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Basel Committee on Banking
Supervision, The Joint Forum
Review of the Differentiated
Nature and Scope of Financial Regulation
Key Issues and
Recommendations (January 2010)
Review of the Differentiated Nature and Scope of
Financial Regulation
Executive Summary
I. Introduction
This report analyses key issues arising from the
differentiated nature of financial
regulation in the international banking, insurance, and
securities sectors.
It also addresses gaps
arising from the scope of financial regulation as it relates to
different financial activities, with a
particular focus on certain unregulated or lightly regulated
entities or activities.
The Joint Forum prepared
this report at the request of the G-20
to help identify potential areas where systemic risks may not be
fully captured in the current regulatory framework and to make
recommendations on needed improvements to strengthen regulation
of the financial system.
The Joint Forum presents its
findings in five key issue areas:
• Key regulatory differences across
the banking, insurance, and securities sectors;
•
Supervision and regulation of financial groups;
•
Mortgage origination;
• Hedge funds;
• Credit risk
transfer products (focusing on credit default swaps and
financial guarantee insurance).
The Joint Forum
focused on these areas because they help shed light on some of
the major sources of systemic risk that emerged from the current
financial crisis.
Unless action is taken, these issues
may continue to pose systemic risk to the
financial system and the global economy.
The Joint
Forum analysed problems that sometimes extend beyond or cut
across the scope of existing regulation of the banking,
insurance, and securities sectors.
The Joint Forum’s
goal was to analyse the key issue areas, identify gaps, and
produce recommendations to address these gaps and bolster
regulatory frameworks over the long term.
The
recommendations are supplemented with policy options when
consensus could not be reached.
This report is
part of a global effort to reform and
strengthen financial regulation by the G-20 Leaders and
co-ordinated by the Financial Stability Board (FSB).
The Joint Forum’s parent committees - the Basel Committee on
Banking Supervision (BCBS), the International Organization of
Securities Commissions (IOSCO), and the International
Association of Insurance Supervisors (IAIS) - have initiated and
conducted several other projects aimed at strengthening
financial regulation and notably at redefining its scope.
Given the Joint Forum’s cross-sectoral perspective, this
report has taken into account all of the analyses and
recommendations from these initiatives, as well as other
authoritative research.
Additionally, the Joint Forum
notes that global policy initiatives aimed at reducing the
impact of future crises are resulting in increased prudential
requirements on regulated entities.
Paradoxically, these
concerted efforts could result in an undesired effect, that is,
providing incentives to operate outside the traditional
boundaries of supervision and regulation for the three sectors.
II. Mandate
At their 15 November 2008 meeting, the
G-20 Leaders called for a review of the differentiated nature
and scope of regulation in the banking, securities, and
insurance sectors.
This report responds to the
following declaration:
“The appropriate bodies
should review the differentiated nature of
regulation in the banking, securities, and insurance
sectors and provide a report outlining the issue and making
recommendations on needed improvements.
A review of the
scope of financial regulation, with a special emphasis on
institutions, instruments, and markets that are currently
unregulated, along with ensuring that all systemically-important
institutions are appropriately regulated, should also be
undertaken.”
In its 25 March 2009 report on Enhancing
Sound Regulation and Strengthening Transparency, the G-20 stated
the following:
“The Joint Forum, a Working Group of the
BCBS, IOSCO and the IAIS, is undertaking a project that
addresses the differentiated nature and scope of financial
regulation.
The main objective of this project is to
identify areas where systemic risks may not be fully captured in
the current regulatory framework.
Special emphasis will
be placed on institutions, instruments, and markets that are
currently unregulated or lightly regulated.
As
appropriate, the Joint Forum will leverage off current work from
other international bodies in its assessment.”
III. Focus and guiding principles of this study
In light of the breadth and short time frame of this
mandate, the Joint Forum took a focused approach for identifying
and analysing key issue areas and gaps.
Drawing
primarily on previous Joint Forum analyses, the Joint Forum
first analysed the differentiated nature of financial regulation
by comparing key differences in existing international
regulation across the banking, insurance, and securities
sectors.
The Joint Forum also focused on areas that
correspond to immediate and well known gaps in supervision and
regulation, have a strong cross-sectoral dimension, have been
addressed by Joint Forum analyses of similar issue areas, and
would benefit from a mix of different regulatory perspectives.
While the areas the Joint Forum focused on obviously do
not represent all of the existing gaps and differences in
financial supervision and regulation, the either contributed to
the crisis in varying degrees or pose
significant systemic risk.
A. Focus of this study
This report focuses on five key issue
areas for the following reasons.
1. Key regulatory differences across the
banking, insurance, and securities sectors
International financial regulation is sector specific as
evidenced by the independent development of core principles or
standards in each financial sector.
A sector-specific
approach to supervision comes with the potential for increasing
regulatory gaps, which causes supervisory challenges and
presents opportunities for regulatory arbitrage.
Differences exist in the nature of
financial regulation among the banking, insurance, and
securities sectors.
