SOME LESSONS
FOR REGULATION
FROM RECENT
BANK CRISES
Loughborough University, Loughborough, Leics, LE11
3TU, UK
Tel: 44 1509
222700
Email: D.T.Llewellyn@lboro.ac.uk
Paper presented at the Second International Conference on
The New Architecture of International Monetary System, Florence
15 October 1999
1. INTRODUCTION AND OUTLINE
Our objective is to consider the experience of recent banking crises in both developed and developing countries, and to draw lessons most especially with respect to the design of an optimum "regulatory regime". This will be done by setting out a series of general principles designed to lower the probability of banking distress. The concept of a "regulatory regime" is considerably wider than the prevailing set of prudential and conduct of business rules established by external regulatory agencies. It is widened to include the nature of the incentive structures operating within banks, the role of monitoring and supervision (by private and official agents), the disclosure regime and the role of market disciplines, and corporate governance arrangements within banks. It also includes the arrangements for official intervention in the event of bank distress. Just as the causes of banking crises are multi-dimensional, so the principles of an effective "regulatory regime" must also incorporate a wider range of issues than just externally imposed rules on bank behaviour.
A central theme is that, while external regulation has a role in fostering a safe and sound banking system, this role is limited. Equally, and increasingly, important are the incentive structures faced by private banking agents, and the efficiency of the necessary monitoring and supervision of banks by official agencies and the market. External regulation is only one component of regimes to create safe and sound banking systems. It is further argued that, over time and as the market environment in which banks operate becomes more complex, two structural shifts are needed within the "regulatory regime": (1) external regulation needs to become less prescriptive, more flexible and differentiated as between different institutions, and (2) more emphasis needs to be given to incentive structures and the contribution that regulation can make to creating appropriate incentive structures.
It is also necessary within the regulatory regime to include the arrangements for intervention in the event of bank distress and failures not the least because they have incentive and moral hazard effects which potentially influence future behaviour by banks and their customers and the probability of future crises. These arrangements also have important implications for the total cost of intervention (e.g. initial forbearance often has the effect of raising the eventual cost of subsequent intervention) and the distribution of those costs between tax-payers and other agents. Different intervention arrangements also have implications for the future efficiency of the financial system in that, for instance, forbearance may have the effect of sustaining inefficient banks and excess capacity in the banking sector.
For instance, it has frequently been argued (e.g. Drage and Mann, 1999) that, in the recent case of South East Asia, the injection of funds by the International Monetary Fund and World Bank (which in effect replaced private finance) effectively bailed out investors and, by shielding them from the full losses of their actions, may have had the effect of encouraging imprudent lending in the future which in turn may subsequently raise the probability of banking crises. It has also been claimed that the aftermath of the Mexico crisis sent a signal to investors that they are less likely to sustain losses by investing in short-term securities.
The focus of the paper is wider than the banking crises recently experienced by countries in Latin American and South East Asia. There are also significant lessons to be learned from the experience in more long-standing developed countries such as the Scandinavian banking crises in the early 1990s.
The outline of the paper is as follows. It begins with a brief overview of recent banking crises and the economic costs that emerge. Section 3 considers the common elements in banking crises. This is followed in section 4 by a discussion of the multi-dimensional nature of recent crises and focuses upon the macro economy, the legacy of pre-liberalisation, the role of bad banking practices, perverse incentive structures and moral hazard, ineffective regulation, weak monitoring and supervision, weak market discipline on banks, and unsound corporate governance arrangements. This is followed (section 5) by a review of the impact of liberalisation with a distinction made between the transitional effects associated with the shift from one regime to another, and the steady-state characteristics of a de-regulated financial system. The characteristics of a robust financial system are outlined in section 6. The final section draws together the implications of the previous analysis of the nature and origin of banking crises by setting out a set of principles for a regulatory regime designed to lower the probability of distress in the banking sector. These are organised in six components: regulation, monitoring and supervision, incentive structures, intervention, market discipline, and corporate governance.
2. RECENT BANKING CRISES
A recent IMF study of banking crises around the world begins as follows: "A review of the experiences since 1980 of the 181 current Fund member countries reveals that 133 have experienced significant banking sector problems at some stage during the past fifteen years (1980-1995)". Crises in the banking sector (in both developing and industrial economies) are clearly not random, isolated events. Around the world, banks in many countries have had very high levels of non-performing loans, there has been a major destruction of bank capital, banks have failed, and massive support operations have been necessary. This represents a greater failure rate amongst banks than at any time since the great depression of the 1920s. They have involved substantial costs. In around 25 per cent of cases the cost has exceeded 10 per cent of GNP (e.g. in Spain, Venezuela, Bulgaria, Mexico, Argentina, Hungary).
The main causes of recent crises have been those that have always attended commercial banking problems: poor risk analysis by banks, weak internal credit control systems, connected lending, insufficient capital, ineffective regulation, monitoring and supervision by regulatory agencies, and weak internal governance. These factors have frequently been aggravated by a volatile conduct of economic policy and structural weaknesses in the macro-economy. In other words, the origins of crises are both internal to banks and external. To focus myopically on one side only misses the essential point that systemic crises have both macro and micro origins.
Almost always and everywhere banking crises are a complex interactive mix of economic, financial and structural weaknesses. For an excellent survey of the two-way link between banking systems and macro policy see Lindgren et.al.(1996). The trigger for many crises has been macro-economic in origin and often associated with a sudden withdrawal of liquid external capital from the country. As noted by Fitzpatrick et.al (1999) financial crises have often involved triple crises of currencies, financial sectors and corporate sectors. Similarly, it has been argued that East Asian countries were vulnerable to a financial crisis because of "reinforcing dynamics between capital flows, macro-policies, and weak financial and corporate sector institutions" (Alba, et.al., 1998). The link between balance of payments and banking crises is certainly not a recent phenomenon and has been extensively studies (e.g. Kaminsky and Reinhart, 1998; Godlayn and Alden, 1997; Sachs, et.al, 1996).
Almost invariably, systemic crises (as opposed to the failure of individual banks within a stable system) in the financial system are preceded by major macroeconomic adjustment. This often leads to the economy moving into recession. Most financial crises have been preceded by sharp fluctuations in the macro economy, and often in asset prices. However, it would be a mistake to ascribe banking crises and financial instability entirely to macroeconomic instability. While macro instability may be the immediate and proximate cause of a banking crisis, such a crisis usually emerges because the instability in the macro economy reveals existing weaknesses within the banking system. It is also usually the case that the seeds of the problem (e.g. over-lending; weak risk analysis and control) were sown in the earlier upswing of the cycle. The downswing phase reveals previous errors and over-optimism. The mistakes made in the upswing emerge in the downswing. Such weaknesses include, for instance poor, weak, or inappropriate incentives in the system, weak internal risk analysis, inefficient management and control systems within banks and financial firms, poor regulation and supervision of financial institutions etc. In South East Asia, for instance, a decade of substantial economic growth up to 1997 concealed the effects of questionable bank lending policies.
