NOTE NUMBER 5 50342 PUBLIC POLICY FOR THE PRIVATE SECTOR JULY 2009 Trust Less, Verify More FINANCIAL AND PRIVATE SECTOR DEVELOPMENT VICE PRESIDENCY Clive Briault Financial Supervision in the Wake of the Crisis Clive Briault (clive F i n an c i al su pe rvi si on wi l l n e e d to c h an ge i n re spon se to th e c au se s .briault@rrconsulting .co.uk) is director of Risk of th e fi n an c i al c ri si s an d th e re gu l atory proposal s ari si n g from i t. and Regulation Consult- S u pe rvi sors wi l l n e e d to take a tou gh e r an d more c h al l e n gi n g ing Limited and former approac h to th e fi rms th e y re gu l ate , e xe rc i se more su pe rvi sory managing director of the U.K. Financial Services j u dgme n t, i n vol ve th e mse l ve s i n mac ro- pru de n ti al ove rsi gh t, an d Authority. parti c i pate more ac ti ve l y i n th e su pe rvi si on of fi rms wi th c ross- This is the fifth in a borde r ac ti vi ti e s. S u pe rvi sors i n al l c ou n tri e s n e e d to take u p th e se series of policy briefs on c h al l e n ge s--n otwi th stan di n g di ffe re n c e s i n th e styl e of su pe rvi si on , the crisis--assessing the policy responses, shedding i n c u l tu re an d l e gal tradi ti on , i n i n sti tu ti on al an d organ i z ati on al light on financial reforms stru c tu re , an d i n th e powe rs an d re sou rc e s avai l abl e to th e currently under debate, su pe rvi sory age n c y. and providing insights for emerging-market policy makers. The causes of the financial crisis have been Shift in supervisory philosophy extensively analyzed, and many proposals have Supervisory approaches differ significantly across been put forward to prevent another such crisis countries. Generally, however, there has been in the future. Most of these proposals relate a shift over time from detailed examination of to regulation--the requirements imposed banks' loan books to greater emphasis on banks' through legislation, rules, and guidance on policies and practices, on the adequacy of their THE WORLD BANK GROUP regulated firms and on market participants to internal systems and controls, on their senior promote safety and soundness and prevent mar- management and boards of directors, and, most ket abuse and financial crime. But less attention recently, on their internal models for the calcula- has been paid to supervision--the people and tion of capital requirements for market, credit, processes that monitor compliance with these and operational risks. This shift has reflected regulatory requirements and intervene when changing perceptions about the effectiveness of they are not being met. This policy brief sets different supervisory approaches; changes in and out four areas in which financial supervision the increased complexity of the activities under- will need to change in response to the causes taken by banks; and the growth of the financial of the crisis and the regulatory proposals aris- sector. Much the same evolution has taken place ing from it.1 in the audit sector. TRUST LESS, VERIFY MORE FINANCIAL SUPERVISION IN THE WAKE OF THE CRISIS The main focus of supervision in many coun- its financial assets) rather than relying on a tries has therefore been on the quality of a firm's firm's internal systems and controls and on senior management, the strength of its systems reports produced by the firm and controls, and the adequacy of its financial Being more intensive and intrusive (for exam- resources (capital and liquidity). Moreover, the ple, in the depth of on-site testing) senior management of regulated firms has gener- Developing a more comprehensive under- ally been trusted to correct compliance failures. standing of the business of a firm and how These developments are well documented in it operates the principles and other guidance issued by the Placing greater emphasis on the performance 2 Basel Committee on Banking Supervision over of boards in fulfilling their duties, including the past 20 years.2 the qualifications of board members and how One reason for the shift in supervisory empha- the board sets the firm's risk appetite, links sis is that in many countries the prevailing phi- business strategy to risk, and monitors and losophy of supervision has increasingly been controls the firm's risks based on two assumptions: that market forces Being more challenging of firms' business and market discipline keep both the economy models and of the ability of firms to survive and regulated firms broadly on track, and that stresses and alternative scenarios the senior management and boards of directors Focusing more on systemwide risks and the of regulated firms have a strong and long-term ability of individual firms to withstand them interest in firms performing well. But the finan- Shifting the "burden of proof" on how well cial crisis has undermined both these assump- a firm is run so that this falls more on the tions (see, for example, FSA 2009). Market forces firm, rather than on the supervisor to provide and senior management have failed to prevent evidence to the contrary large write-downs and losses at many banks (and Imposing more demanding requirements on other financial institutions), inadequacies in risk firms that may be deemed to be "too big to management and other internal controls, and fail," to offset any commercial advantages (for poor corporate governance. example, a lower cost of funding) that this As former U.S. Federal Reserve Chairman Alan status might bring Greenspan commented in a February 17, 2009, Expanding the scope of supervision to address speech to the Economic Club of New York, opportunities for regulatory arbitrage and to ensure that a consolidated view is taken of a All of the sophisticated