Financial Risks, Stability, and Globalization
Chapter

5 Alternative Approaches to Regulation and Corporate Governance in Financial Firms

Author(s):
Omotunde Johnson
Published Date:
April 2002
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The objective of this paper is to draw lessons from recent banking sector crises especially with respect to the design of an optimum “regulatory regime.” Just as the causes of banking crises are multidimensional, so the principles of an effective regulatory regime also need to incorporate a wider range of issues than externally imposed rules on bank behavior. This suggests that strategies to avoid future crises also need to be multidimensional, involving macro policy, the conduct of regulation and supervision, the creation of appropriate incentive structures, the development of market discipline, and the internal governance and management of financial institutions.

In this context, the paper considers alternative approaches to achieving the objective of financial stability. A maintained theme is that what are often defined as alternatives are in fact complements within an overall regulatory strategy. The discussion is set within the context of what will be termed a regulatory regime that is wider than the rules and monitoring conducted by regulatory agencies. In essence, the focus is on how the components of a regulatory regime are to be combined to produce an optimum regulatory strategy. This follows on the tradition of Lindgren, Garcia, and Saal (1996), who emphasize the three key strands of governance: internal to the firm;

When a particular regulatory problem emerges, a regulator often instinctively responds by creating new rules. This implies an incremental approach to regulation by focusing upon the rules component of the regulatory regime. This paper argues that there are potentially serious problems with such an incremental rules approach in that it may blunt the power of the other mechanisms in the regime and may, in the process, reduce the overall effectiveness of the regime.

Although there is considerable academic debate about whether or not banks should be regulated at all, this issue is not addressed here. Some studies (notably those of Benston and Kaufman, 1994) argue that the economic rationale for bank regulation has not been robustly established and that, in some cases, banking problems have their origin in regulatory rather than market failure. In particular, they give emphasis to the moral hazard effects of safety net arrangements. A similar argument is put forward in Schwartz (1995).

The starting point is twofold: (1) by the nature of their structure, banks are potentially vulnerable, and (2) bank failures involve avoidable costs. With respect to the former, Kaufman (2000) stresses the traditional features of low ratios of cash and capital to assets, and a high ratio of demand to total deposits. Under some circumstances, these features may induce bank runs, spillover effects to innocent banks, reduced availability of credit (a credit crunch), reduced money supply, impairment of the efficiency of the payments system, and increased and costly uncertainty.

With respect to the costs of bank failures, in the case of Indonesia, Malaysia, South Korea, and Thailand, nonperforming loans of banks recently amounted to around 30 percent of total assets. Banking crises have involved substantial costs. In around 25 percent of cases, the cost has exceeded 10 percent of gross national product (e.g., in Spain, Venezuela, Bulgaria, Mexico, Argentina, and Hungary). Evans (2000) suggests that the costs of crises amounted to 45 percent of gross domestic product in the case of Indonesia, 15 percent in the case of South Korea, and 40 percent in the case of Thailand. These figures include the costs of meeting obligations to depositors under the blanket guarantees that the authorities introduced to handle systemic crises, and public sector payments to financing the recapitalization of insolvent banks. Barth and others (2000) also note that the costs of recent bank crises in Chile, Argentina, South Korea, and Indonesia are estimated at 41 percent, 55 percent, 60 percent, and 80 percent of GDP respectively.

As bank failures clearly involve avoidable costs that may be significant, there is a welfare benefit to be derived from lowering the probability of bank failures and reducing the cost of bank failures that do occur. In what follows, these are the twin objectives of the regulatory regime. The objective of this paper is to suggest a wider paradigm for ensuring financial stability (i.e., reducing the probability of bank failures and the costs of those that do occur).

The general economic rationale for financial regulation (in terms of externalities, market imperfections, economies of scale in monitoring, gridlock problems, and moral hazard associated with safety nets) has been outlined elsewhere (Llewellyn, 1999). For the purposes of the present paper, the economic rationale for regulation is taken as given.

Although this ground will not be repeated, two observations are entered at the outset. Firstly, the presence of an economic rationale for regulation, and a consumer demand for it, does not justify everything that a regulator does. Secondly, the case for regulation does not exclude a powerful role for other mechanisms to achieve the objectives of systemic stability and legitimate (but limited) consumer protection. On the contrary, the central theme of the paper is to emphasize that the various components of the regulatory regime need to be combined in an overall regulatory strategy, and that although all are necessary, none are sufficient. There is always a potential danger that the regulation component, if pressed too far, will blunt other mechanisms and, in the process, compromise the overall impact.

The structure of the paper is as follows. The main themes are summarized in the remainder of this section. The second section offers a brief overview of recent banking crises as a context for the main themes of the paper. The following section establishes the concept of the regulatory regime and the trade-offs that can exist between its components. This is followed by a more detailed discussion of each of the seven components of the regime. The next section discusses the concept of what is termed contract regulation, whereby regulated firms are able to self-select regulatory contracts. The paper then reviews how the optimum structure of a regulatory regime will vary for different countries and will change over time. The next section suggests a series of desirable shifts within the regulatory regime and offers a brief assessment of the recently issued Basel Committee consultative paper on capital adequacy. A brief overall assessment is offered in the final section.

After a brief overview of the experience of recent banking crises, the main themes of the paper may be summarized as follows.

1. Debate about regulation is often excessively polarized with too many dichotomies. What are often posed as alternative approaches are in truth complementary mechanisms. It is emphasized that the skill in formulating regulatory strategy is not so much in choosing among the various options, but in the way the seven components of the regulatory regime are combined.

2. Regulation needs to be viewed and analyzed not solely in the narrow terms of the rules and edicts of regulatory agencies, but in the wider context of a regulatory regime that has seven core components:

  • the rules established by regulatory agencies (the regulation component);

  • monitoring and supervision by official agencies;

  • the incentive structures faced by regulatory agencies, consumers, and especially banks;

  • the role of market discipline and monitoring;

  • intervention arrangements in the event of compliance failures of one sort or another;

  • the role of internal corporate governance arrangements within financial firms; and

  • the disciplining and accountability arrangements applied to regulatory agencies.

3. Regulatory strategy is not to be viewed solely in terms of the rules and supervision of regulatory agencies. The debate about regulation is often too narrow because it focuses almost exclusively on the first component of the regime—namely, rules imposed by the regulator. The debate should rather be about how to optimize the combination of the seven components of the regime. Strategy should focus on optimizing the overall regulatory regime rather than any one component. This is a difficult and demanding mandate, and to the regulator the more effective approach in the short run might appear to be imposing more rules. The danger is of thinking in terms of incremental change to regulation, rather than strategically with respect to the overall regime. The objective is to move toward an optimum mix of the components, combined with careful choice of the various regulatory instruments within each. Thus, it is not a question of choosing between either regulation or market disciplines.

4. Several reservations are entered about the conventional approach to regulation for financial stability:

  • it tends to be excessively “rules based;”

  • excessive reliance is placed on the first component of the regulatory regime;

  • insufficient emphasis is given to incentive structures, the role of market discipline, and corporate governance arrangements within banks;

  • insufficient attention is given to potential trade-offs within the regulatory regime and the negative externalities of rules;

  • regulation tends to be insufficiently differentiated between banks that have risk profiles that are not homogeneous.

5. A key issue for the regulator is how its actions can not only contribute directly to the objectives of regulation, but how they impact the other components of the regime. Most important is the issue of how regulation affects incentive structures within firms and the role played by market discipline and monitoring.

6. The optimizing strategy needs to be set in the context of tradeoffs between the various components of the regime. In some circumstances, the more emphasis that is given to one of the components (e.g., regulation), the less powerful becomes one or more of the others (e.g., market discipline on financial firms). To an extent, this may reduce the overall effectiveness and efficiency of the regime.

7. The optimum mix of the components of the regulatory regime will vary among countries, over time for all countries, and between banks.

8. The optimum mix of the components of the regime changes over time as market conditions and compliance culture change. It is argued that, in current conditions, there needs to be a shift within the regime in five dimensions: less reliance placed on detailed and prescriptive rules; more emphasis given to official supervision; a greater focus on incentive structures; an enhanced and strengthened role for market discipline and monitoring; and a more central role for corporate governance arrangements within banks.

9. As financial firms and different types of financial business are not homogeneous, the optimum regulatory approach will be different for different banks and businesses. This has been recognized by the regulatory authorities in the United Kingdom with more emphasis being given to a risk-based approach. However, there should be yet more differentiation. The skill lies in making sufficient differentiations to reflect the heterogeneous nature of regulated firms, while not unduly complicating the regulatory process to an extent that can cause unwarranted inequality of treatment.

10. One particular approach to regulation is what will be termed contract regulation. In this model, once the regulator has established objectives and a set of general principles, individual banks are able to choose their own regulation. Once the choice has been agreed with the regulator, a contract is established between them. If the bank fails to deliver on the contract, sanctions are applied in the normal way, and the regulator has the option of withdrawing the choice from the regulated firm and imposing its own contract.

This all amounts to emphasizing an overall “regulatory strategy” rather than focusing on regulation per se. A central theme is that regulation is an important, but only one, component of a regulatory regime designed to achieve the objectives of systemic stability and consumer protection. Giving too much emphasis to regulation per se has the danger that the importance of the other components are downplayed, or even marginalized.

Regulation is about changing the behavior of regulated institutions on the grounds that unconstrained market behavior tends to produce socially suboptimum outcomes. A key question is the extent to which behavior is to be altered by way of externally imposed rules, or through creating incentives for firms to behave in a particular way.

The Experience of Banking Crises

Almost always and everywhere, banking crises are a complex and interactive mix of economic, financial, and structural weaknesses. For an excellent survey of the two-way link between banking systems and macro policy, see Lindgren, Garcia, and Saal (1996). The trigger for many crises has been macroeconomic in origin and often associated with a sudden withdrawal of liquid external capital from a country. As noted by Brownbridge and Kirkpatrick (1999), financial crises have often involved triple crises of currencies, financial sectors, and corporate sectors. Similarly, it has been argued that East Asian countries were vulnerable to a financial crisis because of “reinforcing dynamics between capital flows, macropolicies, and weak financial and corporate sector institutions” (Alba and others, 1998). The link between balance of payments and banking crises is certainly not a recent phenomenon and has been extensively studied (e.g., Kaminsky and Reinhart, 1996; Goldfajn and Valdes, 1997; Sachs, Tornell, and Velasco, 1996). The close parallels between banking and currency crises is emphasized by Kaufman (2000).