A common experience in countries that have experienced serious banking problems is that expectations have been volatile and asset prices (including property) have been subject to wild savings. A sharp (sometimes speculative) rise in asset prices has been followed by an equally dramatic collapse. An initial rise in asset prices induces over-optimism and sometimes euphoria which in turn leads to increased demand for borrowed funds and an increased willingness by banks to lend.
Analysis of financial crises throughout the world indicates very powerfully that two common characteristics are weak internal risk analysis, management and control systems, and/or weak (or even perverse) incentives within the financial system generally and financial institutions in particular. These need to be addressed if a robust and stable financial system is to be created. In particular, the conclusion is that an unstable or unpredictable macro-economic environment is neither a necessary nor sufficient condition for banking crises to emerge: it is an illusion to ascribe such crises to faults in the macro economy alone. The fault also lies internally within banks.
3. SOME COMMON ELEMENTS IN BANKING DISTRESS
While each banking crisis has unique and country-specific features, they also have a lot in common. Several conditions tend to precede most systemic banking crises:
· rapid growth in bank lending within a relatively short period;
· unrealistic expectations and euphoria about economic prospects in the economy;
· a sharp and unsustainable rise in asset prices (part of euphoria speculation ) leading to unrealistic demands for credit and willingness of banks and other lenders to supply loans;
· concentrated bank portfolios often with a high property content, i.e. while project risks may be properly assessed, portfolio risk is often not;
· excessive inter-connected lending within banking groups;
· government involvement in loans and loan decisions which may have the effect of weakening incentive structures, eroding discipline on lenders (an implicit guarantor), and which may also involve undue political influence or insider relationships;
· inappropriate risk premia being charged in lending interest rates,
· insufficient attention being given to the value of collateral most especially if rapid balance sheet growth occurs in a period of asset-price inflation;
weak conduct of monetary policy in a context of high and volatile rates of inflation.
In the final analysis, weak internal risk analysis, management and control systems are at the root of all banking crises. Instability elsewhere should not conceal, or be used to excuse weaknesses, in this area of bank management. Further, when these weaknesses are present they frequently manifest themselves in excessive lending on property projects. Many banking crises around the world have been associated in part with over-lending on property projects. This is partly because, in periods of rapid asset price inflation, property appears to be an attractive lending proposition. However, it is in essence speculative lending and the bubble bursts when the over-capacity in the property sector becomes evident. In other words, when internal risk analysis, management and control systems are weak, and when euphoria supplants analysis, the problem will frequently be focused on property lending which, in essence, is speculative in nature.
Banking crises also often follow major changes in the
regulatory regime which create unfamiliar market conditions. Periods of rapid balance sheet growth, most
especially if it occurs after a regime shift and in a period of intense
competition where market share considerations dominate bank behaviour, almost
inevitably involve banks incurring more risk.
There are several reasons for this:
banks begin to compete for market share by lowering their risk
thresholds; risks are under-priced in order to gain market share; control
systems tend to weaken in periods of rapid balance sheet growth; growth itself
generates unwarranted optimism and a balance sheet growth-momentum develops;
and portfolios become unbalanced if new lending opportunities are concentrated
in a narrow range of business sectors.
When, as is often the case, fast
growth strategies are pursued by all banks simultaneously, borrowers become
over-indebted and more risky which in turn increases the vulnerability of the
banks from whom they are borrowing
4. A MULTI-DIMENSIONAL PROBLEM
The recent banking crises in South East Asia have, as always, been complex and the causes multi-dimensional. While evident macro policy failures, and volatile and structurally weak economies, have been contributory factors, it is also the case that fundamentally unsound banking practices, perverse incentive structures and moral hazards, and weak regulation and supervision have also been major contributory factors. A myopic concentration on any single cause will fail to capture the complex interactions involved in almost all banking and financial crises.
This also suggests that the response to avoid future crises equally needs to be multi-dimensional involving the conduct of macro policy, the conduct of regulation and supervision, the creation of appropriate incentive structures, the development of market discipline, and the internal governance and management of financial institutions. As a prelude to a consideration of the principles to reduce the probability of future banking fragility, the remainder of this section briefly considers in turn the main components of recent banking crises. While the experience of each country varies in detail, there is a remarkable degree of commonalty between them including, to some extent, the experience of financial fragility in some developed economies. A discussion of the factors behind the Scandinavian banking crises of the early 1990s is given in Andersson and Viotti (1999) and Benink and Llewellyn (1994).
Reflecting the multi-dimensional aspect of financial distress, the main causal factors in recent banking crises are now considered under eight headings: (1) volatility in the macro-economy; (2) the inheritance of structural weaknesses in the economy; (3) bad banking practices; (4) hazardous incentive structures and moral hazard within the financial system; (5) ineffective financial regulation; (6) weak monitoring and supervision by official agencies; (7) the absence of effective market discipline against hazardous bank behaviour due partly to the lack of transparency and the disclosure of relevant information, and (8) structurally unsound corporate governance mechanisms within banks and their borrowing customers.
We find that the recent distress of banks in South East Asia is a product of a volatile economy (with strong speculative elements) combined with bad banking practices, weak regulation, ineffective supervision both by the official agencies and the market, and hazardous incentive structures. All of this induced excessive lending and risk-taking by banks.
(1) The
macro-economy
Although growth in the countries of South East Asia had been strong for many years before the onset of the crises, structural weaknesses in some of the economies of the region was also evident. In many cases, exceptionally high investment rates concealed inefficiencies in the allocation of investment funds in the economy. Investment plans were often undertaken without reference to realistic assessment or measurement of expected rates of return. The financial and solvency position of many large investing companies was also seriously over-stated by inaccurate accounting procedures.
Many financial crises have often been preceded by sharp and speculative rises in real and financial asset prices (see, for instance, the experience of Indonesia, Malaysia, Philippines and Thailand in figure 1 and tables 1 and 2). Such sharp and unsustainable rises in asset prices have a bearing on subsequent financial distress through several channels. As already noted, the main route is through the effect on the demand and supply of bank credit.
A key factor in the macro-economic background to recent banking crises has been the dependence on short-term capital inflows intermediated via the banking system. Table 3 shows the pattern of private capital flows to Asian countries over the 1990s and the dependence of the crisis countries (Indonesia, Korea, Malaysia, Philippines and Thailand) on volatile banking flows (the dominant component of the "other" category in table 3). The vulnerability to such volatile flows is shown in the $73 billion turnaround in 1997 when a net inflow of $41 billion in 1996 was followed by a $32 billion net outflow in the following year. A substantial proportion of the short-term capital inflow was intermediated by domestic banks incurring short-term liabilities against foreign banks. The vulnerability of the crisis countries to an external illiquidity problem became substantial and this was a pattern evident in crises faced by other countries (see, Cole and Kehoe, 1996 and Sachs, et.al. 1996). The issue is discussed in more detail in Corsetti, et al,(1998).
