Banking Soundness and Monetary Policy
Chapter

17 Prudential Supervision and Globalization of the Banking Sector: A National Supervisor’s View

Editor(s):
Charles Enoch, and J. Green
Published Date:
September 1997
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Author(s)
WOLFGANG ARTOPOEUS

Liberalization and deregulation have freed competitive forces and opened financial markets the world over. Supported by sweeping technological progress these forces have generated an unprecedented growth of opportunities, brought forth a flow of financial innovation, increased the diversity of market participants, and boosted cross-border activities. But there is no denying that these positive developments also carry new risks of instability. They stem from the very dynamics and complexity of today’s financial markets, from the increased volatility of prices and interest rates resulting from the explosive growth of trading in innovative products, and from the tight linkages among markets that allow disturbances to spread quickly through the financial system. The heavy losses of some banks and the various market disturbances seen in recent years have highlighted some of the dangers facing today’s liberalized financial world.

For national supervisors, the many government controls and restrictions that used to inhibit competition on both national and international markets undoubtedly contributed to the stability of the domestic banking sector. The dismantling of these controls and restrictions has created gaps that supervisors are now called upon to fill. This is a formidable challenge, as the supervisory problems today are as complex as the new world of global finance.

On the home front, supervisors have to show increased vigilance since the volume of financial transactions and the volatility of markets have considerably increased, not least because of the ever-growing trade in highly leveraged products, such as derivatives. Moreover, the intensified competition on both international and national markets will inevitably lead to a selection process within the banking world. As a consequence the potential for banking failures will mount. This may also hold true for banking markets like Germany’s, which until recently had been nicely divided up between the various domestic banking groups and was difficult to penetrate because of the many well-established banks with proliferating branch networks.1 Now, thanks to new selling techniques made possible by modern telecommunication technology, such as direct or electronic banking, even the German banking market has got moving. Large branch networks no longer seem the absolute must for attracting and keeping customers. Moreover, with the help of the electronic media foreign banks will find it much easier and less costly to enter markets like Germany’s, further increasing the competitive pressure. This will probably lead to additional pressure on fees and interest rate spreads, while at the same time necessitating further costly investments in human resources and information technology. There is also a growing danger that banks fighting to keep their place in the market may be tempted to take high risks and to expand their operations into new lines of business without possessing the necessary experience and know-how.

In an overbanked market this will accelerate the process of concentration and may even create difficulties for banks, especially when—as presently in Germany—the weak economic situation forces trade and industry to speed up their restructuring. The supervisory authority, therefore, is called upon to improve its controls in order to detect such developments at an early stage and to ensure that any eventual exit takes place in an orderly way, without shaking the entire banking system.2

New Supervisory Challenges

Being aware of the need for increased watchfulness is one thing; keeping track of new risk constellations in a quickly changing banking world is quite another. The growing flow of financial innovations, especially the explosive growth of the derivative business and the unbroken trend toward securization, has provoked a shift in the traditional risk structure of many banks. In the “universal” banks typical for Germany, market risk had formerly played only a subordinate role to credit risk, but has now grown to prominence and become the object of increased concern by supervisors.

Other risks, such as organizational, operational, and legal risk, which in the past have been of lesser supervisory concern, also have become of major relevance for the smooth and safe running of bank operations. Just think about the complex structures of large banking groups, the comprehensive back-up systems necessary for the management and control of complicated trading activities, the increased use of outsourcing, and the highly complicated netting and clearing arrangements. The associated risks can no longer be neglected by supervisors. Nor will supervisors be allowed to close their eyes to the safety issues posed by the increasing use of electronic media for banking operations.

The mounting competitive pressure is not only transforming business practices but also changing established institutional structures. The once clear-cut distinctions among various types of financial intermediaries, such as commercial banks, investment banks, insurance companies, and specialized finance companies, each with its own typical risk structure, increasingly blur. Major German banks, for instance, whose business has traditionally been “universal” are pushing heavily into investment banking either by setting up specialized subsidiaries or by buying up foreign investment banks. Another outcome of deregulation and international competitive pressure has been the emergence of large, international financial conglomerates—-groups formed of different financial institutions offering a wide range of services, including banking, securities, and insurance. Since solo supervision over such a group’s constituent entities cannot achieve a sufficiently accurate assessment of the group’s total risk and since intragroup activities lack transparency, there is growing uneasiness that potentially dangerous risk volumes could build up without supervisors knowing about them.

