Appendix I. Income Level, Financial Deepening, and Standard Implementation

Appendix Table 2.

Implementation by Regulatory Categories

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Grades of implementation: 4=complaint, 3=largely complaint, 2=broadly complaint, 1=non-complaint.

Appendix II. Regulatory Standards: Main Gaps and Suggested Response

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Prepared by an MFD team of staff and experts led by David Marston and Udaibir S. Das


Standards covered in this paper are (i) Basel Core Principles (BCP) for Effective Banking Supervision; (ii) International Association of Insurance Supervisors (IAIS) Core Principles; and, (iii) International Organization of Securities Commissions (IOSCO) Objectives and Principles for Securities Regulation. The three standards are included in the 12 areas endorsed by the Board in 2001 and 2002 as being useful to the Fund’s operational work.


See SM/03/77 for the most recent reviews of the FSAP. Assessments of regulatory systems in offshore financial centers (OFC) are also carried out under the OFC Program (See SM/04/92 for a recent update).


See SM/03/86 for the most recent review of progress in implementing the initiative.


For ease of reference, the term “regulation” is understood to include supervision.


Some components of standards provide information on the core dimensions of financial stability. These include regulatory infrastructure, effectiveness of regulation, and macroprudential surveillance. In banking and insurance sectors, the assessment information is contributing indirectly to the surveillance by informing on the reliability of reported financial soundness indicators (See SM/03/176).


In addition, assessments of the three sectors were also carried out in another six jurisdictions under the OFC program. These assessments are not considered in this paper.


For example, prudential deficiencies and confidence in the financial condition of firms can have a different impact on banks than on securities intermediaries and insurance companies. Moreover, for securities regulators, the primary emphasis is on investor protection and market efficiency considerations—relying more on disclosure, market discipline, and a sound legal and accounting framework. In the banking and insurance sectors, regulators focus primarily on an institution’s ability to meet its obligations to depositors and policyholders, with some attention in banking to systemic stability.


Individual reviews of financial sector regulatory standards have already been reported to the Board. These indicate substantial room for improvement in individual standards and the assessment process itself (See SM/01/266, SM/02/121, SM/01/266, and SM/04/92).


Financial Sector Regulation: Issues and Gaps—Background Paper.


A recent IMF staff working paper shows that regulatory governance has a significant influence on financial system soundness (See Das, Quintyn, and Chenard, 2004).


In terms of regions, there were 3 countries from Africa, 4 from Asia, 21 from Europe, 6 from the Middle East and Central Asia, and 2 from the Western Hemisphere.


Additional details on the implementation record can be found in Section II of the Background Paper.


It is worth noting that the sample includes over half of the completed FSAPs.


These countries therefore tend to demonstrate relatively more developed financial systems. This is irrespective of the level of economic development, which may increase the average reported level of implementation. The latter point also likely contributed to relative over-representation of European countries in the sample.


In the case of banking, data also shows that financial strength of banks is generally lower in developing countries, and by and large this is associated with weaker implementation of the BCPs. In several cases, though, institutions remain financially weak despite a higher degree of implementation of banking standards.


Twenty-nine out of the 36 countries in our sample published their FSSAs and financial sector ROSC modules. These, along with other published FSSA/ROSCs are available on the webpage, and provide country specific information. See also the Background Paper (Appendix II of Section I) for examples of some country specific weaknesses in banking area found during the FSAP evaluation.


For the securities regulators, the principal issues concerned appointment and tenure of the Board of the agency, reliance on government appropriations for funding purposes, and inability to influence the legislative and regulatory framework pertaining to the role and responsibilities of the agency.


Eligibility requirements in this context relate to the regulator’s role in imposing minimum standards of conduct prior to commencement of marketing an investment scheme, including the honesty and fairness of scheme operators, human and technical resources, diligence and effectiveness, and operator-specific power and duties in the investment process. In many of the assessments, assessors noted that several of these aspects were either lacking or needed to be enhanced through better guidance to schemes.


