Journal Issue

Financial Regulators Need Independence: Granting more operational autonomy to the agencies that keep an eye on the financial sector can bolster financial stability

International Monetary Fund. External Relations Dept.
Published Date:
January 2003
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Udaibir S. Das, Marc Quintyn, and Michael W. Taylor

Political interference in financial sector regulation and supervision contributed to the depth and magnitude of nearly all of the financial crises of the past decade.

As a result, the global community—increasingly aware of the need for good regulatory governance as part of a broader effort to prevent (or better manage) financial crises and improve financial sector supervision—has started to look for ways to insulate regulators and supervisors from improper influence. In recent years, the international community, including the IMF and the World Bank, has launched a number of initiatives to promote and monitor good governance—meaning the way institutions are run, supervised, and held accountable. We are at a point now where we can begin to draw some lessons and rethink our approaches to policymaking. We can also say with greater certainty that the independence of regulatory and supervisory agencies is a cornerstone of good regulatory governance, a topic that has received little attention.

A financial system is only as strong as its governing practices, the financial soundness of its institutions, and the efficiency of its market infrastructure. Instilling and applying sound governance practices is a responsibility shared by market participants and supervisors. Market participants must establish good governance practices to gain the confidence of their clients and the markets. Regulatory agencies play a key role in instilling, and overseeing the implementation of, good governance practices. And regulatory agencies need to follow sound governance practices in their own operations or they will lose the credibility and moral authority they need to be effective in their oversight role—opening the door to moral hazard, unsound market practices, and, ultimately, financial crises.

The case for independence

Establishing adequate independence arrangements is crucial to reducing the likelihood of political interference in the supervisory process. While many central banks have become legally more independent in the past 20 years—with demonstrably positive results in terms of increased monetary stability—the debate on regulatory independence is at the same stage the debate on central bank independence was two decades ago.

Perils of lack of independence

Before the Asian crisis began in 1997, Korea’s specialized banks and nonbank financial institutions were under the authority of the ministry of finance and economy. The ministry’s supervision of nonbanks was generally recognized as weak, encouraging regulatory arbitrage and excessive risk taking. As in many other Asian crisis countries, politically motivated forbearance was widespread. The most glaring examples of political interference in financial sector supervision were the government’s decisions to intervene in certain banks or to provide them with government funds for recapitalization.

In Japan, the lack of independence of the financial supervision function within the ministry of finance is also widely believed to have contributed to financial sector weaknesses. Although there was probably little direct political pressure on the ministry of finance to exercise forbearance, the system lacked transparency and was known for widespread implicit government guarantees of banking sector liabilities. Following a decline in the ministry’s reputation as a supervisor in the late 1990s, the Japanese government created a new, integrated Financial Supervisory Agency, which was more independent and transparent than its predecessor had been. However, the agency, which reports to the prime minister’s office rather than to the finance ministry, has achieved disappointing results to date.

Ineffective regulation, weak and dispersed supervision, and political interference in Venezuela were among the main factors in the weakening of banks in the run-up to the 1994 banking crisis. Former central bank president Ruth de Krivoy has emphasized that one of the main lessons of this crisis was that there was a need for more independence for financial sector regulators and supervisors and political support for their work.

Nonetheless, independence for financial regulatory agencies matters for financial stability for many of the same reasons that central bank independence matters. An independent regulator can ensure that the rules of the regulatory game are applied consistently and objectively over time. If bankers know in advance that insolvent banks will be closed—and that lobbying to keep them open will fail—they will behave more prudently, thereby reducing the likelihood of a full-blown banking crisis. In contrast, when politicians become directly involved in enforcing regulations, they may be influenced by other considerations in making their decisions, which then take on an ad hoc quality.

The crises that erupted during the 1990s in a number of countries where regulatory and supervisory agencies were not independent strongly support the case for independence (see box). Examples of crises averted because of better regulatory governance would also support the case for independence, but, given the confidential nature of supervision, these are not likely to be revealed.

Further evidence of the desirability of independence comes from the Financial Sector Assessment Program (FSAP) launched in May 1999 by the IMF and the World Bank. The FSAP enables the two institutions to assess the extent to which countries’ current regulatory governance arrangements and regulatory independence (or lack thereof) are contributing to vulnerabilities in financial systems. The benchmarks against which a country’s current practices are assessed are the IMF Code of Good Practices on Transparency in Monetary and Financial Policies, the Basel Core Principles for Effective Banking Supervision, the Committee for Payment and Settlement Systems’ Core Principles for Systemically Important Payment Systems, the International Organization of Securities Commissions’ Objectives and Principles of Securities Regulation, and the International Association of Insurance Supervisors’ Insurance Core Principles.

Thus far, about 50 countries have participated in the FSAP, and assessments have revealed numerous shortcomings. Many supervisory agencies struggle with political influence in the form of interference in the decision-making process, arbitrary removal of senior management, or lack of budgetary independence. Improper influence by the entities they are supposed to supervise is also a big problem. Legal action—or the threat of such action—against supervisors who do not have legal protection in the execution of their job, and supervisors’ often inadequate enforcement powers have not only impeded their ability to apply supervisory measures consistently but also undermined the credibility of banking supervision itself. Further undermining supervisory effectiveness is the lack of trained supervisors and uncompetitive salaries. Assessments have revealed that independence and accountability arrangements in the supervision of securities markets and the insurance sector are even weaker than those for banking.

