Ms. Phillips examines whether national financial market regulatory systems
should be harmonised in the light of international competition Remarks by Ms. Susan M.
Phillips, a member of the Board of Governors of the US Federal Reserve System, at the Seminar
on Banking Soundness and Monetary Policy in a World of Global Capital Markets sponsored by
the International Monetary Fund and held in Washington on 28/1/97.
It is a pleasure to be here today to discuss a topic that has become more important
in a world of global financial markets -- the matter of coordinating and harmonizing our national
regulatory systems. On the conference agenda, the topic was phrased as a question, that is,
whether we should harmonize our systems. In a sense, the question is somewhat moot -- the
globalization of the markets and the breadth of international conglomerate financial institutions
is forcing us in that direction. But I would quickly add that one definition of "harmony" is "a
pleasing combination of elements." We can sing compatible and pleasant-sounding notes,
without singing the same note. It is in that sense that I believe harmonization of our regulatory
systems will develop.
In my comments this afternoon, I will mention some of the efforts underway in
which the United States is working with other countries to develop more consistent supervisory
and regulatory systems, particularly for large financial conglomerates. That experience may
provide others with ideas about how they might pursue similar efforts, either on a bilateral or
multilateral basis. Perhaps more importantly, though, I will also offer my views on where our
interests are likely to be most similar and why and how regulators around the world are likely to
continue working toward compatible or "harmonized" systems. Let me begin with those
thoughts.
The Importance of Compatible Regulatory Regimes
One cannot have dealt with U.S. and world financial markets during the past few
decades without being thoroughly impressed with the rapid pace of change and the manner in
which technology and financial innovation have affected market practice. The improvements in
communications and transportation and, importantly, the gains from technology and the
miniaturization of the goods we produce have fueled a growing volume of international trade.
Our financial institutions, in turn, have sought constantly to find more effective and efficient
ways to facilitate and finance these activities, and at the same time manage the related risks. As a
result, we have seen dramatic growth in financial derivatives, strong support within the industry
for new clearinghouses and netting procedures to reduce counterparty credit risk, a growing need
to clarify our laws and regulations regarding financial contracts, and financial markets that are
far more closely linked today than they were even a decade ago.
In the area of bank regulation and supervision, substantial progress has been made
in developing capital standards that help to ensure the financial strength of internationally active
banks and that promote greater competition. Simply put, firms in need of international financial
services will utilize domestic or foreign financial institutions to the extent their prices are
competitive and their financial stability can be assured. As a result, regulators are recognizing
the need to harmonize laws and regulations in order to promote economic growth and to deal
with important and oftentimes increasingly complex matters that are of common interest to us
all.
We are recognizing also the need to enhance financial systems -- including
supervision and regulation -- in the emerging market economies, primarily for the sake of those
economies, themselves, but also because of their increasing importance in international financial
markets. Indeed, G-7 leaders at their summit meeting in Lyon last summer identified this goal as
an important element in efforts to promote international financial stability.
That we need some level of conformity seems, I'm sure, quite clear. Otherwise,
the inconsistency and incompatibility of rules and regulations across countries may make it
difficult, if not impossible, for some firms to engage in global business activities. Such barriers
are detrimental to the efficiency of international trade and finance, generally.
The difficulty, of course, is the precise nature and level of conformity that is
necessary to maintain an efficient and equitable world financial system. Here I submit that it
may be less important that we standardize particular banking laws and regulations, than it is for
us to pursue similar goals, as we independently develop our domestic regulation and supervisory
structures. Specifically, if we apply market-based incentives in our regulatory structures, that,
alone, should keep our rules sufficiently similar and compatible.
We must also recognize that technology and financial innovation are permitting
banks today to become ever-more adept at avoiding regulatory barriers and other restrictions that
artificially constrain their activities. Moreover, to the extent they are effective, such restrictions
can work against local institutions, businesses, or consumers by making banks less competitive
internationally or by withholding from their customers the benefits that competition can bring.
Regulatory regimes are likely to be more effective in the long run for financial institutions and
for domestic economic growth if they are market-compatible.
Areas of Common Interests
In our roles as central bankers, bank supervisors, and regulators, what are the
areas of greatest common interest to us for which we should develop compatible rules and
regulations? To keep it simple, let me suggest two. First, to maintain a healthy, responsive, and
financially strong banking and financial system will facilitate the growing needs of our domestic
economies. Second, to build and maintain an adequate legal and regulatory structure will permit
our institutions to compete safely on an equal and nondiscriminatory basis, both domestically
and abroad. These thoughts may not sound original; they're not. They are essentially the two
reasons the Basle Committee on Supervision exists, and they underpin most other international
efforts to coordinate banking issues.
