Alternative Regulatory Structures

Jeffrey Carmichael[1]

Introduction

Regulatory structure has become one of the most interesting and actively debated topics of the past 5 or so years. An obvious motivation for interest in the topic is the sheer number of countries that have moved in the direction of amalgamating some or all of their existing regulatory agencies - or that are in the process of considering doing so. In past year or two the trend has become something of a stampede – to the point where there must be at least a suspicion that some countries may be joining the trend without sufficient reflection on the many and complex issues involved.

What I want to do in this presentation is to explore systematically the topic of regulatory structure, stripping it down, where possible, to its fundamental underlying elements. In the process I want to give you a flavour of the issues that have been considered by other countries and the ways in which they have sought to find a balance among the many competing pressures[2].

·        I want to start with some general comments on regulation – I will return to these as we dig deeper into the issues.

·        I will then summarise what has been happening internationally.

·        I then want to identify and discuss eight central issues that most commonly run through the decision process faced by those that have gone through the process of reviewing their regulatory structures.

·        Finally, I will look at how the different structural models stand on these issues and how countries that have adopted them have attempted to resolve the problems that remain.

But, before we get into the story, let me be right up front about two main conclusions that emerge from the combined experience of countries that have been through the structural reform process.

First, there is no single regulatory structure that is ideal for all countries – or even necessarily ideal for a single country across all time and circumstances. The ideal regulatory structure at any point in time requires a trade off among some pretty serious advantages and disadvantages - which are often situation specific. What best suits one country will not necessarily suit another.

Second, a good regulatory structure does not guarantee good regulation. Ultimately, if regulatory powers are inadequate, if regulatory skills are inadequate, if regulatory independence and accountability are inadequate, then regulation will probably fail – regardless of the virtuosity or otherwise of the regulatory structure.

It is worth emphasising in this context that the debate about regulatory structure is not about what regulators should do and what functions they should perform, it is about which agencies should be responsible for carrying out these responsibilities.

I am not saying that structure is unimportant for regulatory effectiveness. Structure certainly has a role to play in eliminating regulatory overlaps and conflicts and in improving the effective use of scarce regulatory resources. Structural reforms can also be a way of securing reforms in regulatory powers, skills and governance that might otherwise be difficult if not impossible to obtain.  The message, however, is that structure should be viewed as a means to an end – not as an end in itself. Most importantly, changing the institutional structure of regulation should not be viewed as a panacea or as a substitute for effective and efficient conduct of regulation.

Definitions

Let me start with some definitions.

First, much has been made by some of the distinction between the terms ‘regulation’ and ‘supervision’. Following the usual distinction drawn by the World Bank, regulation usually refers to the establishment of rules of behaviour – most often in law. Supervision refers to the monitoring, oversight and enforcement of those rules.  Some have argued that regulation and supervision should be separated, with one agency responsible for setting the rules and another responsible for monitoring and enforcing them. That distinction may have some foundation in the area of market conduct. It is a much more difficult distinction to sustain in the prudential area where the rules need to evolve as supervisory experience, and as institutions and markets, evolve. I will not comment further on the wisdom or otherwise of separation but, for simplicity I will use the terms regulation and supervision interchangeably to mean the entire process of formulating, monitoring and enforcing rules of behaviour among financial institutions and markets.

Second, by ‘regulatory structure’ I will mean the number and nature of regulatory agencies in any given financial system and the formal relationships among and between them for the purposes of regulating financial institutions and markets.

Third, I will use the term ‘institutional’ in the context of regulatory structure to mean a structure under which each group of financial institutions has its own regulator. At the other end of the scale I will use the term ‘unified’ to refer to a structure in which there is a single agency responsible for regulating all institutional groups and markets. I will not use the terms ‘super’ or ‘mega’ regulator, as I understand that these have a specific meaning in the Indian context that do not necessarily translate to other markets. I will also try to avoid referring to regulatory agencies as ‘integrated’, since this term has been used variously to refer to ‘unified’ agencies and also to systems in which there remain two or more regulators.

Background on Regulation

I mentioned that I would spend a few minute on some underlying principles of regulation before turning to structure. It turns out that the underlying principles are extremely helpful when we begin assessing different structural models as it helps us to keep a clear perspective on what we are looking for from our structure.

The objectives of regulation are usually grouped under some combination of the following:

·        Financial sector stability;

·        Institutional safety;

·        Market fairness; and

·        Market efficiency.

The underlying theory of regulation provides us with a reason why each of these objectives require regulatory intervention. The rationale lies in market failure in one or more of the following areas:

•     anti-competitive behaviour;

•     market misconduct;

•            information asymmetry;  and

•      systemic instability.

What is interesting about these four sources of market failure is that, by and large, they require different regulatory tools to counteract the market failure involved. 

What is also interesting about this analysis is that the sources of market failure not only require different regulatory responses, they line up fairly neatly with the objectives of regulation:

·        Systemic stability – with systemic instability;

·        Institutional safety – with asymmetric information;

·        Fairness – with market misconduct; and

·        Efficiency – with competition.

