphasis on rules-based regulation (detailed rules for opera-tional behavior and the quality of line items in the balance sheet) to anapproach that stresses the soundness of bank management practices es-pecially risk management
Appendix B outlines the systems of financial supervision now in theplace in the G-10 countries plus Spain Some systems like the UK andCanadian approach are models of simplicitymdashorganized to keep pacewith the spreading reach of financial conglomerates Other systems like
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104 WORLD CAPITAL MARKETS
the US and French approaches show traces of the bureaucratic divisionsthat made sense in an era when banking securities and insurance weresharply separated
The US Model
27 See Meyer (1999a)
28 Canada has a similar degree of simplification with the exception that securities firmsare still regulated by provincial authorities
29 See Pratti and Schinasi (1999 67)
30 The agents are the bank regulators and the principals are the taxpayers Agents maypursue their own interests including bureaucratic survival and postgovernment employ-ment opportunities rather than the national interest in banking safety and soundness
The US model of financial regulation delineated in the Financial Ser-vices Modernization Act of 1999 blends functional and umbrella super-vision Bank and thrift regulators oversee depository institutions Newnonbank activities are subject to both functional regulation (eg by theSecurities and Exchange Commission and state insurance examiners) andumbrella supervision (of financial holding companies) by the FederalReserve27
The UK Model
Another supervisory model exists in the United Kingdom as well as inAustralia Canada and Switzerland28 In this model banking supervisionis separated from the monetary policy function The regulatory structureis considerably simplified by relying on a consolidated financial regula-tor separate from the central bank for both banking and nonbankingactivities The remaining question answered differently depending on thecountry is the extent to which the regulator relies on home-country sur-veillance of banks and conglomerates that have a local presence
Regulatory Models Compared
Appendix B provides more detail on the differences in these modelsGerman simplicity contrasts with French complexity In France the bankingcommission is chaired by the governor of the central bank and includesrepresentatives from the Treasury The commission supervises compli-ance with regulations but the central bank inspects banks on behalf ofthe commission29 In countries such as the United States and France withmultiple supervisors and crossover functions internal coordination is criticalAt the same time multiple agencies create regulatory competition Wheneach agency knows what the other is doing transparency within gov-ernment circles can help to limit principal-agent problems of regulation30
The discussion as to where in the public bureaucracy financial super-
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 105
vision should be placed goes back many years Peek Rosengren andTootell (1999) argue that a synergy exists between monetary policy andprudential supervision because information gained in the course of super-vision can increase the accuracy of macroeconomic forecasts A twist tothis argument is that the information on the state of financial institutionsavailable to the central bank as supervisor can facilitate its role as lenderof last resort Conversely there is the concern that a supervisory rolewill compromise the central bankrsquos independence of action with respectto its core mandatemdashmaintaining price stability As these arguments haveplayed out financial supervision has generally been shared between centralbanks and other regulators or placed entirely in the hands of an inde-pendent regulator However in Italy the Netherlands and Spain cen-tral banks are the sole banking supervisor
Goodhart (1995) examined the arguments and evidence for each modeland concluded that there were no overwhelming arguments or evidencefor one or the other31 Going forward a key problem for any financialsupervisory system is dealing with (and closing as necessary) weak banksIf both central banks and other regulators have this responsibility closecoordination between them is critical Another problem is large conglom-erate banks LCBOs Although they are less likely to fail because of thediversification of their assets and liabilities they are more likely to berescued They are also more likely to be multinational enterprises withinternational implications Goodhart observes that regulation of theseentities might be put in the hands of the central bank because it is lessamenable to political pressures In any event the complexity of LCBOoperations suggests that greater supervisory rigor is necessary
The US Congress was persuaded that broad oversight would help containthe moral hazard problem and accordingly gave the Federal Reservethe role of umbrella supervisor with the understanding that the Fed willscrutinize depository activity more intensely than nonbank financial ac-tivities Under this approach LCBOs such as Citigroup are subject tomuch closer monitoring than smaller and simpler institutions32 The USregulatory model requires enormous cooperation between the Fed otherbank supervisors and the functional regulators for insurance and securi-ties but it also benefits from regulatory competition
31 National systems of supervision are path dependent they are determined by the struc-ture of financial institutions and history in each country If Goodhart (1995) is right out-comes are not materially better or worse with one model of supervision rather than another
32 See Ferguson (1999)
Public Safety Nets
One of prudential supervisorsrsquo biggest challenges is to reduce moral hazardFor many years commercial banks engaged in communal self-insurance
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106 WORLD CAPITAL MARKETS
to deal with crises They formed voluntary groups that agreed to rescuetroubled members As financial markets evolved and competition inten-sified banks were no longer willing to play this role Private-sector in-surance is one alternative but moral hazard and adverse selection wouldappear to prevent it from happening Public safety nets have developedbecause of the low probability and high cost of potential bank runs Aclear trade-off is involved The effectiveness of insurance in preventingbank runs is greater the more comprehensive the coverage But the morecomprehensive the coverage the greater the moral hazardmdashbank man-agers bank directors investors and depositors all take on greater risksin the belief that the safety net will protect them against losses
All G-10 countries have compulsory public safety nets for banks (table29) Deposit insurance agencies are officially organized in Canada theNetherlands Sweden Switzerland and the United States organized bythe industry in France Germany Italy and the United Kingdom andjointly organized by the public and private sectors in Belgium Japanand Spain
How well do G-10 governments offset the subsidy provided by thepublic safety net This is a question on which there is substantial debateAs banking organizations have become more complex the challengesthat supervisors face have become more difficult One challenge is toalign the incentives facing bank managers and shareholders with thoseof depositors Another is the principal-agent problem in supervision Wehave discussed the incentive structures for financial institutions but wehave said little about the incentives for supervisors themselves and thedistortions they can generate in the financial system
In one of the many studies of the US savings and loan crisis of the1980s Kane (1989) documented both problems He described managersusing cosmetic approaches to disguise the magnitude of insolvency regulatorspracticing forbearance even though they knew of the deteriorating riskprofiles of the institutions for which they were responsible and legisla-tors increasing deposit insurance without regard for any offsetting changesin supervision A subsequent overhaul of the legislative framework forthe Federal Deposit Insurance Corporation (FDIC) known as the FDICImprovement Act of 1991 (FDICIA) aimed to introduce a clearer incen-tive structure for both regulators and regulated institutions
The changes introduced by this US legislation are worth discussionwith respect to the other G-10 countries as well First FDICIA created astronger signal to management and investors by targeting deposit insur-ance at small depositors only and by risk-weighting the deposit insur-ance premiums paid by banks to reflect their capital adequacy and bankexaminer ratings Among the G-10 countries rated in table 210 depositinsurance premiums vary considerablymdashbut it is not clear that the dif-ferences have much to do with risk-weighting Most G-10 countries em-ploy funding formulas based for example on the total domestic deposit
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E P
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Table 29 Deposit insurance schemes in the G-10 countries Explicit safety net
Coverage limit(dollar Foreign
equivalent currency Interbank Source Bankrsquos Contingency fundingDate Membership Co- at end of deposit deposit of premium from banks
Country established managementa insuranceb July 1998)c covered covered Fundingd funding costs or governments
United 1982 Compulsory Yes Larger of 90 No No Unfunded Banks only Callable (subject Parliament may increase Kingdom private percent co- to maximum the maximum payable
insurance to 03 percent of pound125 million advance 33000 total deposits) facility with Bank of
England
United 1934 Compulsory No 100000 Yes Yes Funded Banks and Up to 027 Borrowing up to $3 States official government percent total billion from US Treasury
domestic deposits
Japan 1971 Compulsory No 71000 but No No Funded Banks and 0084 percent of Borrowing up to yen500bn joint in full until government insured deposits from Bank of Japan
year 2000 subject to Ministry of Finance approval
Canada 1967 Compulsory No 40800 No Yes Funded Banks and 033 percent of Borrowing up to C$6 official government insured deposits billion authorized further
(maximum) borrowing subject to parliamentary approval
Germany 1966 Compulsory Yes 90 percent Yes No Funded Banks only 003 percent of Annual levy may be private coinsurance deposits doubled
to 22000
Italy 1987 Compulsory Yes 125000 Yes No Unfunded Banks and Callable Two options defer private government (maximum of payment or diminish
1 percent of compensation to be paid total deposits)
(table continues next page)
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108W
OR
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CA
PIT
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MA
RK
ET
S
Table 29 Deposit insurance schemes in the G-10 countries Explicit safety net (continued )
Coverage limit(dollar Foreign
equivalent currency Interbank Source Bankrsquos Contingency fundingDate Membership Co- at end of deposit deposit of premium from banks
Country established managementa insuranceb July 1998)c covered covered Fundingd funding costs or governments
Netherlands 1979 Compulsory No 22000 Yes No Unfunded Banks and On demand Government backing official government maximum of subject to parliamentary
5 percent of own approval funds
France 1980 Compulsory No 65400 No No Unfunded Banks only Callable (on Extra calls up to FFr1000 private demand calls million can be made in
up to FFr200 a 5-year period million)
Switzerland 1984 Voluntary No 19700 No No Unfunded Banks only Callable (on Underwritten by member official demand) banks
Sweden 1996 Compulsory No 31400 Yes No Funded Banks and 05 percent of Full emergency coverage official government deposits while replacing it with a
limited system after the emergency
Belgium 1974 Compulsory No 16600 No No Funded Banks and Callable 002 None insurance limited joint 22000 in government percent of to assets in fund
year 2000 deposits from clients
Spain 1977 Compulsory No 16439 Yes No Funded Banks and 02 percent of Government backing joint government deposits through the Banco de
(maximum) Espantildea subject to approval by royal decree
a Bank membership in the fund can be either compulsory or voluntary and the management of the fund can be official and official and private joint or privateb Coinsurance refers to the situation where depositors face a deductible against their insured fundsc Coverage limit refers to the explicit amount the authorities promise to insured Funded scheme means that it is funded ex ante unfunded otherwise
Sources Goodhart (1995) Demirguccedil-Kunt and Detragiache (2000) Demirguccedil-Kunt and Sabaci (2000)
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 109
base Explicit safety net protection also varies but only Canada focuseson the protected class33 All G-10 countries specify a limit on depositorprotection Under FDICIA the insurance fund is prohibited from pro-tecting uninsured depositors or creditors at a failed bank although adiscretionary system-wide override is provided for exceptional circum-stancesmdashbut with stringent requirements for consultation and account-ability Other G-10 countries allow for contingency funding from the publicpurse alongside unwritten lender-of-last-resort support Among large banksa significant and growing portion of deposit liabilities including foreigncurrency and interbank deposits are uninsuredmdashbut depositors assumethey will be protected in a crisis
FDICIA also made some significant qualitative changes to address theprincipal-agent problem by penalizing weak banks and rewarding strongbanks For example banks whose capital declined faced progressivelytougher regulatory sanctions that for example required them to elimi-nate dividends restrict their lending and change their managementsRegulators have also been forced to take prompt corrective action (toreduce the practice of regulatory forbearance in hopes that a bankrsquos for-tunes might improve)34 Unfortunately comparative qualitative assess-ments across the G-10 are difficult to make due to lack of information35
This discussion highlights the complexity of evaluating the extent towhich prudential supervision and market discipline reduce the moralhazard associated with G-10 safety nets Our argument is that publicsafety nets in the G-10 can be linked to banking instability in other coun-tries specifically in the emerging-market economies that have attractedG-10 cross-border bank lending This lending is a leading source of vola-tility in capital flows the large financial institutions many of which arecomplex banking organizations are based in and regulated by authori-ties in the G-10 economies These two features of the international finan-cial system are closely related although it is not possible to test thisrelationship econometrically
Two World Bank studies however indicate a basis for concern Onestudy is a cross-country econometric analysis of the relationship betweenbank stability and deposit insurance (Demirguccedil-Kunt and Detragiache2000) which found a negative relationship Their estimated model forbanking crises in a sample of 61 countries (both industrial and develop-ing) suggests that explicit deposit insurance raises the probability of acrisis by at least 30 percent36 Crises are especially likely in countries
33 Japanrsquos legislation says it does but recent experience shows this is not the case34 See Goldstein (1997) for a summary of the changes35 See Barth Nolle and Rice (2000) for a beginning in this area36 Demirguccedil-Kunt and and Detragiache (2000 table 1) report a logit coefficient of 0696with a standard error of 0397 (the coefficient is significant at the 8 percent threshold)This suggests that the ldquotruerdquo coefficient could well be as small as 030 (the reportedvalue minus the standard error)
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110 WORLD CAPITAL MARKETS
with immature financial supervisory systems (and not in the G-10) buttheir analysis does underscore the view that deposit insurance weakensmarket discipline37
An earlier World Bank analysis established similar results One wasthat market discipline is undermined by deposit insurance schemes an-other was that illiquid banks are forced to pay more for their funds un-less a generous deposit insurance scheme is in place (Demirguccedil-Kuntand Huizinga 1999) This econometric study also provides clear-cut evi-dence that depositor monitoring of banks declines with the existence ofdeposit insurance schemes At the heart of the problem is the questionof whether deposit insurance is accompanied by increased governmentmonitoring
This evidence and the weight of other arguments suggests that moralhazard is still an issue in the G-10 countries Consider the ongoing de-bate about instilling greater market discipline on risk taking by banksAt one extreme is the perennial proposal to do away with safety netsleaving markets to monitor the players and to force adjustments but toprotect small savers by creating ldquonarrow banksrdquo such as postal savingsystems that are allowed to invest these savings only in risk-free gov-ernment securities Whatever the merits of narrow banking this solutionis too extreme to be politically feasible
A moderate alternative is to force more disclosure by financial institu-tions to facilitate market monitoring But transparency has its own prob-lems Persaud (2000) argues that financial markets cannot reliably discernsustainable from unsustainable positions in the short term This uncer-tainty causes banks to ldquoherdrdquo behind market leaders to exploit theirsupposedly superior information ldquoThe more herding investors and bankersknow about what each other is up to the [more] unstable markets maybecomerdquo The implication is that greater transparency in the marketplaceby itself will not solve the problemmdashand in the short term more informa-tion may exacerbate herding Further supervisory steps (discussed in thenext chapter) are required
Yet another proposal is to promote private-sector involvement in bankmonitoring through market-based alternatives such as Calomirisrsquos sub-ordinated debt proposal (Calomiris 1997 Federal Reserve Board 1999)Banks could be required to issue and maintain a minimum amount of
37 Other findings in the Demirguccedil-Kunt and Detragiache (2000) study include thesepropositions The impact of deposit insurance on bank stability tends to be stronger themore extensive is the coverage offered to depositors when the scheme is funded andwhere the scheme is run by the government rather than by the private sector Con-versely deposit insurance is detrimental to bank stability where bank interest rates havebeen deregulated and where the institutional environment is weak Additional findingson deposit insurance are reported from a recent World Bank conference (8-9 June 2000httpwwwworldbankorgresearchinterestconfsupcomingdeposit_insurancehomehtm)Also see Smalhout (2001)
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 111
subordinated debt (eg uninsured certificates of deposit) to finance asmall fraction (such as 2 percent) of their total nonreserve assets Thesubordinated debt would be allowed to earn a set yield no more than 50basis points over the risk-free yield on government treasury bills Thisrule would supposedly force banks to operate in a safe manner Other-wise subordinated debt holders would redeem their uninsured certifi-cates of deposit and equity investors would sell their bank shares Despiteits practical problems the beauty of the subordinated debt requirementis that it enlists market incentives to push banks to avoid excessive port-folio risk38
The thrust of these proposals is very relevant to the arguments in ourstudy Even in the G-10 countries government monitoring by itself hasnot eliminated moral hazard among banks More work is needed to in-troduce market monitoring and to improve the incentive structures bothfor financial institutions and their supervisors We return to this issuewith our recommendations in the next chapter
38 In late 1996 Argentina began requiring its banks to finance 2 percent of total depos-its in the form of subordinated debt but without a maximum yield provision TheArgentine authorities expect that market discipline will act in concert with the publicsafety net One obvious problem with the subordinated debt proposal is that banks mayencourage some of their customers to buy the subordinated debt
Portfolio Institutions Tomorrowrsquos Problem
Before proceeding to the issues of international supervision we flag an-other potential problem for national regulators The big asset managersprofiled in tables 24 and 26 answer to diverse groups of pensionersshareholders and policyholders They allocate funds across a number ofcountries to diversify their risks They hold liquid assets that can be tradedand they have a higher proportion of long-term assets than banks Eco-nomic shocks can be absorbed through price changes and their effectsspread across time and markets Thus when conditions change in a par-ticular market they are more likely to ride out the storm than to flee Inother words they have less incentive than banks to pull their invest-ments in the face of adversity In the 1990s most large asset managersestablished a record of ldquoriding out the stormrdquo rather than ldquorunning withthe windrdquo although as we saw in chapter 1 instances of running withthe wind were detected in some portfolios As we write these insti-tutions have a good record overall in the emerging markets so whyworry
The Russian crisis and the near-collapse of LTCM previewed the dan-gers that may await future portfolio managers and G-10 financial minis-ters We have presented evidence indicating a systemic bias toward bank
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112 WORLD CAPITAL MARKETS
lending and debt finance to emerging markets and we have argued forsubstitution toward equity finance and direct investment39
That is not the end of the story We noted in the previous chapterthat institutional investors can become momentum investors selling in adownturn As more portfolio capital is invested in emerging marketssome players may adopt the high-risk high-leverage strategies of themost aggressive hedge funds Indeed the data in box 11 show that G-10portfolio investors held somewhat more long-term debt (more than $500billion) than equity (less than $400 billion) in emerging markets at theend of 1997 Long-term debt is an ideal vehicle for high-risk high-leveragestrategies These strategies practiced on a large scale could compound afuture crisis harming emerging markets A big enough crisis could inturn pressure G-10 central banks and finance ministers to arrange bail-out plans Instead of shrinking as a systemic financial problem moralhazard could increase
National securities regulators are the first line of defense against thisscenario They play a critical role in the safe evolution of capital mar-kets But regulators today are mandated to approve the issuance of newsecurities and to monitor the continuing disclosure of material informa-tion by issuers They are far less concerned with or empowered to monitorthe behavior of the increasingly large wealth-management firms that arethe major purchasers (and therefore resellers) of these securities
Within their mandates the goals of national securities regulators (table210 and appendix B) are similar to the concerns of bank regulators withsystem safety and soundness Their focus is also on the incentive sys-tems for management and boards of directors and on disclosure by cor-porations that issue marketable securities such as shares bonds andasset-backed securities 40 Issuers of securities possess greater knowledgeabout the quality of these assets than do the purchasers hence investorprotection is a key concern of regulators Moreover market disciplineworks best when markets know what is happening Well-functioning corpora-tions are key agents of wealth creation and social progress Underperform-ing corporations waste resources During recessions bad corporationsget into bad trouble often with severe social consequences Inadequateincentives for managers and inadequate accountability for boards andmanagers thus have negative externalities Regulators play a vital role inexposing weakness so that market disciplines come to bear sooner ratherthan later
Regulatory emphasis is constantly shifting as financial markets evolveand as the macroeconomic environment changes Regulators try to balance
39 See Rogoff (1999) Also see Berlin (2000) for a perspective on the limited role thatbanks play as share owners
40 See Habib and Ljungqvist (2000) for recent empirical analysis showing that corporateshare market values are higher when corporate executives have a larger ownership stake
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E P
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113
Table 210 Financial-sector regulation G-10 countries 2000
Financial institutions and their supervisors
Country and supervisory structure Retail banking Wholesale banking Securities Insurance
Financial conglomeratesFinancial Services Authority (FSA) = umbrella supervisor
United Kingdom FSA FSA FSA FSA
Treasury bull Commercial banks bull Investment funds (Securities and (Insurance Directorate(Securities and Investments Board) bull Unit trust groups Futures Authority) of the Treasury)
Bank of bull Building societies bull Pension funds England (Building Societies Commission) bull Merchant banks
bull Friendly societies bull Clearing houses bull Primary issuers bull Insurance FSA (Friendly Societies Commission) bull Venture capital of securities companies
bull Pensions and life insurance etc bull Stock exchanges bull Insurance brokers(Personal Investment Authority) bull Stockbrokers
Financial holding companiesFederal Reserve (FR) = umbrella supervisor
United States bull National banks(OCC) Securities and Regulated by
Treasury OCC bull State banks Federal Reserve Exchange Commission StatesMembers (FR)
OTS Nonmembers (FDIC) bull Investment banks bull Primary issuers of bull Insurance companies FR bull Cooperative banks (FDICFR) bull Finance companies securities bull Insurance brokers FDIC bull Insured industrial banks (FDIC) bull Stock exchanges
bull Thrift holding companies (OTS) bull Stockbrokers SEC bull Savings banks (OTSFDICFR) bull Investment advisors
bull Savings and loan associations bull Mutual funds(OTS) bull Public utility holding
bull Edge Act corporations (FR) companies
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Table 210 Financial-sector regulation G-10 countries 2000 (continued )
Financial institutions and their supervisors
Country and supervisory structure Retail banking Wholesale banking Securities Insurance
Financial holding companies Japan Financial Supervisory Authority (FSA) = umbrella supervisor
Prime FSA FSA FSA FSA ministerrsquos Ministry of office Finance (Securities and Exchange
Surveillance Commission) FRC Bureau of Financial bull City banks bull Investment banks bull Primary issuers of bull Insurance companies FSA Regulation bull Regional banks bull Asset managers securities bull Insurance brokers
bull Trust banks bull Stock exchanges SESC bull Long-term credit banks bull Stockbrokers
bull Pension funds
Financial holding companiesOffice of the Superintendent of Financial Institutions (OSFI) = umbrella supervisor
Canada Regulated by OSFI OSFI provinces OSFI
Department of Financebull Banks bull Cooperative credit bull Primary issuers of bull Insurance companies
(previously Office of the Inspector associations securities (previously Depart- OSFI General of the Banks) bull Fraternal benefit bull Stock exchanges ment of Insurance) Bank of bull Trust and loan companies society bull Stockbrokers bull Insurance brokers Canada bull Pension funds bull Asset managers
(previously Depart- CDIC ment of Insurance)
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Financial institutions and their supervisors
Country and supervisory structure Retail banking Wholesale banking Securities Insurance
Germany Financial holding groupsFederal Banking Supervisory Office (FBSO) = umbrella supervisor
Ministry of Finance FBSO BSO FSSO FISO
Bundesbankbull Universal banks bull Other financial bull Primary issuers of bull Insurance companies
Federal Banking bull Savings banks institutions (eg securities bull Insurance brokers Supervisory Office bull Securities banks management foreign bull Stock exchanges
currency dealings) bull Stockbrokers Federal Securities bull Financial enterprises bull Asset managers Supervisory Office (eg leasing bull Pension funds
organizations Federal Insurance credit card companies Supervisory Office investment advisors)
Italy Bank foundationsMinistry of Finance = umbrella supervisor
Ministry of Finance Bank of Italy Bank of Italy Consob ISVAP
Bank of Italy bull Commerical banks bull Asset managers bull Primary issuers of bull Insurance companies Consob bull Savings bank bull Open-end investment securities bull Insurance brokers
bull Securities banks companies (SICAVs) bull Stock exchangesbull Stockbrokers
ISVAP
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Table 210 Financial-sector regulation G-10 countries 2000 (continued )
Financial institutions and their supervisors
Country and supervisory structure Retail banking Wholesale banking Securities Insurance
The Netherlands Financial conglomeratesCouncil of Financial Supervisors = umbrella supervisor
Securities Board Securities Board Netherlandsche Netherlands Bank Netherlandsche Bank of the Netherlands Insurance Board Bank Insurance bull Credit institutions (universal banks bull Investment institutions bull Stock exchanges bull Insurance companies Board cooperative banks security credit (securities issuing bull Stockbrokers bull Insurance brokers
institutions mortgage banks) and tradingmdashprimary The Council of Financial and secondary Supervisors markets)
France Commission des Commission de Operations des Controcircle des
Banking and Banking Commission Bourse Assurances Financial Regulatory bull Ensuring that credit institutions (and investment firms since bull Primary issuers of bull Insurance companies Ministry for Committee the Financial Activity Modernization Act of 1996) comply securities bull Insurance brokers Economic with laws and regulations bull Stock exchanges Affairs and bull Execute instructions regarding all off-site monitoring and bull Stockbrokers Finance Credit on-site supervision Institutions and Banking and Financial Regulatory Committee Investment bull Formulates general regulations for credit institutions and investment firms Committee (capital adequacy requirements accounting rules etc) Bank of France Credit Institutions and Investment Committee Banking bull Authorizes and examines financial institutions except for those within the Commission competence of the Banking Commission
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117
Financial institutions and their supervisors
Country and supervisory structure Retail banking Wholesale banking Securities Insurance
Switzerland Large banking groupSwiss Federal Banking Commission (SFBC) = umbrella supervisor
Swiss National Bank Federal Office of
SFBC SFBC SFBC Private Insurance Swiss Federal Banking Commission bull Universal banks bull Investment banks bull Primary issuers of bull Insurance companies
bull Savings banks bull Asset management securities bull Insurance brokerscompanies bull Stock exchanges
Private audit Federal bull Investment funds bull Stockbrokers firms Office of bull Mortgage bond authorized by Private business SFBC Insurance
Sweden Financial holding company groupsFinancial Supervisory Authority = umbrella supervisor
Ministry of Finance Credit Market Securities Market Insurance Market
Credit Market Department Department Department Department
Financial bull Commercial banks bull Investment funds bull Primary issuers of bull Insurance companies Riksbank Supervisory bull Savings banks securities bull Insurance brokers Authority bull Friendly societies bull Stock exchanges
bull Stockbrokers
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Table 210 Financial-sector regulation G-10 countries 2000 (continued )
Financial institutions and their supervisors
Country and supervisory structure Retail banking Wholesale banking Securities Insurance
Belgium Bank holding companiesBanking and Finance Commission = umbrella supervisor
Bank of Belgium Banking Banking
Banking and Finance and Finance Insurance Controland Finance Commission Commission Commission Office
Banking and Insurance Finance Control bull Commercial banks bull Asset management bull Primary issuers of bull Insurance companies Commission Office bull Savings banks firms securities bull Insurance brokers
bull Securities banks bull Investment funds bull Stock exchanges bull Mortgage companiesbull Stockbrokers bull Pension funds
Securities Regulation Fund Securities Regulation Fund
bull Other investment firms and credit institutions(institutions participating in regulated off-exchangemarket in strips and Treasury certificates)
Bank holding companies Spain Banco de Espantildea = umbrella supervisor
Banco de Espantildea Comision Nacional del Mercado de Directorate General
Banco de Espantildea Valores (CNMV) Insurance
bull All credit institutions (commercial banks savings banks credit bull Primary issuers of (Ministry of Economy Ministry of cooperatives official credit institutions finance factoring and securities and Finance) Economy and CNMV leasing companies mortgage-loan companies etc) bull Stock exchanges bull Insurance companies Finance bull Interbank foreign exchange and book-entry public debt bull Stockbrokers bull Pension funds
markets bull Venture capital(companies and funds)
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119
Financial institutions and their supervisors
Country and supervisory structure Banking Securities Insurance
Banking Advisory High Level Securities Supervisors Committee (BAC) Committee (HLSS) Insurance Committee (IC)
Supranational (EU) bull Formulates standards for prudential bull Coordination of securities market bull Formulates standards forsupervision supervision prudential supervision
BACICHLSS Banking Supervision
Conglomerates Committee (BSC) Securities Contact Committee Regulation of prudential bull Systemic risk monitoring bull Regulation and implementation of supervision securities admission
International Association International International Organization of of Insurance Supervisors
Basel Committee Securities Commisison (IOSCO) (IAIS) Joint Forum Conglomerates Supervision bull Supervision and regulation best bull Supervision and regulation best bull Supervision and regulation amp regulation Best practices practices practices best practices
FSF Coordination across supervisors of various functions
Notes See appendix B for more information Boldface type indicates senior or oversight supervisor normal type indicates adjunct or front-line supervisorsolid line indicates direct responsbility to the senior-ranking authority dotted line indicates coordination in supervisory activities
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Table 210 Financial-sector regulation G-10 countries 2000 (continued )
Glossary of names United Kingdom FSA = Financial Services Authority United States FR = Federal Reserve OCC = Office of the Comptroller of theCurrency FDIC = Federal Deposit Insurance Corporation SEC = Securities and Exchange Commission OTS = Office of Thrift Supervision Japan FRC =Financial Reconstruction Commission FSA = Financial Services Agency SESC = Securities and Exchange Surveillance Commission Canada OSFI =Office of the Superintendent of Financial Institutions CDIC = Canada Deposit Insurance Corporation Germany FBSO = Federal Banking SupervisoryOffice FSSO = Federal Securities Supervisory Office FISO = Federal Insurance Supervisory Office BSO = Banking Supervisory Office Italy Consob =Commissione Nazionale per le Societa e la Borsa ISVAP = Instituto per la Vigilanza sulle assicurazioni private e di Interesse colletivo Switzerland SFBC= Swiss Federal Banking Commission Spain CNMV = The Comision Nacional del Mercado de Valores Supranational BAC = Banking Advisory CommitteeBSC = Banking Supervision Committee IC = Insurance Committee HLSS = High Level Securities Supervisors Committee International Dimension FSF =Financial Stability Forum IOSCO = International Organization of Securities Commission IAIS = International Association of Insurance Supervisors
Sources United Kingdom Bank of England httpwwwbankofenglandcouk Financial Services Authority httpwwwfsagovuk United States Board ofGovernors of Federal Reserve System httpwwwfederalreservegov Japan Bank of Japan httpwwwbojorjo Financial Reconstruction Commissionhttpwwwfsagojpfrcindexehtml Financial Services Agency httpwwwfsagojp Canada Bank of Canada httpwwwbank-banque-canadaca Office ofthe Superintendent of Financial Institutions httpwwwosfi-bsifgccaAndreEindexhtml Germany Deutsche Bundesbank httpwwwbundesbankde Fed-eral Banking Supervisory Office httpwwwbakredde Italy Banca drsquoitalia httpwwwbancaditaliait Commissione Nazionale per le Societa e la Borsahttpwwwconsobit Instituto per la Vigilanza sulle assicurazioni private e di Interesse colletivo httpwwwisvapit The Netherlands De NederlandscheBank httpwwwdnbnl France Banque de France httpwwwbanque-francefr Switzerland Schweizerische Nationalbank httpwwwsnbchindex3htmlSweden Sveriges Riksbank httpwwwriksbanksedefaultasp Belgium National Bank of Belgium httpwwwbnbbesgindexhtm Spain Banco de Espantildeahttpwwwbdees The Comision Nacional del Mercado de Valores httpwwwcnmves Supranational (EU) Institutional Arrangements for the Regulationand Supervision of the Financial Sector 2000 International Dimension Bank for International Settlement httpwwwbisorg International Organization ofSecurities Commissions httpwwwioscoorg International Association of Insurance Supervisors httpwwwiaisorg Financial Stability Forum httpwwwfsforumorg
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 121
the inflexibility of tight surveillance against the need to encourage in-novation and growth The US Securities and Exchange Commission isworried about aggressive accounting by firms and biased reports bysecurities analysts in an equity environment that prizes steadily higherquarterly earnings41 Japanese regulators are preoccupied with opaqueinterconnections between portfolio institutions banks and nonfinancialfirms through the keiretsu system Canadian regulators reeling from high-profile scandals of managers intentionally misleading investors are strengtheningmarket discipline through legal penalties aimed at managers and directorsof offending firms
When panic strikes a securities regulator cannot do much As the 1987stock market crash and the LTCM debacle in the fall of 1998 both dem-onstrated steep stock and bond price declines can create systemic risksIf severe enough the wealth effect of falling securities values and thefear of widespread insolvency can depress real activity Flooding thesystem with liquidity is a central bankerrsquos solutionmdashsomething a securi-ties regulator cannot do42 But just as financial supervisors can changethe incentive structure to discourage bankers from making risky loans ingood times so securities regulators can pay more attention to incentiveson the demand side when capital markets are strong
Prudential Supervision and InnovationmdashA Footnote
In concluding this discussion of prudential supervision in the G-10 anadditional point is worth noting National regulators face a persistenttrade-off between emphasizing financial system safety and soundnesswhile encouraging innovationmdashin spite of the added risks innovationbrings to financial markets Former US Treasury Secretary Lawrence Summers(2000 3) has argued by analogy
The jet airplane made airplane air travel more comfortable more efficient andmore safe though the accidents were more spectacular and for a time morenumerous after the jet was invented In the same way modern global financialmarkets carry with them enormous potential for benefit even if some of theaccidents are that much more spectacular As the right public policy response
41 The problem is illustrated by the divergence since mid-1998 between reported earn-ings by the Standard amp Poorrsquos (SampP) 500 and the after-tax profits of all corporations inthe national accounts Generally these two series move closely with one another Be-tween mid-1998 and mid-1999 SampP 500 reported that earnings increased by more than20 percent while after-tax profits of all corporations increased by less than 5 percent(Chase Bank US Economic and Policy Research US Weekly Prospects Chase SecuritiesWeekly Newsletter 5 June 2000 5)
42 For example the US Securities and Exchange Commission had no direct role in calmingmarkets in the 1987 or 1998 panics
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122 WORLD CAPITAL MARKETS
to the jet was longer runways better air-traffic control and better training forpilots and not the discouragement of rapid travel so the right public policyresponse to financial innovation is to assure a safe framework so that the ben-efits can be realized not to stifle the change
Accepting Summersrsquos analogy for the international financial system better-informed supervisors and investors are a necessary part of the financialsystem framework Supervisors require more timely information on therisk profiles resulting from positions taken by financial institutions Theyalso need a better understanding of risk-management systems Snapshotsof an institutionrsquos risk profile and risk-management procedures are nolonger adequate In a world where huge bets are quickly made (andpossibly lostmdashas with Barings Bank in 1995 and LTCM in 1998) super-visors must focus on the soundness of banking systems for evaluatingand managing risk on a daily basis Some progress has been made inaddressing these issues US banking examiners are extending their in-formation requirements in banking examinations and increasing theirinvolvement in large complex institutions43 More awareness is alsorequired of the fact that they are national organizations in a world ofcross-border capital flows To a much greater extent they need a multi-national reach International supervision and coordination among super-visors are the subject of the next section
Our analysis suggests that G-10 supervisors have unfinished businessBank supervisors need to start yesterday securities regulators can waituntil tomorrow One G-10 member acting alone cannot correct the biasIn good times the lending business will simply migrate to other G-10banks In bad times financial problems will not stop at the national bor-der A way has to be found to establish common international standardsfor the key financial players in order to prevent crises and to agree onapproaches for managing them The path has already been laid out Inthe wake of the bank failures of the past 25 years bank supervisors havetried to establish such standards They have done this without creating anew global institution
The essence of the international framework is decentralizationmdashglobalrules and design standards without global institutions that are perceivedto intrude on national sovereignty The awkward jargon for this frame-work is vertical subsidiaritymdashldquothink internationally act nationallyrdquo Theinternational thinking is done by a committee of regulators that meets
International SupervisionA Decentralized Framework
43 These issues are discussed in Ferguson (1999) and Meyer (2000a)
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 123
regularly at the Bank for International Settlements in Basel The commit-tee establishes principles and standards that are interpreted implementedand enforced by national authorities44 In this section we describe thesesupervisory efforts and their weaknesses We present our recommenda-tions for addressing these weaknesses in the next chapter
Basel I
The Basel Capital Accord of 1988 (Basel I)45 drew the lesson from thefinancial crises of the mid-1970s that more adequate capital levels in in-ternational banks would help reduce the systemic risk of bank failureThe primary goal of Basel I was capital adequacy other standards wereput in place not so much for their own virtue as to defend the primarygoal
Capital adequacy requirements were designed to ensure that individualinstitutions have the ability to absorb losses particularly credit lossesAccordingly a backup system of scoring credit risk was devised thatrequired large amounts of bank capital for some types of loans smalleramounts for others and zero for a select list of preferred assets Report-ing requirements were designed to disclose problems and ensure that atroubled bank would take timely steps to restore its capital base in thewake of a loss The Basel I framework worked tolerably well in limitingthe call on the public purse in the G-10 countriesmdashwith the notable ex-ceptions of France and Japan The framework failed to moderate riskybank lending to emerging markets however
Basel I was not developed with emerging markets in mind The origi-nal idea behind it was to develop a common supervisory approach tocross-border banking operations It grew out of political pressure fromUS lawmakers who were determined to require international banks op-erating in the United States to meet US banking standards Toward thisgoal in 1983 Congress passed the International Lending Supervisory ActUS and British banking authorities subsequently agreed on a commontarget the adoption of strict common capital-adequacy standards In 1988other G-10 governments agreed to go along voluntary acceptance ofthe standards throughout much of the rest of the world followed46 Therationale for the capital targets was two-fold The first was to requirebanks to hold sufficient amounts of capital (8 percent of risk-adjusted
44 The international committee of financial authorities agreed on a common definitionof banksrsquo tier-one or ldquocorerdquo capital national authorities defined tier-two capital in theirown manner which permitted greater variations in national working definitions andpractices
45 International Convergence of Capital Measurement and Capital Standards (BIS 1988)was prepared by the Basel Committee on Banking Supervision
46 See Reineke (1998)
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124 WORLD CAPITAL MARKETS
assets) to cushion losses on those assets The second was to dull theirappetites for risk banks with large capital bases would have more tolose if they failed and therefore would take fewer risks
Rapid change in financial markets soon revealed flaws in the Basel IAccord In a complex world with numerous sources of risk it focusedheavily on credit risk but overlooked other risks in a bankrsquos portfolioand the correlation between returns on different asset classes The Baselformula required banks to maintain a fixed amount of capital againsteach of its asset classes But the formula did not distinguish the riskinessof the borrower within each class As a result one large loan to a low-risk corporate borrower such as General Electric would require the sameamount of capital as 10 smaller transactions with high-risk borrowers
The system was also biased toward short-term loans Loans maturingin less than a year required a 20 percent risk weight whereas those ma-turing after more than a year required a 100 percent risk weight Inter-bank lending was particularly favored For example loans to banks inOECD countries required less capital than loans to private firms in thesame countries creating the anomaly that interbank loans to South Ko-rean banks required less capital than loans to General Electric47 Thisanomaly encouraged banks to shed high-quality assets if the Basel rulesrequired the allocation of more capital than banks thought they needed
Another weakness was that financial innovators quickly circumventedthe Accord Because short-term loans required less provisioning than long-term loans banks responded by securitizing their long-term debt port-folios and lending short-term against the collateral of the newly createdasset This allowed banks to circumvent the capital requirements gearedto the terms of the underlying debt At the same time the Basel I Accordfailed to encourage risk mitigation techniques such as credit derivativescollateral guarantees and on-balance-sheet netting the flip side of fi-nancial innovation Because off-balance-sheet products were not coveredby the Accord another anomaly appeared when Barings Bank collapsedin 1995 Barings met capital adequacy standards but collapsed becauseits systems for managing risk failed traders were allowed to speculatein futures contracts that did not appear on the balance sheet
Basel II
Work to overhaul Basel I began in 1995 and produced consultativepapers issued in June 1999 and January 200148 These papers have been
47 South Korean banks have had notoriously weak balance sheets because the practiceof ldquodirected lendingrdquo left them with many poor loans (in making these loans the bankswere expected to follow government objectives rather than creditworthiness criteria)
48 Basel Committee on Banking Supervision (1999 2001)
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 125
the subject of extensive consultation and revision as a result the newAccord is expected to be introduced in 200449 The Basel II frameworkhas three parts (pillars) revisions to Basel I minimum-capital require-ments supervisory review criteria and greater emphasis on market dis-cipline Broadly Basel II aims to maintain the level of capital in the sys-tem but achieve better alignment of banksrsquo capital with their risk pro-files and keep up with financial innovation
To align capital requirements with market realities (the first pillar)Basel II concentrates on the 100 or so largest banksmdashthe type of playerslisted in table 21mdashand on the holding-company parents of banking groups50
Capital requirements will differentiate between an increased number ofcredit groups or ldquorisk bucketsrdquo including claims on governments otherbanks corporations mortgage-backed securities and other asset-backedsecurities
Basel II originally proposed to use external ratings to set capital chargesfor a number of these credit risks Many banks objected arguing thatthey assess credit risk better than Standard amp Poorrsquos Moodyrsquos or FitchIBCA51 Basel II thus proposes two approaches to rating a standard ap-proach using external ratings and an ldquoadvancedrdquo approach that allowsselected banks to use their own internal rating systems To encouragethe development of rigorous internal control systems based on these in-ternal rating systems Basel II also proposes to levy capital charges foroperational risk (the risk of direct or indirect loss resulting from inad-equate or failed internal processes people and systems or from exter-nal events)
Some critics of this proposal dismiss it as an abrogation of the prin-ciple of external independent monitoring and as ldquodangerously naiumlverdquo52
But regulators argue that the new capital charge on operational risk shouldoffset this concern It is also far from clear how cross-national compari-sons of rating and internal risk-assessment systems will be made (Engelen2000) The development by the European Union of its own capital rulescould well complicate the international resolution of these issues Publicassurances by EU officials in January 2001 however indicated that theirmain concerns are to create a level playing field and avoid regulatoryarbitrage (Hargreaves 2001) There is also the significant problem ofthe procyclical character of risk weights When a crisis hits losses are
49 See Berry (2000) for an update in an interview with William J McDonough chair ofthe Basel Committee on Banking Supervision
50 For obvious reasons these proposals are addressed to large banks and simpler capi-tal standards are allowed for small banks that focus on their domestic credit markets
51 See Ammer and Packer (2000) for an empirical critique of the success of rating agen-cies in distinguishing risk by sector and region
52 See Auerback (2001)
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126 WORLD CAPITAL MARKETS
incurred or accrued capital is lost and loan exposure must be reducedor securities sold to restore the requisite capital-adequacy ratios A morerisk-sensitive framework could amplify volatility
As the second pillar of Basel II supervisory review criteria are beingbeefed up to encourage supervisors to intervene earlier in potential problemsituations and to compel banks to align their capital positions with theirrisk profiles Bank supervisors will be authorized to require banks tohold capital in excess of minimum requirements if they have concernsabout general management overall strategy risk-management performanceor the macroeconomic environment Of course if one G-10 supervisorimposes higher capital requirements in isolation the same disparity willemerge that presaged Basel I Some banks will be disadvantaged in theinternational marketplace and will loudly complain that excessive super-vision is driving business to their competitors Hence close internationalcooperation among supervisors is critical
To implement the third pillar market discipline banks will be requiredto make fuller more timely disclosure of capital adequacy and the risksto which that capital is exposed A number of measures are being stud-ied that might help supervisors evaluate bank performance such as com-parisons of uninsured deposit interest rates subordinated debt yieldsand equity prices The idea is that these yields and prices might alertsupervisors to market perceptions of risk Of course market perceptionsare only as good as market information More direct and controversialways to reinforce market discipline would dramatically increase publicdisclosure of bank positions and risk management systems
Many questions are still outstanding about how to resolve the techni-cal details of capital requirements and whether the requirements willachieve their intended goal of better assessment and mitigation of therisks in banksrsquo portfolios There is no substitute for skilled supervisorsThe intricacies of effective design and implementation suggest that su-pervisors need to be highly competent technically knowledgeable aboutbanking portfolio characteristics and the factors that influence bank ex-posure to credit risk (Mishkin 2000) And they must be aided by vigilantshareholders market forces and transparency of information53
Standard setting at the global level is desirable but ultimately theeffectiveness of these efforts will be tested at the national level espe-cially in times of systemic financial distress Here the record of Basel Iwas not a bright shining success Japanese banking regulators havetraditionally allowed banks to include real estate and securities in theircapital base When the value of these assets plummeted in the early 1990sregulators allowed banks to continue valuing these depreciated (andoften bankrupt) assets at their old inflated levels Japanese authorities
53 Benedict Roth Complacency Towards Catastrophe Financial Times 23 January 2001
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 127
insisted until the mid-1990s that eroded capital bases could be rebuiltin a market-driven fashion They rightly foresaw that huge loan losseswould undermine public support for the ruling party and require a po-litically unpopular bailout
Japanese foot dragging on Basel I was the worst54 but not uniqueOther examples can be found of ldquopolitically mandated forbearancerdquo TheFederal Reserve Bank of New York held important hands during theLTCM crisis of 1998 Mexico is still resolving the banking crisis that eruptedin 1995 South Korea has not yet closed the insolvent banks that behavedso badly before the crisis of 1998 In the aftermath of a crisis nationalregulators cannot always be relied upon to discipline politically power-ful bankers55 One of the little-noticed consequences of these differingapproaches is that those banks with strong regulatory systems receivedan implicit ldquoexport subsidyrdquo for their services US banks which had notengaged extensively in emerging-market lending in the 1990s were bet-ter positioned than their German and Japanese counterparts to expandtheir international assets in the wake of the crises
Other Financial Forums
54 See Japanese Banks Fiddling while Marunouchi Burns The Economist 27 January2001 67-69
55 See Calomiris (1997)
The Basel model of vertical subsidiarity has already been extended toother financial regulatory bodies In 1993-94 the BIS established a Tri-partite Group of Banking Insurance and Securities Regulators In 1994-95 the BIS increased its cooperation with the International Organizationof Securities Commissions when the two organizations issued parallelpapers on guidelines for national regulators concerning risk managementand disclosure of derivative trades In 1996 a permanent Joint Forum onFinancial Conglomerates was established to examine supervisory issuesand develop working arrangements among the different functional super-visors of conglomerate institutions that offer combinations of bankingsecurities and insurance products Draft papers on the supervisionof conglomerates were released for comment in 1998 applying capital-adequacy principles to these groups and providing guidelines both forassessing the integrity and competence of top managers and for sharingassessments between regulators
In 1997 the Basel Committee on Banking Supervision extended itsreach beyond capital standards to broader aspects of banking supervi-sion with the publication of the Core Principles for Effective BankingSupervision In 1999 a wide range of regulatory and standard-settingbodies were gathered under the umbrella of the Financial Stability
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128 WORLD CAPITAL MARKETS
Forum (FSF) itself established under BIS aegis56 The FSF has alreadyissued recommendations for stepped-up supervision and transparencyas well as guidelines for best practices in a number of areas includingoffshore financial centers and highly leveraged institutions or hedge funds57
Conclusion
Although the structural weaknesses in emerging-market economies arewidely acknowledged to have been causal factors in international capi-tal-market volatility this chapter points to the role of large G-10 bankingorganizations as major suppliers of the most volatile instrument short-term debt We have examined evidence of the impact of public safetynets in the G-10 economiesmdashthe deposit insurance systems the pruden-tial supervisory systems and the lender-of-last-resort functions of centralbanksmdashon the incentive structures of these organizations
Although supervisors in most countries working nationally and to-gether in the BIS have made significant efforts to mimic market forcesin their prudential supervision the most sophisticated financial institu-tions find innovative ways to circumvent the rules New global regulatorybodies are not about to be created G-10 national bank regulators shouldthemselves address the short-term debt bias in the international financialsystem by changing incentive systems G-10 securities regulators shouldalso take steps to get ahead of the curve paying close attention to largeportfolio swings by institutional investors particularly in times of crisisIn short more needs to be done at national and international levels tochange the rules of the game That is the subject of the next chapter
56 The Financial Stability Forum includes banking securities insurance and accountingregulatory bodies the OECD on taxation corruption and corporate governance and theIMF
57 See Martin (2000)
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100 WORLD CAPITAL MARKETS
financial loss or damage reputations Operational risk devastated BaringsBank in 1995
Financial institutions practice risk management to measure all theserisks the potential damage to their investment positions and ultimatelythe chance of becoming insolvent VAR (value at risk) risk models mea-sure subject to certain assumptions the amount of the firmrsquos capital thatis exposed in each period For example the VAR model might say thatin a 3-standard-deviation worst case (a case that is not supposed to hap-pen more than 1 percent of the time) the firm will loose 25 percent of itscapital during the next year
VAR models are widely used but like all models they have weak-nesses They rely on past values to estimate key variables in financialmarkets past values are not always good predictors of future risks More-over rising volatility and higher loss correlation among different assetclasses in a portfolio will cause all banks using these models to reducetheir exposures at the same time by switching to less volatile and lesscorrelated assets such as US Treasury bills (Persaud 2000)
Newer risk models entail stress testing and scenario analysis Scenarioanalysis envisages possible adverse changes one at a time that mightaffect the investment portfolio Stress testing estimates potential losseswhen several individual risk factors simultaneously move against thefirm but it too uses historical probabilities
Financial Volatility
21 For example derivative markets usually rely on underlying securities markets thatproduce continuous prices When these markets are interrupted financial shocks cantrigger a cascade of margin calls and sell orders that move prices very sharply
22 See IIF (1999a)
The combination of trading activity and modern risk management lie atthe root of financial volatility When risks increase banks must eitherraise more capital to cover the greater risk or reduce their exposure bycutting loan exposure by selling securities or by undertaking new de-rivative trades Raising more capital is time-consuming and in a crisisvery expensive because bank shares are depressed So banks look to theother alternatives If the bank can reduce lending it need not book aloss But most banks use the same VAR models and as indicated abovethese models will encourage them to reduce their outstanding loans atthe same time actually magnifying loan volatility
If banks attempt to reduce their exposure to risk by selling securitiesor undertaking new derivative trades they may trigger large priceshocks because of limited and shrinking market liquidity21 The liquid-ity problem is compounded when a small number of large institu-tions hold the same positions22 Take your pick loan volatility or price
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 101
volatility As two experts have observed (Folkerts-Landau and Garber1998)
[V]olatility even in one country will automatically generate an upward re-estimate of credit and market risk in a correlated country triggering automaticmargin calls and tightening of credit lines Thus apparently bizarre opera-tions that connect otherwise disconnected securities markets are not the re-sponses of panicked green screen traders arbitrarily driving economies from agood to a bad equilibrium Rather they work with relentless predictability andunder the seal of approval of supervisors in the main financial centers
23 See Ferguson (1999)
24 As Gerald Corrigan (1982) put the matter ldquoBanks are specialrdquo Corrigan (2000) reit-erated this view even after all the changes of the past two decades Unlike other institu-tions banks offer on-demand transactions are a backup liquidity source for other insti-tutions and serve as a ldquotransmission beltrdquo for monetary policy
These changes in the banking environment accentuate an existing anomalyThe anomaly is that banks even as they grow larger and increasinglyengage in more risky and complex transactions are perceived to enjoyimplicit and explicit public guarantees
The guarantees grow out of an incentive problem inherent in bankingasymmetric information which we mentioned above Depositors know lessabout a bankrsquos management and the quality of its balance sheet than doits managers and shareholders Thus in times of uncertainty or adver-sity bank depositorsmdashuncertain whether they will have access to theirdepositsmdashare prone to bank runs This prospect has in turn compelledgovernments to treat banks differently than other firms because a bankthat fails can disrupt the rest of the economy24
To prevent such crises governments have entered into quid pro quoarrangements with banks Governments provide them both with an im-plicit safety net in the form of an unstated promise by the central bankto act as a lender of last resort in a liquidity crisis and an explicit safetynet in the form of a public deposit insurance fund to reassure depositorsIn return the banks submit to closer government oversight and regu-lation of their activities than is usual for industries in the private sector
The ldquoinsurancerdquo provided by the public safety net contributes to an-other incentive problem moral hazard Banks acquire greater tastes forrisk and face less market discipline than other firms The explicit depositinsurance safety nets actually have or are perceived to have blanketcoverage that extends beyond the retail depositors (households and small
One of the lessons of the 1997-98 crisis must surely be that market par-ticipants and their regulatory supervisors relied too heavily on quantita-tive tools and insufficiently on judgment23
The Anomaly of Modern Banking
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102 WORLD CAPITAL MARKETS
businesses) for which they were originally intended The implicit centralbank safety nets extend in a crisis to nearly all depositors and banksThus banks are both viewed and behave as if they will be bailed out ifthey get into trouble
The existence of a public safety net raises a perennial question Dobanks have an unfair advantage over other financial institutions becauseof the subsidy provided by the safety net This question was at the heartof intensive study and debate in the United States leading up to thepassage in November 1999 of the Financial Services Modernization Act(also known as the Gramm-Leach-Bliley Act) The size of the gross sub-sidy is difficult to estimate despite determined research efforts Somesuggest it is well under 100 basis points and is at least partly offset bythe direct costs of deposit insurance premiums interest payments on bondsissued by the Financing Corporation25 reserve requirements regulatoryexpenses and operational costs associated with collecting deposits26 Con-versely Kwast and Passmore (2000) suggest that banks can expand theirscope far beyond the levels that other financial institutions could reachwith the same equity base but without the public safety net
A related concern in the US debate is whether allowing banks to ex-pand their activities into securities and insurance will ultimately extendthe safety net and add to the subsidy The Financial Services Moderniza-tion Act deals with this issue by maintaining a legal separation betweenbanks and the rest of the banking organization known as large com-plex banking organizations (LCBOs) They must engage in most securi-ties activities and insurance underwriting through separately capitalizedinvestment bank subsidiaries or holding company affiliates This act canbe said to have merely brought US banking laws closer to those of mostother industrial countries (Barth Brumbaugh and Wilcox 2000 BarthNolle and Rice 2000) If the fire wall is well-maintained and stoutly de-fended the safety net will neither expand in practice nor become a sourceof comfort to noncommercial bank subsidiaries of LCBOs
The quid pro quo exacted by governments to offset the subsidy iscloser public-sector monitoring of banksrsquo activities through prudentialsupervision The effectiveness of this closer official scrutinymdashand closermarket monitoringmdashare the subjects of the next section
25 The Financing Corporation was created by Congress in 1987 to sell bonds to raisefunds to help resolve the savings and loan crisis
26 See Levonian and Furlong (1995) Jones and Kolatch (1999) Shull and White (1998)and Whalen (1999a 1999b)
Are G-10 bank supervisors adequately responding In this section we firstassess the case for and compare the structures of prudential supervisory
Prudential Supervision
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 103
systems both within and among the G-10 economies plus Spain andconsider whether these offset the subsidy provided by the public safetynet Despite offsetting regulation and supervision implicit and explicitguarantees by G-10 governments to their banks are still a source of bank-ing instability in the emerging-market economies
National Systems for Prudential Supervision
Governments use prudential supervision to reduce the moral hazard andadverse selection created by their own safety nets Supervisors establishregulations and monitor compliance to limit risk taking and ensure thesafety and soundness of the banking system In a thoughtful analysis ofthe case for prudential supervision Frederic Mishkin (2000) identifiesthe main forms that supervision can take including the tasks of grantingbanking charters and licenses establishing capital requirements settingdeposit insurance premiums and defining disclosure requirements as wellas carrying out bank examinations Bank examiners gather informationfrom banks and evaluate whether they are following the regulatorsrsquo rulesin cases of weakness they are empowered to change banksrsquo behaviorand close them if necessary
Supervisors also may restrict competition define the activities in whichbanks may engage and restrict their asset holdings and separate banksand other financial (or nonfinancial) activities During the past two de-cades the barriers separating commercial banks investment banks in-surance firms and securities firms have been all but eliminated (tableB1) Deregulation has stimulated competitive forces that drive diversifi-cation and consolidation of the financial industry nowhere faster than inthe United States
The Financial Services Modernization Act of 1999 confirmed this trendIt eliminated restrictions dating back to the Glass Steagall Act of 1933which once prevented banking insurance and securities firms fromentering each otherrsquos businesses (Barth Brumbaugh and Wilcox 2000)Cross-pillar mergers among banks insurance and securities firms arewell under way to form giant financial holding companies The 1999merger between Citibank (banking) and Travelers (insurance) created themodel for megafinance and confirmed new challenges for supervisors
Mishkin (2000) notes the corresponding evolution in US supervisionfrom an emphasis on rules-based regulation (detailed rules for opera-tional behavior and the quality of line items in the balance sheet) to anapproach that stresses the soundness of bank management practices es-pecially risk management
Appendix B outlines the systems of financial supervision now in theplace in the G-10 countries plus Spain Some systems like the UK andCanadian approach are models of simplicitymdashorganized to keep pacewith the spreading reach of financial conglomerates Other systems like
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104 WORLD CAPITAL MARKETS
the US and French approaches show traces of the bureaucratic divisionsthat made sense in an era when banking securities and insurance weresharply separated
The US Model
27 See Meyer (1999a)
28 Canada has a similar degree of simplification with the exception that securities firmsare still regulated by provincial authorities
29 See Pratti and Schinasi (1999 67)
30 The agents are the bank regulators and the principals are the taxpayers Agents maypursue their own interests including bureaucratic survival and postgovernment employ-ment opportunities rather than the national interest in banking safety and soundness
The US model of financial regulation delineated in the Financial Ser-vices Modernization Act of 1999 blends functional and umbrella super-vision Bank and thrift regulators oversee depository institutions Newnonbank activities are subject to both functional regulation (eg by theSecurities and Exchange Commission and state insurance examiners) andumbrella supervision (of financial holding companies) by the FederalReserve27
The UK Model
Another supervisory model exists in the United Kingdom as well as inAustralia Canada and Switzerland28 In this model banking supervisionis separated from the monetary policy function The regulatory structureis considerably simplified by relying on a consolidated financial regula-tor separate from the central bank for both banking and nonbankingactivities The remaining question answered differently depending on thecountry is the extent to which the regulator relies on home-country sur-veillance of banks and conglomerates that have a local presence
Regulatory Models Compared
Appendix B provides more detail on the differences in these modelsGerman simplicity contrasts with French complexity In France the bankingcommission is chaired by the governor of the central bank and includesrepresentatives from the Treasury The commission supervises compli-ance with regulations but the central bank inspects banks on behalf ofthe commission29 In countries such as the United States and France withmultiple supervisors and crossover functions internal coordination is criticalAt the same time multiple agencies create regulatory competition Wheneach agency knows what the other is doing transparency within gov-ernment circles can help to limit principal-agent problems of regulation30
The discussion as to where in the public bureaucracy financial super-
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 105
vision should be placed goes back many years Peek Rosengren andTootell (1999) argue that a synergy exists between monetary policy andprudential supervision because information gained in the course of super-vision can increase the accuracy of macroeconomic forecasts A twist tothis argument is that the information on the state of financial institutionsavailable to the central bank as supervisor can facilitate its role as lenderof last resort Conversely there is the concern that a supervisory rolewill compromise the central bankrsquos independence of action with respectto its core mandatemdashmaintaining price stability As these arguments haveplayed out financial supervision has generally been shared between centralbanks and other regulators or placed entirely in the hands of an inde-pendent regulator However in Italy the Netherlands and Spain cen-tral banks are the sole banking supervisor
Goodhart (1995) examined the arguments and evidence for each modeland concluded that there were no overwhelming arguments or evidencefor one or the other31 Going forward a key problem for any financialsupervisory system is dealing with (and closing as necessary) weak banksIf both central banks and other regulators have this responsibility closecoordination between them is critical Another problem is large conglom-erate banks LCBOs Although they are less likely to fail because of thediversification of their assets and liabilities they are more likely to berescued They are also more likely to be multinational enterprises withinternational implications Goodhart observes that regulation of theseentities might be put in the hands of the central bank because it is lessamenable to political pressures In any event the complexity of LCBOoperations suggests that greater supervisory rigor is necessary
The US Congress was persuaded that broad oversight would help containthe moral hazard problem and accordingly gave the Federal Reservethe role of umbrella supervisor with the understanding that the Fed willscrutinize depository activity more intensely than nonbank financial ac-tivities Under this approach LCBOs such as Citigroup are subject tomuch closer monitoring than smaller and simpler institutions32 The USregulatory model requires enormous cooperation between the Fed otherbank supervisors and the functional regulators for insurance and securi-ties but it also benefits from regulatory competition
31 National systems of supervision are path dependent they are determined by the struc-ture of financial institutions and history in each country If Goodhart (1995) is right out-comes are not materially better or worse with one model of supervision rather than another
32 See Ferguson (1999)
Public Safety Nets
One of prudential supervisorsrsquo biggest challenges is to reduce moral hazardFor many years commercial banks engaged in communal self-insurance
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106 WORLD CAPITAL MARKETS
to deal with crises They formed voluntary groups that agreed to rescuetroubled members As financial markets evolved and competition inten-sified banks were no longer willing to play this role Private-sector in-surance is one alternative but moral hazard and adverse selection wouldappear to prevent it from happening Public safety nets have developedbecause of the low probability and high cost of potential bank runs Aclear trade-off is involved The effectiveness of insurance in preventingbank runs is greater the more comprehensive the coverage But the morecomprehensive the coverage the greater the moral hazardmdashbank man-agers bank directors investors and depositors all take on greater risksin the belief that the safety net will protect them against losses
All G-10 countries have compulsory public safety nets for banks (table29) Deposit insurance agencies are officially organized in Canada theNetherlands Sweden Switzerland and the United States organized bythe industry in France Germany Italy and the United Kingdom andjointly organized by the public and private sectors in Belgium Japanand Spain
How well do G-10 governments offset the subsidy provided by thepublic safety net This is a question on which there is substantial debateAs banking organizations have become more complex the challengesthat supervisors face have become more difficult One challenge is toalign the incentives facing bank managers and shareholders with thoseof depositors Another is the principal-agent problem in supervision Wehave discussed the incentive structures for financial institutions but wehave said little about the incentives for supervisors themselves and thedistortions they can generate in the financial system
In one of the many studies of the US savings and loan crisis of the1980s Kane (1989) documented both problems He described managersusing cosmetic approaches to disguise the magnitude of insolvency regulatorspracticing forbearance even though they knew of the deteriorating riskprofiles of the institutions for which they were responsible and legisla-tors increasing deposit insurance without regard for any offsetting changesin supervision A subsequent overhaul of the legislative framework forthe Federal Deposit Insurance Corporation (FDIC) known as the FDICImprovement Act of 1991 (FDICIA) aimed to introduce a clearer incen-tive structure for both regulators and regulated institutions
The changes introduced by this US legislation are worth discussionwith respect to the other G-10 countries as well First FDICIA created astronger signal to management and investors by targeting deposit insur-ance at small depositors only and by risk-weighting the deposit insur-ance premiums paid by banks to reflect their capital adequacy and bankexaminer ratings Among the G-10 countries rated in table 210 depositinsurance premiums vary considerablymdashbut it is not clear that the dif-ferences have much to do with risk-weighting Most G-10 countries em-ploy funding formulas based for example on the total domestic deposit
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Table 29 Deposit insurance schemes in the G-10 countries Explicit safety net
Coverage limit(dollar Foreign
equivalent currency Interbank Source Bankrsquos Contingency fundingDate Membership Co- at end of deposit deposit of premium from banks
Country established managementa insuranceb July 1998)c covered covered Fundingd funding costs or governments
United 1982 Compulsory Yes Larger of 90 No No Unfunded Banks only Callable (subject Parliament may increase Kingdom private percent co- to maximum the maximum payable
insurance to 03 percent of pound125 million advance 33000 total deposits) facility with Bank of
England
United 1934 Compulsory No 100000 Yes Yes Funded Banks and Up to 027 Borrowing up to $3 States official government percent total billion from US Treasury
domestic deposits
Japan 1971 Compulsory No 71000 but No No Funded Banks and 0084 percent of Borrowing up to yen500bn joint in full until government insured deposits from Bank of Japan
year 2000 subject to Ministry of Finance approval
Canada 1967 Compulsory No 40800 No Yes Funded Banks and 033 percent of Borrowing up to C$6 official government insured deposits billion authorized further
(maximum) borrowing subject to parliamentary approval
Germany 1966 Compulsory Yes 90 percent Yes No Funded Banks only 003 percent of Annual levy may be private coinsurance deposits doubled
to 22000
Italy 1987 Compulsory Yes 125000 Yes No Unfunded Banks and Callable Two options defer private government (maximum of payment or diminish
1 percent of compensation to be paid total deposits)
(table continues next page)
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Table 29 Deposit insurance schemes in the G-10 countries Explicit safety net (continued )
Coverage limit(dollar Foreign
equivalent currency Interbank Source Bankrsquos Contingency fundingDate Membership Co- at end of deposit deposit of premium from banks
Country established managementa insuranceb July 1998)c covered covered Fundingd funding costs or governments
Netherlands 1979 Compulsory No 22000 Yes No Unfunded Banks and On demand Government backing official government maximum of subject to parliamentary
5 percent of own approval funds
France 1980 Compulsory No 65400 No No Unfunded Banks only Callable (on Extra calls up to FFr1000 private demand calls million can be made in
up to FFr200 a 5-year period million)
Switzerland 1984 Voluntary No 19700 No No Unfunded Banks only Callable (on Underwritten by member official demand) banks
Sweden 1996 Compulsory No 31400 Yes No Funded Banks and 05 percent of Full emergency coverage official government deposits while replacing it with a
limited system after the emergency
Belgium 1974 Compulsory No 16600 No No Funded Banks and Callable 002 None insurance limited joint 22000 in government percent of to assets in fund
year 2000 deposits from clients
Spain 1977 Compulsory No 16439 Yes No Funded Banks and 02 percent of Government backing joint government deposits through the Banco de
(maximum) Espantildea subject to approval by royal decree
a Bank membership in the fund can be either compulsory or voluntary and the management of the fund can be official and official and private joint or privateb Coinsurance refers to the situation where depositors face a deductible against their insured fundsc Coverage limit refers to the explicit amount the authorities promise to insured Funded scheme means that it is funded ex ante unfunded otherwise
Sources Goodhart (1995) Demirguccedil-Kunt and Detragiache (2000) Demirguccedil-Kunt and Sabaci (2000)
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 109
base Explicit safety net protection also varies but only Canada focuseson the protected class33 All G-10 countries specify a limit on depositorprotection Under FDICIA the insurance fund is prohibited from pro-tecting uninsured depositors or creditors at a failed bank although adiscretionary system-wide override is provided for exceptional circum-stancesmdashbut with stringent requirements for consultation and account-ability Other G-10 countries allow for contingency funding from the publicpurse alongside unwritten lender-of-last-resort support Among large banksa significant and growing portion of deposit liabilities including foreigncurrency and interbank deposits are uninsuredmdashbut depositors assumethey will be protected in a crisis
FDICIA also made some significant qualitative changes to address theprincipal-agent problem by penalizing weak banks and rewarding strongbanks For example banks whose capital declined faced progressivelytougher regulatory sanctions that for example required them to elimi-nate dividends restrict their lending and change their managementsRegulators have also been forced to take prompt corrective action (toreduce the practice of regulatory forbearance in hopes that a bankrsquos for-tunes might improve)34 Unfortunately comparative qualitative assess-ments across the G-10 are difficult to make due to lack of information35
This discussion highlights the complexity of evaluating the extent towhich prudential supervision and market discipline reduce the moralhazard associated with G-10 safety nets Our argument is that publicsafety nets in the G-10 can be linked to banking instability in other coun-tries specifically in the emerging-market economies that have attractedG-10 cross-border bank lending This lending is a leading source of vola-tility in capital flows the large financial institutions many of which arecomplex banking organizations are based in and regulated by authori-ties in the G-10 economies These two features of the international finan-cial system are closely related although it is not possible to test thisrelationship econometrically
Two World Bank studies however indicate a basis for concern Onestudy is a cross-country econometric analysis of the relationship betweenbank stability and deposit insurance (Demirguccedil-Kunt and Detragiache2000) which found a negative relationship Their estimated model forbanking crises in a sample of 61 countries (both industrial and develop-ing) suggests that explicit deposit insurance raises the probability of acrisis by at least 30 percent36 Crises are especially likely in countries
33 Japanrsquos legislation says it does but recent experience shows this is not the case34 See Goldstein (1997) for a summary of the changes35 See Barth Nolle and Rice (2000) for a beginning in this area36 Demirguccedil-Kunt and and Detragiache (2000 table 1) report a logit coefficient of 0696with a standard error of 0397 (the coefficient is significant at the 8 percent threshold)This suggests that the ldquotruerdquo coefficient could well be as small as 030 (the reportedvalue minus the standard error)
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110 WORLD CAPITAL MARKETS
with immature financial supervisory systems (and not in the G-10) buttheir analysis does underscore the view that deposit insurance weakensmarket discipline37
An earlier World Bank analysis established similar results One wasthat market discipline is undermined by deposit insurance schemes an-other was that illiquid banks are forced to pay more for their funds un-less a generous deposit insurance scheme is in place (Demirguccedil-Kuntand Huizinga 1999) This econometric study also provides clear-cut evi-dence that depositor monitoring of banks declines with the existence ofdeposit insurance schemes At the heart of the problem is the questionof whether deposit insurance is accompanied by increased governmentmonitoring
This evidence and the weight of other arguments suggests that moralhazard is still an issue in the G-10 countries Consider the ongoing de-bate about instilling greater market discipline on risk taking by banksAt one extreme is the perennial proposal to do away with safety netsleaving markets to monitor the players and to force adjustments but toprotect small savers by creating ldquonarrow banksrdquo such as postal savingsystems that are allowed to invest these savings only in risk-free gov-ernment securities Whatever the merits of narrow banking this solutionis too extreme to be politically feasible
A moderate alternative is to force more disclosure by financial institu-tions to facilitate market monitoring But transparency has its own prob-lems Persaud (2000) argues that financial markets cannot reliably discernsustainable from unsustainable positions in the short term This uncer-tainty causes banks to ldquoherdrdquo behind market leaders to exploit theirsupposedly superior information ldquoThe more herding investors and bankersknow about what each other is up to the [more] unstable markets maybecomerdquo The implication is that greater transparency in the marketplaceby itself will not solve the problemmdashand in the short term more informa-tion may exacerbate herding Further supervisory steps (discussed in thenext chapter) are required
Yet another proposal is to promote private-sector involvement in bankmonitoring through market-based alternatives such as Calomirisrsquos sub-ordinated debt proposal (Calomiris 1997 Federal Reserve Board 1999)Banks could be required to issue and maintain a minimum amount of
37 Other findings in the Demirguccedil-Kunt and Detragiache (2000) study include thesepropositions The impact of deposit insurance on bank stability tends to be stronger themore extensive is the coverage offered to depositors when the scheme is funded andwhere the scheme is run by the government rather than by the private sector Con-versely deposit insurance is detrimental to bank stability where bank interest rates havebeen deregulated and where the institutional environment is weak Additional findingson deposit insurance are reported from a recent World Bank conference (8-9 June 2000httpwwwworldbankorgresearchinterestconfsupcomingdeposit_insurancehomehtm)Also see Smalhout (2001)
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 111
subordinated debt (eg uninsured certificates of deposit) to finance asmall fraction (such as 2 percent) of their total nonreserve assets Thesubordinated debt would be allowed to earn a set yield no more than 50basis points over the risk-free yield on government treasury bills Thisrule would supposedly force banks to operate in a safe manner Other-wise subordinated debt holders would redeem their uninsured certifi-cates of deposit and equity investors would sell their bank shares Despiteits practical problems the beauty of the subordinated debt requirementis that it enlists market incentives to push banks to avoid excessive port-folio risk38
The thrust of these proposals is very relevant to the arguments in ourstudy Even in the G-10 countries government monitoring by itself hasnot eliminated moral hazard among banks More work is needed to in-troduce market monitoring and to improve the incentive structures bothfor financial institutions and their supervisors We return to this issuewith our recommendations in the next chapter
38 In late 1996 Argentina began requiring its banks to finance 2 percent of total depos-its in the form of subordinated debt but without a maximum yield provision TheArgentine authorities expect that market discipline will act in concert with the publicsafety net One obvious problem with the subordinated debt proposal is that banks mayencourage some of their customers to buy the subordinated debt
Portfolio Institutions Tomorrowrsquos Problem
Before proceeding to the issues of international supervision we flag an-other potential problem for national regulators The big asset managersprofiled in tables 24 and 26 answer to diverse groups of pensionersshareholders and policyholders They allocate funds across a number ofcountries to diversify their risks They hold liquid assets that can be tradedand they have a higher proportion of long-term assets than banks Eco-nomic shocks can be absorbed through price changes and their effectsspread across time and markets Thus when conditions change in a par-ticular market they are more likely to ride out the storm than to flee Inother words they have less incentive than banks to pull their invest-ments in the face of adversity In the 1990s most large asset managersestablished a record of ldquoriding out the stormrdquo rather than ldquorunning withthe windrdquo although as we saw in chapter 1 instances of running withthe wind were detected in some portfolios As we write these insti-tutions have a good record overall in the emerging markets so whyworry
The Russian crisis and the near-collapse of LTCM previewed the dan-gers that may await future portfolio managers and G-10 financial minis-ters We have presented evidence indicating a systemic bias toward bank
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112 WORLD CAPITAL MARKETS
lending and debt finance to emerging markets and we have argued forsubstitution toward equity finance and direct investment39
That is not the end of the story We noted in the previous chapterthat institutional investors can become momentum investors selling in adownturn As more portfolio capital is invested in emerging marketssome players may adopt the high-risk high-leverage strategies of themost aggressive hedge funds Indeed the data in box 11 show that G-10portfolio investors held somewhat more long-term debt (more than $500billion) than equity (less than $400 billion) in emerging markets at theend of 1997 Long-term debt is an ideal vehicle for high-risk high-leveragestrategies These strategies practiced on a large scale could compound afuture crisis harming emerging markets A big enough crisis could inturn pressure G-10 central banks and finance ministers to arrange bail-out plans Instead of shrinking as a systemic financial problem moralhazard could increase
National securities regulators are the first line of defense against thisscenario They play a critical role in the safe evolution of capital mar-kets But regulators today are mandated to approve the issuance of newsecurities and to monitor the continuing disclosure of material informa-tion by issuers They are far less concerned with or empowered to monitorthe behavior of the increasingly large wealth-management firms that arethe major purchasers (and therefore resellers) of these securities
Within their mandates the goals of national securities regulators (table210 and appendix B) are similar to the concerns of bank regulators withsystem safety and soundness Their focus is also on the incentive sys-tems for management and boards of directors and on disclosure by cor-porations that issue marketable securities such as shares bonds andasset-backed securities 40 Issuers of securities possess greater knowledgeabout the quality of these assets than do the purchasers hence investorprotection is a key concern of regulators Moreover market disciplineworks best when markets know what is happening Well-functioning corpora-tions are key agents of wealth creation and social progress Underperform-ing corporations waste resources During recessions bad corporationsget into bad trouble often with severe social consequences Inadequateincentives for managers and inadequate accountability for boards andmanagers thus have negative externalities Regulators play a vital role inexposing weakness so that market disciplines come to bear sooner ratherthan later
Regulatory emphasis is constantly shifting as financial markets evolveand as the macroeconomic environment changes Regulators try to balance
39 See Rogoff (1999) Also see Berlin (2000) for a perspective on the limited role thatbanks play as share owners
40 See Habib and Ljungqvist (2000) for recent empirical analysis showing that corporateshare market values are higher when corporate executives have a larger ownership stake
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Table 210 Financial-sector regulation G-10 countries 2000
Financial institutions and their supervisors
Country and supervisory structure Retail banking Wholesale banking Securities Insurance
Financial conglomeratesFinancial Services Authority (FSA) = umbrella supervisor
United Kingdom FSA FSA FSA FSA
Treasury bull Commercial banks bull Investment funds (Securities and (Insurance Directorate(Securities and Investments Board) bull Unit trust groups Futures Authority) of the Treasury)
Bank of bull Building societies bull Pension funds England (Building Societies Commission) bull Merchant banks
bull Friendly societies bull Clearing houses bull Primary issuers bull Insurance FSA (Friendly Societies Commission) bull Venture capital of securities companies
bull Pensions and life insurance etc bull Stock exchanges bull Insurance brokers(Personal Investment Authority) bull Stockbrokers
Financial holding companiesFederal Reserve (FR) = umbrella supervisor
United States bull National banks(OCC) Securities and Regulated by
Treasury OCC bull State banks Federal Reserve Exchange Commission StatesMembers (FR)
OTS Nonmembers (FDIC) bull Investment banks bull Primary issuers of bull Insurance companies FR bull Cooperative banks (FDICFR) bull Finance companies securities bull Insurance brokers FDIC bull Insured industrial banks (FDIC) bull Stock exchanges
bull Thrift holding companies (OTS) bull Stockbrokers SEC bull Savings banks (OTSFDICFR) bull Investment advisors
bull Savings and loan associations bull Mutual funds(OTS) bull Public utility holding
bull Edge Act corporations (FR) companies
(table continues next page)
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Table 210 Financial-sector regulation G-10 countries 2000 (continued )
Financial institutions and their supervisors
Country and supervisory structure Retail banking Wholesale banking Securities Insurance
Financial holding companies Japan Financial Supervisory Authority (FSA) = umbrella supervisor
Prime FSA FSA FSA FSA ministerrsquos Ministry of office Finance (Securities and Exchange
Surveillance Commission) FRC Bureau of Financial bull City banks bull Investment banks bull Primary issuers of bull Insurance companies FSA Regulation bull Regional banks bull Asset managers securities bull Insurance brokers
bull Trust banks bull Stock exchanges SESC bull Long-term credit banks bull Stockbrokers
bull Pension funds
Financial holding companiesOffice of the Superintendent of Financial Institutions (OSFI) = umbrella supervisor
Canada Regulated by OSFI OSFI provinces OSFI
Department of Financebull Banks bull Cooperative credit bull Primary issuers of bull Insurance companies
(previously Office of the Inspector associations securities (previously Depart- OSFI General of the Banks) bull Fraternal benefit bull Stock exchanges ment of Insurance) Bank of bull Trust and loan companies society bull Stockbrokers bull Insurance brokers Canada bull Pension funds bull Asset managers
(previously Depart- CDIC ment of Insurance)
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Financial institutions and their supervisors
Country and supervisory structure Retail banking Wholesale banking Securities Insurance
Germany Financial holding groupsFederal Banking Supervisory Office (FBSO) = umbrella supervisor
Ministry of Finance FBSO BSO FSSO FISO
Bundesbankbull Universal banks bull Other financial bull Primary issuers of bull Insurance companies
Federal Banking bull Savings banks institutions (eg securities bull Insurance brokers Supervisory Office bull Securities banks management foreign bull Stock exchanges
currency dealings) bull Stockbrokers Federal Securities bull Financial enterprises bull Asset managers Supervisory Office (eg leasing bull Pension funds
organizations Federal Insurance credit card companies Supervisory Office investment advisors)
Italy Bank foundationsMinistry of Finance = umbrella supervisor
Ministry of Finance Bank of Italy Bank of Italy Consob ISVAP
Bank of Italy bull Commerical banks bull Asset managers bull Primary issuers of bull Insurance companies Consob bull Savings bank bull Open-end investment securities bull Insurance brokers
bull Securities banks companies (SICAVs) bull Stock exchangesbull Stockbrokers
ISVAP
(table continues next page)
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Table 210 Financial-sector regulation G-10 countries 2000 (continued )
Financial institutions and their supervisors
Country and supervisory structure Retail banking Wholesale banking Securities Insurance
The Netherlands Financial conglomeratesCouncil of Financial Supervisors = umbrella supervisor
Securities Board Securities Board Netherlandsche Netherlands Bank Netherlandsche Bank of the Netherlands Insurance Board Bank Insurance bull Credit institutions (universal banks bull Investment institutions bull Stock exchanges bull Insurance companies Board cooperative banks security credit (securities issuing bull Stockbrokers bull Insurance brokers
institutions mortgage banks) and tradingmdashprimary The Council of Financial and secondary Supervisors markets)
France Commission des Commission de Operations des Controcircle des
Banking and Banking Commission Bourse Assurances Financial Regulatory bull Ensuring that credit institutions (and investment firms since bull Primary issuers of bull Insurance companies Ministry for Committee the Financial Activity Modernization Act of 1996) comply securities bull Insurance brokers Economic with laws and regulations bull Stock exchanges Affairs and bull Execute instructions regarding all off-site monitoring and bull Stockbrokers Finance Credit on-site supervision Institutions and Banking and Financial Regulatory Committee Investment bull Formulates general regulations for credit institutions and investment firms Committee (capital adequacy requirements accounting rules etc) Bank of France Credit Institutions and Investment Committee Banking bull Authorizes and examines financial institutions except for those within the Commission competence of the Banking Commission
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Financial institutions and their supervisors
Country and supervisory structure Retail banking Wholesale banking Securities Insurance
Switzerland Large banking groupSwiss Federal Banking Commission (SFBC) = umbrella supervisor
Swiss National Bank Federal Office of
SFBC SFBC SFBC Private Insurance Swiss Federal Banking Commission bull Universal banks bull Investment banks bull Primary issuers of bull Insurance companies
bull Savings banks bull Asset management securities bull Insurance brokerscompanies bull Stock exchanges
Private audit Federal bull Investment funds bull Stockbrokers firms Office of bull Mortgage bond authorized by Private business SFBC Insurance
Sweden Financial holding company groupsFinancial Supervisory Authority = umbrella supervisor
Ministry of Finance Credit Market Securities Market Insurance Market
Credit Market Department Department Department Department
Financial bull Commercial banks bull Investment funds bull Primary issuers of bull Insurance companies Riksbank Supervisory bull Savings banks securities bull Insurance brokers Authority bull Friendly societies bull Stock exchanges
bull Stockbrokers
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Table 210 Financial-sector regulation G-10 countries 2000 (continued )
Financial institutions and their supervisors
Country and supervisory structure Retail banking Wholesale banking Securities Insurance
Belgium Bank holding companiesBanking and Finance Commission = umbrella supervisor
Bank of Belgium Banking Banking
Banking and Finance and Finance Insurance Controland Finance Commission Commission Commission Office
Banking and Insurance Finance Control bull Commercial banks bull Asset management bull Primary issuers of bull Insurance companies Commission Office bull Savings banks firms securities bull Insurance brokers
bull Securities banks bull Investment funds bull Stock exchanges bull Mortgage companiesbull Stockbrokers bull Pension funds
Securities Regulation Fund Securities Regulation Fund
bull Other investment firms and credit institutions(institutions participating in regulated off-exchangemarket in strips and Treasury certificates)
Bank holding companies Spain Banco de Espantildea = umbrella supervisor
Banco de Espantildea Comision Nacional del Mercado de Directorate General
Banco de Espantildea Valores (CNMV) Insurance
bull All credit institutions (commercial banks savings banks credit bull Primary issuers of (Ministry of Economy Ministry of cooperatives official credit institutions finance factoring and securities and Finance) Economy and CNMV leasing companies mortgage-loan companies etc) bull Stock exchanges bull Insurance companies Finance bull Interbank foreign exchange and book-entry public debt bull Stockbrokers bull Pension funds
markets bull Venture capital(companies and funds)
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TH
E P
LAY
ER
S T
HE
IR S
UP
ER
VIS
OR
S A
ND
MO
RA
L HA
ZA
RD
119
Financial institutions and their supervisors
Country and supervisory structure Banking Securities Insurance
Banking Advisory High Level Securities Supervisors Committee (BAC) Committee (HLSS) Insurance Committee (IC)
Supranational (EU) bull Formulates standards for prudential bull Coordination of securities market bull Formulates standards forsupervision supervision prudential supervision
BACICHLSS Banking Supervision
Conglomerates Committee (BSC) Securities Contact Committee Regulation of prudential bull Systemic risk monitoring bull Regulation and implementation of supervision securities admission
International Association International International Organization of of Insurance Supervisors
Basel Committee Securities Commisison (IOSCO) (IAIS) Joint Forum Conglomerates Supervision bull Supervision and regulation best bull Supervision and regulation best bull Supervision and regulation amp regulation Best practices practices practices best practices
FSF Coordination across supervisors of various functions
Notes See appendix B for more information Boldface type indicates senior or oversight supervisor normal type indicates adjunct or front-line supervisorsolid line indicates direct responsbility to the senior-ranking authority dotted line indicates coordination in supervisory activities
(table continues next page)
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Table 210 Financial-sector regulation G-10 countries 2000 (continued )
Glossary of names United Kingdom FSA = Financial Services Authority United States FR = Federal Reserve OCC = Office of the Comptroller of theCurrency FDIC = Federal Deposit Insurance Corporation SEC = Securities and Exchange Commission OTS = Office of Thrift Supervision Japan FRC =Financial Reconstruction Commission FSA = Financial Services Agency SESC = Securities and Exchange Surveillance Commission Canada OSFI =Office of the Superintendent of Financial Institutions CDIC = Canada Deposit Insurance Corporation Germany FBSO = Federal Banking SupervisoryOffice FSSO = Federal Securities Supervisory Office FISO = Federal Insurance Supervisory Office BSO = Banking Supervisory Office Italy Consob =Commissione Nazionale per le Societa e la Borsa ISVAP = Instituto per la Vigilanza sulle assicurazioni private e di Interesse colletivo Switzerland SFBC= Swiss Federal Banking Commission Spain CNMV = The Comision Nacional del Mercado de Valores Supranational BAC = Banking Advisory CommitteeBSC = Banking Supervision Committee IC = Insurance Committee HLSS = High Level Securities Supervisors Committee International Dimension FSF =Financial Stability Forum IOSCO = International Organization of Securities Commission IAIS = International Association of Insurance Supervisors
Sources United Kingdom Bank of England httpwwwbankofenglandcouk Financial Services Authority httpwwwfsagovuk United States Board ofGovernors of Federal Reserve System httpwwwfederalreservegov Japan Bank of Japan httpwwwbojorjo Financial Reconstruction Commissionhttpwwwfsagojpfrcindexehtml Financial Services Agency httpwwwfsagojp Canada Bank of Canada httpwwwbank-banque-canadaca Office ofthe Superintendent of Financial Institutions httpwwwosfi-bsifgccaAndreEindexhtml Germany Deutsche Bundesbank httpwwwbundesbankde Fed-eral Banking Supervisory Office httpwwwbakredde Italy Banca drsquoitalia httpwwwbancaditaliait Commissione Nazionale per le Societa e la Borsahttpwwwconsobit Instituto per la Vigilanza sulle assicurazioni private e di Interesse colletivo httpwwwisvapit The Netherlands De NederlandscheBank httpwwwdnbnl France Banque de France httpwwwbanque-francefr Switzerland Schweizerische Nationalbank httpwwwsnbchindex3htmlSweden Sveriges Riksbank httpwwwriksbanksedefaultasp Belgium National Bank of Belgium httpwwwbnbbesgindexhtm Spain Banco de Espantildeahttpwwwbdees The Comision Nacional del Mercado de Valores httpwwwcnmves Supranational (EU) Institutional Arrangements for the Regulationand Supervision of the Financial Sector 2000 International Dimension Bank for International Settlement httpwwwbisorg International Organization ofSecurities Commissions httpwwwioscoorg International Association of Insurance Supervisors httpwwwiaisorg Financial Stability Forum httpwwwfsforumorg
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 121
the inflexibility of tight surveillance against the need to encourage in-novation and growth The US Securities and Exchange Commission isworried about aggressive accounting by firms and biased reports bysecurities analysts in an equity environment that prizes steadily higherquarterly earnings41 Japanese regulators are preoccupied with opaqueinterconnections between portfolio institutions banks and nonfinancialfirms through the keiretsu system Canadian regulators reeling from high-profile scandals of managers intentionally misleading investors are strengtheningmarket discipline through legal penalties aimed at managers and directorsof offending firms
When panic strikes a securities regulator cannot do much As the 1987stock market crash and the LTCM debacle in the fall of 1998 both dem-onstrated steep stock and bond price declines can create systemic risksIf severe enough the wealth effect of falling securities values and thefear of widespread insolvency can depress real activity Flooding thesystem with liquidity is a central bankerrsquos solutionmdashsomething a securi-ties regulator cannot do42 But just as financial supervisors can changethe incentive structure to discourage bankers from making risky loans ingood times so securities regulators can pay more attention to incentiveson the demand side when capital markets are strong
Prudential Supervision and InnovationmdashA Footnote
In concluding this discussion of prudential supervision in the G-10 anadditional point is worth noting National regulators face a persistenttrade-off between emphasizing financial system safety and soundnesswhile encouraging innovationmdashin spite of the added risks innovationbrings to financial markets Former US Treasury Secretary Lawrence Summers(2000 3) has argued by analogy
The jet airplane made airplane air travel more comfortable more efficient andmore safe though the accidents were more spectacular and for a time morenumerous after the jet was invented In the same way modern global financialmarkets carry with them enormous potential for benefit even if some of theaccidents are that much more spectacular As the right public policy response
41 The problem is illustrated by the divergence since mid-1998 between reported earn-ings by the Standard amp Poorrsquos (SampP) 500 and the after-tax profits of all corporations inthe national accounts Generally these two series move closely with one another Be-tween mid-1998 and mid-1999 SampP 500 reported that earnings increased by more than20 percent while after-tax profits of all corporations increased by less than 5 percent(Chase Bank US Economic and Policy Research US Weekly Prospects Chase SecuritiesWeekly Newsletter 5 June 2000 5)
42 For example the US Securities and Exchange Commission had no direct role in calmingmarkets in the 1987 or 1998 panics
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122 WORLD CAPITAL MARKETS
to the jet was longer runways better air-traffic control and better training forpilots and not the discouragement of rapid travel so the right public policyresponse to financial innovation is to assure a safe framework so that the ben-efits can be realized not to stifle the change
Accepting Summersrsquos analogy for the international financial system better-informed supervisors and investors are a necessary part of the financialsystem framework Supervisors require more timely information on therisk profiles resulting from positions taken by financial institutions Theyalso need a better understanding of risk-management systems Snapshotsof an institutionrsquos risk profile and risk-management procedures are nolonger adequate In a world where huge bets are quickly made (andpossibly lostmdashas with Barings Bank in 1995 and LTCM in 1998) super-visors must focus on the soundness of banking systems for evaluatingand managing risk on a daily basis Some progress has been made inaddressing these issues US banking examiners are extending their in-formation requirements in banking examinations and increasing theirinvolvement in large complex institutions43 More awareness is alsorequired of the fact that they are national organizations in a world ofcross-border capital flows To a much greater extent they need a multi-national reach International supervision and coordination among super-visors are the subject of the next section
Our analysis suggests that G-10 supervisors have unfinished businessBank supervisors need to start yesterday securities regulators can waituntil tomorrow One G-10 member acting alone cannot correct the biasIn good times the lending business will simply migrate to other G-10banks In bad times financial problems will not stop at the national bor-der A way has to be found to establish common international standardsfor the key financial players in order to prevent crises and to agree onapproaches for managing them The path has already been laid out Inthe wake of the bank failures of the past 25 years bank supervisors havetried to establish such standards They have done this without creating anew global institution
The essence of the international framework is decentralizationmdashglobalrules and design standards without global institutions that are perceivedto intrude on national sovereignty The awkward jargon for this frame-work is vertical subsidiaritymdashldquothink internationally act nationallyrdquo Theinternational thinking is done by a committee of regulators that meets
International SupervisionA Decentralized Framework
43 These issues are discussed in Ferguson (1999) and Meyer (2000a)
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 123
regularly at the Bank for International Settlements in Basel The commit-tee establishes principles and standards that are interpreted implementedand enforced by national authorities44 In this section we describe thesesupervisory efforts and their weaknesses We present our recommenda-tions for addressing these weaknesses in the next chapter
Basel I
The Basel Capital Accord of 1988 (Basel I)45 drew the lesson from thefinancial crises of the mid-1970s that more adequate capital levels in in-ternational banks would help reduce the systemic risk of bank failureThe primary goal of Basel I was capital adequacy other standards wereput in place not so much for their own virtue as to defend the primarygoal
Capital adequacy requirements were designed to ensure that individualinstitutions have the ability to absorb losses particularly credit lossesAccordingly a backup system of scoring credit risk was devised thatrequired large amounts of bank capital for some types of loans smalleramounts for others and zero for a select list of preferred assets Report-ing requirements were designed to disclose problems and ensure that atroubled bank would take timely steps to restore its capital base in thewake of a loss The Basel I framework worked tolerably well in limitingthe call on the public purse in the G-10 countriesmdashwith the notable ex-ceptions of France and Japan The framework failed to moderate riskybank lending to emerging markets however
Basel I was not developed with emerging markets in mind The origi-nal idea behind it was to develop a common supervisory approach tocross-border banking operations It grew out of political pressure fromUS lawmakers who were determined to require international banks op-erating in the United States to meet US banking standards Toward thisgoal in 1983 Congress passed the International Lending Supervisory ActUS and British banking authorities subsequently agreed on a commontarget the adoption of strict common capital-adequacy standards In 1988other G-10 governments agreed to go along voluntary acceptance ofthe standards throughout much of the rest of the world followed46 Therationale for the capital targets was two-fold The first was to requirebanks to hold sufficient amounts of capital (8 percent of risk-adjusted
44 The international committee of financial authorities agreed on a common definitionof banksrsquo tier-one or ldquocorerdquo capital national authorities defined tier-two capital in theirown manner which permitted greater variations in national working definitions andpractices
45 International Convergence of Capital Measurement and Capital Standards (BIS 1988)was prepared by the Basel Committee on Banking Supervision
46 See Reineke (1998)
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124 WORLD CAPITAL MARKETS
assets) to cushion losses on those assets The second was to dull theirappetites for risk banks with large capital bases would have more tolose if they failed and therefore would take fewer risks
Rapid change in financial markets soon revealed flaws in the Basel IAccord In a complex world with numerous sources of risk it focusedheavily on credit risk but overlooked other risks in a bankrsquos portfolioand the correlation between returns on different asset classes The Baselformula required banks to maintain a fixed amount of capital againsteach of its asset classes But the formula did not distinguish the riskinessof the borrower within each class As a result one large loan to a low-risk corporate borrower such as General Electric would require the sameamount of capital as 10 smaller transactions with high-risk borrowers
The system was also biased toward short-term loans Loans maturingin less than a year required a 20 percent risk weight whereas those ma-turing after more than a year required a 100 percent risk weight Inter-bank lending was particularly favored For example loans to banks inOECD countries required less capital than loans to private firms in thesame countries creating the anomaly that interbank loans to South Ko-rean banks required less capital than loans to General Electric47 Thisanomaly encouraged banks to shed high-quality assets if the Basel rulesrequired the allocation of more capital than banks thought they needed
Another weakness was that financial innovators quickly circumventedthe Accord Because short-term loans required less provisioning than long-term loans banks responded by securitizing their long-term debt port-folios and lending short-term against the collateral of the newly createdasset This allowed banks to circumvent the capital requirements gearedto the terms of the underlying debt At the same time the Basel I Accordfailed to encourage risk mitigation techniques such as credit derivativescollateral guarantees and on-balance-sheet netting the flip side of fi-nancial innovation Because off-balance-sheet products were not coveredby the Accord another anomaly appeared when Barings Bank collapsedin 1995 Barings met capital adequacy standards but collapsed becauseits systems for managing risk failed traders were allowed to speculatein futures contracts that did not appear on the balance sheet
Basel II
Work to overhaul Basel I began in 1995 and produced consultativepapers issued in June 1999 and January 200148 These papers have been
47 South Korean banks have had notoriously weak balance sheets because the practiceof ldquodirected lendingrdquo left them with many poor loans (in making these loans the bankswere expected to follow government objectives rather than creditworthiness criteria)
48 Basel Committee on Banking Supervision (1999 2001)
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 125
the subject of extensive consultation and revision as a result the newAccord is expected to be introduced in 200449 The Basel II frameworkhas three parts (pillars) revisions to Basel I minimum-capital require-ments supervisory review criteria and greater emphasis on market dis-cipline Broadly Basel II aims to maintain the level of capital in the sys-tem but achieve better alignment of banksrsquo capital with their risk pro-files and keep up with financial innovation
To align capital requirements with market realities (the first pillar)Basel II concentrates on the 100 or so largest banksmdashthe type of playerslisted in table 21mdashand on the holding-company parents of banking groups50
Capital requirements will differentiate between an increased number ofcredit groups or ldquorisk bucketsrdquo including claims on governments otherbanks corporations mortgage-backed securities and other asset-backedsecurities
Basel II originally proposed to use external ratings to set capital chargesfor a number of these credit risks Many banks objected arguing thatthey assess credit risk better than Standard amp Poorrsquos Moodyrsquos or FitchIBCA51 Basel II thus proposes two approaches to rating a standard ap-proach using external ratings and an ldquoadvancedrdquo approach that allowsselected banks to use their own internal rating systems To encouragethe development of rigorous internal control systems based on these in-ternal rating systems Basel II also proposes to levy capital charges foroperational risk (the risk of direct or indirect loss resulting from inad-equate or failed internal processes people and systems or from exter-nal events)
Some critics of this proposal dismiss it as an abrogation of the prin-ciple of external independent monitoring and as ldquodangerously naiumlverdquo52
But regulators argue that the new capital charge on operational risk shouldoffset this concern It is also far from clear how cross-national compari-sons of rating and internal risk-assessment systems will be made (Engelen2000) The development by the European Union of its own capital rulescould well complicate the international resolution of these issues Publicassurances by EU officials in January 2001 however indicated that theirmain concerns are to create a level playing field and avoid regulatoryarbitrage (Hargreaves 2001) There is also the significant problem ofthe procyclical character of risk weights When a crisis hits losses are
49 See Berry (2000) for an update in an interview with William J McDonough chair ofthe Basel Committee on Banking Supervision
50 For obvious reasons these proposals are addressed to large banks and simpler capi-tal standards are allowed for small banks that focus on their domestic credit markets
51 See Ammer and Packer (2000) for an empirical critique of the success of rating agen-cies in distinguishing risk by sector and region
52 See Auerback (2001)
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126 WORLD CAPITAL MARKETS
incurred or accrued capital is lost and loan exposure must be reducedor securities sold to restore the requisite capital-adequacy ratios A morerisk-sensitive framework could amplify volatility
As the second pillar of Basel II supervisory review criteria are beingbeefed up to encourage supervisors to intervene earlier in potential problemsituations and to compel banks to align their capital positions with theirrisk profiles Bank supervisors will be authorized to require banks tohold capital in excess of minimum requirements if they have concernsabout general management overall strategy risk-management performanceor the macroeconomic environment Of course if one G-10 supervisorimposes higher capital requirements in isolation the same disparity willemerge that presaged Basel I Some banks will be disadvantaged in theinternational marketplace and will loudly complain that excessive super-vision is driving business to their competitors Hence close internationalcooperation among supervisors is critical
To implement the third pillar market discipline banks will be requiredto make fuller more timely disclosure of capital adequacy and the risksto which that capital is exposed A number of measures are being stud-ied that might help supervisors evaluate bank performance such as com-parisons of uninsured deposit interest rates subordinated debt yieldsand equity prices The idea is that these yields and prices might alertsupervisors to market perceptions of risk Of course market perceptionsare only as good as market information More direct and controversialways to reinforce market discipline would dramatically increase publicdisclosure of bank positions and risk management systems
Many questions are still outstanding about how to resolve the techni-cal details of capital requirements and whether the requirements willachieve their intended goal of better assessment and mitigation of therisks in banksrsquo portfolios There is no substitute for skilled supervisorsThe intricacies of effective design and implementation suggest that su-pervisors need to be highly competent technically knowledgeable aboutbanking portfolio characteristics and the factors that influence bank ex-posure to credit risk (Mishkin 2000) And they must be aided by vigilantshareholders market forces and transparency of information53
Standard setting at the global level is desirable but ultimately theeffectiveness of these efforts will be tested at the national level espe-cially in times of systemic financial distress Here the record of Basel Iwas not a bright shining success Japanese banking regulators havetraditionally allowed banks to include real estate and securities in theircapital base When the value of these assets plummeted in the early 1990sregulators allowed banks to continue valuing these depreciated (andoften bankrupt) assets at their old inflated levels Japanese authorities
53 Benedict Roth Complacency Towards Catastrophe Financial Times 23 January 2001
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 127
insisted until the mid-1990s that eroded capital bases could be rebuiltin a market-driven fashion They rightly foresaw that huge loan losseswould undermine public support for the ruling party and require a po-litically unpopular bailout
Japanese foot dragging on Basel I was the worst54 but not uniqueOther examples can be found of ldquopolitically mandated forbearancerdquo TheFederal Reserve Bank of New York held important hands during theLTCM crisis of 1998 Mexico is still resolving the banking crisis that eruptedin 1995 South Korea has not yet closed the insolvent banks that behavedso badly before the crisis of 1998 In the aftermath of a crisis nationalregulators cannot always be relied upon to discipline politically power-ful bankers55 One of the little-noticed consequences of these differingapproaches is that those banks with strong regulatory systems receivedan implicit ldquoexport subsidyrdquo for their services US banks which had notengaged extensively in emerging-market lending in the 1990s were bet-ter positioned than their German and Japanese counterparts to expandtheir international assets in the wake of the crises
Other Financial Forums
54 See Japanese Banks Fiddling while Marunouchi Burns The Economist 27 January2001 67-69
55 See Calomiris (1997)
The Basel model of vertical subsidiarity has already been extended toother financial regulatory bodies In 1993-94 the BIS established a Tri-partite Group of Banking Insurance and Securities Regulators In 1994-95 the BIS increased its cooperation with the International Organizationof Securities Commissions when the two organizations issued parallelpapers on guidelines for national regulators concerning risk managementand disclosure of derivative trades In 1996 a permanent Joint Forum onFinancial Conglomerates was established to examine supervisory issuesand develop working arrangements among the different functional super-visors of conglomerate institutions that offer combinations of bankingsecurities and insurance products Draft papers on the supervisionof conglomerates were released for comment in 1998 applying capital-adequacy principles to these groups and providing guidelines both forassessing the integrity and competence of top managers and for sharingassessments between regulators
In 1997 the Basel Committee on Banking Supervision extended itsreach beyond capital standards to broader aspects of banking supervi-sion with the publication of the Core Principles for Effective BankingSupervision In 1999 a wide range of regulatory and standard-settingbodies were gathered under the umbrella of the Financial Stability
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128 WORLD CAPITAL MARKETS
Forum (FSF) itself established under BIS aegis56 The FSF has alreadyissued recommendations for stepped-up supervision and transparencyas well as guidelines for best practices in a number of areas includingoffshore financial centers and highly leveraged institutions or hedge funds57
Conclusion
Although the structural weaknesses in emerging-market economies arewidely acknowledged to have been causal factors in international capi-tal-market volatility this chapter points to the role of large G-10 bankingorganizations as major suppliers of the most volatile instrument short-term debt We have examined evidence of the impact of public safetynets in the G-10 economiesmdashthe deposit insurance systems the pruden-tial supervisory systems and the lender-of-last-resort functions of centralbanksmdashon the incentive structures of these organizations
Although supervisors in most countries working nationally and to-gether in the BIS have made significant efforts to mimic market forcesin their prudential supervision the most sophisticated financial institu-tions find innovative ways to circumvent the rules New global regulatorybodies are not about to be created G-10 national bank regulators shouldthemselves address the short-term debt bias in the international financialsystem by changing incentive systems G-10 securities regulators shouldalso take steps to get ahead of the curve paying close attention to largeportfolio swings by institutional investors particularly in times of crisisIn short more needs to be done at national and international levels tochange the rules of the game That is the subject of the next chapter
56 The Financial Stability Forum includes banking securities insurance and accountingregulatory bodies the OECD on taxation corruption and corporate governance and theIMF
57 See Martin (2000)
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 101
volatility As two experts have observed (Folkerts-Landau and Garber1998)
[V]olatility even in one country will automatically generate an upward re-estimate of credit and market risk in a correlated country triggering automaticmargin calls and tightening of credit lines Thus apparently bizarre opera-tions that connect otherwise disconnected securities markets are not the re-sponses of panicked green screen traders arbitrarily driving economies from agood to a bad equilibrium Rather they work with relentless predictability andunder the seal of approval of supervisors in the main financial centers
23 See Ferguson (1999)
24 As Gerald Corrigan (1982) put the matter ldquoBanks are specialrdquo Corrigan (2000) reit-erated this view even after all the changes of the past two decades Unlike other institu-tions banks offer on-demand transactions are a backup liquidity source for other insti-tutions and serve as a ldquotransmission beltrdquo for monetary policy
These changes in the banking environment accentuate an existing anomalyThe anomaly is that banks even as they grow larger and increasinglyengage in more risky and complex transactions are perceived to enjoyimplicit and explicit public guarantees
The guarantees grow out of an incentive problem inherent in bankingasymmetric information which we mentioned above Depositors know lessabout a bankrsquos management and the quality of its balance sheet than doits managers and shareholders Thus in times of uncertainty or adver-sity bank depositorsmdashuncertain whether they will have access to theirdepositsmdashare prone to bank runs This prospect has in turn compelledgovernments to treat banks differently than other firms because a bankthat fails can disrupt the rest of the economy24
To prevent such crises governments have entered into quid pro quoarrangements with banks Governments provide them both with an im-plicit safety net in the form of an unstated promise by the central bankto act as a lender of last resort in a liquidity crisis and an explicit safetynet in the form of a public deposit insurance fund to reassure depositorsIn return the banks submit to closer government oversight and regu-lation of their activities than is usual for industries in the private sector
The ldquoinsurancerdquo provided by the public safety net contributes to an-other incentive problem moral hazard Banks acquire greater tastes forrisk and face less market discipline than other firms The explicit depositinsurance safety nets actually have or are perceived to have blanketcoverage that extends beyond the retail depositors (households and small
One of the lessons of the 1997-98 crisis must surely be that market par-ticipants and their regulatory supervisors relied too heavily on quantita-tive tools and insufficiently on judgment23
The Anomaly of Modern Banking
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102 WORLD CAPITAL MARKETS
businesses) for which they were originally intended The implicit centralbank safety nets extend in a crisis to nearly all depositors and banksThus banks are both viewed and behave as if they will be bailed out ifthey get into trouble
The existence of a public safety net raises a perennial question Dobanks have an unfair advantage over other financial institutions becauseof the subsidy provided by the safety net This question was at the heartof intensive study and debate in the United States leading up to thepassage in November 1999 of the Financial Services Modernization Act(also known as the Gramm-Leach-Bliley Act) The size of the gross sub-sidy is difficult to estimate despite determined research efforts Somesuggest it is well under 100 basis points and is at least partly offset bythe direct costs of deposit insurance premiums interest payments on bondsissued by the Financing Corporation25 reserve requirements regulatoryexpenses and operational costs associated with collecting deposits26 Con-versely Kwast and Passmore (2000) suggest that banks can expand theirscope far beyond the levels that other financial institutions could reachwith the same equity base but without the public safety net
A related concern in the US debate is whether allowing banks to ex-pand their activities into securities and insurance will ultimately extendthe safety net and add to the subsidy The Financial Services Moderniza-tion Act deals with this issue by maintaining a legal separation betweenbanks and the rest of the banking organization known as large com-plex banking organizations (LCBOs) They must engage in most securi-ties activities and insurance underwriting through separately capitalizedinvestment bank subsidiaries or holding company affiliates This act canbe said to have merely brought US banking laws closer to those of mostother industrial countries (Barth Brumbaugh and Wilcox 2000 BarthNolle and Rice 2000) If the fire wall is well-maintained and stoutly de-fended the safety net will neither expand in practice nor become a sourceof comfort to noncommercial bank subsidiaries of LCBOs
The quid pro quo exacted by governments to offset the subsidy iscloser public-sector monitoring of banksrsquo activities through prudentialsupervision The effectiveness of this closer official scrutinymdashand closermarket monitoringmdashare the subjects of the next section
25 The Financing Corporation was created by Congress in 1987 to sell bonds to raisefunds to help resolve the savings and loan crisis
26 See Levonian and Furlong (1995) Jones and Kolatch (1999) Shull and White (1998)and Whalen (1999a 1999b)
Are G-10 bank supervisors adequately responding In this section we firstassess the case for and compare the structures of prudential supervisory
Prudential Supervision
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 103
systems both within and among the G-10 economies plus Spain andconsider whether these offset the subsidy provided by the public safetynet Despite offsetting regulation and supervision implicit and explicitguarantees by G-10 governments to their banks are still a source of bank-ing instability in the emerging-market economies
National Systems for Prudential Supervision
Governments use prudential supervision to reduce the moral hazard andadverse selection created by their own safety nets Supervisors establishregulations and monitor compliance to limit risk taking and ensure thesafety and soundness of the banking system In a thoughtful analysis ofthe case for prudential supervision Frederic Mishkin (2000) identifiesthe main forms that supervision can take including the tasks of grantingbanking charters and licenses establishing capital requirements settingdeposit insurance premiums and defining disclosure requirements as wellas carrying out bank examinations Bank examiners gather informationfrom banks and evaluate whether they are following the regulatorsrsquo rulesin cases of weakness they are empowered to change banksrsquo behaviorand close them if necessary
