Lars Nyberg: Issues in supervision of banks - the European experience
Speech by Mr Lars Nyberg, Deputy Governor of the Sveriges Riksbank, at the Association of
Professional Bankers, Colombo, Sri Lanka, on 26 August 2000.
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Background
First of all, I want to thank you for giving me this opportunity to discuss with you some questions
concerning the supervision of banks. The issue, I understand, is quite timely, since Sri Lanka has
embarked on an ambitious project of developing the financial sector, opening the banking system to
international influence and modernising it accordingly.
A sound and well functioning financial sector is a key to economic development. This statement may
sound uncontroversial in your ears, but it is not always accepted by the general public and by the
politicians. The contributions of the financial sector are sometimes hard to explain in simple terms and
people tend to look at banks with suspicion. To create credibility and respect for the financial sector in
general and most importantly for banks, a proper and well-developed supervision is essential. Bank of
Sri Lanka has realised this and initiated a comprehensive upgrading of bank supervision. In my view
this is exactly the right point to start developing the financial sector.
Supervision, however, is developing quickly. Supervising a traditional highly regulated banking
system is far different from supervising a deregulated system open to foreign competition.
Furthermore, going from a state of strict regulations to one of deregulation implies risks for
undermining banking stability. Many countries, not least my own, have had bitter and expensive
experiences from this.
Of course, all countries have specific national features in their banking systems. The main risks are
common all over the world, however, and the same challenges to supervision seem to appear
everywhere. I will focus on some important issues seen from my perspective, which includes the
experiences we gained during the Swedish banking crisis in the early nineties.
Deregulation
Why deregulate if the consequences may be so dangerous? The obvious answer is that regulations tend
to create inefficiency and prevent the domestic banking system from developing in response to
international competition. The long run cost to society of extensive regulations is a poorly functioning
financial sector.
While regulations are usually put in place to decrease systemic risk they may indeed in the long run do
quite the opposite. Strong regulations mean that banks have low incentives to adopt good credit
policies and risk management techniques. Supervision tends to be excessively formal, focusing on
formalities rather than on actual risks. Nor are the regulations and techniques of supervision updated
often enough to foster the development of new activities and management of risks. Regulations shelter
the domestic banking industry from outside influence, which slowly tends to decrease efficiency and
increase systemic risk.
Furthermore, in a regulated environment the likelihood is large that some credits may be subsidised,
perhaps even channelled to politically desirable rather than economically sound projects, leading to
misallocation of resources.
Albeit many people today acknowledge that the traditional kind of regulations do not produce the
desired results, we tend to keep them too long. Let me give you an example. In Sweden, we had
foreign exchange controls in place until 1989. Even though it was obvious that the controls were easy
to circumvent and quite inefficient, the authorities were worried by what might happen if they were
abolished. Perhaps there would be a huge capital drain? Hundreds of pages were written in attempts to
map the consequences, but no comfort was provided this way. Eventually the central bank decided to
go ahead in spite of the remaining uncertainty. To some surprise and some disappointment, nothing
particular happened in the market. The move had been anticipated and the controls inefficient enough
to allow the capital flows to adjust prior to the move.
Credit controls and interest rate regulation had been abolished in Sweden four years earlier, in 1985,
again probably far too late. Some people argue that the banking crisis we had in the early nineties
might have been much less severe if the banking system had been forced into a competitive
environment by deregulation a decade earlier.
Keeping regulations too long is a danger, getting rid of them too quickly is another. This may sound
peculiar, but let me again give you an illustration. When, in 1985, credit controls were abolished in
Sweden, they had been in operation for more than forty years. Since the authorities had decided on
how much each bank could increase its credit book every single month, there was really no need to
appraise credit applications in a particularly serious manner. Mortgage credits took most of the
available credit volume and the remainder was allocated to safe projects. Credit losses in the banking
system were only a fraction of a percentage point of the credit stock each year. As a consequence, the
ability to appraise credit risk had slowly dwindled out of the banks. So, unfortunately, was the case for
the supervisors.
When credit controls were finally removed the volume of credit virtually exploded. All banks wanted
to increase their market shares and there was plenty of pent-up demand. Many loans were given to
customers who, as it appeared later, were far from creditworthy and should not have passed a proper
credit appraisal. The regulations had been abolished at the wrong time and without realising what an
extended period of regulation had done to the ability of banks and supervisors to handle credit risk.