These objectives and sources of market failure should be kept firmly in mind as we dig into the question of appropriate regulatory structures[3].

Recent International Trends

Several recent studies (most notably by the IMF and World Bank) have attempted to summarise international trends in regulatory structure. They have each been handicapped by the pace of evolution which has been sufficiently frenetic that any study of structure is almost definitionally out of date from the moment it is published. Whereas studies of five years ago focused on regulatory amalgamations in the UK, Japan, Canada, Australia and Scandinavia, more recent studies have turned to the growing number of amalgamations in emerging market countries as well as changes within some of the more traditional powerhouses of the EU, including Germany and the Netherlands.

According to the most recent World Bank study by Martinez and Rose (2003), at the end of 2002, there were 6 main regulatory structures found throughout the world. For convenience, I will label the various options:

·        the ‘institutional or separate regulators’ model,

·        the ‘Mexican’ model,

·        the ‘South African’ model,

·        the ‘Singaporean’ model,

·        the ‘Canadian’ model and

·        the ‘UK’ model.

This classification should not be taken to imply that these particular countries were necessarily the pioneers of their particular structure.  The classification is purely for convenience and because, by referring to particular countries, it should make the models a little more concrete.

The models can be summarised as follows:

The Institutional Regulators Model

According to the World Bank study there were around 31 countries in the world that – at the end of 2002 - maintained separate regulators for each group of institutions.

The Mexican Model – combining banking and securities regulation.

According to the World Bank study there were 9 countries that combined banking and securities regulation.

The South African Model – combining securities and insurance regulation.

According to the World Bank study there were 3 countries that combined securities and insurance regulation.

The Canadian Model – combining all or most prudential regulation in an agency separate from the central bank.

According to the World Bank study there were 13 countries that combined at least banking and insurance regulation (and in many cases, pension regulation also) in an agency separate from the central bank.

The UK Model – combining all banking and non-banking regulation in an agency separate from the central bank.

According to the World Bank study there were 10 countries that unified all regulation in an agency separate from the central bank.

The Singaporean Model – combining all banking and non-banking regulation within the central bank.

According to the World Bank study there were 3 countries that unified all financial regulation within the central bank.

Note that both the UK and Singaporean models satisfy the criteria for being described as unified regulators.

Clearly, these 6 models are not entirely comprehensive in terms of describing all possible regulatory combinations. Nor do they fully capture the nuances that exist among the various countries that have adopted any particular structure. They will nevertheless serve as a useful reference for discussion.

What are the Critical Issues in Choosing a Regulatory Structure?

Any country setting out to review its regulatory structure in a systematic way is likely to consider some or all of the following issues:

·        First, what role should the central bank play in the regulatory structure?

·        Second, how easily will regulatory cultures combine under the different structural options?

·        Third, how well do the different structural options deal with conflicts among regulatory objectives?

·        Fourth, how well do the different models handle the need for co-operation and co-ordination between regulators?

·        Fifth, how relevant is size?

·        Sixth, does the current structure suffer from regulatory gaps or overlaps that lead to regulatory arbitrages or confusing responsibilities?

·        Seventh, how relevant are financial conglomerates within the financial system?

·        Eighth, how supportive is the government likely to be in providing an appropriate independence/accountability framework for regulatory agencies – i.e. what political dynamics are likely to be involved in any structural reforms?

The first four of these issues are general, in that they apply to most situations. The latter four are more country specific. Some of these issues provide a case towards greater amalgamation, while others provide a case against. In some countries a particular issue may be dominant, while in another it may be irrelevant. In all cases, there are other mechanisms and considerations that can be introduced to counter the challenges introduced by moving in one direction or the other. Precisely where a country chooses to stop on the spectrum of amalgamation should be situation specific. Importantly, it should be the result of a careful weighing of the issues rather than a decision to follow the trend either because it is the trend or because the current structure is perceived to have failed.

I will consider these in order.

The Role of the Central Bank

One of the most difficult issues to resolve in many countries considering structural change is the appropriate role of the central bank. It is universally agreed that central banks should have oversight of the stability of the system as a whole. The dilemmas start from here. One line of argument is that, banks are critical to systemic stability because of their role in the payments systems. Since central banks universally supervise the payments system, they should also supervise banks.  A second line of argument is that central banks cannot adequately provide lender of last resort facilities unless they also regulate banks and are familiar with their balance sheets. A third is that knowledge of developments in the banking sector can be an important input to the central bank’s assessment of macroeconomic conditions for monetary policy purposes.

The upshot of these, and some other minor variations on these three themes, is a case that banks are special and therefore should be therefore regulated by the central bank regardless of whatever other structural changes may be considered.

To these universal arguments, Goodhart (2000) adds some issues of particular relevance in emerging market countries:

·        Central banks in emerging market countries typically have greater independence than other regulatory agencies, which typically reside within the public sector; and

·        Central banks in emerging market countries typically have more resources and greater control over their resources to pay adequate salaries for regulators than do other regulatory agencies.

