2 49515 NUMBER NOTE PUBLIC POLICY FOR THE PRIVATE SECTOR 2009 The Reform Agenda JUNE Constantinos Stephanou Charting the Future of Financial Regulation PRESIDENCY Constantinos Stephanou The crisis has prompted a shift toward a tighter and more macro- (cstephanou@worldbank prudential approach to financial regulation. But the reform agenda still VICE .org) is a senior financial economist in the Financial needs to address the role of supervisory (rather than regulatory) and Private Sector Devel- failures, while the institutional arrangements needed to implement the opment Vice Presidency of the World Bank Group. new framework remain to be worked out. For most emerging economies, the existing reform agenda--developing institutional and legal DEVELOPMENT This is the second in a underpinnings for the financial system and promoting financial access-- series of policy briefs on the crisis--assessing the remains valid. But for those characterized by weak financial oversight SECTOR policy responses, shedding structures and more volatile economic cycles, adopting capital buffers light on financial reforms currently under debate, as part of a macro-prudential regime may be a useful complement. PRIVATE and providing insights for emerging-market policy The ongoing crisis has reaffirmed some fun- Macro-prudential regulation AND makers. damental tenets of financial sector policy mak- Many experts believe that a major cause of the ing, but it has prompted a rethinking of others. crisis was excessive risk-taking by market par- While radical reforms should not be rushed in ticipants due to perverse incentives, pervasive the middle of a crisis, countries and the interna- conflicts of interest, and inaccurate measures FINANCIAL tionalcommunityhavealreadyproposedabroad of financial risk exposures. Compounding the range of new measures (box 1). Reforms that failures by market participants was the inabil- have been announced or are under debate can ity of the authorities to contain the buildup of be grouped into three thematic areas: financial risks across the financial system. This inability GROUP regulation, market infrastructure, and financial stemmed from an excessive prudential focus supervision. on individual financial institutions, inadequate tools for analyzing systemic risks, and gaps in BANK Financial regulation supervisory information and in the regulatory In the area of financial regulation, attention has perimeter.1 focused mainly on macro-prudential regulation, As a result, the most important regulatory WORLD althoughreformsinmicro-prudentialregulation, change that has emerged from the crisis is the financial safety nets, and consumer and investor development of a macro-prudential framework THE protection rules are also under way. that focuses on factors affecting the stability of T H E R E F O R M A G E N D A C H A R T I N G T H E F U T U R E O F F I N A N C I A L R E G U L A T I O N Box G-20 commitments on regulatory reform 1 Gathered in London in April 2009, G-20 leaders committed to the following main regulatory measures in their Declaration on Strengthening the Financial System. Financial Stability Board Establish,asasuccessortotheFinancialStabilityForum(FSF),anewFinancialStabilityBoardwithgreatercapacity,expanded participation, and a stronger mandate for promoting financial stability International cooperation Complete the creation of supervisory colleges for significant cross-border firms in 2009 Implement the FSF principles for cross-border crisis management 2 Support efforts to develop an international framework for cross-border bank resolution Prudential regulation Maintain current international standards for minimum capital levels until recovery is assured, but then strengthen them Once recovery is assured, increase buffers above regulatory minimums, enhance the quality of capital, and develop guidelines for the harmonization of the definition of capital and for minimum capital levels internationally Implement recommendations to mitigate procyclicality, including anticyclical buffers Supplement risk-based capital requirements with an appropriate leverage ratio Improve incentives for risk management of securitization Progressively adopt the Basel II capital framework in all G-20 countries Develop a global framework for promoting stronger liquidity buffers at financial institutions Scope of regulation Amend regulatory systems for macro-prudential risks and develop suitable tools for controlling such risks Ensure that national regulators are able to gather relevant information on all material financial institutions, markets, and instruments to assess systemic risk Produce guidelines for assessing whether a financial institution, market, or instrument is systemically important Require that hedge funds be registered and subject to oversight, including through disclosure to supervisors Require that institutions with hedge funds as counterparties have effective risk management Establish central clearing counterparties for credit derivatives that are subject to regulation Regularly review boundaries of the