Supervisors also may restrict competition define the activities in whichbanks may engage and restrict their asset holdings and separate banksand other financial (or nonfinancial) activities During the past two de-cades the barriers separating commercial banks investment banks in-surance firms and securities firms have been all but eliminated (tableB1) Deregulation has stimulated competitive forces that drive diversifi-cation and consolidation of the financial industry nowhere faster than inthe United States
The Financial Services Modernization Act of 1999 confirmed this trendIt eliminated restrictions dating back to the Glass Steagall Act of 1933which once prevented banking insurance and securities firms fromentering each otherrsquos businesses (Barth Brumbaugh and Wilcox 2000)Cross-pillar mergers among banks insurance and securities firms arewell under way to form giant financial holding companies The 1999merger between Citibank (banking) and Travelers (insurance) created themodel for megafinance and confirmed new challenges for supervisors
Mishkin (2000) notes the corresponding evolution in US supervisionfrom an emphasis on rules-based regulation (detailed rules for opera-tional behavior and the quality of line items in the balance sheet) to anapproach that stresses the soundness of bank management practices es-pecially risk management
Appendix B outlines the systems of financial supervision now in theplace in the G-10 countries plus Spain Some systems like the UK andCanadian approach are models of simplicitymdashorganized to keep pacewith the spreading reach of financial conglomerates Other systems like
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104 WORLD CAPITAL MARKETS
the US and French approaches show traces of the bureaucratic divisionsthat made sense in an era when banking securities and insurance weresharply separated
The US Model
27 See Meyer (1999a)
28 Canada has a similar degree of simplification with the exception that securities firmsare still regulated by provincial authorities
29 See Pratti and Schinasi (1999 67)
30 The agents are the bank regulators and the principals are the taxpayers Agents maypursue their own interests including bureaucratic survival and postgovernment employ-ment opportunities rather than the national interest in banking safety and soundness
The US model of financial regulation delineated in the Financial Ser-vices Modernization Act of 1999 blends functional and umbrella super-vision Bank and thrift regulators oversee depository institutions Newnonbank activities are subject to both functional regulation (eg by theSecurities and Exchange Commission and state insurance examiners) andumbrella supervision (of financial holding companies) by the FederalReserve27
The UK Model
Another supervisory model exists in the United Kingdom as well as inAustralia Canada and Switzerland28 In this model banking supervisionis separated from the monetary policy function The regulatory structureis considerably simplified by relying on a consolidated financial regula-tor separate from the central bank for both banking and nonbankingactivities The remaining question answered differently depending on thecountry is the extent to which the regulator relies on home-country sur-veillance of banks and conglomerates that have a local presence
Regulatory Models Compared
Appendix B provides more detail on the differences in these modelsGerman simplicity contrasts with French complexity In France the bankingcommission is chaired by the governor of the central bank and includesrepresentatives from the Treasury The commission supervises compli-ance with regulations but the central bank inspects banks on behalf ofthe commission29 In countries such as the United States and France withmultiple supervisors and crossover functions internal coordination is criticalAt the same time multiple agencies create regulatory competition Wheneach agency knows what the other is doing transparency within gov-ernment circles can help to limit principal-agent problems of regulation30
The discussion as to where in the public bureaucracy financial super-
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 105
vision should be placed goes back many years Peek Rosengren andTootell (1999) argue that a synergy exists between monetary policy andprudential supervision because information gained in the course of super-vision can increase the accuracy of macroeconomic forecasts A twist tothis argument is that the information on the state of financial institutionsavailable to the central bank as supervisor can facilitate its role as lenderof last resort Conversely there is the concern that a supervisory rolewill compromise the central bankrsquos independence of action with respectto its core mandatemdashmaintaining price stability As these arguments haveplayed out financial supervision has generally been shared between centralbanks and other regulators or placed entirely in the hands of an inde-pendent regulator However in Italy the Netherlands and Spain cen-tral banks are the sole banking supervisor
Goodhart (1995) examined the arguments and evidence for each modeland concluded that there were no overwhelming arguments or evidencefor one or the other31 Going forward a key problem for any financialsupervisory system is dealing with (and closing as necessary) weak banksIf both central banks and other regulators have this responsibility closecoordination between them is critical Another problem is large conglom-erate banks LCBOs Although they are less likely to fail because of thediversification of their assets and liabilities they are more likely to berescued They are also more likely to be multinational enterprises withinternational implications Goodhart observes that regulation of theseentities might be put in the hands of the central bank because it is lessamenable to political pressures In any event the complexity of LCBOoperations suggests that greater supervisory rigor is necessary
The US Congress was persuaded that broad oversight would help containthe moral hazard problem and accordingly gave the Federal Reservethe role of umbrella supervisor with the understanding that the Fed willscrutinize depository activity more intensely than nonbank financial ac-tivities Under this approach LCBOs such as Citigroup are subject tomuch closer monitoring than smaller and simpler institutions32 The USregulatory model requires enormous cooperation between the Fed otherbank supervisors and the functional regulators for insurance and securi-ties but it also benefits from regulatory competition
31 National systems of supervision are path dependent they are determined by the struc-ture of financial institutions and history in each country If Goodhart (1995) is right out-comes are not materially better or worse with one model of supervision rather than another
32 See Ferguson (1999)
Public Safety Nets
One of prudential supervisorsrsquo biggest challenges is to reduce moral hazardFor many years commercial banks engaged in communal self-insurance
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106 WORLD CAPITAL MARKETS
to deal with crises They formed voluntary groups that agreed to rescuetroubled members As financial markets evolved and competition inten-sified banks were no longer willing to play this role Private-sector in-surance is one alternative but moral hazard and adverse selection wouldappear to prevent it from happening Public safety nets have developedbecause of the low probability and high cost of potential bank runs Aclear trade-off is involved The effectiveness of insurance in preventingbank runs is greater the more comprehensive the coverage But the morecomprehensive the coverage the greater the moral hazardmdashbank man-agers bank directors investors and depositors all take on greater risksin the belief that the safety net will protect them against losses
All G-10 countries have compulsory public safety nets for banks (table29) Deposit insurance agencies are officially organized in Canada theNetherlands Sweden Switzerland and the United States organized bythe industry in France Germany Italy and the United Kingdom andjointly organized by the public and private sectors in Belgium Japanand Spain
How well do G-10 governments offset the subsidy provided by thepublic safety net This is a question on which there is substantial debateAs banking organizations have become more complex the challengesthat supervisors face have become more difficult One challenge is toalign the incentives facing bank managers and shareholders with thoseof depositors Another is the principal-agent problem in supervision Wehave discussed the incentive structures for financial institutions but wehave said little about the incentives for supervisors themselves and thedistortions they can generate in the financial system
In one of the many studies of the US savings and loan crisis of the1980s Kane (1989) documented both problems He described managersusing cosmetic approaches to disguise the magnitude of insolvency regulatorspracticing forbearance even though they knew of the deteriorating riskprofiles of the institutions for which they were responsible and legisla-tors increasing deposit insurance without regard for any offsetting changesin supervision A subsequent overhaul of the legislative framework forthe Federal Deposit Insurance Corporation (FDIC) known as the FDICImprovement Act of 1991 (FDICIA) aimed to introduce a clearer incen-tive structure for both regulators and regulated institutions
The changes introduced by this US legislation are worth discussionwith respect to the other G-10 countries as well First FDICIA created astronger signal to management and investors by targeting deposit insur-ance at small depositors only and by risk-weighting the deposit insur-ance premiums paid by banks to reflect their capital adequacy and bankexaminer ratings Among the G-10 countries rated in table 210 depositinsurance premiums vary considerablymdashbut it is not clear that the dif-ferences have much to do with risk-weighting Most G-10 countries em-ploy funding formulas based for example on the total domestic deposit
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Table 29 Deposit insurance schemes in the G-10 countries Explicit safety net
Coverage limit(dollar Foreign
equivalent currency Interbank Source Bankrsquos Contingency fundingDate Membership Co- at end of deposit deposit of premium from banks
Country established managementa insuranceb July 1998)c covered covered Fundingd funding costs or governments
United 1982 Compulsory Yes Larger of 90 No No Unfunded Banks only Callable (subject Parliament may increase Kingdom private percent co- to maximum the maximum payable
insurance to 03 percent of pound125 million advance 33000 total deposits) facility with Bank of
England
United 1934 Compulsory No 100000 Yes Yes Funded Banks and Up to 027 Borrowing up to $3 States official government percent total billion from US Treasury
domestic deposits
Japan 1971 Compulsory No 71000 but No No Funded Banks and 0084 percent of Borrowing up to yen500bn joint in full until government insured deposits from Bank of Japan
year 2000 subject to Ministry of Finance approval
Canada 1967 Compulsory No 40800 No Yes Funded Banks and 033 percent of Borrowing up to C$6 official government insured deposits billion authorized further
(maximum) borrowing subject to parliamentary approval
Germany 1966 Compulsory Yes 90 percent Yes No Funded Banks only 003 percent of Annual levy may be private coinsurance deposits doubled
to 22000
Italy 1987 Compulsory Yes 125000 Yes No Unfunded Banks and Callable Two options defer private government (maximum of payment or diminish
1 percent of compensation to be paid total deposits)
(table continues next page)
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Table 29 Deposit insurance schemes in the G-10 countries Explicit safety net (continued )
Coverage limit(dollar Foreign
equivalent currency Interbank Source Bankrsquos Contingency fundingDate Membership Co- at end of deposit deposit of premium from banks
Country established managementa insuranceb July 1998)c covered covered Fundingd funding costs or governments
Netherlands 1979 Compulsory No 22000 Yes No Unfunded Banks and On demand Government backing official government maximum of subject to parliamentary
5 percent of own approval funds
France 1980 Compulsory No 65400 No No Unfunded Banks only Callable (on Extra calls up to FFr1000 private demand calls million can be made in
up to FFr200 a 5-year period million)
Switzerland 1984 Voluntary No 19700 No No Unfunded Banks only Callable (on Underwritten by member official demand) banks
Sweden 1996 Compulsory No 31400 Yes No Funded Banks and 05 percent of Full emergency coverage official government deposits while replacing it with a
limited system after the emergency
Belgium 1974 Compulsory No 16600 No No Funded Banks and Callable 002 None insurance limited joint 22000 in government percent of to assets in fund
year 2000 deposits from clients
Spain 1977 Compulsory No 16439 Yes No Funded Banks and 02 percent of Government backing joint government deposits through the Banco de
(maximum) Espantildea subject to approval by royal decree
a Bank membership in the fund can be either compulsory or voluntary and the management of the fund can be official and official and private joint or privateb Coinsurance refers to the situation where depositors face a deductible against their insured fundsc Coverage limit refers to the explicit amount the authorities promise to insured Funded scheme means that it is funded ex ante unfunded otherwise
Sources Goodhart (1995) Demirguccedil-Kunt and Detragiache (2000) Demirguccedil-Kunt and Sabaci (2000)
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 109
base Explicit safety net protection also varies but only Canada focuseson the protected class33 All G-10 countries specify a limit on depositorprotection Under FDICIA the insurance fund is prohibited from pro-tecting uninsured depositors or creditors at a failed bank although adiscretionary system-wide override is provided for exceptional circum-stancesmdashbut with stringent requirements for consultation and account-ability Other G-10 countries allow for contingency funding from the publicpurse alongside unwritten lender-of-last-resort support Among large banksa significant and growing portion of deposit liabilities including foreigncurrency and interbank deposits are uninsuredmdashbut depositors assumethey will be protected in a crisis
FDICIA also made some significant qualitative changes to address theprincipal-agent problem by penalizing weak banks and rewarding strongbanks For example banks whose capital declined faced progressivelytougher regulatory sanctions that for example required them to elimi-nate dividends restrict their lending and change their managementsRegulators have also been forced to take prompt corrective action (toreduce the practice of regulatory forbearance in hopes that a bankrsquos for-tunes might improve)34 Unfortunately comparative qualitative assess-ments across the G-10 are difficult to make due to lack of information35
This discussion highlights the complexity of evaluating the extent towhich prudential supervision and market discipline reduce the moralhazard associated with G-10 safety nets Our argument is that publicsafety nets in the G-10 can be linked to banking instability in other coun-tries specifically in the emerging-market economies that have attractedG-10 cross-border bank lending This lending is a leading source of vola-tility in capital flows the large financial institutions many of which arecomplex banking organizations are based in and regulated by authori-ties in the G-10 economies These two features of the international finan-cial system are closely related although it is not possible to test thisrelationship econometrically
Two World Bank studies however indicate a basis for concern Onestudy is a cross-country econometric analysis of the relationship betweenbank stability and deposit insurance (Demirguccedil-Kunt and Detragiache2000) which found a negative relationship Their estimated model forbanking crises in a sample of 61 countries (both industrial and develop-ing) suggests that explicit deposit insurance raises the probability of acrisis by at least 30 percent36 Crises are especially likely in countries
33 Japanrsquos legislation says it does but recent experience shows this is not the case34 See Goldstein (1997) for a summary of the changes35 See Barth Nolle and Rice (2000) for a beginning in this area36 Demirguccedil-Kunt and and Detragiache (2000 table 1) report a logit coefficient of 0696with a standard error of 0397 (the coefficient is significant at the 8 percent threshold)This suggests that the ldquotruerdquo coefficient could well be as small as 030 (the reportedvalue minus the standard error)
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110 WORLD CAPITAL MARKETS
with immature financial supervisory systems (and not in the G-10) buttheir analysis does underscore the view that deposit insurance weakensmarket discipline37
An earlier World Bank analysis established similar results One wasthat market discipline is undermined by deposit insurance schemes an-other was that illiquid banks are forced to pay more for their funds un-less a generous deposit insurance scheme is in place (Demirguccedil-Kuntand Huizinga 1999) This econometric study also provides clear-cut evi-dence that depositor monitoring of banks declines with the existence ofdeposit insurance schemes At the heart of the problem is the questionof whether deposit insurance is accompanied by increased governmentmonitoring
This evidence and the weight of other arguments suggests that moralhazard is still an issue in the G-10 countries Consider the ongoing de-bate about instilling greater market discipline on risk taking by banksAt one extreme is the perennial proposal to do away with safety netsleaving markets to monitor the players and to force adjustments but toprotect small savers by creating ldquonarrow banksrdquo such as postal savingsystems that are allowed to invest these savings only in risk-free gov-ernment securities Whatever the merits of narrow banking this solutionis too extreme to be politically feasible
A moderate alternative is to force more disclosure by financial institu-tions to facilitate market monitoring But transparency has its own prob-lems Persaud (2000) argues that financial markets cannot reliably discernsustainable from unsustainable positions in the short term This uncer-tainty causes banks to ldquoherdrdquo behind market leaders to exploit theirsupposedly superior information ldquoThe more herding investors and bankersknow about what each other is up to the [more] unstable markets maybecomerdquo The implication is that greater transparency in the marketplaceby itself will not solve the problemmdashand in the short term more informa-tion may exacerbate herding Further supervisory steps (discussed in thenext chapter) are required
Yet another proposal is to promote private-sector involvement in bankmonitoring through market-based alternatives such as Calomirisrsquos sub-ordinated debt proposal (Calomiris 1997 Federal Reserve Board 1999)Banks could be required to issue and maintain a minimum amount of
37 Other findings in the Demirguccedil-Kunt and Detragiache (2000) study include thesepropositions The impact of deposit insurance on bank stability tends to be stronger themore extensive is the coverage offered to depositors when the scheme is funded andwhere the scheme is run by the government rather than by the private sector Con-versely deposit insurance is detrimental to bank stability where bank interest rates havebeen deregulated and where the institutional environment is weak Additional findingson deposit insurance are reported from a recent World Bank conference (8-9 June 2000httpwwwworldbankorgresearchinterestconfsupcomingdeposit_insurancehomehtm)Also see Smalhout (2001)
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 111
subordinated debt (eg uninsured certificates of deposit) to finance asmall fraction (such as 2 percent) of their total nonreserve assets Thesubordinated debt would be allowed to earn a set yield no more than 50basis points over the risk-free yield on government treasury bills Thisrule would supposedly force banks to operate in a safe manner Other-wise subordinated debt holders would redeem their uninsured certifi-cates of deposit and equity investors would sell their bank shares Despiteits practical problems the beauty of the subordinated debt requirementis that it enlists market incentives to push banks to avoid excessive port-folio risk38
The thrust of these proposals is very relevant to the arguments in ourstudy Even in the G-10 countries government monitoring by itself hasnot eliminated moral hazard among banks More work is needed to in-troduce market monitoring and to improve the incentive structures bothfor financial institutions and their supervisors We return to this issuewith our recommendations in the next chapter
38 In late 1996 Argentina began requiring its banks to finance 2 percent of total depos-its in the form of subordinated debt but without a maximum yield provision TheArgentine authorities expect that market discipline will act in concert with the publicsafety net One obvious problem with the subordinated debt proposal is that banks mayencourage some of their customers to buy the subordinated debt
Portfolio Institutions Tomorrowrsquos Problem
Before proceeding to the issues of international supervision we flag an-other potential problem for national regulators The big asset managersprofiled in tables 24 and 26 answer to diverse groups of pensionersshareholders and policyholders They allocate funds across a number ofcountries to diversify their risks They hold liquid assets that can be tradedand they have a higher proportion of long-term assets than banks Eco-nomic shocks can be absorbed through price changes and their effectsspread across time and markets Thus when conditions change in a par-ticular market they are more likely to ride out the storm than to flee Inother words they have less incentive than banks to pull their invest-ments in the face of adversity In the 1990s most large asset managersestablished a record of ldquoriding out the stormrdquo rather than ldquorunning withthe windrdquo although as we saw in chapter 1 instances of running withthe wind were detected in some portfolios As we write these insti-tutions have a good record overall in the emerging markets so whyworry
The Russian crisis and the near-collapse of LTCM previewed the dan-gers that may await future portfolio managers and G-10 financial minis-ters We have presented evidence indicating a systemic bias toward bank
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112 WORLD CAPITAL MARKETS
lending and debt finance to emerging markets and we have argued forsubstitution toward equity finance and direct investment39
That is not the end of the story We noted in the previous chapterthat institutional investors can become momentum investors selling in adownturn As more portfolio capital is invested in emerging marketssome players may adopt the high-risk high-leverage strategies of themost aggressive hedge funds Indeed the data in box 11 show that G-10portfolio investors held somewhat more long-term debt (more than $500billion) than equity (less than $400 billion) in emerging markets at theend of 1997 Long-term debt is an ideal vehicle for high-risk high-leveragestrategies These strategies practiced on a large scale could compound afuture crisis harming emerging markets A big enough crisis could inturn pressure G-10 central banks and finance ministers to arrange bail-out plans Instead of shrinking as a systemic financial problem moralhazard could increase
National securities regulators are the first line of defense against thisscenario They play a critical role in the safe evolution of capital mar-kets But regulators today are mandated to approve the issuance of newsecurities and to monitor the continuing disclosure of material informa-tion by issuers They are far less concerned with or empowered to monitorthe behavior of the increasingly large wealth-management firms that arethe major purchasers (and therefore resellers) of these securities
Within their mandates the goals of national securities regulators (table210 and appendix B) are similar to the concerns of bank regulators withsystem safety and soundness Their focus is also on the incentive sys-tems for management and boards of directors and on disclosure by cor-porations that issue marketable securities such as shares bonds andasset-backed securities 40 Issuers of securities possess greater knowledgeabout the quality of these assets than do the purchasers hence investorprotection is a key concern of regulators Moreover market disciplineworks best when markets know what is happening Well-functioning corpora-tions are key agents of wealth creation and social progress Underperform-ing corporations waste resources During recessions bad corporationsget into bad trouble often with severe social consequences Inadequateincentives for managers and inadequate accountability for boards andmanagers thus have negative externalities Regulators play a vital role inexposing weakness so that market disciplines come to bear sooner ratherthan later
Regulatory emphasis is constantly shifting as financial markets evolveand as the macroeconomic environment changes Regulators try to balance
39 See Rogoff (1999) Also see Berlin (2000) for a perspective on the limited role thatbanks play as share owners
40 See Habib and Ljungqvist (2000) for recent empirical analysis showing that corporateshare market values are higher when corporate executives have a larger ownership stake
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Table 210 Financial-sector regulation G-10 countries 2000
Financial institutions and their supervisors
Country and supervisory structure Retail banking Wholesale banking Securities Insurance
Financial conglomeratesFinancial Services Authority (FSA) = umbrella supervisor
United Kingdom FSA FSA FSA FSA
Treasury bull Commercial banks bull Investment funds (Securities and (Insurance Directorate(Securities and Investments Board) bull Unit trust groups Futures Authority) of the Treasury)
Bank of bull Building societies bull Pension funds England (Building Societies Commission) bull Merchant banks
bull Friendly societies bull Clearing houses bull Primary issuers bull Insurance FSA (Friendly Societies Commission) bull Venture capital of securities companies
bull Pensions and life insurance etc bull Stock exchanges bull Insurance brokers(Personal Investment Authority) bull Stockbrokers
Financial holding companiesFederal Reserve (FR) = umbrella supervisor
United States bull National banks(OCC) Securities and Regulated by
Treasury OCC bull State banks Federal Reserve Exchange Commission StatesMembers (FR)
OTS Nonmembers (FDIC) bull Investment banks bull Primary issuers of bull Insurance companies FR bull Cooperative banks (FDICFR) bull Finance companies securities bull Insurance brokers FDIC bull Insured industrial banks (FDIC) bull Stock exchanges
bull Thrift holding companies (OTS) bull Stockbrokers SEC bull Savings banks (OTSFDICFR) bull Investment advisors
bull Savings and loan associations bull Mutual funds(OTS) bull Public utility holding
bull Edge Act corporations (FR) companies
(table continues next page)
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Table 210 Financial-sector regulation G-10 countries 2000 (continued )
Financial institutions and their supervisors
Country and supervisory structure Retail banking Wholesale banking Securities Insurance
Financial holding companies Japan Financial Supervisory Authority (FSA) = umbrella supervisor
Prime FSA FSA FSA FSA ministerrsquos Ministry of office Finance (Securities and Exchange
Surveillance Commission) FRC Bureau of Financial bull City banks bull Investment banks bull Primary issuers of bull Insurance companies FSA Regulation bull Regional banks bull Asset managers securities bull Insurance brokers
bull Trust banks bull Stock exchanges SESC bull Long-term credit banks bull Stockbrokers
bull Pension funds
Financial holding companiesOffice of the Superintendent of Financial Institutions (OSFI) = umbrella supervisor
Canada Regulated by OSFI OSFI provinces OSFI
Department of Financebull Banks bull Cooperative credit bull Primary issuers of bull Insurance companies
(previously Office of the Inspector associations securities (previously Depart- OSFI General of the Banks) bull Fraternal benefit bull Stock exchanges ment of Insurance) Bank of bull Trust and loan companies society bull Stockbrokers bull Insurance brokers Canada bull Pension funds bull Asset managers
(previously Depart- CDIC ment of Insurance)
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Financial institutions and their supervisors
Country and supervisory structure Retail banking Wholesale banking Securities Insurance
Germany Financial holding groupsFederal Banking Supervisory Office (FBSO) = umbrella supervisor
Ministry of Finance FBSO BSO FSSO FISO
Bundesbankbull Universal banks bull Other financial bull Primary issuers of bull Insurance companies
Federal Banking bull Savings banks institutions (eg securities bull Insurance brokers Supervisory Office bull Securities banks management foreign bull Stock exchanges
currency dealings) bull Stockbrokers Federal Securities bull Financial enterprises bull Asset managers Supervisory Office (eg leasing bull Pension funds
organizations Federal Insurance credit card companies Supervisory Office investment advisors)
Italy Bank foundationsMinistry of Finance = umbrella supervisor
Ministry of Finance Bank of Italy Bank of Italy Consob ISVAP
Bank of Italy bull Commerical banks bull Asset managers bull Primary issuers of bull Insurance companies Consob bull Savings bank bull Open-end investment securities bull Insurance brokers
bull Securities banks companies (SICAVs) bull Stock exchangesbull Stockbrokers
ISVAP
(table continues next page)
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Table 210 Financial-sector regulation G-10 countries 2000 (continued )
Financial institutions and their supervisors
Country and supervisory structure Retail banking Wholesale banking Securities Insurance
The Netherlands Financial conglomeratesCouncil of Financial Supervisors = umbrella supervisor
Securities Board Securities Board Netherlandsche Netherlands Bank Netherlandsche Bank of the Netherlands Insurance Board Bank Insurance bull Credit institutions (universal banks bull Investment institutions bull Stock exchanges bull Insurance companies Board cooperative banks security credit (securities issuing bull Stockbrokers bull Insurance brokers
institutions mortgage banks) and tradingmdashprimary The Council of Financial and secondary Supervisors markets)
France Commission des Commission de Operations des Controcircle des
Banking and Banking Commission Bourse Assurances Financial Regulatory bull Ensuring that credit institutions (and investment firms since bull Primary issuers of bull Insurance companies Ministry for Committee the Financial Activity Modernization Act of 1996) comply securities bull Insurance brokers Economic with laws and regulations bull Stock exchanges Affairs and bull Execute instructions regarding all off-site monitoring and bull Stockbrokers Finance Credit on-site supervision Institutions and Banking and Financial Regulatory Committee Investment bull Formulates general regulations for credit institutions and investment firms Committee (capital adequacy requirements accounting rules etc) Bank of France Credit Institutions and Investment Committee Banking bull Authorizes and examines financial institutions except for those within the Commission competence of the Banking Commission
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117
Financial institutions and their supervisors
Country and supervisory structure Retail banking Wholesale banking Securities Insurance
Switzerland Large banking groupSwiss Federal Banking Commission (SFBC) = umbrella supervisor
Swiss National Bank Federal Office of
SFBC SFBC SFBC Private Insurance Swiss Federal Banking Commission bull Universal banks bull Investment banks bull Primary issuers of bull Insurance companies
bull Savings banks bull Asset management securities bull Insurance brokerscompanies bull Stock exchanges
Private audit Federal bull Investment funds bull Stockbrokers firms Office of bull Mortgage bond authorized by Private business SFBC Insurance
Sweden Financial holding company groupsFinancial Supervisory Authority = umbrella supervisor
Ministry of Finance Credit Market Securities Market Insurance Market
Credit Market Department Department Department Department
Financial bull Commercial banks bull Investment funds bull Primary issuers of bull Insurance companies Riksbank Supervisory bull Savings banks securities bull Insurance brokers Authority bull Friendly societies bull Stock exchanges
bull Stockbrokers
(table continues next page)
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Table 210 Financial-sector regulation G-10 countries 2000 (continued )
Financial institutions and their supervisors
Country and supervisory structure Retail banking Wholesale banking Securities Insurance
Belgium Bank holding companiesBanking and Finance Commission = umbrella supervisor
Bank of Belgium Banking Banking
Banking and Finance and Finance Insurance Controland Finance Commission Commission Commission Office
Banking and Insurance Finance Control bull Commercial banks bull Asset management bull Primary issuers of bull Insurance companies Commission Office bull Savings banks firms securities bull Insurance brokers
bull Securities banks bull Investment funds bull Stock exchanges bull Mortgage companiesbull Stockbrokers bull Pension funds
Securities Regulation Fund Securities Regulation Fund
bull Other investment firms and credit institutions(institutions participating in regulated off-exchangemarket in strips and Treasury certificates)
Bank holding companies Spain Banco de Espantildea = umbrella supervisor
Banco de Espantildea Comision Nacional del Mercado de Directorate General
Banco de Espantildea Valores (CNMV) Insurance
bull All credit institutions (commercial banks savings banks credit bull Primary issuers of (Ministry of Economy Ministry of cooperatives official credit institutions finance factoring and securities and Finance) Economy and CNMV leasing companies mortgage-loan companies etc) bull Stock exchanges bull Insurance companies Finance bull Interbank foreign exchange and book-entry public debt bull Stockbrokers bull Pension funds
markets bull Venture capital(companies and funds)
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119
Financial institutions and their supervisors
Country and supervisory structure Banking Securities Insurance
Banking Advisory High Level Securities Supervisors Committee (BAC) Committee (HLSS) Insurance Committee (IC)
Supranational (EU) bull Formulates standards for prudential bull Coordination of securities market bull Formulates standards forsupervision supervision prudential supervision
BACICHLSS Banking Supervision
Conglomerates Committee (BSC) Securities Contact Committee Regulation of prudential bull Systemic risk monitoring bull Regulation and implementation of supervision securities admission
International Association International International Organization of of Insurance Supervisors
Basel Committee Securities Commisison (IOSCO) (IAIS) Joint Forum Conglomerates Supervision bull Supervision and regulation best bull Supervision and regulation best bull Supervision and regulation amp regulation Best practices practices practices best practices
FSF Coordination across supervisors of various functions
Notes See appendix B for more information Boldface type indicates senior or oversight supervisor normal type indicates adjunct or front-line supervisorsolid line indicates direct responsbility to the senior-ranking authority dotted line indicates coordination in supervisory activities
(table continues next page)
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Table 210 Financial-sector regulation G-10 countries 2000 (continued )
Glossary of names United Kingdom FSA = Financial Services Authority United States FR = Federal Reserve OCC = Office of the Comptroller of theCurrency FDIC = Federal Deposit Insurance Corporation SEC = Securities and Exchange Commission OTS = Office of Thrift Supervision Japan FRC =Financial Reconstruction Commission FSA = Financial Services Agency SESC = Securities and Exchange Surveillance Commission Canada OSFI =Office of the Superintendent of Financial Institutions CDIC = Canada Deposit Insurance Corporation Germany FBSO = Federal Banking SupervisoryOffice FSSO = Federal Securities Supervisory Office FISO = Federal Insurance Supervisory Office BSO = Banking Supervisory Office Italy Consob =Commissione Nazionale per le Societa e la Borsa ISVAP = Instituto per la Vigilanza sulle assicurazioni private e di Interesse colletivo Switzerland SFBC= Swiss Federal Banking Commission Spain CNMV = The Comision Nacional del Mercado de Valores Supranational BAC = Banking Advisory CommitteeBSC = Banking Supervision Committee IC = Insurance Committee HLSS = High Level Securities Supervisors Committee International Dimension FSF =Financial Stability Forum IOSCO = International Organization of Securities Commission IAIS = International Association of Insurance Supervisors
Sources United Kingdom Bank of England httpwwwbankofenglandcouk Financial Services Authority httpwwwfsagovuk United States Board ofGovernors of Federal Reserve System httpwwwfederalreservegov Japan Bank of Japan httpwwwbojorjo Financial Reconstruction Commissionhttpwwwfsagojpfrcindexehtml Financial Services Agency httpwwwfsagojp Canada Bank of Canada httpwwwbank-banque-canadaca Office ofthe Superintendent of Financial Institutions httpwwwosfi-bsifgccaAndreEindexhtml Germany Deutsche Bundesbank httpwwwbundesbankde Fed-eral Banking Supervisory Office httpwwwbakredde Italy Banca drsquoitalia httpwwwbancaditaliait Commissione Nazionale per le Societa e la Borsahttpwwwconsobit Instituto per la Vigilanza sulle assicurazioni private e di Interesse colletivo httpwwwisvapit The Netherlands De NederlandscheBank httpwwwdnbnl France Banque de France httpwwwbanque-francefr Switzerland Schweizerische Nationalbank httpwwwsnbchindex3htmlSweden Sveriges Riksbank httpwwwriksbanksedefaultasp Belgium National Bank of Belgium httpwwwbnbbesgindexhtm Spain Banco de Espantildeahttpwwwbdees The Comision Nacional del Mercado de Valores httpwwwcnmves Supranational (EU) Institutional Arrangements for the Regulationand Supervision of the Financial Sector 2000 International Dimension Bank for International Settlement httpwwwbisorg International Organization ofSecurities Commissions httpwwwioscoorg International Association of Insurance Supervisors httpwwwiaisorg Financial Stability Forum httpwwwfsforumorg
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 121
the inflexibility of tight surveillance against the need to encourage in-novation and growth The US Securities and Exchange Commission isworried about aggressive accounting by firms and biased reports bysecurities analysts in an equity environment that prizes steadily higherquarterly earnings41 Japanese regulators are preoccupied with opaqueinterconnections between portfolio institutions banks and nonfinancialfirms through the keiretsu system Canadian regulators reeling from high-profile scandals of managers intentionally misleading investors are strengtheningmarket discipline through legal penalties aimed at managers and directorsof offending firms
When panic strikes a securities regulator cannot do much As the 1987stock market crash and the LTCM debacle in the fall of 1998 both dem-onstrated steep stock and bond price declines can create systemic risksIf severe enough the wealth effect of falling securities values and thefear of widespread insolvency can depress real activity Flooding thesystem with liquidity is a central bankerrsquos solutionmdashsomething a securi-ties regulator cannot do42 But just as financial supervisors can changethe incentive structure to discourage bankers from making risky loans ingood times so securities regulators can pay more attention to incentiveson the demand side when capital markets are strong
Prudential Supervision and InnovationmdashA Footnote
In concluding this discussion of prudential supervision in the G-10 anadditional point is worth noting National regulators face a persistenttrade-off between emphasizing financial system safety and soundnesswhile encouraging innovationmdashin spite of the added risks innovationbrings to financial markets Former US Treasury Secretary Lawrence Summers(2000 3) has argued by analogy
The jet airplane made airplane air travel more comfortable more efficient andmore safe though the accidents were more spectacular and for a time morenumerous after the jet was invented In the same way modern global financialmarkets carry with them enormous potential for benefit even if some of theaccidents are that much more spectacular As the right public policy response
41 The problem is illustrated by the divergence since mid-1998 between reported earn-ings by the Standard amp Poorrsquos (SampP) 500 and the after-tax profits of all corporations inthe national accounts Generally these two series move closely with one another Be-tween mid-1998 and mid-1999 SampP 500 reported that earnings increased by more than20 percent while after-tax profits of all corporations increased by less than 5 percent(Chase Bank US Economic and Policy Research US Weekly Prospects Chase SecuritiesWeekly Newsletter 5 June 2000 5)
42 For example the US Securities and Exchange Commission had no direct role in calmingmarkets in the 1987 or 1998 panics
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122 WORLD CAPITAL MARKETS
to the jet was longer runways better air-traffic control and better training forpilots and not the discouragement of rapid travel so the right public policyresponse to financial innovation is to assure a safe framework so that the ben-efits can be realized not to stifle the change
Accepting Summersrsquos analogy for the international financial system better-informed supervisors and investors are a necessary part of the financialsystem framework Supervisors require more timely information on therisk profiles resulting from positions taken by financial institutions Theyalso need a better understanding of risk-management systems Snapshotsof an institutionrsquos risk profile and risk-management procedures are nolonger adequate In a world where huge bets are quickly made (andpossibly lostmdashas with Barings Bank in 1995 and LTCM in 1998) super-visors must focus on the soundness of banking systems for evaluatingand managing risk on a daily basis Some progress has been made inaddressing these issues US banking examiners are extending their in-formation requirements in banking examinations and increasing theirinvolvement in large complex institutions43 More awareness is alsorequired of the fact that they are national organizations in a world ofcross-border capital flows To a much greater extent they need a multi-national reach International supervision and coordination among super-visors are the subject of the next section
Our analysis suggests that G-10 supervisors have unfinished businessBank supervisors need to start yesterday securities regulators can waituntil tomorrow One G-10 member acting alone cannot correct the biasIn good times the lending business will simply migrate to other G-10banks In bad times financial problems will not stop at the national bor-der A way has to be found to establish common international standardsfor the key financial players in order to prevent crises and to agree onapproaches for managing them The path has already been laid out Inthe wake of the bank failures of the past 25 years bank supervisors havetried to establish such standards They have done this without creating anew global institution
The essence of the international framework is decentralizationmdashglobalrules and design standards without global institutions that are perceivedto intrude on national sovereignty The awkward jargon for this frame-work is vertical subsidiaritymdashldquothink internationally act nationallyrdquo Theinternational thinking is done by a committee of regulators that meets
International SupervisionA Decentralized Framework
43 These issues are discussed in Ferguson (1999) and Meyer (2000a)
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 123
regularly at the Bank for International Settlements in Basel The commit-tee establishes principles and standards that are interpreted implementedand enforced by national authorities44 In this section we describe thesesupervisory efforts and their weaknesses We present our recommenda-tions for addressing these weaknesses in the next chapter
Basel I
The Basel Capital Accord of 1988 (Basel I)45 drew the lesson from thefinancial crises of the mid-1970s that more adequate capital levels in in-ternational banks would help reduce the systemic risk of bank failureThe primary goal of Basel I was capital adequacy other standards wereput in place not so much for their own virtue as to defend the primarygoal
Capital adequacy requirements were designed to ensure that individualinstitutions have the ability to absorb losses particularly credit lossesAccordingly a backup system of scoring credit risk was devised thatrequired large amounts of bank capital for some types of loans smalleramounts for others and zero for a select list of preferred assets Report-ing requirements were designed to disclose problems and ensure that atroubled bank would take timely steps to restore its capital base in thewake of a loss The Basel I framework worked tolerably well in limitingthe call on the public purse in the G-10 countriesmdashwith the notable ex-ceptions of France and Japan The framework failed to moderate riskybank lending to emerging markets however
Basel I was not developed with emerging markets in mind The origi-nal idea behind it was to develop a common supervisory approach tocross-border banking operations It grew out of political pressure fromUS lawmakers who were determined to require international banks op-erating in the United States to meet US banking standards Toward thisgoal in 1983 Congress passed the International Lending Supervisory ActUS and British banking authorities subsequently agreed on a commontarget the adoption of strict common capital-adequacy standards In 1988other G-10 governments agreed to go along voluntary acceptance ofthe standards throughout much of the rest of the world followed46 Therationale for the capital targets was two-fold The first was to requirebanks to hold sufficient amounts of capital (8 percent of risk-adjusted
44 The international committee of financial authorities agreed on a common definitionof banksrsquo tier-one or ldquocorerdquo capital national authorities defined tier-two capital in theirown manner which permitted greater variations in national working definitions andpractices
45 International Convergence of Capital Measurement and Capital Standards (BIS 1988)was prepared by the Basel Committee on Banking Supervision
46 See Reineke (1998)
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124 WORLD CAPITAL MARKETS
assets) to cushion losses on those assets The second was to dull theirappetites for risk banks with large capital bases would have more tolose if they failed and therefore would take fewer risks
Rapid change in financial markets soon revealed flaws in the Basel IAccord In a complex world with numerous sources of risk it focusedheavily on credit risk but overlooked other risks in a bankrsquos portfolioand the correlation between returns on different asset classes The Baselformula required banks to maintain a fixed amount of capital againsteach of its asset classes But the formula did not distinguish the riskinessof the borrower within each class As a result one large loan to a low-risk corporate borrower such as General Electric would require the sameamount of capital as 10 smaller transactions with high-risk borrowers
The system was also biased toward short-term loans Loans maturingin less than a year required a 20 percent risk weight whereas those ma-turing after more than a year required a 100 percent risk weight Inter-bank lending was particularly favored For example loans to banks inOECD countries required less capital than loans to private firms in thesame countries creating the anomaly that interbank loans to South Ko-rean banks required less capital than loans to General Electric47 Thisanomaly encouraged banks to shed high-quality assets if the Basel rulesrequired the allocation of more capital than banks thought they needed
Another weakness was that financial innovators quickly circumventedthe Accord Because short-term loans required less provisioning than long-term loans banks responded by securitizing their long-term debt port-folios and lending short-term against the collateral of the newly createdasset This allowed banks to circumvent the capital requirements gearedto the terms of the underlying debt At the same time the Basel I Accordfailed to encourage risk mitigation techniques such as credit derivativescollateral guarantees and on-balance-sheet netting the flip side of fi-nancial innovation Because off-balance-sheet products were not coveredby the Accord another anomaly appeared when Barings Bank collapsedin 1995 Barings met capital adequacy standards but collapsed becauseits systems for managing risk failed traders were allowed to speculatein futures contracts that did not appear on the balance sheet
Basel II
Work to overhaul Basel I began in 1995 and produced consultativepapers issued in June 1999 and January 200148 These papers have been
47 South Korean banks have had notoriously weak balance sheets because the practiceof ldquodirected lendingrdquo left them with many poor loans (in making these loans the bankswere expected to follow government objectives rather than creditworthiness criteria)
48 Basel Committee on Banking Supervision (1999 2001)
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 125
the subject of extensive consultation and revision as a result the newAccord is expected to be introduced in 200449 The Basel II frameworkhas three parts (pillars) revisions to Basel I minimum-capital require-ments supervisory review criteria and greater emphasis on market dis-cipline Broadly Basel II aims to maintain the level of capital in the sys-tem but achieve better alignment of banksrsquo capital with their risk pro-files and keep up with financial innovation
To align capital requirements with market realities (the first pillar)Basel II concentrates on the 100 or so largest banksmdashthe type of playerslisted in table 21mdashand on the holding-company parents of banking groups50
Capital requirements will differentiate between an increased number ofcredit groups or ldquorisk bucketsrdquo including claims on governments otherbanks corporations mortgage-backed securities and other asset-backedsecurities
Basel II originally proposed to use external ratings to set capital chargesfor a number of these credit risks Many banks objected arguing thatthey assess credit risk better than Standard amp Poorrsquos Moodyrsquos or FitchIBCA51 Basel II thus proposes two approaches to rating a standard ap-proach using external ratings and an ldquoadvancedrdquo approach that allowsselected banks to use their own internal rating systems To encouragethe development of rigorous internal control systems based on these in-ternal rating systems Basel II also proposes to levy capital charges foroperational risk (the risk of direct or indirect loss resulting from inad-equate or failed internal processes people and systems or from exter-nal events)
Some critics of this proposal dismiss it as an abrogation of the prin-ciple of external independent monitoring and as ldquodangerously naiumlverdquo52
But regulators argue that the new capital charge on operational risk shouldoffset this concern It is also far from clear how cross-national compari-sons of rating and internal risk-assessment systems will be made (Engelen2000) The development by the European Union of its own capital rulescould well complicate the international resolution of these issues Publicassurances by EU officials in January 2001 however indicated that theirmain concerns are to create a level playing field and avoid regulatoryarbitrage (Hargreaves 2001) There is also the significant problem ofthe procyclical character of risk weights When a crisis hits losses are
49 See Berry (2000) for an update in an interview with William J McDonough chair ofthe Basel Committee on Banking Supervision
50 For obvious reasons these proposals are addressed to large banks and simpler capi-tal standards are allowed for small banks that focus on their domestic credit markets
51 See Ammer and Packer (2000) for an empirical critique of the success of rating agen-cies in distinguishing risk by sector and region
52 See Auerback (2001)
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126 WORLD CAPITAL MARKETS
incurred or accrued capital is lost and loan exposure must be reducedor securities sold to restore the requisite capital-adequacy ratios A morerisk-sensitive framework could amplify volatility
As the second pillar of Basel II supervisory review criteria are beingbeefed up to encourage supervisors to intervene earlier in potential problemsituations and to compel banks to align their capital positions with theirrisk profiles Bank supervisors will be authorized to require banks tohold capital in excess of minimum requirements if they have concernsabout general management overall strategy risk-management performanceor the macroeconomic environment Of course if one G-10 supervisorimposes higher capital requirements in isolation the same disparity willemerge that presaged Basel I Some banks will be disadvantaged in theinternational marketplace and will loudly complain that excessive super-vision is driving business to their competitors Hence close internationalcooperation among supervisors is critical
To implement the third pillar market discipline banks will be requiredto make fuller more timely disclosure of capital adequacy and the risksto which that capital is exposed A number of measures are being stud-ied that might help supervisors evaluate bank performance such as com-parisons of uninsured deposit interest rates subordinated debt yieldsand equity prices The idea is that these yields and prices might alertsupervisors to market perceptions of risk Of course market perceptionsare only as good as market information More direct and controversialways to reinforce market discipline would dramatically increase publicdisclosure of bank positions and risk management systems
Many questions are still outstanding about how to resolve the techni-cal details of capital requirements and whether the requirements willachieve their intended goal of better assessment and mitigation of therisks in banksrsquo portfolios There is no substitute for skilled supervisorsThe intricacies of effective design and implementation suggest that su-pervisors need to be highly competent technically knowledgeable aboutbanking portfolio characteristics and the factors that influence bank ex-posure to credit risk (Mishkin 2000) And they must be aided by vigilantshareholders market forces and transparency of information53
Standard setting at the global level is desirable but ultimately theeffectiveness of these efforts will be tested at the national level espe-cially in times of systemic financial distress Here the record of Basel Iwas not a bright shining success Japanese banking regulators havetraditionally allowed banks to include real estate and securities in theircapital base When the value of these assets plummeted in the early 1990sregulators allowed banks to continue valuing these depreciated (andoften bankrupt) assets at their old inflated levels Japanese authorities
53 Benedict Roth Complacency Towards Catastrophe Financial Times 23 January 2001
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 127
insisted until the mid-1990s that eroded capital bases could be rebuiltin a market-driven fashion They rightly foresaw that huge loan losseswould undermine public support for the ruling party and require a po-litically unpopular bailout
Japanese foot dragging on Basel I was the worst54 but not uniqueOther examples can be found of ldquopolitically mandated forbearancerdquo TheFederal Reserve Bank of New York held important hands during theLTCM crisis of 1998 Mexico is still resolving the banking crisis that eruptedin 1995 South Korea has not yet closed the insolvent banks that behavedso badly before the crisis of 1998 In the aftermath of a crisis nationalregulators cannot always be relied upon to discipline politically power-ful bankers55 One of the little-noticed consequences of these differingapproaches is that those banks with strong regulatory systems receivedan implicit ldquoexport subsidyrdquo for their services US banks which had notengaged extensively in emerging-market lending in the 1990s were bet-ter positioned than their German and Japanese counterparts to expandtheir international assets in the wake of the crises
Other Financial Forums
54 See Japanese Banks Fiddling while Marunouchi Burns The Economist 27 January2001 67-69
55 See Calomiris (1997)
The Basel model of vertical subsidiarity has already been extended toother financial regulatory bodies In 1993-94 the BIS established a Tri-partite Group of Banking Insurance and Securities Regulators In 1994-95 the BIS increased its cooperation with the International Organizationof Securities Commissions when the two organizations issued parallelpapers on guidelines for national regulators concerning risk managementand disclosure of derivative trades In 1996 a permanent Joint Forum onFinancial Conglomerates was established to examine supervisory issuesand develop working arrangements among the different functional super-visors of conglomerate institutions that offer combinations of bankingsecurities and insurance products Draft papers on the supervisionof conglomerates were released for comment in 1998 applying capital-adequacy principles to these groups and providing guidelines both forassessing the integrity and competence of top managers and for sharingassessments between regulators
In 1997 the Basel Committee on Banking Supervision extended itsreach beyond capital standards to broader aspects of banking supervi-sion with the publication of the Core Principles for Effective BankingSupervision In 1999 a wide range of regulatory and standard-settingbodies were gathered under the umbrella of the Financial Stability
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128 WORLD CAPITAL MARKETS
Forum (FSF) itself established under BIS aegis56 The FSF has alreadyissued recommendations for stepped-up supervision and transparencyas well as guidelines for best practices in a number of areas includingoffshore financial centers and highly leveraged institutions or hedge funds57
Conclusion
Although the structural weaknesses in emerging-market economies arewidely acknowledged to have been causal factors in international capi-tal-market volatility this chapter points to the role of large G-10 bankingorganizations as major suppliers of the most volatile instrument short-term debt We have examined evidence of the impact of public safetynets in the G-10 economiesmdashthe deposit insurance systems the pruden-tial supervisory systems and the lender-of-last-resort functions of centralbanksmdashon the incentive structures of these organizations
Although supervisors in most countries working nationally and to-gether in the BIS have made significant efforts to mimic market forcesin their prudential supervision the most sophisticated financial institu-tions find innovative ways to circumvent the rules New global regulatorybodies are not about to be created G-10 national bank regulators shouldthemselves address the short-term debt bias in the international financialsystem by changing incentive systems G-10 securities regulators shouldalso take steps to get ahead of the curve paying close attention to largeportfolio swings by institutional investors particularly in times of crisisIn short more needs to be done at national and international levels tochange the rules of the game That is the subject of the next chapter
56 The Financial Stability Forum includes banking securities insurance and accountingregulatory bodies the OECD on taxation corruption and corporate governance and theIMF
57 See Martin (2000)
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102 WORLD CAPITAL MARKETS
businesses) for which they were originally intended The implicit centralbank safety nets extend in a crisis to nearly all depositors and banksThus banks are both viewed and behave as if they will be bailed out ifthey get into trouble
The existence of a public safety net raises a perennial question Dobanks have an unfair advantage over other financial institutions becauseof the subsidy provided by the safety net This question was at the heartof intensive study and debate in the United States leading up to thepassage in November 1999 of the Financial Services Modernization Act(also known as the Gramm-Leach-Bliley Act) The size of the gross sub-sidy is difficult to estimate despite determined research efforts Somesuggest it is well under 100 basis points and is at least partly offset bythe direct costs of deposit insurance premiums interest payments on bondsissued by the Financing Corporation25 reserve requirements regulatoryexpenses and operational costs associated with collecting deposits26 Con-versely Kwast and Passmore (2000) suggest that banks can expand theirscope far beyond the levels that other financial institutions could reachwith the same equity base but without the public safety net
A related concern in the US debate is whether allowing banks to ex-pand their activities into securities and insurance will ultimately extendthe safety net and add to the subsidy The Financial Services Moderniza-tion Act deals with this issue by maintaining a legal separation betweenbanks and the rest of the banking organization known as large com-plex banking organizations (LCBOs) They must engage in most securi-ties activities and insurance underwriting through separately capitalizedinvestment bank subsidiaries or holding company affiliates This act canbe said to have merely brought US banking laws closer to those of mostother industrial countries (Barth Brumbaugh and Wilcox 2000 BarthNolle and Rice 2000) If the fire wall is well-maintained and stoutly de-fended the safety net will neither expand in practice nor become a sourceof comfort to noncommercial bank subsidiaries of LCBOs
The quid pro quo exacted by governments to offset the subsidy iscloser public-sector monitoring of banksrsquo activities through prudentialsupervision The effectiveness of this closer official scrutinymdashand closermarket monitoringmdashare the subjects of the next section
25 The Financing Corporation was created by Congress in 1987 to sell bonds to raisefunds to help resolve the savings and loan crisis
26 See Levonian and Furlong (1995) Jones and Kolatch (1999) Shull and White (1998)and Whalen (1999a 1999b)
Are G-10 bank supervisors adequately responding In this section we firstassess the case for and compare the structures of prudential supervisory
Prudential Supervision
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 103
systems both within and among the G-10 economies plus Spain andconsider whether these offset the subsidy provided by the public safetynet Despite offsetting regulation and supervision implicit and explicitguarantees by G-10 governments to their banks are still a source of bank-ing instability in the emerging-market economies
National Systems for Prudential Supervision
Governments use prudential supervision to reduce the moral hazard andadverse selection created by their own safety nets Supervisors establishregulations and monitor compliance to limit risk taking and ensure thesafety and soundness of the banking system In a thoughtful analysis ofthe case for prudential supervision Frederic Mishkin (2000) identifiesthe main forms that supervision can take including the tasks of grantingbanking charters and licenses establishing capital requirements settingdeposit insurance premiums and defining disclosure requirements as wellas carrying out bank examinations Bank examiners gather informationfrom banks and evaluate whether they are following the regulatorsrsquo rulesin cases of weakness they are empowered to change banksrsquo behaviorand close them if necessary
Supervisors also may restrict competition define the activities in whichbanks may engage and restrict their asset holdings and separate banksand other financial (or nonfinancial) activities During the past two de-cades the barriers separating commercial banks investment banks in-surance firms and securities firms have been all but eliminated (tableB1) Deregulation has stimulated competitive forces that drive diversifi-cation and consolidation of the financial industry nowhere faster than inthe United States
The Financial Services Modernization Act of 1999 confirmed this trendIt eliminated restrictions dating back to the Glass Steagall Act of 1933which once prevented banking insurance and securities firms fromentering each otherrsquos businesses (Barth Brumbaugh and Wilcox 2000)Cross-pillar mergers among banks insurance and securities firms arewell under way to form giant financial holding companies The 1999merger between Citibank (banking) and Travelers (insurance) created themodel for megafinance and confirmed new challenges for supervisors
Mishkin (2000) notes the corresponding evolution in US supervisionfrom an emphasis on rules-based regulation (detailed rules for opera-tional behavior and the quality of line items in the balance sheet) to anapproach that stresses the soundness of bank management practices es-pecially risk management
Appendix B outlines the systems of financial supervision now in theplace in the G-10 countries plus Spain Some systems like the UK andCanadian approach are models of simplicitymdashorganized to keep pacewith the spreading reach of financial conglomerates Other systems like
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104 WORLD CAPITAL MARKETS
the US and French approaches show traces of the bureaucratic divisionsthat made sense in an era when banking securities and insurance weresharply separated
The US Model
27 See Meyer (1999a)
28 Canada has a similar degree of simplification with the exception that securities firmsare still regulated by provincial authorities
29 See Pratti and Schinasi (1999 67)
30 The agents are the bank regulators and the principals are the taxpayers Agents maypursue their own interests including bureaucratic survival and postgovernment employ-ment opportunities rather than the national interest in banking safety and soundness
The US model of financial regulation delineated in the Financial Ser-vices Modernization Act of 1999 blends functional and umbrella super-vision Bank and thrift regulators oversee depository institutions Newnonbank activities are subject to both functional regulation (eg by theSecurities and Exchange Commission and state insurance examiners) andumbrella supervision (of financial holding companies) by the FederalReserve27
The UK Model
Another supervisory model exists in the United Kingdom as well as inAustralia Canada and Switzerland28 In this model banking supervisionis separated from the monetary policy function The regulatory structureis considerably simplified by relying on a consolidated financial regula-tor separate from the central bank for both banking and nonbankingactivities The remaining question answered differently depending on thecountry is the extent to which the regulator relies on home-country sur-veillance of banks and conglomerates that have a local presence
Regulatory Models Compared
Appendix B provides more detail on the differences in these modelsGerman simplicity contrasts with French complexity In France the bankingcommission is chaired by the governor of the central bank and includesrepresentatives from the Treasury The commission supervises compli-ance with regulations but the central bank inspects banks on behalf ofthe commission29 In countries such as the United States and France withmultiple supervisors and crossover functions internal coordination is criticalAt the same time multiple agencies create regulatory competition Wheneach agency knows what the other is doing transparency within gov-ernment circles can help to limit principal-agent problems of regulation30
The discussion as to where in the public bureaucracy financial super-
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 105
vision should be placed goes back many years Peek Rosengren andTootell (1999) argue that a synergy exists between monetary policy andprudential supervision because information gained in the course of super-vision can increase the accuracy of macroeconomic forecasts A twist tothis argument is that the information on the state of financial institutionsavailable to the central bank as supervisor can facilitate its role as lenderof last resort Conversely there is the concern that a supervisory rolewill compromise the central bankrsquos independence of action with respectto its core mandatemdashmaintaining price stability As these arguments haveplayed out financial supervision has generally been shared between centralbanks and other regulators or placed entirely in the hands of an inde-pendent regulator However in Italy the Netherlands and Spain cen-tral banks are the sole banking supervisor
Goodhart (1995) examined the arguments and evidence for each modeland concluded that there were no overwhelming arguments or evidencefor one or the other31 Going forward a key problem for any financialsupervisory system is dealing with (and closing as necessary) weak banksIf both central banks and other regulators have this responsibility closecoordination between them is critical Another problem is large conglom-erate banks LCBOs Although they are less likely to fail because of thediversification of their assets and liabilities they are more likely to berescued They are also more likely to be multinational enterprises withinternational implications Goodhart observes that regulation of theseentities might be put in the hands of the central bank because it is lessamenable to political pressures In any event the complexity of LCBOoperations suggests that greater supervisory rigor is necessary
The US Congress was persuaded that broad oversight would help containthe moral hazard problem and accordingly gave the Federal Reservethe role of umbrella supervisor with the understanding that the Fed willscrutinize depository activity more intensely than nonbank financial ac-tivities Under this approach LCBOs such as Citigroup are subject tomuch closer monitoring than smaller and simpler institutions32 The USregulatory model requires enormous cooperation between the Fed otherbank supervisors and the functional regulators for insurance and securi-ties but it also benefits from regulatory competition
31 National systems of supervision are path dependent they are determined by the struc-ture of financial institutions and history in each country If Goodhart (1995) is right out-comes are not materially better or worse with one model of supervision rather than another
32 See Ferguson (1999)
Public Safety Nets
One of prudential supervisorsrsquo biggest challenges is to reduce moral hazardFor many years commercial banks engaged in communal self-insurance
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106 WORLD CAPITAL MARKETS
to deal with crises They formed voluntary groups that agreed to rescuetroubled members As financial markets evolved and competition inten-sified banks were no longer willing to play this role Private-sector in-surance is one alternative but moral hazard and adverse selection wouldappear to prevent it from happening Public safety nets have developedbecause of the low probability and high cost of potential bank runs Aclear trade-off is involved The effectiveness of insurance in preventingbank runs is greater the more comprehensive the coverage But the morecomprehensive the coverage the greater the moral hazardmdashbank man-agers bank directors investors and depositors all take on greater risksin the belief that the safety net will protect them against losses
All G-10 countries have compulsory public safety nets for banks (table29) Deposit insurance agencies are officially organized in Canada theNetherlands Sweden Switzerland and the United States organized bythe industry in France Germany Italy and the United Kingdom andjointly organized by the public and private sectors in Belgium Japanand Spain
How well do G-10 governments offset the subsidy provided by thepublic safety net This is a question on which there is substantial debateAs banking organizations have become more complex the challengesthat supervisors face have become more difficult One challenge is toalign the incentives facing bank managers and shareholders with thoseof depositors Another is the principal-agent problem in supervision Wehave discussed the incentive structures for financial institutions but wehave said little about the incentives for supervisors themselves and thedistortions they can generate in the financial system
In one of the many studies of the US savings and loan crisis of the1980s Kane (1989) documented both problems He described managersusing cosmetic approaches to disguise the magnitude of insolvency regulatorspracticing forbearance even though they knew of the deteriorating riskprofiles of the institutions for which they were responsible and legisla-tors increasing deposit insurance without regard for any offsetting changesin supervision A subsequent overhaul of the legislative framework forthe Federal Deposit Insurance Corporation (FDIC) known as the FDICImprovement Act of 1991 (FDICIA) aimed to introduce a clearer incen-tive structure for both regulators and regulated institutions
The changes introduced by this US legislation are worth discussionwith respect to the other G-10 countries as well First FDICIA created astronger signal to management and investors by targeting deposit insur-ance at small depositors only and by risk-weighting the deposit insur-ance premiums paid by banks to reflect their capital adequacy and bankexaminer ratings Among the G-10 countries rated in table 210 depositinsurance premiums vary considerablymdashbut it is not clear that the dif-ferences have much to do with risk-weighting Most G-10 countries em-ploy funding formulas based for example on the total domestic deposit
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TH
E P
LAY
ER
S T
HE
IR S
UP
ER
VIS
OR
S A
ND
MO
RA
L HA
ZA
RD
107
Table 29 Deposit insurance schemes in the G-10 countries Explicit safety net
Coverage limit(dollar Foreign
equivalent currency Interbank Source Bankrsquos Contingency fundingDate Membership Co- at end of deposit deposit of premium from banks
Country established managementa insuranceb July 1998)c covered covered Fundingd funding costs or governments
United 1982 Compulsory Yes Larger of 90 No No Unfunded Banks only Callable (subject Parliament may increase Kingdom private percent co- to maximum the maximum payable
insurance to 03 percent of pound125 million advance 33000 total deposits) facility with Bank of
England
United 1934 Compulsory No 100000 Yes Yes Funded Banks and Up to 027 Borrowing up to $3 States official government percent total billion from US Treasury
domestic deposits
Japan 1971 Compulsory No 71000 but No No Funded Banks and 0084 percent of Borrowing up to yen500bn joint in full until government insured deposits from Bank of Japan
year 2000 subject to Ministry of Finance approval
Canada 1967 Compulsory No 40800 No Yes Funded Banks and 033 percent of Borrowing up to C$6 official government insured deposits billion authorized further
(maximum) borrowing subject to parliamentary approval
Germany 1966 Compulsory Yes 90 percent Yes No Funded Banks only 003 percent of Annual levy may be private coinsurance deposits doubled
to 22000
Italy 1987 Compulsory Yes 125000 Yes No Unfunded Banks and Callable Two options defer private government (maximum of payment or diminish
1 percent of compensation to be paid total deposits)
(table continues next page)
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ics | httpww
wiiecom
108W
OR
LD
CA
PIT
AL
MA
RK
ET
S
Table 29 Deposit insurance schemes in the G-10 countries Explicit safety net (continued )
Coverage limit(dollar Foreign
equivalent currency Interbank Source Bankrsquos Contingency fundingDate Membership Co- at end of deposit deposit of premium from banks
Country established managementa insuranceb July 1998)c covered covered Fundingd funding costs or governments
Netherlands 1979 Compulsory No 22000 Yes No Unfunded Banks and On demand Government backing official government maximum of subject to parliamentary
5 percent of own approval funds
France 1980 Compulsory No 65400 No No Unfunded Banks only Callable (on Extra calls up to FFr1000 private demand calls million can be made in
up to FFr200 a 5-year period million)
Switzerland 1984 Voluntary No 19700 No No Unfunded Banks only Callable (on Underwritten by member official demand) banks
Sweden 1996 Compulsory No 31400 Yes No Funded Banks and 05 percent of Full emergency coverage official government deposits while replacing it with a
limited system after the emergency
Belgium 1974 Compulsory No 16600 No No Funded Banks and Callable 002 None insurance limited joint 22000 in government percent of to assets in fund
year 2000 deposits from clients
Spain 1977 Compulsory No 16439 Yes No Funded Banks and 02 percent of Government backing joint government deposits through the Banco de
(maximum) Espantildea subject to approval by royal decree
a Bank membership in the fund can be either compulsory or voluntary and the management of the fund can be official and official and private joint or privateb Coinsurance refers to the situation where depositors face a deductible against their insured fundsc Coverage limit refers to the explicit amount the authorities promise to insured Funded scheme means that it is funded ex ante unfunded otherwise
Sources Goodhart (1995) Demirguccedil-Kunt and Detragiache (2000) Demirguccedil-Kunt and Sabaci (2000)
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ics | httpww
wiiecom
THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 109
base Explicit safety net protection also varies but only Canada focuseson the protected class33 All G-10 countries specify a limit on depositorprotection Under FDICIA the insurance fund is prohibited from pro-tecting uninsured depositors or creditors at a failed bank although adiscretionary system-wide override is provided for exceptional circum-stancesmdashbut with stringent requirements for consultation and account-ability Other G-10 countries allow for contingency funding from the publicpurse alongside unwritten lender-of-last-resort support Among large banksa significant and growing portion of deposit liabilities including foreigncurrency and interbank deposits are uninsuredmdashbut depositors assumethey will be protected in a crisis
FDICIA also made some significant qualitative changes to address theprincipal-agent problem by penalizing weak banks and rewarding strongbanks For example banks whose capital declined faced progressivelytougher regulatory sanctions that for example required them to elimi-nate dividends restrict their lending and change their managementsRegulators have also been forced to take prompt corrective action (toreduce the practice of regulatory forbearance in hopes that a bankrsquos for-tunes might improve)34 Unfortunately comparative qualitative assess-ments across the G-10 are difficult to make due to lack of information35
This discussion highlights the complexity of evaluating the extent towhich prudential supervision and market discipline reduce the moralhazard associated with G-10 safety nets Our argument is that publicsafety nets in the G-10 can be linked to banking instability in other coun-tries specifically in the emerging-market economies that have attractedG-10 cross-border bank lending This lending is a leading source of vola-tility in capital flows the large financial institutions many of which arecomplex banking organizations are based in and regulated by authori-ties in the G-10 economies These two features of the international finan-cial system are closely related although it is not possible to test thisrelationship econometrically
Two World Bank studies however indicate a basis for concern Onestudy is a cross-country econometric analysis of the relationship betweenbank stability and deposit insurance (Demirguccedil-Kunt and Detragiache2000) which found a negative relationship Their estimated model forbanking crises in a sample of 61 countries (both industrial and develop-ing) suggests that explicit deposit insurance raises the probability of acrisis by at least 30 percent36 Crises are especially likely in countries
33 Japanrsquos legislation says it does but recent experience shows this is not the case34 See Goldstein (1997) for a summary of the changes35 See Barth Nolle and Rice (2000) for a beginning in this area36 Demirguccedil-Kunt and and Detragiache (2000 table 1) report a logit coefficient of 0696with a standard error of 0397 (the coefficient is significant at the 8 percent threshold)This suggests that the ldquotruerdquo coefficient could well be as small as 030 (the reportedvalue minus the standard error)
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110 WORLD CAPITAL MARKETS
with immature financial supervisory systems (and not in the G-10) buttheir analysis does underscore the view that deposit insurance weakensmarket discipline37
An earlier World Bank analysis established similar results One wasthat market discipline is undermined by deposit insurance schemes an-other was that illiquid banks are forced to pay more for their funds un-less a generous deposit insurance scheme is in place (Demirguccedil-Kuntand Huizinga 1999) This econometric study also provides clear-cut evi-dence that depositor monitoring of banks declines with the existence ofdeposit insurance schemes At the heart of the problem is the questionof whether deposit insurance is accompanied by increased governmentmonitoring
This evidence and the weight of other arguments suggests that moralhazard is still an issue in the G-10 countries Consider the ongoing de-bate about instilling greater market discipline on risk taking by banksAt one extreme is the perennial proposal to do away with safety netsleaving markets to monitor the players and to force adjustments but toprotect small savers by creating ldquonarrow banksrdquo such as postal savingsystems that are allowed to invest these savings only in risk-free gov-ernment securities Whatever the merits of narrow banking this solutionis too extreme to be politically feasible
A moderate alternative is to force more disclosure by financial institu-tions to facilitate market monitoring But transparency has its own prob-lems Persaud (2000) argues that financial markets cannot reliably discernsustainable from unsustainable positions in the short term This uncer-tainty causes banks to ldquoherdrdquo behind market leaders to exploit theirsupposedly superior information ldquoThe more herding investors and bankersknow about what each other is up to the [more] unstable markets maybecomerdquo The implication is that greater transparency in the marketplaceby itself will not solve the problemmdashand in the short term more informa-tion may exacerbate herding Further supervisory steps (discussed in thenext chapter) are required
Yet another proposal is to promote private-sector involvement in bankmonitoring through market-based alternatives such as Calomirisrsquos sub-ordinated debt proposal (Calomiris 1997 Federal Reserve Board 1999)Banks could be required to issue and maintain a minimum amount of
37 Other findings in the Demirguccedil-Kunt and Detragiache (2000) study include thesepropositions The impact of deposit insurance on bank stability tends to be stronger themore extensive is the coverage offered to depositors when the scheme is funded andwhere the scheme is run by the government rather than by the private sector Con-versely deposit insurance is detrimental to bank stability where bank interest rates havebeen deregulated and where the institutional environment is weak Additional findingson deposit insurance are reported from a recent World Bank conference (8-9 June 2000httpwwwworldbankorgresearchinterestconfsupcomingdeposit_insurancehomehtm)Also see Smalhout (2001)
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 111
subordinated debt (eg uninsured certificates of deposit) to finance asmall fraction (such as 2 percent) of their total nonreserve assets Thesubordinated debt would be allowed to earn a set yield no more than 50basis points over the risk-free yield on government treasury bills Thisrule would supposedly force banks to operate in a safe manner Other-wise subordinated debt holders would redeem their uninsured certifi-cates of deposit and equity investors would sell their bank shares Despiteits practical problems the beauty of the subordinated debt requirementis that it enlists market incentives to push banks to avoid excessive port-folio risk38
The thrust of these proposals is very relevant to the arguments in ourstudy Even in the G-10 countries government monitoring by itself hasnot eliminated moral hazard among banks More work is needed to in-troduce market monitoring and to improve the incentive structures bothfor financial institutions and their supervisors We return to this issuewith our recommendations in the next chapter
38 In late 1996 Argentina began requiring its banks to finance 2 percent of total depos-its in the form of subordinated debt but without a maximum yield provision TheArgentine authorities expect that market discipline will act in concert with the publicsafety net One obvious problem with the subordinated debt proposal is that banks mayencourage some of their customers to buy the subordinated debt
Portfolio Institutions Tomorrowrsquos Problem
Before proceeding to the issues of international supervision we flag an-other potential problem for national regulators The big asset managersprofiled in tables 24 and 26 answer to diverse groups of pensionersshareholders and policyholders They allocate funds across a number ofcountries to diversify their risks They hold liquid assets that can be tradedand they have a higher proportion of long-term assets than banks Eco-nomic shocks can be absorbed through price changes and their effectsspread across time and markets Thus when conditions change in a par-ticular market they are more likely to ride out the storm than to flee Inother words they have less incentive than banks to pull their invest-ments in the face of adversity In the 1990s most large asset managersestablished a record of ldquoriding out the stormrdquo rather than ldquorunning withthe windrdquo although as we saw in chapter 1 instances of running withthe wind were detected in some portfolios As we write these insti-tutions have a good record overall in the emerging markets so whyworry
The Russian crisis and the near-collapse of LTCM previewed the dan-gers that may await future portfolio managers and G-10 financial minis-ters We have presented evidence indicating a systemic bias toward bank
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112 WORLD CAPITAL MARKETS
lending and debt finance to emerging markets and we have argued forsubstitution toward equity finance and direct investment39
That is not the end of the story We noted in the previous chapterthat institutional investors can become momentum investors selling in adownturn As more portfolio capital is invested in emerging marketssome players may adopt the high-risk high-leverage strategies of themost aggressive hedge funds Indeed the data in box 11 show that G-10portfolio investors held somewhat more long-term debt (more than $500billion) than equity (less than $400 billion) in emerging markets at theend of 1997 Long-term debt is an ideal vehicle for high-risk high-leveragestrategies These strategies practiced on a large scale could compound afuture crisis harming emerging markets A big enough crisis could inturn pressure G-10 central banks and finance ministers to arrange bail-out plans Instead of shrinking as a systemic financial problem moralhazard could increase
National securities regulators are the first line of defense against thisscenario They play a critical role in the safe evolution of capital mar-kets But regulators today are mandated to approve the issuance of newsecurities and to monitor the continuing disclosure of material informa-tion by issuers They are far less concerned with or empowered to monitorthe behavior of the increasingly large wealth-management firms that arethe major purchasers (and therefore resellers) of these securities
Within their mandates the goals of national securities regulators (table210 and appendix B) are similar to the concerns of bank regulators withsystem safety and soundness Their focus is also on the incentive sys-tems for management and boards of directors and on disclosure by cor-porations that issue marketable securities such as shares bonds andasset-backed securities 40 Issuers of securities possess greater knowledgeabout the quality of these assets than do the purchasers hence investorprotection is a key concern of regulators Moreover market disciplineworks best when markets know what is happening Well-functioning corpora-tions are key agents of wealth creation and social progress Underperform-ing corporations waste resources During recessions bad corporationsget into bad trouble often with severe social consequences Inadequateincentives for managers and inadequate accountability for boards andmanagers thus have negative externalities Regulators play a vital role inexposing weakness so that market disciplines come to bear sooner ratherthan later
Regulatory emphasis is constantly shifting as financial markets evolveand as the macroeconomic environment changes Regulators try to balance
39 See Rogoff (1999) Also see Berlin (2000) for a perspective on the limited role thatbanks play as share owners
40 See Habib and Ljungqvist (2000) for recent empirical analysis showing that corporateshare market values are higher when corporate executives have a larger ownership stake
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Table 210 Financial-sector regulation G-10 countries 2000
Financial institutions and their supervisors
Country and supervisory structure Retail banking Wholesale banking Securities Insurance
Financial conglomeratesFinancial Services Authority (FSA) = umbrella supervisor
United Kingdom FSA FSA FSA FSA
Treasury bull Commercial banks bull Investment funds (Securities and (Insurance Directorate(Securities and Investments Board) bull Unit trust groups Futures Authority) of the Treasury)
Bank of bull Building societies bull Pension funds England (Building Societies Commission) bull Merchant banks
bull Friendly societies bull Clearing houses bull Primary issuers bull Insurance FSA (Friendly Societies Commission) bull Venture capital of securities companies
bull Pensions and life insurance etc bull Stock exchanges bull Insurance brokers(Personal Investment Authority) bull Stockbrokers
Financial holding companiesFederal Reserve (FR) = umbrella supervisor
United States bull National banks(OCC) Securities and Regulated by
Treasury OCC bull State banks Federal Reserve Exchange Commission StatesMembers (FR)
OTS Nonmembers (FDIC) bull Investment banks bull Primary issuers of bull Insurance companies FR bull Cooperative banks (FDICFR) bull Finance companies securities bull Insurance brokers FDIC bull Insured industrial banks (FDIC) bull Stock exchanges
bull Thrift holding companies (OTS) bull Stockbrokers SEC bull Savings banks (OTSFDICFR) bull Investment advisors
bull Savings and loan associations bull Mutual funds(OTS) bull Public utility holding
bull Edge Act corporations (FR) companies
(table continues next page)
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Table 210 Financial-sector regulation G-10 countries 2000 (continued )
Financial institutions and their supervisors
Country and supervisory structure Retail banking Wholesale banking Securities Insurance
Financial holding companies Japan Financial Supervisory Authority (FSA) = umbrella supervisor
Prime FSA FSA FSA FSA ministerrsquos Ministry of office Finance (Securities and Exchange
Surveillance Commission) FRC Bureau of Financial bull City banks bull Investment banks bull Primary issuers of bull Insurance companies FSA Regulation bull Regional banks bull Asset managers securities bull Insurance brokers
bull Trust banks bull Stock exchanges SESC bull Long-term credit banks bull Stockbrokers
bull Pension funds
Financial holding companiesOffice of the Superintendent of Financial Institutions (OSFI) = umbrella supervisor
Canada Regulated by OSFI OSFI provinces OSFI
Department of Financebull Banks bull Cooperative credit bull Primary issuers of bull Insurance companies
(previously Office of the Inspector associations securities (previously Depart- OSFI General of the Banks) bull Fraternal benefit bull Stock exchanges ment of Insurance) Bank of bull Trust and loan companies society bull Stockbrokers bull Insurance brokers Canada bull Pension funds bull Asset managers
(previously Depart- CDIC ment of Insurance)
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Financial institutions and their supervisors
Country and supervisory structure Retail banking Wholesale banking Securities Insurance
Germany Financial holding groupsFederal Banking Supervisory Office (FBSO) = umbrella supervisor
Ministry of Finance FBSO BSO FSSO FISO
Bundesbankbull Universal banks bull Other financial bull Primary issuers of bull Insurance companies
Federal Banking bull Savings banks institutions (eg securities bull Insurance brokers Supervisory Office bull Securities banks management foreign bull Stock exchanges
currency dealings) bull Stockbrokers Federal Securities bull Financial enterprises bull Asset managers Supervisory Office (eg leasing bull Pension funds
organizations Federal Insurance credit card companies Supervisory Office investment advisors)
Italy Bank foundationsMinistry of Finance = umbrella supervisor
Ministry of Finance Bank of Italy Bank of Italy Consob ISVAP
Bank of Italy bull Commerical banks bull Asset managers bull Primary issuers of bull Insurance companies Consob bull Savings bank bull Open-end investment securities bull Insurance brokers
bull Securities banks companies (SICAVs) bull Stock exchangesbull Stockbrokers
ISVAP
(table continues next page)
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Table 210 Financial-sector regulation G-10 countries 2000 (continued )
Financial institutions and their supervisors
Country and supervisory structure Retail banking Wholesale banking Securities Insurance
The Netherlands Financial conglomeratesCouncil of Financial Supervisors = umbrella supervisor
Securities Board Securities Board Netherlandsche Netherlands Bank Netherlandsche Bank of the Netherlands Insurance Board Bank Insurance bull Credit institutions (universal banks bull Investment institutions bull Stock exchanges bull Insurance companies Board cooperative banks security credit (securities issuing bull Stockbrokers bull Insurance brokers
institutions mortgage banks) and tradingmdashprimary The Council of Financial and secondary Supervisors markets)
France Commission des Commission de Operations des Controcircle des
Banking and Banking Commission Bourse Assurances Financial Regulatory bull Ensuring that credit institutions (and investment firms since bull Primary issuers of bull Insurance companies Ministry for Committee the Financial Activity Modernization Act of 1996) comply securities bull Insurance brokers Economic with laws and regulations bull Stock exchanges Affairs and bull Execute instructions regarding all off-site monitoring and bull Stockbrokers Finance Credit on-site supervision Institutions and Banking and Financial Regulatory Committee Investment bull Formulates general regulations for credit institutions and investment firms Committee (capital adequacy requirements accounting rules etc) Bank of France Credit Institutions and Investment Committee Banking bull Authorizes and examines financial institutions except for those within the Commission competence of the Banking Commission
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Financial institutions and their supervisors
Country and supervisory structure Retail banking Wholesale banking Securities Insurance
Switzerland Large banking groupSwiss Federal Banking Commission (SFBC) = umbrella supervisor
Swiss National Bank Federal Office of
SFBC SFBC SFBC Private Insurance Swiss Federal Banking Commission bull Universal banks bull Investment banks bull Primary issuers of bull Insurance companies
bull Savings banks bull Asset management securities bull Insurance brokerscompanies bull Stock exchanges
Private audit Federal bull Investment funds bull Stockbrokers firms Office of bull Mortgage bond authorized by Private business SFBC Insurance
Sweden Financial holding company groupsFinancial Supervisory Authority = umbrella supervisor
Ministry of Finance Credit Market Securities Market Insurance Market
Credit Market Department Department Department Department
Financial bull Commercial banks bull Investment funds bull Primary issuers of bull Insurance companies Riksbank Supervisory bull Savings banks securities bull Insurance brokers Authority bull Friendly societies bull Stock exchanges
bull Stockbrokers
(table continues next page)
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Table 210 Financial-sector regulation G-10 countries 2000 (continued )
Financial institutions and their supervisors
Country and supervisory structure Retail banking Wholesale banking Securities Insurance
Belgium Bank holding companiesBanking and Finance Commission = umbrella supervisor
Bank of Belgium Banking Banking
Banking and Finance and Finance Insurance Controland Finance Commission Commission Commission Office
Banking and Insurance Finance Control bull Commercial banks bull Asset management bull Primary issuers of bull Insurance companies Commission Office bull Savings banks firms securities bull Insurance brokers
bull Securities banks bull Investment funds bull Stock exchanges bull Mortgage companiesbull Stockbrokers bull Pension funds
Securities Regulation Fund Securities Regulation Fund
bull Other investment firms and credit institutions(institutions participating in regulated off-exchangemarket in strips and Treasury certificates)
Bank holding companies Spain Banco de Espantildea = umbrella supervisor
Banco de Espantildea Comision Nacional del Mercado de Directorate General
Banco de Espantildea Valores (CNMV) Insurance
bull All credit institutions (commercial banks savings banks credit bull Primary issuers of (Ministry of Economy Ministry of cooperatives official credit institutions finance factoring and securities and Finance) Economy and CNMV leasing companies mortgage-loan companies etc) bull Stock exchanges bull Insurance companies Finance bull Interbank foreign exchange and book-entry public debt bull Stockbrokers bull Pension funds
markets bull Venture capital(companies and funds)
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119
Financial institutions and their supervisors
Country and supervisory structure Banking Securities Insurance
Banking Advisory High Level Securities Supervisors Committee (BAC) Committee (HLSS) Insurance Committee (IC)
Supranational (EU) bull Formulates standards for prudential bull Coordination of securities market bull Formulates standards forsupervision supervision prudential supervision
BACICHLSS Banking Supervision
Conglomerates Committee (BSC) Securities Contact Committee Regulation of prudential bull Systemic risk monitoring bull Regulation and implementation of supervision securities admission
International Association International International Organization of of Insurance Supervisors
Basel Committee Securities Commisison (IOSCO) (IAIS) Joint Forum Conglomerates Supervision bull Supervision and regulation best bull Supervision and regulation best bull Supervision and regulation amp regulation Best practices practices practices best practices
FSF Coordination across supervisors of various functions
Notes See appendix B for more information Boldface type indicates senior or oversight supervisor normal type indicates adjunct or front-line supervisorsolid line indicates direct responsbility to the senior-ranking authority dotted line indicates coordination in supervisory activities
(table continues next page)
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Table 210 Financial-sector regulation G-10 countries 2000 (continued )
Glossary of names United Kingdom FSA = Financial Services Authority United States FR = Federal Reserve OCC = Office of the Comptroller of theCurrency FDIC = Federal Deposit Insurance Corporation SEC = Securities and Exchange Commission OTS = Office of Thrift Supervision Japan FRC =Financial Reconstruction Commission FSA = Financial Services Agency SESC = Securities and Exchange Surveillance Commission Canada OSFI =Office of the Superintendent of Financial Institutions CDIC = Canada Deposit Insurance Corporation Germany FBSO = Federal Banking SupervisoryOffice FSSO = Federal Securities Supervisory Office FISO = Federal Insurance Supervisory Office BSO = Banking Supervisory Office Italy Consob =Commissione Nazionale per le Societa e la Borsa ISVAP = Instituto per la Vigilanza sulle assicurazioni private e di Interesse colletivo Switzerland SFBC= Swiss Federal Banking Commission Spain CNMV = The Comision Nacional del Mercado de Valores Supranational BAC = Banking Advisory CommitteeBSC = Banking Supervision Committee IC = Insurance Committee HLSS = High Level Securities Supervisors Committee International Dimension FSF =Financial Stability Forum IOSCO = International Organization of Securities Commission IAIS = International Association of Insurance Supervisors
Sources United Kingdom Bank of England httpwwwbankofenglandcouk Financial Services Authority httpwwwfsagovuk United States Board ofGovernors of Federal Reserve System httpwwwfederalreservegov Japan Bank of Japan httpwwwbojorjo Financial Reconstruction Commissionhttpwwwfsagojpfrcindexehtml Financial Services Agency httpwwwfsagojp Canada Bank of Canada httpwwwbank-banque-canadaca Office ofthe Superintendent of Financial Institutions httpwwwosfi-bsifgccaAndreEindexhtml Germany Deutsche Bundesbank httpwwwbundesbankde Fed-eral Banking Supervisory Office httpwwwbakredde Italy Banca drsquoitalia httpwwwbancaditaliait Commissione Nazionale per le Societa e la Borsahttpwwwconsobit Instituto per la Vigilanza sulle assicurazioni private e di Interesse colletivo httpwwwisvapit The Netherlands De NederlandscheBank httpwwwdnbnl France Banque de France httpwwwbanque-francefr Switzerland Schweizerische Nationalbank httpwwwsnbchindex3htmlSweden Sveriges Riksbank httpwwwriksbanksedefaultasp Belgium National Bank of Belgium httpwwwbnbbesgindexhtm Spain Banco de Espantildeahttpwwwbdees The Comision Nacional del Mercado de Valores httpwwwcnmves Supranational (EU) Institutional Arrangements for the Regulationand Supervision of the Financial Sector 2000 International Dimension Bank for International Settlement httpwwwbisorg International Organization ofSecurities Commissions httpwwwioscoorg International Association of Insurance Supervisors httpwwwiaisorg Financial Stability Forum httpwwwfsforumorg
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 121
the inflexibility of tight surveillance against the need to encourage in-novation and growth The US Securities and Exchange Commission isworried about aggressive accounting by firms and biased reports bysecurities analysts in an equity environment that prizes steadily higherquarterly earnings41 Japanese regulators are preoccupied with opaqueinterconnections between portfolio institutions banks and nonfinancialfirms through the keiretsu system Canadian regulators reeling from high-profile scandals of managers intentionally misleading investors are strengtheningmarket discipline through legal penalties aimed at managers and directorsof offending firms
When panic strikes a securities regulator cannot do much As the 1987stock market crash and the LTCM debacle in the fall of 1998 both dem-onstrated steep stock and bond price declines can create systemic risksIf severe enough the wealth effect of falling securities values and thefear of widespread insolvency can depress real activity Flooding thesystem with liquidity is a central bankerrsquos solutionmdashsomething a securi-ties regulator cannot do42 But just as financial supervisors can changethe incentive structure to discourage bankers from making risky loans ingood times so securities regulators can pay more attention to incentiveson the demand side when capital markets are strong
Prudential Supervision and InnovationmdashA Footnote
In concluding this discussion of prudential supervision in the G-10 anadditional point is worth noting National regulators face a persistenttrade-off between emphasizing financial system safety and soundnesswhile encouraging innovationmdashin spite of the added risks innovationbrings to financial markets Former US Treasury Secretary Lawrence Summers(2000 3) has argued by analogy
The jet airplane made airplane air travel more comfortable more efficient andmore safe though the accidents were more spectacular and for a time morenumerous after the jet was invented In the same way modern global financialmarkets carry with them enormous potential for benefit even if some of theaccidents are that much more spectacular As the right public policy response
41 The problem is illustrated by the divergence since mid-1998 between reported earn-ings by the Standard amp Poorrsquos (SampP) 500 and the after-tax profits of all corporations inthe national accounts Generally these two series move closely with one another Be-tween mid-1998 and mid-1999 SampP 500 reported that earnings increased by more than20 percent while after-tax profits of all corporations increased by less than 5 percent(Chase Bank US Economic and Policy Research US Weekly Prospects Chase SecuritiesWeekly Newsletter 5 June 2000 5)
42 For example the US Securities and Exchange Commission had no direct role in calmingmarkets in the 1987 or 1998 panics
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122 WORLD CAPITAL MARKETS
to the jet was longer runways better air-traffic control and better training forpilots and not the discouragement of rapid travel so the right public policyresponse to financial innovation is to assure a safe framework so that the ben-efits can be realized not to stifle the change
Accepting Summersrsquos analogy for the international financial system better-informed supervisors and investors are a necessary part of the financialsystem framework Supervisors require more timely information on therisk profiles resulting from positions taken by financial institutions Theyalso need a better understanding of risk-management systems Snapshotsof an institutionrsquos risk profile and risk-management procedures are nolonger adequate In a world where huge bets are quickly made (andpossibly lostmdashas with Barings Bank in 1995 and LTCM in 1998) super-visors must focus on the soundness of banking systems for evaluatingand managing risk on a daily basis Some progress has been made inaddressing these issues US banking examiners are extending their in-formation requirements in banking examinations and increasing theirinvolvement in large complex institutions43 More awareness is alsorequired of the fact that they are national organizations in a world ofcross-border capital flows To a much greater extent they need a multi-national reach International supervision and coordination among super-visors are the subject of the next section
Our analysis suggests that G-10 supervisors have unfinished businessBank supervisors need to start yesterday securities regulators can waituntil tomorrow One G-10 member acting alone cannot correct the biasIn good times the lending business will simply migrate to other G-10banks In bad times financial problems will not stop at the national bor-der A way has to be found to establish common international standardsfor the key financial players in order to prevent crises and to agree onapproaches for managing them The path has already been laid out Inthe wake of the bank failures of the past 25 years bank supervisors havetried to establish such standards They have done this without creating anew global institution
The essence of the international framework is decentralizationmdashglobalrules and design standards without global institutions that are perceivedto intrude on national sovereignty The awkward jargon for this frame-work is vertical subsidiaritymdashldquothink internationally act nationallyrdquo Theinternational thinking is done by a committee of regulators that meets
International SupervisionA Decentralized Framework
43 These issues are discussed in Ferguson (1999) and Meyer (2000a)
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 123
regularly at the Bank for International Settlements in Basel The commit-tee establishes principles and standards that are interpreted implementedand enforced by national authorities44 In this section we describe thesesupervisory efforts and their weaknesses We present our recommenda-tions for addressing these weaknesses in the next chapter
Basel I
The Basel Capital Accord of 1988 (Basel I)45 drew the lesson from thefinancial crises of the mid-1970s that more adequate capital levels in in-ternational banks would help reduce the systemic risk of bank failureThe primary goal of Basel I was capital adequacy other standards wereput in place not so much for their own virtue as to defend the primarygoal
Capital adequacy requirements were designed to ensure that individualinstitutions have the ability to absorb losses particularly credit lossesAccordingly a backup system of scoring credit risk was devised thatrequired large amounts of bank capital for some types of loans smalleramounts for others and zero for a select list of preferred assets Report-ing requirements were designed to disclose problems and ensure that atroubled bank would take timely steps to restore its capital base in thewake of a loss The Basel I framework worked tolerably well in limitingthe call on the public purse in the G-10 countriesmdashwith the notable ex-ceptions of France and Japan The framework failed to moderate riskybank lending to emerging markets however
Basel I was not developed with emerging markets in mind The origi-nal idea behind it was to develop a common supervisory approach tocross-border banking operations It grew out of political pressure fromUS lawmakers who were determined to require international banks op-erating in the United States to meet US banking standards Toward thisgoal in 1983 Congress passed the International Lending Supervisory ActUS and British banking authorities subsequently agreed on a commontarget the adoption of strict common capital-adequacy standards In 1988other G-10 governments agreed to go along voluntary acceptance ofthe standards throughout much of the rest of the world followed46 Therationale for the capital targets was two-fold The first was to requirebanks to hold sufficient amounts of capital (8 percent of risk-adjusted
44 The international committee of financial authorities agreed on a common definitionof banksrsquo tier-one or ldquocorerdquo capital national authorities defined tier-two capital in theirown manner which permitted greater variations in national working definitions andpractices
45 International Convergence of Capital Measurement and Capital Standards (BIS 1988)was prepared by the Basel Committee on Banking Supervision
46 See Reineke (1998)
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124 WORLD CAPITAL MARKETS
assets) to cushion losses on those assets The second was to dull theirappetites for risk banks with large capital bases would have more tolose if they failed and therefore would take fewer risks
Rapid change in financial markets soon revealed flaws in the Basel IAccord In a complex world with numerous sources of risk it focusedheavily on credit risk but overlooked other risks in a bankrsquos portfolioand the correlation between returns on different asset classes The Baselformula required banks to maintain a fixed amount of capital againsteach of its asset classes But the formula did not distinguish the riskinessof the borrower within each class As a result one large loan to a low-risk corporate borrower such as General Electric would require the sameamount of capital as 10 smaller transactions with high-risk borrowers
The system was also biased toward short-term loans Loans maturingin less than a year required a 20 percent risk weight whereas those ma-turing after more than a year required a 100 percent risk weight Inter-bank lending was particularly favored For example loans to banks inOECD countries required less capital than loans to private firms in thesame countries creating the anomaly that interbank loans to South Ko-rean banks required less capital than loans to General Electric47 Thisanomaly encouraged banks to shed high-quality assets if the Basel rulesrequired the allocation of more capital than banks thought they needed
Another weakness was that financial innovators quickly circumventedthe Accord Because short-term loans required less provisioning than long-term loans banks responded by securitizing their long-term debt port-folios and lending short-term against the collateral of the newly createdasset This allowed banks to circumvent the capital requirements gearedto the terms of the underlying debt At the same time the Basel I Accordfailed to encourage risk mitigation techniques such as credit derivativescollateral guarantees and on-balance-sheet netting the flip side of fi-nancial innovation Because off-balance-sheet products were not coveredby the Accord another anomaly appeared when Barings Bank collapsedin 1995 Barings met capital adequacy standards but collapsed becauseits systems for managing risk failed traders were allowed to speculatein futures contracts that did not appear on the balance sheet
Basel II
Work to overhaul Basel I began in 1995 and produced consultativepapers issued in June 1999 and January 200148 These papers have been
47 South Korean banks have had notoriously weak balance sheets because the practiceof ldquodirected lendingrdquo left them with many poor loans (in making these loans the bankswere expected to follow government objectives rather than creditworthiness criteria)
48 Basel Committee on Banking Supervision (1999 2001)
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 125
the subject of extensive consultation and revision as a result the newAccord is expected to be introduced in 200449 The Basel II frameworkhas three parts (pillars) revisions to Basel I minimum-capital require-ments supervisory review criteria and greater emphasis on market dis-cipline Broadly Basel II aims to maintain the level of capital in the sys-tem but achieve better alignment of banksrsquo capital with their risk pro-files and keep up with financial innovation
To align capital requirements with market realities (the first pillar)Basel II concentrates on the 100 or so largest banksmdashthe type of playerslisted in table 21mdashand on the holding-company parents of banking groups50
Capital requirements will differentiate between an increased number ofcredit groups or ldquorisk bucketsrdquo including claims on governments otherbanks corporations mortgage-backed securities and other asset-backedsecurities
Basel II originally proposed to use external ratings to set capital chargesfor a number of these credit risks Many banks objected arguing thatthey assess credit risk better than Standard amp Poorrsquos Moodyrsquos or FitchIBCA51 Basel II thus proposes two approaches to rating a standard ap-proach using external ratings and an ldquoadvancedrdquo approach that allowsselected banks to use their own internal rating systems To encouragethe development of rigorous internal control systems based on these in-ternal rating systems Basel II also proposes to levy capital charges foroperational risk (the risk of direct or indirect loss resulting from inad-equate or failed internal processes people and systems or from exter-nal events)
Some critics of this proposal dismiss it as an abrogation of the prin-ciple of external independent monitoring and as ldquodangerously naiumlverdquo52
But regulators argue that the new capital charge on operational risk shouldoffset this concern It is also far from clear how cross-national compari-sons of rating and internal risk-assessment systems will be made (Engelen2000) The development by the European Union of its own capital rulescould well complicate the international resolution of these issues Publicassurances by EU officials in January 2001 however indicated that theirmain concerns are to create a level playing field and avoid regulatoryarbitrage (Hargreaves 2001) There is also the significant problem ofthe procyclical character of risk weights When a crisis hits losses are
49 See Berry (2000) for an update in an interview with William J McDonough chair ofthe Basel Committee on Banking Supervision
50 For obvious reasons these proposals are addressed to large banks and simpler capi-tal standards are allowed for small banks that focus on their domestic credit markets
51 See Ammer and Packer (2000) for an empirical critique of the success of rating agen-cies in distinguishing risk by sector and region
52 See Auerback (2001)
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126 WORLD CAPITAL MARKETS
incurred or accrued capital is lost and loan exposure must be reducedor securities sold to restore the requisite capital-adequacy ratios A morerisk-sensitive framework could amplify volatility
As the second pillar of Basel II supervisory review criteria are beingbeefed up to encourage supervisors to intervene earlier in potential problemsituations and to compel banks to align their capital positions with theirrisk profiles Bank supervisors will be authorized to require banks tohold capital in excess of minimum requirements if they have concernsabout general management overall strategy risk-management performanceor the macroeconomic environment Of course if one G-10 supervisorimposes higher capital requirements in isolation the same disparity willemerge that presaged Basel I Some banks will be disadvantaged in theinternational marketplace and will loudly complain that excessive super-vision is driving business to their competitors Hence close internationalcooperation among supervisors is critical
To implement the third pillar market discipline banks will be requiredto make fuller more timely disclosure of capital adequacy and the risksto which that capital is exposed A number of measures are being stud-ied that might help supervisors evaluate bank performance such as com-parisons of uninsured deposit interest rates subordinated debt yieldsand equity prices The idea is that these yields and prices might alertsupervisors to market perceptions of risk Of course market perceptionsare only as good as market information More direct and controversialways to reinforce market discipline would dramatically increase publicdisclosure of bank positions and risk management systems
Many questions are still outstanding about how to resolve the techni-cal details of capital requirements and whether the requirements willachieve their intended goal of better assessment and mitigation of therisks in banksrsquo portfolios There is no substitute for skilled supervisorsThe intricacies of effective design and implementation suggest that su-pervisors need to be highly competent technically knowledgeable aboutbanking portfolio characteristics and the factors that influence bank ex-posure to credit risk (Mishkin 2000) And they must be aided by vigilantshareholders market forces and transparency of information53
Standard setting at the global level is desirable but ultimately theeffectiveness of these efforts will be tested at the national level espe-cially in times of systemic financial distress Here the record of Basel Iwas not a bright shining success Japanese banking regulators havetraditionally allowed banks to include real estate and securities in theircapital base When the value of these assets plummeted in the early 1990sregulators allowed banks to continue valuing these depreciated (andoften bankrupt) assets at their old inflated levels Japanese authorities
53 Benedict Roth Complacency Towards Catastrophe Financial Times 23 January 2001
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 127
insisted until the mid-1990s that eroded capital bases could be rebuiltin a market-driven fashion They rightly foresaw that huge loan losseswould undermine public support for the ruling party and require a po-litically unpopular bailout
Japanese foot dragging on Basel I was the worst54 but not uniqueOther examples can be found of ldquopolitically mandated forbearancerdquo TheFederal Reserve Bank of New York held important hands during theLTCM crisis of 1998 Mexico is still resolving the banking crisis that eruptedin 1995 South Korea has not yet closed the insolvent banks that behavedso badly before the crisis of 1998 In the aftermath of a crisis nationalregulators cannot always be relied upon to discipline politically power-ful bankers55 One of the little-noticed consequences of these differingapproaches is that those banks with strong regulatory systems receivedan implicit ldquoexport subsidyrdquo for their services US banks which had notengaged extensively in emerging-market lending in the 1990s were bet-ter positioned than their German and Japanese counterparts to expandtheir international assets in the wake of the crises
Other Financial Forums
54 See Japanese Banks Fiddling while Marunouchi Burns The Economist 27 January2001 67-69
55 See Calomiris (1997)
The Basel model of vertical subsidiarity has already been extended toother financial regulatory bodies In 1993-94 the BIS established a Tri-partite Group of Banking Insurance and Securities Regulators In 1994-95 the BIS increased its cooperation with the International Organizationof Securities Commissions when the two organizations issued parallelpapers on guidelines for national regulators concerning risk managementand disclosure of derivative trades In 1996 a permanent Joint Forum onFinancial Conglomerates was established to examine supervisory issuesand develop working arrangements among the different functional super-visors of conglomerate institutions that offer combinations of bankingsecurities and insurance products Draft papers on the supervisionof conglomerates were released for comment in 1998 applying capital-adequacy principles to these groups and providing guidelines both forassessing the integrity and competence of top managers and for sharingassessments between regulators
In 1997 the Basel Committee on Banking Supervision extended itsreach beyond capital standards to broader aspects of banking supervi-sion with the publication of the Core Principles for Effective BankingSupervision In 1999 a wide range of regulatory and standard-settingbodies were gathered under the umbrella of the Financial Stability
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128 WORLD CAPITAL MARKETS
Forum (FSF) itself established under BIS aegis56 The FSF has alreadyissued recommendations for stepped-up supervision and transparencyas well as guidelines for best practices in a number of areas includingoffshore financial centers and highly leveraged institutions or hedge funds57
Conclusion
Although the structural weaknesses in emerging-market economies arewidely acknowledged to have been causal factors in international capi-tal-market volatility this chapter points to the role of large G-10 bankingorganizations as major suppliers of the most volatile instrument short-term debt We have examined evidence of the impact of public safetynets in the G-10 economiesmdashthe deposit insurance systems the pruden-tial supervisory systems and the lender-of-last-resort functions of centralbanksmdashon the incentive structures of these organizations
Although supervisors in most countries working nationally and to-gether in the BIS have made significant efforts to mimic market forcesin their prudential supervision the most sophisticated financial institu-tions find innovative ways to circumvent the rules New global regulatorybodies are not about to be created G-10 national bank regulators shouldthemselves address the short-term debt bias in the international financialsystem by changing incentive systems G-10 securities regulators shouldalso take steps to get ahead of the curve paying close attention to largeportfolio swings by institutional investors particularly in times of crisisIn short more needs to be done at national and international levels tochange the rules of the game That is the subject of the next chapter
56 The Financial Stability Forum includes banking securities insurance and accountingregulatory bodies the OECD on taxation corruption and corporate governance and theIMF
57 See Martin (2000)
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 103
systems both within and among the G-10 economies plus Spain andconsider whether these offset the subsidy provided by the public safetynet Despite offsetting regulation and supervision implicit and explicitguarantees by G-10 governments to their banks are still a source of bank-ing instability in the emerging-market economies
National Systems for Prudential Supervision
Governments use prudential supervision to reduce the moral hazard andadverse selection created by their own safety nets Supervisors establishregulations and monitor compliance to limit risk taking and ensure thesafety and soundness of the banking system In a thoughtful analysis ofthe case for prudential supervision Frederic Mishkin (2000) identifiesthe main forms that supervision can take including the tasks of grantingbanking charters and licenses establishing capital requirements settingdeposit insurance premiums and defining disclosure requirements as wellas carrying out bank examinations Bank examiners gather informationfrom banks and evaluate whether they are following the regulatorsrsquo rulesin cases of weakness they are empowered to change banksrsquo behaviorand close them if necessary
Supervisors also may restrict competition define the activities in whichbanks may engage and restrict their asset holdings and separate banksand other financial (or nonfinancial) activities During the past two de-cades the barriers separating commercial banks investment banks in-surance firms and securities firms have been all but eliminated (tableB1) Deregulation has stimulated competitive forces that drive diversifi-cation and consolidation of the financial industry nowhere faster than inthe United States
The Financial Services Modernization Act of 1999 confirmed this trendIt eliminated restrictions dating back to the Glass Steagall Act of 1933which once prevented banking insurance and securities firms fromentering each otherrsquos businesses (Barth Brumbaugh and Wilcox 2000)Cross-pillar mergers among banks insurance and securities firms arewell under way to form giant financial holding companies The 1999merger between Citibank (banking) and Travelers (insurance) created themodel for megafinance and confirmed new challenges for supervisors
Mishkin (2000) notes the corresponding evolution in US supervisionfrom an emphasis on rules-based regulation (detailed rules for opera-tional behavior and the quality of line items in the balance sheet) to anapproach that stresses the soundness of bank management practices es-pecially risk management
Appendix B outlines the systems of financial supervision now in theplace in the G-10 countries plus Spain Some systems like the UK andCanadian approach are models of simplicitymdashorganized to keep pacewith the spreading reach of financial conglomerates Other systems like
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104 WORLD CAPITAL MARKETS
the US and French approaches show traces of the bureaucratic divisionsthat made sense in an era when banking securities and insurance weresharply separated
The US Model
27 See Meyer (1999a)
28 Canada has a similar degree of simplification with the exception that securities firmsare still regulated by provincial authorities
29 See Pratti and Schinasi (1999 67)
30 The agents are the bank regulators and the principals are the taxpayers Agents maypursue their own interests including bureaucratic survival and postgovernment employ-ment opportunities rather than the national interest in banking safety and soundness
The US model of financial regulation delineated in the Financial Ser-vices Modernization Act of 1999 blends functional and umbrella super-vision Bank and thrift regulators oversee depository institutions Newnonbank activities are subject to both functional regulation (eg by theSecurities and Exchange Commission and state insurance examiners) andumbrella supervision (of financial holding companies) by the FederalReserve27
The UK Model
Another supervisory model exists in the United Kingdom as well as inAustralia Canada and Switzerland28 In this model banking supervisionis separated from the monetary policy function The regulatory structureis considerably simplified by relying on a consolidated financial regula-tor separate from the central bank for both banking and nonbankingactivities The remaining question answered differently depending on thecountry is the extent to which the regulator relies on home-country sur-veillance of banks and conglomerates that have a local presence
Regulatory Models Compared
Appendix B provides more detail on the differences in these modelsGerman simplicity contrasts with French complexity In France the bankingcommission is chaired by the governor of the central bank and includesrepresentatives from the Treasury The commission supervises compli-ance with regulations but the central bank inspects banks on behalf ofthe commission29 In countries such as the United States and France withmultiple supervisors and crossover functions internal coordination is criticalAt the same time multiple agencies create regulatory competition Wheneach agency knows what the other is doing transparency within gov-ernment circles can help to limit principal-agent problems of regulation30
The discussion as to where in the public bureaucracy financial super-
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 105
vision should be placed goes back many years Peek Rosengren andTootell (1999) argue that a synergy exists between monetary policy andprudential supervision because information gained in the course of super-vision can increase the accuracy of macroeconomic forecasts A twist tothis argument is that the information on the state of financial institutionsavailable to the central bank as supervisor can facilitate its role as lenderof last resort Conversely there is the concern that a supervisory rolewill compromise the central bankrsquos independence of action with respectto its core mandatemdashmaintaining price stability As these arguments haveplayed out financial supervision has generally been shared between centralbanks and other regulators or placed entirely in the hands of an inde-pendent regulator However in Italy the Netherlands and Spain cen-tral banks are the sole banking supervisor
Goodhart (1995) examined the arguments and evidence for each modeland concluded that there were no overwhelming arguments or evidencefor one or the other31 Going forward a key problem for any financialsupervisory system is dealing with (and closing as necessary) weak banksIf both central banks and other regulators have this responsibility closecoordination between them is critical Another problem is large conglom-erate banks LCBOs Although they are less likely to fail because of thediversification of their assets and liabilities they are more likely to berescued They are also more likely to be multinational enterprises withinternational implications Goodhart observes that regulation of theseentities might be put in the hands of the central bank because it is lessamenable to political pressures In any event the complexity of LCBOoperations suggests that greater supervisory rigor is necessary
The US Congress was persuaded that broad oversight would help containthe moral hazard problem and accordingly gave the Federal Reservethe role of umbrella supervisor with the understanding that the Fed willscrutinize depository activity more intensely than nonbank financial ac-tivities Under this approach LCBOs such as Citigroup are subject tomuch closer monitoring than smaller and simpler institutions32 The USregulatory model requires enormous cooperation between the Fed otherbank supervisors and the functional regulators for insurance and securi-ties but it also benefits from regulatory competition
31 National systems of supervision are path dependent they are determined by the struc-ture of financial institutions and history in each country If Goodhart (1995) is right out-comes are not materially better or worse with one model of supervision rather than another
32 See Ferguson (1999)
Public Safety Nets
One of prudential supervisorsrsquo biggest challenges is to reduce moral hazardFor many years commercial banks engaged in communal self-insurance
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106 WORLD CAPITAL MARKETS
to deal with crises They formed voluntary groups that agreed to rescuetroubled members As financial markets evolved and competition inten-sified banks were no longer willing to play this role Private-sector in-surance is one alternative but moral hazard and adverse selection wouldappear to prevent it from happening Public safety nets have developedbecause of the low probability and high cost of potential bank runs Aclear trade-off is involved The effectiveness of insurance in preventingbank runs is greater the more comprehensive the coverage But the morecomprehensive the coverage the greater the moral hazardmdashbank man-agers bank directors investors and depositors all take on greater risksin the belief that the safety net will protect them against losses
All G-10 countries have compulsory public safety nets for banks (table29) Deposit insurance agencies are officially organized in Canada theNetherlands Sweden Switzerland and the United States organized bythe industry in France Germany Italy and the United Kingdom andjointly organized by the public and private sectors in Belgium Japanand Spain
How well do G-10 governments offset the subsidy provided by thepublic safety net This is a question on which there is substantial debateAs banking organizations have become more complex the challengesthat supervisors face have become more difficult One challenge is toalign the incentives facing bank managers and shareholders with thoseof depositors Another is the principal-agent problem in supervision Wehave discussed the incentive structures for financial institutions but wehave said little about the incentives for supervisors themselves and thedistortions they can generate in the financial system
In one of the many studies of the US savings and loan crisis of the1980s Kane (1989) documented both problems He described managersusing cosmetic approaches to disguise the magnitude of insolvency regulatorspracticing forbearance even though they knew of the deteriorating riskprofiles of the institutions for which they were responsible and legisla-tors increasing deposit insurance without regard for any offsetting changesin supervision A subsequent overhaul of the legislative framework forthe Federal Deposit Insurance Corporation (FDIC) known as the FDICImprovement Act of 1991 (FDICIA) aimed to introduce a clearer incen-tive structure for both regulators and regulated institutions
The changes introduced by this US legislation are worth discussionwith respect to the other G-10 countries as well First FDICIA created astronger signal to management and investors by targeting deposit insur-ance at small depositors only and by risk-weighting the deposit insur-ance premiums paid by banks to reflect their capital adequacy and bankexaminer ratings Among the G-10 countries rated in table 210 depositinsurance premiums vary considerablymdashbut it is not clear that the dif-ferences have much to do with risk-weighting Most G-10 countries em-ploy funding formulas based for example on the total domestic deposit
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Table 29 Deposit insurance schemes in the G-10 countries Explicit safety net
Coverage limit(dollar Foreign
equivalent currency Interbank Source Bankrsquos Contingency fundingDate Membership Co- at end of deposit deposit of premium from banks
Country established managementa insuranceb July 1998)c covered covered Fundingd funding costs or governments
United 1982 Compulsory Yes Larger of 90 No No Unfunded Banks only Callable (subject Parliament may increase Kingdom private percent co- to maximum the maximum payable