In most (but not all) cases, systemic crises (as opposed to the failure of individual banks within a stable system) are preceded by major macroeconomic adjustment, which often leads to the economy moving into recession after a previous, strong cyclical upswing (Llewellyn, 2000). Although financial crises have often been preceded by sharp fluctuations in the macroeconomy and asset prices, it would be a mistake to seek the origin of such crises and financial instability exclusively in macroeconomic instability. While macro instability may often be the proximate cause, banking crises usually emerge because instability in the macroeconomy reveals existing weaknesses within the banking system. It is usually the case that the seeds of a problem (e.g., over-lending, weak risk analysis and control, etc.) are sown in the earlier upswing of the cycle. The downswing phase reveals previous errors and overoptimism. Mistakes made in the upswing emerge in the downswing. In Southeast Asia, for instance, a decade of substantial economic growth up to 1997 concealed the effects of questionable bank lending policies.

This is not exclusively a feature of less developed and emerging economies. Koskenkyla (2000) notes that a rapid pace of bank lending was a contributory factor in the Scandinavian banking crises in the early 1990s, which also had the effect of raising asset prices to unsustainable levels, raising the optimism of bankers, and impacting the real economy through a wealth effect as well as directly on aggregate demand. In particular, the case is made that trends (real and nominal) in the economy and bank behavior are not independent but tend to be reinforcing. Berg (1993) and Benink and Llewellyn (1994) also argue that demand and price trends in an economy are not totally exogenous to the banking system.

Analyses of recent financial crises, in both developed and less developed countries (see, for instance, Brealey, 1999; Corsetti, Pesenti, and Roubini, 1998; Lindgren, Garcia, and Saal, 1996; and Llewellyn, 2000) indicate that “regulatory failures” are not exclusively (or even mainly) an indication that the rules were wrong. Five common characteristics have been weak internal risk analysis, management, and control systems within banks; inadequate official supervision; weak (or even perverse) incentives within the financial system generally and financial institutions in particular; inadequate information disclosure; and inadequate corporate governance arrangements both within banks and with their large corporate customers.

Although, as already noted, banking crises can be triggered by developments in the macroeconomy, an unstable or unpredictable macroeconomic environment is neither a necessary nor a sufficient condition for banking crises to emerge. The fault also lies internally within banks, and with failures of regulation, supervision, and market discipline on banks. This reinforces the concept of a regulatory regime and the potential trade-offs between its components.

Banks can fail and bank insolvencies can be concealed within a reasonably stable macroeconomic environment if, for instance, internal risk analysis and management systems are weak, incentive structures are perverse, regulation and supervision are inadequate, market discipline is weak, and corporate governance arrangements are not well developed. Equally, if these are in place, banks can avoid insolvency even within a volatile economic environment.

Regulatory Regime

The concept of a regulatory regime is wider than the prevailing set of prudential and conduct of business rules established by regulatory agencies. External regulation has a positive role in fostering a safe and sound financial system and consumer protection. However, this role, while important, is limited, and insufficient in itself. Equally, and increasingly, important are the other components of the regime and most especially the incentive structures faced by financial firms, and the efficiency of the necessary monitoring and supervision by official agencies and the market.

There are several reasons why emphasis is given to the overall regulatory regime rather than myopically to regulation:

  • prescriptive regulation is not invariably effective in achieving the twin components of financial stability, reducing the probability of bank failures and the costs of those that do occur;

  • regulation may not be the most effective way of securing these objectives;

  • regulation is itself costly both in terms of its direct costs and unwarranted distortions that may arise (e.g., via inaccurate risk weights applied in capital adequacy arrangements) when regulation is inefficiently constructed;

  • regulation may not be the most efficient mechanism for achieving financial stability objectives in that alternative routes may achieve the same degree of effectiveness at lower cost;

  • regulation tends to be inflexible and insufficiently differentiated;

  • there are always potential dangers arising from a monopolist regulator;

  • regulation may impair the effectiveness and efficiency of other mechanisms for achieving the objective of financial stability.

A maintained theme is that a regulatory regime needs to be viewed more widely than externally imposed regulation on financial institutions. In current conditions it would be a mistake to rely wholly, or even predominantly, on external regulation, monitoring, and supervision by the “official sector.” The world of banking and finance is too complex and volatile to warrant dependence on a simple set of prescriptive rules for prudent behavior. The central role of incentive structures is constantly emphasized. There are many reasons (market imperfections and failures, externalities, “gridlock” problems, and moral hazards associated with safety-net arrangements) why incentive structures within financial firms may not be aligned with regulatory objectives (Llewellyn, 1999).

This means that a central consideration for the regulator is the impact its own rules have on regulated firms’ incentive structures, whether they might have perverse effects, and what regulation can do to improve incentives. Incentive structures need to be at the center of all aspects of regulation because if these are wrong it is unlikely that the other mechanisms in the regime will achieve the regulatory objectives. It is necessary to consider not only how the various components of the regime impact directly on regulatory objectives, but also how they operate indirectly through their impact on the incentives of regulated firms and others. Incentive structures are at the heart of the regulatory process.

Trade-Offs Within the Regime

Within the regulatory regime, trade-offs emerge at two levels. In terms of regulatory strategy, a choice has to be made about the balance of the various components and the relative weight to be assigned to each. For instance, a powerful role for official regulation with little weight assigned to market discipline might be chosen or, alternatively, a relatively light touch of regulation but with heavy reliance on the other components. A given degree of effectiveness can be provided by different combinations of rules, supervision, market discipline, etc., and with various degrees of discretion applied by the regulator.

The second form of trade-off relates to how the components of the regime may be causally related. In some circumstances, the more emphasis that is given to one of the components (e.g., regulation) the less powerful becomes one or more of the others (e.g., market discipline on banks). To an extent, that may reduce the overall impact. Thus, while regulation may be viewed as a response to market failures, weak market discipline, and inadequate corporate governance arrangements, causation may also operate in the other direction with regulation weakening these other mechanisms. For instance, the more emphasis that is given to detailed, extensive, and prescriptive rules, the weaker might be the role of incentive structures, market discipline, and corporate governance arrangements within financial firms. This has been explained by Simpson (2000) as follows: “In a market which is heavily regulated for internal standards of integrity, the incentives to fair dealing diminish. Within the company culture, such norms of fair dealing as ‘the way we do things around here’ would eventually be replaced by ‘It’s OK if we can get away with it.’” In other words, an excessive reliance on detailed and prescriptive rules may weaken incentive structures and market discipline.

Similarly, an excessive focus on detailed and prescriptive rules may weaken corporate governance mechanisms within financial firms, and may blunt the incentive of others to monitor and control the behavior of banks. Weakness in corporate governance mechanisms may also be a reflection of banks being monitored, regulated, and supervised by official agencies. The way intervention is conducted in the event of bank distress (e.g., whether forbearance is practiced) may also have adverse incentive effects on the behavior of banks and the willingness of markets to monitor and control banks’ risk taking.

An empirical study of regulation in the United States by Billett, Garfinkel, and O’Neal (1998) suggests that some types of regulation may undermine market discipline. They examine the costs of market discipline and regulation and show that, as a bank’s risk increases, the cost of uninsured deposits rises and the bank switches to insured deposits. This is because changes in regulatory costs are less sensitive to changes in risk than are market costs. They also show that when rating agencies downgrade a bank, the bank tends to increase its use of insured deposits. The authors conclude: “The disparate costs of insured deposits and uninsured liabilities, combined with the ability and willingness of banks to alter their exposure to each, challenge the notion that market discipline can be an effective deterrent against excessive risk taking.”

The public policy objective is to optimize the outcome of a regulatory strategy in terms of mixing the components of the regime, bearing in mind the possibility of negative trade-offs. The key to optimizing overall effectiveness is the mix of the seven core components. All are necessary but none alone are sufficient. The skill of the regulator in devising a regulatory strategy lies in how the various components of the regime are combined.

Components of a Regulatory Regime

Having established the overall framework and the nature of the regulatory regime, this section considers some of the key issues related to each of the seven components with particular reference to regulatory strategy designed to optimize the overall effect of the regime as a whole rather than any of the components.

Regulation

Five particular issues arise with respect to the regulation part of the regime: the type of rules established, the weight to be given to formal and prescriptive rules of behavior, the form of the rules that are established, the impact that rules may have on the other components of the regulatory regime, and the extent to which regulation and supervision differentiate between different banks.

Types of Rules

Four types of rules can be identified: (1) with respect to the prudential management of banks and other financial firms (e.g., capital adequacy rules, large exposure limitations, rules on interconnected lending, etc.); (2) with respect to conduct of business (e.g., how financial firms conduct business with their customers, disclosure requirements, etc.); (3) rules with respect to allowable business (e.g., the extent to which banks are allowed to conduct securities and insurance business); and (4) rules with respect to ownership (i.e., who is allowed to own banks). A detailed consideration of these different types of rules goes beyond the scope of this paper. Nevertheless, Barth and others (2000), in an extension of the model of Demirgüç-Kunt and Detragiache (1997), find some evidence that regulatory restrictions on activities and ownership increase the probability of bank crises.

Prescriptive Rules

A former U.S. regulator has noted that “Financial services regulation has traditionally tended toward a style that is command-and-control, dictating precisely what a regulated entity can do and how it should do it generally, they focus on the specific steps needed to accomplish a certain regulatory task and specify with detail the actions to be taken by the regulated firm” (Wallman, 1999). This experience of the United States also suggests that the interaction of the interests of the regulator and the regulated may tend toward a high degree of prescription in the regulatory process. Regulators tend to look for standards they can easily monitor and enforce, while the regulated seek standards they can comply with. The result is that regulators seek precision and detail in their requirements, while the regulated look for certainty and firm guidance on what they are to do. Wallman suggests that “The result is specific and detailed guidance, not the kind of pronouncements that reflect fundamental concepts and allow the market to develop on its own.”

Although precise rules have their attractions for both regulators and regulated firms, several problems emerge with a highly prescriptive approach to regulation.

  • An excessive degree of prescription may bring regulation into disrepute if it is perceived by the industry as being excessive, with many redundant rules.

  • Risks are often too complex to be covered by simple rules.

  • Balance sheet rules reflect the position of an institution only at a particular point in time and its position can change substantially within a short period.

  • An inflexible approach based on a detailed rule book has the effect of impeding firms from choosing their own least-cost way of meeting regulatory objectives.

