issues in regulation and supervision of banks
DESCRIPTION
Issues in Regulation and Supervision of Banks. Presentation by Dr.Asish Saha & Dr. T S Ravisankar National Institute of Bank Management Pune, India November 1, 2002 Conference on Adapting India’s Financial Sector for a Globalizing World. 1. Financial Regulation - PowerPoint PPT PresentationTRANSCRIPT
Issues in Regulation and Supervision of Banks
Presentation byDr.Asish Saha
&Dr. T S Ravisankar
National Institute of Bank ManagementPune, India
November 1, 2002Conference on Adapting India’s Financial Sector for a Globalizing World
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1. Financial Regulation
a. Objectives/Purpose of Financial Regulation
b. Special Features of Financial Regulation
c Types of Financial Regulation
d Regulatory Standards
e. Tradeoffs in Regulationf. Paradigm Shift in Regulatory Approach(Micro to Macro)g. Sources of Financial Sector Instabilityh. Macro/Micro Financial Stability/Soundness parameters i. Liberalisation and its impact on Regulation
2. Financial Supervision Supervisory requirements and powers:
3. Emerging Issues in Regulation and Supervision
4. Indian Perspective a. Evolution
b. Three-pronged approach of the Indian Regulator c. Regulation & Supervision : Major Issues in the Indian context5.Conclusion
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1. Financial Regulation
“Financial stability is crucial for sustained economic
growth but this cannot be achieved without strong
financial systems. Even with sound macroeconomic
management, weak financial systems can destabilize
local economies, making them more vulnerable to
external shocks, and may threaten global financial
markets.” (Financial Stability Institute)
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One of the fundamental responsibilities of the government of any country is to foster economic growth and social welfare. Hence the need for a mechanism (regulatory framework) to ensure the strength, stability and soundness of the financial system/markets
A. Objectives/Purpose of Financial Regulation - Maintaining the stability of and confidence in the financial system by ensuring the solvency and financial soundness of financial institutions; ensuring the smooth operation of payments mechanisms. (Prevention of systemic risk)
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-Protecting investors, borrowers and other users of
the financial system against undue risks of losses
and other damage that may arise from failures,
fraud, malpractice, manipulation and other
malconduct on the part of providers of financial
services. (Prevention of individual risk)
-Ensuring a smooth, efficient, reliable and effective
functioning of financial markets, including a proper
working of competitive market forces. (Promotion
of systemic efficiency) -OECD
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B. Special Features of Financial Regulation
-The structure, systems and processes of financial
regulation in any economy are determined by the
country’s social, political and economic forces.
- In a dynamic socio-economic environment, the
regulatory framework has to be responsive to
changes in the financial market in terms of its size,
complexity, procyclicality and volatility, and hence,
to remain effective it needs to be a function of time
and space.
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-While being sensitive to local needs, regulation has
to align itself to global concerns and maintain a
balance on an ongoing basis.
-The scope and coverage of financial regulation
expands alongwith the level of integration in the
financial market.
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-The instruments and mechanisms of regulation are
designed in response to the changes in the
behaviour of financial market and its participants.
-As the financial market operations are information
intensive, asymmetric availability of information
creates distortions which need to be counter-balanced
through appropriate regulatory mandates.
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C. Types of Financial Regulation
(i) Prevention of Systemic Risks:
a) Restriction of Market Forces:
-Price regulation: Administering interest rates,
fees and commissions; permitting price cartels;
-Direct lending control and compulsory
investment schemes
- Restrictions on cross-border capital flows
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-Restrictions on the range of activities:
specialisation of a bank; compartmentalisation of
banking/securities/insurance; separation of
banking and commerce; restrictions on cross-
border financial services.