insurance to 03 percent of pound125 million advance 33000 total deposits) facility with Bank of
England
United 1934 Compulsory No 100000 Yes Yes Funded Banks and Up to 027 Borrowing up to $3 States official government percent total billion from US Treasury
domestic deposits
Japan 1971 Compulsory No 71000 but No No Funded Banks and 0084 percent of Borrowing up to yen500bn joint in full until government insured deposits from Bank of Japan
year 2000 subject to Ministry of Finance approval
Canada 1967 Compulsory No 40800 No Yes Funded Banks and 033 percent of Borrowing up to C$6 official government insured deposits billion authorized further
(maximum) borrowing subject to parliamentary approval
Germany 1966 Compulsory Yes 90 percent Yes No Funded Banks only 003 percent of Annual levy may be private coinsurance deposits doubled
to 22000
Italy 1987 Compulsory Yes 125000 Yes No Unfunded Banks and Callable Two options defer private government (maximum of payment or diminish
1 percent of compensation to be paid total deposits)
(table continues next page)
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Table 29 Deposit insurance schemes in the G-10 countries Explicit safety net (continued )
Coverage limit(dollar Foreign
equivalent currency Interbank Source Bankrsquos Contingency fundingDate Membership Co- at end of deposit deposit of premium from banks
Country established managementa insuranceb July 1998)c covered covered Fundingd funding costs or governments
Netherlands 1979 Compulsory No 22000 Yes No Unfunded Banks and On demand Government backing official government maximum of subject to parliamentary
5 percent of own approval funds
France 1980 Compulsory No 65400 No No Unfunded Banks only Callable (on Extra calls up to FFr1000 private demand calls million can be made in
up to FFr200 a 5-year period million)
Switzerland 1984 Voluntary No 19700 No No Unfunded Banks only Callable (on Underwritten by member official demand) banks
Sweden 1996 Compulsory No 31400 Yes No Funded Banks and 05 percent of Full emergency coverage official government deposits while replacing it with a
limited system after the emergency
Belgium 1974 Compulsory No 16600 No No Funded Banks and Callable 002 None insurance limited joint 22000 in government percent of to assets in fund
year 2000 deposits from clients
Spain 1977 Compulsory No 16439 Yes No Funded Banks and 02 percent of Government backing joint government deposits through the Banco de
(maximum) Espantildea subject to approval by royal decree
a Bank membership in the fund can be either compulsory or voluntary and the management of the fund can be official and official and private joint or privateb Coinsurance refers to the situation where depositors face a deductible against their insured fundsc Coverage limit refers to the explicit amount the authorities promise to insured Funded scheme means that it is funded ex ante unfunded otherwise
Sources Goodhart (1995) Demirguccedil-Kunt and Detragiache (2000) Demirguccedil-Kunt and Sabaci (2000)
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 109
base Explicit safety net protection also varies but only Canada focuseson the protected class33 All G-10 countries specify a limit on depositorprotection Under FDICIA the insurance fund is prohibited from pro-tecting uninsured depositors or creditors at a failed bank although adiscretionary system-wide override is provided for exceptional circum-stancesmdashbut with stringent requirements for consultation and account-ability Other G-10 countries allow for contingency funding from the publicpurse alongside unwritten lender-of-last-resort support Among large banksa significant and growing portion of deposit liabilities including foreigncurrency and interbank deposits are uninsuredmdashbut depositors assumethey will be protected in a crisis
FDICIA also made some significant qualitative changes to address theprincipal-agent problem by penalizing weak banks and rewarding strongbanks For example banks whose capital declined faced progressivelytougher regulatory sanctions that for example required them to elimi-nate dividends restrict their lending and change their managementsRegulators have also been forced to take prompt corrective action (toreduce the practice of regulatory forbearance in hopes that a bankrsquos for-tunes might improve)34 Unfortunately comparative qualitative assess-ments across the G-10 are difficult to make due to lack of information35
This discussion highlights the complexity of evaluating the extent towhich prudential supervision and market discipline reduce the moralhazard associated with G-10 safety nets Our argument is that publicsafety nets in the G-10 can be linked to banking instability in other coun-tries specifically in the emerging-market economies that have attractedG-10 cross-border bank lending This lending is a leading source of vola-tility in capital flows the large financial institutions many of which arecomplex banking organizations are based in and regulated by authori-ties in the G-10 economies These two features of the international finan-cial system are closely related although it is not possible to test thisrelationship econometrically
Two World Bank studies however indicate a basis for concern Onestudy is a cross-country econometric analysis of the relationship betweenbank stability and deposit insurance (Demirguccedil-Kunt and Detragiache2000) which found a negative relationship Their estimated model forbanking crises in a sample of 61 countries (both industrial and develop-ing) suggests that explicit deposit insurance raises the probability of acrisis by at least 30 percent36 Crises are especially likely in countries
33 Japanrsquos legislation says it does but recent experience shows this is not the case34 See Goldstein (1997) for a summary of the changes35 See Barth Nolle and Rice (2000) for a beginning in this area36 Demirguccedil-Kunt and and Detragiache (2000 table 1) report a logit coefficient of 0696with a standard error of 0397 (the coefficient is significant at the 8 percent threshold)This suggests that the ldquotruerdquo coefficient could well be as small as 030 (the reportedvalue minus the standard error)
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110 WORLD CAPITAL MARKETS
with immature financial supervisory systems (and not in the G-10) buttheir analysis does underscore the view that deposit insurance weakensmarket discipline37
An earlier World Bank analysis established similar results One wasthat market discipline is undermined by deposit insurance schemes an-other was that illiquid banks are forced to pay more for their funds un-less a generous deposit insurance scheme is in place (Demirguccedil-Kuntand Huizinga 1999) This econometric study also provides clear-cut evi-dence that depositor monitoring of banks declines with the existence ofdeposit insurance schemes At the heart of the problem is the questionof whether deposit insurance is accompanied by increased governmentmonitoring
This evidence and the weight of other arguments suggests that moralhazard is still an issue in the G-10 countries Consider the ongoing de-bate about instilling greater market discipline on risk taking by banksAt one extreme is the perennial proposal to do away with safety netsleaving markets to monitor the players and to force adjustments but toprotect small savers by creating ldquonarrow banksrdquo such as postal savingsystems that are allowed to invest these savings only in risk-free gov-ernment securities Whatever the merits of narrow banking this solutionis too extreme to be politically feasible
A moderate alternative is to force more disclosure by financial institu-tions to facilitate market monitoring But transparency has its own prob-lems Persaud (2000) argues that financial markets cannot reliably discernsustainable from unsustainable positions in the short term This uncer-tainty causes banks to ldquoherdrdquo behind market leaders to exploit theirsupposedly superior information ldquoThe more herding investors and bankersknow about what each other is up to the [more] unstable markets maybecomerdquo The implication is that greater transparency in the marketplaceby itself will not solve the problemmdashand in the short term more informa-tion may exacerbate herding Further supervisory steps (discussed in thenext chapter) are required
Yet another proposal is to promote private-sector involvement in bankmonitoring through market-based alternatives such as Calomirisrsquos sub-ordinated debt proposal (Calomiris 1997 Federal Reserve Board 1999)Banks could be required to issue and maintain a minimum amount of
37 Other findings in the Demirguccedil-Kunt and Detragiache (2000) study include thesepropositions The impact of deposit insurance on bank stability tends to be stronger themore extensive is the coverage offered to depositors when the scheme is funded andwhere the scheme is run by the government rather than by the private sector Con-versely deposit insurance is detrimental to bank stability where bank interest rates havebeen deregulated and where the institutional environment is weak Additional findingson deposit insurance are reported from a recent World Bank conference (8-9 June 2000httpwwwworldbankorgresearchinterestconfsupcomingdeposit_insurancehomehtm)Also see Smalhout (2001)
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 111
subordinated debt (eg uninsured certificates of deposit) to finance asmall fraction (such as 2 percent) of their total nonreserve assets Thesubordinated debt would be allowed to earn a set yield no more than 50basis points over the risk-free yield on government treasury bills Thisrule would supposedly force banks to operate in a safe manner Other-wise subordinated debt holders would redeem their uninsured certifi-cates of deposit and equity investors would sell their bank shares Despiteits practical problems the beauty of the subordinated debt requirementis that it enlists market incentives to push banks to avoid excessive port-folio risk38
The thrust of these proposals is very relevant to the arguments in ourstudy Even in the G-10 countries government monitoring by itself hasnot eliminated moral hazard among banks More work is needed to in-troduce market monitoring and to improve the incentive structures bothfor financial institutions and their supervisors We return to this issuewith our recommendations in the next chapter
38 In late 1996 Argentina began requiring its banks to finance 2 percent of total depos-its in the form of subordinated debt but without a maximum yield provision TheArgentine authorities expect that market discipline will act in concert with the publicsafety net One obvious problem with the subordinated debt proposal is that banks mayencourage some of their customers to buy the subordinated debt
Portfolio Institutions Tomorrowrsquos Problem
Before proceeding to the issues of international supervision we flag an-other potential problem for national regulators The big asset managersprofiled in tables 24 and 26 answer to diverse groups of pensionersshareholders and policyholders They allocate funds across a number ofcountries to diversify their risks They hold liquid assets that can be tradedand they have a higher proportion of long-term assets than banks Eco-nomic shocks can be absorbed through price changes and their effectsspread across time and markets Thus when conditions change in a par-ticular market they are more likely to ride out the storm than to flee Inother words they have less incentive than banks to pull their invest-ments in the face of adversity In the 1990s most large asset managersestablished a record of ldquoriding out the stormrdquo rather than ldquorunning withthe windrdquo although as we saw in chapter 1 instances of running withthe wind were detected in some portfolios As we write these insti-tutions have a good record overall in the emerging markets so whyworry
The Russian crisis and the near-collapse of LTCM previewed the dan-gers that may await future portfolio managers and G-10 financial minis-ters We have presented evidence indicating a systemic bias toward bank
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112 WORLD CAPITAL MARKETS
lending and debt finance to emerging markets and we have argued forsubstitution toward equity finance and direct investment39
That is not the end of the story We noted in the previous chapterthat institutional investors can become momentum investors selling in adownturn As more portfolio capital is invested in emerging marketssome players may adopt the high-risk high-leverage strategies of themost aggressive hedge funds Indeed the data in box 11 show that G-10portfolio investors held somewhat more long-term debt (more than $500billion) than equity (less than $400 billion) in emerging markets at theend of 1997 Long-term debt is an ideal vehicle for high-risk high-leveragestrategies These strategies practiced on a large scale could compound afuture crisis harming emerging markets A big enough crisis could inturn pressure G-10 central banks and finance ministers to arrange bail-out plans Instead of shrinking as a systemic financial problem moralhazard could increase
National securities regulators are the first line of defense against thisscenario They play a critical role in the safe evolution of capital mar-kets But regulators today are mandated to approve the issuance of newsecurities and to monitor the continuing disclosure of material informa-tion by issuers They are far less concerned with or empowered to monitorthe behavior of the increasingly large wealth-management firms that arethe major purchasers (and therefore resellers) of these securities
Within their mandates the goals of national securities regulators (table210 and appendix B) are similar to the concerns of bank regulators withsystem safety and soundness Their focus is also on the incentive sys-tems for management and boards of directors and on disclosure by cor-porations that issue marketable securities such as shares bonds andasset-backed securities 40 Issuers of securities possess greater knowledgeabout the quality of these assets than do the purchasers hence investorprotection is a key concern of regulators Moreover market disciplineworks best when markets know what is happening Well-functioning corpora-tions are key agents of wealth creation and social progress Underperform-ing corporations waste resources During recessions bad corporationsget into bad trouble often with severe social consequences Inadequateincentives for managers and inadequate accountability for boards andmanagers thus have negative externalities Regulators play a vital role inexposing weakness so that market disciplines come to bear sooner ratherthan later
Regulatory emphasis is constantly shifting as financial markets evolveand as the macroeconomic environment changes Regulators try to balance
39 See Rogoff (1999) Also see Berlin (2000) for a perspective on the limited role thatbanks play as share owners
40 See Habib and Ljungqvist (2000) for recent empirical analysis showing that corporateshare market values are higher when corporate executives have a larger ownership stake
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Table 210 Financial-sector regulation G-10 countries 2000
Financial institutions and their supervisors
Country and supervisory structure Retail banking Wholesale banking Securities Insurance
Financial conglomeratesFinancial Services Authority (FSA) = umbrella supervisor
United Kingdom FSA FSA FSA FSA
Treasury bull Commercial banks bull Investment funds (Securities and (Insurance Directorate(Securities and Investments Board) bull Unit trust groups Futures Authority) of the Treasury)
Bank of bull Building societies bull Pension funds England (Building Societies Commission) bull Merchant banks
bull Friendly societies bull Clearing houses bull Primary issuers bull Insurance FSA (Friendly Societies Commission) bull Venture capital of securities companies
bull Pensions and life insurance etc bull Stock exchanges bull Insurance brokers(Personal Investment Authority) bull Stockbrokers
Financial holding companiesFederal Reserve (FR) = umbrella supervisor
United States bull National banks(OCC) Securities and Regulated by
Treasury OCC bull State banks Federal Reserve Exchange Commission StatesMembers (FR)
OTS Nonmembers (FDIC) bull Investment banks bull Primary issuers of bull Insurance companies FR bull Cooperative banks (FDICFR) bull Finance companies securities bull Insurance brokers FDIC bull Insured industrial banks (FDIC) bull Stock exchanges
bull Thrift holding companies (OTS) bull Stockbrokers SEC bull Savings banks (OTSFDICFR) bull Investment advisors
bull Savings and loan associations bull Mutual funds(OTS) bull Public utility holding
bull Edge Act corporations (FR) companies
(table continues next page)
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Table 210 Financial-sector regulation G-10 countries 2000 (continued )
Financial institutions and their supervisors
Country and supervisory structure Retail banking Wholesale banking Securities Insurance
Financial holding companies Japan Financial Supervisory Authority (FSA) = umbrella supervisor
Prime FSA FSA FSA FSA ministerrsquos Ministry of office Finance (Securities and Exchange
Surveillance Commission) FRC Bureau of Financial bull City banks bull Investment banks bull Primary issuers of bull Insurance companies FSA Regulation bull Regional banks bull Asset managers securities bull Insurance brokers
bull Trust banks bull Stock exchanges SESC bull Long-term credit banks bull Stockbrokers
bull Pension funds
Financial holding companiesOffice of the Superintendent of Financial Institutions (OSFI) = umbrella supervisor
Canada Regulated by OSFI OSFI provinces OSFI
Department of Financebull Banks bull Cooperative credit bull Primary issuers of bull Insurance companies
(previously Office of the Inspector associations securities (previously Depart- OSFI General of the Banks) bull Fraternal benefit bull Stock exchanges ment of Insurance) Bank of bull Trust and loan companies society bull Stockbrokers bull Insurance brokers Canada bull Pension funds bull Asset managers
(previously Depart- CDIC ment of Insurance)
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115
Financial institutions and their supervisors
Country and supervisory structure Retail banking Wholesale banking Securities Insurance
Germany Financial holding groupsFederal Banking Supervisory Office (FBSO) = umbrella supervisor
Ministry of Finance FBSO BSO FSSO FISO
Bundesbankbull Universal banks bull Other financial bull Primary issuers of bull Insurance companies
Federal Banking bull Savings banks institutions (eg securities bull Insurance brokers Supervisory Office bull Securities banks management foreign bull Stock exchanges
currency dealings) bull Stockbrokers Federal Securities bull Financial enterprises bull Asset managers Supervisory Office (eg leasing bull Pension funds
organizations Federal Insurance credit card companies Supervisory Office investment advisors)
Italy Bank foundationsMinistry of Finance = umbrella supervisor
Ministry of Finance Bank of Italy Bank of Italy Consob ISVAP
Bank of Italy bull Commerical banks bull Asset managers bull Primary issuers of bull Insurance companies Consob bull Savings bank bull Open-end investment securities bull Insurance brokers
bull Securities banks companies (SICAVs) bull Stock exchangesbull Stockbrokers
ISVAP
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Table 210 Financial-sector regulation G-10 countries 2000 (continued )
Financial institutions and their supervisors
Country and supervisory structure Retail banking Wholesale banking Securities Insurance
The Netherlands Financial conglomeratesCouncil of Financial Supervisors = umbrella supervisor
Securities Board Securities Board Netherlandsche Netherlands Bank Netherlandsche Bank of the Netherlands Insurance Board Bank Insurance bull Credit institutions (universal banks bull Investment institutions bull Stock exchanges bull Insurance companies Board cooperative banks security credit (securities issuing bull Stockbrokers bull Insurance brokers
institutions mortgage banks) and tradingmdashprimary The Council of Financial and secondary Supervisors markets)
France Commission des Commission de Operations des Controcircle des
Banking and Banking Commission Bourse Assurances Financial Regulatory bull Ensuring that credit institutions (and investment firms since bull Primary issuers of bull Insurance companies Ministry for Committee the Financial Activity Modernization Act of 1996) comply securities bull Insurance brokers Economic with laws and regulations bull Stock exchanges Affairs and bull Execute instructions regarding all off-site monitoring and bull Stockbrokers Finance Credit on-site supervision Institutions and Banking and Financial Regulatory Committee Investment bull Formulates general regulations for credit institutions and investment firms Committee (capital adequacy requirements accounting rules etc) Bank of France Credit Institutions and Investment Committee Banking bull Authorizes and examines financial institutions except for those within the Commission competence of the Banking Commission
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117
Financial institutions and their supervisors
Country and supervisory structure Retail banking Wholesale banking Securities Insurance
Switzerland Large banking groupSwiss Federal Banking Commission (SFBC) = umbrella supervisor
Swiss National Bank Federal Office of
SFBC SFBC SFBC Private Insurance Swiss Federal Banking Commission bull Universal banks bull Investment banks bull Primary issuers of bull Insurance companies
bull Savings banks bull Asset management securities bull Insurance brokerscompanies bull Stock exchanges
Private audit Federal bull Investment funds bull Stockbrokers firms Office of bull Mortgage bond authorized by Private business SFBC Insurance
Sweden Financial holding company groupsFinancial Supervisory Authority = umbrella supervisor
Ministry of Finance Credit Market Securities Market Insurance Market
Credit Market Department Department Department Department
Financial bull Commercial banks bull Investment funds bull Primary issuers of bull Insurance companies Riksbank Supervisory bull Savings banks securities bull Insurance brokers Authority bull Friendly societies bull Stock exchanges
bull Stockbrokers
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Table 210 Financial-sector regulation G-10 countries 2000 (continued )
Financial institutions and their supervisors
Country and supervisory structure Retail banking Wholesale banking Securities Insurance
Belgium Bank holding companiesBanking and Finance Commission = umbrella supervisor
Bank of Belgium Banking Banking
Banking and Finance and Finance Insurance Controland Finance Commission Commission Commission Office
Banking and Insurance Finance Control bull Commercial banks bull Asset management bull Primary issuers of bull Insurance companies Commission Office bull Savings banks firms securities bull Insurance brokers
bull Securities banks bull Investment funds bull Stock exchanges bull Mortgage companiesbull Stockbrokers bull Pension funds
Securities Regulation Fund Securities Regulation Fund
bull Other investment firms and credit institutions(institutions participating in regulated off-exchangemarket in strips and Treasury certificates)
Bank holding companies Spain Banco de Espantildea = umbrella supervisor
Banco de Espantildea Comision Nacional del Mercado de Directorate General
Banco de Espantildea Valores (CNMV) Insurance
bull All credit institutions (commercial banks savings banks credit bull Primary issuers of (Ministry of Economy Ministry of cooperatives official credit institutions finance factoring and securities and Finance) Economy and CNMV leasing companies mortgage-loan companies etc) bull Stock exchanges bull Insurance companies Finance bull Interbank foreign exchange and book-entry public debt bull Stockbrokers bull Pension funds
markets bull Venture capital(companies and funds)
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119
Financial institutions and their supervisors
Country and supervisory structure Banking Securities Insurance
Banking Advisory High Level Securities Supervisors Committee (BAC) Committee (HLSS) Insurance Committee (IC)
Supranational (EU) bull Formulates standards for prudential bull Coordination of securities market bull Formulates standards forsupervision supervision prudential supervision
BACICHLSS Banking Supervision
Conglomerates Committee (BSC) Securities Contact Committee Regulation of prudential bull Systemic risk monitoring bull Regulation and implementation of supervision securities admission
International Association International International Organization of of Insurance Supervisors
Basel Committee Securities Commisison (IOSCO) (IAIS) Joint Forum Conglomerates Supervision bull Supervision and regulation best bull Supervision and regulation best bull Supervision and regulation amp regulation Best practices practices practices best practices
FSF Coordination across supervisors of various functions
Notes See appendix B for more information Boldface type indicates senior or oversight supervisor normal type indicates adjunct or front-line supervisorsolid line indicates direct responsbility to the senior-ranking authority dotted line indicates coordination in supervisory activities
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Table 210 Financial-sector regulation G-10 countries 2000 (continued )
Glossary of names United Kingdom FSA = Financial Services Authority United States FR = Federal Reserve OCC = Office of the Comptroller of theCurrency FDIC = Federal Deposit Insurance Corporation SEC = Securities and Exchange Commission OTS = Office of Thrift Supervision Japan FRC =Financial Reconstruction Commission FSA = Financial Services Agency SESC = Securities and Exchange Surveillance Commission Canada OSFI =Office of the Superintendent of Financial Institutions CDIC = Canada Deposit Insurance Corporation Germany FBSO = Federal Banking SupervisoryOffice FSSO = Federal Securities Supervisory Office FISO = Federal Insurance Supervisory Office BSO = Banking Supervisory Office Italy Consob =Commissione Nazionale per le Societa e la Borsa ISVAP = Instituto per la Vigilanza sulle assicurazioni private e di Interesse colletivo Switzerland SFBC= Swiss Federal Banking Commission Spain CNMV = The Comision Nacional del Mercado de Valores Supranational BAC = Banking Advisory CommitteeBSC = Banking Supervision Committee IC = Insurance Committee HLSS = High Level Securities Supervisors Committee International Dimension FSF =Financial Stability Forum IOSCO = International Organization of Securities Commission IAIS = International Association of Insurance Supervisors
Sources United Kingdom Bank of England httpwwwbankofenglandcouk Financial Services Authority httpwwwfsagovuk United States Board ofGovernors of Federal Reserve System httpwwwfederalreservegov Japan Bank of Japan httpwwwbojorjo Financial Reconstruction Commissionhttpwwwfsagojpfrcindexehtml Financial Services Agency httpwwwfsagojp Canada Bank of Canada httpwwwbank-banque-canadaca Office ofthe Superintendent of Financial Institutions httpwwwosfi-bsifgccaAndreEindexhtml Germany Deutsche Bundesbank httpwwwbundesbankde Fed-eral Banking Supervisory Office httpwwwbakredde Italy Banca drsquoitalia httpwwwbancaditaliait Commissione Nazionale per le Societa e la Borsahttpwwwconsobit Instituto per la Vigilanza sulle assicurazioni private e di Interesse colletivo httpwwwisvapit The Netherlands De NederlandscheBank httpwwwdnbnl France Banque de France httpwwwbanque-francefr Switzerland Schweizerische Nationalbank httpwwwsnbchindex3htmlSweden Sveriges Riksbank httpwwwriksbanksedefaultasp Belgium National Bank of Belgium httpwwwbnbbesgindexhtm Spain Banco de Espantildeahttpwwwbdees The Comision Nacional del Mercado de Valores httpwwwcnmves Supranational (EU) Institutional Arrangements for the Regulationand Supervision of the Financial Sector 2000 International Dimension Bank for International Settlement httpwwwbisorg International Organization ofSecurities Commissions httpwwwioscoorg International Association of Insurance Supervisors httpwwwiaisorg Financial Stability Forum httpwwwfsforumorg
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 121
the inflexibility of tight surveillance against the need to encourage in-novation and growth The US Securities and Exchange Commission isworried about aggressive accounting by firms and biased reports bysecurities analysts in an equity environment that prizes steadily higherquarterly earnings41 Japanese regulators are preoccupied with opaqueinterconnections between portfolio institutions banks and nonfinancialfirms through the keiretsu system Canadian regulators reeling from high-profile scandals of managers intentionally misleading investors are strengtheningmarket discipline through legal penalties aimed at managers and directorsof offending firms
When panic strikes a securities regulator cannot do much As the 1987stock market crash and the LTCM debacle in the fall of 1998 both dem-onstrated steep stock and bond price declines can create systemic risksIf severe enough the wealth effect of falling securities values and thefear of widespread insolvency can depress real activity Flooding thesystem with liquidity is a central bankerrsquos solutionmdashsomething a securi-ties regulator cannot do42 But just as financial supervisors can changethe incentive structure to discourage bankers from making risky loans ingood times so securities regulators can pay more attention to incentiveson the demand side when capital markets are strong
Prudential Supervision and InnovationmdashA Footnote
In concluding this discussion of prudential supervision in the G-10 anadditional point is worth noting National regulators face a persistenttrade-off between emphasizing financial system safety and soundnesswhile encouraging innovationmdashin spite of the added risks innovationbrings to financial markets Former US Treasury Secretary Lawrence Summers(2000 3) has argued by analogy
The jet airplane made airplane air travel more comfortable more efficient andmore safe though the accidents were more spectacular and for a time morenumerous after the jet was invented In the same way modern global financialmarkets carry with them enormous potential for benefit even if some of theaccidents are that much more spectacular As the right public policy response
41 The problem is illustrated by the divergence since mid-1998 between reported earn-ings by the Standard amp Poorrsquos (SampP) 500 and the after-tax profits of all corporations inthe national accounts Generally these two series move closely with one another Be-tween mid-1998 and mid-1999 SampP 500 reported that earnings increased by more than20 percent while after-tax profits of all corporations increased by less than 5 percent(Chase Bank US Economic and Policy Research US Weekly Prospects Chase SecuritiesWeekly Newsletter 5 June 2000 5)
42 For example the US Securities and Exchange Commission had no direct role in calmingmarkets in the 1987 or 1998 panics
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122 WORLD CAPITAL MARKETS
to the jet was longer runways better air-traffic control and better training forpilots and not the discouragement of rapid travel so the right public policyresponse to financial innovation is to assure a safe framework so that the ben-efits can be realized not to stifle the change
Accepting Summersrsquos analogy for the international financial system better-informed supervisors and investors are a necessary part of the financialsystem framework Supervisors require more timely information on therisk profiles resulting from positions taken by financial institutions Theyalso need a better understanding of risk-management systems Snapshotsof an institutionrsquos risk profile and risk-management procedures are nolonger adequate In a world where huge bets are quickly made (andpossibly lostmdashas with Barings Bank in 1995 and LTCM in 1998) super-visors must focus on the soundness of banking systems for evaluatingand managing risk on a daily basis Some progress has been made inaddressing these issues US banking examiners are extending their in-formation requirements in banking examinations and increasing theirinvolvement in large complex institutions43 More awareness is alsorequired of the fact that they are national organizations in a world ofcross-border capital flows To a much greater extent they need a multi-national reach International supervision and coordination among super-visors are the subject of the next section
Our analysis suggests that G-10 supervisors have unfinished businessBank supervisors need to start yesterday securities regulators can waituntil tomorrow One G-10 member acting alone cannot correct the biasIn good times the lending business will simply migrate to other G-10banks In bad times financial problems will not stop at the national bor-der A way has to be found to establish common international standardsfor the key financial players in order to prevent crises and to agree onapproaches for managing them The path has already been laid out Inthe wake of the bank failures of the past 25 years bank supervisors havetried to establish such standards They have done this without creating anew global institution
The essence of the international framework is decentralizationmdashglobalrules and design standards without global institutions that are perceivedto intrude on national sovereignty The awkward jargon for this frame-work is vertical subsidiaritymdashldquothink internationally act nationallyrdquo Theinternational thinking is done by a committee of regulators that meets
International SupervisionA Decentralized Framework
43 These issues are discussed in Ferguson (1999) and Meyer (2000a)
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 123
regularly at the Bank for International Settlements in Basel The commit-tee establishes principles and standards that are interpreted implementedand enforced by national authorities44 In this section we describe thesesupervisory efforts and their weaknesses We present our recommenda-tions for addressing these weaknesses in the next chapter
Basel I
The Basel Capital Accord of 1988 (Basel I)45 drew the lesson from thefinancial crises of the mid-1970s that more adequate capital levels in in-ternational banks would help reduce the systemic risk of bank failureThe primary goal of Basel I was capital adequacy other standards wereput in place not so much for their own virtue as to defend the primarygoal
Capital adequacy requirements were designed to ensure that individualinstitutions have the ability to absorb losses particularly credit lossesAccordingly a backup system of scoring credit risk was devised thatrequired large amounts of bank capital for some types of loans smalleramounts for others and zero for a select list of preferred assets Report-ing requirements were designed to disclose problems and ensure that atroubled bank would take timely steps to restore its capital base in thewake of a loss The Basel I framework worked tolerably well in limitingthe call on the public purse in the G-10 countriesmdashwith the notable ex-ceptions of France and Japan The framework failed to moderate riskybank lending to emerging markets however
Basel I was not developed with emerging markets in mind The origi-nal idea behind it was to develop a common supervisory approach tocross-border banking operations It grew out of political pressure fromUS lawmakers who were determined to require international banks op-erating in the United States to meet US banking standards Toward thisgoal in 1983 Congress passed the International Lending Supervisory ActUS and British banking authorities subsequently agreed on a commontarget the adoption of strict common capital-adequacy standards In 1988other G-10 governments agreed to go along voluntary acceptance ofthe standards throughout much of the rest of the world followed46 Therationale for the capital targets was two-fold The first was to requirebanks to hold sufficient amounts of capital (8 percent of risk-adjusted
44 The international committee of financial authorities agreed on a common definitionof banksrsquo tier-one or ldquocorerdquo capital national authorities defined tier-two capital in theirown manner which permitted greater variations in national working definitions andpractices
45 International Convergence of Capital Measurement and Capital Standards (BIS 1988)was prepared by the Basel Committee on Banking Supervision
46 See Reineke (1998)
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124 WORLD CAPITAL MARKETS
assets) to cushion losses on those assets The second was to dull theirappetites for risk banks with large capital bases would have more tolose if they failed and therefore would take fewer risks
Rapid change in financial markets soon revealed flaws in the Basel IAccord In a complex world with numerous sources of risk it focusedheavily on credit risk but overlooked other risks in a bankrsquos portfolioand the correlation between returns on different asset classes The Baselformula required banks to maintain a fixed amount of capital againsteach of its asset classes But the formula did not distinguish the riskinessof the borrower within each class As a result one large loan to a low-risk corporate borrower such as General Electric would require the sameamount of capital as 10 smaller transactions with high-risk borrowers
The system was also biased toward short-term loans Loans maturingin less than a year required a 20 percent risk weight whereas those ma-turing after more than a year required a 100 percent risk weight Inter-bank lending was particularly favored For example loans to banks inOECD countries required less capital than loans to private firms in thesame countries creating the anomaly that interbank loans to South Ko-rean banks required less capital than loans to General Electric47 Thisanomaly encouraged banks to shed high-quality assets if the Basel rulesrequired the allocation of more capital than banks thought they needed
Another weakness was that financial innovators quickly circumventedthe Accord Because short-term loans required less provisioning than long-term loans banks responded by securitizing their long-term debt port-folios and lending short-term against the collateral of the newly createdasset This allowed banks to circumvent the capital requirements gearedto the terms of the underlying debt At the same time the Basel I Accordfailed to encourage risk mitigation techniques such as credit derivativescollateral guarantees and on-balance-sheet netting the flip side of fi-nancial innovation Because off-balance-sheet products were not coveredby the Accord another anomaly appeared when Barings Bank collapsedin 1995 Barings met capital adequacy standards but collapsed becauseits systems for managing risk failed traders were allowed to speculatein futures contracts that did not appear on the balance sheet
Basel II
Work to overhaul Basel I began in 1995 and produced consultativepapers issued in June 1999 and January 200148 These papers have been
47 South Korean banks have had notoriously weak balance sheets because the practiceof ldquodirected lendingrdquo left them with many poor loans (in making these loans the bankswere expected to follow government objectives rather than creditworthiness criteria)
48 Basel Committee on Banking Supervision (1999 2001)
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 125
the subject of extensive consultation and revision as a result the newAccord is expected to be introduced in 200449 The Basel II frameworkhas three parts (pillars) revisions to Basel I minimum-capital require-ments supervisory review criteria and greater emphasis on market dis-cipline Broadly Basel II aims to maintain the level of capital in the sys-tem but achieve better alignment of banksrsquo capital with their risk pro-files and keep up with financial innovation
To align capital requirements with market realities (the first pillar)Basel II concentrates on the 100 or so largest banksmdashthe type of playerslisted in table 21mdashand on the holding-company parents of banking groups50
Capital requirements will differentiate between an increased number ofcredit groups or ldquorisk bucketsrdquo including claims on governments otherbanks corporations mortgage-backed securities and other asset-backedsecurities
Basel II originally proposed to use external ratings to set capital chargesfor a number of these credit risks Many banks objected arguing thatthey assess credit risk better than Standard amp Poorrsquos Moodyrsquos or FitchIBCA51 Basel II thus proposes two approaches to rating a standard ap-proach using external ratings and an ldquoadvancedrdquo approach that allowsselected banks to use their own internal rating systems To encouragethe development of rigorous internal control systems based on these in-ternal rating systems Basel II also proposes to levy capital charges foroperational risk (the risk of direct or indirect loss resulting from inad-equate or failed internal processes people and systems or from exter-nal events)
Some critics of this proposal dismiss it as an abrogation of the prin-ciple of external independent monitoring and as ldquodangerously naiumlverdquo52
But regulators argue that the new capital charge on operational risk shouldoffset this concern It is also far from clear how cross-national compari-sons of rating and internal risk-assessment systems will be made (Engelen2000) The development by the European Union of its own capital rulescould well complicate the international resolution of these issues Publicassurances by EU officials in January 2001 however indicated that theirmain concerns are to create a level playing field and avoid regulatoryarbitrage (Hargreaves 2001) There is also the significant problem ofthe procyclical character of risk weights When a crisis hits losses are
49 See Berry (2000) for an update in an interview with William J McDonough chair ofthe Basel Committee on Banking Supervision
50 For obvious reasons these proposals are addressed to large banks and simpler capi-tal standards are allowed for small banks that focus on their domestic credit markets
51 See Ammer and Packer (2000) for an empirical critique of the success of rating agen-cies in distinguishing risk by sector and region
52 See Auerback (2001)
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126 WORLD CAPITAL MARKETS
incurred or accrued capital is lost and loan exposure must be reducedor securities sold to restore the requisite capital-adequacy ratios A morerisk-sensitive framework could amplify volatility
As the second pillar of Basel II supervisory review criteria are beingbeefed up to encourage supervisors to intervene earlier in potential problemsituations and to compel banks to align their capital positions with theirrisk profiles Bank supervisors will be authorized to require banks tohold capital in excess of minimum requirements if they have concernsabout general management overall strategy risk-management performanceor the macroeconomic environment Of course if one G-10 supervisorimposes higher capital requirements in isolation the same disparity willemerge that presaged Basel I Some banks will be disadvantaged in theinternational marketplace and will loudly complain that excessive super-vision is driving business to their competitors Hence close internationalcooperation among supervisors is critical
To implement the third pillar market discipline banks will be requiredto make fuller more timely disclosure of capital adequacy and the risksto which that capital is exposed A number of measures are being stud-ied that might help supervisors evaluate bank performance such as com-parisons of uninsured deposit interest rates subordinated debt yieldsand equity prices The idea is that these yields and prices might alertsupervisors to market perceptions of risk Of course market perceptionsare only as good as market information More direct and controversialways to reinforce market discipline would dramatically increase publicdisclosure of bank positions and risk management systems
Many questions are still outstanding about how to resolve the techni-cal details of capital requirements and whether the requirements willachieve their intended goal of better assessment and mitigation of therisks in banksrsquo portfolios There is no substitute for skilled supervisorsThe intricacies of effective design and implementation suggest that su-pervisors need to be highly competent technically knowledgeable aboutbanking portfolio characteristics and the factors that influence bank ex-posure to credit risk (Mishkin 2000) And they must be aided by vigilantshareholders market forces and transparency of information53
Standard setting at the global level is desirable but ultimately theeffectiveness of these efforts will be tested at the national level espe-cially in times of systemic financial distress Here the record of Basel Iwas not a bright shining success Japanese banking regulators havetraditionally allowed banks to include real estate and securities in theircapital base When the value of these assets plummeted in the early 1990sregulators allowed banks to continue valuing these depreciated (andoften bankrupt) assets at their old inflated levels Japanese authorities
53 Benedict Roth Complacency Towards Catastrophe Financial Times 23 January 2001
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 127
insisted until the mid-1990s that eroded capital bases could be rebuiltin a market-driven fashion They rightly foresaw that huge loan losseswould undermine public support for the ruling party and require a po-litically unpopular bailout
Japanese foot dragging on Basel I was the worst54 but not uniqueOther examples can be found of ldquopolitically mandated forbearancerdquo TheFederal Reserve Bank of New York held important hands during theLTCM crisis of 1998 Mexico is still resolving the banking crisis that eruptedin 1995 South Korea has not yet closed the insolvent banks that behavedso badly before the crisis of 1998 In the aftermath of a crisis nationalregulators cannot always be relied upon to discipline politically power-ful bankers55 One of the little-noticed consequences of these differingapproaches is that those banks with strong regulatory systems receivedan implicit ldquoexport subsidyrdquo for their services US banks which had notengaged extensively in emerging-market lending in the 1990s were bet-ter positioned than their German and Japanese counterparts to expandtheir international assets in the wake of the crises
Other Financial Forums
54 See Japanese Banks Fiddling while Marunouchi Burns The Economist 27 January2001 67-69
55 See Calomiris (1997)
The Basel model of vertical subsidiarity has already been extended toother financial regulatory bodies In 1993-94 the BIS established a Tri-partite Group of Banking Insurance and Securities Regulators In 1994-95 the BIS increased its cooperation with the International Organizationof Securities Commissions when the two organizations issued parallelpapers on guidelines for national regulators concerning risk managementand disclosure of derivative trades In 1996 a permanent Joint Forum onFinancial Conglomerates was established to examine supervisory issuesand develop working arrangements among the different functional super-visors of conglomerate institutions that offer combinations of bankingsecurities and insurance products Draft papers on the supervisionof conglomerates were released for comment in 1998 applying capital-adequacy principles to these groups and providing guidelines both forassessing the integrity and competence of top managers and for sharingassessments between regulators
In 1997 the Basel Committee on Banking Supervision extended itsreach beyond capital standards to broader aspects of banking supervi-sion with the publication of the Core Principles for Effective BankingSupervision In 1999 a wide range of regulatory and standard-settingbodies were gathered under the umbrella of the Financial Stability
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128 WORLD CAPITAL MARKETS
Forum (FSF) itself established under BIS aegis56 The FSF has alreadyissued recommendations for stepped-up supervision and transparencyas well as guidelines for best practices in a number of areas includingoffshore financial centers and highly leveraged institutions or hedge funds57
Conclusion
Although the structural weaknesses in emerging-market economies arewidely acknowledged to have been causal factors in international capi-tal-market volatility this chapter points to the role of large G-10 bankingorganizations as major suppliers of the most volatile instrument short-term debt We have examined evidence of the impact of public safetynets in the G-10 economiesmdashthe deposit insurance systems the pruden-tial supervisory systems and the lender-of-last-resort functions of centralbanksmdashon the incentive structures of these organizations
Although supervisors in most countries working nationally and to-gether in the BIS have made significant efforts to mimic market forcesin their prudential supervision the most sophisticated financial institu-tions find innovative ways to circumvent the rules New global regulatorybodies are not about to be created G-10 national bank regulators shouldthemselves address the short-term debt bias in the international financialsystem by changing incentive systems G-10 securities regulators shouldalso take steps to get ahead of the curve paying close attention to largeportfolio swings by institutional investors particularly in times of crisisIn short more needs to be done at national and international levels tochange the rules of the game That is the subject of the next chapter
56 The Financial Stability Forum includes banking securities insurance and accountingregulatory bodies the OECD on taxation corruption and corporate governance and theIMF
57 See Martin (2000)
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104 WORLD CAPITAL MARKETS
the US and French approaches show traces of the bureaucratic divisionsthat made sense in an era when banking securities and insurance weresharply separated
The US Model
27 See Meyer (1999a)
28 Canada has a similar degree of simplification with the exception that securities firmsare still regulated by provincial authorities
29 See Pratti and Schinasi (1999 67)
30 The agents are the bank regulators and the principals are the taxpayers Agents maypursue their own interests including bureaucratic survival and postgovernment employ-ment opportunities rather than the national interest in banking safety and soundness
The US model of financial regulation delineated in the Financial Ser-vices Modernization Act of 1999 blends functional and umbrella super-vision Bank and thrift regulators oversee depository institutions Newnonbank activities are subject to both functional regulation (eg by theSecurities and Exchange Commission and state insurance examiners) andumbrella supervision (of financial holding companies) by the FederalReserve27
The UK Model
Another supervisory model exists in the United Kingdom as well as inAustralia Canada and Switzerland28 In this model banking supervisionis separated from the monetary policy function The regulatory structureis considerably simplified by relying on a consolidated financial regula-tor separate from the central bank for both banking and nonbankingactivities The remaining question answered differently depending on thecountry is the extent to which the regulator relies on home-country sur-veillance of banks and conglomerates that have a local presence
Regulatory Models Compared
Appendix B provides more detail on the differences in these modelsGerman simplicity contrasts with French complexity In France the bankingcommission is chaired by the governor of the central bank and includesrepresentatives from the Treasury The commission supervises compli-ance with regulations but the central bank inspects banks on behalf ofthe commission29 In countries such as the United States and France withmultiple supervisors and crossover functions internal coordination is criticalAt the same time multiple agencies create regulatory competition Wheneach agency knows what the other is doing transparency within gov-ernment circles can help to limit principal-agent problems of regulation30
The discussion as to where in the public bureaucracy financial super-
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 105
vision should be placed goes back many years Peek Rosengren andTootell (1999) argue that a synergy exists between monetary policy andprudential supervision because information gained in the course of super-vision can increase the accuracy of macroeconomic forecasts A twist tothis argument is that the information on the state of financial institutionsavailable to the central bank as supervisor can facilitate its role as lenderof last resort Conversely there is the concern that a supervisory rolewill compromise the central bankrsquos independence of action with respectto its core mandatemdashmaintaining price stability As these arguments haveplayed out financial supervision has generally been shared between centralbanks and other regulators or placed entirely in the hands of an inde-pendent regulator However in Italy the Netherlands and Spain cen-tral banks are the sole banking supervisor
Goodhart (1995) examined the arguments and evidence for each modeland concluded that there were no overwhelming arguments or evidencefor one or the other31 Going forward a key problem for any financialsupervisory system is dealing with (and closing as necessary) weak banksIf both central banks and other regulators have this responsibility closecoordination between them is critical Another problem is large conglom-erate banks LCBOs Although they are less likely to fail because of thediversification of their assets and liabilities they are more likely to berescued They are also more likely to be multinational enterprises withinternational implications Goodhart observes that regulation of theseentities might be put in the hands of the central bank because it is lessamenable to political pressures In any event the complexity of LCBOoperations suggests that greater supervisory rigor is necessary
The US Congress was persuaded that broad oversight would help containthe moral hazard problem and accordingly gave the Federal Reservethe role of umbrella supervisor with the understanding that the Fed willscrutinize depository activity more intensely than nonbank financial ac-tivities Under this approach LCBOs such as Citigroup are subject tomuch closer monitoring than smaller and simpler institutions32 The USregulatory model requires enormous cooperation between the Fed otherbank supervisors and the functional regulators for insurance and securi-ties but it also benefits from regulatory competition
31 National systems of supervision are path dependent they are determined by the struc-ture of financial institutions and history in each country If Goodhart (1995) is right out-comes are not materially better or worse with one model of supervision rather than another
32 See Ferguson (1999)
Public Safety Nets
One of prudential supervisorsrsquo biggest challenges is to reduce moral hazardFor many years commercial banks engaged in communal self-insurance
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106 WORLD CAPITAL MARKETS
to deal with crises They formed voluntary groups that agreed to rescuetroubled members As financial markets evolved and competition inten-sified banks were no longer willing to play this role Private-sector in-surance is one alternative but moral hazard and adverse selection wouldappear to prevent it from happening Public safety nets have developedbecause of the low probability and high cost of potential bank runs Aclear trade-off is involved The effectiveness of insurance in preventingbank runs is greater the more comprehensive the coverage But the morecomprehensive the coverage the greater the moral hazardmdashbank man-agers bank directors investors and depositors all take on greater risksin the belief that the safety net will protect them against losses
All G-10 countries have compulsory public safety nets for banks (table29) Deposit insurance agencies are officially organized in Canada theNetherlands Sweden Switzerland and the United States organized bythe industry in France Germany Italy and the United Kingdom andjointly organized by the public and private sectors in Belgium Japanand Spain
How well do G-10 governments offset the subsidy provided by thepublic safety net This is a question on which there is substantial debateAs banking organizations have become more complex the challengesthat supervisors face have become more difficult One challenge is toalign the incentives facing bank managers and shareholders with thoseof depositors Another is the principal-agent problem in supervision Wehave discussed the incentive structures for financial institutions but wehave said little about the incentives for supervisors themselves and thedistortions they can generate in the financial system
In one of the many studies of the US savings and loan crisis of the1980s Kane (1989) documented both problems He described managersusing cosmetic approaches to disguise the magnitude of insolvency regulatorspracticing forbearance even though they knew of the deteriorating riskprofiles of the institutions for which they were responsible and legisla-tors increasing deposit insurance without regard for any offsetting changesin supervision A subsequent overhaul of the legislative framework forthe Federal Deposit Insurance Corporation (FDIC) known as the FDICImprovement Act of 1991 (FDICIA) aimed to introduce a clearer incen-tive structure for both regulators and regulated institutions
The changes introduced by this US legislation are worth discussionwith respect to the other G-10 countries as well First FDICIA created astronger signal to management and investors by targeting deposit insur-ance at small depositors only and by risk-weighting the deposit insur-ance premiums paid by banks to reflect their capital adequacy and bankexaminer ratings Among the G-10 countries rated in table 210 depositinsurance premiums vary considerablymdashbut it is not clear that the dif-ferences have much to do with risk-weighting Most G-10 countries em-ploy funding formulas based for example on the total domestic deposit
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Table 29 Deposit insurance schemes in the G-10 countries Explicit safety net
Coverage limit(dollar Foreign
equivalent currency Interbank Source Bankrsquos Contingency fundingDate Membership Co- at end of deposit deposit of premium from banks
Country established managementa insuranceb July 1998)c covered covered Fundingd funding costs or governments
United 1982 Compulsory Yes Larger of 90 No No Unfunded Banks only Callable (subject Parliament may increase Kingdom private percent co- to maximum the maximum payable
insurance to 03 percent of pound125 million advance 33000 total deposits) facility with Bank of
England
United 1934 Compulsory No 100000 Yes Yes Funded Banks and Up to 027 Borrowing up to $3 States official government percent total billion from US Treasury
domestic deposits
Japan 1971 Compulsory No 71000 but No No Funded Banks and 0084 percent of Borrowing up to yen500bn joint in full until government insured deposits from Bank of Japan
year 2000 subject to Ministry of Finance approval
Canada 1967 Compulsory No 40800 No Yes Funded Banks and 033 percent of Borrowing up to C$6 official government insured deposits billion authorized further
(maximum) borrowing subject to parliamentary approval
Germany 1966 Compulsory Yes 90 percent Yes No Funded Banks only 003 percent of Annual levy may be private coinsurance deposits doubled
to 22000
Italy 1987 Compulsory Yes 125000 Yes No Unfunded Banks and Callable Two options defer private government (maximum of payment or diminish
1 percent of compensation to be paid total deposits)
(table continues next page)
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Table 29 Deposit insurance schemes in the G-10 countries Explicit safety net (continued )
Coverage limit(dollar Foreign
equivalent currency Interbank Source Bankrsquos Contingency fundingDate Membership Co- at end of deposit deposit of premium from banks
Country established managementa insuranceb July 1998)c covered covered Fundingd funding costs or governments
Netherlands 1979 Compulsory No 22000 Yes No Unfunded Banks and On demand Government backing official government maximum of subject to parliamentary
5 percent of own approval funds
France 1980 Compulsory No 65400 No No Unfunded Banks only Callable (on Extra calls up to FFr1000 private demand calls million can be made in
up to FFr200 a 5-year period million)
Switzerland 1984 Voluntary No 19700 No No Unfunded Banks only Callable (on Underwritten by member official demand) banks
Sweden 1996 Compulsory No 31400 Yes No Funded Banks and 05 percent of Full emergency coverage official government deposits while replacing it with a
limited system after the emergency
Belgium 1974 Compulsory No 16600 No No Funded Banks and Callable 002 None insurance limited joint 22000 in government percent of to assets in fund
year 2000 deposits from clients
Spain 1977 Compulsory No 16439 Yes No Funded Banks and 02 percent of Government backing joint government deposits through the Banco de
(maximum) Espantildea subject to approval by royal decree
a Bank membership in the fund can be either compulsory or voluntary and the management of the fund can be official and official and private joint or privateb Coinsurance refers to the situation where depositors face a deductible against their insured fundsc Coverage limit refers to the explicit amount the authorities promise to insured Funded scheme means that it is funded ex ante unfunded otherwise
Sources Goodhart (1995) Demirguccedil-Kunt and Detragiache (2000) Demirguccedil-Kunt and Sabaci (2000)
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 109
base Explicit safety net protection also varies but only Canada focuseson the protected class33 All G-10 countries specify a limit on depositorprotection Under FDICIA the insurance fund is prohibited from pro-tecting uninsured depositors or creditors at a failed bank although adiscretionary system-wide override is provided for exceptional circum-stancesmdashbut with stringent requirements for consultation and account-ability Other G-10 countries allow for contingency funding from the publicpurse alongside unwritten lender-of-last-resort support Among large banksa significant and growing portion of deposit liabilities including foreigncurrency and interbank deposits are uninsuredmdashbut depositors assumethey will be protected in a crisis
FDICIA also made some significant qualitative changes to address theprincipal-agent problem by penalizing weak banks and rewarding strongbanks For example banks whose capital declined faced progressivelytougher regulatory sanctions that for example required them to elimi-nate dividends restrict their lending and change their managementsRegulators have also been forced to take prompt corrective action (toreduce the practice of regulatory forbearance in hopes that a bankrsquos for-tunes might improve)34 Unfortunately comparative qualitative assess-ments across the G-10 are difficult to make due to lack of information35
This discussion highlights the complexity of evaluating the extent towhich prudential supervision and market discipline reduce the moralhazard associated with G-10 safety nets Our argument is that publicsafety nets in the G-10 can be linked to banking instability in other coun-tries specifically in the emerging-market economies that have attractedG-10 cross-border bank lending This lending is a leading source of vola-tility in capital flows the large financial institutions many of which arecomplex banking organizations are based in and regulated by authori-ties in the G-10 economies These two features of the international finan-cial system are closely related although it is not possible to test thisrelationship econometrically
Two World Bank studies however indicate a basis for concern Onestudy is a cross-country econometric analysis of the relationship betweenbank stability and deposit insurance (Demirguccedil-Kunt and Detragiache2000) which found a negative relationship Their estimated model forbanking crises in a sample of 61 countries (both industrial and develop-ing) suggests that explicit deposit insurance raises the probability of acrisis by at least 30 percent36 Crises are especially likely in countries
33 Japanrsquos legislation says it does but recent experience shows this is not the case34 See Goldstein (1997) for a summary of the changes35 See Barth Nolle and Rice (2000) for a beginning in this area36 Demirguccedil-Kunt and and Detragiache (2000 table 1) report a logit coefficient of 0696with a standard error of 0397 (the coefficient is significant at the 8 percent threshold)This suggests that the ldquotruerdquo coefficient could well be as small as 030 (the reportedvalue minus the standard error)
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110 WORLD CAPITAL MARKETS
with immature financial supervisory systems (and not in the G-10) buttheir analysis does underscore the view that deposit insurance weakensmarket discipline37
An earlier World Bank analysis established similar results One wasthat market discipline is undermined by deposit insurance schemes an-other was that illiquid banks are forced to pay more for their funds un-less a generous deposit insurance scheme is in place (Demirguccedil-Kuntand Huizinga 1999) This econometric study also provides clear-cut evi-dence that depositor monitoring of banks declines with the existence ofdeposit insurance schemes At the heart of the problem is the questionof whether deposit insurance is accompanied by increased governmentmonitoring
This evidence and the weight of other arguments suggests that moralhazard is still an issue in the G-10 countries Consider the ongoing de-bate about instilling greater market discipline on risk taking by banksAt one extreme is the perennial proposal to do away with safety netsleaving markets to monitor the players and to force adjustments but toprotect small savers by creating ldquonarrow banksrdquo such as postal savingsystems that are allowed to invest these savings only in risk-free gov-ernment securities Whatever the merits of narrow banking this solutionis too extreme to be politically feasible
A moderate alternative is to force more disclosure by financial institu-tions to facilitate market monitoring But transparency has its own prob-lems Persaud (2000) argues that financial markets cannot reliably discernsustainable from unsustainable positions in the short term This uncer-tainty causes banks to ldquoherdrdquo behind market leaders to exploit theirsupposedly superior information ldquoThe more herding investors and bankersknow about what each other is up to the [more] unstable markets maybecomerdquo The implication is that greater transparency in the marketplaceby itself will not solve the problemmdashand in the short term more informa-tion may exacerbate herding Further supervisory steps (discussed in thenext chapter) are required
Yet another proposal is to promote private-sector involvement in bankmonitoring through market-based alternatives such as Calomirisrsquos sub-ordinated debt proposal (Calomiris 1997 Federal Reserve Board 1999)Banks could be required to issue and maintain a minimum amount of
37 Other findings in the Demirguccedil-Kunt and Detragiache (2000) study include thesepropositions The impact of deposit insurance on bank stability tends to be stronger themore extensive is the coverage offered to depositors when the scheme is funded andwhere the scheme is run by the government rather than by the private sector Con-versely deposit insurance is detrimental to bank stability where bank interest rates havebeen deregulated and where the institutional environment is weak Additional findingson deposit insurance are reported from a recent World Bank conference (8-9 June 2000httpwwwworldbankorgresearchinterestconfsupcomingdeposit_insurancehomehtm)Also see Smalhout (2001)
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 111
subordinated debt (eg uninsured certificates of deposit) to finance asmall fraction (such as 2 percent) of their total nonreserve assets Thesubordinated debt would be allowed to earn a set yield no more than 50basis points over the risk-free yield on government treasury bills Thisrule would supposedly force banks to operate in a safe manner Other-wise subordinated debt holders would redeem their uninsured certifi-cates of deposit and equity investors would sell their bank shares Despiteits practical problems the beauty of the subordinated debt requirementis that it enlists market incentives to push banks to avoid excessive port-folio risk38
The thrust of these proposals is very relevant to the arguments in ourstudy Even in the G-10 countries government monitoring by itself hasnot eliminated moral hazard among banks More work is needed to in-troduce market monitoring and to improve the incentive structures bothfor financial institutions and their supervisors We return to this issuewith our recommendations in the next chapter
38 In late 1996 Argentina began requiring its banks to finance 2 percent of total depos-its in the form of subordinated debt but without a maximum yield provision TheArgentine authorities expect that market discipline will act in concert with the publicsafety net One obvious problem with the subordinated debt proposal is that banks mayencourage some of their customers to buy the subordinated debt
Portfolio Institutions Tomorrowrsquos Problem
Before proceeding to the issues of international supervision we flag an-other potential problem for national regulators The big asset managersprofiled in tables 24 and 26 answer to diverse groups of pensionersshareholders and policyholders They allocate funds across a number ofcountries to diversify their risks They hold liquid assets that can be tradedand they have a higher proportion of long-term assets than banks Eco-nomic shocks can be absorbed through price changes and their effectsspread across time and markets Thus when conditions change in a par-ticular market they are more likely to ride out the storm than to flee Inother words they have less incentive than banks to pull their invest-ments in the face of adversity In the 1990s most large asset managersestablished a record of ldquoriding out the stormrdquo rather than ldquorunning withthe windrdquo although as we saw in chapter 1 instances of running withthe wind were detected in some portfolios As we write these insti-tutions have a good record overall in the emerging markets so whyworry
The Russian crisis and the near-collapse of LTCM previewed the dan-gers that may await future portfolio managers and G-10 financial minis-ters We have presented evidence indicating a systemic bias toward bank
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112 WORLD CAPITAL MARKETS
lending and debt finance to emerging markets and we have argued forsubstitution toward equity finance and direct investment39
That is not the end of the story We noted in the previous chapterthat institutional investors can become momentum investors selling in adownturn As more portfolio capital is invested in emerging marketssome players may adopt the high-risk high-leverage strategies of themost aggressive hedge funds Indeed the data in box 11 show that G-10portfolio investors held somewhat more long-term debt (more than $500billion) than equity (less than $400 billion) in emerging markets at theend of 1997 Long-term debt is an ideal vehicle for high-risk high-leveragestrategies These strategies practiced on a large scale could compound afuture crisis harming emerging markets A big enough crisis could inturn pressure G-10 central banks and finance ministers to arrange bail-out plans Instead of shrinking as a systemic financial problem moralhazard could increase
National securities regulators are the first line of defense against thisscenario They play a critical role in the safe evolution of capital mar-kets But regulators today are mandated to approve the issuance of newsecurities and to monitor the continuing disclosure of material informa-tion by issuers They are far less concerned with or empowered to monitorthe behavior of the increasingly large wealth-management firms that arethe major purchasers (and therefore resellers) of these securities
Within their mandates the goals of national securities regulators (table210 and appendix B) are similar to the concerns of bank regulators withsystem safety and soundness Their focus is also on the incentive sys-tems for management and boards of directors and on disclosure by cor-porations that issue marketable securities such as shares bonds andasset-backed securities 40 Issuers of securities possess greater knowledgeabout the quality of these assets than do the purchasers hence investorprotection is a key concern of regulators Moreover market disciplineworks best when markets know what is happening Well-functioning corpora-tions are key agents of wealth creation and social progress Underperform-ing corporations waste resources During recessions bad corporationsget into bad trouble often with severe social consequences Inadequateincentives for managers and inadequate accountability for boards andmanagers thus have negative externalities Regulators play a vital role inexposing weakness so that market disciplines come to bear sooner ratherthan later
Regulatory emphasis is constantly shifting as financial markets evolveand as the macroeconomic environment changes Regulators try to balance
39 See Rogoff (1999) Also see Berlin (2000) for a perspective on the limited role thatbanks play as share owners
40 See Habib and Ljungqvist (2000) for recent empirical analysis showing that corporateshare market values are higher when corporate executives have a larger ownership stake
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Table 210 Financial-sector regulation G-10 countries 2000
Financial institutions and their supervisors
Country and supervisory structure Retail banking Wholesale banking Securities Insurance
Financial conglomeratesFinancial Services Authority (FSA) = umbrella supervisor
United Kingdom FSA FSA FSA FSA
Treasury bull Commercial banks bull Investment funds (Securities and (Insurance Directorate(Securities and Investments Board) bull Unit trust groups Futures Authority) of the Treasury)
Bank of bull Building societies bull Pension funds England (Building Societies Commission) bull Merchant banks
bull Friendly societies bull Clearing houses bull Primary issuers bull Insurance FSA (Friendly Societies Commission) bull Venture capital of securities companies
bull Pensions and life insurance etc bull Stock exchanges bull Insurance brokers(Personal Investment Authority) bull Stockbrokers
Financial holding companiesFederal Reserve (FR) = umbrella supervisor
United States bull National banks(OCC) Securities and Regulated by
Treasury OCC bull State banks Federal Reserve Exchange Commission StatesMembers (FR)
OTS Nonmembers (FDIC) bull Investment banks bull Primary issuers of bull Insurance companies FR bull Cooperative banks (FDICFR) bull Finance companies securities bull Insurance brokers FDIC bull Insured industrial banks (FDIC) bull Stock exchanges
bull Thrift holding companies (OTS) bull Stockbrokers SEC bull Savings banks (OTSFDICFR) bull Investment advisors
bull Savings and loan associations bull Mutual funds(OTS) bull Public utility holding
bull Edge Act corporations (FR) companies
(table continues next page)
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Table 210 Financial-sector regulation G-10 countries 2000 (continued )
Financial institutions and their supervisors
Country and supervisory structure Retail banking Wholesale banking Securities Insurance
Financial holding companies Japan Financial Supervisory Authority (FSA) = umbrella supervisor
Prime FSA FSA FSA FSA ministerrsquos Ministry of office Finance (Securities and Exchange
Surveillance Commission) FRC Bureau of Financial bull City banks bull Investment banks bull Primary issuers of bull Insurance companies FSA Regulation bull Regional banks bull Asset managers securities bull Insurance brokers
bull Trust banks bull Stock exchanges SESC bull Long-term credit banks bull Stockbrokers
bull Pension funds
Financial holding companiesOffice of the Superintendent of Financial Institutions (OSFI) = umbrella supervisor
Canada Regulated by OSFI OSFI provinces OSFI
Department of Financebull Banks bull Cooperative credit bull Primary issuers of bull Insurance companies
(previously Office of the Inspector associations securities (previously Depart- OSFI General of the Banks) bull Fraternal benefit bull Stock exchanges ment of Insurance) Bank of bull Trust and loan companies society bull Stockbrokers bull Insurance brokers Canada bull Pension funds bull Asset managers
(previously Depart- CDIC ment of Insurance)
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115
Financial institutions and their supervisors
Country and supervisory structure Retail banking Wholesale banking Securities Insurance
Germany Financial holding groupsFederal Banking Supervisory Office (FBSO) = umbrella supervisor
Ministry of Finance FBSO BSO FSSO FISO
Bundesbankbull Universal banks bull Other financial bull Primary issuers of bull Insurance companies
Federal Banking bull Savings banks institutions (eg securities bull Insurance brokers Supervisory Office bull Securities banks management foreign bull Stock exchanges
currency dealings) bull Stockbrokers Federal Securities bull Financial enterprises bull Asset managers Supervisory Office (eg leasing bull Pension funds
organizations Federal Insurance credit card companies Supervisory Office investment advisors)
Italy Bank foundationsMinistry of Finance = umbrella supervisor
Ministry of Finance Bank of Italy Bank of Italy Consob ISVAP
Bank of Italy bull Commerical banks bull Asset managers bull Primary issuers of bull Insurance companies Consob bull Savings bank bull Open-end investment securities bull Insurance brokers
bull Securities banks companies (SICAVs) bull Stock exchangesbull Stockbrokers
ISVAP
(table continues next page)
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Table 210 Financial-sector regulation G-10 countries 2000 (continued )
Financial institutions and their supervisors
Country and supervisory structure Retail banking Wholesale banking Securities Insurance
The Netherlands Financial conglomeratesCouncil of Financial Supervisors = umbrella supervisor
Securities Board Securities Board Netherlandsche Netherlands Bank Netherlandsche Bank of the Netherlands Insurance Board Bank Insurance bull Credit institutions (universal banks bull Investment institutions bull Stock exchanges bull Insurance companies Board cooperative banks security credit (securities issuing bull Stockbrokers bull Insurance brokers
institutions mortgage banks) and tradingmdashprimary The Council of Financial and secondary Supervisors markets)
France Commission des Commission de Operations des Controcircle des
Banking and Banking Commission Bourse Assurances Financial Regulatory bull Ensuring that credit institutions (and investment firms since bull Primary issuers of bull Insurance companies Ministry for Committee the Financial Activity Modernization Act of 1996) comply securities bull Insurance brokers Economic with laws and regulations bull Stock exchanges Affairs and bull Execute instructions regarding all off-site monitoring and bull Stockbrokers Finance Credit on-site supervision Institutions and Banking and Financial Regulatory Committee Investment bull Formulates general regulations for credit institutions and investment firms Committee (capital adequacy requirements accounting rules etc) Bank of France Credit Institutions and Investment Committee Banking bull Authorizes and examines financial institutions except for those within the Commission competence of the Banking Commission
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117
Financial institutions and their supervisors
Country and supervisory structure Retail banking Wholesale banking Securities Insurance
Switzerland Large banking groupSwiss Federal Banking Commission (SFBC) = umbrella supervisor
Swiss National Bank Federal Office of
SFBC SFBC SFBC Private Insurance Swiss Federal Banking Commission bull Universal banks bull Investment banks bull Primary issuers of bull Insurance companies
bull Savings banks bull Asset management securities bull Insurance brokerscompanies bull Stock exchanges
Private audit Federal bull Investment funds bull Stockbrokers firms Office of bull Mortgage bond authorized by Private business SFBC Insurance
Sweden Financial holding company groupsFinancial Supervisory Authority = umbrella supervisor
Ministry of Finance Credit Market Securities Market Insurance Market
Credit Market Department Department Department Department
Financial bull Commercial banks bull Investment funds bull Primary issuers of bull Insurance companies Riksbank Supervisory bull Savings banks securities bull Insurance brokers Authority bull Friendly societies bull Stock exchanges
bull Stockbrokers
(table continues next page)
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Table 210 Financial-sector regulation G-10 countries 2000 (continued )
Financial institutions and their supervisors
Country and supervisory structure Retail banking Wholesale banking Securities Insurance
Belgium Bank holding companiesBanking and Finance Commission = umbrella supervisor
Bank of Belgium Banking Banking
Banking and Finance and Finance Insurance Controland Finance Commission Commission Commission Office
Banking and Insurance Finance Control bull Commercial banks bull Asset management bull Primary issuers of bull Insurance companies Commission Office bull Savings banks firms securities bull Insurance brokers
bull Securities banks bull Investment funds bull Stock exchanges bull Mortgage companiesbull Stockbrokers bull Pension funds
Securities Regulation Fund Securities Regulation Fund
bull Other investment firms and credit institutions(institutions participating in regulated off-exchangemarket in strips and Treasury certificates)
Bank holding companies Spain Banco de Espantildea = umbrella supervisor
Banco de Espantildea Comision Nacional del Mercado de Directorate General
Banco de Espantildea Valores (CNMV) Insurance
bull All credit institutions (commercial banks savings banks credit bull Primary issuers of (Ministry of Economy Ministry of cooperatives official credit institutions finance factoring and securities and Finance) Economy and CNMV leasing companies mortgage-loan companies etc) bull Stock exchanges bull Insurance companies Finance bull Interbank foreign exchange and book-entry public debt bull Stockbrokers bull Pension funds
markets bull Venture capital(companies and funds)
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119
Financial institutions and their supervisors
Country and supervisory structure Banking Securities Insurance
Banking Advisory High Level Securities Supervisors Committee (BAC) Committee (HLSS) Insurance Committee (IC)
Supranational (EU) bull Formulates standards for prudential bull Coordination of securities market bull Formulates standards forsupervision supervision prudential supervision
BACICHLSS Banking Supervision
Conglomerates Committee (BSC) Securities Contact Committee Regulation of prudential bull Systemic risk monitoring bull Regulation and implementation of supervision securities admission
International Association International International Organization of of Insurance Supervisors
Basel Committee Securities Commisison (IOSCO) (IAIS) Joint Forum Conglomerates Supervision bull Supervision and regulation best bull Supervision and regulation best bull Supervision and regulation amp regulation Best practices practices practices best practices
FSF Coordination across supervisors of various functions
Notes See appendix B for more information Boldface type indicates senior or oversight supervisor normal type indicates adjunct or front-line supervisorsolid line indicates direct responsbility to the senior-ranking authority dotted line indicates coordination in supervisory activities
(table continues next page)
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Table 210 Financial-sector regulation G-10 countries 2000 (continued )
Glossary of names United Kingdom FSA = Financial Services Authority United States FR = Federal Reserve OCC = Office of the Comptroller of theCurrency FDIC = Federal Deposit Insurance Corporation SEC = Securities and Exchange Commission OTS = Office of Thrift Supervision Japan FRC =Financial Reconstruction Commission FSA = Financial Services Agency SESC = Securities and Exchange Surveillance Commission Canada OSFI =Office of the Superintendent of Financial Institutions CDIC = Canada Deposit Insurance Corporation Germany FBSO = Federal Banking SupervisoryOffice FSSO = Federal Securities Supervisory Office FISO = Federal Insurance Supervisory Office BSO = Banking Supervisory Office Italy Consob =Commissione Nazionale per le Societa e la Borsa ISVAP = Instituto per la Vigilanza sulle assicurazioni private e di Interesse colletivo Switzerland SFBC= Swiss Federal Banking Commission Spain CNMV = The Comision Nacional del Mercado de Valores Supranational BAC = Banking Advisory CommitteeBSC = Banking Supervision Committee IC = Insurance Committee HLSS = High Level Securities Supervisors Committee International Dimension FSF =Financial Stability Forum IOSCO = International Organization of Securities Commission IAIS = International Association of Insurance Supervisors
Sources United Kingdom Bank of England httpwwwbankofenglandcouk Financial Services Authority httpwwwfsagovuk United States Board ofGovernors of Federal Reserve System httpwwwfederalreservegov Japan Bank of Japan httpwwwbojorjo Financial Reconstruction Commissionhttpwwwfsagojpfrcindexehtml Financial Services Agency httpwwwfsagojp Canada Bank of Canada httpwwwbank-banque-canadaca Office ofthe Superintendent of Financial Institutions httpwwwosfi-bsifgccaAndreEindexhtml Germany Deutsche Bundesbank httpwwwbundesbankde Fed-eral Banking Supervisory Office httpwwwbakredde Italy Banca drsquoitalia httpwwwbancaditaliait Commissione Nazionale per le Societa e la Borsahttpwwwconsobit Instituto per la Vigilanza sulle assicurazioni private e di Interesse colletivo httpwwwisvapit The Netherlands De NederlandscheBank httpwwwdnbnl France Banque de France httpwwwbanque-francefr Switzerland Schweizerische Nationalbank httpwwwsnbchindex3htmlSweden Sveriges Riksbank httpwwwriksbanksedefaultasp Belgium National Bank of Belgium httpwwwbnbbesgindexhtm Spain Banco de Espantildeahttpwwwbdees The Comision Nacional del Mercado de Valores httpwwwcnmves Supranational (EU) Institutional Arrangements for the Regulationand Supervision of the Financial Sector 2000 International Dimension Bank for International Settlement httpwwwbisorg International Organization ofSecurities Commissions httpwwwioscoorg International Association of Insurance Supervisors httpwwwiaisorg Financial Stability Forum httpwwwfsforumorg
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 121
the inflexibility of tight surveillance against the need to encourage in-novation and growth The US Securities and Exchange Commission isworried about aggressive accounting by firms and biased reports bysecurities analysts in an equity environment that prizes steadily higherquarterly earnings41 Japanese regulators are preoccupied with opaqueinterconnections between portfolio institutions banks and nonfinancialfirms through the keiretsu system Canadian regulators reeling from high-profile scandals of managers intentionally misleading investors are strengtheningmarket discipline through legal penalties aimed at managers and directorsof offending firms
When panic strikes a securities regulator cannot do much As the 1987stock market crash and the LTCM debacle in the fall of 1998 both dem-onstrated steep stock and bond price declines can create systemic risksIf severe enough the wealth effect of falling securities values and thefear of widespread insolvency can depress real activity Flooding thesystem with liquidity is a central bankerrsquos solutionmdashsomething a securi-ties regulator cannot do42 But just as financial supervisors can changethe incentive structure to discourage bankers from making risky loans ingood times so securities regulators can pay more attention to incentiveson the demand side when capital markets are strong
Prudential Supervision and InnovationmdashA Footnote
In concluding this discussion of prudential supervision in the G-10 anadditional point is worth noting National regulators face a persistenttrade-off between emphasizing financial system safety and soundnesswhile encouraging innovationmdashin spite of the added risks innovationbrings to financial markets Former US Treasury Secretary Lawrence Summers(2000 3) has argued by analogy
The jet airplane made airplane air travel more comfortable more efficient andmore safe though the accidents were more spectacular and for a time morenumerous after the jet was invented In the same way modern global financialmarkets carry with them enormous potential for benefit even if some of theaccidents are that much more spectacular As the right public policy response
41 The problem is illustrated by the divergence since mid-1998 between reported earn-ings by the Standard amp Poorrsquos (SampP) 500 and the after-tax profits of all corporations inthe national accounts Generally these two series move closely with one another Be-tween mid-1998 and mid-1999 SampP 500 reported that earnings increased by more than20 percent while after-tax profits of all corporations increased by less than 5 percent(Chase Bank US Economic and Policy Research US Weekly Prospects Chase SecuritiesWeekly Newsletter 5 June 2000 5)
42 For example the US Securities and Exchange Commission had no direct role in calmingmarkets in the 1987 or 1998 panics
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122 WORLD CAPITAL MARKETS
to the jet was longer runways better air-traffic control and better training forpilots and not the discouragement of rapid travel so the right public policyresponse to financial innovation is to assure a safe framework so that the ben-efits can be realized not to stifle the change
Accepting Summersrsquos analogy for the international financial system better-informed supervisors and investors are a necessary part of the financialsystem framework Supervisors require more timely information on therisk profiles resulting from positions taken by financial institutions Theyalso need a better understanding of risk-management systems Snapshotsof an institutionrsquos risk profile and risk-management procedures are nolonger adequate In a world where huge bets are quickly made (andpossibly lostmdashas with Barings Bank in 1995 and LTCM in 1998) super-visors must focus on the soundness of banking systems for evaluatingand managing risk on a daily basis Some progress has been made inaddressing these issues US banking examiners are extending their in-formation requirements in banking examinations and increasing theirinvolvement in large complex institutions43 More awareness is alsorequired of the fact that they are national organizations in a world ofcross-border capital flows To a much greater extent they need a multi-national reach International supervision and coordination among super-visors are the subject of the next section
Our analysis suggests that G-10 supervisors have unfinished businessBank supervisors need to start yesterday securities regulators can waituntil tomorrow One G-10 member acting alone cannot correct the biasIn good times the lending business will simply migrate to other G-10banks In bad times financial problems will not stop at the national bor-der A way has to be found to establish common international standardsfor the key financial players in order to prevent crises and to agree onapproaches for managing them The path has already been laid out Inthe wake of the bank failures of the past 25 years bank supervisors havetried to establish such standards They have done this without creating anew global institution
The essence of the international framework is decentralizationmdashglobalrules and design standards without global institutions that are perceivedto intrude on national sovereignty The awkward jargon for this frame-work is vertical subsidiaritymdashldquothink internationally act nationallyrdquo Theinternational thinking is done by a committee of regulators that meets
International SupervisionA Decentralized Framework
43 These issues are discussed in Ferguson (1999) and Meyer (2000a)
Institute for International Economics | httpwwwiiecom
THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 123
regularly at the Bank for International Settlements in Basel The commit-tee establishes principles and standards that are interpreted implementedand enforced by national authorities44 In this section we describe thesesupervisory efforts and their weaknesses We present our recommenda-tions for addressing these weaknesses in the next chapter
Basel I
The Basel Capital Accord of 1988 (Basel I)45 drew the lesson from thefinancial crises of the mid-1970s that more adequate capital levels in in-ternational banks would help reduce the systemic risk of bank failureThe primary goal of Basel I was capital adequacy other standards wereput in place not so much for their own virtue as to defend the primarygoal
Capital adequacy requirements were designed to ensure that individualinstitutions have the ability to absorb losses particularly credit lossesAccordingly a backup system of scoring credit risk was devised thatrequired large amounts of bank capital for some types of loans smalleramounts for others and zero for a select list of preferred assets Report-ing requirements were designed to disclose problems and ensure that atroubled bank would take timely steps to restore its capital base in thewake of a loss The Basel I framework worked tolerably well in limitingthe call on the public purse in the G-10 countriesmdashwith the notable ex-ceptions of France and Japan The framework failed to moderate riskybank lending to emerging markets however
Basel I was not developed with emerging markets in mind The origi-nal idea behind it was to develop a common supervisory approach tocross-border banking operations It grew out of political pressure fromUS lawmakers who were determined to require international banks op-erating in the United States to meet US banking standards Toward thisgoal in 1983 Congress passed the International Lending Supervisory ActUS and British banking authorities subsequently agreed on a commontarget the adoption of strict common capital-adequacy standards In 1988other G-10 governments agreed to go along voluntary acceptance ofthe standards throughout much of the rest of the world followed46 Therationale for the capital targets was two-fold The first was to requirebanks to hold sufficient amounts of capital (8 percent of risk-adjusted
44 The international committee of financial authorities agreed on a common definitionof banksrsquo tier-one or ldquocorerdquo capital national authorities defined tier-two capital in theirown manner which permitted greater variations in national working definitions andpractices
45 International Convergence of Capital Measurement and Capital Standards (BIS 1988)was prepared by the Basel Committee on Banking Supervision
46 See Reineke (1998)
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124 WORLD CAPITAL MARKETS
assets) to cushion losses on those assets The second was to dull theirappetites for risk banks with large capital bases would have more tolose if they failed and therefore would take fewer risks
Rapid change in financial markets soon revealed flaws in the Basel IAccord In a complex world with numerous sources of risk it focusedheavily on credit risk but overlooked other risks in a bankrsquos portfolioand the correlation between returns on different asset classes The Baselformula required banks to maintain a fixed amount of capital againsteach of its asset classes But the formula did not distinguish the riskinessof the borrower within each class As a result one large loan to a low-risk corporate borrower such as General Electric would require the sameamount of capital as 10 smaller transactions with high-risk borrowers
The system was also biased toward short-term loans Loans maturingin less than a year required a 20 percent risk weight whereas those ma-turing after more than a year required a 100 percent risk weight Inter-bank lending was particularly favored For example loans to banks inOECD countries required less capital than loans to private firms in thesame countries creating the anomaly that interbank loans to South Ko-rean banks required less capital than loans to General Electric47 Thisanomaly encouraged banks to shed high-quality assets if the Basel rulesrequired the allocation of more capital than banks thought they needed
Another weakness was that financial innovators quickly circumventedthe Accord Because short-term loans required less provisioning than long-term loans banks responded by securitizing their long-term debt port-folios and lending short-term against the collateral of the newly createdasset This allowed banks to circumvent the capital requirements gearedto the terms of the underlying debt At the same time the Basel I Accordfailed to encourage risk mitigation techniques such as credit derivativescollateral guarantees and on-balance-sheet netting the flip side of fi-nancial innovation Because off-balance-sheet products were not coveredby the Accord another anomaly appeared when Barings Bank collapsedin 1995 Barings met capital adequacy standards but collapsed becauseits systems for managing risk failed traders were allowed to speculatein futures contracts that did not appear on the balance sheet
Basel II
Work to overhaul Basel I began in 1995 and produced consultativepapers issued in June 1999 and January 200148 These papers have been
47 South Korean banks have had notoriously weak balance sheets because the practiceof ldquodirected lendingrdquo left them with many poor loans (in making these loans the bankswere expected to follow government objectives rather than creditworthiness criteria)
48 Basel Committee on Banking Supervision (1999 2001)
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 125
the subject of extensive consultation and revision as a result the newAccord is expected to be introduced in 200449 The Basel II frameworkhas three parts (pillars) revisions to Basel I minimum-capital require-ments supervisory review criteria and greater emphasis on market dis-cipline Broadly Basel II aims to maintain the level of capital in the sys-tem but achieve better alignment of banksrsquo capital with their risk pro-files and keep up with financial innovation
To align capital requirements with market realities (the first pillar)Basel II concentrates on the 100 or so largest banksmdashthe type of playerslisted in table 21mdashand on the holding-company parents of banking groups50
Capital requirements will differentiate between an increased number ofcredit groups or ldquorisk bucketsrdquo including claims on governments otherbanks corporations mortgage-backed securities and other asset-backedsecurities
Basel II originally proposed to use external ratings to set capital chargesfor a number of these credit risks Many banks objected arguing thatthey assess credit risk better than Standard amp Poorrsquos Moodyrsquos or FitchIBCA51 Basel II thus proposes two approaches to rating a standard ap-proach using external ratings and an ldquoadvancedrdquo approach that allowsselected banks to use their own internal rating systems To encouragethe development of rigorous internal control systems based on these in-ternal rating systems Basel II also proposes to levy capital charges foroperational risk (the risk of direct or indirect loss resulting from inad-equate or failed internal processes people and systems or from exter-nal events)
Some critics of this proposal dismiss it as an abrogation of the prin-ciple of external independent monitoring and as ldquodangerously naiumlverdquo52
But regulators argue that the new capital charge on operational risk shouldoffset this concern It is also far from clear how cross-national compari-sons of rating and internal risk-assessment systems will be made (Engelen2000) The development by the European Union of its own capital rulescould well complicate the international resolution of these issues Publicassurances by EU officials in January 2001 however indicated that theirmain concerns are to create a level playing field and avoid regulatoryarbitrage (Hargreaves 2001) There is also the significant problem ofthe procyclical character of risk weights When a crisis hits losses are
49 See Berry (2000) for an update in an interview with William J McDonough chair ofthe Basel Committee on Banking Supervision
50 For obvious reasons these proposals are addressed to large banks and simpler capi-tal standards are allowed for small banks that focus on their domestic credit markets
51 See Ammer and Packer (2000) for an empirical critique of the success of rating agen-cies in distinguishing risk by sector and region
52 See Auerback (2001)
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126 WORLD CAPITAL MARKETS
incurred or accrued capital is lost and loan exposure must be reducedor securities sold to restore the requisite capital-adequacy ratios A morerisk-sensitive framework could amplify volatility
As the second pillar of Basel II supervisory review criteria are beingbeefed up to encourage supervisors to intervene earlier in potential problemsituations and to compel banks to align their capital positions with theirrisk profiles Bank supervisors will be authorized to require banks tohold capital in excess of minimum requirements if they have concernsabout general management overall strategy risk-management performanceor the macroeconomic environment Of course if one G-10 supervisorimposes higher capital requirements in isolation the same disparity willemerge that presaged Basel I Some banks will be disadvantaged in theinternational marketplace and will loudly complain that excessive super-vision is driving business to their competitors Hence close internationalcooperation among supervisors is critical
To implement the third pillar market discipline banks will be requiredto make fuller more timely disclosure of capital adequacy and the risksto which that capital is exposed A number of measures are being stud-ied that might help supervisors evaluate bank performance such as com-parisons of uninsured deposit interest rates subordinated debt yieldsand equity prices The idea is that these yields and prices might alertsupervisors to market perceptions of risk Of course market perceptionsare only as good as market information More direct and controversialways to reinforce market discipline would dramatically increase publicdisclosure of bank positions and risk management systems
Many questions are still outstanding about how to resolve the techni-cal details of capital requirements and whether the requirements willachieve their intended goal of better assessment and mitigation of therisks in banksrsquo portfolios There is no substitute for skilled supervisorsThe intricacies of effective design and implementation suggest that su-pervisors need to be highly competent technically knowledgeable aboutbanking portfolio characteristics and the factors that influence bank ex-posure to credit risk (Mishkin 2000) And they must be aided by vigilantshareholders market forces and transparency of information53
Standard setting at the global level is desirable but ultimately theeffectiveness of these efforts will be tested at the national level espe-cially in times of systemic financial distress Here the record of Basel Iwas not a bright shining success Japanese banking regulators havetraditionally allowed banks to include real estate and securities in theircapital base When the value of these assets plummeted in the early 1990sregulators allowed banks to continue valuing these depreciated (andoften bankrupt) assets at their old inflated levels Japanese authorities
53 Benedict Roth Complacency Towards Catastrophe Financial Times 23 January 2001
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 127
insisted until the mid-1990s that eroded capital bases could be rebuiltin a market-driven fashion They rightly foresaw that huge loan losseswould undermine public support for the ruling party and require a po-litically unpopular bailout
Japanese foot dragging on Basel I was the worst54 but not uniqueOther examples can be found of ldquopolitically mandated forbearancerdquo TheFederal Reserve Bank of New York held important hands during theLTCM crisis of 1998 Mexico is still resolving the banking crisis that eruptedin 1995 South Korea has not yet closed the insolvent banks that behavedso badly before the crisis of 1998 In the aftermath of a crisis nationalregulators cannot always be relied upon to discipline politically power-ful bankers55 One of the little-noticed consequences of these differingapproaches is that those banks with strong regulatory systems receivedan implicit ldquoexport subsidyrdquo for their services US banks which had notengaged extensively in emerging-market lending in the 1990s were bet-ter positioned than their German and Japanese counterparts to expandtheir international assets in the wake of the crises
Other Financial Forums
54 See Japanese Banks Fiddling while Marunouchi Burns The Economist 27 January2001 67-69
55 See Calomiris (1997)
The Basel model of vertical subsidiarity has already been extended toother financial regulatory bodies In 1993-94 the BIS established a Tri-partite Group of Banking Insurance and Securities Regulators In 1994-95 the BIS increased its cooperation with the International Organizationof Securities Commissions when the two organizations issued parallelpapers on guidelines for national regulators concerning risk managementand disclosure of derivative trades In 1996 a permanent Joint Forum onFinancial Conglomerates was established to examine supervisory issuesand develop working arrangements among the different functional super-visors of conglomerate institutions that offer combinations of bankingsecurities and insurance products Draft papers on the supervisionof conglomerates were released for comment in 1998 applying capital-adequacy principles to these groups and providing guidelines both forassessing the integrity and competence of top managers and for sharingassessments between regulators
In 1997 the Basel Committee on Banking Supervision extended itsreach beyond capital standards to broader aspects of banking supervi-sion with the publication of the Core Principles for Effective BankingSupervision In 1999 a wide range of regulatory and standard-settingbodies were gathered under the umbrella of the Financial Stability
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128 WORLD CAPITAL MARKETS
Forum (FSF) itself established under BIS aegis56 The FSF has alreadyissued recommendations for stepped-up supervision and transparencyas well as guidelines for best practices in a number of areas includingoffshore financial centers and highly leveraged institutions or hedge funds57
Conclusion
Although the structural weaknesses in emerging-market economies arewidely acknowledged to have been causal factors in international capi-tal-market volatility this chapter points to the role of large G-10 bankingorganizations as major suppliers of the most volatile instrument short-term debt We have examined evidence of the impact of public safetynets in the G-10 economiesmdashthe deposit insurance systems the pruden-tial supervisory systems and the lender-of-last-resort functions of centralbanksmdashon the incentive structures of these organizations
Although supervisors in most countries working nationally and to-gether in the BIS have made significant efforts to mimic market forcesin their prudential supervision the most sophisticated financial institu-tions find innovative ways to circumvent the rules New global regulatorybodies are not about to be created G-10 national bank regulators shouldthemselves address the short-term debt bias in the international financialsystem by changing incentive systems G-10 securities regulators shouldalso take steps to get ahead of the curve paying close attention to largeportfolio swings by institutional investors particularly in times of crisisIn short more needs to be done at national and international levels tochange the rules of the game That is the subject of the next chapter
56 The Financial Stability Forum includes banking securities insurance and accountingregulatory bodies the OECD on taxation corruption and corporate governance and theIMF
57 See Martin (2000)
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 105
vision should be placed goes back many years Peek Rosengren andTootell (1999) argue that a synergy exists between monetary policy andprudential supervision because information gained in the course of super-vision can increase the accuracy of macroeconomic forecasts A twist tothis argument is that the information on the state of financial institutionsavailable to the central bank as supervisor can facilitate its role as lenderof last resort Conversely there is the concern that a supervisory rolewill compromise the central bankrsquos independence of action with respectto its core mandatemdashmaintaining price stability As these arguments haveplayed out financial supervision has generally been shared between centralbanks and other regulators or placed entirely in the hands of an inde-pendent regulator However in Italy the Netherlands and Spain cen-tral banks are the sole banking supervisor
Goodhart (1995) examined the arguments and evidence for each modeland concluded that there were no overwhelming arguments or evidencefor one or the other31 Going forward a key problem for any financialsupervisory system is dealing with (and closing as necessary) weak banksIf both central banks and other regulators have this responsibility closecoordination between them is critical Another problem is large conglom-erate banks LCBOs Although they are less likely to fail because of thediversification of their assets and liabilities they are more likely to berescued They are also more likely to be multinational enterprises withinternational implications Goodhart observes that regulation of theseentities might be put in the hands of the central bank because it is lessamenable to political pressures In any event the complexity of LCBOoperations suggests that greater supervisory rigor is necessary
The US Congress was persuaded that broad oversight would help containthe moral hazard problem and accordingly gave the Federal Reservethe role of umbrella supervisor with the understanding that the Fed willscrutinize depository activity more intensely than nonbank financial ac-tivities Under this approach LCBOs such as Citigroup are subject tomuch closer monitoring than smaller and simpler institutions32 The USregulatory model requires enormous cooperation between the Fed otherbank supervisors and the functional regulators for insurance and securi-ties but it also benefits from regulatory competition
31 National systems of supervision are path dependent they are determined by the struc-ture of financial institutions and history in each country If Goodhart (1995) is right out-comes are not materially better or worse with one model of supervision rather than another
32 See Ferguson (1999)
Public Safety Nets
One of prudential supervisorsrsquo biggest challenges is to reduce moral hazardFor many years commercial banks engaged in communal self-insurance
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106 WORLD CAPITAL MARKETS
to deal with crises They formed voluntary groups that agreed to rescuetroubled members As financial markets evolved and competition inten-sified banks were no longer willing to play this role Private-sector in-surance is one alternative but moral hazard and adverse selection wouldappear to prevent it from happening Public safety nets have developedbecause of the low probability and high cost of potential bank runs Aclear trade-off is involved The effectiveness of insurance in preventingbank runs is greater the more comprehensive the coverage But the morecomprehensive the coverage the greater the moral hazardmdashbank man-agers bank directors investors and depositors all take on greater risksin the belief that the safety net will protect them against losses
All G-10 countries have compulsory public safety nets for banks (table29) Deposit insurance agencies are officially organized in Canada theNetherlands Sweden Switzerland and the United States organized bythe industry in France Germany Italy and the United Kingdom andjointly organized by the public and private sectors in Belgium Japanand Spain
How well do G-10 governments offset the subsidy provided by thepublic safety net This is a question on which there is substantial debateAs banking organizations have become more complex the challengesthat supervisors face have become more difficult One challenge is toalign the incentives facing bank managers and shareholders with thoseof depositors Another is the principal-agent problem in supervision Wehave discussed the incentive structures for financial institutions but wehave said little about the incentives for supervisors themselves and thedistortions they can generate in the financial system
In one of the many studies of the US savings and loan crisis of the1980s Kane (1989) documented both problems He described managersusing cosmetic approaches to disguise the magnitude of insolvency regulatorspracticing forbearance even though they knew of the deteriorating riskprofiles of the institutions for which they were responsible and legisla-tors increasing deposit insurance without regard for any offsetting changesin supervision A subsequent overhaul of the legislative framework forthe Federal Deposit Insurance Corporation (FDIC) known as the FDICImprovement Act of 1991 (FDICIA) aimed to introduce a clearer incen-tive structure for both regulators and regulated institutions
The changes introduced by this US legislation are worth discussionwith respect to the other G-10 countries as well First FDICIA created astronger signal to management and investors by targeting deposit insur-ance at small depositors only and by risk-weighting the deposit insur-ance premiums paid by banks to reflect their capital adequacy and bankexaminer ratings Among the G-10 countries rated in table 210 depositinsurance premiums vary considerablymdashbut it is not clear that the dif-ferences have much to do with risk-weighting Most G-10 countries em-ploy funding formulas based for example on the total domestic deposit
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Table 29 Deposit insurance schemes in the G-10 countries Explicit safety net
Coverage limit(dollar Foreign
equivalent currency Interbank Source Bankrsquos Contingency fundingDate Membership Co- at end of deposit deposit of premium from banks
Country established managementa insuranceb July 1998)c covered covered Fundingd funding costs or governments
United 1982 Compulsory Yes Larger of 90 No No Unfunded Banks only Callable (subject Parliament may increase Kingdom private percent co- to maximum the maximum payable
insurance to 03 percent of pound125 million advance 33000 total deposits) facility with Bank of
England
United 1934 Compulsory No 100000 Yes Yes Funded Banks and Up to 027 Borrowing up to $3 States official government percent total billion from US Treasury
domestic deposits
Japan 1971 Compulsory No 71000 but No No Funded Banks and 0084 percent of Borrowing up to yen500bn joint in full until government insured deposits from Bank of Japan
year 2000 subject to Ministry of Finance approval
Canada 1967 Compulsory No 40800 No Yes Funded Banks and 033 percent of Borrowing up to C$6 official government insured deposits billion authorized further
(maximum) borrowing subject to parliamentary approval
Germany 1966 Compulsory Yes 90 percent Yes No Funded Banks only 003 percent of Annual levy may be private coinsurance deposits doubled
to 22000
Italy 1987 Compulsory Yes 125000 Yes No Unfunded Banks and Callable Two options defer private government (maximum of payment or diminish
1 percent of compensation to be paid total deposits)
(table continues next page)
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108W
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Table 29 Deposit insurance schemes in the G-10 countries Explicit safety net (continued )
Coverage limit(dollar Foreign
equivalent currency Interbank Source Bankrsquos Contingency fundingDate Membership Co- at end of deposit deposit of premium from banks
Country established managementa insuranceb July 1998)c covered covered Fundingd funding costs or governments
Netherlands 1979 Compulsory No 22000 Yes No Unfunded Banks and On demand Government backing official government maximum of subject to parliamentary
5 percent of own approval funds
France 1980 Compulsory No 65400 No No Unfunded Banks only Callable (on Extra calls up to FFr1000 private demand calls million can be made in
up to FFr200 a 5-year period million)
Switzerland 1984 Voluntary No 19700 No No Unfunded Banks only Callable (on Underwritten by member official demand) banks
Sweden 1996 Compulsory No 31400 Yes No Funded Banks and 05 percent of Full emergency coverage official government deposits while replacing it with a
limited system after the emergency
Belgium 1974 Compulsory No 16600 No No Funded Banks and Callable 002 None insurance limited joint 22000 in government percent of to assets in fund
year 2000 deposits from clients
Spain 1977 Compulsory No 16439 Yes No Funded Banks and 02 percent of Government backing joint government deposits through the Banco de
(maximum) Espantildea subject to approval by royal decree
a Bank membership in the fund can be either compulsory or voluntary and the management of the fund can be official and official and private joint or privateb Coinsurance refers to the situation where depositors face a deductible against their insured fundsc Coverage limit refers to the explicit amount the authorities promise to insured Funded scheme means that it is funded ex ante unfunded otherwise
Sources Goodhart (1995) Demirguccedil-Kunt and Detragiache (2000) Demirguccedil-Kunt and Sabaci (2000)
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 109
base Explicit safety net protection also varies but only Canada focuseson the protected class33 All G-10 countries specify a limit on depositorprotection Under FDICIA the insurance fund is prohibited from pro-tecting uninsured depositors or creditors at a failed bank although adiscretionary system-wide override is provided for exceptional circum-stancesmdashbut with stringent requirements for consultation and account-ability Other G-10 countries allow for contingency funding from the publicpurse alongside unwritten lender-of-last-resort support Among large banksa significant and growing portion of deposit liabilities including foreigncurrency and interbank deposits are uninsuredmdashbut depositors assumethey will be protected in a crisis
FDICIA also made some significant qualitative changes to address theprincipal-agent problem by penalizing weak banks and rewarding strongbanks For example banks whose capital declined faced progressivelytougher regulatory sanctions that for example required them to elimi-nate dividends restrict their lending and change their managementsRegulators have also been forced to take prompt corrective action (toreduce the practice of regulatory forbearance in hopes that a bankrsquos for-tunes might improve)34 Unfortunately comparative qualitative assess-ments across the G-10 are difficult to make due to lack of information35
This discussion highlights the complexity of evaluating the extent towhich prudential supervision and market discipline reduce the moralhazard associated with G-10 safety nets Our argument is that publicsafety nets in the G-10 can be linked to banking instability in other coun-tries specifically in the emerging-market economies that have attractedG-10 cross-border bank lending This lending is a leading source of vola-tility in capital flows the large financial institutions many of which arecomplex banking organizations are based in and regulated by authori-ties in the G-10 economies These two features of the international finan-cial system are closely related although it is not possible to test thisrelationship econometrically
Two World Bank studies however indicate a basis for concern Onestudy is a cross-country econometric analysis of the relationship betweenbank stability and deposit insurance (Demirguccedil-Kunt and Detragiache2000) which found a negative relationship Their estimated model forbanking crises in a sample of 61 countries (both industrial and develop-ing) suggests that explicit deposit insurance raises the probability of acrisis by at least 30 percent36 Crises are especially likely in countries
33 Japanrsquos legislation says it does but recent experience shows this is not the case34 See Goldstein (1997) for a summary of the changes35 See Barth Nolle and Rice (2000) for a beginning in this area36 Demirguccedil-Kunt and and Detragiache (2000 table 1) report a logit coefficient of 0696with a standard error of 0397 (the coefficient is significant at the 8 percent threshold)This suggests that the ldquotruerdquo coefficient could well be as small as 030 (the reportedvalue minus the standard error)
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110 WORLD CAPITAL MARKETS
with immature financial supervisory systems (and not in the G-10) buttheir analysis does underscore the view that deposit insurance weakensmarket discipline37
An earlier World Bank analysis established similar results One wasthat market discipline is undermined by deposit insurance schemes an-other was that illiquid banks are forced to pay more for their funds un-less a generous deposit insurance scheme is in place (Demirguccedil-Kuntand Huizinga 1999) This econometric study also provides clear-cut evi-dence that depositor monitoring of banks declines with the existence ofdeposit insurance schemes At the heart of the problem is the questionof whether deposit insurance is accompanied by increased governmentmonitoring
This evidence and the weight of other arguments suggests that moralhazard is still an issue in the G-10 countries Consider the ongoing de-bate about instilling greater market discipline on risk taking by banksAt one extreme is the perennial proposal to do away with safety netsleaving markets to monitor the players and to force adjustments but toprotect small savers by creating ldquonarrow banksrdquo such as postal savingsystems that are allowed to invest these savings only in risk-free gov-ernment securities Whatever the merits of narrow banking this solutionis too extreme to be politically feasible
A moderate alternative is to force more disclosure by financial institu-tions to facilitate market monitoring But transparency has its own prob-lems Persaud (2000) argues that financial markets cannot reliably discernsustainable from unsustainable positions in the short term This uncer-tainty causes banks to ldquoherdrdquo behind market leaders to exploit theirsupposedly superior information ldquoThe more herding investors and bankersknow about what each other is up to the [more] unstable markets maybecomerdquo The implication is that greater transparency in the marketplaceby itself will not solve the problemmdashand in the short term more informa-tion may exacerbate herding Further supervisory steps (discussed in thenext chapter) are required
Yet another proposal is to promote private-sector involvement in bankmonitoring through market-based alternatives such as Calomirisrsquos sub-ordinated debt proposal (Calomiris 1997 Federal Reserve Board 1999)Banks could be required to issue and maintain a minimum amount of
37 Other findings in the Demirguccedil-Kunt and Detragiache (2000) study include thesepropositions The impact of deposit insurance on bank stability tends to be stronger themore extensive is the coverage offered to depositors when the scheme is funded andwhere the scheme is run by the government rather than by the private sector Con-versely deposit insurance is detrimental to bank stability where bank interest rates havebeen deregulated and where the institutional environment is weak Additional findingson deposit insurance are reported from a recent World Bank conference (8-9 June 2000httpwwwworldbankorgresearchinterestconfsupcomingdeposit_insurancehomehtm)Also see Smalhout (2001)
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 111
subordinated debt (eg uninsured certificates of deposit) to finance asmall fraction (such as 2 percent) of their total nonreserve assets Thesubordinated debt would be allowed to earn a set yield no more than 50basis points over the risk-free yield on government treasury bills Thisrule would supposedly force banks to operate in a safe manner Other-wise subordinated debt holders would redeem their uninsured certifi-cates of deposit and equity investors would sell their bank shares Despiteits practical problems the beauty of the subordinated debt requirementis that it enlists market incentives to push banks to avoid excessive port-folio risk38
The thrust of these proposals is very relevant to the arguments in ourstudy Even in the G-10 countries government monitoring by itself hasnot eliminated moral hazard among banks More work is needed to in-troduce market monitoring and to improve the incentive structures bothfor financial institutions and their supervisors We return to this issuewith our recommendations in the next chapter
38 In late 1996 Argentina began requiring its banks to finance 2 percent of total depos-its in the form of subordinated debt but without a maximum yield provision TheArgentine authorities expect that market discipline will act in concert with the publicsafety net One obvious problem with the subordinated debt proposal is that banks mayencourage some of their customers to buy the subordinated debt
Portfolio Institutions Tomorrowrsquos Problem
Before proceeding to the issues of international supervision we flag an-other potential problem for national regulators The big asset managersprofiled in tables 24 and 26 answer to diverse groups of pensionersshareholders and policyholders They allocate funds across a number ofcountries to diversify their risks They hold liquid assets that can be tradedand they have a higher proportion of long-term assets than banks Eco-nomic shocks can be absorbed through price changes and their effectsspread across time and markets Thus when conditions change in a par-ticular market they are more likely to ride out the storm than to flee Inother words they have less incentive than banks to pull their invest-ments in the face of adversity In the 1990s most large asset managersestablished a record of ldquoriding out the stormrdquo rather than ldquorunning withthe windrdquo although as we saw in chapter 1 instances of running withthe wind were detected in some portfolios As we write these insti-tutions have a good record overall in the emerging markets so whyworry
The Russian crisis and the near-collapse of LTCM previewed the dan-gers that may await future portfolio managers and G-10 financial minis-ters We have presented evidence indicating a systemic bias toward bank
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112 WORLD CAPITAL MARKETS
lending and debt finance to emerging markets and we have argued forsubstitution toward equity finance and direct investment39
That is not the end of the story We noted in the previous chapterthat institutional investors can become momentum investors selling in adownturn As more portfolio capital is invested in emerging marketssome players may adopt the high-risk high-leverage strategies of themost aggressive hedge funds Indeed the data in box 11 show that G-10portfolio investors held somewhat more long-term debt (more than $500billion) than equity (less than $400 billion) in emerging markets at theend of 1997 Long-term debt is an ideal vehicle for high-risk high-leveragestrategies These strategies practiced on a large scale could compound afuture crisis harming emerging markets A big enough crisis could inturn pressure G-10 central banks and finance ministers to arrange bail-out plans Instead of shrinking as a systemic financial problem moralhazard could increase
National securities regulators are the first line of defense against thisscenario They play a critical role in the safe evolution of capital mar-kets But regulators today are mandated to approve the issuance of newsecurities and to monitor the continuing disclosure of material informa-tion by issuers They are far less concerned with or empowered to monitorthe behavior of the increasingly large wealth-management firms that arethe major purchasers (and therefore resellers) of these securities
Within their mandates the goals of national securities regulators (table210 and appendix B) are similar to the concerns of bank regulators withsystem safety and soundness Their focus is also on the incentive sys-tems for management and boards of directors and on disclosure by cor-porations that issue marketable securities such as shares bonds andasset-backed securities 40 Issuers of securities possess greater knowledgeabout the quality of these assets than do the purchasers hence investorprotection is a key concern of regulators Moreover market disciplineworks best when markets know what is happening Well-functioning corpora-tions are key agents of wealth creation and social progress Underperform-ing corporations waste resources During recessions bad corporationsget into bad trouble often with severe social consequences Inadequateincentives for managers and inadequate accountability for boards andmanagers thus have negative externalities Regulators play a vital role inexposing weakness so that market disciplines come to bear sooner ratherthan later
Regulatory emphasis is constantly shifting as financial markets evolveand as the macroeconomic environment changes Regulators try to balance
39 See Rogoff (1999) Also see Berlin (2000) for a perspective on the limited role thatbanks play as share owners
40 See Habib and Ljungqvist (2000) for recent empirical analysis showing that corporateshare market values are higher when corporate executives have a larger ownership stake
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113
Table 210 Financial-sector regulation G-10 countries 2000
Financial institutions and their supervisors
Country and supervisory structure Retail banking Wholesale banking Securities Insurance
Financial conglomeratesFinancial Services Authority (FSA) = umbrella supervisor
United Kingdom FSA FSA FSA FSA
Treasury bull Commercial banks bull Investment funds (Securities and (Insurance Directorate(Securities and Investments Board) bull Unit trust groups Futures Authority) of the Treasury)
Bank of bull Building societies bull Pension funds England (Building Societies Commission) bull Merchant banks
bull Friendly societies bull Clearing houses bull Primary issuers bull Insurance FSA (Friendly Societies Commission) bull Venture capital of securities companies
bull Pensions and life insurance etc bull Stock exchanges bull Insurance brokers(Personal Investment Authority) bull Stockbrokers
Financial holding companiesFederal Reserve (FR) = umbrella supervisor
United States bull National banks(OCC) Securities and Regulated by
Treasury OCC bull State banks Federal Reserve Exchange Commission StatesMembers (FR)
OTS Nonmembers (FDIC) bull Investment banks bull Primary issuers of bull Insurance companies FR bull Cooperative banks (FDICFR) bull Finance companies securities bull Insurance brokers FDIC bull Insured industrial banks (FDIC) bull Stock exchanges
bull Thrift holding companies (OTS) bull Stockbrokers SEC bull Savings banks (OTSFDICFR) bull Investment advisors
bull Savings and loan associations bull Mutual funds(OTS) bull Public utility holding
bull Edge Act corporations (FR) companies
(table continues next page)
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Table 210 Financial-sector regulation G-10 countries 2000 (continued )
Financial institutions and their supervisors
Country and supervisory structure Retail banking Wholesale banking Securities Insurance
Financial holding companies Japan Financial Supervisory Authority (FSA) = umbrella supervisor
Prime FSA FSA FSA FSA ministerrsquos Ministry of office Finance (Securities and Exchange
Surveillance Commission) FRC Bureau of Financial bull City banks bull Investment banks bull Primary issuers of bull Insurance companies FSA Regulation bull Regional banks bull Asset managers securities bull Insurance brokers
bull Trust banks bull Stock exchanges SESC bull Long-term credit banks bull Stockbrokers
bull Pension funds
Financial holding companiesOffice of the Superintendent of Financial Institutions (OSFI) = umbrella supervisor
Canada Regulated by OSFI OSFI provinces OSFI
Department of Financebull Banks bull Cooperative credit bull Primary issuers of bull Insurance companies
(previously Office of the Inspector associations securities (previously Depart- OSFI General of the Banks) bull Fraternal benefit bull Stock exchanges ment of Insurance) Bank of bull Trust and loan companies society bull Stockbrokers bull Insurance brokers Canada bull Pension funds bull Asset managers
(previously Depart- CDIC ment of Insurance)
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Financial institutions and their supervisors
Country and supervisory structure Retail banking Wholesale banking Securities Insurance
Germany Financial holding groupsFederal Banking Supervisory Office (FBSO) = umbrella supervisor
Ministry of Finance FBSO BSO FSSO FISO
Bundesbankbull Universal banks bull Other financial bull Primary issuers of bull Insurance companies
Federal Banking bull Savings banks institutions (eg securities bull Insurance brokers Supervisory Office bull Securities banks management foreign bull Stock exchanges
currency dealings) bull Stockbrokers Federal Securities bull Financial enterprises bull Asset managers Supervisory Office (eg leasing bull Pension funds
organizations Federal Insurance credit card companies Supervisory Office investment advisors)
Italy Bank foundationsMinistry of Finance = umbrella supervisor
Ministry of Finance Bank of Italy Bank of Italy Consob ISVAP
Bank of Italy bull Commerical banks bull Asset managers bull Primary issuers of bull Insurance companies Consob bull Savings bank bull Open-end investment securities bull Insurance brokers
bull Securities banks companies (SICAVs) bull Stock exchangesbull Stockbrokers
ISVAP
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Table 210 Financial-sector regulation G-10 countries 2000 (continued )
Financial institutions and their supervisors
Country and supervisory structure Retail banking Wholesale banking Securities Insurance
The Netherlands Financial conglomeratesCouncil of Financial Supervisors = umbrella supervisor
Securities Board Securities Board Netherlandsche Netherlands Bank Netherlandsche Bank of the Netherlands Insurance Board Bank Insurance bull Credit institutions (universal banks bull Investment institutions bull Stock exchanges bull Insurance companies Board cooperative banks security credit (securities issuing bull Stockbrokers bull Insurance brokers
institutions mortgage banks) and tradingmdashprimary The Council of Financial and secondary Supervisors markets)
France Commission des Commission de Operations des Controcircle des
Banking and Banking Commission Bourse Assurances Financial Regulatory bull Ensuring that credit institutions (and investment firms since bull Primary issuers of bull Insurance companies Ministry for Committee the Financial Activity Modernization Act of 1996) comply securities bull Insurance brokers Economic with laws and regulations bull Stock exchanges Affairs and bull Execute instructions regarding all off-site monitoring and bull Stockbrokers Finance Credit on-site supervision Institutions and Banking and Financial Regulatory Committee Investment bull Formulates general regulations for credit institutions and investment firms Committee (capital adequacy requirements accounting rules etc) Bank of France Credit Institutions and Investment Committee Banking bull Authorizes and examines financial institutions except for those within the Commission competence of the Banking Commission
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Financial institutions and their supervisors
Country and supervisory structure Retail banking Wholesale banking Securities Insurance
Switzerland Large banking groupSwiss Federal Banking Commission (SFBC) = umbrella supervisor
Swiss National Bank Federal Office of