regulatory framework and promote good international practices Compensation Endorse and ensure significant progress in implementing the FSF principles on pay and compensation in significant financial institutions by the 2009 remuneration round Require supervisors to monitor firms' compensation policies and intervene where necessary Tax havens and noncooperative jurisdictions Encourage all jurisdictions to adhere to international standards on combating tax evasion, money laundering, and terrorist financing Develop a toolbox of effective countermeasures for noncooperative jurisdictions Accounting standards Reduce the complexity of standards for financial instruments and improve standards for provisioning, off-balance-sheet exposures, and valuation uncertainty Strengthen accounting recognition of loan loss provisions by including more credit information Achieve clarity and consistency in the application of valuation standards internationally Make progress toward a single set of global accounting standards Improve the involvement of stakeholders in the process of setting accounting standards Credit rating agencies Subject all credit rating agencies whose ratings are used for regulatory purposes to oversight that includes registration and is consistent with the International Organization of Securities Commissions (IOSCO) Code of Conduct Fundamentals Ensure that national authorities enforce compliance by credit rating agencies and require changes to their practices when needed Require that credit rating agencies differentiate ratings for structured products and provide full disclosure of their ratings track record and the information and assumptions underpinning the rating process Review the role of external ratings in prudential regulation and address any adverse incentives the entire financial system--in contrast with the requirements, taxes, or compulsory purchase traditionalemphasisonmicro-prudentialregula- of insurance--based on their contribution to tion focusing on individual financial institutions. systemic risk (Acharya and Richardson 2009). Macro-prudential factors stem from the business Others have proposed introducing additional, cycle(timedimension)andfromfinancialinstitu- institution-specific capital requirements in the tions that are "too big to fail" and links between Basel II formula based on contribution to sys- different parts of the system (cross-sectional temic risk (Brunnermeier and others 2009). dimension). Still others have called for a return to a narrow Thetimedimensioncanbeaddressedthrough banking model that separates commercial and 3 measures to mitigate procyclicality, a term investment banking activities. Such measures are referring to the complex dynamic mechanisms unlikely to be adopted without the broad con- through which the financial system can amplify sent and coordinated effort of large developed fluctuationsinthebusinesscycleandbreedfinan- economies. cial instability. Such measures would include It remains unclear whether the macro- raising systemwide capital levels as well as intro- prudential measures outlined above will actu- ducing countercyclical capital buffers, potential ally be implemented, how they would apply to adjustments in the Basel II capital framework systemically important nonbank financial insti- to dampen excessive cyclicality, tougher loan tutions, or what their role relative to monetary loss provisioning rules (such as earlier identifi- policy would be in "leaning against" bubbles. cation of and provisioning for credit losses, or Unless accompanied by additional systemwide anticyclical provisions like those in Spain), and responses, such measures would probably miti- greater use of quantitative monitoring indicators gate, but not eliminate, the buildup of bubbles. or constraints on margin and leverage (such as Systemwide responses could be structured either the leverage ratio used in the United States and as rules-based laddered triggers (based on objec- Canada).2 tive parameters such as credit growth or asset The cross-sectional dimension can be price increases) or by giving relevant authorities addressed through measures to reduce systemic the discretion to tighten up if existing measures risk stemming from the size, illiquidity, leverage, do not work. andinterconnectednessoffinancialinstruments, Onbalance,itislikelythatamacro-prudential institutions, and markets. Such measures would framework will require significant discretion, include expanding the regulatory perimeter to which has implications for the design of appro- capture all systemically important financial insti- priate institutional arrangements (see below). tutions,increasingsupervisoryscrutinyandstress In any case, as the current crisis has shown yet testing for such institutions, tightening liquidity again, rules can be--and often are--overridden requirements to address the negative feedback during bad times. loop between deleveraging and loss of liquidity that has been observed in the financial crisis, and Micro-prudential regulation reducing counterparty risks from financial