-Restrictions on establishment (by domestic
institutions, foreign institutions)
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b) Prudential Regulation: Supervision of Balance
sheet ratios and of risk diversification; on-site
inspection and external auditing
(ii) Prevention of individual risks: quality standards
and codes of conduct; disclosure and information
requirements; deposit protection schemes
(iii) Promotion of systemic efficiency: prohibition of
restrictive business practices and cartels;
regulation of mergers & acquisitions
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D. Regulatory Standards
• Standards are good principles, practices and guidelines
(commonly accepted both at domestic and international
levels) relevant for ensuring soundness of the financial
system.
• The standards should thus cover key functional areas
like payment and settlement, accounting, risk
management, capital adequacy, disclosure and
transparency, ethics and governance, etc.
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In order to operationalise the standards, principles
in specific areas are spelt-out in general terms in
order to provide some degree of flexibility to the
supervisors in different countries to tailor the
standards to their country requirements and
circumstances. However, to facilitate uniformity in implementation
across the countries, standards are spelt out
explicitly in terms of acceptable practices on various
dimensions. (BIS initiatives)
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E. Tradeoffs in Regulation
Since regulation is a balancing act between conflicting demands (some which can also be country-specific) there is always a trade-off in its design and formulation.
a) Extent of admissible competition – determined by striking the right balance between perceived benefits and implicit social costs for various levels of competition.
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b) Permissible level of risk taking – trade off between
low economic growth with high social stability and
high economic growth (with increased risk taking)
with potential for instability.
c) Conflicting requirements of assuring soundness of
the financial system and of obtaining allocation of
resources to desired sectors.
d) Liberalised Vs. Restricted entry - Entry barriers stifle
competition and lead to complacency that limits
initiatives for cost reduction, efficiency, improvement
and innovation.
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e) Prudential regulation Vs. Micro-regulatory controls
Micro regulation amounts to intrusion in day-to-day
functioning of the players as against the selective
interventions (prudential regulation) whenever and
wherever needed.
f) Helping hand Vs. Hand-grabbing – Helping hand
approach aims to ‘insulate’ institutions from failure
through a protective umbrella of entry barriers,
restriction of activities, deposit insurance coverage
etc., and by providing appropriate guidance.
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On the other side, in hand-grabbing approach,
regulatory prescriptions are mainly decided by vested
interests of various socio-political constituencies
rather than by considerations of systemic stability and
soundness.
g) Extent of ownership and control of financial entities -
Domestic vis-a-vis Foreign ownership
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h) Government Vs. Private ownership of banks
Government ownership facilitates socially desirable
investments including strategic long-term investments
that may yield beneficial returns only in the long-run.
Private sector initiatives, however, are generally
directed towards sectors which are likely to produce
immediate returns of higher-order.
Also, Government ownership inspires greater public confidence in a financial institution.
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F. Paradigm Shift in Regulatory Approach (Micro to Macro)
“If the objective is to design a regulatory framework that
is able to act as a safeguard against financial instability, a
shift of perspective from individual institutions to a
system level is essential.” (Gugerell)
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Macro-regulatory approach aims at containing the cost of systemic failure to the economy and ensuring the continuity of financial intermediation function without any serious disruptions. At the other end, micro-regulation addresses the issue of limiting failures of individual institutions.
•In crisis situation each individual bank is likely to take defensive stance which may be acceptable under micro-prudential regulatory perspective. However, in the process, the financial fundamentals of the banking system as a whole may become weak which goes against macro-regulatory expectations.
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G. Sources of Financial Sector Instability
“Irrational exuberance of financial sector during boom
period and herding behaviour both during upswing and
subsequent downturn” (IMF)
Market imperfections that hide the real risk profile
embedded in the system
Weaknesses in the supervisory and regulatory
mechanisms that perpetrate irrational risk-taking by
individual players
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Weak public administration/governance
• Lack of Supervisory independence
• Government involvement in the financial sector
(Directed lending to unviable propositions at artificially
low rates of interest; Cross-subsidization affecting
earning potential of banks; Fiscal deficits financed by
borrowings from Central Bank).