There is a counter case in favour of separation. It has been argued that the objectives of monetary policy and banking regulation may, at times, conflict. It has been argued that the central bank’s credibility as a monetary manager may be compromised by weaknesses or failures in the banking system.

Overall, the case for central bank responsibility for banks is powerful. On balance and, in the absence of other considerations, it would probably be persuasive. It is no accident that central banks have had this responsibility in the vast majority of countries. Yet there are countries in which the central bank has never had this responsibility and there is a growing number of countries in which the responsibility is being removed.  Where this has happened it has not generally been for reasons to do with banking alone. The decision is typically taken for other reasons which, on balance, dominate the considerations raised above.

In considering separation, the strength of the individual arguments needs to be considered in the particular context of the country in question. There are also ways of mitigating the risks raised by separation. For example, separation does not necessarily mean that the central bank cannot have access to information about individual banks. In countries that have separated monetary policy and banking supervision, the central bank and the banking regulator have typically entered into a memorandum of understanding detailing the way in which the two agencies will share information and also how they will share responsibilities in the event of a liquidity crisis. Goodhart’s propositions are more problematic and any emerging market country heading down the separation route should be satisfied that it alternative agency has sufficient independence and resources or the result could be a significant step backwards in banking regulation.

Regulatory Cultures

Different types of financial regulation involve fundamentally different cultures. Combining these cultures within the one agency, whether a unified regulator or a combined non-bank regulator such as in the South African model, carries challenges and risks.

Perhaps the most fundamental cultural distinction is that between market conduct and prudential regulation. Howard Davies of the UK FSA aptly described the difference between these two types of regulation as being the same as that between the policeman and the doctor. Market conduct regulators deal largely with human weakness – namely greed. It is a sad but undeniable characteristic of human nature that many people will steal or mislead if they think they have half a chance of getting away with it.

Since we cannot anticipate every potential dishonest action, market conduct regulators have to focus on how best to reduce financial crime by catching those who break the rules. It is in this sense that they are like the policeman. They work within a set of laws and legal sanctions, to which they add rules (especially rules about governance, disclosure and proper behaviour in markets) and administrative penalties. However, it is widely agreed that the real deterrent to crime (both civil and financial) is no so much the severity of the penalties as the likelihood of being caught. Thus the market conduct regulator’s greatest weapon is its ability to investigate, catch and successfully prosecute (either by itself or in combination with a public prosecutory agency) those who violate the rules and laws. In short, the conduct regulator’s credibility is largely tied up in enforcement – what is sometimes referred to as the demonstration effect of “heads on pikes”.

In contrast, the prudential regulator, like the doctor, is more concerned about preventing failure – in this case of financial rather than physical health.

The different types of regulators carry with them different expectations from the public. In the case of conduct regulators we expect them to set rules which, if followed, will lead to strong, healthy and competitive markets. We also expect them to successfully prosecute those who breach the rules. We should not be so unrealistic as to expect that the laws and rules will never be broken – all we can hope for is that that these are strong enough, that the penalties are high enough and that the regulator’s reputation fearsome enough that breaches will occur as the exception rather than the rule.

Expectations in the case of a prudential regulator are somewhat more difficult to pin down.

Prudential regulation involves developing standards of prudential behaviour for regulated institutions, monitoring compliance with those policies, and enforcing remedial action to protect the interests of customers where there are concerns about either compliance or financial sustainability. There are two characteristics of this process that are not well understood by the community.

First, supervisory intervention is usually graduated. Unlike conduct regulation, where a breach of the rules is usually a legal offence, thereby warranting a legal response, breaches of prudential standards are primarily warning signals. The usual response to a prudential breach includes a period of co-operation between the regulator and the financial institution, during which a remedy is sought that is capable of returning the institution to full prudential compliance. Only when the problem becomes intractable, or the institution recalcitrant, does the regulator need to resort to more extreme enforcement measures. The need for careful judgment by the regulator in this process is critical or the co-operative work-out can simply become regulatory forbearance – which usually has disastrous consequences.

Second, prudential regulators are not infallible. Indeed, the process of working with an institution to overcome regulatory breaches or concerns can, in some cases, increase the extent of the losses associated with failure by prolonging the period of operation of an institution that turns out, with the benefit of hindsight, to have been beyond rescue. No prudential regulator can promise a complete absence of failures. In particular, no prudential regulator has the capacity to eliminate fraud.

The different styles and expectations of market conduct and prudential regulators leads to very different regulatory cultures. Conduct regulators tend to be staffed mostly by lawyers and to be aggressively enforcement oriented. Prudential regulators tend to be staffed mostly by accountants, economists and finance experts and to be more focused on working with institutions in a co-operative environment.

A major issue in any consideration of regulatory amalgamation – especially of unified regulation should be whether or not it is feasible to manage the integration of cultures and, if so, to ensure that one does not dominate the other to the point where the focus of regulatory responsibilities is lost in the process.

