Ravi Menon: Global regulatory reforms - what's done, what to watch for
Opening remarks by Mr Ravi Menon, Managing Director of the Monetary Authority of
Singapore, at the 4th Pan-Asian Regulatory Summit, Singapore, 25 September 2013.
* * *
Mr Leas Bachatene, VP & Managing Director (Asia Pacific), Thomson Reuters
Distinguished guests, ladies and gentlemen, good morning.
Exactly five years ago, this month, Lehman Brothers collapsed and unleashed a financial
crisis of unmatched scale and impact. The crisis exposed deep fault lines in the global
financial system and spurred far-reaching financial regulatory reforms, aimed at building a
more resilient financial industry that better serves the needs of the real economy.
This morning, I will take stock of the impact of these regulatory reforms:
• the progress we have made in making the global financial system safer; and
•
the possible unintended consequences that we must watch for.
As a member of the Financial Stability Board, the Basel Committee on Banking Supervision,
and various other international regulatory forums, the MAS has been a strong proponent and
early implementer of many of these reforms. But we have not flinched from going above
international standards where necessary or refraining from some measures in other
jurisdictions which we regard as not relevant in our context.
Progress in regulatory reforms
Let me start with the progress in regulatory reforms.
Increasing the capacity to absorb losses
A centrepiece of the reforms in banking is the new Basel III capital standards. Basel III does
three things.
•
First, it raises the quantity of capital that banks must hold. By providing a buffer for
banks to absorb losses, capital helps to minimise spillovers to the rest of the system.
•
Second, Basel III raises the quality of capital that banks must hold. The crisis has
shown that common equity is the most effective capital instrument to absorb losses
and write-downs.
•
Third, Basel III brings back to banks' balance sheets many off-balance sheet
exposures and applies appropriate capital charges on them. Many banks that had to
be rescued in 2008 had capital adequacy ratios well in excess of the minimum
requirements then. They got into trouble because they had many risky off-balance
sheet exposures they did not hold capital against.
Singapore has fully implemented the Basel III capital requirements, two years ahead of the
timeline prescribed by the Basel Committee. And by 2015, Singapore-incorporated banks will
meet capital requirements which are 2% points higher than the Basel III minimums - in effect
a surcharge to reflect their systemic importance in our economy and financial system.
There is no global capital standard for the insurance industry. This is a lacuna that needs to
be plugged. But the International Association of Insurance Supervisors ("IAIS") has taken the
lead to formulate standards for a risk-based solvency regime for insurers. The EU has built
on this to develop detailed capital standards known as Solvency II. Many jurisdictions are
reviewing their rules with the intent to align with IAIS standards.
Singapore was among the first jurisdictions in Asia to introduce a risk-based capital ("RBC")
framework for insurers, in 2005. In 2012, MAS embarked on a review to enhance the
framework, known as "RBC 2", to take into account the new IAIS standards and best
practices, including relevant aspects of Solvency II. MAS will be conducting a quantitative
study to assess the impact on the insurance industry of the proposals under RBC 2.
There are no global capital standards for capital markets services providers. The
International Organisation of Securities Commission ("IOSCO") has, however, set out
principles for the solvency of securities market intermediaries. Based on these principles,
MAS has implemented a risk-based capital framework for capital markets services licensees.
Strengthening liquidity buffers
The second important area of reform is setting - for the first time - international standards for
bank liquidity. Banks are in the business of transforming short-term liabilities (mainly
deposits) into long-term assets (mainly loans). This fundamental mis-match in maturity opens
banks to the risk that they may not be able to finance short-term liabilities as they fall due.
Even solvent banks with lots of capital can fail if liquidity risks are not well-managed.
The new Liquidity Coverage Ratio ("LCR") sets the global minimum standard for bank
liquidity. Essentially, the LCR framework requires banks to have an adequate stock of high
quality liquid assets that can be converted into cash to survive a 30-day period of stress.
In Singapore we have had liquidity rules for a long time. Our risk-based Minimum Liquid
Assets framework requires every bank to hold a minimum percentage of its qualifying
liabilities in liquid assets. We are now looking to adopt the Basel III LCR rules, with some
enhancements to suit domestic conditions.
• Although Basel III applies the LCR framework only to internationally active banks,
we propose to extend the LCR requirement to all banks in Singapore in the first
instance and grant various reliefs on the basis of risk-mitigating circumstances.
•
We will also have a tighter definition of what qualifies as eligible liquid assets and
not recognise equities and mortgage-backed securities.
MAS has issued a consultation paper on the implementation of the LCR framework and will
carefully consider industry feedback.
Constraining leverage
The third important area of reform is in constraining the build up of excessive leverage. At the
height of the crisis in 2008, the banking industry was forced by markets to reduce leverage in
a manner that led to downward pressure on asset prices, which in turn led to losses, declines
in bank capital, and contraction in credit. Even banks with high risk-based capital adequacy
ratios were found to be excessively leveraged.