mathematics and firm's business computer wizardry essentially rested on Considering whether to introduce more prod- one central premise: that enlightened uct regulation, such as preapproval for com- self-interest of owners and managers of plex products (derivatives, securitizations) financial institutions would lead them to and limits on loan-to-value or loan-to-income maintain a sufficient buffer against insol- ratios on lending for home purchases vency by actively monitoring and managing In summary, supervisors need to rely less their firms' capital and risk positions. When on market discipline and more on regulatory in the summer of 2007 that premise failed, and supervisory discipline. There needs to be a I was deeply dismayed. shift from "trust but verify" to "trust less, verify more." One lesson from the financial crisis is there- fore that supervisors need to be less trusting Greater exercise of judgment and more challenging (recognizing, of course, Some of the proposals for stricter regulation do that countries start from different places). This not require a major shift in supervisory approach. means: For example, supervisors could continue to moni- Being significantly less trusting of firms' senior tor compliance with tougher capital requirements management, boards of directors, and inter- (shifting the emphasis to Tier 1 capital, impos- nal systems and controls ing higher minimum capital levels, introducing Testing outcomes (for example, the qual- an automatic rules-based countercyclical capital ity of a bank's loan book and the value of requirement, and imposing a leverage ratio), and to intervene as necessary to correct any noncom- discussed in the previous section. Moreover, pliance, without significant changes to the style, in many countries the legal and administrative intensity, or structure of supervision. Indeed, if framework makes it difficult for supervisors to stricter regulation succeeds in making banks enforce anything other than detailed and pre- more "boring" and less involved in complex scriptive rules. So these countries in particular activities, supervision could theoretically even will need to convert the higher-level principles as be scaled back accordingly. far as possible into more detailed rules. This will But one driving force for a significant shift be difficult in such areas as remuneration systems, in supervision is that many of the proposals for stress testing, and liquidity, where supervisors will stricter regulation will require supervisors to need to take account of the circumstances of exercise more judgment across a wide range of each firm and where detailed and prescriptive areas, including capital, liquidity, stress testing, rules are unlikely to capture the full range of and remuneration. In addition, some supervisors judgments required under the Basel Committee are being given increased powers to intervene and Financial Stability Forum principles. It may earlier and more decisively to deal with a prob- also be difficult to make some types of "prompt lem bank (such as by moving it into a "special corrective action" fully automatic. resolution regime"). For example, Principle 14 of the Basel Macro-prudential oversight Committee's most recent liquidity principles One of the lessons of the financial crisis is that requires supervisors to "regularly perform a supervision had focused too much on individual comprehensive assessment of a bank's overall firms and not enough on systemwide develop- liquidity risk management framework and liquid- ments and risks. It was difficult for supervisors ity position to determine whether they deliver to identify--and to respond effectively to-- an adequate level of resilience to liquidity stress problems that might arise across the system as a given the bank's role in the financial system" whole, such as an excessive growth in credit or a (2008, p. 4). Supervisors are therefore required sharp dislocation in financial markets. The April to form a judgment about each bank's liquidity, 2009 proposals of the G-20 countries therefore taking account of its individual position and its emphasize the importance of improved macro- role in the financial system. Some supervisors prudential analysis to identify systemwide risks already form such judgments, but others rely on to financial stability, to undertake appropriate a more limited range of quantitative liquidity actions to address and mitigate these risks, and measures. to ensure that these actions are implemented. Similarly, the Basel Committee (2009) and This has four key implications for supervisors. Financial Stability Forum (2009b) principles on First, supervisors will need to engage actively in stress testing require supervisors to exercise more macro-prudential analysis. Supervisors will be judgment on the adequacy of banks' stress tests well placed to contribute to the identification of and on the implications of these tests for the set- risks to financial stability because of the data they ting of Pillar 2 capital requirements under the receive from regular reporting and because of Basel II framework. In addition, the Financial their knowledge and understanding of the firms Stability Forum (2009a) principles on remunera- they supervise. But to do this effectively, supervi- tion arrangements in regulated firms require sors will need to become more aware of the types many supervisors to focus for the first time on the of systemwide risks that can arise, including from appropriateness of banks' remuneration policies. the collective actions of financial institutions Indeed, to some extent these principles on stress (even if each firm appears to be controlling its testing and remuneration policies will require own risks effectively). In