mar- Although the buildup to the crisis took place in ket links (such as by creating clearinghouses and jurisdictions operating mostly under the Basel usingorganizedexchangesforcreditderivatives). I framework, the crisis has nevertheless inten- Other reforms in financial supervision (such as sified the debate on the adequacy of Basel II, setting up supervisory colleges for significant particularly the reliance on credit rating agen- cross-border firms) and in market infrastructure cies and on banks' internal risk management (such as improving accounting and governance models. Even so, regulatory authorities in many standards) are also intended to support these countries remain determined to proceed with its macro-prudential objectives. implementation. Agreement has already been A few commentators have gone beyond these reached on measures to strengthen elements of measures. Some have proposed, for example, theframework,suchastighteningcapitalcharges that large, complex financial institutions be forsecuritizedandtradingbookexposuresunder explicitly charged--through additional capital Pillar 1. In addition, the quality of capital was T H E R E F O R M A G E N D A C H A R T I N G T H E F U T U R E O F F I N A N C I A L R E G U L A T I O N confirmed as an important issue for review given regime that would allow systemically important the financial markets' focus on common equity financial institutions (particularly noninsured as an indicator of banks' financial strength in depository ones in the United States, such as the crisis. bank holding companies, investment banks, and Pillar 2, on the supervisory review process, has insurance groups) to be wound down efficiently clearly emerged as the most critical component and with minimal disruption to financial mar- of the framework, since it offers the discretion kets. The lack of such a regime has stymied the to go beyond Pillar 1 requirements by introduc- ability of the authorities to take over large and ing additional measures. Even if not originally complex financial groups deemed too big to 4 envisaged, such measures could potentially fail. The authorities have been forced instead to include those with a macro-prudential orienta- arrange takeovers by stronger rivals or to under- tion. Differences in the measures that different take ad hoc interventions in order to keep such countries need to adopt call for extensive use financial groups alive. Some countries (such as of Pillar 2. But this approach risks a "race to the the United Kingdom) have introduced special bottom," in which policy makers decide not to bank insolvency frameworks, while work on the introduce certain measures out of fear of placing cross-border resolution of complex banking their domestic banking industry at a competitive groups is ongoing. disadvantage. Pillar 3, on market discipline, has the least Consumer protection and regulation of understood and most poorly defined objectives. market conduct By focusing exclusively on transparency and The crisis has exposed significant failures in the disclosure, it implicitly assumes that the market framework governing the relationship between already has the ability to use information effec- financial institutions and their customers. There tively to exercise discipline. But the crisis has have been numerous instances of mis-selling of shown how complacency and herd behavior can financialproductstopoorlyinformedhouseholds cause market participants to ignore warning sig- (whether subprime mortgages in the United nals when "everybody else is doing it"--and how States or foreign-currency-denominated loans attempting to impose discipline in the middle of in Eastern Europe) and of complex structured a crisis (as in the case of Lehman Brothers) can products to pension fund trustees who did not be counterproductive. The crisis has also shown understand the risks. In response to the failures thatmarketdisciplinecanbeafairlycrudeexpost in financial education and consumer protection, instrument.3 A major rethinking of its role and several countries have already tightened their limitations as a prudential tool is still needed. standards--for example, in information disclo- sure,disputeresolution,andpersonaldataprotec- Financial safety nets tion--although there has been no international Deposit insurance coverage and "lender of last consistency. In addition, some commentators resort"facilitieshavebeensignificantlyexpanded (such as Warren 2008) and the U.S. Department during the crisis, raising the question of longer- oftheTreasury(2009)haveproposedthecreation term changes to their design. Some changes ofaConsumerFinancialProtectionAgencytovet alreadyintroducedmaybecomepermanent,such consumer-oriented financial products. as higher ceilings for deposit coverage and the On the investor front, the Madoff scandal and elimination of the coinsurance component. But the other Ponzi schemes that have emerged will the interplay between the new macro-prudential likely lead to stronger oversight of investment framework and safety net design--in particular, advisers and stricter