Overall, strong economic growth was, at least at the margin, intermediated by domestic banks incurring foreign currency liabilities to foreign banks on the basis of short-term inter-bank lines
(2) The
inheritance
Many of the crisis countries have had a long tradition of substantial government involvement and ownership in the banking system. This has frequently meant that funds have been channelled to ailing industries under overt or covert political pressure. Bisignano (1998) argues that such selective credit allocation has been a factor retarding the development of effective risk analysis and management systems in banks. In effect, banks were not acting as market-orientated financial intermediaries but as a channel for the public policy support of industries that would not have received the scale of support through market mechanisms. In addition, the close connections between banks and industrial corporations, and the general influence of government in the economy and the support of certain industries, created the climate that neither borrowers nor the banks would be allowed to fail. This in turn aggravated a tendency towards imprudent lending. The issues are discussed further in Martinez, et.al., (1999).
This is not a problem restricted to the less developed
countries of South East Asia. Suzuki
(1986) has argued that heavy involvement of government in the financial
intermediation process carries three potential hazards: capital may be
allocated inefficiently and on non-market criteria, it may undermine the
effectiveness of monetary policy, and it may undermine fiscal discipline.
The "inheritance problem" also included weak corporate sector structures with powerful links between companies in a way that could avoid normal market discipline on corporate behaviour. This in turn was aggravated in many cases by weak corporate governance arrangements, and the non-feasibility for the market in corporate control to operate, both of which again muted normal market disciplines.
Before the financial liberalisation process was instigated, many of the crisis countries operated on the basis of quite rigid public control and/or direction. Some of the subsequent problems emanated from losses (which were often concealed) incurred during the previously repressed financial regime. It is also evidently the case that the true financial condition of many banks had been concealed in the pre-liberalisation period because of weak loan classification standards and an expectation that banks would be supported in the event of difficulty. In many Latin American countries, accounting standards were very lax and to an extent that banks were reporting positive net income even during a banking crisis (see, Rojas-Suarez and Weisbrod, 1995). Such questionable accounting practices are not exclusive to developing countries, (Kim and Kross, 1995). In some cases, banks seem to be able to determine loan-loss provisions on the basis of managing the level of declared capital rather than to reflect the true quality of loans (Beatty, et.al., 1993).
(3) Bad banking practices
Several elements of "bad banking" have also played a central role in the emergence of financial fragility and the subsequent failure of banks but which were concealed during the optimism generated during the previous period of rapid economic growth. Mention may be made in particular of:
banks operating on the basis of low capital ratios which were sometimes below minimum levels required by the regulatory authorities and which were not forced to be addressed by the regulators;
substantial foreign currency exposures which were incurred because foreign currency borrowing was cheap, because the alleged commitment to a fixed exchange rate was not questioned, and because of the general expectation of "bail-outs" in the event of difficulty;
very rapid growth in bank lending. As already noted, a common feature of bank crisis (including in advanced economies) is that they are preceded by a period of very rapid growth in bank lending. This is shown for the crisis countries of South East Asia in tables 4 and 5 which show the high rates of growth in bank lending to the private sector, and the sharp rise in the proportion of bank lending to GDP. Periods of rapid growth in bank lending frequently conceal emerging problems: it is more difficult to distinguish good from bad loans (Hausmann and Gavin, 1985); it often involves banks lending to areas with which they are not familiar; herding behaviour develops, credit standards are weakened in a phase of euphoria and some of the lending is based on speculative rises in asset prices. This has also been noted in the Scandinavia banking crises of the early 1990s (Benink and Llewellyn, 1994).
weak risk analysis and management systems within banks;
excessively concentrated portfolios often with a substantial exposure to property and real estate either directly in the form of loans or indirectly through the collateral offered by borrowers; the exposure to property of seven countries of South east Asia is given in table 6.
bank lending on the basis of an unsustainable rise in asset prices;
substantial connected lending by banks to companies within the same group and on the basis of poor (or non-existent) risk assessment and non-market criteria;
the failure to incorporate risk premia in the interest rate on loans. The BIS has noted (BIS, 1998) that in many crisis countries the lending margin was low (and was declining during the period of rapid growth) relative to operating costs which indicates that an insufficient risk premia were being charged;
inaccurate accounting standards and weak loan classification and provisioning which had the effect of over-stating the value of bank loans and hence the true capital position of banks.
An interesting perspective on the effect of excessive bank lending is given by an IMF team ( Adams, et.al.,1998). Bank lending growth was substantially in excess of the growth of GDP in the distress countries of South East Asia (figure 2). This produced high leverage ratios (ratio of credit to the private sector relative to GDP). The IMF study notes that in many of the countries of the region (and particularly those where bank distress was most marked: Korea, Malaysia and Thailand) the loan leverage ratios rose to levels that were higher than those in industrial countries with more developed financial infrastructures (figure 2). Several studies (e.g. Demirguc-Kunt and Detragiache, 1998; Kaminsky and Reinhart, 1999; Benink and Llewellyn, 1994) show that rapid credit growth and high and sharply rising leverage are significant determinants of banking crises in both developing and developed countries. The authors of the IMF study suggest that with respect to figure 2, countries in the early stages of economic development are normally in the north-west quadrant (high loan growth with low leverage) but as they advance in their development they are expected to converge to the border between the south-east and north-east quadrants. The figure shows, however, that Korea, Thailand and Malaysia each had both high growth rates of bank lending and high leverage ratios. A somewhat different picture emerges for the Philippines (very high growth rate of bank lending but comparatively low leverage ratio) and Indonesia with a modest growth rate of bank lending and a modest leverage ratio.
(4) Incentive structures and moral hazard
A central theme of this paper is that the incentive structures and moral hazards faced by decision-makers (bank owners and managers, lenders to banks, borrowers and central banks) are major issues to consider in the "regulatory regime". Some analysts ascribe much of the recent banking crises to various moral hazards and perverse incentive structures such as fixed exchange rate regimes, anticipated lender-of-last-resort actions, what are viewed as bail-outs by the IMF, the ownership structure of banks and their corporate customers, and safety-net arrangements.
Moral hazard effects, while important, may nevertheless also be exaggerated. For instance, Brealey (1999) argues against the adverse incentive effect of IMF lending on the grounds that investors did in fact lose value and also points to the reluctance of governments to resort to IMF facilities because of the resultant conditionality that is applied. It is also argued (Adams, et.al., 1998) that investors in South East Asia were motivated not by any alleged safety-net but by the "star performance" status of the economies. While potential moral hazard effects may be exaggerated, this is not to deny the central importance of identifying the incentive structures implicit in regimes, and the potential moral hazards that can arise.
