Zeti Akhtar Aziz: Deposit insurance and consumer protection
Keynote address by Dr Zeti Akhtar Aziz, Governor of the Central Bank of Malaysia, at the
"Deposit Insurance and Consumer Protection" 6th International Association of Deposit
Insurers (IADI) Annual Conference, Kuala Lumpur, 31 October 2007.
* * *
Introduction
As the international and domestic financial landscape continues to transform, the quest to
secure financial stability has become increasingly challenging. Regardless of the stage of
development, financial systems have continued to be vulnerable to crisis that have resulted
in financial disruptions that have had severe economic repercussions. In these
circumstances regulators and financial safety net frameworks have been tested to the limit.
While the rapid pace of globalisation, the rising internationalisation of the financial system
and the advances in technology have brought benefits in terms of increased access to new
markets, encouraging financial innovation and increasing consumer choice, it has also
brought new risks to the financial system. The intensification of cross-border financing, and
the growing complexity of financial structures has resulted in new international inter-linkages
which has increased the international interdependence. The transmission of negative shocks
in one country to others via the international financial system has demonstrated the potential
for financial crises and economic disruptions to spread on a global scale. These concerns
have been brought into the forefront recently with the developments in the sub-prime
mortgage market in the United States and its contagion effect on financial systems in other
parts of the world. Indeed, it has shown that in today's globalised and increasingly
internationally integrated financial markets, seemingly isolated events in a small segment in
one market can have far reaching and vastly magnified implications in other financial markets
across the world.
This recent episode of financial turmoil has shown that even the more sophisticated and
informed investors are pre-disposed to over-react to uncertainties in financial institutions. It
also needs to be recognised that the changes in the international environment has also
increased the challenges to understanding and managing risks, even for financial institutions
and the authorities. These developments have also brought issues of the effectiveness of
financial safety nets as well as institutional arrangements for the regulation and supervision
of banks, to the forefront.
Elements of financial safety net
It is in this context that the components of the financial safety net, the prudential regulation
and supervision, deposit insurance, liquidity support arrangements, crisis management
approaches and the consumer protection framework - have continued to evolve over the
recent decade. My remarks this morning will consider some of the developments and
challenges that are shaping the calibration of the financial safety net in the current
environment.
Prudential regulation and supervision
Sound risk management by banking institutions, which is reinforced by prudential regulation
and supervision, remains the first line of defence against financial crisis. This recent decade
has seen important strides being achieved at both the international and national levels
towards strengthening the prudential regulatory and supervisory frameworks in response to
the changing nature and scope of banking activities.
While lending and deposit-taking remain the mainstay of commercial banking, the profile of
credit markets has changed significantly. Today, conventional credit products are being
offered alongside the growing significance of asset securitisation and credit derivative
activities. This has had a profound impact on the nature of banking. The rapid development
of these synthetic credit markets, coupled with an extended period of ample liquidity in the
global financial system, has expanded the avenues for banks to engage in more aggressive
lending practices that are funded by borrowing from the wholesale money markets, and by
repackaging and selling loans to other investors in the form of asset-backed securities. This
represents a significant shift from the more traditional banking models where loans are
predominantly funded by deposits.
The increasing complexity in the way that debt is created and distributed in the financial
system raises important implications for financial stability. The "originate and distribute"
strategy that has been adopted by some institutions warrants addressing more
comprehensively the full range of risks to which the banks are exposed. This includes the
liquidity, foreign exchange and moral hazard risks in banking institutions. Credit risk
exposures have also taken on more complicated forms, including counterparty risks on
derivatives and foreign exchange transactions. The valuation of such financial transactions
and instruments are also often difficult to measure particularly under distressed market
conditions. In addition, the correlations between credit and market risk, both within and
across national borders, have become more complex. Of concern has also been lack of
adequate information on debt concentrations in the system partly due to the increasingly
elaborate ways in which debt is passed on from originating institutions to different investors.
The propensity to under-price credit risk, especially under conditions of excess liquidity, has
also increased concerns over underwriting standards. The consequent sharp pricing
corrections would in turn have the potential to result in broader economic disruptions.
Recent developments in the prudential regulatory and supervisory framework have, and will
continue to play an important role in promoting sound risk management practices in the light
of these changes. These of course, include the modification of capital standards that are
more granular in addressing different types of risk. Supervisory approaches globally have
also evolved to place a greater emphasis on sound risk management and early interventions
to address emerging risks before they become major problems. There is also more emphasis
being placed on the expectations of financial institutions to play a greater role in ensuring
that financial products offered to customers and investors are suitable given their needs and
financial circumstances, and that they have a good understanding of risks assumed with the
products.
Bank Negara Malaysia's approach to the financial regulation and supervision has similarly
evolved to achieve a more robust regime that emphasises three key dimensions: first,
creating a strong risk management culture that overlays the operations of banking
institutions; second, facilitating market-led adjustments that will allow the industry to evolve in
response to market and technological; and third, ensuring mutually consistent prudential
policies across the financial sector.