rules for the segregation howtoclearlydemarcatetheboundariesofsafety of client funds through the use of independent nets under a broader regulatory perimeter and custodians. how to price safety nets appropriately--is still undefined.4 Market infrastructure One of the main issues raised by the crisis Reforms in market infrastructure include four has been the lack of an appropriate insolvency distinct issues: accounting and financial report- ing standards, the credit rating industry, pay- the ratings market. But the policy responses ments and securities settlement systems, and announced thus far have been more limited bank governance and remuneration. and pragmatic. They are intended to address the demonstrated failings of credit rating agencies Accounting and financial reporting in structured finance as well as to increase the The crisis has accelerated the process of revising oversight of these agencies to a level commen- accounting standards, particularly with respect surate with the reliance on ratings for regulatory to loan loss provisioning, consolidation of off- purposes. They include measures to improve the balance-sheet exposures, and fair-value account- transparency and quality of the rating process as 5 ing. The concept of fair-value accounting has well as to restrict and manage conflicts of inter- been around for a long time and is considered est. As currently proposed, these measures are an essential ingredient of market integrity. But likely to do little to change the business model somehavearguedthatithasexacerbatedthecrisis or the cartelized industry structure. by forcing institutions to value illiquid assets at artificially depressed prices. While the principle Payments and settlement systems is clear (mark-to-market only when markets are While payments and settlement systems have liquid), the issue is how to define a liquid market not featured in G-20 headlines, key elements and what to do when liquid markets become illiq- of these systems are receiving greater emphasis uid.Recentchangestoaccountingstandardsbythe as part of the longer-term agenda to develop InternationalAccountingStandardsBoard(IASB) sound financial market infrastructure. Reforms andtheU.S.-basedFinancialAccountingStandards under discussion include the development of Board (FASB) gave banks breathing space to deal collateralized markets and central bank facilities withtheseproblemsbyallowingthemtoreclassify for intraday liquidity provision, the settlement financial assets from fair-value accounting obliga- of foreign exchange transactions on a payment- tionsundercertainconditions.Butthesechanges versus-payment basis (as done by CLS Bank, for came at the cost of greater opacity in financial example), the design of clearing and settle- statementsandcomplaintsbyinvestorsaboutinad- ment mechanisms for over-the-counter financial equatedisclosuresandaboutpoliticalexpediency derivatives(particularlycreditdefaultswaps),the in the timing of their introduction. applicationofinternationalstandardsforcentral Additional financial reporting was proposed counterparties,andthedesignofbetteroversight as a solution to earlier crises and will undoubt- and coordination mechanisms. edly be proposed once again in the present one. But given the size and complexity of financial Bank governance and remuneration statements issued by financial institutions these Bankgovernancearrangementsarebeingreeval- days, there is growing concern about the value uated in the light of the crisis. International of more information and the ability of market standard-setters have focused mainly--and per- participants to accurately process it. This is an haps excessively--on executive remuneration areawheremoreworkbytherelevantauthorities plans in an attempt to align incentive structures. is likely to be needed. They have developed principles on sound com- pensation practices and asked supervisors to Credit rating agencies monitor them. While the corporate fraud scandals of the early More fundamentally, the failure of widely 2000s led to reforms of a broad set of financial differing types of financial institutions indicates market "gatekeepers" (auditors, lawyers, under- the difficulties of understanding today's com- writers), during this crisis regulatory attention plex financial market risks. Regulatory solutions has focused mainly on credit rating agencies. introduced to address this problem may include Some commentators have called for the authori- a larger role for risk managers as well as greater ties to eliminate the "hardwiring" of ratings in independence, stronger qualification standards, regulation, to revise the "issuer pays" model of and greater involvement in risk management compensation, and to enhance competition in issues for board members. T H E R E F O R M A G E N D A C H A R T I N G T H E F U T U R E O F F I N A N C I A L R E G U L A T I O N Financial supervision tionalarrangementsforfinancialsectoroversight. Aswithfinancialregulation,thecrisishasprompted Recent pronouncements by the international a fundamental rethinking of the supervisory