Clarity and Conflict among Regulatory Objectives and Agencies

Seldom do regulatory agencies have a single objective. As noted earlier, the objectives of regulation are usually defined in terms of systemic stability (monetary policy and payments system), institutional safety (prudential regulation), market fairness (conduct regulation) and financial efficiency (competition regulation).

In the traditional institutional structure of regulatory agencies it is common for a single agency to have responsibility for more than one objective and, in the case of central bank-based banking regulators, for all four objectives. This is also the case in the unified regulatory models of the UK and Singapore and of most of the other structures. The Canadian model, at least as it is structured in Australia, is arguably the only model that attempts to align regulatory agencies in such a way that each has a single objective.

When agencies face multiple objectives, conflicts can arise between them. Although this is true irrespective of institutional structure, different structures may be more or less efficient at handling conflicts. A central issue is whether these conflicts are better handled within a single agency or between agencies where responsibilities for particular objectives are more clearly defined.

Co-operation Between Regulatory Agencies

There is no regulatory structure that totally avoids the need for co-ordination and co-operation between regulators. At one end of the range, the institutional model requires co-operation where financial conglomerates operate in sectors covered by the different regulators and where there are inadvertent overlaps of gaps in the regulatory structure. At the other end of the range, the unified regulatory model also requires co-ordination in regulating financial conglomerates. The co-ordination and co-operation in this case is need within the agency rather than between agencies. Anyone familiar with bureaucracies will be familiar with the fierce turf battles that can take place between agencies. The battles are not necessarily much less fierce within agencies unless the agency is structured carefully to take account of their potential.

A second area of co-ordination is that across different types of regulation. For example, there can be a natural conflict between market conduct regulation and prudential regulation. As noted earlier, these two forms of regulation involve fundamentally different styles and objectives. Conflict could arise, for example, where a prudentially-regulated institution is found guilty of breaching good conduct either by mis-selling consumer products or by failing disclose adequate information. These conflicts are often resolved in the institutional model by conferring responsibility for all types of regulation on the one agency. This enables the conflicts to be resolved internally, but at the cost of having a potentially uneven playing field in terms of conduct across different institutional groups.

Even in the case of the Canadian model, where the regulatory objectives are aligned with agencies, conflicts can still arise between agencies. In Australia, these conflicts have been resolved by the legal framework. For example, it has been determined that the decision to provide lender of last resort liquidity should be based on systemic considerations, rather than on consideration about any individual institution. Thus the decision to extend last resort finance is a decision taken exclusively by the Reserve bank of Australia. It has also been determined that prudential regulation does not absolve financial institutions from meeting the same high standards of market conduct and disclosure that are imposed on other institutions. Thus, while there would be consultation between the prudential agency, APRA, and the market conduct agency, ASIC, in the event of a breach of market conduct by a prudentially regulated institution the decision about how to handle the breach rests solely with ASIC. In more highly aggregated models these conflicts are handled within the one agency.

 Size

In many cases, size is likely to be the dominant issue in selection of a regulatory structure. The size of the country and financial system come into consideration in several ways. At one end of the scale, small countries are pushed naturally towards one or another of the more amalgamated regulatory structures. At the other end of the scale, large countries are pushed naturally towards more decentralized structures. The issues at the two ends of the spectrum are, however, quite different.

Starting at the small end of the scale, a small country is likely to face a shortage of experienced regulatory resources. It is not uncommon, especially among the emerging market economies, to have a relatively experienced group of banking regulators and either embryonic or non-existent non-bank regulators. Combining these limited resources into a small number of agencies can be a way of sharing the experience of the banking regulators and helping to accelerate the learning curve of the less experienced regulators.

Second, small countries can usually only afford small regulatory agencies. A major concern with any regulatory structure is whether or not the regulators are strong enough and independent enough to withstand regulatory capture by the industries they regulate. In general, capture is more likely the smaller is the regulator relative to the industry. Having many small agencies, each charged with overseeing a single, co-ordinated industry, increases the chances of capture.

Third, small agencies offer fewer career opportunities for regulatory staff than do larger ones, and are therefore less able to attract highly-qualified and ambitious regulators.

Fourth, countries with small financial sectors are likely to be faced with disproportionately high costs associated with regulation for the reason that their industries are too small to carry the burden of an effective regulatory agency. The costs imposed on regulated firms should be reduced to the extent that firms need to deal with fewer agencies. This was a particularly significant issue in the United Kingdom when, prior to creation of the Financial Services Authority, a financial conglomerate might be regulated and supervised by and required to report to nine regulatory agencies. There also can be economies, and greater effectiveness, when all information about financial firms is lodged within a single agency.

Given these considerations it is unlikely to be efficient in small countries to support a large number of independent agencies, each responsible for a single small group of institutions. How far the amalgamation should go is a question that is likely to be determined by other considerations.

At the other end of the scale, size can militate against amalgamation. For a country with a financial system the size of the US issues such as the availability of regulatory resources and regulatory costs are less of an issue than they are in small emerging market countries. While few commentators have suggested using the US regulatory structure as a model for others, I suspect that few would seriously suggest the unified model for the US. The issue at this end of the scale is the power that such a massive agency would wield and the difficulty of managing a bureaucracy of such a size.