addition, supervisors will supervisors to reach a judgment on the business need to be willing--and have a legal gateway--to models and strategies of individual banks. share data on individual firms with the central Even supervisors currently following a more bank's financial stability function or other sys- judgment- and principles-based approach may temic oversight bodies as appropriate. find this broader exercise of judgment demand- Second, supervisors will need to collaborate ing, especially when combined with the more chal- closely with the central bank. Many countries lenging and less trusting supervisory approach already have in place arrangements for regular meetings between the supervisors and the central harmonization of information and reporting, bank (in some cases also including the minis- coordination and cooperation, clarity of respon- try of finance). These meetings will need to be sibilities, crisis management, and the availability extended to cover macro-prudential oversight, of powers to act if necessary. The intention is and it is important that this dialogue focuses that supervisors will become more proactive when not only on discussing risks to financial stabil- participating in supervisory colleges and in their ity but also on prioritizing them and identifying relations more generally with supervisors in other the actions required to address the most signifi- countries. cant ones. Other countries will need to establish Another consequence of the financial crisis, 4 such arrangements or, where the supervisors are however, has been a clear shift in the stance of located in the central bank, to ensure that the some supervisors of branches (and, to a lesser "micro" and "macro" departments work effec- extent, subsidiaries) of foreign banks. These tively together to identify and address systemwide supervisors have been seeking greater assur- risks. In some cases this may require a change ance on: in the objectives or mandate of the supervisory The financial soundness of the parent or agency. group Third, although some of the actions needed The willingness of the parent bank to stand to mitigate risks to financial stability will require behind its branches (and subsidiaries) in policy measures that apply to all firms, supervisors other countries will be on the "front line" in implementing some The adequacy of the liquidity and other of these actions. Supervisors may need to demand resources being held locally by the branch that specific firms restrict their activities--for or subsidiary example, in lending to consumers or to property The standards of regulation and supervision companies, in taking foreign exchange positions, in the home country of the parent bank in securitizing assets, or in outsourcing--to pre- In some cases, the adequacy of the deposit vent the collective behavior of firms from gener- protection arrangements that would apply to ating systemwide risks. Supervisors operating a depositors in the local branch risk-based system will also need to integrate into Moreover, macro-prudential oversight may their system the risks to financial stability identi- lead to prudential supervision becoming more fied through macro-prudential oversight. national in its focus and to supervisors becoming Fourth, macro-prudential analysis may iden- more concerned about the potential contribution tify a need to widen the scope of supervision of foreign branches and subsidiaries to risks to to include banklike firms that pose a threat to national financial stability (for example, through financial stability, for example, consumer finance lending to specific sectors, aggressive funding and mortgage lenders that may not be currently activities, or the introduction of risky products to regulated because they do not take public depos- the local market). This shift may occur especially its, or insurance firms that undertake banklike where foreign banks represent a large share of activities. Supervisors therefore need to be pre- the domestic banking market. pared to take on new responsibilities or to work There is therefore a tension here. Host coun- more closely with other regulators (for example, try supervisors may not be able to rely on greater through closer interaction between prudential cooperation among supervisors to ensure that and conduct-of-business supervision). they have the information they need from the home country supervisor or to satisfy them that Host country supervision a parent firm will control its branches so that Concerns about supervision being fragmented they do not pose a threat to financial stability in (nationally and internationally), and about the the host country. Host country supervisors would ability to resolve problems in international finan- then need to introduce tougher requirements for cial groups, are reflected in proposals from the foreign banks operating in their country. These G-20 (2009) to introduce supervisory colleges requirements could include the ring-fencing of for all major cross-border financial institutions liquidity, the provision of guarantees by the par- and to improve the quality and effectiveness of ent bank that it will stand behind its branches, supervisory colleges. These proposals cover the an insistence that foreign banks operate through subsidiaries rather than branches, or restrictions fail (or require government support), just as on their activities. countries with different institutional structures have had their financial system emerge relatively Implications for supervisory resources unscathed. So although it remains important for and structure each country to choose an institutional structure All the issues discussed in the previous sections that maximizes supervisory