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H. Macro/Micro Financial Soundness & Stability
Parameters (quantitative and qualitative)
CAMEL parameters, Sensitivity to market and
operational risks, Quality of Human Resources, Financial
Innovation, Level and scope of Technology usage, Brand
Equity, etc.
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I. Liberalisation and its impact on Regulation
• In the early eighties, Globalisation, Liberalisation and
Deregulation were advocated in tandem in the
international financial arena as key drivers of
economic growth Cross-country studies,however,have established a
linkage between financial development and economic
growth on the one hand and financial liberalisation and
financial fragility on the other.
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Countries which have liberalised their economy
without putting in place strong regulatory frameworks
have been found to be more vulnerable to crisis
situations, thereby reinforcing the need for
re-regulation rather than deregulation.
Capital account liberalisation without suitable filtering
mechanisms for controlling the inflows and outflows
and their term structure and usage, precipitated
liquidity crisis and the crisis of confidence in the
system in the affected countries
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Excessive capital inflows and the risk of reversal seen
in the crisis cases have created a clear need for
“source country regulations” that will discourage
excessive reversible capital inflows
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2. Financial Supervision• Ensuring systemic stability is one of the core
functions of the supervisor. As such regulation and
supervision are complementary to each other.
• Supervision entails monitoring whether banks are
functioning within the set regulatory boundaries and
initiating appropriate corrective actions in cases of
excessive deviation from the prescribed norms.
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• Supervisory requirements and powers: - Independence in Power/Authority- Sufficient resources for carrying out the functions - Loan classification stringency - Provisioning standards- Diversification Guidelines - Prompt Corrective Action powers - Regulations on information disclosure - Fostering healthy competition- Monitoring of banks
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• It is now well recognised that various banking risks
cannot be looked at in isolation and that there is a
close linkage and reinforcement amongst credit risk,
market risk, liquidity risk, forex risk etc. Thus an
appreciation of these inter-linkages is emerging as the
basis for future supervisory emphasis.
Reliance only on capital adequacy standards have been
found to be inadequate. Supervisory attention is
accordingly getting directed towards monitoring
specific risk exposures of banks and taking an
integrated view of their risk profiles.
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• There is a shift of supervisory focus away from
monitoring prudential ratios for individual risks to
evaluating the overall risk profile of a bank to assess
the strength and sustainability of its financial
performance.
Setting broad guidelines for managing risk and
assessing internal risk management practices of
individual banks are the two major planks of the new
supervisory approach.
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3. Emerging Issues in Regulation and Supervision
i) Growing capital flows across the world in volume
and speed and almost instantaneous movement of
such flows (facilitated by technology usage)
- How to track the flows and manage the impact of
these flows?
- How to build an insulation against short-term
exceptional flows?
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ii) Emergence of new types of products, services and
instruments on a continuous basis (surfeit of
innovations)
- How to assess their positive/negative contributions
to stability, strength and soundness of the financial
system?- How to assess their risk potential?
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iii) How to ensure better transparency in markets’
functioning given the blurring boundaries between the
different segments of the financial market?
iv) How to assess the risk profile of large universal banks
(financial conglomerates)?
v) How to ensure coordinated-regulation of such entities?
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4. Regulation and Supervision: Indian Perspective
a. Evolution
A strong point of the Indian experience has been the
gradual deregulation and slow liberalization in stages.
Parallel prescriptions of checks & balances has in fact
protected our system from internal crisis and also
insulated us from contagion effects of the financial
crises in neighbouring countries.
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b. Three- pronged approach of the Indian Regulator
- Reactive : response to unforeseen crisis/boom
situations(domestically manifested or externally
triggered)
- Preactive: Preparing the financial system and guiding
the same by phasing out introduction of new
standards already accepted but to come into force in
future.
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- Proactive: Exerting influence during the formulation
of norms/standards in global fora (like BIS) to take
care of the socio-economic concerns specific to our
country and to protect the long-term interests of the
domestic banking/financial system.