Underpinning this approach has been a more pronounced shift towards principle-based
regulations. Increasingly, regulations have focused less on prescriptive rules, and more on
establishing broad parameters for sound financial and business practices that leave
substantial flexibility for banks to apply the principles in the manner most appropriate to their
specific circumstances. Of importance, has been the creation of appropriate incentives within
the system to counteract potential market distortions that could undermine financial stability.
The differentiated regulatory framework under which stronger banking institutions would have
substantially greater operating flexibility and a lower level of supervisory intervention, for
example, provides a powerful competitive incentive for the adoption of sound risk
management practices.
While enhanced bank regulatory and supervisory functions have had a direct and significant
impact on improved risk management by banking institutions, the primary responsibility for
sound institutional risk management will continue to rest with the boards and senior
management of banks. It is the boards, and not supervisors, that are principally responsible
for the performance of banks and for their financial strength. Boards set the tone for their
institutions' risk taking activities, and provide effective oversight to ensure that their decisions
are followed. Of paramount importance is the need for boards to ensure that risks are
estimated in a consistent and timely manner, and escalated to the board with attention being
focussed on the management of the emerging risks.
Today, boards face additional challenges of discharging these responsibilities in an
environment that is rapidly changing and highly competitive. Achieving effective boards and
strengthening the foundations of sound corporate governance have therefore become a
priority in the reform agenda for many countries in the recent period. The implementation of
Basel II, new financial reporting standards and principles-based regulatory approaches have
also significantly increased the importance of, and reliance on sound judgement, integrity
and competence by the board and senior management. This, in turn has been a key driver in
galvanising efforts to strengthen market discipline as a countervailing influence that will rein
in high risk behaviour by banking institutions.
Achieving a framework with the right mix of regulatory and market-based incentives,
however, continues to remain a significant challenge. Transitioning to market-based
discipline can be particularly challenging in emerging markets where regulation has tended to
be more prescriptive. In these markets, safety nets are also more prevalent and the tolerance
for institutional failures is lower given its far reaching implications on consumer confidence.
For the most part, the liabilities of banks are not traded in the market, so debtholders
generally lack the opportunity to exercise market discipline. Moreover, the market
preoccupation with short-term stock price, rather than long-term creditworthiness also
presents potential risks to financial stability.
Notwithstanding these challenges, several recent positive developments in emerging
economies have augured well for market discipline to have a more effective role in
reinforcing sound governance. In particular, the development of financial markets have
resulted in more efficient markets with wide options for investors to exert discipline. The
adoption of international financial reporting standards, efforts to strengthen auditor
independence as well as financial capability initiatives will also reinforce market-based
discipline going forward.
All of these initiatives will improve the prospects for financial stability by preventing problems
from occurring at the level of individual institutions. However, the recent events in the
international financial environment have demonstrated the increasing complexity of banking
activities which has raised the broader challenges for financial regulation and the design of
safety nets in the context of managing systemic risk. Regulators have begun to carefully
consider the need to re-calibrate current regulatory approaches to appropriately address
risks to the financial system stemming from large and complex institutions that are
increasingly engaged in non-traditional activities. This has, in turn, placed new demands on
financial regulators as well as for institutions to develop a deeper understanding of the
interlinkages between the financial system and the economy, and in particular, the
macroeconomic transmission of financial risk. Going forward, a more optimal balance of micro (that
is, at the institution level) and macro (that is, affecting broader economy) responses will
become increasingly important in the management of such systemic risks.
An important dimension to effectively manage the increasing inter-linkages between the
financial system and the economy involves the strengthening of cooperative arrangements
between Central Banks and other regulatory authorities, within and across borders. Indeed,
cooperation, coordination and goodwill have become essential in the increasingly integrated
system. Such arrangements could include the more formal institutional arrangements for
cooperation in surveillance efforts and crisis management, as well as the home-host
arrangements for the supervision of international financial institutions, in supporting the early
identification of risks and the pre-emptive interventions that need to be made. Cross border
surveillance in the Asian region in particular has now been enhanced to ensure that
information gaps are identified and that the mechanisms to facilitate information sharing are
put in place.
Achieving effective inter-agency coordination between financial safety net participants also
needs to be considered carefully in the context of crisis management. Inevitably, the task of
managing a financial crisis particularly in the areas of timely decision making, coordination
and communication become much more complex when the functions of lender of last resort,
bank supervision and deposit insurance are allocated to separate agencies, as each
respective agency is accountable for discharging its own mandate having regard to its own
inherent priorities. Consequently, issues relating to information sharing, allocation of powers,
responsibilities, accountability and coordination among the various agencies must be clearly
and explicitly addressed at the outset. The legislative mandates would need to provide clear
roles and responsibilities for each relevant authority. This will form the foundation for the
adoption of an integrated and coordinated approach. The need for such coordinated action
becomes particularly important in conditions of an imminent financial crisis. Having in place a
crisis management framework would allow for its prompt and effective implementation. The
issues relating to the effective management of the inter-relationships between the safety net
participants were brought to the forefront recently in the United Kingdom, testing the
framework in which the functions of lender of the last resort and the supervisory function are
placed in separate entities.
