Institutional Structure of Financial Regulation: Theories and International Experiences

Institutional Structure of Financial Regulation

In light of on-going global financial crises, the institutional structure of financial regulation is currently a subject of significant academic and practical interest. The financial crisis has called into question the adequacy of financial regulation at the national and supranational levels, and has instigated financial regulatory reforms in major markets overseas. This has included the enactment of the Dodd–Frank Act in the US, and the programme to split the Financial Services Authority in the UK. This book examines the institutional structure reform of financial regulation from a comparative perspective, exploring both fundamental theories and international experiences. The book explores the three main institutional structures of financial regulation in the world; the sectorsbased model, adopted in the US, Mainland China and Hong Kong; the twin-peaks model with Australia and the Netherlands as its pioneers; and the single-regulator model as represented by the former Financial Services Authority in the UK and the Financial Services Agency in Japan. The book contains contributions from renowned experts in the field of financial regulation, and will be of interest to students and researchers of banking and finance law, and comparative economics. Robin Hui Huang is Assistant Dean (External Affairs – Asia) as well as Director of the Centre for Financial Regulation and Economic Development at the Faculty of Law, Chinese University of Hong Kong. Dirk Schoenmaker is Dean of the Duisenberg School of Finance. He is also a professor of Finance, Banking and Insurance at the VU University Amsterdam and a member of the Advisory Scientific Committee of the European Systemic Risk Board at the ECB.

A fascinating examination of the structure of financial regulation around the world with detailed studies of how the United States and key jurisdictions in Asia and Europe have reformed their financial regulatory agencies and the allocation of supervisory authority in the wake of the Global Financial Crisis. Contributors to the volume include many of the world’s foremost experts on financial regulation, and together they offer an unusually rich and well-informed overview of the theory and practice of modern financial regulatory design. Howell E. Jackson, James S. Reid, Jr., Professor of Law, Harvard Law School, USA A high-powered group of leading experts on financial regulation have come together to provide a wide-ranging and thorough analysis and critique of regulatory practices in the main countries of the world. Highly recommended. Charles A. E. Goodhart, Emeritus Professor of Banking and Finance, Financial Markets Group, London School of Economics and Political Science, UK There are very few books on the Institutional Structure of Financial Regulation, the order of which can affect the outcome of supervision. This is a book that should be compulsory reading by policy makers and supervisors alike on the lessons from theory and practice. Andrew Sheng, President of the Fung Global Institute, Hong Kong, advisor to the China Banking Regulatory Commission, former Chairman of the Securities and Futures Commission of Hong Kong, former Deputy Chief Executive of the Hong Kong Monetary Authority

Routledge Research in Finance and Banking Law

Available: European Prudential Banking Regulation and Supervision The Legal Dimension Larisa Dragomir International Secured Transactions Law Facilitation of Credit and International Conventions and Instruments Orkun Akseli The Legal and Regulatory Aspects of Islamic Banking A Comparative Look at the United Kingdom and Malaysia Abdul Karim Aldohni Banking Secrecy and Offshore Financial Centres Money Laundering and Offshore Banking Mary Alice Young Fiduciary Law and Responsible Investing In Nature’s Trust Benjamin J. Richardson Redefining the Market–State Relationship Responses to the Financial Crisis and the Future of Regulation Ioannis Glinavos Forthcoming: Competition Law and Financial Services David Harrison Institutional Structure of Financial Regulation Theories and International Experiences Edited by Robin Hui Huang and Dirk Schoenmaker

This page intentionally left blank

Institutional Structure of Financial Regulation Theories and international experiences

Edited by Robin Hui Huang and Dirk Schoenmaker

First published 2015 by Routledge 2 Park Square, Milton Park, Abingdon Oxon, OX14 4RN and by Routledge 711 Third Avenue, New York, NY 10017 Routledge is an imprint of the Taylor & Francis Group, an informa business © 2015 Selection of editorial material: Robin Hui Huang and Dirk Schoenmaker. Individual Chapters: the contributors The right of Robin Hui Huang and Dirk Schoenmaker to be identified as editors of this work has been asserted by them in accordance with sections 77 and 78 of the Copyright, Designs and Patents Act 1988. All rights reserved. No part of this book may be reprinted or reproduced or utilized in any form or by any electronic, mechanical, or other means, now known or hereafter invented, including photocopying and recording, or in any information storage or retrieval system, without permission in writing from the publishers. Trademark notice: Product or corporate names may be trademarks or registered trademarks, and are used only for identification and explanation without intent to infringe. British Library Cataloguing in Publication Data A catalogue record for this book is available from the British Library Library of Congress Cataloging-in-Publication Data Institutional structure of financial regulation : international perspectives and local issues in Hong Kong and Mainland China / edited by Robin Hui Huang, Dirk Schoenmaker. pages cm -- (Routledge research in finance and banking law) Includes bibliographical references and index. ISBN 978-0-415-72687-0 (hardback) -- ISBN 978-1-315-84969-0 (ebk) 1. Financial institutions--Law and legislation. 2. Financial institutions--Government policy. 3. Banks and banking, International--Standards. I. Hui Huang, Robin, author editor of compilation. II. Schoenmaker, Dirk, author editor of compilation. K1066.I56 2014 346'.08--dc23 2013048794 ISBN: 978-0-415-72687-0 (hbk) ISBN: 978-1-315-84969-0 (ebk) Typeset in Baskerville by Wearset Ltd, Boldon, Tyne and Wear

Contents

List of figures List of tables Notes on contributors Acknowledgements Introduction 1 Background 1 2 Content 2

xi xii xiii xvii 1

PART I

Fundamental theories 1 Regulatory reform after the financial crisis: Twin Peaks revisited

7 9

MICHAEL W. TAYLOR

1.1 1.2 1.3 1.4 1.5 1.6

Introduction 9 (Why) does institutional structure matter? 11 The case for Twin Peaks 14 The Twin Peaks structure 18 Four lessons from the financial crisis 20 Conclusion 27

2 Financial stability and proper business conduct: can supervisory structure help to achieve these objectives? DIRK SCHOENMAKER AND JEROEN KREMERS

2.1 2.2 2.3 2.4

Introduction 29 Supervisory objectives and structure 30 Conduct of business: a focused approach 35 Financial stability: strong role for central bank 36

29

viii

Contents 2.5 Emerging Twin Peaks structure in Europe 37 2.6 Conclusion 37

3 Rules, discretion and macro-prudential policy

40

ITAI AGUR AND SUNIL SHARMA

3.1 3.2 3.3 3.4 3.5

Introduction 40 Rules-based macro-prudential regulation is difficult 41 Discretion opens the door to resistance 47 A strong baseline: reducing the burden on time-varying policy 57 Conclusion 60

4 Helping hand or grabbing hand? Supervisory architecture, financial structure and market view

66

DONATO MASCIANDARO AND MARC QUINTYN

4.1 Introduction 66 4.2 Do markets matter in designing financial supervision architectures? Helping hand view versus grabbing hand view 69 4.3 Does the market factor matter? 73 4.4 Case study: the market view in Italy 79 4.5 Conclusion 88 PART II

International experiences 5 Implementing Twin Peaks: lessons from Australia

101 103

JEFF CARMICHAEL

5.1 5.2 5.3 5.4 5.5 5.6 5.7

Introduction 103 Background to Australia’s Twin Peaks model 103 Managing the transition 105 Harmonizing the approach to regulation 107 Defining the regulatory boundaries 107 Inter-agency coordination 108 Conclusion 108

6 The break-up of the Financial Services Authority in the UK EILIS FERRAN

6.1 Introduction 109 6.2 Did the FSA have to go? An examination of the case for abolition 113

109

Contents

ix

6.3 Why it matters that the case for abolition of the FSA cannot be convincingly established 123 6.4 Summary 136 7 One step forward, two steps back? The institutional structure of US financial services regulation after the crisis of 2008

137

SAULE T. OMAROVA

7.1 Introduction 137 7.2 A product of history: an overview of the US financial regulatory structure before 2010 138 7.3 What is to be done? Themes in the debate on reforming the US financial regulatory structure 141 7.4 The Dodd–Frank Act of 2010: key changes in the US financial regulatory structure 150 7.5 What to expect? Uncertain prospects and certain challenges 162 7.6 Conclusion 164 8 Evolving supervisory and regulatory approaches of Japan in the post-crisis era

166

MAMIKO YOKOI-ARAI AND TETSUO MORISHITA

8.1 Introduction 166 8.2 The genesis of the institutional structure of financial supervision 168 8.3 Evolving supervisory approaches 177 8.4 Conclusion 186 9 Financial regulatory structure in Hong Kong: looking forward DOUGLAS W. ARNER AND EVAN GIBSON

9.1 9.2 9.3 9.4 9.5 9.6 9.7 9.8 9.9

Introduction 190 Historical financial development 191 Regulatory structural themes 197 Financial regulatory structure 200 Global Financial Crisis: Hong Kong 210 International organizations 213 G20/FSB financial regulatory reforms 213 Financial regulatory structure: options 224 Conclusion 226

190

x

Contents

10 Institutional structure of financial regulation in China: where is it now and where is it heading?

232

ROBIN HUI HUANG

10.1 10.2 10.3 10.4 10.5 Index

Introduction 232 The current financial regulatory structure 232 Characteristics and problems 243 The future of China’s financial regulatory framework 251 Conclusion 258 259

List of figures

2.1 2.2 3.1 3.2

Policy framework Hierarchy of objectives Macro-prudential policies Central bank versus joint committee as macro-prudential policymaker 3.3a Central bank 3.3b Joint committee 4.1 Concentration of overall sample 4.4 Concentration of OECD sample

31 33 42 53 54 55 82 83

List of tables

2.1

The macro- and micro-prudential perspectives contrasted 3.1 Agencies involved in macro-prudential policies 3.2 Main macro-prudential tools 4.1a Correlation matrix: general 4.1b Correlation matrix: market factor variables 4.1c Summary statistics: market factor variables 4.2 Ordered logit estimates with the basic model 4.3 Ordered probit estimates with the basic model 4.4 Ordered logit estimates with the basic model and the new data 4.5 Ordered probit estimates with the basic model and new data 4.6 Ordered logit estimates with the bandwagon effect 4.7 Ordered probit estimates with the bandwagon effect 4.8 Ordered logit estimates with the conglomeration effect 4.9 Ordered probit estimates with the conglomeration effect 4.10 Ordered logit estimates with the concentration effect 4.11 Ordered probit estimates with concentration effect 8.1 Measures against financial emergency/crisis

32 49 51 93 94 94 94 95 95 96 96 97 97 98 98 99 172

Notes on contributors

Itai Agur joined the IMF-Singapore Regional Training Institute (STI) in October 2011. Prior to that he was an economist in the Research Department of the Dutch Central Bank where he worked on issues related to financial stability and macroeconomic forecasting. Between 2004 and 2008, Itai completed his doctoral degree at the European University Institute in Florence, Italy. Chapters from his PhD thesis won him the 2007 Young Economist Award of the European Economic Association and the 2008 Arrow Award for Junior Economists awarded by the Berkeley Electronic Press. Before enrolling for his doctoral degree, he was an intern at the European Central Bank. Douglas W. Arner is Head of the Department of Law at the University of Hong Kong. Prior to his appointment as Head, he served as Director of the HKU’s Asian Institute of International Financial Law from 2006 to 2011. He is Co-Director of the Duke-HKU Asia America Institute in Transnational Law and a Senior Fellow of Melbourne Law School, University of Melbourne. He has published thirteen books and more than 100 articles, chapters and reports. He has served as a consultant with, among others, the World Bank, Asian Development Bank, European Bank for Reconstruction and Development, APEC and Development Bank of Southern Africa. He is a member of the Hong Kong Financial Services Development Council and of the International Advisory Board of the Australian Centre for International Finance and Regulation. Jeff Carmichael is an internationally recognized expert in regulatory structure, design and effectiveness. He was, until June 2003, the inaugural Chairman of the Australian Prudential Regulation Authority with responsibility for regulating and supervising banks, insurance companies and pension funds. His career includes senior positions in a twenty-year career with the Reserve Bank of Australia, seven years as Professor of Finance at Bond University, and appointment to a number of Government inquiries including the Wallis Inquiry into the Australian financial system. In 1995, he was awarded an Officer of the Order of Australia for service to finance, education and the community.

xiv

Notes on contributors

Eilís Ferran is Professor of Company and Securities Law at Cambridge University, a University JM Keynes Fellow and a Fellow of The British Academy. Since April 2012 she has been Chair of the Cambridge Law Faculty. Her recent publications include contributions to Ferran, Moloney, Hill and Coffee, The Regulatory Aftermath of the Global Financial Crisis (CUP 2012) and Ferrarini, Hopt and Wymeersch (eds), Rethinking Financial Regulation and Supervision in Times of Crisis (OUP, 2012). The new edition of her textbook Principles of Corporate Finance Law (OUP) will be published in 2014. Evan Gibson is a Research Fellow at the Asian Institute of International Financial Law specializing in financial regulation and financial regulatory structures. Mr Gibson holds a Bachelor of Laws and a Bachelor of Commerce from the University of Queensland, a Master of Laws from the University of Sydney and is currently a PhD candidate with the Faculty of Law at the University of Hong Kong. Robin Hui Huang obtained Bachelor of Laws, Bachelor of Engineering and Master of Laws degrees from Tsinghua University, China, and was awarded a Doctor of Philosophy in Law by the University of New South Wales, Australia. Professor Huang is currently Assistant Dean (External Affairs – Asia) as well as Director of the Centre for Financial Regulation and Economic Development in the Faculty of Law at the Chinese University of Hong Kong. He has held visiting or adjunct appointments at a wide range of academic institutions including Harvard Law School, Cambridge Law School, Melbourne Law School and China University of Political Science and Law. Jeroen Kremers is Vice-Chairman and Chief Risk Officer of the Managing Board of RBS NV and Head Global Country Risk at RBS Group. He held senior positions at ABN Amro, the IMF and the Netherlands Finance Ministry. He earned a DPhil at Nuffield College Oxford, following degrees in Quantitative Economics at Bristol and in Econometrics at Tilburg. He was visiting Economics Professor at Erasmus University Rotterdam and chaired the Tinbergen Institute. Mr Kremers serves on the Senior Advisory Board of Oliver Wyman Financial Services and the Supervisory Boards of Maastricht University and NV Nederlandse Spoorwegen. Donato Masciandaro, born in Italy in 1961, has been Full Professor of Economics since 2001. Since 2005 he has held the Chair in Economics of Financial Regulation, at Bocconi University, Milan. Since 2013 he has been Head of the Department of Economics; he was already Department Head from 2008 to 2010. He has been Director of the Paolo Baffi Centre on International Markets, Money and Regulation since 2008. He is a Member of the Board and Honorary Treasurer of the SUERF. He served as Visiting Scholar at the IMF Institute, as well as Consultant at

Notes on contributors

xv

the Inter-American Development Bank and at the United Nations. He is Associated Editor of the Journal of Financial Stability. Tetsuo Morishita is a Professor of Sophia University, School of Law, focusing on international business law, banking and financial law, etc. After his graduation from the University of Tokyo in 1989, he worked for Sumitomo Bank for ten years. He received his master degree from the Graduate School of the University of Tokyo in 1994. Since 1999, he has been teaching at Sophia University. He was a member of the ‘Working Group on Method of Regulations on Banks which Contribute to Stability of the Financial System, etc.’ (May 2012–January 2013) of the Financial System Council of the Financial Services Agency, Japan (FSA). Saule T. Omarova is a Professor of Law at Cornell University, USA. Prior to entering the legal academy, she practised law in the Financial Institutions Group of Davis Polk & Wardwell LLP, a premier New York law firm, and served the US Department of the Treasury as a Special Advisor for Regulatory Policy to the Undersecretary for Domestic Finance. Professor Omarova’s research focuses on US domestic and international regulation of financial institutions and markets. She received her BA in Philosophy from Moscow State University, her PhD in Political Science from the University of Wisconsin-Madison, and her JD from Northwestern University, USA. Marc Quintyn is Advisor, Africa, Technical Assistance Wing, in the IMF ’s Monetary and Financial Systems Department. He has published widely in academic and professional journals and has contributed to a number of books on monetary policy, financial systems and their regulation and supervision, and European monetary and financial integration. Before joining the IMF, he was with the National Bank of Belgium (Research Department) and taught at the University of Limburg, Belgium. He has a PhD from the University of Ghent, Belgium. Dirk Schoenmaker is Dean of the Duisenberg School of Finance. He is also a professor of Finance at the VU University Amsterdam and a member of the Advisory Scientific Committee of the European Systemic Risk Board. He is author of Governance of International Banking: The Financial Trilemma (OUP, 2013) and the textbook Financial Markets and Institutions: A European Perspective (CUP, 2012). He earned his PhD in Economics at the LSE. He is a visiting scholar at the IMF and the OECD. Before joining the Duisenberg School, he served at the Netherlands Ministry of Finance and at the Bank of England. Sunil Sharma is Director of the IMF-Singapore Regional Training Institute (STI) in Singapore. The STI provides training on macroeconomic and financial management, and related legal and statistical issues, to

xvi

Notes on contributors

government officials in the Asia-Pacific region. Before relocating to Singapore in 2006, Sunil was the Chief of the IMF Institute’s Asian Division in Washington, DC. He has also been a staff member of the IMF ’s European and Research Departments, and the IMF ’s Capital Markets Team. Prior to joining the IMF, Sunil was on the Economics faculty at the University of California, Los Angeles (UCLA). He has a doctoral degree in Economics from Cornell University, an MA from the Delhi School of Economics and a BA from St Stephen’s College, Delhi University. Michael W. Taylor is an internationally recognized authority on financial regulation who recently joined the Financial Stability Board Secretariat. Educated at Oxford University, from where he earned his doctorate, his career has previously involved work with the Bank of England, International Monetary Fund, Hong Kong Monetary Authority and, most recently, the Central Bank of Bahrain where he was Advisor to the Governor. Among his extensive publications are the seminal ‘Twin Peaks’ paper (1995) and a textbook, Global Bank Regulation (2010), as well as contributions to leading periodicals and specialist journals. Mamiko Yokoi-Arai (Tsukuba (BA), Tsukuba (MA) and London (PhD)) is Principal Administrator at the Organisation of Economic Co-operation and Development (OECD). She works on financial system policies such as systemic risk, compensation schemes and assessment of financial systems. Dr Yokoi-Arai previously worked in the Bank of Japan and the Financial Services Agency. She was a Reader in International Finance Law at Queen Mary, University of London, teaching financial regulation and emerging market issues. Dr Yokoi-Arai has published extensively in the area of banking regulation, financial services trade, Asian regional issues, financial competition policy and financial consumer protection.

Acknowledgements

We have a number of thanks to pass on. This book project stems from an international conference jointly hosted by the Centre for Financial Regulation and Economic Development (CFRED), Faculty of Law, Chinese University of Hong Kong and the Duisenberg School of Finance, Amsterdam, The Netherlands. We are grateful for the financial support of the Hong Kong Research Grants Council Theme-based Research Scheme, ‘Enhancing Hong Kong’s Future as a Leading International Financial Centre’. Thanks also go to Ms Susanna Leung, the CFRED research assistant, who has provided valuable assistance in organizing the conference and editing the book. Further, we want to extend our appreciation to the staff of Routledge, especially Mark Sapwell, for their characteristically high standards of work and assistance.

This page intentionally left blank

Introduction

1 Background The institutional structure of financial regulation has increasingly become a focus of attention from academia and the wider society, particularly in the aftermath of the global financial crisis of 2008 (GFC), which Alan Greenspan, former chairman of the US Federal Reserve, described as a ‘once-in-a-century event’, and the worst ‘by far’ that he had witnessed. The GFC has called into question the adequacy of financial regulation at the national and supranational levels. What went wrong? What lessons can we take from the GFC? Where are we now and where do we go from here? Financial regulatory structure has been considered one of the key factors behind the GFC and as such, a wave of financial regulatory reforms has ensued in many jurisdictions. Notable examples include the enactment of the Dodd–Frank Act in the US and the abolition of the Financial Services Authority in the UK. In Hong Kong, the much-publicized Lehman Brothers mini-bond saga has prompted the Hong Kong government to reconsider its financial regulatory regime. Likewise, Mainland China has, after the recent once-in-a-decade leadership transition, paid serious attention to the reform of its financial regulatory structure. The aim of this book is thus to examine the issue of institutional structure of financial regulation from a comparative perspective, looking at both fundamental theories and international experiences. In general, there are three main institutional structures of financial regulation in the world, namely the sectors-based model as currently adopted in the US, Mainland China and Hong Kong; the twin-peaks model with Australia and the Netherlands as its pioneers; and the single-regulator model as represented by the former Financial Services Authority in the UK and the Financial Services Agency in Japan. In the post-GFC era, there seems an international trend towards the twin-peaks model, as evidenced by some recent reforms such as the adoption of this model in South Africa and more importantly, the splitting of the Financial Services Authority in line with the twin-peaks model in the UK. This trend is not without its critics, however. There is an ongoing debate on the relative efficiency of the three

2

Introduction

regulatory models. This is further compounded by the fact that the efficacy of a regulatory model in any given jurisdiction depends very much on its compatibility with the local conditions. We are very fortunate to have gathered a group of leading experts to be our contributors to expound on this exciting topic.1 The book is divided into two parts: the first part consists of four chapters, focusing on theoretical issues on financial regulatory models; while the second part has six chapters, examining the practical experiences of financial regulatory architecture in various jurisdictions, among which are Australia, the UK, the US, Japan, Hong Kong and Mainland China. Below is a brief introduction of the chapters.

2 Content The opening chapter, contributed by Michael Taylor who is regarded as the ‘father of the “Twin Peaks” model’ for being the first to systematically express the idea, reviews the issue of regulatory structure in the light of lessons learned from the GFC. It explores the original justification for the Twin Peaks reforms in terms of industry changes and regulatory efficiency, and finds that these justifications have stood up well when tested against the experience of the financial crisis. Moreover, recent experience also suggests the superiority of a Twin Peaks structure over a single regulator in terms of regulatory focus and crisis management. Chapter 2, contributed by Dirk Schoenmaker and Jeroen Kremers, first reviews the objectives of supervision and explores the trade-offs and synergies between them. The analysis suggests that macro-prudential supervision (system-wide) should override micro-prudential supervision (individual banks). Next, the chapter reflects how to achieve best the two key objectives of financial supervision namely financial stability and proper conduct of business. It suggests that two separate and focused supervisory agencies help to achieve each of these two objectives in an effective and efficient way. In Chapter 3, two IMF experts, namely Itai Agur and Sunil Sharma, bring an international systemic perspective on financial regulation. This chapter examines the implementation of macro-prudential policy. Given the coordination, flow of information, analysis and communication required, macro-prudential frameworks will have weaknesses that make it hard to implement policy. And dealing with the political economy is also likely to be challenging. But limiting discretion through the formulation of macro-prudential rules is complicated by the difficulties in detecting and measuring systemic risk. The chapter suggests that oversight is best served by having a strong baseline regulatory regime on which a

1 For brief biographies of the contributors, see Notes on Contributors.

Introduction

3

time-varying macro-prudential policy can be added as conditions warrant and permit. Donato Masciandaro and Marc Quintyn contribute the fourth chapter, empirically examining the role of financial market characteristics in determining the choice of the financial supervision architecture. They present two complementary approaches to gain insights into the above relationship, focusing on the political cost and benefit analysis. First, a crosscountry study tests two alternative theories – the helping hand and the grabbing hand view of government – to determine the impact of the market structure on the supervisory setting. Their evidence seems more consistent with the grabbing hand view, considering the degree of banking concentration a proxy of the capture risk and presuming the market demonstrates a preference for consolidation of supervisory powers. Second, the results of a survey among financial CEOs in Italy confirm a market preference for a more consolidated supervisory regime but reveal only weak consistency between the views of the policymakers and those of the market operators. In Chapter 5, Jeff Carmichael, drawing upon his experience as the inaugural Chairman of the Australian Prudential Regulation Authority, tells an insider’s story of the establishment and functioning of the Australian Twin Peaks financial regulatory structure. In 1998, following twelve months of review and a report by the Wallis Inquiry, Australia implemented a Twin Peaks regulatory architecture for its financial sector. The chapter contends that the experience of the past fifteen years reflects well on this architecture. Not only did the Australian financial system withstand the pressures of the global financial crisis, the sector has exhibited both solid growth and exceptional stability, with remarkably few failures or frauds. While the Australian experiment would be rated successful by most, it has not been without its challenges. This chapter reflects on four aspects of Australia’s Twin Peaks experience: managing the transition; harmonizing the approaches to regulation; defining the boundaries between the different types of regulation; and interagency coordination. In Chapter 6, Eilis Ferran, a leading authority on UK financial market supervision, casts some doubt on the merits of the UK’s recent institutional restructuring towards the twin-peaks model. This chapter contends that while fixing the Financial Services Authority (FSA) was a solid option in principle, politics dictated the result. It then proceeds to examine the substance behind the politics. Since all institutional models for financial market supervision have pros and cons, the chapter argues that flaws must be expected in the objectives-oriented institutional model that the UK has now opted for. Close study of the FSA’s track record could help address the risk of wrong turns in institutional design. The chapter looks at the FSA’s experience in four key areas – style of supervision, enforcement, efficiency and economy and consumer protection. The chapter acknowledges that the loss of some positive features will be an inevitable consequence of

4

Introduction

the break-up. It identifies aspects of the FSA’s approach that will be inherited by its successors but which may not endure in the longer term. It also pinpoints some new challenges. Chapter 7 contributed by Saule Omarova provides an overview of the key changes in the structure of US financial services regulation under the Dodd–Frank Wall Street Reform and Consumer Protection Act of 2010 (the Dodd–Frank Act). Enacted in response to the perceived regulatory and market failures that led to the GFC, the Dodd–Frank Act established a dedicated multi-agency structure for systemic risk oversight, expanded the jurisdictional reach and powers of the existing financial regulators and created the country’s first financial consumer protection agency. Yet, despite these achievements, the new law’s failure to address directly the underlying structural problems in US financial services regulation casts a serious doubt on its ability to ensure systemic financial stability in the long run. The chapter places the discussion of this latest agency restructuring in its broader historical, institutional and intellectual context and argues that, against that broader backdrop, the Dodd–Frank Act can be viewed both as an important advance and as a regrettable retrenchment on the road toward a better regulatory system. After the UK changed its single-regulator model of financial regulation in April 2013, Japan has become the key practitioner of this regulatory model and thus deserves more attention from the international community. Mamiko Yokoi-Arai and Tetsuo Morishita contribute Chapter 8, which provides a comprehensive treatment of the Japanese experience. Changes in the institutional structure of Japanese supervision were made in 1998, and supervision has since remained with the Financial Services Agency of Japan (FSA). While the rationales for its establishment were manifold, the FSA has since taken an approach that adopts its internal processes to changing macroeconomic and market circumstances. This chapter looks into a number of approaches the FSA and other financial system authorities in Japan have taken to improve the health of financial markets, while addressing macroeconomic concerns. It is submitted that good coordination processes which are accompanied by appropriate authority for action may be as important as having the appropriate institutional structure for good financial supervision, unless there is strong interinstitutional competition. Also, macroeconomic considerations may be having a greater impact on how supervision is being carried out in Japan, and will need to be carefully balanced with the primary objective of prudential supervision and being in sync with discussions in global fora. Douglas W. Arner and Evan Gibson contribute Chapter 9 in which Hong Kong’s financial regulatory structure is examined and analysed. The chapter aims to identify Hong Kong’s financial regulatory structural flaws to further the cause for structural change. The first section of this chapter takes a brief journey through Hong Kong’s historical financial development culminating with a summation of the financial regulatory themes.

Introduction

5

This is followed by an overview of Hong Kong’s existing financial regulatory structure with an analysis of the prevailing themes and structural issues, including coordination and cooperation arrangements. After the groundwork has been laid, the chapter undertakes an examination of Hong Kong’s high profile GFC incidents. In this context, Hong Kong’s implementation of the G20/FSB reform agenda and the capacity of the financial regulatory structure to facilitate these reforms are evaluated. To round off this examination and analysis, the financial regulatory structural options are discussed. This chapter then concludes with an appraisal of Hong Kong’s financial regulatory structure. In the last chapter, namely Chapter 10, Robin Hui Huang seeks to critically examine China’s financial regulatory structure in light of the GFC and based on the results of such examination, set out reform proposals for China. At present, China adopts a traditional sectoral system of financial regulation, which has exhibited several inadequacies in meeting the regulatory challenges in a rapidly changing market. In quest of a solution to the problem, a comparative analysis is conducted of the financial regulatory regime in some advanced economies including the US, the UK and Australia, each of which is representative of a distinct regulatory model. When looking to these overseas experiences for guidance, attention should not only be paid to their objective advantages and disadvantages, but also to the local conditions in China. It is concluded that the US model merits consideration in the short term, and with the further growth of China’s financial markets in the long run, the Australian twin-peaks model provides the preferred direction for reform over the UK FSA model.

This page intentionally left blank

Part I

Fundamental theories

This page intentionally left blank

1

Regulatory reform after the financial crisis Twin Peaks revisited Michael W. Taylor

1.1 Introduction Prior to the publication of my 1995 paper Twin Peaks: A Regulatory Structure for the New Century,1 the institutional structure of regulation received little attention in either academic or policy circles. To the extent that issues of institutional structure were noticed at all, they were viewed as at best a second order issue that made little practical difference to the quality or effectiveness of supervision. However, the publication of Twin Peaks gave rise to a vigorous debate in the UK around issues of regulatory structure that was soon replicated in other countries. In the latter half of the 1990s this policy debate began to be mirrored in practical developments and a strong trend towards institutional reform gathered pace in many advanced and developing economies. Australia, the United Kingdom, the Netherlands, Germany, Ireland, Korea, Japan and several other countries introduced or announced changes to their structures of regulation in the years that followed. Institutional developments in turn have encouraged a growing literature on the leading policy issues connected with these reforms. At the core of this literature has been the examination of several closely related questions: should the central bank be directly involved in banking supervision and regulation? Should it be responsible for the regulation of nonbank financial intermediaries? What are the pros and cons of creating a unified regulatory agency – responsible for banking, securities and insurance supervision – outside the central bank? Should prudential (safety and soundness) and consumer protection regulation be combined within the same agency or are they best carried out separately? The last issue has been one of the central points of contention between proponents of a Twin Peaks structure – in which prudential and consumer protection regulation are assigned to separate agencies – and the

1 Michael W. Taylor, ‘Twin Peaks:’ A Regulatory Structure for the New Century (1995); for discussion of the debate inspired by this paper see also, Michael W. Taylor, The Road from Twin Peaks – and the Way Back, 16 Conn. Ins. L.J. 61 (2009).

10

M.W. Taylor

adherents of a single unified regulator. Until the crisis, it had appeared that this issue had been decisively settled in favour of the single regulator model. The UK’s Financial Services Authority (FSA) inspired a wave of countries to adopt a similar institutional structure and gathered many plaudits in the years before the financial crisis, including from such influential bodies as the International Monetary Fund.2 By contrast only relatively few countries – Australia and the Netherlands in particular – quixotically went down the Twin Peaks route.3 Since the Global Financial Crisis first broke in 2007 there has been a reevaluation of the single regulator model, combined with a switch in the focus of the debate. Post-crisis the most pressing issues have appeared to arise from the interaction between prudential regulation (especially of banks and other systemically important firms) and the central bank’s roles as lender of last resort and guardian of financial stability, rather than between prudential and consumer protection regulation. Moreover, the increased emphasis now being given to ‘macro-prudential’ regulation – essentially a set of tools that aim to prevent the build-up of excessive risks across the financial system as a whole – has raised fresh issues about how this new form of regulation should be managed, and what relationship it needs to have to the institution-specific ‘microprudential’ regulation of individual firms. One consequence of the resulting reassessment has been to reawaken interest in the Twin Peaks model of institutional structure. A significant factor in this development has been the decision of the current UK government to dismantle the Financial Services Authority, which was the inspiration for the adoption of a single unified regulator in several countries, and to replace it with a Twin Peaks structure. Two new agencies, the Prudential Regulation Authority (PRA) and the Financial Conduct Authority (FCA) replaced the FSA in April 2013. The FCA has inherited many of the FSA’s former functions, with the exception of the prudential regulation of banks, insurance companies and large securities firms, which has become the responsibility of the PRA. While the FCA remains a standalone agency, the PRA is a ‘subsidiary’ of the Bank of England, thus recreating the close connection between the central bank and the prudential regulator of banks that existed pre-1997. In the context of these developments it is timely to revisit the case for Twin Peaks and to consider what lessons the financial crisis holds for the institutional structure of regulation. Before entering into the case for the

2 Int’l. Monetary Fund, United Kingdom – 1998 Article IV Consultation, Concluding Statement of the Mission, December 21, 1998, available at www.imf.org/external/np/ms/1998/122198. htm. 3 The Dutch Twin Peaks model is discussed in detail in Int’l. Monetary Fund, FINANCIAL SECTOR ASSESSMENT PROGRAM UPDATE, Kingdom of the Netherlands – Financial Sector Supervision: The Twin Peaks Model, Technical Note, June 2011, available at www.imf.org/external/pubs/ft/scr/2011/cr11208.pdf.

Regulatory reform after the financial crisis

11

Twin Peaks I will first consider the issue of why institutional structure should matter at all: in other words, the extent to which the intense debate of the past decade and a half addressed genuine issues or was mere displacement activity that substituted for real reform. Having examined this issue, the chapter then sets out the main justifications for the Twin Peaks structure that were set out in my 1995 paper. Finally, I review four lessons for the institutional structure of regulation suggested by the financial crisis.

1.2 (Why) does institutional structure matter? Until the mid-1990s the institutional structure of regulation was not considered to be a worthy subject of academic study. It appeared to fall between a number of different disciplines: not susceptible to treatment by the techniques of modern economics (which to its detriment generally neglected the impact of different institutional arrangements); too much a matter of policy to greatly interest lawyers; and too esoteric even for academics in the field of public administration. From the point of view of many policy-makers and those charged with the day-to-day task of supervision and regulation such matters also seemed a distraction from the more urgent tasks at hand. What mattered, it was said, was making sure that regulation was done properly: the name on the brass plate on the building in which the regulators were located was of minor importance. Institutional reform has also been tainted by the suspicion that it remains the last refuge of politicians who are keen to be seen to ‘do something’ in the wake of a financial crisis. Too often, changing institutional structures by creating new agencies, or by consolidating or abolishing existing ones, gives the appearance of learning the lessons of regulatory failure without necessarily changing actual regulatory practices. The focus on agency consolidation in the Obama administration’s initial proposals for regulatory reform led one leading economics commentator to dismiss them as an example of the ‘characteristic, but futile, response’ to a financial crisis which ‘is to move the regulatory deckchairs on the deck of the Titanic’.4 Critics of the UK government’s reorganization of regulation have similarly claimed that it is driven more by politics – squarely placing the blame for the financial crisis on the decisions of its predecessor by dismantling an agency it had created – than by an urgent need to repair a flawed model.5 Clearly, any particular institutional structure cannot by itself ensure high standards of supervision and regulation. In an IMF Working Paper, 4 Martin Wolf, ‘The Cautious Approach to Fixing Banks will not Work’, Financial Times, 30 June 2009, available at www.ft.com/intl/cms/s/0/eed3ba7c-659d-11de-8e34–00144 feabdc0.html#axzz21WUP7GPk. 5 Ellis Ferran, ‘The Break-Up of the Financial Services Authority’, University of Cambridge, Legal Studies Research Paper Series, Paper No. 10/04, November 2010.

12

M.W. Taylor

‘Issues in the Unification of Financial Sector Supervision’ my co-author Richard Abrams and I attempted to identify the main elements of an effective regulatory regime.6 We proposed five essential factors: 1.

2.

3.

4.

5.

Clarity of aims and objectives. Clear objectives assist the management of a regulatory agency in the allocation of resources and in determining the policy response to a particular problem; they can also provide a break on regulation expanding beyond the minimum necessary to correct market failures. Independence and accountability. A regulatory agency must be able to make decisions that belong to its sphere of competence without undue outside interference, whether by ministers, parliamentarians or industry leaders. Among the factors that best protect agency independence are safeguards against the arbitrary removal of senior management, and budgetary autonomy in the sense of an earmarked source of funding for the agency. However, agency independence should also be balanced by accountability arrangements to ensure that the agency is answerable for its policies and actions to government and legislature, the source of its powers. Some form of formal consultative mechanism with the regulated industry should also be considered. Adequate resources. The regulatory agency needs to have sufficient resources to recruit, train and retain a cadre of professional staff, and to ensure timely and effective data collection and processing. Effective enforcement powers. A regulatory agency must possess powers to require information from regulated firms, to assess the competence and probity of senior management and owners of regulated firms, to take appropriate graduated measures in the event of failure to comply with regulatory rules, including having the ultimate power to intervene in a firm’s operations if necessary and to revoke licences. The effectiveness of enforcement powers depends on the ability to amend them quickly: for this reason only the broad outlines of the agency’s powers should be set out in legislation, leaving the detailed rules to be issued by the agency itself. Comprehensiveness of regulation. A regulatory system needs to be free of gaps so that no particular types of activity or firm escape regulation simply because there is doubt over which agency is responsible for regulating them. Regulators must also have the flexibility to respond to market innovations.

These five factors were not intended to be an exhaustive list of the characteristics of an effective regulatory regime, but they were intended to put 6 See Richard K. Abrams and Michael W. Taylor, ‘Issues in the Unification of Financial Sector Supervision 22–23’ (Int’l Monetary Fund, Working Paper No. 00/213, 2000), available at www.imf.org/external/pubs/ft/wp/2000/wp00213.pdf.

Regulatory reform after the financial crisis

13

the discussion of regulatory structure into a broader context. Whether regulation should be conducted by a single agency or a multiplicity of agencies, and whether multiple agencies should be organized according to objectives (the Twin Peaks approach) or according to the traditional distinction between different industry segments (banking, insurance, securities) are essentially subsidiary issues to the more fundamental problems of ensuring clarity of objectives, independence and accountability, adequate resources, effective enforcement powers and the comprehensiveness of regulation. Nonetheless, the institutional structure of regulatory agencies is not a mere distraction from more urgent issues as is sometimes suggested. If the regulatory structure is not a sufficient condition for ensuring effective regulation then it is surely a necessary one. This is for three main reasons. First of all, the type of regulatory structure adopted by a jurisdiction has a direct bearing on its ability to meet the last of the effectiveness criteria – comprehensiveness. As observed in Abrams and Taylor, ‘a key factor in a regulatory system’s ability to meet the effectiveness criteria is that the institutional structure of regulation should reflect, at least to some degree, the structure of the industry it is called on to regulate’.7 As will be discussed in the next section, a major inspiration behind the Twin Peaks proposals was the widespread perception in the UK in the early 1990s that a highly fragmented regulatory structure was inhibiting proper oversight of increasingly integrated financial institutions and markets. This consideration was also influential in several other jurisdictions that embarked on institutional reform in the last decade of the twentieth century. Traditional structures of regulation – based on a tripartite distinction between banking, securities and insurance – seemed ill-equipped to provide comprehensive oversight as jurisdictions dismantled the barriers that had previously kept them as distinct activities. Second, regulatory structures also are capable of influencing another effectiveness criterion, the adequacy of resources. Given the budget constraints that exist for all regulatory agencies, whatever their funding source, the multiplication or duplication of regulatory agencies may result in scarce resources being misallocated or deployed inefficiently. An example might be the need for multiple regulatory agencies to each build their own information technology infrastructures, such as are used for data collection and processing. The consolidation of regulatory agencies would reduce the need for this duplication of effort and might be expected to result in efficiency savings. Finally, the regulatory structure also has important implications for the ability of regulatory agencies to coordinate their activities. Agencies with overlapping or conflicting mandates may well reduce the effectiveness of

7 Abrams and Taylor, op. cit, p.152.

14

M.W. Taylor

regulation as they engage in turf wars or bureaucratic stand-offs. As will be discussed later, the guiding assumption behind the unified regulator model was the notion that prudential and consumer protection regulation needed to be better coordinated, and this would be best achieved by combining both activities within a single agency. Since the financial crisis, attention has switched instead to the need to better coordinate the activities of the financial safety net agencies, especially those involved with providing lender of last resort assistance and deposit insurance. Prudential regulation plays an important role in underpinning the safety net and hence in the post-crisis environment coordination between the prudential regulator, the lender of last resort and the deposit insurer has appeared more important than coordination of prudential with consumer protection regulation. This has profound implications for the type of regulatory arrangements that should be adopted, as we will see. It should be clear, therefore, that although the institutional structure of regulation is not the only – or the most important – factor in ensuring regulatory effectiveness, neither is it the irrelevance that is sometimes alleged. Designing a regulatory structure involves far more than simply deciding the name on the brass plate outside a building, or indeed on how many brass plates (or buildings) may be needed. Especially important is the observation that the structure of regulatory agencies needs to mirror the structure of the industry that the agencies are called on to regulate. This insight was at the core of the Twin Peaks proposal.

1.3 The case for Twin Peaks The publication of Twin Peaks in late 1995 did not occur in a vacuum. For several years prior to its publication a debate had ebbed and flowed in the UK concerning the appropriateness of the regulatory system that had been constructed during the 1980s. Regulatory regimes for banking, securities and investment markets had been developed more or less independently of each other at different points during the decade, replacing informal ‘self-regulatory’ systems with formal, statute-based regulation for the first time in the UK.8 However, the new systems suffered from two fundamental flaws. First, they attempted to retain as much as possible of the old self-regulatory approach and ethos despite the fact that the conditions that had made self-regulation relatively effective in the past were rapidly disappearing (for example as a consequence of the ‘Big Bang’ reforms in the City of London in 1986). Second, the regulatory systems of the 1980s were premised on an industry that still remained compartmentalized between banking, securities and insurance. Yet even while the new

8 For an overview of these policy developments see James J. Fishman, The Transformation of Threadneedle Street (1993), Durham, NC: Carolina Academic Press.

Regulatory reform after the financial crisis

15

statute-based regulatory system was in the course of being implemented, the financial services sector was rapidly integrating, eroding the boundaries presupposed by the regulatory system. Banking supervision was placed on a statutory basis in the UK for the first time in 1979; the legislation was revised in 1987 following the failure of Johnson Matthey Bank (JMB) in 1984.9 A formal statute-based system of banking supervision had been a late arrival in the UK compared to most other advanced economies, and had replaced an informal system in which the Bank of England had used its powers of moral suasion and its control of liquidity provision to keep banks in line. This system was not ‘selfregulatory’ in the true sense of the term, but the Bank of England was widely perceived as operating a cosy club of the leading British banks that relied on a significant element of self-policing. Legislation became inevitable once it became clear that informal control was becoming less effective, illustrated most dramatically by the Secondary Banking Crisis of 1973–74, and following the UK’s membership of the (then) European Economic Community in 1972. The latter had adopted a legal framework for bank regulation with which Britain was obliged to comply.10 Under the statute-based system the Bank of England remained the authority responsible for overseeing the banking sector. The Bank regarded its supervisory role as the natural extension of its role as lender of last resort. Nonetheless, the decision to place the Bank in this role was not without controversy. Some members of the 1974–79 Labour government which introduced the first Banking Act had favoured setting up a banking commission outside the central bank.11 Moreover, the Bank’s performance of its supervisory role in the first decade and a half of the statute-based system was marred by several high-profile failures: to JMB can be added the Bank of Commerce and Credit International (BCCI) in 199112 and Barings Bank in 1995.13 Some critics suspected the Bank of wishing to maintain the ‘cosy, club-like’ environment that it had traditionally fostered despite it having assumed formal, statute-based powers. In parallel to these developments a new regulatory structure had been set up to oversee securities and investments, the provision of financial advice and the sale of ‘packaged’ products such as life assurance and pensions. This new system added a functionally based overlay of consumer protection to an institutionally based system of prudential regulation in 9 Stephen Fay, The Portrait of an Old Lady: Turmoil at the Bank of England (1987), London and New York: Viking Press, contains a good account of the JMB saga. 10 Heidi Mandanis Schooner and Michael W. Taylor, Convergence and Competition: The Case of Bank Regulation in Britain and the United States, 20 Mich. J. Int’l L. 595 (1999). 11 Michael Moran, The Politics of Banking (1986), 2nd edition, London: Macmillan. 12 HM Stationery Office, Inquiry into the Supervision of the Bank of Credit & Commerce Int’l. (1992). 13 HM Stationery Office, Report of the Board of Banking Supervision Inquiry into the Circumstances of the Collapse of Barings (1995).

16

M.W. Taylor

which different regulators were responsible for ensuring the financial soundness of banks, securities firms and insurance companies.14 The new consumer protection regime was brought into being by the Financial Services Act 1986 and replaced a framework that had been in places self-regulatory (the London Stock Exchange’s oversight of its member firms and regulation of company listings) and in part nonexistent (the regulation of financial advice). In deference to the selfregulatory traditions of the City of London several new Self-Regulating Organizations (SROs) were created along functional lines: The Securities Association (TSA), responsible for regulating securities firms, was the former membership department of the Stock Exchange under a new name; the Association of Futures Brokers and Dealers performed a similar role with respect to firms active on the futures exchanges; investment managers were regulated by the Investment Management Regulatory Organisation (IMRO), while the ‘packaged’ end of the market had two regulatory bodies – one for the sales practices of financial advisers who were ‘tied’ to one of the life insurance companies (i.e. offered only the products of a specific firm) and another for the financial advisers who took commissions from any firm whose products they sold. These were LAUTRO (the Life Assurance and Unit Trust Regulatory Organisation) and FIMBRA (Financial Intermediaries Managers Brokers Regulatory Association) respectively. The patchwork quilt of SROs was overseen by the Securities and Investments Board (SIB), which exercised powers delegated to it by the relevant government minister (the Secretary of State for Trade and Industry) but which was not itself a government department. The SIB’s role was to act as overseer of the SROs, ensuring that the standards of regulation they applied met the minimum requirements set out in the Financial Services Act. The SRO system, and the advent of statute-based regulation more generally, represented a major cultural change for the City of London. Partly for that reason it produced a backlash from the industry against what was portrayed as heavy-handed and rule-book-based regulation. However, dissatisfaction with the regulatory regime ran deeper than mere aversion to bureaucratic intrusion in accepted market practices. The new system was widely perceived to result in excessive regulatory duplication and overlap. Its inherent complexity was only part of the problem. In parallel to the creation of the new regulatory framework the British government had embarked on a major programme of structural deregulation, commencing with the ‘Big Bang’ reforms to the Stock Exchange in 1986. Structural deregulation in turn permitted the formation of diversified financial conglomerate groups in which banking, securities trading, capital

14 See the account given by David F. Lomax, London Markets After the Financial Services Act (1987), London: Butterworth.

Regulatory reform after the financial crisis

17

markets and insurance activities could be combined. At the point that these financial groups were coming into existence they found themselves caught within the newly formed network of regulatory agencies that had been designed for fragmented and compartmentalized City markets. For diversified financial groups that could potentially include a bank, securities firm, investment manager and a life insurance company, as many as seven different regulatory agencies might be involved in overseeing the group’s various components, making a comprehensive perspective on its activities almost impossible to achieve and posing a formidable coordination challenge. Discontent from the point of view of the industry was matched by public disquiet over a number of alleged regulatory failures. The collapse of banks like BCCI and Barings was mirrored in the investments field: in the early 1990s it became apparent that thousands of customers had been mis-sold personal pensions as the result of commission-hungry salespeople ignoring their obligation under the Financial Services Act to offer only ‘suitable’ products to potential clients. They persuaded a significant number of workers, mainly from the public sector, to switch from final salary occupational schemes to private pensions that, depending on the actuarial assumptions used, would render them significantly worse off in retirement. Such episodes gave rise to a growing sense that the existing regulatory system was not delivering either the high standards of consumer protection or of prudential regulation that it had been designed to deliver. The original Twin Peaks proposal was advanced against this background. Although the perception that the regulatory system was failing ensured that the proposal was widely debated, the concept itself was anchored in an analysis of the changing nature of the financial industry. At its core was the observation that structural deregulation had made obsolete traditional institutionally and functionally based systems of regulation. Not only had the emergence of financial conglomerates created problems of obtaining a group-wide perspective on their safety and soundness, but increasingly financial products seemed to cross traditional distinctions between deposits, securities and insurance. This trend raised awkward questions about which set of consumer protection rules should be applied to some of these new products – for example, when a bank offered deposit products the rate of return on which was linked to the performance of a stock market index. A combination of regulatory change and product innovation had blurred the old demarcation lines between institutions, products and markets. The phrase ‘blurring the boundaries’ was picked up and used in the May 1997 speech to the House of Commons in which Chancellor of the Exchequer, Gordon Brown, announced the intention to create what was to become the Financial Services Authority. An associated claim advanced in Twin Peaks was that the concept of systemic risk had undergone a significant change as a result of these

18

M.W. Taylor

developments. Traditionally banks were seen as the only potential source of systemic risk owing to the maturity transformation in which they engage; this vulnerability was used to justify the supervisory role of the central bank which was accepted practice in many parts of the world. However, in Twin Peaks I argued that the emergence of new financial markets and products had changed the interconnections between financial intermediaries in unanticipated ways. For example, the markets for OTC derivatives – including the market for credit default swaps (CDS) which was then only in its infancy – meant that many different types of firm were now interconnected in the sense that they were exposed to the risk of a default by one counterparty triggering a chain of defaults throughout the financial network. The Twin Peaks proposals contended that the concept of systemic risk needed to be revised in the light of these developments and that a broader array of financial intermediaries were now potentially the source of systemic risk. Finally, the case for a Twin Peaks structure was constructed around the need for greater efficiency in the use of regulatory resources. The proliferation of SROs and other regulatory bodies had created what I described as a ‘Balkanized’ system in which relatively small agencies were obliged to develop their own costly support infrastructures. Where human capital was scarce – such as in the skills needed to review risk management models which were then coming into widespread use and receiving supervisory acceptance – multiple agencies were frequently competing to recruit from the same limited pool of candidates. Reducing the number of regulatory agencies would improve the efficiency with which scarce resources could be deployed as well as creating the conditions for the emergence of a cadre of regulatory professionals.

1.4 The Twin Peaks structure The analysis outlined above pointed to the need to consolidate what Twin Peaks referred to as an ‘alphabet soup’ of regulatory agencies. However, some new principle of organization was required to underpin this process of consolidation given that institutionally and functionally based structures had been outmoded by industry change and product innovation. In response Twin Peaks proposed a radically new regulatory structure organized around two main objectives or purposes of financial regulation – the maintenance of financial stability and the protection of consumers. Subsequent commentators referred to this as an ‘objectives-based’ model of regulatory structure.15

15 Notably the Australian Financial System Inquiry Final Report March 1997, available at http://fsi.treasury.gov.au/content/FinalReport.asp.

Regulatory reform after the financial crisis

19

The eponymous ‘Twin Peaks’ envisaged in the paper were thus two regulatory agencies focused on different objectives of regulation. One agency would be responsible for the prudential regulation of all systemically important financial firms, while the other agency would be responsible for consumer protection irrespective of the nature of the financial products being sold. The proposed structure had the virtue of simplicity, but it raised at least three fundamental issues. The first concerned the exact role and responsibilities of the agency charged with maintaining financial stability (referred to in Twin Peaks as the Financial Stability Commission (FSC)). Twin Peaks was ambiguous as to whether the FSC should be responsible for the prudential regulation of all firms, or only those deemed ‘systemically important’. If only the latter came within the purview of the FSC, a legally sound definition of systemic importance would be required. Moreover, Twin Peaks assumed that financial system stability was best secured by ensuring the financial soundness of individual firms within the system. Although in line with the general assumptions of the time, the crisis has demonstrated that this analysis fails to take into account systemic risks that may not be apparent from the balance sheets of individual firms. The second issue concerned the relationship between the FSC and the central bank. The lender of last resort issue mentioned above implied that this relationship would need to be a close one, and there was no reason in principle why the FSC might not be established as a subsidiary of the central bank.16 The senior management of the Bank of England might have made this case in the debate that took place in the run-up to the 1997 UK General Election but instead chose to try to defend the status quo, with the Bank retaining its role as bank supervisor. In retrospect this was a lost opportunity. Nonetheless, even had the Bank tried to make a positive case for bringing the FSC under its wing, there was no guarantee that it would have received a sympathetic hearing: a succession of regulatory failures had tarnished its reputation and it was unlikely that a case for it having enhanced regulatory powers would have enjoyed much political support in the period 1996–97. Finally, it could be asked why regulatory consolidation should stop at two agencies: would it not be more efficient simply to combine all regulatory activities within a single unified agency? Given subsequent developments it was ironic that many practitioners (both in the industry and in regulatory bodies) had argued that the Twin Peaks proposals were excessively radical and carried agency consolidation too far. Few anticipated that the outcome of the UK’s debate on regulatory structure would be a single regulatory agency on the FSA model. Nonetheless, Twin Peaks did briefly discuss the option of a single mega-regulator, arguing that the financial stability and consumer protection roles required fundamentally

16 This was indeed proposed in my subsequent 2009 paper Twin Peaks Revisited.

20

M.W. Taylor

different skills and cultures which it would be difficult to combine within a single agency. The two objectives would also come into conflict and where they did so it was better they should be resolved at a political level rather than internally within a regulatory agency. An additional problem was that a unified agency could become, in the words of Twin Peaks, a ‘bureaucratic leviathan’.17 After the decision to create the FSA was made, I elaborated on the arguments against a single unified regulator in a short pamphlet entitled Regulatory Leviathan: Will Super-SIB Work?18 This re-emphasized the difficulties of combining financial stability and consumer protection mandates within the same organization and added that management overstretch could arise owing to the very wide range of functions the new single regulator was being asked to assume. As the title of the pamphlet also indicates, a major strand of the case against a single regulator was the excessive concentration of power it represented, although in retrospect this concern was misplaced. The FSA’s regulatory philosophy for most of the years of its existence was to apply a ‘light touch’ regime that delegated many supervisory tasks to firms’ internal risk management systems within a framework of general principles. It was a regulatory approach that meant that the FSA never made full use of the significant powers that it could have potentially exercised.

1.5 Four lessons from the financial crisis The Global Financial Crisis that began in 2007 has led to a re-evaluation of the relative merits of the single unified regulatory agency and a Twin Peaks structure. In particular, the UK experience provided a case study in the operation of a single financial regulatory agency both in the run-up to and during a financial crisis. More broadly, however, it is possible to draw four lessons for the design of a regulatory regime. 1.5.1 Lesson 1: The Twin Peaks analysis was correct As noted above, a central feature of the Twin Peaks analysis was that the nature of systemic risk had been changed by developments in financial markets. Twin Peaks further argued that ‘[a]s the once-clear demarcation lines between types of financial markets and institutions are broken down,

17 This argument was also used against the FSA by Martin McElwee and Andrew Tyrie MP, Leviathan at Large: The New Regulator for the Financial Markets, Centre for Policy Studies (2000) available at www.andrewtyrie.com/upload/Leviathan%20at%20large.pdf (arguing ‘the FSA will be the most powerful, and one of the least accountable, institutions created in the United Kingdom since the War. It will be, in many respects, legislator, investigator, prosecutor, judge, jury and executioner’). 18 Michael W. Taylor, Regulatory Leviathan – Will Super-SIB Work? (1997), London: CTA Financial Publishing.

Regulatory reform after the financial crisis

21

19

the Bank’s role appears increasingly anomalous’. In other words, owing to the changing nature of the financial system, banks could no longer be considered the unique source of systemic risk that traditionalists insisted that they remain. In consequence of these developments, it became increasingly difficult to argue that banks were ‘special’ in the sense that they were uniquely, systemically important. Many large non-banks were now ‘too interconnected to fail’, a phrase that was coined when Bear Stearns teetered on the brink of insolvency in March 2008. On the traditional view, Bear Stearns would not have been considered systemically important; however, the episode confirmed the argument of Twin Peaks that ‘the rise of the OTC markets means that we must extend our concept of what constitutes a systemically important firm’. In consequence it was no longer possible to focus exclusively on banks as the only potentially systemically important firms. This premise was widely challenged at the time, especially by the senior management of the Bank of England who continued to insist that banks alone were systemically important – and should be regulated separately by the central bank. By contrast, the financial crisis has shown that a wide range of financial firms can become systemically important: during the initial stages of the crisis the chain of collapse ran through non-bank financial intermediaries such as securities firms (Bear Stearns, Lehman Brothers), an insurer (AIG) and mortgage securitization companies (Fannie Mae and Freddie Mac). In addition, the Reserve Primary Fund, a money market mutual fund, was unable to meet its commitment to pay its investors at par, necessitating the intervention of the Federal Reserve to support the commercial paper market. The commercial banking sector was also seriously affected by events, but at several firms problems were compounded by difficulties at non-bank affiliates, such as the Structured Investment Vehicles (SIVs or ‘conduits’) sponsored by Citibank. The traditional view that only banks needed to be supervised from a systemic risk perspective has been shown to be inadequate in a twenty-first century financial system. 1.5.2 Lesson 2: Prudential and consumer protection regulation don’t mix Although I had argued at the time the FSA was established that combining prudential and consumer protection regulation in the same agency was likely to be problematic, this analysis was far from widely accepted at the time. However, the evidence of the FSA’s performance before the crisis suggests that it did struggle to keep the prudential and consumer protection roles in balance. One consequence of the FSA’s consumer protection focus was that the financial stability objective did not receive the attention that it either warranted or deserved.

19 Twin Peaks, pp. 13–14.

22

M.W. Taylor

The FSA’s defenders justified the combination of prudential and conduct of business regulation within a single agency on the grounds that there were substantial synergies between the two forms of regulation. Since, in practice, prudential and conduct of business regulation require examination of very similar issues, there would be significant overlap between the Twin Peaks agencies. Briault put the point with characteristic clarity: [T]here is a considerable overlap – both conceptually and in practice – between prudential and conduct of business regulation. Both have a close and legitimate interest in the senior management of any financial institution subject to both of these types of regulation, in particular because of the crucial roles of senior management in setting the ‘compliance culture’ of a firm, in ensuring that management responsibilities are properly allocated and cover comprehensively the business of the firm, and in ensuring that other internal systems and controls are in place. The detail of some of these systems and controls may indeed be specific to either prudential or conduct of business considerations, but many of them will be more general.20 In short, a single regulator was superior to a Twin Peaks structure because many of the same supervisory judgments would arise in considering prudential and sales practice regulation. There seemed little point in having two regulators reaching essentially duplicate judgments of broadly similar matters. Since there is substantial overlap between the two regulatory objectives and, in practice, prudential and conduct of business regulation focus on the same fundamental issues, they are best administered by a single regulatory agency. The financial industry also strongly welcomed the creation of a single regulator, seeing it as an antidote to the duplication and overlap that had existed under the previous system. Nonetheless, the crisis has put a different complexion on these arguments. The British government’s White Paper on regulatory reform after the crisis concluded that the FSA had placed too much weight on ‘ensuring that systems and processes were correctly defined rather than on challenging business models and strategies’ and on ‘conduct of business regulation of the banking sector rather than prudential regulation of banking institutions’.21 Even the FSA’s senior management acknowledged that the agency neglected prudential supervision. In the words of the report on the banking crisis produced by the FSA’s then chairman, Lord Turner, the agency’s regulatory practices resulted in ‘[a] balance between 20 Clive Briault, The Rationale for a Single National Financial Services Regulator 6 (Fin. Servs. Auth., Occasional Paper No. 2, 1999), available at www.fsa.gov.uk/pubs/occpapers/OP02. pdf. 21 HM Treasury, Reforming Financial Markets, 2009, Cm. 7667, at 56.

Regulatory reform after the financial crisis

23

conduct of business and prudential regulation which, with the benefit of hindsight, now appears biased towards the former’. Turner repeated this admission to a committee of the British House of Lords which referred in its final report to the ‘widely held perception that, in recent years, the FSA has emphasized conduct-of-business supervision at the expense of prudential supervision’.22 This situation was especially apparent in the FSA’s supervision of the mortgage bank Northern Rock which was the first British casualty of the crisis. The bank had received numerous contacts from the FSA concerning a consumer protection initiative (‘treating customers fairly’), but supervision of capital and liquidity had been deficient and the bank had been placed in a category that subjected it to one major prudential meeting once every three years. The FSA’s own report on Northern Rock stated that ‘some of the fundamentals of work on assessing risks in firms (notably some of the core elements related to prudential supervision, such as liquidity) have been squeezed out’.23 The reasons for the FSA’s relative lack of attention to prudential issues were discussed by the House of Lords Select Committee on Economic Affairs which offered the following explanation: There is also a cultural difference between conduct-of business and prudential supervision. Conduct-of business supervision is often performed by lawyers. Prudential supervision is largely an economic activity, particularly at the macro level. It seems likely that either a lawyerly or an economic approach would dominate in a supervisory body that performed both prudential and conduct of business supervision, and that this dominance would reduce the effectiveness of the dominated half of the organisation.24 In a single agency, the function that receives the greatest emphasis will be that having the greatest political saliency: this means that in normal times, when bank failures are rare, consumer protection regulation is likely to be the main focus of agency attention. The FSA’s consumer protection focus was compounded by the fact that the primary justification for the 1997 reforms was as a reaction to perceived regulatory failures in consumer protection, especially the pensions mis-selling episode which had adversely affected a core Labour Party constituency. The overarching desire on the part of the FSA’s architects was to establish a strong consumer protection regulator that would be independent of the industry. Thus given the FSA’s

22 Banking Supervision and Regulation, Select Comm. on Econ. Affairs, H.L. 101-I, 33 (2008–09), available at www.publications.parliament.uk/pa/ld200809/ldselect/ ldeconaf/101/101i.pdf. 23 FSA Internal Audit Division, The Supervision of Northern Rock: A Lessons Learned Review (March 2008), available at www.fsa.gov.uk/pubs/other/nr_report.pdf. 24 Banking Supervision and Regulation, Select Comm. on Econ. Affairs, H.L. supra note 20.

24

M.W. Taylor

genesis it was perhaps inevitable that consumer protection regulation should have received far more attention pre-crisis than did prudential regulation. In the immediate aftermath of the crisis the FSA greatly increased the resources it devoted to prudential regulation, but the above analysis suggests that it would have been destined to be a short-term fix, destined to remain in place only as long as political attention was focused on the fallout from the crisis. In the absence of more fundamental reform to the institutional structure of regulation, the incentives that had led the FSA to focus on consumer protection issues to the detriment of prudential regulation would have reasserted themselves. A Twin Peaks structure is superior to a single regulator because the incentives that it creates are such that the two objectives of regulation – financial stability and consumer protection – will be given their due weight, without one needing to subsume the other. 1.5.3 Lesson 3: Macro-prudential surveillance and crisis management need to be part of the institutional structure of regulation In addition to traditional prudential regulation, with its focus on individual firms, the crisis has given greater prominence to what has come to be termed ‘macro-prudential’ regulation which focuses on system-wide risks which might not become apparent from an individual firm perspective. As the financial crisis has made clear, ensuring the soundness of individual firms is a necessary, but not sufficient condition for ensuring financial stability. Firms might look to be well capitalized, but they can be exposed to common shocks – such as a sharp decline in real estate prices – which would threaten the solvency of the system as a whole. Moreover, in a highly interconnected financial system the risk of contagion spreading from one institution to others, or from one market to another, is correspondingly much higher than in the past. An example might be price declines in one type of financial asset triggering declines in the value of other financial asset as when margin calls in the derivatives markets during the crisis led to the liquidation of positions in securities to raise the needed collateral. The result can be cascading losses throughout the financial system. Finally, firms can make similar assumptions about the liquidity of certain types of financial asset, yet such assumptions may be unjustified if all firms are seeking to act on them at the same time. Many of these lessons were learned as the result of hard experience during the crisis. The macro-prudential perspective is a relatively recent innovation. When the UK carried out its reforms in 1997 prudential regulation was still largely conceptualized in terms of ensuring the soundness of individual institutions, and little attention was given to the possibility that this approach might fail to capture certain types of system-wide risks or to the

Regulatory reform after the financial crisis

25

policy tools necessary to mitigate them. Thus, in one respect the UK’s post-1997 arrangements reflected the fact that what is now called the macro-prudential perspective had not then gained the prominence that it now enjoys. In the aftermath of the global financial crisis the need for a macro-prudential approach had become abundantly obvious. Thus, as well as establishing a Twin Peaks regulatory structure for the purposes of ‘micro-prudential’ regulation, the reforms that took effect in April 2013 also attempted to insert an element of macro-prudential regulation into the UK’s regulatory system.25 The UK’s recent regulatory reforms have created a Financial Policy Committee of the Bank of England modelled on the Monetary Policy Committee that was established in 1997 to set interest rates. Like the MPC the FPC contains a number of external members in addition to senior Bank of England officials in an effort to avoid the emergence of ‘groupthink’ and to provide a series of independent perspectives. As well as being responsible for detecting emerging threats to financial stability the FPC can also issue directions to the Twin Peaks authorities – the PRA and the FCA – to apply a range of macro-prudential tools to address these emerging vulnerabilities. Among the instruments that have been added to the new macro-prudential toolkit are capital requirements that vary according to the state of the economic cycle and targeted adjustments to the risk weighting applied to certain assets (for example loans to commercial property or mortgage loans).26 Although macro-prudential in purpose many of these instruments apply at the level of individual institutions. The addition of a macro-prudential dimension to the supervisory system raised issues of institutional structure, in particular how best to coordinate the application of policies at both a system-wide and individual institution level. An IMF working paper that examined the range of possible institutional arrangements concluded that a ‘Twin Peaks’ structure with a close relationship between the central bank and the prudential regulator would be the most efficient arrangement for managing the relationship between micro- and macro-prudential regulation.27 Hence the new structure of regulation in the UK is aligned with an emerging trend which has emphasized the importance of the macro-prudential dimension to policy being well-coordinated between the prudential regulator and the central bank. To this extent, there is some overlap between the new structure and a 25 Sir James Sassoon, ‘Britain deserves better financial regulation’, Financial Times (8 March 2009), available at www.ft.com/intl/cms/s/0/3decd86c-0c13–11de-b87d-0000779fd2ac. html#axzz2TSV3T3uD. 26 Bank of England, Instruments of Macroprudential Policy (20 December 2011) available at www.bankofengland.co.uk/publications/Documents/other/financialstability/discussionpaper111220.pdf. 27 Erlend Walter Nier, Financial Stability Frameworks and the Role of Central Banks: Lessons from the Crisis (Int’l. Monetary Fund, Working Paper No. 09/70), available at www.imf.org/ external/pubs/ft/wp/2009/wp0970.pdf.

26

M.W. Taylor

more traditionalist view which had emphasized that the central bank, in its capacity as lender of last resort (LLR), needed access to information about the financial condition of specific banks and hence (at least in some versions of the argument) needed also to be the prudential regulator.28 Another dimension of financial stability that was comparatively neglected in the post-1997 arrangements related to crisis management. For at least two decades prior to the formation of the FSA, the UK had not experienced any episodes of serious financial distress. This may have bred a certain degree of complacency about the need for adequate crisis management preparedness and planning. Although the Memorandum of Understanding was drawn up between the Treasury, Bank of England, and FSA, the arrangements envisaged were rarely tried in practice and the Joint Crisis Management Committee rarely met.29 The arrangements also assumed that the Treasury would be the glue that held this system together, thus involving it in the minutiae of crisis management decisionmaking – a role that it was ill-equipped to perform and one that hampered the ability to reach quick decisions in an environment where time was of the essence. 1.5.4 Lesson 4: Structures do not prevent financial crises The final lesson is that although the structure of regulation is not unimportant, it is also unlikely to prevent the occurrence of financial crises. The significance of the topic of regulatory structure has to be kept in perspective. This is not to suggest that the Twin Peaks alternative might have avoided some of the design flaws of the UK’s post-1997 arrangements. In particular, given the incentives created by a Twin Peaks structure, it is difficult to believe that a specialist prudential regulator would have neglected its role in ensuring the financial soundness of firms to the extent that the FSA apparently did. In addition, it might have established a clearer hierarchy for crisis management. The Treasury’s role, noted above, was essential to hold the ring and to ensure a cooperative relationship between the two agencies because the Bank and the FSA were assigned equal status in the Tripartite arrangements. By contrast, a specialist prudential regulator might have been established more clearly under the Bank of England’s wing, and as a result could have enjoyed much closer links with the central bank than did the FSA. There are a variety of precedents for this possible

28 For an example of how the Bank of England’s then Deputy Governor Howard Davies understood the justification, see Howard Davies, ‘Financial Regulation: Why, How and By Whom?’, Bank of Eng. Q. Bull. 107, 111 (1997). 29 Gordon Brown et al., Memorandum of Understanding Between HM Treasury, the Bank of England and the Financial Services Authority 4–5 (2009), available at www.bankofengland. co.uk/financialstability/mou.pdf.

Regulatory reform after the financial crisis

27

arrangement: the relationship between the Bank of France and the Authorité de côntrole prudentiel (ACP), or between the Finnish Central Bank and that country’s Financial Supervision Agency could have been potential models. In these structures, although the regulatory agencies are governed by boards separate from those of the central bank, their staff are central bank employees and extensive use is made of shared facilities, information technology platforms and databases. The UK’s April 2013 arrangements largely reflect a similar arrangement between the Bank of England and the PRA. At the same time, however, it must be recognized that the financial crisis has been no respecter of regulatory structures. Although Australia escaped relatively unscathed from the financial crisis, the Netherlands experienced problems with several of its largest banks and required substantial amounts of public funds to bail them out. Regulation failed to prevent the financial crisis whether there were multiple agencies (as in the US) or one (as in the UK); its latest phase has been especially acute in Europe where a number of different models have been adopted, including several variations of Twin Peaks.

1.6 Conclusion The return to favour of the Twin Peaks model in the UK has been the product of hard experience during the financial crisis. The model of a single financial regulator still remains appropriate in some circumstances, such as in countries with small financial systems where there is the need to maximize the efficiency with which scarce regulatory resources can be employed. These considerations were influential in the Scandinavian countries that pioneered the single regulator model.30 However, beyond this limiting case other factors become more important than the search for efficiency in regulatory resources. As this chapter has argued there is a fundamental difference between the prudential and consumer protection objectives of regulation that results in them sitting uncomfortably together in a single agency. One consequence of having a single agency to discharge both objectives is that one of them will be comparatively neglected, and there is good reason for thinking that the loser will be prudential regulation except in the immediate aftermath of a crisis. By contrast, as the UK government has now recognized, the incentives created by the Twin Peaks structure ensures that the public authorities will have to hold these objectives in balance. To this extent the reasoning behind the original proposal of a Twin Peaks structure has been vindicated by events. Nonetheless, as also noted in this chapter, the importance of the institutional structures of regulation should not be overstated. In the first 30 See Michael Taylor and Alex Fleming, ‘Integrated Financial Supervision: Lessons from Northern European Experience’ (Policy Research Working Paper No. 2223, 1999), Washington: World Bank.

28

M.W. Taylor

place, effective supervision depends on several factors such as the adequacy of resources and powers and the comprehensiveness of coverage to which issues of structure are mainly secondary. In addition, as noted above, the financial crisis has been no respecter of regulatory structures. The pre-Twin Peaks neglect of questions of regulatory structure was unjustified and there is a case to be made that structures can make an important difference at the margin. But it would be misguided to expect them to make up for inadequacies of resources or effective powers (including the willingness of regulators to exercise the powers that they have). There is only so much that a good regulatory structure can deliver.

2

Financial stability and proper business conduct Can supervisory structure help to achieve these objectives? Dirk Schoenmaker and Jeroen Kremers1

2.1 Introduction The financial crisis occurring since 2007 has raised profound issues around the organization and implementation of financial sector supervision. The crisis is still ongoing, nevertheless experiences thus far already offer some insights especially for developed Western economies where the crisis hit hard and deep. Across these countries, all sorts of incidents in the realm of financial supervision have been observed: failings of small and large financial institutions; entire financial systems grinding to a halt and even coming to the edge of collapse; miss-selling and customer abuse by banks, insurers and other firms; profound questions about the business model of many financial firms going forward. There is no single factor that can explain the breakdown of the functioning of these markets and of public policy for the financial sector, and no single golden bullet to repair what has gone wrong. A more fundamental rethink of this policy is needed, as well as of its implementation in practice. This chapter looks at whether the structure of financial supervision may help to improve policy performance and to promote the objectives of financial stability and proper business conduct. No single model in any specific country seems to have delivered superior outcomes. Both the UK with its integrated FSA model and the Netherlands with its objectives-based Twin Peaks model have suffered significant failures of supervisory performance. Thus, to learn from the crisis experience we need to take a

1 Jeroen Kremers and Dirk Schoenmaker in the Netherlands Treasury were responsible for financial regulatory reform introducing the Dutch Twin Peaks model in 2002. Since then they moved on to the IMF and then RBS and to the Duisenberg School of Finance, respectively. Jeroen Kremers is now Managing Board Member of RBS N.V. and Head of global country risk exposure for RBS Group. Dirk Schoenmaker is Dean of the Duisenberg School of Finance, Amsterdam, and Professor of Finance, Banking and Insurance at the VU University Amsterdam. This chapter reflects the authors’ personal views.

30

D. Schoenmaker and J. Kremers

more in-depth look at advantages and disadvantages of possible approaches to the structure of financial supervision. This chapter focuses on the objectives-based so-called Twin Peaks approach, which distinguishes between two key objectives of financial supervision namely financial stability and proper conduct of business and assigns a separate supervisor to each of these two objectives.

2.2 Supervisory objectives and structure The analytical background of the objectives-based supervisory structure is briefly reviewed. Four distinct objectives can be observed for the broader monetary and financial system: monetary (price) stability, financial system stability (macro-prudential), soundness of individual financial institutions (microprudential) and orderly and well-functioning markets and fair treatment of consumers (conduct of business).2 Kremers et al. (2003) and Herring and Carmassi (2008) provide a general overview of supervisory objectives and compare different supervisory structures. 2.2.1 Policy framework Tinbergen, the first winner of the Nobel Prize for economics, argued that you need at least one policy instrument for each different policy objective. In practice, the various policy tools and objectives are interrelated. An appropriate institutional structure should obtain the main synergies between the objectives and allow for an orderly and transparent resolution of the main conflicts. So, the challenge is to combine objectives within an authority where synergies dominate and to assign objectives to different authorities where conflicts dominate. Figure 2.1 illustrates the policy framework for the monetary and financial system. To keep it simple, each policy has a primary impact on its direct objective and a secondary impact on the objective(s) next to it. The solid lines in Figure 2.1 illustrate the primary impact and the dotted lines the secondary impact. Discussions about supervisory structure often assume that these four policy areas can all be separated, and that instruments used to promote one objective do not undermine the other. Until recently, the prevalent approach to financial stability assumed that the system as a whole can be made safe by making individual financial institutions safe. But this is 2 A fifth objective, that of competition policy, is not discussed here. While competition policy for the financial sector used to be part of the work domain of financial supervisors in several countries up to the 1990s, in most countries it has been upgraded to a generic policy applying to all economic sectors, including the financial sector, and executed by the competition authorities.