Concentration of power is a particular concern in the case of unified regulatory agencies. As Taylor (1996) puts it, a single regulator “with a remit covering both prudential and conduct-of-business regulation in banking, securities, and insurance and with the power to undertake civil proceedings against those it suspected of insider dealing or market abuse could potentially become an over-mighty bully, a bureaucratic Leviathan divorced from the industry it regulates.”

A second concern that arises from having a very powerful regulator (or two) is the ever-present potential to over-regulate and, in the process, to impose avoidable costs on the system and on the suppliers and consumers of financial services. As Llewellyn (2004) points out, in any structure there is an inherent towards over-regulation “because regulatory and supervisory services are not provided through a market process but are imposed externally. Consumers have no choice with respect to the amount of regulation for which they must pay. This means that regulation has a cost but not a price. In this case, consumers will rationally perceive regulation to be a free good and hence will over-demand it. If this is coupled with a risk-averse regulator (who is blamed when there are regulatory failures but not praised when there are none), it is almost inevitable that over-regulation will result, as it will be both over-demanded and over-supplied.”

When this inherent tendency is coupled with a powerful regulator in a position of monopoly power there is an even greater likelihood of an over-regulated outcome.

Regulatory Arbitrage

It is a fundamental requirement for efficient regulation that the regulatory burden imposed on any institution should be related to the type and extent of market failures involved, rather than to the institutional label that the company carries;  that is, the regulatory system should, to the greatest extent possible, be regulatory neutral. 

Under the institutional regulatory structure, potential non-neutralities arise because the same financial promises can be made by institutions subject to different regulators.  For example, under the institutional model, bank and non-bank deposit takers (such as building societies and credit unions and, in some countries, even finance companies and investment trusts) usually have different regulators, despite the fact that they make essentially the same financial promises.  The potential for conflict is exacerbated in some countries by the presence of both state and federal regulators.  This potential is highlighted in the United States, which has 50 separate regulators for insurance, while the US banking system has two different federal as well as multiple state regulators.  Even the most assiduous efforts at co-ordination are unlikely to prevent differences of application across such a diverse set of regulators, each subject to its own legislative processes and resource constraints.

Where a financial institution is able to choose among different regulators, either by altering its corporate form, its regulatory jurisdiction or simply its institutional label, there is an incentive to arbitrage among the potential regulators so as to minimize the regulatory burden.  This problem is exacerbated in conglomerate situations where a heavily-regulated parent may be able to reduce its regulatory burden by shifting business into an unregulated subsidiary.  Regulatory arbitrage of this type was common in a number of Asian countries and contributed to the depth of the financial crisis in the late 1990s.

The crux of the problem is that, in the institutional structure, the jurisdictions of the regulators are defined by the institutional groups to which they are attached.  Thus, for example, a banking regulator is usually restricted to regulating banks, rather than to regulating banking-type products. This leaves an arbitrage opportunity for new institutions to offer banking-type products under a different banner, thereby remaining outside the jurisdiction of the main regulator.  Where the new, unregulated institutions incur greater risk by avoiding or minimizing regulation, the stability of the whole financial system may be put at risk.  This conflict can be resolving by amalgamating regulators to a level where regulatory gaps are either eliminated or minimal. A single unified agency should, in principle, avoid problems of competitive inequality, inconsistencies, duplication, overlap, and gaps that can arise with a regime based on several agencies. This should make it easier for similar products offered by different types of institutions to be regulated and supervised in a consistent manner

Not only does the institutional structure face potential non-neutralities between competing prudential regulators, it faces a fundamental source of non-neutrality between the prudential and other functional regulators when individual regulators are responsible for all forms of regulation.  For example, a prudential regulator is unlikely to take the same approach as a market conduct regulator in regulating the market behavior and disclosure of a bank or insurance company.  Further, the prudential regulator is less likely to have the expertise or to allocate as many of its scarce resources to market conduct issues as is a specialized market conduct regulator.  Similarly, because of its natural interest in industry stability and soundness, a prudential regulator will be more inclined to impose high entry barriers and will be less concerned with industry concentration than will a specialised competition regulator.  Consequently, countries in which these responsibilities are delegated to prudential regulators for certain industry groups often face complaints about regulatory non-neutrality.

Financial Conglomerates

The emergence of financial conglomerates has challenged traditional demarcations between regulatory agencies and has made the business of regulation more complex for a number of reasons:

Above all, there is a danger that prudential regulation might fail to capture the risk characteristics of the institution as a whole. In effect, the totality of risks may be greater than the sum of the parts, while the totality of effective risk capital available to cover risks may be less than the sum of the parts contained within each business of the conglomerate. A key supervisory issue, therefore, is whether risks arising within the group as a whole are adequately addressed by any of the specialist prudential supervisory agencies that undertake their work on a solo basis. In particular, a structure based on specialist agencies supervising different parts of the business of a financial conglomerate may lose sight of the institution as a whole.