  • Detailed and extensive rules may stifle innovation.

  • A prescriptive regime tends to focus on firms’ processes rather than outcomes and the ultimate objectives of regulation. The rules may become the focus of compliance rather than the objectives they are designed to achieve. In this regard, it can give rise to a perverse culture of “box ticking” by regulated firms. The letter of the regulation may be obeyed but not the spirit or intention.

  • A prescriptive approach is inclined toward “rules escalation,” whereby rules are added over time, but few are withdrawn.

  • A highly prescriptive approach may create a confrontational relationship between the regulator and regulated firms, or alternatively cause firms to overreact and engage in excessive efforts at internal compliance out of fear of being challenged by the regulator. In this sense, regulation may become more prescriptive and detailed than is intended by the regulator because of the culture that a rules-based approach generates.

  • In the interests of “competitive neutrality,” rules may be applied equally to all firms, although they may be sufficiently heterogeneous to warrant different approaches. A highly prescriptive approach to regulation reduces the scope for legitimate differentiations. Treating as equal firms that, in practice, are not equal is not competitive neutrality.

  • A prescriptive rules approach may, in practice, prove to be inflexible and not sufficiently responsive to market conditions.

  • A potential moral hazard arises in that firms may assume that, if something is not explicitly covered in regulations, there is no regulatory dimension to the issue.

  • Detailed rules may also have perverse effects if they are regarded as actual standards to be adopted rather than minimum standards with the result that, in some cases, actual behavior of regulated firms may be of a lower standard than without rules. This is particularly the case if each firm assumes its competitors will adopt the minimum regulatory standard.

Form of Rules

A second issue relates to the type of rules chosen by the regulator. Black (1994) distinguishes different types of rules along three dimensions: precision (how much is prescribed and covered in the rule), simplicity (the degree to which the rule may be easily applied to concrete situations), and clarity. The more precise is the rule, the easier it is to enforce. On the other hand, precise rules are less flexible within the overall regime.

Impact of Rules

A third issue is whether the degree of precision in rules has a positive or negative impact on compliance, and the other components of the regime. For reasons already suggested, precision and detail may have a negative effect on compliance and compliance culture: if something is not explicitly disallowed it is presumed to be allowed. Conversely, a regime based more on broad principles than detailed and extensive rules has certain advantages: principles are easily understood and remembered, they apply to all behavior, and they are more likely to have a positive impact on overall compliance culture. It might also be the case (as suggested by Black, 1994) that principles are more likely to become board issues with the boards of financial firms adopting compliance with principles as a high-level policy issue, rather than a culture of “leaving it to the compliance department.” As stated by Black, “it helps chief executives to see the moral wood for the technical trees.”

Differentiation

A central issue in regulation for financial stability is the extent to which it differentiates among different banks according to their risk characteristics and their risk analysis, management, and control systems. Particularly when supervisory resources are scarce, but also in the interests of efficiency in the banking system, supervision needs to be more detailed and extensive in the case of banks deemed riskier than others. The objective of “competitive neutrality” in regulation does not mean that all banks are to be treated in the same way if their risk characteristics are different. Reflecting the practice in the United Kingdom, Richardson and Stephenson (2000) argue that the Financial Services Authority (and, in the past, the Bank of England) treats the requirements of the Basel Accord as minima and requires individual banks to hold more capital than the minima dependent upon their risk exposure. Capital requirements are set individually for each bank. The authors list the major factors that are taken into account when setting individual banks’ capital requirements: experience and quality of the bank’s management; the bank’s risk appetite; the quality of risk analysis, management, and control systems; the nature of the markets in which it operates; the quality, reliability, and volatility of earnings; the quality of the bank’s capital and access to new capital; the degree of diversification; exposure concentrations; the complexity of a bank’s legal and organizational structure; the support and control provided by shareholders; and the degree to which a bank is supervised by other jurisdictions. As the authors note, “these considerations imply that the appropriate margin above the minimum regulatory capital requirements will differ across banks.”

Monitoring and Supervision

Because of the nature of financial contracts between financial firms and their customers, continuous monitoring of the behavior of financial firms is needed. The question is, who is to undertake the necessary monitoring: customers, shareholders, rating agencies, etc.? In practice, there can be only a limited monitoring role for retail depositors due to major information asymmetries which cannot easily be rectified and because depositors face the less costly option of withdrawal of deposits. Saunders and Wilson (1996) review the empirical evidence on the role of informed depositors. The funding structure of a bank may also militate against effective monitoring in that, unlike with nonfinancial companies, creditors tend to be numerous with a small stake for each.

As most (especially retail) customers cannot in practice undertake monitoring, and in the presence of deposit insurance they may have no incentive to do so, an important role of regulatory agencies is to monitor the behavior of banks on behalf of consumers. In effect, consumers delegate the task of monitoring to a regulatory agency. There are strong efficiency reasons for consumers to delegate monitoring and supervision to a specialist agency to act on their behalf, as the transactions costs for the consumer are lowered by such delegation (Llewellyn, 1999). This is not to argue, however, that a regulatory agency should become a monopolist monitor and supervisor of financial firms.

Incentive Structures

The maintained theme is that the incentive structures and moral hazards faced by decision makers (bank owners and managers, lenders to banks, borrowers, and regulators) are major parts of the regulatory regime. The overall issue is twofold: there need to be appropriate internal incentives for management to behave in appropriate ways, and the regulator has a role in ensuring that internal incentives are compatible with regulatory objectives. Overall, we need to know more about incentive structures within financial firms and whether, for instance, incentive structures align with compliance. Research is also needed into how regulation impacts positively and negatively on incentives within regulated firms. We have already alluded to the possibility that detailed rules may have the negative effect of blunting compliance incentives.

Within the regulatory regime paradigm, a central role for regulation is to create appropriate incentives within regulated firms so that the incentives faced by decision makers are consistent with financial stability. At the same time, regulation needs to avoid the danger of blunting the incentives of other agents (e.g., rating agencies, depositors, shareholders, and debt holders) that have a disciplining role with banks. The position has been stated well by Schinasi, Drees, and Lee (1999): “Policy makers are therefore faced with the difficult challenge of balancing efforts to manage systemic risk against efforts to ensure that market participants bear the costs of imprudent risk taking and have incentives to behave prudently.” They argue that banks have complex incentive structures. There are internal incentives that motivate key decision makers involved with risk, corporate governance mechanisms (such as accountability to shareholders), an external market in corporate control, market disciplines that may affect the cost of capital and deposits, and accountability to bank supervisors. The presence of regulation and official supervision overlays the structure of incentives faced by bank decision makers.

The key is to align incentives of the various stakeholders in the decision-making process. The alignment of incentive structures has three dimensions: between the objectives set by regulators and supervisors and those of the bank; between the overall business objectives of the bank and those of actual decision makers in the management structure; and between managers and owners of banks. Conflicts can arise at each level, making incentive structures within banks particularly complex.

If incentive structures are hazardous, regulation will always face formidable obstacles. There are several dimensions to this in the case of banks: the extent to which reward structures are based on the volume of business undertaken; the extent to which the risk characteristics of decisions are incorporated into reward structures; the nature of internal control systems within banks; internal monitoring of the decision making of loan officers; the nature of profit-sharing schemes and the extent to which decision makers also share in losses, etc. Reward systems based on short-term profits can also be hazardous as they may induce managers to pay less attention to the longer-term risk characteristics of their decisions. High staff turnover and the speed with which officers are moved with the bank may also create incentives for excessive risk taking. A similar effect can arise through the herd behavior that is common in banking. In the case of the Barings Bank collapse, managers who were supposedly monitoring the trading activity of Nick Leeson also benefited through bonuses derived from the profits he was making for the bank.

It is clear that some incentive structures may lead to dysfunctional behavior (Prendergast, 1993). This may often emerge when incentives within regulated firms relate to volume that creates a clear bias toward writing of business. Bank managers may be rewarded by the volume of loans, not by their risk-adjusted profitability. Many cases of bank distress have been associated with inappropriate incentive structures creating a bias in favor of balance sheet growth, and with moral hazard created by anticipated lender-of-last-resort actions (Llewellyn, 2000). Dale (1996) suggests that profit-related bonuses were an important feature in the Barings Bank collapse.

Laws, regulations, and supervisory actions provide incentives for regulated firms to adjust their actions and behavior, and to control their own risks internally. In this regard, they can be viewed as incentive contracts. Within this general framework, regulation involves a process of creating incentive-compatible contracts so that regulated firms have an incentive to act consistently with the objectives of financial stability. Well-designed incentive contracts induce appropriate behavior by regulated firms. Conversely, if they are badly constructed and improperly designed, they might fail to reduce systemic risk (and other hazards regulation is designed to avoid) or have undesirable side effects on the process of financial intermediation (e.g., impose high costs). At center stage is the issue of whether all parties have the right incentives to act in a way that satisfies the objectives of regulation.

Given that incentives for individuals can never be fully aligned with the objectives of the bank, there must be external pressures on managers to encourage adequate internal control systems to be established. Several procedures, processes, and structures can, for instance, reinforce internal risk control mechanisms. These include internal auditors, internal audit committees, procedures for reporting to senior management (and perhaps to the supervisors), and making a named board member of financial firms responsible for compliance and risk analysis and management systems. In some countries, the incentives of bank managers have been strengthened by a policy of increased personal liability for bank directors, and bank directors are personally liable in cases involving disclosure of incomplete or erroneous information. The Financial Services Authority in the United Kingdom has also proposed that individual directors and senior managers of financial firms should, under some circumstances, be made personally liable for compliance failures.

The form and intensity of supervision can differentiate between regulated institutions according to their relative risk and the efficiency of their internal control mechanisms (Goodhart and others, 1998). Supervisors can strengthen incentives by, for instance, relating the frequency and intensity of their supervision and inspection visits (and possibly rules) to the perceived adequacy of the internal risk control procedures and compliance arrangements. In addition, regulators can create appropriate incentives by calibrating the external burden of regulation (e.g., number of inspection visits, allowable business, etc.) to the quality of management and the efficiency of internal incentives. Evans (2000) suggests several routes through which incentive structures can be improved: greater disclosure by financial institutions; subjecting local banks to more foreign competition; ensuring a closer alignment of regulatory and economic capital; greater use of risk-based incentives by supervisors; and lower capital adequacy requirements for banks headquartered in jurisdictions that comply with the Bank for International Settlements’ core principles of supervision.