Financial stability and business conduct Policy

Objective

Monetary policy

Price stability

31

Ultimate goal (level of impact)

Stable economic growth (economic system) Macro-prudential

Financial stability

Macro-prudential

Soundness of financial institutions Protection of consumers (individual institutions)

Conduct of business

Orderly markets and fair treatment of consumers

Figure 2.1 Policy framework (source: Kremers and Schoenmaker, 2010).

wrong. As indicated below, this represents a fallacy of composition. It is more appropriate to think in terms of a hierarchy of objectives (Kremers and Schoenmaker, 2010). The first two objectives, price and financial stability, are equally important and affect the economy at large. The latter two objectives, sound financial institutions and orderly markets/fair treatment, are also equally important. These are addressed at the level of individual financial institutions and aim to protect individual consumers. The first two objectives aimed at the ‘system’ are more important than the latter two objectives aimed at ‘individuals’, for the simple reason that when the system goes down its individual components will go down as well. Moreover, the stability of the financial system for the wider economy is more important than the soundness of its individual components. In a market-driven economy, firms – including financial firms – should be allowed to fail to contain moral hazard (if there is a systemic threat, the firm should be resolved in an orderly fashion). The fallacy of composition (Brunnermeier et al., 2009) concerns the idea, fundamentally at the basis of original Basel banking supervision, that to safeguard the system it suffices to safeguard the components. But in trying to make themselves safer, financial firms can (be made to) behave in a way that collectively undermines the system. Selling an asset when the

32

D. Schoenmaker and J. Kremers

price of risk increases, may be a prudent response from the perspective of an individual bank. However, if many banks act in this way, the asset price will collapse, forcing firms to take yet further steps to rectify the situation. The responses of the banks themselves to such pressures lead to generalized declines in asset prices, and enhanced correlations and instability in asset markets. The micro policies can thus be destructive at the macro level. Macro- and micro-prudential policies have distinct objectives and therefore distinct perspectives (Borio, 2003). Table 2.1 summarizes the differing perspectives, which are intentionally stylized. They are intended to highlight two orientations that inevitably coexist in current prudential frameworks. 2.2.2 Hierarchy of objectives The distinct policy objectives, in terms of Tinbergen, raise two issues. First, it is important to take into account the impact of one area’s instrument not only on that area’s own objective, but also on the objectives of the other areas. Being aware of such cross-effects may lead to a choice and use of instrument that is less damaging to other areas, and thus to better overall results. Second, it may not always be possible in this way to avoid conflict of objectives. In that case it is unavoidable to define a hierarchy of objectives. In such situations, the macro-prudential concerns should clearly override the micro-prudential concerns. Figure 2.2 depicts the proposed hierarchy of objectives. The override should be reversible to prevent forbearance. When a negative stock market shock happens, for example, Table 2.1 The macro- and micro-prudential perspectives contrasted Macro-prudential

Micro-prudential

Policy objective

Limit financial systemwide distress

Limit distress of individual firms

Ultimate goal

Avoid output (GDP) costs Consumer (depositor/ linked to financial investor/policyholder) instability protection

Characterisation of risk

Dependent on collective behaviour; endogenous

Independent of individual agents’ behaviour; exogenous

Correlations and common exposures across firms

Important

Irrelevant

Calibration of prudential controls

In terms of system-wide risk; top-down

In terms of firm risks; bottom-up

Source: Borio (2003).

Financial stability and business conduct Level

Economy

Individual institutions

33

Objectives

Monetary stability

Financial stability: macro-prudential

Financial soundness: micro-prudential

Conduct of business

Figure 2.2 Hierarchy of objectives (source: Kremers and Schoenmaker, 2010).

capital adequacy rules may be temporarily lifted to avoid fire sales. But there must be a clear exit. Otherwise problems may scale up and become worse. Underpinning the case for Twin Peaks, if conduct of business and micro-prudential can be separated in practice, no hierarchy between the two is needed and each objective can best be served by a separate supervisor. For sure, conduct of business ought not to be dominated by microprudential – a bank with a consumer-unfriendly business model should be allowed to disappear from the market. When positioned within a single supervisory entity, one objective may come to unduly dominate the other. In a single supervisor outside the central bank, the conduct of business objective may dominate in practice (Taylor, 2009). In a single supervisor setting within the central bank, the macro-prudential objective may dominate (Kremers et al., 2003). In the first setting, lawyers set the dominant culture; in the second, economists are dominant (Goodhart et al., 2002). With separate conduct of business and prudential supervisors, both can be optimized with the distinctive profiles that each of the two require. By contrast, macro-prudential cannot easily be separated from microprudential and indeed the former must be dominant, suggesting the benefit of an institutional setting where macro-prudential can drive microprudential. Conduct of business can thus be seen as a separate objective with its own supervisor and its own instruments. But where does that leave us regarding the relation between monetary policy with price stability as its objective and the interest rate as its traditional instrument on the one hand, and macro-prudential supervision with financial system stability as its objective and with instruments which are highly complementary to micro-prudential instruments (capital and liquidity requirements, etc.) on the other? We believe the crisis has shown that this is not simply a matter of two separate objectives each with its own separable instrument, but rather of an interrelation involving two objectives (price stability, financial stability) and two instruments (interest rate, prudential toolkit).

34

D. Schoenmaker and J. Kremers

2.2.3 Interaction monetary and financial stability objectives This brings us into uncharted territory, where monetary policy must systematically take into account its consequences not just for price stability but also for financial stability, and macro-prudential supervision must systematically serve not only financial stability but also help avoid bubbleinduced inflation (see e.g. Brunnermeier (2010) and Soros (2010) for some early thoughts). Financial crises such as that in Asia and the 2007–2009 global crisis have made abundantly clear that narrow monetary policy à-la-Greenspan must be replaced by a new monetary policy approach encompassing macro-prudential concerns and hence relying, next to the interest rate, also on the instruments of macro- and microprudential supervision (Schoenmaker, 2013a). In terms of the organization of supervision, this points to a need for a close relationship between the monetary authority and the macro- and micro-prudential supervisor. Macro-prudential instruments are still being developed (Schoenmaker and Wierts, 2011; Houben et al., 2012). On the capital front, one can think of an anti-cyclical capital add-on for macro-prudential reasons and a minimum capital requirement based on micro-considerations. Similarly, a liquidity risk charge to influence short-term funding is suggested by Perotti and Suarez (2010). More broadly, a quarterly or semi-annual review of the financial system can be seen as a macro-prudential instrument, publishing newly collated data relevant for fostering macroprudential stability (e.g. on system-wide or sub-sector exposures that are deemed vulnerable). Several emerging market countries inter alia in Asia have been proactive in the development and use of macro-prudential instruments, and apparently successfully so. A good example is the active use of loan to value (LTV) ratios to constrain asset price booms. LTV policy has been in effect for nearly 20 years in Hong Kong. Also the central banks in China, South Korea, Malaysia, Singapore and Thailand have lowered the LTV ratio to curb the build-up of housing price bubbles (Oh, 2013). But as house prices (that is Values in the LTV ratio) are rising rapidly, the LTV ratio may not be sufficient to prevent a housing bubble. The LTV ratio could usefully be complemented with a loan to income (LTI) or debt to income (DTI) ratio, which constrains the debt servicing capacity of household incomes. Europe and the US have yet to start an active use of LTV (and LTI) ratios in a time-varying manner. The lesson of Asia is that central banks can combine monetary and financial stability objectives by a powerful combination of a general use of the interest rate instrument for the economy as a whole and a targeted use of the LTV ratio (targeted at a particular sector, such as housing).

Financial stability and business conduct

35

2.3 Conduct of business: a focused approach In the objectives-based structure of financial supervision, the objective of proper business conduct can be pursued by a single dedicated supervisor. This makes possible a focused approach with clear external accountability for this single objective and defining a level playing field cross-sector across all financial firms. The skills set of this supervisor will tend toward a legal profile, its culture toward a proactive investigative stance. An example of a typical conduct supervisor with a long track record is the US SEC, although not covering the full breadth of financial firms and the full breadth of conduct of business. The Netherlands AFM, following the introduction of the Twin Peaks model ten years ago, developed into a typical conduct supervisor covering all financial firms cross sector and the full breadth of the conduct supervision field. In the Netherlands’ experience, it has proven to be quite feasible in practice to separate conduct supervision from prudential supervision. This has offered a solid basis for the AFM that has acquired a clear profile and a convincing role in the supervisory landscape.3 For example, in dealing with the high-profile Dexia share lease mis-selling case (see below), AFM was able to focus on consumer protection while prudential supervisor DNB (the Netherlands central bank) covered the stability of Dexia as a firm. As a result, both of these objectives of financial supervision received full attention rather than one overshadowing the other. The term ‘share lease’ covers a variety of financial products that were popular in the Netherlands from the early 1990s until 2000. Share lease products ranged from relatively simple share investment products combined with credit agreements to complicated derivative products. The common feature of share lease products is that borrowed money is invested in shares at the risk of the private investors (retail clients). When the stock market declined sharply in 2001, the expected return on investments evaporated. Many private investors ended up with large debts. Consequently, thousands of civil claims were brought against financial institutions that had sold share lease products. The private investors argued that they were lured into the share lease agreements under false assumptions (without being told about the risk of a rest debt). As the AFM has a cross-sector orientation, it could act proactively avoiding legal disputes about the nature of these complicated products (is it banking because of the credit agreement, or securities because of the investment part?). Moreover, AFM acted forcefully, after informing DNB about the potential solvency consequences.

3 A broader assessment of experiences with the Dutch model can be found in Kremers and Schoenmaker (2010). For a cross-country assessment of the effectiveness of the Twin Peaks approach, see Cihák and Podpiera (2008).

36

D. Schoenmaker and J. Kremers

2.4 Financial stability: strong role for central bank For micro-prudential supervision, next to the separation from conduct of business for reasons of focus of mission mirroring the considerations above, an additional aspect is its relationship with macro-prudential supervision promoting system stability. In the UK model of the past, micro-prudential within the FSA was integrated with rather than separated from conduct of business, and, conversely, micro-prudential was separate from rather than aligned with macro-prudential covered by the Bank of England. Evaluations have indicated that the failing of Northern Rock bank happened in part due to the fact that within the integrated supervisory setup of the FSA microprudential considerations had been overshadowed by attention for conduct of business. Moreover, the co-ordination between the Bank of England and the FSA did not work smoothly (Buiter, 2007).4 The downfall of RBS and associated cost to the UK government was associated in part with the fact that the FSA had not been tasked with covering its systemic relevance. The new UK approach follows the Netherlands Twin Peaks model, with the FSA being split up and a separate micro-prudential supervisor the Prudential Regulation Authority (PRA) being placed under the umbrella of the Bank of England. In this new setup, the Bank of England and PRA is well placed to drive supervisory innovation there where it matters most in drawing lessons from the financial crisis, namely in the interface between micro- and macro-prudential supervision as well as monetary policy. The PRA works alongside the Financial Conduct Authority (FCA) creating a Twin Peaks structure in the UK. That supervisory structure may help but does not guarantee supervisory pre-eminence is evidenced by the history of DNB as the combined microand macro-prudential supervisor as well as central bank in the Netherlands following the introduction of Twin Peaks in 2002. Having been tasked with this coherent set of responsibilities and moreover cross-sector for all financial firms, DNB was particularly well placed to exploit the synergies between micro- and macro-prudential and to lead the way in innovation in the macro-prudential/monetary interface. However, rather than being at the forefront of supervisory cutting edge, DNB is now associated with the ill-fated split-up of ABN Amro during the onset of the crisis subsequently threatening system stability and resulting in large rescue cost to the Netherlands government. DNB also struggled with micro-prudential failures at other firms. Public investigations of these various cases did not implicate the supervisory Twin Peaks structure, but instead pointed toward a general weakness in enforcement as the underlying factor (De Wit 4 Well before the onset of the financial crisis, Goodhart (2000) raised the implication of crisis management by committee (i.e. central bank, supervisor and treasury).

Financial stability and business conduct

37

Commission, 2010, 2012; Scheltema Commission, 2010). DNB is now in the process of strengthening its enforcement and adopting a more proactive organizational culture.

2.5 Emerging Twin Peaks structure in Europe Moving to Europe, a positive experience drawn from the current crisis is the ECB’s track record preserving price stability in the Eurozone while at the same time maintaining financial system stability by providing Eurozone banks with adequate liquidity. The ECB will also be tasked with the micro-prudential supervision of European banks under the Single Supervisory Mechanism (SSM). Following the UK and French model of creating a separate entity within the central bank for prudential supervision, the ECB will create a Supervisory Board for the supervisory task. As the ECB will be formally responsible for micro-prudential supervision, the ECB’s Governing Council needs to approve the proposed decisions of the Supervisory Board. It is important to separate the macro-prudential task and the microprudential task and make sure the former drives the latter (Schoenmaker, 2013b). Otherwise, we may again be bogged down by the details of individual banks (micro), while losing sight of emerging imbalances in the wider financial system (macro). We propose that the macro-prudential function should be executed by a committee reporting directly to the ECB’s Governing Council, separate from the micro-prudential function of the new Supervisory Board. The Governing Council has then the ability to let macro-prudential concerns prevail over micro-prudential concerns, when there are conflicts between the two (as we suggest in Section 2.2). The European Securities and Markets Authority (ESMA) is the European conduct of business supervisor. ESMA’s mission is to enhance the protection of investors and reinforce stable and well-functioning financial markets in the European Union. As an independent institution ESMA achieves this mission by building a single rule book for EU financial markets and ensuring its consistent application and supervision across the EU. ESMA contributes to the supervision of financial services firms with a pan-European reach, either through direct supervision or through the active co-ordination of national supervisory activity. The direct supervisory tasks of ESMA include the supervision of credit rating agencies. There is thus an emerging Twin Peaks structure in Europe with the ECB on the prudential side and ESMA on the conduct of business side.

2.6 Conclusion Against the background of these analytical considerations and recent experiences, the conclusion is that supervisory structure matters – it is not a panacea but may help or hamper supervisory effectiveness.

38

D. Schoenmaker and J. Kremers

The Twin Peaks structure offers two key potential advantages. First, having a separate supervisor for proper conduct of business can help ascertain that this supervisory objective gets the attention and focus that it deserves. Second, having micro-prudential supervision separate from conduct of business supervision but closely aligned with macro-prudential and monetary policy offers an organizational setup conducive to innovation and effectiveness in this interface where it is most needed in light of the crisis. Fullenkamp and Sharma (2012) in their prize-winning essay about what constitutes good financial supervision emphasize a condition that may seem less tangible but that is no less important: intellectual independence of the supervisory agency. Institutional reform may help provide an enabling environment.

References Borio, C. (2003), ‘Towards a Macroprudential Framework for Financial Supervision and Regulation?’, CESifo Economic Studies 49, 181–215. Brunnermeier, M. (2010), ‘Macroprudential Regulation: Optimizing a Currency Area’, Colloquium in Honor of Lucas Papademos, 20 May, Frankfurt. Brunnermeier, M., A. Crockett, C. Goodhart, A. Persaud and H. Shin (2009), The Fundamental Principles of Financial Regulation, 11th Geneva Report on the World Economy, International Center for Monetary and Banking Studies, Geneva. Buiter, W. (2007), ‘Lessons from the 2007 Financial Crisis’, CEPR Discussion Paper No. 6596. Cihák, M. and R. Podpiera (2008), ‘Integrated Financial Supervision: Which Model?’ North American Journal of Economics and Finance 16, 135–152. De Wit Commission (2010), Parliamentary Investigation Financial System, Part I, The Hague. De Wit Commission (2012), Parliamentary Investigation Financial System, Part II, The Hague. Fullenkamp, C. and S. Sharma (2012), ‘Good Financial Regulation: Changing the Process is Crucial’, 7 February 2012 (winner of the ICFR – Financial Times Research Prize 2011). Goodhart, C. (2000), ‘The Organisational Structure of Banking Supervision’, Special Paper, No. 127, LSE Financial Markets Group, London. Goodhart, C., D. Schoenmaker and P. Dasgupta (2002), ‘The Skill Profile of Central Bankers and Supervisors’, European Finance Review 6, 397–427. Herring, R. and J. Carmassi (2008), ‘The Structure of Cross-Sector Financial Supervision’, Financial Markets, Institutions & Instruments, 17(1), 51–76. Houben, A., R. van der Molen and P. Wierts (2012), ‘Making Macroprudential Policy Operational’, Revue de Stabilité Financière 2012, Banque Centrale de Luxembourg, 12–23. Kremers, J. and D. Schoenmaker (2010), ‘Twin Peaks: Experiences in the Netherlands’, Special Paper, No. 196, LSE Financial Markets Group, London. Kremers, J., D. Schoenmaker and P. Wierts (2003), ‘Cross-Sector Supervision: Which Model?’, in: R. Herring and R. Litan (eds), Brookings-Wharton Papers on Financial Services: 2003, Brookings Institution Press, Washington DC, 225–243.

Financial stability and business conduct

39

Oh, Hwa-Se (2013), ‘Loan-to-Value as Macro-Prudential Policy Tool: Experiences and Lessons of Asian Emerging Markets’, DSF Policy Paper No. 33, Duisenberg School of Finance, Amsterdam. Perotti, E. and J. Suarez (2010), ‘Liquidity Risk Charges as a Primary Macroprudential Tool’, DSF Policy Paper No. 1, Duisenberg School of Finance, Amsterdam. Scheltema Commission (2010), Investigation DSB Bank, The Hague. Schoenmaker, D. (2013a), Governance of International Banking: The Financial Trilemma, Oxford University Press, New York. Schoenmaker, D. (2013b), ‘An Integrated Financial Framework for the Banking Union: Don’t Forget Macro-Prudential Supervision’, European Economy – Economic Papers No. 495, DG ECFIN, Brussels. Schoenmaker, D. and P. Wierts (2011), ‘A Two-Pillar Strategy for Macroprudential Policy’, Central Banking XXII, 55–62. Soros, G. (2010), Keynote Address, IIF Spring Membership Meeting, 10 June, Vienna. Taylor, M. (2009), ‘Twin Peaks Revisited’, Centre for Study of Financial Innovation, London.

3

Rules, discretion and macro-prudential policy* Itai Agur and Sunil Sharma

Periods of financial excess in the private sector are also periods of profit increases for many who will resist giving them up. Intellectually, the idea that the public sector knows better than the collective wisdom of the market will be strongly disputed. Practically, a whole host of lobbyists and enlisted media will be engaged to argue the case that ‘this time is different’. William White (2006)

3.1 Introduction An important lesson of the financial crisis has been that regulation and supervision of the financial system needs a greater macro-prudential orientation. Implicit in this is the realization (rediscovery some would say) that traditional macroeconomic stabilization and micro-prudential policies are not sufficient, because they leave a regulatory gap to be filled. This gap is created by externalities that individual financial actors do not internalize, and by collective behaviour that market mechanisms are ill-equipped to address.1 The result is interdependencies, and individual and collective actions that lead to excessive procyclicality and systemic fragilities. To contain systemic risk or deal with the fallout if it should materialize, countries are designing and putting in place macro-prudential frameworks to take a system-wide view and define suitable policy responses. For regulation to be truly effective it has to be designed with an understanding of the regulatory structure, and the possible interventions by financial and political players that could distort the enforcement of the rules. Taking account of the political economy of regulation is likely to be * Discussions with Jeroen Kremers, Dirk Schoenmaker and Andrew Sheng, and comments on an earlier draft from Burkhard Drees, Connel Fullenkamp, Mangal Goswami, Vanessa Le Leslé, Celine Rochon, Manmohan Singh and staff of the Monetary Authority of Singapore are gratefully acknowledged. The usual disclaimer applies. The views expressed in this paper are those of the authors and do not necessarily represent those of the IMF or IMF policy. 1 See, for instance, Brunnermeier et al. (2009) and French et al. (2010).

Rules, discretion and macro-prudential policy

41

especially important for macro-prudential policy. If authorities find it hard to resist forbearance towards individual institutions, they are likely to face even stronger headwinds in dealing with the financial sector as a whole. The design of a macro-prudential framework should not be just about better ways of measuring risk, forging suitable tools and devising ways of calibrating their use. But also importantly about creating institutional incentives and mechanisms to make sure that when the need arises, the decision makers will have the authority and backbone to actually use the macro-prudential tools to contain the buildup of systemic risk. The institutional framework put in place will have to take account of the ground realities that will be faced in implementing policy. Given that macro-prudential policy is aimed at containing systemic risk, it will have to be employed preemptively before system-wide threats become visible. Hence, as White (2006) states, policymakers are likely to face resistance in the application of macro-prudential remedies. A regulatory framework that relies too heavily on a time-varying policy may turn out to be too weak. Thus, macro-prudential regulation is likely to need a reasonably predictable ‘baseline’, a solid foundation on which a time-varying component can be added as conditions warrant; the extent to which countries rely on rules versus discretion will depend on a variety of factors, including institutional and governance structures. This chapter examines some of the issues that may arise in implementing macro-prudential policy.

3.2 Rules-based macro-prudential regulation is difficult Three types of externalities that can lead to systemic fragilities justify the need for macro-prudential policies (De Nicolò et al. (2012)): (i) interconnectedness of markets and intermediaries that can propagate shocks through the financial system; (ii) strategic complementarities that generate correlated risks among financial institutions and markets; and (iii) fire sales of financial assets that can lead to a cycle of declining asset prices and weakened balance sheets of financial intermediaries. The objective of macro-prudential policy is to limit systemic risk by finding ways to dampen the effects of business and financial cycles, to handle interconnectedness and the buildup of common exposures by institutions and market players, and to catch credit and asset bubbles in their infancy rather than having to deal with them when they are considerably distended and their puncturing may lead to much economic and financial mayhem. The approach can be broadly characterized as having a cross-sectional dimension that is concerned with risk distribution at a point in time, and a time dimension that deals with the evolution of aggregate risk. The crosssectional linkages and common exposures are addressed by requiring players to internalize their contribution to system-wide risk. Policies to handle the aggregate risk cycles are focused on stabilizing the system by

42

I. Agur and S. Sharma

building cushions during the booms (when risks are being taken on while measured risks are low), so that players have the room to deal with the downturns (when risks materialize). Policy design and formulation involves some combination of two kinds of strategies (Figure 3.1): time-invariant regulations that make it hard for systemic risk to build up (baseline policies), and time-varying policies that deploy instruments when systemic risk is perceived as rising to dangerous levels. The use and calibration of instruments in a time-varying strategy can be rules-based or left to the discretion of the authorities. But will a time-varying macro-prudential policy be effective? The key questions are: how well can policymakers detect the buildup of systemic risk, and will they be able to apply the tools when needed? The first question relates to measurement, since the ability to apply macro-prudential tools on time depends upon being able to measure systemic risk when it starts to increase beyond certain bounds. The second question refers to the political economy of macro-prudential regulation, and the strong pressures that authorities may face to delay or tone down the measures. These two questions, one associated with the ability to discern the accumulation and magnitude of systemic risk, and the other related to the use of macroprudential instruments, may seem distinct, but are actually related. The measurement challenges arise because defining systemic risk is hard and historical experience limited. By their very nature, systemic threats are ‘tail events’, they represent an agglomeration of risks from a variety of channels, and collecting data and views to make assessments is difficult since in

Baseline policies

Time-varying policies

Micro and macro-prudential regulations

Time-varying addition to baseline policies

Rules-based

Discretionary

Pre-set rules trigger changes in policies

Authorities decide when and how to change policies

Figure 3.1 Macro-prudential policies.

Rules, discretion and macro-prudential policy

43

most situations it is likely to involve a multiplicity of sources and agencies. While systemic risk measurement has made some progress in recent years prodded on by the financial crisis, it has not yet produced a satisfactory measure, despite the variety and complexity of models and methods used (Bisias et al. (2012)). The measurement of systemic risk continues to proceed without a comprehensive operational definition. Complicating matters is the endogenous nature of risk. Actions that fortify individual institutions may, when followed collectively, lead to a destabilization of the financial system as a whole. So even with slow moving ‘fundamentals’, changes in expectations and the resulting adjustments in risk appetites can transform market liquidity, and alter the path and volatility of asset prices. And as Soros (2010) and Shin (2012) point out prices play a dual role: they not only reflect underlying fundamentals, but are also an inducement to action, especially for market players whose balance sheets are affected by the same prices through mark-to-market assessments. The very reliance on prices that have spillover effects can, under certain circumstances, distort the prices themselves, undermine their integrity and impair their role in allocating resources. Shin (2013) shows that the aggregate balance sheet of the banking system expands and contracts endogenously over the cycle. While the aggregate capital buffers remain the same, banks and non-bank financial intermediaries increase their leverage in the booms through collateralized borrowings among themselves and through money and capital markets. He shows how the interdependencies (gross flows across the financial system) increase in the boom, and may make the system more susceptible to an adverse shock. Systemic risk increases both from the higher overall and individual leverage and from the greater cross-holdings across intermediaries. To operationalize matters, systemic risk can be thought of in terms of interlinkages, correlated exposures and the probability of fire sales across institutions and asset classes. This has led to mapping institutional and market networks for quantifying contagion risks (Nier et al. (2007); Aikman et al. (2011)), to calibrating models that take account of assetcorrelations (Adrian and Brunnermeier (2008), Acharya et al. (2011)), and to examining macro-financial models that allow for fire sales (Kashyap et al. (2011); Goodhart et al. (2013)). For all the attention paid to the US subprime mortgage market, it constituted only a relatively small part of total exposures for most banks. And total direct interbank exposures to Lehman Brothers, whose failure triggered the worst wave of the ongoing financial crisis, were not all that large compared to the size of the global financial system. Forced sales at dislocated prices played an important part in pushing down asset prices precipitously and deepening institutional and market distress (Shleifer and Vishny (2011)), but trying to anticipate or provide evidence on the nature and extent of fire sales is by its very nature elusive.

44

I. Agur and S. Sharma

Furthermore, the notion of correlated institutional exposures may not fully capture the role of specific risk-amplifying nodes in the network, such as the highly levered investment banks in the recent crisis (Adrian et al. (2010)). Some key nodes, like the insurance company AIG, may have been ‘invisible’ from a direct asset exposure point of view, since risk was transferred off-balance sheet using new financial instruments. From a risk-taking perspective it is also crucial where such nodes are located in terms of the regulatory perimeter. In the buildup to the recent crisis many key intermediaries were so-called ‘shadow banks’, funded via the repo or money markets, and located outside the realm of traditional commercial banking regulation. These intermediaries became key nodes and were able to play their amplifying role almost unfettered, while (with hindsight) being covered by implicit government guarantees (Claessens et al. (2012); Singh (2012)). Various feedback mechanisms increased the depth of the crisis by propelling it far beyond its direct triggers. One key amplification mechanism was the relationship between funding liquidity and market liquidity (Brunnermeier and Pedersen (2009)). When funding sources dry up and financial institutions are forced to pull out of markets, previously liquid asset classes can become less so. This, in turn, restricts the availability of funding liquidity, and a vicious cycle can take hold. Funding liquidity is threatened not only by fears of insolvency, but also by the fact that high quality assets frequently used as collateral in borrowings, can rapidly fall from grace – for example, the highly rated slices of CDOs and other structured products in the recent crisis. Shin (2013) suggests that the pro-cyclicality of the financial system provides an appropriate organizing framework for identifying indicators of vulnerability to crises, especially for banks and other financial intermediaries. He shows that approaches based on market prices, while a good gauge of concurrent conditions, are not likely to be useful for early signs of trouble. Indicators based on market prices, such as spreads on credit default swaps, did not give notice for the recent global crisis. Credit growth metrics are more valuable in this regard, but there are doubts about their utility as real time measures. Shin argues for keeping an eye on the composition of bank liabilities. In order to increase lending, banks must first borrow. When credit demand is rising, banks exhaust their core supply of funds (e.g. customer deposits) and turn to non-core sources, such as funding from money and capital markets. And hence, when the ratio of non-core to total liabilities surges, it is a good indicator that a boom is under way. The sources of non-core funding and its users depends on the structure of a country’s financial system and may differ across countries: while for example Ireland and the Republic of Korea saw a heavy usage of wholesale funding by commercial banks before the recent crisis, in the US it was mainly the shadow banking system that facilitated the channelling of such funds to the real estate sector.

Rules, discretion and macro-prudential policy

45

No single model of systemic risk is likely to capture all the possible triggers and amplification mechanisms, but the array of measures could be broadened to the point of covering most aspects. For instance, IMF (2009) applies a variety of measures to come to a systemic risk mapping: a network model, two asset correlation based models, a model that estimates the likelihood of systemic defaults and an economy-wide Value-at-Risk model. This raises the issue whether such a set of indicators could constitute an effective ‘early warning system’ for systemic crises? This question can be parsed further. Can we build a reliable warning system and will it be ‘early’ enough to provide policymakers with sufficient reaction time for calibrating and using the macro-prudential toolkit? First, systemic risk in the future may arise in very different ways and it may not be captured by our existing intelligence systems. If so, the current menu of indicators may lull policymakers into a false sense of security. Furthermore, one lesson from this crisis that surely carries over to future crises is the non-linearity of effects in a complex evolving economy (Haldane (2012a)). Suddenly, some very fuzzy boundaries are crossed and the system spirals away from an ostensibly stable equilibrium and into the abyss. Threshold effects severely complicate efforts to quantify the risk of a systemic crisis, and make it particularly difficult for a warning system to be ‘early’, and not just begin to flash red when it is too late to contain the risks or the fallout from their realization. Moreover, decision makers instead of facing risky situations, in which future paths can be assigned probabilities, face Knightian uncertainty under which it is impossible to elaborate all the outcomes, let alone assign them probabilities. Second, policymakers have to contend with the difficulties of discerning and measuring systemic risk. Consider how policymakers would use an early warning system. They have two options: either they specify in advance what measures will be taken when systemic risk is apparent, or they wait until the warning signals are flashing red and then decide on a set of actions – in Figure 3.1 these options are labelled time-varying rules-based policy and time-varying discretionary policy. Under the first option, the policymakers must face the problem of designing rules for systemic contingencies. The latter option leaves full discretion in the hands of the regulators, and depending on institutional and political structures such discretion could open the door to resistance from the financial industry, politicians and even the public. The challenges of systemic risk measurement make it difficult to operationalize the first option: a time-varying policy that is rules based. The classical solution for committing to an action is that of Odysseus, who had his arms tied and told his men not to heed his future words, so that he could sail past the seductive Sirens and hear their music without perishing. The key to a successful rule is the ability to specify in advance the policy action that will be taken when a certain event happens, and having the credibility to implement the policy when the need arises. In the context of

46

I. Agur and S. Sharma

macro-prudential regulation this means that we need to resolve what is meant by ‘event’ and what is meant by the contingent ‘policy action’. The event is the rise of systemic risk beyond some threshold. The action is the application of macro-prudential tools to reduce systemic risk to acceptable levels. Given the intrinsic problems in making systemic risk assessments and designing a suitable macro-prudential toolkit, trying to define preemptive responses to a rare event using fuzzy measures to calibrate (infrequently used) tools is going to be difficult and a hard sell. For comparison, consider monetary policy. The ‘event’, inflation, is well defined, as is the ‘act’ of raising short-term interest rates. Further, there is historical experience, data and reasonably well-founded models that tell us how interest rates have an impact on inflation. Rules can be designed, the Taylor-rule for example, which specify how monetary policy should be conducted. Of course, even for monetary policy, a fully rules-based framework is not implemented by central banks unwaveringly, because the established rules may not be fully adequate for an evolving economy. A policy framework like inflation targeting comes close: the target can be easily measured, there is one policy lever and there is substantial evidence that provides a link between the target and lever in normal times. Moreover, the inflation gauge is a simple one, which is readily available and comprehensible to the public. In the realm of macro-prudential regulation, however, any simple measure is bound to be inadequate. And even complex measures will capture only certain facets of systemic risk. Creating a rule that links an array of measures to a set of tools will be tough, both in terms of calibration and communication with the public. This is especially true since macro-prudential tools are unlikely to be changed frequently and their effect on systemic risk will have to be judged relative to a rare-event counterfactual that is based more on assertions than evidence. Since we are dealing with rare events, historical experience may also be of limited value. Comparisons with past occurrences may not be useful, since with evolution of the financial system in terms of contracts, institutions, operations, technology and regulations, the nature of the interactions among financial players and the contagion mechanisms may be quite different. Measurement difficulties thus preclude an approach to macro-prudential policy that is both rules-based and dynamic. It is worth noting that the difficulties in systemic risk measurement do not diminish the effectiveness of macro-prudential tools. For instance, housing bubbles are less likely in all environments that have, say, more stringent loan-to-value ratios (LTVs) requiring households to make higher down payments when buying a house. This constrains household leverage, makes default less likely, and also limits the ability of banks to expand credit to low quality borrowers. The precision with which we can measure systemic risk affects the ability to calibrate and use macro-prudential tools, not the effectiveness of those tools. That macro-prudential policy is

Rules, discretion and macro-prudential policy

47

essential is not in question. Rather the difficulty of constructing ‘statecontingent’ rules narrows the implementation to a choice between specifying fixed prudential rules in normal times and using discretion when a systemic threat becomes palpable. Hence, intermediate options may have to be considered. The Bank of England (2009) suggests using rules as a ‘rough guide’ and discretion when necessary, which Goodhart (2011) operationalizes as requiring the macro-prudential authority to explain itself whenever previously stated thresholds are crossed and the authorities choose not to react.2 This begs the question how ‘rough’ is defined, and whether it is possible to set meaningful thresholds in advance given the challenges associated with measuring systemic risk. Goodhart (2011) recommends the following three sets of ‘markers’: rate of credit expansion, increases in property prices and the growth of sectoral (financial intermediaries, households, corporations, government) and economy-wide leverage. When at least two of these indicators are growing at a pace that is significantly faster than average, the authority in charge of macro-prudential policy should take action or explain in public why it has not done so. This leaves open the question of what constitutes excessive growth in the different indicators and also, importantly, what exactly is meant by ‘policy action’. It is possible that if decision makers want to forbear, they could circumvent the requirement of public explanation by changing policy only marginally. Goodhart suggests this could be addressed by having the macro-prudential authority undertake research on the magnitude of changes in macro-prudential instruments that would have been required in broadly similar circumstances in the past, thereby creating public expectations on the size and scope of required policy actions.

3.3 Discretion opens the door to resistance How does the process of making macro-prudential policy differ from that of monetary policy? Although central bankers have at times been accused of succumbing to political pressures for changing policy, few would argue that this makes the implementation of a time-varying monetary policy a near impossible task. In the rules versus discretion debate on monetary policy, most of the rules considered are time-varying in nature, rather than completely fixed like a constant money growth target (Fischer (1990)). In many countries monetary policy is fully based on discretion, especially in those where the central bank does not have an explicit quantitative target that must be met. The central bank decides when to apply its tools and in

2 In a similar vein, Enriques and Hertig (2010) argue that regulators should be asked to ‘act or explain’ whenever bank credit default spreads breach pre-set thresholds.

48

I. Agur and S. Sharma

some cases may even choose the objective(s) or combination of objectives (generally inflation control and output growth) it aims to meet with those tools. In what sense is macro-prudential policy different, and discretion more problematic than in the implementation of monetary policy? First, measurement again goes to the heart of the political economy problem. Measurement uncertainty related to systemic risk leaves room for lobbies to argue that policymakers may be wrong. If a central bank moves to raise interest rates when it finds that inflationary pressures are building, there is little scope generally for a lobby to counter that inflation is not being properly measured. The lobby may highlight special circumstances, but such arguments will only carry weight if circumstances are indeed exceptional. Instead, when a macro-prudential policy is made more stringent because some indicators show systemic or sectoral risks are building up, lobbies have scope to argue with the measurement itself. And since compared to the monetary authorities, macro-prudential policymakers are likely to face greater uncertainty and hence have more doubts about assessing the situation, they may be easier to influence.3 Second, the nature of macro-prudential policy makes it more susceptible to political influence than monetary policy. There are two reasons for this: macro-prudential policy may single out one or a few sectors for special attention; and implementation inevitably involves coordination between several agencies. We discuss each of these in turn. Macro-prudential regulation is commonly defined in comparison to micro-prudential regulation. Alternatively, however, macro-prudential regulation can be defined in relation to other macroeconomic stabilization policies, primarily monetary policy (Borio and Shim (2009)). To the extent that real and financial cycles overlap, monetary policy could attempt to stabilize both cycles simultaneously. But there are times when these cycles diverge, as they did during the Great Moderation, when the real economy was stable while financial imbalances built up. Macroprudential tools attempt to diffuse systemic risk and bring about needed corrections in the financial sector without necessarily requiring an adjustment in the entire macro economy.4

3 Another reason why monetary policy may face less resistance compared to macro-prudential policy is given by Borio (2011: 12): ‘There is at least some constituency that dislikes inflation, but none that dislikes the inebriating feeling of getting richer.’ 4 The joint conduct and interaction of monetary and prudential policies has been the subject of much recent research (see, for example, Angeloni and Faia (2013), Goodhart et al. (2009), Wadhwani (2010), IMF (2012)). While broadly these policies should complement each other, macro-prudential policy needs to concentrate on preserving financial stability as it is relatively less suited for managing aggregate demand. Similarly, in differentiating and conducting macro- and micro-prudential policies, the primary focus of macroprudential policy should be on reducing systemic risk; micro-prudential policy in turn should concentrate on firm-specific risks and only indirectly on system-wide fragilities.

Rules, discretion and macro-prudential policy

49

From a political economy perspective, macro-prudential policy is most challenging to implement when it is of the greatest use. Macro-prudential instruments are likely to be most useful when they are able to target a particular sector at times when the financial cycle diverges from that in other sectors of the economy. However, it is more difficult to tell only a few of the proverbial party-goers that they cannot touch the punch bowl than to take the bowl out of the room. If the entire economy is overheating and the central bank decides on a rate hike, the political resistance is likely to be relatively muted. Industry lobbies will not see much scope for changing policy, since it applies to everyone. Instead, when a sector is singled out, especially one that is highly concentrated and has the resources to wield a lot of power, resistance to targeted restrictions may be intense. How exactly can the financial industry affect macro-prudential policy? Lobbies could try to orchestrate a public outcry, but macro-prudential policymakers may be able to garner support for resisting self-serving public criticism from financial players or politicians. A graver and more insidious threat is that political influences could alter the operation of the macroprudential decision-making structure itself in ways that are less visible and more difficult to explain to the public. Consider the coordination between the agencies depicted in Table 3.1 in different institutional frameworks for conducting macro-prudential policy.5 Given differing agency mandates and the need to take a systemic view, such coordination involves sharing information, developing ways and means of communicating and establishing processes for implementing policy. Two key agencies involved in macro-prudential decision making are the central bank and the bank regulator. By central bank we mean the authority in charge of monetary policy and liquidity provision. In practice, sometimes the central bank is both a monetary authority and a bank Table 3.1 Agencies involved in macro-prudential policies Central bank (monetary authority, liquidity provider) Micro-prudential bank regulator(s) (systemically and non-systemically important banks) Markets regulator (money, capital, derivatives)

Markets regulator (conduct of business/consumer protection)

Treasury/Ministry of Finance Other regulators (insurance, competition . . .) 5 Not all countries have separate market regulators. In some countries financial market supervision and/or consumer protection are part of the micro-prudential bank regulator’s mandate. For a discussion on the institutional assignment of the market regulation mandate, see Carmichael (2012), Kremers and Schoenmaker (2012) and Taylor (2012).

50

I. Agur and S. Sharma

regulator, but there are relatively few advanced economies where these two agencies are fully integrated. For practical purposes, therefore, we treat the central bank (i.e. monetary authority) and the bank regulator as separate agencies in our discussion.6 The central bank plays a leading role in macroeconomic surveillance and the interpretation of aggregate risks, because the very nature of its job requires it to have the data and skills to perform system-wide analyses. In terms of potential macro-prudential tools, however, it possesses only a few, such as reserve requirements. Most of the toolkit is with the bank regulator. It is this agency that interacts directly with individual banks and when needed imposes measures upon them. These include for example systemic capital and liquidity surcharges, levy on non-core liabilities, rescaling risk weights, reducing loan-to-value (LTV) ratios and imposing credit growth caps. In fact, several instruments (for example, capital, liquidity and reserve requirements) in the hands of the bank regulator can be used for both micro-prudential and macro-prudential purposes, and this blurs the distinction between the two types of policies – with differences in policy categorization depending on the timing and nature of interventions. Table 3.2 lists the main macro-prudential instruments according to the agencies that control them.7 Three agencies, the central bank, the bank regulator and the markets regulator are the primary sources of information for macro-prudential policy making. The central bank provides ‘hard’ information like data on current macroeconomic developments, as well as ‘soft’ information on macroeconomic analysis and forecasts. Similarly, the bank regulator’s input consists of both hard data, for example, bank capitalization and liquidity levels, and soft information like views on the risk strategies adopted by banks. In addition, the market regulator in charge of financial market supervision may have an important role to play in providing information about new variations in financial contracts, risk transformations and intermediation through non-banks, and money, capital and derivative markets. Other agencies that are likely to play an important role

6 In the United States, the Federal Reserve is only one of several bank regulators; in Japan, Switzerland, Australia and Canada, among others, the central bank and the bank regulator are separated; and even in the United Kingdom where these agencies are being merged again, the bank regulator will remain an operationally independent subsidiary of the Bank of England. In the euro-zone, the ECB is the ‘central bank’ and national central banks or other agencies charged with some micro-prudential responsibilities are the ‘bank regulators’. The ECB is now being endowed with micro-prudential responsibilities. 7 For recent surveys of macro-prudential policy tools see Bank of England (2011), Galati and Moessner (2013), Hanson et al. (2011), Lim et al. (2011) and Bank for International Settlements (2012b).

Rules, discretion and macro-prudential policy

51

Table 3.2 Main macro-prudential tools Agency

Macro-prudential tools

Central bank

Bank reserve requirements Foreign exchange/reserve management

Bank regulator

Capital requirements (systemic surcharges) Liquidity requirements Leverage requirements Rules on maturity mismatches Collateral rules (e.g. LTVs) Credit growth caps Sectoral exposure caps Disclosure regulations Risk-based deposit insurance pricing Bank resolution schemes (including living wills) Accounting rules Restrictions on compensation structures

Market regulator (financial market)

Restrictions on financial contracts Collateral rules (e.g. margin requirements, haircuts) Regulations on short-selling Restrictions on trading venues (e.g. CCPs) Trading stops (e.g. circuit breakers) Disclosure requirements

Market regulator (consumer protection)

Regulation of financial contracts (e.g. terms of mortgage contracts) Rules on selling strategies (e.g. information provision to customers)

Treasury

Financial transaction and other taxes Deductibility of interest payments on certain types of debt

Insurance regulator

Regulation of systemically important insurers

in macro-prudential oversight are the Treasury (Ministry of Finance) and the regulator for the insurance industry.8 One aspect of macro-prudential policy making on which there is some consensus is that the authority to take decisions must be clearly placed somewhere among these agencies (IMF (2011)). If such authority is not explicitly assigned, each agency will have to separately perform what it sees as its role in containing systemic risk with at most informal coordination 8 With the exception of the US where the Treasury has recently established the Office for Financial Research, the Treasury usually does not specialize in the analysis of financial stability, nor is it endowed with many macro-prudential tools. However, since it is the ultimate back-stop to the financial system, the Treasury has to play the role akin to that of an ‘owner’ who is liable when things go wrong. It also plays an important role in defining the financial environment through the issuance of sovereign debt instruments, which play a key role as collateral in market-based financial intermediation.

52

I. Agur and S. Sharma

between the agencies. However, when no agency or committee is given full ownership, systemic risk prevention may end up too low on each agency’s priority list. Moreover, if every agency fulfils only ‘its part’ of macroprudential regulation, without anyone taking a comprehensive view, there are likely to be gaps in the system. Hence the importance of a well-defined and clear mandate for macro-prudential decision making. No matter where this mandate is placed, there will be difficult challenges related to coordination: information sharing, assessment of risks, timing and implementation of interventions and jointly communicating with the public.9 The more so because the bank regulator, which stands both at the beginning (information) and the end (implementation) of the macro-prudential decision process, is unlikely to have the sole lead. It is unlikely to have the required data and human capital for conducting macro-financial analysis, and hence it cannot put together macroprudential policy on its own (Bini Smaghi (2009)).10 This means that during the process of formulating, calibrating and implementing macroprudential policy, the bank regulator will be required to provide information and views to another agency or a joint committee. A simplified representation of this decision process is given in Figure 3.2. We can use this figure to highlight the weak links or vulnerabilities to which the decision process may be subject. The first set of vulnerabilities arises from the fact that agencies need to provide each other with soft information, which is difficult to convey and its presentation is easy to manipulate to suit a given agency’s interests. The bank and markets regulators have to supply soft supervisory information, while the central bank, in addition to its provision of macroeconomic analysis and forecasts, will also be the key source of systemic risk assessments. The central bank is usually the only institution where both the knowledge of the macro economy and the financial sector can be combined together to analyse macro-financial linkages, and a monopoly on this type of analysis implies that it can be presented in whatever way best aligns with the central bank’s interests. Another set of vulnerabilities stem from the separation of the decision maker (the macro-prudential authority) from the implementing agencies, which implies that the extent to which the decision maker is able to effectively implement its policies will depend on the willingness of those agencies to cooperate. Different institutions have different skill-sets and cultures, and differing perspectives may hinder the exchange of information and the formation of a policy response (Schoenmaker and Wierts (2011)). Related to this, a further challenge arises in the external 9 See, for example, Bair (2012), Connaughton (2012) and Blinder (2013) for a discussion in the context of the US response to the financial crisis. 10 Those euro-zone national central banks that are endowed with regulatory responsibilities are an exception to this statement, since they conduct macro-prudential analyses in a domestic context as well as make contributions to the European Systemic Risk Board.

Rules, discretion and macro-prudential policy

53

Financial sector inputs hard and soft data

Macroeconomic inputs hard and soft data Central Bank

Bank regulator

Market regulator

Systemic risk analysis Central Bank

Macro-prudential decision making Agency:?

Public communication Agency:?

Implementation Bank and market regulators, Central Bank, other agencies

Figure 3.2 Central bank versus joint committee as macro-prudential policymaker.

communication to the public, in which the voices of separate agencies have to be combined into a coherent message. Which of these vulnerabilities are likely to be the most significant depends upon which agency gets the macro-prudential mandate and on the institutional power structure in a particular country. As discussed in Nier et al. (2011), many countries are bestowing the macro-prudential mandate on the central bank (e.g. UK) or granting it to a macroprudential policy committee on which the different agencies involved are represented (e.g. EU, US). Many of the vulnerabilities discussed above are magnified when macroprudential policy is made at a supra-national level, as for instance within the European Systemic Risk Board, rather than within a country. Soft information is more likely to be lost across borders and languages. And implementation directives from an authority based outside a country can be more alienating, exacerbating the potential for conflict, and complicating resolution, especially when there may be no acceptable overarching governance or legal framework to address the issues. Systemic risk is globally concentrated in a relatively small number of large banks and nonbanks operating across borders (the Financial Stability Board has identified 29 global systemically important financial institutions (G-SIFIs)), and purely domestic solutions for these financial institutions are likely to be inadequate.

54

I. Agur and S. Sharma

Figure 3.3 depicts the frameworks when the macro-prudential authority rests in the central bank (3.3a) or a joint committee (3.3b). The shaded arrows highlight the points in the policy process where difficulties could arise. Central bank leadership unifies systemic risk analysis and macroprudential decision making, and the central bank does not need to coordinate public communication with other agencies. However, this ‘lack of involvement’ of other agencies is also a drawback and raises the possibility of inter-agency conflict, because the bank and markets regulators must provide key inputs to the central bank and implement the policy response that is devised, without having a say in the decision making. This could endanger the flow of soft supervisory information, as well as the speed and extent of policy implementation, and thereby also the ability to credibly communicate macro-prudential policy to the public. Directives that give the central bank overarching powers to make the bank regulator do its bidding will be difficult to define and enforce. By what means could a financial sector lobby go about exploiting the vulnerabilities of inter-agency conflict? The most direct route would be to try to capture the bank and markets regulators, which could manifest itself in either less stringent regulation or weaker enforcement of supervision.11 Some bank regulators are funded by direct contributions from the banks Financial sector inputs hard and soft data

Macroeconomic inputs hard and soft data Central Bank

Bank regulator

Market regulator

Systemic risk analysis Central Bank

Macro-prudential decision making Central Bank

Public communication Central Bank

Implementation Bank and market regulators, Central Bank, other agencies

Figure 3.3a Central bank.

11 See Pagliari (2012) for a recent analysis of regulatory capture.

Rules, discretion and macro-prudential policy

55

Financial sector inputs hard and soft data

Macroeconomic inputs hard and soft data Central Bank

Bank regulator

Market regulator

Systemic risk analysis Central Bank

Macro-prudential decision making Committee

Public communication Committee

Implementation Bank and market regulators, Central Bank, other agencies

Figure 3.3b Joint committee.

they supervise, which could make them unduly sensitive to the opinions of these institutions. Others receive their funding from the Treasury, presenting banks with an indirect route to influence the bank regulator through political contributions and appointments at the ministry. Overall, the operational independence of regulators may mean little without funding and intellectual independence (Fullenkamp and Sharma (2012)). And a central bank’s independence in making macro-prudential decisions may mean little without the cooperation of other regulators. But what if the bank regulator is placed within the central bank? For instance, in the debates surrounding the formation of an EU-wide banking union, the possibility of assigning full micro-prudential responsibilities to the European Central Bank has been floated. This would make the ECB into a monetary authority cum bank regulator that also chairs macroprudential regulation within the European Systemic Risk Board. In the wake of the financial crisis, the option of making the US Federal Reserve a single super-agency was also discussed, but rejected. Centralizing monetary policy and bank regulation in one agency might resolve the issue of independent funding for the bank regulator, although not necessarily, as for instance in the case of the Dutch Central Bank where the monetary policy departments are funded by the central bank’s own resources whereas the regulatory departments are funded by the supervised institutions. The creation of a super-agency does resolve the problems of inter-agency conflict.

56

I. Agur and S. Sharma

But it creates an unwieldy institution with far-reaching powers that is outside the realm of democratic accountability. This may be unacceptable in many countries and increases the possibility of political interference and second guessing of the decisions taken by such a super-agency. Furthermore, there is a yet more fundamental reason that any central bank led model may weaken the implementation of macro-prudential policy. In such a framework, the central bank not only has responsibility for macro-prudential policy but also for monetary policy. As we have argued, the timing of macro-prudential interventions is difficult to make because of the pre-emptive nature of the policy, the measurement challenges and likely industry resistance. Faced with these hurdles, central banks may not make the right trade-offs in using the two policies at their disposal. For example, central banks may be tempted to delay the use of macro-prudential tools with the knowledge that liquidity provision can be used to deal with systemic disturbances. The ‘Greenspan Put’ was an illustration: since bubbles are difficult to identify ex ante the central bank should not attempt to prick or defuse them, but instead provide ample liquidity if and when things do go wrong.12 A joint committee where all the agencies have a say could prevent dogmatic thinking. Deliberations among officials with different backgrounds and experience should improve the design of policy. Such an arrangement should also minimize inter-agency conflicts and facilitate implementation. In particular, the bank and markets regulators are less likely to resist the enforcement of decisions that they have debated and negotiated, even if they voted against them on the committee. However, consensus on policy interventions may be harder to forge with a committee of representatives from different agencies. It may hamper the speed with which macro-prudential policy can respond to fast changing circumstances, and increase the difficulty of coordinating a coherent message to the public. In addition, with multiple decision makers, a committee structure can increase the channels by which the industry may be able to exercise its influence on regulation and supervision. For example, some of the agencies on the committee may not have the requisite budgetary and political independence. Both financial regulators and central banks can have incentives to forbear. Each of the different institutional frameworks for conducting macro-prudential policy leaves open some paths through which other players can sway decision makers and distort policy and delay or prevent its implementation. Only a rules-based approach can fully protect a timevarying policy from being manipulated, but, as argued earlier, such a tactic may not be feasible for macro-prudential regulation. 12 For further discussion on the conflict of interests that may arise in the joint conduct of financial stability and monetary policies see, for example, Goodhart and Schoenmaker (1995) and Masciandro et al. (2008).

Rules, discretion and macro-prudential policy

57

Counter-cyclical capital requirements in Basel III provide an example of the rules-versus-discretion trade-off in the design of time-varying macroprudential policy. The Basel Committee has stipulated that bank regulators should implement a capital surcharge of up to 2.5 per cent of risk-weighted assets during times of excessive credit growth, where the credit/GDP ratio is to be used as a guiding variable. However, both the extent and the timing of the surcharge are left to the discretion of the national regulators, as well as the manner in which the credit/GDP ratio is to be interpreted. Kowalik (2011) has argued that this is likely to induce regulatory forbearance. However, the alternative of tying capital surcharges to pre-fixed credit/GDP thresholds is unlikely to find traction as long as this ratio does not have sufficient empirical support as a reliable indicator of asset bubbles.

3.4 A strong baseline: reducing the burden on time-varying policy Given the inherent challenges of designing and implementing a timevarying macro-prudential policy, governments should strive to build a strong baseline regulatory regime and then supplement that with a timevarying component. In such a conception of the regulatory framework, there would be trade-offs involved in combining time-invariant (or baseline) and time-varying macro-prudential policy. The time-invariant rules should be designed to create robust institutions in normal times and also prevent or slow down the creation of systemic risk.13 Also, as Haldane (2012b) argues, faced with uncertainties, cognitive limits and the complexity of the economic and financial system, regulations and decision rules may have to be reasonably simple and tractable to be effective. From a systemic perspective, the structure of the financial industry and the incentives embodied in the rules and regulations are crucial for stability, and hence macro-prudence may require limitations on organizational form, activities and governance arrangements. Also, in practice, it is difficult to categorize prudential instruments as micro or macro since many of the same instruments can be used for achieving multiple objectives. To counter the pro-cyclicality of the regulatory framework, even micro-prudential rules (for example those on provisioning) are now being strengthened with forward-looking through the cycle assessments, rather than determining them based on recent experience of defaults and failures.

13 Given the management and regulatory challenges posed by large banks, such institutions should have a higher degree of public accountability compared to smaller ones, and also bear the burden of demonstrating the benefits to society of continued growth and greater bank scale and scope (see, for example, Baxter (2011–12)).

58

I. Agur and S. Sharma

In response to the recent crisis experience, reforms in a number of areas are trying to increase the sturdiness of the financial system. A vital part of the current reform effort is the drive to increase the quantity and quality of bank capital. Controversy continues over the nature of bank capital, and the adequacy of current methods for capturing banking risks properly. Questions remain about the effectiveness of risk-weighting schema, and the extent to which they should be reinforced by limits on raw leverage ratios.14 In tandem with higher capital buffers, there are plans to place restrictions on bank structure and activities, to limit the risk taking on the back of government guarantees.15 For example, the Volcker Rule in the US seeks to limit proprietary trading and puts constraints on hedge fund and private equity investments; the Vickers Rule in the UK proposes ring fencing retail and small business deposits to enforce a separation of investment banking, including derivatives, debt and equity underwriting and trading and investing in securities; the Liikanen Report on the EU banking sector recommends that proprietary and other trading activities be placed in a separate legal entity if such activities are a significant part of a bank’s business. Given the scarcity of funding that developed in many financial systems during the global financial crisis, regulators are keen to establish rules for the holding of liquid assets. Liquidity is a public good, and banks do not consider the externalities created when each of them holds too few liquid assets or has a funding profile with a substantial proportion of short-term debt that comes with rollover risks attached. Liquidity regulations, in the form of a liquidity-coverage ratio and a net-stable funding ratio, will be a part of the new Basel standards. Capital and liquidity surcharges are being contemplated for systemically important financial institutions (SIFIs), including non-bank financial intermediaries. Such additional capital and liquidity requirements, levied on ‘large’ institutions (and possibly increasing in the size of their balance sheets) would impose a cost on expansion beyond certain thresholds, which identify an institution as too-big-to-fail, or too-interconnected-to-fail or too-important-to-fail. Global and domestic SIFIs could also be subjected to risk and size-adjusted deposit insurance premiums, and leverage ratios that are more stringent than for smaller institutions that are not deemed systemically important. An additional option is the imposition of a tax on non-core liabilities, as was done recently in Korea, where a combined leverage cap on foreign exchange derivative contracts and a 20 basis point

14 See, for example, the discussions in Rajan (2009), Admati et al. (2010), Acharya et al. (2011), Duffie (2011), Hart and Zingales (2011), Morrison (2011), Pazarbasioglu et al. (2011), Le Leslé and Avramova (2012) and Admati and Hellwig (2013). 15 See Hoenig (2011), tker-Robe et al. (2011), Hoenig and Morris (2012) and Fisher (2013).

Rules, discretion and macro-prudential policy

59

charge on dollar-denominated wholesale funding, has been quite successful at subduing short-maturity capital inflows (Bruno and Shin, 2014). The regulation of bank activities, and requirements on capital and liquidity, constitute attempts to safeguard retail banking and the payments system from the volatility of financial markets. However, the shadow banks and other parts of the financial system are intimately connected to financial markets, and to the extent that they can cause system-wide stress are also perceived as having ‘implicit’ government guarantees. US money market mutual funds, for instance, had to be back-stopped by the US Treasury when they experienced a run during 2008. As a result of the crisis, there is increasing recognition of the bank-like role played by money market mutual funds and the need for better regulation. A number of measures are being discussed: minimum liquidity and maximum maturity requirements, limits on exposures to single issuers, suspension of redemptions in a crisis, government insurance of deposits for an appropriate fee and floating net asset values. In this regard, the reform of the repurchase agreement (repo) market is also pertinent. The repo market is a significant, if not primary, source of funding for the shadow banking sector, and hence the regulations and procedures for collateral management in the repo market play a vital role in the creation of leverage, maturity mismatches and hence systemic fragilities. The rules need to facilitate the orderly unwinding of repo transactions when counterparties default, and reduce the likelihood of panics and disorderly fire sales of underlying assets.16 Regulators are also trying to make the securitization process more robust, since its contamination in the run up to the crisis produced systemic fragilities in a number of ways. Lax origination, information asymmetries, distorted incentives, and the resulting loss of pertinent information along the securitization chain, led to asset-backed securities whose characteristics were not fully understood by many of the financial players. Structured financial products based on such securities (and artificially manufactured using derivatives) added to the opacity and mispricing of risks. Issuance and distribution of toxic securities, aided and abetted by ratings agencies and faulty analysis, eventually led to market seizures and institutional distress once the true risks became apparent. To the extent that these assets were also used as collateral for borrowings, their sudden re-pricing raised counterparty risks, increased uncertainties and made financial connections more brittle. As a consequence, leverage, collateral re-use, and collateral management more generally are getting a hard look from supervisory bodies (Claessens et al. (2012), Financial Stability Board (2012)). Another aspect of the financial system that has come under increasing scrutiny is the over-the-counter (OTC) derivative markets. The clarity of

16 See, for example, Gorton and Metrick (2010) and Acharya et al. (2011).

60

I. Agur and S. Sharma

contractual obligations and the understanding of exposures are important, especially during times of financial uncertainty when any doubts about market processes and their performance can lead to system-wide stress. OTC products played a significant role in the buildup of hidden exposures before the recent crisis, especially in the shadow banking and insurance sectors. To enhance transparency and enable better handling of risks, the migration of standardized derivatives on to well-managed central counterparties is therefore being encouraged.17 The role of loan-to-value (LTV), debt-to-income (DTI) and loan-toincome (LTI) ratios in addressing procyclicality is being re-examined. Such requirements serve dual purposes: they restrain borrowers from becoming highly levered and prevent lenders from taking on too much counterparty risk. This prepares both borrowers and lenders for better navigating the turns in the business, financial and/or credit cycles when defaults rise and systemic risk may increase. Several Asian countries have constrained household leverage, using both baseline and time-varying regulation: China, Hong Kong SAR, Singapore, India, Malaysia, Thailand and the Republic of Korea implement significant caps on LTVs in property markets, which are supplemented by additional time-varying measures as needed.18 The time-varying rules can be either stricter LTV ratios or other measures, such as Singapore’s tax on foreigners to discourage international capital flows into the domestic property market, China’s restrictions on bank credit for real estate investments to counter rapid growth of house prices, and India’s countercyclical changes in risk weights and in loan provisioning.

3.5 Conclusion The conduct of macro-prudential policy is complicated by a number of factors: systemic risk has to be addressed pre-emptively before it becomes apparent; pre-emption is difficult in the context of ‘tail events’ that are experienced after large time intervals during which public memory of events past has faded and economic and financial systems have evolved in many ways; systemic fragilities are hard to detect and measure given the complexity of interactions within the financial system and between the financial system and the rest of the economy; aggregate risk cycles have multiple drivers, some of them endogenous, and hence early warning indicators are hard to devise; and, the intrinsic difficulty of making policy

17 See Singh (2010) who argues for a capital levy on OTC transactions to encourage the transition. Reliable clearing, settlement and recording of transactions are vital for the functioning of money, capital and derivative markets. Market and transaction arrangements are being strengthened to reduce systemic threats that may arise from weaknesses in the financial infrastructure (Bank for International Settlements (2012a)). 18 See Lim et al. (2011) and Siregar (2011).

Rules, discretion and macro-prudential policy

61

with a system-wide focus that involves collecting information, maintaining surveillance, analysing hard and soft data, allocating authority over decisions, coordinating the action of multiple agencies and communicating with the public. Given the nature of the macro-prudential issues and the inherent problems faced in dealing with them, a discretionary time-varying macroprudential policy may face resistance from interest groups. Limiting discretion through the formulation of macro-prudential rules is complicated by the difficulties in measuring and assessing systemic risk. And the greater the difficulties in appraising systemic risk in a timely manner, and calibrating and using time-varying macro-prudential remedies, the greater should be the emphasis on containing systemic risks by having players and markets internalize the externalities they create. This suggests that oversight is best served by having a strong baseline regulatory regime on which a time-varying macro-prudential component can be added as conditions warrant and permit. Implementing the timevarying component requires conservative ‘markers or thresholds’ which when crossed force a public examination of trends in financial and real variables, and hence lead to appropriate reactions from private and public actors that reduce the likelihood of precipitating systemic crises. In this context, the institutional structure of regulation and supervision, and the incentives it embodies, will be critical. The devastation caused and the costs imposed by the global financial crisis suggest that the system of oversight must be designed to prevent the emergence of systemic threats because once a system-wide meltdown starts it is hard to control due to the complexity of the system, the struggle of managing expectations under stress, and the challenges of coordinating and implementing policy through multiple agencies.

References Acharya, Viral V., Thomas F. Cooley, Mathew Richardson and Ingo Walter, 2011, Regulating Wall Street (New York: John Wiley). Admati, Anat and Martin Hellwig, 2013, The Bankers’ New Clothes: What’s Wrong with Banking and What to Do about It (Princeton: Princeton University Press). Admati, Anat R., Peter M. DeMarzo, Martin F. Hellwig and Paul Pfleiderer, 2010, ‘Fallacies, Irrelevant Facts, and Myths in the Discussion of Capital Regulation: Why Bank Equity is Not Expensive’, Stanford Graduate School of Business Research Paper, No. 2065 (Palo Alto: Stanford University). Adrian, Tobias, and Markus Brunnermeier, 2008, ‘CoVaR’, Federal Reserve Bank of New York Staff Report, No. 348, September. Adrian, Tobias, Emanuel Moench and Hyun Song Shin, 2010, ‘Macro Risk Premium and Intermediary Balance Sheet Quantities’, IMF Economic Review, Vol. 58, pp. 179–207. Aikman, David, Piergiorgio Alessandri, Bruno Eklund, Prasanna Gai, Sujit Kapadia, Elizabeth Martin, Nada Mora, Gabriel Sterne and Matthew Willison, 2011,

62

I. Agur and S. Sharma

‘Funding Liquidity Risk in a Quantitative Model of Systemic Stability’, in: Alfaro, R., ed., Financial Stability, Monetary Policy, and Central Banking (Santiago, Chile: Central Bank of Chile), pp. 371–410. Angeloni, Ignazio, and Ester Faia, 2013, ‘Capital Regulation and Monetary Policy with Fragile Banks’, Journal of Monetary Economics, Vol. 60, pp. 311–382. Bair, Sheila, 2012, Bull by the Horns: Fighting to Save Main Street from Wall Street and Wall Street from Itself (New York: Free Press). Bank of England, 2009, ‘The Role of Macroprudential Policy’, Discussion Paper, November (London: Bank of England). Bank of England, 2011, ‘Instruments of Macroprudential Policy’, Discussion Paper, December (London: Bank of England). Bank for International Settlements, 2012a, ‘Principles for Financial Market Infrastructures’, CPSS-IOSCO, April (Basel: BIS). Bank for International Settlements, 2012b, ‘Operationalising the Selection and Application of Macroprudential Instruments’, CGFS, December (Basel: BIS). Baxter, Lawrence G., 2011–12, ‘Betting Big: Value, Caution and Accountability in an Era of Large Banks and Complex Finance’, Review of Banking and Financial Law, Vol. 31, pp. 765–877. Bini Smaghi, Lorenzo, 2009, ‘Going Forward: Regulation and Supervision after the Financial Turmoil’, speech by ECB Executive Board Member, 19 June. Bisias, Dimitrios, Mark Flood, Andrew W. Lo and Stavros Valavanis, 2012, ‘A Survey of Systemic Risk Analytics’, US Treasury, Office of Financial Research Working Paper No. 0001, Washington, DC, USA. Blinder, Alan, 2013, After the Music Stopped: The Financial Crisis, The Response, and the Work Ahead (New York: The Penguin Press). Borio, Claudio, 2011, ‘Implementing a Macroprudential Framework: Blending Boldness and Realism’, Capitalism and Society, Vol. 6, pp. 1–23. Borio, Claudio and Ilhyock Shim, 2009, ‘What Can (Macro-) Prudential Policy Do To Support Monetary Policy?’ BIS Working Paper No. 242 (Basel: Bank for International Settlements). Bruno, Valentina and Hyun Song Shin, 2014, ‘Assessing Macroprudential Policies: Case of South Korea’, Scandinavian Journal of Economics, Vol. 116, No. 1, pp. 128–157. Brunnermeier, Markus K. and Lasse Heje Pedersen, 2009, ‘Market Liquidity and Funding Liquidity’, Review of Financial Studies, Vol. 22, pp. 2201–2238. Brunnermeier, Markus K., Andrew D. Crockett, Charles A. E. Goodhart, Avinash D. Persaud and Hyun S. Shin, 2009, The Fundamental Principles of Financial Regulation, Geneva Reports on the World Economy No. 11. Carmichael, Jeff, 2012, ‘Implementing Twin Peaks: Lessons from Australia’, mimeo. Claessens, Stijn, Zoltan Pozsar, Lev Ratnovski and Manmohan Singh, 2012, ‘Shadow Banking: Economics and Policy’, IMF Staff Discussion Note, SDN/12/12 (Washington: IMF). Committee on the Global Financial System, 2010, ‘Macroprudential Instruments and Frameworks: A Stocktaking of Issues and Experiences’, CGFS Papers No. 38. Connaughton, Jeff, 2012, The Payoff: Why Wall Street Always Wins (Westport, CT, USA: Prospecta Press). De Nicolò, Gianni, Giovanni Favara and Lev Ratnovski, 2012, ‘Externalities and Macro-prudential Regulation’, IMF Staff Discussion Note 12/05 (Washington: IMF ).

Rules, discretion and macro-prudential policy

63

Duffie, Darrell, 2011, How Big Banks Fail and What to Do About It (Princeton: Princeton University Press). Enriques, Luca, and Gerard Hertig, 2010, ‘The Governance of Financial Supervisors: Improving Responsiveness to Market Developments’, ECGI Law Working Paper No. 171/2010 (Brussels: European Corporate Governance Institute). Financial Stability Board, 2012, ‘Strengthening the Oversight and Regulation of Shadow Banking’, Progress Report to G20 Ministers and Governors, 16 April (Basel: Bank for International Settlements). Fischer, Stanley, 1990, ‘Rules versus Discretion in Monetary Policy’, in Friedman, Benjamin M. and Frank H. Hahn, eds., Handbook of Monetary Economics (Amsterdam: Elsevier), pp. 1156–1184. Fisher, Richard W., 2013, ‘Ending “Too-Big-to-Fail”: A Proposal for Reform Before it’s Too Late’, Remarks before the Committee for the Republic, Washington, DC, 16 January (Dallas: Federal Reserve Bank of Dallas). French, Kenneth R. et al., 2010, Fixing the Financial System, The Squam Lake Report, (Princeton, NJ: Princeton University Press). Fullenkamp, Connel and Sunil Sharma, 2012, ‘Good Financial Regulation – Changing the Process is Crucial’ (London, UK: International Center for Financial Regulation). http://ssrn.com/abstract=2044217. Galati, Gabriele and Richhild Moessner, 2013, ‘Macroprudential Policy: A Literature Review’, Journal of Economic Surveys, Vol. 27, No. 5, pp. 846–878. Goodhart, Charles A. E., 2011, ‘The Macro-Prudential Authority: Powers, Scope and Accountability’, OECD Journal: Financial Market Trends, Vol. 2, pp. 1–26. Goodhart, Charles A. E., and Dirk Schoenmaker, 1995, ‘Should the Functions of Monetary Policy and Banking Supervision Be Separated?’ Oxford Economic Papers, Vol. 47, pp. 539–560. Goodhart, Charles A. E., Carolina Osorio and Dimitrios P. Tsomocos, 2009, ‘Analysis of Monetary Policy and Financial Stability: A New Paradigm’, CESifo Working Paper No. 2885. Goodhart, Charles A. E., Anil. K. Kashyap, Dimitrios P. Tsomocos and Alexandros P. Vardoulakis, 2013, ‘An Integrated Framework for Analyzing Multiple Financial Regulators’, International Journal of Central Banking, Vol. 9, No. 1, pp. 109–144. Gorton, Gary and Andrew Metrick, 2010, ‘Regulating the Shadow Banking System’, Brookings Papers on Economic Activity, Fall issue, pp. 261–312. Haldane, Andrew G., 2012a, ‘Tails of the Unexpected’ speech at the University of Edinburgh, 8 June, (London: Bank of England). Haldane, Andrew G., 2012b, ‘The Dog and the Frisbee’, speech at the Federal Reserve Bank of Kansas City’s Jackson Hole Conference, 31 August (London: Bank of England). Hanson, Samuel G., Anil K. Kashyap and Jeremy C. Stein, 2011, ‘A Macroprudential Approach to Financial Regulation’, Journal of Economic Perspectives, Vol. 25, No. 1 (Winter), pp. 3–28. Hart, Oliver and Luigi Zingales, 2011, ‘A New Capital Regulation for Large Financial Institutions’, American Law and Economics Review, Vol. 13, No. 2 (Fall), pp. 453–490. Hoenig, Thomas, 2011, ‘Do SIFIs Have a Future?’, speech at Pew Financial Reform Project and NYU Stern School of Business seminar on ‘Dodd–Frank One Year

64

I. Agur and S. Sharma

On’, 27 June, Washington, DC (Kansas City: Federal Reserve Bank of Kansas City). Hoenig, Thomas and Charles S. Morris, 2012, ‘Restructuring the Banking System to Improve Safety and Soundness’, mimeo (Washington: Federal Deposit Insurance Corporation). International Monetary Fund, 2009, Global Financial Stability Report, ‘Assessing the Systemic Implications of Financial Linkages’, Chapter 2, April (Washington: IMF). International Monetary Fund, 2011, ‘Macroprudential Policy: An Organizing Framework’, MCM Policy Paper, March (Washington: IMF ). International Monetary Fund, 2012, ‘The Interaction of Monetary and Macroprudential Policies’, December (Washington: IMF ). Kashyap, Anil K., Richard Berner and Charles A. E. Goodhart, 2011, ‘The Macroprudential Toolkit’, IMF Economic Review, Vol. 59, No. 2, pp. 145–161. Kowalik, Michal, 2011, ‘Countercyclical Capital Regulation: Should Bank Regulators Use Rules or Discretion?’ Federal Reserve Bank of Kansas City Economic Review, Second Quarter 2011, pp. 63–84. Kremers, Jeroen and Dirk Schoenmaker, 2012, ‘Financial Stability and Proper Business Conduct: Can Supervisory Structure Help to Achieve these Objectives’, mimeo. Le Leslé, Vanessa, and Sofiya Avramova, 2012, ‘Revisiting Risk-Weighted Assets’, IMF Working Paper WP/12/90 (Washington: IMF ). Lim, Cheng Hoon, Alejo Costa, Torsten Wezel, Akira Otani, Francesco Columba, Mustafa Sayid, Xiaoyong Wu and Piyabha Kongsamut, 2011, ‘Macroprudential Policy: What Instruments and How to Use Them? Lessons from Country Experiences’, IMF Working Paper No. 11/238 (Washington: IMF ). Masciandro, Donato, Marc Quintyn and Michael W. Taylor, 2008, ‘Inside and Outside the Central Bank: Independence and Accountability in Financial Supervision – Trends and Determinants’, European Journal of Political Economy, Vol. 24, pp. 833–848. Morrison, Alan D., 2011, ‘Systemic Risks and the Too-Big-to-Fail Problem’, Oxford Review of Economic Policy, Vol. 27, No. 3, pp. 498–516. Nier, Erlend W., Jing Yang, Tanju Yorulmazer and Amadeo Alentorn, 2007, ‘Network Models and Financial Stability’, Journal of Economic Dynamics and Control, Vol. 31, pp. 2033–2060. Nier, Erlend W., Jacek Osin´ski, Luis I. Jácome and Pamela Madrid, 2011, ‘Towards Effective Macroprudential Policy Frameworks: An Assessment of Stylized Institutional Models’, IMF WP 11/250 (Washington: IMF ). Ötker-Robe, Inci, Aditya Narain, Anna Ilyina and Jay Surti, 2011, ‘The TooImportant-to-Fail Conundrum: Impossible to Ignore and Difficult to Resolve’, IMF Staff Discussion Note SDN/11/12, 27 May (Washington: IMF ). Pagliari, Stefano, ed., 2012, Making Good Financial Regulation: Towards a Policy Response to Regulatory Capture, International Centre for Financial Regulation (Surrey, UK: Grosvenor House Publishing). www.stefanopagliari.net/making_ good_financial_regul.pdf. Pazarbasioglu, Ceyla, Jianping Zhou, Vanessa Le Leslé and Michael Moore, 2011, ‘Contingent Capital: Economic Rationale and Design Features’, IMF Staff Discussion Note, No. SDN/11/01 (Washington: IMF ). Rajan, Raghuram, 2009, ‘Too Systemic to Fail: Consequences, Causes, and Potential Remedies’, US Senate Banking Committee Hearings, 6 May.