Put differently, an argument  commonly used to support amalgamation is the need to build a regulatory structure that better reflects the structure of the industry that is being regulated. At the extreme, a unified agency should be most efficient at coping with conglomerate regulation.

This is particularly relevant given that, over time, changes in institutional structures usually emerge as a response to financial failures, resulting in a pragmatic, piecemeal structure that would not necessarily be created from a clean sheet of paper. It is appropriate from time to time to review the structure and its relevance to the industries involved.

The Politics of Change

My final point is a pragmatic one. Change is inevitably constrained by the dynamics of political and bureaucratic forces involved. It is rare for all stakeholders involved to agree on the ideal outcome of a reform program. For example, almost every central bank that has either lost banking regulation or been threatened with losing it as a result of reforms, has fought staunchly to retain the function. In some countries the relationship between central bank and the Ministry of Finance are such as to eliminate certain outcomes as “politically” infeasible. In other cases, the bureaucracy and the government may have different and possibly conflicting motives and intentions.

My point is not that these pressures are intrinsically good or bad. They are simply a fact of human nature. My point is that any reform program that ignores these factors is likely to result in a sub-optimal outcome that could be worse than the initial starting point. In particular, attempting reform without strong political support is almost certainly doomed to failure.

To pick up Goodhart’s theme, there is little point in removing banking supervision from an independent, well resourced central bank, only to have it end up in a unified regulator within the Ministry, staffed by public servants and funded on budget – regardless of whatever other factors may have made unification and separation a sensible move.

Some Brief Comments on the Regulatory Models and How they Handle the Key Issues

In this final section I would like to summarise briefly the six models and how they stand on the various issues raised in the section above. The discussion is necessarily stylized and cannot do full justice to the subtleties that may exist in any particular country or situation.

The Institutional Regulators Model

Positive features:

Negative features:

Approaches to resolving the problems:

The Mexican Model

Positive features:

Negative features:

Approaches to resolving the problems:

The South African Model

Positive features:

Negative features:

Approaches to resolving the problems:

The Canadian Model

Positive features:

Negative features:

Approaches to resolving the problems:

The UK Model

Positive features:

Negative features:

Approaches to resolving the problems:

The Singaporean Model

Positive features:

Negative features:

Approaches to resolving the problems:

Weighing the Issues

As should be clear from the discussion above, no single option is without both costs and benefits. Choosing among these options requires careful weighing of the relative importance of the costs and benefits. It also requires careful consideration of how the costs of preferred options might be mitigated either by innovative design or by finding ways around roadblocks that may otherwise appear impenetrable.

It is relevant, nevertheless, to observe that those countries that have gone down the road of either partially or fully amalgamating their regulatory agencies in recent years have typically done it for one or more of the following reasons:

·        To eliminate or reduce regulatory arbitrage;

·        To better cope with the regulation of conglomerates; or

·        To make more efficient use of scarce regulatory resources.

In the case of emerging markets, the third of these is quickly becoming the dominant consideration.

To finish off let me leave you with some thoughts on how to make any regulatory structure more effective. Those thoughts cover:

·        Independence and accountability;

·        Governance;

·        Regulatory powers; and

·        Funding.

Independence/Accountability

The sole motivation for granting a degree of independence to a regulatory agency is to enhance its effectiveness by ensuring that it is able to pursue and achieve its legislated objectives.  Good regulation is primarily about making decisions that are based on objective criteria directed towards the achievement of the objectives specified in the Law and free from extraneous considerations and influences.  Independence is about removing those extraneous influences to the greatest extent possible (accountability is about ensuring that they are replaced by the legislated objectives). 

In the context of a financial regulator, independence means that the regulator should have the capacity, without interference, to:

It is important to recognize that independence is a means to an end – not an end within itself.  It is also important to recognize that desiring independence and achieving it can be quite different.  In practice, independence is determined by a wide range of factors including:

All but the last of these can be legislated to varying extents.

Accountability refers to the ways in which an entity reports its decisions and is held responsible for its actions.  Importantly, independence and accountability should be considered together, because one without the other is, at best, meaningless and, at worst, dangerous.  As a general rule, the greater the level of independence of a regulatory agency, the greater also should be its level of accountability.

The first line of accountability of any regulatory agency should be to the Government, and through the Government to the Parliament.  The primary mechanism for acquitting that accountability is through statutory reporting requirements.  Full accountability requires the highest levels of transparency and disclosure in these reports.  Each regulatory agency should be required to keep accounts, to be subject to audit and to report its financial state through its Minister to the Parliament and to the public.  Ideally, each agency should report on its policies and operations as well as matters affecting the achievement of its statutory objectives.  Beyond the reporting requirements to Government, it is also useful to include other reporting responsibilities of each agency in the law.  At a minimum these should include:

An important part of accountability is the need to ensure that policy changes are carefully considered and understood by all stakeholders.  Policies that are introduced without adequate consultation are likely to contain unintended consequences.  With respect to the formulation of regulatory policy, an accountable agency will consult with government, industry, and the public before introducing major policy changes.

