A. Clear Objectives⁷

A regulatory agency must have clear objectives, preferably set out in statute. Clear objectives assist the agency’s senior management in making decisions on the efficient allocation of resources, and in determining the appropriate policy response to a given problem. Clear objectives can also help prevent regulation from expanding beyond the minimum necessary to correct the market failures which regulation is intended to correct (it should not become an unnecessary burden on the regulated institutions). Finally, they also provide a mechanism by which the regulatory agency can be held to account for its decisions and policies.

B. Independence and Accountability

A regulatory agency must be able to take decisions which belong to its sphere of competence without undue outside interference, whether it be from ministers, parliamentarians, industry leaders, or other government officials (including potentially central bankers). In this regard, it is especially important that senior management be protected from arbitrary removal. The rules governing the removal of senior management must therefore be transparent and demanding, ideally set out in an act of parliament. Budgetary autonomy, in the sense of the existence of an earmarked source of funding for the agency and its ability to allocate resources according to its own internal priorities, is equally important, for otherwise efforts to develop an aggressive and effective regulatory body can be stopped by cutting the agency’s budget. Because of this, it is generally desirable that the regulatory agency be funded by a levy on regulated firms, rather than being dependant on allocations from the general government budget.

The need for regulatory independence should be balanced by a corresponding need to ensure that the agency can be held to account for its policies and actions.⁸ Accountability in the first instance needs to be to government and to parliament, since these are the sources of the agency’s powers. However, responsiveness to the regulated industry may also need to be taken into account. This might, for example, be accomplished by creating a mechanism of formal consultation with representatives of these various groups. The statutory industry panel established as part of the UK’s new regulatory arrangements provide one possible way in which these might be achieved.⁹ These types of accountability mechanism are especially important when the regulatory agency is funded by an industry levy, since it provides some means by which the industry can check and balance the regulator’s power to raise funds and prevent the costs of regulation from becoming excessive. On the other hand, care needs to be taken that in introducing accountability to the industry the regulatory agency is not exposed to the risk of regulatory capture by the industry.

C. Adequate Resources

Allied to the funding issue is the consideration that the regulatory agency needs to have adequate resources to discharge its task effectively. Especially important is the ability to recruit, train, and retain a cadre of experienced professional staff. Since the kinds of skills required to make an effective regulator are also likely to be in heavy demand in the private sector, it follows that the regulator must be able to offer its staff competitive remuneration. (This is a further argument in favor of funding by an industry levy since it gives the regulator greater flexibility in remunerating its staff.) Similarly, the regulator must also be able to command adequate resources to ensure timely and effective data collection and processing.

D. Effective Enforcement Powers

A regulatory agency must possess effective enforcement powers over the full range of the firms it is responsible for regulating. These powers should include, as a minimum, the ability to require information from regulated firms, to assess the competence and probity of senior management and the owners of the institution, and to take appropriate graduated sanctions against failure to comply with regulatory rules, including having the ultimate power to intervene the institution if necessary. Ideally, the regulatory authority should have the ability to revoke licenses to conduct financial services business. However, in some countries this may not be compatible with constitutional provisions that require a strict separation of executive and judicial functions. In the latter case, the authority should have the ability to make recommendations on the revocation of licenses, with the decision-taker required to give reasons in the event that the authority’s recommendation is not acted on. Enforcement powers are likely to remain more effective if the regulator has the ability to amend them, quickly: for this reason it is generally preferable to set out only the broad framework of the regulatory agency’s powers in legislation, leaving the details to be filled in by directives and guidelines that can be issued and amended by the regulatory agency itself. To effectively carry out their responsibilities, the staff of the regulatory agency should also have immunity from suit for actions taken in the discharge of their official duties.

E. Comprehensiveness of Regulation

Another essential feature of a regulatory system is that it should be comprehensive and free of regulatory gaps, i.e., there should be no scope for particular activities or types of intermediaries to escape effective regulation simply because there is doubt about which agency should be responsible for regulating it. A central component of comprehensiveness is that regulatory agencies should practice effective consolidated supervision of the institutions for which they are responsible. However, the case for comprehensiveness goes beyond this: all efforts should be made to eliminate gaps in the jurisdiction of the regulatory agencies, which could allow otherwise regulated activities or institutions to escape effective regulation. The regulators must also be in a position to respond quickly to market innovations to ensure that the regulatory framework remains up to date and does not become ineffective or acts as a barrier to the legitimate evolution of the market.