Rules, discretion and macro-prudential policy

65

Schoenmaker, Dirk and Peter Wierts, 2011, ‘Macroprudential Policy: The Need for a Coherent Policy Framework’, DSF Policy Paper, No. 13, July (Duisenberg School of Finance: Amsterdam, The Netherlands). Shin, Hyun Song, 2012, ‘Global Banking Glut and Loan Risk Premium’, IMF Economic Review, Vol. 60, pp. 155–192. Shin, Hyun Song, 2013, ‘Procyclicality and the Search for Early Warning Indicators’, IMF Working Paper No. 13/258 (Washington: IMF). Singh, Manmohan, 2010, ‘Collateral, Netting and Systemic Risk in the OTC Derivatives Market’, IMF Working Paper No. 10/99 (Washington: IMF ). Singh, Manmohan, 2012, ‘Puts in the Shadow’, IMF Working Paper No. 12/229 (Washington: IMF ). Siregar, Reza, 2011, ‘Macro-Prudential Approaches to Banking Regulation: Perspectives of Selected Asian Central Banks’, in: Kawai, M. and Prasad, E., eds., Asian Perspectives on Financial Sector Regulation (Washington: Brookings Institution Press), pp. 101–137. Shleifer, Andrei and Robert Vishny, 2011, ‘Fire Sales in Finance and Macroeconomics’, Journal of Economic Perspectives, Vol. 25, No. 1, pp. 29–48. Soros, George, 2010, The Soros Lectures: At the Central European University (New York: Public Affairs). Taylor, Michael W, 2012, ‘Regulatory Reform after the Financial Crisis: Twin Peaks Revisited’, mimeo. Wadhwani, Sushil, 2010, ‘What Mix of Monetary Policy and Regulation is Best for Stabilizing the Economy’, in The Future of Finance: the LSE Report (London: London School of Economics and Political Science). White, William, 2006, ‘Procyclicality in the Financial System: Do We Need a New Macro-Financial Stabilization Framework?’ BIS Working Paper No. 193 (Basel: Bank for International Settlements).

4

Helping hand or grabbing hand? Supervisory architecture, financial structure and market view* Donato Masciandaro and Marc Quintyn

4.1 Introduction In recent years many countries have made drastic changes to the architecture of financial supervision, and more countries are contemplating modifications. The current restructuring wave is making the supervisory landscape less uniform than in the past. In several countries the architecture still reflects the classic model, with separate agencies for banking, securities and insurance supervision. However, an increasing number of countries show a trend towards consolidation of supervisory powers, which in some cases has culminated in the establishment of a unified regulator, either inside or outside the central bank.1 These changes in the supervisory architecture are taking place against the backdrop of fundamental changes in the financial markets. The financial industry is changing its conventional face, with a blurring of the traditional boundaries between banking, securities and insurance, and the formation of large conglomerates. The natural question that follows from a confrontation of these trends is: in a given country, is there any relationship between the shape of the supervisory regime and the evolving features of its financial industry? As a matter of fact, the authorities in the first eye-catching examples of this trend – the United Kingdom and Australia – explicitly justified the supervisory reorganization by referring to the changes in their financial industries along the lines indicated above.2 In other cases, such as South * This chapter is based on Donato Masciandaroa and Marc Quintyn, ‘Helping hand or grabbing hand? Politicians, supervision regime, financial structure and market view’ (2008) 19 North American Journal of Economics and Finance 153–173. 1 For surveys of recent developments see, among others, De Luna Martinez and Rose (2003), Masciandaro (2005a) and Cihak and Podpiera (2007). 2 See, among others, for the UK Briault (1999) and Davis (2004), and for Australia, Commonwealth of Australia (1996). Years before the current wave of supervisory restructuring started, the Nordic countries (Denmark, Norway and Sweden) had already established a unified supervisor. The high degree of concentration of their financial systems was also mentioned as a main reason for this reform (see, among others, Taylor and Fleming (1999).

Helping hand or grabbing hand?

67

Africa, supervisory unification was seen as premature because the authorities did not see any clear trends of blurring of boundaries, or formation of conglomerates. Hence it was decided that bank supervision would remain with the Reserve Bank of South Africa and that supervision of all other subsectors would be unified in another, new agency (Bezuidenhout, 2004). This last example notwithstanding (and there are a few more), there has been a tendency in recent years among policymakers to allude to developments in their financial markets to justify a consolidation of supervisory powers. More generally, the idea that supervisory consolidation and unification is (in part) in response to the blurring and conglomeration trends in the financial sector has become common place in overview studies devoted to the recent evolution in supervisory design.3 However, against this widespread ‘belief ’ stands the finding that there is a general lack of theoretical underpinning and empirical evidence to corroborate the view that the structure of the financial markets plays a decisive role in shaping a country’s supervisory structure. The only empirical paper on the topic, Masciandaro (2006), finds that when policymakers choose the supervision model, they actually seem to neglect some specific features of their financial markets (market capitalization, bank-based versus market-based setting). So the question regarding the importance of market features for the design of the supervisory structure remains broadly unanswered and this chapter will explore the empirical linkages further. A second, related and equally relevant question in this debate, relates to the views of the supervised entities themselves on the supervisory architecture, and the extent to which these views are taken into account in the decision making process. Systematic and empirical evidence in this domain too is rather scarce. Westrup (2007) is one of the few sources on the topic. He reports for instance that in Germany, at least one part of the financial sector representatives (represented in the Bunderverband Deutscher Banken, BdB) were in favour of a unified model outside the Bundesbank, and with a weaker degree of independence from the government than the latter. This is one of the clearest examples of views expressed by the market at the time of a reform. Moreover, these views seem to have had an impact on the final decision. For the United Kingdom, in contrast, his research finds no evidence of explicit views expressed by the market actors at the time of the reforms. The Wallis Commission in Australia reports prior consultation with the financial sector on the reforms of the supervisory framework (Commonwealth of Australia, 1996). Beyond this, almost anecdotal, evidence we have little information on views from the

3 See, for example, Taylor and Fleming (1999) and the case studies collected in Masciandaro (2005a) and Masciandaro and Quintyn (2007).

68

D. Masciandaro and M. Quintyn

market, and on their potential impact on the decision making process in individual countries. This chapter offers two complementary contributions to the debate about the importance of the ‘market factor’ in reshaping supervisory architectures. By ‘market factor’ we understand hereafter the two elements referred to above: the structure of the markets and the views of the market participants (financial institutions). In the first part of the chapter we take a political-economy view to explore the impact of market structure on the supervisory architecture. Since a purely economic view – represented in the selection of the ‘banks-versus-market’ variable in Masciandaro – does not seem to yield clear results, we explore this issue from a politicaleconomic point of view. From a theoretical point of view, at least two alternative theories can be formulated to explain the relationship between the structure of the markets and the supervisory architecture – the helping hand view (HHV) of government and the grabbing hand view (GHV).4 The premise common to both is that policymakers are politicians: politicians are held accountable at the elections for how they have pleased the voters.5 All politicians are ‘career concerned’ agents, motivated by the goal of pleasing the voters in order to win the elections. The main difference between the two theories concerns which voters they wish to please in the first place. Under HHV, the policymaker’s choices are motivated by improving general welfare. Therefore, it is possible to claim that their efforts to reform the supervisory structure aim at improving the efficiency of overall resource allocation, and that the market features are an important factor to be taken into consideration. According to the GHV approach, the policymakers are motivated by the aim to please the interest of specific, well-defined voters. In our case, the financial industry may be considered a highly organized and powerful interest group. The financial industry is likely to be a smaller and more coherent group than the consumers of their services, and therefore politically better organized. The policymaker, in defining the supervisory setting, is likely to be influenced by the market view of supervision, if this increases the probability of his/her re-election. Therefore the market view becomes the crucial variable in determining the shape of the supervisory regime if we use the grabbing hand approach. This theoretical approach is further elaborated in our chapter and empirically tested in a cross-country setting. The second part of the chapter starts from the view that the opinion of the market participants regarding the supervisory architecture is also an 4 The helping hand view goes back to Pigou (1938) and the grabbing hand view was first elaborated by Shleifer and Vishny (1998). 5 Alesina and Tabellini (2003) stressed that the lines of accountability represent the main difference between politicians and bureaucrats: politicians are held accountable at the elections, while bureaucrats are accountable to their professional peers or to the public at large.

Helping hand or grabbing hand?

69

important aspect to study. Understanding the market preferences can be useful to predict either the effectiveness and/or the likelihood of a supervisory regime. Again, this issue has not been addressed systematically in the literature. So here we present and analyse the results of a survey, held among CEOs of Italian financial institutions, about their preferences and beliefs on supervisory structure and regulatory governance and their views on the political decision making process. This chapter is structured as follows. Sections 4.2 and 4.3 disentangle the two opposite theories (HHV and GVH) on the determinants of emerging supervisory structures with special attention for the role of the market factor in the decision making process. Section 4.2 discusses the background to our analysis in the context of the HHV versus GHV hypotheses, and Section 4.3 reports on our empirical tests. In Section 4.4 we discuss the survey on market views. Section 4.5 brings the main conclusions together.

4.2 Do markets matter in designing financial supervision architectures? Helping hand view versus grabbing hand view Do the features of financial markets matter in determining the shape of the supervisory regime? The relevance of this question is of a recent date. Until roughly 15 years ago, the issue of supervisory architecture was considered irrelevant. First of all, the fact that only banking systems were considered needing supervision made several of the current organizational questions meaningless. In such a context, the supervisory design was either considered deterministic (i.e. it is an exogenous variable), or accidental (i.e. it is a completely random variable).6 The situation has changed. The changes in the financial markets, resulting in the growing systemic importance of insurance, securities and pension fund sectors have made supervision of all segments of the financial system important, and raise the issue as to whether the newly emerging financial supervisory structures are endogenous, i.e. designed in response to these developments and other factors. Our starting point to answer this question is based on three crucial hypotheses. First of all, we claim that gains and losses of a supervisory model7 are expected variables calculated by the policymaker in charge,

6 For an historical perspective, see the discussion in Capie (2007) and Goodhart (2007). 7 For an analysis of pros and cons of alternative models of supervision see, among others, Arnone and Gambini (2007), Cihak and Podpiera (2007), Di Giorgio and Di Noia (2007). See also Section 4.5 below.

70

D. Masciandaro and M. Quintyn

who decides to maintain or reform the supervisory regime.8 Second, the expectations of policymakers, whatever their own specific goals are, will likely be influenced by structural variables – such as the features of the financial markets – that may vary from country to country. We wish to test the hypothesis that in every country, given the structural endowment, these variables can determine, ceteris paribus, the gains or losses policymakers expect from a specific supervisory regime. The supervisory regime is the dependent variable. Finally, economic agents have no information on the true preferences of the policymaker: the latter’s optimal degree of financial supervision concentration is a hidden variable.9 The crucial element in considering the policymaker’s objective as a factor in the design of the supervisory architecture is the identification of his/her preferences. The first approach to identifying the policymaker’s function could be the so-called narrative approach, in which official documents are interpreted to gauge the choices of policymakers.10 One drawback of this approach is that there is often substantial room for differences between the pronouncements of policymakers and their actual preferences. The second approach, which we intend to follow here, is to consider the actual choices of policymakers in determining the level of financial supervision concentration (factual approach). At each point in time, we observe the policymaker’s decision to maintain or reform the financial supervision architecture. In other words, we consider that policymakers are faced with discrete choices. According to the factual approach, we can investigate if the features of the financial markets play any role in determining the actual shape of the supervisory architecture. We can explore two alternative views – the helping hand view of government and the grabbing hand view – which share a common premise: the policymakers are politicians, i.e. they are ‘career concerned’ agents, motivated by the goal of pleasing the voters in order to win the elections. The main difference concerns which voters – general interest versus vested interest – they are trying to please. Thus, although we agree with most scholars that the institutional structure of financial sector supervision is a second order issue, and that the governance of these institutions, the quality of rules and regulations and of the supervisory process are much more important, this chapter 8 The importance of the policymakers’ preferences in explaining how supervisory settings come about can be tackled in different ways. For example, the political economy of financial regulation can be analysed as the outcomes of conflicts which are linked to inclusive and exclusive processes. See Mooslechner et al. (2006) and in particular Lutz (2006). 9 By financial supervision concentration we refer to the degree of integration or consolidation of the supervisory function. At one end of the spectrum are those countries that have several sector-specific supervisory agencies; at the other end of the spectrum are the countries that have established a unified supervisor. 10 The narrative approach has been used in, for instance, Westrup (2007).

Helping hand or grabbing hand?

71

contends that the institutional structure is not unimportant either. By taking a political economy view, we can test the hypothesis that politicians may wish to use reform (or status quo) to gain or keep influence into the supervisory process, and through it, into the operation of the financial system.11 Hence, institutional reforms can be used by politicians to influence the quality of the regulatory and supervisory process. 4.2.1 Helping hand view In general, the HHV policymaker – i.e. a government that aims to maximize social welfare – wishes to correct or prevent market imperfections.12,13 In the case of designing the financial supervision regime, the HHV policymaker can choose to maintain or reform the degree of supervisory concentration in order to improve the overall efficiency in resource allocation, and therefore he/she has to take into account the structure of the financial system. The crucial stylized fact in this regard is the blurring of boundaries in the financial industry which is leading to an increasing integration of the banking, securities and insurance markets, as well as their respective products and instruments. The blurring effect has caused two interdependent phenomena: (i) the emergence of financial conglomerates, which is likely to produce important changes in the nature and dimensions of the individual intermediaries, as well as in the degree of unification of the banking and financial industry; and (ii) growing securitization of the traditional forms of banking activity and the proliferation of sophisticated ways of bundling, repackaging and trading risks, which weakens the classic distinction between equity, debt and loans, and is bringing changes in the nature and dimensions of the financial markets. The HHV policymaker recognizes that the supervisory architecture was created for a structure of the financial system that is no longer consistent with these structural changes. The supervisory boundaries no longer reflect the actual features of the financial industry. The question of the institutional setting of supervision becomes a policy issue. In particular, the HHV policymaker wonders if a unification in supervision has to follow 11 For instance, a majority of commentators agree that the government’s decision to establish a unified regulator in Poland in 2006 was mainly meant to curb the central bank’s power and to regain some government influence over financial sector developments. See for instance remarks and citations in Agence France Press (2006), Associated Press Newswires (2006) and Dow Jones Commodities Service (2006). 12 Pigou (1938). 13 Although the helping hand view was identified by Pigou as the government’s way to address market imperfections and enhance social welfare, it has been pointed out that this view of the government can also lead to excesses. Barth et al. (2004) point out that the helping hand view can stimulate the introduction of regulations that in fact choke financial sector development, such as entry restrictions and limits on activities.

72

D. Masciandaro and M. Quintyn

the blurring trends in the markets. In other words, should supervisory activities be integrated, through the establishment of a single financial regulator? In general, the HHV policymaker will find advantages and disadvantages in the establishment of a unified financial sector supervisor.14 Potential benefits of unification include a more efficient and effective control of financial conglomerates and financial markets in a state of flux. By providing more effective supervision the HHV policymaker would please the financial consumers – i.e. the citizens – but contributing to the existence of a stable financial environment. Most likely this would increase the probability to win the election. The views expressed by the market participants on the optimal structure of supervision could become an important factor in the discussion on improving efficiency and effectiveness of financial supervision. From the point of view of the market participants a unified supervisor could solve problems of duplication, overlap and inconsistency in controls and reporting requirements, and regulatory gaps. It could also increase the possibility of having a level playing field, characterized by competitive neutrality. In other words a unified supervision could mean a decrease in the expected compliance costs. If the market participants like more concentrated supervision, a closer alignment between general interest (effective supervision) and specific (market participants) interest (efficient supervision) is more likely to occur. Therefore, the HHV policymaker can be sensitive to the market view. 4.2.2 Grabbing hand view The GHV policymaker is also an elected politician, for which he/she has to please the voters. But now we consider the case of lobbies, which can influence the policymaker’s choices. In contrast with the HHV policymaker, the GHV government would tend to give benefits only to a small but well organized interest group. The GHV policymaker is captured by a specific interest group, whose support is considered fundamental for (re) election.15 We can suppose16 that, while the common voters can influence the policymaker only through elections, the vested interest group can influence the policymaker through explicit or implicit contributions, important enough to increase the chances of winning the elections. In this case the preferences of the interested group would become the fundamental variable in explaining the policy choices.

14 Abrams and Taylor (2002), Arnone and Gambini (2007), Cihak and Podpiera (2007). 15 We use the terminology of the regulatory capture theory – Stigler (1971) – to describe a situation where both policymaker and industry pursue their own benefits, rather than social welfare. 16 As in Alesina and Tabellini (2003).

Helping hand or grabbing hand?

73

Faced with the issue of (re)shaping the architecture of financial supervision, the GHV policymaker can be influenced by the market features, but – more importantly – he/she will most likely be sensitive to the preferences of the market participants. The demand by the financial industry for more consolidated supervision can be a disguised form of capture. Capture is more likely to occur: (i) the greater the level of concentration in the financial industry is; and (ii) the more the number of supervisory authorities decreases. In these circumstances, if premises (i) and (ii) together hold, the establishment of a single financial authority can become an institutional deficiency from a social welfare point of view, and undermine effectiveness and efficiency of supervision.

4.3 Does the market factor matter? To assess empirically the role of the market structure in determining the degree of concentration in the financial supervision architecture from the perspective of these two alternative views, we estimate a model of the probability of different regime decisions as a function of a set of exogenous structural variables. To that effect, we use the approach introduced in Masciandaro (2005b, 2006). Weaving a cross-country perspective into an empirical analysis consistent with this discrete choice process involves claiming the existence of unobservable policymaker utilities Uij, where each Uij is the utility received by the ith national policymaker from the jth level of supervision consolidation. Since the utility Uij is unobservable, we represent it as a random quantity, assuming that it is composed of a systematic part U and a random error term E. Furthermore, we claim that the utilities Uij are a function of the attributes of the alternative institutional level of supervision consolidation and the structural characteristics of the policymaker’s country. By combining the two hypotheses, we have a random utility framework for the unobservable supervision consolidation variable. As usual, we assume that the errors Eij are independent for each national policymaker and institutional alternative, and normally distributed. The independence assumption implies that the utility derived by one national policymaker is not related to the utility derived by a policymaker in any other country, and that the utility that a policymaker derives from the choice of a given level of financial consolidation is not related to the utility provided by the other alternative. Therefore, supervisory regimes can be viewed as resulting from an unobserved variable: the optimal degree of financial supervision consolidation, consistent with the policymaker’s utility. Each regime corresponds to a specific range of the optimal financial supervision consolidation, with higher discrete values of a given index corresponding to a higher range of financial unification values. We use the Index of Financial Authorities Concentration (FAC) proposed in Masciandaro (2004). Since the FAC Index is a qualitative ordinal variable, the estimation of a model for such a

74

D. Masciandaro and M. Quintyn

dependent variable necessitates the use of a specific technique. Our qualitative dependent variable can be classified into more than two categories, given that the FAC Index is a multinomial variable. But the FAC Index is also an ordinal variable, given that it reflects a ranking. Then the ordered model is an appropriate estimator, given the ordered nature of the policymaker’s alternative. Let y be the policymaker’s ordered choices taking on the values (0, 1, 2, . . ., 7). The ordered model for y, conditional on a set of K explanatory variables x, can be derived from a latent variable model. In order to test this relationship, let us assume that the unobserved variable, the optimal degree of financial supervision consolidation y*, is determined by: y* = B'x + E

(1)

where E is a random disturbance uncorrelated with the regressors, and B is a 1 × K regressors’ vector. The latent variable y* is unobserved. What is observed is the choice of each national policymaker to maintain or to reform the financial supervisory architecture. This choice is summarized in the value of the FAC Index, which represents the threshold value. For the dependent variable we have seven threshold values. Estimation proceeds by maximum likelihood, assuming that E is normally distributed across country observations, and the mean and variance of E are normalized to zero and one. This model can be estimated with an ordered Logit model or with an ordered Probit model.17 On the basis of this framework, we can analyse the role of the market features in the determination of the supervisory architecture. In spite of the contrast between both views, they remain difficult to disentangle from an empirical point of view, among others because it is not easy to find empirical variables that consistently and unambiguously represent each of these two approaches. 4.3.1 Review of existing evidence We start from the model developed in Masciandaro (2005b, 2006). The model identified six potential determinants of the financial supervision regime. First, the probability that a country will move toward a more concentrated form of supervision can depend on the overall size of the country (economic factor). Second, the choice of the policymaker regarding how many institutions are to be involved in supervision seems to be related 17 The Logit model differs from the Probit model only in the cumulative distribution function used to define choice probabilities. The maximum likelihood estimations were carried out by a packaged-ordered Probit and ordered Logit commands in STATA. We present both the Logit and Probit results, given that, as usual, there is little basis for choosing between both models.

Helping hand or grabbing hand?

75

to the traditional role played by the central bank in the supervisory process (central bank factor). Third, the quality of the political environment could be important in determining the policymaker’s choice (political factor), as well as the legal system (legal factor), and the geographical location (geographical factor). Finally, the policymaker can choose to maintain or change the degree of supervisory unification in response to the structure of the financial system (market factor). The market factor is captured by using the classic comparison between the equity dominance model (or market-based regime) and the bank dominance model (or bank-based regime). To test the six potential determinants of financial supervision architectures, the following general specification is adopted (2): (FAC)i = B0 + B1(CBFA)i + B2(GDP)i + B3(OECD)i + B4(MVB)i + B5(MCAP) + B6(GGOV) + B7(EU) + B8(LAT) + B9(LEN) + B10(LFR) + B11(LGS) + Et

(2)

with country18 i = 1 . . . 88. The explanatory variables are defined as follows:19 1 2 3 4

CBFA = variable for the central bank factor. It is the index of involvement of the central bank in supervision;20 GDP = Gross Domestic Product: quantitative variable for the size factor;21 OECD = qualitative variable for the size factor. It is a dummy that signals whether a given country is a member of the OECD or not; MvB = Market vs Bank Index: qualitative variable for the market factor. It is a dummy that expresses the financial system of a given country, market-based versus bank-based;22

18 The country sample depends on the availability of institutional data. Given the 267 world countries (UN members are 180), our 89 countries represent 60 per cent of world GDP and 82 per cent of the world population. 19 The correlation matrix for the variables is in Table 4.1a. 20 Masciandaro (2005b): for each country, and given the three traditional financial sectors (banking, securities and insurance), the CBFA index is equal to: 1 if the central bank is not assigned the main responsibility for banking supervision; 2 if the central bank has the main (or sole) responsibility for banking supervision; 3 if the central bank has responsibility in any two sectors; 4 if the central bank has responsibility in all three sectors. In evaluating the role of the central bank in banking supervision, we considered the fact that, whatever the supervision regime, the monetary authority has responsibility in pursuing macro financial stability. Therefore, we chose the relative role of the central bank as a rule of thumb: we assigned a greater value (2 instead of 1) if the central bank is the sole or principal institution responsible for banking supervision. 21 World Bank, 2003, World Development Indicators. For each variable we calculate the mean of four time values: 1996, 1998, 2000, 2002. 22 The index is calculated using different banking and financial variables: see Beck et al. (1999). For each variable we calculate the mean of four time values: 1996, 1998, 2000, 2002.

76

D. Masciandaro and M. Quintyn MCAP = Market capitalization/GDP: quantitative variable for the market factor. It shows a measure of the securities market size, relative to GDP;23 6 GGOV = Good Governance: quantitative variable for the political factor. It shows the structural capacity of the government to formulate and implement sound policies. Furthermore the index can represent the control variable for the politics and finance view;24 7 EU = binary variable for the geographical factor. It is a dummy that signals whether a given country is European or not; 8 LAT = quantitative variable for the geographical factor. The variable is calculated as the absolute value of the latitude of the country, scaled to take values between 0 and 1;25 9–11 LEN LFR, LGS = binary variables for the law factor. They are dummies that indicate the legal root of a given country, representing the control variables for the law and finance view.26 5

Tables 4.2 and 4.3 show the Logit and Probit estimates of Equation (2). In the multinomial ordered models the impact of a change in an explanatory variable on the estimated probabilities of the highest and lowest of the order classifications – in our case the Single Authority model (unified supervisor) and the ‘pure’ Multi-Sector supervisory model – is unequivocal:

23 World Bank, 2003, World Development Indicators, Stock Markets 5.3. For each variable we calculated the mean of four time values: 1996, 1998, 2000, 2002. Note that the correlation index between the financial regime variable (MvB) and the market capitalization variable (mcap) is high, but their influence on the dependent variable is very low. 24 The index is built using all the indicators proposed by Kaufmann et al. (2003). They define (public) governance as the exercise of authority through formal and informal traditions and institutions for the common good, thus encompassing: (1) the process of selecting, monitoring and replacing governments; (2) the capacity to formulate and implement sound policies and deliver public services; (3) the respect of citizens and the state for the institutions that govern economic and social interactions among them. Furthermore, for measurement and analysis purposes, these three dimensions of governance can be further unbundled to produce two measurable concepts for each of the dimensions above, for a total of six components: (1) voice and external accountability; (2) political stability and lack of violence; 3) government effectiveness; 4) lack of regulatory burden; 5) rule of law; 6) control of corruption. The authors present a set of estimates of these six dimensions of governance for four time periods: 1996,1998,2000,2002. For every country, therefore, we first calculate the mean of the four time values for each dimension of governance; then we build up an index of global good governance in the period 1996–2002, calculating the mean of the six different dimensions. 25 La Porta et al. (1997, 1998). On the endowment view, also see Beck et al. (1999). 26 Beck et al. (1999). There are five legal roots: Anglo-Saxon Law (=Common Law), French, German and Scandinavian Laws (=Civil Laws), Socialist Law (Others); we put together German and Scandinavian roots, and we skip one root – choosing the Socialist Laws, as the least significant from an economic point of view – to avoid multi-collinearity problems.

Helping hand or grabbing hand?

77

If Bj is positive, for example, an increase in the value of xj increases the probability of having the Single Authority model, while it decreases the probability of having the ‘pure’ Multi-supervisory model. The results of the estimates show that the probability that a country will move toward a Single Authority model is higher: (i) the smaller the size of the economy (small country effect);27 (ii) the lesser the central bank is involved in supervision before the reform (path dependence effect); and (iii) when the jurisdiction operates under the Civil Law – particularly if the legal framework is characterized by German and Scandinavian roots (law effect). The market factor does not seem to matter in this specification. 4.3.2 New evidence This section attempts to further the analysis of the role of the market factor by testing three innovations to the basic model. First the original database of the general model is updated by calculating the level of the structural macro variables: gross domestic product, market capitalization and good governance.28 Tables 4.4 and 4.5 show the Logit and Probit Estimates of Equation (2) with the new database. The results confirm the robustness of three main determinants: the institutional, economic and law factors. The market factor becomes significant, showing a positive relationship between the consolidation level and the market oriented structure. Second, since we are studying a policymaker’s general trend in reforming supervision, rather than a specific trend in consolidation, we may wonder if there is some kind of ‘bandwagon effect’ among the policymakers at work: the policymaker in a given country implements a reform of the supervisory framework, because policymakers in other countries did or are doing the same thing, in other words, because it is becoming fashionable. To test the bandwagon effect, we construct a new variable: for each country, we compute the year in which the last reform in supervision was implemented (Yeareform). The hypothesis is that, with a bandwagon effect, recent reforms are likely to correspond to higher level of

27 This finding is consistent with the so-called small open-economy argument for unification of the supervisory functions. The argument was first developed by Taylor and Fleming (1999) in their analysis of the Scandinavian experience with supervisory integration in the late 1980s and early 1990s. The argument has later been used by other countries to justify the establishment of a unified supervision (for examples, see contributions in Masciandaro, 2005a). 28 Masciandaro (2005b) used for each of the three variables the mean of four periods in time: 1996, 1998, 2000, 2002. Here we compute the mean by adding a fifth value: 2004. The source is the same: World Bank.

78

D. Masciandaro and M. Quintyn

consolidation.29 Tables 4.6 and 4.7 show that the new variable is not significant. This finding seems to confirm an activism on the part of the policymakers in reforming the supervisory architecture, rather than an attempt at mimicking the establishment of a single regulatory authority. So, while there might be some form of demonstration effect – reforming because others are reforming – it is certainly not clear from the above finding that the model of complete integration is being copied because it seems fashionable. The third step addresses the question as to which type of policymaker is in action. To take into account the predictions of both the HHV and the GHV, we have to identify new indicators, given that, under this perspective, the above ‘market oriented versus bank oriented’ variable alone is not sufficient to discriminate between the two views. The HHV policymaker, in order to increase the efficiency in resource allocation, will address the two most striking financial sector phenomena: the formation of conglomerates and securitization of financial products. However, the role of market trends in influencing the policymaker’s decisions is not unequivocal, given that – as we highlighted above – the optimal model of supervision is still to be discovered, and ex ante a more consolidated supervisory setting can produce either advantages or disadvantages. Therefore, given the market structure, the expected sign of a relationship between the degree of supervision concentration and a proxy of the new financial trends is undetermined – i.e. can be positive or negative – and remains an empirical question. At the same time, the HHV policymaker is by definition immune with respect to any risks of capture. The GHV policymaker will be sensitive to the preferences of the market participants, irrespective of the actual trends in the financial markets. As we already noted, the demand of the financial industry for more consolidated supervision can hide a risk of capture. Provided that the market participants like a unified supervisory model, and given the market structure, the expected sign of a relationship between the degree of supervision concentration and a proxy of the capture risk is positive. Thus, the predictions of the theory regarding the two types of policymakers are different, although a degree of ambiguity cannot be eliminated. Given the policymakers’ opposite profiles, we can first test the effect of an indicator of market trends: the conglomeration effect. The relationship between the supervisory unification and the conglomeration effect (Cong30) is more likely to be significant if the policymaker is a HHV type.

29 We acknowledge that the yeareform variable is a fairly imperfect proxy for a possible bandwagon effect. The best way to calculate this effect would be the construction of an index of the change in each country in the level of supervision consolidation before and after the last reform. 30 The variable is derived from the database contained in Barth et al. (2004) and corresponds to their question 2.4.

Helping hand or grabbing hand?

79

Second, we can test the consequences of a proxy of the capture risk: the degree of consolidation in the financial industry. The relationship between supervisory unification and the degree of concentration of the financial system (Conc31) is more likely to be significant if the policymaker is a GHH type. In addition, provided that the market participants prefer a unified supervisory model, the expected sign of the relationship is positive. That the two measures of the market factor are different, at least in our sample, is confirmed by their low positive correlation coefficient (0.0731).32 Due to limited data availability on these two variables, the size of the original country sample is reduced from 88 countries to 80 (concentration effect) and 51 countries (conglomeration effect), respectively. The results are reported in Tables 4.8–4.11. The first two tables (4.8 and 4.9) show that the conglomeration effect is not significant. In addition, the overall specification loses significance. In contrast, the results in Tables 4.10 and 4.11 signal that the concentration effect is always positive and significant. Furthermore, the relevance of the institutional factor and the law factor are confirmed in this specification. A tentative conclusion from these regressions is that the behaviour of policymakers is more consistent with the GHV, presuming a market preference toward supervisory consolidation. More research is certainly needed to arrive at more robust conclusions. This could be achieved by identifying better proxies for the market features that are considered relevant in the politicians’ decision making process.

4.4 Case study: the market view in Italy Information on the views of the market participants regarding the desirable supervisory architecture and its governance structure is not generally and systematically available. Thus far, researchers have to rely more on anecdotal evidence. Westrup (2007), for instance, reports that in Germany, at least one part of the financial sector representatives (represented in the Bunderverband Deutscher Banken, BdB) were in favour of a unified model outside the Bundesbank, and with a weaker degree of independence from the government than the latter. This is one of the clearest examples of views expressed by the market at the time of a reform. For the United Kingdom, in contrast, he finds no evidence of explicit views expressed by the market actors at the time of the reforms. The Wallis Commission in Australia also consulted with the financial sector on the reforms of the supervisory framework (Commonwealth of Australia, 1996). 31 The variable is constructed as the percentage of total deposits held by the five largest banks in the country at the end of 2001. The variable is derived from question 2.6.2 of the new database constructed by Barth et al. (2004). 32 The correlation matrix for the market factor variables is in Table 4.1b.

80

D. Masciandaro and M. Quintyn

In this section we will analyse the market view on supervision architecture and regulatory governance in the case of Italy. The analysis is based on a survey conducted among Italian financial businessmen regarding the supervisory structure and its governance. As such it is one of the first attempts to map the views, preferences and beliefs of the sector in a systematic way, and can provide us with a number of additional insights into the dynamics of the evolving debate regarding supervisory structures and their governance. The Italian situation is particularly interesting, with a bank-based financial system, which has gone through a rapid consolidation in recent years and which is governed by a highly decentralized supervisory model, with five authorities. This model was confirmed by the Italian Parliament in December 2005, but more recently the new Centre-Left Government started discussing a reform aimed at introducing a twin peak regime and revisiting the governance rules.33 Thus, we are observing a consolidation process in the markets which will perhaps be accompanied by a consolidation in the supervisory architecture. We wonder if in a more concentrated financial industry the market participants have clear preferences on the level of the supervisory consolidation and on the degree of independence and accountability of the supervisors. The identification of the market view can be useful to analyse the choices of the policymakers, in order to test the chain between the financial structure, the market view and the political preferences. 4.4.1 Italy’s financial system structure The Italian financial industry is a typical bank-based system. We acknowledge that often an arbitrary judgement is made to decide whether a country’s financial industry is bank-based or market-based. Among the many indicators of the financial structure that have been proposed in the literature,34 we use the ratio of the market capitalization of stocks to the gross domestic product. While this measure is intuitively simple and appealing, it remains an imperfect benchmark. However, this ratio is sufficient to show that Italy still has underdeveloped securities markets. In the overall country sample, Italy ranks 30th of 88, and among the 24 advanced OECD countries, Italy ranks 16th. This international comparison confirms that the Italian stock market is still smaller than that of the other advanced

33 The twin peak model was first discussed by Taylor (1995). The model groups supervision of market behaviour of all segments of the financial system in one peak, and conduct of business supervision in another. Thus far the model has only been adopted in Australia and the Netherlands. 34 See among others Beck et al. (1999) and Levine (2002).

Helping hand or grabbing hand?

81

countries, and that firms – particularly small and medium sized enterprises – have to depend heavily on bank credit.35 Looking at the country figures alone, banking sector assets accounted for 66.5 per cent of the financial system’s total assets at end-June 2005. In addition, banks control a substantial share of the asset management industry – the second most important class of financial institutions with 16 per cent of total assets – and the insurance sector, the third class with 12 per cent.36 The pervasive role of the banks is also reflected in the growing concern of the central bank, which drew attention to the need to ensure that asset management companies were independent of the banking and insurance groups which control them and distribute their products.37 The degree of concentration of the banking industry has been increasing in recent years. Looking at the total value of deposits held by the five major banks, Italy ranks 64 out of 80 in the country sample (Figure 4.1, black bar), and 17th among the 21 OECD countries (Figure 4.2, black bar). However, the number of banks declined from 970 in 1995 to 787 in 2004;38 the six largest banks represented 55 per cent of total assets at end2004.39 In 2006 the first and third largest banks merged, building up the biggest Italian bank: Intesa SanPaolo. The consolidation process is likely to continue: in February 2007 the Governor of the Banca d’Italia claimed that ‘there is still room for mergers and acquisitions able to create synergies’.40 4.4.2 Supervisory framework The supervisory framework is a multi-authority model, built around five institutions. The central bank (Banca d’Italia) is the supervisor of the banking system and, with a view to preserving financial stability, is also responsible for supervising the asset management industry, as well as other relevant financial markets, such as wholesale markets for government securities and interbank markets. Furthermore – until the recent law No. 262 of December 2005 – the central bank was the main authority in charge of enforcing the antitrust law. The central bank was by law assigned at least two goals: maintaining financial stability and enforcing the antitrust law. The Italian Companies and Stock Exchange Commission (CONSOB) regulates and supervises the Italian securities markets, while the insurance market is supervised by the Insurance Authority (ISVAP). Pension Funds

35 36 37 38 39 40

Draghi (2006b), Cardia (2006). International Monetary Fund (2006). Draghi (2007). European Central Bank (2005). International Monetary Fund (2006). Draghi (2007).

0

20

40

60

80

100

120

Countries

Figure 4.1 Concentration of overall sample (comparative position of Italy highlighted in black).

Total value of deposits Botswana Iceland Finland Trinidad and Tobago Estonia Nicaragua Lithuania Cyprus Netherlands Mauritius Sweden Israel

Albania Malta

Canada Belgium El Salvador Norway Peru

New Zealand Denmark Mexico Portugal Belarus Macedonia, FYR South Africa Czech Republic Greece Moldova China Morocco Australia Jamaica Kazakhstan Slovak Republic Zimbabwe Slovenia Thailand Ecuador France Pakistan Croatia Korea, Rep. of Switzerland Hungary Jordan Romania Vietnam Tunisia Poland Uruguay Egypt, Arab Rep. Brazil

Bolivia Bosnia and Herzegovina Chile

Kenya Bulgaria Guatemala Russian Federation Georgia Malaysia Turkey Italy

Venezuela, RB United Arab Emirates Argentina Philippines Japan Spain

Latvia Colombia India

Austria Ukraine United States Luxembourg Panama United Kingdom Germany

Helping hand or grabbing hand?

83

120

80 60 40

Germany

Luxembourg

United Kingdom

United States

Spain

Austria

Italy

Japan

Poland

Hungary

France

Korea, Rep. of

Greece

Australia

Mexico

Portugal

Denmark

Norway

New Zealand

Canada

Belgium

Sweden

0

Finland

20

Netherlands

Total value of deposits

100

Figure 4.2 Concentration of OECD sample (comparative position of Italy highlighted in black).

are supervised by the Pension Fund Authority (COVIP). Finally, the Italian Foreign Exchange Office (UIC) is responsible for anti-money laundering and combating terrorist financing.41 From a theoretical point of view, the Italian regime represents a striking example of the so-called central bank fragmentation effect.42 The number of supervisors is directly related to the central bank involvement in supervision itself, reducing the degree of supervisory consolidation. The Italian Parliament, notwithstanding a declaration in favour of supervision by objectives – see below on this type of regime – confirmed the multi-authority regime with the abovementioned law No. 262 of December 2005 (New Law on Savings). The same law was designed to reform the governance of the central bank in a number of crucial areas. The law moved the responsibility for regulating anticompetitive behaviour from the central bank to the Antitrust Authority, with shared responsibilities of the two institutions for bank mergers and acquisitions. The law defined five principles – reaffirmation of central bank autonomy, transfer of central bank ownership to public entities, enhanced collegiality, increased reporting requirements, changes to the mandate of the Governor and the other members of the Directorate – with key provisions to 41 International Monetary Fund (2006). 42 Masciandaro (2006).

84

D. Masciandaro and M. Quintyn

be spelled out in the amendments of the central bank statute.43 The role of a government committee – The Inter-Ministerial Committee on Credit and Savings – in supervision makes it difficult to evaluate the real degree of central bank independence in the supervisory area.44 In February 2006 the Centre-Left government proposed a twin peak supervisory model, or supervision by objectives.45 The twin peak model states that all intermediaries and markets be supervised by two authorities, with each single supervisor being responsible for one goal of regulation. The Banca d’Italia would be in charge of financial stability, while CONSOB would be responsible for transparency and conduct of business. Both agencies supported the view that supervision by objectives is necessary.46 As part of the reforms, the Inter-Ministerial Committee on Credit and Savings would be eliminated and replaced by a Financial Stability Committee, with three members: the Minister of Treasury (Chairperson), the Governor of the Banca d’Italia and the President of CONSOB. The Financial Stability Committee would promote the exchange of information, the coordination between the two supervisory agencies, as well as the cooperation between national and international supervisors. Finally, the government proposal defined common rules on the accountability of the two agencies towards the Parliament and its Commissions. 4.4.3 The market view: the 2006 survey In October–November 2006 a survey, prepared by the authors of this chapter, was carried out by the Asset Management Industry (AMI) Association47 amongst 230 CEOs48 of the AMI firms. Italy currently has 171 AMI firms;49 their shareholders are Italian banks (82 per cent), Italian nonbank financial firms (12 per cent) and foreign financial and banking institutions (6 per cent). The AMI managers are highly representative of the Italian financial community. As noted above, the asset management industry is the second largest segment of the financial sector, but more importantly, the AMI firms are mainly controlled by the domestic banks. The answers to the questionnaires (68 respondents, 30 per cent of the overall CEO population) offer an original picture of the market view on the key features of the supervisory architecture. In addition to the aim of

43 44 45 46 47 48 49

International Monetary Fund (2006), Draghi (2006a). International Monetary Fund (2006). Di Giorgio and Di Noia (2007). Cardia (2005), Draghi (2006a). ‘Assogestioni’. ‘Amministratore delegato’ or ‘Direttore generale’. 167 Società di Gestione del Risparmio (SGR), 3 Fondi Pensione, 1 Società di Intermediazione Mobiliare (SIM).

Helping hand or grabbing hand?

85

increasing our understanding of the market view, specific goals of the survey included the identification of the market preferences on the actual and optimal level of key features of the supervisory setting (efficiency, neutrality, staff saving, responsibility) and governance (independence and accountability), as well as the market’s views on the political feasibility of their reform. 4.4.3.1 Present structure The first part of the questionnaire surveys the views on the present regime. Questions 1–8 inquire about the respondents’ views on the general features of the supervisory architecture such as the risks of supervisory inefficiency, lack of neutrality, staff surplus and low responsibility due to the multitude of agencies. Of the respondents, 80 per cent estimated that the risk of supervisory inefficiency is high (more than 50 per cent) in the present institutional setting. The risk of lack of regulatory neutrality is considered high by 75 per cent of the respondents. For 84 per cent of the managers, the staff surplus risk is high, while 59 per cent of them think that the risk of low responsibility is high. Thus, it appears that the market’s appreciation of the overall efficiency of the multi-authority system is low. This view is confirmed by the fact that only 40 per cent of the respondents consider the current regime as effective. 4.4.3.2 Governance of the present structure Questions 9–14 deal with views on the governance – independence and accountability – of the two main supervisory authorities: Banca d’Italia and CONSOB. The questions start from the assumption that the governance framework has to be designed in such a way that management of the agencies is free from any form of ‘capture’. The risks of supervisory capture can be classified in three categories: ‘political capture’, ‘industry capture’ and ‘self-interest capture’.50 Thus, independence from politicians (political independence) and the supervised industry (industry independence) can be considered good practice.51 Finally, there is always the risk that a supervisor pursues his/her self interest, which may not be consistent with the social welfare. Hence, there must be transparent reporting procedures on the supervisor’s activities, as well as rules on staff integrity, to avoid self bureaucrat capture. Accountability and transparency provide the society with assurances that supervision is not manipulated.52 For 45 per cent of the Italian financial CEOs, political independence of the Banca d’Italia is high (more than 50 per cent), while almost the same

50 See Masciandaro et al. (2007). 51 Quintyn and Taylor (2003, 2007). 52 Quintyn and Taylor (2003).

86

D. Masciandaro and M. Quintyn

percentage of respondents (43 per cent) also consider industry independence high. In contrast, accountability is high in the eyes of only 9 per cent of the respondents. The CONSOB is highly politically independent and industry independent – respectively for 27 per cent and 46 per cent of the responders. The level of accountability of CONSOB is considered high by only 8 per cent. 4.4.3.3 Preferred supervisory model The second part of the questionnaire deals with views on reforms. The aim of questions 15–28 is to discern if there exists an ideal supervisory setting in the minds of the market participants. The shortcomings of the multi-authority model become evident when analysing the market preferences with regard to a possible supervision consolidation. In the eyes of the respondents, a reform of the supervisory setting should produce a high (more than 50 per cent) reduction in the various sources of inefficiencies. Among the respondents, 36 per cent look for a significant reduction in the risk of supervisory inefficiency. The need for a reduction in the risk for a lack of regulatory neutrality is considered high for 47 per cent of the respondents. In 45 per cent of the cases, the managers think that the risk of a bureaucratic staff surplus should be diminished, and a similar share of respondents favour a reduction in the risk of low responsibility. While an overall reform is urgent for 79 per cent of the respondents, 49 per cent of them express a preference for the twin peak model, while the other 51 per cent are in favour of a single supervisor. The survey does not document any particular ‘home bias’ preference: exactly 50 per cent of the CEOs think that a national supervisor is better (as opposed to a supervisor at the European level), and 60 per cent prefer national accountability procedures. Regarding the optimal governance rules for supervisors, the financial professionals are in favour of more political independence (74 per cent), more industry independence (72 per cent), but also more accountability (90 per cent). Among the respondents, 54 per cent are in favour of a mixed financing rule – a combination of public funds and fees from the supervised intermediaries. What is clear from this survey is that the Italian market view expresses a preference for supervisory consolidation. 4.4.3.4 Belief in the feasibility of the reforms The final set of questions (29–42) seeks to clarify the market beliefs in the feasibility of a reform. The purpose is to evaluate the alignment between market preferences and the expected government choice. In general, implementing supervisory reforms is seen as a sign of progress, and respondents see a relatively high probability (more than 50 per cent) that

Helping hand or grabbing hand?

87

a reform will indeed lead to a reduction in the different sources of inefficiencies currently experienced. Among the respondents 68 per cent consider a reduction of the risk for supervisory inefficiency likely. A reduction in the risk of a lack of regulatory neutrality is estimated as likely by 65 per cent of the respondents. Of the managers, 45 per cent think that it will also lead to a reduction in the staff surplus risk, and 50 per cent of them claim that the risk for low responsibility will be reduced. The financial CEOs think that the politicians prefer to establish accountability rules rather than independence procedures. In fact a reform of the supervisory governance is likely to produce higher political independence (41 per cent), higher industry independence (47 per cent), but mainly higher accountability (57 per cent). However, 86 per cent of the respondents think that the probability of a supervisory reform by the end of the legislation (2011) is equal or less than 50 per cent. The conservativeness of the politicians can be explained in different ways. The government can be in general conservative (28 per cent), or sensitive to the opposition of the supervisors (26 per cent), their unions (57 per cent), or their boards of directors (61 per cent). Thus, the policymakers’ expected behaviour seems to be only weakly consistent with the market wishes. However these answers are not sufficient to disentangle the true nature – HHV or GHV – of the Italian policymaker. What we can conclude, though, from this experiment is that the operators in the Italian markets are: (i) fairly dissatisfied with the current supervisory model, although they like the degree of political and industry independence of the main regulators – Banca d’Italia and CONSOB – but have some doubts about the low degrees of accountability towards their main stakeholders; (ii) overwhelmingly in favour of a more consolidated model, although there seems to be no outspoken majority for a unified model. The new model should be independent from government and industry, but respondents are more concerned with addressing the current accountability deficit; and (iii) reluctant to think that the expected behaviour and views of the policymakers will be aligned with theirs. To the extent that parallels can be drawn between these results and worldwide trends, it is worth noting that market participants in Italy are of the view that accountability arrangements are currently weak and should be strengthened significantly, and that they think that politicians are of the same view. This is consistent with worldwide trends, as analysed in Masciandaro et al. (2007) and Quintyn et al. (2007), which show that reformed supervisory agencies have stronger accountability arrangements than their predecessors, and in particular than the central banks. So the focus on accountability is certainly growing.

88

D. Masciandaro and M. Quintyn

4.5 Conclusion The current worldwide wave of reforms in supervisory architectures leaves the interested bystander with a great number of questions regarding the true determinants of, and motivations behind, these changes. These questions are all the more justified because the emerging institutional structures are certainly not homogeneous across countries. Trial and error seems to prevail to some extent. Thus far, academic discussions of the emerging supervisory architectures have been dominated by purely economic views: supervisory structures are being revised because of the blurring boundaries among financial institutions and activities, and the formation of big conglomerates. However, judging from the multiplicity of reform outcomes and politicians’ revealed preferences, the natural question which emerges is: to what extent is the changing nature of the markets really being taken into account? And, related to that, to what extent have policymakers been listening to the views of the markets with respect to the desirable supervisory structure? An answer to these questions requires a political economy approach. Indeed, financial supervisory reform is a political process which involves many stakeholders: the political class, the central bank, the supervised entities, as well as the customers of the financial services. So the all-encompassing question is: which considerations and views prevail in the end in the decision making process, and to what extent are the decision makers taking into account the views of these different classes of stakeholders when deciding on a reform of the supervisory structures. This chapter tries to answer some of these questions by looking specifically at the impact of the market factor on the decision making process. More specifically, it first develops a model to analyse to what extent policymakers are taking into account the features of the market structure. Second, it reports on the results of a survey among Italian market operators on their views on the efficiency of the current supervisory structure, and on the optimal structure – both in terms of architecture and governance. To answer the first question, the chapter starts from two views on the policymaker – the helping hand and the grabbing hand view – to find out empirically how market views are being taken into account. Building upon previous work in this area, we found that the central bank factor, the institutional factor and the law factor, together with the market structure, are significant in the decision making process. Weak evidence also seems to lean towards the grabbing hand view, but further work is needed. The survey sheds interesting light on the Italian case – a strong desire for supervisory consolidation with the aim of making the supervisory

Helping hand or grabbing hand?

89

process more efficient, and a strengthening of governance arrangements through more accountability. The survey also shows that markets believe that the reform views of the politicians are not fully aligned with theirs. However, these findings do not allow us to detect the true nature of the Italian policymaker – HHV versus GHV. While the results of this chapter are encouraging, further research is warranted. More specifically, the analysis on the determinants of supervisory structures in Masciandaro (2006) and this chapter needs to be combined with the research presented in Masciandaro et al. (2007) on the determinants of governance arrangements in supervisory agencies. Both shed light on one aspect, but it would be interesting to find out to what extent these two aspects – supervisory architecture and governance arrangements – are two sides of the same coin. Why do politicians in one country allow the central bank to be the single regulator, and why are they inclined in other countries to take supervision out of the central bank and put it in a newly established unified supervisor? Market trends could be one factor in the decision, as this chapter shows. However, other elements might be at play as well, such as the desire to have more say in the agency (and thus to take the responsibility away from the independent central bank). Thus, the government’s helping or grabbing hand can possibly leave fingerprints all over the new structure.

References Abrams, R.K. and M.W. Taylor, 2002, ‘Assessing the Case for Unified Sector Supervision’, FMG Special Papers, No. 134, Financial Markets Group (London: London School of Economics). Agence France Press, 2006, ‘Polish Ex-Finance Minister Named Head of Finance Sector Super-Commission’ (29 September). Alesina, A. and G. Tabellini, 2003, ‘Bureaucrats or Politicians? Part II: Multiple Policy Task’. Discussion Paper No. 2009, Harvard Institute of Economic Research (Massachusetts: Harvard University). Arnone, M. and A. Gambino, 2007, ‘Architectures of Supervisory Authorities and Banking Supervision’, in Designing Financial Supervision Institutions: Independence, Accountability and Governance, ed. Donato Masciandaro and Marc Quintyn (Cheltenham, UK; Northampton, MA: Edward Elgar). Associated Press Newswires, 2006, ‘The Head of Poland’s Central Bank Said Tuesday that the Bank is Suffering the “Most Extreme” Attack on its Independence since Communism Fell in 1989’ (3 October). Barth, J., G. Caprio and R. Levine, 2004, ‘Bank Regulation and Supervision: What Works Best?’ Journal of Financial Intermediation, Vol. 13 (April), pp. 205–248. Beck, T., A. Demirgüç-Kunt and R. Levine, 1999, ‘A New Database on Financial Development and Structure’, Policy Research Working Paper No. 2146 (Washington: World Bank).

90

D. Masciandaro and M. Quintyn

Bezuidenhout, Andre, 2004, ‘The South African Case’, in Aligning Financial Supervisory Structures with Country Needs, ed. Jeffrey Carmichael, Alexander Fleming and David Llewellyn (Washington: World Bank). Briault, Clive, 1999, ‘The Rationale for a Single National Financial Services Regulator’, Financial Services Authority Occasional Paper No. 2. Capie, F., 2007, ‘Some Historical Perspective on Financial Regulation’, in The Structure of Financial Regulation, ed. D.G. Mayes and G.E. Wood (London and New York: Routledge), pp. 43–65. Cardia, L., 2005, Annual Report 2004, CONSOB, Rome, 31 March (mimeo). Cardia, L., 2006, Annual Report 2005, CONSOB, Rome, 31 March (mimeo). Cihak, M. and R. Podpiera, 2007, ‘Experience with Integrated Supervisors: Governance and Quality of Supervision’, in Designing Financial Supervision Institutions: Independence, Accountability and Governance, ed. Donato Masciandaro and Marc Quintyn (Cheltenham, UK; Northampton, MA: Edward Elgar). Commonwealth of Australia, 1996, ‘Financial System Inquiry Interim Report’, Wallis Commission (Canberra: Australian Government Publishing Service). Davis, Howard, 2004, ‘Integrated Regulation in the United Kingdom and the Lessons for Others’, in Aligning Financial Supervisory Structures with Country Needs, ed. Jeffrey Carmichael, Alexander Fleming and David Llewellyn (Washington: World Bank). De Luna Martinez, J. and T.A. Rose, 2003, ‘International Survey of Integrated Financial Sector Supervision’, Policy Research Working Paper Series No. 3096 (Washington: World Bank). Di Giorgio, G. and C. Di Noia, 2007, ‘Financial Supervisors: Alternative Models’, in Designing Financial Supervision Institutions: Independence, Accountability and Governance, ed. Donato Masciandaro and Marc Quintyn (Cheltenham, UK; Northampton, MA: Edward Elgar). Dow Jones Commodities Service, 2006, ‘EU “Deeply Concerned” by New Polish Finci Supervision Law’ (14 September). Draghi, M., 2006a, ‘Inquiry: Implementation of Law 262/2005’, Sixth Standing Committee, Italian Senate, Rome (26 September) mimeo. Draghi, M., 2006b, ‘World Savings Day’, Association of Italian Savings Banks, Rome (31 October) mimeo. Draghi, M., 2007, ‘Growth and Stability of the Economy and Financial Markets’, AIAF-ASSIOM-ATIC Forex, Turin (3 February), mimeo. European Central Bank, 2005, ‘Consolidation and Diversification in the Euro Area Banking Sector’, Monthly Bulletin (May), pp. 79–87. Goodhart, C.A.E., 2007, ‘Financial Supervision from an Historical Perspective: Was the Development of Such Supervision Designed, or Largely Accidental?’ in The Structure of Financial Regulation, ed. D.G. Mayes and G.E. Wood (London: Routledge, Chapman and Hall; New York: Routledge), pp. 43–65. Kaufmann, D., A. Kraay and M. Mastruzzi, 2003, ‘Governance Matters III: Governance Indicators 1996–2002’, Policy Research Working Paper Series No. 3106 (Washington: World Bank). International Monetary Fund, 2006, Italy: Financial System Stability Assessment, IMF Country Report No. 6/112 (Washington). La Porta, R., F. Lopez de Silanes, A. Shleifer and R.W. Vishny, 1997, ‘Legal Determinants of External Finance’, Journal of Finance, Vol. 52, No. 3, pp. 1131–1150.

Helping hand or grabbing hand?

91

La Porta, R., F. Lopez de Silanes, A. Shleifer and R.W. Vishny, 1998, ‘Law and Finance’, Journal of Political Economy, Vol. 106, No. 6, pp. 1113–1155. Levine, R., 2002, ‘Bank-based or Market-based Financial Systems: Which is Better?’ Journal of Financial Intermediation, No. 11, pp. 398–428. Lutz, S., 2006, ‘Political Economy Approach to Financial Reform’, in The Political Economy of Financial Market Regulation, ed. P. Mooslechner, H. Schuberth and B. Weber (Cheltenham, UK; Northampton, MA: Edward Elgar), pp. 81–109. Masciandaro, D., 2004, ‘Unification in Financial Sector Supervision: The Trade Off Between Central Bank and Single Authority’, Journal of Financial Regulation and Compliance, Vol. 12, No. 2, pp. 151–169. Masciandaro, D. (ed.), 2005a, Handbook of Central Banking and Financial Supervision in Europe (Cheltenham, UK; Northampton, MA: Edward Elgar). Masciandaro, D., 2005b, ‘E Pluribus Unum? Authorities Design in Financial Supervision: Trends and Determinants’, Open Economies Review, Vol. 17, No. 1, pp. 73–102. Masciandaro, D., 2006, ‘Divide et Impera: Financial Supervision Unification and the Central Bank Fragmentation Effect’, European Journal of Political Economy, Vol. 23, pp. 285–315. Masciandaro, D. and M. Quintyn (eds), 2007, Designing Financial Supervision Institutions: Independence, Accountability and Governance (Cheltenham, UK; Northampton, MA: Edward Elgar). Masciandaro, D., M. Quintyn and M. Taylor, 2007, ‘Financial Stability, Independence and Accountability: Central Banks or Financial Supervisors?’ in Designing Financial Supervision Institutions: Independence, Accountability and Governance, ed. Donato Masciandaro and Marc Quintyn (Cheltenham, UK; Northampton, MA: Edward Elgar). Mooslechner, P., H. Schubert and B. Weber, 2006, The Political Economy of Financial Market Regulation (Cheltenham, UK; Northampton, MA: Edward Elgar). Pigou, A., 1938, The Economics of Welfare (London: Macmillan & Co.). Quintyn, M. and M. Taylor, 2003, ‘Regulatory and Supervisory Independence and Financial Stability’, CESifo, Economic Studies, Vol. 49, No. 2, pp. 259–294. Quintyn, M. and M. Taylor, 2007, ‘Robust Regulators and their Political Masters: Independence and Accountability in Theory’, in Designing Financial Supervision Institutions: Independence, Accountability and Governance, ed. Donato Masciandaro and Marc Quintyn (Cheltenham, UK; Northampton, MA: Edward Elgar). Quintyn, Marc, S. Ramirez and M. Taylor, 2007, ‘Fear of Freedom – Politicians and the Independence and Accountability of Financial Sector Supervisors’, in Designing Financial Supervision Institutions: Independence, Accountability and Governance, ed. Donato Masciandaro and Marc Quintyn (Cheltenham, UK; Northampton, MA: Edward Elgar). Shleifer, A. and R. Vishny, 1998, The Grabbing Hand (Cambridge, MA: Harvard University Press). Stigler, G., 1971, ‘The Theory of Economic Regulation’, Bell Journal of Economics and Management Science, Vol. 2, pp. 3–21. Taylor, Michael, 1995, Twin Peaks: A Regulatory Structure for the New Century (London: Centre for the Study of Financial Innovation). Taylor, Michael and Alex Fleming, 1999, ‘Integrated Financial Supervision. Lessons from Northern European Experience’, Policy Research Working Paper No. 2223 (Washington: World Bank).

92

D. Masciandaro and M. Quintyn

Westrup, Jonathan, 2007, ‘Independence and Accountability: Why Politics Matter’, in Designing Financial Supervision Institutions: Independence, Accountability and Governance, ed. Donato Masciandaro and Marc Quintyn (Cheltenham, UK; Northampton, MA: Edward Elgar).

Fac Cbfa Mvb Mktc. Goodg Gdp Eu Ocse Com Civil Latitude

–0.0116 0.3150 0.3987 –0.0695 0.2598 0.3218

1.0000 –0.3332 0.0986 0.2480

Fac

1.0000 0.0173 0.0052 0.4529 –0.0137 0.0083 –0.1424 0.2045 –0.2026 –0.0639

Cbfa

1.0000 0.5043 –0.0955 0.2156 –0.0145 0.3045 0.2928 –0.1181 0.0886

Mvb

Table 4.1a Correlation matrix: general

1.0000 0.1997 0.2931 0.2252 0.4616 0.2955 –0.0121 0.1975

Mktc.

0.6142 0.2675 0.5719 0.7491 0.1543 0.1437 0.4941

Goodg

1.0000 1.0000 0.0109 0.3262 0.1732 –0.0149 0.0924

Gdp

1.0000 0.5569 –0.1320 0.0613 0.5492

Eu

1.0000 –0.0081 0.1755 0.5417

Ocse

1.0000 –0.5188 –0.2062

Com

1.0000 –0.1529

Civil

1.0000

Latitude

94

D. Masciandaro and M. Quintyn

Table 4.1b Correlation matrix: market factor variables

Mvb Mcap Conc Conglo

Mvb

Mcap

Conc

Conglo

1.0000 0.4776 –0.2346 –0.0333

1.0000 –0.1953 –0.0361

1.0000 0.0731

1.0000

Table 4.1c Summary statistics: market factor variables Variable

Obs

Mean

Std. Dev.

Min

Max

Mvb Mcap Conc Conglo

88 88 80 51

0.25 0.4020658 68.04188 46.02882

0.4354942 0.4601134 19.30137 38.11922

0 0 21 0

1 2.339196 100 100

Table 4.2 Ordered logit estimates with the basic model Number of obs = 88 LR _2 (11) = 43.15

Ordered logit estimates

Prob > _2 = 0.0000 Pseudo R2 = 0.1441

Log likelihood = –128.11797 Fac

Coef.

Std. Err.

z

P>z

[95% Conf.

Interval]

Cbfa Gdp Oecd Mvb Mcap Ggov Eu Lat Len Lfr Lgs

–0.5469927 –0.0006181 –0.0856546 0.2726525 0.6775869 0.1887665 0.4574519 1.342584 1.050421 1.447424 3.732267

0.3202533 0.0002351 0.808181 0.6227045 0.6378848 0.5255518 0.6961968 1.788981 0.7972013 0.6550381 1.06465

–1.71 –2.63 –0.11 0.44 1.06 0.36 0.66 0.75 1.32 2.21 3.51

0.088* 0.009*** 0.916 0.661 0.288 0.719 0.511 0.453 0.188 0.027** 0.000***

–1.174678 –0.0010788 –1.66966 –0.9478258 –0.5726443 –0.8412962 –0.9070686 –2.163755 –0.5120653 0.1635731 1.645591

0.0806923 –0.0001573 1.498351 1.493131 1.927818 1.218829 1.821973 4.848923 2.612907 2.731275 5.818943

Notes *** indicates statistical significance at 1 per cent. ** indicates statistical significance at 5 per cent. * indicates statistical significance at 10 per cent.

Helping hand or grabbing hand?

95

Table 4.3 Ordered probit estimates with the basic model Number of obs = 88 LR _2 (11) = 43.24

Ordered probit estimates

Prob > _2 = 0.0000 Pseudo R2 = 0.1444

Log likelihood = –128.07073 Fac

Coef.

Std. Err.

z

P>z

[95% Conf.

Interval]

Cbfa Gdp Oecd Mvb Mcap Ggov Eu Lat Len Lfr Lgs

–0.28307 –0.0003621 –0.1214031 0.093148 0.3261519 0.2049159 0.268889 1.043016 0.5038029 0.804417 1.996772

0.1632141 0.0001446 0.44373 0.3430982 0.3798723 0.3009822 0.3870119 1.026108 0.4549164 0.3718932 0.5875939

–1.73 –2.50 –0.27 0.27 0.86 0.68 0.69 1.02 1.11 2.16 3.40

0.083* 0.012*** 0.784 0.786 0.391 0.496 0.487 0.309 0.268 0.031** 0.001***

–0.6029637 –0.0006455 –0.9910979 –0.5793121 –0.4183842 –0.3849984 –0.4896404 –0.9681181 –0.3878168 0.0755198 0.8451091

0.0368237 –0.0000786 0.7482917 0.7656081 1.070688 0.7948301 1.027418 3.05415 1.395423 1.533314 3.148435

Notes *** indicates statistical significance at 1 per cent. ** indicates statistical significance at 5 per cent. * indicates statistical significance at 10 per cent.

Table 4.4 Ordered logit estimates with the basic model and the new data Number of obs = 88 LR _2 (11) = 41.93

Ordered logistic regression

Prob > _2 = 0.0000 Pseudo R2 = 0.1401

Log likelihood = –128.72628 Fac

Coef.

Std. Err.

z

P>z

[95% Conf.

Interval]

Cbfa Newgdp Oecd Mvb Newmcap Newggov Eu Lat Len Lfr Lgs

–0.5828111 –0.0003561 –0.1628636 0.2034138 0.0494702 –0.0715419 0.7641759 0.9159838 0.7355356 1.382078 3.608785

0.3233523 0.0001913 0.7903904 0.5673338 0.0246236 0.4701814 0.6886317 1.79385 0.790674 0.6465434 1.002717

–1.80 –1.86 –0.21 0.36 2.01 –0.15 1.11 0.51 0.93 2.14 3.60

0.071* 0.063* 0.837 0.720 0.045** 0.879 0.267 0.610 0.352 0.033** 0.000***

–1.21657 –0.000731 –1.712 –0.90854 0.0012087 –0.9930805 –0.5855173 –2.599899 –0.814157 0.114876 1.643496

0.0509478 0.0000188 1.386273 1.315368 0.0977316 0.8499968 2.113869 4.431866 2.285228 2.64928 5.574074

Notes *** indicates statistical significance at 1 per cent. ** indicates statistical significance at 5 per cent. * indicates statistical significance at 10 per cent.

96

D. Masciandaro and M. Quintyn

Table 4.5 Ordered probit estimates with the basic model and new data Number of obs = 88 LR _2 (11) = 41.42

Ordered probit regression

Prob > _2 = 0.0000 Pseudo R2 = 0.1383

Log likelihood = –128.9813 Fac

Coef.

Cbfa –0.296477 Newgdp –0.000187 Oecd –0.1798888 Mvb 0.0537182 Newmcap 0.0254883 Newggov 0.0355907 Eu 0.4748063 Lat 0.8183801 Len 0.366341 Lfr 0.7951951 Lgs 1.962072

Std. Err.

z

P>z

[95% Conf.

Interval]

0.1631718 0.0000979 0.4361038 0.3198931 0.0146022 0.2709747 0.3865006 1.027621 0.4563411 0.3693477 0.5699604

–1.82 –1.91 –0.41 0.17 1.75 0.13 1.23 0.80 0.80 2.15 3.44

0.069* 0.056** 0.680 0.867 0.081* 0.896 0.219 0.426 0.422 0.031** 0.001***

–0.6162878 –0.0003789 –1.034637 –0.5732607 –0.0031315 –0.4955099 –0.282721 –1.19572 –0.5280712 0.0712869 0.8449701

0.0233338 4.89e–06 0.6748589 0.6806971 0.0541082 0.5666913 1.232334 2.83248 1.260753 1.519103 3.079174

Notes *** indicates statistical significance at 1 per cent. ** indicates statistical significance at 5 per cent. * indicates statistical significance at 10 per cent.

Table 4.6 Ordered logit estimates with the bandwagon effect Number of obs = 88 LR _2 (12) = 42.66

Ordered logistic regression

Prob > _2 = 0.0000 Pseudo R2 = 0.1425

Log likelihood = –128.36274 Fac

Coef.

Std. Err.

z

P>z

[95% Conf.

Interval]

Cbfa Newgdp Oecd Mvb Newmcap Newggov Eu Lat Len Lfr Lgs Yeareform

–0.5909381 –0.0003467 –0.1089241 0.2091537 0.0505754 –0.0297826 0.8272687 0.841034 0.5591229 1.258476 2.559906 –0.016023

0.3217871 0.0001916 0.7938823 0.5725651 0.0246978 0.4748239 0.692617 1.808688 0.8201665 0.6640074 3.508817 0.018871

–1.84 –1.81 –0.14 0.37 2.05 –0.06 1.19 0.46 0.68 1.90 3.47 –0.85

0.066* 0.070* 0.891 0.715 0.041** 0.950 0.232 0.642 0.495 0.058* 0.001*** 0.396

–1.221629 –0.0007222 –1.664905 –0.9130532 0.0021686 –0.9604203 –0.5302357 –2.703929 –1.048374 –0.0429548 1.529577 –0.0530095

0.0397529 0.0000289 1.447057 1.331361 0.0989823 0.900855 2.184773 4.385997 2.16662 2.559906 5.488057 0.0209635

Notes *** indicates statistical significance at 1 per cent. ** indicates statistical significance at 5 per cent. * indicates statistical significance at 10 per cent.

Helping hand or grabbing hand?

97

Table 4.7 Ordered probit estimates with the bandwagon effect Number of obs = 88 LR _2 (12) = 42.78

Ordered probit regression

Prob > _2 = 0.0000 Pseudo R2 = 0.1429

Log likelihood = –128.3003 Fac

Coef.

Std. Err.

z

P>z

[95% Conf.

Interval]

Cbfa Newgdp Oecd Mvb Newmcap Newggov Eu Lat Len Lfr Lgs Yeareform

–0.3270944 –0.0001823 –0.1320725 0.0497973 0.0269157 0.0472656 0.5465508 0.8058602 0.2947133 0.7286702 1.908486 –0.0129294

0.165351 0.000098 0.4387068 0.3203195 0.0146982 0.2718108 0.3920994 1.028248 0.461228 0.3743244 0.5724593 0.0110684

–1.98 –1.86 –0.30 0.16 1.83 0.17 1.39 0.78 0.64 1.95 3.33 –1.17

0.048** 0.063* 0.763 0.876 0.067* 0.862 0.163 0.433 0.523 0.052* 0.001*** 0.243

–0.6511765 –0.0003743 –0.9919221 –0.5780174 –0.0018923 –0.4854738 –0.2219498 –1.209469 –0.609277 –0.0049921 0.7864864 –0.0346231

–0.0030124 9.72e–06 0.7277772 0.677612 0.0557236 0.5800049 1.315052 2.82119 1.198704 1.462333 3.030486 0.0087644

Notes *** indicates statistical significance at 1 per cent. ** indicates statistical significance at 5 per cent. * indicates statistical significance at 10 per cent.

Table 4.8 Ordered logit estimates with the conglomeration effect Number of obs = 51 LR _2 (12) = 26.11

Ordered logistic regression

Prob > _2 = 0.0104 Pseudo R2 = 0.1447

Log likelihood = –77.151234 Fac

Coef.

Std. Err.

z

P>z

[95% Conf.

Interval]

Cbfa Newgdp Oecd Mvb Newmcap Newggov Eu Lat Len Lfr Lgs Conglo

–0.5584895 –0.0002723 –0.4108992 0.1391632 0.0795486 0.6318657 1.066609 –1.64438 –0.826891 0.6930749 1.405632 0.0061974

0.4321017 0.0002109 0.9482113 0.7890175 0.0344872 0.6713592 0.9911935 2.786833 1.303059 0.995145 1.77613 0.0079226

–1.29 –1.29 –0.43 0.18 2.31 0.94 1.08 –0.59 –0.63 0.70 0.79 0.78

0.196 0.197 0.665 0.860 0.021** 0.347 0.282 0.555 0.526 0.486 0.429 0.434

–1.405393 –0.0006857 –2.269359 –1.407283 0.011955 –0.6839742 –0.8760946 –7.106473 –3.38084 –1.257373 –2.07552 –0.0093306

0.2884142 0.0001411 1.447561 1.685609 0.1471422 1.947706 3.009312 3.817713 1.727059 2.643523 4.886784 0.0217253

Notes *** indicates statistical significance at 1 per cent. ** indicates statistical significance at 5 per cent. * indicates statistical significance at 10 per cent.

98

D. Masciandaro and M. Quintyn

Table 4.9 Ordered probit estimates with the conglomeration effect Number of obs = 51 LR _2 (12) = 27.64

Ordered probit regression

Prob > _2 = 0.0062 Pseudo R2 = 0.1532

Log likelihood = –76.385243 Fac

Coef.

Std. Err.

z

P>z

[95% Conf.

Interval]

Cbfa Newgdp Oecd Mvb Newmcap Newggov Eu Lat Len Lfr Lgs Conglo

–0.2584639 –0.0001577 –0.3517723 0.1485001 0.0436318 0.5091253 0.5735364 –0.7681367 –0.5681004 0.4505934 0.7567093 0.0045511

0.215036 0.0001086 0.5263712 0.4401387 0.0201429 0.383296 0.5385338 1.603458 0.7593633 0.5699841 0.9622833 0.0046376

–1.20 –1.45 –0.67 0.34 2.17 1.33 1.06 –0.48 –0.75 0.79 0.79 0.98

0.229 0.146 0.504 0.736 0.030** 0.184 0.287 0.632 0.454 0.429 0.432 0.326

–0.6799267 –0.0003705 –1.383441 –0.714156 0.0041524 –0.242121 –0.4819706 –3.910857 –2.056425 –0.6665549 –1.129331 –0.0045383

0.1629989 0.0000551 0.6798963 1.011156 0.0831112 1.260372 1.629043 2.374583 0.9202244 1.567742 2.64275 0.0136405

Notes *** indicates statistical significance at 1 per cent. ** indicates statistical significance at 5 per cent. * indicates statistical significance at 10 per cent.

Table 4.10 Ordered logit estimates with the concentration effect Number of obs = 80 LR _2 (12) = 54.55

Ordered logistic regression

Prob > _2 = 0.0000 Pseudo R2 = 0.1988

Log likelihood = –109.9207 Fac

Coef.

Std. Err.

z

P>z

[95% Conf.

Interval]

Cbfa Newgdp Oecd Mvb Newmkt Newggov Eu Lat Len Lfr Lgs Conc

–1.269573 –0.0002461 –0.5715701 0.7639012 0.0493506 0.2131225 1.300666 –1.225613 0.204566 1.272444 3.847526 0.0268474

0.3780443 0.0001787 0.8203144 0.6186033 0.0270567 0.5620199 0.7456767 2.014232 0.8697491 0.6959135 1.097419 0.0130873

–3.36 –1.38 –0.70 1.23 1.82 0.38 1.74 –0.61 0.24 1.83 3.51 2.05

0.001*** 0.168 0.486 0.217 0.068* 0.705 0.081* 0.543 0.814 0.067* 0.000*** 0.040**

–2.010526 –0.0005964 –2.179357 –0.448539 –0.0036796 –0.8884162 –0.1608337 –5.173434 –1.500111 –0.0915211 1.696623 0.0011967

–0.5286192 0.0001041 1.036216 1.976341 0.1023809 1.314661 2.762165 2.722208 1.909243 2.63641 5.998428 0.0524981

Notes *** indicates statistical significance at 1 per cent. ** indicates statistical significance at 5 per cent. * indicates statistical significance at 10 per cent.

Helping hand or grabbing hand?

99

Table 4.11 Ordered probit estimates with concentration effect Number of obs = 80 LR _2 (12) = 52.35

Ordered probit regression

Prob > _2 = 0.0000 Pseudo R2 = 0.1908

Log likelihood = –111.02214 Fac

Coef.

Std. Err.

z

P>z

[95% Conf.

