Banking Soundness and Monetary Policy

25 The Challenges of a Sound Banking System

Charles Enoch, and J. Green
Published Date:
September 1997
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Everyone here is well aware of the importance of bank soundness—and more broadly, of financial sector soundness—for general economic performance. This much, I am sure, has been agreed in the discussions you have held this week. One of the challenges ahead, then, is to ensure that banking and financial systems, domestic and international, are—-and indeed remain—sound. Given the macroeconomic fallout and other negative externalities of banking system problems, efforts to keep national and international financial systems sound are very much part of the Fund’s mandate. You will recall that I referred to this in my opening remarks. I now want to take the opportunity to focus on what needs to be done to promote bank soundness around the world and how the Fund can be involved in, and assist in, that process.

But in order to assess what needs to be done, we must first understand the causes of the problem. One fundamental cause of banking problems is poor management, and more broadly, weak internal governance by owners and managers. These weaknesses are frequently brought to light by adverse macroeconomic developments, which have a negative impact on all banks, but tend to affect poorly managed ones most heavily. Normally, we would expect the market to help discipline poorly managed banks. But the fact is, the market is often not in a position to do so—in part, because it lacks information. Sometimes this is because of a lack of data disclosure, but often it also has to do with the difficulties that surround the valuation of bank assets for which there are no objective values—particularly when loans become nonperforming. Rules for loan classification, loan loss provisioning, and income recognition seek to correct this information problem, but we all know that such rules are difficult to enforce. Moreover, the problem is compounded by the development of new types of financial instruments, and the organization of banks into financial conglomerates, whose scope is often hard to grasp and whose operations may be impossible for outside observers—even banking supervisors—to monitor.

What is the role of the authorities in the face of such problems? Many governments are concerned about protecting the central role of the banking system and guarding against the negative externalities associated with bank failures, especially when such failures are widespread. Accordingly, they have introduced various types of safeguards to foster proper internal governance, compensate for failures in market discipline, and help protect the banking system in the event of adverse macroeconomic shocks. These safeguards include not only financial safety nets, such as deposit guarantee schemes and lender-of-last-resort facilities, but also the entire framework of prudential regulation and supervisory practices.

But if official safety nets are to bolster incentives for prudent banking and proper internal governance, as well as market discipline, they have to be properly designed. In particular, they must not create moral hazard. Indeed, even the existence of official supervision can lead to this, if market participants expect supervisors to guarantee the safety and soundness of every bank. Thus, the authorities must make clear what official action can and cannot do.

In particular, they need to clarify what prudential regulation and supervision can and should be expected to do. Having been in charge of supervision for some time, I have some views on this. Of course, supervisors should be expected to maintain a sound and efficient banking system. They should make sure that banks are operated in a prudent manner by fit and proper owners and managers; that risks are managed professionally; that prudential norms regarding self-dealing and risk exposures are adhered to; that deviations from sound banking practices are promptly corrected; and that failing banks exit the market before their capital has been exhausted. Indeed, the objective of supervisors should not be to keep every problem bank alive, but rather to initiate an early, orderly, and efficient exit when banks become severely undercapitalized. Only in such a manner can supervisors make sure that bank creditors will lose as little as possible, that the confidence of savers will be maintained, that claims on the financial safety nets will be minimized, and that the banking system as a whole will remain sound.

But supervisors cannot do all of this singlehandedly. The authorities need to put in place proper banking and other financial legislation, as well as an adequate set of prudential regulations. The authorities must also ensure that supervisors have the capacity to assess bank owners and management, their internal risk-management systems, the adequacy of their loan provisioning and accounting practices, and the reliability of the data they report. I wish to stress that without proper loan classification and provisioning, prudential ratios and, in particular, capital adequacy ratios, which are the principal focus of supervisors, generally prove meaningless.

In order to make these complicated assessments, there must be a highly skilled professional staff of banking supervisors who have thorough training and adequate equipment to perform their demanding tasks. None of this will be sufficient, however, if the supervisors lack the institutional and professional authority to carry out their duties free from political interference. When supervisors identify a problem, they must be able to require remedial measures and to enforce penalties if these measures are not taken.

