Issues in Regulation and Supervision of Banks

Issues in Regulation and Supervision of Banks Presentation by Dr.Asish Saha&Dr. T S Ravisankar National Institute of Bank ManagementPune, India November 1, 2002 Conference on Adapting India’s Financial Sector for a Globalizing World

1. Financial Regulation a.Objectives/Purpose of Financial Regulation b. Special Features of Financial Regulation c Types of Financial Regulation d Regulatory Standards e. Tradeoffs in Regulation f. Paradigm Shift in Regulatory Approach(Micro to Macro) g. Sources of Financial Sector Instability h. Macro/Micro Financial Stability/Soundness parameters i. Liberalisation and its impact on Regulation 2. Financial Supervision Supervisory requirements and powers: 3. Emerging Issues in Regulation and Supervision 4. Indian Perspective a. Evolution b. Three-pronged approach of the Indian Regulator c. Regulation & Supervision : Major Issues in the Indian context 5.Conclusion

1. Financial Regulation “Financial stability is crucial for sustained economic growth but this cannot be achieved without strong financial systems. Even with sound macroeconomic management, weak financial systems can destabilize local economies, making them more vulnerable to external shocks, and may threaten global financial markets.” (Financial Stability Institute)

One of the fundamental responsibilities of the government of any country is to foster economic growth and social welfare. Hence the need for a mechanism (regulatory framework) to ensure the strength, stability and soundness of the financial system/markets A. Objectives/Purpose of Financial Regulation - Maintaining the stability of and confidence in the financial system by ensuring the solvency and financial soundness of financial institutions; ensuring the smooth operation of payments mechanisms. (Prevention of systemic risk)

-Protecting investors, borrowers and other users of the financial system against undue risks of losses and other damage that may arise from failures, fraud, malpractice, manipulation and other malconduct on the part of providers of financial services. (Prevention of individual risk) -Ensuring a smooth,efficient, reliable and effective functioning of financial markets, including a proper working of competitive market forces. (Promotion of systemic efficiency) -OECD

B. Special Features of Financial Regulation -The structure, systems and processes of financial regulation in any economy are determined by the country’s social, political and economic forces. - In a dynamic socio-economic environment, the regulatory framework has to be responsive to changes in the financial market in terms of its size, complexity, procyclicality and volatility, and hence, to remain effective it needs to be a function of time and space.

-While being sensitive to local needs, regulation has to align itself to global concerns and maintain a balance on an ongoing basis. -The scope and coverage of financial regulation expands alongwith the level of integration in the financial market.

-The instruments and mechanisms of regulation are designed in response to the changes in the behaviour of financial market and its participants. -As the financial market operations are information intensive, asymmetric availability of information creates distortions which need to be counter-balanced through appropriate regulatory mandates.

C. Types of Financial Regulation (i) Prevention of Systemic Risks: a) Restriction of Market Forces: -Price regulation: Administering interest rates, fees and commissions; permitting price cartels; -Direct lending control and compulsory investment schemes - Restrictions on cross-border capital flows

-Restrictions on the range of activities: specialisation of a bank; compartmentalisation of banking/securities/insurance; separation of banking and commerce; restrictions on cross- border financial services. -Restrictions on establishment (by domestic institutions, foreign institutions)

b) Prudential Regulation:Supervision of Balance sheet ratios and of risk diversification; on-site inspection and external auditing (ii) Prevention of individual risks: quality standards and codes of conduct; disclosure and information requirements; deposit protection schemes (iii) Promotion of systemic efficiency: prohibition of restrictive business practices and cartels; regulation of mergers & acquisitions

D. Regulatory Standards Standards are good principles, practices and guidelines (commonly acceptedboth at domestic and international levels) relevant for ensuring soundness of the financial system. The standards should thus cover key functional areas like payment and settlement, accounting, risk management, capital adequacy, disclosure and transparency, ethics and governance, etc.

In order to operationalise the standards, principles in specific areas are spelt-out in general terms in order to provide some degree of flexibility to the supervisors in different countries to tailor the standards to their country requirements and circumstances. However, to facilitate uniformity in implementation across the countries, standards are spelt out explicitly in terms of acceptable practices on various dimensions. (BIS initiatives)

E. Tradeoffs in Regulation Since regulation is a balancing act between conflicting demands (some which can also be country-specific) there is always a trade-off in its design and formulation. a) Extent of admissible competition – determined by striking the right balance between perceived benefits and implicit social costs for various levels of competition.

b) Permissible level of risk taking – trade off between low economic growth with high social stability and high economic growth (with increased risk taking) with potential for instability. c) Conflicting requirements of assuring soundness of the financial system and of obtaining allocation of resources to desired sectors. d) Liberalised Vs. Restricted entry - Entry barriers stifle competition and lead to complacency that limits initiatives for cost reduction, efficiency, improvement and innovation.

e) Prudential regulation Vs. Micro-regulatory controls Micro regulation amounts to intrusion in day-to-day functioning of the players as against the selective interventions (prudential regulation) whenever and wherever needed. f) Helping hand Vs. Hand-grabbing – Helping hand approach aims to ‘insulate’ institutions from failure through a protective umbrella of entry barriers, restriction of activities, deposit insurance coverage etc., and by providing appropriate guidance.

