Current Directions in Financial Regulation

Current Directions in Financial Regulation
Frank Milne and Edwin H. Neave (eds.), 2005 (Paper ISBN: 1-55339-072-5 $29.95) (Cloth ISBN: 1-55339-071-7 $75.00)

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Acknowledgement . . . v
. . . 1

Financial Integration and Regulation
Regulatory Targeting: Financial Services Strategies across Borders and Sectors
Ingo Walter
. . . 13
Summary of Discussion . . . 45

US Prudential Regulation
Prudential Regulation: A View from the Fed
James V. Houpt
. . . 49
Prudential Regulation: Comments
Jerry Goldstein
. . . 61
Summary of Discussion
. . . 67
Credit Risk
Cyclicality in the Catastrophic Risk of Financial Institutions
Linda Allen, Turan G. Bali and Yi Tang
. . . 71
Cyclicality in the Catastrophic Risk of Financial Institutions: Comments
Ron Giammarino
. . . 113
Summary of Discussion
. . . 117
Concentration and Convergence
Convergence of Banking and Insurance: Opportunities in Wholesale Financial Services
J. David Cummins
. . . 121
Summary of Discussion
. . . 177
Canadian Prudential Regulation
Prudential Regulation: A View from OSFI
Nicholas Le Pan
. . . 181
Summary of Discussion
. . . 187
New Directions in Supervision
Towards a Macroprudential Framework for Financial Supervision and Regulation?
Claudio Borio
. . . 191
Towards a Macroprudential Framework: Comments
David Laidler
. . . 235
Summary of Discussion
. . . 243
Regulatory Evolution
The Value-Added from Observing Bank Mergers
Gayle DeLong and Robert DeYoung
. . . 247
The Value-Added from Observing Bank Mergers: Comments
Paul Halpern
. . . 263
Summary of Discussion
. . . 269
Coming Challenges
Comments on Coming Challenges
James C. Baillie
. . . 273
Financial Regulation, Accounting and Risk Management: What Agenda for the Future?
Claudio Borio
. . . 279
Financial Regulation: International Perspectives and Canadian Issues
Jean Roy
. . . 289
Summary of Discussion
. . . 297

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Over the last 30 years, the international financial system has been evolving rapidly. Financial intermediaries have broadened their activities across traditional boundaries; new financial instruments have allowed firms to introduce innovative methods for hedging and diversifying risks; and national regulators have been inventing new methods and procedures for regulating firm and systemic risks. These rapid and profound changes have stimulated significant research identifying the theoretical, empirical, and institutional factors that drive this innovative process.

In May 2004, the Fourth National Conference on Financial Regulation was held in Toronto. Its aim was to analyze key components of financial innovation and the related regulatory challenges. Because the forces for change are common to all countries, the conference organizers decided to ask international experts to discuss the theoretical and empirical frontiers of key issues, and to represent a Canadian perspective in our choice of discussants and commentators. We think this perspective worked well.

The conference had both microeconomic and macroeconomic foci. The microeconomic focus first considered firm-specific risk-management problems whose solutions involve measuring and estimating credit and market risks. The second microeconomic topic involved financial market organization, examining the processes of firms entering new markets or consolidating operations, in either case in attempts to compete away temporary rents created by financial innovation. Third, speakers discussed the complexity, evolution and reliability of using quantitative methods for regulatory purposes, and the role of prudential supervisors for individual firms.

The macroeconomic issues revolved around the ongoing Basel discussions of assessing risks. Given the growing sophistication of quantitative systems for measuring risks, along with growing international competition in financial markets, the speakers emphasized the need for international regulatory standards. Proposing these standards both raised and resolved tensions: they facilitated international regulatory competition and emphasized appropriate and complimentary roles for financial regulators and central banks. In addition, they led to discussions of the appropriate definition and measurement of financial externalities and systemic risks, as well as to the introduction of new policies intended to anticipate and ameliorate systemic risks.

The summary of the papers that follows outlines their main points, the commentaries, and the discussions that followed. We begin with a paper by Ingo Walter that provides a perspective on financial change.

Ingo Walter Regulatory Targeting: Financial Services Strategies across Borders and Sectors

Ingo Walter's paper discussed rapid change in the financial services sector and assessed the factors that appear to be driving the structural reconfiguration. He explored the strategic options that are open to financial firms in competing in rapidly evolving competitive financial markets. Economies of scale and scope may provide firms with competitive advantages; but the evidence suggests that the economies are restricted to specific activities. In general, there can be diseconomies of scale and scope in other activities due to the impact of complexity, conflicts of interest, and other factors. There appears to be room for large firms, and medium and small specialist firms, to cohabit in a highly competitive financial industry that has a rich menu of financial instruments and services.

The discussion following the Walter paper ranged over a number of issues: the degree of competition in the Canadian financial system, rapid change and turbulence in the US financial system, and the mixed results from the abolition of the Glass-Steagall Act (1933) and the introduction of the Gramm-Leach-Bliley Act (1999). Walter argued that the subsequent corporate scandals have cast doubt on earlier analysis arguing in favour of the abolition of Glass-Steagall unintended consequences make policy proscriptions an uncertain enterprise.