With respect to prudential issues, capital requirements should be structured so as to create incentives for the correct pricing of absolute and relative risk. In this area in particular, the potential for regulation to create perverse incentives and moral hazard is well established. The basic problem is that if regulatory capital requirements do not accurately map risk, then banks are encouraged to engage in regulatory arbitrage. For instance, if differential capital requirements are set against different types of assets (e.g., through applying differential risk weights), the rules should be based on calculations of relative risk. If risk weights are incorrectly specified, perverse incentives may be created for banks because the implied capital requirements are either more or less than justified by true relative risk calculations. A critique of the current Basel capital arrangements is that risk weights bear little relation to the relative risk characteristics of different assets, and the loan book largely carries a uniform risk weight even though the risk characteristics of different loans within a bank’s portfolio vary considerably. The current BIS consultation paper seeks to address this issue.

The moral hazard associated with perceived safety-net arrangements have been extensively analyzed in the literature. Garcia (1996), in particular, analyzes the trade-off between systemic stability and moral hazard. Three possible hazards are associated with deposit insurance: banks may be induced to take excessive risk as they are not required to pay the risk premium on insured deposits; there are particular incentives for excessive risk taking when a bank’s capital ratio falls to a low level; and depositors may also be induced to seek high-risk banks due to the one-way-option bet.

Deposit insurance has two opposing impacts on systemic risk. By reducing the rationality of bank runs (although this is dependent on the extent and coverage of the deposit insurance scheme and the extent of any coinsurance), it has the effect of lowering the potential for financial instability. On the other hand, for reasons outlined above, the moral hazard effects of deposit insurance may increase risk in the system. Given that there is little firm empirical evidence for bank runs in systems without deposit insurance (including in the United States prior to deposit insurance), the second factor probably outweighs the first. There is something of a trade-off in this: the stronger that the deposit protection scheme is, the smaller is the probability of bank runs and systemic instability, but the greater is the moral hazard. This reinforces the case for deposit insurance to be accompanied by regulation to contain risk taking by banks subject to deposit insurance. Reviewing the experience of bank crises in various countries, Demirgüç-Kunt and Detragiache (1997) argue on the basis of their sample of countries: “Our evidence suggests that, in the period under consideration, moral hazard played a significant role in bringing about systemic banking problems, perhaps because countries with deposit insurance schemes were not generally successful at implementing appropriate prudential regulation and supervision, or because the deposit insurance schemes were not properly designed.” This conclusion cannot be generalized to all countries, however, given that the United States and the countries of the European Union have deposit protection schemes.

Bhattacharya and others (1998) consider various schemes to attenuate moral hazards associated with deposit insurance. These include cash-reserve requirements, risk-sensitive capital requirements and deposit insurance premia, partial deposit insurance, bank closure policy, and bank charter value.

There is a particular issue with respect to the incentive structure of state-owned, or state-controlled, banks as their incentives may be ill-defined, if not hazardous. Such banks are not subject to the normal disciplining pressures of the market, their “owners” do not monitor their behavior, and there is no disciplining effect from the market in corporate control. Managers of such banks may face incentives and pressure to make loans for public policy reasons. Political interference in such banks, and the unwitting encouragement of bad banking practices, can itself become a powerful ingredient in bank distress. Lindgren and others (1996) found, for instance, that banks that were, or had recently been, state-owned or controlled were a factor in most of the instances of unsoundness in their sample of banking crises.

Several adverse incentive structures can be identified in many of the countries that have recently experienced distressed banking systems:

  • The expectation that government commitment to the exchange rate was absolute induced imprudent and unhedged foreign currency borrowing both by banks and companies.

  • Expectations of bailouts or support for industrial companies (which had at various times been in receipt of government support) meant that the bankruptcy threat was weak. This may also have affected foreign creditors.

  • There was a belief in the role of the lender of last resort and expectations that banks would not be allowed to fail. The IMF notes that the perception of implicit guarantees was probably strengthened by the bailouts in the resolution of earlier banking crises in Thailand (1983-87), Malaysia (1985-88), and Indonesia (1994).

  • The effect of close relationships between banks, the government, other official agencies, and industrial corporations often meant that lending relationships that would normally be conducted at arm’s length became intertwined in a complex structure of economic and financial linkages within sometimes opaque corporate structures. This also meant that corporate governance arrangements, both within banks and their borrowing customers, were often weak and ill-defined.

Market Discipline

The fourth component of the regulatory regime relates to the arrangements for market discipline on banks. The central theme is that regulation can never be an alternative to market discipline. On the contrary, market discipline needs to be reinforced within the regime. In fact, market discipline is one of the three pillars in the proposed new Basel capital adequacy regime. A starting point is that, as noted by Lang and Robertson (2000), the existence of deposit insurance creates a large class of debt holders who have no incentive to engage in costly monitoring of banks.

Monitoring is not only conducted by official agencies assigned this specialist task. In well-developed regimes, the market has incentives to monitor the behavior of financial firms. The disciplines imposed by the market can be as powerful as any sanctions imposed by official agencies. The disciplining role of the markets (including the interbank market) was weak in the crisis countries of Southeast Asia in the 1990s. This was due predominantly to the lack of disclosure and transparency of banks, and to the fact that little reliance could be placed on the quality of accountancy data provided in bank accounts. In many cases, standard accountancy and auditing procedures were not applied rigorously, and in some cases, there was willful misrepresentation of the financial position of banks and nonfinancial companies. This is not an issue for less developed countries alone. For instance, Nakaso and others (2000) argue that market discipline did not operate efficiently in Japan due largely to insufficient financial infrastructure (weak accountancy rules, inadequate disclosure, etc.).

Market discipline works effectively only on the basis of full and accurate information disclosure and transparency. Good quality, and timely and relevant information needs to be available to all market participants and regulators so that asset quality, creditworthiness, and the condition of financial institutions can be adequately assessed.

A potentially powerful disciplining power of markets derives from the market in corporate control, which, through the threat of removing control from incumbent management, is a discipline on managers to be efficient and not endanger the solvency of their banks. As stated in a recent IMF study: “An open and competitive banking market exerts its own form of discipline against weak banks while encouraging well-managed banks” (Lindgren, Garcia, and Saal, 1996).

Several parties are potentially able to monitor the management of banks and other financial firms: owners, bank depositors and customers, rating agencies, official agencies (e.g. the central bank or other regulatory body), and other banks in the market. In practice, excessive emphasis has been given to official agencies. The danger in this is that a monopoly monitor is established with many of the standard problems associated with monopoly power. There may even be adverse incentive effects in that, given that regulatory agencies conduct monitoring and supervision on a delegated basis, the incentive for others to conduct monitoring may be weakened.

In the interests of an effective and efficient regulatory regime, the role of all potential monitors (and notably the market) needs to be strengthened, with greater incentives for other parties to monitor financial firms in parallel with official agencies. An advantage of having agents other than official supervisory bodies monitor banks is that it removes the inherent danger of having monitoring and supervision conducted by a monopolist with less than perfect and complete information, with the result that inevitably mistakes will be made. A monopolist supervisor may also have a different agenda than purely the maintenance of financial stability. It has been noted that “Broader approaches to bank supervision reach beyond the issues of defining capital and accounting standards, and envisage co-opting other market participants by giving them a greater stake in bank survival. This approach increases the likelihood that problems will be detected earlier [it involves] broadening the number of those who are directly concerned about keeping the banks safe and sound” (Caprio and Honahan, 1999).

Given how the business of banking has evolved, and given the nature of the market environment in which banks now operate, market discipline needs to be strengthened. The issue is not about market versus agency discipline, but the mix of all aspects of monitoring, supervision, and discipline. In its recent consultation document on capital adequacy, the Basel Committee recognized that supervisors have a strong interest in facilitating effective market discipline as a lever to strengthen the safety and soundness of the banking system. It argues, “market discipline has the potential to reinforce capital regulation and other supervisory efforts to promote safety and soundness in banks and financial systems. Market discipline imposes strong incentives on banks to conduct their business in a safe, sound and efficient manner.”

Some analysts (e.g., Calomiris, 1997) are skeptical about the power of official supervisory agencies to identify the risk characteristics of banks compared with the power and incentives of markets. Along with others (including Evanoff and Wall (2000), who present a detailed set of proposals for the implementation of a subordinated debt rule), Calomiris has advocated banks being required to issue a minimum amount of subordinated and uninsured debt as part of the capital base. Holders of subordinated debt have an incentive to monitor the risk taking of banks. As noted by Lang and Robertson (2000), discipline can be imposed through three routes: the cost of raising funds, market signals as expressed in risk premia implicit in the price of subordinated debt, and through supervisors themselves responding to market signals. Discipline would be applied by the market as its assessment of risk would be reflected in the risk premium in the price of traded debt. In particular, because of the nature of the debt contract, holders of a bank’s subordinated debt do not share in the potential upside gain through the bank’s risk taking, but stand to lose if the bank fails. They, therefore, have a particular incentive to monitor the bank’s risk profile compared with shareholders who, under some circumstances, have an incentive to support a high risk profile. This is particularly the case when a “gamble for resurrection” strategy becomes optimal for shareholders. In this respect, there is a degree of symmetry between the reward structures faced by equity and subordinated debt holders. Equity holders have the prospect of unlimited upside gain while losses are restricted to the value of their holding; in contrast, debt holders do not share in any excess rewards (in the absence of default their rewards are fixed) but face the prospect of total loss in the event of default. For such a scheme to work, however, it must be well-established that holders of such subordinated debt will never be rescued in the event of the bank failing.

The impact of a rise in the debt-equity ratio (which occurs by substituting subordinated debt for equity) on the incentives for risk taking by banks is ambiguous. On the one hand, a rise in the ratio raises the proportion of liability holders who have an incentive to monitor risk. This might be expected to lower the risk appetite of banks. On the other hand, a decline in the equity ratio may raise the risk appetite of equity holders as they have less to lose and may face a rational gamble-for-resurrection option. A decline in the equity ratio also has the disadvantage of increasing the probability of insolvency. It is also the case that the market disciplining role of subordinated debt may be limited because in practice such debt will always be a small proportion of a bank’s total liabilities. The most powerful route is likely to be through market signals and how these induce supervisors to respond.

A scheme along these lines has been introduced in Argentina whereby holders of subordinated debt must be entities of substance that are independent of a bank’s shareholders, and it requires issue of the debt in relatively lumpy amounts on a regular basis (Calomiris, 1997). However, while there is a potentially powerful role for market discipline to operate through the pricing of subordinated debt, the interests of holders of such debt do not necessarily precisely coincide with those of depositors or the public interest more generally (Dewatripont and Tirole, 1994). It is not, therefore, a substitute for official monitoring. It is intended as an extension of the role of market monitoring.