SFBC SFBC SFBC Private Insurance Swiss Federal Banking Commission bull Universal banks bull Investment banks bull Primary issuers of bull Insurance companies
bull Savings banks bull Asset management securities bull Insurance brokerscompanies bull Stock exchanges
Private audit Federal bull Investment funds bull Stockbrokers firms Office of bull Mortgage bond authorized by Private business SFBC Insurance
Sweden Financial holding company groupsFinancial Supervisory Authority = umbrella supervisor
Ministry of Finance Credit Market Securities Market Insurance Market
Credit Market Department Department Department Department
Financial bull Commercial banks bull Investment funds bull Primary issuers of bull Insurance companies Riksbank Supervisory bull Savings banks securities bull Insurance brokers Authority bull Friendly societies bull Stock exchanges
bull Stockbrokers
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Table 210 Financial-sector regulation G-10 countries 2000 (continued )
Financial institutions and their supervisors
Country and supervisory structure Retail banking Wholesale banking Securities Insurance
Belgium Bank holding companiesBanking and Finance Commission = umbrella supervisor
Bank of Belgium Banking Banking
Banking and Finance and Finance Insurance Controland Finance Commission Commission Commission Office
Banking and Insurance Finance Control bull Commercial banks bull Asset management bull Primary issuers of bull Insurance companies Commission Office bull Savings banks firms securities bull Insurance brokers
bull Securities banks bull Investment funds bull Stock exchanges bull Mortgage companiesbull Stockbrokers bull Pension funds
Securities Regulation Fund Securities Regulation Fund
bull Other investment firms and credit institutions(institutions participating in regulated off-exchangemarket in strips and Treasury certificates)
Bank holding companies Spain Banco de Espantildea = umbrella supervisor
Banco de Espantildea Comision Nacional del Mercado de Directorate General
Banco de Espantildea Valores (CNMV) Insurance
bull All credit institutions (commercial banks savings banks credit bull Primary issuers of (Ministry of Economy Ministry of cooperatives official credit institutions finance factoring and securities and Finance) Economy and CNMV leasing companies mortgage-loan companies etc) bull Stock exchanges bull Insurance companies Finance bull Interbank foreign exchange and book-entry public debt bull Stockbrokers bull Pension funds
markets bull Venture capital(companies and funds)
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Financial institutions and their supervisors
Country and supervisory structure Banking Securities Insurance
Banking Advisory High Level Securities Supervisors Committee (BAC) Committee (HLSS) Insurance Committee (IC)
Supranational (EU) bull Formulates standards for prudential bull Coordination of securities market bull Formulates standards forsupervision supervision prudential supervision
BACICHLSS Banking Supervision
Conglomerates Committee (BSC) Securities Contact Committee Regulation of prudential bull Systemic risk monitoring bull Regulation and implementation of supervision securities admission
International Association International International Organization of of Insurance Supervisors
Basel Committee Securities Commisison (IOSCO) (IAIS) Joint Forum Conglomerates Supervision bull Supervision and regulation best bull Supervision and regulation best bull Supervision and regulation amp regulation Best practices practices practices best practices
FSF Coordination across supervisors of various functions
Notes See appendix B for more information Boldface type indicates senior or oversight supervisor normal type indicates adjunct or front-line supervisorsolid line indicates direct responsbility to the senior-ranking authority dotted line indicates coordination in supervisory activities
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Table 210 Financial-sector regulation G-10 countries 2000 (continued )
Glossary of names United Kingdom FSA = Financial Services Authority United States FR = Federal Reserve OCC = Office of the Comptroller of theCurrency FDIC = Federal Deposit Insurance Corporation SEC = Securities and Exchange Commission OTS = Office of Thrift Supervision Japan FRC =Financial Reconstruction Commission FSA = Financial Services Agency SESC = Securities and Exchange Surveillance Commission Canada OSFI =Office of the Superintendent of Financial Institutions CDIC = Canada Deposit Insurance Corporation Germany FBSO = Federal Banking SupervisoryOffice FSSO = Federal Securities Supervisory Office FISO = Federal Insurance Supervisory Office BSO = Banking Supervisory Office Italy Consob =Commissione Nazionale per le Societa e la Borsa ISVAP = Instituto per la Vigilanza sulle assicurazioni private e di Interesse colletivo Switzerland SFBC= Swiss Federal Banking Commission Spain CNMV = The Comision Nacional del Mercado de Valores Supranational BAC = Banking Advisory CommitteeBSC = Banking Supervision Committee IC = Insurance Committee HLSS = High Level Securities Supervisors Committee International Dimension FSF =Financial Stability Forum IOSCO = International Organization of Securities Commission IAIS = International Association of Insurance Supervisors
Sources United Kingdom Bank of England httpwwwbankofenglandcouk Financial Services Authority httpwwwfsagovuk United States Board ofGovernors of Federal Reserve System httpwwwfederalreservegov Japan Bank of Japan httpwwwbojorjo Financial Reconstruction Commissionhttpwwwfsagojpfrcindexehtml Financial Services Agency httpwwwfsagojp Canada Bank of Canada httpwwwbank-banque-canadaca Office ofthe Superintendent of Financial Institutions httpwwwosfi-bsifgccaAndreEindexhtml Germany Deutsche Bundesbank httpwwwbundesbankde Fed-eral Banking Supervisory Office httpwwwbakredde Italy Banca drsquoitalia httpwwwbancaditaliait Commissione Nazionale per le Societa e la Borsahttpwwwconsobit Instituto per la Vigilanza sulle assicurazioni private e di Interesse colletivo httpwwwisvapit The Netherlands De NederlandscheBank httpwwwdnbnl France Banque de France httpwwwbanque-francefr Switzerland Schweizerische Nationalbank httpwwwsnbchindex3htmlSweden Sveriges Riksbank httpwwwriksbanksedefaultasp Belgium National Bank of Belgium httpwwwbnbbesgindexhtm Spain Banco de Espantildeahttpwwwbdees The Comision Nacional del Mercado de Valores httpwwwcnmves Supranational (EU) Institutional Arrangements for the Regulationand Supervision of the Financial Sector 2000 International Dimension Bank for International Settlement httpwwwbisorg International Organization ofSecurities Commissions httpwwwioscoorg International Association of Insurance Supervisors httpwwwiaisorg Financial Stability Forum httpwwwfsforumorg
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 121
the inflexibility of tight surveillance against the need to encourage in-novation and growth The US Securities and Exchange Commission isworried about aggressive accounting by firms and biased reports bysecurities analysts in an equity environment that prizes steadily higherquarterly earnings41 Japanese regulators are preoccupied with opaqueinterconnections between portfolio institutions banks and nonfinancialfirms through the keiretsu system Canadian regulators reeling from high-profile scandals of managers intentionally misleading investors are strengtheningmarket discipline through legal penalties aimed at managers and directorsof offending firms
When panic strikes a securities regulator cannot do much As the 1987stock market crash and the LTCM debacle in the fall of 1998 both dem-onstrated steep stock and bond price declines can create systemic risksIf severe enough the wealth effect of falling securities values and thefear of widespread insolvency can depress real activity Flooding thesystem with liquidity is a central bankerrsquos solutionmdashsomething a securi-ties regulator cannot do42 But just as financial supervisors can changethe incentive structure to discourage bankers from making risky loans ingood times so securities regulators can pay more attention to incentiveson the demand side when capital markets are strong
Prudential Supervision and InnovationmdashA Footnote
In concluding this discussion of prudential supervision in the G-10 anadditional point is worth noting National regulators face a persistenttrade-off between emphasizing financial system safety and soundnesswhile encouraging innovationmdashin spite of the added risks innovationbrings to financial markets Former US Treasury Secretary Lawrence Summers(2000 3) has argued by analogy
The jet airplane made airplane air travel more comfortable more efficient andmore safe though the accidents were more spectacular and for a time morenumerous after the jet was invented In the same way modern global financialmarkets carry with them enormous potential for benefit even if some of theaccidents are that much more spectacular As the right public policy response
41 The problem is illustrated by the divergence since mid-1998 between reported earn-ings by the Standard amp Poorrsquos (SampP) 500 and the after-tax profits of all corporations inthe national accounts Generally these two series move closely with one another Be-tween mid-1998 and mid-1999 SampP 500 reported that earnings increased by more than20 percent while after-tax profits of all corporations increased by less than 5 percent(Chase Bank US Economic and Policy Research US Weekly Prospects Chase SecuritiesWeekly Newsletter 5 June 2000 5)
42 For example the US Securities and Exchange Commission had no direct role in calmingmarkets in the 1987 or 1998 panics
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122 WORLD CAPITAL MARKETS
to the jet was longer runways better air-traffic control and better training forpilots and not the discouragement of rapid travel so the right public policyresponse to financial innovation is to assure a safe framework so that the ben-efits can be realized not to stifle the change
Accepting Summersrsquos analogy for the international financial system better-informed supervisors and investors are a necessary part of the financialsystem framework Supervisors require more timely information on therisk profiles resulting from positions taken by financial institutions Theyalso need a better understanding of risk-management systems Snapshotsof an institutionrsquos risk profile and risk-management procedures are nolonger adequate In a world where huge bets are quickly made (andpossibly lostmdashas with Barings Bank in 1995 and LTCM in 1998) super-visors must focus on the soundness of banking systems for evaluatingand managing risk on a daily basis Some progress has been made inaddressing these issues US banking examiners are extending their in-formation requirements in banking examinations and increasing theirinvolvement in large complex institutions43 More awareness is alsorequired of the fact that they are national organizations in a world ofcross-border capital flows To a much greater extent they need a multi-national reach International supervision and coordination among super-visors are the subject of the next section
Our analysis suggests that G-10 supervisors have unfinished businessBank supervisors need to start yesterday securities regulators can waituntil tomorrow One G-10 member acting alone cannot correct the biasIn good times the lending business will simply migrate to other G-10banks In bad times financial problems will not stop at the national bor-der A way has to be found to establish common international standardsfor the key financial players in order to prevent crises and to agree onapproaches for managing them The path has already been laid out Inthe wake of the bank failures of the past 25 years bank supervisors havetried to establish such standards They have done this without creating anew global institution
The essence of the international framework is decentralizationmdashglobalrules and design standards without global institutions that are perceivedto intrude on national sovereignty The awkward jargon for this frame-work is vertical subsidiaritymdashldquothink internationally act nationallyrdquo Theinternational thinking is done by a committee of regulators that meets
International SupervisionA Decentralized Framework
43 These issues are discussed in Ferguson (1999) and Meyer (2000a)
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 123
regularly at the Bank for International Settlements in Basel The commit-tee establishes principles and standards that are interpreted implementedand enforced by national authorities44 In this section we describe thesesupervisory efforts and their weaknesses We present our recommenda-tions for addressing these weaknesses in the next chapter
Basel I
The Basel Capital Accord of 1988 (Basel I)45 drew the lesson from thefinancial crises of the mid-1970s that more adequate capital levels in in-ternational banks would help reduce the systemic risk of bank failureThe primary goal of Basel I was capital adequacy other standards wereput in place not so much for their own virtue as to defend the primarygoal
Capital adequacy requirements were designed to ensure that individualinstitutions have the ability to absorb losses particularly credit lossesAccordingly a backup system of scoring credit risk was devised thatrequired large amounts of bank capital for some types of loans smalleramounts for others and zero for a select list of preferred assets Report-ing requirements were designed to disclose problems and ensure that atroubled bank would take timely steps to restore its capital base in thewake of a loss The Basel I framework worked tolerably well in limitingthe call on the public purse in the G-10 countriesmdashwith the notable ex-ceptions of France and Japan The framework failed to moderate riskybank lending to emerging markets however
Basel I was not developed with emerging markets in mind The origi-nal idea behind it was to develop a common supervisory approach tocross-border banking operations It grew out of political pressure fromUS lawmakers who were determined to require international banks op-erating in the United States to meet US banking standards Toward thisgoal in 1983 Congress passed the International Lending Supervisory ActUS and British banking authorities subsequently agreed on a commontarget the adoption of strict common capital-adequacy standards In 1988other G-10 governments agreed to go along voluntary acceptance ofthe standards throughout much of the rest of the world followed46 Therationale for the capital targets was two-fold The first was to requirebanks to hold sufficient amounts of capital (8 percent of risk-adjusted
44 The international committee of financial authorities agreed on a common definitionof banksrsquo tier-one or ldquocorerdquo capital national authorities defined tier-two capital in theirown manner which permitted greater variations in national working definitions andpractices
45 International Convergence of Capital Measurement and Capital Standards (BIS 1988)was prepared by the Basel Committee on Banking Supervision
46 See Reineke (1998)
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124 WORLD CAPITAL MARKETS
assets) to cushion losses on those assets The second was to dull theirappetites for risk banks with large capital bases would have more tolose if they failed and therefore would take fewer risks
Rapid change in financial markets soon revealed flaws in the Basel IAccord In a complex world with numerous sources of risk it focusedheavily on credit risk but overlooked other risks in a bankrsquos portfolioand the correlation between returns on different asset classes The Baselformula required banks to maintain a fixed amount of capital againsteach of its asset classes But the formula did not distinguish the riskinessof the borrower within each class As a result one large loan to a low-risk corporate borrower such as General Electric would require the sameamount of capital as 10 smaller transactions with high-risk borrowers
The system was also biased toward short-term loans Loans maturingin less than a year required a 20 percent risk weight whereas those ma-turing after more than a year required a 100 percent risk weight Inter-bank lending was particularly favored For example loans to banks inOECD countries required less capital than loans to private firms in thesame countries creating the anomaly that interbank loans to South Ko-rean banks required less capital than loans to General Electric47 Thisanomaly encouraged banks to shed high-quality assets if the Basel rulesrequired the allocation of more capital than banks thought they needed
Another weakness was that financial innovators quickly circumventedthe Accord Because short-term loans required less provisioning than long-term loans banks responded by securitizing their long-term debt port-folios and lending short-term against the collateral of the newly createdasset This allowed banks to circumvent the capital requirements gearedto the terms of the underlying debt At the same time the Basel I Accordfailed to encourage risk mitigation techniques such as credit derivativescollateral guarantees and on-balance-sheet netting the flip side of fi-nancial innovation Because off-balance-sheet products were not coveredby the Accord another anomaly appeared when Barings Bank collapsedin 1995 Barings met capital adequacy standards but collapsed becauseits systems for managing risk failed traders were allowed to speculatein futures contracts that did not appear on the balance sheet
Basel II
Work to overhaul Basel I began in 1995 and produced consultativepapers issued in June 1999 and January 200148 These papers have been
47 South Korean banks have had notoriously weak balance sheets because the practiceof ldquodirected lendingrdquo left them with many poor loans (in making these loans the bankswere expected to follow government objectives rather than creditworthiness criteria)
48 Basel Committee on Banking Supervision (1999 2001)
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 125
the subject of extensive consultation and revision as a result the newAccord is expected to be introduced in 200449 The Basel II frameworkhas three parts (pillars) revisions to Basel I minimum-capital require-ments supervisory review criteria and greater emphasis on market dis-cipline Broadly Basel II aims to maintain the level of capital in the sys-tem but achieve better alignment of banksrsquo capital with their risk pro-files and keep up with financial innovation
To align capital requirements with market realities (the first pillar)Basel II concentrates on the 100 or so largest banksmdashthe type of playerslisted in table 21mdashand on the holding-company parents of banking groups50
Capital requirements will differentiate between an increased number ofcredit groups or ldquorisk bucketsrdquo including claims on governments otherbanks corporations mortgage-backed securities and other asset-backedsecurities
Basel II originally proposed to use external ratings to set capital chargesfor a number of these credit risks Many banks objected arguing thatthey assess credit risk better than Standard amp Poorrsquos Moodyrsquos or FitchIBCA51 Basel II thus proposes two approaches to rating a standard ap-proach using external ratings and an ldquoadvancedrdquo approach that allowsselected banks to use their own internal rating systems To encouragethe development of rigorous internal control systems based on these in-ternal rating systems Basel II also proposes to levy capital charges foroperational risk (the risk of direct or indirect loss resulting from inad-equate or failed internal processes people and systems or from exter-nal events)
Some critics of this proposal dismiss it as an abrogation of the prin-ciple of external independent monitoring and as ldquodangerously naiumlverdquo52
But regulators argue that the new capital charge on operational risk shouldoffset this concern It is also far from clear how cross-national compari-sons of rating and internal risk-assessment systems will be made (Engelen2000) The development by the European Union of its own capital rulescould well complicate the international resolution of these issues Publicassurances by EU officials in January 2001 however indicated that theirmain concerns are to create a level playing field and avoid regulatoryarbitrage (Hargreaves 2001) There is also the significant problem ofthe procyclical character of risk weights When a crisis hits losses are
49 See Berry (2000) for an update in an interview with William J McDonough chair ofthe Basel Committee on Banking Supervision
50 For obvious reasons these proposals are addressed to large banks and simpler capi-tal standards are allowed for small banks that focus on their domestic credit markets
51 See Ammer and Packer (2000) for an empirical critique of the success of rating agen-cies in distinguishing risk by sector and region
52 See Auerback (2001)
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126 WORLD CAPITAL MARKETS
incurred or accrued capital is lost and loan exposure must be reducedor securities sold to restore the requisite capital-adequacy ratios A morerisk-sensitive framework could amplify volatility
As the second pillar of Basel II supervisory review criteria are beingbeefed up to encourage supervisors to intervene earlier in potential problemsituations and to compel banks to align their capital positions with theirrisk profiles Bank supervisors will be authorized to require banks tohold capital in excess of minimum requirements if they have concernsabout general management overall strategy risk-management performanceor the macroeconomic environment Of course if one G-10 supervisorimposes higher capital requirements in isolation the same disparity willemerge that presaged Basel I Some banks will be disadvantaged in theinternational marketplace and will loudly complain that excessive super-vision is driving business to their competitors Hence close internationalcooperation among supervisors is critical
To implement the third pillar market discipline banks will be requiredto make fuller more timely disclosure of capital adequacy and the risksto which that capital is exposed A number of measures are being stud-ied that might help supervisors evaluate bank performance such as com-parisons of uninsured deposit interest rates subordinated debt yieldsand equity prices The idea is that these yields and prices might alertsupervisors to market perceptions of risk Of course market perceptionsare only as good as market information More direct and controversialways to reinforce market discipline would dramatically increase publicdisclosure of bank positions and risk management systems
Many questions are still outstanding about how to resolve the techni-cal details of capital requirements and whether the requirements willachieve their intended goal of better assessment and mitigation of therisks in banksrsquo portfolios There is no substitute for skilled supervisorsThe intricacies of effective design and implementation suggest that su-pervisors need to be highly competent technically knowledgeable aboutbanking portfolio characteristics and the factors that influence bank ex-posure to credit risk (Mishkin 2000) And they must be aided by vigilantshareholders market forces and transparency of information53
Standard setting at the global level is desirable but ultimately theeffectiveness of these efforts will be tested at the national level espe-cially in times of systemic financial distress Here the record of Basel Iwas not a bright shining success Japanese banking regulators havetraditionally allowed banks to include real estate and securities in theircapital base When the value of these assets plummeted in the early 1990sregulators allowed banks to continue valuing these depreciated (andoften bankrupt) assets at their old inflated levels Japanese authorities
53 Benedict Roth Complacency Towards Catastrophe Financial Times 23 January 2001
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 127
insisted until the mid-1990s that eroded capital bases could be rebuiltin a market-driven fashion They rightly foresaw that huge loan losseswould undermine public support for the ruling party and require a po-litically unpopular bailout
Japanese foot dragging on Basel I was the worst54 but not uniqueOther examples can be found of ldquopolitically mandated forbearancerdquo TheFederal Reserve Bank of New York held important hands during theLTCM crisis of 1998 Mexico is still resolving the banking crisis that eruptedin 1995 South Korea has not yet closed the insolvent banks that behavedso badly before the crisis of 1998 In the aftermath of a crisis nationalregulators cannot always be relied upon to discipline politically power-ful bankers55 One of the little-noticed consequences of these differingapproaches is that those banks with strong regulatory systems receivedan implicit ldquoexport subsidyrdquo for their services US banks which had notengaged extensively in emerging-market lending in the 1990s were bet-ter positioned than their German and Japanese counterparts to expandtheir international assets in the wake of the crises
Other Financial Forums
54 See Japanese Banks Fiddling while Marunouchi Burns The Economist 27 January2001 67-69
55 See Calomiris (1997)
The Basel model of vertical subsidiarity has already been extended toother financial regulatory bodies In 1993-94 the BIS established a Tri-partite Group of Banking Insurance and Securities Regulators In 1994-95 the BIS increased its cooperation with the International Organizationof Securities Commissions when the two organizations issued parallelpapers on guidelines for national regulators concerning risk managementand disclosure of derivative trades In 1996 a permanent Joint Forum onFinancial Conglomerates was established to examine supervisory issuesand develop working arrangements among the different functional super-visors of conglomerate institutions that offer combinations of bankingsecurities and insurance products Draft papers on the supervisionof conglomerates were released for comment in 1998 applying capital-adequacy principles to these groups and providing guidelines both forassessing the integrity and competence of top managers and for sharingassessments between regulators
In 1997 the Basel Committee on Banking Supervision extended itsreach beyond capital standards to broader aspects of banking supervi-sion with the publication of the Core Principles for Effective BankingSupervision In 1999 a wide range of regulatory and standard-settingbodies were gathered under the umbrella of the Financial Stability
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128 WORLD CAPITAL MARKETS
Forum (FSF) itself established under BIS aegis56 The FSF has alreadyissued recommendations for stepped-up supervision and transparencyas well as guidelines for best practices in a number of areas includingoffshore financial centers and highly leveraged institutions or hedge funds57
Conclusion
Although the structural weaknesses in emerging-market economies arewidely acknowledged to have been causal factors in international capi-tal-market volatility this chapter points to the role of large G-10 bankingorganizations as major suppliers of the most volatile instrument short-term debt We have examined evidence of the impact of public safetynets in the G-10 economiesmdashthe deposit insurance systems the pruden-tial supervisory systems and the lender-of-last-resort functions of centralbanksmdashon the incentive structures of these organizations
Although supervisors in most countries working nationally and to-gether in the BIS have made significant efforts to mimic market forcesin their prudential supervision the most sophisticated financial institu-tions find innovative ways to circumvent the rules New global regulatorybodies are not about to be created G-10 national bank regulators shouldthemselves address the short-term debt bias in the international financialsystem by changing incentive systems G-10 securities regulators shouldalso take steps to get ahead of the curve paying close attention to largeportfolio swings by institutional investors particularly in times of crisisIn short more needs to be done at national and international levels tochange the rules of the game That is the subject of the next chapter
56 The Financial Stability Forum includes banking securities insurance and accountingregulatory bodies the OECD on taxation corruption and corporate governance and theIMF
57 See Martin (2000)
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106 WORLD CAPITAL MARKETS
to deal with crises They formed voluntary groups that agreed to rescuetroubled members As financial markets evolved and competition inten-sified banks were no longer willing to play this role Private-sector in-surance is one alternative but moral hazard and adverse selection wouldappear to prevent it from happening Public safety nets have developedbecause of the low probability and high cost of potential bank runs Aclear trade-off is involved The effectiveness of insurance in preventingbank runs is greater the more comprehensive the coverage But the morecomprehensive the coverage the greater the moral hazardmdashbank man-agers bank directors investors and depositors all take on greater risksin the belief that the safety net will protect them against losses
All G-10 countries have compulsory public safety nets for banks (table29) Deposit insurance agencies are officially organized in Canada theNetherlands Sweden Switzerland and the United States organized bythe industry in France Germany Italy and the United Kingdom andjointly organized by the public and private sectors in Belgium Japanand Spain
How well do G-10 governments offset the subsidy provided by thepublic safety net This is a question on which there is substantial debateAs banking organizations have become more complex the challengesthat supervisors face have become more difficult One challenge is toalign the incentives facing bank managers and shareholders with thoseof depositors Another is the principal-agent problem in supervision Wehave discussed the incentive structures for financial institutions but wehave said little about the incentives for supervisors themselves and thedistortions they can generate in the financial system
In one of the many studies of the US savings and loan crisis of the1980s Kane (1989) documented both problems He described managersusing cosmetic approaches to disguise the magnitude of insolvency regulatorspracticing forbearance even though they knew of the deteriorating riskprofiles of the institutions for which they were responsible and legisla-tors increasing deposit insurance without regard for any offsetting changesin supervision A subsequent overhaul of the legislative framework forthe Federal Deposit Insurance Corporation (FDIC) known as the FDICImprovement Act of 1991 (FDICIA) aimed to introduce a clearer incen-tive structure for both regulators and regulated institutions
The changes introduced by this US legislation are worth discussionwith respect to the other G-10 countries as well First FDICIA created astronger signal to management and investors by targeting deposit insur-ance at small depositors only and by risk-weighting the deposit insur-ance premiums paid by banks to reflect their capital adequacy and bankexaminer ratings Among the G-10 countries rated in table 210 depositinsurance premiums vary considerablymdashbut it is not clear that the dif-ferences have much to do with risk-weighting Most G-10 countries em-ploy funding formulas based for example on the total domestic deposit
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Table 29 Deposit insurance schemes in the G-10 countries Explicit safety net
Coverage limit(dollar Foreign
equivalent currency Interbank Source Bankrsquos Contingency fundingDate Membership Co- at end of deposit deposit of premium from banks
Country established managementa insuranceb July 1998)c covered covered Fundingd funding costs or governments
United 1982 Compulsory Yes Larger of 90 No No Unfunded Banks only Callable (subject Parliament may increase Kingdom private percent co- to maximum the maximum payable
insurance to 03 percent of pound125 million advance 33000 total deposits) facility with Bank of
England
United 1934 Compulsory No 100000 Yes Yes Funded Banks and Up to 027 Borrowing up to $3 States official government percent total billion from US Treasury
domestic deposits
Japan 1971 Compulsory No 71000 but No No Funded Banks and 0084 percent of Borrowing up to yen500bn joint in full until government insured deposits from Bank of Japan
year 2000 subject to Ministry of Finance approval
Canada 1967 Compulsory No 40800 No Yes Funded Banks and 033 percent of Borrowing up to C$6 official government insured deposits billion authorized further
(maximum) borrowing subject to parliamentary approval
Germany 1966 Compulsory Yes 90 percent Yes No Funded Banks only 003 percent of Annual levy may be private coinsurance deposits doubled
to 22000
Italy 1987 Compulsory Yes 125000 Yes No Unfunded Banks and Callable Two options defer private government (maximum of payment or diminish
1 percent of compensation to be paid total deposits)
(table continues next page)
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Table 29 Deposit insurance schemes in the G-10 countries Explicit safety net (continued )
Coverage limit(dollar Foreign
equivalent currency Interbank Source Bankrsquos Contingency fundingDate Membership Co- at end of deposit deposit of premium from banks
Country established managementa insuranceb July 1998)c covered covered Fundingd funding costs or governments
Netherlands 1979 Compulsory No 22000 Yes No Unfunded Banks and On demand Government backing official government maximum of subject to parliamentary
5 percent of own approval funds
France 1980 Compulsory No 65400 No No Unfunded Banks only Callable (on Extra calls up to FFr1000 private demand calls million can be made in
up to FFr200 a 5-year period million)
Switzerland 1984 Voluntary No 19700 No No Unfunded Banks only Callable (on Underwritten by member official demand) banks
Sweden 1996 Compulsory No 31400 Yes No Funded Banks and 05 percent of Full emergency coverage official government deposits while replacing it with a
limited system after the emergency
Belgium 1974 Compulsory No 16600 No No Funded Banks and Callable 002 None insurance limited joint 22000 in government percent of to assets in fund
year 2000 deposits from clients
Spain 1977 Compulsory No 16439 Yes No Funded Banks and 02 percent of Government backing joint government deposits through the Banco de
(maximum) Espantildea subject to approval by royal decree
a Bank membership in the fund can be either compulsory or voluntary and the management of the fund can be official and official and private joint or privateb Coinsurance refers to the situation where depositors face a deductible against their insured fundsc Coverage limit refers to the explicit amount the authorities promise to insured Funded scheme means that it is funded ex ante unfunded otherwise
Sources Goodhart (1995) Demirguccedil-Kunt and Detragiache (2000) Demirguccedil-Kunt and Sabaci (2000)
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 109
base Explicit safety net protection also varies but only Canada focuseson the protected class33 All G-10 countries specify a limit on depositorprotection Under FDICIA the insurance fund is prohibited from pro-tecting uninsured depositors or creditors at a failed bank although adiscretionary system-wide override is provided for exceptional circum-stancesmdashbut with stringent requirements for consultation and account-ability Other G-10 countries allow for contingency funding from the publicpurse alongside unwritten lender-of-last-resort support Among large banksa significant and growing portion of deposit liabilities including foreigncurrency and interbank deposits are uninsuredmdashbut depositors assumethey will be protected in a crisis
FDICIA also made some significant qualitative changes to address theprincipal-agent problem by penalizing weak banks and rewarding strongbanks For example banks whose capital declined faced progressivelytougher regulatory sanctions that for example required them to elimi-nate dividends restrict their lending and change their managementsRegulators have also been forced to take prompt corrective action (toreduce the practice of regulatory forbearance in hopes that a bankrsquos for-tunes might improve)34 Unfortunately comparative qualitative assess-ments across the G-10 are difficult to make due to lack of information35
This discussion highlights the complexity of evaluating the extent towhich prudential supervision and market discipline reduce the moralhazard associated with G-10 safety nets Our argument is that publicsafety nets in the G-10 can be linked to banking instability in other coun-tries specifically in the emerging-market economies that have attractedG-10 cross-border bank lending This lending is a leading source of vola-tility in capital flows the large financial institutions many of which arecomplex banking organizations are based in and regulated by authori-ties in the G-10 economies These two features of the international finan-cial system are closely related although it is not possible to test thisrelationship econometrically
Two World Bank studies however indicate a basis for concern Onestudy is a cross-country econometric analysis of the relationship betweenbank stability and deposit insurance (Demirguccedil-Kunt and Detragiache2000) which found a negative relationship Their estimated model forbanking crises in a sample of 61 countries (both industrial and develop-ing) suggests that explicit deposit insurance raises the probability of acrisis by at least 30 percent36 Crises are especially likely in countries
33 Japanrsquos legislation says it does but recent experience shows this is not the case34 See Goldstein (1997) for a summary of the changes35 See Barth Nolle and Rice (2000) for a beginning in this area36 Demirguccedil-Kunt and and Detragiache (2000 table 1) report a logit coefficient of 0696with a standard error of 0397 (the coefficient is significant at the 8 percent threshold)This suggests that the ldquotruerdquo coefficient could well be as small as 030 (the reportedvalue minus the standard error)
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110 WORLD CAPITAL MARKETS
with immature financial supervisory systems (and not in the G-10) buttheir analysis does underscore the view that deposit insurance weakensmarket discipline37
An earlier World Bank analysis established similar results One wasthat market discipline is undermined by deposit insurance schemes an-other was that illiquid banks are forced to pay more for their funds un-less a generous deposit insurance scheme is in place (Demirguccedil-Kuntand Huizinga 1999) This econometric study also provides clear-cut evi-dence that depositor monitoring of banks declines with the existence ofdeposit insurance schemes At the heart of the problem is the questionof whether deposit insurance is accompanied by increased governmentmonitoring
This evidence and the weight of other arguments suggests that moralhazard is still an issue in the G-10 countries Consider the ongoing de-bate about instilling greater market discipline on risk taking by banksAt one extreme is the perennial proposal to do away with safety netsleaving markets to monitor the players and to force adjustments but toprotect small savers by creating ldquonarrow banksrdquo such as postal savingsystems that are allowed to invest these savings only in risk-free gov-ernment securities Whatever the merits of narrow banking this solutionis too extreme to be politically feasible
A moderate alternative is to force more disclosure by financial institu-tions to facilitate market monitoring But transparency has its own prob-lems Persaud (2000) argues that financial markets cannot reliably discernsustainable from unsustainable positions in the short term This uncer-tainty causes banks to ldquoherdrdquo behind market leaders to exploit theirsupposedly superior information ldquoThe more herding investors and bankersknow about what each other is up to the [more] unstable markets maybecomerdquo The implication is that greater transparency in the marketplaceby itself will not solve the problemmdashand in the short term more informa-tion may exacerbate herding Further supervisory steps (discussed in thenext chapter) are required
Yet another proposal is to promote private-sector involvement in bankmonitoring through market-based alternatives such as Calomirisrsquos sub-ordinated debt proposal (Calomiris 1997 Federal Reserve Board 1999)Banks could be required to issue and maintain a minimum amount of
37 Other findings in the Demirguccedil-Kunt and Detragiache (2000) study include thesepropositions The impact of deposit insurance on bank stability tends to be stronger themore extensive is the coverage offered to depositors when the scheme is funded andwhere the scheme is run by the government rather than by the private sector Con-versely deposit insurance is detrimental to bank stability where bank interest rates havebeen deregulated and where the institutional environment is weak Additional findingson deposit insurance are reported from a recent World Bank conference (8-9 June 2000httpwwwworldbankorgresearchinterestconfsupcomingdeposit_insurancehomehtm)Also see Smalhout (2001)
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 111
subordinated debt (eg uninsured certificates of deposit) to finance asmall fraction (such as 2 percent) of their total nonreserve assets Thesubordinated debt would be allowed to earn a set yield no more than 50basis points over the risk-free yield on government treasury bills Thisrule would supposedly force banks to operate in a safe manner Other-wise subordinated debt holders would redeem their uninsured certifi-cates of deposit and equity investors would sell their bank shares Despiteits practical problems the beauty of the subordinated debt requirementis that it enlists market incentives to push banks to avoid excessive port-folio risk38
The thrust of these proposals is very relevant to the arguments in ourstudy Even in the G-10 countries government monitoring by itself hasnot eliminated moral hazard among banks More work is needed to in-troduce market monitoring and to improve the incentive structures bothfor financial institutions and their supervisors We return to this issuewith our recommendations in the next chapter
38 In late 1996 Argentina began requiring its banks to finance 2 percent of total depos-its in the form of subordinated debt but without a maximum yield provision TheArgentine authorities expect that market discipline will act in concert with the publicsafety net One obvious problem with the subordinated debt proposal is that banks mayencourage some of their customers to buy the subordinated debt
Portfolio Institutions Tomorrowrsquos Problem
Before proceeding to the issues of international supervision we flag an-other potential problem for national regulators The big asset managersprofiled in tables 24 and 26 answer to diverse groups of pensionersshareholders and policyholders They allocate funds across a number ofcountries to diversify their risks They hold liquid assets that can be tradedand they have a higher proportion of long-term assets than banks Eco-nomic shocks can be absorbed through price changes and their effectsspread across time and markets Thus when conditions change in a par-ticular market they are more likely to ride out the storm than to flee Inother words they have less incentive than banks to pull their invest-ments in the face of adversity In the 1990s most large asset managersestablished a record of ldquoriding out the stormrdquo rather than ldquorunning withthe windrdquo although as we saw in chapter 1 instances of running withthe wind were detected in some portfolios As we write these insti-tutions have a good record overall in the emerging markets so whyworry
The Russian crisis and the near-collapse of LTCM previewed the dan-gers that may await future portfolio managers and G-10 financial minis-ters We have presented evidence indicating a systemic bias toward bank
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112 WORLD CAPITAL MARKETS
lending and debt finance to emerging markets and we have argued forsubstitution toward equity finance and direct investment39
That is not the end of the story We noted in the previous chapterthat institutional investors can become momentum investors selling in adownturn As more portfolio capital is invested in emerging marketssome players may adopt the high-risk high-leverage strategies of themost aggressive hedge funds Indeed the data in box 11 show that G-10portfolio investors held somewhat more long-term debt (more than $500billion) than equity (less than $400 billion) in emerging markets at theend of 1997 Long-term debt is an ideal vehicle for high-risk high-leveragestrategies These strategies practiced on a large scale could compound afuture crisis harming emerging markets A big enough crisis could inturn pressure G-10 central banks and finance ministers to arrange bail-out plans Instead of shrinking as a systemic financial problem moralhazard could increase
National securities regulators are the first line of defense against thisscenario They play a critical role in the safe evolution of capital mar-kets But regulators today are mandated to approve the issuance of newsecurities and to monitor the continuing disclosure of material informa-tion by issuers They are far less concerned with or empowered to monitorthe behavior of the increasingly large wealth-management firms that arethe major purchasers (and therefore resellers) of these securities
Within their mandates the goals of national securities regulators (table210 and appendix B) are similar to the concerns of bank regulators withsystem safety and soundness Their focus is also on the incentive sys-tems for management and boards of directors and on disclosure by cor-porations that issue marketable securities such as shares bonds andasset-backed securities 40 Issuers of securities possess greater knowledgeabout the quality of these assets than do the purchasers hence investorprotection is a key concern of regulators Moreover market disciplineworks best when markets know what is happening Well-functioning corpora-tions are key agents of wealth creation and social progress Underperform-ing corporations waste resources During recessions bad corporationsget into bad trouble often with severe social consequences Inadequateincentives for managers and inadequate accountability for boards andmanagers thus have negative externalities Regulators play a vital role inexposing weakness so that market disciplines come to bear sooner ratherthan later
Regulatory emphasis is constantly shifting as financial markets evolveand as the macroeconomic environment changes Regulators try to balance
39 See Rogoff (1999) Also see Berlin (2000) for a perspective on the limited role thatbanks play as share owners
40 See Habib and Ljungqvist (2000) for recent empirical analysis showing that corporateshare market values are higher when corporate executives have a larger ownership stake
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Table 210 Financial-sector regulation G-10 countries 2000
Financial institutions and their supervisors
Country and supervisory structure Retail banking Wholesale banking Securities Insurance
Financial conglomeratesFinancial Services Authority (FSA) = umbrella supervisor
United Kingdom FSA FSA FSA FSA
Treasury bull Commercial banks bull Investment funds (Securities and (Insurance Directorate(Securities and Investments Board) bull Unit trust groups Futures Authority) of the Treasury)
Bank of bull Building societies bull Pension funds England (Building Societies Commission) bull Merchant banks
bull Friendly societies bull Clearing houses bull Primary issuers bull Insurance FSA (Friendly Societies Commission) bull Venture capital of securities companies
bull Pensions and life insurance etc bull Stock exchanges bull Insurance brokers(Personal Investment Authority) bull Stockbrokers
Financial holding companiesFederal Reserve (FR) = umbrella supervisor
United States bull National banks(OCC) Securities and Regulated by
Treasury OCC bull State banks Federal Reserve Exchange Commission StatesMembers (FR)
OTS Nonmembers (FDIC) bull Investment banks bull Primary issuers of bull Insurance companies FR bull Cooperative banks (FDICFR) bull Finance companies securities bull Insurance brokers FDIC bull Insured industrial banks (FDIC) bull Stock exchanges
bull Thrift holding companies (OTS) bull Stockbrokers SEC bull Savings banks (OTSFDICFR) bull Investment advisors
bull Savings and loan associations bull Mutual funds(OTS) bull Public utility holding
bull Edge Act corporations (FR) companies
(table continues next page)
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Table 210 Financial-sector regulation G-10 countries 2000 (continued )
Financial institutions and their supervisors
Country and supervisory structure Retail banking Wholesale banking Securities Insurance
Financial holding companies Japan Financial Supervisory Authority (FSA) = umbrella supervisor
Prime FSA FSA FSA FSA ministerrsquos Ministry of office Finance (Securities and Exchange
Surveillance Commission) FRC Bureau of Financial bull City banks bull Investment banks bull Primary issuers of bull Insurance companies FSA Regulation bull Regional banks bull Asset managers securities bull Insurance brokers
bull Trust banks bull Stock exchanges SESC bull Long-term credit banks bull Stockbrokers
bull Pension funds
Financial holding companiesOffice of the Superintendent of Financial Institutions (OSFI) = umbrella supervisor
Canada Regulated by OSFI OSFI provinces OSFI
Department of Financebull Banks bull Cooperative credit bull Primary issuers of bull Insurance companies
(previously Office of the Inspector associations securities (previously Depart- OSFI General of the Banks) bull Fraternal benefit bull Stock exchanges ment of Insurance) Bank of bull Trust and loan companies society bull Stockbrokers bull Insurance brokers Canada bull Pension funds bull Asset managers
(previously Depart- CDIC ment of Insurance)
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Financial institutions and their supervisors
Country and supervisory structure Retail banking Wholesale banking Securities Insurance
Germany Financial holding groupsFederal Banking Supervisory Office (FBSO) = umbrella supervisor
Ministry of Finance FBSO BSO FSSO FISO
Bundesbankbull Universal banks bull Other financial bull Primary issuers of bull Insurance companies
Federal Banking bull Savings banks institutions (eg securities bull Insurance brokers Supervisory Office bull Securities banks management foreign bull Stock exchanges
currency dealings) bull Stockbrokers Federal Securities bull Financial enterprises bull Asset managers Supervisory Office (eg leasing bull Pension funds
organizations Federal Insurance credit card companies Supervisory Office investment advisors)
Italy Bank foundationsMinistry of Finance = umbrella supervisor
Ministry of Finance Bank of Italy Bank of Italy Consob ISVAP
Bank of Italy bull Commerical banks bull Asset managers bull Primary issuers of bull Insurance companies Consob bull Savings bank bull Open-end investment securities bull Insurance brokers
bull Securities banks companies (SICAVs) bull Stock exchangesbull Stockbrokers
ISVAP
(table continues next page)
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Table 210 Financial-sector regulation G-10 countries 2000 (continued )
Financial institutions and their supervisors
Country and supervisory structure Retail banking Wholesale banking Securities Insurance
The Netherlands Financial conglomeratesCouncil of Financial Supervisors = umbrella supervisor
Securities Board Securities Board Netherlandsche Netherlands Bank Netherlandsche Bank of the Netherlands Insurance Board Bank Insurance bull Credit institutions (universal banks bull Investment institutions bull Stock exchanges bull Insurance companies Board cooperative banks security credit (securities issuing bull Stockbrokers bull Insurance brokers
institutions mortgage banks) and tradingmdashprimary The Council of Financial and secondary Supervisors markets)
France Commission des Commission de Operations des Controcircle des
Banking and Banking Commission Bourse Assurances Financial Regulatory bull Ensuring that credit institutions (and investment firms since bull Primary issuers of bull Insurance companies Ministry for Committee the Financial Activity Modernization Act of 1996) comply securities bull Insurance brokers Economic with laws and regulations bull Stock exchanges Affairs and bull Execute instructions regarding all off-site monitoring and bull Stockbrokers Finance Credit on-site supervision Institutions and Banking and Financial Regulatory Committee Investment bull Formulates general regulations for credit institutions and investment firms Committee (capital adequacy requirements accounting rules etc) Bank of France Credit Institutions and Investment Committee Banking bull Authorizes and examines financial institutions except for those within the Commission competence of the Banking Commission
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117
Financial institutions and their supervisors
Country and supervisory structure Retail banking Wholesale banking Securities Insurance
Switzerland Large banking groupSwiss Federal Banking Commission (SFBC) = umbrella supervisor
Swiss National Bank Federal Office of
SFBC SFBC SFBC Private Insurance Swiss Federal Banking Commission bull Universal banks bull Investment banks bull Primary issuers of bull Insurance companies
bull Savings banks bull Asset management securities bull Insurance brokerscompanies bull Stock exchanges
Private audit Federal bull Investment funds bull Stockbrokers firms Office of bull Mortgage bond authorized by Private business SFBC Insurance
Sweden Financial holding company groupsFinancial Supervisory Authority = umbrella supervisor
Ministry of Finance Credit Market Securities Market Insurance Market
Credit Market Department Department Department Department
Financial bull Commercial banks bull Investment funds bull Primary issuers of bull Insurance companies Riksbank Supervisory bull Savings banks securities bull Insurance brokers Authority bull Friendly societies bull Stock exchanges
bull Stockbrokers
(table continues next page)
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Table 210 Financial-sector regulation G-10 countries 2000 (continued )
Financial institutions and their supervisors
Country and supervisory structure Retail banking Wholesale banking Securities Insurance
Belgium Bank holding companiesBanking and Finance Commission = umbrella supervisor
Bank of Belgium Banking Banking
Banking and Finance and Finance Insurance Controland Finance Commission Commission Commission Office
Banking and Insurance Finance Control bull Commercial banks bull Asset management bull Primary issuers of bull Insurance companies Commission Office bull Savings banks firms securities bull Insurance brokers
bull Securities banks bull Investment funds bull Stock exchanges bull Mortgage companiesbull Stockbrokers bull Pension funds
Securities Regulation Fund Securities Regulation Fund
bull Other investment firms and credit institutions(institutions participating in regulated off-exchangemarket in strips and Treasury certificates)
Bank holding companies Spain Banco de Espantildea = umbrella supervisor
Banco de Espantildea Comision Nacional del Mercado de Directorate General
Banco de Espantildea Valores (CNMV) Insurance
bull All credit institutions (commercial banks savings banks credit bull Primary issuers of (Ministry of Economy Ministry of cooperatives official credit institutions finance factoring and securities and Finance) Economy and CNMV leasing companies mortgage-loan companies etc) bull Stock exchanges bull Insurance companies Finance bull Interbank foreign exchange and book-entry public debt bull Stockbrokers bull Pension funds
markets bull Venture capital(companies and funds)
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119
Financial institutions and their supervisors
Country and supervisory structure Banking Securities Insurance
Banking Advisory High Level Securities Supervisors Committee (BAC) Committee (HLSS) Insurance Committee (IC)
Supranational (EU) bull Formulates standards for prudential bull Coordination of securities market bull Formulates standards forsupervision supervision prudential supervision
BACICHLSS Banking Supervision
Conglomerates Committee (BSC) Securities Contact Committee Regulation of prudential bull Systemic risk monitoring bull Regulation and implementation of supervision securities admission
International Association International International Organization of of Insurance Supervisors
Basel Committee Securities Commisison (IOSCO) (IAIS) Joint Forum Conglomerates Supervision bull Supervision and regulation best bull Supervision and regulation best bull Supervision and regulation amp regulation Best practices practices practices best practices
FSF Coordination across supervisors of various functions
Notes See appendix B for more information Boldface type indicates senior or oversight supervisor normal type indicates adjunct or front-line supervisorsolid line indicates direct responsbility to the senior-ranking authority dotted line indicates coordination in supervisory activities
(table continues next page)
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Table 210 Financial-sector regulation G-10 countries 2000 (continued )
Glossary of names United Kingdom FSA = Financial Services Authority United States FR = Federal Reserve OCC = Office of the Comptroller of theCurrency FDIC = Federal Deposit Insurance Corporation SEC = Securities and Exchange Commission OTS = Office of Thrift Supervision Japan FRC =Financial Reconstruction Commission FSA = Financial Services Agency SESC = Securities and Exchange Surveillance Commission Canada OSFI =Office of the Superintendent of Financial Institutions CDIC = Canada Deposit Insurance Corporation Germany FBSO = Federal Banking SupervisoryOffice FSSO = Federal Securities Supervisory Office FISO = Federal Insurance Supervisory Office BSO = Banking Supervisory Office Italy Consob =Commissione Nazionale per le Societa e la Borsa ISVAP = Instituto per la Vigilanza sulle assicurazioni private e di Interesse colletivo Switzerland SFBC= Swiss Federal Banking Commission Spain CNMV = The Comision Nacional del Mercado de Valores Supranational BAC = Banking Advisory CommitteeBSC = Banking Supervision Committee IC = Insurance Committee HLSS = High Level Securities Supervisors Committee International Dimension FSF =Financial Stability Forum IOSCO = International Organization of Securities Commission IAIS = International Association of Insurance Supervisors
Sources United Kingdom Bank of England httpwwwbankofenglandcouk Financial Services Authority httpwwwfsagovuk United States Board ofGovernors of Federal Reserve System httpwwwfederalreservegov Japan Bank of Japan httpwwwbojorjo Financial Reconstruction Commissionhttpwwwfsagojpfrcindexehtml Financial Services Agency httpwwwfsagojp Canada Bank of Canada httpwwwbank-banque-canadaca Office ofthe Superintendent of Financial Institutions httpwwwosfi-bsifgccaAndreEindexhtml Germany Deutsche Bundesbank httpwwwbundesbankde Fed-eral Banking Supervisory Office httpwwwbakredde Italy Banca drsquoitalia httpwwwbancaditaliait Commissione Nazionale per le Societa e la Borsahttpwwwconsobit Instituto per la Vigilanza sulle assicurazioni private e di Interesse colletivo httpwwwisvapit The Netherlands De NederlandscheBank httpwwwdnbnl France Banque de France httpwwwbanque-francefr Switzerland Schweizerische Nationalbank httpwwwsnbchindex3htmlSweden Sveriges Riksbank httpwwwriksbanksedefaultasp Belgium National Bank of Belgium httpwwwbnbbesgindexhtm Spain Banco de Espantildeahttpwwwbdees The Comision Nacional del Mercado de Valores httpwwwcnmves Supranational (EU) Institutional Arrangements for the Regulationand Supervision of the Financial Sector 2000 International Dimension Bank for International Settlement httpwwwbisorg International Organization ofSecurities Commissions httpwwwioscoorg International Association of Insurance Supervisors httpwwwiaisorg Financial Stability Forum httpwwwfsforumorg
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 121
the inflexibility of tight surveillance against the need to encourage in-novation and growth The US Securities and Exchange Commission isworried about aggressive accounting by firms and biased reports bysecurities analysts in an equity environment that prizes steadily higherquarterly earnings41 Japanese regulators are preoccupied with opaqueinterconnections between portfolio institutions banks and nonfinancialfirms through the keiretsu system Canadian regulators reeling from high-profile scandals of managers intentionally misleading investors are strengtheningmarket discipline through legal penalties aimed at managers and directorsof offending firms
When panic strikes a securities regulator cannot do much As the 1987stock market crash and the LTCM debacle in the fall of 1998 both dem-onstrated steep stock and bond price declines can create systemic risksIf severe enough the wealth effect of falling securities values and thefear of widespread insolvency can depress real activity Flooding thesystem with liquidity is a central bankerrsquos solutionmdashsomething a securi-ties regulator cannot do42 But just as financial supervisors can changethe incentive structure to discourage bankers from making risky loans ingood times so securities regulators can pay more attention to incentiveson the demand side when capital markets are strong
Prudential Supervision and InnovationmdashA Footnote
In concluding this discussion of prudential supervision in the G-10 anadditional point is worth noting National regulators face a persistenttrade-off between emphasizing financial system safety and soundnesswhile encouraging innovationmdashin spite of the added risks innovationbrings to financial markets Former US Treasury Secretary Lawrence Summers(2000 3) has argued by analogy
The jet airplane made airplane air travel more comfortable more efficient andmore safe though the accidents were more spectacular and for a time morenumerous after the jet was invented In the same way modern global financialmarkets carry with them enormous potential for benefit even if some of theaccidents are that much more spectacular As the right public policy response
41 The problem is illustrated by the divergence since mid-1998 between reported earn-ings by the Standard amp Poorrsquos (SampP) 500 and the after-tax profits of all corporations inthe national accounts Generally these two series move closely with one another Be-tween mid-1998 and mid-1999 SampP 500 reported that earnings increased by more than20 percent while after-tax profits of all corporations increased by less than 5 percent(Chase Bank US Economic and Policy Research US Weekly Prospects Chase SecuritiesWeekly Newsletter 5 June 2000 5)
42 For example the US Securities and Exchange Commission had no direct role in calmingmarkets in the 1987 or 1998 panics
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122 WORLD CAPITAL MARKETS
to the jet was longer runways better air-traffic control and better training forpilots and not the discouragement of rapid travel so the right public policyresponse to financial innovation is to assure a safe framework so that the ben-efits can be realized not to stifle the change
Accepting Summersrsquos analogy for the international financial system better-informed supervisors and investors are a necessary part of the financialsystem framework Supervisors require more timely information on therisk profiles resulting from positions taken by financial institutions Theyalso need a better understanding of risk-management systems Snapshotsof an institutionrsquos risk profile and risk-management procedures are nolonger adequate In a world where huge bets are quickly made (andpossibly lostmdashas with Barings Bank in 1995 and LTCM in 1998) super-visors must focus on the soundness of banking systems for evaluatingand managing risk on a daily basis Some progress has been made inaddressing these issues US banking examiners are extending their in-formation requirements in banking examinations and increasing theirinvolvement in large complex institutions43 More awareness is alsorequired of the fact that they are national organizations in a world ofcross-border capital flows To a much greater extent they need a multi-national reach International supervision and coordination among super-visors are the subject of the next section
Our analysis suggests that G-10 supervisors have unfinished businessBank supervisors need to start yesterday securities regulators can waituntil tomorrow One G-10 member acting alone cannot correct the biasIn good times the lending business will simply migrate to other G-10banks In bad times financial problems will not stop at the national bor-der A way has to be found to establish common international standardsfor the key financial players in order to prevent crises and to agree onapproaches for managing them The path has already been laid out Inthe wake of the bank failures of the past 25 years bank supervisors havetried to establish such standards They have done this without creating anew global institution
The essence of the international framework is decentralizationmdashglobalrules and design standards without global institutions that are perceivedto intrude on national sovereignty The awkward jargon for this frame-work is vertical subsidiaritymdashldquothink internationally act nationallyrdquo Theinternational thinking is done by a committee of regulators that meets
International SupervisionA Decentralized Framework
43 These issues are discussed in Ferguson (1999) and Meyer (2000a)
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 123
regularly at the Bank for International Settlements in Basel The commit-tee establishes principles and standards that are interpreted implementedand enforced by national authorities44 In this section we describe thesesupervisory efforts and their weaknesses We present our recommenda-tions for addressing these weaknesses in the next chapter
Basel I
The Basel Capital Accord of 1988 (Basel I)45 drew the lesson from thefinancial crises of the mid-1970s that more adequate capital levels in in-ternational banks would help reduce the systemic risk of bank failureThe primary goal of Basel I was capital adequacy other standards wereput in place not so much for their own virtue as to defend the primarygoal
Capital adequacy requirements were designed to ensure that individualinstitutions have the ability to absorb losses particularly credit lossesAccordingly a backup system of scoring credit risk was devised thatrequired large amounts of bank capital for some types of loans smalleramounts for others and zero for a select list of preferred assets Report-ing requirements were designed to disclose problems and ensure that atroubled bank would take timely steps to restore its capital base in thewake of a loss The Basel I framework worked tolerably well in limitingthe call on the public purse in the G-10 countriesmdashwith the notable ex-ceptions of France and Japan The framework failed to moderate riskybank lending to emerging markets however
Basel I was not developed with emerging markets in mind The origi-nal idea behind it was to develop a common supervisory approach tocross-border banking operations It grew out of political pressure fromUS lawmakers who were determined to require international banks op-erating in the United States to meet US banking standards Toward thisgoal in 1983 Congress passed the International Lending Supervisory ActUS and British banking authorities subsequently agreed on a commontarget the adoption of strict common capital-adequacy standards In 1988other G-10 governments agreed to go along voluntary acceptance ofthe standards throughout much of the rest of the world followed46 Therationale for the capital targets was two-fold The first was to requirebanks to hold sufficient amounts of capital (8 percent of risk-adjusted
44 The international committee of financial authorities agreed on a common definitionof banksrsquo tier-one or ldquocorerdquo capital national authorities defined tier-two capital in theirown manner which permitted greater variations in national working definitions andpractices
45 International Convergence of Capital Measurement and Capital Standards (BIS 1988)was prepared by the Basel Committee on Banking Supervision
46 See Reineke (1998)
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124 WORLD CAPITAL MARKETS
assets) to cushion losses on those assets The second was to dull theirappetites for risk banks with large capital bases would have more tolose if they failed and therefore would take fewer risks
Rapid change in financial markets soon revealed flaws in the Basel IAccord In a complex world with numerous sources of risk it focusedheavily on credit risk but overlooked other risks in a bankrsquos portfolioand the correlation between returns on different asset classes The Baselformula required banks to maintain a fixed amount of capital againsteach of its asset classes But the formula did not distinguish the riskinessof the borrower within each class As a result one large loan to a low-risk corporate borrower such as General Electric would require the sameamount of capital as 10 smaller transactions with high-risk borrowers
The system was also biased toward short-term loans Loans maturingin less than a year required a 20 percent risk weight whereas those ma-turing after more than a year required a 100 percent risk weight Inter-bank lending was particularly favored For example loans to banks inOECD countries required less capital than loans to private firms in thesame countries creating the anomaly that interbank loans to South Ko-rean banks required less capital than loans to General Electric47 Thisanomaly encouraged banks to shed high-quality assets if the Basel rulesrequired the allocation of more capital than banks thought they needed
Another weakness was that financial innovators quickly circumventedthe Accord Because short-term loans required less provisioning than long-term loans banks responded by securitizing their long-term debt port-folios and lending short-term against the collateral of the newly createdasset This allowed banks to circumvent the capital requirements gearedto the terms of the underlying debt At the same time the Basel I Accordfailed to encourage risk mitigation techniques such as credit derivativescollateral guarantees and on-balance-sheet netting the flip side of fi-nancial innovation Because off-balance-sheet products were not coveredby the Accord another anomaly appeared when Barings Bank collapsedin 1995 Barings met capital adequacy standards but collapsed becauseits systems for managing risk failed traders were allowed to speculatein futures contracts that did not appear on the balance sheet
Basel II
Work to overhaul Basel I began in 1995 and produced consultativepapers issued in June 1999 and January 200148 These papers have been
47 South Korean banks have had notoriously weak balance sheets because the practiceof ldquodirected lendingrdquo left them with many poor loans (in making these loans the bankswere expected to follow government objectives rather than creditworthiness criteria)
48 Basel Committee on Banking Supervision (1999 2001)
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 125
the subject of extensive consultation and revision as a result the newAccord is expected to be introduced in 200449 The Basel II frameworkhas three parts (pillars) revisions to Basel I minimum-capital require-ments supervisory review criteria and greater emphasis on market dis-cipline Broadly Basel II aims to maintain the level of capital in the sys-tem but achieve better alignment of banksrsquo capital with their risk pro-files and keep up with financial innovation
To align capital requirements with market realities (the first pillar)Basel II concentrates on the 100 or so largest banksmdashthe type of playerslisted in table 21mdashand on the holding-company parents of banking groups50
Capital requirements will differentiate between an increased number ofcredit groups or ldquorisk bucketsrdquo including claims on governments otherbanks corporations mortgage-backed securities and other asset-backedsecurities
Basel II originally proposed to use external ratings to set capital chargesfor a number of these credit risks Many banks objected arguing thatthey assess credit risk better than Standard amp Poorrsquos Moodyrsquos or FitchIBCA51 Basel II thus proposes two approaches to rating a standard ap-proach using external ratings and an ldquoadvancedrdquo approach that allowsselected banks to use their own internal rating systems To encouragethe development of rigorous internal control systems based on these in-ternal rating systems Basel II also proposes to levy capital charges foroperational risk (the risk of direct or indirect loss resulting from inad-equate or failed internal processes people and systems or from exter-nal events)
Some critics of this proposal dismiss it as an abrogation of the prin-ciple of external independent monitoring and as ldquodangerously naiumlverdquo52
But regulators argue that the new capital charge on operational risk shouldoffset this concern It is also far from clear how cross-national compari-sons of rating and internal risk-assessment systems will be made (Engelen2000) The development by the European Union of its own capital rulescould well complicate the international resolution of these issues Publicassurances by EU officials in January 2001 however indicated that theirmain concerns are to create a level playing field and avoid regulatoryarbitrage (Hargreaves 2001) There is also the significant problem ofthe procyclical character of risk weights When a crisis hits losses are
49 See Berry (2000) for an update in an interview with William J McDonough chair ofthe Basel Committee on Banking Supervision
50 For obvious reasons these proposals are addressed to large banks and simpler capi-tal standards are allowed for small banks that focus on their domestic credit markets
51 See Ammer and Packer (2000) for an empirical critique of the success of rating agen-cies in distinguishing risk by sector and region
52 See Auerback (2001)
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126 WORLD CAPITAL MARKETS
incurred or accrued capital is lost and loan exposure must be reducedor securities sold to restore the requisite capital-adequacy ratios A morerisk-sensitive framework could amplify volatility
As the second pillar of Basel II supervisory review criteria are beingbeefed up to encourage supervisors to intervene earlier in potential problemsituations and to compel banks to align their capital positions with theirrisk profiles Bank supervisors will be authorized to require banks tohold capital in excess of minimum requirements if they have concernsabout general management overall strategy risk-management performanceor the macroeconomic environment Of course if one G-10 supervisorimposes higher capital requirements in isolation the same disparity willemerge that presaged Basel I Some banks will be disadvantaged in theinternational marketplace and will loudly complain that excessive super-vision is driving business to their competitors Hence close internationalcooperation among supervisors is critical
To implement the third pillar market discipline banks will be requiredto make fuller more timely disclosure of capital adequacy and the risksto which that capital is exposed A number of measures are being stud-ied that might help supervisors evaluate bank performance such as com-parisons of uninsured deposit interest rates subordinated debt yieldsand equity prices The idea is that these yields and prices might alertsupervisors to market perceptions of risk Of course market perceptionsare only as good as market information More direct and controversialways to reinforce market discipline would dramatically increase publicdisclosure of bank positions and risk management systems
Many questions are still outstanding about how to resolve the techni-cal details of capital requirements and whether the requirements willachieve their intended goal of better assessment and mitigation of therisks in banksrsquo portfolios There is no substitute for skilled supervisorsThe intricacies of effective design and implementation suggest that su-pervisors need to be highly competent technically knowledgeable aboutbanking portfolio characteristics and the factors that influence bank ex-posure to credit risk (Mishkin 2000) And they must be aided by vigilantshareholders market forces and transparency of information53
Standard setting at the global level is desirable but ultimately theeffectiveness of these efforts will be tested at the national level espe-cially in times of systemic financial distress Here the record of Basel Iwas not a bright shining success Japanese banking regulators havetraditionally allowed banks to include real estate and securities in theircapital base When the value of these assets plummeted in the early 1990sregulators allowed banks to continue valuing these depreciated (andoften bankrupt) assets at their old inflated levels Japanese authorities
53 Benedict Roth Complacency Towards Catastrophe Financial Times 23 January 2001
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 127
insisted until the mid-1990s that eroded capital bases could be rebuiltin a market-driven fashion They rightly foresaw that huge loan losseswould undermine public support for the ruling party and require a po-litically unpopular bailout
Japanese foot dragging on Basel I was the worst54 but not uniqueOther examples can be found of ldquopolitically mandated forbearancerdquo TheFederal Reserve Bank of New York held important hands during theLTCM crisis of 1998 Mexico is still resolving the banking crisis that eruptedin 1995 South Korea has not yet closed the insolvent banks that behavedso badly before the crisis of 1998 In the aftermath of a crisis nationalregulators cannot always be relied upon to discipline politically power-ful bankers55 One of the little-noticed consequences of these differingapproaches is that those banks with strong regulatory systems receivedan implicit ldquoexport subsidyrdquo for their services US banks which had notengaged extensively in emerging-market lending in the 1990s were bet-ter positioned than their German and Japanese counterparts to expandtheir international assets in the wake of the crises
Other Financial Forums
54 See Japanese Banks Fiddling while Marunouchi Burns The Economist 27 January2001 67-69
55 See Calomiris (1997)
The Basel model of vertical subsidiarity has already been extended toother financial regulatory bodies In 1993-94 the BIS established a Tri-partite Group of Banking Insurance and Securities Regulators In 1994-95 the BIS increased its cooperation with the International Organizationof Securities Commissions when the two organizations issued parallelpapers on guidelines for national regulators concerning risk managementand disclosure of derivative trades In 1996 a permanent Joint Forum onFinancial Conglomerates was established to examine supervisory issuesand develop working arrangements among the different functional super-visors of conglomerate institutions that offer combinations of bankingsecurities and insurance products Draft papers on the supervisionof conglomerates were released for comment in 1998 applying capital-adequacy principles to these groups and providing guidelines both forassessing the integrity and competence of top managers and for sharingassessments between regulators
In 1997 the Basel Committee on Banking Supervision extended itsreach beyond capital standards to broader aspects of banking supervi-sion with the publication of the Core Principles for Effective BankingSupervision In 1999 a wide range of regulatory and standard-settingbodies were gathered under the umbrella of the Financial Stability
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128 WORLD CAPITAL MARKETS
Forum (FSF) itself established under BIS aegis56 The FSF has alreadyissued recommendations for stepped-up supervision and transparencyas well as guidelines for best practices in a number of areas includingoffshore financial centers and highly leveraged institutions or hedge funds57
Conclusion
Although the structural weaknesses in emerging-market economies arewidely acknowledged to have been causal factors in international capi-tal-market volatility this chapter points to the role of large G-10 bankingorganizations as major suppliers of the most volatile instrument short-term debt We have examined evidence of the impact of public safetynets in the G-10 economiesmdashthe deposit insurance systems the pruden-tial supervisory systems and the lender-of-last-resort functions of centralbanksmdashon the incentive structures of these organizations
Although supervisors in most countries working nationally and to-gether in the BIS have made significant efforts to mimic market forcesin their prudential supervision the most sophisticated financial institu-tions find innovative ways to circumvent the rules New global regulatorybodies are not about to be created G-10 national bank regulators shouldthemselves address the short-term debt bias in the international financialsystem by changing incentive systems G-10 securities regulators shouldalso take steps to get ahead of the curve paying close attention to largeportfolio swings by institutional investors particularly in times of crisisIn short more needs to be done at national and international levels tochange the rules of the game That is the subject of the next chapter
56 The Financial Stability Forum includes banking securities insurance and accountingregulatory bodies the OECD on taxation corruption and corporate governance and theIMF
57 See Martin (2000)
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Table 29 Deposit insurance schemes in the G-10 countries Explicit safety net
Coverage limit(dollar Foreign
equivalent currency Interbank Source Bankrsquos Contingency fundingDate Membership Co- at end of deposit deposit of premium from banks
Country established managementa insuranceb July 1998)c covered covered Fundingd funding costs or governments
United 1982 Compulsory Yes Larger of 90 No No Unfunded Banks only Callable (subject Parliament may increase Kingdom private percent co- to maximum the maximum payable
insurance to 03 percent of pound125 million advance 33000 total deposits) facility with Bank of
England
United 1934 Compulsory No 100000 Yes Yes Funded Banks and Up to 027 Borrowing up to $3 States official government percent total billion from US Treasury
domestic deposits
Japan 1971 Compulsory No 71000 but No No Funded Banks and 0084 percent of Borrowing up to yen500bn joint in full until government insured deposits from Bank of Japan
year 2000 subject to Ministry of Finance approval
Canada 1967 Compulsory No 40800 No Yes Funded Banks and 033 percent of Borrowing up to C$6 official government insured deposits billion authorized further
(maximum) borrowing subject to parliamentary approval
Germany 1966 Compulsory Yes 90 percent Yes No Funded Banks only 003 percent of Annual levy may be private coinsurance deposits doubled
to 22000
Italy 1987 Compulsory Yes 125000 Yes No Unfunded Banks and Callable Two options defer private government (maximum of payment or diminish
1 percent of compensation to be paid total deposits)
(table continues next page)
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Table 29 Deposit insurance schemes in the G-10 countries Explicit safety net (continued )
Coverage limit(dollar Foreign
equivalent currency Interbank Source Bankrsquos Contingency fundingDate Membership Co- at end of deposit deposit of premium from banks
Country established managementa insuranceb July 1998)c covered covered Fundingd funding costs or governments
Netherlands 1979 Compulsory No 22000 Yes No Unfunded Banks and On demand Government backing official government maximum of subject to parliamentary
5 percent of own approval funds
France 1980 Compulsory No 65400 No No Unfunded Banks only Callable (on Extra calls up to FFr1000 private demand calls million can be made in
up to FFr200 a 5-year period million)
Switzerland 1984 Voluntary No 19700 No No Unfunded Banks only Callable (on Underwritten by member official demand) banks
Sweden 1996 Compulsory No 31400 Yes No Funded Banks and 05 percent of Full emergency coverage official government deposits while replacing it with a
limited system after the emergency
Belgium 1974 Compulsory No 16600 No No Funded Banks and Callable 002 None insurance limited joint 22000 in government percent of to assets in fund
year 2000 deposits from clients
Spain 1977 Compulsory No 16439 Yes No Funded Banks and 02 percent of Government backing joint government deposits through the Banco de
(maximum) Espantildea subject to approval by royal decree
a Bank membership in the fund can be either compulsory or voluntary and the management of the fund can be official and official and private joint or privateb Coinsurance refers to the situation where depositors face a deductible against their insured fundsc Coverage limit refers to the explicit amount the authorities promise to insured Funded scheme means that it is funded ex ante unfunded otherwise
Sources Goodhart (1995) Demirguccedil-Kunt and Detragiache (2000) Demirguccedil-Kunt and Sabaci (2000)
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 109
base Explicit safety net protection also varies but only Canada focuseson the protected class33 All G-10 countries specify a limit on depositorprotection Under FDICIA the insurance fund is prohibited from pro-tecting uninsured depositors or creditors at a failed bank although adiscretionary system-wide override is provided for exceptional circum-stancesmdashbut with stringent requirements for consultation and account-ability Other G-10 countries allow for contingency funding from the publicpurse alongside unwritten lender-of-last-resort support Among large banksa significant and growing portion of deposit liabilities including foreigncurrency and interbank deposits are uninsuredmdashbut depositors assumethey will be protected in a crisis
FDICIA also made some significant qualitative changes to address theprincipal-agent problem by penalizing weak banks and rewarding strongbanks For example banks whose capital declined faced progressivelytougher regulatory sanctions that for example required them to elimi-nate dividends restrict their lending and change their managementsRegulators have also been forced to take prompt corrective action (toreduce the practice of regulatory forbearance in hopes that a bankrsquos for-tunes might improve)34 Unfortunately comparative qualitative assess-ments across the G-10 are difficult to make due to lack of information35
This discussion highlights the complexity of evaluating the extent towhich prudential supervision and market discipline reduce the moralhazard associated with G-10 safety nets Our argument is that publicsafety nets in the G-10 can be linked to banking instability in other coun-tries specifically in the emerging-market economies that have attractedG-10 cross-border bank lending This lending is a leading source of vola-tility in capital flows the large financial institutions many of which arecomplex banking organizations are based in and regulated by authori-ties in the G-10 economies These two features of the international finan-cial system are closely related although it is not possible to test thisrelationship econometrically
Two World Bank studies however indicate a basis for concern Onestudy is a cross-country econometric analysis of the relationship betweenbank stability and deposit insurance (Demirguccedil-Kunt and Detragiache2000) which found a negative relationship Their estimated model forbanking crises in a sample of 61 countries (both industrial and develop-ing) suggests that explicit deposit insurance raises the probability of acrisis by at least 30 percent36 Crises are especially likely in countries
33 Japanrsquos legislation says it does but recent experience shows this is not the case34 See Goldstein (1997) for a summary of the changes35 See Barth Nolle and Rice (2000) for a beginning in this area36 Demirguccedil-Kunt and and Detragiache (2000 table 1) report a logit coefficient of 0696with a standard error of 0397 (the coefficient is significant at the 8 percent threshold)This suggests that the ldquotruerdquo coefficient could well be as small as 030 (the reportedvalue minus the standard error)
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110 WORLD CAPITAL MARKETS
with immature financial supervisory systems (and not in the G-10) buttheir analysis does underscore the view that deposit insurance weakensmarket discipline37
An earlier World Bank analysis established similar results One wasthat market discipline is undermined by deposit insurance schemes an-other was that illiquid banks are forced to pay more for their funds un-less a generous deposit insurance scheme is in place (Demirguccedil-Kuntand Huizinga 1999) This econometric study also provides clear-cut evi-dence that depositor monitoring of banks declines with the existence ofdeposit insurance schemes At the heart of the problem is the questionof whether deposit insurance is accompanied by increased governmentmonitoring
This evidence and the weight of other arguments suggests that moralhazard is still an issue in the G-10 countries Consider the ongoing de-bate about instilling greater market discipline on risk taking by banksAt one extreme is the perennial proposal to do away with safety netsleaving markets to monitor the players and to force adjustments but toprotect small savers by creating ldquonarrow banksrdquo such as postal savingsystems that are allowed to invest these savings only in risk-free gov-ernment securities Whatever the merits of narrow banking this solutionis too extreme to be politically feasible
A moderate alternative is to force more disclosure by financial institu-tions to facilitate market monitoring But transparency has its own prob-lems Persaud (2000) argues that financial markets cannot reliably discernsustainable from unsustainable positions in the short term This uncer-tainty causes banks to ldquoherdrdquo behind market leaders to exploit theirsupposedly superior information ldquoThe more herding investors and bankersknow about what each other is up to the [more] unstable markets maybecomerdquo The implication is that greater transparency in the marketplaceby itself will not solve the problemmdashand in the short term more informa-tion may exacerbate herding Further supervisory steps (discussed in thenext chapter) are required
Yet another proposal is to promote private-sector involvement in bankmonitoring through market-based alternatives such as Calomirisrsquos sub-ordinated debt proposal (Calomiris 1997 Federal Reserve Board 1999)Banks could be required to issue and maintain a minimum amount of
37 Other findings in the Demirguccedil-Kunt and Detragiache (2000) study include thesepropositions The impact of deposit insurance on bank stability tends to be stronger themore extensive is the coverage offered to depositors when the scheme is funded andwhere the scheme is run by the government rather than by the private sector Con-versely deposit insurance is detrimental to bank stability where bank interest rates havebeen deregulated and where the institutional environment is weak Additional findingson deposit insurance are reported from a recent World Bank conference (8-9 June 2000httpwwwworldbankorgresearchinterestconfsupcomingdeposit_insurancehomehtm)Also see Smalhout (2001)
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 111
subordinated debt (eg uninsured certificates of deposit) to finance asmall fraction (such as 2 percent) of their total nonreserve assets Thesubordinated debt would be allowed to earn a set yield no more than 50basis points over the risk-free yield on government treasury bills Thisrule would supposedly force banks to operate in a safe manner Other-wise subordinated debt holders would redeem their uninsured certifi-cates of deposit and equity investors would sell their bank shares Despiteits practical problems the beauty of the subordinated debt requirementis that it enlists market incentives to push banks to avoid excessive port-folio risk38
The thrust of these proposals is very relevant to the arguments in ourstudy Even in the G-10 countries government monitoring by itself hasnot eliminated moral hazard among banks More work is needed to in-troduce market monitoring and to improve the incentive structures bothfor financial institutions and their supervisors We return to this issuewith our recommendations in the next chapter
38 In late 1996 Argentina began requiring its banks to finance 2 percent of total depos-its in the form of subordinated debt but without a maximum yield provision TheArgentine authorities expect that market discipline will act in concert with the publicsafety net One obvious problem with the subordinated debt proposal is that banks mayencourage some of their customers to buy the subordinated debt
Portfolio Institutions Tomorrowrsquos Problem
Before proceeding to the issues of international supervision we flag an-other potential problem for national regulators The big asset managersprofiled in tables 24 and 26 answer to diverse groups of pensionersshareholders and policyholders They allocate funds across a number ofcountries to diversify their risks They hold liquid assets that can be tradedand they have a higher proportion of long-term assets than banks Eco-nomic shocks can be absorbed through price changes and their effectsspread across time and markets Thus when conditions change in a par-ticular market they are more likely to ride out the storm than to flee Inother words they have less incentive than banks to pull their invest-ments in the face of adversity In the 1990s most large asset managersestablished a record of ldquoriding out the stormrdquo rather than ldquorunning withthe windrdquo although as we saw in chapter 1 instances of running withthe wind were detected in some portfolios As we write these insti-tutions have a good record overall in the emerging markets so whyworry
The Russian crisis and the near-collapse of LTCM previewed the dan-gers that may await future portfolio managers and G-10 financial minis-ters We have presented evidence indicating a systemic bias toward bank
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112 WORLD CAPITAL MARKETS
lending and debt finance to emerging markets and we have argued forsubstitution toward equity finance and direct investment39
That is not the end of the story We noted in the previous chapterthat institutional investors can become momentum investors selling in adownturn As more portfolio capital is invested in emerging marketssome players may adopt the high-risk high-leverage strategies of themost aggressive hedge funds Indeed the data in box 11 show that G-10portfolio investors held somewhat more long-term debt (more than $500billion) than equity (less than $400 billion) in emerging markets at theend of 1997 Long-term debt is an ideal vehicle for high-risk high-leveragestrategies These strategies practiced on a large scale could compound afuture crisis harming emerging markets A big enough crisis could inturn pressure G-10 central banks and finance ministers to arrange bail-out plans Instead of shrinking as a systemic financial problem moralhazard could increase
National securities regulators are the first line of defense against thisscenario They play a critical role in the safe evolution of capital mar-kets But regulators today are mandated to approve the issuance of newsecurities and to monitor the continuing disclosure of material informa-tion by issuers They are far less concerned with or empowered to monitorthe behavior of the increasingly large wealth-management firms that arethe major purchasers (and therefore resellers) of these securities
Within their mandates the goals of national securities regulators (table210 and appendix B) are similar to the concerns of bank regulators withsystem safety and soundness Their focus is also on the incentive sys-tems for management and boards of directors and on disclosure by cor-porations that issue marketable securities such as shares bonds andasset-backed securities 40 Issuers of securities possess greater knowledgeabout the quality of these assets than do the purchasers hence investorprotection is a key concern of regulators Moreover market disciplineworks best when markets know what is happening Well-functioning corpora-tions are key agents of wealth creation and social progress Underperform-ing corporations waste resources During recessions bad corporationsget into bad trouble often with severe social consequences Inadequateincentives for managers and inadequate accountability for boards andmanagers thus have negative externalities Regulators play a vital role inexposing weakness so that market disciplines come to bear sooner ratherthan later
Regulatory emphasis is constantly shifting as financial markets evolveand as the macroeconomic environment changes Regulators try to balance
39 See Rogoff (1999) Also see Berlin (2000) for a perspective on the limited role thatbanks play as share owners
40 See Habib and Ljungqvist (2000) for recent empirical analysis showing that corporateshare market values are higher when corporate executives have a larger ownership stake
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Table 210 Financial-sector regulation G-10 countries 2000
Financial institutions and their supervisors
Country and supervisory structure Retail banking Wholesale banking Securities Insurance
Financial conglomeratesFinancial Services Authority (FSA) = umbrella supervisor
United Kingdom FSA FSA FSA FSA
Treasury bull Commercial banks bull Investment funds (Securities and (Insurance Directorate(Securities and Investments Board) bull Unit trust groups Futures Authority) of the Treasury)
Bank of bull Building societies bull Pension funds England (Building Societies Commission) bull Merchant banks
bull Friendly societies bull Clearing houses bull Primary issuers bull Insurance FSA (Friendly Societies Commission) bull Venture capital of securities companies
bull Pensions and life insurance etc bull Stock exchanges bull Insurance brokers(Personal Investment Authority) bull Stockbrokers
Financial holding companiesFederal Reserve (FR) = umbrella supervisor
United States bull National banks(OCC) Securities and Regulated by
Treasury OCC bull State banks Federal Reserve Exchange Commission StatesMembers (FR)
OTS Nonmembers (FDIC) bull Investment banks bull Primary issuers of bull Insurance companies FR bull Cooperative banks (FDICFR) bull Finance companies securities bull Insurance brokers FDIC bull Insured industrial banks (FDIC) bull Stock exchanges
bull Thrift holding companies (OTS) bull Stockbrokers SEC bull Savings banks (OTSFDICFR) bull Investment advisors
bull Savings and loan associations bull Mutual funds(OTS) bull Public utility holding
bull Edge Act corporations (FR) companies
(table continues next page)
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Table 210 Financial-sector regulation G-10 countries 2000 (continued )
Financial institutions and their supervisors
Country and supervisory structure Retail banking Wholesale banking Securities Insurance
Financial holding companies Japan Financial Supervisory Authority (FSA) = umbrella supervisor
Prime FSA FSA FSA FSA ministerrsquos Ministry of office Finance (Securities and Exchange
Surveillance Commission) FRC Bureau of Financial bull City banks bull Investment banks bull Primary issuers of bull Insurance companies FSA Regulation bull Regional banks bull Asset managers securities bull Insurance brokers
bull Trust banks bull Stock exchanges SESC bull Long-term credit banks bull Stockbrokers
bull Pension funds
Financial holding companiesOffice of the Superintendent of Financial Institutions (OSFI) = umbrella supervisor
Canada Regulated by OSFI OSFI provinces OSFI
Department of Financebull Banks bull Cooperative credit bull Primary issuers of bull Insurance companies
(previously Office of the Inspector associations securities (previously Depart- OSFI General of the Banks) bull Fraternal benefit bull Stock exchanges ment of Insurance) Bank of bull Trust and loan companies society bull Stockbrokers bull Insurance brokers Canada bull Pension funds bull Asset managers
(previously Depart- CDIC ment of Insurance)
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Financial institutions and their supervisors
Country and supervisory structure Retail banking Wholesale banking Securities Insurance
Germany Financial holding groupsFederal Banking Supervisory Office (FBSO) = umbrella supervisor
Ministry of Finance FBSO BSO FSSO FISO
Bundesbankbull Universal banks bull Other financial bull Primary issuers of bull Insurance companies
Federal Banking bull Savings banks institutions (eg securities bull Insurance brokers Supervisory Office bull Securities banks management foreign bull Stock exchanges
currency dealings) bull Stockbrokers Federal Securities bull Financial enterprises bull Asset managers Supervisory Office (eg leasing bull Pension funds
organizations Federal Insurance credit card companies Supervisory Office investment advisors)
Italy Bank foundationsMinistry of Finance = umbrella supervisor
Ministry of Finance Bank of Italy Bank of Italy Consob ISVAP
Bank of Italy bull Commerical banks bull Asset managers bull Primary issuers of bull Insurance companies Consob bull Savings bank bull Open-end investment securities bull Insurance brokers
bull Securities banks companies (SICAVs) bull Stock exchangesbull Stockbrokers
ISVAP
(table continues next page)
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Table 210 Financial-sector regulation G-10 countries 2000 (continued )
Financial institutions and their supervisors
Country and supervisory structure Retail banking Wholesale banking Securities Insurance
The Netherlands Financial conglomeratesCouncil of Financial Supervisors = umbrella supervisor
Securities Board Securities Board Netherlandsche Netherlands Bank Netherlandsche Bank of the Netherlands Insurance Board Bank Insurance bull Credit institutions (universal banks bull Investment institutions bull Stock exchanges bull Insurance companies Board cooperative banks security credit (securities issuing bull Stockbrokers bull Insurance brokers
institutions mortgage banks) and tradingmdashprimary The Council of Financial and secondary Supervisors markets)
France Commission des Commission de Operations des Controcircle des
Banking and Banking Commission Bourse Assurances Financial Regulatory bull Ensuring that credit institutions (and investment firms since bull Primary issuers of bull Insurance companies Ministry for Committee the Financial Activity Modernization Act of 1996) comply securities bull Insurance brokers Economic with laws and regulations bull Stock exchanges Affairs and bull Execute instructions regarding all off-site monitoring and bull Stockbrokers Finance Credit on-site supervision Institutions and Banking and Financial Regulatory Committee Investment bull Formulates general regulations for credit institutions and investment firms Committee (capital adequacy requirements accounting rules etc) Bank of France Credit Institutions and Investment Committee Banking bull Authorizes and examines financial institutions except for those within the Commission competence of the Banking Commission
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Financial institutions and their supervisors
Country and supervisory structure Retail banking Wholesale banking Securities Insurance
Switzerland Large banking groupSwiss Federal Banking Commission (SFBC) = umbrella supervisor
Swiss National Bank Federal Office of
SFBC SFBC SFBC Private Insurance Swiss Federal Banking Commission bull Universal banks bull Investment banks bull Primary issuers of bull Insurance companies
bull Savings banks bull Asset management securities bull Insurance brokerscompanies bull Stock exchanges
Private audit Federal bull Investment funds bull Stockbrokers firms Office of bull Mortgage bond authorized by Private business SFBC Insurance
Sweden Financial holding company groupsFinancial Supervisory Authority = umbrella supervisor
Ministry of Finance Credit Market Securities Market Insurance Market
Credit Market Department Department Department Department
Financial bull Commercial banks bull Investment funds bull Primary issuers of bull Insurance companies Riksbank Supervisory bull Savings banks securities bull Insurance brokers Authority bull Friendly societies bull Stock exchanges
bull Stockbrokers
(table continues next page)
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Table 210 Financial-sector regulation G-10 countries 2000 (continued )
Financial institutions and their supervisors
Country and supervisory structure Retail banking Wholesale banking Securities Insurance
Belgium Bank holding companiesBanking and Finance Commission = umbrella supervisor
Bank of Belgium Banking Banking
Banking and Finance and Finance Insurance Controland Finance Commission Commission Commission Office
Banking and Insurance Finance Control bull Commercial banks bull Asset management bull Primary issuers of bull Insurance companies Commission Office bull Savings banks firms securities bull Insurance brokers
bull Securities banks bull Investment funds bull Stock exchanges bull Mortgage companiesbull Stockbrokers bull Pension funds
Securities Regulation Fund Securities Regulation Fund
bull Other investment firms and credit institutions(institutions participating in regulated off-exchangemarket in strips and Treasury certificates)
Bank holding companies Spain Banco de Espantildea = umbrella supervisor
Banco de Espantildea Comision Nacional del Mercado de Directorate General
Banco de Espantildea Valores (CNMV) Insurance
bull All credit institutions (commercial banks savings banks credit bull Primary issuers of (Ministry of Economy Ministry of cooperatives official credit institutions finance factoring and securities and Finance) Economy and CNMV leasing companies mortgage-loan companies etc) bull Stock exchanges bull Insurance companies Finance bull Interbank foreign exchange and book-entry public debt bull Stockbrokers bull Pension funds
markets bull Venture capital(companies and funds)
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119
Financial institutions and their supervisors
Country and supervisory structure Banking Securities Insurance
Banking Advisory High Level Securities Supervisors Committee (BAC) Committee (HLSS) Insurance Committee (IC)
Supranational (EU) bull Formulates standards for prudential bull Coordination of securities market bull Formulates standards forsupervision supervision prudential supervision
BACICHLSS Banking Supervision
Conglomerates Committee (BSC) Securities Contact Committee Regulation of prudential bull Systemic risk monitoring bull Regulation and implementation of supervision securities admission
International Association International International Organization of of Insurance Supervisors
Basel Committee Securities Commisison (IOSCO) (IAIS) Joint Forum Conglomerates Supervision bull Supervision and regulation best bull Supervision and regulation best bull Supervision and regulation amp regulation Best practices practices practices best practices
FSF Coordination across supervisors of various functions
Notes See appendix B for more information Boldface type indicates senior or oversight supervisor normal type indicates adjunct or front-line supervisorsolid line indicates direct responsbility to the senior-ranking authority dotted line indicates coordination in supervisory activities
(table continues next page)
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S
Table 210 Financial-sector regulation G-10 countries 2000 (continued )
Glossary of names United Kingdom FSA = Financial Services Authority United States FR = Federal Reserve OCC = Office of the Comptroller of theCurrency FDIC = Federal Deposit Insurance Corporation SEC = Securities and Exchange Commission OTS = Office of Thrift Supervision Japan FRC =Financial Reconstruction Commission FSA = Financial Services Agency SESC = Securities and Exchange Surveillance Commission Canada OSFI =Office of the Superintendent of Financial Institutions CDIC = Canada Deposit Insurance Corporation Germany FBSO = Federal Banking SupervisoryOffice FSSO = Federal Securities Supervisory Office FISO = Federal Insurance Supervisory Office BSO = Banking Supervisory Office Italy Consob =Commissione Nazionale per le Societa e la Borsa ISVAP = Instituto per la Vigilanza sulle assicurazioni private e di Interesse colletivo Switzerland SFBC= Swiss Federal Banking Commission Spain CNMV = The Comision Nacional del Mercado de Valores Supranational BAC = Banking Advisory CommitteeBSC = Banking Supervision Committee IC = Insurance Committee HLSS = High Level Securities Supervisors Committee International Dimension FSF =Financial Stability Forum IOSCO = International Organization of Securities Commission IAIS = International Association of Insurance Supervisors
Sources United Kingdom Bank of England httpwwwbankofenglandcouk Financial Services Authority httpwwwfsagovuk United States Board ofGovernors of Federal Reserve System httpwwwfederalreservegov Japan Bank of Japan httpwwwbojorjo Financial Reconstruction Commissionhttpwwwfsagojpfrcindexehtml Financial Services Agency httpwwwfsagojp Canada Bank of Canada httpwwwbank-banque-canadaca Office ofthe Superintendent of Financial Institutions httpwwwosfi-bsifgccaAndreEindexhtml Germany Deutsche Bundesbank httpwwwbundesbankde Fed-eral Banking Supervisory Office httpwwwbakredde Italy Banca drsquoitalia httpwwwbancaditaliait Commissione Nazionale per le Societa e la Borsahttpwwwconsobit Instituto per la Vigilanza sulle assicurazioni private e di Interesse colletivo httpwwwisvapit The Netherlands De NederlandscheBank httpwwwdnbnl France Banque de France httpwwwbanque-francefr Switzerland Schweizerische Nationalbank httpwwwsnbchindex3htmlSweden Sveriges Riksbank httpwwwriksbanksedefaultasp Belgium National Bank of Belgium httpwwwbnbbesgindexhtm Spain Banco de Espantildeahttpwwwbdees The Comision Nacional del Mercado de Valores httpwwwcnmves Supranational (EU) Institutional Arrangements for the Regulationand Supervision of the Financial Sector 2000 International Dimension Bank for International Settlement httpwwwbisorg International Organization ofSecurities Commissions httpwwwioscoorg International Association of Insurance Supervisors httpwwwiaisorg Financial Stability Forum httpwwwfsforumorg
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 121
the inflexibility of tight surveillance against the need to encourage in-novation and growth The US Securities and Exchange Commission isworried about aggressive accounting by firms and biased reports bysecurities analysts in an equity environment that prizes steadily higherquarterly earnings41 Japanese regulators are preoccupied with opaqueinterconnections between portfolio institutions banks and nonfinancialfirms through the keiretsu system Canadian regulators reeling from high-profile scandals of managers intentionally misleading investors are strengtheningmarket discipline through legal penalties aimed at managers and directorsof offending firms
When panic strikes a securities regulator cannot do much As the 1987stock market crash and the LTCM debacle in the fall of 1998 both dem-onstrated steep stock and bond price declines can create systemic risksIf severe enough the wealth effect of falling securities values and thefear of widespread insolvency can depress real activity Flooding thesystem with liquidity is a central bankerrsquos solutionmdashsomething a securi-ties regulator cannot do42 But just as financial supervisors can changethe incentive structure to discourage bankers from making risky loans ingood times so securities regulators can pay more attention to incentiveson the demand side when capital markets are strong
Prudential Supervision and InnovationmdashA Footnote
In concluding this discussion of prudential supervision in the G-10 anadditional point is worth noting National regulators face a persistenttrade-off between emphasizing financial system safety and soundnesswhile encouraging innovationmdashin spite of the added risks innovationbrings to financial markets Former US Treasury Secretary Lawrence Summers(2000 3) has argued by analogy
The jet airplane made airplane air travel more comfortable more efficient andmore safe though the accidents were more spectacular and for a time morenumerous after the jet was invented In the same way modern global financialmarkets carry with them enormous potential for benefit even if some of theaccidents are that much more spectacular As the right public policy response
41 The problem is illustrated by the divergence since mid-1998 between reported earn-ings by the Standard amp Poorrsquos (SampP) 500 and the after-tax profits of all corporations inthe national accounts Generally these two series move closely with one another Be-tween mid-1998 and mid-1999 SampP 500 reported that earnings increased by more than20 percent while after-tax profits of all corporations increased by less than 5 percent(Chase Bank US Economic and Policy Research US Weekly Prospects Chase SecuritiesWeekly Newsletter 5 June 2000 5)
42 For example the US Securities and Exchange Commission had no direct role in calmingmarkets in the 1987 or 1998 panics
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122 WORLD CAPITAL MARKETS
to the jet was longer runways better air-traffic control and better training forpilots and not the discouragement of rapid travel so the right public policyresponse to financial innovation is to assure a safe framework so that the ben-efits can be realized not to stifle the change
Accepting Summersrsquos analogy for the international financial system better-informed supervisors and investors are a necessary part of the financialsystem framework Supervisors require more timely information on therisk profiles resulting from positions taken by financial institutions Theyalso need a better understanding of risk-management systems Snapshotsof an institutionrsquos risk profile and risk-management procedures are nolonger adequate In a world where huge bets are quickly made (andpossibly lostmdashas with Barings Bank in 1995 and LTCM in 1998) super-visors must focus on the soundness of banking systems for evaluatingand managing risk on a daily basis Some progress has been made inaddressing these issues US banking examiners are extending their in-formation requirements in banking examinations and increasing theirinvolvement in large complex institutions43 More awareness is alsorequired of the fact that they are national organizations in a world ofcross-border capital flows To a much greater extent they need a multi-national reach International supervision and coordination among super-visors are the subject of the next section
Our analysis suggests that G-10 supervisors have unfinished businessBank supervisors need to start yesterday securities regulators can waituntil tomorrow One G-10 member acting alone cannot correct the biasIn good times the lending business will simply migrate to other G-10banks In bad times financial problems will not stop at the national bor-der A way has to be found to establish common international standardsfor the key financial players in order to prevent crises and to agree onapproaches for managing them The path has already been laid out Inthe wake of the bank failures of the past 25 years bank supervisors havetried to establish such standards They have done this without creating anew global institution
The essence of the international framework is decentralizationmdashglobalrules and design standards without global institutions that are perceivedto intrude on national sovereignty The awkward jargon for this frame-work is vertical subsidiaritymdashldquothink internationally act nationallyrdquo Theinternational thinking is done by a committee of regulators that meets
International SupervisionA Decentralized Framework
43 These issues are discussed in Ferguson (1999) and Meyer (2000a)
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 123
regularly at the Bank for International Settlements in Basel The commit-tee establishes principles and standards that are interpreted implementedand enforced by national authorities44 In this section we describe thesesupervisory efforts and their weaknesses We present our recommenda-tions for addressing these weaknesses in the next chapter
Basel I
The Basel Capital Accord of 1988 (Basel I)45 drew the lesson from thefinancial crises of the mid-1970s that more adequate capital levels in in-ternational banks would help reduce the systemic risk of bank failureThe primary goal of Basel I was capital adequacy other standards wereput in place not so much for their own virtue as to defend the primarygoal
Capital adequacy requirements were designed to ensure that individualinstitutions have the ability to absorb losses particularly credit lossesAccordingly a backup system of scoring credit risk was devised thatrequired large amounts of bank capital for some types of loans smalleramounts for others and zero for a select list of preferred assets Report-ing requirements were designed to disclose problems and ensure that atroubled bank would take timely steps to restore its capital base in thewake of a loss The Basel I framework worked tolerably well in limitingthe call on the public purse in the G-10 countriesmdashwith the notable ex-ceptions of France and Japan The framework failed to moderate riskybank lending to emerging markets however
Basel I was not developed with emerging markets in mind The origi-nal idea behind it was to develop a common supervisory approach tocross-border banking operations It grew out of political pressure fromUS lawmakers who were determined to require international banks op-erating in the United States to meet US banking standards Toward thisgoal in 1983 Congress passed the International Lending Supervisory ActUS and British banking authorities subsequently agreed on a commontarget the adoption of strict common capital-adequacy standards In 1988other G-10 governments agreed to go along voluntary acceptance ofthe standards throughout much of the rest of the world followed46 Therationale for the capital targets was two-fold The first was to requirebanks to hold sufficient amounts of capital (8 percent of risk-adjusted
44 The international committee of financial authorities agreed on a common definitionof banksrsquo tier-one or ldquocorerdquo capital national authorities defined tier-two capital in theirown manner which permitted greater variations in national working definitions andpractices
45 International Convergence of Capital Measurement and Capital Standards (BIS 1988)was prepared by the Basel Committee on Banking Supervision
46 See Reineke (1998)
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124 WORLD CAPITAL MARKETS
assets) to cushion losses on those assets The second was to dull theirappetites for risk banks with large capital bases would have more tolose if they failed and therefore would take fewer risks
Rapid change in financial markets soon revealed flaws in the Basel IAccord In a complex world with numerous sources of risk it focusedheavily on credit risk but overlooked other risks in a bankrsquos portfolioand the correlation between returns on different asset classes The Baselformula required banks to maintain a fixed amount of capital againsteach of its asset classes But the formula did not distinguish the riskinessof the borrower within each class As a result one large loan to a low-risk corporate borrower such as General Electric would require the sameamount of capital as 10 smaller transactions with high-risk borrowers
The system was also biased toward short-term loans Loans maturingin less than a year required a 20 percent risk weight whereas those ma-turing after more than a year required a 100 percent risk weight Inter-bank lending was particularly favored For example loans to banks inOECD countries required less capital than loans to private firms in thesame countries creating the anomaly that interbank loans to South Ko-rean banks required less capital than loans to General Electric47 Thisanomaly encouraged banks to shed high-quality assets if the Basel rulesrequired the allocation of more capital than banks thought they needed
Another weakness was that financial innovators quickly circumventedthe Accord Because short-term loans required less provisioning than long-term loans banks responded by securitizing their long-term debt port-folios and lending short-term against the collateral of the newly createdasset This allowed banks to circumvent the capital requirements gearedto the terms of the underlying debt At the same time the Basel I Accordfailed to encourage risk mitigation techniques such as credit derivativescollateral guarantees and on-balance-sheet netting the flip side of fi-nancial innovation Because off-balance-sheet products were not coveredby the Accord another anomaly appeared when Barings Bank collapsedin 1995 Barings met capital adequacy standards but collapsed becauseits systems for managing risk failed traders were allowed to speculatein futures contracts that did not appear on the balance sheet
Basel II
Work to overhaul Basel I began in 1995 and produced consultativepapers issued in June 1999 and January 200148 These papers have been
47 South Korean banks have had notoriously weak balance sheets because the practiceof ldquodirected lendingrdquo left them with many poor loans (in making these loans the bankswere expected to follow government objectives rather than creditworthiness criteria)
48 Basel Committee on Banking Supervision (1999 2001)
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 125
the subject of extensive consultation and revision as a result the newAccord is expected to be introduced in 200449 The Basel II frameworkhas three parts (pillars) revisions to Basel I minimum-capital require-ments supervisory review criteria and greater emphasis on market dis-cipline Broadly Basel II aims to maintain the level of capital in the sys-tem but achieve better alignment of banksrsquo capital with their risk pro-files and keep up with financial innovation
To align capital requirements with market realities (the first pillar)Basel II concentrates on the 100 or so largest banksmdashthe type of playerslisted in table 21mdashand on the holding-company parents of banking groups50
Capital requirements will differentiate between an increased number ofcredit groups or ldquorisk bucketsrdquo including claims on governments otherbanks corporations mortgage-backed securities and other asset-backedsecurities
Basel II originally proposed to use external ratings to set capital chargesfor a number of these credit risks Many banks objected arguing thatthey assess credit risk better than Standard amp Poorrsquos Moodyrsquos or FitchIBCA51 Basel II thus proposes two approaches to rating a standard ap-proach using external ratings and an ldquoadvancedrdquo approach that allowsselected banks to use their own internal rating systems To encouragethe development of rigorous internal control systems based on these in-ternal rating systems Basel II also proposes to levy capital charges foroperational risk (the risk of direct or indirect loss resulting from inad-equate or failed internal processes people and systems or from exter-nal events)
Some critics of this proposal dismiss it as an abrogation of the prin-ciple of external independent monitoring and as ldquodangerously naiumlverdquo52
But regulators argue that the new capital charge on operational risk shouldoffset this concern It is also far from clear how cross-national compari-sons of rating and internal risk-assessment systems will be made (Engelen2000) The development by the European Union of its own capital rulescould well complicate the international resolution of these issues Publicassurances by EU officials in January 2001 however indicated that theirmain concerns are to create a level playing field and avoid regulatoryarbitrage (Hargreaves 2001) There is also the significant problem ofthe procyclical character of risk weights When a crisis hits losses are
49 See Berry (2000) for an update in an interview with William J McDonough chair ofthe Basel Committee on Banking Supervision
50 For obvious reasons these proposals are addressed to large banks and simpler capi-tal standards are allowed for small banks that focus on their domestic credit markets
51 See Ammer and Packer (2000) for an empirical critique of the success of rating agen-cies in distinguishing risk by sector and region
52 See Auerback (2001)
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126 WORLD CAPITAL MARKETS
incurred or accrued capital is lost and loan exposure must be reducedor securities sold to restore the requisite capital-adequacy ratios A morerisk-sensitive framework could amplify volatility
As the second pillar of Basel II supervisory review criteria are beingbeefed up to encourage supervisors to intervene earlier in potential problemsituations and to compel banks to align their capital positions with theirrisk profiles Bank supervisors will be authorized to require banks tohold capital in excess of minimum requirements if they have concernsabout general management overall strategy risk-management performanceor the macroeconomic environment Of course if one G-10 supervisorimposes higher capital requirements in isolation the same disparity willemerge that presaged Basel I Some banks will be disadvantaged in theinternational marketplace and will loudly complain that excessive super-vision is driving business to their competitors Hence close internationalcooperation among supervisors is critical
To implement the third pillar market discipline banks will be requiredto make fuller more timely disclosure of capital adequacy and the risksto which that capital is exposed A number of measures are being stud-ied that might help supervisors evaluate bank performance such as com-parisons of uninsured deposit interest rates subordinated debt yieldsand equity prices The idea is that these yields and prices might alertsupervisors to market perceptions of risk Of course market perceptionsare only as good as market information More direct and controversialways to reinforce market discipline would dramatically increase publicdisclosure of bank positions and risk management systems
Many questions are still outstanding about how to resolve the techni-cal details of capital requirements and whether the requirements willachieve their intended goal of better assessment and mitigation of therisks in banksrsquo portfolios There is no substitute for skilled supervisorsThe intricacies of effective design and implementation suggest that su-pervisors need to be highly competent technically knowledgeable aboutbanking portfolio characteristics and the factors that influence bank ex-posure to credit risk (Mishkin 2000) And they must be aided by vigilantshareholders market forces and transparency of information53
Standard setting at the global level is desirable but ultimately theeffectiveness of these efforts will be tested at the national level espe-cially in times of systemic financial distress Here the record of Basel Iwas not a bright shining success Japanese banking regulators havetraditionally allowed banks to include real estate and securities in theircapital base When the value of these assets plummeted in the early 1990sregulators allowed banks to continue valuing these depreciated (andoften bankrupt) assets at their old inflated levels Japanese authorities
53 Benedict Roth Complacency Towards Catastrophe Financial Times 23 January 2001
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 127
insisted until the mid-1990s that eroded capital bases could be rebuiltin a market-driven fashion They rightly foresaw that huge loan losseswould undermine public support for the ruling party and require a po-litically unpopular bailout
Japanese foot dragging on Basel I was the worst54 but not uniqueOther examples can be found of ldquopolitically mandated forbearancerdquo TheFederal Reserve Bank of New York held important hands during theLTCM crisis of 1998 Mexico is still resolving the banking crisis that eruptedin 1995 South Korea has not yet closed the insolvent banks that behavedso badly before the crisis of 1998 In the aftermath of a crisis nationalregulators cannot always be relied upon to discipline politically power-ful bankers55 One of the little-noticed consequences of these differingapproaches is that those banks with strong regulatory systems receivedan implicit ldquoexport subsidyrdquo for their services US banks which had notengaged extensively in emerging-market lending in the 1990s were bet-ter positioned than their German and Japanese counterparts to expandtheir international assets in the wake of the crises
Other Financial Forums
54 See Japanese Banks Fiddling while Marunouchi Burns The Economist 27 January2001 67-69
55 See Calomiris (1997)
The Basel model of vertical subsidiarity has already been extended toother financial regulatory bodies In 1993-94 the BIS established a Tri-partite Group of Banking Insurance and Securities Regulators In 1994-95 the BIS increased its cooperation with the International Organizationof Securities Commissions when the two organizations issued parallelpapers on guidelines for national regulators concerning risk managementand disclosure of derivative trades In 1996 a permanent Joint Forum onFinancial Conglomerates was established to examine supervisory issuesand develop working arrangements among the different functional super-visors of conglomerate institutions that offer combinations of bankingsecurities and insurance products Draft papers on the supervisionof conglomerates were released for comment in 1998 applying capital-adequacy principles to these groups and providing guidelines both forassessing the integrity and competence of top managers and for sharingassessments between regulators
In 1997 the Basel Committee on Banking Supervision extended itsreach beyond capital standards to broader aspects of banking supervi-sion with the publication of the Core Principles for Effective BankingSupervision In 1999 a wide range of regulatory and standard-settingbodies were gathered under the umbrella of the Financial Stability
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128 WORLD CAPITAL MARKETS
Forum (FSF) itself established under BIS aegis56 The FSF has alreadyissued recommendations for stepped-up supervision and transparencyas well as guidelines for best practices in a number of areas includingoffshore financial centers and highly leveraged institutions or hedge funds57
Conclusion
Although the structural weaknesses in emerging-market economies arewidely acknowledged to have been causal factors in international capi-tal-market volatility this chapter points to the role of large G-10 bankingorganizations as major suppliers of the most volatile instrument short-term debt We have examined evidence of the impact of public safetynets in the G-10 economiesmdashthe deposit insurance systems the pruden-tial supervisory systems and the lender-of-last-resort functions of centralbanksmdashon the incentive structures of these organizations
Although supervisors in most countries working nationally and to-gether in the BIS have made significant efforts to mimic market forcesin their prudential supervision the most sophisticated financial institu-tions find innovative ways to circumvent the rules New global regulatorybodies are not about to be created G-10 national bank regulators shouldthemselves address the short-term debt bias in the international financialsystem by changing incentive systems G-10 securities regulators shouldalso take steps to get ahead of the curve paying close attention to largeportfolio swings by institutional investors particularly in times of crisisIn short more needs to be done at national and international levels tochange the rules of the game That is the subject of the next chapter
56 The Financial Stability Forum includes banking securities insurance and accountingregulatory bodies the OECD on taxation corruption and corporate governance and theIMF
57 See Martin (2000)
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108W
OR
LD
CA
PIT
AL
MA
RK
ET
S
Table 29 Deposit insurance schemes in the G-10 countries Explicit safety net (continued )
Coverage limit(dollar Foreign
equivalent currency Interbank Source Bankrsquos Contingency fundingDate Membership Co- at end of deposit deposit of premium from banks
Country established managementa insuranceb July 1998)c covered covered Fundingd funding costs or governments
Netherlands 1979 Compulsory No 22000 Yes No Unfunded Banks and On demand Government backing official government maximum of subject to parliamentary
5 percent of own approval funds
France 1980 Compulsory No 65400 No No Unfunded Banks only Callable (on Extra calls up to FFr1000 private demand calls million can be made in
up to FFr200 a 5-year period million)
Switzerland 1984 Voluntary No 19700 No No Unfunded Banks only Callable (on Underwritten by member official demand) banks
Sweden 1996 Compulsory No 31400 Yes No Funded Banks and 05 percent of Full emergency coverage official government deposits while replacing it with a
limited system after the emergency
Belgium 1974 Compulsory No 16600 No No Funded Banks and Callable 002 None insurance limited joint 22000 in government percent of to assets in fund
year 2000 deposits from clients
Spain 1977 Compulsory No 16439 Yes No Funded Banks and 02 percent of Government backing joint government deposits through the Banco de
(maximum) Espantildea subject to approval by royal decree
a Bank membership in the fund can be either compulsory or voluntary and the management of the fund can be official and official and private joint or privateb Coinsurance refers to the situation where depositors face a deductible against their insured fundsc Coverage limit refers to the explicit amount the authorities promise to insured Funded scheme means that it is funded ex ante unfunded otherwise
Sources Goodhart (1995) Demirguccedil-Kunt and Detragiache (2000) Demirguccedil-Kunt and Sabaci (2000)
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wiiecom
THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 109
base Explicit safety net protection also varies but only Canada focuseson the protected class33 All G-10 countries specify a limit on depositorprotection Under FDICIA the insurance fund is prohibited from pro-tecting uninsured depositors or creditors at a failed bank although adiscretionary system-wide override is provided for exceptional circum-stancesmdashbut with stringent requirements for consultation and account-ability Other G-10 countries allow for contingency funding from the publicpurse alongside unwritten lender-of-last-resort support Among large banksa significant and growing portion of deposit liabilities including foreigncurrency and interbank deposits are uninsuredmdashbut depositors assumethey will be protected in a crisis
FDICIA also made some significant qualitative changes to address theprincipal-agent problem by penalizing weak banks and rewarding strongbanks For example banks whose capital declined faced progressivelytougher regulatory sanctions that for example required them to elimi-nate dividends restrict their lending and change their managementsRegulators have also been forced to take prompt corrective action (toreduce the practice of regulatory forbearance in hopes that a bankrsquos for-tunes might improve)34 Unfortunately comparative qualitative assess-ments across the G-10 are difficult to make due to lack of information35
This discussion highlights the complexity of evaluating the extent towhich prudential supervision and market discipline reduce the moralhazard associated with G-10 safety nets Our argument is that publicsafety nets in the G-10 can be linked to banking instability in other coun-tries specifically in the emerging-market economies that have attractedG-10 cross-border bank lending This lending is a leading source of vola-tility in capital flows the large financial institutions many of which arecomplex banking organizations are based in and regulated by authori-ties in the G-10 economies These two features of the international finan-cial system are closely related although it is not possible to test thisrelationship econometrically
Two World Bank studies however indicate a basis for concern Onestudy is a cross-country econometric analysis of the relationship betweenbank stability and deposit insurance (Demirguccedil-Kunt and Detragiache2000) which found a negative relationship Their estimated model forbanking crises in a sample of 61 countries (both industrial and develop-ing) suggests that explicit deposit insurance raises the probability of acrisis by at least 30 percent36 Crises are especially likely in countries
