Yaseen Anwar: International regulatory initiatives to enhance global
financial stability
Speech by Mr Yaseen Anwar, Governor of the State Bank of Pakistan, at the 9th Islamic
Financial Services Board (IFSB) Summit, hosted by the Central Bank of the Republic of
Turkey, Istanbul, 16 May 2012.
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Mr. Chairman, the Secretary General IFSB, Distinguished Guests, Ladies and Gentlemen!
It is a pleasure and an honor to join you at this 9th IFSB Summit. I am greatful to IFSB for
inviting me to share my views on "international regulatory initiatives to enhance global
financial stability" with this esteemed audience. In my remarks today I will briefly discuss the
events that lead to recent reforms, importance of regulatory initiative introduced so far and
Pakistan's standing.
The crises that hit the global financial landscape during 2007 remains the worst since the
great depression of 1930s. Though originating from financial markets and innovative
"opaque" financial products, it impacted virtually every aspect of the world economy with
consequences affecting the masses. The instruments that were meant to disperse financial
risks instead allowed financial institutions in general and the banking system in particular to
become highly leveraged that ultimately lead to financial meltdown. As a result, it not only put
the innovations in the financial markets under the spotlight, but also singled-out regulatory
and supervisory weaknesses in assessing the risks associated with financial institutions,
markets and innovative financial products. The Euro region still faces the effects of the
financial turbulence in the form of sovereign debt crisis. The fragile GDP growth and the
unemployment data in the UK, USA and other crisis hit advanced economies still falls short
of the pre-crisis level.
On a positive note, the financial crisis provided valuable lessons for improving the
effectiveness of financial system regulation and supervision. To policymakers, it reminded
that the present state of the international financial system requires a complete overhaul of
the functioning of the markets and institutions. From supervisory perspectives, it showed that
the available prudential regulations are simply not effective and prudent enough to ensure
financial system stability.
The lessons learnt from the financial crisis signify the far-reaching changes in the structure
and functioning of the financial systems and institutions. The international regulatory bodies
including Financial Stability Board (FSB), IMF and BIS along with national supervisory bodies
have developed a set of regulatory and supervisory reforms that aim at increasing the
effectiveness of financial sector supervision. Furthermore, the G-20 leaders at various
Summits have endorsed the policy framework recommended by FSB and BCBS, which has
made countries reach a consensus on the selection of a reforms agenda. Much of the focus
of the reforms is on improving the soundness of the banking system, addressing the
Systemically Important Financial Institutions (SIFIs), developing macroprudential policy tools,
strengthening accounting standards, disclosure requirements and crisis resolution
framework.
We know that excessive leveraging by the banking sector, particularly in advanced countries
was one of the key reasons that lead to the recent crisis. Banks took excessive on and
offbalance sheet exposures while maintaining an inferior quality of capital base with insufficient
liquidity buffers. In order to avoid such situations in the future, the Basel Committee on
Banking Supervision (BCBS) introduced fundamental reforms in the Basel II capital
adequacy regime by issuing a number of reforms and enhancements of the existing the
Basel framework. These enhancements commonly referred to as Basel III are aimed at
raising the level and quality of capital, introduction of leverage ratio, capital conservation
buffer, counter cyclical capital buffer and liquidity coverage and net stable funding ratios.
Similarly, in order to facilitate the national supervisory authorities and small and medium
sized banks and to avoid a sudden credit crunch in already fragile economies, the BCBS also
set a rather relaxed timeline from 2013 to 2019 for the adoption of Basel III. It is therefore
expected that increased capital requirements and further consolidation in international
banking will prove to be a major step towards promoting financial stability. However since
Basel III only affects banks, the regulators of other financial sectors such as insurance are
expected to encourage the implementation of solvency II for insurance companies in order to
reduce the presence of shadow banking and restrict the risk to move towards less regulated
entities or creating regulatory arbitrage.
In recent times, an important reforms measure being pursued is to improve regulation and
oversight of Shadow Institutions, so as to limit arbitrage opportunities, arising from the
transfer of risk to relatively less regulated areas/sectors. The regulators therefore, are now
focusing on minimizing the regulatory gaps in the shadow banking framework. To bridge this
gap, the Financial Stability Board (FSB) is working closely on the development of an effective
regulatory regime for shadow banking system that would largely focus on a) mitigating any
spill-over between regular and shadow banking as banks are part of the intermediation chain
of the shadow banking sector, b) reducing buildup of leverage in shadow banking through
securitization, c) assessing systemic risk posed by shadow banking, d) reducing
procyclicality incentives posed by secured lending (REPOs) and e) reducing vulnerability of
Money Market funds to possible runs.
