Aligning Financial Regulatory Architecture with
Country Needs:
Lessons from International Experience
June 5-6, 2004
The Oberoi, New Delhi
REGULATION AND SUPERVISION OF
FINANCIAL CONGLOMERATES
Good afternoon colleagues. Following from my sharing earlier today on
Jamaica’s experiences with regard to regulatory arbitrage, I am happy to add to
this seminar’s valuable exchange of experiences in this presentation on the
topic Regulation and Supervision of Financial Conglomerates or, put shortly,
Consolidated Supervision. This issue is an active one for my own country,
Jamaica, as well as of great relevance for Banking Supervisors of the Caribbean
region.
The perspectives I will share in this presentation will cover our
Jamaican experiences and developments as well as give a quick update on the
current regional initiatives in this regard, as we experience growing investor
interest in the Caribbean region with businesses expanding across borders of
the individual island jurisdictions, mainly through mergers and
acquisitions.
My discussions will focus on the
following topics:
(a)
Financial
conglomeration developments in Jamaica
(b)
Evolution
of Jamaica’s consolidated supervision framework
(c)
Regional
conglomeration trends and the growing importance of consolidated supervision on
a regional basis
(d)
Implementation
issues for supervisors of emerging market/developing jurisdictions;
It is my hope that this presentation
will provide useful insights as your country reviews its own financial
regulatory architecture.
I. Financial Conglomeration Developments in Jamaica
The banking failures that Jamaica
experienced in the late 1990’s originated, in large part from contagion from
non-bank financial institutions (NBFIs) within conglomerates which had quickly
grown, which entities were subject to less stringent regulation than their
banking affiliates. The “knock-on” impact of these failures now forms a not
insignificant portion of Jamaica’s much discussed heavy debt to GDP ratio, as
the country incurred massive costs (just over 50% GDP) to protect the Jamaican
financial system through rehabilitating and restructuring of a significant
number of failed financial entities.
The major role played by
conglomeration in Jamaica’s financial system distress of the 1990’s was due
primarily to the fact that this phenomena evolved in the context of major
changes and developments in the country’s macro-economic framework which
allowed for rapid growth in the number of financial institutions, while there
existed serious inadequacies in Supervisory powers and unevenness in regulatory
framework across the financial system landscape. Taken together, these factors created an environment that
facilitated active regulatory arbitrage, which quickly became a principal motivator
of the growing number of dominant owner/managers who employed substandard
corporate governance and risk management practices in the anxiety for growth
within an over-competitive environment.
The specific circumstances included:
1.
Liberalisation
of the financial sector in the early 1990s was not accompanied by a
sufficiently robust prudential and supervisory infrastructure. The Supervisory Authorities
were left with a deficient legal framework, without adequate sanction and
intervention powers and other key controls necessary to deal with problem
situations.
2.
Rapid
growth in the number of financial intermediaries between 1990 and 1995 in a
high inflation environment lead to increased competition, further strained
available management expertise and sharply focussed the phenomenon of
“over-banking”. Adverse effects of this extreme competition
were evident at the institutional level in a number of indigenously owned
entities and groups, where anxiety for growth combined with sub-standard
management led inevitably to excessive and imprudent risk taking and
concentrations in exposures to connected persons/interests, severe mismatch in
asset/liability maturities (exacerbated in the insurance sector) and a culture
of “loophole mining” or bending prudential norms and regulations.
3.
Uneven
regulatory standards and requirements across the financial system lead to
increased regulatory arbitrage and mushrooming of conglomerates. As bank supervision requirements
became more stringent in the early to mid-90’s, certain financial industry
players restructured and moved activities into less supervised areas so as to
escape oversight and operate beyond the effective reach of the banking
supervisors. Complex financial and
mixed conglomerate structures were therefore established with the deliberate
intention to avoid transparency and conceal relationships so as to take
advantage of regulatory and supervisory arbitrage opportunities (including
taxes and reserve requirements) arising from different types of financial
institutions and uneven standards across the different financial sectors. This represented a classic example of
potential for contagion where problems were quickly transmitted among related
entities (principally from non-banking to banking entities), and posed a huge
challenge to the Bank Supervisory Authority.
4.
Fragmentation
of financial supervisory responsibilities across a number of agencies with
widely varying capacities and operating under outdated/inadequate legislation
resulted in critical gaps and impeded inter-regulatory information sharing.
·
Regulation
was divided amongst multiple regulatory agencies of widely varying capacities,
effectiveness and resources, while certain financial services/entities were not
captured in the various legislations and thus escaped regulatory
oversight.