One important challenge for supervisors in many countries is the increasing complexity of the organizational structures that they are expected to supervise—that is, conglomerates that deal with all types of financial and nonfinancial operations—often not just within one country, but around the globe. Meeting this challenge will require enormous efforts to harmonize regulations and practices among supervisors of different categories of financial institutions, both nationally and internationally. Many such efforts are already under way, and some headway has been made. However, it is not clear that the progress has been commensurate in all respects with the speed with which financial markets are evolving today.

In this connection, I would like to return to the problem I emphasized earlier: the quality of data on banks’ loan portfolios and other assets. As I am sure you have discussed this week, a lack of accurate data undermines not only internal governance in banks, but also market discipline and official oversight. Increasing the availability of reliable information and data will require a truly massive international effort to improve accounting and auditing standards and especially to get common rules and practices on loan classification and provisioning.

Clearly, the major role in ensuring banking system soundness belongs to the national authorities. But the Fund can continue to make an important contribution also. We can help maintain sound and stable financial systems through our traditional work of encouraging appropriate and sound macroeconomic policies. To this end, we will continue to adapt our surveillance work in the context of Article IV consultations; we will also continue to expand our technical assistance in key areas.

What will this entail? In particular, we shall be paying closer attention to the linkages between banking system soundness and macro-economic policy, both in terms of the policy mix and the instruments used. We will also press for transparent fiscal treatment of losses and of contingent costs that may be building up in the banking sector, and for fiscal and monetary policy to take these costs fully into account. And whenever macroeconomic or market signals of likely future trouble in the banking system loom ahead, the Fund will seek to focus the authorities’ attention on those signals and encourage them to undertake policies to address them before the situation deteriorates. We will also be incorporating these factors into our program design and technical assistance.

In addition, the Fund will pay increased attention to the overall institutional and regulatory framework of national financial sectors. This will include assessing whether incentive structures conducive for sound banking are in place; to what extent official safety nets are properly designed; whether the proper legal and regulatory framework is in place; whether the supervisory capacity and integrity exist to maintain a prudent system; and, finally, whether market forces and prudential oversight are mutually reinforcing. We will help countries to address these issues through our technical assistance.

In order to make judgments in all these areas, we need to gain a better understanding of the issues involved and become familiar with the best principles and practices in banking and financial activities. To this end, we are in the process of preparing a paper for discussion in our Executive Board toward the end of March that will lay out a broad framework for sound banking, and include a supplement with a list of existing best principles and practices. To compile this list, we will use standards, guidelines, principles, and practices developed by other institutions, such as the Basle Committee on Banking Supervision, the Commission of the European Union, and the World Bank—where available. In this context, we look forward in particular to the work under way in the Basle Committee. We will also draw on practices that have proven successful in various of our member countries. It is important to note here that we envisage that these best practices will be subject to continued revision and adaptation to ensure that they remain abreast of, and consistent with, market developments.

Initially, our work will focus on banking systems, but we will eventually need to include other financial intermediaries, as well. In this connection, our work should complement the ongoing efforts of banking, securities, insurance, and pension funds supervisors to harmonize rules, regulations, and practices in individual countries, as well as internationally. Among the important discussions presently under way in this area, I look forward in particular to seeing the recommendations of the G-10 Working Party on Financial Sector Fragilities in Emerging Market Economies regarding strategies for reform.

In concluding, let me return once again to what I see as the central issue: namely, the problem of reliable information and data upon which the success of our endeavors ultimately depends. I hope that a serious international effort will be undertaken to improve the quality and timeliness of data and that, as we gather experience, the Fund will be able to expand its recently launched Data Dissemination Standard to include banking and other financial statistics, as needed.

To be sure, improvements in data and the strengthening of prudential frameworks worldwide will require efforts on many fronts. To bear fruit, these efforts will have to involve international cooperation on a large scale and on an ambitious timetable. The Fund looks forward to cooperating with all other institutions involved. I also envisage a major role in this domain for the private sector, including, for example, international credit rating agencies, auditing firms, and market analysts.

Last year I said that I suspected the next international economic crisis would begin with a banking crisis or almost certainly be compounded by one. Let us hope that all of our efforts to increase the awareness of financial sector problems and to seek solutions to them will lead to serious reforms—both nationally and internationally—that promote sound banking and market discipline. Through these efforts, including events such as this Seminar, we can substantially reduce the possibility of my suspicions becoming reality.

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