While focusing on improving the soundness of financial institutions, the reforms emphasized
heavily on the global and national Systemically Important Financial Institutions (SIFIs) and
the moral hazards they pose while being vulnerable. Since the initiation of reforms, there has
been considerable debate on the identification of SIFIs and the institutions that have the
capacity to become SIFIs. Factors such as institution size, suitability and interconnectedness
including "time varying judgment based assessments" have been prescribed for identification
of SIFIs. Under the new reforms agenda, emphasis is on changing Too Big To Fail (TBTF)
status of SIFIs and for devising a resolution regime as well as a safe exit mechanism for
these entities. Further, supervisory authorities are focusing on enhanced supervision of SIFIs
to mitigate the financial risks propagated by them through interconnectedness with other
institutions that cause system-wide distress. Similarly a multipronged strategy has been
adopted for addressing the risks posed by G-SIFIs (Global SIFIs) that comprise development
of a new international standard for resolution regimes, more intensive and effective
supervision, and requirements for cross-border cooperation, recovery, and resolution
planning. The reforms also impose a cost on the SIFIs in the form of increased capital
requirements ranging from 1% to 2.5% of Risk Weighted Assets for enjoying economies of
scale and scope and to have higher loss absorbing capacity. As per FSB and BCBS
assessment, the long term economic benefits of this additional capital requirement in terms
of greater resilience of these institutions far exceed the modest temporary decline of GDP
over the implementation horizon.
Another significant regulatory initiative in the post-crisis period has been greater focus on
adopting a macroprudential framework along with traditional inflation targeting and monetary
policy models. Central banks and regulatory bodies who traditionally have been using
microprudential tools to ensure financial system stability are now increasingly using
macroprudential tools along with traditional microprudential tools to ensure the soundness
and stability of the financial system. The scope of the macroprudential policy framework is
very broad and includes (a) identifying, monitoring and limiting systemic risks, (b) designing
and calibrating instruments for executing macroprudential policies and (c) building
institutional and governance arrangements.
Though at initial stage, the macroprudential framework has already started delivering key
results including broader coverage of central bank financial stability analysis and monitoring
of systemic risks. Furthermore, much work is done in closing data gaps and coming up with
techniques to assess systemic risks and development of new macroprudential tools that
have the capacity to identify systemic risk in a forward-looking way. The stress testing
frameworks have also been redesigned by the regulators that incorporate extreme shocks
(tail risk) to capture systemic risk and to identify the effects of macroeconomic vulnerabilities
on individual institutions as well as on the overall financial system. However, the challenging
task of building institutional and governance arrangements call for additional debate among
policy makers.
The post crisis reforms also stress the need to improve and bring uniformity in international
accounting standards. In this regard, the International Accounting Standards Board (IASB)
and the Financial Accounting Standards Board (FASB) initiated a convergence project of
their accounting standards and practices. The FSB made recommendations for converged
accounting standards of IASB and FASB in four areas including lending activities, impairment
of financial assets, addressing valuation uncertainty in fair value measurement guidance and
offsetting/netting of financial instruments. Accordingly, the IASB and the FASB are jointly
developing a common impairment model to assess and record the impairment in the value of
financial assets/instruments. Both Boards have also agreed to expand the scope of their joint
project of financial instruments to address netting financial assets and liabilities on the
statement of financial position.
Furthermore, disclosure requirements have also been revisited in the reforms agenda. Much
of the focus has been on improved disclosures on structured credit products, instruments
and exposures taken in Special Purpose Entities (SPEs), and on- and off- balance sheet
items of banks. Similarly, Basel III also improved its disclosure requirements for exposures in
securitization, off-balance sheet exposures and exposures in asset-backed papers and
mortgage-backed securities. In a recent survey organized by the FSB it was found that the
disclosure recommendations have improved the disclosure practices in certain OECD
countries. However, it is felt that the disclosure on SPE securitization and exposure before
and after hedging need certain improvements.
The financial crisis resolution framework has also been revisited in the post-crisis period and
its scope has been enhanced to an integrated crisis management and resolution framework.
