Rethinking Regulation for Financial Stability and Growth

1. Rethinking Regulation for Financial Stability and Growth David C. L. NellorInternational Monetary Fund May 2009

2. Outline • Financial Stability – why does it matter • Regulatory Framework – what went wrong • Specific Proposals – is there a solution • Policy Choices – confronting the trade offs • Conclusions – what does it mean for Nigeria

3. Financial Stability – why does it matterEstimates of Bank Restructuring Costs

4. Financial Stability – why does it matterIndex - Ratio of Private Sector Credit to GDP

5. 2. Regulatory Framework – what went wrong? • Macro versus Micro Supervision • Regulatory and Supervisory Perimeter • Supervisory Capacity • Pro-cyclicality • Global Architecture

6. Macro versus Micro Supervision • Macroeconomic developments – asset markets, macro imbalances • Regulators are micro focused and not on interlinkages across financial institutions • Basel based on bank’s own risk models • Presence of foreign intermediaries in some countries and cross-border capital flows

7. Regulatory and Supervisory Perimeter • Coverage of supervision and regulation • Systemic importance of non-banks • Too big to fail – did not mean subject to prudential supervision & regulation • Reporting requirements • Information from wider range of financial institutions & off-balance sheet items • Supervisory insight – “ticking boxes” versus knowledgeable supervision

8. Supervisory Capacity • Regulators/supervisors did not keep pace with developments • “Sophisticated financial engineering” - structured products & off balance sheet entities • Interlinkages across financial institutions and markets (contagion effects) - use of credit risk mitigants and contingent liabilities • Risks of under-resourced supervisory agencies

9. Regulatory System Procyclical • Risk-based capital ratios - capital requirements through the cycle • Loan loss provisions – rules unrelated to expected losses through the cycle • Liquidity risk - liquidity risk management did not require stress tests sensitive to firms’ credit ratings & off-balance sheet obligations

10. Global Architecture • Coordination: inability to address global imbalances or manage crisis effectively at multilateral level • Crisis framework: shortcomings in legislation dealing with cross-border bank resolution and bankruptcy • Liquidity and Financing: limitations of central bank liquidity support; reputational risk to accessing IMF support

11. 3. Specific Proposals – is there a solution • Turner Review • Issing Group • G 30 (Volcker) • De Larosiere

12. Turner Review • Highly regulated broad-based financial sector with central bank and FSA doing macro prudential supervision • Increased capital requirements and avoiding pro-cyclicality through introduction of capital buffers • Limitations on scale of debt/leverage • No specific limitations on activities of banks

13. Issing Group • Risk map – global financial intermediation (net exposures) and risk factors. • Pre-arranged link between findings and actions such as on capital requirements • Regulation of hedge funds • Systematic cooperation of regulators

14. G30 (Volcker) • Redesigning the regulatory structure – overlaps, gaps, limit scope for regulatory arbitrage • Central bank take a lead responsibility on financial stability – may need to be given tools and mandate • Limit scope of bank activities – proprietary trading limited, no hedge fund operations • Prevent non-banks from taking deposits

15. De Larosiere • Macro prudential supervision is essential • Macro supervision must impact the micro supervisors • Macro authority has to be at the regional (global?) level • Consistency of supervision across the region (globally?)

16. 4. Policy Choices – confronting the trade offs • Global versus national • The macro prudential regulator • Narrow or broad banking • Market and regulatory failure • Risk and reward preferences

17. Global versus national • Internationally integrated banking system operating with national level regulatory structure – a mismatch? • Feasibility versus ideal – think globally act nationally • Challenge of building links between surveillance and actions

18. The Macroprudential Regulator • Is a separate/new agency required? • Central bank independence and policy focus • Dealing with the non-bank financial sector • Analytic capacity • Could vary capital and liquidity requirements over time – discretion versus automaticity

19. “Narrow” or “Broad” Banking • Where is the balance? • As deposit takers, want banks to be conservative • As allocators of capital, want banks to be flexible risk takers • Solution – regulatory overlay versus regulation plus limiting activities

20. Market versus Regulatory Failure • Incentives for regulatory arbitrage will persist whatever the structure • Markets are dynamic, can regulators match that change? • Does this favor simplifying the regulatory task by moving to “narrow” banking?

21. Risk and Reward Preferences • Countries at different stages of development and other reasons mean that preferences might not be the same • Global coordination does not mean that all need to be the same • But, some shared principles otherwise regulatory arbitrage will dominate

22. Conclusions • Can agree • the regulatory framework failed • some areas where it failed • Can agree some principles • markets are not self regulating • investors should reap the reward and incur the losses associated with risks they take • markets are dynamic – regulatory structure must match this • Cannot agree on definitive regulatory solutions

23. Conclusions • Need to secure international agreement on principles of regulation and supervision. • Countries will need to define their regulatory and supervisory structures within these international principles • Coordination within regions and internationally will be needed.

24. What does it mean for Nigeria? • Develop regional frameworks and participate in international solutions • CBN as financial stability agency; advisory committee including all regulators • Consider containing scope of banking recognizing supervisory capacity • Accept somewhat greater risk recognizing development needs • A transparent and clear bank resolution framework is essential if take greater risk – bank entry and exit is a sign of a healthy system

25. Thank you!