There is a particular issue with respect to the incentive structure of state-owned, or state-controlled, banks as their incentives may be ill-defined, if not hazardous. Such banks are not subject to the normal disciplining pressures of the market, their "owners" do not monitor their behaviour, and there is no disciplining effect from the market in corporate control. Political interference in such banks, and the unwitting encouragement of "bad banking" practices, can itself become a powerful ingredient in bank distress. Lindgren, et.al. (1996) found, for instance, that banks that are, or were recently, state-owned or controlled were a factor in most of the instances of unsoundness in their sample of banking crises.
Several adverse incentive structures can be identified in many of the countries that have recently experienced distressed banking systems:
the expectation that the government's commitment to the exchange value of the domestic currency was absolute induced imprudent and unhedged foreign currency borrowing both by banks (though these were sometimes hedged) and companies;
expectations of bail-outs or support for industrial companies (which had at various times been in receipt of government support) meant that the bankruptcy threat was weak;
this may also have affected foreign creditors;
a strong belief in the role of the lender-of-last-resort and expectations that banks would not be allowed to fail. The IMF notes that the perception of implicit guarantees was probably strengthened by the bailouts in the resolution of earlier banking crises in Thailand (1983-87), Malaysia (1985-88) and Indonesia (1994);
the effect of close relationships between banks, the government, other official agencies and industrial corporations which often meant that relationships (e.g. lending) that would normally be conducted at arms-length became intertwined in a complex structure of economic and financial linkages within sometimes opaque corporate structures. This also meant that corporate governance arrangements, both within banks and their borrowing customers, were often weak and ill-defined.
(5)
Ineffective regulation
There are many elements of weak regulation in the origin of banking crises in recent years and which aggravated the effect of the other dimensions to the distress:
capital adequacy regulations were often either not in place or were not effectively enforced;
regulatory requirements for capital, while conforming to the letter of international agreements, were nevertheless set too low in relation to the nature of the risks in the economy and the risks being incurred by banks: capital adequacy regulation often did not accurately reflect the banks' risk characteristics (BIS, 1998);
the rules with respect to classification of loan quality and provisions were often too lenient and ill-specified, with the result that provisions were insufficient to cover expected losses, and earnings and capital were over-stated (Brownbridge and Kirkpatrick, 1999; Folkerts-Landau, et.al., 1995);
rules with respect to exposure to single borrowers were often too lax (or not enforced),
regulation and supervision with respect to concentrated exposures (e.g. property) were too lenient;
poor accounting standards enabled banks to evade prudential and other restrictions on insider lending (Rahman, 1998);
many governments and regulatory authorities were slow and hesitant to act in the face of impending solvency problems of banks. Such regulatory forbearance was often due to the fact that regulatory authorities had substantial discretion as to when and whether to intervene, and were often subject to political pressure of one kind or another.
(6)
Weak monitoring and supervision
As with all companies, banks need to be monitored. In addition to the standard principal-agent issues, banks are universally monitored and supervised by official agencies (e.g. central banks). In practice, "some form of supervisory failure was a factor in almost all the sample countries" (Lindgren, et.al., 1998). In many countries supervisory agencies did not enforce compliance with regulations (Reisen, 1998). In Korea and Indonesia in particular, banks did not comply with regulatory capital adequacy requirements and other regulations (UNCTAD, 1998). In particular, connected lending restrictions were not adequately supervised partly because of political pressure and the lack of transparency in the accounts of banks and their corporate customers.
A further aspect of this supervisory failure was that supervisory intensity did not adjust in line with the liberalisation of the financial system and the new business operations and risk characteristics of banks that emerged in a more de-regulated market environment. This is discussed in more detail in the next section. This was also the case with Scandinavian countries when, in the second half the 1980s, banks responded aggressively to de-regulation. The nature and intensity of official supervision needs to reflect the nature of the regulatory regime. In practice, while the latter changed this was not accompanied by sufficiently intensified supervision.
(7) Weak market discipline on banks
Monitoring is not only conducted by official agencies whose specialist task it is. In well-developed financial regimes, the market also monitors the behaviour of financial firms. The disciplines imposed by the market can be as powerful as any sanctions imposed by official regulatory agencies. However, in practice, the disciplining role of the markets (including the inter-bank market which in many jurisdictions is able to impose powerful discipline through the risk premium charged on inter-bank loans) was weak in the crisis countries of South East Asia. This was due predominantly to the lack of disclosure and transparency of banks and the fact that, for reasons already noted, little reliance could be placed on the quality of the accountancy data provided in bank accounts. In many cases standard accountancy and auditing procedures were not applied rigorously. In some cases there was wilful mis-representation of the financial position on banks and non-financial companies. Overall, market disciplines can work effectively only on the basis of full and accurate disclosure and transparency.
Effective competition in the banking system (and especially if this includes competition from foreign banks) can also impose its own discipline and instil good business practice. In general, a competitive banking system is essential for long-term efficiency and soundness. Monopoly rents may engender inefficiency most especially if the monopolies are state-owned or controlled.
A further dimension relates to the potentially powerfully disciplining power of the market in corporate control which, through the threat of removing control from incumbent managements, is a discipline on managers to be efficient and not endanger the solvency of their banks,. As put in a recent IMF study: "An open and competitive banking market exerts its own form of discipline against weak banks while encouraging well-managed banks", (Lindgren, et.al., 1998)
(8) Unsound corporate governance arrangements.
In the final analysis, all aspects of the management of a bank are corporate governance issues. This means that if banks behave hazardously this is, to some extent, a symptom of weak internal corporate governance. This may include, for instance, a hazardous corporate structure for the bank, lack of internal control systems, weak surveillance by (especially non-executive) directors, and ineffective internal audit arrangements. Corporate governance arrangements were evidently weak and under-developed in banks in many of the distress countries.
Some ownership structures of banks in the private sector can produce bad corporate governance. In some cases, particular corporate structures (e.g. banks being part of larger conglomerates) encourage connected lending and weak risk analysis of borrowers. This has been found to be the case in a significant number of bank failures in the countries of South East Asia and Latin America. Some corporate structures also make it comparatively easy for banks to effectively conceal their losses and unsound financial position.
Assessment
The central theme of this section has been that recent banking crises have been multi-dimensional and a complex mix of several interacting pressures and weaknesses. A myopic focus on particular causal components is likely to produce a distorted picture and also to produce inadequate policy and reform proposals. The experience of many countries has demonstrated the lethal cocktail of fundamental and structural weaknesses in the economy, hazardous incentive structures, weak and ineffective regulation, inadequate official supervision, and an inability or unwillingness of the market to impose discipline on banks. It follows that reform needs to proceed along several channels simultaneously which in itself makes the reform process more demanding and challenging.
5. LIBERALISATION: STOCK-ADJUSTMENT V STEADY STATE
Many financial crises have been associated with changes in the regulatory regime and a process of liberalisation in particular. For decades, the economies of South East Asia were highly regulated with interest rate ceilings, limitations on lending growth by financial institutions, restrictions on foreign entry into the banking system, etc. At various times during the 1990s, these restrictions were relaxed, and the pace of financial liberalisation accelerated.