On the other side, in hand-grabbing approach, regulatory prescriptions are mainly decided by vested interests of various socio-political constituencies rather than by considerations of systemic stability and soundness. g) Extent of ownership and control of financial entities - Domestic vis-a-vis Foreign ownership

h) Government Vs. Private ownership of banks Government ownership facilitates socially desirable investments including strategic long-term investments that may yield beneficial returns only in the long-run. Private sector initiatives, however, are generally directed towards sectors which are likely to produce immediate returns of higher-order. Also, Government ownership inspires greater public confidence in a financial institution.

F. Paradigm Shift in Regulatory Approach (Micro to Macro) “If the objective is to design a regulatory framework that is able to act as a safeguard against financial instability, a shift of perspective from individual institutions to a system level is essential.” (Gugerell)

Macro-regulatory approach aims at containing the cost of systemic failure to the economy and ensuring the continuity of financial intermediation function without any serious disruptions. At the other end, micro-regulation addresses the issue of limiting failures of individual institutions. In crisis situation each individual bank is likely to take defensive stance which may be acceptable under micro-prudential regulatory perspective. However, in the process, the financial fundamentals of the banking system as a whole may become weak which goes against macro-regulatory expectations.

G. Sources of Financial Sector Instability “Irrational exuberance of financial sector during boom period and herding behaviour both during upswing and subsequent downturn” (IMF) Market imperfections that hide the real risk profile embedded in the system Weaknesses in the supervisory and regulatory mechanisms that perpetrate irrational risk-taking by individual players

Weak public administration/governance Lack of Supervisory independence Government involvement in the financial sector (Directed lending to unviable propositions at artificially low rates of interest; Cross-subsidization affecting earning potential of banks; Fiscal deficits financed by borrowings from Central Bank).

H. Macro/Micro Financial Soundness & Stability Parameters (quantitative and qualitative) CAMEL parameters, Sensitivity to market and operational risks, Quality of Human Resources, Financial Innovation, Level and scope of Technology usage, Brand Equity, etc.

I. Liberalisation and its impact on Regulation In the early eighties, Globalisation, Liberalisation and Deregulation were advocated in tandem in the international financial arena as key drivers of economic growth Cross-country studies,however,have established a linkage between financial development and economic growth on the one hand and financial liberalisation and financial fragility on the other.

Countries which have liberalised their economy without putting in place strong regulatory frameworks have been found to be more vulnerable to crisis situations, thereby reinforcing the need for re-regulation rather than deregulation. Capital account liberalisation without suitable filtering mechanisms for controlling the inflows and outflows and their term structure and usage, precipitated liquidity crisis and the crisis of confidence in the system in the affected countries

Excessive capital inflows and the risk of reversal seen in the crisis cases have created a clear need for “source country regulations” that will discourage excessive reversible capital inflows

2. Financial Supervision Ensuring systemic stability is one of the core functions of the supervisor. As such regulation and supervision are complementary to each other. Supervision entails monitoring whether banks are functioning within the set regulatory boundaries and initiating appropriate corrective actions in cases of excessive deviation from the prescribed norms.

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

It is now well recognised that various banking risks cannot be looked at in isolation and that there is a close linkage and reinforcement amongst credit risk, market risk, liquidity risk, forex risk etc. Thus an appreciation of these inter-linkages is emerging as the basis for future supervisory emphasis. Reliance only on capital adequacy standards have been found to be inadequate. Supervisory attention is accordingly getting directed towards monitoring specific risk exposures of banks and taking an integrated view of their risk profiles.

There is a shift of supervisory focus away from monitoring prudential ratios for individual risks to evaluating the overall risk profile of a bank to assess the strength and sustainability of its financial performance. Setting broad guidelines for managing risk and assessing internal risk management practices of individual banks are the two major planks of the new supervisory approach.

3.Emerging Issues in Regulation and Supervision i) Growing capital flows across the world in volume and speed and almost instantaneous movement of such flows (facilitated by technology usage) - How to track the flows and manage the impact of these flows? - How to build an insulation against short-term exceptional flows?

ii) Emergence of new types of products, services and instruments on a continuous basis (surfeit of innovations) How to assess their positive/negative contributions to stability, strength and soundness of the financial system? How to assess their risk potential?

iii) How to ensure better transparency in markets’ functioning given the blurring boundaries between the different segments of the financial market? iv) How to assess the risk profile of large universal banks (financial conglomerates)? v) How to ensure coordinated-regulation of such entities?