phi- community do not clarify the roles of different losophy. In addition, the crisis has brought to the actors in such a framework, and countries are fore lingering questions about home-host super- likely to adopt different approaches.6 In addi- vision, institutional arrangements for financial tion, some countries may decide to fold super- sector oversight, and appropriate design and visory agencies into central banks in an attempt governance of supervisory agencies. to strengthen financial stability. International experience shows that such solutions do not 6 Supervisory philosophy necessarily improve supervision and may even Despitedifferingapproaches,thesupervisoryphi- backfire if not properly implemented. losophy in many developed countries had relied heavily on the self-correcting properties of mar- Design and governance of supervisory ketsandtheself-interestofsophisticatedfinancial agencies institutions. The crisis has forced a fundamental While much of the public debate has focused on reconsiderationofthisphilosophy.Theresultwill apparent gaps in regulatory authority, many of likely be more intensive supervision and greater the failures actually occurred in financial institu- questioning of financial institutions' business tions that were subject to extensive supervision. models and financial reporting practices.5 There is strong (though anecdotal) evidence that political interference and industry capture Home-host supervision compromised the ability of supervisory agencies Home-host supervisory issues have come to the to take appropriate actions to avoid or minimize foreasaresultoftheinternationalizationoffinan- the crisis.7 This issue will become even more cial institutions' activities and the transmission important if these agencies are called on to play of problems from the home jurisdiction across a role in macro-prudential supervision, which borders. The crisis has shown yet again the fun- is likely to involve an even greater amount of damental inconsistency of having internationally politically sensitive judgment and discretion. A active banks while central banks (lenders of last credible framework would therefore be needed resort), governments (fiscal support), and bank- to ensure that supervisors have the incentives ruptcy regimes remain national. For this reason, and skills to deal with bubbles, and to put into today's policy responses--such as the creation of place mechanisms to protect them from undue supervisory colleges for significant cross-border external influence. financial institutions and the implementation of the Financial Stability Forum principles for Conclusion cross-border crisis management--are unlikely to Until recently the policy responses to the crisis be sufficient in times of crisis. Moreover, imple- could easily be criticized as a "whack a mole" menting a macro-prudential framework would strategy that does not fundamentally change require distinct country-specific measures given the way that financial regulation is conducted. the differences in the synchronicity of national Recent pronouncements by the G-20 and related credit and asset cycles. work by the Financial Stability Forum represent All this is likely to result in host countries exer- an important, though not radical, shift toward cising greater authority in the future by "ring a more cohesive framework focusing on tighter fencing" (to the extent possible) the domestic and more macro-prudential regulation with less operations of foreign banks. And it will prob- trust in free markets. ably resurrect the debate over the supervision The intellectual underpinnings of this regula- of branches versus subsidiaries. tory shift remain unclear, since they represent anuneasycompromisebetweendifferentschools Institutional arrangements of thought about the proper role of prudential The implementation of a macro-prudential regulation.8 Moreover, the reform agenda is still framework may lead to a rethinking of institu- incomplete. It does not fully address likely key causes of the crisis, such as the role of supervi- funds has resulted in recommendations (Group of Thir- sory (rather than regulatory) failures. And much ty 2009) that such funds be regulated as banking institu- remains to be worked out on the institutional tions rather than as collective investment schemes. arrangements needed to implement the new 5. See FSA (2009) for a description of such an ap- framework and on actual country uptake, par- proach in the United Kingdom. ticularly as it relates to macro-prudential regula- 6. These include the central bank as the systemic stabil- tion. Experimentation is likely in the foreseeable ity regulator, as has been proposed in the United States future as countries try different approaches and (U.S. Department of the Treasury 2009); shared respon- increase the "ring fencing" of domestic financial sibilities between the central bank and a supervisory 7 systems. Whether the proposed reforms actually agency, as in the United Kingdom (FSA 2009); or the treat the root causes of the crisis, rather than just creation