F. Cost Efficient Regulation

Regulation imposes costs both directly and indirectly. The direct costs are those needed to sustain the activities of the regulatory agencies: they include staff salaries, administrative overheads (including accommodation costs), and the information technology budget. The indirect costs of regulation are more difficult to quantify, but are those incurred by the regulated industry as a result of the need to comply with regulatory requirements. These costs can take many different forms, ranging from the costs of employing specialist “compliance” staff to the costs of maintaining special systems for regulatory reporting that go beyond those necessary for an institution’s own internal purposes. As a general principle a regulatory arrangement with lower costs, both direct and indirect, is to be preferred to one which imposes higher costs.

G. The Effectiveness Criteria and Industry Structure

A key factor in a regulatory system’s ability to meet the effectiveness criteria is that the institutional structure of regulation should reflect, at least to some degree, the structure of the industry it is called upon to regulate. Because industry structures vary markedly between countries, this implies that the regulatory structure will in turn need to exhibit a similar degree of variation. For this reason, no one type of regulatory structure will be optimal from the point of view of meeting the effectiveness criteria, and “one size fits all” solutions need to be avoided in this policy area as in any other.

For example, the case for combining banking and securities regulation is especially strong where the model of universal banking prevails. This is especially the case in those countries that have derived their supervisory frameworks from EU law. In addition to providing for the universal banking model, this framework also lays down a set of uniform capital rules, in the form of the Capital Adequacy Directive, that apply to the securities activities of both bank and nonbank financial institutions. Application of these rules by a single agency reduces the scope for competitive distortions and regulatory arbitrage opportunities. Moreover, a single agency is able to obtain oversight of all of a bank’s activities, ensuring that risks arising from both its traditional banking activities and its activities in the securities markets are properly monitored and controlled. These considerations underlie the regulatory structures adopted in France and Germany, where the prudential regulation of banks and securities firms is conducted by the same agencies (the Commission Bancaire and the Bundesaufsichtsamt fur das Kreditwesen respectively).

A further reason for combining banking and securities regulation is that risks tend to arise on the assets side of the balance sheet. However, the case of insurance companies is somewhat different, since here the main financial risks occur on the liabilities side of the balance sheet (i.e., the primary risk is unanticipated claims by policyholders). In consequence, insurance supervision tends to be concerned about ensuring that the company maintains a sufficient stock of liquid assets (the “solvency margin”) to meet claims that can be reasonably anticipated according to an actuarial assessment. Unlike credit or market risk, the scale of these risks tends to change relatively slowly over time. Because of these substantial differences between insurance, and banking or securities regulation, the case for a combination of all three functions is less clear cut. Nonetheless, in a number of countries, the decision to unify their supervisory functions has been taken because of the growth of financial groups, which own both banking and insurance businesses.¹⁰

These considerations imply that in some circumstances a regulatory system might be better able to meet the effectiveness criteria if it is unified. As will be discussed in the next section, where financial conglomerate groups form an important component of the financial system, a unified regulator might improve the comprehensiveness of regulation. In addition, through achieving economies of scale it might also reduce regulatory costs and make more efficient use of resources. However, there are a number of the essential prerequisites of regulation which unification in and of itself will not enhance, for example the effectiveness of regulatory powers and the independence and accountability of the agency. Much will depend on the way that unification is implemented and the way that the legislation is drafted; as will be shown in the next section, for every advantage that can be claimed for unification there is also a risk that needs to be balanced against it.

A. Arguments for Unification

A wide range of arguments have been advanced in favor of unification.¹¹ Some of the most persuasive are based on efficiency grains, in particular the economies of scale, which seem to be offered by unification of supervisory agencies. However, some of the most prominent recent arguments are based on either the need to revise supervisory coverage in light of the rise of financial conglomerates or to ensure competitive neutrality in light of the blurring distinctions between the various classes of financial institutions.¹² These latter arguments, which have been advanced in the context of a number of industrial countries, may not be as universally applicable as those based on regulatory efficiency.