What can be learnt from this? Quite obviously, deregulating does not mean the abolishing of all rules
according to which banks should behave. There are good and well documented reasons for regulating
banks. Deregulation means the adoption of a new legal structure that is consistent with a competitive
market economy. The dilemma of regulation is to balance between having too little and too much. Too
much will stifle the banks, too little will lead to unsound risk taking. The traditional form of regulation
was to set very strict rules or to forbid banks from conducting certain activities. The modern form is to
be more flexible. Regulations set the boundaries while allowing the banks to operate within these
boundaries if they can prove that they have the skills and resources to do it in a sound manner. Modern
regulation puts much more responsibility on the banks themselves and their owners and management.
In Sweden, the former Banking Act actually prohibited the banks to engage in any activity that was
not explicitly permitted in the law. The new Banking Act starts at the other end, permitting the banks
to do whatever they find suitable except for certain activities that are explicitly forbidden.
Today's financial institutions, instruments and markets are, of course, much more sophisticated than
earlier. There is also much broader diversity in the sector. For example, the needs of customers are
satisfied in many different ways and by many different actors, certainly not only by banks.
As a consequence, modern regulation needs to be more flexible than in earlier days, when the market
was more homogeneous. The regulation should encourage competition and innovation, but at the same
time discourage unsound risk taking and generally unbecoming or even illegal behaviour. Only when
there are strong arguments should the regulator outright restrict or prohibit certain activities. Instead,
regulations should provide incentives for banks and others to behave in a sound manner. For instance,
capital requirements do not prohibit risky exposures, but they make them expensive to the bank.
Before moving somewhat deeper into the questions of supervision, there are some things to say about
risk management.
Risk management
Risk management systems are at the core of modern banks. Banks must have consistent systems for
identifying, monitoring, controlling and managing risks. These systems must be endorsed and
understood not only by credit officers, but also by the board and the management.
In a deregulated banking sector, the division of control and responsibilities in a bank is of particular
importance. Owners must take an active interest in the bank by setting broad strategic guidelines and
policies for risk management and internal controls. Bank boards must have access to timely and
adequate information and act on it when necessary. There must be a division of labour making it clear
to all members of management and staff what specific responsibilities they have.
From the Swedish banking crisis I would single out a few types of risk.
Credit risk
in general, linked to the issue of collateral, was - as should be expected - the main problem.
It was our experience that banks coming from the sheltered world of strict regulation did not have
good and consistent systems for credit evaluation and documentation. Today, banks must have credit
policies, stating what kind of credits they wish to grant. Usually, small and simple loans are provided
at branch office level, but larger and complicated loans are provided at successively higher levels.
Banks have also adopted internal risk evaluation systems in which the individual loans are graded
according to their risk. Loan documentation is improved to facilitate monitoring of the loan but also to
ensure that the bank can collect on the loan in the event of a judicial process.
In Sweden, concentration of credit risk was a major problem during the crises. Some two thirds of the
losses were linked to the sharp price declines in real estate.
A loan and its collateral must be evaluated separately, something that we had forgotten during the
many years of regulation. If the expected returns from the investment made by the loan are uncertain
or not adequate the loan should in most cases not be given, irrespective of the collateral. The reason is
that the collateral, in a crisis situation, often proves to be worth far less than expected. This is
particularly true when it is tied to the borrower - such as when a company has put up its own building
as collateral.
The linkage between credit risk and foreign exchange risk was large during the Swedish banking
crises. This was seen also in the Asian crises in 1998. For example: Swedish borrowers wanted loans
in yen and German marks because the interest rates in these currencies were low. When the Swedish
currency depreciated, the borrowers could not repay the higher loan values because their revenue
stream was in local currency. The banks believed themselves to be hedged against the foreign
exchange risk since they were funded in the currency of the loans given, but they failed to see the
corresponding increased credit risk.
Other risks were less prominent in the Swedish crisis but, in my opinion, will be of increasing
importance to banks all over the world. Among those are operational risks. Several recent financial
debacles, such as the Baring crisis, were due to operational risk. Even though the Y2K problem was
successfully managed, the huge computer systems of banks could cause large losses if technical or
other failures occur.
Another risk, which in my mind will become increasingly important, may be called "strategic risk".
The financial market in most countries is highly competitive. In order to survive and prosper, banks
must take bold decisions on new activities, new establishments, mergers, technological investments
and so on. Decisions like these have to be taken, but should they go wrong, banks may suffer large
losses and may even go bankrupt.
