David C. L. NellorInternational Monetary Fund

May 2009

Rethinking Regulation for Financial Stability and

Growth

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Outline

Financial Stability – why does it matter Regulatory Framework – what went wrong Specific Proposals – is there a solution Policy Choices – confronting the trade offs Conclusions – what does it mean for

Nigeria

33

Financial Stability – why does it matter Estimates of Bank Restructuring Costs

-10

0

10

20

30

40

50

60

Perc

ent o

f GD

P

Indonesia Korea Thailand US S&Ls Sweden

Official Est. Final adj.

44

Financial Stability – why does it matter Index - Ratio of Private Sector Credit to GDP

0

20

40

60

80

100

120

-5 -4 -3 -2 -1 0 1 2 3 4 5 6 7 8 9 10 11

Indonesia 0=1997 Sweden 0=1990

55

2. Regulatory Framework – what went wrong?

Macro versus Micro Supervision Regulatory and Supervisory

Perimeter Supervisory Capacity Pro-cyclicality Global Architecture

66

Macro versus Micro Supervision

Macroeconomic developments – asset markets, macro imbalances

Regulators are micro focused and not on interlinkages across financial institutions

Basel based on bank’s own risk models Presence of foreign intermediaries in

some countries and cross-border capital flows

77

Regulatory and Supervisory Perimeter

Coverage of supervision and regulationSystemic importance of non-banks Too big to fail – did not mean subject

to prudential supervision & regulation

Reporting requirementsInformation from wider range of

financial institutions & off-balance sheet items

Supervisory insight – “ticking boxes” versus knowledgeable supervision

88

Supervisory Capacity Regulators/supervisors did not keep

pace with developments“Sophisticated financial

engineering” - structured products & off balance sheet entities

Interlinkages across financial institutions and markets (contagion effects) - use of credit risk mitigants and contingent liabilities

Risks of under-resourced supervisory agencies

99

Regulatory System Procyclical

Risk-based capital ratios - capital requirements through the cycle

Loan loss provisions – rules unrelated to expected losses through the cycle

Liquidity risk - liquidity risk management did not require stress tests sensitive to firms’ credit ratings & off-balance sheet obligations

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Global Architecture

Coordination: inability to address global imbalances or manage crisis effectively at multilateral level

Crisis framework: shortcomings in legislation dealing with cross-border bank resolution and bankruptcy

Liquidity and Financing: limitations of central bank liquidity support; reputational risk to accessing IMF support

1111

3. Specific Proposals – is there a solution

Turner Review Issing Group G 30 (Volcker) De Larosiere

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Turner Review

Highly regulated broad-based financial sector with central bank and FSA doing macro prudential supervision

Increased capital requirements and avoiding pro-cyclicality through introduction of capital buffers

Limitations on scale of debt/leverage No specific limitations on activities

of banks

1313

Issing Group

Risk map – global financial intermediation (net exposures) and risk factors.

Pre-arranged link between findings and actions such as on capital requirements

Regulation of hedge funds Systematic cooperation of

regulators

1414

G30 (Volcker)

Redesigning the regulatory structure – overlaps, gaps, limit scope for regulatory arbitrage

Central bank take a lead responsibility on financial stability – may need to be given tools and mandate

Limit scope of bank activities – proprietary trading limited, no hedge fund operations

Prevent non-banks from taking deposits

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De Larosiere

Macro prudential supervision is essential

Macro supervision must impact the micro supervisors

Macro authority has to be at the regional (global?) level

Consistency of supervision across the region (globally?)

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4. Policy Choices – confronting the trade offs

Global versus national The macro prudential regulator Narrow or broad banking Market and regulatory failure Risk and reward preferences

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Global versus national

Internationally integrated banking system operating with national level regulatory structure – a mismatch?

Feasibility versus ideal – think globally act nationally

Challenge of building links between surveillance and actions

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The Macroprudential Regulator

Is a separate/new agency required? Central bank independence and policy

focus Dealing with the non-bank financial sector Analytic capacity Could vary capital and liquidity

requirements over time – discretion versus automaticity

1919

“Narrow” or “Broad” Banking

Where is the balance?As deposit takers, want banks to

be conservativeAs allocators of capital, want

banks to be flexible risk takers Solution – regulatory overlay

versus regulation plus limiting activities

2020

Market versus Regulatory Failure

Incentives for regulatory arbitrage will persist whatever the structure

Markets are dynamic, can regulators match that change?

Does this favor simplifying the regulatory task by moving to “narrow” banking?

2121

Risk and Reward Preferences

Countries at different stages of development and other reasons mean that preferences might not be the same

Global coordination does not mean that all need to be the same

But, some shared principles otherwise regulatory arbitrage will dominate

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Conclusions

Can agreethe regulatory framework failedsome areas where it failed

Can agree some principlesmarkets are not self regulatinginvestors should reap the reward and

incur the losses associated with risks they take

markets are dynamic – regulatory structure must match this

Cannot agree on definitive regulatory solutions

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Conclusions

Need to secure international agreement on principles of regulation and supervision.

Countries will need to define their regulatory and supervisory structures within these international principles

Coordination within regions and internationally will be needed.

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What does it mean for Nigeria? Develop regional frameworks and

participate in international solutions CBN as financial stability agency;

advisory committee including all regulators

Consider containing scope of banking recognizing supervisory capacity

Accept somewhat greater risk recognizing development needs

A transparent and clear bank resolution framework is essential if take greater risk – bank entry and exit is a sign of a healthy system

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Thank you!