Interval]

Cbfa Newgdp Oecd Mvb Newmcap Newggov Eu Lat Len Lfr Lgs Conc

–0.6355382 –0.000144 –0.478749 0.351308 0.0223934 0.2606445 0.5789867 –0.0633372 0.1246668 0.8179294 1.964422 0.0118962

0.1878457 0.0001031 0.4583656 0.3349718 0.0156801 0.3143304 0.4026509 1.095058 0.4966879 0.3952192 0.5927913 0.0069832

–3.38 –1.40 –1.04 1.05 1.43 0.83 1.44 –0.06 0.25 2.07 3.31 1.70

0.001*** 0.163 0.296 0.294 0.153 0.407 0.150 0.954 0.802 0.038** 0.001*** 0.088*

–1.003709 –0.0003461 –1.377129 –0.3052246 –0.008339 –0.3554317 –0.2101946 –2.209612 –0.8488235 0.0433139 0.802572 –0.0017906

–0.2673673 0.0000581 0.4196311 1.007841 0.0531258 0.8767207 1.368168 2.082938 1.098157 1.592545 3.126271 0.025583

Notes *** indicates statistical significance at 1 per cent. ** indicates statistical significance at 5 per cent. * indicates statistical significance at 10 per cent.

This page intentionally left blank

Part II

International experiences

This page intentionally left blank

5

Implementing Twin Peaks Lessons from Australia Jeff Carmichael

5.1 Introduction In September 1997 the Commonwealth Government of Australia accepted the Report of the Financial System Inquiry (The ‘Wallis Report’) virtually in its entirety. A cornerstone of the recommendations was the introduction of a Twin Peaks architecture for regulating Australia’s financial sector. The experience of the past 15 years has reflected well on this architecture. Not only did the Australian financial system withstand the pressures of the global financial crisis, the sector has exhibited both solid growth and exceptional stability, with remarkably few failures or frauds. While the Australian experiment would be rated successful by most, it has not been without its challenges. This chapter reflects on four key aspects of Australia’s Twin Peaks experience: managing the transition; harmonizing the approaches to regulation; defining the boundaries between the different types of regulation; and interagency coordination. The first section provides some background to the Inquiry and the changes that followed its recommendations.

5.2 Background to Australia’s Twin Peaks model The Financial System Inquiry was the first full-scale review of the Australian financial system since the Campbell Inquiry in the late 1970s (and only the third in Australia’s history). Despite their common foundations in both being established following a period of rapid change in financial markets, the motivations behind their establishment were otherwise remarkably dissimilar. At the time of the Campbell Inquiry the financial system was under intense strain as outdated regulatory structures were breaking down in the face of financial innovation. Importantly, the old framework was inhibiting good monetary and fiscal management as much as it was inhibiting financial efficiency. Against that background, the Campbell Committee faced an almost universally supported mandate for reform. In contrast, the Wallis Committee was asked to propose reforms for a system that was coping adequately with existing pressures. Furthermore,

104

J. Carmichael

large sections of both the financial industry and the regulatory community were quite vocal in expressing their resistance to change. The Treasurer’s terms of reference for the Inquiry were broad ranging. In summary, the Committee was charged with: s s s

PROVIDING A STOCKTAKE OF THE RESULTS OF DEREGULATION SINCE THE EARLY 1980s; ANALYSINGTHEFORCESFORCHANGEINTHEINDUSTRYAND RECOMMENDINGAREGULATORYFRAMEWORKTHATWOULDBESTENSUREANEFlcient, flexible and competitive financial system.

The emphasis in the terms of reference was very firmly on the need for efficiency and for Australia to be competitive in an increasingly competitive world. In this way, the Inquiry was asked to be forward looking in its recommendations, seeking to avoid a potential future crisis rather than dealing with an existing one. The case for reform ultimately rested on two factors: perceived inefficiencies in the Australian financial system; and changes that were occurring in international financial markets that posed potential problems for the regulatory structure in the future. As a result of its deliberations the Committee made some 115 recommendations. The major recommendation was a sweeping change to the regulatory architecture. The revised architecture is still almost unique in international circles, although the Netherlands has since adopted a broadly similar structure, and the UK and South Africa are in the process of moving in this direction. The essence of the Australian architecture is that regulatory agencies are defined by types of regulation (or regulatory objectives) rather than by the institutions that they regulate. Thus there are four key regulatory agencies in Australia: s

! SINGLE PRUDENTIAL REGULATOR THE !USTRALIAN 0RUDENTIAL 2EGULATION Authority – APRA) responsible for the safety and soundness of deposittaking institutions, insurers and pension funds. The boundaries of prudential regulation were defined by the nature of the promises involved.1

1 If an institution made promises that were difficult to keep, difficult to understand and likely to cause significant hardship if they were broken, then the institutions making such promises were considered by the Committee to warrant the intrusive level of regulation usually described as prudential.

Implementing Twin Peaks: Australia s

s

s

105

! SINGLE CONDUCT AND DISCLOSURE REGULATOR THE !USTRALIAN 3ECURITIES and Investments Commission – ASIC) responsible for market integrity (efficiency and fairness) and consumer protection.2 !SINGLECOMPETITIONREGULATORTHE!USTRALIAN#OMPETITIONAND#ONsumer Commission – ACCC) responsible for ensuring that all markets are competitive. ! SINGLE SYSTEMIC STABILITY REGULATOR THE 2ESERVE "ANK OF !USTRALIA n 2"! RESPONSIBLEFORMONETARYPOLICYANDFORREGULATINGTHEPAYMENTS system.

Fundamental to this structure is that ASIC regulates the conduct of all financial market participants, including those institutions that are prudentially regulated by APRA. Similarly, the ACCC makes all decisions on mergers and matters of industry competition. Thus, each institution is still subjected to multiple regulators, but each regulator is responsible for separate aspects of the institution’s business. While there are technically four pillars to the Australian regulatory model, it is known internationally as a ‘twin peaks’ model because of the separation of prudential and conduct regulation.

5.3 Managing the transition The creation of the new prudential regulatory agency, APRA, involved amalgamating nine different agencies. These involved both federal agenCIES SUCH AS THE BANKING REGULATORY ARM OF THE 2"! AND THE )NSURANCE and Superannuation Commission (from within the Commonwealth Treasury), and a centralized structure of State-based non-bank regulatory agencies responsible for credit unions, building societies and friendly societies. Merging these existing agencies involved not only merging different approaches to financial sector supervision, but also very different cultures. Experiences in Australia and elsewhere confirm that there is no unique best way to merge cultures. Inevitably there is a need to strike a balance between continuity of supervision and change. Unless there is some change there can be no real prospect of gaining the benefits from amalgaMATION"UT IFCHANGEISTOORAPID THEREISARISKTHATSTAFFWILLLOSEFOCUS on the job at hand, with potentially damaging consequences.

2 The one exception to the centralization of consumer protection under ASIC was the carveout of credit which remained with the States under the uniform credit code (UCC). The Committee acknowledged that the UCC had not been in operation long enough at the time of the Inquiry to adequately assess its performance. The Committee did recommend, however, that the UCC be reviewed in due course for possible inclusion under ASIC. This review happened subsequently and ASIC is now responsible for administering all aspects of consumer protection in financial markets.

106

J. Carmichael

APRA took a relatively radical approach to changing its organizational structure. For the first 12 months there was minimal change, other than some amalgamation of support services. This period was used to provide staff with the opportunity to learn about the roles and practices of the other agencies and to assess best practice in each area. Considerable effort was devoted to workshops and cross-training during this period. After 12 months, a new organizational structure was announced and staff were invited to apply for positions in the new structure. There were fewer positions in the new structure than in the original structures, and not all staff members were successful in finding suitable positions. The new structure bore no resemblance to the old one and was designed along functional rather than institutional lines. Reflecting this functional orientation, no institutional labels (such as banks, insurance companies, etc.) were used in the new structure. Considerable effort was made to ensure a good spread and mix of staff from the predecessor agencies. This move to a totally new structure after just 12 months was very aggressive and was only possible in the benign economic environment that prevailed at the turn of the twenty-first century. The main benefit of the aggressive approach was the speed with which APRA was able to extract the synergies and meet the objectives of regulatory amalgamation. The main cost was the short-term loss of some critical inherited knowledge. The failure of the HIH Insurance Company in the early 2000s was attributable at least partly to the loss of critical corporate memory in the insurance sector. Lessons from the transition period included the following. First, staff turnover, which ran at around 25 per cent per annum for the first few years, was uncomfortably high. In part this reflected uncertainty on the part of some staff as to their futures and, in part, it reflected uncompetitive salaries being offered by APRA. Salary levels, which were initially targeted at the 50th percentile of the financial sector, were eventually increased to the 75th percentile. This latter level seems to accord with experience in other countries as the critical level at which regulatory agencies can attract and retain good quality staff. Second, harmonizing remuneration benefits across vastly different initial conditions is a challenge. APRA inherited staff with widely different remuneration packages, especially in the area of benefits. Ultimately, the decision was made to pay remuneration almost entirely in the form of salary and to ‘buy out’ the (often very generous) benefits of incoming staff. These benefits ranged from subsidized home loans, to motor vehicles, to pension benefits. In the end, paying out existing benefits and then remunerating transparently through salary was the quickest way to ensure that staff who performed the same duties could be paid the same remuneration. Third, staff must be engaged in the process of change. While some decisions must be made at the most senior level, the more staff can be involved in designing the new agency the more they will take pride and ownership

Implementing Twin Peaks: Australia

107

of it. Key to winning this engagement is communications. Unless staff are kept apprised of the changes that are going on around them they will create rumours to fill the vacuum, and rumours have a destructive impact on morale.

5.4 Harmonizing the approach to regulation As noted above, APRA took an aggressive approach to its organizational structure. This reflected a similarly aggressive approach to regulatory harmonization. In many respects, regulatory harmonization is the ‘holy grail’ of integrated regulation. Harmonization ensures that regulatory arbitrage is minimized and that a consistent approach can be taken to common risks, regardless of the institutions that incur the particular risks. Harmonization is, of course, more straightforward in theory than in practice. In the first place, not all regulatory rules will be equally appropriate in all circumstances. It is common, for example, for many countries to APPLYTHE"ASELCAPITALADEQUACYMODELDIFFERENTLYDEPENDINGONWHETHER it is being applied to a large internationally operating bank, or a small local bank. Indeed, some of the international regulatory standards have been designed explicitly with flexibility to enable them to be applied differently in different circumstances. The benefits of harmonization arise more from applying the broad principles of regulation consistently than in applying the details of any particular regime slavishly. For example, if off-balance sheet activities require capital under one regime, it is more important that the same principle applies to other regimes, than that identical risk weights and measures are used in all cases. The drive towards broad harmonization of regulations was a top priority of APRA’s from the outset. In some areas (e.g. deposit-taking institutions) the objective was achieved relatively quickly. In others, legal constraints were a major hurdle.

5.5 Defining the regulatory boundaries At the time the Twin Peaks model was implemented in Australia the expectation was that there would be clear dividing lines between prudential and conduct regulation and, indeed, between the four different regulatory peaks. In practice the dividing lines were much ‘greyer’ and broader than had been expected. The reality is that many conduct decisions have prudential implications and vice versa. For example, a prudential regulator occasionally requires a regulated institution to raise additional capital because it is concerned that its capital levels are inadequate for the risks it is carrying. In many countries, such a raising would be conducted without explicit disclosure of the regulator’s direction. In Australia the first instance of a directed capital raising by APRA

108

J. Carmichael

was immediately identified as a disclosable matter by ASIC, on the grounds that the regulator’s direction was market-sensitive information. Resolving these grey areas between conduct and prudence was a much more complex and demanding process than had originally been envisaged. The need to resolve conflicts between regulatory objectives is likely to be much amplified in the boundary between macro and micro prudential regulation following the global financial crisis of 2008 and the suggestion in some countries that prudential tools may be used for systemic stability purposes.

5.6 Inter-agency coordination Resolving the conflicts between the different types of regulation is a reflection of a broader issue, namely, the need for coordination between regulatory agencies, regardless of the architecture. While aligning each regulatory objective with a single regulatory agency reduces the need for coordination, it does not remove it. While the need for coordination and the national benefits of coordination are self-evident, in practice coordination is much more difficult to achieve than might be expected. The problem is that human nature is inherently territorial. The problems that territoriality can create for genuine cooperation and information sharing have been highlighted in a number of areas over the past decade, including in the area of monitoring intelligence about potential terrorist activities. Regardless of the number of agencies and the clarity of separation of responsibilities between them, there is always a need to formalize coordination in a way that offsets the natural tendency to be territorial. In Australia, the Council of Financial Regulators provides a regular forum for sharing information and coordinating actions among the major financial regulatory agencies, including the Commonwealth Treasury. The Council proved to be very effective during the crisis of 2008. Importantly, formal coordination mechanisms in the form of committees and joint activities are integrated at a number of levels throughout the agencies.

5.7 Conclusion No regulatory architecture is perfect and no architecture is likely to be optimal under all circumstances. One of the most striking lessons about regulation from historical experience is that architecture is not an end in itself. A good architecture does not guarantee good regulation; more than anything else that requires good quality regulators. A strong architecture is one that supports good regulators by establishing clarity of objectives, minimizing conflicts, empowering the regulators to act, and doing as much as possible to facilitate a common approach across the entire financial sector. The Twin Peaks architecture provides such support. Importantly, it passed its first major test, the financial crisis of 2008, with flying colours.

6

The break-up of the Financial Services Authority in the UK* Eilis Ferran

6.1 Introduction Within days of coming into power in 1997, the new Labour Government announced its intention to engage in fundamental reform of the UK’s institutional arrangements for the supervision of financial market activity that would strip the Bank of England (Bank) of its supervisory responsibilities. This led to the creation of the Financial Services Authority (FSA) as the UK’s integrated financial regulator. Within days of the May 2010 election, the new Conservative–Liberal Democrat Coalition Government announced its intention to engage in fundamental reform of the institutional arrangements for the supervision of UK financial market activity: the FSA is to be abolished, the Bank is to be put back in charge of supervision at the apex of a structure involving an objectives-oriented approach in which one authority, established as a subsidiary of the Bank, will be responsible for micro-prudential supervision and another will oversee conduct, consumer protection and markets issues.1 The prudential supervisor, the Prudential Regulation Authority (PRA), will conduct the prudential regulation of deposit takers, insurers and some investment firms. The other authority, initially dubbed the Consumer Protection and Markets Authority (CPMA) but, after initial consultation rounds, re-named the Financial Conduct Authority (FCA), will be responsible for consumer protection in financial services and the regulation of conduct of business, including the conduct of firms supervised by the PRA, and market regulation, including the listing of securities. The FCA will also assume the

* This chapter is a reprint of Eilis Ferran, ‘The Break-up of the Financial Services Authority’ (2011) 31(3) Oxford Journal of Legal Studies 455–480. The author is grateful to Brian Cheffins, Richard Nolan, Patrick Buckingham, Eric Pan, Howell Jackson and Margaret Cole for comments or for clarification of specific matters. Toussant Boyce and Valia Babis provided excellent research assistance. The usual disclaimers apply. 1 HM Treasury, A New Approach to Financial Regulation: Judgement, Focus and Stability (Cm 7874, 2010); HM Treasury, A New Approach to Financial Regulation: Summary of Consultation Responses (November 2010); HM Treasury, A New Approach to Financial Regulation: Building A Stronger System (Cm 8012, 2011).

110

E. Ferran

responsibility for consumer credit regulation that is currently exercised by the Office of Fair Trading. A new permanent Financial Policy Committee in the Bank will have primary responsibility for macro-prudential supervision of the system in order to maintain overall financial stability. While it will be for the PRA to ‘pull the trigger’ that puts a failing bank into special resolution, responsibility for designing and carrying out that resolution will remain with the Bank itself.2 The Bank will also assume responsibility for the oversight of settlement systems and central counterparty clearing houses to sit alongside its existing responsibilities for payment system oversight. The new institutional structure is expected to be formalized by 2012 but this will be preceded during 2011 by a functional separation of the FSA into two distinct parts,3 and the establishment of an interim Financial Policy Committee.4 Likely transition costs for HM Treasury, the Bank and the supervisory authorities were initially estimated to be in the region of £50 million spread over three years but, after initial consultations, the estimated figure has been increased to between £90 and £175 million.5 This is a dramatic fall from grace for the FSA and a remarkable phoenix-like re-emergence for the Bank as a financial supervisor. For much of its short life the FSA and the integrated supervisory model of which it was a leading example were held in high esteem nationally and internationally.6 Some other European countries adopted their own versions of the model,7 although details, including in particular the extent of continuing central bank involvement in banking supervision, varied from country to country.8 Japan and South Korea also embraced the consolidated supervisory model.9 International experience with the model was found by some commentators to demonstrate that full integration was 2 This function was assigned to the Bank by the Banking Act 2009. See further HM Treasury, Building a Stronger System (n 1) paras 2.149 and 3.39–3.40. 3 Hector Sants, ‘Transition to New Regulatory Structure’ (FSA Dear CEO Letter, 7 February 2011). 4 HM Treasury, Building a Stronger System (n 1) paras 2.99–2.101. 5 HM Treasury, Judgement, Focus and Stability (n 1) Impact Assessment; HM Treasury, Building a Stronger System (n 1) Impact Assessment. 6 For example, Howell E. Jackson, ‘A Pragmatic Approach to the Phased Consolidation of Financial Regulation in the United States’ (2009) Harvard Public Law Working Paper No. 09/19 http://ssrn.com/abstract=1300431 accessed 18 February 2011; National Audit Office, The Financial Services Authority: A Review under Section 12 of the Financial Services and Markets Act 2000 (Report by the Comptroller and Auditor General, HC 2006–7, 500) 5. 7 Eddy Wymeersch, ‘The Structure of Financial Supervision in Europe: About Single, Twin Peaks and Multiple Financial Supervisors’ (2007) 8 EBOR 237–306. 8 For example, the Bundesbank remained closely involved in bank supervision after the 2002 establishment of the Bundesanstalt für Finanzdienstleistungsaufsicht (BaFin): Jochen Sanio, ‘The New Single Regulator in Germany’ in Thea Kuppens, Henriëtte Prast and Sandra Welleling (eds), Banking Supervision at the Crossroads (Edward Elgar, Cheltenham, 2003) 55–58. 9 Hong-Bum Kim and Chung H. Lee, ‘Financial Reform, Institutional Interdependency, and Supervisory Failure in Post-Crisis Korea’ (2006) 6 J E Asian Stud 409–431.

The break-up of the FSA in the UK

111

associated with greater overall consistency and quality of supervision.10 The international business community valued the UK FSA’s ‘single point of contact’ regulatory structure.11 Post-1997, the UK financial markets flourished and attracted a significant share of global financial transactions. In the buoyant market conditions of the mid-2000s it was widely thought that the UK’s approach to financial regulation was helping to give the London financial markets an international competitive edge.12 Was it just politics that is now killing off the FSA? Certainly it is not hard to see the political appeal of dismantling rather than repairing it. The supposedly integrated financial supervisory model did not do a good job of insulating the UK from the effects of the crisis as they reverberated around the world. It became apparent that uncertainties about the role and responsibilities of different bodies that the single regulator structure was supposed to have eliminated had in reality continued in the financial stability Tripartite Arrangement between HM Treasury, the Bank and the FSA.13 There were, as the FSA’s Chairman, Lord Turner, acknowledged in an influential report, problems of ‘underlap’, with important activities ‘[falling] . . . between two stools’.14 In addition, the FSA’s oversight of certain high-profile specific institutions fell short of acceptable standards, as it admitted in a candid internal review of the collapse of Northern Rock.15 Characterizing one of its predecessor’s flagship initiatives as a thoroughly discredited failure allowed the new Government to seek to gain political capital by taking bold action that responded to the public mood. The prominence of the Bank during the crisis and its inevitable involvement in the resolution of failing financial institutions because of its lender of last resort function made it the obvious candidate to be assigned supervisory responsibilities by a government in search of fresh and clear ideas for structural change. The UK is not alone in conducting a politically driven post-crisis reappraisal of the institutional structure of financial market supervision. 10 Martin Cihak and Richard Podpiera, ‘Integrated Financial Supervision: Which Model?’ (2008) 19 N Am J Econ Fin 135–152. 11 McKinsey, Sustaining New York’s and the US’ Global Financial Services Leadership (New York, January 2007). 12 Iain Begg, ‘Regulation and Supervision of Financial Intermediaries in the EU: The Aftermath of the Financial Crisis’ (2009) 47 J Common Mkt Stud 1107–1128, 1108. 13 Colin Thain, ‘A Very Peculiar British Crisis?: Institutions, Ideas and Policy Responses to the Credit Crunch’ (2009) 4 Brit Pol 434–449; Kara M. Westercamp, ‘A Crack in the Facade and the Whole Building Came Tumbling Down: A Critical Examination of the Central Banks’ Response to the Subprime Mortgage Loan Crisis and Global Financial Market Turmoil’ (2009) 18 Transnat’l L & Contemp Probs 197–244. 14 FSA, The Turner Review: A Regulatory Response to the Global Banking Crisis (March 2009), para 2.6. 15 FSA, The Supervision of Northern Rock: A Lessons Learned Review (FSA Internal Audit Report, March 2008). The politicians were equally scathing: Treasury Committee, The Run on the Rock (HC 2007–8, 56–I, 56–II).

112

E. Ferran

This is an issue that has featured in US regulatory reform debates, although, unlike the FSA, most of the US agencies have managed to withstand the sometimes fierce criticism levelled against them in the aftermath of the crisis and, at least in the short term, have successfully fought the political battle for survival.16 Many of those agencies are, however, much older than the FSA and thus have the advantage of being more part of the fabric of the national set-up and therefore presumably harder to dislodge. It has been pointed out that in getting rid of the FSA, the UK is embarking on its third regulatory revamp in as many decades.17 While it does not follow inexorably that politically driven decisions must be wrong, there is an obvious risk that politics will cloud the issues and result in sub-optimal outcomes. With a view to gaining a better understanding of the implications of the reform path that the UK has now embarked upon, this chapter therefore seeks to examine the substance behind the politics. It asks first whether the abolition of the FSA was inevitable, either because the crisis exposed fatal inherent weaknesses in the integrated regulator model or because it revealed that the FSA’s implementation of that model had been so faulty as to make it not worth saving. The chapter will demonstrate there was not a clear-cut case for outright abolition of the FSA and will suggest that fixing it was a solid option. Since the die is already cast in favour of structural reform, picking over the bones of the FSA in this way could appear to be an academic exercise of no practical value but it is not. The chapter goes on to explain why. Whereas it did not fully live up to its pre-crisis reputation as a world-class regulator, the FSA remains a sophisticated, expert organization that has been operating at the highest levels in an intensely demanding field in which respect is not easily won. Not to learn from its experience – forged both in pre-crisis boom times and under the intense pressures of the worst of the financial crisis – and not to build on its achievements in designing the new structure would amount to squandering past successes and could exacerbate the risk of taking a wrong turn in institutional design. At the same time, for this strategy to work there must be clarity about the areas of strength (and weakness). Without this, opportunities to make improvements could be missed and positive features could be inadvertently discarded; at worst, the process could turn into a cosmetic exercise in which ‘business as usual’ simply continues within an expensively constructed new

16 Eric J. Pan, ‘Four Challenges to Financial Regulatory Reform’ (2009) 55 Vill L Rev 743–772. 17 Michael Taylor, ‘Twin Peaks’ Financial World Online (London, 9 September 2009) www. financialworld.co.uk/Archive/2009/2009_09sept/Features/Michael%20Taylor/17268print.cfm accessed 18 February 2011.

The break-up of the FSA in the UK

113

18

framework. This chapter identifies certain features of the FSA that merit close attention as the reform process moves forward. The chapter is structured as follows. After this introduction, Section 6.2 examines the case for outright abolition of the FSA and finds it wanting. Section 6.3 considers the implications of this finding. It looks at the FSA’s experience in four key areas – the effectiveness of its style of supervision, the effectiveness of its approach to enforcement, the efficiency and economy of its operations and its role in consumer protection – and find strengths as well as weaknesses. Looking ahead, it suggests that the loss of some positive features will be an inevitable consequence of the break-up, but that there is scope for minimizing the negative side effects. It identifies aspects of the FSA’s style and approach that will be inherited by its successors but which may not endure in the longer term. It also pinpoints some new challenges for the successor bodies. Section 6.4 summarizes.

6.2 Did the FSA have to go? An examination of the case for abolition 6.2.1 The FSA did not implement the integrated regulator model properly This is indisputable. In post-crisis inquiries, the FSA candidly acknowledged that it had failed to strike the right balance between prudential supervision and conduct of business supervision, and had been too biased in favour of the latter.19 With the benefit of hindsight, its lack of attention to prudential matters does stand out. According to a March 2001 ECB paper, at that time the FSA was devoting 70 per cent of staff working time to conduct of business issues.20 The ECB cited this figure in making the (as it turned out, prescient) point that a separate authority with a mandate for investor protection as well as prudential supervision was likely to concentrate its attention on the relationship between individual intermediaries and their customers more than on systemic concerns. One indication of where the FSA’s priorities lay was that systemic issues, using this term in the sense of the ability of the financial system to withstand shocks, were

18 Describing the break-up as ‘merely a separation of powers’: Lyndon Nelson, FSA director of risk management, quoted in Louise Meeson, ‘FSA Consultation Kicks Off with Confirmation of 2011 Revamp’, Insurance Age (London, 3 August 2010) 11. 19 FSA, Turner Review (n 14) para 2.7. Whilst most attention in this respect has focused on bank failures, it has been argued that problems of balancing objectives plagued the FSA in other areas as well: Daniel Awrey, ‘The FSA, Integrated Regulation and the Curious Case of OTC Derivatives’ (2010) 13 U Pa J Int’l Bus L 101. 20 ECB, The Role of Central Banks in Prudential Supervision (Frankfurt, March 2001), 4.

114

E. Ferran

barely mentioned in its Annual Reports up to 2008.21 Unsurprisingly, issues of systemic risk, systemically significant firms and systemic resilience feature frequently in the more recent FSA Annual Reports – but this is only after the horse had bolted.22 Was the FSA beyond repair because of its failure to pay sufficient attention to prudential matters? Lord Turner certainly thought not: his initial preference (albeit for pragmatic reasons rather than fundamental conviction as to the merits of the integrated model) was for reform along ‘internal twin peaks’ lines, that is with a clearer distinction between prudential and conduct matters within the FSA itself.23 Of course this was not an independent, detached view: even though Lord Turner demonstrated quite remarkable candour in admitting past mistakes by the FSA (helped presumably by the fact that he was appointed FSA Chairman only in September 2008 and thus was not himself professionally implicated in earlier problems), it would surely have been a step too far for him to have signed the death warrant for his own organization.24 However, there was also support in the academic literature for an improved FSA to continue to be responsible for prudential supervision alongside its other goals.25 Support for retention of the FSA even existed within the upper echelons of the Bank itself – again not detached independent views but ones not affected by institutional loyalties likely to generate a bias in favour of retention of the FSA. In February 2009, Sir John Gieve, outgoing Deputy Governor for Financial Stability, revealed that he was not convinced that there was a clearly superior arrangement to the existing one.26 Sir John thought that it 21 Number of references to ‘systemic’ per Report: 2000/1: 0; 2001/2: 4 (3 relating to systemic mis-selling of mortgage products, the other noting that Enron’s collapse had not had systemic consequences for the UK); 2002/3: 2 (both describing conduct of business failures by firms); 2003/4: 1 (customer complaints handling); 2004/5: 1 (describing work with Financial Stability Forum on resilience to financial sector shocks); 2005/6 4 (systemic failures in firms dealings with customers in respect of consumer products); 2006/7: 0; 2007/8: 0. 22 Number of references: 2008/9: 4 (1 referring to the establishment of the European Systemic Risk Board and 3 to the systemic risks posed by hedge funds); 2009/10: 14 (11 relating to the resilience of systemically important firms, 2 referring to the European Systemic Risk Board, 1 noting systemic weaknesses in OTC derivatives markets). Beginning in 2008/9, the FSA Annual Reports now include an entire section on financial stability. 23 Adair Turner, ‘Chairman’s Speech’ (FSA Annual Public Meeting, 24 June 2010) www.fsa. gov.uk/pages/Library/Communication/Speeches/2010/0624_at.shtml accessed 18 February 2011. 24 Niamh Moloney, ‘Regulating the Retail Markets: Law, Policy and the Financial Crisis’ (2010) 63 CLP 375–447. 25 Kern Alexander, ‘Banking Crisis: Regulation and Supervision’ in Iain MacNeil and Justin O’Brien (eds), The Future of Financial Regulation (Hart Publishing, Oxford 2010) 437–444, 441. 26 Sir John Gieve, ‘Seven Lessons from the Last Three Years’ (London School of Economics, 19 February 2009) www.bankofengland.co.uk/publications/speeches/2009/speech377. pdf accessed 18 February 2011.

The break-up of the FSA in the UK

115

was not clear that any country had done much better than the others despite differences in regulatory structure. Furthermore, in his view: The cultures and staffing of the Bank and the FSA have changed a great deal since 1997 and would not be easy to reshape. And there are genuine costs for firms and supervisors in split responsibilities for different parts of complex groups. Rather surprisingly in view of later pronouncements, the Governor, Mervyn King, maintained a similar opinion until quite far into the financial crisis. As late as June 2008 he was still of the view that: It would not be right for the Bank to take back banking supervision from the FSA, as some have suggested. We should remember that the period before 1997, when FSA and the ‘tripartite arrangements’ were set up, was not seen at the time as a golden age of official oversight of banks. Before 1997 the relationship between the Treasury and the Bank in respect of banking supervision was often fraught.27 Among the many underlying causes of the financial crisis that have been identified, fundamental weaknesses, gaps and misconceptions in the internationally agreed Basel capital adequacy framework, which formed the basis for mandatory EU capital requirements to which the FSA as the competent authority in a member state was obliged to give effect,28 stand out prominently.29 These flaws reflected misguided assumptions about the selfcorrecting effects of market disciplines that were pervasive in regulatory and political thinking in many leading economies during the boom. Perhaps the FSA could have been more proactive in seeking to influence the development of the international framework, an aspect of its work that has become more prominent in the post-crisis period.30 Or it might have made more use of the room left within the EU capital requirements 27 Mervyn King, ‘Banking and the Bank of England’ (Speech to British Bankers Association, 10 June 2008) www.bankofengland.co.uk/publications/speeches/2008/speech347.pdf accessed 18 February 2011. 28 Directive 2006/48/EC of the European Parliament and of the Council of 14 June 2006 relating to the taking up and pursuit of the business of credit institutions [2006] OJ L177/1; Directive 2006/49/EC of the European Parliament and of the Council of 14 June 2006 on the capital adequacy of investment firms and credit institutions [2006] OJ L177/201 (together referred to as CRD). 29 Viral V. Acharya and Philipp Schnabl, ‘How Banks Played the Leverage Game’ in Viral V. Acharya and Matthew Richardson (eds), Restoring Financial Stability: How to Repair a Failed System (John Wiley & Sons, Hoboken 2009) 83–100. FSA, The Prudential Regime for Trading Activities: A Fundamental Review (DP 10/04) identifying five key areas of risk not addressed in the capital framework. 30 FSA, DP 10/04 (n 29) was aimed at feeding into the international discussions on Basel III.

116

E. Ferran

framework31 for member states to add to the core rules, as Spain did with its admired dynamic provisioning requirements.32 It could also have been more demanding in its supervisory reviews and evaluations of the overall adequacy of regulated institutions’ capital and more willing to use its discretionary powers to require institutions to hold additional capital.33 On the other hand, in a field in which internationally consistent approaches are deemed to be especially important, there are also drawbacks when individual countries strike out too far on their own.34 While disentangling international regulatory mistakes based on misguided but widely held underlying assumptions from national supervisory shortcomings is not easy, some weight must be given to the fact that misapprehensions about what regulation and supervision should seek to achieve were themselves systemic. In respect of prudential matters, throughout its life the FSA was overseeing a regulatory framework that, for the most part, was not of its own making.35 Moreover, implementing changes in that framework was always a significant drain on its resources.36 None of this implies that the FSA deserves to be fully absolved from blame for its insufficient rigour in the conduct of prudent supervision, but clearly there were mitigating factors. The FSA has suffered a particularly harsh fate compared to many other public bodies that were also implicated in inquiries into the causes of the financial crisis. Many regulators elsewhere, including those with more narrowly defined, prudentially oriented mandates, also made similarly grave mistakes yet have survived (at least so far).37 Even the now-favoured Bank, which still retained some responsibility for systemic risk oversight notwithstanding the UK’s adoption of the integrated supervisory model, did not openly dissent from the prevailing international view or seriously question

31 CRD, recital 15 (Member States allowed to establish stricter rules than those specified in the Directive). 32 FSA, Turner Review (n 14) para 2.7(iii). Generally on dynamic provisioning: Fiona Mann and Ian Michael, ‘Dynamic Provisioning: Issues and Application’ (2002) Bank of England Stability Review 128. 33 FSA Handbook, BIPRU, 2.2. 34 Raghuram G. Rajan, Fault Lines: How Hidden Fractures Still Threaten the World Economy (Princeton University Press, Princeton 2010) 178. 35 FSA, Turner Review (n 14) para 2.2. 36 Ibid., para 2.6. 37 A particularly notable admission that the financial crisis had shaken fundamental beliefs was that of Alan Greenspan, former Federal Reserve Chairman, before a US Congressional Committee in October 2008. Discussed in Roman Tomasic, ‘Regulation of British Banks After the Financial Crisis’ in MacNeil and O’Brien, The Future of Financial Regulation (n 25) 103–122, 105–106.

The break-up of the FSA in the UK

117

38

the FSA’s approach during the boom years. The logic of shifting supervisory responsibilities to the Bank (which, of course, was also caught up in the worldwide monetary policy errors that contributed significantly to the financial crisis) is thus not incontestable. In a more forgiving political climate, the FSA (still a rather young regulator in spite of its prominence and early success) might have been allowed to learn from its mistakes, mature and move on. However, in the prevailing mood of the time another argument resonated more strongly: stacked up against the case for pragmatic, incremental adaption and improvement of a chastened FSA was the view that the integrated regulator model simply cannot work because it asks too much of a single body. 6.2.2 The integrated regulator model does not work (at least not in large economies) In post-crisis reappraisals of the institutional structure of financial market supervision, an approach that has attracted considerable interest is that described by Mervyn King in the following terms: Whatever its theoretical attractions – and there certainly are some – putting prudential regulation into the same organization as the oversight of consumer protection and market conduct didn’t work in practice. The two types of regulation require different skills and a different approach. Separating them – the so-called ‘twin peaks’ model of financial regulation – is the right direction of reform.39 This ‘practical incompatibility’ assessment is the underlying premise on which the Government’s current reform proposals are based.40 That, with experience, has come the realization that it is not practically feasible to expect a single organization to fulfil the different objectives of financial regulation is a view that commanded considerable support in UK parliamentary discussions and inquiries into the causes of the financial

38 For example, Sir John Gieve (Deputy Governor for Financial Stability), ‘Speech’ (2007) 47 Bank of England Quarterly Bulletin 286, mentioning the FSA’s style and the simplicity of the integrated model as factors underlying the City of London’s rapid growth. In another speech (reported in (2006) 46 Bank of England Quarterly Bulletin 464) Alastair Clark, Adviser to the Governor, identified theoretical procyclicality risks in Basel II but saw no urgent need for policy intervention, pointing to ‘market disciplines’ as a factor helping to keep regulatory capital above regulatory minima. The last Bank of England Financial Stability Report before the financial crisis (published April 2007) noted that risks to the UK’s financial system were ‘edging up’ but gave no obvious hints of inter-authority tensions in explaining how the Bank was working with the FSA in mitigating risks. 39 Mervyn King, ‘Speech’ (Mansion House Speech, 16 June 2010) www.bankofengland. co.uk/publications/speeches/2010/speech437.pdf accessed 18 February 2011. 40 HM Treasury, Judgement, Focus and Stability (n 1) para 1.20.

118

E. Ferran 41

crisis. It has also been endorsed internationally. There were signs even before the full force of the financial crisis hit the world’s economies that the pendulum of international sentiment was swinging away from the integrated model and toward the alternative objectives-oriented (also widely known as ‘twin peaks’) approach, which involves separate authorities for prudential and for consumer and conduct of business regulation.42 The financial crisis accelerated the trend. In its assessment of lessons from the financial crisis, the OECD described the twin peaks model as ‘the sound’ institutional model for financial market supervision.43 It held up Australia, which emerged relatively unscathed from the financial crisis, as an example of a country that had been well served by its twin peaks supervisory model. (On the other hand, the many serious blows that Dutch financial institutions suffered during the financial crisis despite a version of the twin peaks model being in operation in that country do not seem to have dented confidence.)44 That dealing with different regulatory objectives that could come into conflict with each other could present problems for an integrated regulator is not a completely new, post-crisis, discovery. Avoiding such frictions featured prominently in the thinking behind the development of the objectives-oriented approach, which entered the UK policy debate in the mid-1990s as a result of seminal papers by Michael Taylor.45 Senior FSA officials used to have a response to this argument that emphasized the alignment and overlap of, rather than divergence between, prudential and conduct of business regulatory objectives and which made claims for the superiority of the integrated regulator model in resolving efficiently and effectively situations in which objectives came into conflict.46 However, the 41 Discussed in Michael W. Taylor, ‘The Road from “Twin Peaks” – and the Way Back’ (2009) 16 Conn Ins L J 61–95, 81–82. 42 Department of the Treasury, Blueprint for a Modernized Financial Regulatory Structure (Washington, March 2008) inclined towards an ‘objectives-based’ approach somewhat resembling that found in Australia as the way forward for the US. The changes enacted in the Dodd–Frank Wall Street Reform and Consumer Protection Act of 2010 do not include sweeping institutional reorganization along these lines but the architecture of supervision remains under discussion: Hal S. Scott, ‘The Reduction of Systemic Risk in the United States Financial System’ (2010) 33 Harv J L & Pub Pol’y 671–734. 43 OECD, The Financial Crisis: Reform and Exit Strategies (OECD, Paris 2009), 18. However, the OECD is against central bank involvement in supervision because of conflicts of interest concerns. 44 Brooke Masters, ‘Shaping Change will be Complex’ Financial Times (London, 17 June 2010) 3. 45 Michael Taylor, “Twin Peaks”: A Regulatory Structure for the New Century. A Proposal to Reform UK Financial Regulation by Splitting Systemic Concerns from Those Involving Consumer Protection (Centre for Financial Innovation, London 1995); Michael Taylor, Peak Practice: How to Reform the UK’s Regulatory System. Implementing Twin Peaks (Centre for Financial Innovation, London 1996). 46 Clive Briault, The Rationale for a Single National Financial Services Regulator (FSA Occasional Paper Series, No. 2, May 1999).

The break-up of the FSA in the UK

119

financial crisis provided empirical evidence to undermine the claims that all the objectives are in close alignment and can be managed well within a single regulator, and thus bolstered the case for an objectives-oriented approach.47 Taylor has recently suggested that, except in comparatively small countries where the gains from economies of scale may be significant, the integrated regulator is unsuitable because it generates large inefficiencies by asking too much of a single organization, and because prudential and conduct of business regulation do not mix.48 Others are less keen to write off the integrated supervisory model or to suggest that its suitability is confined to smaller economies. According to the IMF, the international experience during the crisis did not demonstrate the superiority of any particular regulatory model.49 The Group of 30, an important private, non-profit, international body, has also held to the view that there is no single correct answer to the question of what is the optimal structure for organizing financial regulation and supervision.50 There is still powerful support in the academic literature for consolidated supervision as the model to which even the US should aspire.51 Placing the responsibility for prudential supervision and for conduct of business and consumer oversight in two separate organizations, each with relatively narrow objectives, may alleviate issues relating to organizational culture and differences in the required skill sets but, at the same time, it may also remove opportunities for valuable cross-fertilization of ideas. It could also undermine the quality of supervision in other ways, for example by slowing down decision-making processes on matters that have prudential and conduct of business dimensions and which therefore require approval from both supervisors, and make it more costly.52 Information flows between the two authorities on matters in which they are mutually interested could be sub-optimal. Furthermore, it is important not to lose sight of the fact that this model merely externalizes rather than eradicates the potential for conflicts between different objectives; there is a plausible argument that this arrangement could actually exacerbate problems of this sort.53

47 Pan, ‘Four Challenges’ (n 16) 117. 48 Taylor, ‘The Road’ (n 41) 88–89. 49 IMF, United States Financial System Stability Assessment (IMF Country Report No. 10/247, July 2010) 33. 50 G30, Financial Reform: A Framework for Financial Stability (Washington, 2009) 35; G30, The Structure of Financial Supervision (Washington, 2008). 51 Scott, ‘The Reduction of Systemic Risk’ (n 42) 730–732. See also, Hal S. Scott, ‘A General Evaluation of the Dodd–Frank US Financial Reform Legislation’ (2010) JIBLR 477–480, 479. 52 On the break-up costs, see Section 6.3 below. 53 Wymeersch, ‘The Structure of Financial Market Supervision’ (n 7). Alternatively, the integrated model may erode transparency by driving such conflicts ‘underground’: Awrey, ‘The FSA’ (n 19).

120

E. Ferran

Commentators have already noted the potential scope for the emergence of inefficiencies and for damaging turf wars between the PRA and the FCA.54 In addition, the FCA could also struggle with internal tensions between having the prevention of consumer detriment at the heart of its operating model55 and its responsibilities for the oversight of one of the world’s largest capital markets. Even the extent to which it is relieved from having to reconcile allegedly ‘incompatible’ functions may prove to be less clear-cut in the messy realities of practical operations than theoretical models could suggest: after all, the FCA is to be a prudential regulator and not just of the small fry whose actions are never likely to threaten the stability of the system as a whole but also of many larger investment firms, investment exchanges and providers of trading facilities whose complex activities could have systemic significance.56 6.2.3 The Bank of England should be ‘in charge’ When the Bank was stripped of its banking supervisory responsibilities in the 1990s it was against the background of several banking collapses that had generated some harsh criticism of the Bank.57 Examined through the lens of the near-cataclysmic events that unfolded during the recent financial crisis, those earlier bank failures may look rather quaint. Nevertheless, it is important not to ignore lessons from history, which clearly demonstrate that the Bank’s inevitable superiority as a supervisor should not be assumed. It is impossible to tell whether the Bank would have fared better than the FSA had it held supervisory responsibilities in the years leading up to the crisis but the lack of open constructive dissent from the Bank to the supervisory approach adopted by the FSA during the boom years gives credence to scepticism about whether having the Bank in the supervisory role would have made a meaningful difference. An argument that was influential in the 1990s was that giving the central bank monetary policy independence, whereas at the same time asking it to be the prudential supervisor, could lead to conflicts of interest that would undermine policy independence.58 Key issues were the risk that concerns for the health of supervised institutions could distort monetary policy, and that institutional failures could have adverse reputational 54 Will Roberts, ‘FSA Break-up May Result in “Horrible” Turf Wars’ IFA online (London, 8 July 2010) www.ifaonline.co.uk/ifaonline/news/1721152/fsa-break-result-horrible-turfwars accessed 18 February 2011. 55 HM Treasury, Building a Stronger System (n 1) para 4.52. 56 Ibid., Box 4.E. 57 Eilis Ferran, ‘Examining the UK Experience in Adopting the Single Financial Regulator Model’ (2003) 28 Brook J Int’l L 257–307. 58 For discussion see Charles Goodhart and Dirk Schoenmaker, ‘Should the Functions of Monetary Policy and Banking Supervision Be Separated?’ (1995) 47 Ox Econ Papers 539–560.

The break-up of the FSA in the UK

121

consequences for the central bank or that moral hazard problems would intensify because of expectations that institutions supervised by the central bank could rely on bailouts if they got into trouble. Whether central banks were a natural place in which to find the appropriate expertise to supervise systemically important investment banks and insurance firms was also questioned.59 These lines of argument remain pertinent and, indeed, have acquired additional force because of what has been learnt about the systemic risks posed by non-banks. However, there were, and still are, arguments pointing the other way. In particular, entrusting supervisory responsibilities to the central bank is said to ensure that a proper focus on systemic risk will be maintained, and to be well-designed to take advantage of information-related synergies between core central banking activities and supervisory matters.60 In truth, the arguments about whether to assign supervisory responsibilities to central banks have always been quite finely balanced. Moreover, what has never been seriously questioned is that central banks, as overseers of the money and payment systems and lenders of last resort, must retain some responsibility for systemic stability. This means that central banks can never disappear completely from the supervisory arena. Instead, when countries locate frontline micro-prudential banking supervisory responsibilities in agencies other than their central banks they must put in place arrangements that are intended to ensure effective cooperation and coordination between the supervisor and the central bank, particularly in times of stress. In the UK, this was the Tripartite Arrangement between the Bank, the FSA and the Government. The Tripartite Arrangement undoubtedly buckled under the strain of the financial crisis.61 Even if the politics had worked out differently, there would have been an unavoidable need to engage in a far-reaching reappraisal of this part of the institutional framework. Indeed, the process of improving the relationship between the Bank and the FSA was already underway under the previous Labour administration.62 Those moves reflected a view, which even the Governor of the Bank adhered to for a

59 Taylor, ‘The Road’ (n 41) 85. 60 ECB, The Role of Central Banks in Prudential Supervision (n 20) 3–5. For a general review of the literature on the pros and cons of central banks as supervisors: Marco Arnone and Alessandro Gambini, ‘Architecture of Financial Supervisory Authorities and Banking Supervision’ in Donato Masciandaro and Marc Quintyn (eds), Designing Financial Supervision Institutions: Independence, Accountability and Governance (Edward Elgar, Cheltenham 2007) 262–308. 61 Treasury Committee, The Run (n 15) para 276. 62 HM Treasury, Reforming Financial Markets (July 2009). This led to the Financial Services Act 2010, which enacted some limited reforms including giving the FSA a new financial stability statutory objective.

122

E. Ferran

while, that necessary improvements could be achieved through an evolutionary approach.63 One matter on which a new international consensus has emerged in the aftermath of the financial crisis is with respect to the need to bolster macro-prudential regulation and supervision. New or significantly revamped bodies that are responsible for overseeing the system as a whole are being established around the world.64 It is likely that even if the political back story had taken a different course, the UK would have decided to follow suit and would have embraced more extensive institutional change than would have been possible within the confines of the Tripartite structure. Thus, the new Financial Policy Committee within the Bank can be viewed as an aspect of the new framework that may transcend local politics. The Financial Policy Committee will be responsible for monitoring and addressing systemic or aggregate risks and vulnerabilities that could threaten the stability of the sector as a whole and endanger the wider economy.65 The Financial Policy Committee will not play a direct marketfacing operational role but it will be able to give directions to supervisors and to issue recommendations to supervisors, to the Bank and to the Government. The establishment of the Financial Policy Committee will put the Bank in overall ‘charge’ but in a rather different way from that contemplated by much of the debate on the pros and cons of assigning supervisory responsibilities to central banks because the main focus of that debate historically was micro-prudential supervision. The reform package will also assign micro-prudential supervisory responsibilities in the Bank’s direction, albeit to a new subsidiary of the Bank rather than to the Bank itself.66 This move was not a necessary corollary to the creation of the Financial Policy Committee. Instead, the Government could have chosen to develop the concept of a new Financial Policy Committee within the Bank, giving it the final say in systemic matters but otherwise leaving the FSA intact.67 One important issue arising from the proposed new institutional settlement is whether vesting responsibility for micro-prudential supervision in a subsidiary of the Bank rather than the Bank itself will suffice to put adequate distance between the Bank’s responsibilities for monetary policy and its supervisory functions, and also serve as a clear boundary between those 63 In the 2008 speech referred to in n 27, Mervyn King referred to the Tripartite Arrangement as being ‘not so much faulty as incomplete’. See also Treasury Committee, The Run (n 15) para 277 (Tripartite system should be reformed rather than dismantled). 64 Eilis Ferran and Kern Alexander, ‘Can Soft Law Bodies Be Effective? The Special Case of the European Systemic Risk Board’ (2010) EL Rev 751–776. 65 HM Treasury, Building a Stronger System (n 1) ch 2. 66 Ibid., ch 3. 67 The Lib Dem Party, while in opposition, advocated institutional reform broadly along these lines: James Moore, ‘The End of the Road for the FSA?’ The Independent (London, 21 July 2009) 40.

The break-up of the FSA in the UK

123

functions and the Bank’s role with respect to the resolution of failing banks. This is contestable. Already the Government is sending out rather mixed messages.68 It has emphasized that the PRA will have ‘operational independence for the day-to-day regulation and supervision of firms’69 but, at the same time, it has also trumpeted the fact that all aspects of prudential supervision, macro and micro, will be placed under the auspices of the Bank, so that responsibility for macro- and micro-prudential regulation is located ‘in a single institution’.70 The Governor of the Bank has also spoken of the ‘first-hand’ knowledge of the health of the banks that the Bank will enjoy under the new arrangements.71 The oversight role of the Financial Policy Committee, a committee of the Bank itself and on which the Bank will be strongly represented, is likely to be a further source of potential line blurring. It is worth making a comparison here with the Australian Prudential Regulation Authority (APRA). In spite of the current enthusiasm for the Australian supervisory model, the UK is not proposing to follow it at the more detailed level. The APRA is an autonomous independent entity not under the wing of the Reserve Bank of Australia (RBA). The possibility of assigning prudential supervisory responsibilities to the RBA itself was considered but did not find favour.72

6.3 Why it matters that the case for abolition of the FSA cannot be convincingly established 6.3.1 No perfect system All institutional models for financial market supervision have pros and cons.73 The strengths of the integrated model are said to include that it is well-matched to a market in which traditional boundaries between different lines of business no longer exist and financial conglomerates are common, and that it can deliver efficiency and effectiveness gains/economies of scale and scope through the avoidance of duplication and overlap. On the other hand, the financial crisis has provided compelling evidence that proponents of the integrated model underestimated the challenges involved in the management of multiple regulatory objectives 68 Thereby giving credence to the view that the design of the structure has been driven by pragmatic considerations (i.e. managing the differentials in pay scale between the FSA and the Bank) rather than principle: Nathan Willmott and others, ‘Equipping the Modern Regulator: Assessing the New Regulatory Powers under the Financial Services Act 2010’ (2010) 78 Compliance Officer Bulletin 1. 69 HM Treasury, Judgement, Focus and Stability (n 1) para 3.29. 70 Ibid., para 1.15. 71 King, ‘Speech’ (n 39). 72 Financial System Inquiry, Final Report (Canberra, March 1997) para 8.3.6. 73 Donato Masciandaro, Maria Nieto and Marc Quintyn, ‘Financial Supervision in the EU: Is There Convergence in the National Architectures?’ (2009) 17 JFRC 86–95.

124

E. Ferran

and in resolving conflicts between them. The objectives model is said to allow for a clearer focus on different regulatory objectives but may be less appealing from an efficiency perspective; furthermore, it does not provide a perfect solution to problems of conflicts between objectives and could lead to wasteful inter-agency jurisdictional conflicts. Any supervisory model that assigns in the direction of the central bank responsibilities for prudential supervision of financial institutions has the advantage of usefully eliminating inter-agency fault lines in the flow of macro- and microeconomic information and locating all of that information within the institutional group that will have to make critical lender of last resort judgment calls; but it also creates a risk of conflicts between macro- and microeconomic goals,74 which subsidiarization of the supervisory function may be insufficiently robust to contain. It also raises the spectre of a potentially alarmingly super-powered central bank. Trade-offs are inevitable whichever institutional arrangement is adopted. The UK could have opted to clarify and reinforce the Bank’s position as the body in overall charge of ensuring macro-prudential systemic stability whereas leaving all frontline day-to-day micro-prudential responsibilities with a reformed FSA. Fine-tuning the institutional arrangements in this way would have brought the UK system near to a model that has attracted support as the best way forward for reform of the fragmented US supervisory infrastructure.75 Another option would have been to have left the FSA in place for the most part, but to carve out a separate prudential and conduct of business supervisory regime, either on an autonomous basis or under the responsibility by the Bank, exclusively for large, complex, systemically important financial institutions. The development of special rules for systemically important institutions has become part of mainstream post-crisis regulatory reform thinking and it is a logical progression to consider whether the supervisory infrastructure should follow suit.76 A potentially serious drawback of having a dedicated supervisory regime for systemically important institutions (particularly if that regime is administered by the central bank) is that it could intensify moral hazard problems. Nevertheless, the emergence of this institutional arrangement as a serious policy option demonstrates that supervisory design should not be regarded as a simple binary choice between two well-known models and that there is room for fresh thinking.

74 Heidi M. Schooner and Michael W. Taylor, Global Banking Regulation: Principles and Politics (Academic Press, Burlington 2009) 271. 75 Jackson, ‘A Pragmatic Approach’ (n 6). 76 Anthony Saunders, Roy C. Smith and Ingo Walter, ‘Enhanced Regulation of Large, Complex Financial Institutions’ in Acharya and Richardson, Restoring Financial Stability (n 29) 139–158.

The break-up of the FSA in the UK

125

The objectives-oriented rearrangement of the institutional architecture that the UK has actually embarked upon thus represents a political choice between a number of different options rather than being an inevitable outcome that followed inexorably from the financial crisis. Like the others, this model has flaws. The particular version of this model that the UK has opted for is especially controversial because it locates responsibilities for prudential supervision within the central bank. However, the fact that all of the institutional models turn out to be imperfect when they are examined closely suggests that a sober reassessment of the linkages between supervisory models and economic outcomes is in order. Hindsight reveals that the notion that the UK had somehow alighted upon the perfect supervisory model when it established the FSA was an unwarranted overexaggeration. And experience has also taught us that dire predictions about the impact that institutional reordering could have on the UK’s international competitiveness deserve to be received with a healthy dose of scepticism. Yet even though the decision to rearrange the institutional architecture cannot therefore be condemned as a fundamentally wrong turn, reasons for concern about the break-up remain. 6.3.2 Implications The institutional rearrangement that the UK has embarked upon presents major implementation challenges. The risk is that the UK will endure a painful period of institutional instability only to end up with a system of supervision that is of inferior quality to the one it replaced.77 Self-inflicted blows could exacerbate the damage that the financial crisis inflicted on the UK’s reputation as a country to be looked to for regulatory thought leadership (which, arguably, the FSA’s response to the crisis, in particular the widely admired Turner Review, went some way to repair). How well the reform process deals with the task of extracting the valuable lessons from the FSA’s record and carrying them over into the design and operation of the bodies within the new structure could be a crucial factor in determining whether this risk materializes. Despite its imperfections, the FSA has considerable accumulated strengths. It has the insights on what works (and what does not) that come from more than a decade of practical experience at the best and worst of times. The rhetoric of ‘disaster’ and ‘failure’ that some have used to describe the FSA and to applaud the decision to scrap it is therefore

77 A significant increase in resignations by FSA staff has been linked to institutional instability resulting from the break-up proposals: Brooke Masters, ‘FSA Exodus Intensifies Concerns over City Regulation Proposals’ Financial Times (London, 9 August 2010) 13.

126

E. Ferran

somewhat overblown.78 That the real intention is to build the new regime on FSA foundations is already clear. However, what aspects of the FSA deserve to be given close attention in designing the new regime? The remaining sub-sections of this section examine the FSA’s experience in four key areas and set out some preliminary thoughts on their significance going forward. 6.3.2.1 Effectiveness: style of supervision The FSA has been on an interesting journey with respect to supervisory style. Chastened by experience and informed by post-crisis reflections on the susceptibility of regulatory policymakers to conventional thinking and their tendency to place too much faith in simplified versions of key theories,79 it has gone from being a supervisor that emphasized ‘the desirability of regulation working with the grain of the market rather than against it; [and] . . . the restriction of regulation to those circumstances where the market does not provide adequate answers’80 to one that is sceptical of the ability of markets to self-correct and is willing to ‘lean against the wind of irrational exuberance’.81 A ‘light touch’ approach has been jettisoned in favour of ‘intensive supervision’.82 It now prefers to describe itself as being ‘outcomes focused’ rather than ‘principles-based’.83 Two connected strands of its supervisory philosophy that remain more or less intact are its ‘riskbased’ approach and its emphasis on not being a ‘zero-failure’ regulatory regime;84 but risk-based regulation owes its survival, albeit in a (somewhat) modified form, less to success than to the formidable difficulties involved

78 For example, HL Deb 16 June 2010, vol. 719, cols 984–990 (Lord Sassoon (Commercial Secretary to the Treasury) and Lord Bilimoria). 79 Adair Turner, ‘Economics, Conventional Wisdom and Public Policy’ (Speech at Institute for New Economic Thinking Inaugural Conference, Cambridge, April 2010) http://ineteconomics.org/sites/inet.civicactions.net/files/INET%20Turner%20%20Cambridge%2020100409.pdf accessed 18 February 2011. See also Harry McVea, ‘Financial Services Regulation Under the Financial Services Authority: A Reassertion of the Market Failure Thesis?’ (2005) CLJ 413–448. 80 FSA Business Plan 2004/5, 5. 81 Lord Turner, evidence quoted in Treasury Committee, Banking Crisis: Regulation and Supervision (HC 767, 2009) para 21. 82 FSA Annual Report 2009/10, 6. 83 FSA Annual Report 2008/9, 10. 84 FSA Business Plan 2004/05, 5, describes these ideas as being central to the FSA’s thinking since the beginning. They were strongly reaffirmed in the FSA’s Supervisory Enhancement Programme (April 2008). Some refinements have been made to the FSA risk-assessment processes but see Andromachi Georgosouli, ‘The Revision of the FSA’s Approach to Regulation: An Incomplete Agenda?’ (2010) JBL 599–617.

The break-up of the FSA in the UK

127

in developing more radical but still workable alternatives that address uncertainties as well as measureable risks.85 The current intention is for the successor bodies to the FSA to build on the tougher, judgment-oriented and intrusive supervisory style that the FSA has adopted in the aftermath of the financial crisis (that is the ‘intensive supervision’ mode).86 But since part of the reasoning behind splitting responsibility for supervision is that prudential supervision and conduct of business/consumer protection supervision may require different cultures, even if the PRA and the FCA start in broadly the same place with respect to their supervisory style, some divergence over time can be expected.87 In any case, since there is no guarantee that ‘intensive supervision’ will be any freer of flaws than earlier approaches, the new bodies will need to keep their overarching approaches under constant review and to take care not to fall into the trap of believing that whatever approach is operational at any given time is either permanent or perfect. It is already possible to identify dangers in a heavily judgment-oriented approach to supervision, and other concerns are bound to emerge as time goes on. One obvious risk is that the FSA’s successors will struggle to maintain an aggressively judgmental style when economic conditions improve and political sentiment moves on. Rules that prescribe particular courses of action can shield supervisors from political pressures of this sort, and also from industry lobbying.88 Factors over and above the need to comply with EU law, provide transparent regulation and achieve legal certainty may thus come into play in ongoing determinations of where the balance between reliance on rules and on discretionary supervisory judgment should be struck. Like other straplines, ‘intensive supervision’, whereas serving a useful purpose as a signal of a guiding philosophy, risks oversimplification and could be a poisoned chalice for the new supervisors if it results in them coming under pressure to over-prune rules.89 However, backsliding into a laissez-faire style of supervision is not the only risk inherent in a judgment-based approach to supervision. A plausible alternative scenario is that insufficient supervisory intervention in the

85 On more nuanced concepts of risk-based regulation: Julia Black and Robert Baldwin, ‘Really Responsive Risk-Based Regulation’ (2010) 32 Law & Policy 181–213. 86 HM Treasury, Building a Stronger System (n 1) paras 3.31–3.35 (PRA) and paras 4.4, 4.49–4.51 (FCA). 87 The cultural ethos of the PRA can be expected to follow that of the Bank as a whole: HM Treasury, Judgement, Focus and Stability (n 1) para 3.29. 88 Avinash D. Persaud, ‘The Role of Policy and Banking Supervision’ in Stephany GriffithJones, José A. Ocampo and Joseph E. Stiglitz (eds), Time for a Visible Hand (OUP, Oxford 2010) 150–164, 154–155; FSA, Turner Review (n 14) 61–62; Iain MacNeil, ‘Risk Control Strategies and the Credit Crisis’ in MacNeil and O’Brien, The Future of Financial Regulation (n 25) 141–159, 151. 89 See HM Treasury, Building a Stronger System (n 1) paras 3.33–3.35, which outline a ‘proactive intervention framework’ aimed at reducing the risks of regulatory forbearance.

128

E. Ferran

boom years could be followed by an over-correction. The essence of ‘intensive supervision’ is that the FSA will form its own views and be less reliant on analysis presented to it by firms.90 This policy implies greater willingness to exercise the supervisory discretions to require financial institutions to hold additional capital; but intensive supervision is evidently intended to go much further than this. A key component of the more proactive style is closer supervisory engagement with the corporate governance of financial firms, including a hands-on approach to vetting appointments to senior roles in major firms on competence as well as probity grounds.91 The recent prominence of this policy is understandable given the corporate governance weaknesses that were exposed by the financial crisis92 but there is a danger that it could be over-zealously pursued and that good arguments for those charged with oversight responsibilities to exercise restraint in second-guessing business judgments could be inappropriately marginalized.93 Notwithstanding lessons from the financial crisis about the limits of corporate governance mechanisms in curbing inappropriate risktaking in financial firms, for the FSA to have its ‘fingerprints’ all over management changes in firms, as it has already spoken of doing, is not entirely reassuring.94 Furthermore, there is a danger that an unintended consequence of supervisory engagement with financial institutions’ governance could be an erosion of market disciplines as it could lead investors and other market participants to relax their own scrutiny of these matters.95 The need for safeguards against arbitrary or excessive use of discretionary power is another concern. Whereas industry complaints about the risk of heavy-handed supervision may not garner much support in the current climate, there is nevertheless a legitimate point to be made about the need for the new bodies to be appropriately accountable in the exercise of their powers. Since the system of controls that was devised for the FSA, a body about which accountability concerns loomed large when it was being

90 FSA Annual Report 2009/10, 11. 91 In 2009/10 the FSA conducted 377 interviews and 27 proposed appointments were withdrawn: ibid., 11. 92 Examining the membership of boards of banks in the period leading up to the crisis: Daniel Ferreira, Thomas Kirchmaier and Daniel Metzger, ‘Boards of Banks’ (2010) ECGI – Finance Working Paper No. 289/2010 http://ssrn.com/abstract=1620551 accessed 18 February 2011. See also Roman Tomasic, ‘Corporate Rescue, Governance and Risk Taking in Northern Rock: Part 2’ (2008) 29 Co Law 330–337, 334. 93 For an example of FSA overzealousness in judging fitness and propriety: Panesar v FSA (Upper Tribunal Decision, FIN/2009/0025, 21 October 2010). 94 Jon Pain, ‘FSA’s Approach to Intensive Supervision’ (Speech, 18 May 2010) www.fsa.gov. uk/pages/Library/Communication/Speeches/2010/0518_jp.shtml accessed 18 February 2011. 95 Treasury Committee, Banking Crisis (n 81) paras 34–37.

The break-up of the FSA in the UK

129

established, has worked reasonably well, any proposed departures from it will need to be carefully explained and justified.96 6.3.2.2 Effectiveness: the role of enforcement The FSA’s history with respect to enforcement supports the view that whilst straplines can usefully encapsulate the essence of the matter they address, they can also over-simplify and turn a sophisticated, nuanced concept into a caricature. When the FSA described itself as a ‘nonenforcement led supervisor’, this was meant to be shorthand for a carefully thought-through multi-pronged approach to promoting compliance.97 However, it sent out the wrong signal about the FSA’s willingness to take tough action against abuse.98 The FSA had realized this mistake before the financial crisis and was already taking corrective action. Its new approach, coined ‘credible deterrence’ has been in operation for several years now and there has been a healthy number of high profile criminal and civil cases coming through the pipeline to make good the ‘credibility’ claim.99 Progress has thus been made in providing the ‘fear factor’ that was perceived to be missing from UK financial market regulation.100 The intention is that the PRA and the FCA will each have their own enforcement powers. In the case of the FCA, these will include new powers to ban products and remove misleading advertisements, and it will also be allowed to publicize enforcement action at an earlier stage in proceedings.101 This splitting of enforcement responsibilities will inevitably cause some disruption. The implications of differences in enforcement style – in the case of the PRA, enforcement may more often take the form of supervisory intervention than formal disciplinary or other proceedings – may take some time to work out. There could be problems of coordination in

96 On proposed accountability arrangements: HM Treasury, Building a Stronger System (n 1) paras 3.53–3.73 (PRA) and paras 4.35–4.44 (FCA). This document goes some way to address initial concerns about the robustness of the PRA accountability framework. But questions still remain – e.g. with respect to mechanisms for appeals against PRA enforcement decisions: ibid., para 3.32. 97 Eilis Ferran, Capital Market Competitiveness and Enforcement (City of London, London 2008). 98 John C. Coffee, ‘Law and the Market: The Impact of Enforcement’ (2007) 156 U Pa L Rev 229–311. 99 FSA Annual Report 2009/10, appendix 5 provides the statistical data. The FSA secured its first insider dealing criminal conviction in 2009 and by February 2011 had achieved ten custodial sentences (three suspended). Large fines on the civil side also demonstrated the FSA’s seriousness of purpose (e.g. Morgan Stanley £33.32 million (May 2010) and Goldman Sachs £17.5 million (September 2010)). 100 Hector Sants, ‘Delivering Intensive Supervision and Credible Deterrence’ (Speech, 12 March 2009) www.fsa.gov.uk/pages/Library/Communication/Speeches/2009/0312_hs. shtml accessed 18 February 2011. 101 HM Treasury, Building a Stronger System (n 1) paras 4.60–4.89.

130

E. Ferran

respect of compliance failures that have prudential and conduct of business/consumer angles. It is conceivable that an enforcement step favoured by the FCA, such as banning a particular type of product, could concern the PRA because of its potential to cause systemic disruption.102 However, further potential difficulties have been averted by a welcome modification to the Government’s proposals. When the break-up plans were first announced it was indicated that the Government was considering transferring the FSA’s criminal prosecution powers in respect of insider dealing, market abuse and other economic crimes to a proposed new Economic Crime Agency.103 In November 2010, the Government announced that it had decided against this and criminal prosecution powers would be retained within the FCA.104 This modification was sensible. Leaving responsibility for the prosecution of crimes against the market with the FCA, the successor markets authority, will allow for the seamless, close cooperation between supervision, markets and enforcement that has reputedly been crucial to the FSA’s recent successes in enforcement to continue, and minimize the wastage of the expertise that the FSA has built up in making use of the wide range of enforcement tools at its disposal.105 At a time when senior markets regulators in the USA have spoken out in favour of their agencies being given authority to bring criminal prosecutions in order to enhance their effectiveness,106 it would have been odd for the UK to have stripped its markets supervisor of that power. It never seemed wise to transfer the financial burden of prosecuting market offences onto the public purse, as that would, in all likelihood, have made it impossible to afford the top-flight legal and other professional advisers that have particular expertise in cases of complex financial wrongdoing.

102 HM Treasury, Building a Stronger System (n 1) paras 5.18–5.26 propose the introduction of a limited PRA veto over potentially destabilizing FCA actions. 103 HM Treasury, Judgement, Focus and Stability (n 1) para 5.26. 104 HM Treasury, Summary of Consultation Responses (n 1) para 2.36. 105 Margaret Cole, FSA Director of Enforcement argued forcefully for retention of criminal powers for these reasons: ‘Introduction to the FSA Enforcement Conference 2010’ (Speech, 22 June 2010) www.fsa.gov.uk/pages/Library/Communication/ Speeches/2010/0622_mc.shtml accessed 18 February 2011. 106 Luis A. Aguilar, ‘Empowering the Markets Watchdog to Effect Real Results’ (SEC Commissioner, Speech, 10 January 2009) www.sec.gov/news/speech/2009/spch011009laa. htm accessed 18 February 2011; Bart Chilton, ‘De Principatibus’ (CFTC Commissioner, Speech, 21 October 2009) www.cftc.gov/PressRoom/SpeechesTestimony/opachilton-28. html accessed 18 February 2011. See also A.M. Rose, ‘The Multi-Enforcer Approach to Securities Fraud Deterrence: A Critical Analysis’ (2010) 158 U Pa L Rev 2173–2231.

The break-up of the FSA in the UK

131

6.3.2.3 Efficiency and economy The decision to break up the FSA reflects a fundamental reappraisal of the efficiency of the FSA’s management of regulatory objectives. Yet the Government seems (understandably) loath to lose certain attributes of its operations that attracted praise from an efficiency perspective. Its intention is for the FCA to be responsible for both prudential and conduct of business supervision of non-systemically relevant firms. Thus for the vast majority of regulated firms, there will still be a ‘single point’ of supervisory contact. Things will be different for PRA authorized firms because they will be subject to FCA oversight in respect of how they conduct their business. This new division of supervisory responsibilities will thus once again make pertinent in the UK issues that previously arose with respect to the efficient management of multiple supervisors in areas where their jurisdictions overlap.107 Pre-FSA experience in the UK provides plenty of evidence of the difficulties that can emerge when multiple supervisors are permitted to draw up and apply their own rulebooks.108 The current proposals naturally recognize that subjecting firms that are supervised by the PRA and FCA to duplicative or divergent requirements, or to dissimilar supervisory approaches, as inefficient outcomes that should be avoided.109 However, the goal of having a streamlined dual-track regime may be harder to achieve in practice than has been anticipated, especially if (as discussed above) the two authorities develop different supervisory styles. There is potential, too, for interactions between the Financial Policy Committee and the frontline supervisions to generate new inefficiencies. Whereas, on paper, a system in which the PRA is responsible for writing and supervising the implementation of prudential rules for the firms it authorizes and the FCA does the rest looks straightforward, the reality is likely to be rather different because certain rules (using this term here to include generally worded principles) will be relevant to all aspects of a firm’s business and certain matters requiring the exercise of supervisory judgment will have a pervasive quality. In particular, general regulatory principles relating to the conduct of business with due care, skill and diligence or the competence or capability of individuals who hold key

107 See Barry A.K. Rider, Charles Abrams and Michael Ashe, Guide to Financial Services Regulation (3rd edn, CCH, Bicester 1997) 38–39 (discussing efforts to manage overlaps through lead regulator arrangements under the pre-FSA institutional settlement). 108 Alan C. Page and Robert B. Ferguson, Investor Protection (Weidenfeld and Nicholson, London 1992) 226–229, 266–268 (discussing problems with the first rulebook produced by the Securities and Investments Board and equivalent self-regulating organization rulebooks, the new approach subsequently adopted and the potential for divergence and inconsistency that remained). 109 HM Treasury, Building a Stronger System (n 1) ch 5 outlines proposed arrangements for inter-agency coordination mechanisms. There is likely to be considerable refinement of these mechanisms before the new system becomes operational.

132

E. Ferran

positions in firms could be approached from either direction. There is thus quite a distinct possibility that firms could find themselves repeatedly going through the same material and issues in order to respond to inquiries and inspections coming from two different sources and that on occasions they could be caught between divergent supervisory interpretations. Evidence from Australia indicates that the coordination of supervisory efforts by ‘twin peaks’ supervisors is an issue that its regime has grappled with, not always successfully.110 The FSA’s industry-sourced funding model will be carried over to the PRA and FCA. This is sensible because although there is no universally accepted optimal financial market supervisory model, there is a clear trend for at least partial industry funding111 and this is widely thought to be important in closing the resource gap between the supervisor and the industry, thereby enabling the supervisor to meet its goals more effectively.112 However, the existence of two supervisors and the adoption of particular supervisory styles (intensive supervision is inevitably resource intensive113) could lead to significant overall cost increases, with obvious ramifications for industry sentiment with respect to the value for money of the supervisory system. The Government seems rather sanguine about this aspect of its proposals.114 Its view sits uncomfortably with claims in the theoretical literature with respect to the superiority of the integrated model from a cost-savings perspective but, in fairness, such claims have not been definitively validated from an empirical perspective.115 The Government’s further contention that the margin of benefits over costs is such that the cost-benefit analysis would still support reform even if costs have been materially underestimated is also quite optimistic in that the ‘benefit’ in question rests on rather heroic assumptions about the likely impact of institutional reform on the frequency and severity of future financial crises.

110 Michael A. Adams, Angus Young and Marina Nehme, ‘Preliminary Review of Over-regulation in Australian Financial Services’ (2006) 20 Aust Jnl of Corp Law 1–24; HIH Royal Commission, Report (Canberra, April 2003) ch 8. 111 PA Consulting Group, Financial Services Authority: Researching Regulatory Funding Models (London, April 2009) para 1.4. 112 An argument used, for example, by the SEC in its efforts to have a self-funding mechanism included in the US Dodd–Frank Wall Street Reform and Consumer Protection Act 2010: Mary L. Schapiro, ‘Statement Concerning Agency Self-Funding’ (SEC Chairman, Speech, 15 April 2010) www.sec.gov/news/speech/2010/spch041510mls.htm accessed 18 February 2011. 113 FSA Business Plan, 2010/11, 12. The FSA Annual Requirement increased by 9.5 per cent in 2007/8, 6.9 per cent in 2008/9, 36.5 per cent in 2009/11 and by 9.9 per cent in 2010/11. 114 HM Treasury, Building a Stronger System (n 1) Impact Assessment. This suggests, inter alia, that efficiencies will outweigh costs flowing from more intensive supervision by the PRA, that costs resulting from loss of economies of scale will not be significant and that affected firms will adapt efficiently to having to deal with two regulators rather than one. 115 Jackson, ‘A Pragmatic Approach’ (n 6).

The break-up of the FSA in the UK

133

6.3.2.4 Consumer protection The FSA has a mixed track record in consumer protection. On the positive side, it has conducted a number of high-profile initiatives aimed at ensuring a fair deal for retail customers.116 It has secured significant amounts of redress for consumers affected by compliance failures, such as the £102.7 million that Standard Life made available to compensate customers who had been sold pension-related investments on the basis of misleading marketing material,117 and the total consumer redress for endowment misselling of around £1 billion. It has become increasingly muscular in the taking of enforcement action resulting in the imposition of substantial sanctions against those guilty of compliance failures with respect to dealings with retail customers.118 It has attracted praise both domestically and abroad for its strategic leadership in addressing financial capability.119 While some commentators have sought to characterize the FSA as an agency that became captured by the industry and failed vigorously to defend consumers’ interests, others have pointed to the many FSA consumer-oriented initiatives as yielding evidence to refute this charge.120 The respected organization, Citizens Advice, has given credit to the FSA for its increasing focus on consumer problems and its better understanding of their significance.121 However, this is not to downplay the stinging criticism that the FSA has received for insufficient robustness in its oversight of certain segments of consumer-oriented industry activity.122 Five findings of maladministration against the FSA in respect of its prudential supervision of the Equitable Life insurance company (where it inherited a problem but compounded it with errors of its own) constituted

116 In particular Treating Customers Fairly (first discussion paper 2001, project intensified from 2004 onwards); Retail Distribution Review (launched 2006); Mortgage Market Review (launched 2009). 117 FSA Final Notice, 20 January 2010. In addition Standard Life was fined £2.45 million. 118 FSA Annual Report 2009/10, 48–49. 119 National Audit Office Report (n 6) 51; Jackson, ‘A Pragmatic Approach’ (n 6). Responsibility for promoting consumer education now sits with the Consumer Financial Education Body (Financial Services Act 2010). This body will remain in place and will collaborate with the FCA through a statutory MoU: HM Treasury, Building a Stronger System (n 1) paras 6.24–6.25. 120 Iain D.C. Ramsay and Toni Williams, ‘The Crash that Launched a Thousand Fixes-Regulation of Consumer Credit after the Lending Revolution and the Credit Crunch’ (2009) http://ssrn.com/abstract=1474036 accessed 18 February 2011. 121 In written evidence to the Treasury Committee, published in Treasury Committee, Financial Regulation: A Preliminary Consideration of the Government’s Proposals (2010–11, HC 430–III) Ev w55–58, para 5. 122 Such as Treasury Committee, Mortgage Arrears and Access to Mortgage Finance (2008–9, HC 767) (FSA’s oversight of lenders’ arrears handling practices allowed too much ‘flexibility’ to the industry and was ‘seemingly leisurely’ in respect of review and enforcement action).