B. Arguments Against Unification

Not surprisingly, the list of arguments against unification is almost as long as the list of arguments in favor of unification. These include claims that unification will result in unclear objectives for the regulatory agency; economies of scope will prove hard to achieve as long as banking, securities and insurance business is subject to different regulations; the agency will suffer from diseconomies of scale; and that it will extend moral hazard concerns across the whole financial services sector. There is also the concern that the change process itself may be poorly managed or become politicized. As a result, it will be subject to unpredictable and possibly undesirable outcomes (see Box 1).

C. The Role of the Central Bank

A further dimension to the arguments for and against unification is the extent to which the central bank is, or should be, directly involved in banking supervision. The earliest examples of unified supervision, in Denmark, Norway, and Sweden, were established in systems where the central bank had not been the banking supervisor. This state of affairs remains exceptional in most of the rest of the world. Thus, in many countries, the decision to create a unified supervisory agency will probably necessitate the extraction of banking supervision from the central bank, as has occurred recently in Australia and the United Kingdom. Although an alternative possibility would be to combine all supervision within the central bank, as practiced in Singapore, moral hazard considerations may weigh heavily against this structure. (This option is discussed in more depth later in this section.) For the purposes of the present discussion, it will be assumed that the unification of supervision will involve the separation of the banking supervision and monetary policy functions. This requires some consideration of the arguments for and against the combination and separation of monetary policy and banking supervision within the central bank.

The arguments for and against the separation between supervision and monetary policy have been well examined (Goodhart and Schoenmaker, 1995). The arguments against separation are strong. In particular, since banks are the conduit through which changes in short-term interest rates are transmitted to the wider economy, the central bank needs to be concerned about their financial soundness as a precondition for an effective monetary policy. This argument is reinforced by a number of others, including: the synergies between the information required for the conduct of monetary policy on the one hand and the supervision of the banking sector on the other; the central bank’s need to assess the creditworthiness of participants in the payments system, which will inevitably involve it in forming judgements about the solvency and prudent conduct of banks; and the central bank’s need to have access to information on the solvency and liquidity of individual banks in order to exercise its lender of last resort functions. These arguments have traditionally been seen as making a powerful case for combining the banking supervision and monetary policy functions, and their strength is attested to by the fact that, as was discussed in the introduction, the practice in many countries remains for the central bank to be responsible for banking supervision.

In addition to these arguments, it is also possible to cite a number of operational considerations in favor of combination. First, the economies of scale obtained from the combination of monetary policy and banking supervision may be as substantial as those that arise from combining the regulation of the different financial sectors. The commonalties in the information requirements for these respective functions have already been mentioned. In addition, to the extent that there is an overlap in the knowledge and skills required for these different functions, then a central bank may enjoy a comparative advantage in recruiting and retaining the best staff This argument is particularly strong in countries where the absolute level of human capital with this skill is very small.

Another important consideration, especially in the countries of the BRO, is that in many central banks now have a strong guarantee of their independence, sometimes even written into constitutional law. This degree of independence, established primarily for the purposes of ensuring a credible monetary policy, can also help to shield banking supervision from undue parliamentary or ministerial influence. Thus in transitional or emerging market economies there may be a case for retaining banking supervision within the central bank not only on the traditional grounds cited above, but also out of a concern to avoid the politicization of bank regulation.