James Houpt Prudential Regulation: A View from the Fed

James Houpt addressed issues of prudential regulation. His perspective emphasized financial stability and advancing policies that both recognized banks as risk-takers and that risk-taking must sometimes be traded off against protection of the public interest. As markets grow in breadth and efficiency, as banks grow in size and complexity, regulators recognize that changes pose greater potential for systemic risk, and thus have altered their practices accordingly. Houpt characterized regulators as seeking to find more systematic and sophisticated ways of evaluating risk. In this light, the standards of Basel II are not viewed as an end in themselves, but as an important incentive to encourage the banks, and particularly the world's very large banks, to invest in continuously improving the systems and controls.

Houpt concluded that banking requires risk-taking, but in modern societies that risk-taking should occur only in a context that adequately protects the public interest. Balancing these opposing pressures is crucial to sensitively formulated and effectively implemented regulation.

Linda Allen, Turan Bali and Yi Tang Cyclicality in the Catastrophic Risk of Financial Institutions

The paper by Allen, Bali and Tang considered a macroprudential approach to financial supervision by examining the risk distribution of financial institutions in general, rather than the more conventional microprudential approach of most regulators. Because the goal of macroprudential supervision is to limit downside catastrophic risks, the paper concentrated on extreme downside risks. To explore these risks, the paper used two methodologies: the Generalized Pareto Distribution; and the Skewed Generalized Error Density. Using these empirical methodologies, the paper found evidence of significant cyclicality in catastrophic risk over the period 19732001. The moments of the equity distributions are significantly impacted by macroeconomic, systemic, and regulatory factor shocks. The paper's results suggested that macroeconomic factors cannot be ignored in designing macroprudential regulatory policy; and that internal risk management should use volatility measures conditioned on macro factors.

Following the paper and comments by Ron Giammarino, questioners from the floor raised a series of issues. These ranged from the methods used by credit-rating agencies in smoothing their ratings over the credit cycle, some econometric issues related to the empirical results, and the appropriate methodology to measure operational risk.

David Cummins Convergence of Banking and Insurance: Opportunities in Wholesale Financial Services

J. David Cummins examined the opportunities in wholesale services that result from the convergence of the banking and insurance businesses. Cummins recognized that convergence is due primarily to increasing globalization of the financial services sector, the concomitant deregulation of financial services, and the impact of technological change on computing and communications. The latter changes have brought about much cheaper data processing and have separated communications costs from distance, thus linking world financial services far more effectively than used to be the case. All these developments provide opportunities for the traditional wholesalers of risk-management products, especially investment banks and reinsurers, to make greater use of their core competencies by unbundling traditional insurance value chains.

Cummins discussed especially the products that modify classical insurance and reinsurance models through avenues that both directly access capital markets and arrangements whose access remains indirect. He presented a wealth of examples of such transactions and identified factors that are likely to lead to the success of newly introduced products. He saw future opportunities for both standardized products that will be viable in active markets and for custom-designed, over-the-counter products. He argued that eventually the world will witness a highly liquid market in insurance-linked securities and that as these developments occur, they will improve the efficiency of both investment and insurance markets.

Nicholas Le Pan Prudential Regulation: A View from OSFI

Nicholas Le Pan addressed the role of capital allocation in financial institutions, and the implementations of the recent Basel II Capital Accord. Adequate capital and appropriate risk-management controls are essential for running a safe and sound financial institution. The existing Basel Accord was inadequate: it provided perverse incentives. Basel II is far more sophisticated and rests on three pillars: Pillar 1 allows banks to choose the simplified approach, or the more sophisticated method that matches capital and risks. The latter approach requires sophisticated risk-management techniques to evaluate interest rates, and operational and other risks. Pillar 2 requires the bank to target capital-related risks, and the supervisor is to assess that process. Pillar 3 requires transparency that will allow market participants to assess a bank's risk profile.

The accord will be a major challenge for banks and supervisors requiring advanced and new techniques. The Accord Committee, chaired by Le Pan, will try to induce international cooperation and coordination between national supervisors. Two critiques of the accord were addressed: complexity and pro-cyclicality of capital requirements. Le Pan argued that banking and supervision of large financial institutions are complex; smaller institutions have the simpler rules, merely 12 pages long. The concern that capital requirements will change over the economic cycle is exaggerated: given the longer-term perspective, and the careful uses of capital reserves, the cyclicality could be reduced.

Claudio Borio Towards a Macroprudential Framework for Financial Supervision and Regulation?