When I consider the past successes in coordinating international bank supervisory
or regulatory policies, I think first of the Bank for International Settlements and the work of the
supervisors' committee. After all, the BIS has been the principal forum for developing
international supervisory standards for banks in industrialized countries and, by their voluntary
adoption, for banks and bank supervisors in other countries throughout the world. Bilateral
discussions can also serve useful functions either where particular issues are of concern or as a
basis for subsequent broader dissemination.
Nearly a decade ago, such bilateral and -- through the BIS -- multilateral efforts
produced the risk-based capital standard, known as the Basle Accord. Since then, we have
produced numerous other policy statements dealing with sound risk management practices for
banks. These statements related first to derivatives activities and most recently involve the
management of interest rate risk. Dr. Padoa-Schioppa, chairman of the supervisors' committee,
has probably already discussed these initiatives with you.
One of the Committee's most recent accomplishments, however, is the
development of new capital standards for market risk in trading activities. That standard is
notable because it reflects a new approach for constructing international banking standards. In
particular, the internal models approach contained within that standard builds on leading
industry practices and helps supervisors to promote risk management in banks.
Promoting sound risk management is a goal we should all pursue more
aggressively in considering new banking policies and regulations. It is also the type of approach
I had in mind when I said earlier that our laws and regulations should be compatible with
underlying economics and market demands. To the extent we can continue building on "best" or
sound banking practices in designing our rules and regulations, we will be working toward a
common end. As we work together identifying those practices and deciding how to apply them
as supervisory or regulatory standards, we will also be strengthening relations among ourselves
that can prove invaluable in times of market stress.
Not to over-use the example of the market risk standard, but it illustrates another
useful point, as well. Reliance on a bank's own risk measurement and modeling process in
determining regulatory capital standards also acknowledges that no single or specific technique
is best for everyone. Each institution should tailor its risk measurement and management process
to its own needs. While adhering to basic principles, each institution must determine for itself
the proper incentives and techniques for managing its affairs. No two banks or banking markets
are identical in their operations, structure, or historical development. Permitting a range of
compatible responses to similar situations encourages experimentation, innovation, and growth.
Accommodating a certain level of flexibility is necessary for banks, and it is necessary for
regulators, too.
Indeed, flexibility may be even more important for non-G-10 countries than it is
for those of us with large, developed financial systems because of the greater range of capital
market and economic infrastructures among developing countries. Materially different situations
typically require different solutions. Accommodating differences, though, does not reduce the
need for minimum regulatory or supervisory standards based upon well-known principles of
sound banking. It is up to supervisors and, if necessary, legislators to craft regulations and laws
consistent with internationally recognized standards, but accommodative to local customs and
economic needs.
In developing sufficiently flexible, market-compatible regulations, I believe we
should rely as much as prudently possible on market discipline and on banks' internal incentives
to perform well. This approach requires that the public have information about the risk
exposures of banks and about their procedures for managing those risks. As regulators, we can
encourage this process by requiring or prodding banks to disclose information to the markets
that is both relevant and comparable among institutions.
Whether such disclosures are imposed by official regulations or evolve through
more subtle efforts, supervisors can help guide the process by considering carefully the kinds of
information the private sector needs and that banks use -- or should use -- to manage risk. Even
in the United States, where surveys show disclosure is relatively good, supervisors make
available to the public data collected on Call Reports.
In countries where disclosure practices are minimal at best, bank regulators may
be able to perform a particularly important role by publicly disclosing some, if not much, of the
information banks report to them. By fueling market information in this way, regulators may
stimulate greater investor interest in banks and the growth of local capital markets. Improved
disclosure practices by banks may, in turn, also spill over to other industries. One thing we know
for sure is that investors dislike uncertainty. By shedding light on a bank's condition and future
prospects, some of that uncertainty should disappear.
While it is important that key prudential standards be sufficiently robust and
consistent among countries, certain variations in the details and applications of these standards
can be useful. As with private markets, some level of competition among regulators can
stimulate improvements and change. I will grant that the United States may take regulatory
competition to an extreme, but it also demonstrates, I believe, the advantages that derive from
accommodating different views and permitting financial institutions alternative ways to do
business. In my view, and considering the political difficulties we have faced in trying to change
U.S. banking laws, our current regulatory structure, offering some choice in charter that is
administered by multiple regulators, has provided financial institutions with more freedom and
expanded powers than they would likely have received with a single regulator.