On the other hand, it may be possible to develop governance and funding arrangements for the unified regulator that give it adequate political autonomy. Moreover, it should be borne in mind that there are several general arguments for the separation of banking supervision and monetary policy, irrespective of whether or not the separation arises out of the unification of supervision. First, a central bank, which is also responsible for supervision, may err on the side of laxity if it fears that tight monetary conditions may lead to bank failures.¹⁹ Secondly, bank failures inevitably will occur and when they do they will be blamed on the supervisor. If the supervisor is the central bank its credibility will be undermined, and with it its credibility in the conduct of monetary policy. In addition, it has also been argued that changes in payment system technology, most notably the move to real-time-gross settlement (RTGS), changes of the nature of the oversight the central bank needs to exercise over participants in the system.²⁰ Finally, as the financial system becomes less bank-centered, and more dominated by financial conglomerate groups with banking as only one of their financial services activities, the moral hazard issues discussed above gain increased significance, and these may point to the need for a regulatory structure with comparative distance between the central bank—as provider of lender of last resort assistance—and the agency responsible for routine supervision and regulation.

So far the discussion has concerned only the combination of banking supervision with monetary policy within the central bank. However, another option in structuring regulation would be to combine a wider range of regulatory functions within the central bank. Thus the central bank might be responsible for supervising the securities markets as well as banks, and possibly even insurance companies as well. This arrangement is likely to seem particularly attractive in some of quite specific circumstances: first, when the financial sector, and especially the non-bank financial sector is relatively small, making it difficult to establish viable regulatory agencies outside the central bank; secondly, where banking is the main form of financial intermediation, and other financial sectors are dominated by groups with a bank at their head; thirdly, where the central bank has a strong competitive advantage in attracting staff with the right skills and credentials, for example where central bank salaries are significantly above those available for other public officials; and finally, where the central bank has strong guarantees of its independence, thus providing a defense against the politicization of regulation. In circumstances where all, or most, of these conditions prevail, the option of centralizing all regulatory functions within the central bank may seem to have much to commend it.

However, this option also suffers from a number of serious disadvantages. Clearly, the moral hazard problem will be even more pronounced if the unified supervisory function is conducted by the central bank itself. It may be difficult for a central bank, which also supervises a wide range of financial intermediaries to make sufficiently clear the differentiation between them. Thus it may give rise to a perception in the public mind that all types of financial contract will receive the same degree of protection in the event of firm failures. While it may be possible for the authorities, through a campaign of public education, to explain the different levels of protection available to the holders of different type of financial claim, their attempts to do so may be undermined by the perception that holders of all financial claims will enjoy the prospect of central bank support.

A second difficulty is that this approach might be perceived as granting the central bank excessive powers. If all regulatory functions are combined within the central bank, this will result in the central bank having responsibility for the conduct of monetary policy and the regulation of all financial intermediaries, both banks and nonbanks. A related problem is the risk that particular regulatory failures may tarnish its reputation and credibility, especially in its conduct of monetary policy. Both of these objections might be minimized in the event that the supervisory function remains a legally independent agency albeit one located within the central bank. But if this is done, it will be important to ensure that the supervisory agency is able to establish a distinct identity of its own in the public mind.

A. A Unified Oversight Board

The most limited option would be to leave the existing regulatory structure in place, but to overlay it with a newly established oversight board. The board could be formed from the heads of the various regulatory agencies, or it could be widened to include third parties, such as representatives of the ministry of finance and the central bank. Depending on its terms of reference, the board might provide either a forum for expediting communication and information sharing between the agencies or it could be charged with executive decision-making, including the setting of policy. An important function of this body could be to coordinate regulatory efforts, e.g., by arranging joint inspection visits. (A possible model is represented by board created in South Africa as an alternative to regulatory unification).

An oversight board provides a more formalized basis for coordinating the supervision of financial conglomerates than a lead regulator arrangement, but it does not eliminate problems that can occur from differences in regulations, rulebooks and enforcement powers. It may also provide an opportunity for the regulatory agencies to gain some experience working together with a view to facilitating their unification at some point in the future. Since it leaves in place all of the existing regulatory system, it does not require major new-legislation or a far-reaching change management process. However, the modest ambitions of this approach may also be its greatest weaknesses. The chairmanship of the oversight board could, depending on its functions, be a key position, which will therefore generate rivalry between the heads of the regulatory agencies, and if the board is broadened to allow for an outside leader, political disputes and power plays could easily emerge. Furthermore, this approach is not appropriate when significant economies of scale may be possible. In view of these considerations the oversight board approach is most appropriate for comparatively large financial markets in which conglomerates are an important component of the financial system, but where the overall market size is sufficient to support a number of specialist regulators.

