Regulatory Environment for Banking & Finance (FINA 2001) Semester 1 Year 2014/15Simple and easy. Something that everyone can understand!Lecturer: Warrick Wardelementsofbanking@yahoo.com or e-learning (Moodle)Lecture 21How is Regulation and Supervision Conducted?What is the difference between regulation and supervision?Can they be treated interchangeably? What do you understand by risk-based supervision?

Regulation refers to the provision of rules that define acceptable behavior and conduct for financial institutions Supervision refers to the enforcement of the rules.Risk-based supervision is driven by the principles-based philosophy of regulation and supervision (discussed in a few minutes)Which would you be most concerned about?As the regulator responsible would you be equally concerned with the rollout of a new ATM system and IT framework at a medium-sized bank or credit union or THIS?Which would you place greater emphasis on and why?A small credit union operation

Regulatory PhilosophyPrinciples-based vs. rules-basedMay exist a temptation for the regulator to be prescriptive in the way it regulates due to its detailed knowledge of the industry. In addition to stipulating outcomes, such as service levels and prices, it also largely stipulates the methods by which the companies operate.

Principles-based basic principles, flexible, easier and cheap to comply with; stressed importance of governanceConsistent with efficient markets hypothesis theoryRules-based details rules, very legalistic, little scope for interpretation, detailed reporting requirements, higher compliance costs.A false dichotomy?5Regulatory philosophy: Principles-based 1. Conduct their functions in a transparent and accountable manner.2. Act with prudence and integrity and in the best interests of their customers at all times.3. To maintain at all times sufficient financial resources to meet their commitments.4. Have in place sound corporate governance structures.5. Have oversight and reporting systems that allow board and management to monitor and control all operations.6Regulatory philosophy: Principles-based 6. Have in place internal controls that are adequate for the nature, scale and complexity of their operations.7. Have risk management policies systems appropriate to the nature, scale and complexity of their operations.8. Comply with any regulatory rules set down by the financial regulator in relation to, for example, solvency and capital adequacy, segregation of client funds, consumer protection codes.9. When required, to produce accurate, complete and timely information.10. Have high level legislation with extensive scope for guidance

7Rules-BasedRelevant measures or behaviours are pre-determined by rules

Given the same triggering events (e.g. transactions over a threshold), the same behaviours apply in all situations

Compliance is achieved when pre-determined behaviours are adopted, regardless of their suitability (formal component)

No or little discretion in adapting the measures to the concrete case (equal treatment of different situations)

The rules-based approachAdvantages:

Clarity and certainty

Transparency for registrants

More operational than principlesThe rules-based approachDisadvantages:

High compliance costsInitiative and innovation depressedExcessive litigation Capital markets less attractive to investors

Principles-based legislationWith principles-based legislation, principles aredrafted at a high level of generality, with the intention that they should be overarching requirements that can be applied flexibly to a rapidly changing industry. They contain terms that are qualitative not quantitative:The use general, usually evaluative terms (fair, reasonable, suitable) as opposed to straight rules (within two business days, turnover of $20m). They are purposive, expressing the reason behind the principle. They have very broad application to a diverse range of circumstances. Principles-based legislationLargely behavioural standards more concerned with, for example, the integrity, skill, care and diligence and reasonable care with which authorised firms or approved persons conduct and organise their businesses and the fairness with which they treat customers and manage conflicts of interest. Based on the idea that firms and their management are better placed than regulators to determine what processes and actions are required within their businesses to achieve a given regulatory objective. Regulators, rather than focusing on prescribing the processes or actions that firms must take, now define the outcomes that they require firms to achieve. Regime comparisonType 1: Rules-BasedPrinciple-basedHybrid (Rules-Principle)/Complex RuleA firm must execute all orders of under 5,000 securities instruments within one business dayA firm must pay due regard to the interests of its customers and treat them fairlyA firm must execute all orders for customers within one business day in the following circumstances:[definition of customer, definition of order, restriction as to whether discretionary dealing or execution only, definition of one business day, circumstances where large orders may be worked over a longer period, etc.]Supervisory TypeCertaintyCongruence to supervisory objectivesEase of ApplicationScope for creative complianceRulesHighLowHighHighPrinciplesDependentHighDependentLowComplex RuleHighHighLowHighPARADOXES7 paradoxes of principle-based legislation:

1. THE INTERPRETIVE PARADOX: Principles can be general yet precise

2. THE COMMUNICATIVE PARADOX: Principles can facilitate communication but can also hinder it

3. THE COMPLIANCE PARADOX: Principles provide scope for flexibility in compliance yet can lead to conservative and/or uniform behaviour by regulated firms

4. THE SUPERVISORY AND ENFORCEMENT PARADOX: Principles need enforcement to give them credibility but over- enforcement can lead to their demiseParadoxesSource: Forms and Paradoxes of Principles Based Regulation by Julia BlackLSE Law, Society and Economy Working Papers 13/2008

5. THE INTERNAL MANAGEMENT PARADOX: Principles-based regulation can provide flexibility for internal control systems to develop but can overload them

6. THE ETHICAL PARADOX: Principles-based regulation can facilitate a more ethical approach but it could result in an erosion of ethics

7. THE TRUST PARADOX:Principles-based regulation can give rise to relationships of trust, mutuality and responsibility but these are the very relationships which have to exist for it to be effective.15Hearing problems

RegulatorRegistrantWhat Regulator Says:Capital adequacy, lower leverage, solvency ratios, Market dominance concerns What Registrants Hear:Blah, blah, blah, money, blah, blah, blah, blah, blahConversations in a reconfiguration to Gary Larsons What dogs hearBuilding the ToolkitGiven the scale of resources at the most regulators, a leaning towards principles-based seems logical..BUT A regulator should not institutionally dominated by a conduct of business or market conduct ethos, causing it to lose focus on prudential and financial stability issues.NORExpand the toolkit and does not use the toolsTo be effective in such a situation, a regulatory framework needs to be enforced appropriately. In addition to an effective inspection regime, this requires regulators to use their sanctions (ranging from conditions attached to licences, to financial penalties, or even revoked licences) in a manner that will most benefit the functioning of the market and therefore ultimately the consumer.

Lax Financial Regulation (Have the tools but do not use them or does not know how to use them!!)

Supervisory requirementsEffective regulation of financial institutions requires:Risk-based regulationIntegrated supervisionHigher standards for corporate governanceRisk-Based RegulationWhat do we mean by Riske-Based Regulation?Risk Based Framework Know your Customer (KYC)Capital Adequacy On-site ProgrammesLegislation

Risk-Based FrameworkAssess nature, scale and complexity of entities seeking to be based in Barbados, their related risk and level of sophistication of clients involved

Apply progressively higher levels of scrutiny and more requirements when higher risk profile/exposure determined (e.g. financial, operational, reputational risk)

Need to develop an internal risk management structure that allows regulators to identify and manage the risks that exist20Risk-Based RegulationMove focus away from detailed rules.Transparency to ensure institutions understand risks and how they will be dealt with. Each institution is risk rated, advised of risk level, areas of particular risk so they can begin to take measures to reduce risk.

Risk based supervision monitors risks and aims to reduce risk where necessaryGreater focus is paid on corporate governanceCorporate governance and risk-based supervision are mutually reinforcing. Both are ways of managing and controlling risk Monitor risks: A view to prevent problems from occurring rather than attempting to fix problems that have happenedProblem avoidance a more effective public policy than problem rectificationAlso more efficient because allocate resources only where risks are highRisk-Based Regulation

Risk-Based FrameworkBehaviours differ from case to case, depending on the risk

Given the same triggering events, situations may be treated differently (different treatments for different situations)

Compliance means exercising discretion in determining the most appropriate measures in light of the risk

Compliance is achieved when the risk is tackled appropriately; examples set out in the rules are not exhaustive (substantial component)

High-level legislation; extensive scope for guidance

Corporate Governance Partnership in RegulationPrinciples-based legislationEvery insurer that authorizes one or more agents to act on behalf of the insurer shall establish and maintain a system that is reasonably designed to ensure that each agent complies with the Act and the regulations.This clearly makes the company responsible for maintaining the suitability of its own agentsBy means of benchmarking, the regulator determines the risk levels based on observed net risk situations.