In comparison, when a single agent such as the central bank is entrusted with these
respective functions, the interrelationship issue, as well as potential conflicts and trade-offs
become internal and would be resolved across the organisation. It would nevertheless still
need to rely on an adequate accountability regime among the respective departments or
divisions that are responsible for each mandate.
Malaysia's own experience during the Asian financial crisis exactly ten years ago allowed the
Central Bank as a single regulator, to promptly respond to the liquidity and solvency issues
that were confronting the financial system. The preemptive action that was supported by a
comprehensive resolution programme significantly reduced the cost of the crisis on the
financial system and the overall economy.
More recently, the Central banks in the East Asian region have come together to put in place
a comprehensive regional surveillance system that is supported by a comprehensive
integrated crisis management framework that would deal with any imminent financial crisis in
the region. These initiatives are aimed at effectively preventing or containing developments
that could trigger destabilising consequences, thereby promoting regional financial stability.
Deposit insurance system
Ladies and Gentlemen:
Following the restructuring and reform of our financial system, Malaysia has two years ago
implemented the deposit insurance system as part of our efforts to build a cohesive and
mutually reinforcing financial safety net system. The deposit insurance system has an
important role not just in promoting confidence with explicit coverage of deposits, but also in
reinforcing sound risk management practices. It therefore has embed features that
complements the supervisory process in promoting sound risk management practices in the
financial institutions. In addition, the deposit insurance corporation in Malaysia is also
mandated with the responsibility for the "least-cost" resolution of problem financial
institutions.
A comprehensive approach was thus adopted in establishing the Malaysia Deposit Insurance
Corporation (MDIC). To promote depositors confidence, the deposit insurance scheme was
designed to ensure that there was optimum coverage with sufficient reach to retail
depositors. In designing the deposit insurance scheme, about 95% of all depositors are
covered in full while in value terms about 35% of total deposits is covered. An important
element in the framework is the strong collaboration between the supervisor and deposit
insurer in promoting discipline in the banking system. As the supervisor, recognition is given
to sound risk management practices demonstrated by banking institutions to have greater
business flexibility, while the deposit insurer, through a differential premium system, provides
incentives for financial institutions to adopt sound financial and business practices.
In adopting this framework, clear accountabilities have been critical in ensuring that there is
no duplication in efforts so that the banks would not be over burdened by overlapping
regulation and submission requirements. There was also a need to ensure close
cooperation and collaboration between the supervisor and the deposit insurer to ensure the
intervention and resolution actions instituted by the deposit insurer, would not be to the
detriment of the system as a whole. These resolution powers would be invoked by the
deposit insurer following notification by the Central Bank that a member institution was likely
to cease to be viable.
It is in this context, the strategic alliance between the Central Bank and the deposit insurer
was formed as a basis for cooperation to ensure the safety and soundness of the financial
system. In Malaysia, Bank Negara Malaysia is mandated with the responsibility of
safeguarding and ensuring the stability of the financial system. The overall supervision of the
financial institutions remains within the functions of Bank Negara Malaysia. The Strategic
Alliance Agreement with the Deposit Insurer provides for a structured collaboration between
the Bank and MDIC to share information on key issues and developments to facilitate the
operations of MDIC.
Both formal and informal information exchange mechanisms have been put in place to
facilitate timely data and information exchange that can be leveraged upon to support and
enable MDIC to fulfil its mandated role. This has proven to be effective in minimising
duplication of efforts. These information exchanges include cooperation and consultations on
supervisory and prudential regulations where both agencies are involved from the early
planning stage, particularly in circumstances in which the initiatives impact the functions of
the respective institutions.
Consumer protection framework
To complement the deposit insurance system, Bank Negara Malaysia has also put in place a
comprehensive consumer protection framework that covers financial education, fair
treatment of consumers, avenues for redress, distress management and rehabilitation as
well as advisory services. These include having in place the Financial Mediation Bureau to
ensure that consumers of financial services that are under the purview of the Central Bank
have recourse to a fair and impartial dispute resolution mechanism. The establishment of the
Credit Counselling and Debt Management Agency provides individuals with credit
counselling and assistance in restructuring of debts; and the establishment of the Bank
Negara Malaysia LINK and BNMTELELINK forms an integrated customer service centre for
members of the public and small and medium sized enterprise on matters relating to services
provided in the financial sector. This has evolved a high rate of participation in the financial
system with deposits now accounting for 160% of GDP. This has allowed for the efficient
functioning of the intermediation process to effectively mobilise and channel savings to
productive activity thereby supporting the overall growth and development process.
Conclusion
Ladies and gentlemen
Essential to a progressive financial system is prudential safety and soundness, competition
and consumer protection which needs to co-exist to effectively serve the interests of various
stakeholders. As regulators we need to adopt the right balance between providing adequate
protection for consumers while promoting competition and financial innovation in the financial
system. But it is the combined efforts of regulators, the industry, and consumers that
ultimately maintain market confidence and ensures the effective and efficient functioning of
the financial system. The recognition of, and commitment to this shared responsibility will not
only contribute to the evolution of the financial landscape and preserving financial stability,
but will enhance its overall contribution to the overall functioning of the economy and
securing its full potential.