·
There
were significant disparities between the prudential norms and reporting
requirements governing the various agents in the financial sector. While deposit-taking entities under the
Banking Supervisor became subject to increasingly standards and requirements,
this approach was not replicated across the financial landscape.
·
The
financial sector lobby exerted strong resistance to meaningful legislative
reforms, which would have allowed the Bank Supervisor to effectively deal with
conglomeration and other adverse developments impacting the banking industry.
This created a moral hazard by sending accommodative signals to the market.
·
The
Supervisory Authority was legally unable to access the records of bank parent
companies, thus some institutions escaped supervisory reach by interposing
group structures above the immediate parent entity (including off-shore
corporations/trusts) and concentrating much of potentially contagious
activities in these entities.
5.
Increasingly
blurred distinctions between banks and other non-bank financial institutions
and services developed, as the latter became more creative in offering
deposit-like instruments and services. This
was particularly evident in the insurance sector, where companies gathered heavy
short-term, interest sensitive, bank-like liabilities to finance longer-term
investments. In the context of rising interest rates, the severe maturity
mis-match caused severe liquidity stringencies, which were, in turn,
contagiously transmitted to these companies’ affiliated banks.
6.
Lax
and deficient accounting and audit standards and practices played a major
supporting role,
with instances of auditors’ independence and objectivity clearly compromised in
“creative” accounting, credit, asset valuation and income recognition practices
employed and misleading “clean” audit opinions being issued for entities and
corporate groups which were very shortly thereafter found to be insolvent.
A positive feature in Jamaica’s financial system distress experience however, was that there was no evidence of capital flight from the country as while increased perceived risks of the system fuelled runs in a number of local institutions, the depositors in their “flight to quality” sought to remove funds and place the with foreign owned banks which were perceived as “safe”.
Current Trends
Following the exit of a number of failed
conglomerates in the late 1990s, the Supervisory Authority’s initiatives
towards building a sound banking system underpinned the continued consolidation
and reduction in the number of financial entities within the system, largely
through mergers and acquisitions as institutions sought to gain the “critical
mass” necessary for them to be able to compete effectively. These mergers and acquisitions have been
taking place in the context of much strengthened banking legislation, including
provisions relating to consolidated supervision and requirements for financial
group structures/restructuring acceptable to the Supervisor to be effected. The improved infrastructure of the wider
financial system regulation is also serving to contain, to an increasing
extent, the opportunities for regulatory arbitrage.
As I inferred earlier, Jamaica’s
latest trends in financial conglomeration involve cross-border and cross-sector
expansions on a regional basis.
Consequently, the risks faced in the 1990s in relation to uneven
regulation would seem set to re-emerge on a cross-border basis if no effective
systems of regional consolidated supervision together with region-wide
strengthening of banking and non-banking supervision and harmonisation of
legislative frameworks and supervisory approaches is implemented. There is however, active work in progress in
this regard by the regional grouping of Banking Supervisors, greater details of
which will be dealt with in the update on regional developments in consolidated
supervision.
In response to the systemic issues in the late 1990s, the Government
implemented a number of measures to protect and strengthen the financial
system, which focussed on, among other things enabling more comprehensive,
coherent and effective oversight of the financial system and supporting
implementation of consolidated supervision.
These changes and other developments in this regard included:
1.
Consolidation
and vesting of responsibility for financial system regulation in two agencies:
a)
Bank
of Jamaica, which
was given supervisory responsibility for all deposit-taking institutions. Supervision of building societies (1996) and
credit unions (2002) was added to the Bank’s commercial bank and merchant bank
supervisees.
b)
The
Financial Services Commission (FSC), which was created in 2001 and given
responsibility for regulation of all non-banking financial institutions, notably insurance companies,
securities dealers, collective investment schemes, and is in process of
establishing the regime for regulation of pension funds.
2.
Incorporation
and commencement of operations of the Jamaica Deposit Insurance Corporation
(JDIC) to put in
place the Scheme for coverage of the public’s deposits.
3.
A
Memorandum of Understanding (MOU) was executed in December 2001,which enabled
formation of the Financial Regulatory Council (FRC). This high level financial
inter-regulatory group FRC is chaired by the Central Bank’s Governor
(also statutory Supervisor of banks) and comprises the heads of the FSC and
JDIC as well as the Financial Secretary.
The FRC meets regularly to share information and determine on policy and
action relating to issues of potential or actual systemic impact.