To handle these and other risks, internal controls and internal audit systems are becoming increasingly
important. The huge mass of information in modern banking makes it impossible for supervisors to
monitor individual transactions. They must rely on banks to maintain reliable internal control
functions, which not only verify the accuracy of transactions and operations but also take a broader
view of the bank's compliance with its own rules and policies as well as with external rules and
policies.
Supervision
Traditional supervision was of the type, which you may call "checking the ledger", that is verifying
that all transactions are properly recorded and formally correct. To some extent this must remain, but
the supervisor's efforts in this sense can be reduced by applying modern statistical methods, eg for
sampling, and by making sure that banks have adequate internal control systems.
Instead, supervision should be risk-oriented and focus on those activities, which pose significant risks
to the individual bank (differing from bank to bank). Risk-oriented supervision also implies stricter
supervision for large banks and for banks taking larger risks than others. Supervisors should focus on
evaluating and monitoring risk management systems, internal controls, corporate governance, and
information systems. This calls for large supervisory resources and for more sophisticated skills:
lawyers, but also economists, financial analysts, statisticians, mathematicians and accountants. If the
law permits, which indeed it should, the supervisor could call on outside experts to assist.
In order to be effective, supervision must in most cases be conducted on a consolidated basis, to
include all parts of a financial conglomerate and even its non-financial affiliates. The increasing
blurring of boundaries between different financial activities and the building up of large financial
conglomerates make consolidated supervision crucial. Consolidation includes financial as well as
non-financial entities within a country, but also world-wide. The cooperation and exchange of
information between supervisors for different financial activities (banking, securities trading and
insurance) is important, domestically as well as globally. Informal or formal agreements must be
concluded to facilitate such cooperation. Supervisors should not license banks, or their affiliates, if
their organisational structures prevent effective supervision. In the same vein, home supervisors
should not allow their banks to establish affiliates abroad, if the host authorities are not willing to
exchange important information regarding developments affecting this affiliate.
Transparency is key. Banks should be induced, by force and voluntarily, to properly disclose
information of their activities to the general public. Information must also be timely, relevant and
accurate. In this way, there is daily "supervision" of the bank by market analysts, depositors and
others. It is understood that some bank activities are to be considered as strategic secrets which cannot
be divulged, but in my view these are fewer than we tend to think.
Hence, a related subject of great importance is the issue of accounting. To create transparency,
accounting rules, including valuation rules, must provide a clear picture and reflect the true situation of
a bank. Let me give you an example. A lingering problem in many countries is that banks hold large
amounts of non-performing loans to companies, even those that are state-owned or formerly
state-owned. The loans are usually not valued according to their realistic, low, values. In my view, this
is not helpful even if it seems to improve the financial statements of the banks. Nobody is fooled about
the actual situation because these bad loans are well known in the market. The loans should preferably
be transferred out of the books to some asset management company - priced at a realistic market value,
of course.
Under all circumstances, supervisors should require that banks have consistent and true systems for
the valuation of loans, performing and non-performing, with or without collateral. These systems
should also take into account the setting aside of adequate provisions for weak loans. These provisions
should reflect the expected losses to the bank. In calculating these losses, collateral may be taken into
account, but as earlier mentioned, it is important that the collateral is conservatively valued because its
value tends to decline sharply in a default situation.
For any country aiming for a credible financial system, auditing standards must be high and
approaching the best international practices. Furthermore, the supervisors should maintain close and
regular contacts with the major accounting and auditing firms in their country. This serves to provide
and receive information on individual banks, but also to explain and to get feedback on the
development of new rules and regulations and how they are implemented in the market.
Asset management companies
Before proceeding, I would like to make a few points concerning the asset management companies
(AMC's) touched upon above, since these seem to be controversial in many countries. They certainly
were in Sweden during the peak of the crisis.
Asset management companies are simply companies to which a major part of the non-performing
assets of a bank can be transferred, given that these loans for some historic reason have grown to
become a considerable part of the bank's balance sheet. The purpose of the asset management
company is to dispose of the assets as quickly and profitably as possible and then close down.
As I see it, there may be two main causes for such a transfer of assets. First, experience shows that
bankers are not best equipped to handle the restructuring and work out of collateral taken in by the
bank as a consequence of failing loans. Bankers may possibly be good at lending money and handling
minor non-performing loans, but they usually have little experience in reorganising industrial activities
and managing real estate companies to the extent required in an AMC. These activities require a
different competence.
