Regulation And Supervision

In recent months, Alan Greenspan, chairman of the board of governors of the US Federal Reserve System, has given a number of speeches wherein he has repeatedly focussed attention on the issues of regulation and supervision in the United States. This article draws largely on a series of pronouncements made by Alan Greenspan.

Speaking at the Catholic University of Leuven (January 14, 1997), Mr Greenspan explains that governments and central banks have been given certain responsibilities relating to preventing major financial disruptions through development and enforcement of prudent regulatory standards and they are occasionally expected to undertake direct intervention in the market. At the same time, the authorities do need to allow banks and institutions to take prudent risks even though such risks can result in unanticipated losses or failures. Mr Greenspan makes a very pertinent point that there can be a cascading sequence of defaults that can culminate in a financial implosion unless there is regulatory/supervisory intervention, but he takes great pains to stress that the goal of supervisors should not be to prevent all failures. The regulator/supervisor has, therefore, to signal the kind of circumstances under which it would quell financial turmoil and per contra the kind of problems that the players in the financial sectors are expected to resolve themselves. The balance is sought to be achieved through proper regulation and formal as well as informal supervisory policies and procedures. Losses can be generated at an inconceivably rapid pace and one cannot over-emphasise the need for sound internal risk management systems. Standard capital adequacy standards no longer provide a satisfactory indicator to decide on supervisory action as interest rate risks and operating risks are not covered and a one-size-fits-all rule is totally inappropriate. Thus, regulations covering all banks are just no substitute for a bank-by-bank supervision. The optimal number of failures is not zero as some institutions will fail, either through poor management decision on just plain bad luck .

 

Addressing the issue of who should be the supervisor, Mr Greenspan, in his testimony before the Committee on Banking and Financial Services of the US House of Representative (March 19,1997), asserted that there are compelling reasons why the Fed should continue to be involved in supervision of banks. He claimed that the goal of safety and soundness of banks must be evaluated jointly with the Feds responsibility of stability with growth. He claimed that joint responsibilities would make for better supervision and monetary policy than would be the case if the supervisor was divorced from economic responsibilities or a macro economic policy maker had no experience of individual bank operations. The Fed would use techniques which are less blunt and well calibrated. When crisis emerge all authorities turn to the Fed not only because it has the money but more importantly because it has the expertise and experience. Since the payments and settlements system and monetary policy are the direct concern of the Fed, Mr Greenspan argues that the Fed needs to retain a significant supervisory role. The Fed believes that Umbrella Supervision is necessary to protect the financial system. The umbrella supervision should not be such that decision- making process is hampered and the banking organisation rendered inefficient. Mr Greenspan urged Congress that while financial modernisation should undertaken it should not undermine the authority of the central bank to ensure an efficient and safe payments system and conduct to monetary policy; this requires that the Fed retain a significant role in as a bank supervisor.

Speaking at the annual convention of the Independent Bankers Association of Arizona in Phoenix, Arizona (March 22, 1997), he argued that the job of a banking regulator, difficult under any circumstances, is critical as it regards the connection running between banking risk and the impact of such risk-taking on the macro economy. He goes on to claim that regulation without responsibility for macroeconomic growth and stability tends to have a bias against risk-taking. Such regulation receives no praise if the economy is proceeding well but is criticised if there are too many bank failures. Mr Greenspan recalls the well known adage that mistakes in lending are not generally made during recessions but when the economy is going through a boom.

Coming back to the theme of supervision and regulation of financial markets, at the spring meeting of the Institute of International Finance (April 29, 1997), Mr Greenspan was quite forthright in arguing that bankers are a normal and important part of the market process. Such failures could, however, have large ripple effects that spread through the financial markets at great cost, since the authorities provide some sort of a safety net and this makes regulation and supervision necessary. In a sense, the regulators are compelled to act as a surrogate for market discipline since market signals are muted and the prices of deposit insurance and safety nets do not vary sufficiently to mimic market prices. Thus regulator and supervisor have to simulate market responses that would occur if there were no safety net. The danger is that there can be a cascading sequence of defaults that will culminate in implosion. He stressed that in the current environment a single individual can generate rapid losses in the system.

Furthermore, with gradual global deregulation and the growing importance of emerging market economies, the need to promote financial stability and prudential supervision in these emerging markets is an important objective of international co-ordination in this area. It is in this context that there is a need to enhance market transparency and public disclosure about the nature of corporate risks. Mr Greenspan candidly admits that there are supervisory gaps which need to be filled and that per contra there could be rigidities in the supervisory system which inhibit appropriate responses in emergencies.

Addressing the Conference of State Bank Supervisors (May 3, 1997), he once again said, quite forcefully, that in taking on risks some mistakes will be made and some financial failures will take place. He went on to claim that failures should occur as part of the natural process and should not be viewed as a flaw in the financial system; it is only when the failure rate reaches a prudent threshold that there ought to be concern. On the question of whether the Fed should at all be involved in supervisory functions, Mr Greenspan argues that the obligation to protect against systemic disruption cannot be met solely via open market operations and the discount window, and that the Fed must be directly involved in the supervision of banks.

Rarely has a Fed chairman had to repeatedly address the issues of regulation and supervision with such intensity and frequency. There are many lessons for us to learn from the debate in the United States. One thing is certain. We, in India, are not alone in the recent turmoil about regulation and supervision.