134

E. Ferran

a particularly serious blow to its reputation.123 Close observers of the FSA’s consumer operations have reserved judgment on the practical value of its major initiatives, remaining ‘to be convinced that real and effective change will happen’.124 Most fundamentally, the FSA has not succeeded in finally eradicating the mis-selling of retail financial products, which has been a longstanding problem in the UK. As well as dealing with continuing fallout from mis-selling that took place under previous regulatory regimes,125 the FSA has also had to address problems arising on its own watch, including poor practices in the selling of Lehman-backed structured products.126 Willingness to intervene in product design is the new frontline in the development of consumer financial services regulatory policy. The FSA has already adopted a policy of being willing to proactively intervene earlier in the product chain.127 That ‘prevention is better than cure’ is the obvious animating force here. Implicit in the FSA’s promotion of this new approach is an acknowledgement that earlier flagship projects have had limited effect.128 In the new structure, this policy will be taken a stage further and the FCA will have specific new powers to ban products and to demand the rapid withdrawal of misleading advertisements.129 Historically there was considerable reluctance to consider giving the financial regulator a role in product vetting and the evolution of policy in this direction is thus highly significant.130 With overwhelming evidence from the crisis to substantiate the work of behavioural economists on cognitive limitations and the consequential implications for reliance on disclosure as a consumer protection tool that regulatory scholars have identified, the arguments for the intensification of alternative consumer protection strategies

123 Parliamentary and Health Ombudsman, Equitable Life: A Decade of Regulatory Failure (2007–8, HC 815–I). 124 Financial Services Consumer Panel Annual Report 2008/9, 14. 125 Such as the mis-selling of personal pensions and of mortgage endowments in the 1980s and the 1990s, the split-capital trust mis-selling during the 1990s and precipice bond mis-selling that continued into the 2000s. 126 FSA, Quality of Advice on Structured Investment Products: The Findings of a Review of Advice Given to Consumers to Invest in Structured Investment Products backed by Lehman Brothers from November 2007 to August 2008 (October 2009). 127 FSA, Product Regulation (DP 11/1). 128 See, e.g, reflections by Hector Sants on prior ‘essentially reactive’ strategies: FSA Business Plan 2010/11, 10. 129 HM Treasury, Building a Stronger System (n 1) paras 4.60–4.68 and 4.78–4.84. 130 A possible product vetting role was in the policy debate on the FSA from the very beginning: Joint Committee on Financial Services and Markets, Draft Financial Services and Markets Bill (1998–9 HL 50–I, HC 328-I) paras 38–41.

The break-up of the FSA in the UK

135

131

have become stronger. Yet whether the FCA will be able to avoid the development of a public perception that certain financial products carry its endorsement, with all of the associated reputational risk that this implies, is an unknown. Another standard argument against supervisory intrusion into product design used to be that this could stifle innovation. The shattering of the ideology of continuous promotion of financial innovation means that this argument now carries much less weight. Nevertheless, there still remain important trade-offs between consumer protection and consumer choice, and between building consumer trust and encouraging consumer personal responsibility; where the appropriate place to strike the balance is located and what are the most effective and efficient ways of doing so are matters that will require careful monitoring by the FCA.132 Whatever else the FCA takes from examination of its predecessor’s experience, one clear lesson that stands out is that being a ‘consumer champion’, however defined, is no easy job.133 It is not as if the FSA did not try – part of the standard post-crisis criticism of the FSA is that it prioritized conduct and consumer matters at the expense of prudential concerns. One tenable interpretation of modern British history of consumer-oriented financial market supervision is that failure is inevitable. For an organization tied so closely to consumer-oriented goals as the FCA seems destined to be, notwithstanding the change of name that seems to reflect second thoughts on the wisdom of labelling it a ‘Consumer Protection’ authority, the reputational repercussions of such failure could be especially damaging.

131 Emilios Avgouleas, ‘What Future for Disclosure as a Regulatory Technique: Lessons from Behavioural Decision Theory and the Global Financial Crisis’ in MacNeil and O’Brien (eds), The Future of Financial Regulation (n 25) 205–225, 217–218; Moloney, ‘Regulating the Retail Markets’ (n 24). Generally on limitations of disclosure as an investor protection tool: Niamh Moloney, How to Protect Investors (CUP, Cambridge 2010) ch 5; Troy A. Paredes, ‘Blinded by the Light: Information Overload and Its Consequences for Securities Regulation’ (2003) 81 Wash U LQ 417. The FSA was doing its own work in this area even before the crisis (see, e.g. FSA, Transparency as a Regulatory Tool (DP 08/3)) but those events have sharpened their thinking on the issue. 132 Advocating a disciplined and cautious approach to consumer protection regulation: John Y. Campbell, Howell E. Jackson, Brigitte C. Madrian and Peter Tufano, ‘Consumer Financial Protection’ (2011) 25 J Econo Persp 91–114. 133 Early discussions described the (now) FCA in these terms. The Treasury Committee thought branding it in this way ‘would be inappropriate, confusing, and potentially dangerous’: Treasury Committee, Financial Regulation: A Preliminary Consideration of the Government’s Proposals (2010–11, HC 430–I) 4. HM Treasury has attempted to clarify its use of the term: Building a Stronger System (n 1) para 4.9.

136

E. Ferran

6.4 Summary The financial crisis seriously dented the FSA’s reputation as a world-class regulator. Nevertheless, the case for outright abolition of the FSA was not clear-cut. The objectives-oriented rearrangement of the institutional architecture that is now underway must be viewed as a political choice rather than the inevitable outcome of the financial crisis. In common with other possible alternatives, the objectives model has both strengths and weaknesses. The notion that the UK had somehow alighted upon the perfect supervisory model when it established the FSA is now revealed to have been an unwarranted over-exaggeration. Likewise, dire predictions about the impact that the institutional reordering on which it is now embarking could have on the UK’s international competitiveness deserve to be received with a healthy dose of scepticism. Yet reasons for concern about the break-up remain. The UK could go through a painful period of institutional instability only to end up with a system of supervision that is of inferior quality to the one it replaced. Despite its imperfections, the FSA has considerable accumulated strengths. It is therefore important to draw constructively on its experience to reduce the risk of a wrong turn in institutional design. This chapter has examined four key aspects of the FSA and identified areas of strength that are worth retaining. However, in a system in which there are two supervisors rather than one, and also a systemic oversight body on top, this may not always be possible.

7

One step forward, two steps back? The institutional structure of US financial services regulation after the crisis of 2008 Saule T. Omarova

7.1 Introduction This chapter provides an overview of the key changes in the structure of US financial services regulation in the wake of the global financial crisis of 2008. The crisis exposed numerous weaknesses in the US system of regulatory oversight of the country’s rapidly growing and complex financial services sector. In response, the US Congress adopted the Dodd–Frank Wall Street Reform and Consumer Protection Act of 2010 (the Dodd–Frank Act), a wide-ranging reform statute that explicitly pursues the objective of systemic risk mitigation.1 Among other things, this large-scale reform effort involved a rearrangement of the federal administrative apparatus in charge of overseeing the US financial services sector. At this early stage in the implementation of the Dodd–Frank regime, it is difficult to predict how successful the new financial regulatory structure will be in safeguarding systemic financial stability in the long run. Without claiming to offer any definitive judgments, this chapter nevertheless attempts to draw some preliminary assessments of the Dodd–Frank Act as a major milestone on the path of financial regulation reform in the United States. Placing the discussion of this latest agency restructuring in its broader historical, institutional and intellectual context is particularly instructive. Against that broader backdrop, the Dodd–Frank Act can be viewed, somewhat paradoxically, both as an important advance and as a regrettable retrenchment on the road toward a better regulatory system. Understanding this complex phenomenon may hold the key to future progress.

1 Dodd–Frank Wall Street Reform and Consumer Protection Act, Pub. L. No. 111–203, 124 Stat. 1376 (2010).

138

S.T. Omarova

7.2 A product of history: an overview of the US financial regulatory structure before 2010 The US system of financial services regulation is fundamentally a product of the country’s history. In many respects, that system is unlike anything any other nation has: it is complex, multi-layered and highly fragmented. To some extent, this institutionalized fragmentation is a natural, albeit not inevitable, result of the federalist form of government, which divides regulatory and enforcement powers between the federal and state agencies. Certain traditional American ideological beliefs and political tendencies – such as the deep-seated mistrust of centralized government and fear of economic dominance of ‘big business’ – also played an important role in preventing the emergence of a unified federal regulatory structure in the United States. Strong presumptions in favour of decentralization, dispersion of authority among state governments and minimal regulatory intervention in financial markets defined the context in which the US financial regulatory structure began to take shape. It was mainly in response to various crises, both financial and political, that the modern structure of US financial regulation and supervision evolved over the last 150 years or so – gradually adding layers of federal laws and administrative agencies over the highly decentralized state-based system.2 Thus, the Civil War provided the impetus for the emergence in 1863 of federally chartered banks under the oversight of the new Office of the Comptroller of the Currency (OCC). The 1907 bank panic resulted in the creation in 1913 of the Federal Reserve System, another critically important milestone in the country’s financial history. An even bigger trauma, that of the stock market crash of 1929 and the subsequent Great Depression, led to the emergence, as part of President Roosevelt’s New Deal programme, of an elaborate system of federal securities regulation and oversight of capital markets, as well as a system of federal deposit insurance. In effect, the New Deal reforms created a coherent but internally segmented and multi-faceted regime for the regulation and supervision of the country’s financial markets, which continues to operate largely on the same basis today. From a substantive viewpoint, this regulatory system, conceived primarily as a response to pervasive market failures of the late 1920s–1930s, focused on three principal policy goals: (1) preventing financial institutions from incurring excessive risks; (2) protecting investors and consumers of financial services from fraud and abuse and maintaining integrity of US financial markets; and (3) ensuring stability of the US financial

2 For a recent detailed look at the history of financial services regulation in the US, see, e.g. Alejandro Komai and Gary Richardson, A Brief History of Financial Regulation in the United States from the Beginning Until Today: 1789 to 2009, NBER Working Paper 17443 (2011).

US financial regulation after the 2008 crisis

139

3

system. These policy objectives, however, received different prominence in the context of sector-specific regulatory regimes, which reflected the then-prevailing understanding of the key differences in the business and risk profiles of different types of financial institutions and the relevant market dynamics. Thus, bank regulators traditionally focus primarily on the safety and soundness of US banking institutions, securities regulators’ main concern has been with investor protection and market integrity and insurance regulators seek to prevent both insurer insolvency and consumer fraud. The New Deal reforms were also critical in shaping the current institutional structure of US financial sector regulation. Thus, the Securities and Exchange Commission (SEC), the administrative agency responsible for federal oversight of US securities markets, and the Federal Deposit Insurance Corporation (FDIC) were set up during that formative era in the history of the American administrative state. From the 1930s until 2010, the US financial regulatory structure remained largely unchanged.4 It grew to comprise nearly a dozen federal regulatory agencies, numerous industry self-regulatory bodies and scores of state financial regulators. The system was divided into several parallel regulatory ‘silos’, depending on the type of financial institution or charter: banking, securities, commodity futures and insurance. Many financial institutions and markets – hedge funds, finance companies and markets for over-the-counter (OTC) derivatives and structured products – remained either entirely outside this formal regulatory structure or in grey areas between its formalized sectoral lines. Moreover, even the formally recognized regulatory ‘silos’ were often divided further into various sub-sectors, which further complicated the system. Historically, five different federal agencies shared regulatory and supervisory oversight of US depository institutions (i.e. banks, thrifts and credit unions). Under the US ‘dual banking’ system, banks can choose whether to obtain a state or a federal charter. State-chartered banks are regulated and supervised under the relevant state laws by the state chartering authority. The OCC charters and supervises all national (i.e. federally chartered) banks.5 Despite their choice of charter, however, all state banks are also 3 Government Accountability Office, GAO-05–61, Financial Regulation: Industry Changes Prompt Need to Reconsider US Regulatory Structure (October 2004), at 4. 4 A few notable exceptions included the creation of the Commodity Futures Trading Commission (CFTC) in 1974 for purposes of providing federal oversight of commodity futures markets, and the revamping of the regulatory regime for federal thrifts and the formation of the Office of Thrift Supervision (OTS) in 1989. The OTS was created in the wake of the savings and loan crisis of the late 1980s to replace the FSLIC, a predecessor-agency that had been in charge of thrift regulation and supervision since its original creation during the New Deal. 5 The OCC is a self-funding entity that does not depend on congressional appropriations: it finances its operations primarily through industry fees.

140

S.T. Omarova

subject to extensive federal oversight. Thus, all banks that are members of the Federal Reserve System, regardless of their charter, are subject to regulation by the Board of Governors of the Federal Reserve System (the Federal Reserve).6 All banks whose deposits are federally guaranteed (which is mandatory for the vast majority of US depository institutions) are also subject to regulation by the FDIC, the agency administering the federal deposit insurance system.7 Until 2010, the Office of Thrift Supervision (OTS) regulated and supervised US savings institutions, or thrifts – depository institutions primarily engaged in financing residential mortgages and retail lending.8 Finally, the National Credit Union Administration (NCUA) oversees credit unions, which are membership-based, depositor-owned depository institutions. In addition to these individual agencies, the Federal Financial Institution Examination Council (FFIEC) was created in 1979 as an inter-agency body in charge of coordinating and harmonizing key supervisory standards applicable to all lending institutions at the federal level.9 Perhaps most importantly, the FFIEC developed a single set of reporting forms that federal bank regulators use for their examination purposes. The principal federal regulator of the US securities markets is the SEC, a five-member commission appointed by the President with the advice and consent of the US Senate.10 The SEC’s primary mission is to maintain the integrity and stability of the capital markets and protect investors from fraud and market manipulation. As part of that mission, it manages the registration and disclosure system in connection with securities issuances and regulates the activities of securities broker-dealers, investment advisers and other market professionals. An important feature of US securities

6 The Federal Reserve System is an association of twelve regionally based Federal Reserve Banks, overseen by the Board of Governors (the Federal Reserve), which is composed of seven members appointed by the President and confirmed by the Senate. However, the Federal Reserve is independent from both presidential and congressional influence in policy-making. It funds itself primarily through interest earnings on its holdings of government securities, as well as through collection of fees for services it provides to depository institutions. 7 The FDIC is an independent federal agency whose primary responsibilities include providing federal deposit insurance and acting as a receiver for insolvent banks and thrifts. The FDIC is headed by a five-member Board of Directors appointed by the President, subject to Senate confirmation. The FDIC is self-financing through the premiums it collects from insured institutions and from earnings on investments in government securities. 8 As discussed below, the OTS was abolished in 2010, and its functions transferred to the OCC, FDIC and the Federal Reserve. 9 Before 2010, the FFIEC members were the Federal Reserve, OCC, FDIC and NCUA. Currently, the body also includes the newly created Bureau of Consumer Financial Protection (CFPB). 10 In contrast to federal bank regulators, however, the SEC is funded through congressional appropriations.

US financial regulation after the 2008 crisis

141

regulation is the prominent role of self-regulatory organizations (SROs), such as the Financial Industry Regulatory Authority (FINRA) and the national securities exchanges. Subject to the SEC’s authority and oversight, the SROs exercise extensive regulatory and supervisory functions. They promulgate rules binding on their members, monitor the memberfirms’ compliance with the federal securities laws and regulations and impose sanctions and penalties on their members for non-compliance and misconduct. The Commodity Futures Trading Commission (CFTC) was created in 1974 as an independent federal agency in charge of regulating US commodity futures and options markets. Similarly to the SEC, the CFTC consists of five Commissioners appointed by the President, subject to Senate confirmation, and oversees various futures-industry SROs. The CFTC administers the Commodity Exchange Act of 1936, which focuses primarily on preventing fraud and price manipulation in the futures markets. Insurance companies and transactions in the US are regulated exclusively at the state-level. In the absence of a unified federal scheme of insurance regulation, insurers are licensed and supervised by individual state authorities. As a result, companies with a national presence have to comply with multiple state regulatory regimes that generally combine prudential limitations similar to those applicable to banks with consumer-protection and anti-fraud requirements. Painting a fully comprehensive historical portrait of the entire architecture of the federal regulatory oversight of the US financial services sector is beyond the scope of this chapter. Even a brief overview of the key elements of that architecture, however, highlights the high levels of internal complexity and fragmentation that define its unique institutional dynamics and ongoing evolution.

7.3 What is to be done? Themes in the debate on reforming the US financial regulatory structure The need to streamline and simplify the US financial regulatory structure has been a subject of intense policy debates for several decades. According to the critics, the key defect of the multi-headed silo-based US system was its inherent inefficiency. This inefficiency manifested itself in many ways, including high public costs of running a bloated regulatory apparatus, unnecessary duplication of regulatory functions, an increasingly high burden of regulatory compliance on private market participants, jurisdictional conflicts and overlaps that masked potential regulatory gaps, and the inherent lack of a system-wide focus. In the last forty-plus years, these themes shaped the national debate on redesigning the institutional structure of financial services oversight. The principal focus of the debate, however, changed over time, reflecting the broader underlying shifts in regulatory priorities, policy goals and overall political climate. Tracing

142

S.T. Omarova

some of the key shifts in the debate provides the necessary context for understanding and evaluating the potential significance of the most recent reform of the US financial regulatory structure. 7.3.1 Key issues in the policy debate before the Gramm-Leach-Bliley Act of 1999 Since the 1970s, the twin forces of globalization and financial innovation have been putting increasing pressure on the US regulatory structure. These pressures intensified in the 1980s–1990s, as rapid technological advances enabled financial institutions to develop and offer increasingly complex financial products and to compete more aggressively on a global scale. In the emerging world of new finance, the boundaries among various financial markets became more fluid and difficult to fit neatly into pre-existing legal and regulatory categories. US financial regulators struggled to fulfil their old statutory mandates in the context of the new financial marketplace – and came under increasingly vocal criticism from different constituencies. Not surprisingly, during the 1980s–1990s, the task of simplifying and rationalizing this complex and internally fragmented regulatory structure became a recurring item on US policy-makers’ reform agenda.11 In addition to numerous academic and industry reports calling for ‘modernization’ of the country’s financial regulation, several official reform proposals – produced under each of the Reagan, Bush and Clinton administrations – were unveiled during that period.12 Although the details of individual proposals differed, the policy debate on reforming the US financial regulatory structure generally focused on several key issues: (1) consolidating federal banking agencies; (2) redefining the role of the Federal Reserve; (3) integrating regulatory oversight of the securities and futures markets; and (4) creating a brand new scheme for federal insurance regulation. The first pivotal issue in the reform debate was the structural integration of US bank regulation and supervision. Nearly all of the official proposals in the years preceding the 2008 crisis envisioned the creation of a single agency responsible for chartering, regulation and supervision of all federally licensed depository institutions. The most commonly proposed solution was to merge the OTS into the OCC and to reconstitute the thusenlarged OCC as the single federal bank and thrift regulator – an idea to

11 For a description of the regulatory fragmentation and prior efforts to simplify the US regulatory framework, see, for example, Carl Felsenfeld, Banking Regulation in the United States 29–35 (2nd edn, Huntingdon, NY: Juris, 2006). 12 See Task Group on Regulation of Financial Services, ‘Blueprint for Reform: Report of the Task Group on Regulation of Financial Services’, (1984); US Dep’t. of the Treasury, ‘Modernizing the Financial System: Recommendations for Safer, More Competitive Banks’ (1991); Clinton Administration proposal (1994).

US financial regulation after the 2008 crisis

143

which the OTS strenuously objected. Individual proposals differed as to the precise scope of the new unified agency’s jurisdiction and degree of independence.13 The second major theme in the debate concerned the proper role and functions of the Federal Reserve. To a great extent, this issue was part of the same general effort to rationalize the structure of US bank regulation. Thus, while all of the proposals agreed on the importance of the Federal Reserve’s continuing role as the lender of last resort and the agency in charge of monetary policy and oversight of the country’s payments system, they often differed with respect to its role as the primary federal regulator and supervisor of state-chartered banks and bank holding companies. The third theme in the debate on reforming US financial regulatory structure was the need for integrated oversight of the country’s growing capital markets, primarily through combining the functions of the SEC and CFTC. The proponents of this agency merger argued that it would help to eliminate the increasingly artificial jurisdictional division between securities and futures markets and to close the regulatory gap that effectively left the burgeoning OTC derivatives markets unregulated. In that sense, the debate on the SEC–CFTC merger encompassed the broader issue of creating a system for substantive oversight of OTC derivatives.14 Finally, the fourth perennially debated issue concerned the possibility of creating a new federal insurance charter, which was expected to alleviate the burden of regulatory compliance on insurance companies. While richly varied, all of the most influential reform proposals of the 1980s–1990s reflected that era’s preoccupation with increasing the efficiency of US financial markets and institutions, primarily by reducing regulatory costs and removing what was seen as outdated regulatory impediments to their growth and profitability. At the time, the overarching goal of regulatory consolidation was to empower private market participants to fulfil their potential for prosperity-generating growth. In that sense, the efforts to modernize the country’s financial regulatory structure reflected a fundamentally de-regulatory sentiment. At the same time, however, private market participants often preferred the fragmented and complex regulatory structure that enabled them to 13 Thus, both Reagan and Bush administration proposals argued in favour of the agency remaining under the Treasury, while the Clinton administration advocated the creation of a fully independent commission-type body similar to the SEC and CFTC. Different reform proposals generally sought to expand the scope of the new agency’s authority beyond chartering, regulating and supervising banks and thrifts to include at least some degree of direct oversight of bank and thrift holding companies, currently performed by the Federal Reserve. 14 It is worth noting that, in the mid-1990s, after a series of high-profile scandals involving huge losses on derivatives instruments (including the infamous bankruptcy of California’s Orange County), there were unsuccessful attempts to introduce legislation creating a separate federal agency with a specific mandate to regulate derivatives markets.

144

S.T. Omarova

take advantage of plentiful regulatory arbitrage opportunities. By choosing specific charters or by structuring their transactions to fall between the regulatory lines, financial institutions were able to escape unwanted constraints on their profit-making activities. Moreover, private market actors also learned to extract significant benefits from turf-related competition among financial regulators who often viewed their own bureaucratic interests more closely aligned with the interests of their regulated firms than with those of other government agencies. This internal tension between the perceived need to streamline the regulatory structure, on the one hand, and the built-in incentives to resist such streamlining, on the other, has been – and continues to be – one of the defining factors in the political battles over the proper shape of the US financial regulatory architecture. 7.3.2 After Gramm–Leach–Bliley: new landscape, new concerns Two decades of intense political lobbying and struggle to modernize US financial services regulation – which, at the time, meant primarily the repeal of the Glass–Steagall Act of 1933 that prevented the formation of diversified ‘universal’ banks in the US – finally culminated in the enactment of the Gramm–Leach–Bliley Act of 1999.15 The Gramm-Leach-Bliley Act permitted banks and securities firms to affiliate within a single financial holding company (FHC) structure, which set the stage for a wave of industry consolidation and the emergence of a handful of large, internationally active bankcentred financial conglomerates. The Federal Reserve became the so-called ‘umbrella’ regulator and supervisor of FHCs, while the SEC, CFTC and state insurance regulators retained their jurisdictional primacy as ‘functional regulators’ of individual FHC subsidiaries. Other than that, however, the Gramm–Leach–Bliley Act had surprisingly little direct impact on the regulatory structure in the financial sector. One year later, Congress adopted the Commodity Futures Modernization Act of 2000, which resolved the main jurisdictional tension between the SEC and CFTC by simply declaring OTC derivatives largely outside either agency’s purview.16 Once the financial services industry received both of its main wishes – the ability to combine deposit-taking and investment banking businesses within a single conglomerate and the legal certainty with respect to unregulated OTC derivatives transactions – the impetus for rationalizing the regulatory structure along the lines discussed above seemed to have diminished. Yet, in the post-Gramm–Leach–Bliley era, the fundamental tension between the increasingly dynamic and complex financial marketplace of 15 Financial Services Modernization Act of 1999 (Gramm–Leach–Bliley Act), Pub. L. No. 106–102, 113 Stat. 1338 (codified as amended in scattered sections of 12 and 15 U.S.C.). 16 Commodity Futures Modernization Act of 2000, Pub. L. No. 106–554, 114 Stat. 2763 (codified as amended in scattered sections of 7, 11, 12 and 15 U.S.C).

US financial regulation after the 2008 crisis

145

the twenty-first century and the rigid silo-based system of financial regulation and supervision, rooted in the realities of the 1930s, continued to intensify and raise new policy dilemmas. In 2004, the Government Accountability Office (GAO), an independent investigative and oversight arm of US Congress, produced an extensive report assessing the efficacy of the US financial regulatory structure.17 In that report, the GAO concluded that the country’s fragmented and multilayered regulatory structure was not well suited to provide – and even hindered – effective oversight of the system-wide trends, nor to detect and prevent systemic risks posed by the new, complex financial products and firms. Globalization of financial markets, consolidation and conglomeration in the financial services industry and cross-sector convergence of institutional roles and products dramatically changed the business context in which US financial regulators had to operate. The law, however, has not kept up with these changes, leaving potentially dangerous gaps – structural and substantive – in financial sector oversight. According to the GAO report, ‘The increased sophistication in and interconnections throughout the industry now make it difficult to determine the location and extent of [systemic] risk.’18 The GAO studied the recent experience with regulatory consolidation in other countries, including the United Kingdom, Germany, Japan and Australia. In the end, the report identified four principal options for structural reform in the US: (1) consolidating the regulatory structure within the existing ‘functional’ areas; (2) adopting the ‘twin peaks’ model that organized the regulatory realm by regulatory objective; (3) combining all regulatory agencies in a single financial regulator; (4) creating a single systemic risk regulator in charge of supervising all large, complex, internationally active financial institutions, while leaving the rest of the existing regulatory structure intact.19 To understand fully the dynamics of the debate on institutional reforms in the years immediately before the crisis, it is important to view it in the broader context of the industry’s ongoing campaign for further deregulation. In 2004–2007, many large US and foreign companies began actively lobbying for rolling back some of the key provisions of the Sarbanes–Oxley Act of 2002, which was adopted in response to Enron’s failure and other revelations of corporate fraud.20 Because many of the statute’s rigorous new corporate governance and reporting requirements were incorporated

17 See GAO-05–61, supra note 3. 18 Id., p. 6. The GAO defined systemic risk as ‘the risk that a disruption (at a firm, in a market segment, to a settlement system, etc.) could cause widespread difficulties at other firms, in other market segments, or in the financial system as a whole’. Id., p. 30. 19 Id., pp. 128–129. 20 Public Company Accounting Reform and Investor Protection Act, Pub. L. 107–204, 116 Stat. 745 (July 30, 2002).

146

S.T. Omarova

into the US securities laws and regulations, this campaign against Sarbanes–Oxley was fought under the banner of preserving the competitiveness of US capital markets. The industry argued that unreasonably burdensome regulatory demands forced corporate issuers of securities to abandon New York and raise capital in London, which was rapidly becoming the new global financial centre.21 According to that argument, one of the key factors behind the rise of London’s City was the ‘principles-based’ and ‘risk-based’ approach to regulation on the part of the UK’s financial regulator, the Financial Services Authority (FSA).22 The FSA, established in 1997 as a universal regulator overseeing activities of all financial service providers, combined regulatory and supervisory functions of the US federal and state banking regulators, SEC, CFTC, state insurance and securities commissions and various SROs.23 Guided by the statutory ‘principles of good regulation’, FSA emphasized its commitment to practicing risk-based regulation and supervision, working with the grain of the market rather than against it, and limiting regulatory intervention to those circumstances where the market did not provide adequate answers and where regulation had the prospect of doing so at a reasonable cost. Financial institutions and their corporate clients praised the FSA’s ‘light-touch’ approach as an effective alternative to the US regulators’ heavy-handed supervision. In lieu of rigid rules governing every aspect of financial firms’ business, the FSA defined the overall regulatory objectives and principles but let individual firms figure out how to implement them in the most efficient manner.24 Although the industry’s infatuation with the FSA was primarily a matter of regulatory philosophy rather than structure, it indirectly seemed to support arguments in favour of a universal-regulator model and a broader concept of ‘objective-based’ regulation. These themes – and, more generally, an increased emphasis on other countries’ institutional 21 See, e.g. US Chamber of Commerce, Commission on the Regulation of US Capital Markets in the 21st Century, Report and Recommendations (March 2007), available at www.uschamber.com/sites/default/files/reports/0703capmarkets_full.pdf.; Committee on Capital Markets Regulation, Interim Report (Nov. 2006), available at www.capmktsreg. org/pdfs/11.30Committee_Interim_ReportREV2.pdf. 22 For a general analysis of the FSA model, see, e.g. Eilis Ferran, ‘Do Financial Supermarkets Need Super Regulators? Examining the United Kingdom’s Experience in Adopting the Single Financial Regulator Model’, 28 Brooklyn J. Int’l L. 257 (2003). 23 For comparisons of the regulatory structures in the US and UK during that period, see, e.g. Jerry W. Markham, ‘A Comparative Analysis of Consolidated and Functional Regulation: Super Regulator: A Comparative Analysis of Securities and Derivatives Regulation in the United States, the United Kingdom and Japan’, 28 Brooklyn J. Int’l L. 319 (2003); Heidi Mandanis Schooner and Michael Taylor, ‘United Kingdom and United States Responses to the Regulatory Challenges of Modern Financial Markets’, 38 Tex. Int’l L.J. 317 (2003). 24 For the FSA’s programmatic vision and the description of risk-based regulatory approach, see Financial Services Authority, A New Regulator for the New Millennium (January 2000), available at www.fsa.gov.uk/pubs/policy/P29.pdf.

US financial regulation after the 2008 crisis

147

experiments – set the stage for the next round of the policy debate in 2008–2010, during the most severe financial crisis since the Great Depression. 7.3.3 Debating institutional reforms amidst the crisis The latest crisis, unprecedented in terms of its severity and the speed with which it spread across different markets and geographic borders, brought the issue of systemic risk prevention into the very centre of the debate, both as a matter of substantive regulation and as a matter of structural reform. The crisis exposed the undeniable fact that the lack of effective coordination and information-sharing among the multiple agencies overseeing separate pieces of the financial system was one of the major contributing factors behind the collective regulatory failure. As a result, the pre-crisis list of rationales for regulatory consolidation – reducing jurisdictional overlaps and duplication of functions, providing more effective oversight of diversified financial conglomerates, facilitating financial innovation and enhancing global competitiveness of US capital markets, and improving transparency and accountability of regulatory agencies – grew to include the calls to designate an agency specifically focused on systemic risk and market stability issues.25 In 2008, the Group of Thirty, an influential group of former government officials and financial industry luminaries, published a report comparing the structure of financial services regulation in seventeen countries.26 On the basis of these comparisons, the Group’s report identified four principal approaches to supervision: (1) ‘institutional’ approach (in which a firm’s legal charter defines which regulator oversees its activities); (2) ‘functional’ approach (in which supervisory oversight is tied to the nature of the activity rather than an entity that conducts it); (3) ‘integrated’ approach (in which a single universal regulator oversees all financial institutions and markets); and (4) the ‘twin peaks’ approach (in which one regulator performs safety and soundness oversight, and a different regulator focuses on conduct-of-business oversight).27 According to the report, the US model was an exception that combined elements of institutional and functional supervision – the two approaches that came under the most stress as a result of financial innovation and increasingly blurred lines among different financial products and markets. By contrast, the report concluded that the integrated approach (exemplified by the UK’s

25 See Sabrina R. Pellerin, John R. Walter and Patricia E. Wescott, ‘The Consolidation of Financial Regulation: Pros, Cons, and Implications for the United States’, Economic Quarterly, Vol. 95, Number 2 (Spring 2009), pp. 121–160, at pp. 121–122. 26 Group of Thirty, The Structure of Financial Supervision: Approaches and Challenges in a Global Marketplace (2008). 27 Id., p. 13.

148

S.T. Omarova

FSA) and the twin peaks model (or regulation ‘by objective’) ‘may more rationally reflect the changes that have taken place in the financial services business over the past several years, and thus are widely viewed as more efficient and cost-effective by both regulators and regulated entities’.28 As the crisis unfolded, the momentum behind this view of institutional reform seemed to grow stronger. In March 2008, the US Treasury published a document entitled ‘Blueprint for a Modernized Financial Regulatory Structure’ in which it proposed a comprehensive agency reform.29 The Blueprint contained a long list of short-term, medium-term and longterm recommendations. Conceptually, the proposal advocated the adoption of an ‘objective-based’ regulatory model that drew organizational lines along three policy objectives: market stability, prudential (safety and soundness) regulation and regulation of ‘business conduct’.30 This ‘three peaks’ model, accordingly, called for dividing regulatory and supervisory functions among three agencies: a market stability regulator, a prudential regulator and a business conduct regulator. Under that scheme, the Federal Reserve would be the market stability regulator and, in effect, assume an extension of its current roles: setting monetary policy, serving as the lender of last resort, supervise and collect information from financial firms and generally keep a watchful eye on systemic risk. The role of the prudential regulator would go to the OCC (which would subsume the OTS and other federal agencies regulating depository institutions), which would charter, regulate, and supervise all firms subject to federal guarantees and administer federal guarantee funds themselves. The new business conduct regulator, formed by merging SEC and CFTC, would oversee all investor and consumer protection matters and even charter certain financial institutions.31 In addition to these strategic reform goals, the Blueprint advocated a wide range of intermediate-term measures, including creation of an optional federal insurance charter and an Office of National Insurance that would regulate federally licensed insurers and phasing out of a federal thrift charter.32 As this brief summary demonstrates, the Blueprint largely drew upon the well-established pre-crisis themes in the US debate on structural reform but tried to embed them within the new conceptual framework of objective-based regulation, essentially developing a version of the ‘twin 28 Id., p. 50. 29 US Dep’t of the Treasury, Blueprint for a Modernized Financial Regulatory Structure (2008) [hereinafter Blueprint], available at www.group30.org/images/PDF/The%20Structure%20of%20Financial%20Supervision.pdf. 30 Blueprint, pp. 13–14. 31 The Blueprint also envisioned the creation of a separate corporate finance regulator to administer some of the SEC’s and CFTC’s functions related to corporations’ capitalraising efforts. 32 See Blueprint, pp. 8–13.

US financial regulation after the 2008 crisis

149

33

peak’ model. Because of the timing of its publication, however, the Blueprint’s recommendations failed to make a significant impact on the process of reform and quickly faded away. Already in January of 2009, with the publication of several new influential reform proposals, the Blueprint appeared to be outdated and outdone.34 Reflecting the sombre lessons of the autumn of 2008, these reports focused much more forcefully on the need for systemic risk regulation and put much of the blame for the unfolding crisis on regulatory fragmentation and structural gaps in the financial sector oversight.35 Later that year, the new Obama administration made its own attempt to weigh in on the debate, with the publication of a comprehensive plan for financial regulatory reforms.36 In this White Paper, Obama’s Treasury moved away from the Blueprint’s ambitious model with many time horizons, proposing instead several immediate reform measures, both substantive and structural, aimed explicitly at reducing systemic risk in the financial sphere. The White Paper, however, sought to achieve these goals primarily through expanding and enhancing the existing regulatory mechanisms and approaches rather than radically reshaping the entire regulatory landscape. The new Treasury’s plan called for extending regulatory oversight to previously unregulated (or lightly regulated) entities and transactions, strengthening prudential regulation and supervision of all systemically significant financial firms and eliminating jurisdictional conflicts and functional overlaps among financial regulators. According to the Treasury’s vision, these steps, if implemented correctly, were sufficient to safeguard the financial system from another major meltdown. While the White Paper focused mainly on substantive regulation and supervision, it contained several proposals for reorganizing the regulatory apparatus. These included, most importantly, the creation of a cross-sector systemic risk regulator and a consumer protection agency, the consolidation of prudential oversight of all US depository institutions in the hands of a newly created federal agency, the expansion of the Federal Reserve’s regulatory jurisdiction and functions and the establishment of a federal

33 See Michael W. Taylor, ‘Twin Peaks:’ A Regulatory Structure for the New Century (London: Centre for the Study of Financial Innovation, 1995). 34 See, e.g. Congressional Oversight Panel, Modernizing the American Financial Regulatory System: Recommendations for Improving Oversight, Protecting Consumers, and Ensuring Stability (2009); US Gov. Accountability Office, GAO-09–216, Financial Regulation: A Framework for Crafting and Assessing Proposals to Modernize the Outdated US Financial Regulatory System (2009); Committee on Capital Markets Regulation, Recommendations for Reorganizing the US Financial Regulatory Structure (2009). 35 For a discussion of the key reform proposals advanced in the early 2009, see Saule Omarova and Adam Feibelman, ‘Risks, Rules, and Institutions: A Process for Reforming Financial Regulation’, 39 U. Mem. L. Rev. 881 (2009). 36 US Dep’t of the Treasury, Financial Regulatory Reform: A New Foundation: Rebuilding Financial Supervision and Regulation (2009) [hereinafter, White Paper].

150

S.T. Omarova

insurance regulator.37 In proposing these measures, which clearly defied the calls for a radical institutional restructuring, Obama’s Treasury signalled a critical turn in the ongoing debate. The White Paper was published during the congressional negotiation of legislative proposals for a comprehensive financial regulatory reform. When that contentious process finally culminated in the passage of the Dodd–Frank Wall Street Reform and Consumer Protection Act of 2010 (the Dodd–Frank Act), the new law incorporated many of the Treasury’s proposals. Thus, after decades of intense debates, Congress finally took a decisive step forward on the path of institutional reform. How far forward, however, is a complicated question that may not have a simple answer, at least not yet.

7.4 The Dodd–Frank Act of 2010: key changes in the US financial regulatory structure The Dodd–Frank Act is widely viewed as the most far-reaching and comprehensive overhaul of US financial regulation since the New Deal. In fact, the new law ran hundreds of pages and mandated changes across a much broader spectrum of regulatory issues than any previous legislation since the 1930s. From the viewpoint of substantive regulatory change, however, there are good reasons to doubt the extent to which the Dodd–Frank Act represents a truly fundamental shift in the paradigm of US financial services regulation.38 Without claiming to provide a full analysis of the Dodd– Frank Act, this chapter identifies and evaluates the key changes to the US financial regulatory structure under the new regime. The Congressional debate on reshaping the regulatory architecture in response to the crisis followed the typical complex bargaining pattern. Notably, early versions of the Senate bill sought to consolidate all federal bank regulators in a single agency.39 As enacted, however, the Dodd–Frank Act fell short of delivering a large-scale structural reform that would eliminate, or at least significantly reduce, regulatory fragmentation and increasingly meaningless formal separation among different regulatory silos. Instead, Congress adopted a more incremental approach to reform implementing most of the recommendations in the Obama Treasury’s White Paper. Despite the early momentum behind consolidation proposals, in the end, Congress eliminated only one regulatory agency – the

37 Id., pp. 10–15. 38 For an analysis of the continuities in the regulatory philosophy before and after the latest financial crisis, as manifested in the Dodd–Frank Act, see Saule T. Omarova, ‘The Dodd– Frank Act: A New Deal for a New Age?’, 15 N.C. Banking Inst. 83–98 (2011). 39 See Edward V. Murphy, ‘Who Regulates Whom and How? An Overview of US Financial Regulatory Policy for Banking and Securities Markets’, Congressional Research Service Report (28 May 2013), p. 10.

US financial regulation after the 2008 crisis

151

significantly weakened OTS – and created a host of new ones to address specific problems that the crisis brought to the fore. Yet, although the post-Dodd–Frank US regulatory structure is even more complex than before the crisis, in many respects, it represents a potentially significant step forward. Under the new regime, the key changes that may ultimately enhance the efficacy of the regulatory architecture include the creation of a dedicated multi-agency structure for systemic risk oversight, expansion of the scope and nature of regulatory authority of the existing agencies and the establishment of the first federal agency charged with financial consumer protection. 7.4.1 (Not too radically) new architecture for systemic risk regulation There are three key actors in the new regime for systemic risk regulation under the Dodd–Frank Act: the newly created Financial Stability Oversight Council (FSOC), the Federal Reserve and the new Office of Financial Research (OFR). The statute envisions a complex pattern of interaction and cooperation among these three regulatory bodies. 7.4.1.1 The Financial Stability Oversight Council One of the most significant – and widely advertised – changes in the US regulatory structure after Dodd–Frank is the creation of the FSOC, an inter-agency body responsible for integrated monitoring and prevention of systemic risk in the financial system and for harmonization of prudential standards applicable to various financial institutions.40 FSOC consists of fifteen members, each of whom is a head of a financial regulatory agency or other government body with financial sector oversight responsibilities. The key voting members of FSOC are the Secretary of the Treasury, who also serves as the Chairman, and the heads of the Federal Reserve, OCC, SEC, CFTC, FDIC, NCUA, etc. FSOC’s main charge is to identify and respond to risks to the country’s financial system that could arise either from the activities of large, systemically important financial institutions or from the broader macro-economic trends. To fulfil this task, FSOC must collect a wide variety of data, facilitate inter-agency and cross-border information-sharing, conduct studies and identify regulatory gaps, make recommendations to financial regulators and provide a forum for resolving jurisdictional disputes and advise Congress on significant domestic and international regulatory developments. The Council is required to submit an annual report and testimony to Congress.

40 Dodd–Frank Act, Sec. 111.

152

S.T. Omarova

The Council’s powers are correspondingly broad and include, among other things, the authority to require a wide range of financial data from private market participants. FSOC also has the power to designate systemically important non-bank financial institutions that, under Dodd–Frank, are subject to regulation and supervision by the Federal Reserve.41 FSOC also can make recommendations to the Federal Reserve with respect to prudential standards and reporting requirements applicable to systemically important firms. It may also issue recommendations to impose heightened prudential safeguards on, or even to prohibit entirely, specific activities and market practices that pose risks to financial stability.42 However, FSOC lacks the power to actually prescribe any such heightened standards, nor does it have any direct supervisory authority over systemically important non-bank financial institutions. Regulatory agencies have to take into account FSOC’s recommendations but the Council generally cannot impose any resolution on its members. In that sense, FSOC remains mainly an advisory and consultative body along the lines of the President’s Working Group on Financial Markets (PWG), a multi-agency forum with a similar membership structure, which was established in the late 1980s for the purposes of ‘enhancing the integrity, efficiency, orderliness, and competitiveness of our Nation’s financial markets and maintaining investor confidence’.43 Despite potential availability of other institutional options, Congress used the PWG as the conceptual basis for FSOC – a systemic risk overseer with limited powers of direct regulatory intervention.44 Yet, some of FSOC’s powers – e.g. the power to designate systemically important non-bank firms and the power to veto the Federal Reserve’s decisions to break up systemically significant financial firms that pose a ‘grave threat’ to financial stability – potentially set the Council apart from its less formalized predecessor. How effectively the new Council will use its powers, both hard and soft, remains to be seen.

41 Dodd–Frank Act, Sec. 113, 115. 42 Dodd–Frank Act, Sec. 115(a). 43 The PWG was established by President Ronald Reagan’s Executive Order 12631 in 1988, in response to the stock market crash of 1987. See Exec. Order No. 12,631, 53 Fed. Reg. 9421 (18 March 1988). The PWG consisted of the heads of key financial regulatory agencies, such as the Federal Reserve, SEC, CFTC and FDIC, under the chairmanship of the Secretary of the Treasury. The Comptroller of the Currency and the head of the Federal Reserve Bank of New York (FRBNY) also often attended the PWG’s meetings. 44 In the run-up to the Dodd–Frank Act, academics and policy-makers discussed several alternative forms of a systemic risk regulator, including the delegation of systemic risk monitoring functions to the Federal Reserve and the creation of an entirely new systemic risk regulatory agency. For a discussion of these alternatives, see Roberta S. Karmel, ‘The Controversy over Systemic Risk Regulation’, 35 Brook. J. Int’l L. 823 (2010).

US financial regulation after the 2008 crisis

153

7.4.1.2 The Federal Reserve’s new regulatory role By contrast, the Federal Reserve has clearly emerged as a significantly more powerful agency at the very centre of the post-2010 regime of systemic risk regulation. Thus, the Dodd–Frank Act greatly expanded the Federal Reserve’s jurisdictional reach by putting it in charge of regulating and supervising all systemically important non-bank financial firms, in addition to its existing oversight of bank holding companies.45 While FSOC designates such firms, it is the Federal Reserve that has direct authority to establish substantive and procedural regulatory requirements, including heightened prudential standards, applicable to these firms. In mid-2013, FSOC designated the first set of systemically important financial institutions (SIFIs), which included AIG, Prudential and General Electric. As the list of designated non-bank SIFIs grows, so will the Federal Reserve’s power to mandate regular reports by, demand more capital from and impose conditions on activities of a broad range of firms outside the traditional banking sector. The Dodd–Frank Act also explicitly authorized the Federal Reserve to regulate certain payment, clearing, and settlement systems designated by the FSOC as systemically important financial market utilities. Furthermore, the statute enhanced the Federal Reserve’s back-up examination and enforcement powers by authorizing it to take direct action with respect to functionally regulated subsidiaries of systemically important financial firms it supervises, if any such subsidiary’s primary regulator fails to act in accordance with the Federal Reserve’s recommendation. Finally, under the new regime, the Federal Reserve is authorized, with the concurrence of two-thirds of the FSOC members, to break up or shut down any systemically important financial firm that it determines to pose a ‘grave threat’ to the financial stability of the United States.46 This is a potentially powerful weapon in the Federal Reserve’s arsenal that may be used to force a break-up of any too-big-to-fail financial conglomerate. Although the Federal Reserve had similarly powerful tools with respect to bank holding companies even before the Dodd–Frank Act, this new 45 Dodd–Frank Act, Sec. 113. 46 It is important to note, however, that this expansion of the Federal Reserve’s regulatory and supervisory powers under the Dodd–Frank regime is hardly an unqualified trend toward an ‘imperial central bank’ model. Congress also stripped the Federal Reserve of some of its pre-crisis regulatory powers and responsibilities (such as, e.g. consumer protection oversight) and subjected many of its decisions to the effective veto power of the FSOC or, in some cases, the FDIC. Perhaps most importantly, the Dodd–Frank Act expressly limited the Federal Reserve’s ability to use its emergency lending authority under Section 13(3) of the Federal Reserve Act. See Marc Labonte, ‘The Dodd–Frank Wall Street Reform and Consumer Protection Act: Systemic Risk and the Federal Reserve’, Congressional Research Service, CRS Report R41384 (27 August 2010). During the legislative process, there were proposals to take away the Federal Reserve’s regulatory authority over state-chartered banks. However, the Federal Reserve retained its function as the primary federal regulator of state member-banks.

154

S.T. Omarova

authorization expands the agency’s reach far beyond the banking world. Whether, or how aggressively, the Federal Reserve will use this new power to reshape the structure of the financial services industry is one of the most intriguing and critically important questions that only time can answer. After all, if the Federal Reserve continues to exhibit aversion to such decisive measures, this seemingly broad legal mandate is likely to be irrelevant in practice. 7.4.1.3 The Office of Financial Research In addition to the newly created FSOC and the beefed-up Federal Reserve, the emerging structure of systemic risk oversight after the enactment of Dodd–Frank includes a third important actor, the new Office of Financial Research (OFR) within the Treasury Department. The OFR’s mission is to provide research and informational support for FSOC and other financial regulators, particularly for purposes of detecting and containing systemic risk. Envisioned as the FSOC’s data-gathering and analytical arm, the OFR has broad statutory authority (backed by subpoena power) to collect information from any and all financial market participants. The OFR is explicitly authorized to mandate standardization of the types and format of financial market data reported to FSOC or other regulatory agencies. In addition, the OFR is expected to produce applied and long-term economic research and to develop special metrics and tools for measuring and monitoring risk in the financial system. Although it is a department within the Treasury, the OFR sets its own budget and funds itself through the fees on large banks and non-bank financial institutions supervised by the Federal Reserve. The OFR has to submit annual reports to Congress on the state of the US financial system, and its Director has to testify annually to Congress on the office’s activities and its assessment of systemic risk. To assure the integrity of the process, the statute prohibits any government official or agency from reviewing the Director’s testimony prior to its submission. These provisions are designed to ensure the OFR’s role as an independent source of objective analysis and unbiased expert opinion on systemic trends in the financial sector.47 How well the new office will actually perform this critical role in practice depends on many factors, including the ability of its staff to develop the necessary expertise and to avoid both cultural capture and intellectual ossification.48 One of the fundamental difficulties in this respect, however,

47 See Brett McDonnell and Daniel Schwarcz, ‘Regulatory Contrarians’, 89 N.C. L. Rev. 1629 (2011). 48 See id. For an insightful discussion of the phenomenon of cultural, or cognitive, capture of regulators by the industry, see James Kwak, ‘Cultural Capture and the Financial Crisis’, in Daniel Carpenter and David Moss (eds), Preventing Regulatory Capture: Special Interest Influence and How to Limit it (Cambridge: Cambridge University Press, Tobin Project, 2013).

US financial regulation after the 2008 crisis

155

is that it is not clear what kind of substantive expertise is necessary in order to understand and manage the highly complex and dynamic phenomena in today’s financial markets. Under conditions of extreme uncertainty, deciphering systemic risk patterns – or even knowing what to look for – is an inherently difficult task. To date, there is little evidence that the newly created OFR will be able to rise to this challenge. 7.4.2 Agency reshuffle: one out, one in As noted above, despite the initial hope for a bold rationalization of the fragmented and inefficient US regulatory structure in the wake of a major crisis, Congress ultimately decided against any significant agency consolidation. The Dodd–Frank Act eliminated only one major federal financial regulator – OTS – and transferred its functions to other federal banking agencies.49 The OCC assumed the chartering, regulatory and supervisory role with respect to federal thrifts. The FDIC became the primary federal regulator of state-chartered thrifts, and the Federal Reserve became the umbrella regulator for thrift holding companies.50 The dissolution of OTS came as no surprise to industry observers. The decisive event that sealed the OTS’s fate was the failure of Washington Mutual, the largest savings association under the OTS’s regulatory oversight, which left OTS in charge of a far smaller segment of the industry and significantly eroded its political clout. The practical effect of this modest attempt at regulatory consolidation was even less visible, because Congress created several new federal regulatory bodies and actually raised the total number of financial regulators. In addition to FSOC and the OFR, discussed above, the Dodd–Frank Act established a new Federal Insurance Office (FIO) within the Treasury Department. The FIO has only very limited powers. It does not have any direct regulatory and supervisory responsibilities over insurance companies that remain subject to state regulation. The FIO’s mission is primarily information-gathering and regulatory coordination. The office is charged with monitoring key trends and developments in the insurance sector and identifying potential systemic risks associated with insurers’ activities. For these purposes, it is authorized to request financial and market data from all insurance companies and their affiliates above a certain size threshold.51 Like the OFR, the FIO has subpoena power, and

49 This was one of the main differences between the Dodd–Frank Act, as signed into law, and the Obama Treasury’s original White Paper, which advocated the creation of a single federal bank regulatory agency. 50 See Dodd–Frank Act, Sec. 312. 51 The FIO does not have authority over some forms of insurance, such as health and crop insurance.

156

S.T. Omarova

the two offices are expected to share data. The Director of the FIO serves as a non-voting member of the FSOC. Even with limited powers, the FIO was conceived as an important first step toward greater federalization of insurance regulation. It is expected to develop insurance-specific expertise within the Treasury, to facilitate national uniformity throughout the sector and to provide a federal focus for the coordination of international insurance regulation.52 Yet, the creation of the FIO does not in any way guarantee the lawmakers’ resolve to federalize insurance regulation in the US. If anything, it signals their reluctance to take any decisive steps toward that goal, at least in the near future. 7.4.3 Shifting jurisdictional lines: ‘Twin Peaks’ of derivatives regulation and new vistas of orderly liquidation Another important theme in the Dodd–Frank reforms of the US regulatory structure is a significant expansion of substantive regulatory powers and responsibilities of the existing federal agencies (other than the Federal Reserve). Two examples stand out in this respect: the SEC’s and CFTC’s new powers to oversee derivatives markets and the FDIC’s new role in resolving systemically important financial conglomerates. 7.4.3.1 The SEC and CFTC as new derivatives regulators Title VII of the Dodd–Frank Act establishes the first federal scheme for the regulation of OTC derivatives markets. Government oversight of OTC derivatives transactions has been a topic of intense academic debates and administrative turf wars since the 1980s–1990s.53 The inherent complexity and nearly infinite malleability of these new instruments made them difficult to fit into a particular regulatory category, such as securities or commodity futures. This ambiguity caused significant jurisdictional conflicts between the SEC and CFTC, which Congress finally resolved by passing the CFMA in 2000.54 The CFMA explicitly barred both the SEC and CFTC from directly regulating off-exchange derivatives trading among sophisticated market participants, although such trading remained subject to general anti-fraud regulation. The explosive growth of unregulated OTC derivatives in the post-CFMA era, however, turned out to be a mixed blessing, insofar as it significantly contributed

52 Among other things, the FIO is charged with representing the United States at the International Association of Insurance Supervisors and determining whether any state regulation is pre-empted by the applicable international agreements. 53 See, e.g. Coleen M. Baker, ‘Regulating the Invisible: The Case of Over-the-Counter Derivatives’, 85 Notre Dame L. Rev. 1287 (2010). 54 See Commodity Futures Modernization Act of 2000, supra note 16.

US financial regulation after the 2008 crisis

157

to the hidden accumulation of leverage and risk in the financial system and, ultimately, the crisis of 2008.55 In response, Congress publicly reversed its pre-crisis deregulatory policy and brought swap transactions (a broadly defined term for derivatives) under direct government oversight. Among other things, Title VII of the Dodd–Frank Act requires reporting of derivatives transactions (including public reports of swap prices and volumes), central clearing of standardized swaps and registration and prudential regulation of major market participants. Yet, in many important respects, the Dodd–Frank Act merely seeks to strengthen the operation of the existing market mechanisms for limiting counterparty risk rather than to develop a fundamentally new regulatory paradigm for derivatives regulation.56 The choice of the institutional structure for derivatives oversight illustrates this pattern of path-dependency and incremental change. Following the recommendations in the Treasury White Paper, Congress simply divided regulatory authority over swap markets between the old rivals, the SEC and CFTC. Under the new law, the SEC has regulatory authority over security-based swaps (derivatives linked to the value of a single security or a small basket of securities), while the CFTC gets the broader mandate to oversee all other swaps.57 The two agencies share authority over so-called ‘mixed’ swaps, or security-based swaps with a commodity component. Title VII greatly expanded these agencies’ jurisdictional powers and, somewhat ironically, officially and inextricably tied them together. The SEC and CFTC are now directly responsible for overseeing new categories of regulated market actors – swap dealers, major swap participants, derivatives clearing houses and trading facilities – for compliance with a wide range of rules aimed at reducing counterparty risk in derivatives transactions, increasing transparency in derivatives trading and preventing fraud and market manipulation. To make the task even more difficult, the vast majority of these rules have to be promulgated by the SEC and CFTC, in accordance with the statute and in close cooperation with one another. Yet, such cooperation is inherently challenging, not only because of the history of past conflicts between the SEC and CFTC but also as a result of deeper structural divisions built into the silo-based US regulatory system. Because the Dodd–Frank Act does not significantly alter the principal statutory framework within which each of these agencies operates, the fundamental differences between the SEC’s and CFTC’s original mandates, statutory missions, regulatory focus and tools and institutional cultures 55 See, e.g. Lynn A. Stout, ‘Derivatives and the Legal Origin of the 2008 Credit Crisis’, 1 Harvard Bus. L. Rev. 1 (2011). 56 See, e.g. Arthur W.S. Duff and David Zaring, ‘New Paradigms and Familiar Tools in the New Derivatives Regulation’, 81 Geo. Wash. L. Rev. 677 (2013). 57 See Dodd–Frank Act, Sec. 712.

158

S.T. Omarova

remain. The Dodd–Frank Act envisions the expansion of the SEC’s and CFTC’s respective jurisdictions to derivatives oversight as a logical extension of their existing regulatory functions, which would close the pre-crisis gap and create a seamless regulatory coverage of securities and derivatives markets. At the same time, Congress refused to take this approach to its logical conclusion and formally combine the SEC and CFTC into a single agency.58 Whether the less radical (and, therefore, politically more viable) ‘twin peak’ solution will work as intended, however, remains to be seen. 7.4.3.2 The FDIC as the new resolution czar Much like the Federal Reserve, SEC and CFTC, the FDIC came out of this latest round of regulatory reforms with a significantly expanded regulatory authority. For instance, the Dodd–Frank Act gave the FDIC a critically important role in the regulation of banks’ transactions with their nonbank affiliates by giving it the right to veto the Federal Reserve’s decisions to exempt individual banks from specific prohibitions and limitations on such transactions.59 But perhaps the most important example of the statutory expansion of the FDIC’s jurisdiction is the creation of the new ‘orderly liquidation authority’ (OLA), a specialized resolution regime for large financial institutions.60 The OLA regime is designed to replace the regular corporate bankruptcy process in order to allow the federal government to wind down failing financial institutions that present systemic risk – and, thus, to avoid taxpayer bailouts of such too-big-to-fail firms. It is fashioned largely after the longstanding receivership mechanism for federally insured US banks, successfully administered by the FDIC. Not surprisingly, Congress chose the FDIC as the key agency in charge of liquidating a much wider range of financial firms, including the country’s largest diversified financial conglomerates.61 Under Title II of the Dodd–Frank Act, the Secretary of the Treasury may appoint the FDIC as a receiver for a financial institution, upon making a series of determinations to the effect that a particular financial company is in danger of defaulting on its obligations and that such default

58 Powerful political reasons have traditionally prevented a formal merger of the SEC and CFTC, the chief among them being the jurisdictional struggle between different Congressional committees overseeing securities and commodities markets, respectively. It is safe to assume that, at least partly, the same dynamics shaped Congressional decision-making in 2010. 59 Dodd–Frank Act, Sec. 608(a)(4)(A). 60 See 12 U.S.C. §§ 5381 et seq. 61 The OLA regime applies not only to SIFIs formally designated by the FSOC but to any US financial company, if the Secretary of the Treasury determines that its imminent failure would have serious adverse effects. The term ‘financial company’ includes bank holding companies, non-financial SIFIs supervised by the Federal Reserve, securities brokerdealers, etc.

US financial regulation after the 2008 crisis

159

would have ‘serious adverse effects on financial stability in the United States’.62 In its capacity as a receiver, the FDIC may operate or liquidate the financial institution as it sees fit and has nearly the same broad powers it typically exercises in a traditional bank receivership. The agency’s powers under OLA include the power to cherry-pick the assets and liabilities of the failing institution for a transfer to a third party or a bridge financial company set up by the FDIC, to determine the amounts and priority of payments on creditors’ claims and to repudiate certain burdensome contracts to which the failing financial company is a party.63 To fulfil its new responsibilities under the OLA regime, the FDIC established a new Office of Complex Financial Institutions to monitor risks within large financial conglomerates and to conduct resolution planning to respond to potential crises. In 2011, the FDIC adopted rules setting forth the priority of claims and other elements of the OLA regime and issued regulations regarding financial firms’ internal resolution plans, or ‘living wills’.64 Together with the Federal Reserve, the FDIC receives and reviews ‘living wills’ that large bank holding companies and non-bank SIFIs must prepare on an annual basis.65 Thus, the FDIC, which was generally viewed as the least influential among the US bank regulators during the pre-crisis era, is poised to reinvent itself as a powerful player and one of the principal guardians of financial stability of the United States. Yet, despite the FDIC’s enthusiastic embrace of its new high-profile place in the regulatory structure, there are reasons to doubt the agency’s ability to live up to its demands in practice. The FDIC’s rich experience with resolving individual banks may not be enough to lead the agency through the far more complicated and intensely political process of resolving, in an orderly and safe manner, much bigger and complex financial conglomerates like Citigroup or Bank of America Corporation.66 Moreover, given the global nature of many financial institutions’ businesses, the FDIC’s new role puts a huge amount of pressure on the agency to reach 62 Dodd–Frank Act, Sec. 203(b). The Secretary must obtain an order from the US District Court for the District of Columbia before the appointment becomes effective. However, the judicial review of the Secretary’s decision is limited and must be completed within 24 hours after the Secretary’s petition for a court order. 63 For a detailed explanation of the statutory provisions defining the scope of the FDIC’s powers under OLA, see Davis Polk & Wardwell LLP, Summary of the Dodd–Frank Wall Street Reform and Consumer Protection Act, Enacted into Law on July 21, 2010 (21 July 2010), pp. 27–31. 64 Sec. 165 of the Dodd–Frank Act requires all SIFIs to create so-called ‘living wills’ or detailed and credible plans for the rapid and orderly resolution of their businesses in the event of material financial distress. 65 Nine largest US financial conglomerates submitted their living wills to the regulators in July 2012. See Jessica Silver-Greenberg and Nelson D. Schwartz, ‘Living Wills for Too-Bigto-Fail Banks Are Released’, New York Times, 3 July 2012. 66 See, e.g. Stephen J. Lubben, ‘Resolution, Orderly or Otherwise: B of A in OLA’, 81 U. of Cincinnati L. Rev. 1 (2013).

160

S.T. Omarova

an international agreement on cross-border resolution rules, a notoriously difficult and politically challenging undertaking. It remains to be seen whether the FDIC has necessary resources, expertise and administrative capacity to fulfil its new tasks successfully. 7.4.4 A new cop on the beat: the Bureau of Consumer Financial Protection One of the most important reforms accomplished by the Dodd–Frank Act is the creation of the Consumer Financial Protection Bureau (CFPB), the first independent federal agency charged with the task of protecting consumers in all types of financial transactions.67 Prior to 2010, there was no single regulatory regime applicable to all financial institutions engaged in consumer finance, regardless of such institutions’ legal status or the type of financial products they offered to retail customers. Numerous financial regulators – including the Federal Reserve, OCC and FDIC – had authority to protect consumers of financial services but the scope and nature of their authority were generally limited to a particular subset of products or institutions.68 These agencies often treated consumer protection as a relatively low-priority regulatory objective, especially if it conflicted with the regulated firms’ interests in increasing their profitability.69 As a result, protecting consumers of financial services remained an ‘orphan’ mission that did not have a permanent ‘home’ in the regulatory structure.70 Shortly before the latest financial crisis, Harvard Law School Professor Elizabeth Warren proposed the establishment of a Financial Product Safety Commission, a federal agency charged with protecting ordinary Americans from dangerous financial products in the same way as they were protected from dangerous household products.71 As the crisis

67 See Adam J. Levitin, ‘The Consumer Financial Protection Bureau: An Introduction’, 32 Rev. Banking & Fin. L. 321 (2013). 68 The federal financial regulators shared consumer protection responsibilities with the numerous state regulatory authorities and other federal agencies, such as the Federal Trade Commission and Department of Justice, which further complicated the situation and encouraged regulatory arbitrage. 69 For example, various post-crisis investigations revealed a consistent pattern of the Federal Reserve knowingly ignoring warnings about consumer fraud and other abusive behaviour in residential mortgage markets. See, e.g. Kathleen Engel and Patricia A. McCoy, The Subprime Virus: Reckless Credit, Regulatory Failure, and Next Steps (New York: Oxford University Press, 2011). For an analysis of the OCC’s consistent use of pre-emption to thwart states’ attempts to protect consumers of banking products, see Arthur E. Wilmarth, Jr, ‘The OCC’s Preemption Rules Exceed the Agency’s Authority and Present a Serious Threat to the Dual Banking System and Consumer Protection’, 23 Ann. Rev. Banking & Fin. L. 225 (2004). 70 Levitin, supra note 67, at 329. 71 See Elizabeth Warren, ‘Unsafe at Any Rate’, Democracy, Summer 2007; Oren Bar-Gill and Elizabeth Warren, ‘Making Credit Safer’, 157 U. Pa. L. Rev. 1 (2008).

US financial regulation after the 2008 crisis

161

unfolded, the idea became increasingly popular among academics and policy reform activists.72 It moved into the centre of the legislative debate in 2009, when the Obama Treasury’s White Paper explicitly recommended the creation of a new federal agency with broad jurisdiction to protect consumers of credit, savings, payment and other retail financial products and services.73 Despite the intense political battle over the proposal, the White Paper’s recommendation became the template for Title X of the Dodd–Frank Act establishing the CFPB and a brand new regime of financial consumer protection.74 The CFPB is an independent bureau within the Federal Reserve and is, therefore, not funded through congressional appropriations. Despite not having a stand-alone status and getting its funding from the Federal Reserve, the CFPB enjoys significant operational independence, and its Director is appointed by the President with Senate’s approval.75 The bureau has extensive rulemaking, supervisory, and enforcement powers over a broad cross-segment of the financial services industry. Generally, the CFPB has rule-making power over any ‘covered person’, which is defined, in effect, as any entity engaged in marketing or providing any consumer financial product (i.e. a financial product or service used primarily for personal, family or household purposes).76 Thus, the CFPB’s rules may define certain ‘unfair, deceptive, or abusive’ practices,77 mandate disclosure,78 and restrict financial firms’ ability to bind consumers to arbitration.79 The CFPB also has the authority to examine and otherwise supervise certain entities, including residential mortgage brokers, payday lenders, and banks with more than $10 billion in assets that participate in

72 See, e.g. Joseph E. Stiglitz, The Financial Crisis of 2007/2008 and its Macroeconomic Consequences 29–30 (2009), available at www2.gsb.columbia.edu/faculty/jstiglitz/download/ papers/2008_Financial_Crisis.pdf; Daniel Carpenter, ‘Particulars of a Financial Product Safety Commission’, in Tobin Project: Considering A Financial Product Safety Commission 8 (May 2009). 73 See White Paper, supra note 36, at 14–15. 74 The creation of CFPB was one of the most controversial issues in the legislative debate over the Dodd–Frank Act, as the financial services industry fought hard against what it viewed as a dangerous and costly ‘super-nanny’ government agency. See, e.g. Levitin, supra note 67, at 336–338. 75 This does not mean that the CFPB is not subject to political and administrative controls. Among other things, the CFPB is subject to significant oversight by Congress; its rulemaking must comply with the Administrative Procedure Act; and, in certain circumstances, its decisions may be vetoed by the FSOC. See Levitin, supra note 67, at 348–355. 76 See 12 U.S.C. § 5481 (2011). The statute specifically excludes certain types of financial institutions from the CFPB’s jurisdiction. For example, the CFPB generally cannot regulate institutions regulated by the SEC or CFTC. 12 U.S.C. § 5517 (2011). 77 12 U.S.C. §§ 5531(d); 5536(a)(1) (2011). 78 12 U.S.C. § 5532(a) (2011). 79 12 U.S.C. § 5518(b) (2011). Importantly, however, the CFPB cannot mandate the offering of any financial service or product or force private parties to enter into transactions.

162

S.T. Omarova

markets for consumer financial products.80 Finally, the CFPB has the power to enforce numerous federal consumer financial laws and to impose a wide range of penalties for violations of such laws and the CFPB’s own rules.81 While it is difficult to describe in detail the intricate scheme under which the CFPB operates, even a cursory overview above shows that the creation of the CFPB as a federal agency focused specifically on consumer protection across a wide spectrum of financial activities and markets was the most tangible transformative change in the US regulatory structure under the Dodd–Frank Act. Not only did it introduce a potentially powerful new regulator into the existing mix, but it also exemplified a shift, albeit a partial one, toward a more explicitly objective-oriented form of regulation.82 However, for the same reasons, it is especially difficult to predict to what extent the CFPB will be able to establish itself as a truly significant and effective regulator in practice. Ever since its official creation, the CFPB has been a target of ongoing political attacks, and it continues to operate under a great deal of political pressure. The agency also faces serious challenges in terms of developing effective and workable substantive rules that would help to protect consumers of financial products without negatively affecting the cost and availability of consumer financial services in the United States. Despite all that uncertainty, it is clear that the CFPB’s future performance trajectory will, to a significant extent, determine whether or not the Dodd–Frank Act’s institutional reforms are ultimately viewed as an overall success story.

7.5 What to expect? Uncertain prospects and certain challenges It is still too early to tell whether, and to what extent, the Dodd–Frank reforms will actually lead to the emergence of a more effective, focused and well-coordinated network of federal agencies capable of delivering tangible results and achieving regulatory goals in practice. The new system remains fragmented and complex, with an even greater number of different regulatory bodies connected to one another through an even more intricate web of procedural rules. These bodies are even more varied in terms of their institutional status, structure, funding and substantive responsibilities. Under the Dodd–Frank regime that emphasizes the new post-crisis policy goal of preventing systemic financial crises, each of these 80 12 U.S.C. § 5514(a) (2011). 81 12 U.S.C. § 5565 (2011). 82 Ironically, consumer protection is not quite the kind of a regulatory objective that the financial industry had in mind when lobbying for a more objective-oriented regulatory approach in the pre-crisis era.

US financial regulation after the 2008 crisis

163

regulatory bodies faces serious challenges both in terms of fulfilling their agency-specific functions and in terms of cooperating with other regulators in domestic and international settings. In adopting the Dodd–Frank Act, Congress left many important and inherently difficult decisions to be made by financial regulators. Federal regulatory agencies have to adopt hundreds of new rules defining, explaining and operationalizing broad, and often internally contradictory, mandates of the new law.83 Developing such rules is often an inherently complex undertaking that requires balancing of many factors under conditions of extreme uncertainty. Intense lobbying by financial institutions trying to minimize the impact of the new systemic risk regulation on their businesses further complicates the implementation of the Dodd–Frank Act.84 Opponents of the new law also challenge its legality in courts, which creates delays and exacerbates uncertainty in the process. Furthermore, financial regulators can – and, in recent times, often have – become victims of Congressional political dysfunction, as the opponents of the Obama administration try to thwart or delay the implementation of Dodd– Frank by withholding funding or otherwise incapacitating individual agencies.85 Not surprisingly, under these conditions, agency rule-making has been chronically lagging behind the original implementation schedule. The failure of Dodd–Frank to streamline the regulatory structure exacerbated another chronic problem plaguing the US system of financial regulation: the lack of reliably smooth and effective inter-agency coordination and cooperation.86 Numerous provisions of the Dodd–Frank Act require close cooperation on the part of multiple regulators either engaged in joint rule-making or issuing separate rules on related matters. In a 2012 report to Congress, the GAO stated that, while the agencies generally attempted to improve coordination, such coordination was

83 As of 1 October 2013, federal regulators finalized only 161 out of the 398 rules required to implement the Dodd–Frank Act. See Davis Polk & Wardwell LLP, Dodd–Frank Progress Report (October 2013), available at www.davispolk.com/sites/default/files/Oct2013_ Dodd.Frank_.Progress.Report_0.pdf. 84 For an insightful scholarly analysis of the industry’s role in shaping the process of rulemaking in the context of implementing the controversial Volcker Rule, see Kimberly Krawiec, ‘Don’t “Screw Joe the Plummer”: the Sausage-Making of Financial Reform’, 55 Ariz. L. Rev. 53 (2013). 85 The SEC, which is funded through budget appropriations, and CFTC, which is periodically re-authorized by Congress, are particularly vulnerable in this respect. The CFPB, which is not funded through congressional appropriations, also experienced a major delay in its work as a result of Congressional Republicans’ persistent refusal to approve the appointment of the bureau’s Director. See Levitin, supra note 67, at 362–364. The opponents of Dodd–Frank also actively use the administrative requirement of cost-benefit analysis for political purposes, to block the adoption of rules implementing the law. 86 For example, in 2004, the GAO concluded that the existing means of inter-agency communication did not allow for an effective sharing of important information and monitoring of system-wide risks. See, GAO-05–61, supra note 3, at 109–112.

164

S.T. Omarova

mostly informal and did not eliminate the potential for different agencies adopting inconsistent or duplicative rules.87 The creation of the FSOC improved interagency cooperation but there appears to be little uniformity in the process. The GAO report cited the FSOC’s Chairman as saying that coordinating agency rule-making ‘represented a challenge because the Dodd–Frank left in place a financial system with multiple, independent agencies with overlapping jurisdictions and different responsibilities’.88 This tension between the increased demand for inter-agency coordination, on the one hand, and the structural fragmentation that makes such coordination less likely to succeed, on the other, illustrates the fundamental flaw in the Dodd–Frank’s regulatory philosophy. Unlike any previous legislative reforms, the Dodd–Frank Act directly targets the problem of containing systemic risks and adopts an explicitly and predominantly system-wide regulatory focus. In that sense, the law is both ambitious and aspirationally radical. However, it attempts to fulfil this system-transforming task primarily through incremental improvements to, or modified uses of, the pre-existing regulatory mechanisms designed to address discrete, non-systemic issues. In effect, the Dodd–Frank regime seeks to rebuild and rewire the entire financial sector regulation without touching its structural foundation. This internal contradiction between the ends and the means of regulatory reform makes its practical implementation inherently difficult, if not impossible.89

7.6 Conclusion This chapter provided an overview of the key changes in the US financial regulatory structure under the Dodd–Frank Act of 2010. Although it is still too early to measure the practical effects of these changes, it may be possible to make a few preliminary observations regarding the overall significance of the new law. Undoubtedly, the Dodd–Frank Act represents a major step on the path of regulatory reform. Yet, it falls visibly short of a radical overhaul of the complex, multi-layered and internally fragmented US system of financial services oversight. A truly comprehensive reform of financial sector regulation has to rest on, and be driven by, a conceptually consistent and systematic vision of substantive regulatory goals and structural means of achieving them. Developing such a programmatic vision would require, among

87 See Government Accountability Office, GAO-13–101, Dodd–Frank Act: Agencies’ Efforts to Analyze and Coordinate Their Rules (December 2012), at 22. 88 Id. at 24. 89 For a more detailed discussion of the fundamental flaws in the regulatory philosophy of the Dodd–Frank Act, see Omarova, supra note 38.