Similarly, the FSB has put forward the principles for cross-border cooperation on crisis
management that includes effective coordination amongst the national supervisory agencies,
central banks and government finance ministries for making advanced preparations for
managing the financial crises.
In the backdrop of the recent Global Financial Crises, the remuneration of Directors and
Executives of banks and financial institutions have lately come under scrutiny around the
globe. In order to put things in the right direction, there has been a growing effort globally to
address the issues related to rationalization of compensation in the financial sector.
Institutions like BIS, FSB and many national regulators like FSA, APRA and HKMA, among
others, have made purposeful attempts to bring the issue of excessive remunerations to the
forefront and make it more transparent and fair, not only by making enhanced disclosure
requirements, but also drawing a detailed structure of requirements and guidelines for
determining the remuneration and compensation of executives. FSB issued "Principles for
Sound Compensation Practices" in April 2009 and relevant "Implementation Standards" in
September 2009. Both these documents were later adopted in a consolidated form by the
Basel Committee on Banking Supervision in January 2010.
Pakistan is a small, open economy, with domestically an active financial sector with limited
interconnectedness with advanced economies. Like many other developing countries, it did
not face the direct impact of the crisis on its banking system and financial markets. In terms
of banking concentration, top 5 banks (all locally incorporated) account for 51% of industry
assets; while foreign assets of the system are 10.4% of total assets. Moreover
locallyincorporated banks and most foreign branches don't have significant exposures to the
complex financial assets that caused the financial meltdown in the U.S. and Europe. SBP
has always required banks to meet higher capital and liquidity standards, exceeding
international norms in several areas. More importantly, we have a strong legal framework,
which has been tested for effectiveness during the last decade and half. SBP has
successfully restructured a number of banks, successfully demonstrating the problem bank
resolution regime.
SBP being the regulator of the banking sector, has introduced and implemented key
regulatory reforms and prudential measures to ensure financial system stability. Further, in
order to align its regulatory framework with international regulatory standards and best
practices, it regularly reviews and evaluates the standards issued by them for their possible
implementation keeping in view our own local legal, regulatory and economic environment.
Similarly, SBP has taken steps to improve the effectiveness of macroprudential supervision
by revising its prudential regulations like rationalization of loan classification and loan loss
provisioning requirements whereby the loan loss provisioning framework was made more
stringent during economic booms and relaxed during stressed economic conditions. In
addition, SBP has devised a stress testing mechanism that not only stress tests the solvency
and liquidity profile of the banking system under various extreme scenarios but also conducts
macroeconomic stress testing under which macroeconomic indicators are set to influence the
financials and solvency and liquidity profile of the banks.
We are also working on the subject of Consolidated Supervision of Conglomerates having
direct or indirect holdings or influence on banks through shareholdings as well as large
exposures. A legal framework is being formulated in consultation and coordination with the
regulator of the non-banking sector i.e., Securities and Exchange Commission. We believe
that this framework will provide an overarching supervisory control over the major
stakeholders of the financial services. Additionally, the disclosure standards for banks are
being revised to make performance of the banks more transparent and management of the
banks more accountable.
While the regulatory reforms agenda being pursued vigorously by policy makers and
regulatory bodies across the globe is likely to strengthen the financial system and may
possibly be instrumental in preventing financial crisis in the foreseeable future, history says
that reforms initiated after each crisis could not prevent the next crisis and each time the
nature and dimension of the crisis was different from the earlier ones. This suggests that
there may be fundamental and structural problems with the financial system like risk transfer
rather than risk sharing, development of speculative products in the name of risk
management instruments (derivatives), allowing unprecedented growth of the financial sector
without any comparable growth in the real sector etc. Incidentally, these are some of the key
features and principles of Islamic Finance as it believes in risk sharing, encourages growth of
the financial sector in tandem with the real sector and prohibits investment in speculative
activities. I would thus suggest that national and international supervisory authorities to
objectively evaluate the potential of Islamic Finance principles in mitigating the existential
risks faced by the financial system. I would also request Islamic Finance scholars and
practitioners to reach out to their conventional counterparts to highlight the potential of the
Islamic Finance system addressing the issues faced by the financial system.
Finally, I will reiterate that every crisis brings an opportunity, and it is upon us how we benefit
from it. Let this crisis be the one whose lessons help us in improving the soundness and
stability of international and domestic financial systems.
Thank you.