Prudential Regulation—Problems and Shortfalls

To keep up with the developments in banking, German regulators are under constant pressure to overhaul and refine prudential rules, methods, and standards. Of course, prudential regulation has always followed market developments. But, whereas in former times the process of change has been gradual and regulatory updates considered only occasionally, nowadays the frequency by which existing regulations have to be amended and new prudential standards created has dramatically increased.

As a result, rules and regulations tend to grow in volume and complexity. This causes considerable problems. Today’s banking laws and regulations increasingly lack intelligibility. They also have become a growing administrative burden for both supervisors and bankers. On the other hand, considering the speed at which things change in the world of banking, the slow and cumbersome process of adapting rules and regulations is still likely to cause supervisors to rapidly fall behind.

In addition, the traditional mix of supervisory methods with its emphasis on mechanistic quantitative rules can no longer adequately control the complex and varying risk structures typical of modern banking. If supervisors have ever believed that compliance with quantitative prudential standards and high capital ratios guaranteed the safety of banks they should no longer do so. Capital standards, as traditionally used to assess credit and market risks, cannot capture with sufficient precision the varied and highly complex risks inherent in a modern bank’s operations. By their very nature as prescriptive uniform criteria they cannot be more than crude measurement instruments. They look simplistic and antiquated in comparison with the sophisticated risk management techniques used by leading banks. Quantitative prudential standards will remain useful only as rough indicators of capital adequacy and as a means of slowing down risk expansion.

Given the multitude of risk situations and the growing relevance of nonquantifiable risks (such as operational, legal, and safety risks) supervisors—instead of trying to contain banking risks by ever more refined prudential ratios—will have to make banks’ internal risk management the focus of their surveillance. A British supervisor recently remarked, “It is risk management, not capital, that protects a firm.” This may be an overstatement, since banks must have adequate capital not only for funding but for absorbing losses and limiting risk taking. But there is no doubt that supervisors would miss their goals if they did not make it their primary concern to monitor and evaluate the adequacy of the risk management and control systems of their banks. It is both a solid capital base coupled with a prudent, well-designed, and comprehensive risk management system that make a bank safe.

A first important step toward a more quality-oriented kind of supervision has been made by permitting banks to use their internal risk-steering models for calculating the amount of capital necessary to cover the market risks contained in a trading portfolio. The Basle Committee’s recent guidelines for the control of interest rate risk is another example of the new type of risk management standards to be used by bank and national supervisory authorities. This approach will have to be expanded, which will be easier said than done. If supervisors are to concentrate more on ensuring that banks use adequate risk management procedures, they will have to do so on the basis of clear and objective minimum standards; banks need certainty about what is required of them, and supervisors must be able to enforce their demands on risk management. Such standards will have to be designed in such a way as to ensure equal treatment of all banks and to avoid too much reliance on the judgment of the individual supervisor. At the same time, they should be sufficiently flexible to be applied in a differentiated manner to varying conditions and to allow for financial innovation and structural change.

Too-general standards or principles on risk management will be difficult to enforce and give too much leeway to supervisory discretion. On the other hand, a too-detailed regime will lack flexibility and have the same flaws as the traditional legalistic approach. It will not be easy to find the right mix. Furthermore, in a financial environment in which national and institutional frontiers have lost their significance, it does not make much sense to develop purely national standards. Prudential rules and regulations ought to be coordinated across a broad international front and made applicable to both banks and other financial institutions if they are engaged in the same type of business. Only in this way will it be possible to avoid “regulatory arbitrage,” which causes competitive distortions and weakens the overall supervisory network. Besides, major divergences in prudential standards would be an obstacle to effective cooperation among supervisors.

Putting more emphasis on banks’ risk management procedures will require supervisors to show a much higher degree of sophistication than when traditional capital and liquidity ratios were predominantly used. Above all, supervisors will have to familiarize themselves with the businesses of supervised institutions and their internal management structures much more thoroughly than in the past. In applying risk management standards, they will have to rely on their own judgment much more than when applying quantitative rules. Yet, the exercise of judgment will be prone to criticism from the banks concerned and may invite extensive discussions with supervisors.

To meet the demands of this more qualitative form of supervision, the banking authorities will need highly qualified and specially trained staff, especially risk management specialists. For a government agency such as the German supervisory office, which is integrated into the public salary scheme, it will be hard to compete with banks for this type of personnel.