Governance

Governance refers to the systems and procedures adopted by an entity to manage its business and resolve conflicts among its various stakeholders.  Good governance imposes certain requirements on the internal structure of a regulatory agency to ensure that the necessary checks and balances are in place and to ensure that governance policies are adhered to.  At a minimum the agency should have an internal risk management and audit sub-committee of its board if it has a board.  Good practice requires that  the CEO and Chairman should not be formal members of this sub-committee (assuming the agency has both a CEO and Chairman), though they may be required to attend if needed.  A human resources sub-committee is also considered to be good practice. 

Every financial regulatory agency should have a Code of Conduct for staff.  Such a code should deal with conflicts of interest, improper behaviour by staff and general issues of how staff members are expected to conduct themselves.  The requirement for such a code should ideally be included in the Law, although the details (other than on the broadest issues) should be a matter for the agency’s Board to determine from time to time.

As suggested above, regulatory agencies and their staff should be protected against legal action for decisions taken in good faith in carrying out their duties under the Act.  Such an indemnity, however, should be balanced by adequate provisions to protect industry participants against capricious decisions by the agency.  Natural justice requires both that the agency’s decisions, and the basis of those decisions, be available to affected parties, and that there be adequate processes for appealing decisions.  Ideally, these processes should allow for internal review as well as appeal to an external tribunal or court.

Powers

Identifying the powers appropriate to any regulatory agency requires consideration not only of the particular needs of the regulator but also of the appropriate form these should take in the law.

Powers included explicitly in primary law have the advantage that they are unlikely to be challenged in a court of law.  They have the disadvantage that they are difficult to change, in that they require legislative amendment.  Repeated returns to the Parliament use up precious political capital, and should therefore be used sparingly.

Consequently, it is important to limit powers in primary law to those that are unlikely to change with the evolution of time and technology in the financial sector, and about which there is a need for certainty.  Thus, while certain fundamental legal powers will always need to be contained in primary legislation, the majority of the detailed policies and practices that define how these delegated powers are to be used should be contained in regulations and guidelines issued by the relevant Minister or the agency itself.

Experience has shown that countries that “hard wired” regulatory details into primary law, such as the 8% capital adequacy requirement of the Basel Accord for banks, have found it difficult to apply discretion in dealing with situations that do not fit the norm.  Similarly, some countries that set minimum solvency requirements for insurance companies in primary law have found their prudential objectives over-run by inflation and the passage of time.  They have also found it difficult to adjust to the more risk-based framework for supervision that has been emerging worldwide.

In an ideal world regulatory agencies would have the following powers (covering both prudential and market conduct regulation):

Registration and deregistration - the power to register financial institutions under financial sector laws, and to administer registration requirements under those laws. This includes the power to impose relevant conditions, and the power to vary and revoke registrations in appropriate circumstances.

Making of legally binding regulations/standards and (less formal) guidance notes - the power to formulate and promulgate regulations for all registered institutions and the power to vary and revoke them. These should include at least the following:

·        standards of corporate governance of registered entities, including codes of conduct, roles of boards and management, and methods for resolving conflicts;
·        standards governing the ownership and control of financial institutions, including fit and proper conditions and minimum qualification requirements;
·        standards of business conduct, including resolving conflicts between financial institutions and their clients, prohibition of certain abuses and insider trading;
·        standards governing the prevention of financial crime;
·        standards defining capital adequacy/solvency and the measurement of capital;
·        standards defining valuation methods where relevant for both assets and liabilities, including choice of discount rates and levels of sufficiency in provisioning in the case of insurance regulation;
·        standards concerning the management of risks by financial institutions; and
·        standards of disclosure for securities and retail investment products, including bank deposits, insurance policies, and pension products.

Reporting obligations and information gathering - the power to require all financial institutions to provide whatever information the regulator requires in whatever form it judges to be appropriate. This should include both regular reporting and specific reporting in non-routine situations.

Monitoring and surveillance - clear monitoring and surveillance powers are an integral part of supervisory and market conduct functions. These include the powers:

·        to require the production of documents and the giving of information;
·        to inspect and copy documents; and
·        to test an institution’s compliance with prudential regulations/standards including appointing, at the institution’s expense, an appropriate expert to report on any aspect of the institution’s business, or the business of a group of which it may be a part, for the purpose of establishing compliance with regulatory requirements.

Directions – the power to direct any registered financial institution to do something specific (such as to remove an officer from a particular position or from the institution, to not pay a dividend, etc) or to cease doing something specific (such as promoting a product in a certain way, investing in certain assets, doing certain types of business, etc) for the purposes of ensuring compliance with a financial sector law or regulation/standard.

Investigating breaches - where the regulator has reason to suspect a breach of a financial sector law, it should have comprehensive powers to investigate the suspected breach.