A further example of market discipline could be to link deposit insurance premia paid by banks to the implied risk of the bank as incorporated in subordinated debt yields or classifications of rating agencies.

The merit of increasing the role of market discipline is that large, well-informed creditors (including other banks) have the resources, expertise, market knowledge, and incentives to conduct monitoring and to impose market discipline. For instance, the hazardous state of BCCI was reflected in market prices and interbank interest rates before the Bank of England closed the bank. Market reports also indicate that some money brokers in London had ceased to deal with BCCI in advance of it being closed.

Leaving aside the merits and drawbacks of particular mechanisms that might be proposed (and one such mechanism has been suggested above as an example), the overall assessment is that regulation needs to reinforce, not replace, market discipline. The regulatory regime needs to be structured so as to provide greater incentives than exist at present for markets to monitor banks and other financial firms.

In addition, there is considerable advantage in regulators utilizing market data in their supervisory procedures whenever possible. Evidence indicates that markets give signals about the credit standing of financial firms that, when combined with inside information gained by supervisory procedures, can increase the efficiency of the overall supervisory process. Flannery (1998) suggests that market information may improve two features of the overall process: (1) regulators can identify developing problems more promptly, and (2) regulators have the incentive and justification to take action more quickly once problems have been identified. He concludes that market information should be incorporated into the process of identifying and correcting problems.

If financial markets are able to assess a bank’s market value as reflected in the market price, an asset-pricing model can, in principle, be used to infer the risk of insolvency that the market has assigned to each bank. Such a model has been applied to U.K. banks by Hall and Miles (1990). Similar analysis for countries that had recently liberalized their financial systems has been applied by Fischer and Gueyie (1995). On the other hand, there are clear limitations to such an approach (see Simons and Cross, 1991) and hence it would be hazardous to rely exclusively on it. For instance, it assumes that markets have sufficient data upon which to make accurate assessments of banks, and it equally assumes that the market is able to efficiently assess the available information and incorporate it into an efficient pricing of bank securities.

An additional route is to develop the role of rating agencies in the oversight role. Rating agencies have considerable resources and expertise in monitoring banks and making assessments of risk. It could be made a requirement, as in Argentina, for all banks to have a rating that would be made public.

Although market discipline is potentially powerful, it has its limitations and Bliss and Flannery (2000) argue that there is no strong evidence that equity and debt holders do in fact affect managerial decisions. This means that, in practice, it is unlikely to be an effective, complete alternative to the role of official regulatory and supervisory agencies.

  • Markets are concerned with the private costs of a bank failure and reflect the risk of this in market prices. The social cost of bank failures, on the other hand, may exceed the private cost (Llewellyn, 1999) and hence the total cost of a bank failure may not be fully reflected in market prices.

  • The cost of private monitoring and information collection may exceed the benefits.

  • Market disciplines are not effective in monitoring and disciplining public sector banks.

  • “Free-rider” problems may emerge.

  • In many countries, there are limits imposed on the extent to which the market in corporate control (the take-over market) is allowed to operate. In particular, there are often limits, if not bars, on the extent to which foreign institutions are able to take control of banks, even though they may offer a solution to under-capitalized institutions.

  • The market is able to efficiently price bank securities and interbank loans only to the extent that relevant information is available, and in many cases the necessary information is not available. Disclosure requirements are, therefore, an integral part of the market disciplining process.

  • It is not self-evident that market participants always have the necessary expertise to make risk assessment of complex, and sometimes opaque, banks. In addition, there are some areas within a bank (e.g., its risk analysis and control systems) where disclosure is not feasible.

  • In some countries, the market in debt of all kinds (including securities and debt issued by banks) is limited, inefficient, and cartelized, although market discipline can also operate through interbank and swaps markets.

  • When debt issues are very small, it is not always economic for rating agencies to conduct a full credit rating on a bank.

While there are clear limitations to the role of market discipline (discussed further in Lane, 1993) the global trend is in the direction of placing more emphasis on market data in the supervisory process. The theme being developed is not that market monitoring and discipline can effectively replace official supervision, but that it has a powerful role which should be strengthened within the overall regulatory regime. In addition, Caprio (1997) argues that broadening the number of those who are directly concerned about the safety and soundness of banks reduces the extent to which insider political pressure can be brought to bear on bank regulation and supervision. In fact, the recent consultative document issued by the Basel Committee on Banking Supervision (Basel Committee, 1999a) incorporates the role of market discipline as one of the three pillars of a proposed new approach to banking supervision. The Committee emphasizes that its approach “will encourage high disclosure standards and enhance the role of market participants in encouraging banks to hold adequate capital.”

As neither the market nor regulatory agencies are perfect, the obvious solution is to utilize both with neither having a monopoly of wisdom and judgment. The conclusion is that more systematic research is needed into the predictive power of market data and how market information can usefully be incorporated into the supervisory process both by regulators and the markets.

This section should not conclude without reference to competition. However well-intentioned, regulation has the potential to compromise competition and to condone, if not in some cases endorse, unwarranted entry barriers, restrictive practices, and other anticompetitive mechanisms. Historically, regulation in finance has often been anticompetitive in nature. But this is not an inherent property of regulation. The purpose of regulation is not to displace competitive pressures or market mechanisms, but to correct for market imperfections and failures. As there are clear consumer benefits and efficiency gains to be secured through competition, regulation should not be constructed in a way that impairs it. Regulation and competition need not be in conflict: on the contrary, properly constructed they are complementary. Regulation can also make competition more effective in the market place by, for instance, requiring the disclosure of relevant information that can aid market participants to make informed choices.

Discipline can also be exerted by competition. Opening domestic financial markets to external competition can contribute to the promotion of market discipline. There are many benefits to be derived from foreign institutions entering a country. They bring expertise and experience and, because they themselves are diversified throughout the world, a macro shock to a particular country can become a regional shock. Hence, they are more able to sustain purely national shocks which domestic institutions are less able to do. It is generally the case that competition that develops from outside a system tends to have a greater impact on competition and efficiency than internal competition. Foreign institutions tend to be less subject to domestic political pressures in the conduct of their business, and are also less susceptible to local euphoria, which, at times, leads to excessive lending and overly optimistic expectations.

Intervention

A key component of the regulatory regime is the nature, timing, and form of intervention by regulatory agencies in the event of either some form of compliance failure within a regulated firm, or when financial distress occurs with banks. Although not downgrading the significance of the former, in the interest of brevity we reserve discussion of this issue to the question of intervention in the event of bank distress.

The closure of an insolvent or, under a Structured Early Intervention and Resolution (SEIR) regime, a near-insolvent bank, can impose a powerful discipline on the future behavior of banks. Such “creative destruction” has a positive dimension. It is also necessary to define the nature of “closure.” It does not necessarily mean that, even in the absence of deposit insurance, depositors lose. Nor do bank-customer relationships and information sharing need to be destroyed. As with the bankruptcy of any company, there is always some residual value within an insolvent bank. Bank closure may simply mean a change in ownership of a bank and the imposition of losses on equity holders. In most countries, “bank closure” has not meant the destruction of the bank. Thus, Barings Bank was purchased by ING Bank. In many instances, regulatory authorities have brokered a change in ownership of insolvent banks while imposing losses on shareholders. The skill in intervention that leads to the “closure” of an institution lies in ensuring that its remaining value is maintained.

Intervention arrangements are important not the least because they have incentive and moral hazard effects, which potentially influence future behavior by banks and their customers. These arrangements may also have important implications for the total cost of intervention (e.g., initial forbearance often has the effect of raising the eventual cost of subsequent intervention), and the distribution of those costs between tax payers and other agents. Different intervention arrangements also have implications for the future efficiency of the financial system in that, for instance, forbearance may have the effect of sustaining inefficient banks and excess capacity in the banking sector.

The issue focuses on when intervention should occur. The experience of banking crises in both developed and developing countries indicates that a well-defined strategy for responding to the possible insolvency of financial institutions is needed. A response strategy in the event of bank distress has three key components:

  • taking prompt corrective action to address financial problems before they reach critical proportions;

  • being prepared to close insolvent financial institutions while nevertheless preserving their remaining value;

  • closing unviable institutions and vigorously monitoring weak and/or restructured institutions.

A key issue relates to rules versus discretion in the event of bank distress: the extent to which intervention should be circumscribed by clearly defined rules (so that intervention agencies have no discretion about whether, how, and when to act), or whether there should always be discretion simply because relevant circumstances cannot be set out in advance. The obvious advantage for allowing discretion is that it is impossible to foresee all future circumstances and conditions for when a bank might become distressed and close to (or actually) insolvent. It might be judged that it is not always the right policy to close a bank in such circumstances.

However, there are strong arguments against allowing such discretion and in favor of a rules approach to intervention. Firstly, it enhances the credibility of the intervention agency in that market participants, including banks, have a high degree of certainty that action will be taken. Secondly, allowing discretion may increase the probability of forbearance which usually eventually leads to higher costs when intervention is finally made. Kane (2002; Chapter 11 of this book), for instance, argues that officials may forbear because they face different incentives from those of the market: their own welfare, the interests of the agency they represent, political interests, reputation, future employment prospects, etc. Perhaps less plausibly, he also argues that, under some circumstances, the present generation of tax payers may believe they can shift the cost of resolution to future generations. Thirdly, and this was relevant in some countries that recently experienced banking distress, it removes the danger of undue political interference in the disciplining of banks and regulated firms. Experience in many countries indicates that supervisory authorities face substantial pressure to delay action and intervention. Fourthly, and related to the first, a rules approach to intervention is likely to have a beneficial impact on ex ante behavior of financial firms.

A rules-based approach, by removing any prospect that a hazardous bank might be treated leniently, has the advantage of enhancing the incentives for bank managers to manage their banks prudently so as to reduce the probability of insolvency (Glaessner and Mas, 1995). It also enhances the credibility of the regulator’s threat to close institutions. Finally, it guards against hazards associated with risk-averse regulators who themselves might be disinclined to take action for fear that it will be interpreted as a regulatory failure and the temptation to allow a firm to trade out of its difficulty. This amounts to the regulator also “gambling for resurrection.” In this sense, a rules approach may be of assistance to the intervention agency as its hands are tied and it is forced to do what it believes to be the right thing.