Basel III's leverage ratio seeks to set a 3% floor for the amount of Tier 1 capital that a bank
needs to hold relative to its total exposure. The ratio is designed as a non-risk based
measure to complement the risk-sensitive capital adequacy ratios. It acts like a stop-gap to
constrain the overall size of the balance sheet, especially given the uncertainty involved in
the risk models that banks use to calculate their capital needs. But the leverage ratio
- precisely because it is a non-risk based measure - cannot be a substitute for risk-based
capital requirements and should not be set at too high a level as to become the binding
constraint on banks. If it were so, banks may have the perverse incentive to increase their
exposure to risky assets so as to earn a higher return on capital.
The final calibration and definition of the leverage ratio is expected to be finalised in 2017,
with the minimum leverage ratio requirement coming into effect in 2018.
Singaporeincorporated banks can comfortably meet the current testing minimum of a 3% leverage
ratio.
Making OTC derivatives trading safer
The fourth fundamental area of reform is in the OTC derivatives market. The crisis
highlighted how the opaque inter-connections across financial institutions engaged in trading
complex derivative contracts over-the-counter led to rapid contagion and systemic crisis
when liquidity suddenly dried up.
Reforms have focused on four areas: standardisation of derivative contracts; central clearing;
higher margin requirements for non-centrally cleared trades; and mandatory reporting of all
trades. In particular, reporting to trade repositories will provide much-needed transparency
on exposures across market participants.
MAS has taken steps to implement the trade reporting regime in Singapore. Financial
institutions which book prescribed OTC derivatives in Singapore are required to report such
trades to a trade repository licensed by MAS. The reporting framework will be up and running
next month, starting with interest rate and credit derivatives. The degree of standardisation of
contracts in these asset classes is higher, so starting with these contracts will provide for a
smoother phase-in.
We have received feedback from the industry on operational difficulties in obtaining customer
consent in order to report counterparty information to trade repositories. We are looking to
amending legislation to address this issue.
Ending too-big-to-fail
The high-profile, public rescue of many large, systemically important financial institutions in
the last crisis has galvanised a powerful resolve to end the "too-big-to-fail" problem. But this
has proven to be one of the most challenging tasks facing global regulators.
To be sure, the FSB and Basel Committee have made good progress on several fronts.
•
First, they have identified a list of global systemically important banks (G-SIBs).
• Second, they have set out additional loss absorbency requirements for G-SIBs to
reduce the probability of these institutions failing.
• Third, there is ongoing work on a resolution framework to minimise the cross-border
negative externalities that can be created by their failure.
At the same time, major jurisdictions are embarking on plans to reform banking structures in
a bid to end "too-big-to-fail".
•
In the US, the Volcker rule prohibits US-operating banks from engaging in
proprietary trading or from acquiring or retaining an ownership interest in a hedge
fund or private equity fund.
• In the UK, the Vickers Commission recommends ring-fencing retail banking
activities, and subjecting the ring-fenced entity to higher capital requirements.
•
In the EU, the Liikanen report proposes a mandatory fencing off of banks'
proprietary trading and market making activities from the rest of the banking group, if
the activities exceed a certain threshold, with higher capital charges imposed on the
investment banking ring-fence.
To the extent that structural measures help to simplify business models and facilitate the
resolvability of very large and complex global banking groups, they can help to reduce the
risk and impact of failures. But it is not clear if the benefits of such measures outweigh the
costs in all instances.
First, it is worth considering whether size or complexity are the critical factors. The Global
Financial Crisis started not with large universal banks or large global banks, but with narrow
or specialised players: Northern Rock in the UK, and investment banks like Bear Stearns and
Lehman Brothers. Interestingly, the Liikanen report observed that there was no business
model that performed particularly well or poorly during the crisis.
Second, it remains unclear if structural reform measures can make a bank or banking group
safer if a culture of excessive risk-taking is not curtailed and if risk governance frameworks
are not strengthened.
MAS subscribes to the universal banking model on the premise that it is not the separation
between risky and non-risky activities that matters as much as ensuring that risk is well
managed wherever it is.
•
For domestic banks, MAS does not impose any structural measures. The focus is
instead on ensuring that their risk management capabilities are commensurate with
the complexity of their activities and that capital and liquidity buffers are healthy.
•
For foreign banks that have a significant presence in the retail market, MAS will
require local incorporation of their retail operations. The banks can choose to
subsidiarise their entire operations within the same legal entity or continue to
operate its wholesale banking business under a branch structure. There is no retail
ring-fence required.
Unintended consequences
It is imperative that we press on with the regulatory reform agenda and not succumb to
reform fatigue. But even as we do so, we need to be mindful of unintended consequences.
