Banking Soundness and Monetary Policy


Charles Enoch, and J. Green
Published Date:
September 1997
  • ShareShare
Show Summary Details

Wolfgang Artopoeus’s presentation underlines the growing dilemma facing the supervisors of national banking systems in the context of increasing globalization of the banking sector. As he rightly stresses, the risks in the portfolios of banks are growing in tandem with the dynamic forces of competition unleashed by deregulation and the dramatic innovations in telecommunications and information technology. More important, the resulting volatility of markets raises concerns about the stability of the financial system. The new techniques of financial engineering, expansion of cross-border activities, and the trend toward securitization and the use of derivatives are making the activities of banks more complicated and complex to supervise.

As a representative of a supervisory authority in an emerging-market economy, which has recently launched a structural adjustment program, I can vouch for the growing strains in the supervisory role arising from the rapid transformation of the target financial system. These strains have called for major changes in the techniques and tools of supervision as well as the retraining of the supervisory staff. In emerging markets like India, exchange controls and nonconvertibility of national currencies have, for many years, insulated domestic markets from international capital markets. Such controls held at bay the transmission effects emanating from transnational markets. The domestic money and capital markets were also underdeveloped, and the banks rarely had to contend in any substantial measure with market risks; instead they focused on credit and operational risks. The assessment of these latter risks did not lend itself to pure quantitative or objective measure, and this is where the need to enhance quality of supervision becomes significant. Thus, it is necessary to vastly upgrade supervisory skills to evaluate and assess risk management in banks.

The structural reforms and the deregulation programs on which most developing countries, including India, embarked in recent years have begun to shift supervisory priorities, however. The banks as well as bank supervisors now must learn to cope with market risks and volatile interest rates and exchange rates. The increasing competition, largely by lifting the barriers to market entry for both domestic and overseas entities, has put tremendous pressure on formerly large margins, which had been protected by administered interest rates and almost total dependence on retail deposits, which are stable and relatively less interest-elastic as compared with those in interbank and intercorporate markets. This pressure on margins squeezes out weak players, and the supervisory concerns are consequently heightened in a country like India where the exit route is also inhibited.

As Artopoeus observed, prudential regulations have to follow market developments in order to control the risks devolving on bank portfolios through market exposures. This, as he emphasized, needs constant vigilance and the fine-tuning of existing regulations by the supervisory authority, which become intense in a transitional economy going through structural adjustment. In such a situation, the regulators will be under pressure to redefine their rules, methods, and standards. Banking laws must be adapted in the context of emerging-market issues.

Artopoeus also remarks that quantitative prudential standards have become outmoded and do not capture the new risks. He refers to them as crude measurement instruments and cites a dire need to upgrade national risk management and control systems. This necessitates upgrading the skills of the supervisory staff at high costs.

With the growth of derivatives and cross-border banking, the risk profile has undergone a change. Market risk has become more important than credit risk, and off-balance sheet items have become a cause of concern for supervisors. The distinction between banks and their subsidiaries, investment banks, nonbanks, insurance companies, and financial institutions is getting blurred. This requires, as Artopoeus rightly stressed, a shift of emphasis in supervisory strategy and adoption of new tools from quantitative to a more quality-oriented kind of supervision.

A reference was also made to financial conglomerates. Supervision of financial conglomerates is posing a serious challenge to banking supervisors. Banks have set up securities companies, mutual funds, factoring companies, and stock brokering subsidiaries. Although regulations on arm’s-length relationships and legal separation exist, in times of serious problems, the banking entity is invariably expected to bail out the subsidiary either through soft loans or temporary financing. It is increasingly difficult to make firewalls effective between the banking entity and its subsidiary/affiliate in times of crisis. Here again, there are generally two regulators involved—the banking regulator and the securities regulator—and conflicts between them can arise.

Besides improving the competence of the supervisors for evaluating risks and risk control mechanisms in supervised banks and financial institutions, the need for national supervisors to coordinate with their counterparts in other countries has become essential. I endorse Artopoeus’s views on the pioneering work done by the Basle Committee in promoting the cause of international bank supervisory cooperation.

In conclusion, I believe that the explosive expansion and innovation in the financial activities, riding the back of modern technology and communications network, has given rise to more opportunities than threats. As such, regulators and supervisors should rise to the challenge by becoming more vigilant, and yet more responsive to the changed environment. I would also add that, whereas Artopoeus focused on the growing market risks facing supervisors, credit risk also remains a formidable concern (see Chapter 17). In my opinion, credit risk will continue to be a very important supervisory concern. The prudential norms of capital adequacy, asset classification, income recognition, and provisioning, developed over years of research, have stood the test of time, and the BIS is continuously updating and evolving new risk-measuring instruments. Moreover, the Basle Committees on Banking Supervision are continuously debating these emerging concerns.

The reality is that markets will be always ahead of supervisory technique, and the players will continue to get more attention than the umpires. The whole effort has to be to ensure that the gaps do not widen. I think as supervisors we should be more concerned that banks undertake only those jobs that they are equipped to handle and whose risks they can measure. There are no short answers or shortcuts to supervision. The future will continue to pose challenges. The focus must shift to more internal rather than external supervision. BIS will have to strengthen, as Carl-Johan Lindgren mentioned yesterday, corporate governance, internal controls and systems, and disclosure norms. The on-site and off-site monitoring has its time limitations. The data of even one previous quarter become old. Keeping in mind the volume of transactions involved and their attendant risks, new instruments of supervision need to be devised, including tightening existing norms and building new market intelligence mechanisms.

    Other Resources Citing This Publication