Williamson and Mahar (1998) show that almost all of their sample of thirty-four economies (both industrialised and developing) that undertook financial liberalisation over the 1980s and 1990s experienced varying degrees of financial crisis. Similarly, Kaminsky and Reinhart (1998) found that in the majority in their sample of countries that had experienced banking crises, the financial sector had been liberalised during the period five years. They conclude that financial liberalisation helps predict banking crises across a range of countries. Goldstein and Folkerts-Landau (1993) observe a general pattern of de-regulation inducing more competition to be followed by increasing financial fragility.
While in both developed and less developed countries banking distress has often followed periods of de-regulation and liberalisation, a distinction needs to be made between the transitional effect of moving from one regulatory regime to another, and the characteristics of a steady-state liberalised financial system. The instabilities that may occur in the transition period do not necessarily carry over into the new steady-state.
The Transitional Phase
The universal evidence is that financial liberalisation enhances efficiency in the financial system, and that financial repression distorts the incentives for saving and investment. However, financial liberalisation often brings problems most especially in the transition period:
· One effect of increased competition that results from liberalisation is often to erode the economic rents of financial firms associated with the previously uncompetitive environment. This reduced profitability may induce financial institutions into taking more risk.
· In the stock-adjustment phase (i.e. during the period when the new regime is being introduced) uncertainty may be created as financial firms are unfamiliar with the requirements of the new regime. Previously protected institutions need to adapt behaviour though this may occur only with a considerable lag. New behaviour patterns need to be learned. Some mistakes during the process of financial liberalisation occur because banks do not adjust quickly enough to the new regime. Behaviour which is appropriate under one regime may be totally inappropriate in another (see Benink and Llewellyn, 1994 for a more formal discussion).
· In the first instance, liberalisation may also increase inflationary pressure as balance sheet restraints are lifted and financial firms increase their lending very rapidly in a relatively short period. This is often associated with a sharp rise in asset prices within a relatively short period. The implication is that financial liberalisation needs to be accompanied by an appropriate stabilisation policy to reduce the potential impact on inflation which can distort lending decisions.
In countries that have liberalised their financial systems after decades of controls, banks responded in a remarkably similar way by substantially increasing the volume of lending in a short period. As a result of increased competitive pressures, banks tend to lower equilibrium and disequilibrium credit rationing and risk thresholds (Llewellyn and Holmes, 1992), bank lending margins are squeezed, and bank profitability at first rises due to this expansion, but later deteriorates sharply due to massive loan losses.
· The rapid growth in lending during the stock-adjustment phase may also increase risk because banks’ internal control systems are weak. This is compounded when banks adopt market-share strategies in a strongly expanding loans market.
In general, periods of substantial growth of bank lending are likely to involve banks moving into more risky business and adopting a higher risk profile, (OECD, 1992). The removal of controls often unleashes a pent-up demand for credit, and suppliers of credit are freed to compete which in some cases leads to a relaxation of standards (see also Schinsi and Hargreaves, 1993). There are many reasons why risks might rise in a period of a sharp growth in lending following a period of de-regulation: economic rents created by regulation are suddenly removed, more risky business appears to be profitable, and credit-rationing is eroded. The same competitive pressures may also make it difficult, in the short-run, for banks to incorporate higher risk premia in loan rates, with the results that bank loans are under-priced.
The initial stock-adjustment reaction often involves a phase of over-reaction by lenders as balance sheet structures are taken beyond long-run sustainable positions. There are several reasons for this: reactions times in financial markets are short, adjustments can be made quickly, and the financial system is characterised by oligopolistic competition. As a result, competitive pressures seem to force firms to move together: sometimes described as a "herd instinct". Some analysts have ascribed it to a property of the incentive structure within banks in that, in a world of uncertainty, the desire to avoid personal blame for mismanagement is liable to make risk-averse bank managers subject to peer-group pressure to follow the same policy.
· The rise in interest rates that often follows the process of liberalisation leads to an erosion of credit rationing and interest rate ceilings imposed by financial firms. This in itself may both increase risk and reduce the profitability of banks.
· Liberalisation may also reveal inherent weaknesses in the banking system both with respect to structure and the traditional way of conducting business.
· If supervision is not intensified at the same time as the financial system is liberalised, the financial system may become crisis prone. In liberalising their financial systems, the countries of South East Asia ignored the risks posed by rapid liberalisation which is not accompanied by significant strengthening of regulation and supervision of bank behaviour, (Furman and Stiglitz, 1998). In this, they followed the earlier experience of the Scandinavian countries (Benink and Llewellyn, 1994). Bisignano (1998) suggests that it represented a combination of "excess momentum" by the private sector and "excess inertia" by the regulatory authorities. Put another way, there is a trade-off between regulation and supervision in that if regulation is eased to allow banks to conduct more business, there is an increased requirement for effective supervision of the way that business is conducted. There are many examples, in both developing and developed countries where liberalisation was not accompanied by more intensive supervision.
However, many of these problems are ones of transition. A distinction is be made between what happens during a stock-adjustment phase of liberalisation, and the characteristics of a steady-state, deregulated financial system. The evidence powerfully indicates that a liberalised financial system is more efficient and contributes more substantially to economic development. However, when moving from one regime to another (especially from a highly controlled financial system to a more market-orientated system) instability may be created as new behaviour patterns need to be learned. The fact that instability may occur during the transitional, stock-adjustment period does not mean that a deregulated financial system is inherently unstable, or even less stable than a regulated regime. Many of the financial crises experienced in recent years have been associated with the uncertainties and mistakes during the transitional phase during which liberalisation measures were adopted. The crisis is often a function of the uncertainty associated with regime changes (as the system moves from one regime to another) rather than the inherent characteristics of the new regime per se. A de-regulated system is not to be discredited because of the problems sometimes associated with moving towards it.
The policy implication is that care is needed in the process of liberalisation, and that supervision of financial institutions needs to move in pace with liberalisation. Deregulation without enhanced supervision is likely to be hazardous irrespective of the long-run benefits of liberalisation and the erosion of financial repression. Liberalisation is often not accompanied by necessary changes in regulation and supervision, corporate governance reforms, and enhanced market monitoring and control.
The Steady State
However, there is an argument that, while some of the financial distress is associated with the transition from one regime to another, a more competitive market environment is potentially more risky than an uncompetitive market structure. This is because the value of the banking franchise is reduced by competition. The more valuable is the franchise the less likely are owners to risk losing it. Keeley (1990), for example, analyses how de-regulation and increased competition can induce banks to behave with less regard to risk because it lowers the value of the banking franchise. Similar conclusions are found in Caprio and Summers, (1993), and Demsetz, et.al., (1997). Using data to proxy bank franchise values, Hellman and others (1995) examine the relationship between bank franchise values and financial market liberalisation as a test of the argument that moral hazard increases as banks' franchise values fall. Their results confirm that banking crises are more likely to occur in countries with a liberalised financial sector, and that franchise values tend to be lower when financial markets are liberalised.