Put another way, time inconsistency and credibility problems should be addressed through precommitments and graduated responses with the possibility of overrides. Many analysts have advocated various forms of predetermined intervention through a general policy of “Structured Early Intervention and Resolution” (SEIR). There is a case for a graduated response approach since, for example, there is no magical capital ratio below which an institution is in danger and above which it is safe. Other things equal, potential danger gradually increases as the capital ratio declines. This, in itself, suggests that there should be a graduated series of responses from the regulator as capital diminishes. No single dividing line should trigger action but there should be a series of such trigger points with the effect of going through any one of them being relatively minor, but the cumulative effect being large. Goldstein and Turner (1996) argue that SEIR is designed to imitate the remedial action that private bond holders would impose on banks in the absence of government insurance or guarantees. In this sense, it is a mimic of market solutions to troubled banks. An example of the rules-based approach is to be found in the Prompt Corrective Action (PCA) rules in the United States. These specify graduated intervention by the regulators with predetermined responses triggered by capital thresholds. In fact, several countries have such rules of intervention (Basel Committee, 1999a). SEIR strategies can, therefore, act as a powerful incentive for prudent behavior.

The need to maintain the credibility of supervisory agencies creates a strong case against forbearance. The overall conclusion is that there should be a clear bias (although not a bar) against forbearance when a bank is in difficulty. Although there should be a strong presumption against forbearance, and that this is best secured through having clearly defined rules, there will always be exceptional circumstances when it might be warranted in the interests of systemic stability. However, when forbearance is exercised the regulatory agency should, in some way or another, be made accountable for its actions.

A useful case study is to be found in the example of Finland, where strict conditions were imposed in the support program. These are summarized by Koskenkyla (2000) as follows:

  • support was to be transparent and public;

  • the attractiveness of public funding of the program was to be minimized;

  • the owners of supported banks were, where possible, to be held financially responsible;

  • the terms of the program were to support the efficiency of the banking system and the promotion of necessary structural adjustments within the system;

  • the potential impact on competitive distortions were to be minimized;

  • banks receiving support were to be publicly monitored; and

  • the employment terms of bank directors were to be reasonable and possible inequities removed.

It is also the case that some bank directors and managers in Finland have been held financially liable for hazardous behavior (see Halme, 2000).

Corporate Governance

The focus of corporate governance is the principal-agent relationship that exists between managers and shareholders (owners) of companies. The owners (principals) delegate the task of management to professional managers (agents) who, in theory, act in the interests of the shareholders. In practice, managers have information advantages over shareholders and also have their own interests, which may not coincide with those of the owners. Differences may emerge between the owners and managers with respect to their appetite for risk. For instance, managers may at times have a greater appetite for risk than shareholders do because they do not stand to lose if the risk fails. On the other hand, at other times (e.g., when capital in the bank is low) shareholders may have a strong appetite for risk in a gamble for resurrection strategy.

In the final analysis, all aspects of the management of financial firms (including compliance) are ultimately corporate governance issues. This means that, while shareholders may at times have an incentive to take high risks, if a financial firm behaves hazardously it is, to some extent, a symptom of weak corporate governance. This may include, for instance, a hazardous corporate structure for the financial firm; interconnected lending within a closely related group of companies; lack of internal control systems; weak surveillance by (especially nonexecutive) directors, and ineffective internal audit arrangements, which often include serious underreporting of problem loans. Corporate governance arrangements were evidently weak and underdeveloped in banks in many of the countries that have recently experienced bank distress.

A particular feature of corporate governance relates to cross shareholdings and interconnected lending within a group (Falkena and Llewellyn, 1999). With respect to Japan, Nakaso (2002, Chapter 13 of this book) notes that such cross shareholdings, which have long been a feature of Japanese corporate structures, increased during the “bubble era” that preceded the banking crisis. In some cases, banks sold capital to companies (in order to raise their capital-asset ratios) and at the same time purchased stock in the companies. Several problems arise in cross shareholding arrangements: credit assessment may be weak; the mix of debt and equity contracts held by banks may create conflicts of interest; when equity prices fall, banks simultaneously face credit and market risk; and banks often count unrealized gains as capital even when, in practice, they cannot be realized.

There are several reasons why corporate governance arrangements operate differently with banks than with other types of firms. First, banks are subject to regulation, which adds an additional dimension to corporate governance arrangements. Second, banks are also subject to continuous supervision and monitoring by official agencies. This has two immediate implications for private corporate governance: shareholders and official agencies are to some extent duplicating monitoring activity, and the actions of official agencies may have an impact on the incentives faced by other monitors, such as shareholders and even depositors. However, official and market monitoring are not perfectly substitutable. Third, banks have a fiduciary relationship with their customers (e.g., they are holding the wealth of depositors), which is rare with other types of firm. This creates additional principal-agent relationships—and potentially agency costs—with banks that generally do not exist with nonfinancial firms.

A fourth reason why corporate governance mechanisms are different in banks is that there is a systemic dimension to banks. Because in some circumstances (e.g., presence of externalities) the social cost of a bank failure may exceed the private costs, there is a systemic concern with the behavior of banks that does not exist with other companies. Fifth, banks are subject to safety-net arrangements that are not available to other companies. This has implications for incentive structures faced by owners, managers, depositors, and the market with respect to monitoring and control.

All these considerations have an impact on the two general mechanisms for exercising discipline on the management of firms: internal corporate governance and the market in corporate control. Although there are significant differences between banks and other firms, corporate governance issues in banks have received remarkably little attention. A key issue noted by Flannery (1998) is that little is known about how the two governance systems (regulation and private) interact with each other and, in particular, the extent to which they are complementary or offsetting.

A key issue in the management of banks is the extent to which corporate governance arrangements are suitable and efficient for the management and control of risks. In the United Kingdom, the Financial Services Authority has argued as follows: “Senior management set the business strategy, regulatory climate, and ethical standards of the firm. Effective management of these activities will benefit firms and contribute to the delivery of the FSA’s statutory objectives.” Corporate governance arrangements include issues of corporate structure, the power of shareholders to exercise accountability of managers, the transparency of corporate structures, the authority and power of directors, internal audit arrangements, and lines of accountability of managers. In the final analysis, shareholders are the ultimate risk takers and agency problems may induce managers to take more risks with the bank than the owners would wish. This, in turn, raises issues about the information available to shareholders about the actions of the managers to which they delegate decision-making powers, the extent to which shareholders are represented on the board of directors of the bank, and the extent to which shareholders have power to discipline managers.

Corporate governance arrangements need to provide for effective monitoring and supervision of the risk-taking profile of banks. These arrangements need to provide for, among other things, a management structure with clear lines of accountability; independent nonexecutive directors on the board; an independent audit committee; the four-eyes principle for important decisions involving the risk profile of the bank; a transparent ownership structure; internal structures that enable the risk profile of the firm to be clear, transparent and managed; and the creation and monitoring of risk analysis and management systems. There also would be advantage in having a board director responsible for the bank’s risk analysis, management, and control systems. Some bank ownership structures also produce ineffective corporate governance. Particular corporate structures (e.g., when banks are part of larger conglomerates) may encourage connected lending and weak risk analysis of borrowers. This was the case in a significant number of bank failures in the countries of Southeast Asia and Latin America. Some corporate structures also make it comparatively easy for banks to conceal their losses and unsound financial position.

The Basel Committee has appropriately argued that effective oversight by a bank’s board of directors and senior management is critical. It suggests that the board should approve overall policies of the bank and its internal systems. It argues in particular that “lack of adequate corporate governance in the banks seems to have been an important contributory factor in the Asian crisis. The boards of directors and management committees of the banks did not play the role they were expected to play” (Basel Committee, 1999b). According to the Committee, good corporate governance includes

  • establishing strategic objectives and a set of corporate values that are communicated throughout the banking organization;

  • setting and enforcing clear lines of responsibility and accountability throughout the organization;

  • ensuring that board members are qualified for their positions, have a clear understanding of their role in corporate governance, and are not subject to undue influence from management or outside concerns;

  • ensuring there is appropriate oversight by senior management;

  • effectively utilizing the work conducted by internal and external auditors;

  • ensuring that compensation approaches are consistent with the bank’s ethical values, objectives, strategy, and control environment; and

  • conducting corporate governance in a transparent manner.

Some useful insights have been provided by Sinha (1998), who concludes, for instance, that while the regulatory authorities may approve the appointment of non-executive directors of banks, such directors often monitor top management less effectively than is the case in manufacturing firms. Sinha compares corporate governance arrangements in banks and manufacturing firms in the United Kingdom and finds that top management turnover in banks is less than in other firms, and that turnover seems not to be related to share price performance. Prowse (1997) also shows that accountability to shareholders, and the effectiveness of board monitoring, is lower in banks than in nonfinancial firms.

An interesting possibility is the extent to which all this results from moral hazard associated with official regulation and supervision: a further negative trade-off within the regulatory regime. It could be that the assumption that regulatory authorities impose regulation and monitor banks reduces the incentive for nonexecutive directors and shareholders to do so. The presumption may be that regulators have more information than do nonexecutive directors and shareholders, and that their own monitoring would only be wastefully duplicating that being conducted by official supervisors. Further research is needed into the role of nonexecutive directors and institutional investors in the effectiveness of corporate governance mechanisms in banks.

There is a further dimension to this issue. A major market discipline on any firm comes from the market in corporate control where, in principle, alternative managements seek control of companies. It is reasonably well established that there is something of a trade-off between internal corporate governance mechanisms and the power of the market in corporate control (the take-over market). In general, corporate governance arrangements tend to be stronger when the market in corporate control operates weakly. Sinha (1998) argues that this trade-off does not apply to banks as corporate governance arrangements are weak and so is the discipline of the market in corporate control. It is possible that restrictions imposed on the ownership of banks may reduce the disciplining power of markets.

Disciplines on the Regulator

Four perspectives reinforce the case for regulatory authorities being subject to strong disciplining and accountability measures: (1) there is an ever present potential for overregulation as it may be both overde-manded and oversupplied (Goodhart and others, 1998); (2) regulatory agencies have considerable power on both consumers and regulated firms; (3) the regulator is often supplying regulatory services as a monopolist although, in the United States, there is scope for banks to switch regulators; and (4) the regulator is not subject to the normal disciplines of the market in the supply of its services.