Inconsistent implementation of rules
The first unintended consequence is the inconsistent application of rules across jurisdictions
and across sectors.
Inconsistent application of rules across jurisdictions leads to the risk of regulatory arbitrage.
Take for example, the new capital rules. It is laudable that within such a short period of its
promulgation, 25 of the 27 member jurisdictions of the Basel Committee have issued the final
set of Basel III regulations.
But the implementation has been uneven. The Basel Committee conducted studies on the
consistency of risk-weighted assets measured in the banking book under the internal model
approach. It found considerable variation across banks in average risk-weighted assets for
credit risk. A material part of this variation was due to different bank and supervisory
practices. Such differences in measurement could result in capital ratios varying, in extreme
cases, by as much as two percentage points in either direction.
To enhance consistency in implementation, the Basel Committee is considering three steps:
•
first, improve public disclosure and regulatory data collection to help the market and
regulators to better understand how risk-weighted assets are derived;
•
second, narrow the range of acceptable modelling choices for banks; and
• third, provide additional supervisory guidance for model approvals.
Inconsistent application of rules across entities carrying out similar activities leads to the
issue of shadow banking. The higher capital and liquidity requirements required under Basel
III may create the incentive for activities to be conducted outside the regulated banking
sector. The FSB estimates that shadow banking constitutes about 25% of the total financial
system, and with regulation of banks still tightening, analysts expect the shadow banking
sector will continue to grow.
But this is not to suggest that intermediating credit through non-bank channels is to be
discouraged. The shadow banking system can provide market participants and corporations
with a useful alternative source of funding and liquidity. Some non-bank entities may have
specialised expertise that enables them to provide certain credit intermediation services
more efficiently and at lower risk. Shadow banking need not be a bad word in finance.
What we do need to watch out for is the accumulation of risks in the shadow banking sector
and the potential spill-over of these risks to the regulated banking sector. The FSB is setting
out approaches to monitor the shadow banking system and to identify possible regulatory
measures to mitigate shadow banking risks.
In Singapore, MAS has taken steps to limit the opportunities for regulatory arbitrage between
the bank- and non-bank sectors by adopting broadly consistent rules for similar activities,
even if they are being conducted by different types of entities. For instance, capital
requirements for banks, insurance companies, and capital market intermediaries are broadly
aligned for similar types of risks, to deter regulatory arbitrage.
Cross-border implications of national rules
The second unintended consequence is the cross-border implications of national rules.
•
Take for example, the US CFTC's OTC swap rules. These rules apply to financial
institutions operating outside the US including foreign-domiciled financial institutions
and foreign branches of US financial institutions.
•
Another recent example: the European Market Infrastructure Regulation requires
financial market infrastructures to be subject to European rules or rules that are
deemed equivalent to Europe's before they can provide services to EU players.
These rules are well-intended and seek to address genuine regulatory concerns in these
jurisdictions. But extending national rules across borders often gives rise to overlapping
regulations, which can create additional compliance costs for internationally active financial
institutions. If there are conflicts between different national requirements, or if the burden of
complying with multiple sets of rules is significant, this may prevent the execution of trades
on a cross-border basis. The risk is that the global derivatives and foreign exchange
businesses, for example, might become trapped within regional borders, creating fragmented
markets.
Cross-border application of national rules may also risk complicating home-host
collaboration, the principle of consolidated supervision, and cross-border resolution.
• A BIS working paper published in April 2013 cautioned that it may be difficult to
design resolution plans for global banks which are required by different national
regulations to operate different business models.
•
An IMF staff discussion paper published in May 2013 highlighted that differences
between national structural reforms could lead to cross-border regulatory arbitrage
by global banks, posing a challenge to consolidated supervision.
In the event that the imposition of national regulations across borders is unavoidable, we
need robust mutual recognition frameworks in place. Such frameworks should be based on
an outcome-based approach, and not a line-by-line correspondence of rules.
•
We are encouraged that regulators in the US and Europe have adopted a
substituted compliance or equivalence assessment approach so that entities can
comply with just the set of rules applied by the jurisdictions in which they operate.
•
MAS supports substituted compliance and equivalence assessments as an
important measure to avoid potentially duplicative or inconsistent rules, particularly
for entities with international operations.
In the area of OTC derivatives trading, MAS is putting in place the rules and infrastructure to
support cross-border operations and to help reduce uncertainty to the industry. To allay
concerns from the industry over the regulatory burden of having to comply with both home
and host regulations, we are participating in equivalence assessments under the US and
European regimes.
Thus far, ESMA, the European securities regulator, has recommended to the European
Commission that the Singapore framework is broadly equivalent to Europe's, paving the way
for central counterparties in Singapore to offer their services to European participants.
