After a financial crisis, questions are usually asked about the regulators and their decision-making bodies. What can we do to strengthen the resilience of the banking system? More specifically: is the adoption of international standards necessary and enough to promote financial stability? What else is needed?
Coming up with a clear response to these two questions is a good starting point for the implementation of any strategy aimed at gradually and realistically strengthening the resilience of any banking system.
Regarding the first question: Is the adoption of international standards necessary to promote financial stability?
The response is yes and there is little debate about it. The main reason for this is the globalization of the banking industry and the corresponding need for standardizing prudential regulation to create sound conditions for competition and avoid unintended costs, such as regulatory arbitrage.
This phenomenon started during the early 1970s as the banking sector became ever more interconnected. This was a consequence of the expansion of financial services attached to growing international trade and showed the need for standardized banking regulation.
This was achieved through the prudential standards delivered by the Basel Committee on Banking Supervision (BCBS), which was created during the 70s and conceived as a forum for regular cooperation on banking supervisory matters. Its objective was to enhance the understanding of key supervisory issues and improve the quality of banking supervision of its country members.
After this, the growing financial globalization that began in the 90s created the conditions for the BCBS recommendations to become the worldwide prudential regulatory standard for banking regulators. This went well beyond the original BCBS’s idea of promoting general and no-binding recommendations for country members.
As a result, the quality of banking regulation of any jurisdiction, regardless if it is a member country of the BCBS or not, is currently gauged according to its level of compliance with these standards, which cover key prudential areas, including capital adequacy, liquidity risk, arrangements for effective banking supervision, cross-border banking supervision, etc.
However, in adopting international standards it is important to take into account two important issues. First, these standards are shaped to fit developed countries, thus some calibration to domestic conditions might be needed, particularly in emerging countries. Second, international standards represent a minimum to be reached, thus leaving to discretion the adoption of more stringent standards.
Therefore, the implementation of BCBS standards is crucial to accomplish good regulation and supervision, but to get there it is crucial that supervisors have the capability to adapt international standards to meet the needs of different countries and, if deemed necessary, to have the power to impose more demanding prudential regulation to cope with idiosyncratic vulnerabilities.
Regarding the second question: What else is needed?
The response is easy: a lot! Relying on good regulation is far from enough when talking about financial stability. Risk-based supervision is the crux of the matter.
Historically, supervision focused on a compliance-based approach, which aims to ensure banks observe laws and prudential regulations. This approach relies extensively on transaction testing such as reconciling data and accounting, and other detailed check-oriented activities. These supervisory activities are important but insufficient to prevent problems arising from mismanagement and bad banking practices.
By contrast, risk-based supervision aims to assess whether banking activities adhere to best management practices. This approach relies on the ability of supervisors on qualitative aspects of bank management and board oversight.
This risk-based approach is critical to promoting financial stability. Unfortunately, there are few good experiences in this field and, actually, the recent financial global crisis somehow showed the challenge of implementing effective risk-based supervision worldwide. This approach relies on expert judgment and, equally important, on the ability and willingness of regulatory authorities to act based on a qualitative assessment of how management and boards do what they do and how they oversee risk and make decisions.
This qualitative approach to supervision is necessary since effective bank governance cannot be entirely ruled, thus “ticking the box” for “best practice” compliance does not work.
The adequate use of risk-based supervision promotes analysis of bank governance and prompts supervisors to encourage sound bank practices. Sound bank governance is an attitude, a way of doing things, and the manner in which owners, directors and management fulfill the obligation assigned by the public trust.
But attempting to implement risk-based supervision might be null and void if some important preconditions are not met, among which supervisory independence and legal protection for supervisors are paramount.
This blog is part of a series of articles published ahead of the World Economic Forum on Latin America 2016, taking place from 16 to 17 June in Medellin, Colombia.