Rules-based legislationPrior to the issuance of a license to an insurance salesman the applicant must meet certain suitability criteria enforced by the regulator.Results in filings, correspondence between the regulator and the applicant.Comparison of Traditional, Compliance Based with Corporate Governance, Risk Assessment Based Rules-based Known globally as an army of compliance checkers Proliferation of rules In fast changing environment (such as financial services), many rules no longer make sense, some may be contrary to public interest. Expensive stifles competition, destroys initiative, discourages innovation

Principles based Fewer personnel but higher calibre Few behaviour, more corporate governance rules Stipulate public policy intent, board and senior management put in place systems to meet compliance can be a matter of competitive advantage Encourages innovation, competit- ion, and initiativeKey Success Factors in the Regulatory FrameworkCulture

Rigorous challenge of risk models and governanceRequire firms to explain why business models are safe before approvedFocus Pro-active oversight of whole financial systemForward looking assessment of potential risks (not backward looking legalistic rules)Firms should address conflicts of interest and consumers need for timely, accurate and intelligible information

Philosophy Macro-prudential systemic risks and controlling externalitiesFirms should act honestly, fairly and professionally in best interest of customersExercise of supervisory judgement based on discretionary powers

Legislation can influence culture, focus and philosophy

Need to set clear objectives

Effectively allocate powers and responsibilities

Establishes appropriate system of accountability of regulatory bodies

The Optimal Regulatory Regime How Well are Regularors Doing?Ex-ante tools Impact AssessmentImpact Assessment (IA) is a tool which aims to ensure that regulatory proposals are subject to a transparent, publicly accountable and rigorous analysis to determine if they are a proportional means of meeting regulatory objectives.

Used effectively, they help ensure the burden of regulation is not unnecessarily increased by answering the questions:

Should a new regulation be introduced?Should an existing regulation be abolished?Are there better ways of achieving the objective rather than regulation?Do the benefits justify the costs?What is the most cost-effective option?28The Optimal Regulatory Regime How Well Are We Doing?Ex-post tools post implementation reviewFurther to the analysis of the administrative costs imposed by regulation, post-implementation review involving the full range of estimates and assumptions on which the regulatory framework was based. This requires the regulator to consult with the relevant stakeholders, and allows more consideration of the more indirect policy costs as well as wider industry issues.

Though often neglected, this process is key to ascertaining if the stated objectives of regulatory frameworks are being met, if there is scope to further reduce the regulatory burden, and if specific regulation is proving effective or should perhaps even be removed.

29 Key Considerations for CaptivesApplication for Captive Registration in Barbados:Companies apply as Exempt Insurance CompaniesApplication fee is US$250.00Minimum Start Up Capital of US$125,000 is required

Annual License Fee:US $10,000.00 Key Considerations for CaptivesSolvency Requirements:The value of the assets in the first financial year must always exceed the value of the liabilities by a minimum of US$125,000.

After the first financial year, if the premium income of the company is between US $750,000 and US$5 Million, then to be solvent the assets of the company must exceed the liability by an amount equivalent to one fifth (1/5) of the premium income. If the premium income exceeds US$5 Million, then to be solvent the assets of the company must exceed the liabilities by an aggregate of US$1 Million and one tenth (1/10) of the premium income in excess of US $5 Million.

Key Considerations for Captives in BarbadosStatutory Reporting Requirements:Audited financial statements submitted annually. Annual actuarial certificate evaluating the companys reserves and liabilities.Auditors certificate indicating the licensees compliance with the prescribed solvency requirements.Quarterly financial statements. These could take the form as management accounts and will be used by the regulator as a means of conducting on-going supervision.