In many cases previous, highly regulated, regimes acted as a protection to financial institutions by effectively limiting competition. The extent of the economic rents that were created in this regime were probably under-estimated by the regulatory authorities. In many cases, they under-estimated the extent to which deregulation and liberalisation would increase competition in the banking industry even though that was one of the public policy objectives. These errors inhibited approprioate responses in the areas of prudential regulation and monitoring and supervision.
6. ROBUST FINANCIAL SYSTEM
Given this experience it is instructive to consider the basic characteristics of a robust financial system, i.e. one that satisfies the ‘test of markets’. Basically robustness refers to the ability of the financial system to remain stable and efficient under a wide range of market conditions and shocks. We may identify three particular elements in this: flexibility (the ability of the financial system to operate in all circumstances and to change the way it operates as market conditions alter); resilience (the ability to continue to function in the face of external shocks including instability in the macro economy), and internally stable (the financial system does not itself generate its own shocks or magnify shocks in the macro economy).
Regulation can contribute towards a robust financial system through six main routes: by prescribing risk-taking activity and by establishing certain basic prudential standards (e.g. minimum capital adequacy requirements); through the effect on inventive structures and limiting moral hazard within the financial system; by requiring a high degree of information disclosure and transparency; by establishing a robust basic financial infrastructure; through setting corporate governance standards and structures, and through monitoring and supervision of financial institutions. These are discussed in some detail in later sections.
The infrastructure
A central prerequisite for a robust financial system is to create an institutional setting and financial infrastructure for sound credit culture and effective market functioning. This includes aspects such as legal arrangements, information disclosure and availability, and the basic tools of sound accountancy and auditing. Several particular elements are identified:
1. A strong legal framework to ensure that property rights are well defined and easily and reasonably costlessly exercisable. This implies creating a legal environment where the terms and conditions of contracts are observed, and the rights and obligations of all agents involved in loans or transactions in financial assets are well-defined, understood and enforceable without undue delay or cost.
2. A legal framework for the pledging of collateral and the ability to take possession of collateral. Without these conditions moral hazard and adverse incentives are created with bank borrowers.
3. Clearly defined bankruptcy laws and codes, along with effective enforcement mechanisms.
4. Good quality, timely and relevant information disclosure available to all market participants and regulators so that asset quality, creditworthiness and the condition of financial institutions can be assessed. This includes timely publication of relevant financial data on the soundness of financial institutions, and the adoption of comprehensive and well-defined accounting principles that conform to agreed international standards.
5. Effective rating agencies operating independently of government authorities.
6. Robust payment, settlement and custody arrangements and systems.
7. A wide variety of financial instruments (including derivatives) and markets that can assist financial institutions in the management of risks.
These considerations relate to the basic infrastructure of a financial system and many require public policy initiatives by public agencies with responsibility for systemic stability. Lindgren et. al. (1996) found that an inadequate legal framework was a common characteristic in the sample of developing and transition economies that had experienced banking crises.
7. THE "REGULATORY REGIME"
Having discussed some of the common origins of banking distress, we turn now to consider a set of principles to reduce the future probability of crises. In the final analysis, regulation is about changing the behaviour of regulated institutions. One of the key questions is the extent to which behaviour is to be altered by externally imposed rules, or through creating incentives for firms to behave in a particular way. The arguments against reliance on detailed and prescriptive rules are outlined in Goodhart, et.al. (1998). Regulation can be endogenous within the financial firm as well as exogenous. A major issue, therefore, is whether regulation should proceed through externally imposed, prescriptive and detailed rules, or by the regulator creating incentives for appropriate behaviour.
Financial systems are changing substantially to an extent that may undermine traditional approaches to regulation and most especially the balance between regulation and supervision, and the role of market discipline. In particular, globalisation, the pace of financial innovation and the creation of new financial instruments, the blurring of traditional distinctions between different types of financial firm, the speed with which portfolios can change through banks trading in derivatives etc., and the increased complexity of banking business, create a fundamentally new - in particular, more competitive - environment in which regulation and supervision are undertaken. They also change the viability of different approaches to regulation which, if it is to be effective, must constantly respond to changes in the market environment in which regulated firms operate.
A robust financial system requires three particular properties: (i) proper decision making and control within financial institutions with effective risk analysis, management and control systems; (ii) an efficient regulatory and supervisory regime for financial institutions; and (iii) sound incentive structures for all parties including regulators. These three dominant themes may, on the face of it, seem fairly obvious. However, when the detailed implications are considered they are not so obvious. Some of the measures designed to achieve what is required are difficult to implement and the transactions costs of change can be substantial.
A sustained theme in this paper is that a "regulatory regime" is to be viewed more widely than externally-imposed regulation on financial institutions. Regulation is only one of six key components: regulation, monitoring and supervision (private and official), incentive structures, intervention and sanctions, market discipline, amd corporate governance. In current conditions (globalisation, etc.) it would be a mistake to rely wholly, or even predominantly, on external regulation, monitoring and supervision by the "official sector" of the regulatory regime. The world of banking and finance is too complex and volatile to be able to rely on a simple set of prescriptive rules for prudent behaviour.
The key to optimising the effectiveness of a regulatory regime is the portfolio mix of the six core components. All are necessary but none alone are sufficient. Particular emphasis is given to incentive structures because, in the final analysis, if these are perverse or inefficient, no amount of formal regulation will prevent problems emerging in the banking sector. In practice, there needs to be a switch in emphasis from prescriptive regulation to creating appropriate incentive structures.
Having established the general framework of the "regulatory regime", the following sections outline a set of general principles designed to reduce the probability of banking distress. They are focused on each of the six core components:
(I) regulation,
(II) incentive structures
(III) monitoring and supervision
(IV) official intervention in the event of bank distress
(V) the role of market disciple
(VI) corporate governance arrangements..
(I) REGULATION
Goodhart, et.al. argue that there is always an inherent
danger of over-regulation because consumers perceive regulation to be a
costless actrivity (and hence is over-demanded) and regulatory agencies tend to
be risk-averse (which means that regulation may be over-supplied). The case for regulation of banks depends on
various market imperfections and failures (especially externalities and asymmetric information) which, in the absence
of regulation, produce sub-optimal results and reduce consumer welfare. In other words, the objective of regulation
should be limited to correcting identified
market imperfections and failures. six
main principles are suggested:
(1) The objectives of
regulation need to be clearly defined and circumscribed.
Financial regulation should have only a limited number of objectives. In the final analysis the objectives are to sustain systemic stability and to protect the consumer. Regulation should not be overloaded by being required to achieve other and wider objectives, such as social outcomes Constructing effective and efficient regulation is difficult enough with limited objectives, and the more it is over-burdened by wider considerations the more likely it is to fail in all of them.