Supervisors must be careful, however, as they try new or different techniques,
that they do not impair their oversight efforts or relax them beyond prudent bounds. In such
global markets as we have today, weak or ineffective supervision in either large or small
countries can have far reaching consequences. Those concerns were at the heart of early work of
the Basle Committee and its efforts to identify the respective roles and responsibilities of home
and host authorities for internationally active banks. It is important for supervisors to be able to
rely on their counterparts in other countries to administer agreed-upon standards of financial
institution safety and soundness.
Whether we conduct our own on-site examinations, rely on external auditors, or
use combinations of other supervisory techniques, we need to assure ourselves that all banking
offices are adequately managed and supervised. I would note here that among G-10 countries a
more consistent approach may begin to emerge. We in the United States are making greater use
of the findings of a bank's internal and external auditors to guide or supplement our on-site
examinations, while some of our counterparts abroad are recognizing more the benefits of
onsite exams.
Financial Conglomerates
Some of the greatest challenges to bank supervisors may arise when organizations
link banking activities with other financial or nonfinancial businesses. Such financial
conglomerates, which often combine banking, insurance, and securities activities, are not
currently allowed to provide a full array of financial services in the United States, but they may
do so abroad.
The existence of such firms -- and the fact that some of them are headquartered in
this country -- have required regulators and supervisors in the United States to work with
counterparts abroad to discuss oversight arrangements and develop ways to deal with matters in
times of crises. This very issue is one of our current challenges. I have to say that this is not a
particularly quick or easy process and is further complicated by the diverse regulatory structures,
both here and abroad, involving banking, securities, and sometimes insurance regulators.
These discussions often raise difficult issues, since they tend to break new ground
in supervision. For example, what approach should be taken regarding nonbank -- or even
nonfinancial -- activities of companies that own banks? In the context of these conglomerates,
what does or should "consolidated supervision" mean? Within the context of consolidated
supervision, how can the traditional safety-and-soundness approach used by bank supervisors be
reconciled with the disclosure/self-regulatory approach used by many securities regulators?
Moreover, do the diverse operating structures of conglomerates imply an extension of the safety
net that virtually all governments currently extend to banks? One thing is clear: as we address
the challenges of promoting a more consistent bank supervisory and regulatory process
worldwide, we cannot always take official descriptions of regulatory and oversight regimes at
face value. We need to dig deeper to understand how laws are interpreted and how individual
banking agencies monitor and enforce safe banking.
Different countries necessarily have different banking and financial systems that
face unique combinations of exposures and business risks. Even within the United States, for
example, we have a relatively uniform supervisory approach for all banks and a risk-based
capital standard that applies to them all. In practice, however, the activities of our banks, their
capital levels, and their operating practices are quite diverse, and our oversight efforts take those
differences into account. Small banks, themselves, recognize the greater risks they face from
their lack of size and diversity, and have consistently maintained higher capital ratios than do
money center banks. But they also have less formal procedures and internal controls, simply
because their staffing and operations are so much smaller. The point is that even a uniform set of
rules within a given country can and should be implemented differently as conditions demand.
Conclusion
It seems clear that as financial markets become more and more integrated, bank
regulators around the world will be seeing more of each other than they have in the past. Even in
countries that have no internationally active domestic banks, authorities need to ensure that the
banks operating in their markets are sound and subject to adequate supervision, whether by
home or host authorities. Banks operating imprudently and without proper supervision are the
ones most likely to mismeasure their risks, misprice their products, and disrupt the markets.
Detecting and deterring such institutions does not require us to have uniform regulatory or
supervisory systems, but it does require a certain level of cooperation and coordination and a
material level of consistency in our regulatory regimes. Our experience in the United States
suggests that achieving an appropriate convergence takes time, not only to develop but to
maintain. Progress we have seen through the European Union and the BIS goes far in
coordinating, or harmonizing, banking laws, regulations, and operating standards, but that's just
a start. As managers of large financial institutions develop more sophisticated and more
comprehensive risk management systems, they are paying less attention every day to the peculiar
legal structure of their organizations. As regulators, we need to understand how banking
organizations manage and control risks and the full implications of their practices for the
financial safety of depository institutions. By doing so, we can do much to protect our own
interests while still recognizing and accommodating the business needs of banks.
In developing our laws and regulations we need to work together, for sure. But
perhaps more importantly, we need to understand the market forces and incentives that banks
face. If we keep those factors in mind in developing our individual rules, we may go far in
developing regulatory systems that are both compatible among countries and less intrusive to the
institutions we oversee.