In the insurance area, the IAIS has taken a significant step forward by incorporating the basic conditions for good insurance regulation as the first principle of its recently revised regulatory standard.


The cited reference is an update of previous work by Kaufmann, Kraay, and Zoido-Lobaton (KKZ indices). The rule of law index includes perceptions of incidence of crime, the effectiveness and predictability of the judiciary, and the enforceability of contracts.


In our sample, the correlation coefficient between the rule of law and income was 0.84 and the same indicator for government effectiveness and income stood at 0.85.


In response to a recent Fund staff survey, regulators indicated that they could only “draw attention to problems in a bank and try to find a solution in consultation with the government which (is the only authority which) could take corrective action,” while many stated that they would “take minor action while leaving stronger action to the government.”


See Appendix II for an overview of the main gaps in regulatory standards.


This is done in the assessment methodologies. The banking and insurance standards distinguish the essential assessment or implementation criteria from the more advanced criteria.


For a detailed discussion of financial stability in dollarized economies, see SM/03/112. In a recent discussion of this paper, the directors agreed that the dollarization of bank liabilities and bank loans poses unique challenges and generally agreed that the range of policy responses observed at the country level and recommended by standard-setting bodies often remain insufficient, particularly in the most highly dollarized economies (BUFF/03/77).


For example, a legal framework built on approaches of arbitration and consensus may be no less effective that one where litigation is the principal means for dispute resolution.


This limitation has been recognized in the 2003 revisions to the IAIS Insurance Core Principles, which now require an assessment of preconditions important for insurance regulation. The revised supervisory standard explicitly incorporates preconditions as an element of the standard. It also provides implementation guidance, and states that, where these conditions do not yet sufficiently exist, the supervisor could have additional powers to address the weaknesses. However, no guidance is provided on how precondition-related weaknesses should be taken into account when evaluating implementation.


See Section I of the Background Paper. Also, other sectors not considered here may offer substantial potential for regulatory arbitrage. These include banking activities of various kinds of nonbank financial institutions, leasing and factoring companies, and pension funds.


The scope for regulatory arbitrage by these institutions using offshore centers is being minimized through the OFC and similar initiatives.


The securities standard states that where responsibilities are shared for securities regulation, there should be no inequities of regulation. However, this does not address inconsistencies between the various sector supervisors.


The capital required by an insurer under the index-based solvency regime currently used in the European Union and various other jurisdictions does not depend on the composition of its investment portfolio. The IAIS and other organizations are working to strengthen and bring convergence to standards in this area, although much remains to be done.


The standard setters could articulate the direct or indirect link between principles and financial stability wherever applicable. This would help address some of the important practical issues involved in the FSAP assessments, including an evaluation of the actual regulatory practices on the ground, and linking the assessment outcome with the financial stability analysis.


Both banking and insurance standards do mention financial stability as an objective of regulation but do not provide guidance on how the various elements of the standards are linked to that goal. In the securities areas, this is not traditionally thought of as something that securities regulators are involved in, with a focus mainly on investor protection. However, given the number of integrated regulators, the need for more cohesive guidance on cross-sector regulation, and the overall role of regulation for ensuring market stability, financial stability objective could be integrated within the elements of various standards.


The Basel II framework will introduce detailed requirements on disclosures.


This gap only applies to privately owned securities firms, as firms with public shareholders are subject to extensive disclosure requirements.


The Fund staff, in collaboration with the standard setters, is undertaking a stock taking of barriers, gateways, and practices on the basis of an expanded survey and information from FSAP and OFC assessments. The stock taking could include a comparison of the standards’ principles on information exchange to identify common elements and differences and ways to help facilitate compliance with the standards.


Ongoing work by standard setters is reviewed in Section III of the Background Paper.


The main areas for strengthening standards and suggested responses are detailed in Appendix II.

Financial Sector Regulation - Issues and Gaps
Author: International Monetary Fund