Regulation And Supervision Ii

Only a few months ago, Davies, in a watershed speech at the Federal Reserve Bank of Atlantas Financial Markets Conference (February 22) set out a penetrative analysis of the issues in regulation and supervision. He argues that the relationship between structure and effectiveness is loose and that the regulatory structure should follow the market. Since markets should work efficiently in the interest of consumers, Davies feels that there should be constant dialogue between markets and regulators.

While the BoE is formally entrusted with supervision, on the securities side the frontline regulators are essentially self-regulatory organisations. The system has not been free from episodes of failure the Maxwell affair, the private pensions misselling saga, the BCCI and Barings. Davies makes the bold pronouncement that as in other countries much of the criticism of the regulators/supervisors has a political overtone.

 

There is one school of thought that there should be a single financial regulator and then accountability would be clear. Davies interestingly argues that while banks and securities firms develop this is not true of their core functions. Banks face risks linked to maturity transformations and draining of liquidity could cause forced realisation of illiquid assets at Fire-Sale prices and there is also the risk of contagion; again banks are central to the payments system and forex trading. Davies makes the important pronouncement that there is enough that is special about banks for their prudential supervision to be kept separate from supervision of other activity, he recognises that the question whether the central bank should be in charge of supervision is a separate question being debated. His own predilection, however, is that there are important synergies between the supervisory function and other responsibilities of the central bank. He categorically says that it makes sense for the micro-supervision

of individual banks to be carried out by the same body that is entrusted with the macro functions of maintainability. Davies draws attention to the fact that even where the frontline supervisory functions are carried out by agencies other than the central bank, recognising that there are things which only the central bank can do, irrespective of the format decided by a country, the central bank has an important say in the regulatory/supervisory framework. As such, Davies sees much merit in three agencies focussing on financial services, banking and insurance.

He raises a provocative question when he asks whether supervision should simply set out rules and shoot those who break them. He recognises that such an approach could generate a climate which stifles initiative. His own inclination is towards a judgemental approach. While the BoE approach to supervision is largely off-site though it has turned increasingly to on-site supervision also. More recently, the Bank has been using the RATE model - risk assessment, tools of supervision and evaluation. This will bring about a better understanding of the quality of management, the characteristics of the business and the risks the banks face. It is interesting to note that while the BoE sets a minimum capital ratio of 8 per cent, the trigger capital rate is set for each bank above the 8 per cent floor and moreover the trigger ratio is adjusted whenever the risk profile undergoes substantial change.

Davies raises a teaser when he argues that while regulators internationally converge, they could all be converging on an inappropriate model. He raises a soul-searching question as to whether regulators create as much problems as they solve . The issue that arises is whether the regulator/supervisor should get out of this business altogether and let the markets regulate themselves.

Speaking at the London School of Economics annual lecture on central banking (March 1997), he emphasises that while monetary policy requires a highly trained but small cadre of economists, a large number of supervisors are needed to deal with banks with poor quality accounts. He stressed that the skills of assessing risk and quality of management are not easily adapted to by staff whose instincts are to tick boxes rather than make judgements. He observes that staff with the requisite skills are frequently enticed away by other institutions. Paradoxical as it might seem, Davies is the one ordained to the head the enlarged SIB. The loss of key personnel is a real problem which the SIB under him will have to deal with.

Talking at the IMF conference on banking soundness and the role of the market (January 1997,) Donald T Brash, governor, Reserve Bank of New Zealand, made the interesting point that the major review of the New Zealand banking supervision arrangement was motivated by the concern that there is an insufficient use of market discipline as a means of promoting a sound and efficient financial system. The new approach is to provide greater use of market discipline to promote systemic stability and in this context the directors and management of banks are held more accountable. The markets ability to make well-informed judgements on banks would be greatly enhanced. Brash argues that conventional banking supervision has inherent limitations in minimising the incidence of bank failures. He goes on to make the provocative point that conventional banking supervision could even be increasing the risk of bank failure or distress by reducing the incentive for banks managements to make their own judgement of what constitutes prudent behaviour.

Under the new arrangement, all banks in New Zealand are requested to publish quarterly disclosure requirements which has two parts; first, a key information summary aimed at the ordinary depositor and a comprehensive general disclosure statement aimed at professional analysts. The summary contains the banks credit rating, the capital ratio, exposures, asset quality, guarantees and profitability. It has to be written in a language understood by depositors and has to be approved by the supervisors and then prominently displayed at every branch and when soliciting deposits.

The general disclosure statement controls detailed information including a five- year summary of performance credit rating, capital adequacy, information on banks managements, risk management systems and any specific measures taken by the central bank in relation to the bank concerned. The disclosure statement is subject to full external audit. Directors face severe criminal and civil penalties (including up to three years in jail and personal liability for creditor losses) if a disclosure statement is held to be false. With full disclosure the market has greater scope for reacting to developments in a bank. Under these conditions the stronger banks will automatically grow at a faster pace than the weaker banks. The central bank does not abandon its responsibility for the financial system. The monitoring by the central bank should focus on the public disclosure statements rather than private statements to the supervisor.

Brash argues that the efficacy of the disclosure regime rests on the assumption that financial analysts and the media would assess them. There is also the argument that banks directors do not understand disclosures and should not be expected to sign the disclosure statement. Herein lies the essence of the process of selection of the board of directors of banks. Brash makes the important point that each country has to evolve its own supervisory system and that transplants invariably fail but market discipline can play an important role. He recognises that new disclosure requirements can have repercussions in a fragile system. He, however, claims rather modestly that at least the New Zealand model could help provide international debate on supervisory options.