These issues can be illustrated by the recent experience of the United Kingdom which has created a single regulatory authorities for all financial institutions and markets. As well as conferring substantial powers, the Financial Services and Markets Bill in the United Kingdom gives the Financial Services Authority substantial discretion in the use of its powers. In some respects, the way this discretion will be used will prove to be more significant than the powers the Bill confers. This, in turn, emphasizes the importance of the disciplining and accountability mechanisms of the FSA, and of the FSA being open in the way it plans to develop its approach to regulation. The agency has been open in describing its intended approach to regulation (see, for instance, its document Meeting Our Responsibilities).

Several accountability mechanisms have been put in place with respect to the FSA. Its objectives have been clearly defined in the Bill and the FSA reports directly to Parliament. In addition, there is a formal legislative requirement for the FSA to use its resources in the most efficient way and to make any regulatory burden proportionate to its benefits. The last-mentioned includes a requirement on the FSA to conduct cost-benefit analyses on its regulation. The Bill also outlines a strong set of accountability mechanisms including the scope for judicial review, public reporting mechanisms to the Treasury, requirements for consultation, the creation of Consumer and Practitioner Panels, independent review of its rules and decisions including by the Office of Fair Trading, independent investigation of complaints against the FSA, and an independent appeals and enforcement procedure. A further disciplining mechanism is the requirement to conduct a cost-benefit study on major regulatory changes.

Contract Regulation

We return to the question of differentiation among banks. A given degree of regulatory intensity does not in itself imply anything about the degree of prescription or detail. Even within the regulation component of the regime a wide range of options is available and, in particular, with respect to the degree of discretion exercised by the regulator. At the risk of oversimplification, two alternative approaches may be identified. At one end of the spectrum, the regulator lays down precise regulatory requirements that are applied to all banks. Although there may be limited differentiations within the rules, the presumption is for a high degree of uniformity. At the other end of the spectrum (in what might be termed Contract Regulation), the regulator establishes objectives and general principles. It is then up to each regulated firm to demonstrate to the regulator how these objectives and principles are to be satisfied by its own chosen procedures.

A detailed and prescriptive rule book approach may add to compliance costs without commensurate benefit in terms of meeting the objectives of regulation. If the objectives can be achieved by an alternative regime that is less costly for banks to operate with lower compliance costs, there would be advantage in reducing the deadweight costs. It may, for instance, be possible to achieve the same objectives in a way that allows firms more scope to choose the manner in which they satisfy the regulator’s requirements, and at the same time minimize their own compliance costs.

Under this regime, the regulator sets a clear set of objectives and general principles. It is then up to each bank to demonstrate how these objectives and principles are to be satisfied by its own chosen procedures. In effect, the bank chooses its own regulation but within the strict constraints set by the objectives and principles set by the regulator. Put another way, the firm is able to choose its preferred route to achieving the objectives of regulation. Presumably, each bank would choose its own least-cost way of satisfying the regulator. Once the regulator has agreed with each bank how the objectives and principles are to be satisfied, a contract is established between the regulator and the bank. The contract requires the bank to deliver on its agreed standards and procedures, and sanctions apply in the case of nonperformance on the contract. If the bank does not deliver on the contract, sanctions apply in the normal way and the regulator has the option of withdrawing the choice from the bank, which would then be required to accept a standard contract devised by the regulator.

The advantage of this general approach is that individual banks are able to minimize their own costs of regulation by submitting to the regulator a plan that, while fully satisfying the requirements of the regulator, most suits their own particular circumstances and structure. As part of this paradigm, and in order to save costs in devising their own regime, banks would also have the option of adopting an approach established by the regulator. In effect, what is involved is a regime of “self-selecting regulatory contracts.” Contract regulation necessarily implies increased differentiation in the regulatory arrangements among banks.

An analogy can be drawn with regulation in other areas. For instance, pollution regulation (say, with respect to factories not contaminating local rivers) is framed in terms of the ultimate objective related to the measurable quality of water. Regulation does not prescribe how the factory is to undertake its production processes in order to meet the objective. It is for each firm to choose its own least-cost way of satisfying water quality standards. Providing the standards are met, the regulator is indifferent about how the standards are achieved, or what the production processes are. This is in sharp contrast to most aspects of financial regulation.

Under a regime of contract regulation, the role of the regulator is fivefold: defining the degree of regulatory intensity, establishing regulatory objectives, approving self-selected contracts, monitoring standards and the performance on agreed contracts, and disciplining infringements of contracts. A by-product advantage is that the regulator would learn more about optimum regulatory arrangements through the experience of the variety of contracts.

Although there are clear limits to how far this regime could be taken in practice, in some areas the regulator could offer a menu of contracts to regulated firms requiring them to self-select. Many countries are moving toward a precommitment approach to regulation (Kupiec and O’Brien, 1997). In this approach, each bank agrees with the supervisory agency on the models and procedures it will use to evaluate risks faced by the bank but is subject to penalties for violation of these procedures. The main feature is that each bank indicates how much it is expected to lose from its trading operation over the next quarter and sets aside capital to cover it. It is penalized if losses exceed the stated level. There are several advantages to a precommitment strategy: it avoids the necessity of detailed and prescriptive regulation; it creates powerful incentives for bank decision makers (the choice of an excessive amount of capital imposes costs on the bank while choosing too low a level of capital risks the imposition of penalties); and it is flexible to the extent that it offers scope for each bank to choose a level of capital which is appropriate to its own particular circumstances. On the other hand, Estrella (1998) argues that the precise design of the penalty structure is likely to be complex.

Differentiations in the Regime

A central theme has been that the two components of the financial stability objective (reducing the probability of bank failures and minimizing the costs of those that do occur) are most effectively and efficiently served by a regulatory strategy that optimizes the regulatory regime. This is necessarily more complex than myopically focusing upon regulation per se. The skill lies in combining the seven key components, incorporating various positive and negative trade-offs that may exist among them.

However, there is no presumption for a single optimum combination of the components of the regime. On the contrary, optima will vary among countries at any point in time, over time for all countries, and among different banks within a country at any particular time. The optimum mix of the components of a regulatory regime and of instruments will change over time as financial structures, market conditions, and compliance cultures evolve. For instance, the combination of external regulation and market discipline that is most effective and efficient in one set of market circumstances, and one type of financial structure in a country, may become ill-suited if structures change. Also, if the norms and compliance culture of the industry change, it may be appropriate to rely less on detailed and prescriptive regulation, at least for some banks.

Neither does the same approach and mix of components in the regulatory regime need to apply to all regulated firms, or all types of business. On the contrary, given that none of these are homogeneous, it would be suboptimal to apply the same approach. A key issue is the extent to which differentiations are to be made among different banks.

Financial systems are changing substantially and to an extent that may undermine traditional approaches to regulation and, most especially, the balance between regulation and official supervision, on the one hand, and the role of market discipline, on the other. In particular, globalization, the pace of financial innovation and the creation of new financial instruments, the blurring of traditional distinctions between different types of financial firm, the speed with which portfolios can change through banks trading in derivatives etc., and the increased complexity of banking business, create a fundamentally new—in particular, more competitive—environment in which regulation and supervision are undertaken. They also change the viability of different approaches to regulation, which, if it is to be effective, must constantly respond to changes in the market environment in which regulated firms operate.

Space precludes an extensive discussion of these differentiations. Nevertheless, the major determinants may be summarized as follows:

  • the expertise that exists within banks and the extent to which reliance can be placed on internal management;

  • the incentive structures within banks and those faced by regulators, supervisors, and intervention agencies;

  • the quality of risk analysis, management, and control systems within banks;

  • the skills of regulatory and supervisory agencies;

  • the nature and efficiency of the basic financial infrastructure of a country: quality and reliability of accounting and auditing; nature, definition, and enforceability of property rights; enforceability of collateral contracts; information disclosure and transparency, etc.;

  • the existence of financial markets;

  • the efficiency of financial markets, particularly with respect to issues such as the extent to which market prices accurately reflect all publicly available information about the true value and risk characteristics of banks;

  • the existence of financial instruments to enable banks to mitigate risks;

  • the strength of incentives for stakeholders to monitor the risk characteristics of banks;

  • the extent of moral hazard created by public intervention (e.g., deposit insurance);

  • whether rating agencies provide rating services to investors in banks;

  • the complexity and opaqueness of bank structures;

  • ownership structures of banks and the extent to which owners are able to effectively monitor banks and influence the behavior of bank managers to whom they delegate the responsibility of managing the bank;

  • the degree of complexity of the business operations of banks;

  • the existence (or otherwise) of an effective market in corporate control in the banking sector;

  • the degree of ownership independence of banks from their corporate customers;

  • the extent to which decision making in banks is independent of political influence; and

  • the capital structure of banks.

With respect to the differences in the optimum structure of the regulatory regime as between countries, it is likely that in developing countries a substantial reliance will be placed on the explicit regulation component. This will reflect, for instance, considerations such as limited banking expertise; relatively unsophisticated techniques of risk analysis and management; a shortage of high-quality supervisory personnel; rudimentary financial infrastructure, financial markets, and financial instruments; absence of rating agencies; limited corporate governance mechanisms and sometimes close relationships between banks and their corporate customers.

These considerations will vary from country to country, although they generally imply that for developing countries more reliance probably needs to be placed on formal, prescriptive rules with less reliance on discretionary supervision, incentive structures, market discipline, and corporate governance arrangements.

A potential problem in allowing different mixes of the components of the regime between countries is that competitive neutrality issues may arise. Banks in countries that rely more on detailed and prescriptive regulation may be placed at a competitive disadvantage vis-à-vis other nationalities of banks competing on an international basis. Conversely, banks operating in a less prescriptive regime may gain competitive advantages. However, this only applies to the extent that the differences that exist do not reflect risk considerations. It cannot legitimately be claimed that a bank with inadequate risk analysis and management systems and which, as a result, is subject to more formal regulation than other banks, is inequitably being penalized or placed at an unwarranted competitive disadvantage.

Over time, and as the complexity of banks’ operations increases, it is likely that less reliance can be placed on detailed and prescriptive rules. Risk becomes too complex and volatile an issue to be adequately covered by a simple set of prescriptive rules. Also, as markets develop and become more efficient, a greater role can be envisaged for market discipline. Similarly, less reliance may be needed on regulation to the extent that the skills within banks raise the sophistication and accuracy of banks’ risk analysis and management systems is raised.

Equally, banks within a country are not homogeneous with respect to their skills, risk analysis and management systems, corporate governance arrangements, their overall significance within the financial system, legal, organizational, and corporate structures, or access to markets for capital. These differences may also create differences among banks in the optimum mix of the components of the regulatory regime.