33 Japanrsquos legislation says it does but recent experience shows this is not the case34 See Goldstein (1997) for a summary of the changes35 See Barth Nolle and Rice (2000) for a beginning in this area36 Demirguccedil-Kunt and and Detragiache (2000 table 1) report a logit coefficient of 0696with a standard error of 0397 (the coefficient is significant at the 8 percent threshold)This suggests that the ldquotruerdquo coefficient could well be as small as 030 (the reportedvalue minus the standard error)
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110 WORLD CAPITAL MARKETS
with immature financial supervisory systems (and not in the G-10) buttheir analysis does underscore the view that deposit insurance weakensmarket discipline37
An earlier World Bank analysis established similar results One wasthat market discipline is undermined by deposit insurance schemes an-other was that illiquid banks are forced to pay more for their funds un-less a generous deposit insurance scheme is in place (Demirguccedil-Kuntand Huizinga 1999) This econometric study also provides clear-cut evi-dence that depositor monitoring of banks declines with the existence ofdeposit insurance schemes At the heart of the problem is the questionof whether deposit insurance is accompanied by increased governmentmonitoring
This evidence and the weight of other arguments suggests that moralhazard is still an issue in the G-10 countries Consider the ongoing de-bate about instilling greater market discipline on risk taking by banksAt one extreme is the perennial proposal to do away with safety netsleaving markets to monitor the players and to force adjustments but toprotect small savers by creating ldquonarrow banksrdquo such as postal savingsystems that are allowed to invest these savings only in risk-free gov-ernment securities Whatever the merits of narrow banking this solutionis too extreme to be politically feasible
A moderate alternative is to force more disclosure by financial institu-tions to facilitate market monitoring But transparency has its own prob-lems Persaud (2000) argues that financial markets cannot reliably discernsustainable from unsustainable positions in the short term This uncer-tainty causes banks to ldquoherdrdquo behind market leaders to exploit theirsupposedly superior information ldquoThe more herding investors and bankersknow about what each other is up to the [more] unstable markets maybecomerdquo The implication is that greater transparency in the marketplaceby itself will not solve the problemmdashand in the short term more informa-tion may exacerbate herding Further supervisory steps (discussed in thenext chapter) are required
Yet another proposal is to promote private-sector involvement in bankmonitoring through market-based alternatives such as Calomirisrsquos sub-ordinated debt proposal (Calomiris 1997 Federal Reserve Board 1999)Banks could be required to issue and maintain a minimum amount of
37 Other findings in the Demirguccedil-Kunt and Detragiache (2000) study include thesepropositions The impact of deposit insurance on bank stability tends to be stronger themore extensive is the coverage offered to depositors when the scheme is funded andwhere the scheme is run by the government rather than by the private sector Con-versely deposit insurance is detrimental to bank stability where bank interest rates havebeen deregulated and where the institutional environment is weak Additional findingson deposit insurance are reported from a recent World Bank conference (8-9 June 2000httpwwwworldbankorgresearchinterestconfsupcomingdeposit_insurancehomehtm)Also see Smalhout (2001)
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 111
subordinated debt (eg uninsured certificates of deposit) to finance asmall fraction (such as 2 percent) of their total nonreserve assets Thesubordinated debt would be allowed to earn a set yield no more than 50basis points over the risk-free yield on government treasury bills Thisrule would supposedly force banks to operate in a safe manner Other-wise subordinated debt holders would redeem their uninsured certifi-cates of deposit and equity investors would sell their bank shares Despiteits practical problems the beauty of the subordinated debt requirementis that it enlists market incentives to push banks to avoid excessive port-folio risk38
The thrust of these proposals is very relevant to the arguments in ourstudy Even in the G-10 countries government monitoring by itself hasnot eliminated moral hazard among banks More work is needed to in-troduce market monitoring and to improve the incentive structures bothfor financial institutions and their supervisors We return to this issuewith our recommendations in the next chapter
38 In late 1996 Argentina began requiring its banks to finance 2 percent of total depos-its in the form of subordinated debt but without a maximum yield provision TheArgentine authorities expect that market discipline will act in concert with the publicsafety net One obvious problem with the subordinated debt proposal is that banks mayencourage some of their customers to buy the subordinated debt
Portfolio Institutions Tomorrowrsquos Problem
Before proceeding to the issues of international supervision we flag an-other potential problem for national regulators The big asset managersprofiled in tables 24 and 26 answer to diverse groups of pensionersshareholders and policyholders They allocate funds across a number ofcountries to diversify their risks They hold liquid assets that can be tradedand they have a higher proportion of long-term assets than banks Eco-nomic shocks can be absorbed through price changes and their effectsspread across time and markets Thus when conditions change in a par-ticular market they are more likely to ride out the storm than to flee Inother words they have less incentive than banks to pull their invest-ments in the face of adversity In the 1990s most large asset managersestablished a record of ldquoriding out the stormrdquo rather than ldquorunning withthe windrdquo although as we saw in chapter 1 instances of running withthe wind were detected in some portfolios As we write these insti-tutions have a good record overall in the emerging markets so whyworry
The Russian crisis and the near-collapse of LTCM previewed the dan-gers that may await future portfolio managers and G-10 financial minis-ters We have presented evidence indicating a systemic bias toward bank
Institute for International Economics | httpwwwiiecom
112 WORLD CAPITAL MARKETS
lending and debt finance to emerging markets and we have argued forsubstitution toward equity finance and direct investment39
That is not the end of the story We noted in the previous chapterthat institutional investors can become momentum investors selling in adownturn As more portfolio capital is invested in emerging marketssome players may adopt the high-risk high-leverage strategies of themost aggressive hedge funds Indeed the data in box 11 show that G-10portfolio investors held somewhat more long-term debt (more than $500billion) than equity (less than $400 billion) in emerging markets at theend of 1997 Long-term debt is an ideal vehicle for high-risk high-leveragestrategies These strategies practiced on a large scale could compound afuture crisis harming emerging markets A big enough crisis could inturn pressure G-10 central banks and finance ministers to arrange bail-out plans Instead of shrinking as a systemic financial problem moralhazard could increase
National securities regulators are the first line of defense against thisscenario They play a critical role in the safe evolution of capital mar-kets But regulators today are mandated to approve the issuance of newsecurities and to monitor the continuing disclosure of material informa-tion by issuers They are far less concerned with or empowered to monitorthe behavior of the increasingly large wealth-management firms that arethe major purchasers (and therefore resellers) of these securities
Within their mandates the goals of national securities regulators (table210 and appendix B) are similar to the concerns of bank regulators withsystem safety and soundness Their focus is also on the incentive sys-tems for management and boards of directors and on disclosure by cor-porations that issue marketable securities such as shares bonds andasset-backed securities 40 Issuers of securities possess greater knowledgeabout the quality of these assets than do the purchasers hence investorprotection is a key concern of regulators Moreover market disciplineworks best when markets know what is happening Well-functioning corpora-tions are key agents of wealth creation and social progress Underperform-ing corporations waste resources During recessions bad corporationsget into bad trouble often with severe social consequences Inadequateincentives for managers and inadequate accountability for boards andmanagers thus have negative externalities Regulators play a vital role inexposing weakness so that market disciplines come to bear sooner ratherthan later
Regulatory emphasis is constantly shifting as financial markets evolveand as the macroeconomic environment changes Regulators try to balance
39 See Rogoff (1999) Also see Berlin (2000) for a perspective on the limited role thatbanks play as share owners
40 See Habib and Ljungqvist (2000) for recent empirical analysis showing that corporateshare market values are higher when corporate executives have a larger ownership stake
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TH
E P
LAY
ER
S T
HE
IR S
UP
ER
VIS
OR
S A
ND
MO
RA
L HA
ZA
RD
113
Table 210 Financial-sector regulation G-10 countries 2000
Financial institutions and their supervisors
Country and supervisory structure Retail banking Wholesale banking Securities Insurance
Financial conglomeratesFinancial Services Authority (FSA) = umbrella supervisor
United Kingdom FSA FSA FSA FSA
Treasury bull Commercial banks bull Investment funds (Securities and (Insurance Directorate(Securities and Investments Board) bull Unit trust groups Futures Authority) of the Treasury)
Bank of bull Building societies bull Pension funds England (Building Societies Commission) bull Merchant banks
bull Friendly societies bull Clearing houses bull Primary issuers bull Insurance FSA (Friendly Societies Commission) bull Venture capital of securities companies
bull Pensions and life insurance etc bull Stock exchanges bull Insurance brokers(Personal Investment Authority) bull Stockbrokers
Financial holding companiesFederal Reserve (FR) = umbrella supervisor
United States bull National banks(OCC) Securities and Regulated by
Treasury OCC bull State banks Federal Reserve Exchange Commission StatesMembers (FR)
OTS Nonmembers (FDIC) bull Investment banks bull Primary issuers of bull Insurance companies FR bull Cooperative banks (FDICFR) bull Finance companies securities bull Insurance brokers FDIC bull Insured industrial banks (FDIC) bull Stock exchanges
bull Thrift holding companies (OTS) bull Stockbrokers SEC bull Savings banks (OTSFDICFR) bull Investment advisors
bull Savings and loan associations bull Mutual funds(OTS) bull Public utility holding
bull Edge Act corporations (FR) companies
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Table 210 Financial-sector regulation G-10 countries 2000 (continued )
Financial institutions and their supervisors
Country and supervisory structure Retail banking Wholesale banking Securities Insurance
Financial holding companies Japan Financial Supervisory Authority (FSA) = umbrella supervisor
Prime FSA FSA FSA FSA ministerrsquos Ministry of office Finance (Securities and Exchange
Surveillance Commission) FRC Bureau of Financial bull City banks bull Investment banks bull Primary issuers of bull Insurance companies FSA Regulation bull Regional banks bull Asset managers securities bull Insurance brokers
bull Trust banks bull Stock exchanges SESC bull Long-term credit banks bull Stockbrokers
bull Pension funds
Financial holding companiesOffice of the Superintendent of Financial Institutions (OSFI) = umbrella supervisor
Canada Regulated by OSFI OSFI provinces OSFI
Department of Financebull Banks bull Cooperative credit bull Primary issuers of bull Insurance companies
(previously Office of the Inspector associations securities (previously Depart- OSFI General of the Banks) bull Fraternal benefit bull Stock exchanges ment of Insurance) Bank of bull Trust and loan companies society bull Stockbrokers bull Insurance brokers Canada bull Pension funds bull Asset managers
(previously Depart- CDIC ment of Insurance)
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Financial institutions and their supervisors
Country and supervisory structure Retail banking Wholesale banking Securities Insurance
Germany Financial holding groupsFederal Banking Supervisory Office (FBSO) = umbrella supervisor
Ministry of Finance FBSO BSO FSSO FISO
Bundesbankbull Universal banks bull Other financial bull Primary issuers of bull Insurance companies
Federal Banking bull Savings banks institutions (eg securities bull Insurance brokers Supervisory Office bull Securities banks management foreign bull Stock exchanges
currency dealings) bull Stockbrokers Federal Securities bull Financial enterprises bull Asset managers Supervisory Office (eg leasing bull Pension funds
organizations Federal Insurance credit card companies Supervisory Office investment advisors)
Italy Bank foundationsMinistry of Finance = umbrella supervisor
Ministry of Finance Bank of Italy Bank of Italy Consob ISVAP
Bank of Italy bull Commerical banks bull Asset managers bull Primary issuers of bull Insurance companies Consob bull Savings bank bull Open-end investment securities bull Insurance brokers
bull Securities banks companies (SICAVs) bull Stock exchangesbull Stockbrokers
ISVAP
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Table 210 Financial-sector regulation G-10 countries 2000 (continued )
Financial institutions and their supervisors
Country and supervisory structure Retail banking Wholesale banking Securities Insurance
The Netherlands Financial conglomeratesCouncil of Financial Supervisors = umbrella supervisor
Securities Board Securities Board Netherlandsche Netherlands Bank Netherlandsche Bank of the Netherlands Insurance Board Bank Insurance bull Credit institutions (universal banks bull Investment institutions bull Stock exchanges bull Insurance companies Board cooperative banks security credit (securities issuing bull Stockbrokers bull Insurance brokers
institutions mortgage banks) and tradingmdashprimary The Council of Financial and secondary Supervisors markets)
France Commission des Commission de Operations des Controcircle des
Banking and Banking Commission Bourse Assurances Financial Regulatory bull Ensuring that credit institutions (and investment firms since bull Primary issuers of bull Insurance companies Ministry for Committee the Financial Activity Modernization Act of 1996) comply securities bull Insurance brokers Economic with laws and regulations bull Stock exchanges Affairs and bull Execute instructions regarding all off-site monitoring and bull Stockbrokers Finance Credit on-site supervision Institutions and Banking and Financial Regulatory Committee Investment bull Formulates general regulations for credit institutions and investment firms Committee (capital adequacy requirements accounting rules etc) Bank of France Credit Institutions and Investment Committee Banking bull Authorizes and examines financial institutions except for those within the Commission competence of the Banking Commission
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117
Financial institutions and their supervisors
Country and supervisory structure Retail banking Wholesale banking Securities Insurance
Switzerland Large banking groupSwiss Federal Banking Commission (SFBC) = umbrella supervisor
Swiss National Bank Federal Office of
SFBC SFBC SFBC Private Insurance Swiss Federal Banking Commission bull Universal banks bull Investment banks bull Primary issuers of bull Insurance companies
bull Savings banks bull Asset management securities bull Insurance brokerscompanies bull Stock exchanges
Private audit Federal bull Investment funds bull Stockbrokers firms Office of bull Mortgage bond authorized by Private business SFBC Insurance
Sweden Financial holding company groupsFinancial Supervisory Authority = umbrella supervisor
Ministry of Finance Credit Market Securities Market Insurance Market
Credit Market Department Department Department Department
Financial bull Commercial banks bull Investment funds bull Primary issuers of bull Insurance companies Riksbank Supervisory bull Savings banks securities bull Insurance brokers Authority bull Friendly societies bull Stock exchanges
bull Stockbrokers
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Table 210 Financial-sector regulation G-10 countries 2000 (continued )
Financial institutions and their supervisors
Country and supervisory structure Retail banking Wholesale banking Securities Insurance
Belgium Bank holding companiesBanking and Finance Commission = umbrella supervisor
Bank of Belgium Banking Banking
Banking and Finance and Finance Insurance Controland Finance Commission Commission Commission Office
Banking and Insurance Finance Control bull Commercial banks bull Asset management bull Primary issuers of bull Insurance companies Commission Office bull Savings banks firms securities bull Insurance brokers
bull Securities banks bull Investment funds bull Stock exchanges bull Mortgage companiesbull Stockbrokers bull Pension funds
Securities Regulation Fund Securities Regulation Fund
bull Other investment firms and credit institutions(institutions participating in regulated off-exchangemarket in strips and Treasury certificates)
Bank holding companies Spain Banco de Espantildea = umbrella supervisor
Banco de Espantildea Comision Nacional del Mercado de Directorate General
Banco de Espantildea Valores (CNMV) Insurance
bull All credit institutions (commercial banks savings banks credit bull Primary issuers of (Ministry of Economy Ministry of cooperatives official credit institutions finance factoring and securities and Finance) Economy and CNMV leasing companies mortgage-loan companies etc) bull Stock exchanges bull Insurance companies Finance bull Interbank foreign exchange and book-entry public debt bull Stockbrokers bull Pension funds
markets bull Venture capital(companies and funds)
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119
Financial institutions and their supervisors
Country and supervisory structure Banking Securities Insurance
Banking Advisory High Level Securities Supervisors Committee (BAC) Committee (HLSS) Insurance Committee (IC)
Supranational (EU) bull Formulates standards for prudential bull Coordination of securities market bull Formulates standards forsupervision supervision prudential supervision
BACICHLSS Banking Supervision
Conglomerates Committee (BSC) Securities Contact Committee Regulation of prudential bull Systemic risk monitoring bull Regulation and implementation of supervision securities admission
International Association International International Organization of of Insurance Supervisors
Basel Committee Securities Commisison (IOSCO) (IAIS) Joint Forum Conglomerates Supervision bull Supervision and regulation best bull Supervision and regulation best bull Supervision and regulation amp regulation Best practices practices practices best practices
FSF Coordination across supervisors of various functions
Notes See appendix B for more information Boldface type indicates senior or oversight supervisor normal type indicates adjunct or front-line supervisorsolid line indicates direct responsbility to the senior-ranking authority dotted line indicates coordination in supervisory activities
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Table 210 Financial-sector regulation G-10 countries 2000 (continued )
Glossary of names United Kingdom FSA = Financial Services Authority United States FR = Federal Reserve OCC = Office of the Comptroller of theCurrency FDIC = Federal Deposit Insurance Corporation SEC = Securities and Exchange Commission OTS = Office of Thrift Supervision Japan FRC =Financial Reconstruction Commission FSA = Financial Services Agency SESC = Securities and Exchange Surveillance Commission Canada OSFI =Office of the Superintendent of Financial Institutions CDIC = Canada Deposit Insurance Corporation Germany FBSO = Federal Banking SupervisoryOffice FSSO = Federal Securities Supervisory Office FISO = Federal Insurance Supervisory Office BSO = Banking Supervisory Office Italy Consob =Commissione Nazionale per le Societa e la Borsa ISVAP = Instituto per la Vigilanza sulle assicurazioni private e di Interesse colletivo Switzerland SFBC= Swiss Federal Banking Commission Spain CNMV = The Comision Nacional del Mercado de Valores Supranational BAC = Banking Advisory CommitteeBSC = Banking Supervision Committee IC = Insurance Committee HLSS = High Level Securities Supervisors Committee International Dimension FSF =Financial Stability Forum IOSCO = International Organization of Securities Commission IAIS = International Association of Insurance Supervisors
Sources United Kingdom Bank of England httpwwwbankofenglandcouk Financial Services Authority httpwwwfsagovuk United States Board ofGovernors of Federal Reserve System httpwwwfederalreservegov Japan Bank of Japan httpwwwbojorjo Financial Reconstruction Commissionhttpwwwfsagojpfrcindexehtml Financial Services Agency httpwwwfsagojp Canada Bank of Canada httpwwwbank-banque-canadaca Office ofthe Superintendent of Financial Institutions httpwwwosfi-bsifgccaAndreEindexhtml Germany Deutsche Bundesbank httpwwwbundesbankde Fed-eral Banking Supervisory Office httpwwwbakredde Italy Banca drsquoitalia httpwwwbancaditaliait Commissione Nazionale per le Societa e la Borsahttpwwwconsobit Instituto per la Vigilanza sulle assicurazioni private e di Interesse colletivo httpwwwisvapit The Netherlands De NederlandscheBank httpwwwdnbnl France Banque de France httpwwwbanque-francefr Switzerland Schweizerische Nationalbank httpwwwsnbchindex3htmlSweden Sveriges Riksbank httpwwwriksbanksedefaultasp Belgium National Bank of Belgium httpwwwbnbbesgindexhtm Spain Banco de Espantildeahttpwwwbdees The Comision Nacional del Mercado de Valores httpwwwcnmves Supranational (EU) Institutional Arrangements for the Regulationand Supervision of the Financial Sector 2000 International Dimension Bank for International Settlement httpwwwbisorg International Organization ofSecurities Commissions httpwwwioscoorg International Association of Insurance Supervisors httpwwwiaisorg Financial Stability Forum httpwwwfsforumorg
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 121
the inflexibility of tight surveillance against the need to encourage in-novation and growth The US Securities and Exchange Commission isworried about aggressive accounting by firms and biased reports bysecurities analysts in an equity environment that prizes steadily higherquarterly earnings41 Japanese regulators are preoccupied with opaqueinterconnections between portfolio institutions banks and nonfinancialfirms through the keiretsu system Canadian regulators reeling from high-profile scandals of managers intentionally misleading investors are strengtheningmarket discipline through legal penalties aimed at managers and directorsof offending firms
When panic strikes a securities regulator cannot do much As the 1987stock market crash and the LTCM debacle in the fall of 1998 both dem-onstrated steep stock and bond price declines can create systemic risksIf severe enough the wealth effect of falling securities values and thefear of widespread insolvency can depress real activity Flooding thesystem with liquidity is a central bankerrsquos solutionmdashsomething a securi-ties regulator cannot do42 But just as financial supervisors can changethe incentive structure to discourage bankers from making risky loans ingood times so securities regulators can pay more attention to incentiveson the demand side when capital markets are strong
Prudential Supervision and InnovationmdashA Footnote
In concluding this discussion of prudential supervision in the G-10 anadditional point is worth noting National regulators face a persistenttrade-off between emphasizing financial system safety and soundnesswhile encouraging innovationmdashin spite of the added risks innovationbrings to financial markets Former US Treasury Secretary Lawrence Summers(2000 3) has argued by analogy
The jet airplane made airplane air travel more comfortable more efficient andmore safe though the accidents were more spectacular and for a time morenumerous after the jet was invented In the same way modern global financialmarkets carry with them enormous potential for benefit even if some of theaccidents are that much more spectacular As the right public policy response
41 The problem is illustrated by the divergence since mid-1998 between reported earn-ings by the Standard amp Poorrsquos (SampP) 500 and the after-tax profits of all corporations inthe national accounts Generally these two series move closely with one another Be-tween mid-1998 and mid-1999 SampP 500 reported that earnings increased by more than20 percent while after-tax profits of all corporations increased by less than 5 percent(Chase Bank US Economic and Policy Research US Weekly Prospects Chase SecuritiesWeekly Newsletter 5 June 2000 5)
42 For example the US Securities and Exchange Commission had no direct role in calmingmarkets in the 1987 or 1998 panics
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122 WORLD CAPITAL MARKETS
to the jet was longer runways better air-traffic control and better training forpilots and not the discouragement of rapid travel so the right public policyresponse to financial innovation is to assure a safe framework so that the ben-efits can be realized not to stifle the change
Accepting Summersrsquos analogy for the international financial system better-informed supervisors and investors are a necessary part of the financialsystem framework Supervisors require more timely information on therisk profiles resulting from positions taken by financial institutions Theyalso need a better understanding of risk-management systems Snapshotsof an institutionrsquos risk profile and risk-management procedures are nolonger adequate In a world where huge bets are quickly made (andpossibly lostmdashas with Barings Bank in 1995 and LTCM in 1998) super-visors must focus on the soundness of banking systems for evaluatingand managing risk on a daily basis Some progress has been made inaddressing these issues US banking examiners are extending their in-formation requirements in banking examinations and increasing theirinvolvement in large complex institutions43 More awareness is alsorequired of the fact that they are national organizations in a world ofcross-border capital flows To a much greater extent they need a multi-national reach International supervision and coordination among super-visors are the subject of the next section
Our analysis suggests that G-10 supervisors have unfinished businessBank supervisors need to start yesterday securities regulators can waituntil tomorrow One G-10 member acting alone cannot correct the biasIn good times the lending business will simply migrate to other G-10banks In bad times financial problems will not stop at the national bor-der A way has to be found to establish common international standardsfor the key financial players in order to prevent crises and to agree onapproaches for managing them The path has already been laid out Inthe wake of the bank failures of the past 25 years bank supervisors havetried to establish such standards They have done this without creating anew global institution
The essence of the international framework is decentralizationmdashglobalrules and design standards without global institutions that are perceivedto intrude on national sovereignty The awkward jargon for this frame-work is vertical subsidiaritymdashldquothink internationally act nationallyrdquo Theinternational thinking is done by a committee of regulators that meets
International SupervisionA Decentralized Framework
43 These issues are discussed in Ferguson (1999) and Meyer (2000a)
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 123
regularly at the Bank for International Settlements in Basel The commit-tee establishes principles and standards that are interpreted implementedand enforced by national authorities44 In this section we describe thesesupervisory efforts and their weaknesses We present our recommenda-tions for addressing these weaknesses in the next chapter
Basel I
The Basel Capital Accord of 1988 (Basel I)45 drew the lesson from thefinancial crises of the mid-1970s that more adequate capital levels in in-ternational banks would help reduce the systemic risk of bank failureThe primary goal of Basel I was capital adequacy other standards wereput in place not so much for their own virtue as to defend the primarygoal
Capital adequacy requirements were designed to ensure that individualinstitutions have the ability to absorb losses particularly credit lossesAccordingly a backup system of scoring credit risk was devised thatrequired large amounts of bank capital for some types of loans smalleramounts for others and zero for a select list of preferred assets Report-ing requirements were designed to disclose problems and ensure that atroubled bank would take timely steps to restore its capital base in thewake of a loss The Basel I framework worked tolerably well in limitingthe call on the public purse in the G-10 countriesmdashwith the notable ex-ceptions of France and Japan The framework failed to moderate riskybank lending to emerging markets however
Basel I was not developed with emerging markets in mind The origi-nal idea behind it was to develop a common supervisory approach tocross-border banking operations It grew out of political pressure fromUS lawmakers who were determined to require international banks op-erating in the United States to meet US banking standards Toward thisgoal in 1983 Congress passed the International Lending Supervisory ActUS and British banking authorities subsequently agreed on a commontarget the adoption of strict common capital-adequacy standards In 1988other G-10 governments agreed to go along voluntary acceptance ofthe standards throughout much of the rest of the world followed46 Therationale for the capital targets was two-fold The first was to requirebanks to hold sufficient amounts of capital (8 percent of risk-adjusted
44 The international committee of financial authorities agreed on a common definitionof banksrsquo tier-one or ldquocorerdquo capital national authorities defined tier-two capital in theirown manner which permitted greater variations in national working definitions andpractices
45 International Convergence of Capital Measurement and Capital Standards (BIS 1988)was prepared by the Basel Committee on Banking Supervision
46 See Reineke (1998)
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124 WORLD CAPITAL MARKETS
assets) to cushion losses on those assets The second was to dull theirappetites for risk banks with large capital bases would have more tolose if they failed and therefore would take fewer risks
Rapid change in financial markets soon revealed flaws in the Basel IAccord In a complex world with numerous sources of risk it focusedheavily on credit risk but overlooked other risks in a bankrsquos portfolioand the correlation between returns on different asset classes The Baselformula required banks to maintain a fixed amount of capital againsteach of its asset classes But the formula did not distinguish the riskinessof the borrower within each class As a result one large loan to a low-risk corporate borrower such as General Electric would require the sameamount of capital as 10 smaller transactions with high-risk borrowers
The system was also biased toward short-term loans Loans maturingin less than a year required a 20 percent risk weight whereas those ma-turing after more than a year required a 100 percent risk weight Inter-bank lending was particularly favored For example loans to banks inOECD countries required less capital than loans to private firms in thesame countries creating the anomaly that interbank loans to South Ko-rean banks required less capital than loans to General Electric47 Thisanomaly encouraged banks to shed high-quality assets if the Basel rulesrequired the allocation of more capital than banks thought they needed
Another weakness was that financial innovators quickly circumventedthe Accord Because short-term loans required less provisioning than long-term loans banks responded by securitizing their long-term debt port-folios and lending short-term against the collateral of the newly createdasset This allowed banks to circumvent the capital requirements gearedto the terms of the underlying debt At the same time the Basel I Accordfailed to encourage risk mitigation techniques such as credit derivativescollateral guarantees and on-balance-sheet netting the flip side of fi-nancial innovation Because off-balance-sheet products were not coveredby the Accord another anomaly appeared when Barings Bank collapsedin 1995 Barings met capital adequacy standards but collapsed becauseits systems for managing risk failed traders were allowed to speculatein futures contracts that did not appear on the balance sheet
Basel II
Work to overhaul Basel I began in 1995 and produced consultativepapers issued in June 1999 and January 200148 These papers have been
47 South Korean banks have had notoriously weak balance sheets because the practiceof ldquodirected lendingrdquo left them with many poor loans (in making these loans the bankswere expected to follow government objectives rather than creditworthiness criteria)
48 Basel Committee on Banking Supervision (1999 2001)
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 125
the subject of extensive consultation and revision as a result the newAccord is expected to be introduced in 200449 The Basel II frameworkhas three parts (pillars) revisions to Basel I minimum-capital require-ments supervisory review criteria and greater emphasis on market dis-cipline Broadly Basel II aims to maintain the level of capital in the sys-tem but achieve better alignment of banksrsquo capital with their risk pro-files and keep up with financial innovation
To align capital requirements with market realities (the first pillar)Basel II concentrates on the 100 or so largest banksmdashthe type of playerslisted in table 21mdashand on the holding-company parents of banking groups50
Capital requirements will differentiate between an increased number ofcredit groups or ldquorisk bucketsrdquo including claims on governments otherbanks corporations mortgage-backed securities and other asset-backedsecurities
Basel II originally proposed to use external ratings to set capital chargesfor a number of these credit risks Many banks objected arguing thatthey assess credit risk better than Standard amp Poorrsquos Moodyrsquos or FitchIBCA51 Basel II thus proposes two approaches to rating a standard ap-proach using external ratings and an ldquoadvancedrdquo approach that allowsselected banks to use their own internal rating systems To encouragethe development of rigorous internal control systems based on these in-ternal rating systems Basel II also proposes to levy capital charges foroperational risk (the risk of direct or indirect loss resulting from inad-equate or failed internal processes people and systems or from exter-nal events)
Some critics of this proposal dismiss it as an abrogation of the prin-ciple of external independent monitoring and as ldquodangerously naiumlverdquo52
But regulators argue that the new capital charge on operational risk shouldoffset this concern It is also far from clear how cross-national compari-sons of rating and internal risk-assessment systems will be made (Engelen2000) The development by the European Union of its own capital rulescould well complicate the international resolution of these issues Publicassurances by EU officials in January 2001 however indicated that theirmain concerns are to create a level playing field and avoid regulatoryarbitrage (Hargreaves 2001) There is also the significant problem ofthe procyclical character of risk weights When a crisis hits losses are
49 See Berry (2000) for an update in an interview with William J McDonough chair ofthe Basel Committee on Banking Supervision
50 For obvious reasons these proposals are addressed to large banks and simpler capi-tal standards are allowed for small banks that focus on their domestic credit markets
51 See Ammer and Packer (2000) for an empirical critique of the success of rating agen-cies in distinguishing risk by sector and region
52 See Auerback (2001)
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126 WORLD CAPITAL MARKETS
incurred or accrued capital is lost and loan exposure must be reducedor securities sold to restore the requisite capital-adequacy ratios A morerisk-sensitive framework could amplify volatility
As the second pillar of Basel II supervisory review criteria are beingbeefed up to encourage supervisors to intervene earlier in potential problemsituations and to compel banks to align their capital positions with theirrisk profiles Bank supervisors will be authorized to require banks tohold capital in excess of minimum requirements if they have concernsabout general management overall strategy risk-management performanceor the macroeconomic environment Of course if one G-10 supervisorimposes higher capital requirements in isolation the same disparity willemerge that presaged Basel I Some banks will be disadvantaged in theinternational marketplace and will loudly complain that excessive super-vision is driving business to their competitors Hence close internationalcooperation among supervisors is critical
To implement the third pillar market discipline banks will be requiredto make fuller more timely disclosure of capital adequacy and the risksto which that capital is exposed A number of measures are being stud-ied that might help supervisors evaluate bank performance such as com-parisons of uninsured deposit interest rates subordinated debt yieldsand equity prices The idea is that these yields and prices might alertsupervisors to market perceptions of risk Of course market perceptionsare only as good as market information More direct and controversialways to reinforce market discipline would dramatically increase publicdisclosure of bank positions and risk management systems
Many questions are still outstanding about how to resolve the techni-cal details of capital requirements and whether the requirements willachieve their intended goal of better assessment and mitigation of therisks in banksrsquo portfolios There is no substitute for skilled supervisorsThe intricacies of effective design and implementation suggest that su-pervisors need to be highly competent technically knowledgeable aboutbanking portfolio characteristics and the factors that influence bank ex-posure to credit risk (Mishkin 2000) And they must be aided by vigilantshareholders market forces and transparency of information53
Standard setting at the global level is desirable but ultimately theeffectiveness of these efforts will be tested at the national level espe-cially in times of systemic financial distress Here the record of Basel Iwas not a bright shining success Japanese banking regulators havetraditionally allowed banks to include real estate and securities in theircapital base When the value of these assets plummeted in the early 1990sregulators allowed banks to continue valuing these depreciated (andoften bankrupt) assets at their old inflated levels Japanese authorities
53 Benedict Roth Complacency Towards Catastrophe Financial Times 23 January 2001
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 127
insisted until the mid-1990s that eroded capital bases could be rebuiltin a market-driven fashion They rightly foresaw that huge loan losseswould undermine public support for the ruling party and require a po-litically unpopular bailout
Japanese foot dragging on Basel I was the worst54 but not uniqueOther examples can be found of ldquopolitically mandated forbearancerdquo TheFederal Reserve Bank of New York held important hands during theLTCM crisis of 1998 Mexico is still resolving the banking crisis that eruptedin 1995 South Korea has not yet closed the insolvent banks that behavedso badly before the crisis of 1998 In the aftermath of a crisis nationalregulators cannot always be relied upon to discipline politically power-ful bankers55 One of the little-noticed consequences of these differingapproaches is that those banks with strong regulatory systems receivedan implicit ldquoexport subsidyrdquo for their services US banks which had notengaged extensively in emerging-market lending in the 1990s were bet-ter positioned than their German and Japanese counterparts to expandtheir international assets in the wake of the crises
Other Financial Forums
54 See Japanese Banks Fiddling while Marunouchi Burns The Economist 27 January2001 67-69
55 See Calomiris (1997)
The Basel model of vertical subsidiarity has already been extended toother financial regulatory bodies In 1993-94 the BIS established a Tri-partite Group of Banking Insurance and Securities Regulators In 1994-95 the BIS increased its cooperation with the International Organizationof Securities Commissions when the two organizations issued parallelpapers on guidelines for national regulators concerning risk managementand disclosure of derivative trades In 1996 a permanent Joint Forum onFinancial Conglomerates was established to examine supervisory issuesand develop working arrangements among the different functional super-visors of conglomerate institutions that offer combinations of bankingsecurities and insurance products Draft papers on the supervisionof conglomerates were released for comment in 1998 applying capital-adequacy principles to these groups and providing guidelines both forassessing the integrity and competence of top managers and for sharingassessments between regulators
In 1997 the Basel Committee on Banking Supervision extended itsreach beyond capital standards to broader aspects of banking supervi-sion with the publication of the Core Principles for Effective BankingSupervision In 1999 a wide range of regulatory and standard-settingbodies were gathered under the umbrella of the Financial Stability
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128 WORLD CAPITAL MARKETS
Forum (FSF) itself established under BIS aegis56 The FSF has alreadyissued recommendations for stepped-up supervision and transparencyas well as guidelines for best practices in a number of areas includingoffshore financial centers and highly leveraged institutions or hedge funds57
Conclusion
Although the structural weaknesses in emerging-market economies arewidely acknowledged to have been causal factors in international capi-tal-market volatility this chapter points to the role of large G-10 bankingorganizations as major suppliers of the most volatile instrument short-term debt We have examined evidence of the impact of public safetynets in the G-10 economiesmdashthe deposit insurance systems the pruden-tial supervisory systems and the lender-of-last-resort functions of centralbanksmdashon the incentive structures of these organizations
Although supervisors in most countries working nationally and to-gether in the BIS have made significant efforts to mimic market forcesin their prudential supervision the most sophisticated financial institu-tions find innovative ways to circumvent the rules New global regulatorybodies are not about to be created G-10 national bank regulators shouldthemselves address the short-term debt bias in the international financialsystem by changing incentive systems G-10 securities regulators shouldalso take steps to get ahead of the curve paying close attention to largeportfolio swings by institutional investors particularly in times of crisisIn short more needs to be done at national and international levels tochange the rules of the game That is the subject of the next chapter
56 The Financial Stability Forum includes banking securities insurance and accountingregulatory bodies the OECD on taxation corruption and corporate governance and theIMF
57 See Martin (2000)
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 109
base Explicit safety net protection also varies but only Canada focuseson the protected class33 All G-10 countries specify a limit on depositorprotection Under FDICIA the insurance fund is prohibited from pro-tecting uninsured depositors or creditors at a failed bank although adiscretionary system-wide override is provided for exceptional circum-stancesmdashbut with stringent requirements for consultation and account-ability Other G-10 countries allow for contingency funding from the publicpurse alongside unwritten lender-of-last-resort support Among large banksa significant and growing portion of deposit liabilities including foreigncurrency and interbank deposits are uninsuredmdashbut depositors assumethey will be protected in a crisis
FDICIA also made some significant qualitative changes to address theprincipal-agent problem by penalizing weak banks and rewarding strongbanks For example banks whose capital declined faced progressivelytougher regulatory sanctions that for example required them to elimi-nate dividends restrict their lending and change their managementsRegulators have also been forced to take prompt corrective action (toreduce the practice of regulatory forbearance in hopes that a bankrsquos for-tunes might improve)34 Unfortunately comparative qualitative assess-ments across the G-10 are difficult to make due to lack of information35
This discussion highlights the complexity of evaluating the extent towhich prudential supervision and market discipline reduce the moralhazard associated with G-10 safety nets Our argument is that publicsafety nets in the G-10 can be linked to banking instability in other coun-tries specifically in the emerging-market economies that have attractedG-10 cross-border bank lending This lending is a leading source of vola-tility in capital flows the large financial institutions many of which arecomplex banking organizations are based in and regulated by authori-ties in the G-10 economies These two features of the international finan-cial system are closely related although it is not possible to test thisrelationship econometrically
Two World Bank studies however indicate a basis for concern Onestudy is a cross-country econometric analysis of the relationship betweenbank stability and deposit insurance (Demirguccedil-Kunt and Detragiache2000) which found a negative relationship Their estimated model forbanking crises in a sample of 61 countries (both industrial and develop-ing) suggests that explicit deposit insurance raises the probability of acrisis by at least 30 percent36 Crises are especially likely in countries
33 Japanrsquos legislation says it does but recent experience shows this is not the case34 See Goldstein (1997) for a summary of the changes35 See Barth Nolle and Rice (2000) for a beginning in this area36 Demirguccedil-Kunt and and Detragiache (2000 table 1) report a logit coefficient of 0696with a standard error of 0397 (the coefficient is significant at the 8 percent threshold)This suggests that the ldquotruerdquo coefficient could well be as small as 030 (the reportedvalue minus the standard error)
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110 WORLD CAPITAL MARKETS
with immature financial supervisory systems (and not in the G-10) buttheir analysis does underscore the view that deposit insurance weakensmarket discipline37
An earlier World Bank analysis established similar results One wasthat market discipline is undermined by deposit insurance schemes an-other was that illiquid banks are forced to pay more for their funds un-less a generous deposit insurance scheme is in place (Demirguccedil-Kuntand Huizinga 1999) This econometric study also provides clear-cut evi-dence that depositor monitoring of banks declines with the existence ofdeposit insurance schemes At the heart of the problem is the questionof whether deposit insurance is accompanied by increased governmentmonitoring
This evidence and the weight of other arguments suggests that moralhazard is still an issue in the G-10 countries Consider the ongoing de-bate about instilling greater market discipline on risk taking by banksAt one extreme is the perennial proposal to do away with safety netsleaving markets to monitor the players and to force adjustments but toprotect small savers by creating ldquonarrow banksrdquo such as postal savingsystems that are allowed to invest these savings only in risk-free gov-ernment securities Whatever the merits of narrow banking this solutionis too extreme to be politically feasible
A moderate alternative is to force more disclosure by financial institu-tions to facilitate market monitoring But transparency has its own prob-lems Persaud (2000) argues that financial markets cannot reliably discernsustainable from unsustainable positions in the short term This uncer-tainty causes banks to ldquoherdrdquo behind market leaders to exploit theirsupposedly superior information ldquoThe more herding investors and bankersknow about what each other is up to the [more] unstable markets maybecomerdquo The implication is that greater transparency in the marketplaceby itself will not solve the problemmdashand in the short term more informa-tion may exacerbate herding Further supervisory steps (discussed in thenext chapter) are required
Yet another proposal is to promote private-sector involvement in bankmonitoring through market-based alternatives such as Calomirisrsquos sub-ordinated debt proposal (Calomiris 1997 Federal Reserve Board 1999)Banks could be required to issue and maintain a minimum amount of
37 Other findings in the Demirguccedil-Kunt and Detragiache (2000) study include thesepropositions The impact of deposit insurance on bank stability tends to be stronger themore extensive is the coverage offered to depositors when the scheme is funded andwhere the scheme is run by the government rather than by the private sector Con-versely deposit insurance is detrimental to bank stability where bank interest rates havebeen deregulated and where the institutional environment is weak Additional findingson deposit insurance are reported from a recent World Bank conference (8-9 June 2000httpwwwworldbankorgresearchinterestconfsupcomingdeposit_insurancehomehtm)Also see Smalhout (2001)
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 111
subordinated debt (eg uninsured certificates of deposit) to finance asmall fraction (such as 2 percent) of their total nonreserve assets Thesubordinated debt would be allowed to earn a set yield no more than 50basis points over the risk-free yield on government treasury bills Thisrule would supposedly force banks to operate in a safe manner Other-wise subordinated debt holders would redeem their uninsured certifi-cates of deposit and equity investors would sell their bank shares Despiteits practical problems the beauty of the subordinated debt requirementis that it enlists market incentives to push banks to avoid excessive port-folio risk38
The thrust of these proposals is very relevant to the arguments in ourstudy Even in the G-10 countries government monitoring by itself hasnot eliminated moral hazard among banks More work is needed to in-troduce market monitoring and to improve the incentive structures bothfor financial institutions and their supervisors We return to this issuewith our recommendations in the next chapter
38 In late 1996 Argentina began requiring its banks to finance 2 percent of total depos-its in the form of subordinated debt but without a maximum yield provision TheArgentine authorities expect that market discipline will act in concert with the publicsafety net One obvious problem with the subordinated debt proposal is that banks mayencourage some of their customers to buy the subordinated debt
Portfolio Institutions Tomorrowrsquos Problem
Before proceeding to the issues of international supervision we flag an-other potential problem for national regulators The big asset managersprofiled in tables 24 and 26 answer to diverse groups of pensionersshareholders and policyholders They allocate funds across a number ofcountries to diversify their risks They hold liquid assets that can be tradedand they have a higher proportion of long-term assets than banks Eco-nomic shocks can be absorbed through price changes and their effectsspread across time and markets Thus when conditions change in a par-ticular market they are more likely to ride out the storm than to flee Inother words they have less incentive than banks to pull their invest-ments in the face of adversity In the 1990s most large asset managersestablished a record of ldquoriding out the stormrdquo rather than ldquorunning withthe windrdquo although as we saw in chapter 1 instances of running withthe wind were detected in some portfolios As we write these insti-tutions have a good record overall in the emerging markets so whyworry
The Russian crisis and the near-collapse of LTCM previewed the dan-gers that may await future portfolio managers and G-10 financial minis-ters We have presented evidence indicating a systemic bias toward bank
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112 WORLD CAPITAL MARKETS
lending and debt finance to emerging markets and we have argued forsubstitution toward equity finance and direct investment39
That is not the end of the story We noted in the previous chapterthat institutional investors can become momentum investors selling in adownturn As more portfolio capital is invested in emerging marketssome players may adopt the high-risk high-leverage strategies of themost aggressive hedge funds Indeed the data in box 11 show that G-10portfolio investors held somewhat more long-term debt (more than $500billion) than equity (less than $400 billion) in emerging markets at theend of 1997 Long-term debt is an ideal vehicle for high-risk high-leveragestrategies These strategies practiced on a large scale could compound afuture crisis harming emerging markets A big enough crisis could inturn pressure G-10 central banks and finance ministers to arrange bail-out plans Instead of shrinking as a systemic financial problem moralhazard could increase
National securities regulators are the first line of defense against thisscenario They play a critical role in the safe evolution of capital mar-kets But regulators today are mandated to approve the issuance of newsecurities and to monitor the continuing disclosure of material informa-tion by issuers They are far less concerned with or empowered to monitorthe behavior of the increasingly large wealth-management firms that arethe major purchasers (and therefore resellers) of these securities
Within their mandates the goals of national securities regulators (table210 and appendix B) are similar to the concerns of bank regulators withsystem safety and soundness Their focus is also on the incentive sys-tems for management and boards of directors and on disclosure by cor-porations that issue marketable securities such as shares bonds andasset-backed securities 40 Issuers of securities possess greater knowledgeabout the quality of these assets than do the purchasers hence investorprotection is a key concern of regulators Moreover market disciplineworks best when markets know what is happening Well-functioning corpora-tions are key agents of wealth creation and social progress Underperform-ing corporations waste resources During recessions bad corporationsget into bad trouble often with severe social consequences Inadequateincentives for managers and inadequate accountability for boards andmanagers thus have negative externalities Regulators play a vital role inexposing weakness so that market disciplines come to bear sooner ratherthan later
Regulatory emphasis is constantly shifting as financial markets evolveand as the macroeconomic environment changes Regulators try to balance
39 See Rogoff (1999) Also see Berlin (2000) for a perspective on the limited role thatbanks play as share owners
40 See Habib and Ljungqvist (2000) for recent empirical analysis showing that corporateshare market values are higher when corporate executives have a larger ownership stake
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Table 210 Financial-sector regulation G-10 countries 2000
Financial institutions and their supervisors
Country and supervisory structure Retail banking Wholesale banking Securities Insurance
Financial conglomeratesFinancial Services Authority (FSA) = umbrella supervisor
United Kingdom FSA FSA FSA FSA
Treasury bull Commercial banks bull Investment funds (Securities and (Insurance Directorate(Securities and Investments Board) bull Unit trust groups Futures Authority) of the Treasury)
Bank of bull Building societies bull Pension funds England (Building Societies Commission) bull Merchant banks
bull Friendly societies bull Clearing houses bull Primary issuers bull Insurance FSA (Friendly Societies Commission) bull Venture capital of securities companies
bull Pensions and life insurance etc bull Stock exchanges bull Insurance brokers(Personal Investment Authority) bull Stockbrokers
Financial holding companiesFederal Reserve (FR) = umbrella supervisor
United States bull National banks(OCC) Securities and Regulated by
Treasury OCC bull State banks Federal Reserve Exchange Commission StatesMembers (FR)
OTS Nonmembers (FDIC) bull Investment banks bull Primary issuers of bull Insurance companies FR bull Cooperative banks (FDICFR) bull Finance companies securities bull Insurance brokers FDIC bull Insured industrial banks (FDIC) bull Stock exchanges
bull Thrift holding companies (OTS) bull Stockbrokers SEC bull Savings banks (OTSFDICFR) bull Investment advisors
bull Savings and loan associations bull Mutual funds(OTS) bull Public utility holding
bull Edge Act corporations (FR) companies
(table continues next page)
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Table 210 Financial-sector regulation G-10 countries 2000 (continued )
Financial institutions and their supervisors
Country and supervisory structure Retail banking Wholesale banking Securities Insurance
Financial holding companies Japan Financial Supervisory Authority (FSA) = umbrella supervisor
Prime FSA FSA FSA FSA ministerrsquos Ministry of office Finance (Securities and Exchange
Surveillance Commission) FRC Bureau of Financial bull City banks bull Investment banks bull Primary issuers of bull Insurance companies FSA Regulation bull Regional banks bull Asset managers securities bull Insurance brokers
bull Trust banks bull Stock exchanges SESC bull Long-term credit banks bull Stockbrokers
bull Pension funds
Financial holding companiesOffice of the Superintendent of Financial Institutions (OSFI) = umbrella supervisor
Canada Regulated by OSFI OSFI provinces OSFI
Department of Financebull Banks bull Cooperative credit bull Primary issuers of bull Insurance companies
(previously Office of the Inspector associations securities (previously Depart- OSFI General of the Banks) bull Fraternal benefit bull Stock exchanges ment of Insurance) Bank of bull Trust and loan companies society bull Stockbrokers bull Insurance brokers Canada bull Pension funds bull Asset managers
(previously Depart- CDIC ment of Insurance)
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Financial institutions and their supervisors
Country and supervisory structure Retail banking Wholesale banking Securities Insurance
Germany Financial holding groupsFederal Banking Supervisory Office (FBSO) = umbrella supervisor
Ministry of Finance FBSO BSO FSSO FISO
Bundesbankbull Universal banks bull Other financial bull Primary issuers of bull Insurance companies
Federal Banking bull Savings banks institutions (eg securities bull Insurance brokers Supervisory Office bull Securities banks management foreign bull Stock exchanges
currency dealings) bull Stockbrokers Federal Securities bull Financial enterprises bull Asset managers Supervisory Office (eg leasing bull Pension funds
organizations Federal Insurance credit card companies Supervisory Office investment advisors)
Italy Bank foundationsMinistry of Finance = umbrella supervisor
Ministry of Finance Bank of Italy Bank of Italy Consob ISVAP
Bank of Italy bull Commerical banks bull Asset managers bull Primary issuers of bull Insurance companies Consob bull Savings bank bull Open-end investment securities bull Insurance brokers
bull Securities banks companies (SICAVs) bull Stock exchangesbull Stockbrokers
ISVAP
(table continues next page)
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Table 210 Financial-sector regulation G-10 countries 2000 (continued )
Financial institutions and their supervisors
Country and supervisory structure Retail banking Wholesale banking Securities Insurance
The Netherlands Financial conglomeratesCouncil of Financial Supervisors = umbrella supervisor
Securities Board Securities Board Netherlandsche Netherlands Bank Netherlandsche Bank of the Netherlands Insurance Board Bank Insurance bull Credit institutions (universal banks bull Investment institutions bull Stock exchanges bull Insurance companies Board cooperative banks security credit (securities issuing bull Stockbrokers bull Insurance brokers
institutions mortgage banks) and tradingmdashprimary The Council of Financial and secondary Supervisors markets)
France Commission des Commission de Operations des Controcircle des
Banking and Banking Commission Bourse Assurances Financial Regulatory bull Ensuring that credit institutions (and investment firms since bull Primary issuers of bull Insurance companies Ministry for Committee the Financial Activity Modernization Act of 1996) comply securities bull Insurance brokers Economic with laws and regulations bull Stock exchanges Affairs and bull Execute instructions regarding all off-site monitoring and bull Stockbrokers Finance Credit on-site supervision Institutions and Banking and Financial Regulatory Committee Investment bull Formulates general regulations for credit institutions and investment firms Committee (capital adequacy requirements accounting rules etc) Bank of France Credit Institutions and Investment Committee Banking bull Authorizes and examines financial institutions except for those within the Commission competence of the Banking Commission
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117
Financial institutions and their supervisors
Country and supervisory structure Retail banking Wholesale banking Securities Insurance
Switzerland Large banking groupSwiss Federal Banking Commission (SFBC) = umbrella supervisor
Swiss National Bank Federal Office of
SFBC SFBC SFBC Private Insurance Swiss Federal Banking Commission bull Universal banks bull Investment banks bull Primary issuers of bull Insurance companies
bull Savings banks bull Asset management securities bull Insurance brokerscompanies bull Stock exchanges
Private audit Federal bull Investment funds bull Stockbrokers firms Office of bull Mortgage bond authorized by Private business SFBC Insurance
Sweden Financial holding company groupsFinancial Supervisory Authority = umbrella supervisor
Ministry of Finance Credit Market Securities Market Insurance Market
Credit Market Department Department Department Department
Financial bull Commercial banks bull Investment funds bull Primary issuers of bull Insurance companies Riksbank Supervisory bull Savings banks securities bull Insurance brokers Authority bull Friendly societies bull Stock exchanges
bull Stockbrokers
(table continues next page)
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Table 210 Financial-sector regulation G-10 countries 2000 (continued )
Financial institutions and their supervisors
Country and supervisory structure Retail banking Wholesale banking Securities Insurance
Belgium Bank holding companiesBanking and Finance Commission = umbrella supervisor
Bank of Belgium Banking Banking
Banking and Finance and Finance Insurance Controland Finance Commission Commission Commission Office
Banking and Insurance Finance Control bull Commercial banks bull Asset management bull Primary issuers of bull Insurance companies Commission Office bull Savings banks firms securities bull Insurance brokers
bull Securities banks bull Investment funds bull Stock exchanges bull Mortgage companiesbull Stockbrokers bull Pension funds
Securities Regulation Fund Securities Regulation Fund
bull Other investment firms and credit institutions(institutions participating in regulated off-exchangemarket in strips and Treasury certificates)
Bank holding companies Spain Banco de Espantildea = umbrella supervisor
Banco de Espantildea Comision Nacional del Mercado de Directorate General
Banco de Espantildea Valores (CNMV) Insurance
bull All credit institutions (commercial banks savings banks credit bull Primary issuers of (Ministry of Economy Ministry of cooperatives official credit institutions finance factoring and securities and Finance) Economy and CNMV leasing companies mortgage-loan companies etc) bull Stock exchanges bull Insurance companies Finance bull Interbank foreign exchange and book-entry public debt bull Stockbrokers bull Pension funds
markets bull Venture capital(companies and funds)
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119
Financial institutions and their supervisors
Country and supervisory structure Banking Securities Insurance
Banking Advisory High Level Securities Supervisors Committee (BAC) Committee (HLSS) Insurance Committee (IC)
Supranational (EU) bull Formulates standards for prudential bull Coordination of securities market bull Formulates standards forsupervision supervision prudential supervision
BACICHLSS Banking Supervision
Conglomerates Committee (BSC) Securities Contact Committee Regulation of prudential bull Systemic risk monitoring bull Regulation and implementation of supervision securities admission
International Association International International Organization of of Insurance Supervisors
Basel Committee Securities Commisison (IOSCO) (IAIS) Joint Forum Conglomerates Supervision bull Supervision and regulation best bull Supervision and regulation best bull Supervision and regulation amp regulation Best practices practices practices best practices
FSF Coordination across supervisors of various functions
Notes See appendix B for more information Boldface type indicates senior or oversight supervisor normal type indicates adjunct or front-line supervisorsolid line indicates direct responsbility to the senior-ranking authority dotted line indicates coordination in supervisory activities
(table continues next page)
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Table 210 Financial-sector regulation G-10 countries 2000 (continued )
Glossary of names United Kingdom FSA = Financial Services Authority United States FR = Federal Reserve OCC = Office of the Comptroller of theCurrency FDIC = Federal Deposit Insurance Corporation SEC = Securities and Exchange Commission OTS = Office of Thrift Supervision Japan FRC =Financial Reconstruction Commission FSA = Financial Services Agency SESC = Securities and Exchange Surveillance Commission Canada OSFI =Office of the Superintendent of Financial Institutions CDIC = Canada Deposit Insurance Corporation Germany FBSO = Federal Banking SupervisoryOffice FSSO = Federal Securities Supervisory Office FISO = Federal Insurance Supervisory Office BSO = Banking Supervisory Office Italy Consob =Commissione Nazionale per le Societa e la Borsa ISVAP = Instituto per la Vigilanza sulle assicurazioni private e di Interesse colletivo Switzerland SFBC= Swiss Federal Banking Commission Spain CNMV = The Comision Nacional del Mercado de Valores Supranational BAC = Banking Advisory CommitteeBSC = Banking Supervision Committee IC = Insurance Committee HLSS = High Level Securities Supervisors Committee International Dimension FSF =Financial Stability Forum IOSCO = International Organization of Securities Commission IAIS = International Association of Insurance Supervisors
Sources United Kingdom Bank of England httpwwwbankofenglandcouk Financial Services Authority httpwwwfsagovuk United States Board ofGovernors of Federal Reserve System httpwwwfederalreservegov Japan Bank of Japan httpwwwbojorjo Financial Reconstruction Commissionhttpwwwfsagojpfrcindexehtml Financial Services Agency httpwwwfsagojp Canada Bank of Canada httpwwwbank-banque-canadaca Office ofthe Superintendent of Financial Institutions httpwwwosfi-bsifgccaAndreEindexhtml Germany Deutsche Bundesbank httpwwwbundesbankde Fed-eral Banking Supervisory Office httpwwwbakredde Italy Banca drsquoitalia httpwwwbancaditaliait Commissione Nazionale per le Societa e la Borsahttpwwwconsobit Instituto per la Vigilanza sulle assicurazioni private e di Interesse colletivo httpwwwisvapit The Netherlands De NederlandscheBank httpwwwdnbnl France Banque de France httpwwwbanque-francefr Switzerland Schweizerische Nationalbank httpwwwsnbchindex3htmlSweden Sveriges Riksbank httpwwwriksbanksedefaultasp Belgium National Bank of Belgium httpwwwbnbbesgindexhtm Spain Banco de Espantildeahttpwwwbdees The Comision Nacional del Mercado de Valores httpwwwcnmves Supranational (EU) Institutional Arrangements for the Regulationand Supervision of the Financial Sector 2000 International Dimension Bank for International Settlement httpwwwbisorg International Organization ofSecurities Commissions httpwwwioscoorg International Association of Insurance Supervisors httpwwwiaisorg Financial Stability Forum httpwwwfsforumorg
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 121
the inflexibility of tight surveillance against the need to encourage in-novation and growth The US Securities and Exchange Commission isworried about aggressive accounting by firms and biased reports bysecurities analysts in an equity environment that prizes steadily higherquarterly earnings41 Japanese regulators are preoccupied with opaqueinterconnections between portfolio institutions banks and nonfinancialfirms through the keiretsu system Canadian regulators reeling from high-profile scandals of managers intentionally misleading investors are strengtheningmarket discipline through legal penalties aimed at managers and directorsof offending firms
When panic strikes a securities regulator cannot do much As the 1987stock market crash and the LTCM debacle in the fall of 1998 both dem-onstrated steep stock and bond price declines can create systemic risksIf severe enough the wealth effect of falling securities values and thefear of widespread insolvency can depress real activity Flooding thesystem with liquidity is a central bankerrsquos solutionmdashsomething a securi-ties regulator cannot do42 But just as financial supervisors can changethe incentive structure to discourage bankers from making risky loans ingood times so securities regulators can pay more attention to incentiveson the demand side when capital markets are strong
Prudential Supervision and InnovationmdashA Footnote
In concluding this discussion of prudential supervision in the G-10 anadditional point is worth noting National regulators face a persistenttrade-off between emphasizing financial system safety and soundnesswhile encouraging innovationmdashin spite of the added risks innovationbrings to financial markets Former US Treasury Secretary Lawrence Summers(2000 3) has argued by analogy
The jet airplane made airplane air travel more comfortable more efficient andmore safe though the accidents were more spectacular and for a time morenumerous after the jet was invented In the same way modern global financialmarkets carry with them enormous potential for benefit even if some of theaccidents are that much more spectacular As the right public policy response
41 The problem is illustrated by the divergence since mid-1998 between reported earn-ings by the Standard amp Poorrsquos (SampP) 500 and the after-tax profits of all corporations inthe national accounts Generally these two series move closely with one another Be-tween mid-1998 and mid-1999 SampP 500 reported that earnings increased by more than20 percent while after-tax profits of all corporations increased by less than 5 percent(Chase Bank US Economic and Policy Research US Weekly Prospects Chase SecuritiesWeekly Newsletter 5 June 2000 5)
42 For example the US Securities and Exchange Commission had no direct role in calmingmarkets in the 1987 or 1998 panics
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122 WORLD CAPITAL MARKETS
to the jet was longer runways better air-traffic control and better training forpilots and not the discouragement of rapid travel so the right public policyresponse to financial innovation is to assure a safe framework so that the ben-efits can be realized not to stifle the change
Accepting Summersrsquos analogy for the international financial system better-informed supervisors and investors are a necessary part of the financialsystem framework Supervisors require more timely information on therisk profiles resulting from positions taken by financial institutions Theyalso need a better understanding of risk-management systems Snapshotsof an institutionrsquos risk profile and risk-management procedures are nolonger adequate In a world where huge bets are quickly made (andpossibly lostmdashas with Barings Bank in 1995 and LTCM in 1998) super-visors must focus on the soundness of banking systems for evaluatingand managing risk on a daily basis Some progress has been made inaddressing these issues US banking examiners are extending their in-formation requirements in banking examinations and increasing theirinvolvement in large complex institutions43 More awareness is alsorequired of the fact that they are national organizations in a world ofcross-border capital flows To a much greater extent they need a multi-national reach International supervision and coordination among super-visors are the subject of the next section
Our analysis suggests that G-10 supervisors have unfinished businessBank supervisors need to start yesterday securities regulators can waituntil tomorrow One G-10 member acting alone cannot correct the biasIn good times the lending business will simply migrate to other G-10banks In bad times financial problems will not stop at the national bor-der A way has to be found to establish common international standardsfor the key financial players in order to prevent crises and to agree onapproaches for managing them The path has already been laid out Inthe wake of the bank failures of the past 25 years bank supervisors havetried to establish such standards They have done this without creating anew global institution
The essence of the international framework is decentralizationmdashglobalrules and design standards without global institutions that are perceivedto intrude on national sovereignty The awkward jargon for this frame-work is vertical subsidiaritymdashldquothink internationally act nationallyrdquo Theinternational thinking is done by a committee of regulators that meets
International SupervisionA Decentralized Framework
43 These issues are discussed in Ferguson (1999) and Meyer (2000a)
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 123
regularly at the Bank for International Settlements in Basel The commit-tee establishes principles and standards that are interpreted implementedand enforced by national authorities44 In this section we describe thesesupervisory efforts and their weaknesses We present our recommenda-tions for addressing these weaknesses in the next chapter
Basel I
The Basel Capital Accord of 1988 (Basel I)45 drew the lesson from thefinancial crises of the mid-1970s that more adequate capital levels in in-ternational banks would help reduce the systemic risk of bank failureThe primary goal of Basel I was capital adequacy other standards wereput in place not so much for their own virtue as to defend the primarygoal
Capital adequacy requirements were designed to ensure that individualinstitutions have the ability to absorb losses particularly credit lossesAccordingly a backup system of scoring credit risk was devised thatrequired large amounts of bank capital for some types of loans smalleramounts for others and zero for a select list of preferred assets Report-ing requirements were designed to disclose problems and ensure that atroubled bank would take timely steps to restore its capital base in thewake of a loss The Basel I framework worked tolerably well in limitingthe call on the public purse in the G-10 countriesmdashwith the notable ex-ceptions of France and Japan The framework failed to moderate riskybank lending to emerging markets however
Basel I was not developed with emerging markets in mind The origi-nal idea behind it was to develop a common supervisory approach tocross-border banking operations It grew out of political pressure fromUS lawmakers who were determined to require international banks op-erating in the United States to meet US banking standards Toward thisgoal in 1983 Congress passed the International Lending Supervisory ActUS and British banking authorities subsequently agreed on a commontarget the adoption of strict common capital-adequacy standards In 1988other G-10 governments agreed to go along voluntary acceptance ofthe standards throughout much of the rest of the world followed46 Therationale for the capital targets was two-fold The first was to requirebanks to hold sufficient amounts of capital (8 percent of risk-adjusted
44 The international committee of financial authorities agreed on a common definitionof banksrsquo tier-one or ldquocorerdquo capital national authorities defined tier-two capital in theirown manner which permitted greater variations in national working definitions andpractices
45 International Convergence of Capital Measurement and Capital Standards (BIS 1988)was prepared by the Basel Committee on Banking Supervision
46 See Reineke (1998)
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124 WORLD CAPITAL MARKETS
assets) to cushion losses on those assets The second was to dull theirappetites for risk banks with large capital bases would have more tolose if they failed and therefore would take fewer risks
Rapid change in financial markets soon revealed flaws in the Basel IAccord In a complex world with numerous sources of risk it focusedheavily on credit risk but overlooked other risks in a bankrsquos portfolioand the correlation between returns on different asset classes The Baselformula required banks to maintain a fixed amount of capital againsteach of its asset classes But the formula did not distinguish the riskinessof the borrower within each class As a result one large loan to a low-risk corporate borrower such as General Electric would require the sameamount of capital as 10 smaller transactions with high-risk borrowers
The system was also biased toward short-term loans Loans maturingin less than a year required a 20 percent risk weight whereas those ma-turing after more than a year required a 100 percent risk weight Inter-bank lending was particularly favored For example loans to banks inOECD countries required less capital than loans to private firms in thesame countries creating the anomaly that interbank loans to South Ko-rean banks required less capital than loans to General Electric47 Thisanomaly encouraged banks to shed high-quality assets if the Basel rulesrequired the allocation of more capital than banks thought they needed
Another weakness was that financial innovators quickly circumventedthe Accord Because short-term loans required less provisioning than long-term loans banks responded by securitizing their long-term debt port-folios and lending short-term against the collateral of the newly createdasset This allowed banks to circumvent the capital requirements gearedto the terms of the underlying debt At the same time the Basel I Accordfailed to encourage risk mitigation techniques such as credit derivativescollateral guarantees and on-balance-sheet netting the flip side of fi-nancial innovation Because off-balance-sheet products were not coveredby the Accord another anomaly appeared when Barings Bank collapsedin 1995 Barings met capital adequacy standards but collapsed becauseits systems for managing risk failed traders were allowed to speculatein futures contracts that did not appear on the balance sheet
Basel II
Work to overhaul Basel I began in 1995 and produced consultativepapers issued in June 1999 and January 200148 These papers have been
47 South Korean banks have had notoriously weak balance sheets because the practiceof ldquodirected lendingrdquo left them with many poor loans (in making these loans the bankswere expected to follow government objectives rather than creditworthiness criteria)
48 Basel Committee on Banking Supervision (1999 2001)
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 125
the subject of extensive consultation and revision as a result the newAccord is expected to be introduced in 200449 The Basel II frameworkhas three parts (pillars) revisions to Basel I minimum-capital require-ments supervisory review criteria and greater emphasis on market dis-cipline Broadly Basel II aims to maintain the level of capital in the sys-tem but achieve better alignment of banksrsquo capital with their risk pro-files and keep up with financial innovation
To align capital requirements with market realities (the first pillar)Basel II concentrates on the 100 or so largest banksmdashthe type of playerslisted in table 21mdashand on the holding-company parents of banking groups50
Capital requirements will differentiate between an increased number ofcredit groups or ldquorisk bucketsrdquo including claims on governments otherbanks corporations mortgage-backed securities and other asset-backedsecurities
Basel II originally proposed to use external ratings to set capital chargesfor a number of these credit risks Many banks objected arguing thatthey assess credit risk better than Standard amp Poorrsquos Moodyrsquos or FitchIBCA51 Basel II thus proposes two approaches to rating a standard ap-proach using external ratings and an ldquoadvancedrdquo approach that allowsselected banks to use their own internal rating systems To encouragethe development of rigorous internal control systems based on these in-ternal rating systems Basel II also proposes to levy capital charges foroperational risk (the risk of direct or indirect loss resulting from inad-equate or failed internal processes people and systems or from exter-nal events)
Some critics of this proposal dismiss it as an abrogation of the prin-ciple of external independent monitoring and as ldquodangerously naiumlverdquo52
But regulators argue that the new capital charge on operational risk shouldoffset this concern It is also far from clear how cross-national compari-sons of rating and internal risk-assessment systems will be made (Engelen2000) The development by the European Union of its own capital rulescould well complicate the international resolution of these issues Publicassurances by EU officials in January 2001 however indicated that theirmain concerns are to create a level playing field and avoid regulatoryarbitrage (Hargreaves 2001) There is also the significant problem ofthe procyclical character of risk weights When a crisis hits losses are
49 See Berry (2000) for an update in an interview with William J McDonough chair ofthe Basel Committee on Banking Supervision
50 For obvious reasons these proposals are addressed to large banks and simpler capi-tal standards are allowed for small banks that focus on their domestic credit markets
51 See Ammer and Packer (2000) for an empirical critique of the success of rating agen-cies in distinguishing risk by sector and region
52 See Auerback (2001)
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126 WORLD CAPITAL MARKETS
incurred or accrued capital is lost and loan exposure must be reducedor securities sold to restore the requisite capital-adequacy ratios A morerisk-sensitive framework could amplify volatility
As the second pillar of Basel II supervisory review criteria are beingbeefed up to encourage supervisors to intervene earlier in potential problemsituations and to compel banks to align their capital positions with theirrisk profiles Bank supervisors will be authorized to require banks tohold capital in excess of minimum requirements if they have concernsabout general management overall strategy risk-management performanceor the macroeconomic environment Of course if one G-10 supervisorimposes higher capital requirements in isolation the same disparity willemerge that presaged Basel I Some banks will be disadvantaged in theinternational marketplace and will loudly complain that excessive super-vision is driving business to their competitors Hence close internationalcooperation among supervisors is critical
To implement the third pillar market discipline banks will be requiredto make fuller more timely disclosure of capital adequacy and the risksto which that capital is exposed A number of measures are being stud-ied that might help supervisors evaluate bank performance such as com-parisons of uninsured deposit interest rates subordinated debt yieldsand equity prices The idea is that these yields and prices might alertsupervisors to market perceptions of risk Of course market perceptionsare only as good as market information More direct and controversialways to reinforce market discipline would dramatically increase publicdisclosure of bank positions and risk management systems
Many questions are still outstanding about how to resolve the techni-cal details of capital requirements and whether the requirements willachieve their intended goal of better assessment and mitigation of therisks in banksrsquo portfolios There is no substitute for skilled supervisorsThe intricacies of effective design and implementation suggest that su-pervisors need to be highly competent technically knowledgeable aboutbanking portfolio characteristics and the factors that influence bank ex-posure to credit risk (Mishkin 2000) And they must be aided by vigilantshareholders market forces and transparency of information53
Standard setting at the global level is desirable but ultimately theeffectiveness of these efforts will be tested at the national level espe-cially in times of systemic financial distress Here the record of Basel Iwas not a bright shining success Japanese banking regulators havetraditionally allowed banks to include real estate and securities in theircapital base When the value of these assets plummeted in the early 1990sregulators allowed banks to continue valuing these depreciated (andoften bankrupt) assets at their old inflated levels Japanese authorities
53 Benedict Roth Complacency Towards Catastrophe Financial Times 23 January 2001
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 127
insisted until the mid-1990s that eroded capital bases could be rebuiltin a market-driven fashion They rightly foresaw that huge loan losseswould undermine public support for the ruling party and require a po-litically unpopular bailout
Japanese foot dragging on Basel I was the worst54 but not uniqueOther examples can be found of ldquopolitically mandated forbearancerdquo TheFederal Reserve Bank of New York held important hands during theLTCM crisis of 1998 Mexico is still resolving the banking crisis that eruptedin 1995 South Korea has not yet closed the insolvent banks that behavedso badly before the crisis of 1998 In the aftermath of a crisis nationalregulators cannot always be relied upon to discipline politically power-ful bankers55 One of the little-noticed consequences of these differingapproaches is that those banks with strong regulatory systems receivedan implicit ldquoexport subsidyrdquo for their services US banks which had notengaged extensively in emerging-market lending in the 1990s were bet-ter positioned than their German and Japanese counterparts to expandtheir international assets in the wake of the crises
Other Financial Forums
54 See Japanese Banks Fiddling while Marunouchi Burns The Economist 27 January2001 67-69
55 See Calomiris (1997)
The Basel model of vertical subsidiarity has already been extended toother financial regulatory bodies In 1993-94 the BIS established a Tri-partite Group of Banking Insurance and Securities Regulators In 1994-95 the BIS increased its cooperation with the International Organizationof Securities Commissions when the two organizations issued parallelpapers on guidelines for national regulators concerning risk managementand disclosure of derivative trades In 1996 a permanent Joint Forum onFinancial Conglomerates was established to examine supervisory issuesand develop working arrangements among the different functional super-visors of conglomerate institutions that offer combinations of bankingsecurities and insurance products Draft papers on the supervisionof conglomerates were released for comment in 1998 applying capital-adequacy principles to these groups and providing guidelines both forassessing the integrity and competence of top managers and for sharingassessments between regulators
In 1997 the Basel Committee on Banking Supervision extended itsreach beyond capital standards to broader aspects of banking supervi-sion with the publication of the Core Principles for Effective BankingSupervision In 1999 a wide range of regulatory and standard-settingbodies were gathered under the umbrella of the Financial Stability
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128 WORLD CAPITAL MARKETS
Forum (FSF) itself established under BIS aegis56 The FSF has alreadyissued recommendations for stepped-up supervision and transparencyas well as guidelines for best practices in a number of areas includingoffshore financial centers and highly leveraged institutions or hedge funds57
Conclusion
Although the structural weaknesses in emerging-market economies arewidely acknowledged to have been causal factors in international capi-tal-market volatility this chapter points to the role of large G-10 bankingorganizations as major suppliers of the most volatile instrument short-term debt We have examined evidence of the impact of public safetynets in the G-10 economiesmdashthe deposit insurance systems the pruden-tial supervisory systems and the lender-of-last-resort functions of centralbanksmdashon the incentive structures of these organizations
Although supervisors in most countries working nationally and to-gether in the BIS have made significant efforts to mimic market forcesin their prudential supervision the most sophisticated financial institu-tions find innovative ways to circumvent the rules New global regulatorybodies are not about to be created G-10 national bank regulators shouldthemselves address the short-term debt bias in the international financialsystem by changing incentive systems G-10 securities regulators shouldalso take steps to get ahead of the curve paying close attention to largeportfolio swings by institutional investors particularly in times of crisisIn short more needs to be done at national and international levels tochange the rules of the game That is the subject of the next chapter
56 The Financial Stability Forum includes banking securities insurance and accountingregulatory bodies the OECD on taxation corruption and corporate governance and theIMF
57 See Martin (2000)
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110 WORLD CAPITAL MARKETS
with immature financial supervisory systems (and not in the G-10) buttheir analysis does underscore the view that deposit insurance weakensmarket discipline37
An earlier World Bank analysis established similar results One wasthat market discipline is undermined by deposit insurance schemes an-other was that illiquid banks are forced to pay more for their funds un-less a generous deposit insurance scheme is in place (Demirguccedil-Kuntand Huizinga 1999) This econometric study also provides clear-cut evi-dence that depositor monitoring of banks declines with the existence ofdeposit insurance schemes At the heart of the problem is the questionof whether deposit insurance is accompanied by increased governmentmonitoring
This evidence and the weight of other arguments suggests that moralhazard is still an issue in the G-10 countries Consider the ongoing de-bate about instilling greater market discipline on risk taking by banksAt one extreme is the perennial proposal to do away with safety netsleaving markets to monitor the players and to force adjustments but toprotect small savers by creating ldquonarrow banksrdquo such as postal savingsystems that are allowed to invest these savings only in risk-free gov-ernment securities Whatever the merits of narrow banking this solutionis too extreme to be politically feasible
A moderate alternative is to force more disclosure by financial institu-tions to facilitate market monitoring But transparency has its own prob-lems Persaud (2000) argues that financial markets cannot reliably discernsustainable from unsustainable positions in the short term This uncer-tainty causes banks to ldquoherdrdquo behind market leaders to exploit theirsupposedly superior information ldquoThe more herding investors and bankersknow about what each other is up to the [more] unstable markets maybecomerdquo The implication is that greater transparency in the marketplaceby itself will not solve the problemmdashand in the short term more informa-tion may exacerbate herding Further supervisory steps (discussed in thenext chapter) are required
Yet another proposal is to promote private-sector involvement in bankmonitoring through market-based alternatives such as Calomirisrsquos sub-ordinated debt proposal (Calomiris 1997 Federal Reserve Board 1999)Banks could be required to issue and maintain a minimum amount of
37 Other findings in the Demirguccedil-Kunt and Detragiache (2000) study include thesepropositions The impact of deposit insurance on bank stability tends to be stronger themore extensive is the coverage offered to depositors when the scheme is funded andwhere the scheme is run by the government rather than by the private sector Con-versely deposit insurance is detrimental to bank stability where bank interest rates havebeen deregulated and where the institutional environment is weak Additional findingson deposit insurance are reported from a recent World Bank conference (8-9 June 2000httpwwwworldbankorgresearchinterestconfsupcomingdeposit_insurancehomehtm)Also see Smalhout (2001)
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 111
subordinated debt (eg uninsured certificates of deposit) to finance asmall fraction (such as 2 percent) of their total nonreserve assets Thesubordinated debt would be allowed to earn a set yield no more than 50basis points over the risk-free yield on government treasury bills Thisrule would supposedly force banks to operate in a safe manner Other-wise subordinated debt holders would redeem their uninsured certifi-cates of deposit and equity investors would sell their bank shares Despiteits practical problems the beauty of the subordinated debt requirementis that it enlists market incentives to push banks to avoid excessive port-folio risk38
The thrust of these proposals is very relevant to the arguments in ourstudy Even in the G-10 countries government monitoring by itself hasnot eliminated moral hazard among banks More work is needed to in-troduce market monitoring and to improve the incentive structures bothfor financial institutions and their supervisors We return to this issuewith our recommendations in the next chapter
38 In late 1996 Argentina began requiring its banks to finance 2 percent of total depos-its in the form of subordinated debt but without a maximum yield provision TheArgentine authorities expect that market discipline will act in concert with the publicsafety net One obvious problem with the subordinated debt proposal is that banks mayencourage some of their customers to buy the subordinated debt
Portfolio Institutions Tomorrowrsquos Problem
Before proceeding to the issues of international supervision we flag an-other potential problem for national regulators The big asset managersprofiled in tables 24 and 26 answer to diverse groups of pensionersshareholders and policyholders They allocate funds across a number ofcountries to diversify their risks They hold liquid assets that can be tradedand they have a higher proportion of long-term assets than banks Eco-nomic shocks can be absorbed through price changes and their effectsspread across time and markets Thus when conditions change in a par-ticular market they are more likely to ride out the storm than to flee Inother words they have less incentive than banks to pull their invest-ments in the face of adversity In the 1990s most large asset managersestablished a record of ldquoriding out the stormrdquo rather than ldquorunning withthe windrdquo although as we saw in chapter 1 instances of running withthe wind were detected in some portfolios As we write these insti-tutions have a good record overall in the emerging markets so whyworry
The Russian crisis and the near-collapse of LTCM previewed the dan-gers that may await future portfolio managers and G-10 financial minis-ters We have presented evidence indicating a systemic bias toward bank
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112 WORLD CAPITAL MARKETS
lending and debt finance to emerging markets and we have argued forsubstitution toward equity finance and direct investment39
That is not the end of the story We noted in the previous chapterthat institutional investors can become momentum investors selling in adownturn As more portfolio capital is invested in emerging marketssome players may adopt the high-risk high-leverage strategies of themost aggressive hedge funds Indeed the data in box 11 show that G-10portfolio investors held somewhat more long-term debt (more than $500billion) than equity (less than $400 billion) in emerging markets at theend of 1997 Long-term debt is an ideal vehicle for high-risk high-leveragestrategies These strategies practiced on a large scale could compound afuture crisis harming emerging markets A big enough crisis could inturn pressure G-10 central banks and finance ministers to arrange bail-out plans Instead of shrinking as a systemic financial problem moralhazard could increase
National securities regulators are the first line of defense against thisscenario They play a critical role in the safe evolution of capital mar-kets But regulators today are mandated to approve the issuance of newsecurities and to monitor the continuing disclosure of material informa-tion by issuers They are far less concerned with or empowered to monitorthe behavior of the increasingly large wealth-management firms that arethe major purchasers (and therefore resellers) of these securities
Within their mandates the goals of national securities regulators (table210 and appendix B) are similar to the concerns of bank regulators withsystem safety and soundness Their focus is also on the incentive sys-tems for management and boards of directors and on disclosure by cor-porations that issue marketable securities such as shares bonds andasset-backed securities 40 Issuers of securities possess greater knowledgeabout the quality of these assets than do the purchasers hence investorprotection is a key concern of regulators Moreover market disciplineworks best when markets know what is happening Well-functioning corpora-tions are key agents of wealth creation and social progress Underperform-ing corporations waste resources During recessions bad corporationsget into bad trouble often with severe social consequences Inadequateincentives for managers and inadequate accountability for boards andmanagers thus have negative externalities Regulators play a vital role inexposing weakness so that market disciplines come to bear sooner ratherthan later
Regulatory emphasis is constantly shifting as financial markets evolveand as the macroeconomic environment changes Regulators try to balance
39 See Rogoff (1999) Also see Berlin (2000) for a perspective on the limited role thatbanks play as share owners
40 See Habib and Ljungqvist (2000) for recent empirical analysis showing that corporateshare market values are higher when corporate executives have a larger ownership stake
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Table 210 Financial-sector regulation G-10 countries 2000
Financial institutions and their supervisors
Country and supervisory structure Retail banking Wholesale banking Securities Insurance
Financial conglomeratesFinancial Services Authority (FSA) = umbrella supervisor
United Kingdom FSA FSA FSA FSA
Treasury bull Commercial banks bull Investment funds (Securities and (Insurance Directorate(Securities and Investments Board) bull Unit trust groups Futures Authority) of the Treasury)
Bank of bull Building societies bull Pension funds England (Building Societies Commission) bull Merchant banks
bull Friendly societies bull Clearing houses bull Primary issuers bull Insurance FSA (Friendly Societies Commission) bull Venture capital of securities companies
bull Pensions and life insurance etc bull Stock exchanges bull Insurance brokers(Personal Investment Authority) bull Stockbrokers
Financial holding companiesFederal Reserve (FR) = umbrella supervisor
United States bull National banks(OCC) Securities and Regulated by
Treasury OCC bull State banks Federal Reserve Exchange Commission StatesMembers (FR)
OTS Nonmembers (FDIC) bull Investment banks bull Primary issuers of bull Insurance companies FR bull Cooperative banks (FDICFR) bull Finance companies securities bull Insurance brokers FDIC bull Insured industrial banks (FDIC) bull Stock exchanges
bull Thrift holding companies (OTS) bull Stockbrokers SEC bull Savings banks (OTSFDICFR) bull Investment advisors
bull Savings and loan associations bull Mutual funds(OTS) bull Public utility holding
bull Edge Act corporations (FR) companies
(table continues next page)
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Table 210 Financial-sector regulation G-10 countries 2000 (continued )
Financial institutions and their supervisors
Country and supervisory structure Retail banking Wholesale banking Securities Insurance
Financial holding companies Japan Financial Supervisory Authority (FSA) = umbrella supervisor
Prime FSA FSA FSA FSA ministerrsquos Ministry of office Finance (Securities and Exchange
Surveillance Commission) FRC Bureau of Financial bull City banks bull Investment banks bull Primary issuers of bull Insurance companies FSA Regulation bull Regional banks bull Asset managers securities bull Insurance brokers
bull Trust banks bull Stock exchanges SESC bull Long-term credit banks bull Stockbrokers
bull Pension funds
Financial holding companiesOffice of the Superintendent of Financial Institutions (OSFI) = umbrella supervisor
Canada Regulated by OSFI OSFI provinces OSFI
Department of Financebull Banks bull Cooperative credit bull Primary issuers of bull Insurance companies
(previously Office of the Inspector associations securities (previously Depart- OSFI General of the Banks) bull Fraternal benefit bull Stock exchanges ment of Insurance) Bank of bull Trust and loan companies society bull Stockbrokers bull Insurance brokers Canada bull Pension funds bull Asset managers
(previously Depart- CDIC ment of Insurance)
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Financial institutions and their supervisors
Country and supervisory structure Retail banking Wholesale banking Securities Insurance
Germany Financial holding groupsFederal Banking Supervisory Office (FBSO) = umbrella supervisor
Ministry of Finance FBSO BSO FSSO FISO
Bundesbankbull Universal banks bull Other financial bull Primary issuers of bull Insurance companies
Federal Banking bull Savings banks institutions (eg securities bull Insurance brokers Supervisory Office bull Securities banks management foreign bull Stock exchanges
currency dealings) bull Stockbrokers Federal Securities bull Financial enterprises bull Asset managers Supervisory Office (eg leasing bull Pension funds
organizations Federal Insurance credit card companies Supervisory Office investment advisors)
Italy Bank foundationsMinistry of Finance = umbrella supervisor
Ministry of Finance Bank of Italy Bank of Italy Consob ISVAP
Bank of Italy bull Commerical banks bull Asset managers bull Primary issuers of bull Insurance companies Consob bull Savings bank bull Open-end investment securities bull Insurance brokers
bull Securities banks companies (SICAVs) bull Stock exchangesbull Stockbrokers
ISVAP
(table continues next page)
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Table 210 Financial-sector regulation G-10 countries 2000 (continued )
Financial institutions and their supervisors
Country and supervisory structure Retail banking Wholesale banking Securities Insurance
The Netherlands Financial conglomeratesCouncil of Financial Supervisors = umbrella supervisor
Securities Board Securities Board Netherlandsche Netherlands Bank Netherlandsche Bank of the Netherlands Insurance Board Bank Insurance bull Credit institutions (universal banks bull Investment institutions bull Stock exchanges bull Insurance companies Board cooperative banks security credit (securities issuing bull Stockbrokers bull Insurance brokers
institutions mortgage banks) and tradingmdashprimary The Council of Financial and secondary Supervisors markets)
France Commission des Commission de Operations des Controcircle des
Banking and Banking Commission Bourse Assurances Financial Regulatory bull Ensuring that credit institutions (and investment firms since bull Primary issuers of bull Insurance companies Ministry for Committee the Financial Activity Modernization Act of 1996) comply securities bull Insurance brokers Economic with laws and regulations bull Stock exchanges Affairs and bull Execute instructions regarding all off-site monitoring and bull Stockbrokers Finance Credit on-site supervision Institutions and Banking and Financial Regulatory Committee Investment bull Formulates general regulations for credit institutions and investment firms Committee (capital adequacy requirements accounting rules etc) Bank of France Credit Institutions and Investment Committee Banking bull Authorizes and examines financial institutions except for those within the Commission competence of the Banking Commission
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Financial institutions and their supervisors
Country and supervisory structure Retail banking Wholesale banking Securities Insurance
Switzerland Large banking groupSwiss Federal Banking Commission (SFBC) = umbrella supervisor
Swiss National Bank Federal Office of
SFBC SFBC SFBC Private Insurance Swiss Federal Banking Commission bull Universal banks bull Investment banks bull Primary issuers of bull Insurance companies
bull Savings banks bull Asset management securities bull Insurance brokerscompanies bull Stock exchanges
Private audit Federal bull Investment funds bull Stockbrokers firms Office of bull Mortgage bond authorized by Private business SFBC Insurance
Sweden Financial holding company groupsFinancial Supervisory Authority = umbrella supervisor
Ministry of Finance Credit Market Securities Market Insurance Market
Credit Market Department Department Department Department
Financial bull Commercial banks bull Investment funds bull Primary issuers of bull Insurance companies Riksbank Supervisory bull Savings banks securities bull Insurance brokers Authority bull Friendly societies bull Stock exchanges
bull Stockbrokers
(table continues next page)
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Table 210 Financial-sector regulation G-10 countries 2000 (continued )
Financial institutions and their supervisors
Country and supervisory structure Retail banking Wholesale banking Securities Insurance
Belgium Bank holding companiesBanking and Finance Commission = umbrella supervisor
Bank of Belgium Banking Banking
Banking and Finance and Finance Insurance Controland Finance Commission Commission Commission Office
Banking and Insurance Finance Control bull Commercial banks bull Asset management bull Primary issuers of bull Insurance companies Commission Office bull Savings banks firms securities bull Insurance brokers
bull Securities banks bull Investment funds bull Stock exchanges bull Mortgage companiesbull Stockbrokers bull Pension funds
Securities Regulation Fund Securities Regulation Fund
bull Other investment firms and credit institutions(institutions participating in regulated off-exchangemarket in strips and Treasury certificates)
Bank holding companies Spain Banco de Espantildea = umbrella supervisor
Banco de Espantildea Comision Nacional del Mercado de Directorate General
Banco de Espantildea Valores (CNMV) Insurance
bull All credit institutions (commercial banks savings banks credit bull Primary issuers of (Ministry of Economy Ministry of cooperatives official credit institutions finance factoring and securities and Finance) Economy and CNMV leasing companies mortgage-loan companies etc) bull Stock exchanges bull Insurance companies Finance bull Interbank foreign exchange and book-entry public debt bull Stockbrokers bull Pension funds
markets bull Venture capital(companies and funds)
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Financial institutions and their supervisors
Country and supervisory structure Banking Securities Insurance
Banking Advisory High Level Securities Supervisors Committee (BAC) Committee (HLSS) Insurance Committee (IC)
Supranational (EU) bull Formulates standards for prudential bull Coordination of securities market bull Formulates standards forsupervision supervision prudential supervision
BACICHLSS Banking Supervision
Conglomerates Committee (BSC) Securities Contact Committee Regulation of prudential bull Systemic risk monitoring bull Regulation and implementation of supervision securities admission
International Association International International Organization of of Insurance Supervisors
Basel Committee Securities Commisison (IOSCO) (IAIS) Joint Forum Conglomerates Supervision bull Supervision and regulation best bull Supervision and regulation best bull Supervision and regulation amp regulation Best practices practices practices best practices
FSF Coordination across supervisors of various functions
Notes See appendix B for more information Boldface type indicates senior or oversight supervisor normal type indicates adjunct or front-line supervisorsolid line indicates direct responsbility to the senior-ranking authority dotted line indicates coordination in supervisory activities
(table continues next page)
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Table 210 Financial-sector regulation G-10 countries 2000 (continued )
Glossary of names United Kingdom FSA = Financial Services Authority United States FR = Federal Reserve OCC = Office of the Comptroller of theCurrency FDIC = Federal Deposit Insurance Corporation SEC = Securities and Exchange Commission OTS = Office of Thrift Supervision Japan FRC =Financial Reconstruction Commission FSA = Financial Services Agency SESC = Securities and Exchange Surveillance Commission Canada OSFI =Office of the Superintendent of Financial Institutions CDIC = Canada Deposit Insurance Corporation Germany FBSO = Federal Banking SupervisoryOffice FSSO = Federal Securities Supervisory Office FISO = Federal Insurance Supervisory Office BSO = Banking Supervisory Office Italy Consob =Commissione Nazionale per le Societa e la Borsa ISVAP = Instituto per la Vigilanza sulle assicurazioni private e di Interesse colletivo Switzerland SFBC= Swiss Federal Banking Commission Spain CNMV = The Comision Nacional del Mercado de Valores Supranational BAC = Banking Advisory CommitteeBSC = Banking Supervision Committee IC = Insurance Committee HLSS = High Level Securities Supervisors Committee International Dimension FSF =Financial Stability Forum IOSCO = International Organization of Securities Commission IAIS = International Association of Insurance Supervisors
Sources United Kingdom Bank of England httpwwwbankofenglandcouk Financial Services Authority httpwwwfsagovuk United States Board ofGovernors of Federal Reserve System httpwwwfederalreservegov Japan Bank of Japan httpwwwbojorjo Financial Reconstruction Commissionhttpwwwfsagojpfrcindexehtml Financial Services Agency httpwwwfsagojp Canada Bank of Canada httpwwwbank-banque-canadaca Office ofthe Superintendent of Financial Institutions httpwwwosfi-bsifgccaAndreEindexhtml Germany Deutsche Bundesbank httpwwwbundesbankde Fed-eral Banking Supervisory Office httpwwwbakredde Italy Banca drsquoitalia httpwwwbancaditaliait Commissione Nazionale per le Societa e la Borsahttpwwwconsobit Instituto per la Vigilanza sulle assicurazioni private e di Interesse colletivo httpwwwisvapit The Netherlands De NederlandscheBank httpwwwdnbnl France Banque de France httpwwwbanque-francefr Switzerland Schweizerische Nationalbank httpwwwsnbchindex3htmlSweden Sveriges Riksbank httpwwwriksbanksedefaultasp Belgium National Bank of Belgium httpwwwbnbbesgindexhtm Spain Banco de Espantildeahttpwwwbdees The Comision Nacional del Mercado de Valores httpwwwcnmves Supranational (EU) Institutional Arrangements for the Regulationand Supervision of the Financial Sector 2000 International Dimension Bank for International Settlement httpwwwbisorg International Organization ofSecurities Commissions httpwwwioscoorg International Association of Insurance Supervisors httpwwwiaisorg Financial Stability Forum httpwwwfsforumorg
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 121
the inflexibility of tight surveillance against the need to encourage in-novation and growth The US Securities and Exchange Commission isworried about aggressive accounting by firms and biased reports bysecurities analysts in an equity environment that prizes steadily higherquarterly earnings41 Japanese regulators are preoccupied with opaqueinterconnections between portfolio institutions banks and nonfinancialfirms through the keiretsu system Canadian regulators reeling from high-profile scandals of managers intentionally misleading investors are strengtheningmarket discipline through legal penalties aimed at managers and directorsof offending firms
When panic strikes a securities regulator cannot do much As the 1987stock market crash and the LTCM debacle in the fall of 1998 both dem-onstrated steep stock and bond price declines can create systemic risksIf severe enough the wealth effect of falling securities values and thefear of widespread insolvency can depress real activity Flooding thesystem with liquidity is a central bankerrsquos solutionmdashsomething a securi-ties regulator cannot do42 But just as financial supervisors can changethe incentive structure to discourage bankers from making risky loans ingood times so securities regulators can pay more attention to incentiveson the demand side when capital markets are strong
Prudential Supervision and InnovationmdashA Footnote
In concluding this discussion of prudential supervision in the G-10 anadditional point is worth noting National regulators face a persistenttrade-off between emphasizing financial system safety and soundnesswhile encouraging innovationmdashin spite of the added risks innovationbrings to financial markets Former US Treasury Secretary Lawrence Summers(2000 3) has argued by analogy
The jet airplane made airplane air travel more comfortable more efficient andmore safe though the accidents were more spectacular and for a time morenumerous after the jet was invented In the same way modern global financialmarkets carry with them enormous potential for benefit even if some of theaccidents are that much more spectacular As the right public policy response
41 The problem is illustrated by the divergence since mid-1998 between reported earn-ings by the Standard amp Poorrsquos (SampP) 500 and the after-tax profits of all corporations inthe national accounts Generally these two series move closely with one another Be-tween mid-1998 and mid-1999 SampP 500 reported that earnings increased by more than20 percent while after-tax profits of all corporations increased by less than 5 percent(Chase Bank US Economic and Policy Research US Weekly Prospects Chase SecuritiesWeekly Newsletter 5 June 2000 5)
42 For example the US Securities and Exchange Commission had no direct role in calmingmarkets in the 1987 or 1998 panics
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122 WORLD CAPITAL MARKETS
to the jet was longer runways better air-traffic control and better training forpilots and not the discouragement of rapid travel so the right public policyresponse to financial innovation is to assure a safe framework so that the ben-efits can be realized not to stifle the change
Accepting Summersrsquos analogy for the international financial system better-informed supervisors and investors are a necessary part of the financialsystem framework Supervisors require more timely information on therisk profiles resulting from positions taken by financial institutions Theyalso need a better understanding of risk-management systems Snapshotsof an institutionrsquos risk profile and risk-management procedures are nolonger adequate In a world where huge bets are quickly made (andpossibly lostmdashas with Barings Bank in 1995 and LTCM in 1998) super-visors must focus on the soundness of banking systems for evaluatingand managing risk on a daily basis Some progress has been made inaddressing these issues US banking examiners are extending their in-formation requirements in banking examinations and increasing theirinvolvement in large complex institutions43 More awareness is alsorequired of the fact that they are national organizations in a world ofcross-border capital flows To a much greater extent they need a multi-national reach International supervision and coordination among super-visors are the subject of the next section
Our analysis suggests that G-10 supervisors have unfinished businessBank supervisors need to start yesterday securities regulators can waituntil tomorrow One G-10 member acting alone cannot correct the biasIn good times the lending business will simply migrate to other G-10banks In bad times financial problems will not stop at the national bor-der A way has to be found to establish common international standardsfor the key financial players in order to prevent crises and to agree onapproaches for managing them The path has already been laid out Inthe wake of the bank failures of the past 25 years bank supervisors havetried to establish such standards They have done this without creating anew global institution
The essence of the international framework is decentralizationmdashglobalrules and design standards without global institutions that are perceivedto intrude on national sovereignty The awkward jargon for this frame-work is vertical subsidiaritymdashldquothink internationally act nationallyrdquo Theinternational thinking is done by a committee of regulators that meets
International SupervisionA Decentralized Framework
43 These issues are discussed in Ferguson (1999) and Meyer (2000a)
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 123
regularly at the Bank for International Settlements in Basel The commit-tee establishes principles and standards that are interpreted implementedand enforced by national authorities44 In this section we describe thesesupervisory efforts and their weaknesses We present our recommenda-tions for addressing these weaknesses in the next chapter
Basel I
The Basel Capital Accord of 1988 (Basel I)45 drew the lesson from thefinancial crises of the mid-1970s that more adequate capital levels in in-ternational banks would help reduce the systemic risk of bank failureThe primary goal of Basel I was capital adequacy other standards wereput in place not so much for their own virtue as to defend the primarygoal
Capital adequacy requirements were designed to ensure that individualinstitutions have the ability to absorb losses particularly credit lossesAccordingly a backup system of scoring credit risk was devised thatrequired large amounts of bank capital for some types of loans smalleramounts for others and zero for a select list of preferred assets Report-ing requirements were designed to disclose problems and ensure that atroubled bank would take timely steps to restore its capital base in thewake of a loss The Basel I framework worked tolerably well in limitingthe call on the public purse in the G-10 countriesmdashwith the notable ex-ceptions of France and Japan The framework failed to moderate riskybank lending to emerging markets however
Basel I was not developed with emerging markets in mind The origi-nal idea behind it was to develop a common supervisory approach tocross-border banking operations It grew out of political pressure fromUS lawmakers who were determined to require international banks op-erating in the United States to meet US banking standards Toward thisgoal in 1983 Congress passed the International Lending Supervisory ActUS and British banking authorities subsequently agreed on a commontarget the adoption of strict common capital-adequacy standards In 1988other G-10 governments agreed to go along voluntary acceptance ofthe standards throughout much of the rest of the world followed46 Therationale for the capital targets was two-fold The first was to requirebanks to hold sufficient amounts of capital (8 percent of risk-adjusted
44 The international committee of financial authorities agreed on a common definitionof banksrsquo tier-one or ldquocorerdquo capital national authorities defined tier-two capital in theirown manner which permitted greater variations in national working definitions andpractices
45 International Convergence of Capital Measurement and Capital Standards (BIS 1988)was prepared by the Basel Committee on Banking Supervision
46 See Reineke (1998)
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124 WORLD CAPITAL MARKETS
assets) to cushion losses on those assets The second was to dull theirappetites for risk banks with large capital bases would have more tolose if they failed and therefore would take fewer risks
Rapid change in financial markets soon revealed flaws in the Basel IAccord In a complex world with numerous sources of risk it focusedheavily on credit risk but overlooked other risks in a bankrsquos portfolioand the correlation between returns on different asset classes The Baselformula required banks to maintain a fixed amount of capital againsteach of its asset classes But the formula did not distinguish the riskinessof the borrower within each class As a result one large loan to a low-risk corporate borrower such as General Electric would require the sameamount of capital as 10 smaller transactions with high-risk borrowers
The system was also biased toward short-term loans Loans maturingin less than a year required a 20 percent risk weight whereas those ma-turing after more than a year required a 100 percent risk weight Inter-bank lending was particularly favored For example loans to banks inOECD countries required less capital than loans to private firms in thesame countries creating the anomaly that interbank loans to South Ko-rean banks required less capital than loans to General Electric47 Thisanomaly encouraged banks to shed high-quality assets if the Basel rulesrequired the allocation of more capital than banks thought they needed
Another weakness was that financial innovators quickly circumventedthe Accord Because short-term loans required less provisioning than long-term loans banks responded by securitizing their long-term debt port-folios and lending short-term against the collateral of the newly createdasset This allowed banks to circumvent the capital requirements gearedto the terms of the underlying debt At the same time the Basel I Accordfailed to encourage risk mitigation techniques such as credit derivativescollateral guarantees and on-balance-sheet netting the flip side of fi-nancial innovation Because off-balance-sheet products were not coveredby the Accord another anomaly appeared when Barings Bank collapsedin 1995 Barings met capital adequacy standards but collapsed becauseits systems for managing risk failed traders were allowed to speculatein futures contracts that did not appear on the balance sheet
Basel II
Work to overhaul Basel I began in 1995 and produced consultativepapers issued in June 1999 and January 200148 These papers have been
47 South Korean banks have had notoriously weak balance sheets because the practiceof ldquodirected lendingrdquo left them with many poor loans (in making these loans the bankswere expected to follow government objectives rather than creditworthiness criteria)
48 Basel Committee on Banking Supervision (1999 2001)
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 125
the subject of extensive consultation and revision as a result the newAccord is expected to be introduced in 200449 The Basel II frameworkhas three parts (pillars) revisions to Basel I minimum-capital require-ments supervisory review criteria and greater emphasis on market dis-cipline Broadly Basel II aims to maintain the level of capital in the sys-tem but achieve better alignment of banksrsquo capital with their risk pro-files and keep up with financial innovation
To align capital requirements with market realities (the first pillar)Basel II concentrates on the 100 or so largest banksmdashthe type of playerslisted in table 21mdashand on the holding-company parents of banking groups50
Capital requirements will differentiate between an increased number ofcredit groups or ldquorisk bucketsrdquo including claims on governments otherbanks corporations mortgage-backed securities and other asset-backedsecurities
Basel II originally proposed to use external ratings to set capital chargesfor a number of these credit risks Many banks objected arguing thatthey assess credit risk better than Standard amp Poorrsquos Moodyrsquos or FitchIBCA51 Basel II thus proposes two approaches to rating a standard ap-proach using external ratings and an ldquoadvancedrdquo approach that allowsselected banks to use their own internal rating systems To encouragethe development of rigorous internal control systems based on these in-ternal rating systems Basel II also proposes to levy capital charges foroperational risk (the risk of direct or indirect loss resulting from inad-equate or failed internal processes people and systems or from exter-nal events)
Some critics of this proposal dismiss it as an abrogation of the prin-ciple of external independent monitoring and as ldquodangerously naiumlverdquo52
But regulators argue that the new capital charge on operational risk shouldoffset this concern It is also far from clear how cross-national compari-sons of rating and internal risk-assessment systems will be made (Engelen2000) The development by the European Union of its own capital rulescould well complicate the international resolution of these issues Publicassurances by EU officials in January 2001 however indicated that theirmain concerns are to create a level playing field and avoid regulatoryarbitrage (Hargreaves 2001) There is also the significant problem ofthe procyclical character of risk weights When a crisis hits losses are
49 See Berry (2000) for an update in an interview with William J McDonough chair ofthe Basel Committee on Banking Supervision
50 For obvious reasons these proposals are addressed to large banks and simpler capi-tal standards are allowed for small banks that focus on their domestic credit markets
51 See Ammer and Packer (2000) for an empirical critique of the success of rating agen-cies in distinguishing risk by sector and region
52 See Auerback (2001)
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126 WORLD CAPITAL MARKETS
incurred or accrued capital is lost and loan exposure must be reducedor securities sold to restore the requisite capital-adequacy ratios A morerisk-sensitive framework could amplify volatility
As the second pillar of Basel II supervisory review criteria are beingbeefed up to encourage supervisors to intervene earlier in potential problemsituations and to compel banks to align their capital positions with theirrisk profiles Bank supervisors will be authorized to require banks tohold capital in excess of minimum requirements if they have concernsabout general management overall strategy risk-management performanceor the macroeconomic environment Of course if one G-10 supervisorimposes higher capital requirements in isolation the same disparity willemerge that presaged Basel I Some banks will be disadvantaged in theinternational marketplace and will loudly complain that excessive super-vision is driving business to their competitors Hence close internationalcooperation among supervisors is critical
To implement the third pillar market discipline banks will be requiredto make fuller more timely disclosure of capital adequacy and the risksto which that capital is exposed A number of measures are being stud-ied that might help supervisors evaluate bank performance such as com-parisons of uninsured deposit interest rates subordinated debt yieldsand equity prices The idea is that these yields and prices might alertsupervisors to market perceptions of risk Of course market perceptionsare only as good as market information More direct and controversialways to reinforce market discipline would dramatically increase publicdisclosure of bank positions and risk management systems
Many questions are still outstanding about how to resolve the techni-cal details of capital requirements and whether the requirements willachieve their intended goal of better assessment and mitigation of therisks in banksrsquo portfolios There is no substitute for skilled supervisorsThe intricacies of effective design and implementation suggest that su-pervisors need to be highly competent technically knowledgeable aboutbanking portfolio characteristics and the factors that influence bank ex-posure to credit risk (Mishkin 2000) And they must be aided by vigilantshareholders market forces and transparency of information53
Standard setting at the global level is desirable but ultimately theeffectiveness of these efforts will be tested at the national level espe-cially in times of systemic financial distress Here the record of Basel Iwas not a bright shining success Japanese banking regulators havetraditionally allowed banks to include real estate and securities in theircapital base When the value of these assets plummeted in the early 1990sregulators allowed banks to continue valuing these depreciated (andoften bankrupt) assets at their old inflated levels Japanese authorities
53 Benedict Roth Complacency Towards Catastrophe Financial Times 23 January 2001
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 127
insisted until the mid-1990s that eroded capital bases could be rebuiltin a market-driven fashion They rightly foresaw that huge loan losseswould undermine public support for the ruling party and require a po-litically unpopular bailout
Japanese foot dragging on Basel I was the worst54 but not uniqueOther examples can be found of ldquopolitically mandated forbearancerdquo TheFederal Reserve Bank of New York held important hands during theLTCM crisis of 1998 Mexico is still resolving the banking crisis that eruptedin 1995 South Korea has not yet closed the insolvent banks that behavedso badly before the crisis of 1998 In the aftermath of a crisis nationalregulators cannot always be relied upon to discipline politically power-ful bankers55 One of the little-noticed consequences of these differingapproaches is that those banks with strong regulatory systems receivedan implicit ldquoexport subsidyrdquo for their services US banks which had notengaged extensively in emerging-market lending in the 1990s were bet-ter positioned than their German and Japanese counterparts to expandtheir international assets in the wake of the crises
Other Financial Forums
54 See Japanese Banks Fiddling while Marunouchi Burns The Economist 27 January2001 67-69
55 See Calomiris (1997)
The Basel model of vertical subsidiarity has already been extended toother financial regulatory bodies In 1993-94 the BIS established a Tri-partite Group of Banking Insurance and Securities Regulators In 1994-95 the BIS increased its cooperation with the International Organizationof Securities Commissions when the two organizations issued parallelpapers on guidelines for national regulators concerning risk managementand disclosure of derivative trades In 1996 a permanent Joint Forum onFinancial Conglomerates was established to examine supervisory issuesand develop working arrangements among the different functional super-visors of conglomerate institutions that offer combinations of bankingsecurities and insurance products Draft papers on the supervisionof conglomerates were released for comment in 1998 applying capital-adequacy principles to these groups and providing guidelines both forassessing the integrity and competence of top managers and for sharingassessments between regulators
In 1997 the Basel Committee on Banking Supervision extended itsreach beyond capital standards to broader aspects of banking supervi-sion with the publication of the Core Principles for Effective BankingSupervision In 1999 a wide range of regulatory and standard-settingbodies were gathered under the umbrella of the Financial Stability
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128 WORLD CAPITAL MARKETS
Forum (FSF) itself established under BIS aegis56 The FSF has alreadyissued recommendations for stepped-up supervision and transparencyas well as guidelines for best practices in a number of areas includingoffshore financial centers and highly leveraged institutions or hedge funds57
Conclusion
Although the structural weaknesses in emerging-market economies arewidely acknowledged to have been causal factors in international capi-tal-market volatility this chapter points to the role of large G-10 bankingorganizations as major suppliers of the most volatile instrument short-term debt We have examined evidence of the impact of public safetynets in the G-10 economiesmdashthe deposit insurance systems the pruden-tial supervisory systems and the lender-of-last-resort functions of centralbanksmdashon the incentive structures of these organizations
Although supervisors in most countries working nationally and to-gether in the BIS have made significant efforts to mimic market forcesin their prudential supervision the most sophisticated financial institu-tions find innovative ways to circumvent the rules New global regulatorybodies are not about to be created G-10 national bank regulators shouldthemselves address the short-term debt bias in the international financialsystem by changing incentive systems G-10 securities regulators shouldalso take steps to get ahead of the curve paying close attention to largeportfolio swings by institutional investors particularly in times of crisisIn short more needs to be done at national and international levels tochange the rules of the game That is the subject of the next chapter
56 The Financial Stability Forum includes banking securities insurance and accountingregulatory bodies the OECD on taxation corruption and corporate governance and theIMF
57 See Martin (2000)
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 111
subordinated debt (eg uninsured certificates of deposit) to finance asmall fraction (such as 2 percent) of their total nonreserve assets Thesubordinated debt would be allowed to earn a set yield no more than 50basis points over the risk-free yield on government treasury bills Thisrule would supposedly force banks to operate in a safe manner Other-wise subordinated debt holders would redeem their uninsured certifi-cates of deposit and equity investors would sell their bank shares Despiteits practical problems the beauty of the subordinated debt requirementis that it enlists market incentives to push banks to avoid excessive port-folio risk38
The thrust of these proposals is very relevant to the arguments in ourstudy Even in the G-10 countries government monitoring by itself hasnot eliminated moral hazard among banks More work is needed to in-troduce market monitoring and to improve the incentive structures bothfor financial institutions and their supervisors We return to this issuewith our recommendations in the next chapter
38 In late 1996 Argentina began requiring its banks to finance 2 percent of total depos-its in the form of subordinated debt but without a maximum yield provision TheArgentine authorities expect that market discipline will act in concert with the publicsafety net One obvious problem with the subordinated debt proposal is that banks mayencourage some of their customers to buy the subordinated debt
Portfolio Institutions Tomorrowrsquos Problem