(2) The
rationale of regulation and supervision should be limited.
The rationale for regulation lies in correcting for identified market
imperfections and failures; incorporating externalities; the economies of scale
in monitoring, breaking a "grid lock", and limiting moral hazard
associated with safety-nets, (see Llewellyn, 1999). Regulation in general, and regulatory measures in particular,
need to be assessed according to these criteria. If they do not satisfy any of these criteria, particular
regulatory measures should be abandoned.
(3) Regulation should be seen in terms of a set of contracts.
Laws, regulations, and supervisory actions provide incentives for regulated firms to adjust their actions and behaviour, and to control their own risks internally. They can usefully be viewed as incentive contracts within a standard principal-agent relationship where the principal is the regulator and the agent is the regulated firm. Within this general framework, regulation involves a process of creating incentive compatible contracts so that regulated firms have an incentive to behave in a way consistent with the objectives of systemic stability and investor protection. Similarly, there need to be incentives for the regulator to set appropriate objectives, to adopt well-designed rules, not to over-regulate, and to act in a timely fashion (for instance, in the face of pressure for forbearance). If incentive contracts are well-designed they will induce appropriate behaviour by regulated firms. Conversely, if they are badly constructed and improperly designed, they might fail to reduce systemic risk (and other hazards regulation is designed to avoid) or have undesirable side-effects on the process of financial intermediation (e.g. impose high cost). At centre stage is the issue of whether all parties have the right incentives to act in a way that satisfies the objectives of regulation.
(4) The form and intensity of regulatory and supervisory requirements
should differentiate between regulated institutions according to their relative
portfolio risk and efficiency of internal control mechanisms.
While the objective of ‘competitive neutrality’ in regulation is something of a mantra, this is not satisfied if unequal institutions are treated equally. In this respect, ‘equality' relates to the risk characteristics of institutions. It might be argued that, in order to maintain competitive neutrality, two banks with different risk characteristics and quality of risk management systems should be treated equally because they are both ‘banks’ and in competition with each other. However, in terms of satisfying the objectives of regulation a sub-optimum outcome will emerge if they are subject to the same regulatory requirements. One of the hazards of a detailed and prescriptive rule book approach is that it may fail to make the necessary distinctions between non-homogeneous firms because the same rules are applied to all; it reduces the scope for legitimate differentiations to be made. The adoption of an internal model’s approach, such has been introduced by G-10 countries after the Market Risk Amendment of the Basle Accord, recognises this point. Other considerations that should govern the setting of minimum capital adequacy requirements for individual banks include the quality of management; the quality, reliability and volatility of the bank's earnings; and the bank's liability and liquidity profile.
(5) In
some areas the regulator could offer a menu of
contracts to regulated firms requiring them to self-select into the
correct category.
There is an information, and possibly efficiency, loss if a high degree of conformity in the behaviour of regulated firms is enforced. If, alternatively, firms have a choice about how to satisfy the regulator's stated objectives and principles, they would be able to choose their own, least-cost way of satisfying these objectives. The regulator could offer a menu of self-selecting contracts rather than the same one to all institutions. Equally, banks could offer their own contracts. An example of this approach is the variable add-on in the multiplication factor of the Basle internal models approach. Since this add-on varies with the performance of a VaR model during back-testing procedures, a bank has the choice between using a simple (less precise) model with a higher capital requirement for market risk, or incurring costs in developing a better model and benefit from a lower capital requirement. However, empirical tests of VaR models show that the fixed part of 3 in the Basle multiplication factor is already so high that there is little incentive to use the best models because of the relatively small variable add-on (between 0 and 1). Our suggestion, therefore, is to lower the fixed part of the multiplication factor and to increase the variable part. Another approach which could be adopted for more qualitative measures of internal control and risk management quality is risk-related examination schedules. Here, financial institutions can be given a risk rating (say, between 0 and 10) on the basis of a series of internal control indicators. The higher the rating, the greater the perceived overall risk and the more frequent and intrusive would be on-site examinations. A more far-reaching proposal is the pre-commitment approach which gives a bank the possibility to pre-announce a maximum trading loss and incur regulatory penalties or other incentives in proportion to the extent to which pre-announced maximum losses are exceeded (this is discussed below).
(6) Capital
regulation should create incentives for the correct pricing of absolute and
relative risk.
If differential capital requirements are set against different types of assets (e.g. through applying differential risk weights) the rules should be based on actuarial calculations of relative risk. If risk weights are incorrectly specified, perverse incentives can be created for banks because the implied capital requirements are more or less than justified by true relative risk calculations. A major critique of the current Basle capital requirements is that the risk weights bear little relation to relative risk characteristics of different assets, and the loan book carries a uniform risk weight even though the risk characteristics of different loans within a bank's portfolio vary considerably.
(II) INCENTIVE STRUCTURES
Emphasis has been given to the central importance of incentives within banks and the role that regulation can have in positively creating appropriate incentives. As banking crises frequently occur when there are weak incentives to act prudently, a necessary ingredient of a robust and stable financial system is the creation of appropriate and efficient incentives and disciplining mechanisms for all market participants and most especially bank owners, bank managers and financial system supervisors. These are now briefly considered.
(7)
There should be appropriate incentives for Bank Owners
Bank owners have an important role in the monitoring of bank management and their risk-taking. In the final analysis, it is bank owners who absorb the risks of the bank. There are several ways in which bank owners can be appropriately incentivised:
One route is to ensure that banks have appropriate levels of equity capital. Capital serves three main roles as far as incentive structures are concerned: a commitment of the owners to supply risk resources to the business and which they can lose in the event that the bank makes bad loans; an internal insurance fund, and the avoidance of the bank becoming the captive of its bad debtors. In general, the higher is the capital ratio the more the owners have to lose and hence the greater the incentive for them to monitor the behaviour of managers. Low capital creates a moral hazard in that, given the small amount owners have to lose, the more likely they are to condone excessive risk-taking in a gamble-for-resurrection strategy. This was evidently the case at times during the Savings and Loan crisis in the United States.
Corporate governance arrangements should be such that equity holders actively supervise managers.
Supervisors and safety net agencies should ensure that owners lose out in any re- , tructuring operations in the event of failure. Failure to penalise shareholders in the restructuring of unsuccessful banks has been a major shortcoming in some rescue operations in Latin America.
In some countries (e.g. New Zealand) the incentive on owners has been strengthened by experimenting with a policy of increased personal liability for bank directors.
(8) There should be appropriate internal incentives for management.