We have also submitted to CFTC an application for substituted compliance in respect of
requirements on US banks operating here. We are in active discussions with CFTC, and will
work with them on the substituted compliance determination, where appropriate, as our OTC
regulatory regime comes into force.
Impact on trade finance and long-term finance
The final unintended consequence is the impact on trade finance and long-term finance.
There are concerns that the various regulatory reforms taken together may lead to a
pullback in trade finance and long-term investment financing. The global regulatory community
and national governments have become increasingly sensitised to these concerns.
In the area of trade finance, the Basel Committee consulted the World Bank, the World Trade
Organisation, and other relevant bodies. A number of adjustments were made to the capital
and liquidity rules to facilitate trade finance.
•
In the area of capital rules, the Basel Committee waived the one year maturity floor
for certain trade finance instruments under the advanced internal ratings-based
approach for credit risk. It also waived the sovereign risk-weight floor for certain
trade finance-related claims using the standardised approach for credit risk.
•
In the area of liquidity, the Basel Committee issued guidance for national
supervisors to apply relatively low run-off rates for trade finance commitments.
Preliminary data suggests that the availability and cost of trade finance has not been greatly
impacted to-date by the implementation of Basel III. Spreads have normalised post-crisis and
pricing appears to be influenced more by broader macro factors and competition. Further,
there are many well-capitalised banks, especially in Asia, that are well-placed to operate in
the new regulatory regime; and many of them have stepped up.
We should continue to monitor closely the impact of regulatory changes on trade finance.
Trade is the lifeblood of Asian economies.
But we have a bigger challenge in long-term financing, especially for infrastructure. It may be
the case that the post-crisis financial system may not be adequately structured to provide
certain types of long-term financing.
•
First, longer-term corporate and project finance loans already attract a higher capital
charge compared to short term loans. Coupled with the increased overall capital
requirements under Basel III, this may create a disincentive for long-term loans.
•
Second, to meet liquidity requirements, banks may substitute long-term lending
activities with short-term lending. In calculating the Net Stable Funding Ratio, lower
weights are assigned to loans with maturities of less than a year.
•
Third, Solvency II, which will impose higher risk charges on longer-dated assets,
may result in insurers de-risking by taking on shorter-dated assets.
•
Fourth, the interaction between central clearing, margining and capital requirements
may impact the variety and liquidity of some derivatives such as long-dated interest
rate swaps used to hedge risks associated with long-term financing.
There may be scope for some intelligent, risk-sensitive fine-tuning of regulation:
•
The design of risk weights for insurers should not penalise them for holding good
quality long term assets, if they are matched by long term liabilities.
•
The preferential treatment of sovereign debt in bank regulation should be
reexamined, so that banks are not disincentivised from holding good quality, long term
corporate debt.
•
Better calibration of the risk weights for securitisation for banks and insurers may be
necessary.
But the fundamental solution does not lie in diluting regulatory requirements. Policymakers
should also focus on ways to develop sustainable alternative sources of long-term finance.
At the same time, we must recognise that the immediate constraint on infrastructure
development in Asia is not financing per se but the supply of bankable projects with an
acceptable risk-return profile to attract banks or investors. We need integrated solutions that
involve risk-sharing arrangements and bring together bank and non-bank capital.
In Singapore, we are working in partnership with a diverse group of stakeholders, to help
build such an ecosystem to support long-term financing and unlock the supply of bankable
projects.
•
Multilateral agencies and well-rated public sector entities could provide guarantees
or credit wraps that would allow banks to reduce their risk exposures to such
longterm projects, thereby encouraging them to originate such loans.
•
Bank loans could be structured in ways that facilitate their seamless migration from
banks to capital markets.
•
Institutional investors such as pension funds, insurance companies, and sovereign
wealth funds could invest in project bonds, infrastructure debt funds, and securitised
project loans, taking the risks off banks' balance sheets.
Conclusion
Let me conclude.
We have made reasonable progress in making global finance safer. The regulatory reforms
since the crisis have helped to strengthen the resilience of the financial system. But the work
is far from complete.
We must not forget that regulation must be complemented by rigorous supervision and
sound risk management. We cannot rely too much on regulation alone to make finance safer.
As Jacques de Larosiere reminds us:
"Strong, intrusive supervision as well as careful risk assessment and management by
bankers are of the essence. They will never be replaced by rules."
Put differently, a culture of prudence and risk governance is a better guarantee of safety and
soundness than all the rules on capital and liquidity that we can draw up.
Finally, we want finance that is not only safe but also purposeful. Regulation must not seek to
eliminate all risk and must be impact-sensitive. Let us not lose sight of the bigger picture: a
sound financial system that is able to play its vital role of intermediation, to support sustained
economic growth and help create opportunities for individuals and enterprises.
Thank you.