Before proceeding to the issues of international supervision we flag an-other potential problem for national regulators The big asset managersprofiled in tables 24 and 26 answer to diverse groups of pensionersshareholders and policyholders They allocate funds across a number ofcountries to diversify their risks They hold liquid assets that can be tradedand they have a higher proportion of long-term assets than banks Eco-nomic shocks can be absorbed through price changes and their effectsspread across time and markets Thus when conditions change in a par-ticular market they are more likely to ride out the storm than to flee Inother words they have less incentive than banks to pull their invest-ments in the face of adversity In the 1990s most large asset managersestablished a record of ldquoriding out the stormrdquo rather than ldquorunning withthe windrdquo although as we saw in chapter 1 instances of running withthe wind were detected in some portfolios As we write these insti-tutions have a good record overall in the emerging markets so whyworry
The Russian crisis and the near-collapse of LTCM previewed the dan-gers that may await future portfolio managers and G-10 financial minis-ters We have presented evidence indicating a systemic bias toward bank
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112 WORLD CAPITAL MARKETS
lending and debt finance to emerging markets and we have argued forsubstitution toward equity finance and direct investment39
That is not the end of the story We noted in the previous chapterthat institutional investors can become momentum investors selling in adownturn As more portfolio capital is invested in emerging marketssome players may adopt the high-risk high-leverage strategies of themost aggressive hedge funds Indeed the data in box 11 show that G-10portfolio investors held somewhat more long-term debt (more than $500billion) than equity (less than $400 billion) in emerging markets at theend of 1997 Long-term debt is an ideal vehicle for high-risk high-leveragestrategies These strategies practiced on a large scale could compound afuture crisis harming emerging markets A big enough crisis could inturn pressure G-10 central banks and finance ministers to arrange bail-out plans Instead of shrinking as a systemic financial problem moralhazard could increase
National securities regulators are the first line of defense against thisscenario They play a critical role in the safe evolution of capital mar-kets But regulators today are mandated to approve the issuance of newsecurities and to monitor the continuing disclosure of material informa-tion by issuers They are far less concerned with or empowered to monitorthe behavior of the increasingly large wealth-management firms that arethe major purchasers (and therefore resellers) of these securities
Within their mandates the goals of national securities regulators (table210 and appendix B) are similar to the concerns of bank regulators withsystem safety and soundness Their focus is also on the incentive sys-tems for management and boards of directors and on disclosure by cor-porations that issue marketable securities such as shares bonds andasset-backed securities 40 Issuers of securities possess greater knowledgeabout the quality of these assets than do the purchasers hence investorprotection is a key concern of regulators Moreover market disciplineworks best when markets know what is happening Well-functioning corpora-tions are key agents of wealth creation and social progress Underperform-ing corporations waste resources During recessions bad corporationsget into bad trouble often with severe social consequences Inadequateincentives for managers and inadequate accountability for boards andmanagers thus have negative externalities Regulators play a vital role inexposing weakness so that market disciplines come to bear sooner ratherthan later
Regulatory emphasis is constantly shifting as financial markets evolveand as the macroeconomic environment changes Regulators try to balance
39 See Rogoff (1999) Also see Berlin (2000) for a perspective on the limited role thatbanks play as share owners
40 See Habib and Ljungqvist (2000) for recent empirical analysis showing that corporateshare market values are higher when corporate executives have a larger ownership stake
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Table 210 Financial-sector regulation G-10 countries 2000
Financial institutions and their supervisors
Country and supervisory structure Retail banking Wholesale banking Securities Insurance
Financial conglomeratesFinancial Services Authority (FSA) = umbrella supervisor
United Kingdom FSA FSA FSA FSA
Treasury bull Commercial banks bull Investment funds (Securities and (Insurance Directorate(Securities and Investments Board) bull Unit trust groups Futures Authority) of the Treasury)
Bank of bull Building societies bull Pension funds England (Building Societies Commission) bull Merchant banks
bull Friendly societies bull Clearing houses bull Primary issuers bull Insurance FSA (Friendly Societies Commission) bull Venture capital of securities companies
bull Pensions and life insurance etc bull Stock exchanges bull Insurance brokers(Personal Investment Authority) bull Stockbrokers
Financial holding companiesFederal Reserve (FR) = umbrella supervisor
United States bull National banks(OCC) Securities and Regulated by
Treasury OCC bull State banks Federal Reserve Exchange Commission StatesMembers (FR)
OTS Nonmembers (FDIC) bull Investment banks bull Primary issuers of bull Insurance companies FR bull Cooperative banks (FDICFR) bull Finance companies securities bull Insurance brokers FDIC bull Insured industrial banks (FDIC) bull Stock exchanges
bull Thrift holding companies (OTS) bull Stockbrokers SEC bull Savings banks (OTSFDICFR) bull Investment advisors
bull Savings and loan associations bull Mutual funds(OTS) bull Public utility holding
bull Edge Act corporations (FR) companies
(table continues next page)
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Table 210 Financial-sector regulation G-10 countries 2000 (continued )
Financial institutions and their supervisors
Country and supervisory structure Retail banking Wholesale banking Securities Insurance
Financial holding companies Japan Financial Supervisory Authority (FSA) = umbrella supervisor
Prime FSA FSA FSA FSA ministerrsquos Ministry of office Finance (Securities and Exchange
Surveillance Commission) FRC Bureau of Financial bull City banks bull Investment banks bull Primary issuers of bull Insurance companies FSA Regulation bull Regional banks bull Asset managers securities bull Insurance brokers
bull Trust banks bull Stock exchanges SESC bull Long-term credit banks bull Stockbrokers
bull Pension funds
Financial holding companiesOffice of the Superintendent of Financial Institutions (OSFI) = umbrella supervisor
Canada Regulated by OSFI OSFI provinces OSFI
Department of Financebull Banks bull Cooperative credit bull Primary issuers of bull Insurance companies
(previously Office of the Inspector associations securities (previously Depart- OSFI General of the Banks) bull Fraternal benefit bull Stock exchanges ment of Insurance) Bank of bull Trust and loan companies society bull Stockbrokers bull Insurance brokers Canada bull Pension funds bull Asset managers
(previously Depart- CDIC ment of Insurance)
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Financial institutions and their supervisors
Country and supervisory structure Retail banking Wholesale banking Securities Insurance
Germany Financial holding groupsFederal Banking Supervisory Office (FBSO) = umbrella supervisor
Ministry of Finance FBSO BSO FSSO FISO
Bundesbankbull Universal banks bull Other financial bull Primary issuers of bull Insurance companies
Federal Banking bull Savings banks institutions (eg securities bull Insurance brokers Supervisory Office bull Securities banks management foreign bull Stock exchanges
currency dealings) bull Stockbrokers Federal Securities bull Financial enterprises bull Asset managers Supervisory Office (eg leasing bull Pension funds
organizations Federal Insurance credit card companies Supervisory Office investment advisors)
Italy Bank foundationsMinistry of Finance = umbrella supervisor
Ministry of Finance Bank of Italy Bank of Italy Consob ISVAP
Bank of Italy bull Commerical banks bull Asset managers bull Primary issuers of bull Insurance companies Consob bull Savings bank bull Open-end investment securities bull Insurance brokers
bull Securities banks companies (SICAVs) bull Stock exchangesbull Stockbrokers
ISVAP
(table continues next page)
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Table 210 Financial-sector regulation G-10 countries 2000 (continued )
Financial institutions and their supervisors
Country and supervisory structure Retail banking Wholesale banking Securities Insurance
The Netherlands Financial conglomeratesCouncil of Financial Supervisors = umbrella supervisor
Securities Board Securities Board Netherlandsche Netherlands Bank Netherlandsche Bank of the Netherlands Insurance Board Bank Insurance bull Credit institutions (universal banks bull Investment institutions bull Stock exchanges bull Insurance companies Board cooperative banks security credit (securities issuing bull Stockbrokers bull Insurance brokers
institutions mortgage banks) and tradingmdashprimary The Council of Financial and secondary Supervisors markets)
France Commission des Commission de Operations des Controcircle des
Banking and Banking Commission Bourse Assurances Financial Regulatory bull Ensuring that credit institutions (and investment firms since bull Primary issuers of bull Insurance companies Ministry for Committee the Financial Activity Modernization Act of 1996) comply securities bull Insurance brokers Economic with laws and regulations bull Stock exchanges Affairs and bull Execute instructions regarding all off-site monitoring and bull Stockbrokers Finance Credit on-site supervision Institutions and Banking and Financial Regulatory Committee Investment bull Formulates general regulations for credit institutions and investment firms Committee (capital adequacy requirements accounting rules etc) Bank of France Credit Institutions and Investment Committee Banking bull Authorizes and examines financial institutions except for those within the Commission competence of the Banking Commission
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Financial institutions and their supervisors
Country and supervisory structure Retail banking Wholesale banking Securities Insurance
Switzerland Large banking groupSwiss Federal Banking Commission (SFBC) = umbrella supervisor
Swiss National Bank Federal Office of
SFBC SFBC SFBC Private Insurance Swiss Federal Banking Commission bull Universal banks bull Investment banks bull Primary issuers of bull Insurance companies
bull Savings banks bull Asset management securities bull Insurance brokerscompanies bull Stock exchanges
Private audit Federal bull Investment funds bull Stockbrokers firms Office of bull Mortgage bond authorized by Private business SFBC Insurance
Sweden Financial holding company groupsFinancial Supervisory Authority = umbrella supervisor
Ministry of Finance Credit Market Securities Market Insurance Market
Credit Market Department Department Department Department
Financial bull Commercial banks bull Investment funds bull Primary issuers of bull Insurance companies Riksbank Supervisory bull Savings banks securities bull Insurance brokers Authority bull Friendly societies bull Stock exchanges
bull Stockbrokers
(table continues next page)
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Table 210 Financial-sector regulation G-10 countries 2000 (continued )
Financial institutions and their supervisors
Country and supervisory structure Retail banking Wholesale banking Securities Insurance
Belgium Bank holding companiesBanking and Finance Commission = umbrella supervisor
Bank of Belgium Banking Banking
Banking and Finance and Finance Insurance Controland Finance Commission Commission Commission Office
Banking and Insurance Finance Control bull Commercial banks bull Asset management bull Primary issuers of bull Insurance companies Commission Office bull Savings banks firms securities bull Insurance brokers
bull Securities banks bull Investment funds bull Stock exchanges bull Mortgage companiesbull Stockbrokers bull Pension funds
Securities Regulation Fund Securities Regulation Fund
bull Other investment firms and credit institutions(institutions participating in regulated off-exchangemarket in strips and Treasury certificates)
Bank holding companies Spain Banco de Espantildea = umbrella supervisor
Banco de Espantildea Comision Nacional del Mercado de Directorate General
Banco de Espantildea Valores (CNMV) Insurance
bull All credit institutions (commercial banks savings banks credit bull Primary issuers of (Ministry of Economy Ministry of cooperatives official credit institutions finance factoring and securities and Finance) Economy and CNMV leasing companies mortgage-loan companies etc) bull Stock exchanges bull Insurance companies Finance bull Interbank foreign exchange and book-entry public debt bull Stockbrokers bull Pension funds
markets bull Venture capital(companies and funds)
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Financial institutions and their supervisors
Country and supervisory structure Banking Securities Insurance
Banking Advisory High Level Securities Supervisors Committee (BAC) Committee (HLSS) Insurance Committee (IC)
Supranational (EU) bull Formulates standards for prudential bull Coordination of securities market bull Formulates standards forsupervision supervision prudential supervision
BACICHLSS Banking Supervision
Conglomerates Committee (BSC) Securities Contact Committee Regulation of prudential bull Systemic risk monitoring bull Regulation and implementation of supervision securities admission
International Association International International Organization of of Insurance Supervisors
Basel Committee Securities Commisison (IOSCO) (IAIS) Joint Forum Conglomerates Supervision bull Supervision and regulation best bull Supervision and regulation best bull Supervision and regulation amp regulation Best practices practices practices best practices
FSF Coordination across supervisors of various functions
Notes See appendix B for more information Boldface type indicates senior or oversight supervisor normal type indicates adjunct or front-line supervisorsolid line indicates direct responsbility to the senior-ranking authority dotted line indicates coordination in supervisory activities
(table continues next page)
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Table 210 Financial-sector regulation G-10 countries 2000 (continued )
Glossary of names United Kingdom FSA = Financial Services Authority United States FR = Federal Reserve OCC = Office of the Comptroller of theCurrency FDIC = Federal Deposit Insurance Corporation SEC = Securities and Exchange Commission OTS = Office of Thrift Supervision Japan FRC =Financial Reconstruction Commission FSA = Financial Services Agency SESC = Securities and Exchange Surveillance Commission Canada OSFI =Office of the Superintendent of Financial Institutions CDIC = Canada Deposit Insurance Corporation Germany FBSO = Federal Banking SupervisoryOffice FSSO = Federal Securities Supervisory Office FISO = Federal Insurance Supervisory Office BSO = Banking Supervisory Office Italy Consob =Commissione Nazionale per le Societa e la Borsa ISVAP = Instituto per la Vigilanza sulle assicurazioni private e di Interesse colletivo Switzerland SFBC= Swiss Federal Banking Commission Spain CNMV = The Comision Nacional del Mercado de Valores Supranational BAC = Banking Advisory CommitteeBSC = Banking Supervision Committee IC = Insurance Committee HLSS = High Level Securities Supervisors Committee International Dimension FSF =Financial Stability Forum IOSCO = International Organization of Securities Commission IAIS = International Association of Insurance Supervisors
Sources United Kingdom Bank of England httpwwwbankofenglandcouk Financial Services Authority httpwwwfsagovuk United States Board ofGovernors of Federal Reserve System httpwwwfederalreservegov Japan Bank of Japan httpwwwbojorjo Financial Reconstruction Commissionhttpwwwfsagojpfrcindexehtml Financial Services Agency httpwwwfsagojp Canada Bank of Canada httpwwwbank-banque-canadaca Office ofthe Superintendent of Financial Institutions httpwwwosfi-bsifgccaAndreEindexhtml Germany Deutsche Bundesbank httpwwwbundesbankde Fed-eral Banking Supervisory Office httpwwwbakredde Italy Banca drsquoitalia httpwwwbancaditaliait Commissione Nazionale per le Societa e la Borsahttpwwwconsobit Instituto per la Vigilanza sulle assicurazioni private e di Interesse colletivo httpwwwisvapit The Netherlands De NederlandscheBank httpwwwdnbnl France Banque de France httpwwwbanque-francefr Switzerland Schweizerische Nationalbank httpwwwsnbchindex3htmlSweden Sveriges Riksbank httpwwwriksbanksedefaultasp Belgium National Bank of Belgium httpwwwbnbbesgindexhtm Spain Banco de Espantildeahttpwwwbdees The Comision Nacional del Mercado de Valores httpwwwcnmves Supranational (EU) Institutional Arrangements for the Regulationand Supervision of the Financial Sector 2000 International Dimension Bank for International Settlement httpwwwbisorg International Organization ofSecurities Commissions httpwwwioscoorg International Association of Insurance Supervisors httpwwwiaisorg Financial Stability Forum httpwwwfsforumorg
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 121
the inflexibility of tight surveillance against the need to encourage in-novation and growth The US Securities and Exchange Commission isworried about aggressive accounting by firms and biased reports bysecurities analysts in an equity environment that prizes steadily higherquarterly earnings41 Japanese regulators are preoccupied with opaqueinterconnections between portfolio institutions banks and nonfinancialfirms through the keiretsu system Canadian regulators reeling from high-profile scandals of managers intentionally misleading investors are strengtheningmarket discipline through legal penalties aimed at managers and directorsof offending firms
When panic strikes a securities regulator cannot do much As the 1987stock market crash and the LTCM debacle in the fall of 1998 both dem-onstrated steep stock and bond price declines can create systemic risksIf severe enough the wealth effect of falling securities values and thefear of widespread insolvency can depress real activity Flooding thesystem with liquidity is a central bankerrsquos solutionmdashsomething a securi-ties regulator cannot do42 But just as financial supervisors can changethe incentive structure to discourage bankers from making risky loans ingood times so securities regulators can pay more attention to incentiveson the demand side when capital markets are strong
Prudential Supervision and InnovationmdashA Footnote
In concluding this discussion of prudential supervision in the G-10 anadditional point is worth noting National regulators face a persistenttrade-off between emphasizing financial system safety and soundnesswhile encouraging innovationmdashin spite of the added risks innovationbrings to financial markets Former US Treasury Secretary Lawrence Summers(2000 3) has argued by analogy
The jet airplane made airplane air travel more comfortable more efficient andmore safe though the accidents were more spectacular and for a time morenumerous after the jet was invented In the same way modern global financialmarkets carry with them enormous potential for benefit even if some of theaccidents are that much more spectacular As the right public policy response
41 The problem is illustrated by the divergence since mid-1998 between reported earn-ings by the Standard amp Poorrsquos (SampP) 500 and the after-tax profits of all corporations inthe national accounts Generally these two series move closely with one another Be-tween mid-1998 and mid-1999 SampP 500 reported that earnings increased by more than20 percent while after-tax profits of all corporations increased by less than 5 percent(Chase Bank US Economic and Policy Research US Weekly Prospects Chase SecuritiesWeekly Newsletter 5 June 2000 5)
42 For example the US Securities and Exchange Commission had no direct role in calmingmarkets in the 1987 or 1998 panics
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122 WORLD CAPITAL MARKETS
to the jet was longer runways better air-traffic control and better training forpilots and not the discouragement of rapid travel so the right public policyresponse to financial innovation is to assure a safe framework so that the ben-efits can be realized not to stifle the change
Accepting Summersrsquos analogy for the international financial system better-informed supervisors and investors are a necessary part of the financialsystem framework Supervisors require more timely information on therisk profiles resulting from positions taken by financial institutions Theyalso need a better understanding of risk-management systems Snapshotsof an institutionrsquos risk profile and risk-management procedures are nolonger adequate In a world where huge bets are quickly made (andpossibly lostmdashas with Barings Bank in 1995 and LTCM in 1998) super-visors must focus on the soundness of banking systems for evaluatingand managing risk on a daily basis Some progress has been made inaddressing these issues US banking examiners are extending their in-formation requirements in banking examinations and increasing theirinvolvement in large complex institutions43 More awareness is alsorequired of the fact that they are national organizations in a world ofcross-border capital flows To a much greater extent they need a multi-national reach International supervision and coordination among super-visors are the subject of the next section
Our analysis suggests that G-10 supervisors have unfinished businessBank supervisors need to start yesterday securities regulators can waituntil tomorrow One G-10 member acting alone cannot correct the biasIn good times the lending business will simply migrate to other G-10banks In bad times financial problems will not stop at the national bor-der A way has to be found to establish common international standardsfor the key financial players in order to prevent crises and to agree onapproaches for managing them The path has already been laid out Inthe wake of the bank failures of the past 25 years bank supervisors havetried to establish such standards They have done this without creating anew global institution
The essence of the international framework is decentralizationmdashglobalrules and design standards without global institutions that are perceivedto intrude on national sovereignty The awkward jargon for this frame-work is vertical subsidiaritymdashldquothink internationally act nationallyrdquo Theinternational thinking is done by a committee of regulators that meets
International SupervisionA Decentralized Framework
43 These issues are discussed in Ferguson (1999) and Meyer (2000a)
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 123
regularly at the Bank for International Settlements in Basel The commit-tee establishes principles and standards that are interpreted implementedand enforced by national authorities44 In this section we describe thesesupervisory efforts and their weaknesses We present our recommenda-tions for addressing these weaknesses in the next chapter
Basel I
The Basel Capital Accord of 1988 (Basel I)45 drew the lesson from thefinancial crises of the mid-1970s that more adequate capital levels in in-ternational banks would help reduce the systemic risk of bank failureThe primary goal of Basel I was capital adequacy other standards wereput in place not so much for their own virtue as to defend the primarygoal
Capital adequacy requirements were designed to ensure that individualinstitutions have the ability to absorb losses particularly credit lossesAccordingly a backup system of scoring credit risk was devised thatrequired large amounts of bank capital for some types of loans smalleramounts for others and zero for a select list of preferred assets Report-ing requirements were designed to disclose problems and ensure that atroubled bank would take timely steps to restore its capital base in thewake of a loss The Basel I framework worked tolerably well in limitingthe call on the public purse in the G-10 countriesmdashwith the notable ex-ceptions of France and Japan The framework failed to moderate riskybank lending to emerging markets however
Basel I was not developed with emerging markets in mind The origi-nal idea behind it was to develop a common supervisory approach tocross-border banking operations It grew out of political pressure fromUS lawmakers who were determined to require international banks op-erating in the United States to meet US banking standards Toward thisgoal in 1983 Congress passed the International Lending Supervisory ActUS and British banking authorities subsequently agreed on a commontarget the adoption of strict common capital-adequacy standards In 1988other G-10 governments agreed to go along voluntary acceptance ofthe standards throughout much of the rest of the world followed46 Therationale for the capital targets was two-fold The first was to requirebanks to hold sufficient amounts of capital (8 percent of risk-adjusted
44 The international committee of financial authorities agreed on a common definitionof banksrsquo tier-one or ldquocorerdquo capital national authorities defined tier-two capital in theirown manner which permitted greater variations in national working definitions andpractices
45 International Convergence of Capital Measurement and Capital Standards (BIS 1988)was prepared by the Basel Committee on Banking Supervision
46 See Reineke (1998)
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124 WORLD CAPITAL MARKETS
assets) to cushion losses on those assets The second was to dull theirappetites for risk banks with large capital bases would have more tolose if they failed and therefore would take fewer risks
Rapid change in financial markets soon revealed flaws in the Basel IAccord In a complex world with numerous sources of risk it focusedheavily on credit risk but overlooked other risks in a bankrsquos portfolioand the correlation between returns on different asset classes The Baselformula required banks to maintain a fixed amount of capital againsteach of its asset classes But the formula did not distinguish the riskinessof the borrower within each class As a result one large loan to a low-risk corporate borrower such as General Electric would require the sameamount of capital as 10 smaller transactions with high-risk borrowers
The system was also biased toward short-term loans Loans maturingin less than a year required a 20 percent risk weight whereas those ma-turing after more than a year required a 100 percent risk weight Inter-bank lending was particularly favored For example loans to banks inOECD countries required less capital than loans to private firms in thesame countries creating the anomaly that interbank loans to South Ko-rean banks required less capital than loans to General Electric47 Thisanomaly encouraged banks to shed high-quality assets if the Basel rulesrequired the allocation of more capital than banks thought they needed
Another weakness was that financial innovators quickly circumventedthe Accord Because short-term loans required less provisioning than long-term loans banks responded by securitizing their long-term debt port-folios and lending short-term against the collateral of the newly createdasset This allowed banks to circumvent the capital requirements gearedto the terms of the underlying debt At the same time the Basel I Accordfailed to encourage risk mitigation techniques such as credit derivativescollateral guarantees and on-balance-sheet netting the flip side of fi-nancial innovation Because off-balance-sheet products were not coveredby the Accord another anomaly appeared when Barings Bank collapsedin 1995 Barings met capital adequacy standards but collapsed becauseits systems for managing risk failed traders were allowed to speculatein futures contracts that did not appear on the balance sheet
Basel II
Work to overhaul Basel I began in 1995 and produced consultativepapers issued in June 1999 and January 200148 These papers have been
47 South Korean banks have had notoriously weak balance sheets because the practiceof ldquodirected lendingrdquo left them with many poor loans (in making these loans the bankswere expected to follow government objectives rather than creditworthiness criteria)
48 Basel Committee on Banking Supervision (1999 2001)
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 125
the subject of extensive consultation and revision as a result the newAccord is expected to be introduced in 200449 The Basel II frameworkhas three parts (pillars) revisions to Basel I minimum-capital require-ments supervisory review criteria and greater emphasis on market dis-cipline Broadly Basel II aims to maintain the level of capital in the sys-tem but achieve better alignment of banksrsquo capital with their risk pro-files and keep up with financial innovation
To align capital requirements with market realities (the first pillar)Basel II concentrates on the 100 or so largest banksmdashthe type of playerslisted in table 21mdashand on the holding-company parents of banking groups50
Capital requirements will differentiate between an increased number ofcredit groups or ldquorisk bucketsrdquo including claims on governments otherbanks corporations mortgage-backed securities and other asset-backedsecurities
Basel II originally proposed to use external ratings to set capital chargesfor a number of these credit risks Many banks objected arguing thatthey assess credit risk better than Standard amp Poorrsquos Moodyrsquos or FitchIBCA51 Basel II thus proposes two approaches to rating a standard ap-proach using external ratings and an ldquoadvancedrdquo approach that allowsselected banks to use their own internal rating systems To encouragethe development of rigorous internal control systems based on these in-ternal rating systems Basel II also proposes to levy capital charges foroperational risk (the risk of direct or indirect loss resulting from inad-equate or failed internal processes people and systems or from exter-nal events)
Some critics of this proposal dismiss it as an abrogation of the prin-ciple of external independent monitoring and as ldquodangerously naiumlverdquo52
But regulators argue that the new capital charge on operational risk shouldoffset this concern It is also far from clear how cross-national compari-sons of rating and internal risk-assessment systems will be made (Engelen2000) The development by the European Union of its own capital rulescould well complicate the international resolution of these issues Publicassurances by EU officials in January 2001 however indicated that theirmain concerns are to create a level playing field and avoid regulatoryarbitrage (Hargreaves 2001) There is also the significant problem ofthe procyclical character of risk weights When a crisis hits losses are
49 See Berry (2000) for an update in an interview with William J McDonough chair ofthe Basel Committee on Banking Supervision
50 For obvious reasons these proposals are addressed to large banks and simpler capi-tal standards are allowed for small banks that focus on their domestic credit markets
51 See Ammer and Packer (2000) for an empirical critique of the success of rating agen-cies in distinguishing risk by sector and region
52 See Auerback (2001)
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126 WORLD CAPITAL MARKETS
incurred or accrued capital is lost and loan exposure must be reducedor securities sold to restore the requisite capital-adequacy ratios A morerisk-sensitive framework could amplify volatility
As the second pillar of Basel II supervisory review criteria are beingbeefed up to encourage supervisors to intervene earlier in potential problemsituations and to compel banks to align their capital positions with theirrisk profiles Bank supervisors will be authorized to require banks tohold capital in excess of minimum requirements if they have concernsabout general management overall strategy risk-management performanceor the macroeconomic environment Of course if one G-10 supervisorimposes higher capital requirements in isolation the same disparity willemerge that presaged Basel I Some banks will be disadvantaged in theinternational marketplace and will loudly complain that excessive super-vision is driving business to their competitors Hence close internationalcooperation among supervisors is critical
To implement the third pillar market discipline banks will be requiredto make fuller more timely disclosure of capital adequacy and the risksto which that capital is exposed A number of measures are being stud-ied that might help supervisors evaluate bank performance such as com-parisons of uninsured deposit interest rates subordinated debt yieldsand equity prices The idea is that these yields and prices might alertsupervisors to market perceptions of risk Of course market perceptionsare only as good as market information More direct and controversialways to reinforce market discipline would dramatically increase publicdisclosure of bank positions and risk management systems
Many questions are still outstanding about how to resolve the techni-cal details of capital requirements and whether the requirements willachieve their intended goal of better assessment and mitigation of therisks in banksrsquo portfolios There is no substitute for skilled supervisorsThe intricacies of effective design and implementation suggest that su-pervisors need to be highly competent technically knowledgeable aboutbanking portfolio characteristics and the factors that influence bank ex-posure to credit risk (Mishkin 2000) And they must be aided by vigilantshareholders market forces and transparency of information53
Standard setting at the global level is desirable but ultimately theeffectiveness of these efforts will be tested at the national level espe-cially in times of systemic financial distress Here the record of Basel Iwas not a bright shining success Japanese banking regulators havetraditionally allowed banks to include real estate and securities in theircapital base When the value of these assets plummeted in the early 1990sregulators allowed banks to continue valuing these depreciated (andoften bankrupt) assets at their old inflated levels Japanese authorities
53 Benedict Roth Complacency Towards Catastrophe Financial Times 23 January 2001
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 127
insisted until the mid-1990s that eroded capital bases could be rebuiltin a market-driven fashion They rightly foresaw that huge loan losseswould undermine public support for the ruling party and require a po-litically unpopular bailout
Japanese foot dragging on Basel I was the worst54 but not uniqueOther examples can be found of ldquopolitically mandated forbearancerdquo TheFederal Reserve Bank of New York held important hands during theLTCM crisis of 1998 Mexico is still resolving the banking crisis that eruptedin 1995 South Korea has not yet closed the insolvent banks that behavedso badly before the crisis of 1998 In the aftermath of a crisis nationalregulators cannot always be relied upon to discipline politically power-ful bankers55 One of the little-noticed consequences of these differingapproaches is that those banks with strong regulatory systems receivedan implicit ldquoexport subsidyrdquo for their services US banks which had notengaged extensively in emerging-market lending in the 1990s were bet-ter positioned than their German and Japanese counterparts to expandtheir international assets in the wake of the crises
Other Financial Forums
54 See Japanese Banks Fiddling while Marunouchi Burns The Economist 27 January2001 67-69
55 See Calomiris (1997)
The Basel model of vertical subsidiarity has already been extended toother financial regulatory bodies In 1993-94 the BIS established a Tri-partite Group of Banking Insurance and Securities Regulators In 1994-95 the BIS increased its cooperation with the International Organizationof Securities Commissions when the two organizations issued parallelpapers on guidelines for national regulators concerning risk managementand disclosure of derivative trades In 1996 a permanent Joint Forum onFinancial Conglomerates was established to examine supervisory issuesand develop working arrangements among the different functional super-visors of conglomerate institutions that offer combinations of bankingsecurities and insurance products Draft papers on the supervisionof conglomerates were released for comment in 1998 applying capital-adequacy principles to these groups and providing guidelines both forassessing the integrity and competence of top managers and for sharingassessments between regulators
In 1997 the Basel Committee on Banking Supervision extended itsreach beyond capital standards to broader aspects of banking supervi-sion with the publication of the Core Principles for Effective BankingSupervision In 1999 a wide range of regulatory and standard-settingbodies were gathered under the umbrella of the Financial Stability
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128 WORLD CAPITAL MARKETS
Forum (FSF) itself established under BIS aegis56 The FSF has alreadyissued recommendations for stepped-up supervision and transparencyas well as guidelines for best practices in a number of areas includingoffshore financial centers and highly leveraged institutions or hedge funds57
Conclusion
Although the structural weaknesses in emerging-market economies arewidely acknowledged to have been causal factors in international capi-tal-market volatility this chapter points to the role of large G-10 bankingorganizations as major suppliers of the most volatile instrument short-term debt We have examined evidence of the impact of public safetynets in the G-10 economiesmdashthe deposit insurance systems the pruden-tial supervisory systems and the lender-of-last-resort functions of centralbanksmdashon the incentive structures of these organizations
Although supervisors in most countries working nationally and to-gether in the BIS have made significant efforts to mimic market forcesin their prudential supervision the most sophisticated financial institu-tions find innovative ways to circumvent the rules New global regulatorybodies are not about to be created G-10 national bank regulators shouldthemselves address the short-term debt bias in the international financialsystem by changing incentive systems G-10 securities regulators shouldalso take steps to get ahead of the curve paying close attention to largeportfolio swings by institutional investors particularly in times of crisisIn short more needs to be done at national and international levels tochange the rules of the game That is the subject of the next chapter
56 The Financial Stability Forum includes banking securities insurance and accountingregulatory bodies the OECD on taxation corruption and corporate governance and theIMF
57 See Martin (2000)
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112 WORLD CAPITAL MARKETS
lending and debt finance to emerging markets and we have argued forsubstitution toward equity finance and direct investment39
That is not the end of the story We noted in the previous chapterthat institutional investors can become momentum investors selling in adownturn As more portfolio capital is invested in emerging marketssome players may adopt the high-risk high-leverage strategies of themost aggressive hedge funds Indeed the data in box 11 show that G-10portfolio investors held somewhat more long-term debt (more than $500billion) than equity (less than $400 billion) in emerging markets at theend of 1997 Long-term debt is an ideal vehicle for high-risk high-leveragestrategies These strategies practiced on a large scale could compound afuture crisis harming emerging markets A big enough crisis could inturn pressure G-10 central banks and finance ministers to arrange bail-out plans Instead of shrinking as a systemic financial problem moralhazard could increase
National securities regulators are the first line of defense against thisscenario They play a critical role in the safe evolution of capital mar-kets But regulators today are mandated to approve the issuance of newsecurities and to monitor the continuing disclosure of material informa-tion by issuers They are far less concerned with or empowered to monitorthe behavior of the increasingly large wealth-management firms that arethe major purchasers (and therefore resellers) of these securities
Within their mandates the goals of national securities regulators (table210 and appendix B) are similar to the concerns of bank regulators withsystem safety and soundness Their focus is also on the incentive sys-tems for management and boards of directors and on disclosure by cor-porations that issue marketable securities such as shares bonds andasset-backed securities 40 Issuers of securities possess greater knowledgeabout the quality of these assets than do the purchasers hence investorprotection is a key concern of regulators Moreover market disciplineworks best when markets know what is happening Well-functioning corpora-tions are key agents of wealth creation and social progress Underperform-ing corporations waste resources During recessions bad corporationsget into bad trouble often with severe social consequences Inadequateincentives for managers and inadequate accountability for boards andmanagers thus have negative externalities Regulators play a vital role inexposing weakness so that market disciplines come to bear sooner ratherthan later
Regulatory emphasis is constantly shifting as financial markets evolveand as the macroeconomic environment changes Regulators try to balance
39 See Rogoff (1999) Also see Berlin (2000) for a perspective on the limited role thatbanks play as share owners
40 See Habib and Ljungqvist (2000) for recent empirical analysis showing that corporateshare market values are higher when corporate executives have a larger ownership stake
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Table 210 Financial-sector regulation G-10 countries 2000
Financial institutions and their supervisors
Country and supervisory structure Retail banking Wholesale banking Securities Insurance
Financial conglomeratesFinancial Services Authority (FSA) = umbrella supervisor
United Kingdom FSA FSA FSA FSA
Treasury bull Commercial banks bull Investment funds (Securities and (Insurance Directorate(Securities and Investments Board) bull Unit trust groups Futures Authority) of the Treasury)
Bank of bull Building societies bull Pension funds England (Building Societies Commission) bull Merchant banks
bull Friendly societies bull Clearing houses bull Primary issuers bull Insurance FSA (Friendly Societies Commission) bull Venture capital of securities companies
bull Pensions and life insurance etc bull Stock exchanges bull Insurance brokers(Personal Investment Authority) bull Stockbrokers
Financial holding companiesFederal Reserve (FR) = umbrella supervisor
United States bull National banks(OCC) Securities and Regulated by
Treasury OCC bull State banks Federal Reserve Exchange Commission StatesMembers (FR)
OTS Nonmembers (FDIC) bull Investment banks bull Primary issuers of bull Insurance companies FR bull Cooperative banks (FDICFR) bull Finance companies securities bull Insurance brokers FDIC bull Insured industrial banks (FDIC) bull Stock exchanges
bull Thrift holding companies (OTS) bull Stockbrokers SEC bull Savings banks (OTSFDICFR) bull Investment advisors
bull Savings and loan associations bull Mutual funds(OTS) bull Public utility holding
bull Edge Act corporations (FR) companies
(table continues next page)
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Table 210 Financial-sector regulation G-10 countries 2000 (continued )
Financial institutions and their supervisors
Country and supervisory structure Retail banking Wholesale banking Securities Insurance
Financial holding companies Japan Financial Supervisory Authority (FSA) = umbrella supervisor
Prime FSA FSA FSA FSA ministerrsquos Ministry of office Finance (Securities and Exchange
Surveillance Commission) FRC Bureau of Financial bull City banks bull Investment banks bull Primary issuers of bull Insurance companies FSA Regulation bull Regional banks bull Asset managers securities bull Insurance brokers
bull Trust banks bull Stock exchanges SESC bull Long-term credit banks bull Stockbrokers
bull Pension funds
Financial holding companiesOffice of the Superintendent of Financial Institutions (OSFI) = umbrella supervisor
Canada Regulated by OSFI OSFI provinces OSFI
Department of Financebull Banks bull Cooperative credit bull Primary issuers of bull Insurance companies
(previously Office of the Inspector associations securities (previously Depart- OSFI General of the Banks) bull Fraternal benefit bull Stock exchanges ment of Insurance) Bank of bull Trust and loan companies society bull Stockbrokers bull Insurance brokers Canada bull Pension funds bull Asset managers
(previously Depart- CDIC ment of Insurance)
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Financial institutions and their supervisors
Country and supervisory structure Retail banking Wholesale banking Securities Insurance
Germany Financial holding groupsFederal Banking Supervisory Office (FBSO) = umbrella supervisor
Ministry of Finance FBSO BSO FSSO FISO
Bundesbankbull Universal banks bull Other financial bull Primary issuers of bull Insurance companies
Federal Banking bull Savings banks institutions (eg securities bull Insurance brokers Supervisory Office bull Securities banks management foreign bull Stock exchanges
currency dealings) bull Stockbrokers Federal Securities bull Financial enterprises bull Asset managers Supervisory Office (eg leasing bull Pension funds
organizations Federal Insurance credit card companies Supervisory Office investment advisors)
Italy Bank foundationsMinistry of Finance = umbrella supervisor
Ministry of Finance Bank of Italy Bank of Italy Consob ISVAP
Bank of Italy bull Commerical banks bull Asset managers bull Primary issuers of bull Insurance companies Consob bull Savings bank bull Open-end investment securities bull Insurance brokers
bull Securities banks companies (SICAVs) bull Stock exchangesbull Stockbrokers
ISVAP
(table continues next page)
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Table 210 Financial-sector regulation G-10 countries 2000 (continued )
Financial institutions and their supervisors
Country and supervisory structure Retail banking Wholesale banking Securities Insurance
The Netherlands Financial conglomeratesCouncil of Financial Supervisors = umbrella supervisor
Securities Board Securities Board Netherlandsche Netherlands Bank Netherlandsche Bank of the Netherlands Insurance Board Bank Insurance bull Credit institutions (universal banks bull Investment institutions bull Stock exchanges bull Insurance companies Board cooperative banks security credit (securities issuing bull Stockbrokers bull Insurance brokers
institutions mortgage banks) and tradingmdashprimary The Council of Financial and secondary Supervisors markets)
France Commission des Commission de Operations des Controcircle des
Banking and Banking Commission Bourse Assurances Financial Regulatory bull Ensuring that credit institutions (and investment firms since bull Primary issuers of bull Insurance companies Ministry for Committee the Financial Activity Modernization Act of 1996) comply securities bull Insurance brokers Economic with laws and regulations bull Stock exchanges Affairs and bull Execute instructions regarding all off-site monitoring and bull Stockbrokers Finance Credit on-site supervision Institutions and Banking and Financial Regulatory Committee Investment bull Formulates general regulations for credit institutions and investment firms Committee (capital adequacy requirements accounting rules etc) Bank of France Credit Institutions and Investment Committee Banking bull Authorizes and examines financial institutions except for those within the Commission competence of the Banking Commission
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Financial institutions and their supervisors
Country and supervisory structure Retail banking Wholesale banking Securities Insurance
Switzerland Large banking groupSwiss Federal Banking Commission (SFBC) = umbrella supervisor
Swiss National Bank Federal Office of
SFBC SFBC SFBC Private Insurance Swiss Federal Banking Commission bull Universal banks bull Investment banks bull Primary issuers of bull Insurance companies
bull Savings banks bull Asset management securities bull Insurance brokerscompanies bull Stock exchanges
Private audit Federal bull Investment funds bull Stockbrokers firms Office of bull Mortgage bond authorized by Private business SFBC Insurance
Sweden Financial holding company groupsFinancial Supervisory Authority = umbrella supervisor
Ministry of Finance Credit Market Securities Market Insurance Market
Credit Market Department Department Department Department
Financial bull Commercial banks bull Investment funds bull Primary issuers of bull Insurance companies Riksbank Supervisory bull Savings banks securities bull Insurance brokers Authority bull Friendly societies bull Stock exchanges
bull Stockbrokers
(table continues next page)
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Table 210 Financial-sector regulation G-10 countries 2000 (continued )
Financial institutions and their supervisors
Country and supervisory structure Retail banking Wholesale banking Securities Insurance
Belgium Bank holding companiesBanking and Finance Commission = umbrella supervisor
Bank of Belgium Banking Banking
Banking and Finance and Finance Insurance Controland Finance Commission Commission Commission Office
Banking and Insurance Finance Control bull Commercial banks bull Asset management bull Primary issuers of bull Insurance companies Commission Office bull Savings banks firms securities bull Insurance brokers
bull Securities banks bull Investment funds bull Stock exchanges bull Mortgage companiesbull Stockbrokers bull Pension funds
Securities Regulation Fund Securities Regulation Fund
bull Other investment firms and credit institutions(institutions participating in regulated off-exchangemarket in strips and Treasury certificates)
Bank holding companies Spain Banco de Espantildea = umbrella supervisor
Banco de Espantildea Comision Nacional del Mercado de Directorate General
Banco de Espantildea Valores (CNMV) Insurance
bull All credit institutions (commercial banks savings banks credit bull Primary issuers of (Ministry of Economy Ministry of cooperatives official credit institutions finance factoring and securities and Finance) Economy and CNMV leasing companies mortgage-loan companies etc) bull Stock exchanges bull Insurance companies Finance bull Interbank foreign exchange and book-entry public debt bull Stockbrokers bull Pension funds
markets bull Venture capital(companies and funds)
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Financial institutions and their supervisors
Country and supervisory structure Banking Securities Insurance
Banking Advisory High Level Securities Supervisors Committee (BAC) Committee (HLSS) Insurance Committee (IC)
Supranational (EU) bull Formulates standards for prudential bull Coordination of securities market bull Formulates standards forsupervision supervision prudential supervision
BACICHLSS Banking Supervision
Conglomerates Committee (BSC) Securities Contact Committee Regulation of prudential bull Systemic risk monitoring bull Regulation and implementation of supervision securities admission
International Association International International Organization of of Insurance Supervisors
Basel Committee Securities Commisison (IOSCO) (IAIS) Joint Forum Conglomerates Supervision bull Supervision and regulation best bull Supervision and regulation best bull Supervision and regulation amp regulation Best practices practices practices best practices
FSF Coordination across supervisors of various functions
Notes See appendix B for more information Boldface type indicates senior or oversight supervisor normal type indicates adjunct or front-line supervisorsolid line indicates direct responsbility to the senior-ranking authority dotted line indicates coordination in supervisory activities
(table continues next page)
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Table 210 Financial-sector regulation G-10 countries 2000 (continued )
Glossary of names United Kingdom FSA = Financial Services Authority United States FR = Federal Reserve OCC = Office of the Comptroller of theCurrency FDIC = Federal Deposit Insurance Corporation SEC = Securities and Exchange Commission OTS = Office of Thrift Supervision Japan FRC =Financial Reconstruction Commission FSA = Financial Services Agency SESC = Securities and Exchange Surveillance Commission Canada OSFI =Office of the Superintendent of Financial Institutions CDIC = Canada Deposit Insurance Corporation Germany FBSO = Federal Banking SupervisoryOffice FSSO = Federal Securities Supervisory Office FISO = Federal Insurance Supervisory Office BSO = Banking Supervisory Office Italy Consob =Commissione Nazionale per le Societa e la Borsa ISVAP = Instituto per la Vigilanza sulle assicurazioni private e di Interesse colletivo Switzerland SFBC= Swiss Federal Banking Commission Spain CNMV = The Comision Nacional del Mercado de Valores Supranational BAC = Banking Advisory CommitteeBSC = Banking Supervision Committee IC = Insurance Committee HLSS = High Level Securities Supervisors Committee International Dimension FSF =Financial Stability Forum IOSCO = International Organization of Securities Commission IAIS = International Association of Insurance Supervisors
Sources United Kingdom Bank of England httpwwwbankofenglandcouk Financial Services Authority httpwwwfsagovuk United States Board ofGovernors of Federal Reserve System httpwwwfederalreservegov Japan Bank of Japan httpwwwbojorjo Financial Reconstruction Commissionhttpwwwfsagojpfrcindexehtml Financial Services Agency httpwwwfsagojp Canada Bank of Canada httpwwwbank-banque-canadaca Office ofthe Superintendent of Financial Institutions httpwwwosfi-bsifgccaAndreEindexhtml Germany Deutsche Bundesbank httpwwwbundesbankde Fed-eral Banking Supervisory Office httpwwwbakredde Italy Banca drsquoitalia httpwwwbancaditaliait Commissione Nazionale per le Societa e la Borsahttpwwwconsobit Instituto per la Vigilanza sulle assicurazioni private e di Interesse colletivo httpwwwisvapit The Netherlands De NederlandscheBank httpwwwdnbnl France Banque de France httpwwwbanque-francefr Switzerland Schweizerische Nationalbank httpwwwsnbchindex3htmlSweden Sveriges Riksbank httpwwwriksbanksedefaultasp Belgium National Bank of Belgium httpwwwbnbbesgindexhtm Spain Banco de Espantildeahttpwwwbdees The Comision Nacional del Mercado de Valores httpwwwcnmves Supranational (EU) Institutional Arrangements for the Regulationand Supervision of the Financial Sector 2000 International Dimension Bank for International Settlement httpwwwbisorg International Organization ofSecurities Commissions httpwwwioscoorg International Association of Insurance Supervisors httpwwwiaisorg Financial Stability Forum httpwwwfsforumorg
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 121
the inflexibility of tight surveillance against the need to encourage in-novation and growth The US Securities and Exchange Commission isworried about aggressive accounting by firms and biased reports bysecurities analysts in an equity environment that prizes steadily higherquarterly earnings41 Japanese regulators are preoccupied with opaqueinterconnections between portfolio institutions banks and nonfinancialfirms through the keiretsu system Canadian regulators reeling from high-profile scandals of managers intentionally misleading investors are strengtheningmarket discipline through legal penalties aimed at managers and directorsof offending firms
When panic strikes a securities regulator cannot do much As the 1987stock market crash and the LTCM debacle in the fall of 1998 both dem-onstrated steep stock and bond price declines can create systemic risksIf severe enough the wealth effect of falling securities values and thefear of widespread insolvency can depress real activity Flooding thesystem with liquidity is a central bankerrsquos solutionmdashsomething a securi-ties regulator cannot do42 But just as financial supervisors can changethe incentive structure to discourage bankers from making risky loans ingood times so securities regulators can pay more attention to incentiveson the demand side when capital markets are strong
Prudential Supervision and InnovationmdashA Footnote
In concluding this discussion of prudential supervision in the G-10 anadditional point is worth noting National regulators face a persistenttrade-off between emphasizing financial system safety and soundnesswhile encouraging innovationmdashin spite of the added risks innovationbrings to financial markets Former US Treasury Secretary Lawrence Summers(2000 3) has argued by analogy
The jet airplane made airplane air travel more comfortable more efficient andmore safe though the accidents were more spectacular and for a time morenumerous after the jet was invented In the same way modern global financialmarkets carry with them enormous potential for benefit even if some of theaccidents are that much more spectacular As the right public policy response
41 The problem is illustrated by the divergence since mid-1998 between reported earn-ings by the Standard amp Poorrsquos (SampP) 500 and the after-tax profits of all corporations inthe national accounts Generally these two series move closely with one another Be-tween mid-1998 and mid-1999 SampP 500 reported that earnings increased by more than20 percent while after-tax profits of all corporations increased by less than 5 percent(Chase Bank US Economic and Policy Research US Weekly Prospects Chase SecuritiesWeekly Newsletter 5 June 2000 5)
42 For example the US Securities and Exchange Commission had no direct role in calmingmarkets in the 1987 or 1998 panics
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122 WORLD CAPITAL MARKETS
to the jet was longer runways better air-traffic control and better training forpilots and not the discouragement of rapid travel so the right public policyresponse to financial innovation is to assure a safe framework so that the ben-efits can be realized not to stifle the change
Accepting Summersrsquos analogy for the international financial system better-informed supervisors and investors are a necessary part of the financialsystem framework Supervisors require more timely information on therisk profiles resulting from positions taken by financial institutions Theyalso need a better understanding of risk-management systems Snapshotsof an institutionrsquos risk profile and risk-management procedures are nolonger adequate In a world where huge bets are quickly made (andpossibly lostmdashas with Barings Bank in 1995 and LTCM in 1998) super-visors must focus on the soundness of banking systems for evaluatingand managing risk on a daily basis Some progress has been made inaddressing these issues US banking examiners are extending their in-formation requirements in banking examinations and increasing theirinvolvement in large complex institutions43 More awareness is alsorequired of the fact that they are national organizations in a world ofcross-border capital flows To a much greater extent they need a multi-national reach International supervision and coordination among super-visors are the subject of the next section
Our analysis suggests that G-10 supervisors have unfinished businessBank supervisors need to start yesterday securities regulators can waituntil tomorrow One G-10 member acting alone cannot correct the biasIn good times the lending business will simply migrate to other G-10banks In bad times financial problems will not stop at the national bor-der A way has to be found to establish common international standardsfor the key financial players in order to prevent crises and to agree onapproaches for managing them The path has already been laid out Inthe wake of the bank failures of the past 25 years bank supervisors havetried to establish such standards They have done this without creating anew global institution
The essence of the international framework is decentralizationmdashglobalrules and design standards without global institutions that are perceivedto intrude on national sovereignty The awkward jargon for this frame-work is vertical subsidiaritymdashldquothink internationally act nationallyrdquo Theinternational thinking is done by a committee of regulators that meets
International SupervisionA Decentralized Framework
43 These issues are discussed in Ferguson (1999) and Meyer (2000a)
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 123
regularly at the Bank for International Settlements in Basel The commit-tee establishes principles and standards that are interpreted implementedand enforced by national authorities44 In this section we describe thesesupervisory efforts and their weaknesses We present our recommenda-tions for addressing these weaknesses in the next chapter
Basel I
The Basel Capital Accord of 1988 (Basel I)45 drew the lesson from thefinancial crises of the mid-1970s that more adequate capital levels in in-ternational banks would help reduce the systemic risk of bank failureThe primary goal of Basel I was capital adequacy other standards wereput in place not so much for their own virtue as to defend the primarygoal
Capital adequacy requirements were designed to ensure that individualinstitutions have the ability to absorb losses particularly credit lossesAccordingly a backup system of scoring credit risk was devised thatrequired large amounts of bank capital for some types of loans smalleramounts for others and zero for a select list of preferred assets Report-ing requirements were designed to disclose problems and ensure that atroubled bank would take timely steps to restore its capital base in thewake of a loss The Basel I framework worked tolerably well in limitingthe call on the public purse in the G-10 countriesmdashwith the notable ex-ceptions of France and Japan The framework failed to moderate riskybank lending to emerging markets however
Basel I was not developed with emerging markets in mind The origi-nal idea behind it was to develop a common supervisory approach tocross-border banking operations It grew out of political pressure fromUS lawmakers who were determined to require international banks op-erating in the United States to meet US banking standards Toward thisgoal in 1983 Congress passed the International Lending Supervisory ActUS and British banking authorities subsequently agreed on a commontarget the adoption of strict common capital-adequacy standards In 1988other G-10 governments agreed to go along voluntary acceptance ofthe standards throughout much of the rest of the world followed46 Therationale for the capital targets was two-fold The first was to requirebanks to hold sufficient amounts of capital (8 percent of risk-adjusted
44 The international committee of financial authorities agreed on a common definitionof banksrsquo tier-one or ldquocorerdquo capital national authorities defined tier-two capital in theirown manner which permitted greater variations in national working definitions andpractices
45 International Convergence of Capital Measurement and Capital Standards (BIS 1988)was prepared by the Basel Committee on Banking Supervision
46 See Reineke (1998)
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124 WORLD CAPITAL MARKETS
assets) to cushion losses on those assets The second was to dull theirappetites for risk banks with large capital bases would have more tolose if they failed and therefore would take fewer risks
Rapid change in financial markets soon revealed flaws in the Basel IAccord In a complex world with numerous sources of risk it focusedheavily on credit risk but overlooked other risks in a bankrsquos portfolioand the correlation between returns on different asset classes The Baselformula required banks to maintain a fixed amount of capital againsteach of its asset classes But the formula did not distinguish the riskinessof the borrower within each class As a result one large loan to a low-risk corporate borrower such as General Electric would require the sameamount of capital as 10 smaller transactions with high-risk borrowers
The system was also biased toward short-term loans Loans maturingin less than a year required a 20 percent risk weight whereas those ma-turing after more than a year required a 100 percent risk weight Inter-bank lending was particularly favored For example loans to banks inOECD countries required less capital than loans to private firms in thesame countries creating the anomaly that interbank loans to South Ko-rean banks required less capital than loans to General Electric47 Thisanomaly encouraged banks to shed high-quality assets if the Basel rulesrequired the allocation of more capital than banks thought they needed
Another weakness was that financial innovators quickly circumventedthe Accord Because short-term loans required less provisioning than long-term loans banks responded by securitizing their long-term debt port-folios and lending short-term against the collateral of the newly createdasset This allowed banks to circumvent the capital requirements gearedto the terms of the underlying debt At the same time the Basel I Accordfailed to encourage risk mitigation techniques such as credit derivativescollateral guarantees and on-balance-sheet netting the flip side of fi-nancial innovation Because off-balance-sheet products were not coveredby the Accord another anomaly appeared when Barings Bank collapsedin 1995 Barings met capital adequacy standards but collapsed becauseits systems for managing risk failed traders were allowed to speculatein futures contracts that did not appear on the balance sheet
Basel II
Work to overhaul Basel I began in 1995 and produced consultativepapers issued in June 1999 and January 200148 These papers have been
47 South Korean banks have had notoriously weak balance sheets because the practiceof ldquodirected lendingrdquo left them with many poor loans (in making these loans the bankswere expected to follow government objectives rather than creditworthiness criteria)
48 Basel Committee on Banking Supervision (1999 2001)
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 125
the subject of extensive consultation and revision as a result the newAccord is expected to be introduced in 200449 The Basel II frameworkhas three parts (pillars) revisions to Basel I minimum-capital require-ments supervisory review criteria and greater emphasis on market dis-cipline Broadly Basel II aims to maintain the level of capital in the sys-tem but achieve better alignment of banksrsquo capital with their risk pro-files and keep up with financial innovation
To align capital requirements with market realities (the first pillar)Basel II concentrates on the 100 or so largest banksmdashthe type of playerslisted in table 21mdashand on the holding-company parents of banking groups50
Capital requirements will differentiate between an increased number ofcredit groups or ldquorisk bucketsrdquo including claims on governments otherbanks corporations mortgage-backed securities and other asset-backedsecurities
Basel II originally proposed to use external ratings to set capital chargesfor a number of these credit risks Many banks objected arguing thatthey assess credit risk better than Standard amp Poorrsquos Moodyrsquos or FitchIBCA51 Basel II thus proposes two approaches to rating a standard ap-proach using external ratings and an ldquoadvancedrdquo approach that allowsselected banks to use their own internal rating systems To encouragethe development of rigorous internal control systems based on these in-ternal rating systems Basel II also proposes to levy capital charges foroperational risk (the risk of direct or indirect loss resulting from inad-equate or failed internal processes people and systems or from exter-nal events)
Some critics of this proposal dismiss it as an abrogation of the prin-ciple of external independent monitoring and as ldquodangerously naiumlverdquo52
But regulators argue that the new capital charge on operational risk shouldoffset this concern It is also far from clear how cross-national compari-sons of rating and internal risk-assessment systems will be made (Engelen2000) The development by the European Union of its own capital rulescould well complicate the international resolution of these issues Publicassurances by EU officials in January 2001 however indicated that theirmain concerns are to create a level playing field and avoid regulatoryarbitrage (Hargreaves 2001) There is also the significant problem ofthe procyclical character of risk weights When a crisis hits losses are
49 See Berry (2000) for an update in an interview with William J McDonough chair ofthe Basel Committee on Banking Supervision
50 For obvious reasons these proposals are addressed to large banks and simpler capi-tal standards are allowed for small banks that focus on their domestic credit markets
51 See Ammer and Packer (2000) for an empirical critique of the success of rating agen-cies in distinguishing risk by sector and region
52 See Auerback (2001)
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126 WORLD CAPITAL MARKETS
incurred or accrued capital is lost and loan exposure must be reducedor securities sold to restore the requisite capital-adequacy ratios A morerisk-sensitive framework could amplify volatility
As the second pillar of Basel II supervisory review criteria are beingbeefed up to encourage supervisors to intervene earlier in potential problemsituations and to compel banks to align their capital positions with theirrisk profiles Bank supervisors will be authorized to require banks tohold capital in excess of minimum requirements if they have concernsabout general management overall strategy risk-management performanceor the macroeconomic environment Of course if one G-10 supervisorimposes higher capital requirements in isolation the same disparity willemerge that presaged Basel I Some banks will be disadvantaged in theinternational marketplace and will loudly complain that excessive super-vision is driving business to their competitors Hence close internationalcooperation among supervisors is critical
To implement the third pillar market discipline banks will be requiredto make fuller more timely disclosure of capital adequacy and the risksto which that capital is exposed A number of measures are being stud-ied that might help supervisors evaluate bank performance such as com-parisons of uninsured deposit interest rates subordinated debt yieldsand equity prices The idea is that these yields and prices might alertsupervisors to market perceptions of risk Of course market perceptionsare only as good as market information More direct and controversialways to reinforce market discipline would dramatically increase publicdisclosure of bank positions and risk management systems
Many questions are still outstanding about how to resolve the techni-cal details of capital requirements and whether the requirements willachieve their intended goal of better assessment and mitigation of therisks in banksrsquo portfolios There is no substitute for skilled supervisorsThe intricacies of effective design and implementation suggest that su-pervisors need to be highly competent technically knowledgeable aboutbanking portfolio characteristics and the factors that influence bank ex-posure to credit risk (Mishkin 2000) And they must be aided by vigilantshareholders market forces and transparency of information53
Standard setting at the global level is desirable but ultimately theeffectiveness of these efforts will be tested at the national level espe-cially in times of systemic financial distress Here the record of Basel Iwas not a bright shining success Japanese banking regulators havetraditionally allowed banks to include real estate and securities in theircapital base When the value of these assets plummeted in the early 1990sregulators allowed banks to continue valuing these depreciated (andoften bankrupt) assets at their old inflated levels Japanese authorities
53 Benedict Roth Complacency Towards Catastrophe Financial Times 23 January 2001
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 127
insisted until the mid-1990s that eroded capital bases could be rebuiltin a market-driven fashion They rightly foresaw that huge loan losseswould undermine public support for the ruling party and require a po-litically unpopular bailout
Japanese foot dragging on Basel I was the worst54 but not uniqueOther examples can be found of ldquopolitically mandated forbearancerdquo TheFederal Reserve Bank of New York held important hands during theLTCM crisis of 1998 Mexico is still resolving the banking crisis that eruptedin 1995 South Korea has not yet closed the insolvent banks that behavedso badly before the crisis of 1998 In the aftermath of a crisis nationalregulators cannot always be relied upon to discipline politically power-ful bankers55 One of the little-noticed consequences of these differingapproaches is that those banks with strong regulatory systems receivedan implicit ldquoexport subsidyrdquo for their services US banks which had notengaged extensively in emerging-market lending in the 1990s were bet-ter positioned than their German and Japanese counterparts to expandtheir international assets in the wake of the crises
Other Financial Forums
54 See Japanese Banks Fiddling while Marunouchi Burns The Economist 27 January2001 67-69
55 See Calomiris (1997)
The Basel model of vertical subsidiarity has already been extended toother financial regulatory bodies In 1993-94 the BIS established a Tri-partite Group of Banking Insurance and Securities Regulators In 1994-95 the BIS increased its cooperation with the International Organizationof Securities Commissions when the two organizations issued parallelpapers on guidelines for national regulators concerning risk managementand disclosure of derivative trades In 1996 a permanent Joint Forum onFinancial Conglomerates was established to examine supervisory issuesand develop working arrangements among the different functional super-visors of conglomerate institutions that offer combinations of bankingsecurities and insurance products Draft papers on the supervisionof conglomerates were released for comment in 1998 applying capital-adequacy principles to these groups and providing guidelines both forassessing the integrity and competence of top managers and for sharingassessments between regulators
In 1997 the Basel Committee on Banking Supervision extended itsreach beyond capital standards to broader aspects of banking supervi-sion with the publication of the Core Principles for Effective BankingSupervision In 1999 a wide range of regulatory and standard-settingbodies were gathered under the umbrella of the Financial Stability
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128 WORLD CAPITAL MARKETS
Forum (FSF) itself established under BIS aegis56 The FSF has alreadyissued recommendations for stepped-up supervision and transparencyas well as guidelines for best practices in a number of areas includingoffshore financial centers and highly leveraged institutions or hedge funds57
Conclusion
Although the structural weaknesses in emerging-market economies arewidely acknowledged to have been causal factors in international capi-tal-market volatility this chapter points to the role of large G-10 bankingorganizations as major suppliers of the most volatile instrument short-term debt We have examined evidence of the impact of public safetynets in the G-10 economiesmdashthe deposit insurance systems the pruden-tial supervisory systems and the lender-of-last-resort functions of centralbanksmdashon the incentive structures of these organizations
Although supervisors in most countries working nationally and to-gether in the BIS have made significant efforts to mimic market forcesin their prudential supervision the most sophisticated financial institu-tions find innovative ways to circumvent the rules New global regulatorybodies are not about to be created G-10 national bank regulators shouldthemselves address the short-term debt bias in the international financialsystem by changing incentive systems G-10 securities regulators shouldalso take steps to get ahead of the curve paying close attention to largeportfolio swings by institutional investors particularly in times of crisisIn short more needs to be done at national and international levels tochange the rules of the game That is the subject of the next chapter
56 The Financial Stability Forum includes banking securities insurance and accountingregulatory bodies the OECD on taxation corruption and corporate governance and theIMF
57 See Martin (2000)
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Table 210 Financial-sector regulation G-10 countries 2000
Financial institutions and their supervisors
Country and supervisory structure Retail banking Wholesale banking Securities Insurance
Financial conglomeratesFinancial Services Authority (FSA) = umbrella supervisor
United Kingdom FSA FSA FSA FSA
Treasury bull Commercial banks bull Investment funds (Securities and (Insurance Directorate(Securities and Investments Board) bull Unit trust groups Futures Authority) of the Treasury)
Bank of bull Building societies bull Pension funds England (Building Societies Commission) bull Merchant banks
bull Friendly societies bull Clearing houses bull Primary issuers bull Insurance FSA (Friendly Societies Commission) bull Venture capital of securities companies
bull Pensions and life insurance etc bull Stock exchanges bull Insurance brokers(Personal Investment Authority) bull Stockbrokers
Financial holding companiesFederal Reserve (FR) = umbrella supervisor
United States bull National banks(OCC) Securities and Regulated by
Treasury OCC bull State banks Federal Reserve Exchange Commission StatesMembers (FR)
OTS Nonmembers (FDIC) bull Investment banks bull Primary issuers of bull Insurance companies FR bull Cooperative banks (FDICFR) bull Finance companies securities bull Insurance brokers FDIC bull Insured industrial banks (FDIC) bull Stock exchanges
bull Thrift holding companies (OTS) bull Stockbrokers SEC bull Savings banks (OTSFDICFR) bull Investment advisors
bull Savings and loan associations bull Mutual funds(OTS) bull Public utility holding
bull Edge Act corporations (FR) companies
(table continues next page)
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Table 210 Financial-sector regulation G-10 countries 2000 (continued )
Financial institutions and their supervisors
Country and supervisory structure Retail banking Wholesale banking Securities Insurance
Financial holding companies Japan Financial Supervisory Authority (FSA) = umbrella supervisor
Prime FSA FSA FSA FSA ministerrsquos Ministry of office Finance (Securities and Exchange
Surveillance Commission) FRC Bureau of Financial bull City banks bull Investment banks bull Primary issuers of bull Insurance companies FSA Regulation bull Regional banks bull Asset managers securities bull Insurance brokers
bull Trust banks bull Stock exchanges SESC bull Long-term credit banks bull Stockbrokers
bull Pension funds
Financial holding companiesOffice of the Superintendent of Financial Institutions (OSFI) = umbrella supervisor
Canada Regulated by OSFI OSFI provinces OSFI
Department of Financebull Banks bull Cooperative credit bull Primary issuers of bull Insurance companies
(previously Office of the Inspector associations securities (previously Depart- OSFI General of the Banks) bull Fraternal benefit bull Stock exchanges ment of Insurance) Bank of bull Trust and loan companies society bull Stockbrokers bull Insurance brokers Canada bull Pension funds bull Asset managers
(previously Depart- CDIC ment of Insurance)
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Financial institutions and their supervisors
Country and supervisory structure Retail banking Wholesale banking Securities Insurance
Germany Financial holding groupsFederal Banking Supervisory Office (FBSO) = umbrella supervisor
Ministry of Finance FBSO BSO FSSO FISO
Bundesbankbull Universal banks bull Other financial bull Primary issuers of bull Insurance companies
Federal Banking bull Savings banks institutions (eg securities bull Insurance brokers Supervisory Office bull Securities banks management foreign bull Stock exchanges
currency dealings) bull Stockbrokers Federal Securities bull Financial enterprises bull Asset managers Supervisory Office (eg leasing bull Pension funds
organizations Federal Insurance credit card companies Supervisory Office investment advisors)
Italy Bank foundationsMinistry of Finance = umbrella supervisor
Ministry of Finance Bank of Italy Bank of Italy Consob ISVAP
Bank of Italy bull Commerical banks bull Asset managers bull Primary issuers of bull Insurance companies Consob bull Savings bank bull Open-end investment securities bull Insurance brokers
bull Securities banks companies (SICAVs) bull Stock exchangesbull Stockbrokers
ISVAP
(table continues next page)
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Table 210 Financial-sector regulation G-10 countries 2000 (continued )
Financial institutions and their supervisors
Country and supervisory structure Retail banking Wholesale banking Securities Insurance
The Netherlands Financial conglomeratesCouncil of Financial Supervisors = umbrella supervisor
Securities Board Securities Board Netherlandsche Netherlands Bank Netherlandsche Bank of the Netherlands Insurance Board Bank Insurance bull Credit institutions (universal banks bull Investment institutions bull Stock exchanges bull Insurance companies Board cooperative banks security credit (securities issuing bull Stockbrokers bull Insurance brokers
institutions mortgage banks) and tradingmdashprimary The Council of Financial and secondary Supervisors markets)
France Commission des Commission de Operations des Controcircle des
Banking and Banking Commission Bourse Assurances Financial Regulatory bull Ensuring that credit institutions (and investment firms since bull Primary issuers of bull Insurance companies Ministry for Committee the Financial Activity Modernization Act of 1996) comply securities bull Insurance brokers Economic with laws and regulations bull Stock exchanges Affairs and bull Execute instructions regarding all off-site monitoring and bull Stockbrokers Finance Credit on-site supervision Institutions and Banking and Financial Regulatory Committee Investment bull Formulates general regulations for credit institutions and investment firms Committee (capital adequacy requirements accounting rules etc) Bank of France Credit Institutions and Investment Committee Banking bull Authorizes and examines financial institutions except for those within the Commission competence of the Banking Commission
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Financial institutions and their supervisors
Country and supervisory structure Retail banking Wholesale banking Securities Insurance
Switzerland Large banking groupSwiss Federal Banking Commission (SFBC) = umbrella supervisor
Swiss National Bank Federal Office of
SFBC SFBC SFBC Private Insurance Swiss Federal Banking Commission bull Universal banks bull Investment banks bull Primary issuers of bull Insurance companies
bull Savings banks bull Asset management securities bull Insurance brokerscompanies bull Stock exchanges
Private audit Federal bull Investment funds bull Stockbrokers firms Office of bull Mortgage bond authorized by Private business SFBC Insurance
Sweden Financial holding company groupsFinancial Supervisory Authority = umbrella supervisor
Ministry of Finance Credit Market Securities Market Insurance Market
Credit Market Department Department Department Department
Financial bull Commercial banks bull Investment funds bull Primary issuers of bull Insurance companies Riksbank Supervisory bull Savings banks securities bull Insurance brokers Authority bull Friendly societies bull Stock exchanges
bull Stockbrokers
(table continues next page)
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Table 210 Financial-sector regulation G-10 countries 2000 (continued )
Financial institutions and their supervisors
Country and supervisory structure Retail banking Wholesale banking Securities Insurance
Belgium Bank holding companiesBanking and Finance Commission = umbrella supervisor
Bank of Belgium Banking Banking
Banking and Finance and Finance Insurance Controland Finance Commission Commission Commission Office
Banking and Insurance Finance Control bull Commercial banks bull Asset management bull Primary issuers of bull Insurance companies Commission Office bull Savings banks firms securities bull Insurance brokers
bull Securities banks bull Investment funds bull Stock exchanges bull Mortgage companiesbull Stockbrokers bull Pension funds
Securities Regulation Fund Securities Regulation Fund
bull Other investment firms and credit institutions(institutions participating in regulated off-exchangemarket in strips and Treasury certificates)
Bank holding companies Spain Banco de Espantildea = umbrella supervisor
Banco de Espantildea Comision Nacional del Mercado de Directorate General
Banco de Espantildea Valores (CNMV) Insurance
bull All credit institutions (commercial banks savings banks credit bull Primary issuers of (Ministry of Economy Ministry of cooperatives official credit institutions finance factoring and securities and Finance) Economy and CNMV leasing companies mortgage-loan companies etc) bull Stock exchanges bull Insurance companies Finance bull Interbank foreign exchange and book-entry public debt bull Stockbrokers bull Pension funds
markets bull Venture capital(companies and funds)
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Financial institutions and their supervisors
Country and supervisory structure Banking Securities Insurance
Banking Advisory High Level Securities Supervisors Committee (BAC) Committee (HLSS) Insurance Committee (IC)
Supranational (EU) bull Formulates standards for prudential bull Coordination of securities market bull Formulates standards forsupervision supervision prudential supervision
BACICHLSS Banking Supervision
Conglomerates Committee (BSC) Securities Contact Committee Regulation of prudential bull Systemic risk monitoring bull Regulation and implementation of supervision securities admission
International Association International International Organization of of Insurance Supervisors
Basel Committee Securities Commisison (IOSCO) (IAIS) Joint Forum Conglomerates Supervision bull Supervision and regulation best bull Supervision and regulation best bull Supervision and regulation amp regulation Best practices practices practices best practices
FSF Coordination across supervisors of various functions
Notes See appendix B for more information Boldface type indicates senior or oversight supervisor normal type indicates adjunct or front-line supervisorsolid line indicates direct responsbility to the senior-ranking authority dotted line indicates coordination in supervisory activities
(table continues next page)
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Table 210 Financial-sector regulation G-10 countries 2000 (continued )
Glossary of names United Kingdom FSA = Financial Services Authority United States FR = Federal Reserve OCC = Office of the Comptroller of theCurrency FDIC = Federal Deposit Insurance Corporation SEC = Securities and Exchange Commission OTS = Office of Thrift Supervision Japan FRC =Financial Reconstruction Commission FSA = Financial Services Agency SESC = Securities and Exchange Surveillance Commission Canada OSFI =Office of the Superintendent of Financial Institutions CDIC = Canada Deposit Insurance Corporation Germany FBSO = Federal Banking SupervisoryOffice FSSO = Federal Securities Supervisory Office FISO = Federal Insurance Supervisory Office BSO = Banking Supervisory Office Italy Consob =Commissione Nazionale per le Societa e la Borsa ISVAP = Instituto per la Vigilanza sulle assicurazioni private e di Interesse colletivo Switzerland SFBC= Swiss Federal Banking Commission Spain CNMV = The Comision Nacional del Mercado de Valores Supranational BAC = Banking Advisory CommitteeBSC = Banking Supervision Committee IC = Insurance Committee HLSS = High Level Securities Supervisors Committee International Dimension FSF =Financial Stability Forum IOSCO = International Organization of Securities Commission IAIS = International Association of Insurance Supervisors
Sources United Kingdom Bank of England httpwwwbankofenglandcouk Financial Services Authority httpwwwfsagovuk United States Board ofGovernors of Federal Reserve System httpwwwfederalreservegov Japan Bank of Japan httpwwwbojorjo Financial Reconstruction Commissionhttpwwwfsagojpfrcindexehtml Financial Services Agency httpwwwfsagojp Canada Bank of Canada httpwwwbank-banque-canadaca Office ofthe Superintendent of Financial Institutions httpwwwosfi-bsifgccaAndreEindexhtml Germany Deutsche Bundesbank httpwwwbundesbankde Fed-eral Banking Supervisory Office httpwwwbakredde Italy Banca drsquoitalia httpwwwbancaditaliait Commissione Nazionale per le Societa e la Borsahttpwwwconsobit Instituto per la Vigilanza sulle assicurazioni private e di Interesse colletivo httpwwwisvapit The Netherlands De NederlandscheBank httpwwwdnbnl France Banque de France httpwwwbanque-francefr Switzerland Schweizerische Nationalbank httpwwwsnbchindex3htmlSweden Sveriges Riksbank httpwwwriksbanksedefaultasp Belgium National Bank of Belgium httpwwwbnbbesgindexhtm Spain Banco de Espantildeahttpwwwbdees The Comision Nacional del Mercado de Valores httpwwwcnmves Supranational (EU) Institutional Arrangements for the Regulationand Supervision of the Financial Sector 2000 International Dimension Bank for International Settlement httpwwwbisorg International Organization ofSecurities Commissions httpwwwioscoorg International Association of Insurance Supervisors httpwwwiaisorg Financial Stability Forum httpwwwfsforumorg
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 121
the inflexibility of tight surveillance against the need to encourage in-novation and growth The US Securities and Exchange Commission isworried about aggressive accounting by firms and biased reports bysecurities analysts in an equity environment that prizes steadily higherquarterly earnings41 Japanese regulators are preoccupied with opaqueinterconnections between portfolio institutions banks and nonfinancialfirms through the keiretsu system Canadian regulators reeling from high-profile scandals of managers intentionally misleading investors are strengtheningmarket discipline through legal penalties aimed at managers and directorsof offending firms
When panic strikes a securities regulator cannot do much As the 1987stock market crash and the LTCM debacle in the fall of 1998 both dem-onstrated steep stock and bond price declines can create systemic risksIf severe enough the wealth effect of falling securities values and thefear of widespread insolvency can depress real activity Flooding thesystem with liquidity is a central bankerrsquos solutionmdashsomething a securi-ties regulator cannot do42 But just as financial supervisors can changethe incentive structure to discourage bankers from making risky loans ingood times so securities regulators can pay more attention to incentiveson the demand side when capital markets are strong
Prudential Supervision and InnovationmdashA Footnote
In concluding this discussion of prudential supervision in the G-10 anadditional point is worth noting National regulators face a persistenttrade-off between emphasizing financial system safety and soundnesswhile encouraging innovationmdashin spite of the added risks innovationbrings to financial markets Former US Treasury Secretary Lawrence Summers(2000 3) has argued by analogy
The jet airplane made airplane air travel more comfortable more efficient andmore safe though the accidents were more spectacular and for a time morenumerous after the jet was invented In the same way modern global financialmarkets carry with them enormous potential for benefit even if some of theaccidents are that much more spectacular As the right public policy response
41 The problem is illustrated by the divergence since mid-1998 between reported earn-ings by the Standard amp Poorrsquos (SampP) 500 and the after-tax profits of all corporations inthe national accounts Generally these two series move closely with one another Be-tween mid-1998 and mid-1999 SampP 500 reported that earnings increased by more than20 percent while after-tax profits of all corporations increased by less than 5 percent(Chase Bank US Economic and Policy Research US Weekly Prospects Chase SecuritiesWeekly Newsletter 5 June 2000 5)
42 For example the US Securities and Exchange Commission had no direct role in calmingmarkets in the 1987 or 1998 panics
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122 WORLD CAPITAL MARKETS
to the jet was longer runways better air-traffic control and better training forpilots and not the discouragement of rapid travel so the right public policyresponse to financial innovation is to assure a safe framework so that the ben-efits can be realized not to stifle the change
Accepting Summersrsquos analogy for the international financial system better-informed supervisors and investors are a necessary part of the financialsystem framework Supervisors require more timely information on therisk profiles resulting from positions taken by financial institutions Theyalso need a better understanding of risk-management systems Snapshotsof an institutionrsquos risk profile and risk-management procedures are nolonger adequate In a world where huge bets are quickly made (andpossibly lostmdashas with Barings Bank in 1995 and LTCM in 1998) super-visors must focus on the soundness of banking systems for evaluatingand managing risk on a daily basis Some progress has been made inaddressing these issues US banking examiners are extending their in-formation requirements in banking examinations and increasing theirinvolvement in large complex institutions43 More awareness is alsorequired of the fact that they are national organizations in a world ofcross-border capital flows To a much greater extent they need a multi-national reach International supervision and coordination among super-visors are the subject of the next section
Our analysis suggests that G-10 supervisors have unfinished businessBank supervisors need to start yesterday securities regulators can waituntil tomorrow One G-10 member acting alone cannot correct the biasIn good times the lending business will simply migrate to other G-10banks In bad times financial problems will not stop at the national bor-der A way has to be found to establish common international standardsfor the key financial players in order to prevent crises and to agree onapproaches for managing them The path has already been laid out Inthe wake of the bank failures of the past 25 years bank supervisors havetried to establish such standards They have done this without creating anew global institution
The essence of the international framework is decentralizationmdashglobalrules and design standards without global institutions that are perceivedto intrude on national sovereignty The awkward jargon for this frame-work is vertical subsidiaritymdashldquothink internationally act nationallyrdquo Theinternational thinking is done by a committee of regulators that meets
International SupervisionA Decentralized Framework
43 These issues are discussed in Ferguson (1999) and Meyer (2000a)
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 123
regularly at the Bank for International Settlements in Basel The commit-tee establishes principles and standards that are interpreted implementedand enforced by national authorities44 In this section we describe thesesupervisory efforts and their weaknesses We present our recommenda-tions for addressing these weaknesses in the next chapter
Basel I
The Basel Capital Accord of 1988 (Basel I)45 drew the lesson from thefinancial crises of the mid-1970s that more adequate capital levels in in-ternational banks would help reduce the systemic risk of bank failureThe primary goal of Basel I was capital adequacy other standards wereput in place not so much for their own virtue as to defend the primarygoal
Capital adequacy requirements were designed to ensure that individualinstitutions have the ability to absorb losses particularly credit lossesAccordingly a backup system of scoring credit risk was devised thatrequired large amounts of bank capital for some types of loans smalleramounts for others and zero for a select list of preferred assets Report-ing requirements were designed to disclose problems and ensure that atroubled bank would take timely steps to restore its capital base in thewake of a loss The Basel I framework worked tolerably well in limitingthe call on the public purse in the G-10 countriesmdashwith the notable ex-ceptions of France and Japan The framework failed to moderate riskybank lending to emerging markets however
Basel I was not developed with emerging markets in mind The origi-nal idea behind it was to develop a common supervisory approach tocross-border banking operations It grew out of political pressure fromUS lawmakers who were determined to require international banks op-erating in the United States to meet US banking standards Toward thisgoal in 1983 Congress passed the International Lending Supervisory ActUS and British banking authorities subsequently agreed on a commontarget the adoption of strict common capital-adequacy standards In 1988other G-10 governments agreed to go along voluntary acceptance ofthe standards throughout much of the rest of the world followed46 Therationale for the capital targets was two-fold The first was to requirebanks to hold sufficient amounts of capital (8 percent of risk-adjusted
44 The international committee of financial authorities agreed on a common definitionof banksrsquo tier-one or ldquocorerdquo capital national authorities defined tier-two capital in theirown manner which permitted greater variations in national working definitions andpractices
45 International Convergence of Capital Measurement and Capital Standards (BIS 1988)was prepared by the Basel Committee on Banking Supervision
46 See Reineke (1998)
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124 WORLD CAPITAL MARKETS
assets) to cushion losses on those assets The second was to dull theirappetites for risk banks with large capital bases would have more tolose if they failed and therefore would take fewer risks
Rapid change in financial markets soon revealed flaws in the Basel IAccord In a complex world with numerous sources of risk it focusedheavily on credit risk but overlooked other risks in a bankrsquos portfolioand the correlation between returns on different asset classes The Baselformula required banks to maintain a fixed amount of capital againsteach of its asset classes But the formula did not distinguish the riskinessof the borrower within each class As a result one large loan to a low-risk corporate borrower such as General Electric would require the sameamount of capital as 10 smaller transactions with high-risk borrowers
The system was also biased toward short-term loans Loans maturingin less than a year required a 20 percent risk weight whereas those ma-turing after more than a year required a 100 percent risk weight Inter-bank lending was particularly favored For example loans to banks inOECD countries required less capital than loans to private firms in thesame countries creating the anomaly that interbank loans to South Ko-rean banks required less capital than loans to General Electric47 Thisanomaly encouraged banks to shed high-quality assets if the Basel rulesrequired the allocation of more capital than banks thought they needed
Another weakness was that financial innovators quickly circumventedthe Accord Because short-term loans required less provisioning than long-term loans banks responded by securitizing their long-term debt port-folios and lending short-term against the collateral of the newly createdasset This allowed banks to circumvent the capital requirements gearedto the terms of the underlying debt At the same time the Basel I Accordfailed to encourage risk mitigation techniques such as credit derivativescollateral guarantees and on-balance-sheet netting the flip side of fi-nancial innovation Because off-balance-sheet products were not coveredby the Accord another anomaly appeared when Barings Bank collapsedin 1995 Barings met capital adequacy standards but collapsed becauseits systems for managing risk failed traders were allowed to speculatein futures contracts that did not appear on the balance sheet
Basel II
Work to overhaul Basel I began in 1995 and produced consultativepapers issued in June 1999 and January 200148 These papers have been
47 South Korean banks have had notoriously weak balance sheets because the practiceof ldquodirected lendingrdquo left them with many poor loans (in making these loans the bankswere expected to follow government objectives rather than creditworthiness criteria)
48 Basel Committee on Banking Supervision (1999 2001)
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 125
the subject of extensive consultation and revision as a result the newAccord is expected to be introduced in 200449 The Basel II frameworkhas three parts (pillars) revisions to Basel I minimum-capital require-ments supervisory review criteria and greater emphasis on market dis-cipline Broadly Basel II aims to maintain the level of capital in the sys-tem but achieve better alignment of banksrsquo capital with their risk pro-files and keep up with financial innovation
To align capital requirements with market realities (the first pillar)Basel II concentrates on the 100 or so largest banksmdashthe type of playerslisted in table 21mdashand on the holding-company parents of banking groups50
Capital requirements will differentiate between an increased number ofcredit groups or ldquorisk bucketsrdquo including claims on governments otherbanks corporations mortgage-backed securities and other asset-backedsecurities
Basel II originally proposed to use external ratings to set capital chargesfor a number of these credit risks Many banks objected arguing thatthey assess credit risk better than Standard amp Poorrsquos Moodyrsquos or FitchIBCA51 Basel II thus proposes two approaches to rating a standard ap-proach using external ratings and an ldquoadvancedrdquo approach that allowsselected banks to use their own internal rating systems To encouragethe development of rigorous internal control systems based on these in-ternal rating systems Basel II also proposes to levy capital charges foroperational risk (the risk of direct or indirect loss resulting from inad-equate or failed internal processes people and systems or from exter-nal events)
Some critics of this proposal dismiss it as an abrogation of the prin-ciple of external independent monitoring and as ldquodangerously naiumlverdquo52
But regulators argue that the new capital charge on operational risk shouldoffset this concern It is also far from clear how cross-national compari-sons of rating and internal risk-assessment systems will be made (Engelen2000) The development by the European Union of its own capital rulescould well complicate the international resolution of these issues Publicassurances by EU officials in January 2001 however indicated that theirmain concerns are to create a level playing field and avoid regulatoryarbitrage (Hargreaves 2001) There is also the significant problem ofthe procyclical character of risk weights When a crisis hits losses are
49 See Berry (2000) for an update in an interview with William J McDonough chair ofthe Basel Committee on Banking Supervision
50 For obvious reasons these proposals are addressed to large banks and simpler capi-tal standards are allowed for small banks that focus on their domestic credit markets
51 See Ammer and Packer (2000) for an empirical critique of the success of rating agen-cies in distinguishing risk by sector and region
52 See Auerback (2001)
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126 WORLD CAPITAL MARKETS
incurred or accrued capital is lost and loan exposure must be reducedor securities sold to restore the requisite capital-adequacy ratios A morerisk-sensitive framework could amplify volatility
As the second pillar of Basel II supervisory review criteria are beingbeefed up to encourage supervisors to intervene earlier in potential problemsituations and to compel banks to align their capital positions with theirrisk profiles Bank supervisors will be authorized to require banks tohold capital in excess of minimum requirements if they have concernsabout general management overall strategy risk-management performanceor the macroeconomic environment Of course if one G-10 supervisorimposes higher capital requirements in isolation the same disparity willemerge that presaged Basel I Some banks will be disadvantaged in theinternational marketplace and will loudly complain that excessive super-vision is driving business to their competitors Hence close internationalcooperation among supervisors is critical
To implement the third pillar market discipline banks will be requiredto make fuller more timely disclosure of capital adequacy and the risksto which that capital is exposed A number of measures are being stud-ied that might help supervisors evaluate bank performance such as com-parisons of uninsured deposit interest rates subordinated debt yieldsand equity prices The idea is that these yields and prices might alertsupervisors to market perceptions of risk Of course market perceptionsare only as good as market information More direct and controversialways to reinforce market discipline would dramatically increase publicdisclosure of bank positions and risk management systems
Many questions are still outstanding about how to resolve the techni-cal details of capital requirements and whether the requirements willachieve their intended goal of better assessment and mitigation of therisks in banksrsquo portfolios There is no substitute for skilled supervisorsThe intricacies of effective design and implementation suggest that su-pervisors need to be highly competent technically knowledgeable aboutbanking portfolio characteristics and the factors that influence bank ex-posure to credit risk (Mishkin 2000) And they must be aided by vigilantshareholders market forces and transparency of information53
Standard setting at the global level is desirable but ultimately theeffectiveness of these efforts will be tested at the national level espe-cially in times of systemic financial distress Here the record of Basel Iwas not a bright shining success Japanese banking regulators havetraditionally allowed banks to include real estate and securities in theircapital base When the value of these assets plummeted in the early 1990sregulators allowed banks to continue valuing these depreciated (andoften bankrupt) assets at their old inflated levels Japanese authorities
53 Benedict Roth Complacency Towards Catastrophe Financial Times 23 January 2001
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 127
insisted until the mid-1990s that eroded capital bases could be rebuiltin a market-driven fashion They rightly foresaw that huge loan losseswould undermine public support for the ruling party and require a po-litically unpopular bailout
Japanese foot dragging on Basel I was the worst54 but not uniqueOther examples can be found of ldquopolitically mandated forbearancerdquo TheFederal Reserve Bank of New York held important hands during theLTCM crisis of 1998 Mexico is still resolving the banking crisis that eruptedin 1995 South Korea has not yet closed the insolvent banks that behavedso badly before the crisis of 1998 In the aftermath of a crisis nationalregulators cannot always be relied upon to discipline politically power-ful bankers55 One of the little-noticed consequences of these differingapproaches is that those banks with strong regulatory systems receivedan implicit ldquoexport subsidyrdquo for their services US banks which had notengaged extensively in emerging-market lending in the 1990s were bet-ter positioned than their German and Japanese counterparts to expandtheir international assets in the wake of the crises
Other Financial Forums
54 See Japanese Banks Fiddling while Marunouchi Burns The Economist 27 January2001 67-69
55 See Calomiris (1997)
The Basel model of vertical subsidiarity has already been extended toother financial regulatory bodies In 1993-94 the BIS established a Tri-partite Group of Banking Insurance and Securities Regulators In 1994-95 the BIS increased its cooperation with the International Organizationof Securities Commissions when the two organizations issued parallelpapers on guidelines for national regulators concerning risk managementand disclosure of derivative trades In 1996 a permanent Joint Forum onFinancial Conglomerates was established to examine supervisory issuesand develop working arrangements among the different functional super-visors of conglomerate institutions that offer combinations of bankingsecurities and insurance products Draft papers on the supervisionof conglomerates were released for comment in 1998 applying capital-adequacy principles to these groups and providing guidelines both forassessing the integrity and competence of top managers and for sharingassessments between regulators
In 1997 the Basel Committee on Banking Supervision extended itsreach beyond capital standards to broader aspects of banking supervi-sion with the publication of the Core Principles for Effective BankingSupervision In 1999 a wide range of regulatory and standard-settingbodies were gathered under the umbrella of the Financial Stability
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128 WORLD CAPITAL MARKETS
Forum (FSF) itself established under BIS aegis56 The FSF has alreadyissued recommendations for stepped-up supervision and transparencyas well as guidelines for best practices in a number of areas includingoffshore financial centers and highly leveraged institutions or hedge funds57
Conclusion
Although the structural weaknesses in emerging-market economies arewidely acknowledged to have been causal factors in international capi-tal-market volatility this chapter points to the role of large G-10 bankingorganizations as major suppliers of the most volatile instrument short-term debt We have examined evidence of the impact of public safetynets in the G-10 economiesmdashthe deposit insurance systems the pruden-tial supervisory systems and the lender-of-last-resort functions of centralbanksmdashon the incentive structures of these organizations
Although supervisors in most countries working nationally and to-gether in the BIS have made significant efforts to mimic market forcesin their prudential supervision the most sophisticated financial institu-tions find innovative ways to circumvent the rules New global regulatorybodies are not about to be created G-10 national bank regulators shouldthemselves address the short-term debt bias in the international financialsystem by changing incentive systems G-10 securities regulators shouldalso take steps to get ahead of the curve paying close attention to largeportfolio swings by institutional investors particularly in times of crisisIn short more needs to be done at national and international levels tochange the rules of the game That is the subject of the next chapter
56 The Financial Stability Forum includes banking securities insurance and accountingregulatory bodies the OECD on taxation corruption and corporate governance and theIMF
57 See Martin (2000)
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Table 210 Financial-sector regulation G-10 countries 2000 (continued )
Financial institutions and their supervisors
Country and supervisory structure Retail banking Wholesale banking Securities Insurance
Financial holding companies Japan Financial Supervisory Authority (FSA) = umbrella supervisor
Prime FSA FSA FSA FSA ministerrsquos Ministry of office Finance (Securities and Exchange
Surveillance Commission) FRC Bureau of Financial bull City banks bull Investment banks bull Primary issuers of bull Insurance companies FSA Regulation bull Regional banks bull Asset managers securities bull Insurance brokers
bull Trust banks bull Stock exchanges SESC bull Long-term credit banks bull Stockbrokers
bull Pension funds
Financial holding companiesOffice of the Superintendent of Financial Institutions (OSFI) = umbrella supervisor
Canada Regulated by OSFI OSFI provinces OSFI
Department of Financebull Banks bull Cooperative credit bull Primary issuers of bull Insurance companies
(previously Office of the Inspector associations securities (previously Depart- OSFI General of the Banks) bull Fraternal benefit bull Stock exchanges ment of Insurance) Bank of bull Trust and loan companies society bull Stockbrokers bull Insurance brokers Canada bull Pension funds bull Asset managers
(previously Depart- CDIC ment of Insurance)
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RD
115
Financial institutions and their supervisors
Country and supervisory structure Retail banking Wholesale banking Securities Insurance
Germany Financial holding groupsFederal Banking Supervisory Office (FBSO) = umbrella supervisor
Ministry of Finance FBSO BSO FSSO FISO
Bundesbankbull Universal banks bull Other financial bull Primary issuers of bull Insurance companies
Federal Banking bull Savings banks institutions (eg securities bull Insurance brokers Supervisory Office bull Securities banks management foreign bull Stock exchanges
currency dealings) bull Stockbrokers Federal Securities bull Financial enterprises bull Asset managers Supervisory Office (eg leasing bull Pension funds
organizations Federal Insurance credit card companies Supervisory Office investment advisors)
Italy Bank foundationsMinistry of Finance = umbrella supervisor
Ministry of Finance Bank of Italy Bank of Italy Consob ISVAP
Bank of Italy bull Commerical banks bull Asset managers bull Primary issuers of bull Insurance companies Consob bull Savings bank bull Open-end investment securities bull Insurance brokers
bull Securities banks companies (SICAVs) bull Stock exchangesbull Stockbrokers
ISVAP
(table continues next page)
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Table 210 Financial-sector regulation G-10 countries 2000 (continued )
Financial institutions and their supervisors
Country and supervisory structure Retail banking Wholesale banking Securities Insurance
The Netherlands Financial conglomeratesCouncil of Financial Supervisors = umbrella supervisor
Securities Board Securities Board Netherlandsche Netherlands Bank Netherlandsche Bank of the Netherlands Insurance Board Bank Insurance bull Credit institutions (universal banks bull Investment institutions bull Stock exchanges bull Insurance companies Board cooperative banks security credit (securities issuing bull Stockbrokers bull Insurance brokers
institutions mortgage banks) and tradingmdashprimary The Council of Financial and secondary Supervisors markets)
France Commission des Commission de Operations des Controcircle des
Banking and Banking Commission Bourse Assurances Financial Regulatory bull Ensuring that credit institutions (and investment firms since bull Primary issuers of bull Insurance companies Ministry for Committee the Financial Activity Modernization Act of 1996) comply securities bull Insurance brokers Economic with laws and regulations bull Stock exchanges Affairs and bull Execute instructions regarding all off-site monitoring and bull Stockbrokers Finance Credit on-site supervision Institutions and Banking and Financial Regulatory Committee Investment bull Formulates general regulations for credit institutions and investment firms Committee (capital adequacy requirements accounting rules etc) Bank of France Credit Institutions and Investment Committee Banking bull Authorizes and examines financial institutions except for those within the Commission competence of the Banking Commission
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117
Financial institutions and their supervisors
Country and supervisory structure Retail banking Wholesale banking Securities Insurance
Switzerland Large banking groupSwiss Federal Banking Commission (SFBC) = umbrella supervisor
Swiss National Bank Federal Office of
SFBC SFBC SFBC Private Insurance Swiss Federal Banking Commission bull Universal banks bull Investment banks bull Primary issuers of bull Insurance companies
bull Savings banks bull Asset management securities bull Insurance brokerscompanies bull Stock exchanges
Private audit Federal bull Investment funds bull Stockbrokers firms Office of bull Mortgage bond authorized by Private business SFBC Insurance
Sweden Financial holding company groupsFinancial Supervisory Authority = umbrella supervisor
Ministry of Finance Credit Market Securities Market Insurance Market
Credit Market Department Department Department Department
Financial bull Commercial banks bull Investment funds bull Primary issuers of bull Insurance companies Riksbank Supervisory bull Savings banks securities bull Insurance brokers Authority bull Friendly societies bull Stock exchanges
bull Stockbrokers
(table continues next page)
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Table 210 Financial-sector regulation G-10 countries 2000 (continued )
Financial institutions and their supervisors
Country and supervisory structure Retail banking Wholesale banking Securities Insurance
Belgium Bank holding companiesBanking and Finance Commission = umbrella supervisor
Bank of Belgium Banking Banking
Banking and Finance and Finance Insurance Controland Finance Commission Commission Commission Office
Banking and Insurance Finance Control bull Commercial banks bull Asset management bull Primary issuers of bull Insurance companies Commission Office bull Savings banks firms securities bull Insurance brokers
bull Securities banks bull Investment funds bull Stock exchanges bull Mortgage companiesbull Stockbrokers bull Pension funds
Securities Regulation Fund Securities Regulation Fund
bull Other investment firms and credit institutions(institutions participating in regulated off-exchangemarket in strips and Treasury certificates)
Bank holding companies Spain Banco de Espantildea = umbrella supervisor
Banco de Espantildea Comision Nacional del Mercado de Directorate General
Banco de Espantildea Valores (CNMV) Insurance
bull All credit institutions (commercial banks savings banks credit bull Primary issuers of (Ministry of Economy Ministry of cooperatives official credit institutions finance factoring and securities and Finance) Economy and CNMV leasing companies mortgage-loan companies etc) bull Stock exchanges bull Insurance companies Finance bull Interbank foreign exchange and book-entry public debt bull Stockbrokers bull Pension funds
markets bull Venture capital(companies and funds)
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119
Financial institutions and their supervisors
Country and supervisory structure Banking Securities Insurance
Banking Advisory High Level Securities Supervisors Committee (BAC) Committee (HLSS) Insurance Committee (IC)
Supranational (EU) bull Formulates standards for prudential bull Coordination of securities market bull Formulates standards forsupervision supervision prudential supervision
BACICHLSS Banking Supervision
Conglomerates Committee (BSC) Securities Contact Committee Regulation of prudential bull Systemic risk monitoring bull Regulation and implementation of supervision securities admission
International Association International International Organization of of Insurance Supervisors
Basel Committee Securities Commisison (IOSCO) (IAIS) Joint Forum Conglomerates Supervision bull Supervision and regulation best bull Supervision and regulation best bull Supervision and regulation amp regulation Best practices practices practices best practices
FSF Coordination across supervisors of various functions
Notes See appendix B for more information Boldface type indicates senior or oversight supervisor normal type indicates adjunct or front-line supervisorsolid line indicates direct responsbility to the senior-ranking authority dotted line indicates coordination in supervisory activities
(table continues next page)
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Table 210 Financial-sector regulation G-10 countries 2000 (continued )
Glossary of names United Kingdom FSA = Financial Services Authority United States FR = Federal Reserve OCC = Office of the Comptroller of theCurrency FDIC = Federal Deposit Insurance Corporation SEC = Securities and Exchange Commission OTS = Office of Thrift Supervision Japan FRC =Financial Reconstruction Commission FSA = Financial Services Agency SESC = Securities and Exchange Surveillance Commission Canada OSFI =Office of the Superintendent of Financial Institutions CDIC = Canada Deposit Insurance Corporation Germany FBSO = Federal Banking SupervisoryOffice FSSO = Federal Securities Supervisory Office FISO = Federal Insurance Supervisory Office BSO = Banking Supervisory Office Italy Consob =Commissione Nazionale per le Societa e la Borsa ISVAP = Instituto per la Vigilanza sulle assicurazioni private e di Interesse colletivo Switzerland SFBC= Swiss Federal Banking Commission Spain CNMV = The Comision Nacional del Mercado de Valores Supranational BAC = Banking Advisory CommitteeBSC = Banking Supervision Committee IC = Insurance Committee HLSS = High Level Securities Supervisors Committee International Dimension FSF =Financial Stability Forum IOSCO = International Organization of Securities Commission IAIS = International Association of Insurance Supervisors
Sources United Kingdom Bank of England httpwwwbankofenglandcouk Financial Services Authority httpwwwfsagovuk United States Board ofGovernors of Federal Reserve System httpwwwfederalreservegov Japan Bank of Japan httpwwwbojorjo Financial Reconstruction Commissionhttpwwwfsagojpfrcindexehtml Financial Services Agency httpwwwfsagojp Canada Bank of Canada httpwwwbank-banque-canadaca Office ofthe Superintendent of Financial Institutions httpwwwosfi-bsifgccaAndreEindexhtml Germany Deutsche Bundesbank httpwwwbundesbankde Fed-eral Banking Supervisory Office httpwwwbakredde Italy Banca drsquoitalia httpwwwbancaditaliait Commissione Nazionale per le Societa e la Borsahttpwwwconsobit Instituto per la Vigilanza sulle assicurazioni private e di Interesse colletivo httpwwwisvapit The Netherlands De NederlandscheBank httpwwwdnbnl France Banque de France httpwwwbanque-francefr Switzerland Schweizerische Nationalbank httpwwwsnbchindex3htmlSweden Sveriges Riksbank httpwwwriksbanksedefaultasp Belgium National Bank of Belgium httpwwwbnbbesgindexhtm Spain Banco de Espantildeahttpwwwbdees The Comision Nacional del Mercado de Valores httpwwwcnmves Supranational (EU) Institutional Arrangements for the Regulationand Supervision of the Financial Sector 2000 International Dimension Bank for International Settlement httpwwwbisorg International Organization ofSecurities Commissions httpwwwioscoorg International Association of Insurance Supervisors httpwwwiaisorg Financial Stability Forum httpwwwfsforumorg
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 121
the inflexibility of tight surveillance against the need to encourage in-novation and growth The US Securities and Exchange Commission isworried about aggressive accounting by firms and biased reports bysecurities analysts in an equity environment that prizes steadily higherquarterly earnings41 Japanese regulators are preoccupied with opaqueinterconnections between portfolio institutions banks and nonfinancialfirms through the keiretsu system Canadian regulators reeling from high-profile scandals of managers intentionally misleading investors are strengtheningmarket discipline through legal penalties aimed at managers and directorsof offending firms
When panic strikes a securities regulator cannot do much As the 1987stock market crash and the LTCM debacle in the fall of 1998 both dem-onstrated steep stock and bond price declines can create systemic risksIf severe enough the wealth effect of falling securities values and thefear of widespread insolvency can depress real activity Flooding thesystem with liquidity is a central bankerrsquos solutionmdashsomething a securi-ties regulator cannot do42 But just as financial supervisors can changethe incentive structure to discourage bankers from making risky loans ingood times so securities regulators can pay more attention to incentiveson the demand side when capital markets are strong
Prudential Supervision and InnovationmdashA Footnote
In concluding this discussion of prudential supervision in the G-10 anadditional point is worth noting National regulators face a persistenttrade-off between emphasizing financial system safety and soundnesswhile encouraging innovationmdashin spite of the added risks innovationbrings to financial markets Former US Treasury Secretary Lawrence Summers(2000 3) has argued by analogy
The jet airplane made airplane air travel more comfortable more efficient andmore safe though the accidents were more spectacular and for a time morenumerous after the jet was invented In the same way modern global financialmarkets carry with them enormous potential for benefit even if some of theaccidents are that much more spectacular As the right public policy response
41 The problem is illustrated by the divergence since mid-1998 between reported earn-ings by the Standard amp Poorrsquos (SampP) 500 and the after-tax profits of all corporations inthe national accounts Generally these two series move closely with one another Be-tween mid-1998 and mid-1999 SampP 500 reported that earnings increased by more than20 percent while after-tax profits of all corporations increased by less than 5 percent(Chase Bank US Economic and Policy Research US Weekly Prospects Chase SecuritiesWeekly Newsletter 5 June 2000 5)
42 For example the US Securities and Exchange Commission had no direct role in calmingmarkets in the 1987 or 1998 panics
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122 WORLD CAPITAL MARKETS
to the jet was longer runways better air-traffic control and better training forpilots and not the discouragement of rapid travel so the right public policyresponse to financial innovation is to assure a safe framework so that the ben-efits can be realized not to stifle the change
Accepting Summersrsquos analogy for the international financial system better-informed supervisors and investors are a necessary part of the financialsystem framework Supervisors require more timely information on therisk profiles resulting from positions taken by financial institutions Theyalso need a better understanding of risk-management systems Snapshotsof an institutionrsquos risk profile and risk-management procedures are nolonger adequate In a world where huge bets are quickly made (andpossibly lostmdashas with Barings Bank in 1995 and LTCM in 1998) super-visors must focus on the soundness of banking systems for evaluatingand managing risk on a daily basis Some progress has been made inaddressing these issues US banking examiners are extending their in-formation requirements in banking examinations and increasing theirinvolvement in large complex institutions43 More awareness is alsorequired of the fact that they are national organizations in a world ofcross-border capital flows To a much greater extent they need a multi-national reach International supervision and coordination among super-visors are the subject of the next section
Our analysis suggests that G-10 supervisors have unfinished businessBank supervisors need to start yesterday securities regulators can waituntil tomorrow One G-10 member acting alone cannot correct the biasIn good times the lending business will simply migrate to other G-10banks In bad times financial problems will not stop at the national bor-der A way has to be found to establish common international standardsfor the key financial players in order to prevent crises and to agree onapproaches for managing them The path has already been laid out Inthe wake of the bank failures of the past 25 years bank supervisors havetried to establish such standards They have done this without creating anew global institution
The essence of the international framework is decentralizationmdashglobalrules and design standards without global institutions that are perceivedto intrude on national sovereignty The awkward jargon for this frame-work is vertical subsidiaritymdashldquothink internationally act nationallyrdquo Theinternational thinking is done by a committee of regulators that meets
International SupervisionA Decentralized Framework
43 These issues are discussed in Ferguson (1999) and Meyer (2000a)
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 123
regularly at the Bank for International Settlements in Basel The commit-tee establishes principles and standards that are interpreted implementedand enforced by national authorities44 In this section we describe thesesupervisory efforts and their weaknesses We present our recommenda-tions for addressing these weaknesses in the next chapter
Basel I
The Basel Capital Accord of 1988 (Basel I)45 drew the lesson from thefinancial crises of the mid-1970s that more adequate capital levels in in-ternational banks would help reduce the systemic risk of bank failureThe primary goal of Basel I was capital adequacy other standards wereput in place not so much for their own virtue as to defend the primarygoal
Capital adequacy requirements were designed to ensure that individualinstitutions have the ability to absorb losses particularly credit lossesAccordingly a backup system of scoring credit risk was devised thatrequired large amounts of bank capital for some types of loans smalleramounts for others and zero for a select list of preferred assets Report-ing requirements were designed to disclose problems and ensure that atroubled bank would take timely steps to restore its capital base in thewake of a loss The Basel I framework worked tolerably well in limitingthe call on the public purse in the G-10 countriesmdashwith the notable ex-ceptions of France and Japan The framework failed to moderate riskybank lending to emerging markets however
Basel I was not developed with emerging markets in mind The origi-nal idea behind it was to develop a common supervisory approach tocross-border banking operations It grew out of political pressure fromUS lawmakers who were determined to require international banks op-erating in the United States to meet US banking standards Toward thisgoal in 1983 Congress passed the International Lending Supervisory ActUS and British banking authorities subsequently agreed on a commontarget the adoption of strict common capital-adequacy standards In 1988other G-10 governments agreed to go along voluntary acceptance ofthe standards throughout much of the rest of the world followed46 Therationale for the capital targets was two-fold The first was to requirebanks to hold sufficient amounts of capital (8 percent of risk-adjusted
44 The international committee of financial authorities agreed on a common definitionof banksrsquo tier-one or ldquocorerdquo capital national authorities defined tier-two capital in theirown manner which permitted greater variations in national working definitions andpractices
45 International Convergence of Capital Measurement and Capital Standards (BIS 1988)was prepared by the Basel Committee on Banking Supervision
46 See Reineke (1998)
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124 WORLD CAPITAL MARKETS
assets) to cushion losses on those assets The second was to dull theirappetites for risk banks with large capital bases would have more tolose if they failed and therefore would take fewer risks
Rapid change in financial markets soon revealed flaws in the Basel IAccord In a complex world with numerous sources of risk it focusedheavily on credit risk but overlooked other risks in a bankrsquos portfolioand the correlation between returns on different asset classes The Baselformula required banks to maintain a fixed amount of capital againsteach of its asset classes But the formula did not distinguish the riskinessof the borrower within each class As a result one large loan to a low-risk corporate borrower such as General Electric would require the sameamount of capital as 10 smaller transactions with high-risk borrowers
The system was also biased toward short-term loans Loans maturingin less than a year required a 20 percent risk weight whereas those ma-turing after more than a year required a 100 percent risk weight Inter-bank lending was particularly favored For example loans to banks inOECD countries required less capital than loans to private firms in thesame countries creating the anomaly that interbank loans to South Ko-rean banks required less capital than loans to General Electric47 Thisanomaly encouraged banks to shed high-quality assets if the Basel rulesrequired the allocation of more capital than banks thought they needed
Another weakness was that financial innovators quickly circumventedthe Accord Because short-term loans required less provisioning than long-term loans banks responded by securitizing their long-term debt port-folios and lending short-term against the collateral of the newly createdasset This allowed banks to circumvent the capital requirements gearedto the terms of the underlying debt At the same time the Basel I Accordfailed to encourage risk mitigation techniques such as credit derivativescollateral guarantees and on-balance-sheet netting the flip side of fi-nancial innovation Because off-balance-sheet products were not coveredby the Accord another anomaly appeared when Barings Bank collapsedin 1995 Barings met capital adequacy standards but collapsed becauseits systems for managing risk failed traders were allowed to speculatein futures contracts that did not appear on the balance sheet
Basel II
Work to overhaul Basel I began in 1995 and produced consultativepapers issued in June 1999 and January 200148 These papers have been
47 South Korean banks have had notoriously weak balance sheets because the practiceof ldquodirected lendingrdquo left them with many poor loans (in making these loans the bankswere expected to follow government objectives rather than creditworthiness criteria)
48 Basel Committee on Banking Supervision (1999 2001)
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 125
the subject of extensive consultation and revision as a result the newAccord is expected to be introduced in 200449 The Basel II frameworkhas three parts (pillars) revisions to Basel I minimum-capital require-ments supervisory review criteria and greater emphasis on market dis-cipline Broadly Basel II aims to maintain the level of capital in the sys-tem but achieve better alignment of banksrsquo capital with their risk pro-files and keep up with financial innovation
To align capital requirements with market realities (the first pillar)Basel II concentrates on the 100 or so largest banksmdashthe type of playerslisted in table 21mdashand on the holding-company parents of banking groups50
Capital requirements will differentiate between an increased number ofcredit groups or ldquorisk bucketsrdquo including claims on governments otherbanks corporations mortgage-backed securities and other asset-backedsecurities
Basel II originally proposed to use external ratings to set capital chargesfor a number of these credit risks Many banks objected arguing thatthey assess credit risk better than Standard amp Poorrsquos Moodyrsquos or FitchIBCA51 Basel II thus proposes two approaches to rating a standard ap-proach using external ratings and an ldquoadvancedrdquo approach that allowsselected banks to use their own internal rating systems To encouragethe development of rigorous internal control systems based on these in-ternal rating systems Basel II also proposes to levy capital charges foroperational risk (the risk of direct or indirect loss resulting from inad-equate or failed internal processes people and systems or from exter-nal events)
Some critics of this proposal dismiss it as an abrogation of the prin-ciple of external independent monitoring and as ldquodangerously naiumlverdquo52
But regulators argue that the new capital charge on operational risk shouldoffset this concern It is also far from clear how cross-national compari-sons of rating and internal risk-assessment systems will be made (Engelen2000) The development by the European Union of its own capital rulescould well complicate the international resolution of these issues Publicassurances by EU officials in January 2001 however indicated that theirmain concerns are to create a level playing field and avoid regulatoryarbitrage (Hargreaves 2001) There is also the significant problem ofthe procyclical character of risk weights When a crisis hits losses are
49 See Berry (2000) for an update in an interview with William J McDonough chair ofthe Basel Committee on Banking Supervision
50 For obvious reasons these proposals are addressed to large banks and simpler capi-tal standards are allowed for small banks that focus on their domestic credit markets