4.
Legislative
amendments to the deposit-taking statutes in 1997 and further in 2002,
strengthened the Supervisory Authority’s powers over the banking system and
provided the framework for implementation of the Basel Core Principles (and Core Principle 20 in
particular)[1]. These amendments included:
·
Powers
to require acceptable and veto inappropriate conglomerate structures that
include a deposit-taking licensee, including restructuring of a mixed
conglomerate to establish a financial sub-group under a financial holding
company, comprising all group financial entities. This is to facilitate transparency and comprehensive prudential
assessment of all financial risks and exposures within the group.
·
Supervisory
reach and access to records of immediate through to ultimate owners of
deposit-taking entities.
·
Establishing
reporting requirements for all group entities wherein the Supervisor may
require returns to be made by financial holding companies as well as
deposit-taking licensees (on an individual and consolidated basis) and receive
audited financials of all companies in the conglomerate each year.
·
Enhancement
of provisions relating to cross-border inter-regulatory cooperation and
information sharing as well as establishment of similar mechanisms for domestic
intra-regulatory relationships
·
Requirement
for the separation of the substantial and burgeoning funds-management and
(retail) securities trading activities from deposit-taking licensees into
legally separate corporate entities.
While this latter may appear to run counter to Gramm-Leach and other
“universal banking” practices engaged in other jurisdictions, this measure was
informed by Jamaica’s particular experiences and needs. In particular, these activities which fell
under the operational oversight of the FSC, had grown rapidly to represent the
major business operations of some deposit-taking licensees, albeit with a
radically different risk profile and in the context of an unsophisticated
public whose perception was that they were undertaking banking business. It was the Supervisor’s view that the
potential for contagion would therefore be better contained and defined with
the separation that was effected.
5.
Consequent
on the legislative enhancements, cross-border relationships with home/host
Supervisors were strengthened and a reciprocal MOU with certain regional
Supervisors has recently been established. This
MOU originated amongst the jurisdictions impacted by the establishment of a
regional bank, but is now extended to incorporate all members of the Caribbean
Group of Bank Supervisors (CGBS)[2],
pursuant to development of a coherent, regional consolidated supervision
framework.
6.
Restructuring
of Supervisory methodologies and approaches to facilitate more coherent
assessment of conglomerates long preceded and were important in early
recognition of the pending financial system distress. These operational changes enabled
the Supervisor to better see what was happening across groups, made clear the
evils of regulatory gaps and overlaps which facilitate regulatory arbitrage,
and included:
·
Re-organising
the on-site examination approach from entity-type to portfolio-based on and
off-site monitoring of conglomerates and stand-alone licensees. This
required portfolio managers to establish key relationships with all
deposit-taking licensees within a group, understand group structures and
receive continuing updates thereon. The
simultaneous examination of related deposit-taking licensees also yielded
information critical to the more realistic assessment of pending systemic
problems.
·
Establishing
closer operating links between the Statistics and Early Warnings Systems Unit
(which receives and assesses the regular returns from licensees) and the
Examination Portfolios so as to support coherence and timeliness of reviews and
follow-up of issues and trends as they become evident from the returns.
Forthcoming measures to be
implemented to strengthen the consolidated supervision framework and which are
currently in process of development, include:
a)
Updating
and streamlining of reporting and disclosure requirements to incorporate
capital, large exposure, market risk and risk management standards as
appropriate, for financial groups;
b)
Further
developing on MOUs to include cross-sector relationships in financial
groups. In this regard we are
contemplating and have raised with our regional colleagues, the issue of
establishing MOUs with non-bank regulators in the region where related to
home/host responsibilities impacting financial groups.
As indicated earlier, the emerging
trends in conglomeration are reflected in the growing establishment of
financial conglomerates across the Caribbean region. This development has implications for the harmonisation of laws
and accounting standards and even application thereof, as well as consistency
and comparable high standards in supervisory definitions, policies,
methodologies, practices and procedures across the region. As experience has taught us in Jamaica, it
is crucial that consolidated supervision of financial conglomerates is in
place, with global standards applied according to a conglomerate’s risks, so as
to avoid supervisory arbitrage and ensure that group transactions and
structures facilitate effective supervision.
The CGBS recognises the effective execution of Consolidated Supervision across the region has to be premised on the establishment of harmonised laws and supervisory standards by regional jurisdictions. Allied to this is the issue of a common accounting and reporting framework, which is essential for any effective consolidated regime. It is therefore necessary that the region adopt a common standard of the measurement of its assets and liabilities as well as the reporting of these, to facilitate not only the consolidation process, but comparability of financial statements.