Making independence work

To be effective, agencies must enjoy independence in four areas.

Regulatory independence—which is critical for effective rule making—means that agencies should have an appropriate degree of autonomy in setting prudential regulations, within the broader legal framework. Supervisors who can define regulations are in a better position to respond quickly and flexibly to changing needs and trends in the international markets. Supervisors will also be more motivated to implement and enforce regulations if they have been closely involved in the rule-making process.

Although supervisors have the autonomy to issue prudential regulations in a large number of countries, they lack such powers in, for instance, Germany, Hungary, Italy, Korea, and South Africa, among others, while in some other countries, the regulatory powers of government and supervisors are not clearly delineated. Encouraging news is that in several countries where supervisory arrangements have been revised recently (Australia, Japan, and the United Kingdom), regulatory autonomy has been strengthened.

Supervisory independence is critical to enforcing rules, imposing sanctions, and managing crises. To be effective, supervision must be largely invisible, but this very invisibility makes supervision vulnerable to interference from both politicians and supervised entities. To protect their integrity, supervisors should enjoy legal protection when carrying out their responsibilities so that they cannot be sued personally for their actions—which can paralyze the supervisory process. Appropriate salaries should help agencies attract and retain competent staff and discourage bribe taking. Introducing rules-based systems for sanctions and interventions could also discourage improper interference.

Supervisors should be given sole authority to grant and revoke licenses—with proper appeals procedures in place for those whose licenses have been revoked—because they have the best view on the composition of supervised sectors. Moreover, supervisors are more effective if they have the power to remove licenses. If that power is in the hands of another government agency or ministry, threats to revoke licenses lack teeth. Practices with respect to licensing and withdrawing licenses differ greatly around the world, ranging from the government having sole responsibility (Malaysia), to consultation arrangements (Austria, the Czech Republic, Hungary), to total autonomy for the supervisors (Australia, Belgium, Italy, the United Kingdom). Typically, governments tend to be more involved in withdrawing than in granting licenses.

Institutional independence is guaranteed by clear arrangements for appointing and dismissing senior personnel, the agency’s governance structure, the roles and responsibilities of board members, and transparency in decision making.

Budgetary independence is needed so that the agency has the freedom to determine its staffing, training, and remuneration needs. Budgetary autonomy is generally better established in countries where supervisors are part of the central bank, because of the latter’s budgetary autonomy, and in countries that recently established an integrated (unified) supervisory agency. Many countries are increasingly using an industry levy to fund regulation, and this can reinforce autonomy by freeing regulators from the government’s direct budgetary control.

To be sure, independence for regulatory agencies does not mean the complete absence of political control. One legitimate concern is that independent agencies will turn into “an uncontrolled fourth branch of government.” This concern is especially acute for financial sector supervisors, because they possess powers unmatched by most other regulatory agencies. When intervening in the operations of financial institutions or revoking licenses, these agencies exert the coercive power of the state against private citizens. Therefore, accountability, transparency, and integrity are crucial in preventing the abuse of such far-reaching powers. Because they need to justify their actions in terms of their mandate, independent agencies must be accountable not only to those who delegated their responsibilities to them—the executive or legislative branches of government—but also to the public at large. They must also make public—in a comprehensive, accessible, and timely manner—data and other information, particularly about objectives, frameworks, decisions and their rationales, and terms of accountability. Finally, the integrity of agency staff is critical in ensuring that they pursue institutional goals without compromising the goals in their own behavior or self-interest.

Some aspects of financial sector supervision—including the need for confidentiality and the difficulty of measuring the extent to which supervisors are achieving their objectives—make it difficult to ensure accountability. A legal basis for supervisors’ actions needs to be established, along with clear objectives; well-defined relationships with the executive, legislative, and judicial branches of government; procedures for appointment and dismissal of chief executives; override mechanisms; budgetary accountability rules; and rules supporting transparency.

More work is needed

Despite the importance of regulatory independence as a component of good regulatory governance, current practice in many countries falls short of the ideal. Much work remains to be done to strengthen the independence of regulatory agencies around the world and, by the same token, improve the quality of regulatory governance.

In the interest of financial stability, as much attention should be given to ensuring the independence of the supervisory agencies as has been given to ensuring central bank independence. The current trend toward the unification of supervisory agencies provides an opportunity not only to harmonize independence arrangements among sector supervisors but also to raise them to a higher level.

Effective independence cannot be achieved without support from the broader political environment, however. Vested political interests in the financial system remain strong in many parts of the world, and the cost of overriding regulators is often low. Nevertheless, the need to pursue the goal of independent and accountable regulators and supervisors in the interest of long-term financial stability is as great as ever. Politicians must be convinced of this view.

Marc Quintyn and Udaibir S. Das are Deputy Division Chiefs in the IMF’s Monetary and Exchange Affairs Department. Michael W. Taylor is the IMF’s Financial Sector Issues Representative in Indonesia.

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