Creating the right incentive structures for the managers of financial institutions is equally as important as those for the owners. In fact, the two should be seen in combination. In the final analysis, all aspects of the behaviour of a firm are corporate governance issues. There are several procedures, processes and structures that can reinforce internal risk control mechanisms. These include internal auditors, internal audit committees, procedures for reporting to senior management (and perhaps to the supervisors), and making a named board member responsible for compliance and risk analysis and management systems. Supervisors can strengthen the incentives for these by, for instance, relating the frequency and intensity of their supervision and inspection visits (and possibly rules) to the perceived adequacy of the internal risk control procedures, and compliance arrangements. In addition, regulators can create appropriate incentives by calibrating the external burden of regulation (e.g. number of inspection visits, allowable business etc.) to the quality of management and the efficiency of internal incentives.
Specific measures designed to create correct incentive structures include:
Strong and effective risk analysis, management and control systems in place in all financial institutions for assessing risks ex ante, and asset values ex post. This includes systems and incentives are required for timely and accurate provisioning against bad or doubtful debts. In the final analysis, most bank failures are ultimately due to weaknesses in this area. Regulatory agencies have a powerful role in promoting, and insisting upon, effective systems of internal management and risk control in financial institutions by strict accountability of owners, directors and senior management.
Managers should also lose if the bank fails. This requires a high degree of professionalism in bank managers and decision-makers and penalties (including dismissal) for incompetence amongst bank managers. Remuneration packages may be related to regulatory compliance
Subject to prudential standards being maintained, proper incentives can be created by the fostering of competition in the financial sector. This can be achieved, for instance, by removing restrictions on business activity, allowing the entry of foreign banks and other financial institutions, and forcing the abandoning of restrictive practices, cartels and other anti-competitive mechanisms.
Mechanisms need to be in place to ensure that loan valuation, asset classification, loan concentrations, inter-connected lending, and risk assessment practices reflect sound and accurate assessments of claims and counterparties. This also requires mechanisms for the independent verification of financial statements and compliance with the principles of sound practice through professional external auditing and on-site inspection by supervisory agencies.
Ownership structures that foster shareholder monitoring and oversight. This includes private ownership of banks to strengthen the monitoring of management performance and to reduce distortions in incentives for managers.
Require large banks to establish internal audit committees.
The key is that there needs to be appropriate internal incentives for management to behave in appropriate ways, and the regulator has a role in ensuring internal incentives are compatible with the objectives of regulation. Combining appropriate incentives for owners and managers contributes to a robust financial system and, in principle, the market would evolve such incentives. However, experience indicates that, in many areas, and most especially when the competitive environment is changing and the regulatory regime is being adjusted, it is hazardous to rely on the market evolving appropriate incentives.
(III) MONITORING AND SUPERVISION
Because of the nature of financial contracts between financial firms and their customers (e.g. many are long-term in nature and involve a fiduciary obligation) there is a need for continuous monitoring of the behaviour of all financial firms. Because most (especially retail) customers are not in practice able to undertake such monitoring, and because there are substantial economies of scale in such activity, an important role of regulatory agencies is to monitor the behaviour of financial firms on behalf of customers. In effect, consumers delegate the task of monitoring to a dedicated agency.
The key issue is who is to undertake the monitoring. Several parties can potentially monitor the management of banks: bank owners, bank depositors, rating agencies, official agencies (e.g. the central bank or other regulatory body), and other banks in the market. In general, excessive emphasis has been given to official agencies. There may even be an adverse incentive effect in that, given that regulatory agencies conduct monitoring and supervision on a delegated basis, this may reduce the incentive for others to conduct efficient monitoring. The role of other potential monitors (and notably the market) needs to be strengthened in many, including well-developed, financial systems. This in turn requires adequate information disclosure and transparency in banking operations. There need to be greater incentives for other parties to monitor banks in parallel with official agencies. A major advantage of having agents other than official supervispory bodies to monitor banks is that it removes the inherent danger of having monitoring and supervision being conducted by a monopolist with less than perfect and complete information with the result that inevitably mistakes will be made.
Two principles related to official monitoring and supervision are suggested:
(9) Official agencies need to have sufficient powers and independence to
conduct effective monitoring and supervision.
This means that they need to be independent of political authorities and able to licence, refuse to licence, and to withdraw licences from banks. They need to have the authority and ability to monitor the full range of banks' activities and business and be able to monitor and assess banks' systems for risk analysis and control. Because of the moral hazard created in some bank structures, the agency needs to have power to establish rules on ownership and corporate structure of banks and to be able to establish minimum requirements for the competency and integrity of bank management.
(10) Less emphasis should be placed on detailed and prescriptive rules and
more on internal risk analysis, management and control systems.
Externally imposed regulation in the form of prescriptive and detailed rules is becoming increasingly inappropriate and ineffective. More reliance should be placed on institutions’ own internal risk analysis, management and control systems. This relates not only to quantitative techniques such as value-at-risk (VaR) models but also to the management ‘culture’ of those who handle models and supervise traders. There should be a shift of emphasis towards monitoring risk-control mechanisms, and a recasting of the nature and functions of external regulation away from generalised rule-setting towards establishing incentives and sanctions to reinforce such internal control systems. The recently issued consultative document by the Basle Committee on Banking Supervision (Basle Committee, 1999) explicitly recognises that a major role of the supervisory process is to monitor banks' own internal capital management processes and "the setting of targets for capital that are commensurate with the bank's particular risk profile and control environment. This process would be subject to supervisory review and intervention, where appropriate."
(IV) INTERVENTION
Regulation and supervision sometimes fail, and at times to a degree that requires official intervention to maintain systemic stability. The way such intervention is made has signalling and incentive effects for the future behaviour of financial institutions. The conditions under which intervention is made, the manner of intervention and its timing may, therefore, have powerful moral hazard effects.
Care is evidently needed when devising bank restructuring
policies. There also need to be appropriate incentives for intervention
agencies. Several principles can be
established to guide the timing and form of intervention.
(11) The
design and application of safety-net arrangements (lender-of-last-resort and
deposit insurance) should create incentives for stakeholders to exercise
oversight and to act prudently so as to reduce the probability of recourse
being made to public funds.
It is well established that, dependent upon how deposit insurance schemes are constructed (most especially with respect to which deposits are insured and the extent of any co-insurance) serious moral hazard can be created: depositors may be induced to act with less care, under some circumstances they may be induced to seek risky banks on the grounds that a one-way-bet is involved, insured institutions may be induced to take more risk because they are not required to pay the full risk premium on insured deposits, risk is therefore subsidised, banks may be induced to hold less capital, and the cost of deposit protection is passed to others who have no say in the risk-taking activity of the insured bank.
(12) The
extent and coverage of deposit insurance schemes should be strictly limited.
Maintaining the integrity of the banking system requires
that some bank liability holders are to be protected from the consequences of
bank failure. But this should be
limited because such protection may create adverse incentives. In particular, and in order to avoid the
potential moral hazards emerging, coverage should be explicit (rather than
assumed) and restricted to comparatively small deposits and there should always
be an element of co-insurance to the extent that less than 100 percent of any
deposit is insured. There should be a
clear and public commitment to the limits imposed.