Role of the Market

The need to adapt prudential standards and methods to a rapidly changing financial environment should, however, not obscure the fact that supervision alone cannot ensure market stability. After all, entrepreneurial behavior is best guided by market incentives and sanctions. The more information available to the market, the better market forces will discipline banks and prevent them from imprudent risk taking. Therefore, the transparency of banks’ and securities firms’ activities, especially risk-related disclosure, should be improved so that market participants can fully evaluate the partner risks in which they may be engaged. Thanks to the work of the Basle Committee, the International Organization of Securities Commission, and the Group of Thirty considerable progress has been made in enhancing international banks’ and securities firms’ disclosure. But much remains to be done, on both the national and the international level, to improve disclosure practices, and especially to ensure the comparability and the meaningfulness of the data disclosed. This is a difficult task as accounting philosophies and practices vary widely, but it has to be tackled.

In many countries—Germany among them—supervisors have traditionally held the opinion that too much disclosure is detrimental, since it could cause depositors to react in destabilizing ways and make it more difficult to resolve a bank’s difficulties quietly. But as a supervisor’s primary task is not getting banks out of trouble but preventing them from getting into difficulties in the first place, it would be counterproductive under today’s conditions not to allow the disciplinary forces of the market to assist supervisors to the fullest extent possible in ensuring sound and prudent banking.

Cross-Border Banking

Deregulation and liberalization have boosted the expansion of banks’ cross-border activities and thus added an international dimension to bank supervision. Major banks have extended their branch net works beyond national frontiers or built up strategic bases in foreign financial centers by acquiring either local banks or subsidiaries. The network of financial connections among banks and among banks and other financial institutions is now embracing the globe and more densely woven than ever. Because of the growing globalization of trade and increasing competitive pressure, even those banks that continue to concentrate their business on local customers still must get more and more involved in international transactions.

This high degree of market interdependence worries the national supervisor since his or her country’s banking industry can no longer be protected from financial disturbances originating elsewhere. Nor do national competencies and supervisory powers exercise more than just partial control over those multinational banking groups that operate globally. Because of the natural limitations of any national supervisory body, such groups may—under certain circumstances—go largely unsupervised as the well-known case of the BCCI demonstrated.

The deficiencies of today’s fragmented national supervisory systems show the fundamental dilemma all national supervisors confront: to date, their mission has been a national one—securing the stability of their country’s financial system. Their methods and instruments were designed to this purpose; their competence has ended at the national frontier. But increasingly many of the risks they are to control originate beyond their sphere of influence, and to a very large degree the stability of home financial systems now depends on the safety and soundness of international markets. Thus, supervising banks and other financial market participants has become a supranational task. The only way for supervisors to live up to this new responsibility is to follow closely internationally coordinated standards and rules.

Although international coordination and cooperation has intensified over the past few years, cross-border banking still presents many practical issues for the national supervisor. If—as it is now widely accepted—international banking groups and their cross-border establishments are to be supervised on a global and consolidated basis by the home supervisor, he or she must have regular access to all the financial information relevant to the safety and soundness of the group’s operations; in other words, the supervisor must have the right to gather such information from the group’s foreign subsidiaries and branches. Furthermore, he or she should be able to conduct on-site inspections to verify the accuracy of the information received and to examine the operations and the risk situations of such cross-border establishments.

In practice, however, home supervisors may have serious difficulty establishing communication with or gaining access to host country establishments. The reason may be formal legal restrictions, such as bank secrecy laws or administrative hindrances. If such obstacles cannot be overcome, at least not in the short run, the home supervisor may be faced with a difficult choice. In the best case, he or she may be comforted by the fact that the host country, though not willing or able to grant access to prudential information, does at least supervise all banks on its territory. If that is not the case, the home supervisor will have to consider whether to trust that the banks with foreign operations will not exploit such a situation in order to escape from the strict regulations applied at home. Eventually the supervisor will have to decide whether to prohibit “his” or “her” banks from having branches or subsidiaries in a country where there is neither access to supervisory information nor a reasonable way to cooperate with the host supervisor. Many European countries, Germany included, have the legal power to restrict institutions from business abroad if there are prudential risks or if the data necessary to assure consolidated supervision cannot be obtained. Nevertheless, it is not easy to take such a decision, since it could impair a bank’s business and put it at a competitive disadvantage, especially if supervisors from other countries take a more lenient position. Such situations are entirely unsatisfactory, not least since no single national supervisory authority can hope to make a host country change its attitude if it has no other leverage than preventing its banks from setting up subsidiaries or branches in that country.