B. Unification of Support Services

One way to achieve economies of scale without unification would be to keep the agencies as separate legal entities, but to locate them in the same building with shared infrastructure and support services. An oversight board structure could also be included to give overall direction to the separate agencies and to ensure that they coordinate their efforts; alternatively, a centralized management structure could be developed as an administrative rather than legislative matter. The physical proximity of regulatory staff may also encourage greater informal information sharing and coordination.

Such an arrangement could be continued indefinitely or used as a prelude to eventual formal unification. It could be relatively quick and easy to implement, although finding an appropriate building to house all of the regulatory agencies might take time.²¹ On the other hand, it appears to offer many of the advantages of unification without some of the associated costs, and it avoids the risk that new legislation might result in a suboptimal outcome. Its primary disadvantage is that the absence of a strong central management authority might lead to rivalries and unresolved tensions between the senior staff of the different agencies.²² This arrangement may also not be well-designed to deal with financial conglomerates. For though administratively unified, the different agencies would continue to operate under different statutes, rule books, and would exercise different powers. Hence, consistent treatment of diversified financial groups might be hard to achieve.

This approach would therefore seem best suited to countries with small financial sectors in which financial conglomerates are not a significant presence. In such cases, this approach would allow them to achieve the economies of scale without running the risks associated with more fundamental change. However, in those cases where banking supervision is currently conducted by the central bank, this may not be a feasible option, since, as noted earlier, removing the banking supervision function from the central bank—in fact if not in law—would be likely to result in the problems of staff retention and a reduction of regulatory capacity.

C. Share Facilities with the Central Bank

The above-noted problem might be avoided if the regulatory agencies were to share the central bank’s facilities. One option, discussed in the previous section, would be to make the central bank responsible for the supervision of all financial intermediaries. However, an alternative approach would be to establish the supervisory agency as a separate legal entity, but one that shares the support services of the central bank, as was done in Finland.²³

The Finnish approach has two main attractions. First, it allows for the realization of significant economies of scale, comparable—or perhaps greater—than those that might be expected from a stand-alone unified supervisory agency. Second, this arrangement may actually prove superior to a stand-alone agency for crisis management. If the supervisory agency shares the same premises and IT systems as the central bank, and its staff are also employees of the central bank (as is the case in Finland), then information flows and coordinated action in the event of a crisis should be facilitated. This was a major factor behind Finland’s decision to adopt this approach.

The primary disadvantage of this approach is moral hazard. As noted previously, one of the most serious objections to unification within the central bank is that it might extend the perceived central bank guarantee of support to all financial institutions, including nonbanks. Hence, if a unified supervisory agency is located within the central bank, even while remaining legally distinct, there is a risk that the public and industry perception will be that the two institutions are in fact the same, which may, in turn, encourage the view that central bank support will be available to all supervised institutions.

A. Issues of Agency Scope

A fundamental issue is whether the unified agency should be responsible for both prudential (safety and soundness) and consumer protection (business conduct) regulation. Most integrated agencies are concerned only with ensuring the prudential soundness of financial intermediaries. The United Kingdom’s FSA is practically unique among unified authorities in being responsible for both prudential and business conduct matters.

There are arguments both for and against the separation of prudential and business conduct objectives. Arguments in favor of separation are that the skills sets required of prudential and conduct of business regulators are different.²⁴ Moreover, separation also allows the agency charged with prudential oversight to focus more explicitly on the detection and management of risks to the financial system. The ability to adopt a narrow focus is especially important in countries, which are prone to periods of financial instability. Furthermore, consumer protection regulation tends to be relatively resource-intensive. As a result, taking on the broader mandate may actually act to undercut a supervisory authority’s efforts to establish a system of effective prudential regulation, particularly in smaller and developing countries.