Shifts Within the Regulatory Regime

Drawing together some of the earlier themes, several shifts within the regulatory regime are recommended in order to maximize its overall effectiveness and efficiency.

  • Less emphasis to be given to formal and detailed prescriptive rules dictating the behavior of regulated firms.

  • A greater focus to be given to incentive structures within regulated firms, and how regulation might have a beneficial impact on such structures.

  • Market discipline and market monitoring of financial firms need to be strengthened within the overall regime.

  • Greater differentiation between banks and different types of financial business.

  • Less emphasis to be placed on detailed and prescriptive rules and more on internal risk analysis, management, and control systems. In some areas, externally imposed regulation in the form of prescriptive and detailed rules is becoming increasingly inappropriate and ineffective. More emphasis must be given to monitoring risk management and control systems, and to recasting the nature and functions of external regulation away from generalized rule-setting toward establishing incentives and sanctions to reinforce such internal control systems. The recently issued consultative document by the Basel Committee on Banking Supervision (Basel Committee, 1999a) explicitly recognizes that a major role of the supervisory process is to monitor banks’ own internal capital management processes and “the setting of targets for capital that are commensurate with the bank’s particular risk profile and control environment. This process would be subject to supervisory review and intervention, where appropriate.”

  • Corporate governance mechanisms for financial firms need to be strengthened so that, for instance, owners play a greater role in the monitoring and control of banks, and compliance issues are identified as the ultimate responsibility of a nominated main board director.

This paper has emphasized the central importance of incentive structures and the potential for regulation to affect them. The key is how to align incentive structures to reduce the conflict between the objectives of the firm and those of the regulator. It is not a question of replacing one mechanism with another. It amounts to a rebalancing within the regime. It is unfortunate that public discussion of regulation often poses false dichotomies rather than recognizing that the key issue is how the various mechanisms are to be combined. To make the case for regulation is not to undermine the central importance of market disciplines. Equally, to emphasize the role of incentives and market monitoring is not to argue that there is no role for regulation or supervision by an official agency.

Recent Trends in Regulatory Practice

Space precludes a detailed review of how regulatory arrangements have been evolving in practice. However, in some areas substantial changes have been made and others are in the pipeline. This section briefly considers some of the trends that are emerging with respect to the international approach to the prudential regulation and supervision of banks. Although the Bank for International Settlements would not necessarily adopt the paradigm of the regulatory regime outlined earlier, there are some shifts in approach along the lines outlined in this paper.

When setting capital adequacy standards for banks, the regulator confronts a negative trade-off between the efficiency and costs of financial intermediation, on the one hand, and financial stability, on the other. Although it is a complex calculation—absent the Modigliani-Miller theorem (which does not, in any case, apply to banks with deposit insurance)—as the cost of equity exceeds the cost of debt (deposits), the total cost of financial intermediation rises as the equity-assets ratio rises. If the regulator imposes an unnecessarily high capital ratio (in the sense that it exceeds what is warranted by the risk profile of the bank), an avoidable cost is imposed on society through a high cost of financial intermediation. On the other hand, a high capital ratio reduces the probability of bank failure and hence the social costs of financial instability. It also means that a higher proportion of the costs of a bank failure is borne by specialist risk takers rather than depositors.

When judging the efficiency and effectiveness of capital adequacy regulation, four basic criteria are to be applied: (1) does it bring regulatory capital into line with economic capital? (2) does it create the correct risk-management incentives for owners and managers of banks? (3) does it produce the correct internal allocation of capital as between alternative risk assets and therefore the correct pricing of risk? and (4) to what extent does it create moral hazard?

BIS Approach to Capital Adequacy

The problems with the current BIS capital adequacy regime (1988 Accord) are well established. In particular,

  • The risk-weights applied to different assets and contingent liabilities are not based on precise measures of absolute and relative risk. This in turn creates incentives for banks to misallocate the internal distribution of capital, to choose an uneconomic structure of assets, and to arbitrage capital requirements. It is also liable to produce a mispricing of risks. There is, for instance, an incentive to choose assets whose regulatory risk weights are low relative to the economic (true) risk weights even though, in absolute terms, the risk weights may be higher than on alternative assets. The distortion arises not because of the differences in risk weights but to the extent that differentials between regulatory and economic risk weights vary across different asset classes.

  • The methodology involves the summing of risk assets and does not take into account the extent to which assets and risks are efficiently diversified.

  • No allowance is made for risk-mitigating factors such as hedging strategies within the banking book, although allowance is made for risk mitigation in the trading book.

  • Almost all loans carry a risk-weight of unity whereas the major differences within a bank’s overall portfolio exist within the loan book.

  • Banks are able to arbitrage their regulatory capital requirements in a way that lowers capital costs without any corresponding reduction in risk.

  • The current Basel Accord only applies to credit and market risk.

Although some national regulatory and supervisory authorities have discretion in how the Accord is applied (subject to certain minima), and therefore the distortions may not be as serious in practice as the Accord might suggest, the fact remains that the Accord is seriously flawed. However, there are many countries where no discretion is allowed and the Basel requirements are adopted precisely.

Partly because of these weaknesses, the Basel Committee on Banking Supervision has recently proposed a new framework for setting capital adequacy requirements (Basel Committee, 1999a). It has issued a substantial consultation document that, if adopted, would represent a significant shift in the approach to bank regulation. This is not discussed in detail here other than to note that it is based on three pillars: minimum capital requirements, the supervisory review process, and market discipline requirements. The proposed new approach can be viewed in terms of the regulatory regime paradigm:

  • Substantial emphasis is given to the importance of banks developing their own risk analysis, management and control systems, and it is envisaged that incentives will be strengthened for this.

  • The Committee’s consultative paper stresses the important role of supervision in the overall regulatory process. This second pillar of the capital adequacy framework will “seek to ensure that a bank’s capital position is consistent with its overall risk profile and strategy and, as such, will encourage early supervisory intervention” (italics added).

  • In an attempt to bring regulatory capital more into alignment with economic capital, it is proposed to widen the range of risk weights and to introduce weights greater than unity.

  • A wider range of risks are to be covered, including legal, reputa-tional, and operational risk.

  • Capital requirements are to take into account the volatility of risks and the extent to which risks are diversified.

  • Although a modified form of the current Accord will remain as the “standardized” approach, the Committee believes that for some sophisticated banks, use of internal and external credit ratings should be incorporated, and also that portfolio models of risk could contribute toward aligning economic and regulatory capital requirements. However, the Committee does not believe that portfolio models of risk can be used in the foreseeable future. The Committee recognizes that use of internal ratings is likely to incorporate information about customers that is not available either to regulators or external rating agencies. In effect, in some respects this would involve asking banks themselves what they believe their capital should be. This is a form of pre-commitment. In practice, while banks will slot loans into buckets according to the internal ratings, the capital requirements for each bucket will be set by Basel. The object is to bring the regulatory process more into line with the way banks undertake risk assessment.

  • A major aspect of the proposed new approach is to ask banks what they judge their capital should be. Any use of internal ratings would be subject to supervisor approval: this is an element of what was termed earlier as contract regulation.

  • Allowance is to be made for risk-mitigating factors.

  • Greater emphasis is to be given to the role of market discipline. The third pillar in the proposed new approach is market discipline. It will encourage high standards of transparency and disclosure standards and “enhance the role of market participants in encouraging banks to hold adequate capital.” It is envisaged that market discipline should play a greater role in the monitoring of banks and the creation of appropriate incentives. The Committee has recognized that supervisors have a strong interest in facilitating effective market discipline as a lever to strengthen the safety and soundness of the banking system. The Committee argues that “market discipline has the potential to reinforce capital regulation and other supervisory efforts to promote safety and soundness in banks and financial systems. Market discipline imposes strong incentives on banks to conduct their business in a safe, sound, and efficient manner.”

  • The proposals also include the possibility of external credit assessments in determining risk weights for some types of bank assets. This would enhance the role of external rating agencies in the regulatory process. The Committee also suggests there could usefully be greater use of the assessment by credit rating agencies with respect to asset securitizations made by banks.

  • The consultation document gives some emphasis to the important role that shareholders have in monitoring and controlling banks. Overall, the new approach being proposed envisages more differentiation among banks, a less formal reliance on prescriptive rules, elements of choice for regulated institutions, an enhanced role for market discipline, a greater focus on risk analysis and management systems, some degree of precommitment, and a recognition that incentives for prudential behavior have an important role in the overall approach to regulation. The new approach would create incentives for banks to improve their risk management methods and to develop their own estimates of economic capital. Equally, there would be powerful incentives for supervisors to develop and enhance their monitoring skills (Stephen and Fischer, 2002;Chapter 3 of this book).

Assessment

This paper has introduced the concepts of regulatory regime and regulatory strategy. Seven components of the regime have been identified: each is important but none alone is sufficient for achieving the objectives of regulation. These components are complementary and not alternatives. Regulatory strategy is ultimately about optimizing the outcome of the overall regime rather than any one of the components. Regulators need to consider that, if regulation is badly constructed or taken too far, there may be negative impacts on other components to the extent that the overall effect is diluted. However, there may also be positive relationships among the components and regulation can have a beneficial effect on incentive structures within financial firms.

Effective regulation and supervision of banks and financial institutions has the potential to make a significant contribution to the stability and robustness of a financial system. However, there are limits to what regulation and supervision can achieve in practice. Although regulation is an important part of the regulatory regime, it is only a part and the other components are equally important. In the final analysis, there is no viable alternative to placing the main responsibility for risk management and general compliance on the shoulders of the management of financial institutions. Management must not be able to hide behind the cloak of regulation or pretend that, if regulation and supervisory arrangements are in place, this absolves it from its own responsibility. Nothing should ever be seen as taking away the responsibility of supervision of financial firms by shareholders, managers, and the markets.

The objective is to optimize the outcome of a regulatory strategy in terms of mixing the components of the regime, bearing in mind that negative trade-offs may be encountered. The emphasis is on the combination of mechanisms rather than alternative approaches to achieving the objectives. The skill of the regulator in devising a regulatory strategy lies in how the various components in the regime are combined, and how the various instruments available to the regulator (rules, principles, guidelines, mandatory disclosure requirements, authorisation, supervision, intervention, sanctions, redress, etc.) are to be used.

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The author is grateful for invaluable comments on an earlier draft of this paper from Klaas Knot and David Marston.

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