Rethinking Regulation for Financial Stability and Growth

David C. L. Nellor International Monetary Fund May 2009

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

Financial Stability why does it matter

Estimates of Bank Restructuring Costs

60 50
Percent of GDP

40 30 20 10 0 -10 Indonesia Korea Thailand US S&Ls Sweden

Official Est.

Final adj.
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Financial Stability why does it matter

Index - Ratio of Private Sector Credit to GDP
Indonesia 0=1997
120 100 80 60 40 20 0 -5 -4 -3 -2 -1 0 1 2 3 4 5 6 7 8 9 10 11

Sweden 0=1990

2. Regulatory Framework what went wrong?

Macro versus Micro Supervision Regulatory and Supervisory Perimeter Supervisory Capacity Pro-cyclicality Global Architecture

Macro versus Micro Supervision

Macroeconomic developments asset markets, macro imbalances Regulators are micro focused and not on interlinkages across financial institutions Basel based on banks own risk models Presence of foreign intermediaries in some countries and cross-border capital flows

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
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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
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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

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
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3. Specific Proposals is there a solution

Turner Review Issing Group G 30 (Volcker) De Larosiere

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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
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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

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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
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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?)
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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

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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
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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

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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
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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?

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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

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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
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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.
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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
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Thank you!

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