In a wide-ranging paper, Claudio Borio discusses the macroprudential approach to regulation. Normally, banking and financial supervisors concentrate on individual financial firms using a microprudential approach, whereas the macroprudential perspective observes the whole financial system and its interactions. Because the system is integrated, there are two sources of systemic risk: the first is the possibility of contagion; and the second is the impact of common macroeconomic shocks that impact all financial institutions. This second risk is the most important, as it has an impact across the whole financial system and has direct costs in reductions in gross domestic product and unemployment. The impact of these shocks can be amplified by financial contagion, compounding the costs of the original shock. An important set of issues, which are evolving, are the choices of appropriate macroeconomic, monetary, and prudential policies to reduce the risks of costly systemic risks. Borio suggests that the use of conservative financial practices in cyclical upturns, the use of indices identifying irrational exuberance in a financial and economic expansion, and closer cooperation between prudential supervisors may reduce the subsequent costs in a future downturn.

Commenting on this paper, David Laidler agreed with much of Borio's analysis, but cautioned that the problems may be difficult to solve in a straightforward manner. Drawing on lessons from Bagehot, Mill and twentieth century experience, he argued that the successful pursuit of monetary stability may reduce financial stability, but it does not eliminate it. There appears to be a gap in the policy framework, and the issue that Borio addresses is an approach to closing it. Laidler was concerned that the appropriate policies may be difficult to implement because it requires the regulator to observe the errors of individual agents, and it requires the regulator to have political support to implement policies "leaning against the wind".

Gayle DeLong and Robert DeYoung The Value- Added from Observing Bank Mergers

Gayle DeLong and Robert DeYoung addressed questions of estimating the value-added in recent bank mergers. In particular, they attempted to explain how some 216 mergers of publicly-traded US banking companies taking place between 1987 and 1999 show such mixed evidence of adding value. They argued that a precondition for mergers to create value is that there has been learning-by-doing. Through learning-by-doing, banks become better at consummating mergers, and investors become better at pricing the mergers' effects.

After controlling for learning-by-doing, DeLong and DeYoung interpret the data as supporting the idea that mergers do create value once banks have learned to perform them, and that investors can better assess the effects once they have become more familiar with interpreting them. They argue that previous academic studies may well have rejected the notion that such mergers create value primarily because they failed to account for the learning-by-doing phenomenon.

Coming Challenges

The panel on looking ahead offered highly valuable perspectives for the future. James Baillie first identified the effects of how standards formulation has international impacts, providing eloquent illustrations of the difficulties of maintaining sovereignty in an increasingly interconnected world. He then identified the cumbersomeness of bank-merger procedures in Canada as presenting a serious impediment to restructuring the Canadian financial services industry.

Finally, Baillie also identified Canadian difficulties with establishing a national securities commission as still another impediment that impairs Canada's ability to adapt to changing international standards. Thus, Baillie addressed both sides of sovereignty-efficiency issues: through the development of international standards Canada faces impairments to sovereignty despite herself, and through failure to adapt domestically Canada faces the possible costs of lost opportunities stemming from inability to compete in a rapidly changing global financial system.

The second panelist, Claudio Borio, addressed the evolving financial system from another and different international perspective. Borio was concerned with the conflicts, real and potential, that arise between the formulation of accounting standards on the one hand and prudential regulation on the other. Regulators face incentives to emphasize risks in their advocacy of prudential behaviour, while accounting is concerned primarily with measuring value. To Borio, reconciling these conflicts is crucial because financial reporting can have profound effects on assessments of safety and soundness. Borio's approach to reconciliation advocates attempts to produce unbiased accounting information (as opposed to the prudential information frequently advocated) and then to use other tools to provide incentives for prudent behaviour. This advocacy of decoupling information from incentives has roots both in well-known economic debates about targets and instruments (the usual position is to advocate using one instrument for each separate target) and in agency theory, where the notions of information and incentives are sharply distinguished. Borio's important arguments bring this clarity to an area that has, as he points out, suffered considerably from earlier failures to make such distinctions.

Panellist Jean Roy was, like James Baillie, concerned with how financial regulation drawn up on the basis of international perspectives has particular impacts on Canadian issues. To Roy, the conference's emphasis on macroeconomic perspectives raises issues regarding both cyclicality and structural issues. He first interpreted the contributions of individual papers from this perspective. For example, should operational and catastrophic risks be identified using point in time or cyclical estimations? Can reducing informational asymmetries improve the financial system's cyclical behaviour? To what extent do knowledge cycles play a role in modifying financial cycles? How might counter-party risks be better controlled in a world of greater risk-trading? With this background perspective, Roy then turned to three domestic issues: bank mergers, bank and life insurance company mergers, and the national/provincial division of regulatory powers. Roy pointed out that it is not the regulators' function to guard shareholder interests in assessing the importance of merger proposals, whether they are solely bank mergers or bank-insurance mergers. Rather, regulators should provide clear assessments of the positive and negative public interest effects mergers might bring. And so far, the literature provides little help regarding this issue. With respect to national versus provincial regulation, Roy pointed to the trade-off: there can be value in regulatory competition, but it may be that these values have already been realized and the current regulatory debates may bring more in fragmentation costs than in competitive benefits. Moreover, Roy saw the potential value in exporting Canadian banking services, particularly by an internationally competitive industry, as being much greater than many observers have so far recognized.

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