US financial regulation after the 2008 crisis 90

165

other things, making certain fundamental normative choices. In 2010, Congress avoided making difficult political decisions and relied instead on combining a multitude of technical solutions to individual regulatory problems. In that sense, the Dodd–Frank Act, despite all of its achievements, essentially preserves the pre-crisis regulatory status quo. Moreover, one could argue that, by failing to take full advantage of a rare political opportunity to redesign the outdated regulatory system, the Dodd–Frank may ultimately prove to be a setback in the process of financial regulation reform. Time will tell which view of the current reform effort is more accurate. Today, however, it is clear that rationalizing and effectively refocusing the US regulatory apparatus, in order to enable it to safeguard long-term financial stability in today’s complex, dynamic, and globally interconnected financial markets, remains a task for future reformers.

90 See Omarova, supra note 38, at 94–97.

8

Evolving supervisory and regulatory approaches of Japan in the post-crisis era Mamiko Yokoi-Arai * and Tetsuo Morishita

8.1 Introduction The appropriate institutional structure of financial supervision has been the subject of debate with many countries taking action to establish the appropriate structure in the past two decades. This has been accompanied by greater harmonization of financial supervision since the Basel Committee of Banking Supervision first agreed the ‘Concordat’ in 1975. Common understanding of how to best carry out supervision and greater recognition of the benefits of harmonized rules for the financial system have also led to discussions on the appropriate institutional structure for financial supervision taking into consideration their increasingly similar objectives and functions. Japan carried out its most radical restructuring of the financial supervisory institution in 1998 with the establishment of the Financial Services Agency (FSA).1 The FSA is a unified supervisor, with responsibility for supervision and regulation of the banking, securities and insurance sectors. While the institutional structure has not changed, the inner workings of the FSA have evolved and adapted to the current state of the Japanese economy and development of global standards. Changes in supervisory approaches are easier to comprehend when a large change in institutional structure takes place, but how the supervisor processes the various information it receives, whether it be global discussions or individual financial institution information, effectively and efficiently is an important element in terms of the actual operation of financial supervision. The ‘lost decade’ of Japan has been well documented on the Japanese economy, but the decline of the stock market commenced in 1989, so it has been a prolonged period of over two decades of economic decline, which was prompted by the non-performing loan problems of the financial

* Views expressed in this chapter are the author’s personal views, and do not reflect the view of the institutions the author is affiliated with. 1 Although the FSA was called the Financial Supervisory Agency when it was established in 1998, it was eventually renamed as the current Financial Services Agency in 2001.

Supervisory and regulatory approaches in Japan

167

2

system. In 2013, Japan’s economy started to show signs of recovery and nearing the end of the deflationary pressures, and financial institutions, which have been inward looking for the past decades, have begun the process of expanding operations and entering new markets. The environment in which the Japanese financial system has had to operate has been challenging, but may have resulted in building up the resilience of the financial system and alternative ways for the supervisors to approach the financial system. The objective of this chapter is to look into a number of approaches the FSA and other financial system authorities in Japan have taken to improve the health of financial markets, given the challenging macroeconomic conditions. Japan has, in particular, been proactive in developing and changing its supervisory approaches, whether to address high risk exposures or financing needs of the economy. The processes of developing legislation and regulation are highly inclusive and consensual, with transparent processes that provide input into the framework of legislation to improve its quality and ensure adequate market communication. Compliance with international standards has also been an important cornerstone of the Japanese supervisory framework, with banks already compliant with the main gist of Basel III. The experience of Japan may provide insight into what approaches supervisors can take in adverse macroeconomic environments to improve the standards of prudential supervision while addressing adherence to global standards. In a post-crisis situation, countries will often be required to accommodate financing needs of the real economy. This can compromise prudential standards and may not be viewed to contribute to financial stability, with the potential of igniting financial weaknesses. However, financial institutions do not operate in a vacuum and need to lend to be a profitable enterprise. Balancing the need for financial institutions to be profitable and solvent, and requiring sufficient capital and standards to ensure financial stability is the essence of financial supervision. Recent changes in the institutional structure of supervision indicates that a number of countries consider that a better structure could better address such problems. There is no question that a better institutional structure would better address certain issues in the financial system. However, as often voiced, there is not a ‘one size fit all’ institutional structure for financial supervision, and countries need to take into account the appropriate structure for its financial institutions and system, and regulatory and supervisory culture. In addition, the processes, governance and coordination of supervision are as important in determining the strength of financial supervision.

2 See Chapter 3 of M. Yokoi-Arai, Financial Stability Issues: The Case of East Asia, London: Kluwer Law International, 2002, for details of the banking crisis of Japan.

168

M. Yokoi-Arai and T. Morishita

It is a more technical and less ‘sexy’ approach to analysing financial supervision, but greater focus on supervisory processes could provide insight into how financial supervision can better address financial stability and economic growth. There is also the need to better consider the role of the financial supervisor in terms of independence, as governments look to financial institutions to accommodate economic growth needs.

8.2 The genesis of the institutional structure of financial supervision Japan’s institutional structure of financial supervision has remained the same since 1998. Nevertheless, the historical background to this change provides an important insight into the current supervisory structure and culture of the FSA. This section explores the historical context and the various financial authority actors. Given the ongoing policy discussions on the appropriate framework for financial institution resolution, Japan’s resolution regime is explained. The legislative and regulatory processes of financial regulation in Japan are provided, as a good example of openness of regulatory process. 8.2.1 Pre crisis to current structure Prior to 1998, financial supervision in Japan was carried out in a department of the Ministry of Finance (MOF ). The Bank of Japan (BOJ) also carries out bank supervision, although this activity is contractual and not subject to statutory sanctions. The main rationale of establishing a financial supervisory agency in 1998 was to separate the financial and fiscal role of the MOF. The FSA was established in April 1998 with the enactment of the Establishing Law of the Financial Supervisory Agency,3 which was later abolished and replaced by the Establishing Law of the Financial Reconstruction Commission and then the Establishing Law of the Financial Services Agency.4 The objective of the FSA is ‘to ensure the stability of the financial system’, ‘to protect depositors, insurance policyholders, investors or any relevant consumers’ and ‘to ensure the smooth operation of financial intermediation’.5 For this purpose, it licenses all financial institutions, carries out their inspection and monitors deposit insurance.6 The Financial Reconstruction Commission (FRC), which was responsible for the resolution of financial

3 Establishing Law of the Financial Supervisory Agency, Law No. 101 of 1997. 4 Establishing Law of the Financial Revitalization Commission (FRC Law), Law No. 130 of 1998. The Establishing Law of the Financial Services Agency (FSA Law), Law No. 130 of 2000. 5 FSA Law, Art 3. 6 Ibid., Arts 4–3 to 4–27.

Supervisory and regulatory approaches in Japan

169

institutions and financial crisis management, was later abolished, consolidating its functions and renaming FSA to the current Financial Services Agency in January 2001.7 This gave the FSA an even greater mandate, including the restructuring of financial institutions.8 The FSA has three main departments: the Planning and Coordination Bureau, Inspection Bureau and Supervisory Bureau.9 The Securities and Exchange Surveillance Commission and Certified Public Accountants and Auditors Oversight Board are part of the FSA, but structured independently of the main departments. The Planning and Coordination Bureau is responsible for drafting bills and other initiatives. The Supervisory Bureau is responsible for off-site monitoring, while the Inspection Bureau is responsible for on-site monitoring. The separation of the Supervisory and Inspection Bureau is a unique feature of financial supervision in Japan, since most countries would consolidate these functions in one section.10 An important background to understanding the institutional structure and culture of the FSA is how its establishment came to be. Formally, its establishment was decided to separate the government’s fiscal and financial supervision, and part of the wider administrative reforms of the government. However, the MOF ’s less than professional supervision, the BOJ’s role in causing the bubble economy, and the corruption scandals of both the MOF and BOJ are important elements that have determined the way in which the FSA has operated. The government and FSA developed strict rules concerning relations with external parties which may have potential conflicts of interest. While officials of the FSA are conscientious to ensure that suspicion of conflicts of interest cannot arise to ensure neutrality of supervision, this resulted in discouraging open dialogue with financial institutions on their strategy and concerns. The internal structure of the FSA has not changed much since its establishment. While staff were mainly drawn from MOF officials in the first ten years of its establishment, the managerial ranks of the FSA are increasingly being populated by staff who were recruited as new graduates by the FSA, which builds loyalty to and institutional memory of the organization. The FSA is headed by a politically appointed Minister of Financial Services, who is supported by the Commissioner who heads the administrative body. The Commissioner is appointed by the Minister of Financial Services from civil servants working in the FSA.11 Operationally and usually, the Commissioner proposes senior appointments of the FSA to the Minister,

7 The FRC was abolished to signal the completion of the financial reconstruction phase. The FRC was abolished with Law No. 102 of 1999. 8 FSA Law., Art 4–5. 9 For reference, the total number of staff of the FSA was 1,539 at June 2012. 10 However, it should be noted that this separation is being reviewed at the moment. See below, Section 8.3.2. 11 Art 4 of the Law on Senior Civil Servants.

170

M. Yokoi-Arai and T. Morishita

including the next Commissioner. As of November 2013, Commissioner Hatanaka was reappointed to serve his third year as Commissioner. It is unusual to remain in the same position in the Japanese civil service for more than two years, and Minister Aso attributed the reappointment to the limited number of personnel of the FSA. With time, the FSA should be able to build up its human resources and expertise, but it does point to a quintessentially Japanese problem of seniority being a decisive factor when deciding appointments of senior civil servant in a technical agency. 8.2.2 Key players in prudential policy and crisis management For the financial system, the FSA and BOJ are key financial authorities, while the MOF plays a limited role to ensure fiscal soundness in relation to planning of resolution mechanisms and crisis management.12 The relationship of the FSA with the MOF is stated in the clause on ‘relation with other administrative organs’. The FSA can require the submission of necessary material to accomplish its objectives and call for the cooperation of other ministries to achieve efficient inspections.13 As such, the FSA has the power to demand the MOF to comply with its requirements if the purpose is justified. The actual operation of the FSA has been independent from the MOF, and no interference is evident. The BOJ became independent from the government in 1997 with the amendment of the Bank of Japan Law.14 However, this did not change the nature of the BOJ’s supervision which was based on a contract between the BOJ and the financial institution, as a condition for using the BOJ-Net which is the main large, wholesale payment system in Japan. In terms of the operation of lender of last resort (LOLR) financing, BOJ Law articles 38 and 39 state that if required by the Prime Minister or Minister of Finance for the ‘preservation of the financial system’, the BOJ should provide ‘temporary loans to financial institutions’15 and ‘business contributing to the maintenance of an orderly financial system’.16 The BOJ has published a guideline containing four principles in assessing the provision of Article 38 loans: (1) the threat of systemic risk is imminent; (2) the provision of BOJ loans are absolutely necessary; (3) appropriate measures to clarify the responsibility of related parties will be taken to prevent morally hazardous behaviour; and (4) due consideration is given to the fiscal soundness of the BOJ.17

12 MOF, ‘Financial System Stabilization’ www.mof.go.jp/english/financial_system/ (last visited on 26 November 2013). 13 FSA Law, Art 5. 14 Bank of Japan Law, Law No. 89 of 1997. 15 Ibid., Art 38. 16 Ibid., Art 39. 17 BOJ, ‘Operational Report for the Fiscal Year of 1998’ (1999).

Supervisory and regulatory approaches in Japan

171

The Deposit Insurance Corporation (DIC) has played an important role in the prudential policy of Japan, given its wide ranging powers in capital assistance and financial institution resolution. The DIC can purchase assets from financial institutions (including banks merging failed institutions, nationalized or sound),18 and be designated as the administrator of an administered bank with the power to manage and dispose the asset of financial institutions when the DIC is appointed as the administrator.19 Chapter 7 of the Law on Deposit Insurance20 states measures that can be taken in a financial emergency situation. If a financial institution covered by deposit insurance experiences a default event, deposits subject to deposit insurance will be protected. Nevertheless, the Prime Minister may, when deeming that an extremely serious threat is posed to financial stability, in Japan or a regional economy where financial institutions are basing operations, determine the need to implement exceptional measures, as stipulated in Article 102 of the Deposit Insurance Law, following discussions of the Financial Crisis Response Council.21 The Financial Crisis Response Council deliberates on responses to financial emergencies or crisis, such as large-scale and systemic failures of financial institutions, and other serious matters, and oversees the implementation of these measures by the relevant government bodies. The Council is chaired by the Prime Minister with other members being the Chief Cabinet Secretary, Minister of Financial Services, Commissioner of FSA, Minister of Finance and Governor of BOJ. The Council can take the following three measures in Table 8.1 in response to a financial emergency or crisis, in accordance with various categories of financial institution. When the above measures are taken, DIC does not use its general accounts, but a special emergency account. In the past, taxpayers’ money was injected into the special emergency account of the DIC. While global standards for resolution have a strong focus on avoiding taxpayer money from being used for crisis management, Japan’s current system permits taxpayer money to be used in exceptional circumstances.22 8.2.3 Resolution framework Since the Lehman shock of 2008, global financial standard setting has been focused on measures to remove regulatory and supervisory forbearance resulting from ‘Too big to fail’ (TBTF ), to enable the smooth

18 19 20 21 22

DIC Law, Art 59. Id., Arts 74 and 77. Id., Arts 102 to 126. DIC, ‘A Guide to the Deposit Insurance System’ (2005). Masamichi Kono, ‘Trends in international financial regulatory reform (in Japanese)’, Securities Review (in Japanese) 51(12), 2011, 32.

172

M. Yokoi-Arai and T. Morishita

Table 8.1 Measures against financial emergency/crisis Law on Deposit Insurance Category of financial Article 102, para 1 institutions

Possible measures

Item 1 measure: Capital injection (subscription of shares, etc. by DIC to achieve the necessary capital adequacy ratio)

All financial institutions (except those under Item 2 measures)

s DIC subscribes shares, etc., upon receiving an application from a financial institution that has been authorised for Item 1 measure. s When applying, the financial institution submits a plan for improved business viability.

Item 2 measure: Financial assistance exceeding the pay-out cost

Failed or insolvency financial institutions

s Financial institutions authorized for Item 2 measure are immediately made subject to an order for management by an administrator.

Item 3 measure: Acquisition of shares by DIC (special crisis management)

Insolvent banks, etc., s Item 2 measure may only be categorized as failed authorized when it is deemed financial institutions that a very serious threat to financial stability in Japan or a regional economy where financial institutions are based cannot be avoided using Item 2 measure.

Source: DIC, ‘A Guide to the Deposit Insurance System’ (2005).

resolution of large, complex and interconnected financial institutions. The Financial Stability Forum’s (FSB) work has, in particular, focused on the Systemically Important Financial Institutions (SIFIs) with the publication of the Key Attributes of Effective Resolution Regimes for Financial Institutions (Key Attributes) in October 2011, although work is still ongoing on sector-specific work for resolution and monitoring of implementation. The Key Attributes of Effective Resolution Regimes for Financial Institutions provides legislative requirements of the insolvency framework of financial institutions. The main legal requirements of the Key Attributes are: s

2ESOLUTIONAUTHORITIESSHOULDHAVEATTHEIRDISPOSALABROADRANGEOF resolution powers, which should include powers to: (i) Remove and replace the senior management and directors and recover monies from responsible persons; (ii) Appoint an administrator to take control of and manage the affected firm with the objective of restoring the firm, or parts of its business; (iii) Operate and resolve the firm, including powers to terminate contracts, continue or assign contracts, purchase or sell assets, write down; (iv) Override rights of shareholders of the firm in resolution; (v) Transfer or sell assets and

Supervisory and regulatory approaches in Japan

s

s

173

liabilities; and (vi) Establish a temporary bridge institution to take over and continue operating certain critical functions and viable operations of a failed firm. 0OWERSTOCARRYOUTBAIL INSWITHINRESOLUTIONSHOULDENABLERESOLUTION authorities to: (i) write down in a manner that respects the hierarchy of claims in liquidation, equity or other instruments of ownership of the firm, unsecured and uninsured creditor claims to the extent necessary to absorb the losses; and (ii) convert into equity or other instruments of ownership of the firm under resolution, all or parts of unsecured and uninsured creditor claims in a manner that respects the hierarchy of claims in liquidation; (iii) upon entry into resolution, convert or write-down any contingent convertible or contractual bailin instruments whose terms had not been triggered prior to entry into resolution and treat the resulting instruments in line with (i) or (ii). *URISDICTIONSSHOULDPUTINPLACEANONGOINGPROCESSFORRECOVERYAND resolution planning (RRP), covering, at minimum, domestically incorporated firms that could be systemically significant or critical if they fail. Jurisdictions should require that robust and credible RRPs are developed and firm’s senior management be responsible for providing the necessary input to the resolution authorities for (i) the assessment of the recovery plans; and (ii) the preparation by the resolution authority of resolution plans.

In Japan, the process of resolution and recovery of financial institutions is well developed given the problems encountered in the aftermath of the bubble economy, and the resolution scheme for individual financial institutions are in line with the FSB Key Attributes. The resolution scheme already requires timely and prompt responses, appointment of an administrator to take control of and manage the affected firm, and resolution can take the form of continuity of business, transfer of business and liquidation, with industry funded deposit insurance and financial emergency measures.23 In order to better respond to the requirements of FSB’s Key Attributes, Japan amended the Law on Deposit Insurance in June 2013. The amendment established an orderly resolution regime for financial institutions, including banks, securities companies, insurance companies and financial holding companies. The new regime may be triggered when the Prime Minister decides that severe disruption of financial market and financial system is expected unless one or more measures of the new regime is applied to a financial institution following the deliberation of the Financial 23 In Japan, there has only been one case of payoff of deposit insurance towards the failure of Japan Shinkou Bank in 2010, which was applied the maximum payoff amount of ten million yen. On demand, current accounts which do not earn interest are given nonlimited protection by deposit insurance.

174

M. Yokoi-Arai and T. Morishita

Crisis Response Council. Once such a determination is made, the institution shall be put under the observation of the DIC and various measures such as provision of liquidity and financial assistance may be taken depending on the situation of the institution and necessity. However, Japanese law does not have powers for statutory bail-ins, and does not have a concrete mechanism for resolutions of group and cross-border resolutions.24 8.2.4 Legislative and regulatory process 8.2.4.1 The role of the Financial Council The Financial Council has contributed to improving the transparency of financial legislative and regulatory process. The Financial Council is established under the aegis of article 6 of the FSA Law.25 The maximum number of Council members is 30, with the current Council made up of 17 experts. Ten of the 17 members are academics, and there are no members from the financial sector (four members work in general business management). The role of the Council is to examine and report on issues which the Minister of Financial Services requests consultation. When the FSA has important policy issues on financial regulation, which may require new legislation or amendments of key legislation, the Minister will usually consult the Council. Over several months, the Council holds several meetings to examine the issue and reports to the Minister their deliberations. If necessary, the Council will set up special working groups to discuss specific issues. If legislation is deemed necessary on the issue, the FSA prepares a bill, heavily relying on the conclusions of the Financial Council. Although the report of the Council has no binding power, and both the FSA and the Diet are free to take different positions from the Council, the examination and conclusions of the Council are usually respected. This, typical, legislative process was followed for the above-mentioned amendment of the Law on Deposit Insurance which introduced the new regime for orderly resolution of financial institutions. The discussions and conclusions of the Financial Council are important steps, which not only provide input into the legislative process, but also improve the transparency and quality of legislation. The meetings and minutes of the Council are open to the public, being made publicly available shortly after each meeting. In the meetings, FSA officials explain 24 FSA, ‘Overview of “Review of Regulations on Banks which Contribute to Stability of the Financial System, etc.” ’, www.fsa.go.jp/en/refer/councils/singie_kinyu/reports/20130128/01. pdf (last visited on 21 November 2013). 25 FSA Law, Arts. 6 to 23.

Supervisory and regulatory approaches in Japan

175

to members the issues, and members discuss ideas and proposals prepared by the FSA and express their opinion on the matter. Through this process, market players and the public can learn the FSA’s thinking, and transparency of the legislative process is improved. When the Democratic Party became the ruling party in 2009, it declared to halt the activities of the Council as the Council conflicted with the main policy of the Democratic Party which was that politicians should lead decision making. However, the Council was re-convened in 2011. During the moratorium of the Council, market participants had fewer opportunities to know FSA policies, and had the perception of worsening transparency.26 The Council’s experts scrutinize the FSA proposals, leading to, sometimes, proposals being withdrawn or amended. For example, the FSA proposed to drastically loosen restrictions on shares of small and medium sized enterprises (SMEs) that can be held by banks, but members of the Council expressed strong concerns about the proposal and the FSA amended the proposal substantially.27 The process is essential for the FSA to understand the responses from the public and financial markets. Though the majority of Council members are academics, various practitioners and financial market experts are invited to give presentations. Also, financial institutions and officials of other ministries attend as observers and provide comments. The Financial Council has been an important tool to improve the legislative and regulatory process in terms of quality and transparency. While there is clearly some stage management of their meetings, discussion among members is open and free, enabling a good exchange of views on the issue at hand. There is a separate public consultation process as well, but the work of the Council has clearly contributed to ensuring that logic and best practices are taken into account of proposals, and they are not biased to the financial industry’s interest. 8.2.4.2 Efforts towards ‘better regulation’ In 2007, the FSA launched its initiative ‘Better Regulation – Improving the quality of financial regulation’ as a basic tenet of financial regulation, and this principle is maintained to this day. ‘Better Regulation’ refers to

26 T. Kondo, ‘Measures to improve the transparency of policy making’ (in Japanese), NRI Financial Information Technology Focus, 2010.1. 27 Previously, banks could only hold up to 5 per cent of the shares of general business enterprises, including SMEs. The FSA proposed an exemption to this rule for enterprises being restructured to up to 100 per cent. The Council expressed strong reservations to such a change. Nikkei news, ‘Bank shareholding and the capital market’, 13 November 2012.

176

M. Yokoi-Arai and T. Morishita

improving the quality of financial regulation for a better regulatory environment28 and is comprised of four pillars:29 s

s

s

s

0ILLAR ONE optimal combination of rules-based and principles-based supervisory approaches: combining rules-based approach for individual cases, and a principles-based approach for key principles so as to encourage voluntary efforts by financial institutions with maximum freedom of business management. 0ILLAR TWO prompt and effective responses to high-priority issues: for a ‘riskfocused, forward-looking’ approach, promptly foreseeing and identifying the areas where serious problems could be hidden and where huge risks might materialize in the future, and effectively allocating resources to these areas. 0ILLAR THREE encouraging voluntary efforts by financial institutions, and to place greater emphasis on incentives for them: promote incentivecompatible approach to create incentives for financial institutions to improve their systems and controls in business operations and risk management. 0ILLARFOURimprove the transparency and predictability of regulatory actions: in accordance with the FSA’s principle since 1998 to pursue fair and transparent financial regulation and supervision, the FSA compiles and publishes inspection manuals and supervisory guidelines. Since 2006, the FSA has been publishing the criteria of its administrative sanctions from past cases and details of the ‘No Action Letter system’30 to provide greater clarity of the standards of supervision.

The FSA identified specific areas to implement the four pillars:31 1. 2. 3.

Better communication with financial institutions. Disseminating information more widely and effectively. Strengthening cooperation with other foreign authorities.

28 FSA, ‘Better Regulation – Improving the quality of financial regulation’, www.fsa.go.jp/ en/policy/iqfrs/ (last visited on 21 November 2013). 29 Former Commissioner Takafumi Sato’s speech on Better Regulation summarizes the main points (25 and 26 September 2007), www.fsa.go.jp/en/announce/state/20070925. html (last visited on 21 November 2013). 30 The ‘No Action Letter System’ of the FSA is to enable financial institutions and other private enterprises to inquire with the FSA on whether their planned instruments or actions comply with the relevant legislation and regulation. The FSA is obliged to provide its interpretation within 30 days of receiving the formal query. FSA, ‘No Action Letter System of FSA’, www.fsa.go.jp/en/refer/noact/index_menu.html (last visited on 21 November 2013). 31 Former Commissioner T. Sato, ‘Progress of the FSA’s Efforts toward “Better Regulation”’, Speech at the International Bankers Association, 26 June 2008, www.fsa.go.jp/en/ announce/state/20080626.html (last visited on 21 November 2013).

Supervisory and regulatory approaches in Japan 4. 5.

177

Enhancing research so as to better understand market developments. Strengthening human resource development of the FSA.

It is important to note that these efforts were announced just before the financial crisis in 2007, although it was decided to maintain the initiative through to this present day. In particular, crisis management requires pillar two: prompt and effective responses to high-priority issues. For which, FSA recognized that action should be taken in the following areas to support recovery from the crisis:32 s s s

&INANCIALSTABILITYANDCONSUMERPROTECTION -AINTAININGTHEPRICEDISCOVERYPROCESSOFTHESTOCKMARKET %NHANCINGlNANCIALINTERMEDIATIONINCLUDINGRELAXINGASSETCLASSIlcation standards for better SME financing (November 2008), partial relaxation of the capital adequacy requirement for SME loans (December 2008) and amendment of the Law to Strengthen Financial Functions to enable further capital injections (December 2008).33

FSA has acted to self-regulate its supervisory and regulatory actions to build up its supervisory capacity. The FSA is a relatively new agency which had relatively limited institutional procedures, at the outset at least, that enabled it to establish new procedures. This initiative has been an important exercise in setting up a new tradition of selfdiscipline and reflection, so the agency does not rely on inertia to carry out its responsibilities dealing with quickly changing markets and institutions.

8.3 Evolving supervisory approaches While the institutional structure of financial supervision forms an essential part of establishing effective financial supervision, it needs to be accompanied by supervisory approaches and processes that correspond to the financial system. As part of the shift of supervisors to risk-based supervision, Japan has implemented principle-based supervision, with efforts to find the optimal

32 FSA, ‘Third Progress Report on Better Regulation’, 13 July 2009, www.fsa.go.jp/en/ news/2009/20090917.html (last visited on 21 November 2013). 33 The Law to Strengthen Financial Functions was enacted to prepare for the end of the moratorium on deposit insurance payoffs in April 2005. The Law enables the government to make capital injections to weak financial institutions, but was due to expire in March 2008. This was subsequently extended to March 2012, with a relaxation of the requirements for capital injection. Given the Great East Japan Earthquake, it was further extended to March 2017 in June 2011.

178

M. Yokoi-Arai and T. Morishita

combination with more prescriptive supervision. While promoting principle-based supervision, FSA also publishes an annual supervisory strategy, which can be interpreted as adding details to its supervisory approach or targeting certain areas deemed vulnerable. The latest Financial Monitoring Policy (September 2013) reviews the separation of its Supervisory and Inspection Bureaus, and incorporates greater risk-based consideration for its supervision. This section will analyse the supervisory approaches that the FSA has taken in recent years, and considers the impact of changes in its supervision and inspection. 8.3.1 Development of new supervisory approaches There have been three main strands of supervisory approaches taken in the post-crisis era of Japan: to address financial intermediation to the real economy, implementation of global standards and development of the Japanese financial markets. 8.3.1.1 Financial intermediation for the real economy Given the difficult economic environment that financial institutions are operating in, and the stricter capital requirements to all financial institutions, less financial intermediation is increasingly becoming the norm, inhibiting opportunities for enterprises to grow. If the market is unfavourable for financial institutions to raise equity capital, financial institutions could even be forced to dispose its liabilities. During the past decade, one of the primary issues of Japanese banking has been the refusal to lend and work has been carried out on this matter.34 In particular, financial supervision has been focused on improving financing to SMEs. In November 2009, the Law to Improve SME Financing was passed. The law requires financial institutions to make the best effort to improve lending conditions upon the request of an SME, set up and disclose its framework for SME financing and report to the FSA conditions revised for SME financing. This law was originally valid until March 2011 but was extended to March 2013. To ensure that the law does not result in just relaxation of financing conditions, the FSA has been encouraging financial institutions to provide consultation to SMEs on business management. With the end of the law, in April 2012, the Prime Minister’s Office, the FSA and the Small and Medium Enterprise Agency agreed on measures to support the business management of SMEs. Financial institutions are requested to make best effort to continue the relaxed lending conditions.

34 The ‘Working Group on Refusal to Lend’ was established by the Minister of Financial Services in September 2009.

Supervisory and regulatory approaches in Japan

179

35

Regional Economy Vitalization Corporation of Japan (REVIC) Law was amended to ensure that REVIC and financial institutions cooperated to support better financial intermediation. Financial institutions will be requested to disclose their lending conditions to SMEs. The government has taken active measures to ensure that financing needs of SMEs can be met. However, for example, although disclosure of financing to SMEs is no longer obligatory, it is clear that financial institutions will be required to disclose their efforts. The Minister of Financial Services has stated that even though the Law to Improve SME Financing ended in March 2013, he, in fact, expects financing conditions to remain the same for SMEs, as well as the supervisory measures related to SME financing.36 While requesting financial institutions to provide SME loans may be a simple way of addressing the immediate issue, it does not address the fundamental issues of encouraging greater innovation and better financial management. REVIC’s new role as business consultant to SMEs will be an important initiative of whether better financial expertise and management could better support SMEs, although there remain concerns on the effectiveness of such measures.37 Diverse financing mechanisms such as venture capitals and angel investors could play an important role in assessing the business plans of start-ups, so tax breaks for such endeavours would be a useful avenue to consider. 8.3.1.2 Implementation of global standards Given the discussions in FSB and the peer reviews on implementation, Japan has been actively implementing the standards agreed in the various work streams. Basel 2.5 measures to increase the risk weighting of securitised products were implemented in 2011. Basel III increases the Tier 1 capital required, and applies a minimum liquidity ratio and leverage ratio. Capital requirements for SIFIs have also been raised. Deposit-taking institutions with overseas operations have been subject to the Basel III capital requirements since March 2013. Domestic deposit-taking institutions will be required to have core assets greater than 4 per cent of risk assets with implementation being introduced gradually from March 2014. 35 The Corporate Restructuring and Revitalization Corporation was restructured into REVIC in March 2013 given the government’s decision to continue to address SME financing and revitalize regional economies. 36 Minister of Financial Services press statement, ‘The supervisory direction given the impending end of the Law to Improve SME Financing’ (1 November 2012), www.fsa.go. jp/common/conference/danwa/2012/20121101–1.html (in Japanese) (last visited on 26 November 2013). 37 ‘The end of the Law to Improve SME Financing’ (in Japanese) Kinyu Zaisei jijou (in Japanese), 25 November 2013.

180

M. Yokoi-Arai and T. Morishita

The Financial Instruments and Exchange Law was amended in 2009 to introduce a voluntary registration system for rating agencies. Rating agencies, their senior managers and staff are required to operate independently, fairly and with integrity. The FSA further published its supervisory guidelines of rating agencies in 2011. The amendments to the Financial Instruments and Exchange Law in 2010 require that large and complex securities companies be supervised on a consolidated basis. Reporting of consolidated financial statement, and consolidated capital requirements are applied. Currently, Daiwa Securities and Nomura Securities are designated parent securities companies subject to consolidated governance requirements. In addition, the Financial Instruments and Exchange Law requires that for certain OTC derivatives transactions, centralized clearing with designated clearing systems is required in accordance with FSB recommendations.38 8.3.1.3 Development of Japanese financial markets Given the post-crisis era, the government has been looking to address development of the financial market. Prime Minister Abe has been taking action on many fronts to reverse the deflationary economy and start economic growth. In June 2013, the Cabinet decided on the Japan Recovery Strategy which includes a number of FSA-related measures. This includes greater alternative funding, including crowd funding and tax breaks towards small value investments, and strengthened corporate governance. Technical assistance to improve the financial infrastructure of Asian countries would support SMEs operating in Asia and encourage investment into Asia. In January 2014, a new tax exemption system was introduced towards small value investors. NISA, which draws on the UK ISA (individual saving account) system, permits tax exemption towards capital gained from investment in stocks and collective investment schemes of up to 1 million yen every year for a period of five years. Previously, a 20 per cent capital gains tax was applied to such investments. This tax aims to shift money from savings to investments given the high saving rate in Japan. One issue in which FSA involvement may need to be further strengthened is supervision of asset management. A recent case in 2012 had led to the amendment of supervisory rules to effectively impose an audit requirement on funds into which investment managers invest client

38 The reform of OTC derivatives transactions was made in the G20 leaders’ statement in 2009, and has been progressing based on FSB recommendations to be carried out by end 2012. Para 13 of G20, ‘Leaders’ Statement, Pittsburgh Summit’, 24–25 September 2000, www.treasury.gov/resource-center/international/g7-g20/Documents/pittsburgh_summit_ leaders_statement_250909.pdf (last visited on 26 November 2013). FSB, ‘Implementing OTC Derivatives Market Reform’, 25 October 2010.

Supervisory and regulatory approaches in Japan

181

39

assets. Given the ageing society, for greater retirement security, the role of occupational and private pension funds is likely to strengthen. Given that beneficiaries will be individuals dependent on retirement saving products for financial security, good supervision and clear guidelines on what guarantees are being provided and what risks are inherent in the product need to be better conveyed. 8.3.2 Revised supervisory manual for better on-site and off-site monitoring In September 2013, the FSA announced a new Financial Monitoring Policy that better integrates the on-site and off-site monitoring carried out by the Inspection and Supervisory Bureaus respectively. The formal and institutional separation of on-site and off-site monitoring was a characteristic of the FSA. The new policy focuses particularly on macro-prudential issues, G-SIFIs,40 regional banks, foreign banks and insurers. In terms of issues, the new policy will review sustainability of business models and banks’ ability to appraise borrowers. It is important to reflect on the legacy of Japan’s financial crisis of the 1990s. During the height of the Japanese financial crisis, Japan recorded one of the highest levels of non-performing loans (NPL) to total loans in history which was 35 per cent at its peak in 1997.41 Given the size of the economy, the volume of NPLs was extremely large, necessitating a revamp of financial supervision and resolution mechanism to cope with the situation at the time.42 The bureaucratic structure of Japan should enable the institutional memory of the time to remain a lesson to the practices of FSA, but emphasizing this could be viewed as a hindrance to developing supervisory approaches that encourage innovation and advances of the financial system, and some argue that recent policies of the FSA stressing financing to SMEs and contribution by the financial sector to strengthen Japan’s economy, already indicate an erosion of

39 AIJ Investment Advisors Co., Ltd (‘AIJ’) was a Tokyo-based alternative investment manager that managed primarily Japanese pension fund assets. In January 2012, an investigation by the Securities and Exchange Surveillance Commission revealed that AIJ had long falsified its performance and that, in fact, it had been operating a fraudulent Ponzi scheme, whereby the majority of its clients’ assets, in an amount of approximately JPY 200 billion (US$2.5 billion), had disappeared. Morrison Foerster, ‘Amendment to Japanese Investment Management Regulations in Response to AIJ Incident’, 8 November 2012, www.mofo.jp/topics/legal-updates/legal-updates/20121108–2.html (last visited on 21 November 2013). 40 G-SIFIs that are based in Japan are Mizuho Financial Group, Sumitomo Mitsui and Mitsubishi UFJ Financial Group. 41 As reference, Iceland’s NPL to total gross loan ratio was 42 per cent in 2009, and Greece’s NPL to total gross loans ratio 17 per cent in 2012. From World Bank Open Data. 42 For details on the Japanese financial crisis, see Chapter 3 of Yokoi-Arai (see note 2).

182

M. Yokoi-Arai and T. Morishita

such institutional memories. Admittedly, distinguishing and evolving supervisory approaches to changing financial markets outlooks is a difficult task for even the most well-informed market analysts. It would be more fitting for supervisors to be conservative in their approaches than diluting supervisory standards prematurely. In this respect, while the FSA’s policy may be deemed delayed by some market pundits, it may have been inevitable given the overall government policy. Further, it should be noted that changes in policy have been in response to the current administration’s so called Abenomics approach.43 The FSA announced the main focus of its supervision for the coming year in its Annual Policy Measures for Financial Monitoring and Inspection. For the administrative year of 2013,44 it announced the new monitoring policy which is in response to the government’s change of direction to steer the economy towards greater growth.45 As the FSA has reportedly been called the ‘Financial Disciplinary Agency’, Minister of Financial Services Aso has repeated his intention to change the FSA into the ‘Financial Development Agency’.46 In response, the new Financial Monitoring Policy respects banks’ self-assessment of credit decisions, in particular towards SMEs, in so far as the bank has an internal mechanism to enable appropriate provisions to be made. The Financial Monitoring Policy has three key elements.47 The first is unifying monitoring and inspection. The separation of on-site and off-site supervision and accompanying separate guidelines for respectively on-site and off-site supervision have been criticized for creating duplicate but similar standards of supervision. FSA will rationalize supervision by unification of the two lines of supervision, while strengthening cooperation between the two bureaus. The second is the change of emphasis of supervision, with a greater focus on macro-prudence and continuous monitoring. The third is the horizontal review which will look across the industry at best practices in order to improve the overall practice of the financial industry.

43 Financial market measures are part of the industry revitalization plan, in terms of revitalizing private sector investment and vitalizing financial and capital markets of Japan. Prime Minister of Japan and His Cabinet, ‘Japan Revitalization Plan – Japan is Back’, 14 June 2013, www.kantei.go.jp/jp/singi/keizaisaisei/pdf/en_saikou_jpn_hon.pdf (last visited on 17 November 2013). 44 The concept of administrative year is unique to the operation of the FSA, which starts from July of that year to June of the next year, in response to the annual personnel rotation of the civil service that takes place in June or July every year. 45 FSA, ‘The Japan Financial Services Agency’s New Financial Monitoring Policy (summary)’, 6 September 2013. 46 Nikkei news, 26 October 2013. 47 ‘FSA announces New Monitoring Policy’ (in Japanese) Kinyu Zaisei jijou, 16 September 2013.

Supervisory and regulatory approaches in Japan

183

8.3.2.1 SME and start-up financing and regional economies In the past, FSA inspection would require that borrowers’ loans classified as ‘with caution’ borrowers, were classified into NPL borrower classes of ‘close to bankruptcy’ or ‘marked’ borrowers. Once a borrower is classified as an NPL borrower, accompanying provisioning requirements would be necessary, having a direct impact on the capital necessary for capital requirements. For start-up enterprises, early stages are notoriously unprofitable for prolonged periods. Some SMEs with advanced technology may have experienced failed investments, making them unprofitable. The new Financial Monitoring Policy is hoped to address lending to such borrowers that have the high potential to grow. Currently, 10 per cent of loans are said to be with ‘marked’ borrowers, and it is likely that such borrowers will benefit from the new policy.48 Another important issue of the new Financial Monitoring Policy is the need for regional banks to take into consideration the ageing economy which is particularly problematic in Japan’s regions. The focus of monitoring regional banks’ activities will be to revitalize regional economies. Banks will be required to consider their long-term management strategy of five to ten years as well as ensuring that their short-term decisions are adapted to market developments. Long-term management strategies will include whether their business models are sustainable and viable, and taking short-term actions to address them. While the Financial Monitoring Policy is a useful turning point in bringing the supervisory policy of the FSA into the current macroeconomic situation, there are a number of concerns. In effect, the FSA is diluting its previous supervisory standards, although these could be assessed as being previously too strict. Potential changes in borrower classification will have a real and material impact on credit decisions of banks, but to what extent banks will use their self-assessment to adjust borrower classification is not clear. As banks will not be required to report loans to SMEs, and their overall financial strength to absorb any losses from SME lending will be taken into account, some financial institutions may be willing to take on risks that they previously avoided for compliance purposes. Further, changes in the supervisory approaches that are being introduced require that financial institutions have the appropriate knowledge and expertise to assess the businesses of start-ups and SMEs. Experience and knowledge of technology would be essential for this purpose, and building up this expertise will take time for any institution. So this may be an aspect that banks need to take into account when developing their long-term management strategy. Greater cooperation with institutions like the REVIC could become important for financial institutions to lend to new business areas and the new businesses to learn sound business practices. 48 Nikkei news, 17 August 2013.

184

M. Yokoi-Arai and T. Morishita

Even for regional banks, the tide of the strong yen in the past decade has left many regional economies losing manufacturing bases to overseas sites, but assessing viable regional businesses which may have a possible foreign investment element will require sectoral expertise and know-how of foreign investment. The scale of regional banks’ operations is much smaller than the large megabanks of Japan, and many will not have overseas offices that can collect information on foreign investment environment. Regional banks will have to find a way to assess businesses which could be riskier than those that are being assessed by the larger banks. From March 2013, credit unions are being permitted to directly lend to foreign subsidiaries of clients up to 20 per cent of total loans. New businesses that regional banks assess will include those related to the ageing society. Given the speed at which ageing is progressing in Japan, mobilizing resources in businesses that respond to societal needs will be important, but as these businesses target a much older cohort with less spending, assessing the viability of such businesses would be much more challenging. One of the potentially most difficult components of the Financial Monitoring Policy may be the possible intervention into the business models of banks. The Policy effectively endorses financial institutions to lend more to SMEs and start-ups. Given the history of the government’s policy for SME financing, and the difficulty it has had in encouraging it so far, whether the new policy will result in greater SME financing, and lending to innovative industry and vibrant start-ups, will need to be observed. However, it is clear that financial institutions are being encouraged to lend to SMEs, and profitability of some banks may be affected as a result. FSA has indicated its intention to intensively verify financial institutions’ management’s involvement in carrying out new lending for this purpose.49 The requirement for banks to contemplate their long-term management strategy is also being viewed by some as intervention by the FSA into their business models, as financial institutions must consider the appropriateness of their business models. 8.3.2.2 Horizontal reviews The new Financial Monitoring Policy will introduce horizontal reviews for G-SIFIs, regional banks and large insurers to identify risks and vulnerabilities of the financial system. Horizontal reviews for G-SIFIs will be addressing not only risks, but also their adherence to global best practices. Further, monitoring of G-SIFIs will be led by an Examiner-in-Charge (EiC) and experts/specialists for each risk and business category. Horizontal

49 This is included in the Financial Monitoring Policy of 2013.

Supervisory and regulatory approaches in Japan

185

reviews of regional banks will include revitalization of regional economies and cooperation with the local Finance Bureaus.50 These new practices will be based on a change in the institutional structure of supervision which hitherto separated off-site and on-site monitoring, as well as develop technical expertise to cope with the specialization of bank operations. The Inspection and Supervisory Bureaus will jointly carry out monitoring, and respond to emerging issues on a timely basis by being more risk-based in supervision. While the structure of FSA has not been formally changed, closer joint action may lead to eventual restructuring. 8.3.3 Macro-prudential policy In Japan, responsibility of the micro-prudential policy, to ensure the stability of individual financial institutions, lies squarely with the FSA. However, how macro-prudential policy should be addressed is less clear despite the calls to strengthen it.51 Macro-prudential policy is focused on broader, financial system-wide issues. While there is a structure to address financial system-wide issues in a crisis situation, there has hitherto not been an effective mechanism to consider macro-prudential policy in Japan. Japanese market players can often be heard criticizing the FSA for its lack of a higher viewpoint when considering action. Which may be a symptom of insufficient macro-prudential policy. An important element of the new Financial Monitoring Policy is its intention of better addressing macroeconomic developments in the financial markets. While it is not the role of the financial supervisor to be accommodative to macroeconomic policy, the recessionary pressure of the last decade has forced Japanese supervisors to reconsider whether its approach was appropriate as profitability of financial institutions is essential to ensure good solvency of financial institutions can be maintained. The new Policy will examine the various submitted reports and data of financial institutions, and collect better information on the overall lending trend of financial institutions and the financial system. Reporting requirements will be revised to ensure that the appropriate information is being collected for this purpose.

50 The Ministry of Finance and FSA have joint local finance bureaus in each region of Japan which are tasked with carrying out duties related to fiscal activities and financial supervisory services. 51 For example, former Commissioner Sato penned an article emphasizing the need for greater macro-prudential policy. T. Sato, ‘Trends of Financial Re-regulation and Ideas for a Desirable Prudential Policy’, Hitotsubashi Review, Autumn 2011.

186

M. Yokoi-Arai and T. Morishita

Better and frequent monitoring of various aspects of the financial institutions’ business will be carried out to comprehend the nature of business strategy and decisions of banks. Market analysis and stress scenarios by FSB will be used to determine which areas should be examined to remain forward looking in supervision. Given the formality of Japanese financial supervision, the lack of a formal mechanism to address macro-prudential considerations has likely led to its weakness in addressing them. This is a first step to introducing a formal monitoring mechanism to analyse and take action on macroprudential issues such as changing business models of financial institutions, market movements which would have a large impact on the profitability of financial institutions, herd behaviour of financial institutions and the relation between the real economy and the financial system.

8.4 Conclusion The institutional structure of Japanese supervision emerged from the need to prevent conflicts of interest and tackle the large NPL problems that plagued Japan for an extended period, and it has served those purposes well. However, as the country enters a post-crisis era, as many European countries are beginning to do so, how to transition from a supervisory system that supports economic growth will become an important issue which institutional structure in itself may not be able to adequately address. While the Basel Committee on Banking Supervision,52 the International Organization of Securities Commissions (IOSCO)53 and International Association of Insurance Supervisors (IAIS)54 all include independence of financial supervisors as a core principle, there is not an institutional structure that is recommended for all countries. The nature of the financial system and supervisory culture are important elements that should also figure in the consideration of the appropriate supervisory structure, although its intangible nature may make its role in informing the appropriate structure less clear. The twin peaks model of institutionally separating prudential regulation and market conduct has become a popular structure, especially with the UK’s adoption of this model. But while there are basic safeguards that need to be fulfilled by the institutional structure, such as prevention of conflicts of interest and the need to address consolidated supervision, unless there are obstacles posed by the current structure, such as institutional turf wars which can only be resolved by merging institutions, there

52 Principle 2 of Basel Committee’s Core Principles for Effective Bank Supervision. 53 Principle A.2. of IOSCO’s Objective and Principles of Securities Regulation. 54 Insurance Core Principle 1 of the IAIS’ Insurance Core Principles.

Supervisory and regulatory approaches in Japan

187

is no consensus on the best institutional structure whatever structure other supervisors may be adopting. As this is the case, in fact, the processes and coordination are as critical as institutional structure in determining that good and timely supervision can be carried out, and standards which are universal, although the mode of them may differ. Japan’s financial supervisory culture is strongly influenced by the experiences in disposing of the mountain of NPLs. This has in turn led to supervisory processes being highly coordinated and principled to ensure that global standards are being complied with and financial institutions are well capitalized to cope with any vulnerability. Although financial emergencies involve different authorities, such as the FSA, BOJ and DIC, there is good coordination among the authorities to ensure that the mandated functions can be carried out, and the Financial Crisis Response Council has real authority to intervene when necessary. Clear processes enable action to be taken in a timely manner, while good coordination has meant that regulatory forbearance has been avoided. In the UK, the lack of coordination to address macro-prudential issues is thought to have contributed to the banking crisis. Clear responsibilities and procedures for coordination, as well as real authority for coordinated action, appear to be essential in financial supervision, in particular where the markets are large and institutions complex. Macro-prudential policy will need to be better addressed in Japan taking into consideration strengthened overall oversight and better coordination on macro-prudential issues. In Japan, micro-prudential and emergency measures are well laid out, but risks between the two do not yet have a well-developed framework to address them. Macro-prudential issues can potentially be quite wide ranging but more important will be the ability to take action addressing future risks in changing macroeconomic environments. Better market analysis and dialogue will be important, and which the current framework may not be sufficiently addressing. Stress testing would assist in communicating the vulnerabilities the FSA is monitoring, but may not be sufficient to capture some of the systemic risks. The Financial Monitoring Policy should be further developed to take account of such concerns. Better and frequent dialogue with financial institutions should take place so that confidence in exchanging views can be developed without compromising being arm’s length. The new supervisory approaches of the FSA will be important in observing how financial supervisors could adopt to the post-crisis era. While the general gist of the Financial Monitoring Policy has been welcomed by financial markets, the actual relaxation of lending conditions needs to be well monitored to ensure that this does not lead to unnecessarily lax credit decisions. Getting financial institutions to improve their business assessment skills will be essential in ensuring that the Financial Monitoring Policy has the intended effect and SMEs and start-ups can benefit from better business advice from financial institutions.

188

M. Yokoi-Arai and T. Morishita

While the objective of financial supervision should be to maintain financial stability, governments are increasingly requiring that they take into account the need for financial institutions to be accommodative to wider economic needs. This can be a slippery slope and why independence of the financial supervisor is advocated by the international standard setters. While certain accommodations can be made to create greater opportunities for borrowers, any relaxing of lending conditions should be taken with caution, as unless a fundamental shift in the business strategy is observed, an unprofitable business will be difficult to turn around. As the FSA highlights the importance of lending to SMEs, both officially and informally, how to ensure that such losses are not transmitted to the financial system and allowing financial institutions to actually fail if such lending policies result in insolvency will be essential. Better safeguards that comprehend the nature of enterprises so that action can be taken when necessary will continue to be important processes as financial supervision adapts to post-crisis mode. The new supervisory approach of the FSA points to a wider issue that has not been well addressed by financial supervisors, which is their independence. Independence of financial supervisors is a core principle of banking, securities and insurance core principles as mentioned above, although adherence to this core principle may not be as widespread as that for central banks. This is as appointment of the financial supervisor often includes a political process, which would compromise the level of independence required by the core principles. The FSA did benefit from strong political support in tackling NPLs and the orderly resolution of failed financial institutions, so the FSA being part of the government has had its advantages. But the flip side is that the FSA must actively promote relevant government policies, for example by giving administrative guidance, which in Japan is used by ministries and agencies to guide industry towards certain governmental policies, which compels financial institutions to lend to certain sectors, which could compromise its standards of supervision. There is a fine balance between ensuring that banks, in particular, can fulfil their distinct role of providing appropriate financial intermediation for the smooth running of the real economy, and the government encouraging financial intermediation to areas in the economy which they deem not to be benefiting from this intermediation.55 This is an institutional issue of financial supervision, which requires further consideration given that financial supervisors will be carrying out their work through both economic booms and recessions, and trust in supervisors can only be nurtured through taking appropriate supervisory 55 Banks’ role in the economy is considered unique in two main respects: their involvement in maintaining financial stability through their involvement in the payment system, and they are the only source of finance for a large number of borrowers. C. Goodhart et al, Financial Regulation: Why, How and Where Now?, London: Routledge, 1998.

Supervisory and regulatory approaches in Japan

189

policies and decisions in any economic environment. It is apparent that the 2008 financial crisis has made governments conscious of how risks posed by banks can have real economic and fiscal impact on the sovereign. Thus, investigations into institutional or procedural safeguards to balance these two opposing forces should be further carried out.

9

Financial regulatory structure in Hong Kong Looking forward Douglas W. Arner and Evan Gibson *

9.1 Introduction In 2008 the global financial system suffered the deepest financial crisis since the Great Depression. The global financial crisis (GFC) not only highlighted gaps in financial regulation but also a failure of financial regulatory structures to maintain financial stability. In the aftermath the Group of Twenty (G20) delegated a complete review of financial sector regulation to the Financial Stability Board (FSB). At the top of the FSB’s agenda is overseeing the implementation of regulatory reforms that more effectively maintain financial stability. Although Hong Kong emerged from the GFC relatively unscathed it was nonetheless affected by several high profile incidents of financial regulatory failure. In response Hong Kong has adopted financial regulatory reforms in accordance with the FSB’s agenda. However, these failures were not merely attributable to financial regulatory gaps, but more broadly to financial regulatory structural flaws. Despite these flaws being exposed well before the GFC, redesigning Hong Kong’s financial regulatory structure has not been forthcoming. Looking forward, Hong Kong’s history of regulatory failures serves as a forewarning that its financial regulatory structure needs to be redesigned before a failure occurs that fatally undermines financial stability. In this chapter Hong Kong’s financial regulatory structure will be examined and analysed. Our aim is to identify Hong Kong’s financial regulatory structural flaws in support of structural change. The first section of this chapter will take a brief journey through Hong Kong’s historical financial development culminating with a summation of the financial regulatory themes. This will be followed by an overview of Hong Kong’s existing financial regulatory structure with an analysis of the prevailing themes and structural issues, including coordination and cooperation arrangements. Once this groundwork has been laid, there will be an examination of * The authors gratefully acknowledge the financial support of the Hong Kong Research Grants Council Theme-based Research Scheme, ‘Enhancing Hong Kong’s Future as a Leading International Financial Centre’.

Financial regulatory structure in Hong Kong

191

Hong Kong’s high profile GFC incidents, which will be analysed and compared from a structural perspective with findings from the 2003 IMF Report. In this context, Hong Kong’s implementation of the G20/FSB reform agenda and the capacity of the financial regulatory structure to facilitate these reforms will be evaluated. Rounding off this examination and analysis will be a discussion of the financial regulatory structural options. This chapter will then conclude with an appraisal of Hong Kong’s financial regulatory structure.

9.2 Historical financial development 9.2.1 1840s–1864 Hong Kong became a British Colony subject to British law in 1842. At this time banking functions were performed by large agency houses1 with their subsidiaries operating insurance businesses.2 The first British joint stock bank, the Orient Banking Corporation, commenced operations in 1845.3 By 1859 the Hong Kong branch of the Chartered Bank of India, Australia and China (a predecessor of Standard Chartered Bank) commenced operations and was granted a licence to issue bank notes three years later.4 Development of the banking system was slow early on, taking almost 20 years before a local bank, the Bank of China, was incorporated.5 9.2.2 1865–1947 In 1865 the Hong Kong and Shanghai Banking Corporation (HSBC) began operations. The following year securities began being traded in Hong Kong, and the Hong Kong Fire Insurance Company was established, becoming the first local insurer.6 Hong Kong’s first formal stock exchange started trading in 1891 as the Association of Stock Brokers, which would later be renamed the Hong Kong Stock Exchange.7 The Exchange

1 Tushar K. Ghose, The Banking System of Hong Kong (Chai Wan, Hong Kong: Butterworths Asia (Hong Kong), 2nd edn, 1995), p. 2: Jardine Matherson; Dent & Co; Gibb Livingstone and Russell and Co. 2 Feng Bangyan and Nyaw Mee Kau, Enriching Lives: A History of Insurance in Hong Kong, 1841–2010 (Aberdeen, Hong Kong: Hong Kong University Press, 2010), p. 17. 3 Tushar K. Ghose, The Banking System of Hong Kong (Chai Wan, Hong Kong: Butterworths Asia (Hong Kong), 2nd edn, 1995), pp. 2–3. 4 Ibid., p. 10. 5 Bank of China (Hong Kong) was incorporated in 1864. 6 Feng Bangyan and Nyaw Mee Kau, Enriching Lives: A History of Insurance in Hong Kong, 1841–2010 (Aberdeen, Hong Kong: Hong Kong University Press, 2010), p. 28. 7 Hong Kong Exchanges and Clearing Limited, ‘Hong Kong Securities Market’, available at www.hkex.com.hk/eng/stat/statrpt/factbook/documents/fb99_01.pdf (visited on 3 July 2011).

192

D.W. Arner and E. Gibson

Bankers Association (EBA) was founded in 1897 as a private industry association that regulated exchange transactions and interest rates.8 Interestingly the EBA was a self-regulatory organization, the first in Hong Kong, that precluded government designed regulators by over half a century. 9.2.3 1948–1986 In 1948 Hong Kong’s first Banking Ordinance was enacted. The Ordinance defined inter alia banking business, enforced compulsory licences and set up a Banking Advisory Committee. Effectively, the Ordinance put in place a dual regulatory approach, one for local banks and one for foreign banks. Around this time the Government began regulating the insurance sector through the enactment of several ordinances.9 By the early 1960s an interest rate war broke out amongst banks which dramatically drove down rates. This triggered an economic boom characterized by an extremely bullish stock market which was succeeded by a liquidity squeeze. Concerned, the Bank of England sent out H.J. Tomkins to issue a report on the Hong Kong banking system and review the Banking Ordinance. In accepting Tomkins’ recommendations, the Hong Kong Government instigated wide-ranging reforms which led to the 1964 subrogation of a new Banking Ordinance. The Ordinance focused on micro-prudential stability, namely: minimum capital requirements, a minimum liquidity ratio and stricter auditing requirements.10 Hong Kong experienced its worst banking crisis in one hundred years when the Ming Tak Bank, Canton Trust and Commercial Bank were declared bankrupt in 1965. Queues started forming outside several other banks that soon developed into runs. With bank runs escalating and the new Banking Ordinance yet to be fully implemented, the Government was forced to introduce emergency bank control regulations. Due to the absence of a central bank and government backed bank notes, Bank of England notes were declared legal tender, and limits were placed on cash withdrawals. HSBC and the Chartered Bank declared support for several banks, and HSBC acted as the lender of last resort. Substantial amendments to the Banking Ordinance were made in the wake of the crisis, namely: regulatory powers were placed under the direct control of the Commissioner of Banking forming the first direct association between regulations and a government designed regulatory structure; the

8 Tushar K. Ghose, The Banking System of Hong Kong (Chai Wan, Hong Kong: Butterworths Asia (Hong Kong), 2nd edn, 1995), p. 76. 9 See Feng Bangyan and Nyaw Mee Kau, Enriching Lives: A History of Insurance in Hong Kong, 1841–2010 (Aberdeen, Hong Kong: Hong Kong University Press, 2010), p. 130. 10 Tushar K. Ghose, The Banking System of Hong Kong (Chai Wan, Hong Kong: Butterworths Asia (Hong Kong), 2nd edn, 1995), pp. 68–70.

Financial regulatory structure in Hong Kong

193

interpretation of liquidity narrowed; minimum banking licence levels were raised; and a ban was placed on the issue of new bank licences.11 Further regulatory flaws were exposed in 1973 when the stock market experienced a spectacular boom and an equally spectacular crash.12 Numerous reforms were prompted by the stock market crash that included the formation of a Securities Commission, the Hong Kong Commodities Exchange – the predecessor to the Hong Kong Futures Exchange Limited – a Commodities Trading Commission and a Stock Exchange Compensation Fund, with the first series of securities ordinances promulgated.13 Establishing the Securities Commission as an additional financial regulator to the Commissioner of Banking sowed the seeds of Hong Kong’s current financial regulatory structural design. The EBA was renamed the Hong Kong Association of Banks (HKAB) in 1980.14 Two years later the Government founded the Insurance Advisory Committee and promulgated the Insurance Companies Ordinance which provided the framework to institute the Insurance Authority.15 The lifting on the moratorium on bank licences in 1978 and the rapid expansion of deposit-taking companies (DTCs) triggered another economic boom. By November 1982 cracks in the rapidly expanding DTC market began to appear. A large DTC, Dollar Credit and Financing, could not meet its liabilities and Chiap Luen Finance came under pressure. To avert a DTCs panic, HSBC and Chartered Bank pledged support for all prudently managed DTCs. Nonetheless six DTCs collapsed before spreading contagion to the banking sector. A run ensued on Hang Lung Bank, which by 1983 was facing severe liquidity constraints. The Legislative Council was forced to nationalize Hang Lung Bank because it believed that there could be systemic repercussions if the bank failed. Within a

11 Frank H.H. King, The History of the Hong Kong and Shanghai Banking Corporation; Volume IV: The Hong Kong Bank in the Period of Development and Nationalism 1841–1984: From Regional Bank to Multinational Group (Cambridge: Cambridge University Press, 1991), pp. 702 and 741; Tushar K. Ghose, The Banking System of Hong Kong (Chai Wan, Hong Kong: Butterworths Asia (Hong Kong), 2nd edn, 1995), pp. 71–76. 12 Frank H.H. King, The History of the Hong Kong and Shanghai Banking Corporation; Volume IV: The Hong Kong Bank in the Period of Development and Nationalism 1841–1984: From Regional Bank to Multinational Group (Cambridge: Cambridge University Press, 1991), p. 741. 13 Douglas W. Arner, Berry F.C. Hsu, Antonio M. Da Roza, Francisco A. Da Roza, Syren Johnstone and Paul Lejot, ‘The Global Financial Crisis and the Future of Financial Regulation in Hong Kong’, (2009) Asian Institute of International Financial Law, AIIFL Working Paper No. 4, 13; Hong Kong Exchanges and Clearing Limited, ‘History of HKEx and its Markets’, available at www.hkex.com.hk/eng/exchange/corpinfo/history/history. htm (visited on 4 July 2011). 14 Hong Kong Association of Banks, ‘Role’, available at www.hkab.org.hk/DisplayArticleAction.do?sid=2&ss=0 (visited on 10 June 2011). 15 Feng Bangyan and Nyaw Mee Kau, Enriching Lives: A History of Insurance in Hong Kong, 1841–2010 (Aberdeen, Hong Kong: Hong Kong University Press, 2010), pp. 133–135.

194

D.W. Arner and E. Gibson

week of Hang Lung getting into difficulty another bank had to undergo financial restructuring. The destabilization of the banking sector from the DTCs crisis once again resurfaced in 1985 when the Legislature called an emergency sitting to nationalize the Overseas Trust Bank, the third largest local bank.16 Two weeks later Ka Wah Bank started to suffer the beginning of a run and Hang Seng took over Wing On Bank after it found itself in financial difficulties. At this time Chartered Bank and Standard Bank merged to become the Standard Chartered Bank.17 By 1986 a major banking crisis erupted. The Government announced that the Union Bank would be placed under the management of Jardine Fleming. After experiencing some financial difficulties, the Far East Bank undertook a restructure. The Commissioner of Banking also took control of the Hong Nin Bank. As in the early 1960s, the Bank of England sent out an advisor with the brief to review the banking regulations. This led to the promulgation of the current Banking Ordinance (Cap 155) in 1986. Among other things the Banking Ordinance legislated: the merger of the Commissioner of DTCs and Commissioner of Banking; the introduction of a capital adequacy ratio in the context of risky assets; and new liquidity requirements.18 Merging the two Commissioners into one agency transformed the then strict legal entity oversight into one of banking sector oversight with institutional limitations pertaining to explicit banking and banking-like activities. This merger also propagated the regulatory structural design blueprint, in a basic form, of the yet to be established HKMA. At this time the Stock Exchange of Hong Kong Limited (SEHK) was formed and the Hong Kong Commodities Exchange was renamed the Hong Kong Futures Exchange (HKFE).19 9.2.4 1987–2008 On 20 October 1987, in the wake of the stock market crash on Wall Street, the Chairman of the SEHK informed the Financial Secretary of his intention to suspend trading. When the markets reopened on 26 October, the Hang Seng Index fell 33 per cent. Addressing the incident the Security

16 Hong Kong Monetary Authority, Money and Banking in Hong Kong (Hong Kong: Press & Publications Section, Hong Kong Monetary Authority, 1995), p. 17. 17 Tushar K. Ghose, The Banking System of Hong Kong (Chai Wan, Hong Kong: Butterworths Asia (Hong Kong), 2nd edn, 1995), pp. 3, 92–94. 18 Ibid., pp. 80–97. 19 Hong Kong Exchanges and Clearing Limited, ‘History of HKEx and its Markets’, available at www.hkex.com.hk/eng/exchange/corpinfo/history/history.htm (visited on 4 July 2011).

Financial regulatory structure in Hong Kong

195

20

Review Committee handed down the Davidson Report. Recommendations in the Davidson Report prompted a complete reform of the SEHK.21 These reforms would serve as a blueprint for the modernization of the securities sector to international standards throughout the late 1980s and 1990s.22 One of the principal recommendations of the Davidson Report was to draft a new securities ordinance. The first Securities and Futures Commission Ordinance (Cap 24) was promulgated in 1989, establishing an independent securities and futures regulator – the Securities and Futures Commission (SFC) – and incorporated the Hong Kong Securities Clearing Company Limited.23 The Hong Kong Federation of Insurers and the Office of Commission of Insurance (OCI) were founded in 1988 and 1992 respectively.24 Legislative reforms in 1990 which categorized licenced DTCs as restricted licenced banks further reinforced banking and banking-like activity oversight in Hong Kong. The next year the Bank of Credit and Commercial International (BCCI) collapsed after a major international scandal. BCCI’s Hong Kong subsidiary, BCCHK, was initially allowed to stay open after the Banking Commissioner had declared the bank was solvent, based upon receiving a letter of comfort from the Abu Dubai Government. Later the same day the Abu Dubai Government refused to put up further capital. Because BCCHK was not considered systemically important the Banking Commissioner was forced to close it down. Consequently a run on four other banks ensued, including Standard Chartered Bank and Citibank, with the Hang Seng Index dropping sharply.25 The fallout from the BCCI incident prompted Hong Kong to institutionalize its first government designed central bank, the Hong Kong Monetary Authority, on 1 April 1993.26 As an independent authority, the

20 Securities and Futures Commission, ‘Establishment of the Securities and Futures Commission – the Davidson Report’ (27 May 1988), pp. 28–32, available at www.sfc.hk/sfc/ doc/EN/aboutsfc/background/chapter2.pdf (visited on 15 June 2011). 21 Douglas W. Arner, Berry F.C. Hsu and Antonio M. Da Roza, ‘Financial Regulation in Hong Kong: Time for a Change’ (2010) 5 Asian Journal of Comparative Law 1, 4. 22 Berry Fong-Chung Hsu, Douglas W. Arner, Maurice Kwok-Sang Tse and Syren Johnstone, Financial Markets in Hong Kong: Law and Practice (Oxford: Oxford University Press, 2006). 23 Hong Kong Exchanges and Clearing Limited, ‘History of HKEx and its Markets’, available at www.hkex.com.hk/eng/exchange/corpinfo/history/history.htm (visited on 4 July 2011). 24 Hong Kong Federation of Insurers, ‘About the HKFI’, available at www.hkfi.org.hk/en_ about.htm (visited on 20 July 2011). 25 Tushar K. Ghose, The Banking System of Hong Kong (Chai Wan, Hong Kong: Butterworths Asia (Hong Kong), 2nd edn, 1995), pp. 61, 98–100. 26 Douglas W. Arner, Berry F.C. Hsu, Antonio M. Da Roza, Francisco A. Da Roza, Syren Johnstone and Paul Lejot, ‘The Global Financial Crisis and the Future of Financial Regulation in Hong Kong’ (2009) Asian Institute of International Financial Law, AIIFL Working Paper No. 4, 23.

196

D.W. Arner and E. Gibson

HKMA was created in accordance with the Exchange Fund Ordinance from the merger of the Office of Exchange Fund with the Office of the Commissioner of Banking, the then banking supervisor.27 This merger conferred the dual role of de facto central bank and banking regulator on the HKMA. On 1 July 1997 Hong Kong reverted to the Peoples’ Republic of China (PRC). The Asian Financial Crisis reached Hong Kong later that year. After some initial financial instability, short positions were taken on the Hong Kong dollar. To discourage speculation the HKMA stated that banks should not depend on the Liquidity Adjustment Facility and that penal rates might be imposed.28 This regulatory intervention caused an acute interbank liquidity shortage. Banks were forced to buy Hong Kong dollars to hedge against soaring interest rates. The following year Hong Kong entered its worst recession since 1965. Speculators took short positions on the stock index futures market, having primed themselves with large holdings of Hong Kong dollars. A coordinated attack of selling Hong Kong dollars was launched with the intention of pushing up interest rates and sending the Hang Seng Index into free fall. The HKMA intervened by buying HK$118 billion worth of stocks which stabilized the stock market.29 Effects from the Asian Financial Crisis were also felt in the insurance sector where premium revenues and profits dropped precipitously.30 That year the Mandatory Provident Fund Schemes Authority (MPFA) was established. The Hong Kong Exchanges and Clearing Limited (HKEx) listed as a company on its own stock market in June 2000. On 25 July 2002, the HKEx released a consultation paper proposing reforms to the Listing Rules. Proposed reforms were to consolidate listed companies’ shares quoted at less than HK$0.50, failing which, they should be delisted. A day later the market shed HK$10.91 billion which would become known as the ‘Penny Stocks’ incident. Angry investors demanded compensation. Pressured, the HKEx announced a withdrawal of the proposals which had the effect of stabilising markets. An independent panel was appointed to investigate the incident and report their findings. The Kotewall Report recommended a review of the three-tier listing arrangement between the 27 Hong Kong Monetary Authority, ‘About the HKMA’, available at www.info.gov.hk/hkma/ eng/hkma/index.htm (visited on 4 June 2011). 28 Hong Kong Monetary Authority, ‘HKMA’s Statement on Liquidity Adjustment Facility’ (23 October 1997) Press Release, available at www.info.gov.hk.hkma/eng/press/index. htm (visited on 15 July 2011). 29 Andrew Sheng, From Asian to Global Financial Crisis: An Asian Regulator’s View of Unfettered Finance in the 1990’s and 2000’s (Cambridge: Cambridge University Press, 2009), pp. 263–273. 30 Berry Fong-Chung Hsu, Douglas W. Arner, Maurice Kwok-Sang Tse and Syren Johnstone, Financial Markets in Hong Kong: Law and Practice (Oxford: Oxford University Press, 2006), p. 181.

Financial regulatory structure in Hong Kong

197

31

Government, SFC and HKEx. This prompted another report in 2003, the Expert Group Report, which reviewed the regulatory structure.32 That year the current Securities and Futures Ordinance (Cap 571) (SFO) was enacted, consolidating ten existing ordinances.33 The consolidation was symbolic in reinforcing the SFC’s current securities sector oversight. In July 2008 the HKMA released the Carse Review which focused on banking stability. Recommendations included reviewing deposit protection arrangements and the financial regulatory structure. The Carse Review correctly predicted that the lessons learned from the Global Financial Crisis (GFC) would be a priority over the next few years but did not envisage the extent of the fallout. Hong Kong suffered four high-profile incidents from Lehman Brothers’ bankruptcy on 15 September 2008. These incidents were sourced directly from Lehman Brothers’ failure. The highest profile incident was the Lehman’s Minibond collapse, seconded by the run on the Bank of East Asia. AIA, AIG’s Hong Kong insurance subsidiary, was subject to a minor rush by policy holders and CITIC Pacific suffered a significant loss after investing in derivatives. In response to the Lehman Minibonds incident both the HKMA and SFC issued separate reports. All four GFC incidents will be discussed in more detail later in this chapter.

9.3 Regulatory structural themes 9.3.1 British period From the discussion of Hong Kong’s historical financial development one can ascertain that banking and securities regulation developed ad hoc in response to financial crises and British intervention. The post war financial crises of 1965 (banking), 1973 (securities), 1982 (DTCs), 1986 (banking), 1987 (securities) and 1991 (BCCI) were typically denoted by reactive legislative and structural reforms. When regulatory reforms preempted crises, such as in 1965 and 1982, they were largely ineffective at stabilising markets because economic bubbles had already began to destabilize these sectors. The most significant British era structural reforms were the establishment of the SFC, from the recommendation of the Davidson Report in 31 Robert G. Kotewall and Gordon C.K. Kwong, ‘Report of the Panel of Inquiry on the Penny Stocks Incident’ (September 2002), available at www.info.gov.hk/info/pennystocke.htm (visited on 15 May 2011). 32 The Expert Group to Review the Operation of the Securities and Markets Regulatory Structure, ‘Report by the Expert Group to Review the Operation of the Securities and Futures Market Regulatory Structure’ (March 2003), available at www.info.gov.hk/info/ expert/expertreport-e.htm (visited on 15 May 2011). 33 Financial Services and Treasury Bureau, ‘Hong Kong: The Facts’ (October 2010), 2, available at www.fstb.gov.hk (visited on 23 May 2011).

198

D.W. Arner and E. Gibson

response to the 1987 stock market crisis, and the HKMA after the BCCI collapse. 9.3.2 Post-1997 9.3.2.1 Legal structure Upon Hong Kong’s reversion in 1997, the PRC designated Hong Kong as a Special Administrative Region (SAR) and enacted the Basic Law as the region’s de facto constitutional document. Article 8 of the Basic Law guided the legal transition by providing: The laws previously in force in Hong Kong, that is, the common law, rules of equity, ordinances, subordinate legislation and customary law shall be maintained, except for any that contravene this Law, and subject to any amendment by the legislature of the Hong Kong Special Administrative Region. In effect Article 8 instituted and detailed the ‘One Country, Two Systems’ policy, with Article 5 reinforcing and maintaining Hong Kong’s autonomous capitalist system until 1 July 2047. Hong Kong’s capitalist system is dominated by the financial sector. The Basic Law obliges the Government to maintain and enhance Hong Kong’s financial system. This obligation is clearly expressed under Article 109: The Government of the Hong Kong Special Administrative Region shall provide an appropriate economic and legal environment for the maintenance and status of Hong Kong as an international financial centre. Article 109 refers to ‘an appropriate economic and legal environment’. For the Government to accommodate the appropriate legal and economic environment in the context of financial regulation and supervision, Article 110 of the Basic Law stipulates that: The Government of the Hong Kong Special Administrative Region shall, on its own, formulate monetary and financial policies, safeguard the free operation of business and financial markets, and regulate and supervise them in accordance with law. When reading Articles 109 and 110 together, the appropriate legal and economic environment to maintain Hong Kong’s status as an international financial centre is to be safeguarded by regulation and supervision in accordance with the law. The legal requirement of Article 110 is underpinned by Article 73(1) which permits the Legislative Council to enact

Financial regulatory structure in Hong Kong

199

laws and specifically ordinances. The responsibility for supervising compliance with an ordinance, in relation to the financial system, is conferred on a designated financial regulator by the ordinance in question. Ordinances may also prescribe the power to issue, or delegate, subordinatelegislation such as rules, codes and guidelines on the respective regulator or self-regulatory organization. Rules will only have statutory force if explicitly backed by ordinance and are not qualified by statutory exclusion. Generally codes and guidelines do not have legislative backing and therefore do not have the force of law. Enforcement may, however, be a prerequisite of an authorization, licensing or registration regime that has the force of law. Judicial precedent transplanted with the British common law serves most aspects of financial laws. However, precedent from all common law jurisdictions including the United Kingdom carry only persuasive weight and are not legally binding.34 9.3.2.2 Regulatory themes Hong Kong’s current regulatory structure has worked well when a regulatory incident falls neatly within a designated regulatory jurisdiction pertaining to a regulator. Since 1997 regulatory reforms have tended to be ad hoc responses to regulatory failures. Significant structural reforms have not been forthcoming despite recommendations to the contrary. During this period there have been two prominent reports, a review and two very significant financial crises, the Asian Financial Crisis and the GFC. The HKMA’s intervention during the Asian Financial Crisis was significant as it was the first major intervention by a macro-prudential regulator in Hong Kong to stabilize financial markets. In the aftermath of the Penny Stocks incident, the Kotewall Report recommended a review of the regulatory structure and the exact roles of the SFC and HKEx overseeing listing matters.35 The subsequent Expert Group Report exposed gaps and overlaps in the regulatory structure from the roles of the SFC and HKEx.36 However, the recommended structural reforms from both Reports were not instigated. Focusing solely on Hong Kong’s banking sector, the Carse Review found that there were no fundamental deficiencies in the regulatory and supervisory framework. Although regulatory structural reform was beyond

34 Article 84, Basic Law. 35 Robert G. Kotewall and Gordon C.K. Kwong, ‘Report of the Panel of Inquiry on the Penny Stocks Incident’ (September 2002), available at www.info.gov.hk/info/pennystocke.htm (visited on 15 May 2011). 36 The Expert Group to Review the Operation of the Securities and Markets Regulatory Structure, ‘Report by the Expert Group to Review the Operation of the Securities and Futures Market Regulatory Structure’ (March 2003), available at www.info.gov.hk/info/ expert/expertreport-e.htm (visited on 15 May 2011).