To this end, a technical sub-committee of the
CGBS was formed last year and was mandated with the task of recommending to the
Committee, the options available to the region, for a common approach in the
implementation of Core Principle 20, including areas such as capital
requirements and large exposure prohibitions.
The sub-committee has had a number of face-to-face meetings in addition
to extensive electronic and telephonic correspondence. Reports on progress in these regards are
made twice yearly to the group of CARICOM Central Bank Governors under whose
sponsorship the CGBS evolved and who fully support these initiatives.
The imperatives for implementation of
consolidated supervision structures and practices identified by the group
include the following:
a) Supervisory authorities must implement
through careful planning and use of their staffing and resources, the key
mechanisms for the day to day monitoring of a banking group, viz:
·
Information
Sharing and Collaboration. Legislative frameworks must allow for MOUs and information sharing on
both a domestic intra-regulator and overseas inter-regulator basis as
appropriate. These should incorporate
“Lead Supervisor”[3] provisions
and criteria with regard to consolidated supervision responsibilities.
· Achieving a proper balance between risk focussed as against rules based supervisory techniques so as to maximize the benefits from each. (It must be appreciated that the new methodologies for evaluating risks are technologically driven, (and largely untested) complex models and require strong specialist skills on the part of Supervisors.)
·
Monitoring and analysis of group
risks. A critical output of any Consolidated
Supervision process must be the preparation of a comprehensive annual report
produced by the Consolidated Supervisor on the risks of the groups being
supervised. These reports should incorporate all of the information accessed by
the Consolidated Supervisor including the views/assessments of all Supervisors
involved, so as to inform regulatory action at the group level as well as to
assist functional regulators and policy makers. The report should include an
assessment of the key risks, weaknesses and strengths within the group’s
capital adequacy and risk management structures. It could also propose
ameliorative action, including limitations on future expansion until
deficiencies are remedied or even termination/discontinuation of business
lines/subsidiaries.
·
Resources and Training. Supervisors need
to acquire further specialist skills relevant to consolidated supervision and
develop some expertise in non-banking areas so as to better determine the risks
that can arise in NBFI affiliates and products.
·
Information
Gathering to allow
for evaluation of the key areas of risks (and the institutions from which they
arise), and which will include:
- Consolidated prudential reports - provided on a periodic basis,
covering capital adequacy positions, all large exposures and the maintenance of
prudential ratios;
- Regulatory Reports – including the reports/assessments
of a NBFI Supervisor to allow the Consolidated Supervisor to understand the key
issues arising in a NBFI;
-
Audited
financial statements and other relevant data from group members;
-
Risk
Management Policies and Procedures which indicate management’s risk management approaches at the group
level, covering areas such as authority/transaction levels, internal control
systems and reporting requirements;
-
Business plans and projections to inform evaluations of the business risks inherent in the group’s
strategic direction and management quality.
b) The
issue of acceptable group structures[4]
is central to effective consolidated supervision and should benefit from
thorough discussion among the regional grouping. Common definitions and approaches should be agreed, including as
to the effective role of a regional “lead supervisor” and the treatment of controlling
entities located above or “upstream” the regional banking and other regulated
entities.
c)
The
impact of certain regional and international treaties/agreements, which
incorporate “free entry” and “open borders” requirements will have to be
considered. In particular, the pending
CSME[5]
is designed to result in the removal of legal, economic
and trade barriers and
will result in even further integration of regional financial sectors and
banking groups. This holds the
potential for systemic risk to be increased exponentially as the various
financial systems become increasingly integrated and correlated, and reinforces
the imperative for the regional authorities to put in place a framework
sufficiently robust to minimise/prevent Supervisory arbitrage, promote
financial stability, while facilitating healthy market development and
expansion. Further, regional
Supervisors will need to clearly articulate their position on a number of key
regulatory issues that must be preserved in the design of the CSME framework,
so as to ensure that regulatory standards are harmonised, but not diluted.
However, it is recognised from both
an individual jurisdiction and regional perspective, that such countervailing
factors have to be considered with country needs in terms of structuring of
regulatory architecture and adaptation of principles to work in the context of
the realities and peculiarities of each jurisdiction, so as to secure its
stability and sound development. Simply
put, regional supervisors will have to balance the imperatives of financial
stability with those of national development (under e.g., trade agreements),
which require increasing openness with the international financial network.