effectiveness in the have implications for supervisory resources. specific circumstances it faces, a more immediate Supervisors will need to be better able to take objective is to put into place arrangements for 5 a more challenging and less trusting approach effective macro-prudential oversight that include to firms; to make difficult judgments about a close cooperation among the supervisors, the firm's capital, liquidity, stress tests, remunera- central bank, and the ministry of finance. tion policies, and business models; to challenge firms effectively on the basis of these judgments; Conclusion to engage actively in macro-prudential oversight Supervision needs to become generally more and in the actions that flow from it; and either challenging toward, and less trusting of, regulated to cooperate more closely and actively with over- firms; to become even more judgment based to seas supervisors or to take a more interventionist ensure the effective implementation of proposals approach to the domestic activities of foreign for the stricter regulation of the financial sector; firms. to engage actively in macro-prudential oversight; These requirements will place extreme pres- and to create more effective cross-border over- sure on supervisory resources, which in most coun- sight of financial institutions. tries fall short of both the quantity and the quality Doing so will be difficult in all countries and needed. Supervisory agencies should therefore especially so in emerging economies with more be seeking additional funding to recruit, train, volatile economic and political environments and compensate supervisors accordingly. In many and weaker institutional structures. It will require countries their ability to do so will depend on increasing the quantity and quality of supervisory the adequacy of funding from the ministry of resources, effectively translating high-level inter- finance. national principles into national rules and guid- The financial crisis has also generated impor- ance, and implementing effective institutional tant lessons for risk-based supervision: the need arrangements for macro-prudential oversight to maintain an adequate minimum level of super- that bring together the contributions of both the visory resources devoted to each systemically supervisors and the "macro" department of the important firm, even if the firm seems to be well central bank. There may also be a widening of the run and well controlled; the need to maintain regulatory--and thus supervisory--perimeter. oversight of key risks, such as liquidity (which was Public expectations about the positive impact of downplayed by some national supervisors and by stricter regulatory requirements and more chal- global policy makers in favor of negotiating and lenging supervision of firms will make the job of implementing the Basel II capital accord); and being a supervisor even more demanding. the need to integrate risks identified through macro-prudential analysis into the supervision of individual firms. In some countries the financial crisis has Notes reignited debate about the optimal institutional The author would like to thank Laura Ard, Damodaran structure of supervision--for example, whether Krishnamurti, Joaquin Gutierrez, Katia D'Hulster, David to have a single regulator for all financial sectors, Scott, and Constantinos Stephanou for their valuable whether to separate prudential and conduct-of- comments and suggestions, although the views ex- business regulation, and whether the central pressed in this policy brief remain those of the author. bank should undertake regulation and supervi- 1. While this policy brief focuses primarily on banking sion. But countries with very different institu- supervision, much of it is also applicable to insurance tional structures have had financial institutions and securities supervision. TRUST LESS, VERIFY MORE FINANCIAL SUPERVISION IN THE WAKE OF THE CRISIS 2. The Basel Committee Core Principles (2006) empha- size the need for supervisors to satisfy themselves about the adequacy of banks' systems and controls, including board and senior management oversight. Similarly, the adequacy of banks' risk management controls and that of senior management oversight are important criteria crisisresponse for supervisors to assess when banks apply to use the more advanced "internal model" methods for calculat- The views published here ing capital requirements. are those of the authors and should not be attributed References to the World Bank Group. Basel Committee on Banking Supervision. 2006. Core Nor do any of the conclusions Principles for Effective Banking Supervision. Basel. represent official policy of ------. 2008. Principles for Sound Liquidity Risk Manage- the World Bank Group or ment and Supervision. Basel. of its Executive Directors or ------. 2009. Principles for Sound Stress Testing Practices the countries they represent. and Supervision. Basel. May. Financial Stability Forum. 2009a. FSF Principles for Sound To order additional copies Compensation Practices. Basel. April. contact Suzanne Smith, ------. 2009b. Report of the Financial Stability Forum on managing editor, Addressing Procyclicality in the Financial System. Basel. The World Bank, April. 1818 H Street, NW, FSA (U.K. Financial Services Authority). 2009. The Washington, DC 20433. Turner Review: A Regulatory Response to the Global Bank- ing Crisis. London. March. Telephone: G-20 (Group of Twenty). 2009. Declaration on Strengthen- 001 202 458 7281 ing the Financial System. London. April. Fax: 001 202 522 3480 Email: ssmith7@worldbank.org Produced by Grammarians, Inc. Printed on recycled paper This Note is available online: http://rru.worldbank.org/PublicPolicyJournal