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c. Regulation & Supervision:
Major Issues in the Indian context
i) Regulatory and Supervisory functions to be separated
or combined?
ii) Regulatory coverage to include all institutions/
organizations accepting public deposits and/or all
institutions involved in any of the banking activities?
iii)Whether regulator should continue as a member of the
Board of a public sector bank?
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iv) How to design preventive regulatory measures - to maintain and safeguard the confidence in and integrity of the financial system
- to prevent possible fund flows from undesirable entities (Customer due diligence)- to assure the security and integrity of payment and settlement systems.
v) Resolution of the conflict of RBI being owner as well as regulator of institutions like SBI.vi) Should offshore banking units of commercial banks be under the purview of domestic supervision and regulation?
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5.Summary of Observations
• Given the current stage of development of the financial
sector in India, the transition from a micro to macro
prudential standards (as envisaged at the global level)
should be paced-out in a phased manner as is presently
being pursued by the Reserve Bank of India.
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Overall funding requirements of the country have to be
met by a judicial balance between internal resource
mobilisation and liberalised external funding.Keeping
in view other country experiences in this regard, the
regulatory and supervisory role would be to establish
appropriate prudential standards for this purpose and
monitor the same on an ongoing basis.
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Under the globalising conditions of the modern world,
the major role of a regulator would be to mediate
between diverse expectations of various economic
interest groups (domestic and international). This will
ultimately determine the extent of regulatory control
and the approach towards regulation.The situation is
more pronounced in the Indian context making the job
of the Indian regulator more demanding
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There is a need for moving towards incentive-based
regulation and supervision that may encourage
prudent behaviour by individual banking institutions,
and lead to a corresponding reduction in the cost of
maintaining a safety-net.
Supervision needs to play a watchdog role to see that
super-competition does not lead to total erosion of
financial fundamentals of the individual players.
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In view of the complexity and opacity of the financial
market, the collection and processing of relevant
control data should be at a much accelerated pace-
preferably in an on line mode.
Explicit cost of regulation to the supervisor and the
implicit cost to the regulated needs to be kept in view
while determining the extent and depth of regulation
and supervision
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Liberalised environment opens up multiple channels
and mechanisms of financial resource transfer across
the countries. Hence, there is an imminent need for a
single authority vested with the powers to monitor and
control all such capital flows. However, it needs to be
recognised that it would be difficult to control the
volatility expectations arising out of free information
flows across the markets.
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Due to increasing convergence in the activities of the
market players and the resultant diffusion in their
accountability, there is a need for explicitly spelling out
the supervisory domains of different regulators. To ensure continuing financial stability and soundness
of the system at the aggregate level, there may be need
for taking drastic measures against delinquent units.
The regulator should be accordingly empowered to
force closure/merger/restructuring of the ailing units
as demanded by the situation.
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“The availability of mechanisms which can ensure that
banks are soundly governed and thus that both
technical and moral mismanagement is avoided, is the
decisive pre-requisite for successful financial system
development.” (Winkler A) While reform initiatives address the technical aspects
of sound management, there is an equally strong need
for ensuring adherence to good corporate governance
practices amongst the financial players. Indeed ,
“sound corporate governance must be regarded as the
very heart and motor of financial system
development”. (Winkler A.)
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Effectiveness of the Financial Sector’s contribution to
economic growth and development will be determined
by its efficiency in the allocation of the mobilised
savings in competing projects. In the context of a
developing country like India, the allocative efficiency
was sought to be established by regulatory prescription
of directed credit flows with an element of built-in
subsidy, especially in its early stages of economic
development.In the changed economic context, this
approach needs a relook.
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Essentially regulation and supervision should be
proactive and be a step ahead of the market
innovations and developments.
Competency level of the supervisor has to be atleast
equal if not higher than those of the regulatees for
effective supervision.
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To conclude,
Regulation and Supervision will have to be ultimately
concerned with (borrowing the words of Dr.Y.V.Reddy)
“Maintaining a convincingly efficient and stable
financial sector”
and
“ Conforming to the extent possible to international
practices”
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Thank You