On the other hand, defenders of a combined function argue that there are several regulatory judgements—especially relating to the adequacy of systems and controls and the fitness and probity of management—which overlap in the two functions (Briault, 1999). It should be noted, however, that the degree of overlap may not be particularly extensive, and in most countries it has not been regarded as a sufficiently strong reason to bring consumer protection within the unified agency’s scope. Prudential and conduct of business regulation are most frequently combined in securities regulation, whereas in banking and insurance regulation it has been the general practice to keep the two functions clearly separate. If a unified regulator is to focus only on prudential regulation, this raises the issue of where responsibility for the securities regulator’s business conduct functions is to be assigned.

This consideration also leads to the further question of whether the unified agency should be responsible for regulating markets—e.g., the stock market or futures exchange—as well as intermediaries. One solution might be to combine the business conduct and market oversight functions within a specialist agency, leaving the unified regulator to focus only on prudential matters.²⁵ The skills required to ensure that a market meets standards for transparency and trade reporting, and that it is not subject to manipulation, are similar to those required for business conduct regulation, while in turn being somewhat different from those that are normally needed for effective prudential regulation. On the other hand, the activities of securities and investment firms may be difficult to monitor without access to the type of information which the market oversight function will normally provide, although close cooperation and coordination between the relevant agencies should minimize this problem.

A final set of issues relates to the types of nonbank financial intermediaries that should come within the integrated agency’s scope. One issue which frequently arises is the whether the unified agency should regulate pension funds. Defined contribution schemes are usually provided by investment management companies, and therefore it might be a natural extension of the agency’s functions to bring them within its scope. By contrast, defined benefit schemes raise issues similar to those that arise in assessing the solvency of insurance companies and, indeed, are often provided by those companies. Actuarial assumptions are the most important factor in the assessment of the balance sheets of both insurance companies and defined benefit pension funds, which also share in common the need for a long-term asset structure combined with short-term liquidity requirements. Hence there is a strong case for combining the regulation of defined benefit pension funds with that of insurance companies.

Other nonbank financial intermediaries that might potentially come within the scope of a unified agency include finance houses and leasing companies. In many jurisdictions these types of companies are not subject to regulation. However, their role in initiating a number of financial crises raises the question whether the unified authority should at least have the power to require them to provide it with information on request. On the other hand, when considering which nonbank financial intermediaries to include within a unified agency’s scope, it is worth bearing in mind that over-extending the scope of the supervisory authority may blur its focus and seriously erode its effectiveness. Moreover, the case for explicitly including these types of institutions within the agency’s scope only arises if they are not covered by the consolidated supervision of banks and other regulated entities. Provided that the regulatory agency conducts effective consolidated supervision, many of the systemic risks arising from this sector will be contained.

B. Ancillary Functions

In addition to the above array of functions, unified agencies may also be asked to take on a number of functions that are either ancillary to their primary functions or do not directly relate to the regulation of financial markets and institutions. One such function concerns the setting of accounting standards, or at least the oversight of the professional body responsible for setting them. In some jurisdictions, for example in the United States, the capital markets regulator (SEC) is responsible for overseeing accounting standards that apply to publicly listed companies. Consequently, in countries where the capital markets authority has been modeled on the SEC, one result of unification may be that the new agency will acquire this role from its predecessor agency. On the other hand, while it can be helpful for the regulatory agency to have responsibility for the accounting standards which apply to regulated institutions (especially banks), there is no necessary connection between prudential soundness regulation and oversight of accounting and auditing firms. Hence it would appear generally preferable for this function to be transferred elsewhere. Similarly, the extent to which the unified agency becomes involved in the implementation of Stock Exchange listing requirements will depend partly on the pre-existing scope of the capital markets regulator.

Competition policy is another function that is peripheral to the primary responsibilities of a financial regulator. In most jurisdictions, it is normal for competition in the financial sector to be subject to the general rules on industrial competition and, hence, to be under the jurisdiction of a specialist competition authority. However, in some countries, an argument has been advanced that the financial sector regulator should also have an obligation to promote competition within its sector. This point of view has been urged in particular in the U.K., where some have argued that the FSA should have this obligation incorporated in its statutory duties. However, this argument is made largely on consumer protection grounds, since competition is seen as a partial substitute for sales practice regulation. Where the unified regulator has a specifically prudential scope, this question is unlikely to arise.