Financial Risks, Stability, and Globalization
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Author(s):
Omotunde Johnson
Published Date:
April 2002
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I find a lot to agree with in the conceptual approach of the paper and the notions of a regulatory regime and regulatory strategy. The discussion of the components of the described regime, rules established by regulatory agencies, monitoring and supervision by official agencies, incentive structures, market discipline, intervention arrangements, corporate governance and accountability, are comprehensive. Moreover, the theme of a strategy to optimize the balance between the components of the regime is, from a policy perspective, very appealing.

The paper makes a good case for the need for balance between the components of a regulatory regime. An overreliance on detailed prescriptive rules could create a culture of reliance on “official assessments” and weaken the role of incentive structure, market discipline, and governance arrangements in financial firms. Moreover, ill-designed regulations or overregulation could have the perverse effect of pushing institutions into excessive risk taking to preserve returns on capital. The paper also encourages attention to the types of rules (their precision, simplicity, and clarity), the impact of rules on incentives, and the flexibility to differentiate among institutions according to the risk profiles of respective portfolios of institutions. These rule considerations combined with an incentive structure that induces banks to act in concert with the objectives of prudence and strong arrangements for market discipline, constitute the core elements of an overall regulatory framework.

As a conceptual approach, there can be little disagreement with the elements enunciated. Some refinements and nuance could help in improving the approach’s usefulness as a diagnostic tool to assess the adequacy of country frameworks, however. In this regard, I wish to note the following.

The regulatory framework and its elements are ultimately a framework for managing risks in intermediation, while promoting innovation and service. As such, in my mind, the adequacy of a particular regime and the regulatory strategy, has to be assessed in the context of the overall risks facing financial institutions, in general, which could impact on portfolios. Some of these risks emanate from macroeconomic imbalances—potentially having an impact on credit and possibly increasing foreign exchange, interest rate, and liquidity risks. Other stresses could derive from the institutional and legal framework—for example, affecting contract enforcement. Some risks derive from the state of market development. Other things being equal, institutions operating in an environment of shallow money markets—or operating in an environment of capital and foreign exchange controls—may be less able to withstand liquidity shocks or to hedge foreign exchange risks, and so on.

With this in mind, while there is no issue with the broad themes of the paper, greater nuance on the context of the regulatory framework could be useful when adapting the ideas to country diagnostic work. The context could be important and impact on the judgment of the appropriateness of a particular mix, at a given stage. For example, for countries where elements of the regulatory framework are underdeveloped—whether by policy (foreign exchange controls), or due to capacity (internal risk management procedures)—would not a prescriptive rule-based system be preferable as an anchor in a reform process, as opposed to a less prescriptive arrangement?

Secondly, it also may be useful to nuance the discussion of the “incentive structures” component of the regulatory framework, with a broader definition of a prompt corrective action framework (PCA)—which in the paper is only discussed in the context of “intervention.”

In my mind, early graduated corrective procedures by regulators combined with a disclosure framework that allows markets to take steps to progressively punish excessive risk taking—from the imposition of higher interest rate charges on credits through exclusion from markets—are powerful incentives to prudence. This market action should be encouraged and disclosure frameworks should be constructed with this in mind to reinforce PCA frameworks.

Thirdly, while differentiation between banks according to their risk characteristics, capacity for risk analysis, and management is to be encouraged, there is some ambiguity in the paper on the need for uniformity in intervention rules.

One application of the approach of differentiation is, as the paper points out, an approach of contract regulation. Under this regime, the regulator sets a clear set of objectives and general principles. It is then up to each regulated firm to demonstrate how these objectives and principles are to be satisfied by its own chosen procedures. Once a regulator has agreed with each firm how the objectives and principles are to be satisfied, a contract is established between the regulator and the regulated firm.

As the paper notes, Estrella (1998) argues that the precise design of the penalty structure, under these arrangements, is likely to be complex. I would extend that argument to say that, not only would it be complex, but possibly the benefits of clearly articulated and understood rules for intervention—where supervisors at least commit to, and are seen to act on, decisions to close unviable institutions promptly, and vigorously monitor weak and/or restructured institutions—could be compromised and transparency could be inhibited. The point here is not to argue against differentiation, which must be at the heart of any supervisory process, but to point out that differentiation brings the companion challenge of maintaining transparency and not conveying any sense of selective forbearance.

Further on the issue of differentiation, while there is intuitive appeal for greater reliance on banks’ internal risk management processes, there is a companion need for regulators to develop the skills needed to assess the quality of bank systems. In its comments to the Basel Committee on internal ratings and new capital framework, IMF staff noted that for this shift to advance smoothly there was a need for the following:

1. guidelines for supervisory assessment of internal rating systems, including the development of a supporting methodology;

2. more evidence on the accuracy of internal rating systems;

3. guidance and training of supervisors on how to assess banks’ risk-management capabilities, not least to ensure that banks’ self-assessment does not lead to an underestimation of risks.

Again, here, the point is not to argue against differentiation, but to point to a more nuanced approach to the system of differentiation based on the stage of market development and capacity. It is one thing to differentiate using a “watch list” and focused action on institutions on that list. It is another matter to fully adopt an internal rating approach to supervision.

Finally, I would only wish to underscore my support for the notion of a need for strong disciplining and accountability measures for regulatory authorities. Regulators are often monopolists, have considerable power, and are often not subject to the disciplines of the market. That said, I think the paper could better balance this need for accountability with the need for the protection of supervisors against legal actions, without which supervisory professionalism could be compromised.

Conclusion

My bias has been to approach the paper with an eye for its diagnostic value-added to the IMF’s work. Notwithstanding my comments for greater nuance and amplification, I think the paper is excellent in underscoring the point that regulations per se do not constitute a regulatory regime and more comprehensive audits of the framework will lead to more robust assessments. In amplifying the components of a regime, the paper also implicitly encourages a new paradigm of responsibilities, where issues of the safety and soundness of institutions have more active stakeholders. The substantive challenge posed by the paper is the adaptation of the framework over time and in line with the risk challenges facing the particular financial system. In addition, there is the challenge of an incentive structure for stakeholders to assume their respective roles on an ongoing basis, as opposed to acting only in times of crisis.

Reference

    EstrellaArturo1998Formulas or Supervision? Remarks on the Future of Regulatory Capital,Economic Policy Review Vol 4 (October) pp. 191200.

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