51 See Ammer and Packer (2000) for an empirical critique of the success of rating agen-cies in distinguishing risk by sector and region
52 See Auerback (2001)
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126 WORLD CAPITAL MARKETS
incurred or accrued capital is lost and loan exposure must be reducedor securities sold to restore the requisite capital-adequacy ratios A morerisk-sensitive framework could amplify volatility
As the second pillar of Basel II supervisory review criteria are beingbeefed up to encourage supervisors to intervene earlier in potential problemsituations and to compel banks to align their capital positions with theirrisk profiles Bank supervisors will be authorized to require banks tohold capital in excess of minimum requirements if they have concernsabout general management overall strategy risk-management performanceor the macroeconomic environment Of course if one G-10 supervisorimposes higher capital requirements in isolation the same disparity willemerge that presaged Basel I Some banks will be disadvantaged in theinternational marketplace and will loudly complain that excessive super-vision is driving business to their competitors Hence close internationalcooperation among supervisors is critical
To implement the third pillar market discipline banks will be requiredto make fuller more timely disclosure of capital adequacy and the risksto which that capital is exposed A number of measures are being stud-ied that might help supervisors evaluate bank performance such as com-parisons of uninsured deposit interest rates subordinated debt yieldsand equity prices The idea is that these yields and prices might alertsupervisors to market perceptions of risk Of course market perceptionsare only as good as market information More direct and controversialways to reinforce market discipline would dramatically increase publicdisclosure of bank positions and risk management systems
Many questions are still outstanding about how to resolve the techni-cal details of capital requirements and whether the requirements willachieve their intended goal of better assessment and mitigation of therisks in banksrsquo portfolios There is no substitute for skilled supervisorsThe intricacies of effective design and implementation suggest that su-pervisors need to be highly competent technically knowledgeable aboutbanking portfolio characteristics and the factors that influence bank ex-posure to credit risk (Mishkin 2000) And they must be aided by vigilantshareholders market forces and transparency of information53
Standard setting at the global level is desirable but ultimately theeffectiveness of these efforts will be tested at the national level espe-cially in times of systemic financial distress Here the record of Basel Iwas not a bright shining success Japanese banking regulators havetraditionally allowed banks to include real estate and securities in theircapital base When the value of these assets plummeted in the early 1990sregulators allowed banks to continue valuing these depreciated (andoften bankrupt) assets at their old inflated levels Japanese authorities
53 Benedict Roth Complacency Towards Catastrophe Financial Times 23 January 2001
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 127
insisted until the mid-1990s that eroded capital bases could be rebuiltin a market-driven fashion They rightly foresaw that huge loan losseswould undermine public support for the ruling party and require a po-litically unpopular bailout
Japanese foot dragging on Basel I was the worst54 but not uniqueOther examples can be found of ldquopolitically mandated forbearancerdquo TheFederal Reserve Bank of New York held important hands during theLTCM crisis of 1998 Mexico is still resolving the banking crisis that eruptedin 1995 South Korea has not yet closed the insolvent banks that behavedso badly before the crisis of 1998 In the aftermath of a crisis nationalregulators cannot always be relied upon to discipline politically power-ful bankers55 One of the little-noticed consequences of these differingapproaches is that those banks with strong regulatory systems receivedan implicit ldquoexport subsidyrdquo for their services US banks which had notengaged extensively in emerging-market lending in the 1990s were bet-ter positioned than their German and Japanese counterparts to expandtheir international assets in the wake of the crises
Other Financial Forums
54 See Japanese Banks Fiddling while Marunouchi Burns The Economist 27 January2001 67-69
55 See Calomiris (1997)
The Basel model of vertical subsidiarity has already been extended toother financial regulatory bodies In 1993-94 the BIS established a Tri-partite Group of Banking Insurance and Securities Regulators In 1994-95 the BIS increased its cooperation with the International Organizationof Securities Commissions when the two organizations issued parallelpapers on guidelines for national regulators concerning risk managementand disclosure of derivative trades In 1996 a permanent Joint Forum onFinancial Conglomerates was established to examine supervisory issuesand develop working arrangements among the different functional super-visors of conglomerate institutions that offer combinations of bankingsecurities and insurance products Draft papers on the supervisionof conglomerates were released for comment in 1998 applying capital-adequacy principles to these groups and providing guidelines both forassessing the integrity and competence of top managers and for sharingassessments between regulators
In 1997 the Basel Committee on Banking Supervision extended itsreach beyond capital standards to broader aspects of banking supervi-sion with the publication of the Core Principles for Effective BankingSupervision In 1999 a wide range of regulatory and standard-settingbodies were gathered under the umbrella of the Financial Stability
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128 WORLD CAPITAL MARKETS
Forum (FSF) itself established under BIS aegis56 The FSF has alreadyissued recommendations for stepped-up supervision and transparencyas well as guidelines for best practices in a number of areas includingoffshore financial centers and highly leveraged institutions or hedge funds57
Conclusion
Although the structural weaknesses in emerging-market economies arewidely acknowledged to have been causal factors in international capi-tal-market volatility this chapter points to the role of large G-10 bankingorganizations as major suppliers of the most volatile instrument short-term debt We have examined evidence of the impact of public safetynets in the G-10 economiesmdashthe deposit insurance systems the pruden-tial supervisory systems and the lender-of-last-resort functions of centralbanksmdashon the incentive structures of these organizations
Although supervisors in most countries working nationally and to-gether in the BIS have made significant efforts to mimic market forcesin their prudential supervision the most sophisticated financial institu-tions find innovative ways to circumvent the rules New global regulatorybodies are not about to be created G-10 national bank regulators shouldthemselves address the short-term debt bias in the international financialsystem by changing incentive systems G-10 securities regulators shouldalso take steps to get ahead of the curve paying close attention to largeportfolio swings by institutional investors particularly in times of crisisIn short more needs to be done at national and international levels tochange the rules of the game That is the subject of the next chapter
56 The Financial Stability Forum includes banking securities insurance and accountingregulatory bodies the OECD on taxation corruption and corporate governance and theIMF
57 See Martin (2000)
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115
Financial institutions and their supervisors
Country and supervisory structure Retail banking Wholesale banking Securities Insurance
Germany Financial holding groupsFederal Banking Supervisory Office (FBSO) = umbrella supervisor
Ministry of Finance FBSO BSO FSSO FISO
Bundesbankbull Universal banks bull Other financial bull Primary issuers of bull Insurance companies
Federal Banking bull Savings banks institutions (eg securities bull Insurance brokers Supervisory Office bull Securities banks management foreign bull Stock exchanges
currency dealings) bull Stockbrokers Federal Securities bull Financial enterprises bull Asset managers Supervisory Office (eg leasing bull Pension funds
organizations Federal Insurance credit card companies Supervisory Office investment advisors)
Italy Bank foundationsMinistry of Finance = umbrella supervisor
Ministry of Finance Bank of Italy Bank of Italy Consob ISVAP
Bank of Italy bull Commerical banks bull Asset managers bull Primary issuers of bull Insurance companies Consob bull Savings bank bull Open-end investment securities bull Insurance brokers
bull Securities banks companies (SICAVs) bull Stock exchangesbull Stockbrokers
ISVAP
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Table 210 Financial-sector regulation G-10 countries 2000 (continued )
Financial institutions and their supervisors
Country and supervisory structure Retail banking Wholesale banking Securities Insurance
The Netherlands Financial conglomeratesCouncil of Financial Supervisors = umbrella supervisor
Securities Board Securities Board Netherlandsche Netherlands Bank Netherlandsche Bank of the Netherlands Insurance Board Bank Insurance bull Credit institutions (universal banks bull Investment institutions bull Stock exchanges bull Insurance companies Board cooperative banks security credit (securities issuing bull Stockbrokers bull Insurance brokers
institutions mortgage banks) and tradingmdashprimary The Council of Financial and secondary Supervisors markets)
France Commission des Commission de Operations des Controcircle des
Banking and Banking Commission Bourse Assurances Financial Regulatory bull Ensuring that credit institutions (and investment firms since bull Primary issuers of bull Insurance companies Ministry for Committee the Financial Activity Modernization Act of 1996) comply securities bull Insurance brokers Economic with laws and regulations bull Stock exchanges Affairs and bull Execute instructions regarding all off-site monitoring and bull Stockbrokers Finance Credit on-site supervision Institutions and Banking and Financial Regulatory Committee Investment bull Formulates general regulations for credit institutions and investment firms Committee (capital adequacy requirements accounting rules etc) Bank of France Credit Institutions and Investment Committee Banking bull Authorizes and examines financial institutions except for those within the Commission competence of the Banking Commission
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117
Financial institutions and their supervisors
Country and supervisory structure Retail banking Wholesale banking Securities Insurance
Switzerland Large banking groupSwiss Federal Banking Commission (SFBC) = umbrella supervisor
Swiss National Bank Federal Office of
SFBC SFBC SFBC Private Insurance Swiss Federal Banking Commission bull Universal banks bull Investment banks bull Primary issuers of bull Insurance companies
bull Savings banks bull Asset management securities bull Insurance brokerscompanies bull Stock exchanges
Private audit Federal bull Investment funds bull Stockbrokers firms Office of bull Mortgage bond authorized by Private business SFBC Insurance
Sweden Financial holding company groupsFinancial Supervisory Authority = umbrella supervisor
Ministry of Finance Credit Market Securities Market Insurance Market
Credit Market Department Department Department Department
Financial bull Commercial banks bull Investment funds bull Primary issuers of bull Insurance companies Riksbank Supervisory bull Savings banks securities bull Insurance brokers Authority bull Friendly societies bull Stock exchanges
bull Stockbrokers
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Table 210 Financial-sector regulation G-10 countries 2000 (continued )
Financial institutions and their supervisors
Country and supervisory structure Retail banking Wholesale banking Securities Insurance
Belgium Bank holding companiesBanking and Finance Commission = umbrella supervisor
Bank of Belgium Banking Banking
Banking and Finance and Finance Insurance Controland Finance Commission Commission Commission Office
Banking and Insurance Finance Control bull Commercial banks bull Asset management bull Primary issuers of bull Insurance companies Commission Office bull Savings banks firms securities bull Insurance brokers
bull Securities banks bull Investment funds bull Stock exchanges bull Mortgage companiesbull Stockbrokers bull Pension funds
Securities Regulation Fund Securities Regulation Fund
bull Other investment firms and credit institutions(institutions participating in regulated off-exchangemarket in strips and Treasury certificates)
Bank holding companies Spain Banco de Espantildea = umbrella supervisor
Banco de Espantildea Comision Nacional del Mercado de Directorate General
Banco de Espantildea Valores (CNMV) Insurance
bull All credit institutions (commercial banks savings banks credit bull Primary issuers of (Ministry of Economy Ministry of cooperatives official credit institutions finance factoring and securities and Finance) Economy and CNMV leasing companies mortgage-loan companies etc) bull Stock exchanges bull Insurance companies Finance bull Interbank foreign exchange and book-entry public debt bull Stockbrokers bull Pension funds
markets bull Venture capital(companies and funds)
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119
Financial institutions and their supervisors
Country and supervisory structure Banking Securities Insurance
Banking Advisory High Level Securities Supervisors Committee (BAC) Committee (HLSS) Insurance Committee (IC)
Supranational (EU) bull Formulates standards for prudential bull Coordination of securities market bull Formulates standards forsupervision supervision prudential supervision
BACICHLSS Banking Supervision
Conglomerates Committee (BSC) Securities Contact Committee Regulation of prudential bull Systemic risk monitoring bull Regulation and implementation of supervision securities admission
International Association International International Organization of of Insurance Supervisors
Basel Committee Securities Commisison (IOSCO) (IAIS) Joint Forum Conglomerates Supervision bull Supervision and regulation best bull Supervision and regulation best bull Supervision and regulation amp regulation Best practices practices practices best practices
FSF Coordination across supervisors of various functions
Notes See appendix B for more information Boldface type indicates senior or oversight supervisor normal type indicates adjunct or front-line supervisorsolid line indicates direct responsbility to the senior-ranking authority dotted line indicates coordination in supervisory activities
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Table 210 Financial-sector regulation G-10 countries 2000 (continued )
Glossary of names United Kingdom FSA = Financial Services Authority United States FR = Federal Reserve OCC = Office of the Comptroller of theCurrency FDIC = Federal Deposit Insurance Corporation SEC = Securities and Exchange Commission OTS = Office of Thrift Supervision Japan FRC =Financial Reconstruction Commission FSA = Financial Services Agency SESC = Securities and Exchange Surveillance Commission Canada OSFI =Office of the Superintendent of Financial Institutions CDIC = Canada Deposit Insurance Corporation Germany FBSO = Federal Banking SupervisoryOffice FSSO = Federal Securities Supervisory Office FISO = Federal Insurance Supervisory Office BSO = Banking Supervisory Office Italy Consob =Commissione Nazionale per le Societa e la Borsa ISVAP = Instituto per la Vigilanza sulle assicurazioni private e di Interesse colletivo Switzerland SFBC= Swiss Federal Banking Commission Spain CNMV = The Comision Nacional del Mercado de Valores Supranational BAC = Banking Advisory CommitteeBSC = Banking Supervision Committee IC = Insurance Committee HLSS = High Level Securities Supervisors Committee International Dimension FSF =Financial Stability Forum IOSCO = International Organization of Securities Commission IAIS = International Association of Insurance Supervisors
Sources United Kingdom Bank of England httpwwwbankofenglandcouk Financial Services Authority httpwwwfsagovuk United States Board ofGovernors of Federal Reserve System httpwwwfederalreservegov Japan Bank of Japan httpwwwbojorjo Financial Reconstruction Commissionhttpwwwfsagojpfrcindexehtml Financial Services Agency httpwwwfsagojp Canada Bank of Canada httpwwwbank-banque-canadaca Office ofthe Superintendent of Financial Institutions httpwwwosfi-bsifgccaAndreEindexhtml Germany Deutsche Bundesbank httpwwwbundesbankde Fed-eral Banking Supervisory Office httpwwwbakredde Italy Banca drsquoitalia httpwwwbancaditaliait Commissione Nazionale per le Societa e la Borsahttpwwwconsobit Instituto per la Vigilanza sulle assicurazioni private e di Interesse colletivo httpwwwisvapit The Netherlands De NederlandscheBank httpwwwdnbnl France Banque de France httpwwwbanque-francefr Switzerland Schweizerische Nationalbank httpwwwsnbchindex3htmlSweden Sveriges Riksbank httpwwwriksbanksedefaultasp Belgium National Bank of Belgium httpwwwbnbbesgindexhtm Spain Banco de Espantildeahttpwwwbdees The Comision Nacional del Mercado de Valores httpwwwcnmves Supranational (EU) Institutional Arrangements for the Regulationand Supervision of the Financial Sector 2000 International Dimension Bank for International Settlement httpwwwbisorg International Organization ofSecurities Commissions httpwwwioscoorg International Association of Insurance Supervisors httpwwwiaisorg Financial Stability Forum httpwwwfsforumorg
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 121
the inflexibility of tight surveillance against the need to encourage in-novation and growth The US Securities and Exchange Commission isworried about aggressive accounting by firms and biased reports bysecurities analysts in an equity environment that prizes steadily higherquarterly earnings41 Japanese regulators are preoccupied with opaqueinterconnections between portfolio institutions banks and nonfinancialfirms through the keiretsu system Canadian regulators reeling from high-profile scandals of managers intentionally misleading investors are strengtheningmarket discipline through legal penalties aimed at managers and directorsof offending firms
When panic strikes a securities regulator cannot do much As the 1987stock market crash and the LTCM debacle in the fall of 1998 both dem-onstrated steep stock and bond price declines can create systemic risksIf severe enough the wealth effect of falling securities values and thefear of widespread insolvency can depress real activity Flooding thesystem with liquidity is a central bankerrsquos solutionmdashsomething a securi-ties regulator cannot do42 But just as financial supervisors can changethe incentive structure to discourage bankers from making risky loans ingood times so securities regulators can pay more attention to incentiveson the demand side when capital markets are strong
Prudential Supervision and InnovationmdashA Footnote
In concluding this discussion of prudential supervision in the G-10 anadditional point is worth noting National regulators face a persistenttrade-off between emphasizing financial system safety and soundnesswhile encouraging innovationmdashin spite of the added risks innovationbrings to financial markets Former US Treasury Secretary Lawrence Summers(2000 3) has argued by analogy
The jet airplane made airplane air travel more comfortable more efficient andmore safe though the accidents were more spectacular and for a time morenumerous after the jet was invented In the same way modern global financialmarkets carry with them enormous potential for benefit even if some of theaccidents are that much more spectacular As the right public policy response
41 The problem is illustrated by the divergence since mid-1998 between reported earn-ings by the Standard amp Poorrsquos (SampP) 500 and the after-tax profits of all corporations inthe national accounts Generally these two series move closely with one another Be-tween mid-1998 and mid-1999 SampP 500 reported that earnings increased by more than20 percent while after-tax profits of all corporations increased by less than 5 percent(Chase Bank US Economic and Policy Research US Weekly Prospects Chase SecuritiesWeekly Newsletter 5 June 2000 5)
42 For example the US Securities and Exchange Commission had no direct role in calmingmarkets in the 1987 or 1998 panics
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122 WORLD CAPITAL MARKETS
to the jet was longer runways better air-traffic control and better training forpilots and not the discouragement of rapid travel so the right public policyresponse to financial innovation is to assure a safe framework so that the ben-efits can be realized not to stifle the change
Accepting Summersrsquos analogy for the international financial system better-informed supervisors and investors are a necessary part of the financialsystem framework Supervisors require more timely information on therisk profiles resulting from positions taken by financial institutions Theyalso need a better understanding of risk-management systems Snapshotsof an institutionrsquos risk profile and risk-management procedures are nolonger adequate In a world where huge bets are quickly made (andpossibly lostmdashas with Barings Bank in 1995 and LTCM in 1998) super-visors must focus on the soundness of banking systems for evaluatingand managing risk on a daily basis Some progress has been made inaddressing these issues US banking examiners are extending their in-formation requirements in banking examinations and increasing theirinvolvement in large complex institutions43 More awareness is alsorequired of the fact that they are national organizations in a world ofcross-border capital flows To a much greater extent they need a multi-national reach International supervision and coordination among super-visors are the subject of the next section
Our analysis suggests that G-10 supervisors have unfinished businessBank supervisors need to start yesterday securities regulators can waituntil tomorrow One G-10 member acting alone cannot correct the biasIn good times the lending business will simply migrate to other G-10banks In bad times financial problems will not stop at the national bor-der A way has to be found to establish common international standardsfor the key financial players in order to prevent crises and to agree onapproaches for managing them The path has already been laid out Inthe wake of the bank failures of the past 25 years bank supervisors havetried to establish such standards They have done this without creating anew global institution
The essence of the international framework is decentralizationmdashglobalrules and design standards without global institutions that are perceivedto intrude on national sovereignty The awkward jargon for this frame-work is vertical subsidiaritymdashldquothink internationally act nationallyrdquo Theinternational thinking is done by a committee of regulators that meets
International SupervisionA Decentralized Framework
43 These issues are discussed in Ferguson (1999) and Meyer (2000a)
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 123
regularly at the Bank for International Settlements in Basel The commit-tee establishes principles and standards that are interpreted implementedand enforced by national authorities44 In this section we describe thesesupervisory efforts and their weaknesses We present our recommenda-tions for addressing these weaknesses in the next chapter
Basel I
The Basel Capital Accord of 1988 (Basel I)45 drew the lesson from thefinancial crises of the mid-1970s that more adequate capital levels in in-ternational banks would help reduce the systemic risk of bank failureThe primary goal of Basel I was capital adequacy other standards wereput in place not so much for their own virtue as to defend the primarygoal
Capital adequacy requirements were designed to ensure that individualinstitutions have the ability to absorb losses particularly credit lossesAccordingly a backup system of scoring credit risk was devised thatrequired large amounts of bank capital for some types of loans smalleramounts for others and zero for a select list of preferred assets Report-ing requirements were designed to disclose problems and ensure that atroubled bank would take timely steps to restore its capital base in thewake of a loss The Basel I framework worked tolerably well in limitingthe call on the public purse in the G-10 countriesmdashwith the notable ex-ceptions of France and Japan The framework failed to moderate riskybank lending to emerging markets however
Basel I was not developed with emerging markets in mind The origi-nal idea behind it was to develop a common supervisory approach tocross-border banking operations It grew out of political pressure fromUS lawmakers who were determined to require international banks op-erating in the United States to meet US banking standards Toward thisgoal in 1983 Congress passed the International Lending Supervisory ActUS and British banking authorities subsequently agreed on a commontarget the adoption of strict common capital-adequacy standards In 1988other G-10 governments agreed to go along voluntary acceptance ofthe standards throughout much of the rest of the world followed46 Therationale for the capital targets was two-fold The first was to requirebanks to hold sufficient amounts of capital (8 percent of risk-adjusted
44 The international committee of financial authorities agreed on a common definitionof banksrsquo tier-one or ldquocorerdquo capital national authorities defined tier-two capital in theirown manner which permitted greater variations in national working definitions andpractices
45 International Convergence of Capital Measurement and Capital Standards (BIS 1988)was prepared by the Basel Committee on Banking Supervision
46 See Reineke (1998)
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124 WORLD CAPITAL MARKETS
assets) to cushion losses on those assets The second was to dull theirappetites for risk banks with large capital bases would have more tolose if they failed and therefore would take fewer risks
Rapid change in financial markets soon revealed flaws in the Basel IAccord In a complex world with numerous sources of risk it focusedheavily on credit risk but overlooked other risks in a bankrsquos portfolioand the correlation between returns on different asset classes The Baselformula required banks to maintain a fixed amount of capital againsteach of its asset classes But the formula did not distinguish the riskinessof the borrower within each class As a result one large loan to a low-risk corporate borrower such as General Electric would require the sameamount of capital as 10 smaller transactions with high-risk borrowers
The system was also biased toward short-term loans Loans maturingin less than a year required a 20 percent risk weight whereas those ma-turing after more than a year required a 100 percent risk weight Inter-bank lending was particularly favored For example loans to banks inOECD countries required less capital than loans to private firms in thesame countries creating the anomaly that interbank loans to South Ko-rean banks required less capital than loans to General Electric47 Thisanomaly encouraged banks to shed high-quality assets if the Basel rulesrequired the allocation of more capital than banks thought they needed
Another weakness was that financial innovators quickly circumventedthe Accord Because short-term loans required less provisioning than long-term loans banks responded by securitizing their long-term debt port-folios and lending short-term against the collateral of the newly createdasset This allowed banks to circumvent the capital requirements gearedto the terms of the underlying debt At the same time the Basel I Accordfailed to encourage risk mitigation techniques such as credit derivativescollateral guarantees and on-balance-sheet netting the flip side of fi-nancial innovation Because off-balance-sheet products were not coveredby the Accord another anomaly appeared when Barings Bank collapsedin 1995 Barings met capital adequacy standards but collapsed becauseits systems for managing risk failed traders were allowed to speculatein futures contracts that did not appear on the balance sheet
Basel II
Work to overhaul Basel I began in 1995 and produced consultativepapers issued in June 1999 and January 200148 These papers have been
47 South Korean banks have had notoriously weak balance sheets because the practiceof ldquodirected lendingrdquo left them with many poor loans (in making these loans the bankswere expected to follow government objectives rather than creditworthiness criteria)
48 Basel Committee on Banking Supervision (1999 2001)
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 125
the subject of extensive consultation and revision as a result the newAccord is expected to be introduced in 200449 The Basel II frameworkhas three parts (pillars) revisions to Basel I minimum-capital require-ments supervisory review criteria and greater emphasis on market dis-cipline Broadly Basel II aims to maintain the level of capital in the sys-tem but achieve better alignment of banksrsquo capital with their risk pro-files and keep up with financial innovation
To align capital requirements with market realities (the first pillar)Basel II concentrates on the 100 or so largest banksmdashthe type of playerslisted in table 21mdashand on the holding-company parents of banking groups50
Capital requirements will differentiate between an increased number ofcredit groups or ldquorisk bucketsrdquo including claims on governments otherbanks corporations mortgage-backed securities and other asset-backedsecurities
Basel II originally proposed to use external ratings to set capital chargesfor a number of these credit risks Many banks objected arguing thatthey assess credit risk better than Standard amp Poorrsquos Moodyrsquos or FitchIBCA51 Basel II thus proposes two approaches to rating a standard ap-proach using external ratings and an ldquoadvancedrdquo approach that allowsselected banks to use their own internal rating systems To encouragethe development of rigorous internal control systems based on these in-ternal rating systems Basel II also proposes to levy capital charges foroperational risk (the risk of direct or indirect loss resulting from inad-equate or failed internal processes people and systems or from exter-nal events)
Some critics of this proposal dismiss it as an abrogation of the prin-ciple of external independent monitoring and as ldquodangerously naiumlverdquo52
But regulators argue that the new capital charge on operational risk shouldoffset this concern It is also far from clear how cross-national compari-sons of rating and internal risk-assessment systems will be made (Engelen2000) The development by the European Union of its own capital rulescould well complicate the international resolution of these issues Publicassurances by EU officials in January 2001 however indicated that theirmain concerns are to create a level playing field and avoid regulatoryarbitrage (Hargreaves 2001) There is also the significant problem ofthe procyclical character of risk weights When a crisis hits losses are
49 See Berry (2000) for an update in an interview with William J McDonough chair ofthe Basel Committee on Banking Supervision
50 For obvious reasons these proposals are addressed to large banks and simpler capi-tal standards are allowed for small banks that focus on their domestic credit markets
51 See Ammer and Packer (2000) for an empirical critique of the success of rating agen-cies in distinguishing risk by sector and region
52 See Auerback (2001)
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126 WORLD CAPITAL MARKETS
incurred or accrued capital is lost and loan exposure must be reducedor securities sold to restore the requisite capital-adequacy ratios A morerisk-sensitive framework could amplify volatility
As the second pillar of Basel II supervisory review criteria are beingbeefed up to encourage supervisors to intervene earlier in potential problemsituations and to compel banks to align their capital positions with theirrisk profiles Bank supervisors will be authorized to require banks tohold capital in excess of minimum requirements if they have concernsabout general management overall strategy risk-management performanceor the macroeconomic environment Of course if one G-10 supervisorimposes higher capital requirements in isolation the same disparity willemerge that presaged Basel I Some banks will be disadvantaged in theinternational marketplace and will loudly complain that excessive super-vision is driving business to their competitors Hence close internationalcooperation among supervisors is critical
To implement the third pillar market discipline banks will be requiredto make fuller more timely disclosure of capital adequacy and the risksto which that capital is exposed A number of measures are being stud-ied that might help supervisors evaluate bank performance such as com-parisons of uninsured deposit interest rates subordinated debt yieldsand equity prices The idea is that these yields and prices might alertsupervisors to market perceptions of risk Of course market perceptionsare only as good as market information More direct and controversialways to reinforce market discipline would dramatically increase publicdisclosure of bank positions and risk management systems
Many questions are still outstanding about how to resolve the techni-cal details of capital requirements and whether the requirements willachieve their intended goal of better assessment and mitigation of therisks in banksrsquo portfolios There is no substitute for skilled supervisorsThe intricacies of effective design and implementation suggest that su-pervisors need to be highly competent technically knowledgeable aboutbanking portfolio characteristics and the factors that influence bank ex-posure to credit risk (Mishkin 2000) And they must be aided by vigilantshareholders market forces and transparency of information53
Standard setting at the global level is desirable but ultimately theeffectiveness of these efforts will be tested at the national level espe-cially in times of systemic financial distress Here the record of Basel Iwas not a bright shining success Japanese banking regulators havetraditionally allowed banks to include real estate and securities in theircapital base When the value of these assets plummeted in the early 1990sregulators allowed banks to continue valuing these depreciated (andoften bankrupt) assets at their old inflated levels Japanese authorities
53 Benedict Roth Complacency Towards Catastrophe Financial Times 23 January 2001
Institute for International Economics | httpwwwiiecom
THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 127
insisted until the mid-1990s that eroded capital bases could be rebuiltin a market-driven fashion They rightly foresaw that huge loan losseswould undermine public support for the ruling party and require a po-litically unpopular bailout
Japanese foot dragging on Basel I was the worst54 but not uniqueOther examples can be found of ldquopolitically mandated forbearancerdquo TheFederal Reserve Bank of New York held important hands during theLTCM crisis of 1998 Mexico is still resolving the banking crisis that eruptedin 1995 South Korea has not yet closed the insolvent banks that behavedso badly before the crisis of 1998 In the aftermath of a crisis nationalregulators cannot always be relied upon to discipline politically power-ful bankers55 One of the little-noticed consequences of these differingapproaches is that those banks with strong regulatory systems receivedan implicit ldquoexport subsidyrdquo for their services US banks which had notengaged extensively in emerging-market lending in the 1990s were bet-ter positioned than their German and Japanese counterparts to expandtheir international assets in the wake of the crises
Other Financial Forums
54 See Japanese Banks Fiddling while Marunouchi Burns The Economist 27 January2001 67-69
55 See Calomiris (1997)
The Basel model of vertical subsidiarity has already been extended toother financial regulatory bodies In 1993-94 the BIS established a Tri-partite Group of Banking Insurance and Securities Regulators In 1994-95 the BIS increased its cooperation with the International Organizationof Securities Commissions when the two organizations issued parallelpapers on guidelines for national regulators concerning risk managementand disclosure of derivative trades In 1996 a permanent Joint Forum onFinancial Conglomerates was established to examine supervisory issuesand develop working arrangements among the different functional super-visors of conglomerate institutions that offer combinations of bankingsecurities and insurance products Draft papers on the supervisionof conglomerates were released for comment in 1998 applying capital-adequacy principles to these groups and providing guidelines both forassessing the integrity and competence of top managers and for sharingassessments between regulators
In 1997 the Basel Committee on Banking Supervision extended itsreach beyond capital standards to broader aspects of banking supervi-sion with the publication of the Core Principles for Effective BankingSupervision In 1999 a wide range of regulatory and standard-settingbodies were gathered under the umbrella of the Financial Stability
Institute for International Economics | httpwwwiiecom
128 WORLD CAPITAL MARKETS
Forum (FSF) itself established under BIS aegis56 The FSF has alreadyissued recommendations for stepped-up supervision and transparencyas well as guidelines for best practices in a number of areas includingoffshore financial centers and highly leveraged institutions or hedge funds57
Conclusion
Although the structural weaknesses in emerging-market economies arewidely acknowledged to have been causal factors in international capi-tal-market volatility this chapter points to the role of large G-10 bankingorganizations as major suppliers of the most volatile instrument short-term debt We have examined evidence of the impact of public safetynets in the G-10 economiesmdashthe deposit insurance systems the pruden-tial supervisory systems and the lender-of-last-resort functions of centralbanksmdashon the incentive structures of these organizations
Although supervisors in most countries working nationally and to-gether in the BIS have made significant efforts to mimic market forcesin their prudential supervision the most sophisticated financial institu-tions find innovative ways to circumvent the rules New global regulatorybodies are not about to be created G-10 national bank regulators shouldthemselves address the short-term debt bias in the international financialsystem by changing incentive systems G-10 securities regulators shouldalso take steps to get ahead of the curve paying close attention to largeportfolio swings by institutional investors particularly in times of crisisIn short more needs to be done at national and international levels tochange the rules of the game That is the subject of the next chapter
56 The Financial Stability Forum includes banking securities insurance and accountingregulatory bodies the OECD on taxation corruption and corporate governance and theIMF
57 See Martin (2000)
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Table 210 Financial-sector regulation G-10 countries 2000 (continued )
Financial institutions and their supervisors
Country and supervisory structure Retail banking Wholesale banking Securities Insurance
The Netherlands Financial conglomeratesCouncil of Financial Supervisors = umbrella supervisor
Securities Board Securities Board Netherlandsche Netherlands Bank Netherlandsche Bank of the Netherlands Insurance Board Bank Insurance bull Credit institutions (universal banks bull Investment institutions bull Stock exchanges bull Insurance companies Board cooperative banks security credit (securities issuing bull Stockbrokers bull Insurance brokers
institutions mortgage banks) and tradingmdashprimary The Council of Financial and secondary Supervisors markets)
France Commission des Commission de Operations des Controcircle des
Banking and Banking Commission Bourse Assurances Financial Regulatory bull Ensuring that credit institutions (and investment firms since bull Primary issuers of bull Insurance companies Ministry for Committee the Financial Activity Modernization Act of 1996) comply securities bull Insurance brokers Economic with laws and regulations bull Stock exchanges Affairs and bull Execute instructions regarding all off-site monitoring and bull Stockbrokers Finance Credit on-site supervision Institutions and Banking and Financial Regulatory Committee Investment bull Formulates general regulations for credit institutions and investment firms Committee (capital adequacy requirements accounting rules etc) Bank of France Credit Institutions and Investment Committee Banking bull Authorizes and examines financial institutions except for those within the Commission competence of the Banking Commission
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Financial institutions and their supervisors
Country and supervisory structure Retail banking Wholesale banking Securities Insurance
Switzerland Large banking groupSwiss Federal Banking Commission (SFBC) = umbrella supervisor
Swiss National Bank Federal Office of
SFBC SFBC SFBC Private Insurance Swiss Federal Banking Commission bull Universal banks bull Investment banks bull Primary issuers of bull Insurance companies
bull Savings banks bull Asset management securities bull Insurance brokerscompanies bull Stock exchanges
Private audit Federal bull Investment funds bull Stockbrokers firms Office of bull Mortgage bond authorized by Private business SFBC Insurance
Sweden Financial holding company groupsFinancial Supervisory Authority = umbrella supervisor
Ministry of Finance Credit Market Securities Market Insurance Market
Credit Market Department Department Department Department
Financial bull Commercial banks bull Investment funds bull Primary issuers of bull Insurance companies Riksbank Supervisory bull Savings banks securities bull Insurance brokers Authority bull Friendly societies bull Stock exchanges
bull Stockbrokers
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Table 210 Financial-sector regulation G-10 countries 2000 (continued )
Financial institutions and their supervisors
Country and supervisory structure Retail banking Wholesale banking Securities Insurance
Belgium Bank holding companiesBanking and Finance Commission = umbrella supervisor
Bank of Belgium Banking Banking
Banking and Finance and Finance Insurance Controland Finance Commission Commission Commission Office
Banking and Insurance Finance Control bull Commercial banks bull Asset management bull Primary issuers of bull Insurance companies Commission Office bull Savings banks firms securities bull Insurance brokers
bull Securities banks bull Investment funds bull Stock exchanges bull Mortgage companiesbull Stockbrokers bull Pension funds
Securities Regulation Fund Securities Regulation Fund
bull Other investment firms and credit institutions(institutions participating in regulated off-exchangemarket in strips and Treasury certificates)
Bank holding companies Spain Banco de Espantildea = umbrella supervisor
Banco de Espantildea Comision Nacional del Mercado de Directorate General
Banco de Espantildea Valores (CNMV) Insurance
bull All credit institutions (commercial banks savings banks credit bull Primary issuers of (Ministry of Economy Ministry of cooperatives official credit institutions finance factoring and securities and Finance) Economy and CNMV leasing companies mortgage-loan companies etc) bull Stock exchanges bull Insurance companies Finance bull Interbank foreign exchange and book-entry public debt bull Stockbrokers bull Pension funds
markets bull Venture capital(companies and funds)
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Financial institutions and their supervisors
Country and supervisory structure Banking Securities Insurance
Banking Advisory High Level Securities Supervisors Committee (BAC) Committee (HLSS) Insurance Committee (IC)
Supranational (EU) bull Formulates standards for prudential bull Coordination of securities market bull Formulates standards forsupervision supervision prudential supervision
BACICHLSS Banking Supervision
Conglomerates Committee (BSC) Securities Contact Committee Regulation of prudential bull Systemic risk monitoring bull Regulation and implementation of supervision securities admission
International Association International International Organization of of Insurance Supervisors
Basel Committee Securities Commisison (IOSCO) (IAIS) Joint Forum Conglomerates Supervision bull Supervision and regulation best bull Supervision and regulation best bull Supervision and regulation amp regulation Best practices practices practices best practices
FSF Coordination across supervisors of various functions
Notes See appendix B for more information Boldface type indicates senior or oversight supervisor normal type indicates adjunct or front-line supervisorsolid line indicates direct responsbility to the senior-ranking authority dotted line indicates coordination in supervisory activities
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Table 210 Financial-sector regulation G-10 countries 2000 (continued )
Glossary of names United Kingdom FSA = Financial Services Authority United States FR = Federal Reserve OCC = Office of the Comptroller of theCurrency FDIC = Federal Deposit Insurance Corporation SEC = Securities and Exchange Commission OTS = Office of Thrift Supervision Japan FRC =Financial Reconstruction Commission FSA = Financial Services Agency SESC = Securities and Exchange Surveillance Commission Canada OSFI =Office of the Superintendent of Financial Institutions CDIC = Canada Deposit Insurance Corporation Germany FBSO = Federal Banking SupervisoryOffice FSSO = Federal Securities Supervisory Office FISO = Federal Insurance Supervisory Office BSO = Banking Supervisory Office Italy Consob =Commissione Nazionale per le Societa e la Borsa ISVAP = Instituto per la Vigilanza sulle assicurazioni private e di Interesse colletivo Switzerland SFBC= Swiss Federal Banking Commission Spain CNMV = The Comision Nacional del Mercado de Valores Supranational BAC = Banking Advisory CommitteeBSC = Banking Supervision Committee IC = Insurance Committee HLSS = High Level Securities Supervisors Committee International Dimension FSF =Financial Stability Forum IOSCO = International Organization of Securities Commission IAIS = International Association of Insurance Supervisors
Sources United Kingdom Bank of England httpwwwbankofenglandcouk Financial Services Authority httpwwwfsagovuk United States Board ofGovernors of Federal Reserve System httpwwwfederalreservegov Japan Bank of Japan httpwwwbojorjo Financial Reconstruction Commissionhttpwwwfsagojpfrcindexehtml Financial Services Agency httpwwwfsagojp Canada Bank of Canada httpwwwbank-banque-canadaca Office ofthe Superintendent of Financial Institutions httpwwwosfi-bsifgccaAndreEindexhtml Germany Deutsche Bundesbank httpwwwbundesbankde Fed-eral Banking Supervisory Office httpwwwbakredde Italy Banca drsquoitalia httpwwwbancaditaliait Commissione Nazionale per le Societa e la Borsahttpwwwconsobit Instituto per la Vigilanza sulle assicurazioni private e di Interesse colletivo httpwwwisvapit The Netherlands De NederlandscheBank httpwwwdnbnl France Banque de France httpwwwbanque-francefr Switzerland Schweizerische Nationalbank httpwwwsnbchindex3htmlSweden Sveriges Riksbank httpwwwriksbanksedefaultasp Belgium National Bank of Belgium httpwwwbnbbesgindexhtm Spain Banco de Espantildeahttpwwwbdees The Comision Nacional del Mercado de Valores httpwwwcnmves Supranational (EU) Institutional Arrangements for the Regulationand Supervision of the Financial Sector 2000 International Dimension Bank for International Settlement httpwwwbisorg International Organization ofSecurities Commissions httpwwwioscoorg International Association of Insurance Supervisors httpwwwiaisorg Financial Stability Forum httpwwwfsforumorg
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 121
the inflexibility of tight surveillance against the need to encourage in-novation and growth The US Securities and Exchange Commission isworried about aggressive accounting by firms and biased reports bysecurities analysts in an equity environment that prizes steadily higherquarterly earnings41 Japanese regulators are preoccupied with opaqueinterconnections between portfolio institutions banks and nonfinancialfirms through the keiretsu system Canadian regulators reeling from high-profile scandals of managers intentionally misleading investors are strengtheningmarket discipline through legal penalties aimed at managers and directorsof offending firms
When panic strikes a securities regulator cannot do much As the 1987stock market crash and the LTCM debacle in the fall of 1998 both dem-onstrated steep stock and bond price declines can create systemic risksIf severe enough the wealth effect of falling securities values and thefear of widespread insolvency can depress real activity Flooding thesystem with liquidity is a central bankerrsquos solutionmdashsomething a securi-ties regulator cannot do42 But just as financial supervisors can changethe incentive structure to discourage bankers from making risky loans ingood times so securities regulators can pay more attention to incentiveson the demand side when capital markets are strong
Prudential Supervision and InnovationmdashA Footnote
In concluding this discussion of prudential supervision in the G-10 anadditional point is worth noting National regulators face a persistenttrade-off between emphasizing financial system safety and soundnesswhile encouraging innovationmdashin spite of the added risks innovationbrings to financial markets Former US Treasury Secretary Lawrence Summers(2000 3) has argued by analogy
The jet airplane made airplane air travel more comfortable more efficient andmore safe though the accidents were more spectacular and for a time morenumerous after the jet was invented In the same way modern global financialmarkets carry with them enormous potential for benefit even if some of theaccidents are that much more spectacular As the right public policy response
41 The problem is illustrated by the divergence since mid-1998 between reported earn-ings by the Standard amp Poorrsquos (SampP) 500 and the after-tax profits of all corporations inthe national accounts Generally these two series move closely with one another Be-tween mid-1998 and mid-1999 SampP 500 reported that earnings increased by more than20 percent while after-tax profits of all corporations increased by less than 5 percent(Chase Bank US Economic and Policy Research US Weekly Prospects Chase SecuritiesWeekly Newsletter 5 June 2000 5)
42 For example the US Securities and Exchange Commission had no direct role in calmingmarkets in the 1987 or 1998 panics
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122 WORLD CAPITAL MARKETS
to the jet was longer runways better air-traffic control and better training forpilots and not the discouragement of rapid travel so the right public policyresponse to financial innovation is to assure a safe framework so that the ben-efits can be realized not to stifle the change
Accepting Summersrsquos analogy for the international financial system better-informed supervisors and investors are a necessary part of the financialsystem framework Supervisors require more timely information on therisk profiles resulting from positions taken by financial institutions Theyalso need a better understanding of risk-management systems Snapshotsof an institutionrsquos risk profile and risk-management procedures are nolonger adequate In a world where huge bets are quickly made (andpossibly lostmdashas with Barings Bank in 1995 and LTCM in 1998) super-visors must focus on the soundness of banking systems for evaluatingand managing risk on a daily basis Some progress has been made inaddressing these issues US banking examiners are extending their in-formation requirements in banking examinations and increasing theirinvolvement in large complex institutions43 More awareness is alsorequired of the fact that they are national organizations in a world ofcross-border capital flows To a much greater extent they need a multi-national reach International supervision and coordination among super-visors are the subject of the next section
Our analysis suggests that G-10 supervisors have unfinished businessBank supervisors need to start yesterday securities regulators can waituntil tomorrow One G-10 member acting alone cannot correct the biasIn good times the lending business will simply migrate to other G-10banks In bad times financial problems will not stop at the national bor-der A way has to be found to establish common international standardsfor the key financial players in order to prevent crises and to agree onapproaches for managing them The path has already been laid out Inthe wake of the bank failures of the past 25 years bank supervisors havetried to establish such standards They have done this without creating anew global institution
The essence of the international framework is decentralizationmdashglobalrules and design standards without global institutions that are perceivedto intrude on national sovereignty The awkward jargon for this frame-work is vertical subsidiaritymdashldquothink internationally act nationallyrdquo Theinternational thinking is done by a committee of regulators that meets
International SupervisionA Decentralized Framework
43 These issues are discussed in Ferguson (1999) and Meyer (2000a)
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 123
regularly at the Bank for International Settlements in Basel The commit-tee establishes principles and standards that are interpreted implementedand enforced by national authorities44 In this section we describe thesesupervisory efforts and their weaknesses We present our recommenda-tions for addressing these weaknesses in the next chapter
Basel I
The Basel Capital Accord of 1988 (Basel I)45 drew the lesson from thefinancial crises of the mid-1970s that more adequate capital levels in in-ternational banks would help reduce the systemic risk of bank failureThe primary goal of Basel I was capital adequacy other standards wereput in place not so much for their own virtue as to defend the primarygoal
Capital adequacy requirements were designed to ensure that individualinstitutions have the ability to absorb losses particularly credit lossesAccordingly a backup system of scoring credit risk was devised thatrequired large amounts of bank capital for some types of loans smalleramounts for others and zero for a select list of preferred assets Report-ing requirements were designed to disclose problems and ensure that atroubled bank would take timely steps to restore its capital base in thewake of a loss The Basel I framework worked tolerably well in limitingthe call on the public purse in the G-10 countriesmdashwith the notable ex-ceptions of France and Japan The framework failed to moderate riskybank lending to emerging markets however
Basel I was not developed with emerging markets in mind The origi-nal idea behind it was to develop a common supervisory approach tocross-border banking operations It grew out of political pressure fromUS lawmakers who were determined to require international banks op-erating in the United States to meet US banking standards Toward thisgoal in 1983 Congress passed the International Lending Supervisory ActUS and British banking authorities subsequently agreed on a commontarget the adoption of strict common capital-adequacy standards In 1988other G-10 governments agreed to go along voluntary acceptance ofthe standards throughout much of the rest of the world followed46 Therationale for the capital targets was two-fold The first was to requirebanks to hold sufficient amounts of capital (8 percent of risk-adjusted
44 The international committee of financial authorities agreed on a common definitionof banksrsquo tier-one or ldquocorerdquo capital national authorities defined tier-two capital in theirown manner which permitted greater variations in national working definitions andpractices
45 International Convergence of Capital Measurement and Capital Standards (BIS 1988)was prepared by the Basel Committee on Banking Supervision
46 See Reineke (1998)
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124 WORLD CAPITAL MARKETS
assets) to cushion losses on those assets The second was to dull theirappetites for risk banks with large capital bases would have more tolose if they failed and therefore would take fewer risks
Rapid change in financial markets soon revealed flaws in the Basel IAccord In a complex world with numerous sources of risk it focusedheavily on credit risk but overlooked other risks in a bankrsquos portfolioand the correlation between returns on different asset classes The Baselformula required banks to maintain a fixed amount of capital againsteach of its asset classes But the formula did not distinguish the riskinessof the borrower within each class As a result one large loan to a low-risk corporate borrower such as General Electric would require the sameamount of capital as 10 smaller transactions with high-risk borrowers
The system was also biased toward short-term loans Loans maturingin less than a year required a 20 percent risk weight whereas those ma-turing after more than a year required a 100 percent risk weight Inter-bank lending was particularly favored For example loans to banks inOECD countries required less capital than loans to private firms in thesame countries creating the anomaly that interbank loans to South Ko-rean banks required less capital than loans to General Electric47 Thisanomaly encouraged banks to shed high-quality assets if the Basel rulesrequired the allocation of more capital than banks thought they needed
Another weakness was that financial innovators quickly circumventedthe Accord Because short-term loans required less provisioning than long-term loans banks responded by securitizing their long-term debt port-folios and lending short-term against the collateral of the newly createdasset This allowed banks to circumvent the capital requirements gearedto the terms of the underlying debt At the same time the Basel I Accordfailed to encourage risk mitigation techniques such as credit derivativescollateral guarantees and on-balance-sheet netting the flip side of fi-nancial innovation Because off-balance-sheet products were not coveredby the Accord another anomaly appeared when Barings Bank collapsedin 1995 Barings met capital adequacy standards but collapsed becauseits systems for managing risk failed traders were allowed to speculatein futures contracts that did not appear on the balance sheet
Basel II
Work to overhaul Basel I began in 1995 and produced consultativepapers issued in June 1999 and January 200148 These papers have been
47 South Korean banks have had notoriously weak balance sheets because the practiceof ldquodirected lendingrdquo left them with many poor loans (in making these loans the bankswere expected to follow government objectives rather than creditworthiness criteria)
48 Basel Committee on Banking Supervision (1999 2001)
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 125
the subject of extensive consultation and revision as a result the newAccord is expected to be introduced in 200449 The Basel II frameworkhas three parts (pillars) revisions to Basel I minimum-capital require-ments supervisory review criteria and greater emphasis on market dis-cipline Broadly Basel II aims to maintain the level of capital in the sys-tem but achieve better alignment of banksrsquo capital with their risk pro-files and keep up with financial innovation
To align capital requirements with market realities (the first pillar)Basel II concentrates on the 100 or so largest banksmdashthe type of playerslisted in table 21mdashand on the holding-company parents of banking groups50
Capital requirements will differentiate between an increased number ofcredit groups or ldquorisk bucketsrdquo including claims on governments otherbanks corporations mortgage-backed securities and other asset-backedsecurities
Basel II originally proposed to use external ratings to set capital chargesfor a number of these credit risks Many banks objected arguing thatthey assess credit risk better than Standard amp Poorrsquos Moodyrsquos or FitchIBCA51 Basel II thus proposes two approaches to rating a standard ap-proach using external ratings and an ldquoadvancedrdquo approach that allowsselected banks to use their own internal rating systems To encouragethe development of rigorous internal control systems based on these in-ternal rating systems Basel II also proposes to levy capital charges foroperational risk (the risk of direct or indirect loss resulting from inad-equate or failed internal processes people and systems or from exter-nal events)
Some critics of this proposal dismiss it as an abrogation of the prin-ciple of external independent monitoring and as ldquodangerously naiumlverdquo52
But regulators argue that the new capital charge on operational risk shouldoffset this concern It is also far from clear how cross-national compari-sons of rating and internal risk-assessment systems will be made (Engelen2000) The development by the European Union of its own capital rulescould well complicate the international resolution of these issues Publicassurances by EU officials in January 2001 however indicated that theirmain concerns are to create a level playing field and avoid regulatoryarbitrage (Hargreaves 2001) There is also the significant problem ofthe procyclical character of risk weights When a crisis hits losses are
49 See Berry (2000) for an update in an interview with William J McDonough chair ofthe Basel Committee on Banking Supervision
50 For obvious reasons these proposals are addressed to large banks and simpler capi-tal standards are allowed for small banks that focus on their domestic credit markets
51 See Ammer and Packer (2000) for an empirical critique of the success of rating agen-cies in distinguishing risk by sector and region
52 See Auerback (2001)
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126 WORLD CAPITAL MARKETS
incurred or accrued capital is lost and loan exposure must be reducedor securities sold to restore the requisite capital-adequacy ratios A morerisk-sensitive framework could amplify volatility
As the second pillar of Basel II supervisory review criteria are beingbeefed up to encourage supervisors to intervene earlier in potential problemsituations and to compel banks to align their capital positions with theirrisk profiles Bank supervisors will be authorized to require banks tohold capital in excess of minimum requirements if they have concernsabout general management overall strategy risk-management performanceor the macroeconomic environment Of course if one G-10 supervisorimposes higher capital requirements in isolation the same disparity willemerge that presaged Basel I Some banks will be disadvantaged in theinternational marketplace and will loudly complain that excessive super-vision is driving business to their competitors Hence close internationalcooperation among supervisors is critical
To implement the third pillar market discipline banks will be requiredto make fuller more timely disclosure of capital adequacy and the risksto which that capital is exposed A number of measures are being stud-ied that might help supervisors evaluate bank performance such as com-parisons of uninsured deposit interest rates subordinated debt yieldsand equity prices The idea is that these yields and prices might alertsupervisors to market perceptions of risk Of course market perceptionsare only as good as market information More direct and controversialways to reinforce market discipline would dramatically increase publicdisclosure of bank positions and risk management systems
Many questions are still outstanding about how to resolve the techni-cal details of capital requirements and whether the requirements willachieve their intended goal of better assessment and mitigation of therisks in banksrsquo portfolios There is no substitute for skilled supervisorsThe intricacies of effective design and implementation suggest that su-pervisors need to be highly competent technically knowledgeable aboutbanking portfolio characteristics and the factors that influence bank ex-posure to credit risk (Mishkin 2000) And they must be aided by vigilantshareholders market forces and transparency of information53
Standard setting at the global level is desirable but ultimately theeffectiveness of these efforts will be tested at the national level espe-cially in times of systemic financial distress Here the record of Basel Iwas not a bright shining success Japanese banking regulators havetraditionally allowed banks to include real estate and securities in theircapital base When the value of these assets plummeted in the early 1990sregulators allowed banks to continue valuing these depreciated (andoften bankrupt) assets at their old inflated levels Japanese authorities
53 Benedict Roth Complacency Towards Catastrophe Financial Times 23 January 2001
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 127
insisted until the mid-1990s that eroded capital bases could be rebuiltin a market-driven fashion They rightly foresaw that huge loan losseswould undermine public support for the ruling party and require a po-litically unpopular bailout
Japanese foot dragging on Basel I was the worst54 but not uniqueOther examples can be found of ldquopolitically mandated forbearancerdquo TheFederal Reserve Bank of New York held important hands during theLTCM crisis of 1998 Mexico is still resolving the banking crisis that eruptedin 1995 South Korea has not yet closed the insolvent banks that behavedso badly before the crisis of 1998 In the aftermath of a crisis nationalregulators cannot always be relied upon to discipline politically power-ful bankers55 One of the little-noticed consequences of these differingapproaches is that those banks with strong regulatory systems receivedan implicit ldquoexport subsidyrdquo for their services US banks which had notengaged extensively in emerging-market lending in the 1990s were bet-ter positioned than their German and Japanese counterparts to expandtheir international assets in the wake of the crises
Other Financial Forums
54 See Japanese Banks Fiddling while Marunouchi Burns The Economist 27 January2001 67-69
55 See Calomiris (1997)
The Basel model of vertical subsidiarity has already been extended toother financial regulatory bodies In 1993-94 the BIS established a Tri-partite Group of Banking Insurance and Securities Regulators In 1994-95 the BIS increased its cooperation with the International Organizationof Securities Commissions when the two organizations issued parallelpapers on guidelines for national regulators concerning risk managementand disclosure of derivative trades In 1996 a permanent Joint Forum onFinancial Conglomerates was established to examine supervisory issuesand develop working arrangements among the different functional super-visors of conglomerate institutions that offer combinations of bankingsecurities and insurance products Draft papers on the supervisionof conglomerates were released for comment in 1998 applying capital-adequacy principles to these groups and providing guidelines both forassessing the integrity and competence of top managers and for sharingassessments between regulators
In 1997 the Basel Committee on Banking Supervision extended itsreach beyond capital standards to broader aspects of banking supervi-sion with the publication of the Core Principles for Effective BankingSupervision In 1999 a wide range of regulatory and standard-settingbodies were gathered under the umbrella of the Financial Stability
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128 WORLD CAPITAL MARKETS
Forum (FSF) itself established under BIS aegis56 The FSF has alreadyissued recommendations for stepped-up supervision and transparencyas well as guidelines for best practices in a number of areas includingoffshore financial centers and highly leveraged institutions or hedge funds57
Conclusion
Although the structural weaknesses in emerging-market economies arewidely acknowledged to have been causal factors in international capi-tal-market volatility this chapter points to the role of large G-10 bankingorganizations as major suppliers of the most volatile instrument short-term debt We have examined evidence of the impact of public safetynets in the G-10 economiesmdashthe deposit insurance systems the pruden-tial supervisory systems and the lender-of-last-resort functions of centralbanksmdashon the incentive structures of these organizations
Although supervisors in most countries working nationally and to-gether in the BIS have made significant efforts to mimic market forcesin their prudential supervision the most sophisticated financial institu-tions find innovative ways to circumvent the rules New global regulatorybodies are not about to be created G-10 national bank regulators shouldthemselves address the short-term debt bias in the international financialsystem by changing incentive systems G-10 securities regulators shouldalso take steps to get ahead of the curve paying close attention to largeportfolio swings by institutional investors particularly in times of crisisIn short more needs to be done at national and international levels tochange the rules of the game That is the subject of the next chapter
56 The Financial Stability Forum includes banking securities insurance and accountingregulatory bodies the OECD on taxation corruption and corporate governance and theIMF
57 See Martin (2000)
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Financial institutions and their supervisors
Country and supervisory structure Retail banking Wholesale banking Securities Insurance
Switzerland Large banking groupSwiss Federal Banking Commission (SFBC) = umbrella supervisor
Swiss National Bank Federal Office of
SFBC SFBC SFBC Private Insurance Swiss Federal Banking Commission bull Universal banks bull Investment banks bull Primary issuers of bull Insurance companies
bull Savings banks bull Asset management securities bull Insurance brokerscompanies bull Stock exchanges
Private audit Federal bull Investment funds bull Stockbrokers firms Office of bull Mortgage bond authorized by Private business SFBC Insurance
Sweden Financial holding company groupsFinancial Supervisory Authority = umbrella supervisor
Ministry of Finance Credit Market Securities Market Insurance Market
Credit Market Department Department Department Department
Financial bull Commercial banks bull Investment funds bull Primary issuers of bull Insurance companies Riksbank Supervisory bull Savings banks securities bull Insurance brokers Authority bull Friendly societies bull Stock exchanges
bull Stockbrokers
(table continues next page)
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Table 210 Financial-sector regulation G-10 countries 2000 (continued )
Financial institutions and their supervisors
Country and supervisory structure Retail banking Wholesale banking Securities Insurance
Belgium Bank holding companiesBanking and Finance Commission = umbrella supervisor
Bank of Belgium Banking Banking
Banking and Finance and Finance Insurance Controland Finance Commission Commission Commission Office
Banking and Insurance Finance Control bull Commercial banks bull Asset management bull Primary issuers of bull Insurance companies Commission Office bull Savings banks firms securities bull Insurance brokers
bull Securities banks bull Investment funds bull Stock exchanges bull Mortgage companiesbull Stockbrokers bull Pension funds
Securities Regulation Fund Securities Regulation Fund
bull Other investment firms and credit institutions(institutions participating in regulated off-exchangemarket in strips and Treasury certificates)
Bank holding companies Spain Banco de Espantildea = umbrella supervisor
Banco de Espantildea Comision Nacional del Mercado de Directorate General
Banco de Espantildea Valores (CNMV) Insurance
bull All credit institutions (commercial banks savings banks credit bull Primary issuers of (Ministry of Economy Ministry of cooperatives official credit institutions finance factoring and securities and Finance) Economy and CNMV leasing companies mortgage-loan companies etc) bull Stock exchanges bull Insurance companies Finance bull Interbank foreign exchange and book-entry public debt bull Stockbrokers bull Pension funds
markets bull Venture capital(companies and funds)
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119
Financial institutions and their supervisors
Country and supervisory structure Banking Securities Insurance
Banking Advisory High Level Securities Supervisors Committee (BAC) Committee (HLSS) Insurance Committee (IC)
Supranational (EU) bull Formulates standards for prudential bull Coordination of securities market bull Formulates standards forsupervision supervision prudential supervision
BACICHLSS Banking Supervision
Conglomerates Committee (BSC) Securities Contact Committee Regulation of prudential bull Systemic risk monitoring bull Regulation and implementation of supervision securities admission
International Association International International Organization of of Insurance Supervisors
Basel Committee Securities Commisison (IOSCO) (IAIS) Joint Forum Conglomerates Supervision bull Supervision and regulation best bull Supervision and regulation best bull Supervision and regulation amp regulation Best practices practices practices best practices
FSF Coordination across supervisors of various functions
Notes See appendix B for more information Boldface type indicates senior or oversight supervisor normal type indicates adjunct or front-line supervisorsolid line indicates direct responsbility to the senior-ranking authority dotted line indicates coordination in supervisory activities
(table continues next page)
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Table 210 Financial-sector regulation G-10 countries 2000 (continued )
Glossary of names United Kingdom FSA = Financial Services Authority United States FR = Federal Reserve OCC = Office of the Comptroller of theCurrency FDIC = Federal Deposit Insurance Corporation SEC = Securities and Exchange Commission OTS = Office of Thrift Supervision Japan FRC =Financial Reconstruction Commission FSA = Financial Services Agency SESC = Securities and Exchange Surveillance Commission Canada OSFI =Office of the Superintendent of Financial Institutions CDIC = Canada Deposit Insurance Corporation Germany FBSO = Federal Banking SupervisoryOffice FSSO = Federal Securities Supervisory Office FISO = Federal Insurance Supervisory Office BSO = Banking Supervisory Office Italy Consob =Commissione Nazionale per le Societa e la Borsa ISVAP = Instituto per la Vigilanza sulle assicurazioni private e di Interesse colletivo Switzerland SFBC= Swiss Federal Banking Commission Spain CNMV = The Comision Nacional del Mercado de Valores Supranational BAC = Banking Advisory CommitteeBSC = Banking Supervision Committee IC = Insurance Committee HLSS = High Level Securities Supervisors Committee International Dimension FSF =Financial Stability Forum IOSCO = International Organization of Securities Commission IAIS = International Association of Insurance Supervisors
Sources United Kingdom Bank of England httpwwwbankofenglandcouk Financial Services Authority httpwwwfsagovuk United States Board ofGovernors of Federal Reserve System httpwwwfederalreservegov Japan Bank of Japan httpwwwbojorjo Financial Reconstruction Commissionhttpwwwfsagojpfrcindexehtml Financial Services Agency httpwwwfsagojp Canada Bank of Canada httpwwwbank-banque-canadaca Office ofthe Superintendent of Financial Institutions httpwwwosfi-bsifgccaAndreEindexhtml Germany Deutsche Bundesbank httpwwwbundesbankde Fed-eral Banking Supervisory Office httpwwwbakredde Italy Banca drsquoitalia httpwwwbancaditaliait Commissione Nazionale per le Societa e la Borsahttpwwwconsobit Instituto per la Vigilanza sulle assicurazioni private e di Interesse colletivo httpwwwisvapit The Netherlands De NederlandscheBank httpwwwdnbnl France Banque de France httpwwwbanque-francefr Switzerland Schweizerische Nationalbank httpwwwsnbchindex3htmlSweden Sveriges Riksbank httpwwwriksbanksedefaultasp Belgium National Bank of Belgium httpwwwbnbbesgindexhtm Spain Banco de Espantildeahttpwwwbdees The Comision Nacional del Mercado de Valores httpwwwcnmves Supranational (EU) Institutional Arrangements for the Regulationand Supervision of the Financial Sector 2000 International Dimension Bank for International Settlement httpwwwbisorg International Organization ofSecurities Commissions httpwwwioscoorg International Association of Insurance Supervisors httpwwwiaisorg Financial Stability Forum httpwwwfsforumorg
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THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 121
the inflexibility of tight surveillance against the need to encourage in-novation and growth The US Securities and Exchange Commission isworried about aggressive accounting by firms and biased reports bysecurities analysts in an equity environment that prizes steadily higherquarterly earnings41 Japanese regulators are preoccupied with opaqueinterconnections between portfolio institutions banks and nonfinancialfirms through the keiretsu system Canadian regulators reeling from high-profile scandals of managers intentionally misleading investors are strengtheningmarket discipline through legal penalties aimed at managers and directorsof offending firms
When panic strikes a securities regulator cannot do much As the 1987stock market crash and the LTCM debacle in the fall of 1998 both dem-onstrated steep stock and bond price declines can create systemic risksIf severe enough the wealth effect of falling securities values and thefear of widespread insolvency can depress real activity Flooding thesystem with liquidity is a central bankerrsquos solutionmdashsomething a securi-ties regulator cannot do42 But just as financial supervisors can changethe incentive structure to discourage bankers from making risky loans ingood times so securities regulators can pay more attention to incentiveson the demand side when capital markets are strong
Prudential Supervision and InnovationmdashA Footnote
In concluding this discussion of prudential supervision in the G-10 anadditional point is worth noting National regulators face a persistenttrade-off between emphasizing financial system safety and soundnesswhile encouraging innovationmdashin spite of the added risks innovationbrings to financial markets Former US Treasury Secretary Lawrence Summers(2000 3) has argued by analogy
The jet airplane made airplane air travel more comfortable more efficient andmore safe though the accidents were more spectacular and for a time morenumerous after the jet was invented In the same way modern global financialmarkets carry with them enormous potential for benefit even if some of theaccidents are that much more spectacular As the right public policy response
41 The problem is illustrated by the divergence since mid-1998 between reported earn-ings by the Standard amp Poorrsquos (SampP) 500 and the after-tax profits of all corporations inthe national accounts Generally these two series move closely with one another Be-tween mid-1998 and mid-1999 SampP 500 reported that earnings increased by more than20 percent while after-tax profits of all corporations increased by less than 5 percent(Chase Bank US Economic and Policy Research US Weekly Prospects Chase SecuritiesWeekly Newsletter 5 June 2000 5)
42 For example the US Securities and Exchange Commission had no direct role in calmingmarkets in the 1987 or 1998 panics
Institute for International Economics | httpwwwiiecom
122 WORLD CAPITAL MARKETS
to the jet was longer runways better air-traffic control and better training forpilots and not the discouragement of rapid travel so the right public policyresponse to financial innovation is to assure a safe framework so that the ben-efits can be realized not to stifle the change
Accepting Summersrsquos analogy for the international financial system better-informed supervisors and investors are a necessary part of the financialsystem framework Supervisors require more timely information on therisk profiles resulting from positions taken by financial institutions Theyalso need a better understanding of risk-management systems Snapshotsof an institutionrsquos risk profile and risk-management procedures are nolonger adequate In a world where huge bets are quickly made (andpossibly lostmdashas with Barings Bank in 1995 and LTCM in 1998) super-visors must focus on the soundness of banking systems for evaluatingand managing risk on a daily basis Some progress has been made inaddressing these issues US banking examiners are extending their in-formation requirements in banking examinations and increasing theirinvolvement in large complex institutions43 More awareness is alsorequired of the fact that they are national organizations in a world ofcross-border capital flows To a much greater extent they need a multi-national reach International supervision and coordination among super-visors are the subject of the next section
Our analysis suggests that G-10 supervisors have unfinished businessBank supervisors need to start yesterday securities regulators can waituntil tomorrow One G-10 member acting alone cannot correct the biasIn good times the lending business will simply migrate to other G-10banks In bad times financial problems will not stop at the national bor-der A way has to be found to establish common international standardsfor the key financial players in order to prevent crises and to agree onapproaches for managing them The path has already been laid out Inthe wake of the bank failures of the past 25 years bank supervisors havetried to establish such standards They have done this without creating anew global institution
The essence of the international framework is decentralizationmdashglobalrules and design standards without global institutions that are perceivedto intrude on national sovereignty The awkward jargon for this frame-work is vertical subsidiaritymdashldquothink internationally act nationallyrdquo Theinternational thinking is done by a committee of regulators that meets
International SupervisionA Decentralized Framework
43 These issues are discussed in Ferguson (1999) and Meyer (2000a)
Institute for International Economics | httpwwwiiecom
THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 123
regularly at the Bank for International Settlements in Basel The commit-tee establishes principles and standards that are interpreted implementedand enforced by national authorities44 In this section we describe thesesupervisory efforts and their weaknesses We present our recommenda-tions for addressing these weaknesses in the next chapter
Basel I
The Basel Capital Accord of 1988 (Basel I)45 drew the lesson from thefinancial crises of the mid-1970s that more adequate capital levels in in-ternational banks would help reduce the systemic risk of bank failureThe primary goal of Basel I was capital adequacy other standards wereput in place not so much for their own virtue as to defend the primarygoal
Capital adequacy requirements were designed to ensure that individualinstitutions have the ability to absorb losses particularly credit lossesAccordingly a backup system of scoring credit risk was devised thatrequired large amounts of bank capital for some types of loans smalleramounts for others and zero for a select list of preferred assets Report-ing requirements were designed to disclose problems and ensure that atroubled bank would take timely steps to restore its capital base in thewake of a loss The Basel I framework worked tolerably well in limitingthe call on the public purse in the G-10 countriesmdashwith the notable ex-ceptions of France and Japan The framework failed to moderate riskybank lending to emerging markets however
Basel I was not developed with emerging markets in mind The origi-nal idea behind it was to develop a common supervisory approach tocross-border banking operations It grew out of political pressure fromUS lawmakers who were determined to require international banks op-erating in the United States to meet US banking standards Toward thisgoal in 1983 Congress passed the International Lending Supervisory ActUS and British banking authorities subsequently agreed on a commontarget the adoption of strict common capital-adequacy standards In 1988other G-10 governments agreed to go along voluntary acceptance ofthe standards throughout much of the rest of the world followed46 Therationale for the capital targets was two-fold The first was to requirebanks to hold sufficient amounts of capital (8 percent of risk-adjusted
44 The international committee of financial authorities agreed on a common definitionof banksrsquo tier-one or ldquocorerdquo capital national authorities defined tier-two capital in theirown manner which permitted greater variations in national working definitions andpractices
45 International Convergence of Capital Measurement and Capital Standards (BIS 1988)was prepared by the Basel Committee on Banking Supervision
46 See Reineke (1998)
Institute for International Economics | httpwwwiiecom
124 WORLD CAPITAL MARKETS
assets) to cushion losses on those assets The second was to dull theirappetites for risk banks with large capital bases would have more tolose if they failed and therefore would take fewer risks
Rapid change in financial markets soon revealed flaws in the Basel IAccord In a complex world with numerous sources of risk it focusedheavily on credit risk but overlooked other risks in a bankrsquos portfolioand the correlation between returns on different asset classes The Baselformula required banks to maintain a fixed amount of capital againsteach of its asset classes But the formula did not distinguish the riskinessof the borrower within each class As a result one large loan to a low-risk corporate borrower such as General Electric would require the sameamount of capital as 10 smaller transactions with high-risk borrowers
The system was also biased toward short-term loans Loans maturingin less than a year required a 20 percent risk weight whereas those ma-turing after more than a year required a 100 percent risk weight Inter-bank lending was particularly favored For example loans to banks inOECD countries required less capital than loans to private firms in thesame countries creating the anomaly that interbank loans to South Ko-rean banks required less capital than loans to General Electric47 Thisanomaly encouraged banks to shed high-quality assets if the Basel rulesrequired the allocation of more capital than banks thought they needed
Another weakness was that financial innovators quickly circumventedthe Accord Because short-term loans required less provisioning than long-term loans banks responded by securitizing their long-term debt port-folios and lending short-term against the collateral of the newly createdasset This allowed banks to circumvent the capital requirements gearedto the terms of the underlying debt At the same time the Basel I Accordfailed to encourage risk mitigation techniques such as credit derivativescollateral guarantees and on-balance-sheet netting the flip side of fi-nancial innovation Because off-balance-sheet products were not coveredby the Accord another anomaly appeared when Barings Bank collapsedin 1995 Barings met capital adequacy standards but collapsed becauseits systems for managing risk failed traders were allowed to speculatein futures contracts that did not appear on the balance sheet
Basel II
Work to overhaul Basel I began in 1995 and produced consultativepapers issued in June 1999 and January 200148 These papers have been
47 South Korean banks have had notoriously weak balance sheets because the practiceof ldquodirected lendingrdquo left them with many poor loans (in making these loans the bankswere expected to follow government objectives rather than creditworthiness criteria)
48 Basel Committee on Banking Supervision (1999 2001)
Institute for International Economics | httpwwwiiecom
THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 125
the subject of extensive consultation and revision as a result the newAccord is expected to be introduced in 200449 The Basel II frameworkhas three parts (pillars) revisions to Basel I minimum-capital require-ments supervisory review criteria and greater emphasis on market dis-cipline Broadly Basel II aims to maintain the level of capital in the sys-tem but achieve better alignment of banksrsquo capital with their risk pro-files and keep up with financial innovation
To align capital requirements with market realities (the first pillar)Basel II concentrates on the 100 or so largest banksmdashthe type of playerslisted in table 21mdashand on the holding-company parents of banking groups50
Capital requirements will differentiate between an increased number ofcredit groups or ldquorisk bucketsrdquo including claims on governments otherbanks corporations mortgage-backed securities and other asset-backedsecurities
Basel II originally proposed to use external ratings to set capital chargesfor a number of these credit risks Many banks objected arguing thatthey assess credit risk better than Standard amp Poorrsquos Moodyrsquos or FitchIBCA51 Basel II thus proposes two approaches to rating a standard ap-proach using external ratings and an ldquoadvancedrdquo approach that allowsselected banks to use their own internal rating systems To encouragethe development of rigorous internal control systems based on these in-ternal rating systems Basel II also proposes to levy capital charges foroperational risk (the risk of direct or indirect loss resulting from inad-equate or failed internal processes people and systems or from exter-nal events)
Some critics of this proposal dismiss it as an abrogation of the prin-ciple of external independent monitoring and as ldquodangerously naiumlverdquo52
But regulators argue that the new capital charge on operational risk shouldoffset this concern It is also far from clear how cross-national compari-sons of rating and internal risk-assessment systems will be made (Engelen2000) The development by the European Union of its own capital rulescould well complicate the international resolution of these issues Publicassurances by EU officials in January 2001 however indicated that theirmain concerns are to create a level playing field and avoid regulatoryarbitrage (Hargreaves 2001) There is also the significant problem ofthe procyclical character of risk weights When a crisis hits losses are
49 See Berry (2000) for an update in an interview with William J McDonough chair ofthe Basel Committee on Banking Supervision
50 For obvious reasons these proposals are addressed to large banks and simpler capi-tal standards are allowed for small banks that focus on their domestic credit markets
51 See Ammer and Packer (2000) for an empirical critique of the success of rating agen-cies in distinguishing risk by sector and region
52 See Auerback (2001)
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126 WORLD CAPITAL MARKETS
incurred or accrued capital is lost and loan exposure must be reducedor securities sold to restore the requisite capital-adequacy ratios A morerisk-sensitive framework could amplify volatility
As the second pillar of Basel II supervisory review criteria are beingbeefed up to encourage supervisors to intervene earlier in potential problemsituations and to compel banks to align their capital positions with theirrisk profiles Bank supervisors will be authorized to require banks tohold capital in excess of minimum requirements if they have concernsabout general management overall strategy risk-management performanceor the macroeconomic environment Of course if one G-10 supervisorimposes higher capital requirements in isolation the same disparity willemerge that presaged Basel I Some banks will be disadvantaged in theinternational marketplace and will loudly complain that excessive super-vision is driving business to their competitors Hence close internationalcooperation among supervisors is critical
To implement the third pillar market discipline banks will be requiredto make fuller more timely disclosure of capital adequacy and the risksto which that capital is exposed A number of measures are being stud-ied that might help supervisors evaluate bank performance such as com-parisons of uninsured deposit interest rates subordinated debt yieldsand equity prices The idea is that these yields and prices might alertsupervisors to market perceptions of risk Of course market perceptionsare only as good as market information More direct and controversialways to reinforce market discipline would dramatically increase publicdisclosure of bank positions and risk management systems
Many questions are still outstanding about how to resolve the techni-cal details of capital requirements and whether the requirements willachieve their intended goal of better assessment and mitigation of therisks in banksrsquo portfolios There is no substitute for skilled supervisorsThe intricacies of effective design and implementation suggest that su-pervisors need to be highly competent technically knowledgeable aboutbanking portfolio characteristics and the factors that influence bank ex-posure to credit risk (Mishkin 2000) And they must be aided by vigilantshareholders market forces and transparency of information53
Standard setting at the global level is desirable but ultimately theeffectiveness of these efforts will be tested at the national level espe-cially in times of systemic financial distress Here the record of Basel Iwas not a bright shining success Japanese banking regulators havetraditionally allowed banks to include real estate and securities in theircapital base When the value of these assets plummeted in the early 1990sregulators allowed banks to continue valuing these depreciated (andoften bankrupt) assets at their old inflated levels Japanese authorities
53 Benedict Roth Complacency Towards Catastrophe Financial Times 23 January 2001
Institute for International Economics | httpwwwiiecom
THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 127
insisted until the mid-1990s that eroded capital bases could be rebuiltin a market-driven fashion They rightly foresaw that huge loan losseswould undermine public support for the ruling party and require a po-litically unpopular bailout
Japanese foot dragging on Basel I was the worst54 but not uniqueOther examples can be found of ldquopolitically mandated forbearancerdquo TheFederal Reserve Bank of New York held important hands during theLTCM crisis of 1998 Mexico is still resolving the banking crisis that eruptedin 1995 South Korea has not yet closed the insolvent banks that behavedso badly before the crisis of 1998 In the aftermath of a crisis nationalregulators cannot always be relied upon to discipline politically power-ful bankers55 One of the little-noticed consequences of these differingapproaches is that those banks with strong regulatory systems receivedan implicit ldquoexport subsidyrdquo for their services US banks which had notengaged extensively in emerging-market lending in the 1990s were bet-ter positioned than their German and Japanese counterparts to expandtheir international assets in the wake of the crises
Other Financial Forums
54 See Japanese Banks Fiddling while Marunouchi Burns The Economist 27 January2001 67-69
55 See Calomiris (1997)
The Basel model of vertical subsidiarity has already been extended toother financial regulatory bodies In 1993-94 the BIS established a Tri-partite Group of Banking Insurance and Securities Regulators In 1994-95 the BIS increased its cooperation with the International Organizationof Securities Commissions when the two organizations issued parallelpapers on guidelines for national regulators concerning risk managementand disclosure of derivative trades In 1996 a permanent Joint Forum onFinancial Conglomerates was established to examine supervisory issuesand develop working arrangements among the different functional super-visors of conglomerate institutions that offer combinations of bankingsecurities and insurance products Draft papers on the supervisionof conglomerates were released for comment in 1998 applying capital-adequacy principles to these groups and providing guidelines both forassessing the integrity and competence of top managers and for sharingassessments between regulators
In 1997 the Basel Committee on Banking Supervision extended itsreach beyond capital standards to broader aspects of banking supervi-sion with the publication of the Core Principles for Effective BankingSupervision In 1999 a wide range of regulatory and standard-settingbodies were gathered under the umbrella of the Financial Stability
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128 WORLD CAPITAL MARKETS
Forum (FSF) itself established under BIS aegis56 The FSF has alreadyissued recommendations for stepped-up supervision and transparencyas well as guidelines for best practices in a number of areas includingoffshore financial centers and highly leveraged institutions or hedge funds57
Conclusion
Although the structural weaknesses in emerging-market economies arewidely acknowledged to have been causal factors in international capi-tal-market volatility this chapter points to the role of large G-10 bankingorganizations as major suppliers of the most volatile instrument short-term debt We have examined evidence of the impact of public safetynets in the G-10 economiesmdashthe deposit insurance systems the pruden-tial supervisory systems and the lender-of-last-resort functions of centralbanksmdashon the incentive structures of these organizations
Although supervisors in most countries working nationally and to-gether in the BIS have made significant efforts to mimic market forcesin their prudential supervision the most sophisticated financial institu-tions find innovative ways to circumvent the rules New global regulatorybodies are not about to be created G-10 national bank regulators shouldthemselves address the short-term debt bias in the international financialsystem by changing incentive systems G-10 securities regulators shouldalso take steps to get ahead of the curve paying close attention to largeportfolio swings by institutional investors particularly in times of crisisIn short more needs to be done at national and international levels tochange the rules of the game That is the subject of the next chapter
56 The Financial Stability Forum includes banking securities insurance and accountingregulatory bodies the OECD on taxation corruption and corporate governance and theIMF
57 See Martin (2000)
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118W
OR
LD
CA
PIT
AL
MA
RK
ET
S
Table 210 Financial-sector regulation G-10 countries 2000 (continued )
Financial institutions and their supervisors
Country and supervisory structure Retail banking Wholesale banking Securities Insurance
Belgium Bank holding companiesBanking and Finance Commission = umbrella supervisor
Bank of Belgium Banking Banking
Banking and Finance and Finance Insurance Controland Finance Commission Commission Commission Office
Banking and Insurance Finance Control bull Commercial banks bull Asset management bull Primary issuers of bull Insurance companies Commission Office bull Savings banks firms securities bull Insurance brokers
bull Securities banks bull Investment funds bull Stock exchanges bull Mortgage companiesbull Stockbrokers bull Pension funds
Securities Regulation Fund Securities Regulation Fund
bull Other investment firms and credit institutions(institutions participating in regulated off-exchangemarket in strips and Treasury certificates)
Bank holding companies Spain Banco de Espantildea = umbrella supervisor
Banco de Espantildea Comision Nacional del Mercado de Directorate General
Banco de Espantildea Valores (CNMV) Insurance
bull All credit institutions (commercial banks savings banks credit bull Primary issuers of (Ministry of Economy Ministry of cooperatives official credit institutions finance factoring and securities and Finance) Economy and CNMV leasing companies mortgage-loan companies etc) bull Stock exchanges bull Insurance companies Finance bull Interbank foreign exchange and book-entry public debt bull Stockbrokers bull Pension funds
markets bull Venture capital(companies and funds)
Institute for International Econom
ics | httpww
wiiecom
TH
E P
LAY
ER
S T
HE
IR S
UP
ER
VIS
OR
S A
ND
MO
RA
L HA
ZA
RD
119
Financial institutions and their supervisors
Country and supervisory structure Banking Securities Insurance
Banking Advisory High Level Securities Supervisors Committee (BAC) Committee (HLSS) Insurance Committee (IC)
Supranational (EU) bull Formulates standards for prudential bull Coordination of securities market bull Formulates standards forsupervision supervision prudential supervision
BACICHLSS Banking Supervision
Conglomerates Committee (BSC) Securities Contact Committee Regulation of prudential bull Systemic risk monitoring bull Regulation and implementation of supervision securities admission
International Association International International Organization of of Insurance Supervisors
Basel Committee Securities Commisison (IOSCO) (IAIS) Joint Forum Conglomerates Supervision bull Supervision and regulation best bull Supervision and regulation best bull Supervision and regulation amp regulation Best practices practices practices best practices
FSF Coordination across supervisors of various functions
Notes See appendix B for more information Boldface type indicates senior or oversight supervisor normal type indicates adjunct or front-line supervisorsolid line indicates direct responsbility to the senior-ranking authority dotted line indicates coordination in supervisory activities
(table continues next page)
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wiiecom
120W
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MA
RK
ET
S
Table 210 Financial-sector regulation G-10 countries 2000 (continued )
Glossary of names United Kingdom FSA = Financial Services Authority United States FR = Federal Reserve OCC = Office of the Comptroller of theCurrency FDIC = Federal Deposit Insurance Corporation SEC = Securities and Exchange Commission OTS = Office of Thrift Supervision Japan FRC =Financial Reconstruction Commission FSA = Financial Services Agency SESC = Securities and Exchange Surveillance Commission Canada OSFI =Office of the Superintendent of Financial Institutions CDIC = Canada Deposit Insurance Corporation Germany FBSO = Federal Banking SupervisoryOffice FSSO = Federal Securities Supervisory Office FISO = Federal Insurance Supervisory Office BSO = Banking Supervisory Office Italy Consob =Commissione Nazionale per le Societa e la Borsa ISVAP = Instituto per la Vigilanza sulle assicurazioni private e di Interesse colletivo Switzerland SFBC= Swiss Federal Banking Commission Spain CNMV = The Comision Nacional del Mercado de Valores Supranational BAC = Banking Advisory CommitteeBSC = Banking Supervision Committee IC = Insurance Committee HLSS = High Level Securities Supervisors Committee International Dimension FSF =Financial Stability Forum IOSCO = International Organization of Securities Commission IAIS = International Association of Insurance Supervisors
Sources United Kingdom Bank of England httpwwwbankofenglandcouk Financial Services Authority httpwwwfsagovuk United States Board ofGovernors of Federal Reserve System httpwwwfederalreservegov Japan Bank of Japan httpwwwbojorjo Financial Reconstruction Commissionhttpwwwfsagojpfrcindexehtml Financial Services Agency httpwwwfsagojp Canada Bank of Canada httpwwwbank-banque-canadaca Office ofthe Superintendent of Financial Institutions httpwwwosfi-bsifgccaAndreEindexhtml Germany Deutsche Bundesbank httpwwwbundesbankde Fed-eral Banking Supervisory Office httpwwwbakredde Italy Banca drsquoitalia httpwwwbancaditaliait Commissione Nazionale per le Societa e la Borsahttpwwwconsobit Instituto per la Vigilanza sulle assicurazioni private e di Interesse colletivo httpwwwisvapit The Netherlands De NederlandscheBank httpwwwdnbnl France Banque de France httpwwwbanque-francefr Switzerland Schweizerische Nationalbank httpwwwsnbchindex3htmlSweden Sveriges Riksbank httpwwwriksbanksedefaultasp Belgium National Bank of Belgium httpwwwbnbbesgindexhtm Spain Banco de Espantildeahttpwwwbdees The Comision Nacional del Mercado de Valores httpwwwcnmves Supranational (EU) Institutional Arrangements for the Regulationand Supervision of the Financial Sector 2000 International Dimension Bank for International Settlement httpwwwbisorg International Organization ofSecurities Commissions httpwwwioscoorg International Association of Insurance Supervisors httpwwwiaisorg Financial Stability Forum httpwwwfsforumorg
Institute for International Econom
ics | httpww
wiiecom
THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 121
the inflexibility of tight surveillance against the need to encourage in-novation and growth The US Securities and Exchange Commission isworried about aggressive accounting by firms and biased reports bysecurities analysts in an equity environment that prizes steadily higherquarterly earnings41 Japanese regulators are preoccupied with opaqueinterconnections between portfolio institutions banks and nonfinancialfirms through the keiretsu system Canadian regulators reeling from high-profile scandals of managers intentionally misleading investors are strengtheningmarket discipline through legal penalties aimed at managers and directorsof offending firms
When panic strikes a securities regulator cannot do much As the 1987stock market crash and the LTCM debacle in the fall of 1998 both dem-onstrated steep stock and bond price declines can create systemic risksIf severe enough the wealth effect of falling securities values and thefear of widespread insolvency can depress real activity Flooding thesystem with liquidity is a central bankerrsquos solutionmdashsomething a securi-ties regulator cannot do42 But just as financial supervisors can changethe incentive structure to discourage bankers from making risky loans ingood times so securities regulators can pay more attention to incentiveson the demand side when capital markets are strong
Prudential Supervision and InnovationmdashA Footnote
In concluding this discussion of prudential supervision in the G-10 anadditional point is worth noting National regulators face a persistenttrade-off between emphasizing financial system safety and soundnesswhile encouraging innovationmdashin spite of the added risks innovationbrings to financial markets Former US Treasury Secretary Lawrence Summers(2000 3) has argued by analogy
The jet airplane made airplane air travel more comfortable more efficient andmore safe though the accidents were more spectacular and for a time morenumerous after the jet was invented In the same way modern global financialmarkets carry with them enormous potential for benefit even if some of theaccidents are that much more spectacular As the right public policy response
41 The problem is illustrated by the divergence since mid-1998 between reported earn-ings by the Standard amp Poorrsquos (SampP) 500 and the after-tax profits of all corporations inthe national accounts Generally these two series move closely with one another Be-tween mid-1998 and mid-1999 SampP 500 reported that earnings increased by more than20 percent while after-tax profits of all corporations increased by less than 5 percent(Chase Bank US Economic and Policy Research US Weekly Prospects Chase SecuritiesWeekly Newsletter 5 June 2000 5)
42 For example the US Securities and Exchange Commission had no direct role in calmingmarkets in the 1987 or 1998 panics
Institute for International Economics | httpwwwiiecom
122 WORLD CAPITAL MARKETS
to the jet was longer runways better air-traffic control and better training forpilots and not the discouragement of rapid travel so the right public policyresponse to financial innovation is to assure a safe framework so that the ben-efits can be realized not to stifle the change
Accepting Summersrsquos analogy for the international financial system better-informed supervisors and investors are a necessary part of the financialsystem framework Supervisors require more timely information on therisk profiles resulting from positions taken by financial institutions Theyalso need a better understanding of risk-management systems Snapshotsof an institutionrsquos risk profile and risk-management procedures are nolonger adequate In a world where huge bets are quickly made (andpossibly lostmdashas with Barings Bank in 1995 and LTCM in 1998) super-visors must focus on the soundness of banking systems for evaluatingand managing risk on a daily basis Some progress has been made inaddressing these issues US banking examiners are extending their in-formation requirements in banking examinations and increasing theirinvolvement in large complex institutions43 More awareness is alsorequired of the fact that they are national organizations in a world ofcross-border capital flows To a much greater extent they need a multi-national reach International supervision and coordination among super-visors are the subject of the next section
Our analysis suggests that G-10 supervisors have unfinished businessBank supervisors need to start yesterday securities regulators can waituntil tomorrow One G-10 member acting alone cannot correct the biasIn good times the lending business will simply migrate to other G-10banks In bad times financial problems will not stop at the national bor-der A way has to be found to establish common international standardsfor the key financial players in order to prevent crises and to agree onapproaches for managing them The path has already been laid out Inthe wake of the bank failures of the past 25 years bank supervisors havetried to establish such standards They have done this without creating anew global institution
The essence of the international framework is decentralizationmdashglobalrules and design standards without global institutions that are perceivedto intrude on national sovereignty The awkward jargon for this frame-work is vertical subsidiaritymdashldquothink internationally act nationallyrdquo Theinternational thinking is done by a committee of regulators that meets
International SupervisionA Decentralized Framework
43 These issues are discussed in Ferguson (1999) and Meyer (2000a)
Institute for International Economics | httpwwwiiecom
THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 123
regularly at the Bank for International Settlements in Basel The commit-tee establishes principles and standards that are interpreted implementedand enforced by national authorities44 In this section we describe thesesupervisory efforts and their weaknesses We present our recommenda-tions for addressing these weaknesses in the next chapter
Basel I
The Basel Capital Accord of 1988 (Basel I)45 drew the lesson from thefinancial crises of the mid-1970s that more adequate capital levels in in-ternational banks would help reduce the systemic risk of bank failureThe primary goal of Basel I was capital adequacy other standards wereput in place not so much for their own virtue as to defend the primarygoal
Capital adequacy requirements were designed to ensure that individualinstitutions have the ability to absorb losses particularly credit lossesAccordingly a backup system of scoring credit risk was devised thatrequired large amounts of bank capital for some types of loans smalleramounts for others and zero for a select list of preferred assets Report-ing requirements were designed to disclose problems and ensure that atroubled bank would take timely steps to restore its capital base in thewake of a loss The Basel I framework worked tolerably well in limitingthe call on the public purse in the G-10 countriesmdashwith the notable ex-ceptions of France and Japan The framework failed to moderate riskybank lending to emerging markets however
Basel I was not developed with emerging markets in mind The origi-nal idea behind it was to develop a common supervisory approach tocross-border banking operations It grew out of political pressure fromUS lawmakers who were determined to require international banks op-erating in the United States to meet US banking standards Toward thisgoal in 1983 Congress passed the International Lending Supervisory ActUS and British banking authorities subsequently agreed on a commontarget the adoption of strict common capital-adequacy standards In 1988other G-10 governments agreed to go along voluntary acceptance ofthe standards throughout much of the rest of the world followed46 Therationale for the capital targets was two-fold The first was to requirebanks to hold sufficient amounts of capital (8 percent of risk-adjusted
44 The international committee of financial authorities agreed on a common definitionof banksrsquo tier-one or ldquocorerdquo capital national authorities defined tier-two capital in theirown manner which permitted greater variations in national working definitions andpractices
45 International Convergence of Capital Measurement and Capital Standards (BIS 1988)was prepared by the Basel Committee on Banking Supervision
46 See Reineke (1998)
Institute for International Economics | httpwwwiiecom
124 WORLD CAPITAL MARKETS
assets) to cushion losses on those assets The second was to dull theirappetites for risk banks with large capital bases would have more tolose if they failed and therefore would take fewer risks
Rapid change in financial markets soon revealed flaws in the Basel IAccord In a complex world with numerous sources of risk it focusedheavily on credit risk but overlooked other risks in a bankrsquos portfolioand the correlation between returns on different asset classes The Baselformula required banks to maintain a fixed amount of capital againsteach of its asset classes But the formula did not distinguish the riskinessof the borrower within each class As a result one large loan to a low-risk corporate borrower such as General Electric would require the sameamount of capital as 10 smaller transactions with high-risk borrowers
The system was also biased toward short-term loans Loans maturingin less than a year required a 20 percent risk weight whereas those ma-turing after more than a year required a 100 percent risk weight Inter-bank lending was particularly favored For example loans to banks inOECD countries required less capital than loans to private firms in thesame countries creating the anomaly that interbank loans to South Ko-rean banks required less capital than loans to General Electric47 Thisanomaly encouraged banks to shed high-quality assets if the Basel rulesrequired the allocation of more capital than banks thought they needed
Another weakness was that financial innovators quickly circumventedthe Accord Because short-term loans required less provisioning than long-term loans banks responded by securitizing their long-term debt port-folios and lending short-term against the collateral of the newly createdasset This allowed banks to circumvent the capital requirements gearedto the terms of the underlying debt At the same time the Basel I Accordfailed to encourage risk mitigation techniques such as credit derivativescollateral guarantees and on-balance-sheet netting the flip side of fi-nancial innovation Because off-balance-sheet products were not coveredby the Accord another anomaly appeared when Barings Bank collapsedin 1995 Barings met capital adequacy standards but collapsed becauseits systems for managing risk failed traders were allowed to speculatein futures contracts that did not appear on the balance sheet
Basel II
Work to overhaul Basel I began in 1995 and produced consultativepapers issued in June 1999 and January 200148 These papers have been
47 South Korean banks have had notoriously weak balance sheets because the practiceof ldquodirected lendingrdquo left them with many poor loans (in making these loans the bankswere expected to follow government objectives rather than creditworthiness criteria)
48 Basel Committee on Banking Supervision (1999 2001)
Institute for International Economics | httpwwwiiecom
THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 125
the subject of extensive consultation and revision as a result the newAccord is expected to be introduced in 200449 The Basel II frameworkhas three parts (pillars) revisions to Basel I minimum-capital require-ments supervisory review criteria and greater emphasis on market dis-cipline Broadly Basel II aims to maintain the level of capital in the sys-tem but achieve better alignment of banksrsquo capital with their risk pro-files and keep up with financial innovation
To align capital requirements with market realities (the first pillar)Basel II concentrates on the 100 or so largest banksmdashthe type of playerslisted in table 21mdashand on the holding-company parents of banking groups50
Capital requirements will differentiate between an increased number ofcredit groups or ldquorisk bucketsrdquo including claims on governments otherbanks corporations mortgage-backed securities and other asset-backedsecurities
Basel II originally proposed to use external ratings to set capital chargesfor a number of these credit risks Many banks objected arguing thatthey assess credit risk better than Standard amp Poorrsquos Moodyrsquos or FitchIBCA51 Basel II thus proposes two approaches to rating a standard ap-proach using external ratings and an ldquoadvancedrdquo approach that allowsselected banks to use their own internal rating systems To encouragethe development of rigorous internal control systems based on these in-ternal rating systems Basel II also proposes to levy capital charges foroperational risk (the risk of direct or indirect loss resulting from inad-equate or failed internal processes people and systems or from exter-nal events)
Some critics of this proposal dismiss it as an abrogation of the prin-ciple of external independent monitoring and as ldquodangerously naiumlverdquo52
But regulators argue that the new capital charge on operational risk shouldoffset this concern It is also far from clear how cross-national compari-sons of rating and internal risk-assessment systems will be made (Engelen2000) The development by the European Union of its own capital rulescould well complicate the international resolution of these issues Publicassurances by EU officials in January 2001 however indicated that theirmain concerns are to create a level playing field and avoid regulatoryarbitrage (Hargreaves 2001) There is also the significant problem ofthe procyclical character of risk weights When a crisis hits losses are
49 See Berry (2000) for an update in an interview with William J McDonough chair ofthe Basel Committee on Banking Supervision
50 For obvious reasons these proposals are addressed to large banks and simpler capi-tal standards are allowed for small banks that focus on their domestic credit markets
51 See Ammer and Packer (2000) for an empirical critique of the success of rating agen-cies in distinguishing risk by sector and region
52 See Auerback (2001)
Institute for International Economics | httpwwwiiecom
126 WORLD CAPITAL MARKETS
incurred or accrued capital is lost and loan exposure must be reducedor securities sold to restore the requisite capital-adequacy ratios A morerisk-sensitive framework could amplify volatility
As the second pillar of Basel II supervisory review criteria are beingbeefed up to encourage supervisors to intervene earlier in potential problemsituations and to compel banks to align their capital positions with theirrisk profiles Bank supervisors will be authorized to require banks tohold capital in excess of minimum requirements if they have concernsabout general management overall strategy risk-management performanceor the macroeconomic environment Of course if one G-10 supervisorimposes higher capital requirements in isolation the same disparity willemerge that presaged Basel I Some banks will be disadvantaged in theinternational marketplace and will loudly complain that excessive super-vision is driving business to their competitors Hence close internationalcooperation among supervisors is critical
To implement the third pillar market discipline banks will be requiredto make fuller more timely disclosure of capital adequacy and the risksto which that capital is exposed A number of measures are being stud-ied that might help supervisors evaluate bank performance such as com-parisons of uninsured deposit interest rates subordinated debt yieldsand equity prices The idea is that these yields and prices might alertsupervisors to market perceptions of risk Of course market perceptionsare only as good as market information More direct and controversialways to reinforce market discipline would dramatically increase publicdisclosure of bank positions and risk management systems
Many questions are still outstanding about how to resolve the techni-cal details of capital requirements and whether the requirements willachieve their intended goal of better assessment and mitigation of therisks in banksrsquo portfolios There is no substitute for skilled supervisorsThe intricacies of effective design and implementation suggest that su-pervisors need to be highly competent technically knowledgeable aboutbanking portfolio characteristics and the factors that influence bank ex-posure to credit risk (Mishkin 2000) And they must be aided by vigilantshareholders market forces and transparency of information53
Standard setting at the global level is desirable but ultimately theeffectiveness of these efforts will be tested at the national level espe-cially in times of systemic financial distress Here the record of Basel Iwas not a bright shining success Japanese banking regulators havetraditionally allowed banks to include real estate and securities in theircapital base When the value of these assets plummeted in the early 1990sregulators allowed banks to continue valuing these depreciated (andoften bankrupt) assets at their old inflated levels Japanese authorities
53 Benedict Roth Complacency Towards Catastrophe Financial Times 23 January 2001
Institute for International Economics | httpwwwiiecom
THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 127
insisted until the mid-1990s that eroded capital bases could be rebuiltin a market-driven fashion They rightly foresaw that huge loan losseswould undermine public support for the ruling party and require a po-litically unpopular bailout
Japanese foot dragging on Basel I was the worst54 but not uniqueOther examples can be found of ldquopolitically mandated forbearancerdquo TheFederal Reserve Bank of New York held important hands during theLTCM crisis of 1998 Mexico is still resolving the banking crisis that eruptedin 1995 South Korea has not yet closed the insolvent banks that behavedso badly before the crisis of 1998 In the aftermath of a crisis nationalregulators cannot always be relied upon to discipline politically power-ful bankers55 One of the little-noticed consequences of these differingapproaches is that those banks with strong regulatory systems receivedan implicit ldquoexport subsidyrdquo for their services US banks which had notengaged extensively in emerging-market lending in the 1990s were bet-ter positioned than their German and Japanese counterparts to expandtheir international assets in the wake of the crises
Other Financial Forums
54 See Japanese Banks Fiddling while Marunouchi Burns The Economist 27 January2001 67-69
55 See Calomiris (1997)
The Basel model of vertical subsidiarity has already been extended toother financial regulatory bodies In 1993-94 the BIS established a Tri-partite Group of Banking Insurance and Securities Regulators In 1994-95 the BIS increased its cooperation with the International Organizationof Securities Commissions when the two organizations issued parallelpapers on guidelines for national regulators concerning risk managementand disclosure of derivative trades In 1996 a permanent Joint Forum onFinancial Conglomerates was established to examine supervisory issuesand develop working arrangements among the different functional super-visors of conglomerate institutions that offer combinations of bankingsecurities and insurance products Draft papers on the supervisionof conglomerates were released for comment in 1998 applying capital-adequacy principles to these groups and providing guidelines both forassessing the integrity and competence of top managers and for sharingassessments between regulators
In 1997 the Basel Committee on Banking Supervision extended itsreach beyond capital standards to broader aspects of banking supervi-sion with the publication of the Core Principles for Effective BankingSupervision In 1999 a wide range of regulatory and standard-settingbodies were gathered under the umbrella of the Financial Stability
Institute for International Economics | httpwwwiiecom
128 WORLD CAPITAL MARKETS
Forum (FSF) itself established under BIS aegis56 The FSF has alreadyissued recommendations for stepped-up supervision and transparencyas well as guidelines for best practices in a number of areas includingoffshore financial centers and highly leveraged institutions or hedge funds57
Conclusion
Although the structural weaknesses in emerging-market economies arewidely acknowledged to have been causal factors in international capi-tal-market volatility this chapter points to the role of large G-10 bankingorganizations as major suppliers of the most volatile instrument short-term debt We have examined evidence of the impact of public safetynets in the G-10 economiesmdashthe deposit insurance systems the pruden-tial supervisory systems and the lender-of-last-resort functions of centralbanksmdashon the incentive structures of these organizations
Although supervisors in most countries working nationally and to-gether in the BIS have made significant efforts to mimic market forcesin their prudential supervision the most sophisticated financial institu-tions find innovative ways to circumvent the rules New global regulatorybodies are not about to be created G-10 national bank regulators shouldthemselves address the short-term debt bias in the international financialsystem by changing incentive systems G-10 securities regulators shouldalso take steps to get ahead of the curve paying close attention to largeportfolio swings by institutional investors particularly in times of crisisIn short more needs to be done at national and international levels tochange the rules of the game That is the subject of the next chapter
56 The Financial Stability Forum includes banking securities insurance and accountingregulatory bodies the OECD on taxation corruption and corporate governance and theIMF
57 See Martin (2000)
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TH
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LAY
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S T
HE
IR S
UP
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VIS
OR
S A
ND
MO
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ZA
RD
119
Financial institutions and their supervisors
Country and supervisory structure Banking Securities Insurance
Banking Advisory High Level Securities Supervisors Committee (BAC) Committee (HLSS) Insurance Committee (IC)
Supranational (EU) bull Formulates standards for prudential bull Coordination of securities market bull Formulates standards forsupervision supervision prudential supervision
BACICHLSS Banking Supervision
Conglomerates Committee (BSC) Securities Contact Committee Regulation of prudential bull Systemic risk monitoring bull Regulation and implementation of supervision securities admission
International Association International International Organization of of Insurance Supervisors
Basel Committee Securities Commisison (IOSCO) (IAIS) Joint Forum Conglomerates Supervision bull Supervision and regulation best bull Supervision and regulation best bull Supervision and regulation amp regulation Best practices practices practices best practices
FSF Coordination across supervisors of various functions
Notes See appendix B for more information Boldface type indicates senior or oversight supervisor normal type indicates adjunct or front-line supervisorsolid line indicates direct responsbility to the senior-ranking authority dotted line indicates coordination in supervisory activities
(table continues next page)
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120W
OR
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Table 210 Financial-sector regulation G-10 countries 2000 (continued )
Glossary of names United Kingdom FSA = Financial Services Authority United States FR = Federal Reserve OCC = Office of the Comptroller of theCurrency FDIC = Federal Deposit Insurance Corporation SEC = Securities and Exchange Commission OTS = Office of Thrift Supervision Japan FRC =Financial Reconstruction Commission FSA = Financial Services Agency SESC = Securities and Exchange Surveillance Commission Canada OSFI =Office of the Superintendent of Financial Institutions CDIC = Canada Deposit Insurance Corporation Germany FBSO = Federal Banking SupervisoryOffice FSSO = Federal Securities Supervisory Office FISO = Federal Insurance Supervisory Office BSO = Banking Supervisory Office Italy Consob =Commissione Nazionale per le Societa e la Borsa ISVAP = Instituto per la Vigilanza sulle assicurazioni private e di Interesse colletivo Switzerland SFBC= Swiss Federal Banking Commission Spain CNMV = The Comision Nacional del Mercado de Valores Supranational BAC = Banking Advisory CommitteeBSC = Banking Supervision Committee IC = Insurance Committee HLSS = High Level Securities Supervisors Committee International Dimension FSF =Financial Stability Forum IOSCO = International Organization of Securities Commission IAIS = International Association of Insurance Supervisors
Sources United Kingdom Bank of England httpwwwbankofenglandcouk Financial Services Authority httpwwwfsagovuk United States Board ofGovernors of Federal Reserve System httpwwwfederalreservegov Japan Bank of Japan httpwwwbojorjo Financial Reconstruction Commissionhttpwwwfsagojpfrcindexehtml Financial Services Agency httpwwwfsagojp Canada Bank of Canada httpwwwbank-banque-canadaca Office ofthe Superintendent of Financial Institutions httpwwwosfi-bsifgccaAndreEindexhtml Germany Deutsche Bundesbank httpwwwbundesbankde Fed-eral Banking Supervisory Office httpwwwbakredde Italy Banca drsquoitalia httpwwwbancaditaliait Commissione Nazionale per le Societa e la Borsahttpwwwconsobit Instituto per la Vigilanza sulle assicurazioni private e di Interesse colletivo httpwwwisvapit The Netherlands De NederlandscheBank httpwwwdnbnl France Banque de France httpwwwbanque-francefr Switzerland Schweizerische Nationalbank httpwwwsnbchindex3htmlSweden Sveriges Riksbank httpwwwriksbanksedefaultasp Belgium National Bank of Belgium httpwwwbnbbesgindexhtm Spain Banco de Espantildeahttpwwwbdees The Comision Nacional del Mercado de Valores httpwwwcnmves Supranational (EU) Institutional Arrangements for the Regulationand Supervision of the Financial Sector 2000 International Dimension Bank for International Settlement httpwwwbisorg International Organization ofSecurities Commissions httpwwwioscoorg International Association of Insurance Supervisors httpwwwiaisorg Financial Stability Forum httpwwwfsforumorg
Institute for International Econom
ics | httpww
wiiecom
THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 121
the inflexibility of tight surveillance against the need to encourage in-novation and growth The US Securities and Exchange Commission isworried about aggressive accounting by firms and biased reports bysecurities analysts in an equity environment that prizes steadily higherquarterly earnings41 Japanese regulators are preoccupied with opaqueinterconnections between portfolio institutions banks and nonfinancialfirms through the keiretsu system Canadian regulators reeling from high-profile scandals of managers intentionally misleading investors are strengtheningmarket discipline through legal penalties aimed at managers and directorsof offending firms
When panic strikes a securities regulator cannot do much As the 1987stock market crash and the LTCM debacle in the fall of 1998 both dem-onstrated steep stock and bond price declines can create systemic risksIf severe enough the wealth effect of falling securities values and thefear of widespread insolvency can depress real activity Flooding thesystem with liquidity is a central bankerrsquos solutionmdashsomething a securi-ties regulator cannot do42 But just as financial supervisors can changethe incentive structure to discourage bankers from making risky loans ingood times so securities regulators can pay more attention to incentiveson the demand side when capital markets are strong
Prudential Supervision and InnovationmdashA Footnote
In concluding this discussion of prudential supervision in the G-10 anadditional point is worth noting National regulators face a persistenttrade-off between emphasizing financial system safety and soundnesswhile encouraging innovationmdashin spite of the added risks innovationbrings to financial markets Former US Treasury Secretary Lawrence Summers(2000 3) has argued by analogy
The jet airplane made airplane air travel more comfortable more efficient andmore safe though the accidents were more spectacular and for a time morenumerous after the jet was invented In the same way modern global financialmarkets carry with them enormous potential for benefit even if some of theaccidents are that much more spectacular As the right public policy response
41 The problem is illustrated by the divergence since mid-1998 between reported earn-ings by the Standard amp Poorrsquos (SampP) 500 and the after-tax profits of all corporations inthe national accounts Generally these two series move closely with one another Be-tween mid-1998 and mid-1999 SampP 500 reported that earnings increased by more than20 percent while after-tax profits of all corporations increased by less than 5 percent(Chase Bank US Economic and Policy Research US Weekly Prospects Chase SecuritiesWeekly Newsletter 5 June 2000 5)
42 For example the US Securities and Exchange Commission had no direct role in calmingmarkets in the 1987 or 1998 panics
Institute for International Economics | httpwwwiiecom
122 WORLD CAPITAL MARKETS
to the jet was longer runways better air-traffic control and better training forpilots and not the discouragement of rapid travel so the right public policyresponse to financial innovation is to assure a safe framework so that the ben-efits can be realized not to stifle the change
Accepting Summersrsquos analogy for the international financial system better-informed supervisors and investors are a necessary part of the financialsystem framework Supervisors require more timely information on therisk profiles resulting from positions taken by financial institutions Theyalso need a better understanding of risk-management systems Snapshotsof an institutionrsquos risk profile and risk-management procedures are nolonger adequate In a world where huge bets are quickly made (andpossibly lostmdashas with Barings Bank in 1995 and LTCM in 1998) super-visors must focus on the soundness of banking systems for evaluatingand managing risk on a daily basis Some progress has been made inaddressing these issues US banking examiners are extending their in-formation requirements in banking examinations and increasing theirinvolvement in large complex institutions43 More awareness is alsorequired of the fact that they are national organizations in a world ofcross-border capital flows To a much greater extent they need a multi-national reach International supervision and coordination among super-visors are the subject of the next section
Our analysis suggests that G-10 supervisors have unfinished businessBank supervisors need to start yesterday securities regulators can waituntil tomorrow One G-10 member acting alone cannot correct the biasIn good times the lending business will simply migrate to other G-10banks In bad times financial problems will not stop at the national bor-der A way has to be found to establish common international standardsfor the key financial players in order to prevent crises and to agree onapproaches for managing them The path has already been laid out Inthe wake of the bank failures of the past 25 years bank supervisors havetried to establish such standards They have done this without creating anew global institution