The trouble is that bankers often fail to see this, in particular if they have been heavily involved in
handling the failing credits. They talk about long term relations with the customer. They argue that the
loans could be kept in the book of the bank and that relevant competence could be hired. I strongly
believe that this is not true. If a proper restructuring is to be done, professional restructuring people
without historical relations to the customer should do it. Whenever I have been persuaded otherwise I
have later been proved wrong.
The second argument for transferring the non-performing assets is related to this. When the
management of a bank has a large number of bad credits to take care of, that is exactly what they do.
All their capacity is used up taking care of problems and there is no time - and no money - to think
about the future. This is disastrous for the whole organisation, which tends to become backward
looking and defensive instead of forward looking and offensive. Only when the bad assets are out of
the books of the bank, the minds of the management and thus of the employees can become aimed
towards the future.
Having decided to transfer the bad assets, the next obstacle will be to decide on the prices. The bank
usually considers the non-performing assets to be quite valuable, at least in the long run. Selling at
what might be considered present market prices will create too big a hole in the balance sheet to make
management comfortable. The management of the new AMC quite naturally has a different view. It
has no wish to get assets into its balance sheet at values that later turn out to be excessively high.
According to my experience, it is important to listen to the AMC rather than to the bank if the purpose
is to get the restructuring
done. If the management and board of the AMC can make reasonable profits
by selling its assets, which indeed is the purpose, this is what they will do. However, if they have
acquired the assets at too high prices, every sale will show a loss and they may even have to approach
the owners to get more capital. The owners will not like this, whether the company is owned by the
bank which delivered the assets or some external financial investors. Hence the board will avoid
showing losses and consequently little restructuring will be done.
Thus transferring assets at market prices is essential if the restructuring process is to work. The trouble
is that by doing this you may be forced to write down the assets in the books of the bank, since they
have not been valued correctly. This in turn will uncover the hole in the balance sheet and may require
a capital injection. And putting more capital into the bank may not be feasible at the time, for political
or for other reasons. At this point, you can always start a discussion of what market prices really are.
This happened in Sweden and it has happened elsewhere. But a hole in the balance sheet is always a
hole, whether you decide to see it or not. Either new capital must be put into the bank before the
transfer of assets or it must be injected into the AMC when the real value of its assets becomes
obvious to everyone. Putting the money straight into the bank speeds up the restructuring process.
Consolidated supervisory authorities
I mentioned that supervision should be conducted on a consolidated basis, covering activities in
different financial and non-financial sectors. Should also the organisation of the supervisory authority
be "consolidated"? Several countries, including the UK, Korea, Australia and others have recently
moved in the direction of creating an "FSA" which is responsible for the supervision of banks,
securities markets and insurance. In Sweden, we have had an FSA since 1990.
Is such a consolidation necessary and useful in all countries? In my view, the optimal structure of the
supervisory authority depends on the structure of the individual country. In many countries, banks
conduct the most important financial activities while securities markets are less important. Here at
least bank supervision must be independent, have adequate resources and skilled staff. This is crucial.
In many countries, bank supervision is a part of the central bank. This has benefited bank supervision
because the central bank usually has legal independence, adequate resources and can attract qualified
staff. Combining bank supervision with securities and insurance supervision will probably imply that
supervision will move outside the central bank, since securities and insurance supervision is not
normally a task of central banks. In this sense, bank supervision may become weaker. In my view, in
markets where banks are dominating the financial sector and where the integration with securities and
insurance markets are less pronounced, keeping the supervision separate and within the central bank
makes good sense.
Having said this, I acknowledge that the present tendencies are for banks to merge with other financial
institutions, and for financial instruments to look increasingly alike whether they are created in banks
or in other institutions. These tendencies would indicate a corresponding need for supervision of
different financial sectors to cooperate closer and closer and, perhaps, finally to merge. The trend is
clearly seen in Europe, reinforced by the common currency, but is gradually developing also in other
countries. As mentioned above, this is the way we have organised supervision in Sweden. But I do not
see a need to consolidate the supervisory authorities in a specific country until the structure of its
financial markets so requires. As an intermediate step, cooperation agreements between the
supervisory authorities should be encouraged.
A strong rationale for locating bank supervision in a central bank is that bank stability is of crucial
importance for the conduct of monetary policy. In addition, a central bank has the powers to provide
liquidity - under normal as well as exceptional circumstances - to banks, for instance as a lender of last
resort. To do this, it is obvious that the central bank must have full knowledge about the financial
situation of a bank.