There is also already in
evidence, a strong push for all jurisdictions to adopt a standardised
regulatory framework inclusive of wholesale adoption of international
principles. However for these
principles to be effective, their implementation must again be through
adaptation to the peculiarities and regulatory powers/capacity that exist in a
jurisdiction. In the context of small,
open, developing island economies where sensitivities and impacts are magnified
manifold in comparison to their larger, more developed counterparts and can
easily translate to crises of confidence, all appropriate measures must be
undertaken as necessary to ensure financial system stability and minimise
potential for arbitrage exploitation and systemic risk. This may require in some circumstances that,
given acknowledged weaknesses in other areas, certain activities be constrained
until, for example, supervisory or other required capacity or framework is
built to allow wider operations in these regards.
CONCLUSION
Ultimately, each
jurisdiction must use its experience, good judgement and intimate knowledge of
its environment, financial sophistication, risk profile and stage of
development to inform its adaptation of international principles and best
practice in updating and enhancing its regulatory infrastructure.
In closing, let me share
a few examples, which further illustrate how this approach has served us well
in Jamaica:
a)
In the
adaptation of the Basel Capital Accord, we ascribed higher weightings and more
stringent criteria in some areas than were prescribed in the Accord, one such
being the total exclusion of Capital Reserves (unrealised gains on revaluation)
from computation of both Tier 1 and Tier 2, notwithstanding the Accord
permitting this. This approach was
later adapted by many international jurisdictions as they experienced our
ealier realisation that its inclusion created the opportunity for capital to be
imprudently increased by “the stroke of a pen”.
b)
Despite
the current approach prescribed by IFRS/IAS as regards allowing income to be
taken on past due loans based on managerial assessment as to realisability of
collateral on a time-discounted basis, the Bank of Jamaica has maintained its
strict non-accrual statutory provision for loans 90 days and over past
due. This approach avoids discretion
and judgement issues which can only adversely impact (overstate) reported
profits and nonetheless immediately recognises income on such accounts on a
cash basis until the facility is returned to performing status under the
existing Loan Classification criteria.
Similar constraints have been put in place relative to unrealised gains
on non-trading book assets under mark-to-market rules, which must be taken to a
Revaluation Reserve until realised when it can then be booked in profits.
c)
Jamaica
has also promoted legislative amendments and the Bank of Jamaica has used moral
suasion approaches even where specific legal provisions may not yet be in
place, where issues which may be allowed in other jurisdictions are seen as
endemic and present potential for impacting stability, as in
·
Parliament
took the decision to prohibit unsecured connected party lending as well as
lower the ceilings for aggregate investments in and secured lending by banks to
connected parties;
·
Criminal
sanctions were imposed in law in relation to breaches in reporting requirements
by auditors of deposit-taking entities (this is a unique provision which has
been commended by our international colleagues, including large developed
jurisdictions which have not been successful in similar initiatives)
·
The
Bank of Jamaica dis-allowed cross directorships across institutions (unless
they fall within the same conglomerate), and incorporated this conflict of interest
requirement in its “fit and proper” processes.
This is now promoted as a standard of good corporate governance.
[1] Core Principle 20 states that “… an
essential element of banking supervision is the ability of the supervisors to
supervise the banking organization on a consolidated basis”. The objective of Consolidated Supervision is
to ensure that:
(a.)
No financial entity within the group goes
unsupervised or escapes supervision;
(b.)
Double/multiple leveraging of capital is not facilitated (see
Attachment 1);
(c.)
The upgrading of debt to equity as it is
transferred down the chain of subsidiaries is disallowed; and
(d.)
All risks (including contagion risks) incurred
by a banking group, no matter where such risks are booked, are evaluated and
controlled on a global basis.
[2] The CGBS is a formal sub-group of the Basel Committee on Banking Supervision.
[3] An example of this model in action is that of the United States, where the Federal Reserve has been statutorily appointed as lead Supervisor with responsibility for holding company supervision.
[4] An appropriate financial group structure may
mean a group of regulated financial institutions headed by either a
non-operating financial entity (with a
limited banking license or subject to financial holding company requirements),
a bank or a non-banking financial entity (subject to supervision and/or or
subject to financial holding company requirements). With regards to insurance companies, in determining on the
required capital adequacy of the group, the assessed capital for the insurance company is added to the
consolidated group capital (“consol plus”). On a qualitative basis, the
financial condition and risk profile of an insurance company is to be included
in the Supervisor’s assessment of the overall group risk position.
[5] Caribbean Single Market Economy