The essence of the international framework is decentralizationmdashglobalrules and design standards without global institutions that are perceivedto intrude on national sovereignty The awkward jargon for this frame-work is vertical subsidiaritymdashldquothink internationally act nationallyrdquo Theinternational thinking is done by a committee of regulators that meets
International SupervisionA Decentralized Framework
43 These issues are discussed in Ferguson (1999) and Meyer (2000a)
Institute for International Economics | httpwwwiiecom
THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 123
regularly at the Bank for International Settlements in Basel The commit-tee establishes principles and standards that are interpreted implementedand enforced by national authorities44 In this section we describe thesesupervisory efforts and their weaknesses We present our recommenda-tions for addressing these weaknesses in the next chapter
Basel I
The Basel Capital Accord of 1988 (Basel I)45 drew the lesson from thefinancial crises of the mid-1970s that more adequate capital levels in in-ternational banks would help reduce the systemic risk of bank failureThe primary goal of Basel I was capital adequacy other standards wereput in place not so much for their own virtue as to defend the primarygoal
Capital adequacy requirements were designed to ensure that individualinstitutions have the ability to absorb losses particularly credit lossesAccordingly a backup system of scoring credit risk was devised thatrequired large amounts of bank capital for some types of loans smalleramounts for others and zero for a select list of preferred assets Report-ing requirements were designed to disclose problems and ensure that atroubled bank would take timely steps to restore its capital base in thewake of a loss The Basel I framework worked tolerably well in limitingthe call on the public purse in the G-10 countriesmdashwith the notable ex-ceptions of France and Japan The framework failed to moderate riskybank lending to emerging markets however
Basel I was not developed with emerging markets in mind The origi-nal idea behind it was to develop a common supervisory approach tocross-border banking operations It grew out of political pressure fromUS lawmakers who were determined to require international banks op-erating in the United States to meet US banking standards Toward thisgoal in 1983 Congress passed the International Lending Supervisory ActUS and British banking authorities subsequently agreed on a commontarget the adoption of strict common capital-adequacy standards In 1988other G-10 governments agreed to go along voluntary acceptance ofthe standards throughout much of the rest of the world followed46 Therationale for the capital targets was two-fold The first was to requirebanks to hold sufficient amounts of capital (8 percent of risk-adjusted
44 The international committee of financial authorities agreed on a common definitionof banksrsquo tier-one or ldquocorerdquo capital national authorities defined tier-two capital in theirown manner which permitted greater variations in national working definitions andpractices
45 International Convergence of Capital Measurement and Capital Standards (BIS 1988)was prepared by the Basel Committee on Banking Supervision
46 See Reineke (1998)
Institute for International Economics | httpwwwiiecom
124 WORLD CAPITAL MARKETS
assets) to cushion losses on those assets The second was to dull theirappetites for risk banks with large capital bases would have more tolose if they failed and therefore would take fewer risks
Rapid change in financial markets soon revealed flaws in the Basel IAccord In a complex world with numerous sources of risk it focusedheavily on credit risk but overlooked other risks in a bankrsquos portfolioand the correlation between returns on different asset classes The Baselformula required banks to maintain a fixed amount of capital againsteach of its asset classes But the formula did not distinguish the riskinessof the borrower within each class As a result one large loan to a low-risk corporate borrower such as General Electric would require the sameamount of capital as 10 smaller transactions with high-risk borrowers
The system was also biased toward short-term loans Loans maturingin less than a year required a 20 percent risk weight whereas those ma-turing after more than a year required a 100 percent risk weight Inter-bank lending was particularly favored For example loans to banks inOECD countries required less capital than loans to private firms in thesame countries creating the anomaly that interbank loans to South Ko-rean banks required less capital than loans to General Electric47 Thisanomaly encouraged banks to shed high-quality assets if the Basel rulesrequired the allocation of more capital than banks thought they needed
Another weakness was that financial innovators quickly circumventedthe Accord Because short-term loans required less provisioning than long-term loans banks responded by securitizing their long-term debt port-folios and lending short-term against the collateral of the newly createdasset This allowed banks to circumvent the capital requirements gearedto the terms of the underlying debt At the same time the Basel I Accordfailed to encourage risk mitigation techniques such as credit derivativescollateral guarantees and on-balance-sheet netting the flip side of fi-nancial innovation Because off-balance-sheet products were not coveredby the Accord another anomaly appeared when Barings Bank collapsedin 1995 Barings met capital adequacy standards but collapsed becauseits systems for managing risk failed traders were allowed to speculatein futures contracts that did not appear on the balance sheet
Basel II
Work to overhaul Basel I began in 1995 and produced consultativepapers issued in June 1999 and January 200148 These papers have been
47 South Korean banks have had notoriously weak balance sheets because the practiceof ldquodirected lendingrdquo left them with many poor loans (in making these loans the bankswere expected to follow government objectives rather than creditworthiness criteria)
48 Basel Committee on Banking Supervision (1999 2001)
Institute for International Economics | httpwwwiiecom
THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 125
the subject of extensive consultation and revision as a result the newAccord is expected to be introduced in 200449 The Basel II frameworkhas three parts (pillars) revisions to Basel I minimum-capital require-ments supervisory review criteria and greater emphasis on market dis-cipline Broadly Basel II aims to maintain the level of capital in the sys-tem but achieve better alignment of banksrsquo capital with their risk pro-files and keep up with financial innovation
To align capital requirements with market realities (the first pillar)Basel II concentrates on the 100 or so largest banksmdashthe type of playerslisted in table 21mdashand on the holding-company parents of banking groups50
Capital requirements will differentiate between an increased number ofcredit groups or ldquorisk bucketsrdquo including claims on governments otherbanks corporations mortgage-backed securities and other asset-backedsecurities
Basel II originally proposed to use external ratings to set capital chargesfor a number of these credit risks Many banks objected arguing thatthey assess credit risk better than Standard amp Poorrsquos Moodyrsquos or FitchIBCA51 Basel II thus proposes two approaches to rating a standard ap-proach using external ratings and an ldquoadvancedrdquo approach that allowsselected banks to use their own internal rating systems To encouragethe development of rigorous internal control systems based on these in-ternal rating systems Basel II also proposes to levy capital charges foroperational risk (the risk of direct or indirect loss resulting from inad-equate or failed internal processes people and systems or from exter-nal events)
Some critics of this proposal dismiss it as an abrogation of the prin-ciple of external independent monitoring and as ldquodangerously naiumlverdquo52
But regulators argue that the new capital charge on operational risk shouldoffset this concern It is also far from clear how cross-national compari-sons of rating and internal risk-assessment systems will be made (Engelen2000) The development by the European Union of its own capital rulescould well complicate the international resolution of these issues Publicassurances by EU officials in January 2001 however indicated that theirmain concerns are to create a level playing field and avoid regulatoryarbitrage (Hargreaves 2001) There is also the significant problem ofthe procyclical character of risk weights When a crisis hits losses are
49 See Berry (2000) for an update in an interview with William J McDonough chair ofthe Basel Committee on Banking Supervision
50 For obvious reasons these proposals are addressed to large banks and simpler capi-tal standards are allowed for small banks that focus on their domestic credit markets
51 See Ammer and Packer (2000) for an empirical critique of the success of rating agen-cies in distinguishing risk by sector and region
52 See Auerback (2001)
Institute for International Economics | httpwwwiiecom
126 WORLD CAPITAL MARKETS
incurred or accrued capital is lost and loan exposure must be reducedor securities sold to restore the requisite capital-adequacy ratios A morerisk-sensitive framework could amplify volatility
As the second pillar of Basel II supervisory review criteria are beingbeefed up to encourage supervisors to intervene earlier in potential problemsituations and to compel banks to align their capital positions with theirrisk profiles Bank supervisors will be authorized to require banks tohold capital in excess of minimum requirements if they have concernsabout general management overall strategy risk-management performanceor the macroeconomic environment Of course if one G-10 supervisorimposes higher capital requirements in isolation the same disparity willemerge that presaged Basel I Some banks will be disadvantaged in theinternational marketplace and will loudly complain that excessive super-vision is driving business to their competitors Hence close internationalcooperation among supervisors is critical
To implement the third pillar market discipline banks will be requiredto make fuller more timely disclosure of capital adequacy and the risksto which that capital is exposed A number of measures are being stud-ied that might help supervisors evaluate bank performance such as com-parisons of uninsured deposit interest rates subordinated debt yieldsand equity prices The idea is that these yields and prices might alertsupervisors to market perceptions of risk Of course market perceptionsare only as good as market information More direct and controversialways to reinforce market discipline would dramatically increase publicdisclosure of bank positions and risk management systems
Many questions are still outstanding about how to resolve the techni-cal details of capital requirements and whether the requirements willachieve their intended goal of better assessment and mitigation of therisks in banksrsquo portfolios There is no substitute for skilled supervisorsThe intricacies of effective design and implementation suggest that su-pervisors need to be highly competent technically knowledgeable aboutbanking portfolio characteristics and the factors that influence bank ex-posure to credit risk (Mishkin 2000) And they must be aided by vigilantshareholders market forces and transparency of information53
Standard setting at the global level is desirable but ultimately theeffectiveness of these efforts will be tested at the national level espe-cially in times of systemic financial distress Here the record of Basel Iwas not a bright shining success Japanese banking regulators havetraditionally allowed banks to include real estate and securities in theircapital base When the value of these assets plummeted in the early 1990sregulators allowed banks to continue valuing these depreciated (andoften bankrupt) assets at their old inflated levels Japanese authorities
53 Benedict Roth Complacency Towards Catastrophe Financial Times 23 January 2001
Institute for International Economics | httpwwwiiecom
THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 127
insisted until the mid-1990s that eroded capital bases could be rebuiltin a market-driven fashion They rightly foresaw that huge loan losseswould undermine public support for the ruling party and require a po-litically unpopular bailout
Japanese foot dragging on Basel I was the worst54 but not uniqueOther examples can be found of ldquopolitically mandated forbearancerdquo TheFederal Reserve Bank of New York held important hands during theLTCM crisis of 1998 Mexico is still resolving the banking crisis that eruptedin 1995 South Korea has not yet closed the insolvent banks that behavedso badly before the crisis of 1998 In the aftermath of a crisis nationalregulators cannot always be relied upon to discipline politically power-ful bankers55 One of the little-noticed consequences of these differingapproaches is that those banks with strong regulatory systems receivedan implicit ldquoexport subsidyrdquo for their services US banks which had notengaged extensively in emerging-market lending in the 1990s were bet-ter positioned than their German and Japanese counterparts to expandtheir international assets in the wake of the crises
Other Financial Forums
54 See Japanese Banks Fiddling while Marunouchi Burns The Economist 27 January2001 67-69
55 See Calomiris (1997)
The Basel model of vertical subsidiarity has already been extended toother financial regulatory bodies In 1993-94 the BIS established a Tri-partite Group of Banking Insurance and Securities Regulators In 1994-95 the BIS increased its cooperation with the International Organizationof Securities Commissions when the two organizations issued parallelpapers on guidelines for national regulators concerning risk managementand disclosure of derivative trades In 1996 a permanent Joint Forum onFinancial Conglomerates was established to examine supervisory issuesand develop working arrangements among the different functional super-visors of conglomerate institutions that offer combinations of bankingsecurities and insurance products Draft papers on the supervisionof conglomerates were released for comment in 1998 applying capital-adequacy principles to these groups and providing guidelines both forassessing the integrity and competence of top managers and for sharingassessments between regulators
In 1997 the Basel Committee on Banking Supervision extended itsreach beyond capital standards to broader aspects of banking supervi-sion with the publication of the Core Principles for Effective BankingSupervision In 1999 a wide range of regulatory and standard-settingbodies were gathered under the umbrella of the Financial Stability
Institute for International Economics | httpwwwiiecom
128 WORLD CAPITAL MARKETS
Forum (FSF) itself established under BIS aegis56 The FSF has alreadyissued recommendations for stepped-up supervision and transparencyas well as guidelines for best practices in a number of areas includingoffshore financial centers and highly leveraged institutions or hedge funds57
Conclusion
Although the structural weaknesses in emerging-market economies arewidely acknowledged to have been causal factors in international capi-tal-market volatility this chapter points to the role of large G-10 bankingorganizations as major suppliers of the most volatile instrument short-term debt We have examined evidence of the impact of public safetynets in the G-10 economiesmdashthe deposit insurance systems the pruden-tial supervisory systems and the lender-of-last-resort functions of centralbanksmdashon the incentive structures of these organizations
Although supervisors in most countries working nationally and to-gether in the BIS have made significant efforts to mimic market forcesin their prudential supervision the most sophisticated financial institu-tions find innovative ways to circumvent the rules New global regulatorybodies are not about to be created G-10 national bank regulators shouldthemselves address the short-term debt bias in the international financialsystem by changing incentive systems G-10 securities regulators shouldalso take steps to get ahead of the curve paying close attention to largeportfolio swings by institutional investors particularly in times of crisisIn short more needs to be done at national and international levels tochange the rules of the game That is the subject of the next chapter
56 The Financial Stability Forum includes banking securities insurance and accountingregulatory bodies the OECD on taxation corruption and corporate governance and theIMF
57 See Martin (2000)
Institute for International Economics | httpwwwiiecom
120W
OR
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PIT
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ET
S
Table 210 Financial-sector regulation G-10 countries 2000 (continued )
Glossary of names United Kingdom FSA = Financial Services Authority United States FR = Federal Reserve OCC = Office of the Comptroller of theCurrency FDIC = Federal Deposit Insurance Corporation SEC = Securities and Exchange Commission OTS = Office of Thrift Supervision Japan FRC =Financial Reconstruction Commission FSA = Financial Services Agency SESC = Securities and Exchange Surveillance Commission Canada OSFI =Office of the Superintendent of Financial Institutions CDIC = Canada Deposit Insurance Corporation Germany FBSO = Federal Banking SupervisoryOffice FSSO = Federal Securities Supervisory Office FISO = Federal Insurance Supervisory Office BSO = Banking Supervisory Office Italy Consob =Commissione Nazionale per le Societa e la Borsa ISVAP = Instituto per la Vigilanza sulle assicurazioni private e di Interesse colletivo Switzerland SFBC= Swiss Federal Banking Commission Spain CNMV = The Comision Nacional del Mercado de Valores Supranational BAC = Banking Advisory CommitteeBSC = Banking Supervision Committee IC = Insurance Committee HLSS = High Level Securities Supervisors Committee International Dimension FSF =Financial Stability Forum IOSCO = International Organization of Securities Commission IAIS = International Association of Insurance Supervisors
Sources United Kingdom Bank of England httpwwwbankofenglandcouk Financial Services Authority httpwwwfsagovuk United States Board ofGovernors of Federal Reserve System httpwwwfederalreservegov Japan Bank of Japan httpwwwbojorjo Financial Reconstruction Commissionhttpwwwfsagojpfrcindexehtml Financial Services Agency httpwwwfsagojp Canada Bank of Canada httpwwwbank-banque-canadaca Office ofthe Superintendent of Financial Institutions httpwwwosfi-bsifgccaAndreEindexhtml Germany Deutsche Bundesbank httpwwwbundesbankde Fed-eral Banking Supervisory Office httpwwwbakredde Italy Banca drsquoitalia httpwwwbancaditaliait Commissione Nazionale per le Societa e la Borsahttpwwwconsobit Instituto per la Vigilanza sulle assicurazioni private e di Interesse colletivo httpwwwisvapit The Netherlands De NederlandscheBank httpwwwdnbnl France Banque de France httpwwwbanque-francefr Switzerland Schweizerische Nationalbank httpwwwsnbchindex3htmlSweden Sveriges Riksbank httpwwwriksbanksedefaultasp Belgium National Bank of Belgium httpwwwbnbbesgindexhtm Spain Banco de Espantildeahttpwwwbdees The Comision Nacional del Mercado de Valores httpwwwcnmves Supranational (EU) Institutional Arrangements for the Regulationand Supervision of the Financial Sector 2000 International Dimension Bank for International Settlement httpwwwbisorg International Organization ofSecurities Commissions httpwwwioscoorg International Association of Insurance Supervisors httpwwwiaisorg Financial Stability Forum httpwwwfsforumorg
Institute for International Econom
ics | httpww
wiiecom
THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 121
the inflexibility of tight surveillance against the need to encourage in-novation and growth The US Securities and Exchange Commission isworried about aggressive accounting by firms and biased reports bysecurities analysts in an equity environment that prizes steadily higherquarterly earnings41 Japanese regulators are preoccupied with opaqueinterconnections between portfolio institutions banks and nonfinancialfirms through the keiretsu system Canadian regulators reeling from high-profile scandals of managers intentionally misleading investors are strengtheningmarket discipline through legal penalties aimed at managers and directorsof offending firms
When panic strikes a securities regulator cannot do much As the 1987stock market crash and the LTCM debacle in the fall of 1998 both dem-onstrated steep stock and bond price declines can create systemic risksIf severe enough the wealth effect of falling securities values and thefear of widespread insolvency can depress real activity Flooding thesystem with liquidity is a central bankerrsquos solutionmdashsomething a securi-ties regulator cannot do42 But just as financial supervisors can changethe incentive structure to discourage bankers from making risky loans ingood times so securities regulators can pay more attention to incentiveson the demand side when capital markets are strong
Prudential Supervision and InnovationmdashA Footnote
In concluding this discussion of prudential supervision in the G-10 anadditional point is worth noting National regulators face a persistenttrade-off between emphasizing financial system safety and soundnesswhile encouraging innovationmdashin spite of the added risks innovationbrings to financial markets Former US Treasury Secretary Lawrence Summers(2000 3) has argued by analogy
The jet airplane made airplane air travel more comfortable more efficient andmore safe though the accidents were more spectacular and for a time morenumerous after the jet was invented In the same way modern global financialmarkets carry with them enormous potential for benefit even if some of theaccidents are that much more spectacular As the right public policy response
41 The problem is illustrated by the divergence since mid-1998 between reported earn-ings by the Standard amp Poorrsquos (SampP) 500 and the after-tax profits of all corporations inthe national accounts Generally these two series move closely with one another Be-tween mid-1998 and mid-1999 SampP 500 reported that earnings increased by more than20 percent while after-tax profits of all corporations increased by less than 5 percent(Chase Bank US Economic and Policy Research US Weekly Prospects Chase SecuritiesWeekly Newsletter 5 June 2000 5)
42 For example the US Securities and Exchange Commission had no direct role in calmingmarkets in the 1987 or 1998 panics
Institute for International Economics | httpwwwiiecom
122 WORLD CAPITAL MARKETS
to the jet was longer runways better air-traffic control and better training forpilots and not the discouragement of rapid travel so the right public policyresponse to financial innovation is to assure a safe framework so that the ben-efits can be realized not to stifle the change
Accepting Summersrsquos analogy for the international financial system better-informed supervisors and investors are a necessary part of the financialsystem framework Supervisors require more timely information on therisk profiles resulting from positions taken by financial institutions Theyalso need a better understanding of risk-management systems Snapshotsof an institutionrsquos risk profile and risk-management procedures are nolonger adequate In a world where huge bets are quickly made (andpossibly lostmdashas with Barings Bank in 1995 and LTCM in 1998) super-visors must focus on the soundness of banking systems for evaluatingand managing risk on a daily basis Some progress has been made inaddressing these issues US banking examiners are extending their in-formation requirements in banking examinations and increasing theirinvolvement in large complex institutions43 More awareness is alsorequired of the fact that they are national organizations in a world ofcross-border capital flows To a much greater extent they need a multi-national reach International supervision and coordination among super-visors are the subject of the next section
Our analysis suggests that G-10 supervisors have unfinished businessBank supervisors need to start yesterday securities regulators can waituntil tomorrow One G-10 member acting alone cannot correct the biasIn good times the lending business will simply migrate to other G-10banks In bad times financial problems will not stop at the national bor-der A way has to be found to establish common international standardsfor the key financial players in order to prevent crises and to agree onapproaches for managing them The path has already been laid out Inthe wake of the bank failures of the past 25 years bank supervisors havetried to establish such standards They have done this without creating anew global institution
The essence of the international framework is decentralizationmdashglobalrules and design standards without global institutions that are perceivedto intrude on national sovereignty The awkward jargon for this frame-work is vertical subsidiaritymdashldquothink internationally act nationallyrdquo Theinternational thinking is done by a committee of regulators that meets
International SupervisionA Decentralized Framework
43 These issues are discussed in Ferguson (1999) and Meyer (2000a)
Institute for International Economics | httpwwwiiecom
THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 123
regularly at the Bank for International Settlements in Basel The commit-tee establishes principles and standards that are interpreted implementedand enforced by national authorities44 In this section we describe thesesupervisory efforts and their weaknesses We present our recommenda-tions for addressing these weaknesses in the next chapter
Basel I
The Basel Capital Accord of 1988 (Basel I)45 drew the lesson from thefinancial crises of the mid-1970s that more adequate capital levels in in-ternational banks would help reduce the systemic risk of bank failureThe primary goal of Basel I was capital adequacy other standards wereput in place not so much for their own virtue as to defend the primarygoal
Capital adequacy requirements were designed to ensure that individualinstitutions have the ability to absorb losses particularly credit lossesAccordingly a backup system of scoring credit risk was devised thatrequired large amounts of bank capital for some types of loans smalleramounts for others and zero for a select list of preferred assets Report-ing requirements were designed to disclose problems and ensure that atroubled bank would take timely steps to restore its capital base in thewake of a loss The Basel I framework worked tolerably well in limitingthe call on the public purse in the G-10 countriesmdashwith the notable ex-ceptions of France and Japan The framework failed to moderate riskybank lending to emerging markets however
Basel I was not developed with emerging markets in mind The origi-nal idea behind it was to develop a common supervisory approach tocross-border banking operations It grew out of political pressure fromUS lawmakers who were determined to require international banks op-erating in the United States to meet US banking standards Toward thisgoal in 1983 Congress passed the International Lending Supervisory ActUS and British banking authorities subsequently agreed on a commontarget the adoption of strict common capital-adequacy standards In 1988other G-10 governments agreed to go along voluntary acceptance ofthe standards throughout much of the rest of the world followed46 Therationale for the capital targets was two-fold The first was to requirebanks to hold sufficient amounts of capital (8 percent of risk-adjusted
44 The international committee of financial authorities agreed on a common definitionof banksrsquo tier-one or ldquocorerdquo capital national authorities defined tier-two capital in theirown manner which permitted greater variations in national working definitions andpractices
45 International Convergence of Capital Measurement and Capital Standards (BIS 1988)was prepared by the Basel Committee on Banking Supervision
46 See Reineke (1998)
Institute for International Economics | httpwwwiiecom
124 WORLD CAPITAL MARKETS
assets) to cushion losses on those assets The second was to dull theirappetites for risk banks with large capital bases would have more tolose if they failed and therefore would take fewer risks
Rapid change in financial markets soon revealed flaws in the Basel IAccord In a complex world with numerous sources of risk it focusedheavily on credit risk but overlooked other risks in a bankrsquos portfolioand the correlation between returns on different asset classes The Baselformula required banks to maintain a fixed amount of capital againsteach of its asset classes But the formula did not distinguish the riskinessof the borrower within each class As a result one large loan to a low-risk corporate borrower such as General Electric would require the sameamount of capital as 10 smaller transactions with high-risk borrowers
The system was also biased toward short-term loans Loans maturingin less than a year required a 20 percent risk weight whereas those ma-turing after more than a year required a 100 percent risk weight Inter-bank lending was particularly favored For example loans to banks inOECD countries required less capital than loans to private firms in thesame countries creating the anomaly that interbank loans to South Ko-rean banks required less capital than loans to General Electric47 Thisanomaly encouraged banks to shed high-quality assets if the Basel rulesrequired the allocation of more capital than banks thought they needed
Another weakness was that financial innovators quickly circumventedthe Accord Because short-term loans required less provisioning than long-term loans banks responded by securitizing their long-term debt port-folios and lending short-term against the collateral of the newly createdasset This allowed banks to circumvent the capital requirements gearedto the terms of the underlying debt At the same time the Basel I Accordfailed to encourage risk mitigation techniques such as credit derivativescollateral guarantees and on-balance-sheet netting the flip side of fi-nancial innovation Because off-balance-sheet products were not coveredby the Accord another anomaly appeared when Barings Bank collapsedin 1995 Barings met capital adequacy standards but collapsed becauseits systems for managing risk failed traders were allowed to speculatein futures contracts that did not appear on the balance sheet
Basel II
Work to overhaul Basel I began in 1995 and produced consultativepapers issued in June 1999 and January 200148 These papers have been
47 South Korean banks have had notoriously weak balance sheets because the practiceof ldquodirected lendingrdquo left them with many poor loans (in making these loans the bankswere expected to follow government objectives rather than creditworthiness criteria)
48 Basel Committee on Banking Supervision (1999 2001)
Institute for International Economics | httpwwwiiecom
THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 125
the subject of extensive consultation and revision as a result the newAccord is expected to be introduced in 200449 The Basel II frameworkhas three parts (pillars) revisions to Basel I minimum-capital require-ments supervisory review criteria and greater emphasis on market dis-cipline Broadly Basel II aims to maintain the level of capital in the sys-tem but achieve better alignment of banksrsquo capital with their risk pro-files and keep up with financial innovation
To align capital requirements with market realities (the first pillar)Basel II concentrates on the 100 or so largest banksmdashthe type of playerslisted in table 21mdashand on the holding-company parents of banking groups50
Capital requirements will differentiate between an increased number ofcredit groups or ldquorisk bucketsrdquo including claims on governments otherbanks corporations mortgage-backed securities and other asset-backedsecurities
Basel II originally proposed to use external ratings to set capital chargesfor a number of these credit risks Many banks objected arguing thatthey assess credit risk better than Standard amp Poorrsquos Moodyrsquos or FitchIBCA51 Basel II thus proposes two approaches to rating a standard ap-proach using external ratings and an ldquoadvancedrdquo approach that allowsselected banks to use their own internal rating systems To encouragethe development of rigorous internal control systems based on these in-ternal rating systems Basel II also proposes to levy capital charges foroperational risk (the risk of direct or indirect loss resulting from inad-equate or failed internal processes people and systems or from exter-nal events)
Some critics of this proposal dismiss it as an abrogation of the prin-ciple of external independent monitoring and as ldquodangerously naiumlverdquo52
But regulators argue that the new capital charge on operational risk shouldoffset this concern It is also far from clear how cross-national compari-sons of rating and internal risk-assessment systems will be made (Engelen2000) The development by the European Union of its own capital rulescould well complicate the international resolution of these issues Publicassurances by EU officials in January 2001 however indicated that theirmain concerns are to create a level playing field and avoid regulatoryarbitrage (Hargreaves 2001) There is also the significant problem ofthe procyclical character of risk weights When a crisis hits losses are
49 See Berry (2000) for an update in an interview with William J McDonough chair ofthe Basel Committee on Banking Supervision
50 For obvious reasons these proposals are addressed to large banks and simpler capi-tal standards are allowed for small banks that focus on their domestic credit markets
51 See Ammer and Packer (2000) for an empirical critique of the success of rating agen-cies in distinguishing risk by sector and region
52 See Auerback (2001)
Institute for International Economics | httpwwwiiecom
126 WORLD CAPITAL MARKETS
incurred or accrued capital is lost and loan exposure must be reducedor securities sold to restore the requisite capital-adequacy ratios A morerisk-sensitive framework could amplify volatility
As the second pillar of Basel II supervisory review criteria are beingbeefed up to encourage supervisors to intervene earlier in potential problemsituations and to compel banks to align their capital positions with theirrisk profiles Bank supervisors will be authorized to require banks tohold capital in excess of minimum requirements if they have concernsabout general management overall strategy risk-management performanceor the macroeconomic environment Of course if one G-10 supervisorimposes higher capital requirements in isolation the same disparity willemerge that presaged Basel I Some banks will be disadvantaged in theinternational marketplace and will loudly complain that excessive super-vision is driving business to their competitors Hence close internationalcooperation among supervisors is critical
To implement the third pillar market discipline banks will be requiredto make fuller more timely disclosure of capital adequacy and the risksto which that capital is exposed A number of measures are being stud-ied that might help supervisors evaluate bank performance such as com-parisons of uninsured deposit interest rates subordinated debt yieldsand equity prices The idea is that these yields and prices might alertsupervisors to market perceptions of risk Of course market perceptionsare only as good as market information More direct and controversialways to reinforce market discipline would dramatically increase publicdisclosure of bank positions and risk management systems
Many questions are still outstanding about how to resolve the techni-cal details of capital requirements and whether the requirements willachieve their intended goal of better assessment and mitigation of therisks in banksrsquo portfolios There is no substitute for skilled supervisorsThe intricacies of effective design and implementation suggest that su-pervisors need to be highly competent technically knowledgeable aboutbanking portfolio characteristics and the factors that influence bank ex-posure to credit risk (Mishkin 2000) And they must be aided by vigilantshareholders market forces and transparency of information53
Standard setting at the global level is desirable but ultimately theeffectiveness of these efforts will be tested at the national level espe-cially in times of systemic financial distress Here the record of Basel Iwas not a bright shining success Japanese banking regulators havetraditionally allowed banks to include real estate and securities in theircapital base When the value of these assets plummeted in the early 1990sregulators allowed banks to continue valuing these depreciated (andoften bankrupt) assets at their old inflated levels Japanese authorities
53 Benedict Roth Complacency Towards Catastrophe Financial Times 23 January 2001
Institute for International Economics | httpwwwiiecom
THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 127
insisted until the mid-1990s that eroded capital bases could be rebuiltin a market-driven fashion They rightly foresaw that huge loan losseswould undermine public support for the ruling party and require a po-litically unpopular bailout
Japanese foot dragging on Basel I was the worst54 but not uniqueOther examples can be found of ldquopolitically mandated forbearancerdquo TheFederal Reserve Bank of New York held important hands during theLTCM crisis of 1998 Mexico is still resolving the banking crisis that eruptedin 1995 South Korea has not yet closed the insolvent banks that behavedso badly before the crisis of 1998 In the aftermath of a crisis nationalregulators cannot always be relied upon to discipline politically power-ful bankers55 One of the little-noticed consequences of these differingapproaches is that those banks with strong regulatory systems receivedan implicit ldquoexport subsidyrdquo for their services US banks which had notengaged extensively in emerging-market lending in the 1990s were bet-ter positioned than their German and Japanese counterparts to expandtheir international assets in the wake of the crises
Other Financial Forums
54 See Japanese Banks Fiddling while Marunouchi Burns The Economist 27 January2001 67-69
55 See Calomiris (1997)
The Basel model of vertical subsidiarity has already been extended toother financial regulatory bodies In 1993-94 the BIS established a Tri-partite Group of Banking Insurance and Securities Regulators In 1994-95 the BIS increased its cooperation with the International Organizationof Securities Commissions when the two organizations issued parallelpapers on guidelines for national regulators concerning risk managementand disclosure of derivative trades In 1996 a permanent Joint Forum onFinancial Conglomerates was established to examine supervisory issuesand develop working arrangements among the different functional super-visors of conglomerate institutions that offer combinations of bankingsecurities and insurance products Draft papers on the supervisionof conglomerates were released for comment in 1998 applying capital-adequacy principles to these groups and providing guidelines both forassessing the integrity and competence of top managers and for sharingassessments between regulators
In 1997 the Basel Committee on Banking Supervision extended itsreach beyond capital standards to broader aspects of banking supervi-sion with the publication of the Core Principles for Effective BankingSupervision In 1999 a wide range of regulatory and standard-settingbodies were gathered under the umbrella of the Financial Stability
Institute for International Economics | httpwwwiiecom
128 WORLD CAPITAL MARKETS
Forum (FSF) itself established under BIS aegis56 The FSF has alreadyissued recommendations for stepped-up supervision and transparencyas well as guidelines for best practices in a number of areas includingoffshore financial centers and highly leveraged institutions or hedge funds57
Conclusion
Although the structural weaknesses in emerging-market economies arewidely acknowledged to have been causal factors in international capi-tal-market volatility this chapter points to the role of large G-10 bankingorganizations as major suppliers of the most volatile instrument short-term debt We have examined evidence of the impact of public safetynets in the G-10 economiesmdashthe deposit insurance systems the pruden-tial supervisory systems and the lender-of-last-resort functions of centralbanksmdashon the incentive structures of these organizations
Although supervisors in most countries working nationally and to-gether in the BIS have made significant efforts to mimic market forcesin their prudential supervision the most sophisticated financial institu-tions find innovative ways to circumvent the rules New global regulatorybodies are not about to be created G-10 national bank regulators shouldthemselves address the short-term debt bias in the international financialsystem by changing incentive systems G-10 securities regulators shouldalso take steps to get ahead of the curve paying close attention to largeportfolio swings by institutional investors particularly in times of crisisIn short more needs to be done at national and international levels tochange the rules of the game That is the subject of the next chapter
56 The Financial Stability Forum includes banking securities insurance and accountingregulatory bodies the OECD on taxation corruption and corporate governance and theIMF
57 See Martin (2000)
Institute for International Economics | httpwwwiiecom
THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 121
the inflexibility of tight surveillance against the need to encourage in-novation and growth The US Securities and Exchange Commission isworried about aggressive accounting by firms and biased reports bysecurities analysts in an equity environment that prizes steadily higherquarterly earnings41 Japanese regulators are preoccupied with opaqueinterconnections between portfolio institutions banks and nonfinancialfirms through the keiretsu system Canadian regulators reeling from high-profile scandals of managers intentionally misleading investors are strengtheningmarket discipline through legal penalties aimed at managers and directorsof offending firms
When panic strikes a securities regulator cannot do much As the 1987stock market crash and the LTCM debacle in the fall of 1998 both dem-onstrated steep stock and bond price declines can create systemic risksIf severe enough the wealth effect of falling securities values and thefear of widespread insolvency can depress real activity Flooding thesystem with liquidity is a central bankerrsquos solutionmdashsomething a securi-ties regulator cannot do42 But just as financial supervisors can changethe incentive structure to discourage bankers from making risky loans ingood times so securities regulators can pay more attention to incentiveson the demand side when capital markets are strong
Prudential Supervision and InnovationmdashA Footnote
In concluding this discussion of prudential supervision in the G-10 anadditional point is worth noting National regulators face a persistenttrade-off between emphasizing financial system safety and soundnesswhile encouraging innovationmdashin spite of the added risks innovationbrings to financial markets Former US Treasury Secretary Lawrence Summers(2000 3) has argued by analogy
The jet airplane made airplane air travel more comfortable more efficient andmore safe though the accidents were more spectacular and for a time morenumerous after the jet was invented In the same way modern global financialmarkets carry with them enormous potential for benefit even if some of theaccidents are that much more spectacular As the right public policy response
41 The problem is illustrated by the divergence since mid-1998 between reported earn-ings by the Standard amp Poorrsquos (SampP) 500 and the after-tax profits of all corporations inthe national accounts Generally these two series move closely with one another Be-tween mid-1998 and mid-1999 SampP 500 reported that earnings increased by more than20 percent while after-tax profits of all corporations increased by less than 5 percent(Chase Bank US Economic and Policy Research US Weekly Prospects Chase SecuritiesWeekly Newsletter 5 June 2000 5)
42 For example the US Securities and Exchange Commission had no direct role in calmingmarkets in the 1987 or 1998 panics
Institute for International Economics | httpwwwiiecom
122 WORLD CAPITAL MARKETS
to the jet was longer runways better air-traffic control and better training forpilots and not the discouragement of rapid travel so the right public policyresponse to financial innovation is to assure a safe framework so that the ben-efits can be realized not to stifle the change
Accepting Summersrsquos analogy for the international financial system better-informed supervisors and investors are a necessary part of the financialsystem framework Supervisors require more timely information on therisk profiles resulting from positions taken by financial institutions Theyalso need a better understanding of risk-management systems Snapshotsof an institutionrsquos risk profile and risk-management procedures are nolonger adequate In a world where huge bets are quickly made (andpossibly lostmdashas with Barings Bank in 1995 and LTCM in 1998) super-visors must focus on the soundness of banking systems for evaluatingand managing risk on a daily basis Some progress has been made inaddressing these issues US banking examiners are extending their in-formation requirements in banking examinations and increasing theirinvolvement in large complex institutions43 More awareness is alsorequired of the fact that they are national organizations in a world ofcross-border capital flows To a much greater extent they need a multi-national reach International supervision and coordination among super-visors are the subject of the next section
Our analysis suggests that G-10 supervisors have unfinished businessBank supervisors need to start yesterday securities regulators can waituntil tomorrow One G-10 member acting alone cannot correct the biasIn good times the lending business will simply migrate to other G-10banks In bad times financial problems will not stop at the national bor-der A way has to be found to establish common international standardsfor the key financial players in order to prevent crises and to agree onapproaches for managing them The path has already been laid out Inthe wake of the bank failures of the past 25 years bank supervisors havetried to establish such standards They have done this without creating anew global institution
The essence of the international framework is decentralizationmdashglobalrules and design standards without global institutions that are perceivedto intrude on national sovereignty The awkward jargon for this frame-work is vertical subsidiaritymdashldquothink internationally act nationallyrdquo Theinternational thinking is done by a committee of regulators that meets
International SupervisionA Decentralized Framework
43 These issues are discussed in Ferguson (1999) and Meyer (2000a)
Institute for International Economics | httpwwwiiecom
THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 123
regularly at the Bank for International Settlements in Basel The commit-tee establishes principles and standards that are interpreted implementedand enforced by national authorities44 In this section we describe thesesupervisory efforts and their weaknesses We present our recommenda-tions for addressing these weaknesses in the next chapter
Basel I
The Basel Capital Accord of 1988 (Basel I)45 drew the lesson from thefinancial crises of the mid-1970s that more adequate capital levels in in-ternational banks would help reduce the systemic risk of bank failureThe primary goal of Basel I was capital adequacy other standards wereput in place not so much for their own virtue as to defend the primarygoal
Capital adequacy requirements were designed to ensure that individualinstitutions have the ability to absorb losses particularly credit lossesAccordingly a backup system of scoring credit risk was devised thatrequired large amounts of bank capital for some types of loans smalleramounts for others and zero for a select list of preferred assets Report-ing requirements were designed to disclose problems and ensure that atroubled bank would take timely steps to restore its capital base in thewake of a loss The Basel I framework worked tolerably well in limitingthe call on the public purse in the G-10 countriesmdashwith the notable ex-ceptions of France and Japan The framework failed to moderate riskybank lending to emerging markets however
Basel I was not developed with emerging markets in mind The origi-nal idea behind it was to develop a common supervisory approach tocross-border banking operations It grew out of political pressure fromUS lawmakers who were determined to require international banks op-erating in the United States to meet US banking standards Toward thisgoal in 1983 Congress passed the International Lending Supervisory ActUS and British banking authorities subsequently agreed on a commontarget the adoption of strict common capital-adequacy standards In 1988other G-10 governments agreed to go along voluntary acceptance ofthe standards throughout much of the rest of the world followed46 Therationale for the capital targets was two-fold The first was to requirebanks to hold sufficient amounts of capital (8 percent of risk-adjusted
44 The international committee of financial authorities agreed on a common definitionof banksrsquo tier-one or ldquocorerdquo capital national authorities defined tier-two capital in theirown manner which permitted greater variations in national working definitions andpractices
45 International Convergence of Capital Measurement and Capital Standards (BIS 1988)was prepared by the Basel Committee on Banking Supervision
46 See Reineke (1998)
Institute for International Economics | httpwwwiiecom
124 WORLD CAPITAL MARKETS
assets) to cushion losses on those assets The second was to dull theirappetites for risk banks with large capital bases would have more tolose if they failed and therefore would take fewer risks
Rapid change in financial markets soon revealed flaws in the Basel IAccord In a complex world with numerous sources of risk it focusedheavily on credit risk but overlooked other risks in a bankrsquos portfolioand the correlation between returns on different asset classes The Baselformula required banks to maintain a fixed amount of capital againsteach of its asset classes But the formula did not distinguish the riskinessof the borrower within each class As a result one large loan to a low-risk corporate borrower such as General Electric would require the sameamount of capital as 10 smaller transactions with high-risk borrowers
The system was also biased toward short-term loans Loans maturingin less than a year required a 20 percent risk weight whereas those ma-turing after more than a year required a 100 percent risk weight Inter-bank lending was particularly favored For example loans to banks inOECD countries required less capital than loans to private firms in thesame countries creating the anomaly that interbank loans to South Ko-rean banks required less capital than loans to General Electric47 Thisanomaly encouraged banks to shed high-quality assets if the Basel rulesrequired the allocation of more capital than banks thought they needed
Another weakness was that financial innovators quickly circumventedthe Accord Because short-term loans required less provisioning than long-term loans banks responded by securitizing their long-term debt port-folios and lending short-term against the collateral of the newly createdasset This allowed banks to circumvent the capital requirements gearedto the terms of the underlying debt At the same time the Basel I Accordfailed to encourage risk mitigation techniques such as credit derivativescollateral guarantees and on-balance-sheet netting the flip side of fi-nancial innovation Because off-balance-sheet products were not coveredby the Accord another anomaly appeared when Barings Bank collapsedin 1995 Barings met capital adequacy standards but collapsed becauseits systems for managing risk failed traders were allowed to speculatein futures contracts that did not appear on the balance sheet
Basel II
Work to overhaul Basel I began in 1995 and produced consultativepapers issued in June 1999 and January 200148 These papers have been
47 South Korean banks have had notoriously weak balance sheets because the practiceof ldquodirected lendingrdquo left them with many poor loans (in making these loans the bankswere expected to follow government objectives rather than creditworthiness criteria)
48 Basel Committee on Banking Supervision (1999 2001)
Institute for International Economics | httpwwwiiecom
THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 125
the subject of extensive consultation and revision as a result the newAccord is expected to be introduced in 200449 The Basel II frameworkhas three parts (pillars) revisions to Basel I minimum-capital require-ments supervisory review criteria and greater emphasis on market dis-cipline Broadly Basel II aims to maintain the level of capital in the sys-tem but achieve better alignment of banksrsquo capital with their risk pro-files and keep up with financial innovation
To align capital requirements with market realities (the first pillar)Basel II concentrates on the 100 or so largest banksmdashthe type of playerslisted in table 21mdashand on the holding-company parents of banking groups50
Capital requirements will differentiate between an increased number ofcredit groups or ldquorisk bucketsrdquo including claims on governments otherbanks corporations mortgage-backed securities and other asset-backedsecurities
Basel II originally proposed to use external ratings to set capital chargesfor a number of these credit risks Many banks objected arguing thatthey assess credit risk better than Standard amp Poorrsquos Moodyrsquos or FitchIBCA51 Basel II thus proposes two approaches to rating a standard ap-proach using external ratings and an ldquoadvancedrdquo approach that allowsselected banks to use their own internal rating systems To encouragethe development of rigorous internal control systems based on these in-ternal rating systems Basel II also proposes to levy capital charges foroperational risk (the risk of direct or indirect loss resulting from inad-equate or failed internal processes people and systems or from exter-nal events)
Some critics of this proposal dismiss it as an abrogation of the prin-ciple of external independent monitoring and as ldquodangerously naiumlverdquo52
But regulators argue that the new capital charge on operational risk shouldoffset this concern It is also far from clear how cross-national compari-sons of rating and internal risk-assessment systems will be made (Engelen2000) The development by the European Union of its own capital rulescould well complicate the international resolution of these issues Publicassurances by EU officials in January 2001 however indicated that theirmain concerns are to create a level playing field and avoid regulatoryarbitrage (Hargreaves 2001) There is also the significant problem ofthe procyclical character of risk weights When a crisis hits losses are
49 See Berry (2000) for an update in an interview with William J McDonough chair ofthe Basel Committee on Banking Supervision
50 For obvious reasons these proposals are addressed to large banks and simpler capi-tal standards are allowed for small banks that focus on their domestic credit markets
51 See Ammer and Packer (2000) for an empirical critique of the success of rating agen-cies in distinguishing risk by sector and region
52 See Auerback (2001)
Institute for International Economics | httpwwwiiecom
126 WORLD CAPITAL MARKETS
incurred or accrued capital is lost and loan exposure must be reducedor securities sold to restore the requisite capital-adequacy ratios A morerisk-sensitive framework could amplify volatility
As the second pillar of Basel II supervisory review criteria are beingbeefed up to encourage supervisors to intervene earlier in potential problemsituations and to compel banks to align their capital positions with theirrisk profiles Bank supervisors will be authorized to require banks tohold capital in excess of minimum requirements if they have concernsabout general management overall strategy risk-management performanceor the macroeconomic environment Of course if one G-10 supervisorimposes higher capital requirements in isolation the same disparity willemerge that presaged Basel I Some banks will be disadvantaged in theinternational marketplace and will loudly complain that excessive super-vision is driving business to their competitors Hence close internationalcooperation among supervisors is critical
To implement the third pillar market discipline banks will be requiredto make fuller more timely disclosure of capital adequacy and the risksto which that capital is exposed A number of measures are being stud-ied that might help supervisors evaluate bank performance such as com-parisons of uninsured deposit interest rates subordinated debt yieldsand equity prices The idea is that these yields and prices might alertsupervisors to market perceptions of risk Of course market perceptionsare only as good as market information More direct and controversialways to reinforce market discipline would dramatically increase publicdisclosure of bank positions and risk management systems
Many questions are still outstanding about how to resolve the techni-cal details of capital requirements and whether the requirements willachieve their intended goal of better assessment and mitigation of therisks in banksrsquo portfolios There is no substitute for skilled supervisorsThe intricacies of effective design and implementation suggest that su-pervisors need to be highly competent technically knowledgeable aboutbanking portfolio characteristics and the factors that influence bank ex-posure to credit risk (Mishkin 2000) And they must be aided by vigilantshareholders market forces and transparency of information53
Standard setting at the global level is desirable but ultimately theeffectiveness of these efforts will be tested at the national level espe-cially in times of systemic financial distress Here the record of Basel Iwas not a bright shining success Japanese banking regulators havetraditionally allowed banks to include real estate and securities in theircapital base When the value of these assets plummeted in the early 1990sregulators allowed banks to continue valuing these depreciated (andoften bankrupt) assets at their old inflated levels Japanese authorities
53 Benedict Roth Complacency Towards Catastrophe Financial Times 23 January 2001
Institute for International Economics | httpwwwiiecom
THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 127
insisted until the mid-1990s that eroded capital bases could be rebuiltin a market-driven fashion They rightly foresaw that huge loan losseswould undermine public support for the ruling party and require a po-litically unpopular bailout
Japanese foot dragging on Basel I was the worst54 but not uniqueOther examples can be found of ldquopolitically mandated forbearancerdquo TheFederal Reserve Bank of New York held important hands during theLTCM crisis of 1998 Mexico is still resolving the banking crisis that eruptedin 1995 South Korea has not yet closed the insolvent banks that behavedso badly before the crisis of 1998 In the aftermath of a crisis nationalregulators cannot always be relied upon to discipline politically power-ful bankers55 One of the little-noticed consequences of these differingapproaches is that those banks with strong regulatory systems receivedan implicit ldquoexport subsidyrdquo for their services US banks which had notengaged extensively in emerging-market lending in the 1990s were bet-ter positioned than their German and Japanese counterparts to expandtheir international assets in the wake of the crises
Other Financial Forums
54 See Japanese Banks Fiddling while Marunouchi Burns The Economist 27 January2001 67-69
55 See Calomiris (1997)
The Basel model of vertical subsidiarity has already been extended toother financial regulatory bodies In 1993-94 the BIS established a Tri-partite Group of Banking Insurance and Securities Regulators In 1994-95 the BIS increased its cooperation with the International Organizationof Securities Commissions when the two organizations issued parallelpapers on guidelines for national regulators concerning risk managementand disclosure of derivative trades In 1996 a permanent Joint Forum onFinancial Conglomerates was established to examine supervisory issuesand develop working arrangements among the different functional super-visors of conglomerate institutions that offer combinations of bankingsecurities and insurance products Draft papers on the supervisionof conglomerates were released for comment in 1998 applying capital-adequacy principles to these groups and providing guidelines both forassessing the integrity and competence of top managers and for sharingassessments between regulators
In 1997 the Basel Committee on Banking Supervision extended itsreach beyond capital standards to broader aspects of banking supervi-sion with the publication of the Core Principles for Effective BankingSupervision In 1999 a wide range of regulatory and standard-settingbodies were gathered under the umbrella of the Financial Stability
Institute for International Economics | httpwwwiiecom
128 WORLD CAPITAL MARKETS
Forum (FSF) itself established under BIS aegis56 The FSF has alreadyissued recommendations for stepped-up supervision and transparencyas well as guidelines for best practices in a number of areas includingoffshore financial centers and highly leveraged institutions or hedge funds57
Conclusion
Although the structural weaknesses in emerging-market economies arewidely acknowledged to have been causal factors in international capi-tal-market volatility this chapter points to the role of large G-10 bankingorganizations as major suppliers of the most volatile instrument short-term debt We have examined evidence of the impact of public safetynets in the G-10 economiesmdashthe deposit insurance systems the pruden-tial supervisory systems and the lender-of-last-resort functions of centralbanksmdashon the incentive structures of these organizations
Although supervisors in most countries working nationally and to-gether in the BIS have made significant efforts to mimic market forcesin their prudential supervision the most sophisticated financial institu-tions find innovative ways to circumvent the rules New global regulatorybodies are not about to be created G-10 national bank regulators shouldthemselves address the short-term debt bias in the international financialsystem by changing incentive systems G-10 securities regulators shouldalso take steps to get ahead of the curve paying close attention to largeportfolio swings by institutional investors particularly in times of crisisIn short more needs to be done at national and international levels tochange the rules of the game That is the subject of the next chapter
56 The Financial Stability Forum includes banking securities insurance and accountingregulatory bodies the OECD on taxation corruption and corporate governance and theIMF
57 See Martin (2000)
Institute for International Economics | httpwwwiiecom
122 WORLD CAPITAL MARKETS
to the jet was longer runways better air-traffic control and better training forpilots and not the discouragement of rapid travel so the right public policyresponse to financial innovation is to assure a safe framework so that the ben-efits can be realized not to stifle the change
Accepting Summersrsquos analogy for the international financial system better-informed supervisors and investors are a necessary part of the financialsystem framework Supervisors require more timely information on therisk profiles resulting from positions taken by financial institutions Theyalso need a better understanding of risk-management systems Snapshotsof an institutionrsquos risk profile and risk-management procedures are nolonger adequate In a world where huge bets are quickly made (andpossibly lostmdashas with Barings Bank in 1995 and LTCM in 1998) super-visors must focus on the soundness of banking systems for evaluatingand managing risk on a daily basis Some progress has been made inaddressing these issues US banking examiners are extending their in-formation requirements in banking examinations and increasing theirinvolvement in large complex institutions43 More awareness is alsorequired of the fact that they are national organizations in a world ofcross-border capital flows To a much greater extent they need a multi-national reach International supervision and coordination among super-visors are the subject of the next section
Our analysis suggests that G-10 supervisors have unfinished businessBank supervisors need to start yesterday securities regulators can waituntil tomorrow One G-10 member acting alone cannot correct the biasIn good times the lending business will simply migrate to other G-10banks In bad times financial problems will not stop at the national bor-der A way has to be found to establish common international standardsfor the key financial players in order to prevent crises and to agree onapproaches for managing them The path has already been laid out Inthe wake of the bank failures of the past 25 years bank supervisors havetried to establish such standards They have done this without creating anew global institution
The essence of the international framework is decentralizationmdashglobalrules and design standards without global institutions that are perceivedto intrude on national sovereignty The awkward jargon for this frame-work is vertical subsidiaritymdashldquothink internationally act nationallyrdquo Theinternational thinking is done by a committee of regulators that meets
International SupervisionA Decentralized Framework
43 These issues are discussed in Ferguson (1999) and Meyer (2000a)
Institute for International Economics | httpwwwiiecom
THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 123
regularly at the Bank for International Settlements in Basel The commit-tee establishes principles and standards that are interpreted implementedand enforced by national authorities44 In this section we describe thesesupervisory efforts and their weaknesses We present our recommenda-tions for addressing these weaknesses in the next chapter
Basel I
The Basel Capital Accord of 1988 (Basel I)45 drew the lesson from thefinancial crises of the mid-1970s that more adequate capital levels in in-ternational banks would help reduce the systemic risk of bank failureThe primary goal of Basel I was capital adequacy other standards wereput in place not so much for their own virtue as to defend the primarygoal
Capital adequacy requirements were designed to ensure that individualinstitutions have the ability to absorb losses particularly credit lossesAccordingly a backup system of scoring credit risk was devised thatrequired large amounts of bank capital for some types of loans smalleramounts for others and zero for a select list of preferred assets Report-ing requirements were designed to disclose problems and ensure that atroubled bank would take timely steps to restore its capital base in thewake of a loss The Basel I framework worked tolerably well in limitingthe call on the public purse in the G-10 countriesmdashwith the notable ex-ceptions of France and Japan The framework failed to moderate riskybank lending to emerging markets however
Basel I was not developed with emerging markets in mind The origi-nal idea behind it was to develop a common supervisory approach tocross-border banking operations It grew out of political pressure fromUS lawmakers who were determined to require international banks op-erating in the United States to meet US banking standards Toward thisgoal in 1983 Congress passed the International Lending Supervisory ActUS and British banking authorities subsequently agreed on a commontarget the adoption of strict common capital-adequacy standards In 1988other G-10 governments agreed to go along voluntary acceptance ofthe standards throughout much of the rest of the world followed46 Therationale for the capital targets was two-fold The first was to requirebanks to hold sufficient amounts of capital (8 percent of risk-adjusted
44 The international committee of financial authorities agreed on a common definitionof banksrsquo tier-one or ldquocorerdquo capital national authorities defined tier-two capital in theirown manner which permitted greater variations in national working definitions andpractices
45 International Convergence of Capital Measurement and Capital Standards (BIS 1988)was prepared by the Basel Committee on Banking Supervision
46 See Reineke (1998)
Institute for International Economics | httpwwwiiecom
124 WORLD CAPITAL MARKETS
assets) to cushion losses on those assets The second was to dull theirappetites for risk banks with large capital bases would have more tolose if they failed and therefore would take fewer risks
Rapid change in financial markets soon revealed flaws in the Basel IAccord In a complex world with numerous sources of risk it focusedheavily on credit risk but overlooked other risks in a bankrsquos portfolioand the correlation between returns on different asset classes The Baselformula required banks to maintain a fixed amount of capital againsteach of its asset classes But the formula did not distinguish the riskinessof the borrower within each class As a result one large loan to a low-risk corporate borrower such as General Electric would require the sameamount of capital as 10 smaller transactions with high-risk borrowers
The system was also biased toward short-term loans Loans maturingin less than a year required a 20 percent risk weight whereas those ma-turing after more than a year required a 100 percent risk weight Inter-bank lending was particularly favored For example loans to banks inOECD countries required less capital than loans to private firms in thesame countries creating the anomaly that interbank loans to South Ko-rean banks required less capital than loans to General Electric47 Thisanomaly encouraged banks to shed high-quality assets if the Basel rulesrequired the allocation of more capital than banks thought they needed
Another weakness was that financial innovators quickly circumventedthe Accord Because short-term loans required less provisioning than long-term loans banks responded by securitizing their long-term debt port-folios and lending short-term against the collateral of the newly createdasset This allowed banks to circumvent the capital requirements gearedto the terms of the underlying debt At the same time the Basel I Accordfailed to encourage risk mitigation techniques such as credit derivativescollateral guarantees and on-balance-sheet netting the flip side of fi-nancial innovation Because off-balance-sheet products were not coveredby the Accord another anomaly appeared when Barings Bank collapsedin 1995 Barings met capital adequacy standards but collapsed becauseits systems for managing risk failed traders were allowed to speculatein futures contracts that did not appear on the balance sheet
Basel II
Work to overhaul Basel I began in 1995 and produced consultativepapers issued in June 1999 and January 200148 These papers have been
47 South Korean banks have had notoriously weak balance sheets because the practiceof ldquodirected lendingrdquo left them with many poor loans (in making these loans the bankswere expected to follow government objectives rather than creditworthiness criteria)
48 Basel Committee on Banking Supervision (1999 2001)
Institute for International Economics | httpwwwiiecom
THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 125
the subject of extensive consultation and revision as a result the newAccord is expected to be introduced in 200449 The Basel II frameworkhas three parts (pillars) revisions to Basel I minimum-capital require-ments supervisory review criteria and greater emphasis on market dis-cipline Broadly Basel II aims to maintain the level of capital in the sys-tem but achieve better alignment of banksrsquo capital with their risk pro-files and keep up with financial innovation
To align capital requirements with market realities (the first pillar)Basel II concentrates on the 100 or so largest banksmdashthe type of playerslisted in table 21mdashand on the holding-company parents of banking groups50
Capital requirements will differentiate between an increased number ofcredit groups or ldquorisk bucketsrdquo including claims on governments otherbanks corporations mortgage-backed securities and other asset-backedsecurities
Basel II originally proposed to use external ratings to set capital chargesfor a number of these credit risks Many banks objected arguing thatthey assess credit risk better than Standard amp Poorrsquos Moodyrsquos or FitchIBCA51 Basel II thus proposes two approaches to rating a standard ap-proach using external ratings and an ldquoadvancedrdquo approach that allowsselected banks to use their own internal rating systems To encouragethe development of rigorous internal control systems based on these in-ternal rating systems Basel II also proposes to levy capital charges foroperational risk (the risk of direct or indirect loss resulting from inad-equate or failed internal processes people and systems or from exter-nal events)
Some critics of this proposal dismiss it as an abrogation of the prin-ciple of external independent monitoring and as ldquodangerously naiumlverdquo52
But regulators argue that the new capital charge on operational risk shouldoffset this concern It is also far from clear how cross-national compari-sons of rating and internal risk-assessment systems will be made (Engelen2000) The development by the European Union of its own capital rulescould well complicate the international resolution of these issues Publicassurances by EU officials in January 2001 however indicated that theirmain concerns are to create a level playing field and avoid regulatoryarbitrage (Hargreaves 2001) There is also the significant problem ofthe procyclical character of risk weights When a crisis hits losses are
49 See Berry (2000) for an update in an interview with William J McDonough chair ofthe Basel Committee on Banking Supervision
50 For obvious reasons these proposals are addressed to large banks and simpler capi-tal standards are allowed for small banks that focus on their domestic credit markets
51 See Ammer and Packer (2000) for an empirical critique of the success of rating agen-cies in distinguishing risk by sector and region
52 See Auerback (2001)
Institute for International Economics | httpwwwiiecom
126 WORLD CAPITAL MARKETS
incurred or accrued capital is lost and loan exposure must be reducedor securities sold to restore the requisite capital-adequacy ratios A morerisk-sensitive framework could amplify volatility
As the second pillar of Basel II supervisory review criteria are beingbeefed up to encourage supervisors to intervene earlier in potential problemsituations and to compel banks to align their capital positions with theirrisk profiles Bank supervisors will be authorized to require banks tohold capital in excess of minimum requirements if they have concernsabout general management overall strategy risk-management performanceor the macroeconomic environment Of course if one G-10 supervisorimposes higher capital requirements in isolation the same disparity willemerge that presaged Basel I Some banks will be disadvantaged in theinternational marketplace and will loudly complain that excessive super-vision is driving business to their competitors Hence close internationalcooperation among supervisors is critical
To implement the third pillar market discipline banks will be requiredto make fuller more timely disclosure of capital adequacy and the risksto which that capital is exposed A number of measures are being stud-ied that might help supervisors evaluate bank performance such as com-parisons of uninsured deposit interest rates subordinated debt yieldsand equity prices The idea is that these yields and prices might alertsupervisors to market perceptions of risk Of course market perceptionsare only as good as market information More direct and controversialways to reinforce market discipline would dramatically increase publicdisclosure of bank positions and risk management systems
Many questions are still outstanding about how to resolve the techni-cal details of capital requirements and whether the requirements willachieve their intended goal of better assessment and mitigation of therisks in banksrsquo portfolios There is no substitute for skilled supervisorsThe intricacies of effective design and implementation suggest that su-pervisors need to be highly competent technically knowledgeable aboutbanking portfolio characteristics and the factors that influence bank ex-posure to credit risk (Mishkin 2000) And they must be aided by vigilantshareholders market forces and transparency of information53
Standard setting at the global level is desirable but ultimately theeffectiveness of these efforts will be tested at the national level espe-cially in times of systemic financial distress Here the record of Basel Iwas not a bright shining success Japanese banking regulators havetraditionally allowed banks to include real estate and securities in theircapital base When the value of these assets plummeted in the early 1990sregulators allowed banks to continue valuing these depreciated (andoften bankrupt) assets at their old inflated levels Japanese authorities
53 Benedict Roth Complacency Towards Catastrophe Financial Times 23 January 2001
Institute for International Economics | httpwwwiiecom
THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 127
insisted until the mid-1990s that eroded capital bases could be rebuiltin a market-driven fashion They rightly foresaw that huge loan losseswould undermine public support for the ruling party and require a po-litically unpopular bailout
Japanese foot dragging on Basel I was the worst54 but not uniqueOther examples can be found of ldquopolitically mandated forbearancerdquo TheFederal Reserve Bank of New York held important hands during theLTCM crisis of 1998 Mexico is still resolving the banking crisis that eruptedin 1995 South Korea has not yet closed the insolvent banks that behavedso badly before the crisis of 1998 In the aftermath of a crisis nationalregulators cannot always be relied upon to discipline politically power-ful bankers55 One of the little-noticed consequences of these differingapproaches is that those banks with strong regulatory systems receivedan implicit ldquoexport subsidyrdquo for their services US banks which had notengaged extensively in emerging-market lending in the 1990s were bet-ter positioned than their German and Japanese counterparts to expandtheir international assets in the wake of the crises
Other Financial Forums
54 See Japanese Banks Fiddling while Marunouchi Burns The Economist 27 January2001 67-69
55 See Calomiris (1997)
The Basel model of vertical subsidiarity has already been extended toother financial regulatory bodies In 1993-94 the BIS established a Tri-partite Group of Banking Insurance and Securities Regulators In 1994-95 the BIS increased its cooperation with the International Organizationof Securities Commissions when the two organizations issued parallelpapers on guidelines for national regulators concerning risk managementand disclosure of derivative trades In 1996 a permanent Joint Forum onFinancial Conglomerates was established to examine supervisory issuesand develop working arrangements among the different functional super-visors of conglomerate institutions that offer combinations of bankingsecurities and insurance products Draft papers on the supervisionof conglomerates were released for comment in 1998 applying capital-adequacy principles to these groups and providing guidelines both forassessing the integrity and competence of top managers and for sharingassessments between regulators
In 1997 the Basel Committee on Banking Supervision extended itsreach beyond capital standards to broader aspects of banking supervi-sion with the publication of the Core Principles for Effective BankingSupervision In 1999 a wide range of regulatory and standard-settingbodies were gathered under the umbrella of the Financial Stability
Institute for International Economics | httpwwwiiecom
128 WORLD CAPITAL MARKETS
Forum (FSF) itself established under BIS aegis56 The FSF has alreadyissued recommendations for stepped-up supervision and transparencyas well as guidelines for best practices in a number of areas includingoffshore financial centers and highly leveraged institutions or hedge funds57
Conclusion
Although the structural weaknesses in emerging-market economies arewidely acknowledged to have been causal factors in international capi-tal-market volatility this chapter points to the role of large G-10 bankingorganizations as major suppliers of the most volatile instrument short-term debt We have examined evidence of the impact of public safetynets in the G-10 economiesmdashthe deposit insurance systems the pruden-tial supervisory systems and the lender-of-last-resort functions of centralbanksmdashon the incentive structures of these organizations
Although supervisors in most countries working nationally and to-gether in the BIS have made significant efforts to mimic market forcesin their prudential supervision the most sophisticated financial institu-tions find innovative ways to circumvent the rules New global regulatorybodies are not about to be created G-10 national bank regulators shouldthemselves address the short-term debt bias in the international financialsystem by changing incentive systems G-10 securities regulators shouldalso take steps to get ahead of the curve paying close attention to largeportfolio swings by institutional investors particularly in times of crisisIn short more needs to be done at national and international levels tochange the rules of the game That is the subject of the next chapter
56 The Financial Stability Forum includes banking securities insurance and accountingregulatory bodies the OECD on taxation corruption and corporate governance and theIMF
57 See Martin (2000)
Institute for International Economics | httpwwwiiecom
THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 123
regularly at the Bank for International Settlements in Basel The commit-tee establishes principles and standards that are interpreted implementedand enforced by national authorities44 In this section we describe thesesupervisory efforts and their weaknesses We present our recommenda-tions for addressing these weaknesses in the next chapter
Basel I
The Basel Capital Accord of 1988 (Basel I)45 drew the lesson from thefinancial crises of the mid-1970s that more adequate capital levels in in-ternational banks would help reduce the systemic risk of bank failureThe primary goal of Basel I was capital adequacy other standards wereput in place not so much for their own virtue as to defend the primarygoal
Capital adequacy requirements were designed to ensure that individualinstitutions have the ability to absorb losses particularly credit lossesAccordingly a backup system of scoring credit risk was devised thatrequired large amounts of bank capital for some types of loans smalleramounts for others and zero for a select list of preferred assets Report-ing requirements were designed to disclose problems and ensure that atroubled bank would take timely steps to restore its capital base in thewake of a loss The Basel I framework worked tolerably well in limitingthe call on the public purse in the G-10 countriesmdashwith the notable ex-ceptions of France and Japan The framework failed to moderate riskybank lending to emerging markets however
Basel I was not developed with emerging markets in mind The origi-nal idea behind it was to develop a common supervisory approach tocross-border banking operations It grew out of political pressure fromUS lawmakers who were determined to require international banks op-erating in the United States to meet US banking standards Toward thisgoal in 1983 Congress passed the International Lending Supervisory ActUS and British banking authorities subsequently agreed on a commontarget the adoption of strict common capital-adequacy standards In 1988other G-10 governments agreed to go along voluntary acceptance ofthe standards throughout much of the rest of the world followed46 Therationale for the capital targets was two-fold The first was to requirebanks to hold sufficient amounts of capital (8 percent of risk-adjusted
44 The international committee of financial authorities agreed on a common definitionof banksrsquo tier-one or ldquocorerdquo capital national authorities defined tier-two capital in theirown manner which permitted greater variations in national working definitions andpractices
45 International Convergence of Capital Measurement and Capital Standards (BIS 1988)was prepared by the Basel Committee on Banking Supervision
46 See Reineke (1998)
Institute for International Economics | httpwwwiiecom
124 WORLD CAPITAL MARKETS
assets) to cushion losses on those assets The second was to dull theirappetites for risk banks with large capital bases would have more tolose if they failed and therefore would take fewer risks
Rapid change in financial markets soon revealed flaws in the Basel IAccord In a complex world with numerous sources of risk it focusedheavily on credit risk but overlooked other risks in a bankrsquos portfolioand the correlation between returns on different asset classes The Baselformula required banks to maintain a fixed amount of capital againsteach of its asset classes But the formula did not distinguish the riskinessof the borrower within each class As a result one large loan to a low-risk corporate borrower such as General Electric would require the sameamount of capital as 10 smaller transactions with high-risk borrowers
The system was also biased toward short-term loans Loans maturingin less than a year required a 20 percent risk weight whereas those ma-turing after more than a year required a 100 percent risk weight Inter-bank lending was particularly favored For example loans to banks inOECD countries required less capital than loans to private firms in thesame countries creating the anomaly that interbank loans to South Ko-rean banks required less capital than loans to General Electric47 Thisanomaly encouraged banks to shed high-quality assets if the Basel rulesrequired the allocation of more capital than banks thought they needed
Another weakness was that financial innovators quickly circumventedthe Accord Because short-term loans required less provisioning than long-term loans banks responded by securitizing their long-term debt port-folios and lending short-term against the collateral of the newly createdasset This allowed banks to circumvent the capital requirements gearedto the terms of the underlying debt At the same time the Basel I Accordfailed to encourage risk mitigation techniques such as credit derivativescollateral guarantees and on-balance-sheet netting the flip side of fi-nancial innovation Because off-balance-sheet products were not coveredby the Accord another anomaly appeared when Barings Bank collapsedin 1995 Barings met capital adequacy standards but collapsed becauseits systems for managing risk failed traders were allowed to speculatein futures contracts that did not appear on the balance sheet
Basel II
Work to overhaul Basel I began in 1995 and produced consultativepapers issued in June 1999 and January 200148 These papers have been
47 South Korean banks have had notoriously weak balance sheets because the practiceof ldquodirected lendingrdquo left them with many poor loans (in making these loans the bankswere expected to follow government objectives rather than creditworthiness criteria)
48 Basel Committee on Banking Supervision (1999 2001)
Institute for International Economics | httpwwwiiecom
THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 125
the subject of extensive consultation and revision as a result the newAccord is expected to be introduced in 200449 The Basel II frameworkhas three parts (pillars) revisions to Basel I minimum-capital require-ments supervisory review criteria and greater emphasis on market dis-cipline Broadly Basel II aims to maintain the level of capital in the sys-tem but achieve better alignment of banksrsquo capital with their risk pro-files and keep up with financial innovation
To align capital requirements with market realities (the first pillar)Basel II concentrates on the 100 or so largest banksmdashthe type of playerslisted in table 21mdashand on the holding-company parents of banking groups50
Capital requirements will differentiate between an increased number ofcredit groups or ldquorisk bucketsrdquo including claims on governments otherbanks corporations mortgage-backed securities and other asset-backedsecurities
Basel II originally proposed to use external ratings to set capital chargesfor a number of these credit risks Many banks objected arguing thatthey assess credit risk better than Standard amp Poorrsquos Moodyrsquos or FitchIBCA51 Basel II thus proposes two approaches to rating a standard ap-proach using external ratings and an ldquoadvancedrdquo approach that allowsselected banks to use their own internal rating systems To encouragethe development of rigorous internal control systems based on these in-ternal rating systems Basel II also proposes to levy capital charges foroperational risk (the risk of direct or indirect loss resulting from inad-equate or failed internal processes people and systems or from exter-nal events)
Some critics of this proposal dismiss it as an abrogation of the prin-ciple of external independent monitoring and as ldquodangerously naiumlverdquo52
But regulators argue that the new capital charge on operational risk shouldoffset this concern It is also far from clear how cross-national compari-sons of rating and internal risk-assessment systems will be made (Engelen2000) The development by the European Union of its own capital rulescould well complicate the international resolution of these issues Publicassurances by EU officials in January 2001 however indicated that theirmain concerns are to create a level playing field and avoid regulatoryarbitrage (Hargreaves 2001) There is also the significant problem ofthe procyclical character of risk weights When a crisis hits losses are
49 See Berry (2000) for an update in an interview with William J McDonough chair ofthe Basel Committee on Banking Supervision
50 For obvious reasons these proposals are addressed to large banks and simpler capi-tal standards are allowed for small banks that focus on their domestic credit markets
51 See Ammer and Packer (2000) for an empirical critique of the success of rating agen-cies in distinguishing risk by sector and region
52 See Auerback (2001)
Institute for International Economics | httpwwwiiecom
126 WORLD CAPITAL MARKETS
incurred or accrued capital is lost and loan exposure must be reducedor securities sold to restore the requisite capital-adequacy ratios A morerisk-sensitive framework could amplify volatility
As the second pillar of Basel II supervisory review criteria are beingbeefed up to encourage supervisors to intervene earlier in potential problemsituations and to compel banks to align their capital positions with theirrisk profiles Bank supervisors will be authorized to require banks tohold capital in excess of minimum requirements if they have concernsabout general management overall strategy risk-management performanceor the macroeconomic environment Of course if one G-10 supervisorimposes higher capital requirements in isolation the same disparity willemerge that presaged Basel I Some banks will be disadvantaged in theinternational marketplace and will loudly complain that excessive super-vision is driving business to their competitors Hence close internationalcooperation among supervisors is critical
To implement the third pillar market discipline banks will be requiredto make fuller more timely disclosure of capital adequacy and the risksto which that capital is exposed A number of measures are being stud-ied that might help supervisors evaluate bank performance such as com-parisons of uninsured deposit interest rates subordinated debt yieldsand equity prices The idea is that these yields and prices might alertsupervisors to market perceptions of risk Of course market perceptionsare only as good as market information More direct and controversialways to reinforce market discipline would dramatically increase publicdisclosure of bank positions and risk management systems
Many questions are still outstanding about how to resolve the techni-cal details of capital requirements and whether the requirements willachieve their intended goal of better assessment and mitigation of therisks in banksrsquo portfolios There is no substitute for skilled supervisorsThe intricacies of effective design and implementation suggest that su-pervisors need to be highly competent technically knowledgeable aboutbanking portfolio characteristics and the factors that influence bank ex-posure to credit risk (Mishkin 2000) And they must be aided by vigilantshareholders market forces and transparency of information53
Standard setting at the global level is desirable but ultimately theeffectiveness of these efforts will be tested at the national level espe-cially in times of systemic financial distress Here the record of Basel Iwas not a bright shining success Japanese banking regulators havetraditionally allowed banks to include real estate and securities in theircapital base When the value of these assets plummeted in the early 1990sregulators allowed banks to continue valuing these depreciated (andoften bankrupt) assets at their old inflated levels Japanese authorities
53 Benedict Roth Complacency Towards Catastrophe Financial Times 23 January 2001
Institute for International Economics | httpwwwiiecom
THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 127
insisted until the mid-1990s that eroded capital bases could be rebuiltin a market-driven fashion They rightly foresaw that huge loan losseswould undermine public support for the ruling party and require a po-litically unpopular bailout
Japanese foot dragging on Basel I was the worst54 but not uniqueOther examples can be found of ldquopolitically mandated forbearancerdquo TheFederal Reserve Bank of New York held important hands during theLTCM crisis of 1998 Mexico is still resolving the banking crisis that eruptedin 1995 South Korea has not yet closed the insolvent banks that behavedso badly before the crisis of 1998 In the aftermath of a crisis nationalregulators cannot always be relied upon to discipline politically power-ful bankers55 One of the little-noticed consequences of these differingapproaches is that those banks with strong regulatory systems receivedan implicit ldquoexport subsidyrdquo for their services US banks which had notengaged extensively in emerging-market lending in the 1990s were bet-ter positioned than their German and Japanese counterparts to expandtheir international assets in the wake of the crises
Other Financial Forums
54 See Japanese Banks Fiddling while Marunouchi Burns The Economist 27 January2001 67-69
55 See Calomiris (1997)
The Basel model of vertical subsidiarity has already been extended toother financial regulatory bodies In 1993-94 the BIS established a Tri-partite Group of Banking Insurance and Securities Regulators In 1994-95 the BIS increased its cooperation with the International Organizationof Securities Commissions when the two organizations issued parallelpapers on guidelines for national regulators concerning risk managementand disclosure of derivative trades In 1996 a permanent Joint Forum onFinancial Conglomerates was established to examine supervisory issuesand develop working arrangements among the different functional super-visors of conglomerate institutions that offer combinations of bankingsecurities and insurance products Draft papers on the supervisionof conglomerates were released for comment in 1998 applying capital-adequacy principles to these groups and providing guidelines both forassessing the integrity and competence of top managers and for sharingassessments between regulators
In 1997 the Basel Committee on Banking Supervision extended itsreach beyond capital standards to broader aspects of banking supervi-sion with the publication of the Core Principles for Effective BankingSupervision In 1999 a wide range of regulatory and standard-settingbodies were gathered under the umbrella of the Financial Stability
Institute for International Economics | httpwwwiiecom
128 WORLD CAPITAL MARKETS
Forum (FSF) itself established under BIS aegis56 The FSF has alreadyissued recommendations for stepped-up supervision and transparencyas well as guidelines for best practices in a number of areas includingoffshore financial centers and highly leveraged institutions or hedge funds57
Conclusion
Although the structural weaknesses in emerging-market economies arewidely acknowledged to have been causal factors in international capi-tal-market volatility this chapter points to the role of large G-10 bankingorganizations as major suppliers of the most volatile instrument short-term debt We have examined evidence of the impact of public safetynets in the G-10 economiesmdashthe deposit insurance systems the pruden-tial supervisory systems and the lender-of-last-resort functions of centralbanksmdashon the incentive structures of these organizations
Although supervisors in most countries working nationally and to-gether in the BIS have made significant efforts to mimic market forcesin their prudential supervision the most sophisticated financial institu-tions find innovative ways to circumvent the rules New global regulatorybodies are not about to be created G-10 national bank regulators shouldthemselves address the short-term debt bias in the international financialsystem by changing incentive systems G-10 securities regulators shouldalso take steps to get ahead of the curve paying close attention to largeportfolio swings by institutional investors particularly in times of crisisIn short more needs to be done at national and international levels tochange the rules of the game That is the subject of the next chapter
56 The Financial Stability Forum includes banking securities insurance and accountingregulatory bodies the OECD on taxation corruption and corporate governance and theIMF
57 See Martin (2000)
Institute for International Economics | httpwwwiiecom
124 WORLD CAPITAL MARKETS
assets) to cushion losses on those assets The second was to dull theirappetites for risk banks with large capital bases would have more tolose if they failed and therefore would take fewer risks
Rapid change in financial markets soon revealed flaws in the Basel IAccord In a complex world with numerous sources of risk it focusedheavily on credit risk but overlooked other risks in a bankrsquos portfolioand the correlation between returns on different asset classes The Baselformula required banks to maintain a fixed amount of capital againsteach of its asset classes But the formula did not distinguish the riskinessof the borrower within each class As a result one large loan to a low-risk corporate borrower such as General Electric would require the sameamount of capital as 10 smaller transactions with high-risk borrowers
The system was also biased toward short-term loans Loans maturingin less than a year required a 20 percent risk weight whereas those ma-turing after more than a year required a 100 percent risk weight Inter-bank lending was particularly favored For example loans to banks inOECD countries required less capital than loans to private firms in thesame countries creating the anomaly that interbank loans to South Ko-rean banks required less capital than loans to General Electric47 Thisanomaly encouraged banks to shed high-quality assets if the Basel rulesrequired the allocation of more capital than banks thought they needed
Another weakness was that financial innovators quickly circumventedthe Accord Because short-term loans required less provisioning than long-term loans banks responded by securitizing their long-term debt port-folios and lending short-term against the collateral of the newly createdasset This allowed banks to circumvent the capital requirements gearedto the terms of the underlying debt At the same time the Basel I Accordfailed to encourage risk mitigation techniques such as credit derivativescollateral guarantees and on-balance-sheet netting the flip side of fi-nancial innovation Because off-balance-sheet products were not coveredby the Accord another anomaly appeared when Barings Bank collapsedin 1995 Barings met capital adequacy standards but collapsed becauseits systems for managing risk failed traders were allowed to speculatein futures contracts that did not appear on the balance sheet
Basel II
Work to overhaul Basel I began in 1995 and produced consultativepapers issued in June 1999 and January 200148 These papers have been
47 South Korean banks have had notoriously weak balance sheets because the practiceof ldquodirected lendingrdquo left them with many poor loans (in making these loans the bankswere expected to follow government objectives rather than creditworthiness criteria)
48 Basel Committee on Banking Supervision (1999 2001)
Institute for International Economics | httpwwwiiecom
THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 125
the subject of extensive consultation and revision as a result the newAccord is expected to be introduced in 200449 The Basel II frameworkhas three parts (pillars) revisions to Basel I minimum-capital require-ments supervisory review criteria and greater emphasis on market dis-cipline Broadly Basel II aims to maintain the level of capital in the sys-tem but achieve better alignment of banksrsquo capital with their risk pro-files and keep up with financial innovation
To align capital requirements with market realities (the first pillar)Basel II concentrates on the 100 or so largest banksmdashthe type of playerslisted in table 21mdashand on the holding-company parents of banking groups50
Capital requirements will differentiate between an increased number ofcredit groups or ldquorisk bucketsrdquo including claims on governments otherbanks corporations mortgage-backed securities and other asset-backedsecurities
Basel II originally proposed to use external ratings to set capital chargesfor a number of these credit risks Many banks objected arguing thatthey assess credit risk better than Standard amp Poorrsquos Moodyrsquos or FitchIBCA51 Basel II thus proposes two approaches to rating a standard ap-proach using external ratings and an ldquoadvancedrdquo approach that allowsselected banks to use their own internal rating systems To encouragethe development of rigorous internal control systems based on these in-ternal rating systems Basel II also proposes to levy capital charges foroperational risk (the risk of direct or indirect loss resulting from inad-equate or failed internal processes people and systems or from exter-nal events)
Some critics of this proposal dismiss it as an abrogation of the prin-ciple of external independent monitoring and as ldquodangerously naiumlverdquo52
But regulators argue that the new capital charge on operational risk shouldoffset this concern It is also far from clear how cross-national compari-sons of rating and internal risk-assessment systems will be made (Engelen2000) The development by the European Union of its own capital rulescould well complicate the international resolution of these issues Publicassurances by EU officials in January 2001 however indicated that theirmain concerns are to create a level playing field and avoid regulatoryarbitrage (Hargreaves 2001) There is also the significant problem ofthe procyclical character of risk weights When a crisis hits losses are
49 See Berry (2000) for an update in an interview with William J McDonough chair ofthe Basel Committee on Banking Supervision
50 For obvious reasons these proposals are addressed to large banks and simpler capi-tal standards are allowed for small banks that focus on their domestic credit markets
51 See Ammer and Packer (2000) for an empirical critique of the success of rating agen-cies in distinguishing risk by sector and region
52 See Auerback (2001)
Institute for International Economics | httpwwwiiecom
126 WORLD CAPITAL MARKETS
incurred or accrued capital is lost and loan exposure must be reducedor securities sold to restore the requisite capital-adequacy ratios A morerisk-sensitive framework could amplify volatility
As the second pillar of Basel II supervisory review criteria are beingbeefed up to encourage supervisors to intervene earlier in potential problemsituations and to compel banks to align their capital positions with theirrisk profiles Bank supervisors will be authorized to require banks tohold capital in excess of minimum requirements if they have concernsabout general management overall strategy risk-management performanceor the macroeconomic environment Of course if one G-10 supervisorimposes higher capital requirements in isolation the same disparity willemerge that presaged Basel I Some banks will be disadvantaged in theinternational marketplace and will loudly complain that excessive super-vision is driving business to their competitors Hence close internationalcooperation among supervisors is critical
To implement the third pillar market discipline banks will be requiredto make fuller more timely disclosure of capital adequacy and the risksto which that capital is exposed A number of measures are being stud-ied that might help supervisors evaluate bank performance such as com-parisons of uninsured deposit interest rates subordinated debt yieldsand equity prices The idea is that these yields and prices might alertsupervisors to market perceptions of risk Of course market perceptionsare only as good as market information More direct and controversialways to reinforce market discipline would dramatically increase publicdisclosure of bank positions and risk management systems
Many questions are still outstanding about how to resolve the techni-cal details of capital requirements and whether the requirements willachieve their intended goal of better assessment and mitigation of therisks in banksrsquo portfolios There is no substitute for skilled supervisorsThe intricacies of effective design and implementation suggest that su-pervisors need to be highly competent technically knowledgeable aboutbanking portfolio characteristics and the factors that influence bank ex-posure to credit risk (Mishkin 2000) And they must be aided by vigilantshareholders market forces and transparency of information53
Standard setting at the global level is desirable but ultimately theeffectiveness of these efforts will be tested at the national level espe-cially in times of systemic financial distress Here the record of Basel Iwas not a bright shining success Japanese banking regulators havetraditionally allowed banks to include real estate and securities in theircapital base When the value of these assets plummeted in the early 1990sregulators allowed banks to continue valuing these depreciated (andoften bankrupt) assets at their old inflated levels Japanese authorities
53 Benedict Roth Complacency Towards Catastrophe Financial Times 23 January 2001
Institute for International Economics | httpwwwiiecom
THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 127
insisted until the mid-1990s that eroded capital bases could be rebuiltin a market-driven fashion They rightly foresaw that huge loan losseswould undermine public support for the ruling party and require a po-litically unpopular bailout
Japanese foot dragging on Basel I was the worst54 but not uniqueOther examples can be found of ldquopolitically mandated forbearancerdquo TheFederal Reserve Bank of New York held important hands during theLTCM crisis of 1998 Mexico is still resolving the banking crisis that eruptedin 1995 South Korea has not yet closed the insolvent banks that behavedso badly before the crisis of 1998 In the aftermath of a crisis nationalregulators cannot always be relied upon to discipline politically power-ful bankers55 One of the little-noticed consequences of these differingapproaches is that those banks with strong regulatory systems receivedan implicit ldquoexport subsidyrdquo for their services US banks which had notengaged extensively in emerging-market lending in the 1990s were bet-ter positioned than their German and Japanese counterparts to expandtheir international assets in the wake of the crises
Other Financial Forums
54 See Japanese Banks Fiddling while Marunouchi Burns The Economist 27 January2001 67-69
55 See Calomiris (1997)
The Basel model of vertical subsidiarity has already been extended toother financial regulatory bodies In 1993-94 the BIS established a Tri-partite Group of Banking Insurance and Securities Regulators In 1994-95 the BIS increased its cooperation with the International Organizationof Securities Commissions when the two organizations issued parallelpapers on guidelines for national regulators concerning risk managementand disclosure of derivative trades In 1996 a permanent Joint Forum onFinancial Conglomerates was established to examine supervisory issuesand develop working arrangements among the different functional super-visors of conglomerate institutions that offer combinations of bankingsecurities and insurance products Draft papers on the supervisionof conglomerates were released for comment in 1998 applying capital-adequacy principles to these groups and providing guidelines both forassessing the integrity and competence of top managers and for sharingassessments between regulators
In 1997 the Basel Committee on Banking Supervision extended itsreach beyond capital standards to broader aspects of banking supervi-sion with the publication of the Core Principles for Effective BankingSupervision In 1999 a wide range of regulatory and standard-settingbodies were gathered under the umbrella of the Financial Stability
Institute for International Economics | httpwwwiiecom
128 WORLD CAPITAL MARKETS
Forum (FSF) itself established under BIS aegis56 The FSF has alreadyissued recommendations for stepped-up supervision and transparencyas well as guidelines for best practices in a number of areas includingoffshore financial centers and highly leveraged institutions or hedge funds57
Conclusion
Although the structural weaknesses in emerging-market economies arewidely acknowledged to have been causal factors in international capi-tal-market volatility this chapter points to the role of large G-10 bankingorganizations as major suppliers of the most volatile instrument short-term debt We have examined evidence of the impact of public safetynets in the G-10 economiesmdashthe deposit insurance systems the pruden-tial supervisory systems and the lender-of-last-resort functions of centralbanksmdashon the incentive structures of these organizations
Although supervisors in most countries working nationally and to-gether in the BIS have made significant efforts to mimic market forcesin their prudential supervision the most sophisticated financial institu-tions find innovative ways to circumvent the rules New global regulatorybodies are not about to be created G-10 national bank regulators shouldthemselves address the short-term debt bias in the international financialsystem by changing incentive systems G-10 securities regulators shouldalso take steps to get ahead of the curve paying close attention to largeportfolio swings by institutional investors particularly in times of crisisIn short more needs to be done at national and international levels tochange the rules of the game That is the subject of the next chapter
56 The Financial Stability Forum includes banking securities insurance and accountingregulatory bodies the OECD on taxation corruption and corporate governance and theIMF
57 See Martin (2000)
Institute for International Economics | httpwwwiiecom
THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 125
the subject of extensive consultation and revision as a result the newAccord is expected to be introduced in 200449 The Basel II frameworkhas three parts (pillars) revisions to Basel I minimum-capital require-ments supervisory review criteria and greater emphasis on market dis-cipline Broadly Basel II aims to maintain the level of capital in the sys-tem but achieve better alignment of banksrsquo capital with their risk pro-files and keep up with financial innovation
To align capital requirements with market realities (the first pillar)Basel II concentrates on the 100 or so largest banksmdashthe type of playerslisted in table 21mdashand on the holding-company parents of banking groups50
Capital requirements will differentiate between an increased number ofcredit groups or ldquorisk bucketsrdquo including claims on governments otherbanks corporations mortgage-backed securities and other asset-backedsecurities
Basel II originally proposed to use external ratings to set capital chargesfor a number of these credit risks Many banks objected arguing thatthey assess credit risk better than Standard amp Poorrsquos Moodyrsquos or FitchIBCA51 Basel II thus proposes two approaches to rating a standard ap-proach using external ratings and an ldquoadvancedrdquo approach that allowsselected banks to use their own internal rating systems To encouragethe development of rigorous internal control systems based on these in-ternal rating systems Basel II also proposes to levy capital charges foroperational risk (the risk of direct or indirect loss resulting from inad-equate or failed internal processes people and systems or from exter-nal events)
Some critics of this proposal dismiss it as an abrogation of the prin-ciple of external independent monitoring and as ldquodangerously naiumlverdquo52
But regulators argue that the new capital charge on operational risk shouldoffset this concern It is also far from clear how cross-national compari-sons of rating and internal risk-assessment systems will be made (Engelen2000) The development by the European Union of its own capital rulescould well complicate the international resolution of these issues Publicassurances by EU officials in January 2001 however indicated that theirmain concerns are to create a level playing field and avoid regulatoryarbitrage (Hargreaves 2001) There is also the significant problem ofthe procyclical character of risk weights When a crisis hits losses are
49 See Berry (2000) for an update in an interview with William J McDonough chair ofthe Basel Committee on Banking Supervision
50 For obvious reasons these proposals are addressed to large banks and simpler capi-tal standards are allowed for small banks that focus on their domestic credit markets
51 See Ammer and Packer (2000) for an empirical critique of the success of rating agen-cies in distinguishing risk by sector and region
52 See Auerback (2001)
Institute for International Economics | httpwwwiiecom
126 WORLD CAPITAL MARKETS
incurred or accrued capital is lost and loan exposure must be reducedor securities sold to restore the requisite capital-adequacy ratios A morerisk-sensitive framework could amplify volatility
As the second pillar of Basel II supervisory review criteria are beingbeefed up to encourage supervisors to intervene earlier in potential problemsituations and to compel banks to align their capital positions with theirrisk profiles Bank supervisors will be authorized to require banks tohold capital in excess of minimum requirements if they have concernsabout general management overall strategy risk-management performanceor the macroeconomic environment Of course if one G-10 supervisorimposes higher capital requirements in isolation the same disparity willemerge that presaged Basel I Some banks will be disadvantaged in theinternational marketplace and will loudly complain that excessive super-vision is driving business to their competitors Hence close internationalcooperation among supervisors is critical
To implement the third pillar market discipline banks will be requiredto make fuller more timely disclosure of capital adequacy and the risksto which that capital is exposed A number of measures are being stud-ied that might help supervisors evaluate bank performance such as com-parisons of uninsured deposit interest rates subordinated debt yieldsand equity prices The idea is that these yields and prices might alertsupervisors to market perceptions of risk Of course market perceptionsare only as good as market information More direct and controversialways to reinforce market discipline would dramatically increase publicdisclosure of bank positions and risk management systems
Many questions are still outstanding about how to resolve the techni-cal details of capital requirements and whether the requirements willachieve their intended goal of better assessment and mitigation of therisks in banksrsquo portfolios There is no substitute for skilled supervisorsThe intricacies of effective design and implementation suggest that su-pervisors need to be highly competent technically knowledgeable aboutbanking portfolio characteristics and the factors that influence bank ex-posure to credit risk (Mishkin 2000) And they must be aided by vigilantshareholders market forces and transparency of information53
Standard setting at the global level is desirable but ultimately theeffectiveness of these efforts will be tested at the national level espe-cially in times of systemic financial distress Here the record of Basel Iwas not a bright shining success Japanese banking regulators havetraditionally allowed banks to include real estate and securities in theircapital base When the value of these assets plummeted in the early 1990sregulators allowed banks to continue valuing these depreciated (andoften bankrupt) assets at their old inflated levels Japanese authorities
53 Benedict Roth Complacency Towards Catastrophe Financial Times 23 January 2001
Institute for International Economics | httpwwwiiecom
THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 127
insisted until the mid-1990s that eroded capital bases could be rebuiltin a market-driven fashion They rightly foresaw that huge loan losseswould undermine public support for the ruling party and require a po-litically unpopular bailout
Japanese foot dragging on Basel I was the worst54 but not uniqueOther examples can be found of ldquopolitically mandated forbearancerdquo TheFederal Reserve Bank of New York held important hands during theLTCM crisis of 1998 Mexico is still resolving the banking crisis that eruptedin 1995 South Korea has not yet closed the insolvent banks that behavedso badly before the crisis of 1998 In the aftermath of a crisis nationalregulators cannot always be relied upon to discipline politically power-ful bankers55 One of the little-noticed consequences of these differingapproaches is that those banks with strong regulatory systems receivedan implicit ldquoexport subsidyrdquo for their services US banks which had notengaged extensively in emerging-market lending in the 1990s were bet-ter positioned than their German and Japanese counterparts to expandtheir international assets in the wake of the crises
Other Financial Forums
54 See Japanese Banks Fiddling while Marunouchi Burns The Economist 27 January2001 67-69
55 See Calomiris (1997)
The Basel model of vertical subsidiarity has already been extended toother financial regulatory bodies In 1993-94 the BIS established a Tri-partite Group of Banking Insurance and Securities Regulators In 1994-95 the BIS increased its cooperation with the International Organizationof Securities Commissions when the two organizations issued parallelpapers on guidelines for national regulators concerning risk managementand disclosure of derivative trades In 1996 a permanent Joint Forum onFinancial Conglomerates was established to examine supervisory issuesand develop working arrangements among the different functional super-visors of conglomerate institutions that offer combinations of bankingsecurities and insurance products Draft papers on the supervisionof conglomerates were released for comment in 1998 applying capital-adequacy principles to these groups and providing guidelines both forassessing the integrity and competence of top managers and for sharingassessments between regulators
In 1997 the Basel Committee on Banking Supervision extended itsreach beyond capital standards to broader aspects of banking supervi-sion with the publication of the Core Principles for Effective BankingSupervision In 1999 a wide range of regulatory and standard-settingbodies were gathered under the umbrella of the Financial Stability
Institute for International Economics | httpwwwiiecom
128 WORLD CAPITAL MARKETS
Forum (FSF) itself established under BIS aegis56 The FSF has alreadyissued recommendations for stepped-up supervision and transparencyas well as guidelines for best practices in a number of areas includingoffshore financial centers and highly leveraged institutions or hedge funds57
Conclusion
Although the structural weaknesses in emerging-market economies arewidely acknowledged to have been causal factors in international capi-tal-market volatility this chapter points to the role of large G-10 bankingorganizations as major suppliers of the most volatile instrument short-term debt We have examined evidence of the impact of public safetynets in the G-10 economiesmdashthe deposit insurance systems the pruden-tial supervisory systems and the lender-of-last-resort functions of centralbanksmdashon the incentive structures of these organizations
Although supervisors in most countries working nationally and to-gether in the BIS have made significant efforts to mimic market forcesin their prudential supervision the most sophisticated financial institu-tions find innovative ways to circumvent the rules New global regulatorybodies are not about to be created G-10 national bank regulators shouldthemselves address the short-term debt bias in the international financialsystem by changing incentive systems G-10 securities regulators shouldalso take steps to get ahead of the curve paying close attention to largeportfolio swings by institutional investors particularly in times of crisisIn short more needs to be done at national and international levels tochange the rules of the game That is the subject of the next chapter
56 The Financial Stability Forum includes banking securities insurance and accountingregulatory bodies the OECD on taxation corruption and corporate governance and theIMF
57 See Martin (2000)
Institute for International Economics | httpwwwiiecom
126 WORLD CAPITAL MARKETS
incurred or accrued capital is lost and loan exposure must be reducedor securities sold to restore the requisite capital-adequacy ratios A morerisk-sensitive framework could amplify volatility
As the second pillar of Basel II supervisory review criteria are beingbeefed up to encourage supervisors to intervene earlier in potential problemsituations and to compel banks to align their capital positions with theirrisk profiles Bank supervisors will be authorized to require banks tohold capital in excess of minimum requirements if they have concernsabout general management overall strategy risk-management performanceor the macroeconomic environment Of course if one G-10 supervisorimposes higher capital requirements in isolation the same disparity willemerge that presaged Basel I Some banks will be disadvantaged in theinternational marketplace and will loudly complain that excessive super-vision is driving business to their competitors Hence close internationalcooperation among supervisors is critical
To implement the third pillar market discipline banks will be requiredto make fuller more timely disclosure of capital adequacy and the risksto which that capital is exposed A number of measures are being stud-ied that might help supervisors evaluate bank performance such as com-parisons of uninsured deposit interest rates subordinated debt yieldsand equity prices The idea is that these yields and prices might alertsupervisors to market perceptions of risk Of course market perceptionsare only as good as market information More direct and controversialways to reinforce market discipline would dramatically increase publicdisclosure of bank positions and risk management systems
Many questions are still outstanding about how to resolve the techni-cal details of capital requirements and whether the requirements willachieve their intended goal of better assessment and mitigation of therisks in banksrsquo portfolios There is no substitute for skilled supervisorsThe intricacies of effective design and implementation suggest that su-pervisors need to be highly competent technically knowledgeable aboutbanking portfolio characteristics and the factors that influence bank ex-posure to credit risk (Mishkin 2000) And they must be aided by vigilantshareholders market forces and transparency of information53
Standard setting at the global level is desirable but ultimately theeffectiveness of these efforts will be tested at the national level espe-cially in times of systemic financial distress Here the record of Basel Iwas not a bright shining success Japanese banking regulators havetraditionally allowed banks to include real estate and securities in theircapital base When the value of these assets plummeted in the early 1990sregulators allowed banks to continue valuing these depreciated (andoften bankrupt) assets at their old inflated levels Japanese authorities
53 Benedict Roth Complacency Towards Catastrophe Financial Times 23 January 2001
Institute for International Economics | httpwwwiiecom
THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 127
insisted until the mid-1990s that eroded capital bases could be rebuiltin a market-driven fashion They rightly foresaw that huge loan losseswould undermine public support for the ruling party and require a po-litically unpopular bailout
Japanese foot dragging on Basel I was the worst54 but not uniqueOther examples can be found of ldquopolitically mandated forbearancerdquo TheFederal Reserve Bank of New York held important hands during theLTCM crisis of 1998 Mexico is still resolving the banking crisis that eruptedin 1995 South Korea has not yet closed the insolvent banks that behavedso badly before the crisis of 1998 In the aftermath of a crisis nationalregulators cannot always be relied upon to discipline politically power-ful bankers55 One of the little-noticed consequences of these differingapproaches is that those banks with strong regulatory systems receivedan implicit ldquoexport subsidyrdquo for their services US banks which had notengaged extensively in emerging-market lending in the 1990s were bet-ter positioned than their German and Japanese counterparts to expandtheir international assets in the wake of the crises
Other Financial Forums
54 See Japanese Banks Fiddling while Marunouchi Burns The Economist 27 January2001 67-69
55 See Calomiris (1997)
The Basel model of vertical subsidiarity has already been extended toother financial regulatory bodies In 1993-94 the BIS established a Tri-partite Group of Banking Insurance and Securities Regulators In 1994-95 the BIS increased its cooperation with the International Organizationof Securities Commissions when the two organizations issued parallelpapers on guidelines for national regulators concerning risk managementand disclosure of derivative trades In 1996 a permanent Joint Forum onFinancial Conglomerates was established to examine supervisory issuesand develop working arrangements among the different functional super-visors of conglomerate institutions that offer combinations of bankingsecurities and insurance products Draft papers on the supervisionof conglomerates were released for comment in 1998 applying capital-adequacy principles to these groups and providing guidelines both forassessing the integrity and competence of top managers and for sharingassessments between regulators
In 1997 the Basel Committee on Banking Supervision extended itsreach beyond capital standards to broader aspects of banking supervi-sion with the publication of the Core Principles for Effective BankingSupervision In 1999 a wide range of regulatory and standard-settingbodies were gathered under the umbrella of the Financial Stability
Institute for International Economics | httpwwwiiecom
128 WORLD CAPITAL MARKETS
Forum (FSF) itself established under BIS aegis56 The FSF has alreadyissued recommendations for stepped-up supervision and transparencyas well as guidelines for best practices in a number of areas includingoffshore financial centers and highly leveraged institutions or hedge funds57
Conclusion
Although the structural weaknesses in emerging-market economies arewidely acknowledged to have been causal factors in international capi-tal-market volatility this chapter points to the role of large G-10 bankingorganizations as major suppliers of the most volatile instrument short-term debt We have examined evidence of the impact of public safetynets in the G-10 economiesmdashthe deposit insurance systems the pruden-tial supervisory systems and the lender-of-last-resort functions of centralbanksmdashon the incentive structures of these organizations
Although supervisors in most countries working nationally and to-gether in the BIS have made significant efforts to mimic market forcesin their prudential supervision the most sophisticated financial institu-tions find innovative ways to circumvent the rules New global regulatorybodies are not about to be created G-10 national bank regulators shouldthemselves address the short-term debt bias in the international financialsystem by changing incentive systems G-10 securities regulators shouldalso take steps to get ahead of the curve paying close attention to largeportfolio swings by institutional investors particularly in times of crisisIn short more needs to be done at national and international levels tochange the rules of the game That is the subject of the next chapter
56 The Financial Stability Forum includes banking securities insurance and accountingregulatory bodies the OECD on taxation corruption and corporate governance and theIMF
57 See Martin (2000)
Institute for International Economics | httpwwwiiecom
THE PLAYERS THEIR SUPERVISORS AND MORAL HAZARD 127
insisted until the mid-1990s that eroded capital bases could be rebuiltin a market-driven fashion They rightly foresaw that huge loan losseswould undermine public support for the ruling party and require a po-litically unpopular bailout
Japanese foot dragging on Basel I was the worst54 but not uniqueOther examples can be found of ldquopolitically mandated forbearancerdquo TheFederal Reserve Bank of New York held important hands during theLTCM crisis of 1998 Mexico is still resolving the banking crisis that eruptedin 1995 South Korea has not yet closed the insolvent banks that behavedso badly before the crisis of 1998 In the aftermath of a crisis nationalregulators cannot always be relied upon to discipline politically power-ful bankers55 One of the little-noticed consequences of these differingapproaches is that those banks with strong regulatory systems receivedan implicit ldquoexport subsidyrdquo for their services US banks which had notengaged extensively in emerging-market lending in the 1990s were bet-ter positioned than their German and Japanese counterparts to expandtheir international assets in the wake of the crises
Other Financial Forums
54 See Japanese Banks Fiddling while Marunouchi Burns The Economist 27 January2001 67-69
55 See Calomiris (1997)
The Basel model of vertical subsidiarity has already been extended toother financial regulatory bodies In 1993-94 the BIS established a Tri-partite Group of Banking Insurance and Securities Regulators In 1994-95 the BIS increased its cooperation with the International Organizationof Securities Commissions when the two organizations issued parallelpapers on guidelines for national regulators concerning risk managementand disclosure of derivative trades In 1996 a permanent Joint Forum onFinancial Conglomerates was established to examine supervisory issuesand develop working arrangements among the different functional super-visors of conglomerate institutions that offer combinations of bankingsecurities and insurance products Draft papers on the supervisionof conglomerates were released for comment in 1998 applying capital-adequacy principles to these groups and providing guidelines both forassessing the integrity and competence of top managers and for sharingassessments between regulators
In 1997 the Basel Committee on Banking Supervision extended itsreach beyond capital standards to broader aspects of banking supervi-sion with the publication of the Core Principles for Effective BankingSupervision In 1999 a wide range of regulatory and standard-settingbodies were gathered under the umbrella of the Financial Stability
Institute for International Economics | httpwwwiiecom
128 WORLD CAPITAL MARKETS
Forum (FSF) itself established under BIS aegis56 The FSF has alreadyissued recommendations for stepped-up supervision and transparencyas well as guidelines for best practices in a number of areas includingoffshore financial centers and highly leveraged institutions or hedge funds57
Conclusion
Although the structural weaknesses in emerging-market economies arewidely acknowledged to have been causal factors in international capi-tal-market volatility this chapter points to the role of large G-10 bankingorganizations as major suppliers of the most volatile instrument short-term debt We have examined evidence of the impact of public safetynets in the G-10 economiesmdashthe deposit insurance systems the pruden-tial supervisory systems and the lender-of-last-resort functions of centralbanksmdashon the incentive structures of these organizations
Although supervisors in most countries working nationally and to-gether in the BIS have made significant efforts to mimic market forcesin their prudential supervision the most sophisticated financial institu-tions find innovative ways to circumvent the rules New global regulatorybodies are not about to be created G-10 national bank regulators shouldthemselves address the short-term debt bias in the international financialsystem by changing incentive systems G-10 securities regulators shouldalso take steps to get ahead of the curve paying close attention to largeportfolio swings by institutional investors particularly in times of crisisIn short more needs to be done at national and international levels tochange the rules of the game That is the subject of the next chapter
56 The Financial Stability Forum includes banking securities insurance and accountingregulatory bodies the OECD on taxation corruption and corporate governance and theIMF
57 See Martin (2000)
Institute for International Economics | httpwwwiiecom
128 WORLD CAPITAL MARKETS
Forum (FSF) itself established under BIS aegis56 The FSF has alreadyissued recommendations for stepped-up supervision and transparencyas well as guidelines for best practices in a number of areas includingoffshore financial centers and highly leveraged institutions or hedge funds57
Conclusion
Although the structural weaknesses in emerging-market economies arewidely acknowledged to have been causal factors in international capi-tal-market volatility this chapter points to the role of large G-10 bankingorganizations as major suppliers of the most volatile instrument short-term debt We have examined evidence of the impact of public safetynets in the G-10 economiesmdashthe deposit insurance systems the pruden-tial supervisory systems and the lender-of-last-resort functions of centralbanksmdashon the incentive structures of these organizations
Although supervisors in most countries working nationally and to-gether in the BIS have made significant efforts to mimic market forcesin their prudential supervision the most sophisticated financial institu-tions find innovative ways to circumvent the rules New global regulatorybodies are not about to be created G-10 national bank regulators shouldthemselves address the short-term debt bias in the international financialsystem by changing incentive systems G-10 securities regulators shouldalso take steps to get ahead of the curve paying close attention to largeportfolio swings by institutional investors particularly in times of crisisIn short more needs to be done at national and international levels tochange the rules of the game That is the subject of the next chapter
56 The Financial Stability Forum includes banking securities insurance and accountingregulatory bodies the OECD on taxation corruption and corporate governance and theIMF
57 See Martin (2000)
Institute for International Economics | httpwwwiiecom