200

D.W. Arner and E. Gibson

the remit of the review, David Carse did address the issue of whether Hong Kong SAR should consider structural reform. Carse stated that the advantages were unclear and questioned whether such a radical change to the existing structure could be justified. However, Carse clearly expressed his doubt that the HKMA would be able to appreciate all the activities that banks engaged in, and particularly those activities that fell outside the traditional bank model.37 The HKMA’s structure with its banking sectoral regulatory limitations was an issue of concern for Carse. Before analysing the financial regulatory structural impacts of the GFC, Hong Kong’s regulatory structure will be examined in detail.

9.4 Financial regulatory structure 9.4.1 Three tiered framework Hong Kong’s financial regulatory structure is executed through a three tiered framework. Fundamentally the relevant stages of responsibility are designated through a hierarchy with the Government at the apex above the regulators. At the bottom of the hierarchy, self-regulatory organizations are positioned below the regulators. 9.4.1.1 The first tier: the Government The first tier embodies the Government which has the primary responsibility of formulating and interpreting policy and enacting legislation. Formulating policy is the responsibility of the Financial Secretary, with implementation and interpretation being the responsibility of the Financial Services and Treasury Bureau (FSTB). In this context the Government is a facilitator and coordinator and not a regulator per se because it does not get involved in day-to-day regulatory functions. The Government will only intervene in markets under extraordinary circumstances to safeguard the public interest, such as when there are serious threats to financial stability which require a coordinated response with the regulators. 9.4.1.2 The second tier: the regulators The second tier embodies the specialist regulatory agencies that are effectively the market watchdogs involved in day-to-day regulatory functions. Regulators are primarily responsible for regulation and supervision of a financial regulatory jurisdiction pursuant to ordinance. The financial

37 David T.R. Carse, ‘Review of the Hong Kong Monetary Authority’s Work on Banking Stability’ (July 2008), 15–16, available at www.info.gov.hk/hkma/eng/public/rwbs/ david%20carse%20report.pdf (visited on 23 February 2011).

Financial regulatory structure in Hong Kong

201

regulatory scope of the regulators within the structure will be discussed in more detail below. 9.4.1.3 The third tier: self-regulatory organizations Self-regulatory organizations (SROs) are responsible to promote the interests and facilitate regulatory oversight of their members. Regulatory oversight of SROs is subject to the overarching supervision of the second tier, the regulators, pursuant to ordinance. The financial regulatory scope of the pertinent SROs will be discussed in more detail below. 9.4.2 Regulatory agencies, organizations and bodies This section will provide a detailed overview of Hong Kong’s financial regulatory structure focusing on the second (regulators) and third tiers (SROs) of the three tiered framework. An examination of regulatory agencies and organizations will include the central bank, banking, securities and futures, insurance, mandatory provident fund scheme regulators, and related regulatory organizations. 9.4.2.1 The central bank function: monetary policy Monetary policy objectives are determined by the Financial Secretary.38 Hong Kong’s de facto central bank is the Hong Kong Monetary Authority (HKMA). The ‘de facto’ central bank description is termed because there is no specific legislation that legally confers the role of central bank or traditional monetary policy on the HKMA. Further, the Linked Exchange Rate system precludes the HKMA from having absolute control over Hong Kong’s monetary supply. Most bank notes are issued by three privatesector note-issuing banks.39 The HKMA is responsible for the operation of a Linked Exchange Rate system which maintains currency stability, an element of Hong Kong’s financial stability. This is complemented by an automatic interest rate adjustment mechanism which ties Hong Kong’s interest rates to the United States’ interest rates in the longer term. Hong Kong’s currency stability is defined as a stable external exchange value of the Hong Kong dollar in terms of its exchange rate with the United States dollar.40 The monetary base to back the Linked Exchange Rate system is provided by the Exchange Fund, which is controlled by the HKMA in accordance with the Exchange Fund Ordinance 38 Articles 106 to 113, Basic Law. 39 HSBC, Bank of China (Hong Kong) and Standard Chartered issue bank notes under powers devolved by the Legal Tender Notes Issue Ordinance (Cap 65). The Government issues polymer ten-dollar notes and Hong Kong coinage. 40 Approximately HK$7.8 to one United States dollar.

202

D.W. Arner and E. Gibson

(Cap 66).41 Therefore the HKMA’s ability to maintain financial stability through monetary policy is constrained by the Linked Exchange Rate system and the automatic interest rate adjustment mechanism. 9.4.2.2 Banking H O N G K O N G M O NETARY AUTHORITY

Regulation of the banking industry is conferred on the HKMA under the Banking Ordinance (Cap 155). The HKMA is responsible for compliance with the Ordinance’s provisions42 and upholding the principal function: ‘. . . to promote the general stability and effective working of the banking system’43; through a risk-based approach concentrating on a policy of continuous supervision. Hong Kong’s banking system is characterized by three tiers of deposittaking institutions: licensed banks; restricted licensed banks; and deposittaking companies; collectively known as Authorized Institutions (AIs).44 All AIs are required to be licensed. The HKMA also acts as the front-line regulator of AIs that deal in securities,45 derivatives, insurance subsidiaries of AIs46 and banks engaged in selling Mandatory Provident Funds.47 Hence, Hong Kong banks are regulated as universal banks because they offer not only banking products and services but also equities, insurance, derivatives and pension fund products and services. Money lenders that are not classified as AIs are not regulated by the HKMA but are nonetheless required to be licensed in accordance with the Money Lenders Ordinance (Cap 163). H O N G K O N G DE P OS IT PROTEC TION B OARD

The Hong Kong Deposit Protection Board (HKDPB) was established in 2004 as an independent statutory body that maintains the Deposit 41 42 43 44

ss3(1) and 5A, Exchange Fund Ordinance (Cap 66). s7(2)(a), Banking Ordinance (Cap 155). s7(1), Banking Ordinance (Cap 155). Hong Kong Monetary Authority, ‘The Three Tier Banking System’, available at www. hkma.gov.hk/eng/key-functions//banking-stability/banking-policy-and-supervisory/ three-tier-banking-system.shtml (visited on 18 January 2012). 45 David T.R. Carse, ‘Review of the Hong Kong Monetary Authority’s Work on Banking Stability’ (July 2008), 13, available at www.info.gov.hk/hkma/eng/public/rwbs/david%20 carse%20report.pdf (visited on 23 February 2011): see Securities and Futures Ordinance (Cap 571). 46 Hong Kong SAR Government, ‘Memorandum of Understanding Between the Monetary Authority and the Insurance Authority’ (September 2003), 2–3, available at www.info.gov. hk/hkma/eng/bank/sup_coop/HKMA-IA_MOU.pdf (visited on 22 July 2011). 47 Mandatory Provident Fund Schemes Authority, ‘Memorandum of Understanding Concerning the Regulation of MPF Intermediaries’ (January 2004), 5, available at www.mpfa. org.hk/english/leg_reg_mous/files/mou_int.pdf (visited on 20 July 2011).

Financial regulatory structure in Hong Kong

203

Protection Scheme (DPS). Both the HKDPB and the DPS are created under the Deposit Protection Scheme Ordinance (Cap 581). The primary objective of the DPS is to provide a measure of protection to depositors and contribute to banking system stability by providing compensation from the DPS to depositors. All authorized banks are required to participate in the DPS which offers a protection limit of HK$500,000 for each depositor per member bank unless otherwise exempt by the HKDPB.48 H O N G K O N G AS S OC IATION OF B AN KS

The Hong Kong Association of Banks (HKAB) is an SRO subject to the Hong Kong Association of Banks Ordinance (Cap 364). Rules for the conduct of banking business are formulated by the HKAB in consultation with the Financial Secretary. The HKAB also consults with the Government on law reform, new legislation and regulatory matters.49 Endorsed by the HKMA, a Code of Banking Practice is issued by the HKAB and the Deposit-taking Companies Association which promotes consumer protection in the banking sector. Although the Code of Banking Practice is voluntary, all AIs are expected to comply.50 9.4.2.3 Securities and futures S E CU R I TI E S AN D FUTURES C OMM IS S ION

The Securities and Futures Commission (SFC) is an independent statutory body that regulates the securities and futures markets in accordance with the Securities and Futures Ordinance (Cap 571) (SFO).51 The SFC’s six regulatory objectives are: to maintain and promote the fairness, efficiency, competitiveness, transparency and orderliness; promote public understanding; protect the investing public; minimize crime and misconduct; reduce systemic risks; and to assist the Financial Secretary in maintaining financial stability.52 Intermediaries are regulated by the SFC to: ensure

48 Hong Kong Deposit Protection Board, ‘Home’, available at www.dps.org.hk/en/home. html (visited on 20 July 2011). 49 Hong Kong Association of Banks, ‘Role’, available at www.hkab.org.hk/DisplayArticleAction.do?sid=2&ss=0 (visited on 10 June 2011). 50 Hong Kong Association of Banks, ‘Code of Banking Practice’, available at www.hkab.org. hk/Display/ArticleAction.do?sid=5&ss=3 (visited on 10 June 2011). 51 s3, Securities and Futures Ordinance (Cap 571); Securities and Futures Commission, ‘About the SFC, Our Role’, available at www.sfc.hk/sfc/html/EN/about-the-sfc/our-role/ (last visited on 28 August 2013). 52 s4, Securities and Futures Ordinance (Cap 571).

204

D.W. Arner and E. Gibson

compliance with relevant laws and statutes; investigate breaches and misconduct; and take enforcement and disciplinary actions.53 The SFC performs the two key functional roles of being a gatekeeper in respect of entry requirements for intermediaries and the prudential regulator.54 These two key functional roles are enforced by the SFC granting licences to Licensed Corporations (LCs) to carry out regulated activities. Each licence specifies which of the current ten regulated activities can be performed.55 Listed companies and listing applicants are bound to public disclosure, regulated by the SFC, in accordance with the Securities and Futures (Stock Market Listing) Rules (Cap 571V) (Listing Rules) and the SFO. A number of market participants which are outside the institutional demarcation of the securities and futures industry are nonetheless within the SFC’s regulatory jurisdiction. Banks carrying on regulated activities are required to be registered with the SFC.56 Insurance companies engaging in SFO regulated activities57 and Mandatory Provident Funds who advise on securities are also regulated by the SFC. H O N G K O N G E X CHAN GES AN D C LEARIN G LIM ITED

The Hong Kong Exchanges and Clearing Limited (HKEx) is an independent statutory body and recognized exchange controller whose powers are vested from the SFO. Hong Kong’s securities and futures exchanges and related clearing houses are owned and operated by HKEx which is listed on the Main Board of the Stock Exchange of Hong Kong Limited (SEHK).58 The SEHK, the Hong Kong Futures Exchange Limited (HKFE) and the Clearing Houses are wholly owned subsidiaries of the HKEx.59 There are three recognized clearing houses in operation: Hong Kong Securities Clearing Company Limited; HKFE Clearing Company Limited;

53 Securities and Futures Commission, ‘Regulatory Framework for Intermediaries’ (June 2011), 3–6, available at www.sfc.hk/sfc/doc/EN/aboutsfc/Regulatoryframework.pdf (visited on 10 March 2012). 54 Douglas W. Arner, Berry F.C. Hsu, Antonio M. Da Roza, Francisco A. Da Roza, Syren Johnstone and Paul Lejot, ‘The Global Financial Crisis and the Future of Financial Regulation in Hong Kong’ (2009) Asian Institute of International Financial Law, AIIFL Working Paper No. 4, 14. 55 s116, Securities and Futures Ordinance (Cap 571). 56 Mandatory Provident Fund Schemes Authority, ‘Memorandum of Understanding Concerning the Regulation of MPF Intermediaries’ (January 2004), 7, available at www.mpfa. org.hk/english/leg_reg_mous/files/mou_int.pdf (visited on 20 July 2011). 57 s5(1)(b)(i), Securities and Futures Ordinance (Cap 571). 58 Hong Kong Exchanges and Clearing Limited, ‘Introduction to Regulatory Framework’, available at www.hkex.com.hk/eng/rulesreg/regintro/introreg.htm (visited on 29 August 2013). 59 Hong Kong Exchanges and Clearing Limited, ‘Outline of the Current Roles of the Exchange and the SFC in Listing Regulations’, available at www.hkex.com.hk/eng/rulesreg/regdoc/hkexrole.htm (visited on 29 August 2013).

Financial regulatory structure in Hong Kong

205

and the SEHK Options Clearing House Limited; that are subsidiaries of the HKEx, HKFE and SEHK respectively.60 Each of the three recognized Clearing House issues their own set of rules and operating procedures which are binding on all market participants under the SFO.61 In 2013 a new central counterparty clearing house, OTC Clear, was established for over-the-counter derivatives including RMB-denominated products. The SFC supervises, monitors and regulates the activities of the HKEx, the Exchanges and the Clearing Houses.62 Each body has a public duty to ensure orderly and fair markets and that risks are managed prudently consistent with the public interest. Listed companies and companies seeking an initial public listing on the SEHK are primarily regulated and supervised by the HKEx63 in conjunction with the SFC’s public disclosure requirements, creating a dual-filing regime. 9.4.2.3 Insurance O F F I CE O F CO M M IS S ION OF IN S URAN C E

Hong Kong’s insurance sector is regulated by the current insurance authority, Office of Commission of Insurance (OCI), a statutory body empowered by the Insurance Companies Ordinance (Cap 41) (IO). Under the IO the principal function of the OCI is to: . . . regulate and supervise the insurance industry for the promotion of the general stability of the insurance industry and for the protection of existing and potential policy holders.64 The OCI’s regulatory jurisdiction extends outside the traditional insurance institutional demarcation by including Mandatory Provident Funds’ insurance activities. However, the HKMA regulates insurance subsidiaries of AIs,65 and securities activities of insurance companies generally fall within the regulatory jurisdiction of the SFC.

60 61 62 63

Ibid.. s5, Securities and Futures Ordinance (Cap 571). s5(1)(b)(i), Securities and Futures Ordinance (Cap 571). Hong Kong Exchanges and Clearing Limited, ‘Outline of the Current Roles of the Exchange and the SFC in Listing Regulations’ (March 2005), available at www.hkex.com. hk/eng/rulesreg/regdoc/hkexrole.htm (visited on 29 August 2013). 64 s4A(1), Insurance Companies Ordinance (Cap 41). 65 Hong Kong SAR Government, ‘Memorandum of Understanding Between the Monetary Authority and the Insurance Authority’ (September 2003), 2–3 and 6, available at www. info.gov.hk/hkma/eng/bank/sup_coop/HKMA-IA_MOU.pdf (visited on 29 August 2013).

206

D.W. Arner and E. Gibson

PR O P O S E D I N DE P EN DEN T IN S URAN C E AUTHORITY

Depending on the progress of legislation, the current OCI will be replaced with a new Independent Insurance Authority (IIA) in 2015.66 Principal functions of the OCI will be carried over to the new IIA. The new IIA is intended to enhance regulation of insurance companies, insurance intermediaries and reinforce Hong Kong’s position as an international financial centre. Specific functions of the insurance authority have recently been amended to synchronize with the expanded regulatory and supervisory ambit of the new IIA.67 Additional functions of the IIA include: directly regulating the conduct of insurance intermediaries; to organize public education programmes; to conduct thematic researches and studies concerning the industry; and to assist the Financial Secretary in maintaining the financial stability of Hong Kong. Insurance intermediaries will come under the regulatory ambit of the insurance authority for the first time68 through a licensing regime. Three SROs will be superseded by the IIA: Hong Kong Confederation of Insurance Brokers, the Professional Insurance Brokers Association and the Insurance Agents Registration Board. The OCI’s regulatory jurisdiction extending over Mandatory Provident Funds’ insurance activities will be carried over. Both the proposed IIA and the HKMA will carry out joint supervision of banks’ insurance intermediary activities with the proposed IIA being the primary and lead supervisor.69 T H E H O N G KO N G FEDERATION OF IN S URERS

The Hong Kong Federation of Insurers (HKFI) is an SRO nongovernmental body70 that will contribute to the industry by representing members’ interests, continual professional development programmes, training courses, road shows and trade promotions.

66 Financial Services Branch, Financial Services and Treasury Branch, ‘Key Legislative Proposals on the Establishment of the Independent Insurance Authority’ (26 October 2012), 13, available at wwwfstb.gov.hk/fsb/ppr/consult/doc/iiakeylegislation_faq_e.pdf (visited on 29 August 2013). 67 See: s4A, Insurance Companies Ordinance (Cap 41). 68 Financial Services Branch, Financial Services and Treasury Bureau, ‘Proposed Establishment of an Independent Insurance Authority Consultation Conclusions and Detailed Proposals’ (June 2011), 2–3, available at www.fstb.gov.hk/fsb/ppr/consult/doc/iia_ concul_proposals_e.pdf (visited on 30 June 2011). 69 Financial Services Branch, Financial Services and Treasury Branch, ‘Key Legislative Proposals on the Establishment of the Independent Insurance Authority’ (26 October 2012), 9–10, available at wwwfstb.gov.hk/fsb/ppr/consult/doc/iiakeylegislation_faq_e.pdf (visited on 29 August 2013). 70 Authorized under the: Insurance Companies Ordinance (Cap 41).

Financial regulatory structure in Hong Kong

207

9.4.2.4 Mandatory Provident Fund Schemes Authority As a statutory body, the Mandatory Provident Fund Schemes Authority (MPFA) regulates, supervises and monitors Hong Kong SAR’s retirement pension sector.71 The two principal ordinances that the MPFA is responsible for are: Mandatory Provident Fund Schemes Ordinance (Cap 485) (MPFSO); and Occupational Retirement Schemes Ordinance (Cap 426). Functions of the MPFA under the MPFSO are to, inter alia: ensure compliance with the MPFSO; register provident fund schemes; approve trustees of registered schemes; regulate approved trustees; make rules and guidelines for the payment of mandatory contributions; and consider and propose law reforms.72 Mandatory Provident Funds are regulated by the HKMA, SFC and OCI which fall within their respective regulatory jurisdictions.73 9.4.3 Financial regulatory structure: themes The HKMA’s regulatory jurisdiction reflects the universal-banking business model that is commonplace in Hong Kong. This regulatory jurisdiction covers the operational scope of statutorily defined AIs across all activities and financial sectors. Therefore the HKMA’s regulatory jurisdiction, which is mirrored by the HKAB, can be described as institutionally based with a cross-sectoral characteristic. A pure institutional jurisdiction pertaining to commercial banking distinguishes the HKDPB’s regulatory scope. The SFC’s licensing and registration regime facilitates a crossinstitutional focus on the securities and futures sector. This regulatory jurisdiction, which is conceptually adopted by the HKEx, can be described as sectoral based with a cross-institutional characteristic or more precisely ‘sectoral’ as the cross-institutional characteristic is a given. The OCI and new IIA have a similar regulatory jurisdictional structure to the SFC, The MPFA has a sectoral regulatory jurisdiction that is institutionally restricted to schemes that are not regulated by the HKMA, SFC or OCI. Therefore the HKMA is unique amongst Hong Kong’s financial regulators because it operates an institutionally based cross-sectoral regulatory jurisdiction whereas the others operate within sectoral regulatory jurisdictions qualified by statutory institutional exclusions. Managing the frictions and regulatory gaps between regulatory jurisdictions is delegated to Committees and subject to Memorandums of Understanding.

71 Douglas Arner and Jan-juy Lin (eds), Financial Regulation: A Guide to Structural Reform (Hong Kong: Sweet & Maxwell Asia, 2003), 388: Alexa Lam, ‘Regulation by Multiple Authorities: The Hong Kong Experience’, a presentation at the conference. 72 s6E, Mandatory Provident Fund Schemes Ordinance (Cap 485). 73 Berry Fong-Chung Hsu, Douglas W. Arner, Maurice Kwok-Sang Tse and Syren Johnstone, Financial Markets in Hong Kong: Law and Practice (Oxford: Oxford University Press, 2006), p. 81.

208

D.W. Arner and E. Gibson

9.4.4 Regulatory cooperation and coordination 9.4.4.1 Cross-Market Surveillance Committee In 1998 the Cross-Market Surveillance Committee (CMSC) was established. The CMSC is composed of representatives from the FSTB, HKMA, SFC, HKEx, OCI and MPFA. Representatives of the CMSC participate in exchanging information, formulating prompt and appropriate actions where necessary, and facilitating supervision of financial groups.74 In 2003 the CMSC was structurally reorganized into the Council of Financial Regulators (CFR) and the Financial Stability Committee (FSC). C O U N CI L O F F I N A N C IAL REGULATORS

Constituting the CFR are representatives from the HKMA, SFC, OCI, MPFA, FSTB, with the Financial Secretary being the Chair.75 The CFR’s objectives are to contribute to the efficiency and effectiveness of regulations, the supervision of financial institutions, the promotion and development of financial markets and the maintenance of financial stability. At a fundamental level, the CFR facilitates cooperation and coordination amongst regulators. The CFR focuses on cross-sectoral regulation and minimising regulatory gaps and duplication relating to micro-prudential supervision.76 F I N A N CI AL S TAB I LITY C OM M ITTEE

Members of the FSC comprise representatives from HKMA, SFC, OCI, with the FSTB Financial Secretary being the Chair. Responsibilities include monitoring the functioning of the financial system and any events or developments with cross-sectoral and systemic implications. The FSC coordinates responses to issues, events and developments that have possible systemic and cross-market impacts that can impact macro-prudential stability.77

74 Douglas W. Arner, Berry F.C. Hsu and Antonio M. Da Roza, ‘Financial Regulation in Hong Kong: Time for a Change’ (2010) 5 Asian Journal of Comparative Law 1, 6. 75 Ibid. 76 Hong Kong Monetary Authority, ‘Mandate and Governance of the Hong Kong Monetary Authority’ (2003), 80–82, available at www.info.gov.hk/hkma/eng/public/bg_brief_3/E_ Section3.pdf (visited on 4 June 2011). 77 Financial Secretary, ‘Council of Financial Regulators: Terms of Reference’ (2006), available at www.fso.gov.hk/pdf/CFR-TOR%20_Sep06_.pdf (visited on 4 June 2011); Hong Kong Monetary Authority, ‘Mandate and Governance of the Hong Kong Monetary Authority’ (2003), 80, available at www.info.gov.hk/hkma/eng/public/bg_brief_3/E_ Section3.pdf (visited on 4 June 2011).

Financial regulatory structure in Hong Kong

209

9.4.4.2 Memorandums of understanding Regulatory cooperation and coordination is supplemented by a framework of predominantly bilateral memorandums of understanding (MoUs) between the HKMA, SFC, OCI, MPFA, and subordinately between these primary regulators and the HKEx, SEHK, Hong Kong Exchanges and Clearing Limited, Hong Kong Deposit Protection Board, Financial Reporting Council, SROs, Financial Dispute Resolution Centre, Hong Kong Institute of Certified Public Accountants and Investor Compensation Company Limited. In 2003 the Financial Secretary stated that the MoUs set an operational framework for cooperation, further delineate regulatory roles and responsibilities, and set out lines of communication and coordination.78 Therefore the MoUs’ objective is to enhance cross-sectoral cooperation and coordination. 9.4.5 Regulatory cooperation and coordination: structural issues Hong Kong’s CMSC and MoUs endeavour to bridge the cross-sectoral gaps emanating from the securities, futures and insurances sectors and the broader cross-institutional gaps emanating from the banking sector. Part of the process of bridging these regulatory gaps is to minimize jurisdictional frictions through cooperation, coordination and delineated regulatory roles and responsibilities. However, the primary function of minimising jurisdictional frictions is to address the overlaps from the HKMA’s cross-sectoral regulatory jurisdiction and the other regulators’ cross-institutional jurisdictions. Problematically, the mere existence of the CSMC and the extensive framework of MoUs is testimony to the many regulatory gaps, overlaps and frictions pertaining to not only the roles and regulatory jurisdictions of the HKMA, SFC, OCI and MPFA, but also the regulatory structure more generally. The CMSC’s cooperation and coordination arrangements in conjunction with the extensive framework of MoUs and the segregated regulatory jurisdictions manifest an overtly complex structure that may in fact confuse rather than delineate the roles and responsibilities of the regulators. These issues were first raised in the 2003 IMF Report. 9.4.6 2003 IMF report Following the Asian Financial Crisis the IMF and the World Bank launched a Financial System Stability Assessment of member countries. Hong Kong was reviewed in 2003, with the IMF finding that the regulatory and legal structures were generally appropriate. From a structural supervisory 78 Douglas W. Arner, Berry F.C. Hsu and Antonio M. Da Roza, ‘Financial Regulation in Hong Kong: Time for a Change’ (2010) 5 Asian Journal of Comparative Law 1, 7.

210

D.W. Arner and E. Gibson

perspective there were numerous weaknesses including: regulatory arbitrage with the Mainland from both the banking and securities sectors having the potential to increase instability in the banking sector; the institutional interdependence of regulators; the effectiveness of the HKMA supervising banks active in non-banking financial sectors; and the HKMA cooperating with other supervisors to deal with risks stemming from crosssectoral activities of banks. In this regard particular attention was placed on systemic risks transmitted from the insurance sector as it was found that they would likely manifest through linkages to the banking sector. Concern was raised over the SFC’s relationship with the HKEx in regulating disclosure obligations of listed companies. Recommendations included the SFC and HKMA further strengthening their supervision to ensure uniform standards were applied.79 Cross-sectoral risks were found to be growing with the involvement of banks in the securities sector. In this context the IMF stated: . . . securities activities on behalf of retail investors is rising, and may pose reputational risk if the products sold are inappropriate or perform poorly.80 In hindsight this statement forewarned of the Lehman Minibonds incident that arose during the GFC.

9.5 Global Financial Crisis: Hong Kong Hong Kong was not immune from the GFC. The first effects of the GFC were caused by Lehman Brothers’ bankruptcy on 15 September 2008, directly triggering the highest profile financial regulatory incident in Hong Kong. 9.5.1 Lehman Minibonds Prior to the bankruptcy, Lehman Brothers’ Hong Kong subsidiary had arranged several issues of financial products branded as ‘Minibonds’. However, this branding or label was inappropriate because these financial products had little structural characteristics in common with conventional bonds. In substance Minibonds were complex structured products comprising predominantly unlisted credit-linked notes that originated from a Cayman Islands incorporated Special Purpose Vehicle issuer, 79 International Monetary Fund, ‘People’s Republic of China – Hong Kong Special Administrative Region: Financial System Stability Assessment’ (2003) IMF Country Report No. 03/191, 10, 15, 17, 28, 39 and 44, available at www.imf.org/external/pubs/ft/ scr/2003/cr03191.pdf (visited on 28 January 2011). 80 Ibid., 30 and 44.

Financial regulatory structure in Hong Kong

211

Pacific International Finance Limited (PIFL). Minibonds were sold in Hong Kong through 21 licensed banks and securities broker distributers. Retail investors acquired claims against PIFL from HK$/US$ interest rate or basis swap contracts issued between Lehman Brothers and collateral pool provided by PIFL. Net proceeds from the sale of Minibonds were used to purchase tranches of collateral debt obligations from Lehman Brothers to provide security for the retail investors’ claims. To enhance the revenue to service Minibond claims, PIFL sold credit default swaps to Lehman Brothers. This gave Lehman Brothers a priority over the retail investors’ security against PIFL. The intra-group chain reaction from Lehman Brothers’ bankruptcy caused the Minibonds’ structure to be unwound and accelerated, triggering a liquidation of the credit default obligations which mostly covered Lehman Brothers’ claims and expenses in priority.81 These events resulted in a dramatic fall in the Minibonds’ face value, accentuated by the then prevailing market conditions. Lehman Brothers’ Hong Kong subsidiary was supervised by the SFC, although Minibonds were regulated by either the SFC or the HKMA, depending on whether they were sold by an AI or LC. In the aftermath separate reports were issued by the HKMA and SFC. Predominant regulatory issues raised in the reports related to market conduct and consumer protection. From a structural perspective, the HKMA recommended that all aspects of banks’ securities business be placed under the supervision of the HKMA and that regulatory coordination with the HKMA be strengthened.82 In contrast, the SFC questioned whether the existing regulatory structure is best suited to facilitate Hong Kong’s further development as an international financial centre. Several alternative structures were suggested.83 The anomaly of having the SFC as the lead regulator of the securities industry and the HKMA as the lead regulator of banks undertaking securities business is a sectoral structural regulatory weakness84 inherent to Hong Kong’s current financial regulatory design that was pointed out in the 2003 IMF Report. Minibonds provide an excellent example of a financial product that was engineered to exploit the regulatory gaps between the HKMA’s and SFC’s financial regulatory structures. 81 Douglas W. Arner, Berry F.C. Hsu, Antonio M. Da Roza, Francisco A. Da Roza, Syren Johnstone and Paul Lejot, ‘The Global Financial Crisis and the Future of Financial Regulation in Hong Kong’ (2009) Asian Institute of International Financial Law, AIIFL Working Paper No. 4, 46. 82 Hong Kong Monetary Authority, ‘Report of the Hong Kong Monetary Authority on Issues Concerning the Distribution of Structured Products Connected to Lehman Group Companies’ (December 2008), available at www.fstb.gov.hk/eng/minibond/HKMAminibond. pdf (visited on 14 November 2011). 83 Douglas W. Arner, Berry F.C. Hsu and Antonio M. Da Roza, ‘Financial Regulation in Hong Kong: Time for a Change’ (2010) 5 Asian Journal of Comparative Law 1, 26. 84 Ibid., 9.

212

D.W. Arner and E. Gibson

9.5.2 Bank of East Asia On 24 September 2008, Hong Kong experienced its first major bank run since the Asian Financial Crisis. The run on the Bank of East Asia, Hong Kong’s fifth largest bank, exemplified a local bank becoming intertwined with the insurance and securities sectors from exposures to both Lehman Brothers and AIG. To avert the panic, the HKMA granted a general liquidity provision to the bank and issued public statements, in conjunction with the Financial Secretary and major business figures, to reassure depositors. The run subsided and the bank experienced no further difficulties.85 As a consequence of the run, deposit insurance has been raised from HK$100,000 to HK$500,000.86 Despite the HKMA being able to avert the run it nonetheless raises the issue made out by the 2003 IMF Report – the sectoral effectiveness of the HKMA to supervise banks active in non-banking financial sectors, most notably in the securities and insurance activities. 9.5.3 AIA The near failure of AIG during the GFC triggered a rush by policyholders seeking redemption on its solvent US$30 billion Hong Kong subsidiary, AIA. However, the rush was insignificant as it only involved about 2,000 policy holders. The US Government’s effective nationalization of AIG and the OCI’s ring-fencing of AIA’s assets averted the panic. Although the rush on AIA was directly correlated to its relationship with AIG, the systemic risks emanating from AIG to AIA demonstrated an indirect feedback transmission. The AIA incident reinforces the 2003 IMF Review’s warning that systemic risks from the insurance sector can manifest from linkages to the banking sector. Furthermore the incident highlights the flaw with Hong Kong’s regulatory structural design reflecting specific financial sectors and the dependence and faith in MoUs, CFR and FSC to maintain financial stability when systemic risks bridge financial sectors. 9.5.4 CITIC Pacific On 20 October 2008 CITIC Pacific lost HK$15.5 billion, the largest loss to date by a Hong Kong listed company. The loss was attributed to CITIC Pacific investing in long-dated structured foreign exchange option contracts (derivatives) known as ‘accumulators’ that literally accumulated huge losses when the Australian dollar rapidly depreciated against the

85 Douglas W. Arner, Berry F.C. Hsu, Antonio M. Da Roza, Francisco A. Da Roza, Syren Johnstone and Paul Lejot, ‘The Global Financial Crisis and the Future of Financial Regulation in Hong Kong’ (2009) Asian Institute of International Financial Law, AIIFL Working Paper No. 4, 32–33. 86 Ibid., 83.

Financial regulatory structure in Hong Kong

213

United States dollar. Investigations were launched by both the SFC and HKEx concerning CITIC Pacific’s disclosure compliance with the Listing Rules. Although consumer protection actions under the SFO were adequate, the incident questioned the effectiveness of the dual-filing regime. Unfortunately this issue was raised five years earlier in the Expert Group Report and the 2003 IMF report.87 The regulatory defect had as much to do with the absence of a comprehensive derivatives regulatory framework as the potentially flawed financial regulatory design of having two regulators overseeing a single supervisory function analogous to flaw discussed in relation to Minibonds.

9.6 International organizations Post-GFC recommendations have been undertaken by several international organizations to address common regulatory failings, most notably the Financial Stability Board (FSB). Regulatory reforms recommended by international organizations have a profound influence over the formulation, standardization and harmonization of financial laws which can, in turn, influence the regulatory structure. Hong Kong is currently a member of Basel Committee of Banking Supervision (BCBS), International Organization of Securities Commissions (IOSCO), International Association of Insurance Supervisors (IAIS) and the FSB. China is a member of the World Trade Organization, International Monetary Fund and the G20. Accordingly, Hong Kong is bound to the G20/FSB Financial Regulatory Reform Agenda that has been instigated in the wake of the GFC. The next section will evaluate Hong Kong’s implementation of the G20/FSB regulatory reforms and the capacity of Hong Kong’s regulatory structure to facilitate these reforms.

9.7 G20/FSB financial regulatory reforms 9.7.1 Capital, leverage, liquidity and pro-cyclicality All G20 members committed to implement Basel II and the subsequent enhancements (Basel 2.5) by 31 December 2011. The HKMA implemented Basel II on 1 January 2007. Basel 2.5 was introduced in Hong Kong on 1 January 2012 after amendments were made to the Banking (Capital) Rules and Banking (Disclosure) Rules. On 12 September 2010 the BCBS announced the introduction of Basel III.88 Endorsed by the G20, Basel III focused on raising capital and liquidity standards by enhancing the quality of the regulatory capital base 87 Ibid., 58. 88 A global regulatory framework for more resilient banks and banking systems; international framework for liquidity risk measurements, standards and monitoring.

214

D.W. Arner and E. Gibson

and introducing new leverage and liquidity ratios. Pro-cyclicality was addressed through the introduction of capital conservation and countercyclical capital buffers. Basel III began being implemented on 1 January 2013, and is scheduled for full implementation by 1 January 2019. To improve flexibility, the existing capital and liquidity ratios in the Banking Ordinance are to be repealed and reinstated in stand-alone rules, supplemented by supervisory guidance issued by the HKMA. Amended Banking Capital (Amendment) Rules 2011 and Banking (Disclosure) (Amendment) Rules 2011 came into effect on 1 January 2012 with the Banking Ordinance being revised on 9 March 2012 to give the HKMA powers, after consulting with the Financial Secretary, to make rules for AIs in accordance with the Basel III capital adequacy and liquidity reforms. The first phase of the Basel III capital standards recommendations were implemented on 19 October 2012 under the Banking (Capital) (Amendment) Rules 2012 which was followed by further refinements to the calculation of the capital adequacy ratio on 12 April 2013. Consultation is currently being undertaken by the HKMA to revise the existing liquidity ratio to meet the Basel III recommendations. A current proposal is for the existing modified liquidity ratio to be complemented by a liquidity coverage ratio, in accordance with Basel III, taking effect from 1 January 2015. Both the FSB and the HKMA have stated that Hong Kong’s banks should not have any major difficulties in meeting the Basel III capital requirements because the existing levels are already relatively high. Discussions on the introduction of a leverage ratio have been encouraged from the HKMA’s participation with the BCBS and Group of Central Bank Governors and Head of Supervision. The 2011 FSB Report has indicated that Hong Kong’s AIs generally should have no major difficulty in complying with the 3 per cent testing level for the leverage ratio.89 Currently, the HKMA is analysing the technical aspects and options for institutional arrangements underlying the operation of countercyclical capital buffers in Hong Kong.90 The HKMA states that Hong Kong SAR banks should have no major problems complying with the Basel III liquidity standards, although some banks may need to adjust their liquidity profiles or the composition of their liquid assets.91 89 Financial Stability Board, ‘FSB G20 Monitoring Progress Hong Kong’ (September 2011), 2, available at www.financialstabilityboard.org/publications/r_111104h.pdf (visited on 3 October 2011). 90 Hong Kong Monetary Authority, ‘Annual Report 2011’ (30 April 2012), 62, available at www.hkma.gov.hk/eng/publication-and-research/annual-report/2011.shtml (visited on 2 July 2012). 91 Karen Kemp, ‘Implementation of Basel III in Hong Kong’ (26 January 2011) Hong Kong Monetary Authority, Guidelines and Circulars, 2, 4–5, available at www.hkma.gov.hk/media/ eng/doc/key-information/guidelines-and-circular/2011/20110126e1.pdf (visited on 3 March 2011).

Financial regulatory structure in Hong Kong

215

9.7.2 OTC derivatives On 25 October 2010, the FSB made 21 recommendations for implementing over-the-counter (OTC) derivative market reforms. Principal recommendations included the: reporting of OTC derivative transactions to trade repositories; mandatory clearing of standardized OTC derivative transactions through central counterparties (CCPs); mandatory trading on exchanges or electronic trading platforms; and the imposition of higher capital requirements for OTC derivative transactions that are not centrally cleared. The HKMA and SFC released the Consultation Conclusions & Supplemented Consultation on the Proposed Regulatory Regime for the OTC Derivatives Market in Hong Kong on 11 July 2012. A Hong Kong Trade Repository (HKTR) for the collection of data relating to OTC derivative transactions has been established under the HKMA’s Central Moneymarkets Unit with a link being developed between the HKEx’s clearing facilities, the CCP.92 Entities subject to mandatory reporting requirements will be required to report to the HKTR.93 Higher capital requirements for non-centrally cleared OTC derivatives have been adopted in line with the IOSCO and BCBS recommendations with margin requirements still in the proposal stage.94 Relevant legislation for the regime will be set out in the SFO. The Securities and Futures (Amendment) Bill 2013 was gazetted on 28 June 2013 to enable Hong Kong to implement its OTC derivative regulatory regime in accordance with the G20’s recommendations. Subsidiary legislation, namely, detailed rules for mandatory clearing, reporting and trading requirements are being jointly developed by the HKMA and SFC.95 This proposal stage of the subsidiary legislation is lagging behind the adoption of similar legislation by the majority of G20 members.96

92 Hong Kong Monetary Authority, ‘Over-the-Counter Derivatives Trade Repository’ (30 August 2013), available at www.hkma.gov.hk/eng/key-functions/international-fnancialcentre/infrastructure/otc-derivatives-trade-repository.shtml (visited on 2 September 2013). 93 Ibid. 94 Financial Stability Baord, ‘OTC Derivatives Market Reforms: Fifth Progress Report on Implementation’ (15 April 2013), 9, available at www.financialstabilityboard.org/ publications/r_130415pdf (visited on 2 September 2013). 95 Financial Stability Board, ‘FSB G20 Monitoring Progress Hong Kong’ (September 2011), 18–19, available at www.financialstabilityboard.org/publications/r_111104h.pdf (visited on 3 October 2011); Hong Kong Monetary Authority and Securities and Futures Commission, ‘Joint Consultation Conclusions on the Proposed Regulatory Regime for the Over-the-counter Derivatives Market in Hong Kong’ (11 July 2012), 6, 10, 13 and 14, available at www. hkma.gov.hk/media/eng/doc/key-information/press-release/2012/20120711e3a34.pdf (visited on 13 July 2012). 96 Financial Stability Baord, ‘OTC Derivatives Market Reforms: Fifth Progress Report on Implementation’ (15 April 2013), 9, available at www.financialstabilityboard.org/ publications/r_130415pdf (visited on 2 September 2013).

216

D.W. Arner and E. Gibson

Hong Kong’s OTC derivative’s market is overseen by two regulators, the HKMA regulating AIs and approved money brokers (AMBs), whilst the SFC regulates persons other than AIs and AMBs, and systemically important participants.97 9.7.3 Systemically important financial institutions and resolution regimes In October 2011 the FSB released: ‘Key Attributes of Effective Resolution Regimes for Financial Institutions’ with the intention of forming an international standard. The core of these reforms is to equip regulators with the tools to resolve systemically important financial institutions (SIFIs) without systemic disruptions and without exposing taxpayers to financial loss. Generally, the resolution regime requires all domestically incorporated global SIFIs to: have in place a recovery and resolution plan; have regular resolvability assessments; and have institutional-specific crossborder cooperation agreements.98 The HKMA is a member of the FSB Cross-Border Crisis Management Group. Under the Banking Ordinance, AIs that are going concerns and gone concerns are subject to corporate winding up procedure. Currently the HKMA is considering the need for enhancing the framework on recovery and resolution plans for systemically important banks.99 The SFC will participate with IOSCO to develop methodologies to identify firms that carry out potentially systemic activities.100 Cooperative arrangements and cross-border MoUs have been entered into by the SFC to exchange information and participate in investigatory assistance.

97 New SFC Type 11 and Type 12 Regulated Activities will be introduced to capture activities of dealers and advisors, and clearing agents respectively. Existing SFC Type 9 and Type 7 Regulatory Activities will be expanded to cover portfolio management of OTC derivatives and transactions respectively. 98 Financial Stability Board, ‘Effective Resolution of Systemically Important Financial Institutions: Overview of Responses to the Public Consultation’ (4 November 2011), 1, available at www.financialstabilityboard.org/publications/r_110719cc.pdf (visited on 27 February 2012; Financial Stability Board, ‘Key Attributes of Effective Resolution Regimes for Financial Institutions’ (October 2011), 5, available at www.financialstabilityboard. org/publications/r_111104cc.pdf (visited on 27 February 2012). The FSB released a consultative assessment methodology for the preceding document on 28 August 2013. 99 Financial Stability Board, ‘FSB G20 Monitoring Progress Hong Kong’ (September 2011), 6–7, available at www.financialstabilityboard.org/publications/r_111104h.pdf (visited on 3 October 2011); Financial Stability Board, ‘Progress of Implementation of G20/FSB Recommendations (Hong Kong)’ (June 2012), 17, available at www.financialstabilityboard.org/publications/r_120619hh.pdf (visited on 1 July 2012). 100 Financial Stability Board, ‘Progress of Implementation of G20/FSB Recommendations (Hong Kong)’ (June 2012), 16, available at www.financialstabilityboard.org/ publications/r_120619hh.pdf (visited on 1 July 2012).

Financial regulatory structure in Hong Kong

217

Both the HKMA and SFC conduct regular stress testing on financial institutions.101 The OCI has been actively participating in supervisory colleges for major insurance groups and in the IAIS. A review of the approaches under Insurance Core Principle 25: Supervisory Cooperation and Coordination, is being undertaken. Currently the IAIS is developing a Common Framework for the Supervision of Internationally Active Insurance Groups and is reviewing the assessment methodology for identifying global systemically important insurers.102 9.7.4 Compensation arrangements Principles for Sound Compensation Practices (Principles) and their Implementation Standards (Standards) were introduced by the Financial Stability Forum on 2 April 2009. From the outset there was general acceptance that the Principles were not intended to be a ‘one size fits all’ as financial firms differ in goals, activities and culture, as do employees’ roles within a firm. These measures were developed to align employees’ risk-taking incentives with the long-term profitability of the financial institution, particularly SIFIs. In response, the FSB has set up a Compensation Monitoring Contact Group that is responsible for monitoring and reporting on national implementation of the FSB’s Principles and Standards.103 The HKMA supervises all AIs’ remuneration practices. On 19 March 2010 the HKMA issued the Guideline on a Sound Remuneration System (2010 Guideline) which generally reflected the Principles and Standards. Hong Kong is focusing on the identification of material risk takers, comprehensiveness of risk capture and risk adjustment of the remuneration processes.104 In particular the 2010 Guideline refers to section 7 Banking Ordinance (Cap 155) which creates an implied obligation on AIs to ensure that remuneration systems are sound and prudent and do not pose risks to AIs’ safety and soundness under ‘sound and prudent business practices’. This

101 Financial Stability Board, ‘Progress of Implementation of G20/FSB Recommendations (Hong Kong)’ (June 2012), 22–23, available at www.financialstabilityboard.org/ publications/r_120619hh.pdf (visited on 1 July 2012). 102 Ibid., 15–21. 103 Financial Stability Forum, ‘FSF Principles for Sound Compensation Practices’, (2 April 2009), 1, available at www.financialstabilityboard.org/publications/r_0904b.pdf (visited on 6 November 2010); Financial Stability Board; ‘Implementing the FSB Principles for Sound Compensation Practices and Their Implementation Standards (Progress Report)’ (13 June 2012), 4, available at www.financialstabilityboard.org/publications/r_120613.pdf (visited on 1 July 2012). 104 Financial Stability Board, ‘Implementing the FSB Principles for Sound Compensation Practices and Their Implementation Standards (Progress Report)’ (13 June 2012), 12, available at www.financialstabilityboard.org/publications/r_120613.pdf (visited on 1 July 2012).

218

D.W. Arner and E. Gibson

is to be achieved through internal control systems and adequate disclosure. On 23 November 2011 the HKMA issued a letter encouraging AIs to follow the amended July 2011 Basel disclosure requirements (on a proportionate basis) because they went beyond the 2010 Guideline. A series of on-site thematic examinations of major banks’ remuneration systems and practices were conducted by the HKMA in 2011. Investigative findings suggest that Hong Kong banks have generally implemented the FSB’s Principles and Standards.105 The SFC supports the FSB’s Principles and Standards and encourages major investment banks to adopt these measures. Letters were sent out to major investment banks highlighting the FSB’s recommendations and asking for confirmation that their compensation policies complied. The SFC participated in the FSB’s compensation peer review in 2011.106 Currently, insurers are required to review remuneration policies periodically in accordance with the OCI’s July 2002 Guidance Note on Corporate Governance of Authorised Institutions.107 The OCI issued a circular on 19 March 2010 lending support to the FSB’s Principles and Standards and the IAIS’s Standard and Guidance on Remuneration, based on the FSB’s Principles and Standards. 9.7.5 Credit rating agencies The G20 Leaders agreed at the 2009 London Summit that the regulatory oversight of credit rating agencies (CRAs) should be consistent with the IOSCO CRA Code of Conduct Fundamentals.108 A reduction in the mechanistic reliance on ratings and incentivising improvements in independent credit risk assessments and due diligence capacities is being sought by the FSB after the GFC experiences of herding and cliff effects amplified pro-cyclicality and caused systemic disruptions.109 Hence the FSB published the Principles for Reducing the Reliance on Credit Rating Agency Ratings.

105 Financial Stability Board, ‘FSB G20 Monitoring Progress Hong Kong’ (September 2011), 31, available at www.financialstabilityboard.org/publications/r_111104h.pdf (visited on 3 October 2011). 106 Ibid., 32. 107 Ibid. 108 Financial Stability Board, ‘Overview of Progress in the Implementation of the G20 Recommendations for Strengthening Financial Stability: Report of the Financial Stability Board to G20 Leaders’ (18 June 2010), 13, available at www.financialstabilityboard.org/ publications/r_100627c.pdf (visited on 23 February 2011). 109 Financial Stability Board, ‘FSB Report on Principles for Reducing Reliance on CRA Ratings’ (27 October 2010), 1, available at www.financialstabilityboard.org/ publications/r_101027.pdf (visited on 26 November 2010).

Financial regulatory structure in Hong Kong

219

In response the SFC commenced a public consultation for establishing a CRA regulatory regime. Legislative amendments were made to Schedule 5 of the SFO and Securities and Futures (Financial Resources) Rules (Cap 571N) which came into operation on 1 June 2011. CRAs and their rating analysts who provide credit rating services in Hong Kong are supervised by the SFC under the SFO as a Type 10 regulated activity and accordingly are required to be licensed. The SFC has issued a Code of Conduct for Persons Providing Credit Rating Services based upon IOSCO’s 2008 Code of Conduct Fundamentals for Credit Rating Agencies. Hong Kong’s use of banking CRA ratings are following the Basel III regulatory capital and liquidity frameworks being implemented by the HKMA.110 The OCI has checked that the role of credit ratings is consistent with investors making independent judgements of risks and that they perform their own due diligence.111 9.7.6 Hedge funds At the 2010 Seoul Summit the G20 agreed to strengthen the regulation and supervision of hedge funds. IOSCO carried out a hedge fund survey in 2010, providing results to the FSB in July 2011, issued revised Objectives and Principles of Securities Regulation (June 2010) and reported those results to the FSB in October 2011.112 Of the major principles, registration and regulatory oversight were a recurring theme. The SFC is a member of IOSCO Task Force on Unregulated Financial Entities. In 2010 the SFC participated in an IOSCO data collection exercise with managers of potentially systemically important hedge funds and conducted its own Hong Kong survey in 2011.113 Generally, hedge fund managers providing asset management services to third parties are required to be licensed by the SFC. In May 2002 the SFC issued Hedge Fund Guidelines which were recently updated in the April 110 Financial Stability Board, ‘Thematic Review on FSB Principles for Reducing Reliance on Credit Rating Agency Ratings: Interim Report’ (29 August 2013), 25, available at www. financialstabilityboard.og/publications/r_130829e.pdf (visited on 4 September 2013). 111 Financial Stability Board, ‘FSB G20 Monitoring Progress Hong Kong’, (September 2011), 35–36, available at www.financialstabilityboard.org/publications/r_111104h.pdf (visited on 3 October 2011). 112 Financial Stability Board, ‘Overview of Progress in the Implementation of the G20 Recommendations for Strengthening Financial Stability: Report of the Financial Stability Board to G20 Leaders’ (18 June 2010), 13, available at www.financialstabilityboard.org/ publications/r_100627c.pdf (visited on 23 February 2011). 113 Financial Stability Board, ‘Progress of Implementation of G20/FSB Recommendations (Hong Kong)’ (June 2012), available at www.financialstabilityboard.org/ publications/r_120619hh.pdf (visited on 1 July 2012); Securities and Futures Commission, ‘Report of the Survey on Hedge Fund Activities of SFC-licensed Managers/Advisers’, (March 2011), available at www.sfc.hk/sfc/doc/EN/speeches/public/surveys/11/ Hedge%20fund%20managers_201103.pdf (visited on 21 May 2011).

220

D.W. Arner and E. Gibson

2013 edition. The focus of the SFC’s Hedge Fund Guidelines is on reporting requirements. Since 2001 the HKMA has issued a caution to Hong Kong banks when entering into transactions with highly leveraged hedge funds.114 9.7.7 Securitization On behalf of the FSB, IOSCO issued the Global Developments in Securitization Regulation in November 2012 which was followed by the BCBS’s consultation paper on Revisions to the Basel Securitization Framework in December 2012. IOSCO focused on standardization to enhance transparency and disclosure with the BCBS looking at banks’ regulatory capital requirements. Amendments have been made to the HKMA’s Banking (Capital) Rules and the Banking (Disclosure) Rules to implement Basel 2.5 – strengthening of securitization requirements. Although Hong Kong banks’ securitization origination activities have been minimal, the HKMA will nonetheless assess the extent to which a seller has retained ownership of assets.115 The HKMA is developing a Guidance on Credit Risk Transfer Activities which includes due diligence requirements for banks investing in structured products.116 An annual survey of securitization activities is conducted by the HKMA. The SFC, as a member of IOSCO’s Task Force on Unregulated Markets and Products, will consider appropriate implementation.117 9.7.8 Accounting standards At the Pittsburgh Summit, the G20 Leaders endorsed the Financial Stability Forum’s countercyclical recommendations on accounting standards, and the International Accounting Standards Board’s (IASB) revised institutional framework. The FSB recommended improved converged accounting standards in four areas: fair value accounting; off-balance sheet entities; expected loss impairment approach; and netting and offsetting

114 Financial Stability Board, ‘Progress of Implementation of G20/FSB Recommendations (Hong Kong)’ (June 2012), 9, available at www.financialstabilityboard.org/publications/ r_120619hh.pdf (visited on 1 July 2012). 115 Hong Kong Monetary Authority, ‘Supervisory Treatment on Asset Securitisation and Mortgage backed Securities’ (August 2011) Guideline No. 4.6, available at www.hkma. gov.hk/eng/key-information/guidelines-and-circulars/guidelines/guide_46b.shtml (visited on 5 September 2013). 116 Financial Stability Board, ‘Progress of Implementation of G20/FSB Recommendations (Hong Kong)’ (June 2012), 12, available at www.financialstabilityboard.org/ publications/r_120619hh.pdf (visited on 1 July 2012). 117 Ibid., 11.

Financial regulatory structure in Hong Kong

221

118

financial instruments. Subsequently the ISAB has issued International Accounting Standards (IAS) addressing the FSB’s recommendations. The accounting standards setting body is the Hong Kong Institute of Certified Public Accountants (HKICPA) which monitors the IASB’s exposure drafts. Hong Kong modelled its financial reporting standards (HKFRS) on the IASB International Financial Reporting Standards (IFRS) in 2005. The HKICPA adopted the IFRS standards on mixed amortized cost and the fair value accounting model in November 2009, effective from 1 January 2013. A final standard on fair value measurement was issued by the IASB in May 2011, which was accepted by the HKICPA in June 2011. On 1 January 2013, HKICPA implemented Disclosure of Interests in Other Entities; Financial Instruments: Disclosures – Offsetting Financial Assets and Financial Liabilities was revised in February 2013; and proposed amendments to, Financial Instruments: Presentation – Offsetting Financial Assets and Financial Liabilities, on 1 January 2014.119 Regular bilateral meetings are held between the HKMA and the HKICPA’s Banking and Regulatory Liaison Group. Supervisory guidance on Financial Instrument Fair Valuation Practices was issued by the HKMA in December 2011. The SFC is actively involved in commenting on exposure drafts of the IASB from its IOSCO membership.120 Both the FRC and HKICPA are responsible for ensuring consistent application and enforcement of high quality accounting standards for Hong Kong listed companies and SFC licensees respectively.121 The OCI is in continuous contact with the accounting standard setters to ensure consistent application and enforcement of high quality accounting standards.122 9.7.9 Macro-prudential frameworks In response to the Seoul Summit, the FSB, IMF and Bank for International Settlements published a joint progress report on macro-prudential policy frameworks and tools in October 2011. The report focused on three main areas: advances in the identification and monitoring of systemic risks; the designation and calibration of instruments for macro-prudential purposes; and building institutional and governance arrangements in the domestic 118 119 120 121

Ibid., 28–29. Ibid., 42. Ibid., 43. Financial Stability Board, ‘FSB G20 Monitoring Progress Hong Kong’ (September 2011), 26, available at www.financialstabilityboard.org/publications/r_111104h.pdf (visited on 3 October 2011). 122 Financial Stability Board, ‘Progress of Implementation of G20/FSB Recommendations (Hong Kong)’ (June 2012), 43, available at www.financialstabilityboard.org/ publications/r_120619hh.pdf (visited on 1 July 2012).

222

D.W. Arner and E. Gibson

and international context. Monitoring efforts have focused on closing data gaps and addressing systemic risks.123 The HKMA participates in the FSB’s Standing Committee on Assessment of Vulnerabilities, is a member of the FSB’s Working Group on Data Gaps and Systemic Linkages, the FSB Data Gaps Implementation Group and is a coordinator of the Monetary and Financial Stability Committee’s macro surveillance for East-Asia-Pacific Central Banks.124 The SFC participates in IOSCO data collection exercises and is a member of its Working Group on Systemic Risk and the OCI has entered into MoUs with regulators in other jurisdictions to work closely in the supervision of insurers with cross-border operations.125 Cross-sectoral information exchange to monitor systemic risks and maintain financial stability in Hong Kong is undertaken by the CFR and FSC. The HKMA established the Macro Surveillance Committee (MSC) to facilitate regular monitoring of the risks and vulnerabilities to the monetary and financial system. A Financial Surveillance Division has been set up within the HKMA to assimilate inputs from different departments to produce financial stability analyses which will form the basis of the MSC’s policy discussion and formulation.126 On 2 March 2012 the SFC established a centralized unit on risk management and strategic planning compatible with the SFO’s objectives of reducing systemic risks and maintaining financial stability in the securities and futures market.127 The OCI is currently considering adopting the IAIS’s Insurance Core Principle 24: Macro-prudential Surveillance and Insurance Supervision.128 9.7.10 Adherence to international standards In January 2010, the FSB issued a Framework for Strengthening Adherence to International Standards. FSB members, including Hong Kong, commit to 123 Financial Stability Board, ‘Overview of Progress of Implementation of G20 Recommendations for Strengthening Financial Stability: Report of the Financial Stability Board to G20 Leaders’ (4 November 2011), 19, available at www.financialstabilityboard.org/ publications/r_111104.pdf (visited on 15 March 2012). 124 Hong Kong Monetary Authority, ‘Annual Report 2011’ (30 April 2012), 81–82, available at www.hkma.gov.hk/eng/publication-and-research/annual-report/2011.shtml (visited on 11 February 2012). 125 Financial Stability Board, ‘Progress of Implementation of G20/FSB Recommendations (Hong Kong)’ (June 2012), 30–31, available at www.financialstabilityboard.org/ publications/r_120619hh.pdf (visited on 1 July 2012). 126 Ibid., 28–29. 127 Ashley Adler, ‘SFC Sets Up Centralised Unit on Risk Management’, (2 March 2012) Securities and Futures Commission, Press Release, available at www.sfc.hk/sfcPressRelease/EN/sfcOpenDocServlet?docno=12PR22 (visited on 11 March 2012). 128 Financial Stability Board, ‘Progress of Implementation of G20/FSB Recommendations (Hong Kong)’ (June 2012), 32, available at www.financialstabilityboard.org/ publications/r_120619hh.pdf (visited on 1 July 2012).

Financial regulatory structure in Hong Kong

223

lead by example in implementing international financial standards, undergoing assessments by the IMF-World Bank Financial Sector Assessment Program every five years, participate in thematic and country peer reviews of FSB members and publish the results of these assessments.129 Hong Kong’s last IMF/World Bank Financial Sector Assessment Program was conducted in 2003. Therefore another assessment is well overdue. In terms of FSB peer reviews, Hong Kong is yet to undertake a Country Review but has participated in thematic reviews. As the research in the section has indicated, Hong Kong is adhering to implementation of G20/FSB standards and is, and will be, complying with the FSB reform agenda timetable. 9.7.11 G20/FSB reforms: regulatory structural capacity Conceptually, the FSB’s reforms can be viewed as a ‘tool kit’ operating within the regulatory structure. From a structural perspective, Hong Kong’s implementation of the FSB’s reforms pertaining to OTC derivatives, SIFIs, compensation arrangements, accounting standards, securitization and macro-prudential systemic regulatory reforms will be subject to the capacity of the current regulatory structure – the HKMA’s institutional (cross-sectoral) approach, the SFC’s and OCI’s sectoral approach excluding the activities of AIs, and coordination and cooperation arrangements amongst these regulators. Interestingly the SFC will regulate CRAs although their activities are cross-sectoral in nature. Hedge funds and large unregulated players in the OTC derivative market that are not intermediaries which have the potential to heighten systemic risks are, and will be, regulated respectively within the SFC’s sectoral regulatory jurisdiction despite the HKMA being the only regulator considering a resolution and recovery plan for SIFIs, namely significantly important AIs. Broadly, the supervision of OTC derivatives reflects that of Minibonds with the inherent structural design flaw of financial products being subject to supervision by two regulators. The supervision of SIFIs according to the financial regulatory jurisdiction of each regulator does not reflect the characteristics of systemic risks to bridge financial sectors and reinforces the overarching dependence on MoUs, CFR and FSC to maintain financial stability across financial sectors. Therefore the effectiveness of the FSB’s reforms will be subject to the capacity of Hong Kong’s regulatory structure, and challenged by current and new regulatory gaps, overlaps, frictions and conflicts that in turn will impact on the effectiveness of these

129 Financial Stability Board, ‘Overview of Progress in the Implementation of the G20 Recommendations for Strengthening Financial Stability: Report of the Financial Stability Board to G20 Leaders’ (18 June 2010), 9, available at www.financialstabilityboard.org/ publications/r_100627c.pdf (visited on 23 February 2011).

224

D.W. Arner and E. Gibson

reforms. This point substantiates why the choice of regulatory structure is critically important.

9.8 Financial regulatory structure: options The abovementioned assessment highlighted that the overall focus of the G20/FSB reforms is on the tool kit rather than the regulatory structure. However, from a practical perspective the implementation of these reforms should also focus on how effectively the regulatory structure accommodates the FSB’s tool kit. In the aftermath of the GFC the jurisdictions that housed the two truly global financial centres are not only implementing the G20/FSB reforms but have also addressed the importance of regulatory structure to effectively implement these reforms. The United Kingdom has gone so far as to completely redesign its regulatory infrastructure by moving to a Twin Peaks model. In 2008 the US Department of Treasury released: ‘Blueprint for a Modernized Financial Regulatory Structure’ that advocated the adoption of what was coined an objectives based model. Both jurisdictions appreciated that the effectiveness of the FSB’s tool kit is intimately linked to the regulatory structure. This is not to say that the international push for regulatory reform has overlooked the importance of the regulatory structure. In 2008 the Group of Thirty (G30) issued: ‘The Structure of Financial Supervision: Approaches and Challenges in a Global Marketplace’, and found after interviewing policymakers and regulators in 17 jurisdictions that they: . . . underscored the critical importance of regulatory frame-works accommodating and keeping pace with dramatic changes and innovation in financial markets. As financial markets and institutions evolve, so too must the regulatory systems [structures] that oversee them.130 From this statement one can make the inference that because the FSB’s reforms will influence the evolution of markets and institutions this will influence the choice of regulatory structure. More generally, selecting the optimum regulatory structure or model revolves around tailoring regulatory agencies to a jurisdiction’s financial characteristics, policies and circumstances. Categorising a jurisdiction’s regulatory structure in terms of a specific type of regulatory model is more a case of best fit rather than a neat fit. The final section of this chapter will describe the different types of regulatory models, namely, Institutional; Sectoral; Integrated; Functional/Objectives; and Twin Peaks.

130 Group of Thirty, ‘The Structure of Financial Supervision: Approaches and Challenges in a Global Marketplace’ (2008), 13, available at www.group30.org/rpt_06.shtml (visited on 2 May 2011).

Financial regulatory structure in Hong Kong

225

9.8.1 Regulatory models Under the Institutional model, regulation is conducted by one regulator per type of financial intermediary based on its legal definition, regardless of financial activities undertaken by that financial intermediary. Although this model has not been generally adopted, jurisdictions that do adopt the Institutional model tend to focus on banking regulation. This species of Institutional model focuses on banks’ unique systemic risks. Accordingly this model is best suited to an amalgamation between the banking regulator and the central bank. For example, Hong Kong is best described as this species of Institutional model. Such a description is based on the HKMA being the de facto central bank, lead regulator and banking regulator which best reflects Hong Kong’s jurisdiction’s financial characteristics – being a leading Asian banking centre with an extremely high density of international banks. In accordance with the Sectoral model, a jurisdiction has regulators for each financial sector, normally banking, securities and insurance. The Sectoral model focuses on sales practice aligned to the type of activity or financial service, rather than the type of institution offering that activity or service.131 This model is relatively common, and is currently in operation within the world’s two largest economies, the United States and China.132 The model is suited to clear demarcations between financial sectors. Under the Integrated model one regulator is responsible for all financial sectors so that it is sectorally integrated.133 Prudential regulation, conduct of business and consumer protection are all integrated within the one regulator. The Integrated model is best known as being adopted in the United Kingdom (Financial Services Agency) prior to the GFC and is also operational in Japan (Financial Supervisory Agency) and Singapore (Monetary Authority of Singapore). The model works well with integrated financial institutions such as universal banks and financial conglomerates.134 However, conflicts between consumer protection and prudential regulation can inhibit its effectiveness as was experienced with the Northern Rock incident during the GFC.

131 Heidi M. Schooner and Michael W. Taylor, Global Bank Regulation: Principles and Policies (London: Elsevier, 2010), p. 262. 132 China’s financial regulatory structure exemplifies the Sectoral model. The Central Bank – People’s Bank of China; the banking regulator – China Banking Regulatory Commission; the securities regulator – China Securities Regulatory Commission; and the insurance regulator – China Insurance Regulatory Commission. 133 Clive Briault, ‘The Rationale for a Single National Financial Services Regulator’, (May 1999) FSA Occasional Papers in Financial Regulation 2, 17, available at www.fsa.gov.uk/ pubs/occpapers/op02.pdf (visited on 15 January 2011). 134 Douglas W. Arner, Berry F.C. Hsu and Antonio M. Da Roza, ‘Financial Regulation in Hong Kong: Time for a Change’ (2010) 5 Asian Journal of Comparative Law 1, 42–43.

226

D.W. Arner and E. Gibson

A Functional/Objectives model assigns each regulator with a separate function/objective. Australia has adopted this model. The Australian model was designed to combat the then identified four different types of market failure by assigning one financial regulator with an objective or function to combat each type of market failure. This model would potentially overcome structural limitations of the HKMA overseeing the resolution of SIFIs. The Twin Peaks model focuses on two objectives of regulation: financial stability and conduct of business, housed within two separate agencies.135 Structurally, the financial stability objective will usually be housed within one agency that combines the supervision of systemic financial stability (macro-prudential) with the financial stability supervision of all financial institutions (micro-prudential). Conduct of business will be housed in the other agency. This model has been adopted in the United Kingdom, the Netherlands and France. The principal benefit of the Twin Peaks model is that it can adapt to any financial intermediary activity and financial institutional structure.136 Potentially such a model would address Hong Kong’s sectoral structural design flaws by more effectively maintaining financial stability from systemic disturbances emanating from securitization, OTC derivatives and SIFIs. The Twin Peaks model would also provide a structure to bridge the current sectoral gaps pertaining to macro-prudential supervision that would not be as dependent on MoUs.

9.9 Conclusion Hong Kong’s financial regulatory structure is typified by second tier specialist regulatory agencies. Regulatory ambits are demarcated according to the HKMA’s institutionally based cross-sectoral jurisdiction and the SFC, OCI and MPFA’s sectoral jurisdictions qualified by statutory institutional exclusions. Cooperation and coordination amongst the regulators to address the cross-institutional limitations of the HKMA and the crosssectoral limitations of the SFC, OCI and MPFA is managed through Committees and MoUs. The design of Hong Kong’s financial regulatory structural has evolved in response to financial crises and regulatory failures. This ad hoc structural design has resulted in Hong Kong’s current regulatory structure being characterized by regulatory jurisdictional gaps, overlaps, frictions and conflicts. Implementation of the FSB’s recommendations has initiated some minor structural reforms that will influence Hong Kong’s market and institutional evolution and thus its financial structure in the longer term. 135 Michael Taylor, ‘ “Twin Peaks”: A Regulatory Structure for the New Century’ (December 1995) Centre for the Study of Financial Innovation 20, 10. 136 Douglas W. Arner, Berry F.C. Hsu and Antonio M. Da Roza, ‘Financial Regulation in Hong Kong: Time for a Change’ (2010) 5 Asian Journal of Comparative Law 1, 44.

Financial regulatory structure in Hong Kong

227

In the past decade there have been five prominent reports and a review that have questioned the effectiveness of Hong Kong’s financial regulatory structure. Although structural flaws were revealed in the 2002 Kotewall Report, 2003 Expert Group Report, 2003 IMF Report and the 2008 Carse Review, no remedial redesign has been forthcoming. Arguably this inaction can be attributed to the fact that all were released prior to the GFC when the prevailing view of financial regulatory structures, particularly in the United States and the United Kingdom, was par excellence. Several high profile incidents during the GFC have once again revealed serious flaws with Hong Kong’s financial regulatory structure. Specifically, the high profile Lehman Minibond incident prompted the SFC and HKMA to release reports recommending reforms to Hong Kong’s financial regulatory structure. These reports restated some of the structural flaws exposed in the pre-GFC reports and the Carse Review. The Kotewall Report and the Expert Group Report elucidated the gaps and overlaps arising from a fragmented regulatory structure which is subject to dual regulation and the resultant confusion regarding the regulators’ exact roles. From a regulatory structural perspective, the 2003 IMF Report’s recurring themes were the supervisory weaknesses and manifold risks stemming from cross-sectoral activities, both within Hong Kong and from the Mainland. Although Carse questioned the justification for structural regulatory reform, there was serious doubt concerning the effectiveness of the HKMA’s cross-sectoral supervision. If the Carse Review had been released post-GFC and flaws with other financial models elucidated, perhaps the push for structural change would have been greater. Structural flaws raised in the 2003 IMF Report and the Carse Review resurfaced during the GFC. The Bank of East Asia incident exposed a weakness when regulating banks active in non-bank financial sectors outside the HKMA’s regulatory jurisdiction. AIA’s rush by policy holders served to demonstrate that cross-sector cross-border systemic risks between the insurance and banking sectors can be transmitted indirectly through feedback. CITIC Pacific highlighted the ambiguous arrangement between of the SFC, the HKEx and the Listing Rules, which was raised in 2003 by both the IMF Report and the Expert Group Report, and more generally the problems pertaining to fragmented regulatory oversight. The HKMA’s Lehman Minibonds Report recommended a broadening of the HKMA’s regulatory jurisdiction. Thus the HKMA is implying that Hong Kong’s fragmented institutional model is suboptimal when managing crosssectoral activities. The fact that there are so many coordination and cooperation arrangements between the regulators in the form of Committees and MoUs reinforces the fact the Hong Kong’s regulatory structure per se is suboptimal at managing the cross-institutional limitations of the HKMA and the cross-sectoral limitations of the SFC, OCI and MPFA. The SFC’s Lehman Minibond Report questioned the effectiveness of Hong Kong’s regulatory structure in instances where financial products

228

D.W. Arner and E. Gibson

converged but the point of sale was subject to segregated regulatory oversight. This statement implies that the SFC considers that the coordination and cooperation arrangements are somewhat ineffective when managing cross-sectoral activities. Remedial recommendations advocated the adoption of either an integrated regulator similar to the United Kingdom, the Twin Peaks model or refinement of the current regulatory structure to cater for market developments.137 The SFC’s report stressed the risks posed by the United Kingdom’s integrated model, especially in light of Northern Rock.138 From the lessons learned during the GFC, the United Kingdom has rejected the integrated model and the G30 asserted that Hong Kong’s institutional model is suboptimal given the evolution of the markets. Accordingly there is some difficulty in envisaging how Hong Kong’s institutional model could be refined to effectively cater for future market developments, including effective implementation of the FSB reforms during a financial crisis. Recurring themes from the numerous reports, review and regulatory incidents over the past decade reinforce that Hong Kong financial regulatory structure is suboptimal. The fragmented financial regulatory structure is fundamentally flawed when oversight is outside a traditional regulatory jurisdiction. Hong Kong’s financial regulatory structure functions relatively well when an incident falls within a clear regulatory demarcation. Problematically, markets and institutions are continually evolving with many activities failing to neatly fall within a clear regulatory demarcation. Rather than waiting for the next financial crisis or regulatory failure to dictate ad hoc financial regulatory structural reform, Hong Kong needs to address the current financial regulatory structural flaws. Hong Kong’s ongoing history of regulatory failures serves as a forewarning that the financial regulatory structure needs to be redesigned before a failure occurs that fatally undermines financial stability. Only when the financial regulatory structure has been redesigned to reflect markets, institutions and the FSB’s regulatory recommendations can Hong Kong confidently endure future financial challenges looking forward.

Bibliography Arner, Douglas and Jan-juy Lin (eds), Financial Regulation: A Guide to Structural Reform (Hong Kong: Sweet & Maxwell Asia, 2003). Arner, Douglas, W. Berry, F.C. Hsu and Antonio M. Da Roza, ‘Financial Regulation in Hong Kong: Time for a Change’, (2010) 5 Asian Journal of Comparative Law 1.

137 Securities and Futures Commission, ‘Issues Raised by the Lehmans Minibonds Crisis: Report to the Financial Secretary’ (December 2008), 7, available at www.sfc.hk/sfc/doc/ EN/general/general/lehman/Review%20Report/Review%20Report.pdf (visited on 27 March 2011). 138 Ibid., 44.

Financial regulatory structure in Hong Kong

229

Arner, Douglas, W. Berry, F.C. Hsu, Antonio M. Da Roza, Francisco A. Da Roza, Syren Johnstone and Paul Lejot, ‘The Global Financial Crisis and the Future of Financial Regulation in Hong Kong’ (2009) Asian Institute of International Financial Law, AIIFL Working Paper No. 4. Bangyan, Feng and Nyaw Mee Kau, Enriching Lives: A History of Insurance in Hong Kong, 1841–2010 (Aberdeen, Hong Kong: Hong Kong University Press, 2010). Briault, Clive ‘The Rationale for a Single National Financial Services Regulator’ (May 1999) FSA Occasional Papers in Financial Regulation 2, available at www.fsa. gov.uk/pubs/occpapers/op02.pdf (visited on 15 January 2011). Carse, David T.R. ‘Review of the Hong Kong Monetary Authority’s Work on Banking Stability’ (July 2008), available at www.info.gov.hk/hkma/eng/public/ rwbs/david%20carse%20report.pdf (visited on 23 February 2011). Financial Services Branch, Financial Services and Treasury Bureau, ‘Proposed Establishment of an Independent Insurance Authority Consultation Conclusions and Detailed Proposals’ (June 2011), available at: www.fstb.gov.hk/fsb/ppr/ consult/doc/iia_concul_proposals_e.pdf (visited on 30 June 2011). Financial Services Branch, Financial Services and Treasury Branch, ‘Key Legislative Proposals on the Establishment of the Independent Insurance Authority’ (26 October 2012), 9–10, available at www.fstb.gov.hk/fsb/ppr/consult/doc/iiakeylegislation_faq_e.pdf (visited on 29 August 2013). Financial Stability Board, ‘Effective Resolution of Systemically Important Financial Institutions: Overview of Responses to the Public Consultation’ (4 November 2011), available at www.financialstabilityboard.org/publications/r_110719cc.pdf (visited on 27 February 2012). Financial Stability Board, ‘FSB G20 Monitoring Progress Hong Kong’ (September 2011), available at www.financialstabilityboard.org/publications/r_111104h.pdf (visited on 3 October 2011). Financial Stability Board, ‘FSB Report on Principles for Reducing Reliance on CRA Ratings’ (27 October 2010), available at www.financialstabilityboard.org/ publications/r_101027.pdf (visited on 26 November 2010). Financial Stability Board, ‘Implementing the FSB Principles for Sound Compensation Practices and Their Implementation Standards (Progress Report)’ (13 June 2012), available at www.financialstabilityboard.org/publications/r_120613.pdf (visited on 1 July 2012). Financial Stability Board, ‘Key Attributes of Effective Resolution Regimes for Financial Institutions’ (October 2011), available at www.financialstabilityboard.org/ publications/r_111104cc.pdf (visited on 27 February 2012). Financial Stability Board, ‘OTC Derivatives Market Reforms: Fifth Progress Report on Implementation’ (15 April 2013), available at www.financialstabilityboard. org/publications/r_130415pdf (visited on 2 September 2013). Financial Stability Board, ‘Overview of Progress in the Implementation of the G20 Recommendations for Strengthening Financial Stability: Report of the Financial Stability Board to G20 Leaders’ (18 June 2010), available at www.financialstabilityboard.org/publications/r_100627c.pdf (visited on 23 February 2011). Financial Stability Board, ‘Overview of Progress of Implementation of G20 Recommendations for Strengthening Financial Stability: Report of the Financial Stability Board to G20 Leaders’ (4 November 2011), available at www.financialstabilityboard.org/publications/r_111104.pdf (visited on 15 March 2012).