However, there are also good arguments for keeping supervision separate from the central bank. There
may be a conflict between the role as supervisor and the role of being a lender of last resort. If a bank
would fail, being supervised by the central bank, the central bank may feel more inclined to provide
liquidity support than is economically defendable. Bankers may know this and the case for moral
hazard may therefore be stronger than with a separate supervisor. Rules for public administration of
troubled banks outside the central bank may give some help in this respect.
There may also be a conflict of interest relating to monetary policy. If a bank fails while being
supervised by the central bank, this may affect the central bank's reputation and credibility. In my
view, these are important arguments, because credibility of the central bank is basic not only to
systemic stability but also to the conduct of monetary policy.
What is the role of the central bank in relation to financial stability when there is an independent
supervisory authority? There are still remaining the increasingly important questions concerning the
macroeconomic "oversight" or macro prudential supervision of the financial system. As a matter of
fact, these questions often tend to be neglected when the ordinary supervision remains within the
central bank, because they are in many ways different in character from the day to day supervision.
To effectuate its responsibilities of conducting monetary policy and ensuring a stable payment system,
a central bank must monitor the risks in the financial sector. In this capacity, the central bank is mainly
interested in systemic risks, not in the potential problems of individual banks unless these are large
enough to affect the whole system. The macro prudential analysis aims at identifying risks which are
common to a number of banks and other financial institutions or markets, including payment systems.
Such risks often stem from the development of the macro economy. Volatile inflation developments or
exchange rate fluctuations could lead to problems for a number of banks. Asset price "bubbles",
excessive loan concentrations or excessive leverage ratios for borrowers might do the same. It is
natural for the central bank to closely monitor such developments and take prompt action if it finds
that financial stability is endangered. In some cases it may not have the powers to take direct action
itself, but it may inform other parties, such as the political authorities or the supervisors, urging them
to apply necessary measures.
I would like to emphasise that macro prudential analysis does not mean that the central bank is
duplicating the work of the supervisory authority. We do not examine and audit the individual
financial institutions, this is clearly the task of the supervisors. Most of our information is gathered
from other sources, including from the supervisory authority itself.
An increasing number of central banks, eg those in England, Canada and Sweden have established a
structured procedure to macro prudential analyses. In Sweden, our conclusions are published in a
semi-annual Stability Report, where we analyse the development of risks in the banking system and
where we state our overall view on systemic stability. The reports have increased the general
knowledge about the stability situation of the Swedish financial sector and they constitute the basis for
discussions with the financial institutions and with other authorities. Whether they will help us avoid
the next financial crisis is still to be seen.
International standards
Financial systems and markets are increasingly interlinked across the country borders. In order to
avoid international financial disturbances all countries that wishes to participate in cross-border
transactions must adhere to a set of minimum rules for regulation. Also supervision must reach
adequate levels in all countries, including cooperation and exchange of information between
supervisors in different countries.
In 1997, the Basel Committee took the initiative of writing the Core Principles for Effective Banking
Supervision. Complying with the Principles constitutes a minimum platform for any country that
strives to have basically sound regulation and supervision of banks. If I may say so, there is nothing
radically new with the Core Principles - all the underlying standards that countries are asked to fulfil
are well established and internationally recognised. The main use of the principles is rather as a
yardstick, whereby a country can evaluate itself in order to identify weaknesses in its present
regulations and supervision and to take remedial measures to improve. There are national and
international arguments for a country to adhere to the Core Principles.
The domestic argument is the one of avoiding or reducing the impact of bank problems, not least
because they are costly to the macro economy. While the Principles are not intended to prevent single
banks from failures, effective regulation and supervision should reduce potential risks and make them
easier to identify at an early stage. The international argument for compliance is that other countries
will require this before they open their financial markets. The fear of contagion, implying that
problems of one country spread into others, remains strong.
Conducting an evaluation of compliance towards the Core Principles is especially helpful when a
country is in a stage of modernising its financial sector, such as Sri Lanka. The result of the evaluation
will identify weaknesses and can serve as a guide to reform measures. It is also the experience of other
countries that the result of the evaluation may be a useful tool for the supervisory authority in
convincing the politicians of needed legal and regulatory amendments.
Conclusions
I have touched upon a number of aspects of supervision, all in one way or another related to lessons
learned during the last ten years. I shall make no attempt to summarise, just return to my first point
that a high quality, risk-oriented and flexible supervision will create credibility for the financial sector
and make it prosper. Inadequate and old-fashioned supervision based on rigid regulations will do right
the opposite. And supervision is a dynamic concept. The tools and art of supervision must, in all
countries, continuously improve along with the development of markets and market technology.