There is a similar problem for host supervisors when foreign banks want to set up branches or subsidiaries in the national market. Of course, the banks will have to fulfill the same licensing requirements as local banks. But the host supervisor will also need to be assured that the foreign banks are subject to effective consolidated supervision by the home supervisory authority and that this authority is willing to cooperate in an efficient and satisfactory way. Furthermore, in a time when organized crime is putting out its tentacles all over the globe and actively seeking to infiltrate regular business, most supervisors are anxious to keep “their” markets clear of shady foreign banks. Therefore, it is of particular importance to the home supervisor to establish beyond a reasonable doubt that a foreign bank’s owner is of good standing and unquestionable trustworthiness.

If these requirements are not fulfilled, the home supervisor will have to consider whether to refuse a license to the foreign bank. In Germany, where foreign banks have always been welcomed and enjoyed liberal access, the German supervisory authority will soon be empowered to turn down a licensing request if the foreign bank is not properly supervised by a competent home supervisor or if the home supervisor is not disposed to cooperate with the German supervisory authorities.

The real problem, however, is again a practical one. How can a host supervisor determine whether or not a foreign bank is subject to effective supervision in its home country? The issue was intensely debated at the Ninth International Conference of Banking Supervisors in Stockholm (1996). While suggestions and proposals were made, no clear solutions have yet arisen. Getting reliable information about a foreign bank’s ownership may prove an even more intricate task. If—as it happens in a number of cases—host supervisors are left with an unclear picture of a foreign bank’s background, they ought to deny the license. In such cases, the burden of proof is clearly on the foreign bank and its home supervisor. But such a rejection may prove difficult if considerations of a more political nature come into play.

The days when banks wanting to enter a foreign market had to set up branches or subsidiaries, and thus automatically come under the control of the local supervisor, may be numbered, however. As most barriers to the free flow of financial services have been abolished and modern technology has allowed financial service providers to communicate with their customers at almost any place in the world and at any time of the day, the necessity for banks to have local bases of operations is diminishing. Even if electronic banking does not entirely drive out the more traditional forms of banking, it will certainly gain considerable importance and give rise to supervisory problems of an entirely new dimension. As long as direct or on-line banking is carried out by banks that are properly supervised, there will be no problem. But what if firms offering banking services through modern communications media operate from places without effective prudential regulation and supervision? How does one protect investors and depositors against the risks emanating from such uncontrolled entities? The most that national supervisors can do at present is publicly warn the public against doing business with unsupervised foreign firms. Over the long term, however, the question arises of how to make sure that problems originating from such entities do not contaminate other banks, trigger a market crisis, and pose a threat to the worldwide financial system.

Close and trusting cooperation will be of particular importance when a major international bank runs into problems. The good handling of such a situation may critically depend on the timely and full exchange of information among all the supervisory authorities involved. But there is a considerable potential for conflicts of interest in such cases. A regulator in charge of a banking group, some part of which experiences difficulties, may feel compelled to withhold timely and comprehensive information from other supervisors because he is concerned that other regulators could take measures counterproductive to his own efforts or because he fears that other regulators could try to ring-fence the assets of the group’s institution under their regulation. Such measures need not be taken in bad faith. Often regulators are compelled by law to take certain actions. It is necessary, therefore, to find a supranational mechanism suitable to solving such conflicts of interest and allowing such crises to be handled in the best mutual interest of all concerned. It is best, of course, to prevent such situations from happening in the first place. The better the routine cooperation between supervisors, the better are the chances of achieving this goal. Therefore, the importance of the international efforts that have been launched to strengthen supervisory systems in emerging-market countries and to enhance the cooperation among supervisors of G-10 and non-G-10 countries cannot be stressed enough.

Conclusion

In today’s global financial environment, with its highly interdependent markets, the soundness and safety of banking must be ensured on a worldwide basis. This requires efficient supervisory systems to be in place wherever banks carry on their activities, internationally coordinated prudential standards and strategies, and close cross-border cooperation between supervisory authorities.

Much progress has already been made toward meeting these goals. But further efforts on the national, regional, and international levels are needed to establish the worldwide supervisory network essential for preserving the stability of the international financial system.

1

At the end of 1995, there were 3,831 banks and more than 48,000 bank in Germany.

2

Germany has a clear policy of not supporting ailing banks. It has always been held that banks should be allowed to fail, and indeed quite a few banks have been closed by the supervisory authority and subsequently liquidated. The German banking act (Gesetz über das Kreditwesen), however, contains provisions enabling the supervisory authority, in the case of a bank being threatened by insolvency, to take temporary measures by issuing a ban on sales and payments by the bank, ordering the bank to be closed for business with customers, and prohibiting the acceptance of payments not intended for the discharge of debts to the bank. The aim of such temporary measures is to gain time for the search for appropriate solutions to the impending insolvency.

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