of a European Systemic Risk Council under its symptoms, can be assessed only in the years to the auspices of the European Central Bank comple- come.Indeed,thetruetestofthenewframework mented by a European System of Financial Supervisors will come only after the measures to control the to coordinate supervision in the European Union (de crisis are fully rolled back. Larosiere Group 2009). See Nier (2009) for a discus- What do these reforms mean for emerging sion on the role of central banks in financial stability economies? As in the past, these countries are following the crisis. likelytofollowthenewrulesthatwillbedecidedby 7. Examples include weak institutional mandates the standard-setting bodies, even though several and related resources (such as in the case of the Of- of them--such as a revised Basel II framework-- fice of Federal Housing Enterprise Oversight, which may not be relevant or even appropriate. For supervised Fannie Mae and Freddie Mac); lack of new most emerging economies, the existing financial regulations on rapidly growing financial players and sector reform agenda--developing institutional markets (the U.S. Federal Reserve in the case of over- and legal underpinnings for the financial system the-counter derivatives); nonintrusive, "arm's length" and promoting financial access--remains valid. supervision (the U.K. Financial Services Authority); Butforthosethatarecharacterizedbyweakfinan- loosening of existing regulatory restrictions (the U.S. cial oversight structures and are prone to more Securities and Exchange Commission, which relaxed volatile economic cycles, the adoption of capital leverage ratio limits for broker-dealers in 2004); and buffers as part of a macro-prudential regime may general leniency in the oversight of politically popular be a useful complement to their current reform financial sector activities (residential mortgage financ- agenda. ing, including subprime lending). 8. See, for example, de la Torre and Ize (2009) on the distinctions and policy implications for prudential regulation arising from the moral hazard, externalities, Notes and uncertainty paradigms. The author would like to thank Roberto Rocha for his considerable input on an earlier version, and Katia References D'Hulster, Dimitri Vittas, Jack Katz, and Cedric Mousset Acharya, V. V., and M. Richardson, eds. 2009. Restoring for helpful comments and suggestions. Financial Stability: How to Repair a Failed System. Hobo- 1. For a discussion, see Acharya and Richardson ken, NJ: Wiley Finance. (2009); Brunnermeier and others (2009); de Larosiere Brunnermeier, M., A. Crocket, C. Goodhart, M. Group (2009); FSA (2009); and Group of Thirty (2009). Hellwig, A. D. Persaud, and H. Shin. 2009. The 2. For details, see FSF (2009). Fundamental Principles of Financial Regulation. Geneva 3. For example, the demise of Bear Stearns before its Report on the World Economy 11. Geneva: Interna- arranged takeover has been attributed to the decision tional Center for Monetary and Banking Studies. of other market players not to roll over short-term de Larosiere Group. 2009. Report of the High-Level Group repurchase agreements with it, resulting in a rapid loss on Financial Supervision in the EU. Brussels. of working cash. de la Torre, A., and A. Ize. 2009. "Regulatory Reform: 4. For example, in the United States the crisis- Integrating Paradigms." Policy Research Working provoked temporary decision to insure money market Paper 4842, World Bank, Washington, DC. T H E R E F O R M A G E N D A C H A R T I N G T H E F U T U R E O F F I N A N C I A L R E G U L A T I O N FSA (U.K. Financial Services Authority). 2009. The Turner Review: A Regulatory Response to the Global Bank- ing Crisis. London. FSF (Financial Stability Forum). 2009. Report of the Financial Stability Forum on Addressing Procyclicality in crisisresponse the Financial System. Basel. Group of Thirty. 2009. Financial Reform: A Framework for Financial Stability. Washington, DC. The views published here Nier, E. W. 2009. "Financial Stability Frameworks and are those of the authors and the Role of Central Banks: Lessons from the Crisis." should not be attributed IMF Working Paper 09/70, International Monetary to the World Bank Group. Fund, Washington, DC. Nor do any of the conclusions U.S. Department of the Treasury. 2009. Financial Regula- represent official policy of tory Reform--A New Foundation: Rebuilding Financial the World Bank Group or Supervision and Regulation. Washington, DC. of its Executive Directors or Warren, E. 2008. "Product Safety Regulation as a Model the countries they represent. for Financial Services Regulation." Journal of Con- sumer Affairs 42 (3): 452­60. To order additional copies contact Suzanne Smith, managing editor, The World Bank, 1818 H Street, NW, Washington, DC 20433. Telephone: 001 202 458 7281 Fax: 001 202 522 3480 Email: ssmith7@worldbank.org Produced by Grammarians, Inc. Printed on recycled paper T h i s N o t e i s a v a i l a b l e o n l i n e : h t t p : / / r r u . w o r l d b a n k . o r g / P u b l i c P o l i c y J o u r n a l