4. Regulation and Supervision: Indian Perspective a. Evolution A strong point of the Indian experience has been the gradual deregulation and slow liberalization in stages. Parallel prescriptions of checks & balances has in fact protected our system from internal crisis and also insulatedus from contagion effects of the financial crises in neighbouring countries.

b. Three- prongedapproach of the Indian Regulator - Reactive : response to unforeseen crisis/boom situations(domestically manifested or externally triggered) - Preactive: Preparing the financial system and guiding the same by phasing out introduction of new standards already accepted but to come into force in future.

- Proactive: Exerting influence during the formulation of norms/standards in global fora (like BIS) to take care of the socio-economic concerns specific to our country and to protect the long-term interests of the domestic banking/financial system.

c. Regulation & Supervision: Major Issues in the Indian context i) Regulatory and Supervisory functions to be separated or combined? ii) Regulatory coverage to include all institutions/ organizations accepting public deposits and/or all institutions involved in any of the banking activities? iii)Whether regulator should continue as a member of the Board of a public sector bank?

iv) How to design preventive regulatory measures - to maintain and safeguard the confidence in and integrity of the financial system to prevent possible fund flows from undesirable entities (Customer due diligence) to assure the security and integrity of payment and settlement systems. v) Resolution of the conflict of RBI being owner as well as regulator of institutions like SBI. vi) Should offshore banking units of commercial banks be under the purview of domestic supervision and regulation?

5.Summary of Observations Given the current stage of development of the financial sector in India, the transition from a micro to macro prudential standards (as envisaged at the global level) should be paced-out in a phased manner as is presently being pursued by the Reserve Bank of India.

Overall funding requirements of the country have to be met by a judicial balance between internal resource mobilisation and liberalised external funding.Keeping in view other country experiences in this regard, the regulatory and supervisory role would be to establish appropriate prudential standards for this purpose and monitor the same on an ongoing basis.

Under the globalising conditions of the modern world, the major role of a regulator would be to mediate between diverse expectations of various economic interest groups (domestic and international). This will ultimately determine the extent of regulatory control and the approach towards regulation.The situation is more pronounced in the Indian context making the job of the Indian regulator more demanding

There is a need for moving towards incentive-based regulation and supervision that may encourage prudent behaviour by individual banking institutions, and lead to a corresponding reduction in the cost of maintaining a safety-net. Supervision needs to play a watchdog role to see that super-competition does not lead to total erosion of financial fundamentals of the individual players.

In view of the complexity and opacity of the financial market, the collection and processing of relevant control data should be at a much accelerated pace- preferably in an on line mode. Explicit cost of regulation to the supervisor and the implicit cost to the regulated needs to be kept in view while determining the extent and depth of regulation and supervision

Liberalised environment opens up multiple channels and mechanisms of financial resource transfer across the countries. Hence, there is an imminent need for a single authority vested with the powers to monitor and control all such capital flows. However, it needs to be recognised that it would be difficult to control the volatility expectations arising out of free information flows across the markets.

Due to increasing convergence in the activities of the market players and the resultant diffusion in their accountability, there is a need for explicitly spelling out the supervisory domains of different regulators. To ensure continuing financial stability and soundness of the system at the aggregate level, there may be need for taking drastic measures against delinquent units. The regulator should be accordingly empowered to force closure/merger/restructuring of the ailing units as demanded by the situation.

“The availability of mechanisms which can ensure that banks are soundly governed and thus that both technical and moral mismanagement is avoided, is the decisive pre-requisite for successful financial system development.” (Winkler A) While reform initiatives address the technical aspects of sound management, there is an equally strong need for ensuring adherence to good corporate governance practices amongst the financial players. Indeed , “sound corporate governance must be regarded as the very heart and motor of financial system development”. (Winkler A.)

Effectiveness of the Financial Sector’s contribution to economic growth and development will be determined by its efficiency in the allocation of the mobilised savings in competing projects. In the context of a developing country like India, the allocative efficiency was sought to be established by regulatory prescription of directed credit flows with an element of built-in subsidy, especially in its early stages of economic development.In the changed economic context, this approach needs a relook.

Essentially regulation and supervision should be proactive and be a step ahead of the market innovations and developments. Competency level of the supervisor has to be atleast equal if not higher than those of the regulatees for effective supervision.

To conclude, Regulation and Supervision will have to be ultimately concerned with (borrowing the words of Dr.Y.V.Reddy) “Maintaining a convincingly efficient and stable financial sector” and “ Conforming to the extent possible to international practices”

Thank You

Issues in Regulation and Supervision of Banks