230

D.W. Arner and E. Gibson

Financial Stability Board, ‘Progress of Implementation of G20/FSB Recommendations (Hong Kong)’ (June 2012), available at www.financialstabilityboard.org/ publications/r_120619hh.pdf (visited on 1 July 2012). Financial Stability Board, ‘Thematic Review on FSB Principles for Reducing Reliance on Credit Rating Agency Ratings: Interim Report’ (29 August 2013), available at www.financialstabilityboard.og/publications/r_130829e.pdf (visited on 4 September 2013). Financial Stability Forum, ‘FSF Principles for Sound Compensation Practices’ (2 April 2009), available at www.financialstabilityboard.org/publications/r_0904b. pdf (visited on 6 November 2010). Ghose, Tushar K. The Banking System of Hong Kong (Chai Wan, Hong Kong: Butterworths Asia (Hong Kong), 2nd edn, 1995). Group of Thirty, ‘Financial Reform: A Framework to Financial Stability’ (2009), available at www.group30.org/rpt_03.shtml (visited 12 October 2009). Group of Thirty, ‘The Structure of Financial Supervision: Approaches and Challenges in a Global Marketplace’ (2008), available at www.group30.org/rpt_06. shtml (visited on 2 May 2011). Hong Kong Monetary Authority, ‘Annual Report 2011’ (30 April 2012), available at www.hkma.gov.hk/eng/publication-and-research/annual-report/2011.shtml (visited on 2 July 2012). Hong Kong Monetary Authority, ‘Report of the Hong Kong Monetary Authority on Issues Concerning the Distribution of Structured Products Connected to Lehman Group Companies’ (December 2008), available at www.fstb.gov.hk/ eng/minibond/HKMAminibond.pdf (visited on 14 November 2011). Hong Kong Monetary Authority, ‘Supervisory Policy Manual: Guidance on a Sound Remuneration System’ (19 March 2010) CG-5, available at www.hkma.gov.hk/ media/chi/doc/key-functions/banking-stability/supervisory-policy-manual/ CG-5.pdf (visited on 2 July 2012). Hong Kong Monetary Authority, ‘Supervisory Treatment on Asset Securitisation and Mortgage Backed Securities’ (August 2011) Guideline No. 4.6, available at www.hkma.gov.hk/eng/key-information/guidelines-and-circulars/guidelines/ guide_46b.shtml (visited on 8 February 2012). Hong Kong Monetary Authority and Securities and Futures Commission, ‘Joint Consultation Conclusions on the Proposed Regulatory Regime for the Over-thecounter Derivatives Market in Hong Kong’ (11 July 2012), available at www. hkma.gov.hk/media/eng/doc/key-information/press-release/2012/20120711 e3a34.pdf (visited on 13 July 2012). Hsu, Berry Fong-Chung, Douglas W. Arner, Maurice Kwok-Sang Tse and Syren Johnstone, Financial Markets in Hong Kong: Law and Practice (Oxford: Oxford University Press, 2006). Kemp, Karen ‘Implementation of Basel III in Hong Kong’ (26 January 2011) Hong Kong Monetary Authority, Guidelines and Circulars, available at www.hkma.gov.hk/ media/eng/doc/key-information/guidelines-and-circular/2011/20110126e1. pdf (visited on 3 March 2011). King, Frank H.H. The History of the Hong Kong and Shanghai Banking Corporation; Volume IV: The Hong Kong Bank in the Period of Development and Nationalism 1841–1984: From Regional Bank to Multinational Group (Cambridge: Cambridge University Press, 1991). Kotewall, Robert G. and Gordon C.K. Kwong, ‘Report of the Panel of Inquiry on

Financial regulatory structure in Hong Kong

231

the Penny Stocks Incident’ (September 2002), available at www.info.gov.hk/ info/pennystock-e.htm (visited on 15 May 2011). Schooner, Heidi M. and Michael W. Taylor, Global Bank Regulation: Principles and Policies (London: Elsevier, 2010). Securities and Futures Commission, ‘Issues Raised by the Lehmans Minibonds Crisis: Report to the Financial Secretary’ (December 2008), available at www.sfc. hk/sfc/doc/EN/general/general/lehman/Review%20Report/Review%20 Report.pdf (visited on 27 March 2011). Securities and Futures Commission, ‘Regulatory Framework for Intermediaries’ (June 2011), available at www.sfc.hk/sfc/doc/EN/aboutsfc/Regulatoryframework.pdf (visited on 10 March 2012). Securities and Futures Commission, ‘Report of the Survey on Hedge Fund Activities of SFC-licensed Managers/Advisers’ (March 2011), available at www.sfc.hk/sfc/ doc/EN/speeches/public/surveys/11/Hedge%20fund%20managers_201103.pdf (visited 21 May 2011). Sheng, Andrew From Asian to Global Financial Crisis: An Asian Regulator’s View of Unfettered Finance in the 1990’s and 2000’s (Cambridge: Cambridge University Press, 2009). Taylor, Michael ‘ “Twin Peaks”: A Regulatory Structure for the New Century’ (December 1995) Centre for the Study of Financial Innovation 20. The Expert Group to Review the Operation of the Securities and Markets Regulatory Structure, ‘Report by the Expert Group to Review the Operation of the Securities and Futures Market Regulatory Structure’ (March 2003), available at www.info.gov.hk/info/expert/expertreport-e.htm (visited on 15 May 2011).

10 Institutional structure of financial regulation in China Where is it now and where is it heading?* Robin Hui Huang 10.1 Introduction This chapter examines the legal and institutional regulatory framework for China’s financial markets, and evaluates how China may need to restructure its regulatory regime in order to keep up with the market developments. It first provides a detailed discussion of the current Chinese financial regulatory framework. In light of the recent global financial crisis of 2008, this chapter identifies several major structural problems with the Chinese regulatory regime. It then conducts a comparative analysis of financial regulatory structure in overseas jurisdictions, as well as a contextual consideration of China’s local conditions, with a view to setting forward an appropriate agenda for reform of China’s financial regulatory structure.

10.2 The current financial regulatory structure The current financial regulatory structure in China has the defining feature of being sectors-based. As the central bank, the PBC assumes responsibility for monetary policy and the stability of the financial system generally. The CBRC, the CSRC and the CIRC are the authorities responsible for regulating the banking, securities and insurance sectors respectively. These regulatory bodies will be examined below in detail. It should be noted however that certain other government agencies also perform important regulatory functions in the financial markets. For instance, the Ministry of Finance has the authority to make strategic and policy decisions on finance and taxation, set accounting standards and issue treasury bonds; the National Development and Reform Commission is empowered to approve the issuance of enterprise bonds and get involved in making financial and monetary policies; and the National

* This chapter is based on Hui Huang, ‘Institutional Structure of Financial Regulation in China: Lessons from the Global Financial Crisis’ (2010) 10(1) The Journal of Corporate Law Studies 219.

Financial regulatory structure in China

233

Audit Office has responsibility to audit the financial accounts of stateowned banks, securities firms and insurance companies. It is worth noting that the above government agencies, along with the PBC, the CBRC, the CSRC and the CIRC, are all ranked equally under the direct leadership of the State Council.1 Apart from governmental agencies, there exist a variety of selfregulatory organizations (SROs) which are subject to the regulatory oversight of the relevant governmental regulatory agencies and with varying levels of responsibility for their respective markets and the conduct of their members. These include China Banking Association (CBA), Insurance Association of China (IAC), Securities Association of China (SAC), China Futures Association (CFA) and China Trustee Association (CTA). In addition, the market operators, including the two stock exchanges and the four futures exchanges play an important self-regulatory role, subject to the oversight of the CSRC. 10.2.1 Central banking 10.2.1.1 PBC The PBC is the central bank in China, a role legally confirmed by the Law of PRC on the People’s Bank of China (PBC Law).2 Pursuant to the PBC Law, the PBC must formulate and implement monetary policies, guard against financial risks and maintain financial stability under the leadership of the State Council.3 As with most central banks in the world, the PBC has a threefold role: the currency-issuing bank; the bank of banks; and the government bank. More specifically, the PBC performs the following functions: (1) promulgating and implementing orders and regulations in relation to its functions; (2) formulating and implementing monetary policies in accordance with the law; (3) issuing the Chinese currency, namely Renminbi (RMB), and controlling its circulation; (4) supervising the inter-bank borrowing or lending market and inter-bank bonds markets; (5) administering foreign exchange, and supervising inter-bank foreign exchange market; (6) supervising gold market; (7) holding, controlling and managing the state foreign exchange reserve and gold reserve; (8) managing the state treasury; (9) maintaining the normal operation of the systems for

1 Guowuyuan Guanyu Jigou Shezhi de Tongzhi [Notice on the Institutional Structure of the State Council] (promulgated by the State Council on 21 March 2008). 2 Zhonghua Renmin Gongheguo Zhongguo Renmin Yinhang Fa [The Law of PRC on the People’s Bank of China] (adopted at the 3rd session of the Standing Committee of the 8th National People’s Congress of the PRC on 18 March 1995, amended on 27 December 2003), art. 2. 3 PBC Law, art. 2.

234

R.H. Huang

payments and settlements of accounts; (10) directing and disposing the anti-money-laundering work of the financial industry, being responsible for capital supervision and measurement over anti-money-laundering; (11) being responsible for the statistics, investigation, analysis and forecasting of the financial industry; (12) undertaking the relevant international banking operations as the central bank of the state; and (13) other functions assigned to it by the State Council.4 As noted earlier, in 2003, the PBC was divested of its direct banking supervisory powers. These powers were transferred to the newly established CBRC in order to provide the PBC with the necessary independence to implement the nation’s monetary policy. The PBC now seeks to stabilize the currency and the financial system by indirect, macroeconomic means rather than through a direct, interventionist approach as it did in the planned economy era. It therefore exercises macro-economic control over the financial markets primarily through a range of monetary tools such as deposit reserves, rediscount rate, interest rate and open market operations. 10.2.1.2 Exchange rate The Chinese currency, the Renminbi or yuan, had long been fixed to the US dollar until 21 July 2005, when China introduced the so-called managed floating mechanism of exchange rate. Under this mechanism, China allows its currency to float within a managed range. At the same time, the fixed peg to the US dollar is replaced with a basket of currencies of China’s major trading partners. Since then, the Chinese current has appreciated by about 25–30 per cent against the US dollar. The appreciation of the Chinese currency has had significant impact on, amongst other things, its financial markets. 10.2.1.3 Interest rates Historically, China has adopted the policy of interest rate control, under which the PBC as the central bank sets the base interest rates, and commercial banks cannot freely depart from the official rates. One of the consequences of this policy is that there is limited scope for banks to compete by way of interest rates and thus the banking industry as a whole can easily make profits from the traditional business of lending. Indeed, Chinese banks’ main source of revenue is the spread between its average borrowing and lending rates. The net interest rate income of Chinese banks generally accounts for more than 80 per cent of their total revenue, while 4 PBC Law, art. 4. It should be noted that the State Administration of Foreign Exchange is a government agency under the leadership of the PBC, and it acts as the implementation branch of the PBC in relation to foreign exchange administration and supervision.

235

Financial regulatory structure in China 5

the figure is less than 60 per cent for banks in developed economies. This means Chinese banks rely too heavily on the traditional business of lending and need more fee-based income. As the financial reform deepens, interest rate liberalization has been listed as one of the reform priorities. Since 2004, deposit and loan interest rate control has been gradually relaxed. On the one hand, the loan rate was allowed to fluctuate within 10 per cent of the official rate in 2004, and then 20 per cent in June 2012, 30 per cent in July 2012; on the other hand, 10 per cent fluctuation was allowed for the deposit rate for the first time in June 2012. The liberalization process of the interest rate will undoubtedly lead to greater competition amongst banks and thus smaller spread between borrowing and lending rates, making it more difficult for banks to make money with the traditional lending business. Given the heavy reliance of Chinese banks on net interest rate income, the liberalization process is seen as, in the words of the president of the Merchant Bank, ‘a life and death test for China’s banking industry’.6 10.2.2 Banking regulation 10.2.2.1 CBRC In 2003, the CBRC came into existence as the banking ‘watch dog’, taking over the role previously performed by the PBC. The legal and regulatory framework for banking regulation comprises the Law of the PRC on Commercial Banks,7 and the Law of the PRC on Banking Regulation and Supervision.8 Like its peers in the securities and insurance markets, the CBRC is a ministry rank unit under the direct leadership of the State Council. The main objectives of the CBRC as banking regulator are to: (1) promote the lawful, smooth, and sound operations of the banking industry, and maintain the confidence of the general public in the banking industry; (2) ensure fair competition in the banking market and improve competiveness of the banking industry.9 It should be noted that the CBRC regulates not only banks, but also a variety of specified non-bank financial institutions. The former group covers those banks discussed above, such as 5 Website of the CBRC, www.cbrc.gov.cn. 6 ‘Ma Weihua: Interest Rate Liberalization is a Life and Death Test for China’s Banking Industry’, Jinrong Shibao [Financial Times] 7 August 2012. 7 Zhonghua Renmin Gongheguo Shangye Yinhang Fa [Law of the PRC on Commercial Banks] (adopted at the 13th session of the Standing Committee of the 8th National People’s Congress of the PRC on 10 May 1995, amended on 27 December 2003). 8 Zhonghua Renmin Gongheguo Yinhangye Jiandu Guanli Fa [Law of the PRC on Banking Regulation and Supervision] (adopted at the 6th session of the Standing Committee of the 10th National People’s Congress of the PRC on 27 December 2003, amended on 31 October 2006). 9 Ibid., art. 3.

236

R.H. Huang

commercial banks, policy banks, urban/rural credit unions and other financial institutions engaged in taking deposits of the general public. The latter group includes financial assets management companies, trust investment companies, financing companies, financial lease companies and other financial institutions established with approval of the CBRC.10 As trust investment companies are subject to the CBRC’s regulation, approval is needed for the establishment of private-equity funds which usually take the legal structure of trust. In its regulatory role under the relevant law, the CBRC is responsible for both market conduct regulation and prudential regulation. Under Article 16 of the Law of the PRC on Banking Regulation and Supervision, the CBRC is responsible for the examination and approval of the establishment, modifications, termination and operation scope of the financial institutions it regulates.11 Article 18 provides that certain types of financial operations, as prescribed by the rules of the CBRC, need to be examined and approved by the CBRC before the financial institutions can carry out those operations.12 Under Article 21, the CBRC has powers to make and enforce rules regarding prudential regulation.13 This way, the CBRC exercises its supervisory function through prudential standards such as asset/ liability ratio requirement, capital adequacy ratio and risk management, as opposed to the more interventionist means like the imposition of loan quotas as used under the planned economy. 10.2.2.2 Regulatory issues: non-performing loans In general, the CBRC has done a great job of supervising China’s banking industry in a relatively short period of time. In 2003, when the CBRC was established, China’s banking industry was described as ‘technically bankrupt’, with the non-performing loans (NPL) of the ‘Big Four’ state-owned banks amounting to 17.9 per cent of all loans; and before 1998, the figure was even as high as 25 per cent. In recognition of this issue, the Chinese government established the Central Huijin Investment Ltd (Central Huijin) in 2003, which is wholly state-owned and authorized by the State Council to exercise rights and obligations as an investor in major state-owned financial enterprises on behalf of the State. Through Central Huijin, money from China’s foreign exchange reserve was injected into the then financially ailing banks. Moreover, a total amount of about CYN 1.19 trillion worth of non-performing loans from the state-owned banks were spun off to four financial asset management companies, including Xinda, Huarong, Changcheng and 10 11 12 13

Ibid., art. 2. Ibid., art. 16. Ibid., art. 18. Ibid., art. 21.

Financial regulatory structure in China

237

Dongfang. These measures combined to have the effect of bringing the capital adequacy ratio of the banks into line with the regulatory standard of 8 per cent. After this exercise, the banks have been required to operate on a market-oriented basis and their regulation improved progressively. In the face of rapidly changing financial markets, the CBRC regulatory strategy is to adhere to clear prudential supervisory policies and focus on traditional indicators, such as capital adequacy ratio (CAR), large items of risk exposure, rate of non-performing assets and provisioning adequacy and coverage. This has resulted in significant improvement in key aspects of China’s banking industry, including the quality of assets and risk resilience. For instance, the capital adequacy ratio of all commercial banks in China increased to 13.25 per cent in 2012, up from minus 2.98 per cent at the end of 2003; the NPL rate has been declining steadily from 17.9 per cent in 2003 to 0.95 per cent in 2012.14 Despite the remarkable achievements outlined above, some worrying problems loom for Chinese banking regulation. One of the major sources of bank loan risk is the high volume of housing mortgages. As China’s housing market has continued to develop at a rapid rate in the past decade, so has the demand for housing mortgages, giving rise to a sharp increase in the ratio of housing loans to all bank loans to a level widely judged to be too high for the safety of the banks. The problem is exacerbated by the increasing bubble in the housing market. The government has been trying to cool the overheated property market with a series of measures, such as the tightened housing loan policy and the limit on the number of properties one can buy in the same city. This may cause significant housing price fluctuations which in turn will put pressure on the balance sheet of Chinese banks. Mr Liu MinKang, the former Chairperson of the CBRC, expressed concerns that after a steady decrease in bad loan rate since 2003, bad loans may start to grow in the years ahead.15 10.2.3 Insurance regulation Against the backdrop of the fast-growing insurance market, the regulatory regime has been reformed over the years. The CIRC was set up in 1998 to assume regulatory responsibility for the insurance industry in China under the Insurance Law of the PRC.16 The principal duties and responsibilities

14 Website of the CBRC, www.cbrc.gov.cn. 15 For more discussion of non-performing loans of Chinese banks, see Hui Huang, ‘China’s Legal Responses to the Global Financial Crisis: From Domestic Reform to International Engagement’ (2010) 12(2) Australian Journal of Asian Law 157. 16 Zhonghua Renmin Gongheguo Baoxian Fa [Insurance Law of the PRC] (adopted at the 14th session of the Standing Committee of the 8th National People’s Congress of the People’s Republic of China on 30 June 1995, amended 28 October 2002 and 28 February 2009), art. 9.

238

R.H. Huang

of the CIRC are to supervise and administer the insurance sector in accordance with the principle of legality, openness and fairness, with the aim of maintaining the order of the insurance market and protecting the legitimate rights and interests of insurance purchasers, insurants and beneficiaries. As with the CBRC, the CIRC is charged with both market conduct regulation and prudential regulation in relation to insurance companies. The Insurance Law of the PRC devotes a whole chapter to the making and enforcement of insurance contracts.17 In China, life insurance is separated from property insurance and thus one insurance company cannot conduct both of them concurrently.18 The CIRC is also tasked with licensing and regulating insurance agents and brokers to make sure that the financial intermediaries operate in a fair and efficient manner. On the front of prudential regulation, the CIRC needs to ensure the compliance of insurance companies with various prudential requirements, including the requirement to draw guarantee fund, liability reserve fund, capital reserve and insurance protection fund. In addition, the CIRC is required to set up and improve a system to monitor the solvency of insurance companies. Particular regulatory attention will be paid to those insurance companies whose ability to pay indemnity is regarded as inadequate, and the CIRC has power to take a variety of measures to deal with the issue, such as ordering an increase of capital or reinsurance; limiting the scope of business; restricting the payment of dividends to shareholders; restricting the purchase of fixed assets or the scale of operation costs; and restricting the level of salaries of directors, supervisors and senior managers.19 10.2.4 Securities regulation 10.2.4.1 CSRC The legal and regulatory framework for the securities market in China is largely based on the Securities Law of the PRC (Securities Law).20 As noted before, established in 1992 and upgraded in 1998, the CSRC is the oldest of the three industry-specific regulatory bodies in the financial markets. Since then, the CSRC has assumed responsibility for securities regulation in China. It should be noted that the coverage of the Securities Law and

17 18 19 20

Ibid., Ch. 2. Ibid., art. 95. Ibid., art. 139. Zhonghua Renming Gongheguo Zhengquanfa [Securities Law of the PRC] (promulgated by the 6th session of the Standing Committee of the 9th National People’s Congress of the PRC on 29 December 1998 and effective from 1 July 1999, amended in 2004 and 2005).

Financial regulatory structure in China

239

therefore the authority of the CSRC is so broad as to include the regulation of shares, corporate bonds, treasury bonds, securities investment funds and derivative products such as futures contracts, options and warrants.21 Thus, in terms of the regulatory area, the CSRC is roughly equivalent to the combination of the Securities and Exchange Commission (SEC) and the Commodity Futures Trading Commission (CFTC) in the US. However, the CSRC’s regulatory territory is narrower than that of its Australian counterpart, namely the Australian Securities and Investment Commission, which acts as both securities regulator and corporate regulator in Australia. The principal function of the CSRC is to ‘carry out supervision and administration of the securities market according to law so as to preserve the order of the securities market and ensure the legitimate operations thereof ’.22 More precisely, the CSRC performs the following regulatory duties: (1) formulating the relevant rules and regulations on the supervision and administration of the securities market and exercising the power of examination or verification according to law; (2) carrying out supervision and administration of the issuance, listing, trading, registration, custody and settlement of securities according to law; (3) carrying out supervision and administration of the securities activities of the securities issuers, listed companies, stock exchanges, securities companies, securities registration and clearing institutions, securities investment fund management companies and securities trading service institutions according to law; (4) formulating the standards for securities practice qualification and code of conduct and carrying out supervision and implementation according to law; (5) carrying out supervision and examination of information disclosure regarding the issuance, listing and trading of securities; (6) offering guidance for and carrying out supervision of the activities of the securities industrial associations according to law; (7) investigating into and punishing any violation of any law or administrative regulation on the supervision and administration of the securities market according to law; and (8) performing any other functions and duties as prescribed by any law or administrative regulation.23 In discharging its duties, the CSRC has a number of important semilegislative, investigative and adjudicative powers. First, it is empowered to make relevant rules and regulations. Second, it can take a range of investigative measures. For instance, it has power to undertake an on-the-spot examination of securities intermediaries; to enter into the place of occurrence of misconduct to investigate and collect evidence; to question the parties concerned or any entity or individual relating to a case requiring them to give explanations on relevant matters; to examine the capital 21 Ibid., art. 2. 22 Ibid., art. 178. 23 Ibid., art. 179.

240

R.H. Huang

account, security account or bank account of any relevant party concerned in or any entity or individual relating to a case under investigation; to freeze or seal up relevant assets and/or evidence which is in jeopardy of dissipation, waste or improper removal, with the approval of the responsible officer of the CSRC; to restrict the securities transactions of the parties concerned in a case under investigation, when investigating any major securities irregularity such as manipulation of the securities market or insider trading, with the approval of the responsible officer of the CSRC. It is remarkable that, unlike its counterparts in many overseas jurisdictions, the CSRC can take the above investigative measures as they deem necessary without the need to apply to the court. In fact, before the 2005 revision of the Securities Law, the CSRC was required to apply to courts to take those measures. However, this mechanism was proven ineffective, because in practice, the courts always failed to efficiently respond to the application of the CSRC, due to factors such as: (1) localism – the courts at local levels are generally amenable to local governments who often protect their listed companies from the CSRC; (2) endemic judiciary corruption; and (3) red tape and bureaucracy. This situation made it very difficult for the CSRC to carry out its investigative work and thus the 2005 Securities Law empowers the CSRC to take those measures on its own. The CSRC, according to the results of investigation, can decide to impose administrative sanctions for relevant securities irregularity. The usual weapons in the CSRC’s arsenal include warning, fine, suspension and cancellation of licences. Further, the CSRC can issue a barring order (shichang jinru), under which a person is prohibited from undertaking any securities practice or holding any post of director, supervisor or senior manager of a listed company within a prescribed term or for life. Finally, if the case is serious enough to warrant criminal sanction, the CSRC will refer the case to the procuratorate to bring criminal charges. As an administrative body, the CSRC’s administrative decisions on various issues such as securities offerings and administrative punishment are subject to administrative review (xingzheng fuyi) and administrative litigation (xingzheng susong). As the CSRC is a very powerful agency, bringing administrative litigation to challenge the CSRC is certainly not a light decision to be taken for market participants. The first administrative litigation against the CSRC did not come until 2000, involving a company named Hannan Kaili (Kaili). The CSRC rejected Kaili’s application for securities offering on the grounds that Kaili’s financial reports were fraudulent. More importantly, Kaili was barred from reapplying in future. In light of this life ban, Kaili had nothing to lose and thus decided to take the CSRC to court. The court of first instance, namely the First Intermediate Court of Beijing, held on 18 December 2000 that the CSRC’s decision to impose a life ban on Kaili had no legal basis and the issue of whether Kaili’s financial reports were fraudulent should be decided by professionals. The CSRC appealed to the High

Financial regulatory structure in China

241

Court of Beijing, and on 5 July 2001, the judgment of the court of first instance was affirmed. This case has had far-reaching implications for Chinese securities regulation, in that it acts a check on the CSRC. 10.2.4.2 Stock exchanges Self-regulation by stock exchanges is a necessary and important supplement to governmental regulation by the CSRC. The two stock exchanges in Shanghai and Shenzhen are assigned the role of front-line regulator in the respective markets they operate. More specifically, the securities exchanges can make and enforce their rules such as listing rules and business rules;24 have discretion concerning the admission of an entity to the official list (and its removal) and quotation of its securities (and their suspension).25 Further, the securities exchanges shall exercise the real-time monitoring of securities trading and report certain abnormal trading to the CSRC; they also need to carry out supervision over information disclosure by listed companies or relevant disclosing entities, so as to ensure information is disclosed in a timely and accurate manner.26 It is important to note that the securities exchanges are subject to the oversight of the CSRC. The CSRC supervises and monitors the activities of securities exchanges, approves their constitutions and amendments,27 approves their operating rules and amendments28 and administers and enforces the relevant applicable legislation.29 The stock exchanges perform their front-line regulatory functions principally through the promulgation and enforcement of operating rules, which include, but are not limited to, listing rules (shangshi guize) and trading rules (jiaoyi guize). The trading rules basically regulate the machinery of stock exchange transactions and the conduct of securities business by market participants. The provisions are internal to the stock exchange, relating to issues such as prudential controls and supervision over member organizations, as well as the clearing and settlement of dealings. The listing rules, on the other hand, mainly govern the admission of companies to the official lists maintained by the stock exchanges and the conduct of companies whose securities are granted quotation. The 24 Ibid., art. 118. 25 Ibid., arts. 48, 55, 56. Before the 2005 amendment to the Securities Law, the CSRC had the power (or to delegate the power to securities exchanges) to decide on matters relating to listing, trading suspension and delisting. 26 Ibid., art. 115. 27 Ibid., art. 103. 28 Ibid., art. 118. 29 Ibid., arts. 116, 117 (providing that securities exchanges must draw a risk fund and deposit it into a special bank account).

242

R.H. Huang

provisions specify criteria for companies to get listed, and impose continuing obligations, particularly disclosure, upon listed companies. The listing rules can set out more stringent requirements than those prescribed by the Securities Law for quotation of securities on the stock exchanges.30 If a person who is under an obligation to comply with the stock exchange’s operating rules fails to meet the obligation, the stock exchange can take relevant measures, including notices of criticism (tongbao piping), public censure (gongkai qianze) and disqualification of individuals to serve as directors, senior managers and secretaries of the board of directors.31 As notices of criticism and public censure are reputational sanctions in nature and are not backed by legal liabilities, it is not entirely clear how effective they are.32 However, there are more powerful weapons in the arsenal of the stock exchange. For instance, in the case that a listed company breaches the listing rules, the stock exchange has power to suspend quotation of the company’s securities or even remove the company from the official list.33 An interesting issue here is whether the decisions of the stock exchange, particularly those relating to admission, suspension and removal of a company to the official list, are subject to judicial review. Under the Chinese legal system, administrative litigation can be brought against illegal specific administrative acts such as licensing decisions and penalty decisions made by administrative bodies. According to a judicial interpretation issued by the Supreme People’s Court of the PRC in 2005, the stock exchange may be subject to either civil or administrative litigation for acts they make in relation to its regulatory functions, including decisions towards securities issuers and the relevant personnel thereof, stock exchange members and the relevant personnel thereof, or regarding the listing of securities and transaction activities.34 The judicial interpretation does not however provide clear guidance on what acts of stock exchanges give rise to what kind of litigation. Further, it is stated that

30 For more discussion of this, see Chapter 4. 31 See, e.g. Shanghai Stock Exchange Listing Rules, chapter 17. 32 An empirical study suggests that Shenzhen Stock Exchange has used the measure of public criticism more often than Shanghai Stock Exchange, and overall the measure seems to be effective. See Benjamin L. Liebman and Curtis J. Milhaupt, ‘Reputational Sanctions in China’s Securities Market’ (2008) 108 Columbia Law Review 929. This empirical study, however, has suffered from some methodological problems and thus its conclusion should be treated with caution. See Hui Huang, ‘The Evolution of Stock Exchanges in China: Past, Present and Future’ (working paper). 33 For more discussion of this, see Chapter 5. 34 Guanyu dui yu Zhengquan Jiaoyisuo Jianguan Zhineng Xiangguan de Susong Anjian Guanxia yu Shouli Wenti de Guiding [Rules on the Jurisdiction and Acceptance of Cases Relating to the Regulatory Function of Stock Exchanges] (issued by the Supreme People’s Court in 2005), arts1, 2.

Financial regulatory structure in China

243

The people’s court shall not accept the lawsuits brought by investors against stock exchanges due to their acts upon securities issuers or the relevant personnel thereof, stock exchange members or the relevant personnel thereof, or regarding the listing of securities or transaction activities, which are conducted in the process of their implementation of regulatory duties but do not directly impact on the investors’ interests.35 On one view, the above provision suggests that investors cannot sue, either civilly or administratively, against decisions made by stock exchanges in relation to securities listing, trading suspension and delisting. But the validity of this view depends on how to interpret the phrase of ‘do not directly impact on the investors’ interests’. Indeed, it could be argued that listing decisions have a direct bearing on investors. Thus, the Chinese law is quite ambiguous on this important issue. An empirical study done by this author has not found any case against listing decisions of stock exchanges by way of administrative litigation in China. This is actually a subject of international debate, which depends essentially on the nature of stock exchanges and listing rules they issue. In many overseas jurisdictions, judicial reviews are usually not conducted over the enforcement by stock exchanges of their listing rules, because stock exchanges are considered private bodies; listing rules are seen as contractual arrangements between the listed company and the stock exchange, and not administrative acts. The international experience may not be readily applicable in China, however, given the special nature of Chinese securities market, particularly the quasi-administrative role of stock exchanges there. It thus remains debatable whether China’s stock exchanges exercise powers of administrative character and thus they should be subject to judicial review.

10.3 Characteristics and problems 10.3.1 Lack of regulatory independence Lack of regulatory independence is a longstanding issue plaguing China’s financial regulation. Although the PBC Law seeks to preserve some measure of independence for the PBC, it is in essence a ministry-ranking constituent department directly under the leadership of the State Council – the Chinese central government. The PBC has one governor and a certain number of deputy governors. The governor of the PBC is appointed or removed by the President of the PRC on the nomination of the Premier of the State Council and also with the approval from the

35 Ibid., art3 (emphasis added).

244

R.H. Huang

National People’s Congress. When the National People’s Congress is not in session, he or she should be affirmed by the Standing Committee of the National People’s Congress. But the deputy governors of the PBC are appointed or removed directly by the Premier of the State Council.36 The PBC is required to submit working reports to the Standing Committee of the National People’s Congress.37 The lack of independence of the PBC from the central government is further illustrated in the way it performs its functions. Under the PBC Law, the PBC shall, under the leadership of the State Council, independently implement monetary policies, perform its functions and carry out its operations according to law free from any intervention of local governments, departments of governments at all levels, public organizations or individuals.38 Article 5 of the PBC Law further provides that the PBC must obtain the approval of the State Council before it is able to take actions on certain important matters such as the annual supply of currency, interest rates and foreign exchange rates.39 The three specialist regulatory commissions, namely the CBRC, the CSRC and the CIRC, may have even less independence from the government. Take the CBRC as an example. To begin with, the CBRC is formally an instrumentality of the central government and is subject to the direct leadership of the State Council. In the relevant law, the CBRC is referred to as ‘the banking supervision institution of the State Council’.40 All the chairpersons of the CBRC are appointed by the State Council and are accountable to the Premier. This is also the case with the CSRC and CIRC. Second, the authority of the CBRC is further undermined due to the role of the state in the financial markets. As discussed before, the Chinese financial system exhibits a high degree of concentration with the state ownership taking a dominating position. Traditionally, the State Council appoints the presidents and other senior officers of the Big Four stateowned banks. Those people have a dual role: on the one hand, they are business persons in the sense that they work in the industry; on the other hand, they are government staff in the sense that they still have relevant administrative ranks and are subject to the administrative system. Simply put, they are quasi-governmental officials, and may even rank equally with the Chairman of the CBRC in the hierarchy of China’s administrative system. This feature largely remains even after those banks started reform

36 37 38 39 40

PBC Law, art. 10. PBC Law, art. 6. PBC Law, art. 7. PBC Law, art. 5. Zhonghua Renmin Gongheguo Yinhangye Jiandu Guanli Fa [Law of the PRC on Banking Regulation and Supervision] (adopted at the 6th session of the Standing Committee of the 10th National People’s Congress of the PRC on 27 December 2003, amended on 31 October 2006), art. 2.

Financial regulatory structure in China

245

and went public in the past several years, as the state is still able to do so in its capacity as the controlling shareholder. This has affected the authority of the CBRC vis-à-vis the major state-owned/controlled banks it regulates. Given that the securities and insurance markets are less influential than the banking sector, the above ‘too big to regulate’ problem is less severe, but nevertheless exists to a certain extent. The strong position and governmental background enjoyed by the presidents of state-owned banks has also caused corporate governance problems. On the surface, the state-owned banks have put in place relevant corporate organs in accordance with modern corporate governance requirements, but the practical effects of those mechanisms are far from satisfactory. For instance, the risk management department and the audit department are supposed to be accountable to the risk management committee and the audit committee established under the board of directors. In reality, however, the two departments must first report to the president, and the relevant information can only reach the board of directors after it has been screened and approved by the president. Needless to say, without relevant reliable information, the board of directors is not able to effectively perform its monitoring role. Moreover, the issue of lack of independence is manifested in the relationship between the governmental regulators and self-regulatory bodies. Indeed, although securities exchanges are referred to as self-regulatory legal persons and are given a range of self-regulatory powers, they are not suitably structured and constituted so as to ensure an adequate level of independence. The two stock exchanges in Shanghai and Shenzhen are both membership-based mutual organizations, and the right to trade upon the exchange is confined to brokers who have been admitted to exchange membership.41 Under the Securities Law, the securities exchange shall have a council,42 and it is further clarified that the council is the decisionmaking organ of the securities exchange.43 The council of a stock exchange consists of seven to thirteen persons, with the number of nonmembership council members being no less than one-third but no more than one-half of the total of the council members. The membership council members shall be elected by the membership congress and the 41 This is in contrast with the international trend of stock exchange demutualisation and self-delisting. In 1998, the Australian Stock Exchange decided to simultaneously demutualize and self-list, being the first stock exchange to do so in the world, and was soon followed by many other prominent stock exchanges, including the Singapore Stock Exchange, Hong Kong Stock Exchange, London Stock Exchange, Toronto Stock Exchange, Deutsche Boerse and New York Stock Exchange. 42 Securities Law, art. 106. 43 Zhengquan Jiaoyisuo Guanli Banfa [Measures for the Administration of Securities Exchanges] (promulgated by the China Securities Regulatory Commission on 10 December 1997, emended on 12 December 2001).

246

R.H. Huang

non-membership council members shall be appointed by the CSRC.44 This has meant that the CSRC can appoint up to half of the members of the council of the securities exchange. Further, the council shall have a president and one or two vice presidents, all of whom shall be elected by the council upon the nomination of the CSRC.45 In other words, the CSRC exerts control over who could become the president and vice-presidents of securities exchanges. Finally, a stock exchange shall have one general manager and one to three deputy general-managers. The general manager and deputy managers are appointed and dismissed by the CSRC.46 The appointment and dismissal of middle-level officers of the stock exchanges shall be registered with the CSRC for record-keeping purposes, but the appointment and dismissal of the heads of departments of finance and personnel need the approval of the CSRC.47 In short, the CSRC has a tight grip over the personnel of all ranks in securities exchanges, from council presidents to council members and from general managers to mid-level officers. This makes a mockery of the members’ meeting of securities exchanges, which is on paper said to be the highest organ of the securities exchange.48 This organizational structure renders the relationship between the CSRC and securities exchanges one of superior and subordinate, or has the effect that the securities exchange is essentially a department of the CSRC. 10.3.2 Resources constraints and regulatory capture The issue of regulatory resources constraints is another problem associated with China’s financial regulation. Take the CSRC as an example. The CSRC is hampered by a lack of resources, including funding and staffing. On the surface, compared to other government agencies of the same rank, the CSRC enjoys more resources in terms of funding and staffing. The CSRC, in its annual report, is usually silent on its funding and accounting issue, except for a simple sentence to the effect that its regulatory costs and incomes are totally managed within the state fiscal budget system. Anecdotal evidence suggests, however, that CSRC officials generally receive more perks than their counterparts in other departments. Hence there is more intense competition for positions in the CSRC. As a specialist commission, the CSRC has many technocrat staff who are young, energetic and well educated. Up to 58.3 per cent of the CSRC staff

44 45 46 47 48

Ibid., art. 21. Ibid., art. 22. Ibid., art. 24. Ibid., art. 25. Ibid., art. 17.

Financial regulatory structure in China

247

49

have Masters degrees, and the staff averages 34.7 years old. The CSRC is also quite international in the profile of its staff, with 12.6 per cent of its employees having overseas education and even work experience. Mr Anthony Neoh, the former chief advisor of the CSRC and a current member of the CSRC’s International Advisory Committee, is the former chairman of the Securities and Futures Commission of Hong Kong (‘SFCHK’); Ms Laura Cha, one of the former deputy chairwomen of the CSRC, previously served as a deputy chairwoman of the SFCHK; Mr Gao Xiqing, the former executive deputy chairman of the CSRC, was a prominent professional who was educated in the US and had work experience on Wall Street; Mr Yao Gang, the current deputy chairman of the CSRC, has studied and worked in Japan before. However, the CSRC still suffers from big problems in the area of funding and staffing. Resource constraints are a universal problem faced by regulatory bodies worldwide, including the US’s Securities and Exchange Commission (‘SEC’).50 However, this problem is particularly severe for the CSRC. As of the end of 2011, the CSRC had a staff of 2,745, and the staffing level per million of China’s population was about 2.02, compared with 23.75 in the US, 19.04 in the UK, 34.44 in Australia and 59.59 in Hong Kong.51 As the budget figure is not disclosed in the CSRC’s annual report, it is not possible to compare the ratio of budget to national GDP in China with that in other jurisdictions. In practice, the CSRC has difficulties in retaining good staff. Anecdotally, many people choose to work with the agency to gain experience and establish networks, in the hope that it will help them to find a much better-paid job in the private sector. Over the years, a large number of CSRC staff have left for industry, particularly securities firms and securities investment fund management companies, which they regulate at the CSRC. The recent high-profile case of Mr Lin Haizhong is a good example in point. Mr Lin started working with the CSRC in 2002, and moved up through the ranks to become a director in the CSRC’s Department of Fund Supervision. This is an important post in an important department, but on 22 August 2012, a fund management company made a public announcement that Mr Lin had joined it as Chief Supervision Officer, with responsibility of overseeing all risks in its management and operations. The above situation is dubbed the ‘revolving door phenomenon’, where senior officers of private companies in the financial sector are former regulatory officials. To be sure, it is a global phenomenon, and is 49 CSRC, CSRC Annual Report 2011, 6. 50 Donald C. Langevoort, Insider Trading: Regulation, Enforcement, and Prevention (St Paul, MN: West Group, 1991) §1.04, 1–24. 51 Howell E. Jackson and Mark J. Roe, ‘Public and Private Enforcement of Securities Laws: Resources-based Evidence’ (2009) 93 Journal of Financial Economics 207, 214–215.

248

R.H. Huang

in no way unique to China. The worrying issue though is the scale of the phenomenon in China and the lack of effective regime to regulate it. Apparently, the revolving door phenomenon presents conflicts of interest and, if not properly regulated, may lead to the problem of regulatory capture, a term used to refer to the situation where the regulator becomes captive to the objects it regulates. On the one hand, as the incumbent regulatory officials hope to work in the private sector in future, they would not rigorously regulate the industry, particularly the firms which may be their future employers. On the other, after the regulatory officials leave for the private sector, they can take advantage of their personal networks at the regulatory agency to get favourable treatment for their new employers. China has had in place some laws in relation to the revolving door issue, but there are problems. As a government instrumentality, the leaders of the CSRC are public servants and thus are subject to the 2005 Civil Servant Law.52 Under Article 102 of this law, where a civil servant resigns his post or retires and if he is a leading member before resignation, he shall not take any post in an enterprise or any other profit-making organization that is directly related to his original post, or shall not engage in any profit-making activity directly related to his prior work within three years after he leaves his post. In November 2009, the CSRC issued the Code of Conduct for CSRC Officials, further stipulating that the coolingoff period for the CSRC leaders is three years and ordinary staff one year.53 However, there is a huge loophole in the regime. According to the CSRC, the restriction does not apply if the post in the private sector is Chief Supervision Officer, Chief Counsel or Chief Risk Officer, because they are special posts and do not involve business management responsibilities. Thus, in practice, this loophole has become the main route CSRC officials comfortably enter into the private sector without the cooling-off period restriction. Further, in some cases, the restriction is not applied even though the posts are not the special posts noted above. 10.3.3 Challenges of financial modernization and innovation Another key issue with China’s financial regulation lies in its traditional sectoral regulatory structure. Over recent years, China’s financial regulation has come under increasing pressure from the latest developments in the Chinese financial markets. China has followed the international trend of gradually removing structural restraints which segment financial markets and confine institutions to specific business lines, a process 52 Zhonghua Renmin Gongheguo Gongwuyuan Fa [Civil Servant Law of the People’s Republic of China] (issued 27 April 2005, effective 1 January 2006). 53 CSRC, Zhongguo Zhengjianhui Gongzuo Renyuan Xingwei Zhunze [Code of Conduct for CSRC Officials] (issued in November 2009).

Financial regulatory structure in China

249

sometimes dubbed financial modernization. As a result, the once brightline boundaries between different types of financial institutions are increasingly blurred. To start with, the Law of the PRC on Commercial Banks was revised in 2003 to add a clause ‘unless the State Council provides otherwise’ to the traditional prohibition on banks engaging in securities business activities.54 Before long, the amendment to the Securities Law of the PRC in 2005 provides an exception to the traditional sectoral segregation through a similar clause ‘unless the State Council provides otherwise’.55 Finally, the Insurance Law of the PRC has recently been amended and made a number of significant changes, including the dismantling of the previous rule strictly segregating insurance companies from other financial businesses. Article 8 of the Insurance Law of the PRC now provides that insurance shall be segregated from banking, securities and trust sectors, unless it is otherwise provided for by the state.56 This leaves the door open for insurance companies branching into other kinds of financial services. Under Article 106, insurance companies now have a broader range of investment forms. Apart from those previously allowed investment forms such as bank deposits, treasury bonds and financial bonds, insurance companies now can also invest in shares, units of securities investment funds, real estate and other forms prescribed by the State Council.57 The legislative memorandum to the amendment states that the change is in line with the international trend and is also suited to China’s local economic conditions. The above legislative amendments have formalized and encouraged the ongoing process of financial modernization in China. As discussed before, traditionally, strict segregation was enforced amongst the major sectors of the financial markets, namely banking, securities and insurance. Since China’s entry to the WTO, financial modernization has been carried out on a trial basis and has made significant progress. The development is exemplified by the emergence of some large financial conglomerates, such as China Everbright Group, CITIC Group, China PingAn Group, which involve a diversity of institutions operating in a range of different sectors including banking, securities, insurance, trust and asset investment. This gives rise to what is called the business model of Hunye Jingying 54 Zhonghua Renmin Gongheguo Shangye Yinhang Fa [Law of the PRC on Commercial Banks] (promulgated on 10 May 1995, amended on 27 December 2003), art. 43. 55 Zhonghua Renming Gongheguo Zhengquanfa [Securities Law of the PRC] (promulgated by the 6th session of the Standing Committee of the 9th National People’s Congress of the PRC on 29 December 1998 and effective from 1 July 1999, amended in 2004 and 2005), art. 6. 56 Zhonghua Renmin Gongheguo Baoxian Fa [Insurance Law of the PRC] (adopted at the 14th session of the Standing Committee of the 8th National People’s Congress of the People’s Republic of China on 30 June 1995, amended 28 October 2002 and 28 February 2009), art. 8. 57 Ibid., art. 106.

250

R.H. Huang

(combining the business activities of banking, securities and insurance), representing a departure from the traditional model of Fenye Jingying (separating financial services and markets). Now with the legislative backing mentioned above, the process of financial modernization is set to accelerate and there will be progressively more large financial groups. Further, financial innovation has created products such as sophisticated derivatives which cannot be easily accommodated within the traditional contractual forms of debt, equity and insurance. This development has resulted in significant changes to the nature and distribution of risk in the financial system, with the risk profiles of different financial institutions having begun to converge. A prime example is securitization whereby securities firms become exposed to the banking-type risks by holding mortgagebacked securities or securitized bank loans. China has used this financial technique, with considerable success, to deal with its massive amount of non-performing loans in the banking sector. As discussed earlier, although securitization has the potential to be abused, it remains an ingenious financial innovation capable of performing important economic functions, provided it is regulated properly. This is particularly so for China where the banks still have a relatively high level of bad loans and the home mortgage market is huge and rapidly growing. It would seem to follow that China will not, nor should it, abandon the efforts of financial innovation in the face of the global financial crisis. Hence, there will likely be more financial products that straddle the traditional boundaries of financial sectors. Therefore, the ongoing process of financial modernization and innovation – as symbolized by the emergence of large multi-service financial conglomerates and complex cross-sectoral financial products – has significantly changed the way the financial markets operate in China. These market developments pose a serious challenge to China’s traditional sectoral regulation under which regulatory responsibility is divided along the traditional line of banking, securities and insurance. Not surprisingly, China’s current regulatory structure has shown significant inadequacies in response to the changing financial landscape. For instance, it is difficult to have a system-wide perspective necessary to obtain an adequate supervisory overview of the large financial groups, as separate regulators are responsible for supervising different lines of business of those multiservice financial groups, that is, the CSRC for their securities arm, the CIRC for their insurance arm and the CBRC for their banking arm. Furthermore, some of the innovative financial products do not fit neatly into the traditional classification of banking, securities and insurance businesses which underpin China’s current sector-based regulation. In short, the mismatch between China’s regulatory structure and the underlying market it regulates has increased the regulatory costs and more importantly has led to overlaps and gaps in regulatory coverage. The following part will explore this issue in great detail and seek to find an appropriate solution from a comparative perspective.

Financial regulatory structure in China

251

10.4 The future of China’s financial regulatory framework As discussed in the preceding part, the new financial landscape as brought about by financial modernization and innovation demands suitably designed reforms to China’s current financial regulatory restructure which is based on the traditional segmentation of financial services and markets. Added to this picture is the longstanding problem of structural imbalances with China’s financial system, which requires a regulatory framework better able to take concerted action across the financial sectors. In quest of a solution to the above problems, a comparative analysis of the financial regulatory structure in various jurisdictions is conducted below. The US, the UK and Australia are chosen for comparison due to the fact that they are all advanced economies and more importantly each of them is typical of one of three major regulatory models currently in use around the world.58 10.4.1 Major structural models of financial regulation 10.4.1.1 ‘Sectoral regulation’ model The US financial regulation is typical of this model, under which the different financial sectors of banking, securities and insurance are subject to separate statutes, and supervised by separate regulatory agencies. In brief, the US sectoral regulatory framework includes: (1) five federal depository institution regulators in addition to state-based supervision, including the famous Federal Reserve which also serves as the central bank in the US; (2) one federal securities regulator, namely the Securities and Exchange Commission (SEC), and one federal futures regulator, namely the Commodity Futures Trading Commission (CFTC). The US has additional statebased supervision of securities firms as well as self-regulatory organizations with broad regulatory powers; and (3) insurance regulation is almost wholly state-based, with more than fifty regulators. As this regulatory structure consists of separate agencies responsible for different financial sectors, with the boundaries divided institutionally or functionally, it can be termed ‘sectoral regulation’ model. In response to the global financial crisis of 2008, the US adopted the Dodd–Frank Wall Street Reform and Consumer Protection Act (Dodd– Frank Act). It does make some structural changes to the US financial regulatory framework: eliminating one financial regulatory agency (the Office of Thrift Supervision) and creating two agencies (Financial Stability Oversight Council and the Office of Financial Research) in addition to several

58 For a more detailed discussion, see Hui Huang, ‘Institutional Structure of Financial Regulation in China: Lessons from the Global Financial Crisis’ (2010) 10(1) The Journal of Corporate Law Studies 219.

252

R.H. Huang

consumer protection agencies, including the Bureau of Consumer Financial Protection. However, the reform does not fundamentally change the ‘sectoral regulation’ model. 10.4.1.2 ‘Integrated regulation’ model This model was best represented by the UK until its recent reform.59 The UK was the first jurisdiction in the world – soon followed by some countries including Germany, Japan and South Korea – to adopt this model in setting up a powerful and nearly universal regulator for its financial services industry, namely the Financial Services Authority (FSA), to integrate regulatory and supervisory functions previously carried out by nine bodies in the UK.60 The FSA was a super regulator in terms of its unusually broad regulatory mandate: it was mandated to not only regulate a diversity of businesses, including banking, securities and insurance, but was also charged with both prudential and business conduct regulation. Thus, this regulatory structure is called the ‘integrated regulation’ model. 10.4.1.3 ‘Twin-Peaks’ model Australia is the champion of this model, being the first to establish a financial regulatory framework comprised of two main regulators. The first regulator, the Australian Securities and Investment Commission (ASIC), has responsibility for business conduct regulation across banking, securities and insurance.61 Unlike the SEC in the US whose responsibilities are limited to regulating the markets for corporate securities, the ASIC’s power extends to a wide range of financial products. However, the authority of the ASIC is not as extensive as that of the FSA in the UK due to the existence of the second regulator in the Australian regime, namely the Australian Prudential Regulatory Authority (APRA). As the name suggests, the APRA is responsible for prudential regulation, ensuring the financial soundness of all licensed financial institutions except for securities firms which are regulated by the ASIC. As the Australian regulatory regime consists of two separate regulators with different mandates in relation to prudential regulation and business conduct regulation respectively, it is vividly named the ‘twin-peaks’ model, or the ‘objectives-based regulation’ model. It is noteworthy that apart from the ASIC and the APRA, some other agencies perform certain regulatory functions in the financial markets, most notably the Reserve Bank of Australia, the central bank in Australia. It is responsible for monetary policy 59 The recent reform of the FSA will be discussed later, see section 10.4.2.2. 60 Eilis Ferran, ‘Examining the UK’s Experience in Adopting the Single Financial Regulator Model’ (2003) 28 Brooklyn Journal of International Law 257. 61 Australian Securities and Investments Commission Act 2001.

Financial regulatory structure in China

253

and financial stability, but no longer has any direct banking regulatory responsibilities.62 10.4.2 The way forward for China As shown above, there are three major structural models of financial regulation at the international arena: (1) the ‘sectoral regulation’ model; (2) the ‘integrated regulation’ model; and (3) the ‘twin-regulators’ model. While the first model has a multiplicity of financial regulators segregated on the basis of the type of financial institutions or activities, the second model sits at the other end of the spectrum with only one universal regulator for most of its financial markets. The third model lies somewhere in between, dividing responsibility for financial regulation into two agencies. 10.4.2.1 A comparison of structural models Naturally, each regulatory model has its own advantages and disadvantages. The merits of one model are always the demerits of another, and vice versa. As to the sectoral regulation model, it has significant problems. First, it is essentially a model designed for the traditional segmented financial markets, and thus is ill-suited to the new financial landscape brought about by the tide of financial modernization such as the emergence of large financial conglomerates and innovative financial derivatives. As each regulator is focused on its designated part of the financial system, they often fail to see the woods for the trees. In other words, no single regulator possesses all of the information and authority necessary to monitor systemic risk. By contrast, a unified regulator is able to approach financial regulation from a large perspective, dealing with regulatory hazards in a holistic fashion. 62 In this sense, the Australian financial regulatory system is composed of three regulators, namely the ASIC, the APRA and the Reserve Bank of Australia, and therefore it is sometimes classified as not two but ‘three-peaked’. This is in contrast with the Netherlands, the other country with the ‘twin peaks’ model. In the Netherlands, prudential regulation is combined with financial stability regulation in a single agency (i.e. the Dutch central bank called ‘De Nederlandsche Bank’), with conduct of business regulation being assigned to a separate agency called ‘Autoriteit Financiele Markten’ (Financial Markets Authority). There are three major reasons behind the Australian decision to separate prudential responsibilities from the central bank. First, the central bank is ill-equipped to deal with institutions other than banks; second, it avoids the expectation that the central bank would automatically provide liquidity support in the event of a crisis; third, separation of the central banking and prudential functions would enable each institution to become more focused and efficient. In recognition of the view that there is some degree of connection between prudential regulation and systemic stability and that the information gathered through prudential regulation is important for effective systemic regulation, the Reserve Bank of Australia has power to request the APRA to collect financial sector data for it.

254

R.H. Huang

Second, the demarcation of responsibilities between various regulators is not always clear-cut or logical due to historical and political reasons, which gives rise to regulatory gaps while at the same time regulatory overlaps. In some circumstances involving thorny problems, regulators may rationally shirk their responsibilities as much as they can, leaving the markets regulated by nobody. In other cases, regulators may fight hard over turf and result in regulatory duplication, causing significant costs for both regulators and regulatees. Although the integrated regulation model addresses the above problems facing the sectoral regulation model, it does not come without its own shortcomings. First, while the integrated regulation model has the advantage of economy of scale, it is a legitimate concern that the single universal regulator is far too powerful. This problem is somewhat mitigated under the twin-peaks model. Second, the broad scope of regulatory responsibilities assigned to a single regulator may be such that the senior management of the regulator is overloaded and regulatory efficiency reduced. In contrast, the division of regulatory tasks to a number of regulators allows regulatory diversity and specialization. Third, a unified agency may be susceptible to reputational contagion, as a mistake in one part of the agency may undermine their credibility over the broad range of their responsibilities. Finally and most importantly, one should be wary of the one-size-fits-all approach under the single-regulator model. Although the distinctions between financial industries may be increasingly blurred at the fringes, the core businesses of banking, insurance and securities remain separate. It would be dangerous if insufficient attention was paid to the differences between financial industries. Moreover, it is very difficult for one single regulator to discharge all regulatory responsibilities and meet various regulatory objectives as they may be different in nature and even conflict with each other. For example, prudential regulation is concerned with the financial soundness of regulated institutions, whereas business conduct regulation is concerned with the way in which financial products are marketed and sold. It follows that the two types of regulation are so different that they are best carried out by two separate agencies as is the case under the twin-peaks model. 10.4.2.2 Short- and long-term reform suggestions for China The foregoing discussion reveals the respective strengths and weaknesses of each of the three regulatory models. However, an objective assessment of each approach, in isolation from their jurisdictional financial landscapes, is hardly meaningful. Thus, this section will put the assessment into the Chinese context with a view to finding an appropriate solution to the problems confronting China’s financial regulation.

Financial regulatory structure in China

255

As shown earlier, the Chinese financial regulatory regime is broadly similar to the US, both adopting the traditional sectoral structure with a multiplicity of regulators. One major difference is that unlike the US, China has removed the central bank, i.e. the PBC, from the responsibility for regulating individual banks. This is in line with the international trend of divesting the central bank of a direct role in banking supervision. In response to the problems with China’s sectoral financial regulation, some have suggested that China should make an immediate transfer towards the UK model by merging the existing three sector-specific regulatory agencies, namely the CSRC, the CBRC and the CIRC, into a single financial regulator. While there is merit in this suggestion, it does not adequately consider other options and the Chinese local conditions. It is necessary to perform a cost-benefit analysis of transferring to another system. An immediate and wholesale shift for China across to the UK model will not be cost-effective as it would involve large costs which may well outweigh the corresponding benefits. China would be best advised to adopt a staged reform agenda for its financial regulation in line with the gradual growth of the underlying markets. In the short term, China may learn from the US practice to improve its financial regulation without radically changing the overarching structural model. In the US, the Federal Reserve is given umbrella regulatory authority over bank holding companies. Under the Dodd–Frank Act, the Federal Reserve will have new authority to supervise all firms that could pose a threat to financial stability, even those that do not own banks.63 This effectively extends the Federal Reserve’s consolidated supervision to all large, interconnected financial groups whose failure could have serious systemic effects. As a result, financial firms will not be able to escape regulatory oversight simply by manipulating their legal structure. Moreover, a new Financial Services Oversight Council of financial regulators is to be created to improve interagency cooperation and prevent things falling down the cracks amongst various regulators. The above reforms seem to be a pragmatic response to the problems with the US financial regulation as highlighted by the 2008 global financial crisis. Indeed, the Dodd–Frank Act stops short of holistically addressing the structural inadequacies of the US financial regulation, and its structural model remains sectors-based with separate regulators responsible for each financial sector. But the reform has the advantage of being quick and measured to deal with the pressing issues in practice. The US approach merits consideration in the context of China. On the one hand, the PBC can be authorized to supervise the consolidated operations of large financial groups; on the other hand, an interagency oversight council can be created to bring together regulators from across

63 H.R. 4173 §§ 162(a), 163.

256

R.H. Huang

markets and other relevant agencies to coordinate and share information, and to identify gaps in regulation. In order to promote efficiency and continuity, the council may set up a standing committee composed of the PBC and the three sector-specific regulatory agencies, namely the CBRC, the CSRC and the CIRC. As with the case of the Dodd–Frank Act, this solution can be a practical expedient for China in the short term.64 More importantly, the short-term recommendation is based on a realistic appraisal of the present needs of China’s financial markets. While the US current regulatory regime is said to be suboptimal for its financial markets, it may well be a suitable model for the less developed Chinese markets. Despite the rapid progress in recent years, China’s financial markets are still largely segmented along the traditional banking, securities and insurance lines. Financial innovation and modernization are relatively limited in extent and cautiously carried out at an experimental stage. Thus, the US model will be adequate to meet the challenges China’s financial regulatory regime currently faces due to the emergence of financial conglomerates and financial innovation. After all, China’s current financial regulatory regime was shaped just several years ago, and should be given a period of time to demonstrate its ability to adapt to the recent market developments. More importantly, although the Chinese financial regulators are suffering teething problems associated with maintaining independence from the government, they have done a great job of managing financial risks, as shown in the recent global financial crisis of 2008. It follows that the current Chinese financial regulatory system is functioning reasonably well and radical structural changes are not warranted at this stage. In the intermediate or long run, however, China cannot rely on the US experience, but instead needs to consider the twin-peaks model or to a lesser extent the integrated regulation model. The US reform under the Dodd–Frank Act does little more than just fine-tuning regulatory authorities within the pre-existing regulatory framework, which has proved to be an antiquated system for a well-developed economy like the US. By contrast, the twin-peaks and integrated regulation models attempt to thoroughly overhaul the regulatory structure, taking a novel approach to financial regulation. They are better adapted to the realities of modern financial markets than the sectoral structure, dispensing with the traditional boundaries between banking, securities and insurance. Both

64 The Chinese government appears to have proceeded in line with the short-term reform strategy discussed here. On 20 August 2013, the Chinese government made an announcement to establish a financial regulatory inter-agency coordination mechanism which will be led by the PBC and will include representatives from the CBRC, the CSRC and the CIRC, as well as the State Administration of Foreign Exchange. See Bettina Wassener and Chris Buckley, ‘New Chinese Agency to Increase Financial Coordination’, The New York Times, 21 August 2013.

Financial regulatory structure in China

257

represent genuine efforts to modernize financial regulation to deal with the issues created by the formation of financial conglomerates and the blurring of distinctions between financial products. In this sense, they point out the right direction for financial regulatory reforms in the future. The key difference between the integrated regulation and the twinpeaks models is that while the former assigns all regulatory responsibilities to a single regulator, the latter divides responsibilities and creates two separate regulators: one for prudential regulation and the other for business conduct regulation. Compared to the twin-peaks model, the integrated regulation model has a number of disadvantages. First, prudential regulation and business conduct regulation deal with different forms of market failure and therefore require different approaches to be taken. Indeed, there are significant differences in the focus of their work and the way it is carried out between prudential regulators and business conduct regulators. The former is focused on the soundness of financial institutions while the focus of the latter is on protection of consumer interests. What this means is that prudential regulators need essentially different mindset and training from conduct of business regulators. This is broadly mirrored in the fact that prudential regulators are typically of economics background while business conduct regulators are often selected from lawyers. Second, it is difficult to reconcile the competing demands of prudential and conduct of business regulation. There is a risk that if both prudential regulation and business conduction regulation are housed in one entity, one of them may be prioritized at the expense of the other. Potential conflicts of interest may arise between prudential and conduct of business regulation because of the different nature of their objectives. A good example is that a business conduct regulator might argue for early and full disclosure of a firm’s problems while a prudential regulator might place greater weight on the potential threat to the solvency of the institution of an early announcement. Finally, there are a number of other considerations in favour of a ‘twin peaks’ model such as clear mandates and accountability, avoiding the problem of reputational contagion. Due to its strengths, the twin-peaks model has attracted increasing attention as a template for reform in many countries, particularly after the global financial crisis of 2008. The US government carried out a thorough investigation into its financial regulatory regime in 2008, concluding that the ultimate reform goal for financial regulation in the US is not the integrated regulation model, but rather the twin-peaks model.65 Most interestingly, the UK, the pioneer and symbol of the integrated regulation model, has recently carried out reform in line with the twin-peaks model: From 1

65 US Department of the Treasury, Blue Print for a Modernized Financial Regulatory Structure (2008).

258

R.H. Huang

April 2013, the FSA has been abolished and its responsibilities split into two agencies: (1) the Financial Conduct Authority, which watches how financial institutions treat their customers, and (2) the Prudential Regulatory Authority, which conducts prudential regulation of financial institutions. Moreover, the South African government issued the National Treasury Policy Document in February 2011 that set out proposals for strengthening its financial regulatory system by adopting the twin-peak model.66 These latest international developments should shed light on the debate over the future development of China’s financial regulation.

10.5 Conclusion This chapter has shown that the current Chinese regulatory regime is broadly similar to its US counterpart, adopting a traditional sectoral regulatory structure. It comprises the PBC as the central bank and three sectorspecific regulators, namely the CBRC, the CSRC and the CIRC responsible for banking, securities and insurance respectively. This regulatory framework exhibits several inadequacies in the face of recent market developments such as financial globalization, financial innovation and the emergence of financial conglomerates. From a comparative perspective, there are three main approaches to financial regulation at the international arena, including the ‘sectoral regulation’ model, the ‘integrated regulation’ model and the ‘twin-peaks’ model. When looking to these models for guidance, China should have regard not only to their objective merits, but also to its local conditions. There is no urgent need for China to scrap its current sectoral regulation model in the short term, but with the further growth of its financial markets in the long run, China should adopt the twin-peak model.

66 South Africa Department of National Treasury, ‘A Safer Financial Sector to Serve South Africa Better’, February 2011.

Index

Page numbers in italics denote tables, those in bold denote figures. ABN Amro 36 Abrams, R. P. 12–13 agency consolidation, Obama administration’s focus 11 AIG 21, 44, 153, 212 American Civil War 138 asset bubbles 41, 57 Australia: impact of the financial crisis on 27; structure of regulatory model 105; Wallis Committee 103–4; the Wallis Report 67, 79, 103 Australia’s Twin Peaks model: background 103–5; defining regulatory boundaries 107–8; harmonization of regulation 107; inter-agency coordination 108; transition period 105–7 Bank of Commerce and Credit International (BCCI) 15, 17, 195, 197–8 Bank of England 10, 15, 19, 21, 25–7, 36, 47, 50, 109, 120, 192, 194 banking supervision, UK legislation 15 Barings Bank 15, 17 Basel Accords 107, 115, 167, 179, 213–14, 219–20 ‘Big Bang’ reforms 14, 16 Brown, Gordon 17 Brunnermeier, M. 34 bubbles 34, 41, 46, 56–7, 169, 173, 197, 237 Campbell Inquiry 103 Carmassi, J. 30 Carse, D. T. R. 200 China 34, 60

China’s regulatory structure: banking regulation 235–7; central banking 233–5; the future of 251–8; insurance regulation 237–8; modernization and innovation challenges 248–50; regulatory independence 243–6; resources constraints and regulatory capture 246–8; securities regulation 238–43; and the Twin Peaks model 252–3 City of London 14, 16 Commodity Futures Trading Commission (CFTC) 141, 143–4, 146, 148, 151, 156–8, 239, 251 competition policy 30n2 conduct of business regulation, overlap between prudential and 22 Consumer Financial Protection Bureau (CFPB) 140, 160–2, 252 consumer protection: and the breakup of the FSA 133–5; FCA’s responsibility 109; the FSA’s new regime 15–17; Hong Kong perspective 203, 211; Japanese perspective 177; and the twin peaks structure 18–20, 117, 127; US perspective 137, 141, 148–51, 160–2, 251 consumer protection regulation: compatibility with prudential regulation 9–10, 21–4, 225; coordinating prudential regulation and 14 crisis management, post-crisis neglect 26 Davidson Report 195, 197

260

Index

derivatives 50, 59, 139, 157, 197, 202, 212, 223, 250 Dexia 35 Dodd–Frank Act (US, 2010) 150–1, 153, 155–6, 158, 160, 162–4 early warning system 45 Europe, emerging Twin Peaks model 37 European Securities and Markets Authority (ESMA) 37 FCA (Financial Conduct Authority) 10, 25, 36, 109, 120, 129–35, 258 Federal Reserve 21, 50, 140, 142–4, 148–9, 151–6, 158–61, 251, 255 FIMBRA (Financial Intermediaries Managers Brokers Regulatory Association) 16 financial crisis: chain of collapse 21; four lessons from the 20–7; implications for financial sector supervision 29 (see also financial sector supervision) financial sector supervision: central bank’s role 36–7; emerging Twin Peaks structure in Europe 37; supervisory architecture design see supervisory architecture design; supervisory objectives and structure 30–4 (see also objectives-based supervisory structure) Financial Services Act (1986) 16 Financial Services Agency (Japan), establishment 166, 168 Financial Services Authority (UK) see FSA Financial Stability Commission (FSC) 19, 208, 212, 222–3 Financial Stability Oversight Council (FSOC) 151–6, 164, 251 FSA (Financial Services Authority): creation 17; new consumer protection regime 16–17; replacement agencies 10 FSA break-up: background 109; Bank of England’s role 120–3; establishing evidence for 123; examining the case for 113–23; implications 125–35; integrated regulator model implementation 113–17; practical incompatibility of the integrated regulator model 117–20; and the

pros and cons of institutional supervisory models 123–5 Germany 67, 79 Gieve, John 114 Goodhart, A. E. 47 Gramm–Leach–Bliley Act (US, 1999) 144 Great Depression 138 Greenspan, A. 34 Haldane, A. G. 57 Herring, R. 30 Hong Kong 34, 60 Hong Kong’s regulatory structure: accounting standards 220–1; British era structural reforms 197–8; compensation arrangements 217–18; cooperation and coordination 208–9; credit rating agencies 218–19; G20/ FSB reforms 213–24; hedge funds 219–20; historical financial development 191, 197; IMF Report (2003) 209–10; impact of the global financial crisis 210–13; institutional overview 201–7; international organizations 213; international standards adherence 222–3; jurisdiction themes 207; and Lehman Minibonds 210–11; macro-prudential frameworks 221–2; options for 224–6; post-1997 legal structure 198–9; post1997 regulatory themes 199–200; securitization 220; three tiered framework 200–1; and the Twin Peaks model 226 housing bubbles 34, 46 HSBC (Hong Kong and Shanghai Banking Corporation) 191–3, 201 IMF 25, 29, 40, 45, 48, 51, 119, 209–10 India 60 institutional reform: political economy view 71; suspicions about 11 institutional structure: Twin Peaks model see Twin Peaks model; why does it matter? 11–14 institutional structure of regulation, need for macro-prudential surveillance and crisis management to be included 24–6 Investment Management Regulatory Organization (IMRO) 16

Index Ireland 44 Japan 110 Japan’s financial supervisory structure: financial intermediation 178–9; financial market development 180–1; horizontal reviews 184–5; implementation of global standards 179–80; key players 170–1; legislative and regulatory process 174–7; macroprudential policy 185–6; measures against financial emergency/crisis 172; pre-crisis to current structure 168–70; resolution framework 171–4; revised supervisory manual 181–5; SME and start-up financing and regional economies 183–4 Johnson Matthey Bank (JMB) 15 joint committee 52–4, 55, 56 King, Mervyn 115, 117 Korea 9, 58, 83 Kowalik, M. 57 Kremers, J. 30 LAUTRO (the Life Assurance and Unit Trust Regulatory Organization) 16 Lehman Brothers 21, 43, 197, 210–12 macro-prudential policy: agencies involved 49; central bank vs joint committee as maker of 53; design factors 41; vs micro- 32–3, 37; objective 41; susceptibility to political influence 48 macro-prudential regulation: challenges of rules-based 41–7; concept analysis 10, 24–5; defining 48; development and use of instruments for 34; Hong Kong’s framework 221–2; main tools 51; need for 40; reducing the burden on time-varying policy 57–60; and the rules vs discretion debate 47–57 macro-prudential tools, range of new 25 macroeconomic surveillance, central bank’s role 50 Malaysia 34, 60 markers, Goodhart’s 47 Masciandaro, D. 67–8, 73–4, 87 micro-prudential perspectives 10, 32 mis-selling 17, 23, 35

261

monetary policy 33–4, 36, 46–9, 56, 105, 122, 143, 148, 201–2, 232–3, 244, 252 Netherlands 35–6, 104, 253; impact of the financial crisis on 27 New Deal 138–9, 150 Nier, E. W. 53 Northern Rock 23, 36, 111, 128, 225 Obama administration 11, 149–50, 161, 163 objectives-based supervisory structure: conduct of business approach 35; monetary and financial stability objectives 34; objectives hierarchy 32–3; policy framework 30–2 Office of Thrift Supervision (OTS) 140, 142–3, 148, 155, 251 over-the-counter derivatives 59, 139, 156, 205 Pagliari, S. 54 pensions, mis-selling of 17, 23 Poland 71n11 prudential regulation: Australian perspective 104, 252; vs business conduct regulation 254; Chinese perspective 236, 238; compatibility with consumer protection regulation 9–10, 21–4, 225; coordinating consumer protection regulation and 14; Dutch perspective 253; overlap between conduct of business regulation and 22; post-crisis role 14; and the twin peaks structure 17, 19, 117, 257; and UK reform 24, 109; US perspective 149, 157 Prudential Regulation Authority (PRA) 10, 25, 27, 36, 109–10, 120, 123, 127, 129–32 Quintyn, M. 87 regulation, traditional structure 13 regulatory reforms, Obama administration’s initial focus on agency consolidation 11 regulatory regime, effectiveness criteria 12 regulatory structure: agency coordination implications 13–14; impact of duplication 13; lessons from the financial crisis for 20–7

262

Index

repo market 59 Republic of Korea 44, 60 risk-weighting schema, effectiveness 58 Roosevelt, Franklin D. 138 Sarbanes–Oxley 146 Securities and Investments Board (SIB) 16 The Securities Association (TSA) 16 self-regulation 14–16, 18, 141, 146, 201, 206, 209, 233 shadow banking sector 44, 59–60 share lease 35 Shin, S. 43–4 Singapore 34, 60 single regulator model, post-crisis re-evaluation 10 Soros, G. 34, 43 South Korea 34, 110 Spain 116 supervisory architecture design: and the features of financial markets 69–71; grabbing hand view 72–3; helping hand view 71–2; Italian market view case study 79–87; relevance of the market factor 73–9 Taylor, M. W. 12–13, 118–19 Thailand 34, 60 Tinbergen, J. 30, 32 Tomkins, H. J. 192 Turner, Lord 22–3, 111, 114 Twin Peaks model: Australia’s see Australia’s Twin Peaks model; background of the proposal 17; the case for 14–18; central feature of the analysis 20; China’s regulatory structure and the 252–3; comparison with UK’s post-1997 arrangements 26–7; correctness of the analysis 20–1; creation of a twin peaks structure in the UK 36; Hong Kong’s

regulatory structure and the 226; Italian proposal 84; major inspiration 13; as most efficient arrangement for managing the relationship between micro-and macro-prudential regulation 25; OECD description 118; reawakening of interest 10; structural analysis 18–20; superiority of single regulator to 22 Twin Peaks: A Regulatory Structure for the New Century (Taylor) 9, 14, 17–20; publication 14 United Kingdom: creation of a Twin Peaks structure in 36; Financial Services Authority see FSA; Tripartite Arrangement 121–2 United States, subprime mortgage market 43 US financial services regulation: the 2010 Dodd–Frank Act 150–62; consumer protection bureau 160, 162; derivatives regulators 156–8; Federal Deposit Insurance Corporation 158–60; Federal Reserve’s regulatory role 153–4; FSOC (Financial Stability Oversight Council) 151–2; the institutional reform debate 147–50; key issues 150–62; Office of Financial Research 154–5; overview of pre-2010 structure 138–41; pre-Gramm-Leach-Bliley Act policy debate issues 142, 147; prospects and challenges 162–4; reform debate themes 141–50; reshuffle of agencies 155–6; systemic risk regulation architecture 151–5 Vickers Rule 58 Westrup, J. 67, 79 White, W. 41