Responding to breaches – effective responses to breaches of financial sector laws require a combination of the powers to:

o       revoke registration;
o       suspend the operations of a registered institution;
o       remove directors of a registered institution;
o       require a registered institution to appoint new auditors and/or actuaries;

o       levy administrative fines – the regulator should be able to penalise non-criminal breaches appropriately with administrative penalties. Ideally, the agency should have the power and discretion to negotiate administrative penalties and remedial action without the need to rely on court proceedings. Where such remedies cannot be negotiated, prosecution should result.

o       freeze assets of or under the control of a registered institution where the regulator suspects that the interests of the customers of the institution may be at risk;
o       require a registered institution to publish corrective material;
o       require a registered institution to terminate or unwind specific transactions; and
o       accept enforceable undertakings from registered institutions, as well as from unregistered institutions or individuals who are in breach of financial sector laws or regulations/standards. These written undertakings can cover any aspect of an activity that is required to be registered under a financial sector law. An enforceable undertaking should be published and, in the event of a breach of the undertaking, the regulator should be able to apply to the court for an order directing compliance with the undertaking.

Prosecuting breaches - In many countries the prosecution of criminal breaches of financial sector laws are shared between the regulatory agency and the Department of Justice (or its equivalent). The case for the regulator to prosecute at least some breaches rests on both the support it adds to the agency’s credibility as an effective regulator and to the particular expertise that it brings to the area. Prosecution can nevertheless be expensive and demanding on staff resources. In small countries it usually makes sense for most prosecutions to be referred to the relevant Government Department. The regulatory agency should nevertheless have standing to bring legal action against financial institutions and others who breach financial sector laws.

Imposing judicial management – Where the regulator is concerned that a registered prudentially-supervised institution may be insolvent, behaving imprudently in a manner that is putting clients’ interests at risk, or is violating financial sector laws, it should have the power to appoint a judicial (or statutory) manager. The judicial manager should take directions from the regulator. A judicial manager should not be able to be appointed to a prudentially-regulated financial institution without the regulator’s consent.

Transfers of business – the power to approve mergers and acquisitions of registered institutions.

Winding up a registered institution – standing to apply to the Courts for the winding up of registered institutions. No application to the Court to wind up a registered prudentially-regulated institution should be able to be made without the regulator’s prior approval.

Authorising self-regulatory organisations - the power to authorise and make appropriate arrangements with industry self-regulatory organisations and other agencies with regulatory roles as the regulator sees fit.

Information sharing powers - the power to share information with other regulatory agencies (some of which may not yet be established), other relevant domestic agencies, and overseas financial regulators, as well as the Police. In all cases, the nature and extent of the information sharing arrangements should be detailed in a Memorandum of Understanding between the agencies.

Funding

It is fundamental that any regulator should have sufficient resources to meet its regulatory responsibilities.  The regulator should be sufficiently financially independent that it can form regulatory judgements and decisions without fear that its resources will be reduced in retaliation.  Independence in this context needs to be carefully defined.  In practice no financial regulator can be completely financially independent – nor should it be.  Accountability includes the need for the agency to be accountable for its use of resources.  Financial independence in the context of a regulatory agency is usually taken to mean that the funds made available to the regulator are not put at risk by changes in the budgetary position of the Government.

It is generally agreed internationally that financial independence for regulators is best achieved by having the agency financed by levies and charges imposed on industry. 

Summary and Conclusions

The institutional structure of regulation and supervision has recently become an issue of public policy debate in several countries, reflecting some unease with prevailing structures. International experience, however, indicates a wide variety of institutional regulatory formats, suggesting that there is no universal ideal model.

In considering structural change it is important to be conscious of the local circumstances, history and culture. Each of these is relevant in assessing which of the many structural options is most appropriate.  

It is also important to recognize that institutional structure does not, by itself, guarantee effective regulation, and it would be dangerous to assume that changing the structure of regulatory institutions will automatically solve regulatory deficiencies. What institutional structure does is to establish the framework in which to optimize a regulatory regime. New structures do not guarantee better regulation. More appropriate structures may help, but, fundamentally, better regulation comes from stronger laws, good governance, better-trained staff, and better enforcement. Any country that thinks that tinkering with the structure of agencies will, by itself, fix past shortcomings is doomed to relive its past crises.

References

Carmichael, J. and Pomerleano, M., (2002) The Development and Regulation of Non-Bank Financial Institutions, World Bank, Washington DC.

Llewellyn, D., (2004). The Institutional Structure of Financial Regulation: The Basic Issues, World Bank, (forthcoming), Washington DC.

Martínez, J. and Thomas A. Rose, T.A., (2003) International Survey of Integrated Supervision, World Bank, Washington DC.

Taylor, M. (1996), Peak Practice:  How to Reform the UK’s regulatory System, London, Centre for Study of Financial Innovation, October.

 


[1]     Chairman, Carmichael Consulting and former Chairman, Australian Prudential Regulation Authority.

[2]     This paper has benefited greatly from the excellent survey of regulatory structures and issues by Llewellyn (2004). It also draws on the discussion in Carmichael and Pomerleano (2001).

[3]     A more extensive discussion of these sources of market failure is provided in the companion paper for this conference – Australia’s Approach to Regulatory Reform.