These differences are
warranted in some cases due to specific attributes of each
financial sector, but, in others, these differences may
contribute to gaps in the regulation of the financial system as
a whole.
One way to understand the differences and
identify the gaps is to compare the core principles for
financial supervision across each sector.
The core
principles reflect characteristics of the respective sector and
the nature of the supervised financial institutions.
They represent the key components and features of the
supervisory and regulatory framework of each financial sector.
These principles, issued independently by the BCBS,
IAIS, and IOSCO, correspond to the minimum requirements for
sound supervision.
This analysis provides insights into
the differentiated nature of regulation across sectors from an
international perspective2 but not into the unregulated sector.
2. Supervision and regulation of financial groups
Financial groups, through networks of legal entities and
structures, offer a wide range of financial services and are
often active across multiple jurisdictions and with multiple
interdependencies.
The financial crisis has shown the significant roles these
financial groups play in the stability of global and local
economies.
Because of their
economic reach and the mix of regulated and unregulated entities
(such as special purpose entities and unregulated holding
companies), financial groups blur the boundaries among the
sectors and present challenges for the application of
sector-specific financial regulation and also for their review
and assessment by supervisors.
3. Mortgage origination
The focus of the role of mortgage products in the financial
crisis has been on the securitisation of mortgage loans or the
sale of securitisations.
This has been addressed in
several international fora, including the Joint Forum and its
parent committees.
Receiving far less attention,
however, is the fundamental building block of sound
securitisation: the quality of underwriting of the component
mortgages.
The G-20 noted that the
credit quality of loans granted with the intention of
transferring them to other entities through the securitization
process was not adequately assessed.
Therefore,
this report focuses on standards for the origination of mortgage
loans that contribute to sound securitisations and global market
stability.
4. Hedge funds
Hedge funds, especially the largest of them,
could have a systemic impact on financial
stability.
Failure in particular of a large,
highly leveraged hedge fund might not only impact its investors,
but also financial institutions and markets.
Yet
hedge funds are perceived as largely unregulated because they,
like individual investors, typically do not have legal or
regulatory investment restrictions, although their operators are
regulated in many countries.
While the possible
contribution of hedge funds to the financial crisis is still a
subject of debate, the Joint Forum agreed that the lack of a
consistent prudential regime for monitoring and assessing hedge
funds is a critical gap in the regulatory framework.
5. Credit risk transfer products
Credit default swaps and financial
guarantee insurance products transfer risks within but also
outside the regulated sectors.
There is broad
agreement that these products should be subject to sound
counterparty credit risk management and that more transparency
is needed.
This report focuses on areas not already
specifically addressed by other fora and on areas where
additional input on previous recommendations would be
beneficial.
This report also consolidates and emphasises
recommendations that have been made in other fora.
B. Guiding principles of this study
The broad mandate led to analysis of a diverse and large
range of issues.
Consequently, some recommendations and
policy options are aimed at supervisors while others target more
generally policymakers.
In developing these
recommendations and policy options, the Joint Forum applied
certain guiding principles that reflect general views about the
nature of financial regulation and, to a great extent, echo
general recommendations made by the G-20.
Articulating
these principles helps ensure that these recommendations are
designed for the long term.
•
Similar activities, products, and markets should be subject to
similar minimum supervision and regulation.
• Consistency
in regulation across sectors is necessary; however, legitimate
differences can exist across the three sectors.
•
Supervision and regulation should consider the risks posed,
particularly any systemic risk, which may arise not only in
large financial institutions but also through interactions and
interconnectedness among institutions of all sizes.
•
Consistent implementation of international standards is critical
to avoid competitive issues and regulatory arbitrage.
Because of the dynamic, changing nature of the global
financial system, the scope of financial regulation must be
continuously monitored and reviewed.
IV. Key issues and gaps
The following summarises the
findings and observations in the five areas reviewed.
A. Key regulatory differences across the
banking, insurance, and securities sectors
To undertake the review of the differentiated nature of
existing regulation in the banking, securities, and insurance
sectors, the Joint Forum focused on updating a review of the
respective core principles of supervision in the banking,
insurance, and securities sectors conducted in 2001.
The
core principles reflect the main characteristics of the
respective sector and the nature of the financial institutions
supervised under each framework.
The purpose of such
comparsion was to identify common
principles and understanding differences when they arise.
Despite different formats, content and language used, the
core principles review revealed substantial commonalities across
sectors.
Indeed, differences among each sector’s core
principles have been decreasing slightly over time, reflecting
the converging nature of the business in the three sectors.
Furthermore, some of the existing differences among the core
principles are warranted as they reflect - at least in part -
intrinsic characteristics of the banking, insurance, and
securities
sectors.
Examples of
these intrinsic differences include the following ones:
• There are many unique aspects in
securities regulation reflecting the broader scope of securities
supervisors.
The IOSCO core principles therefore encompass not only
the regulation and supervision of securities firms, but also
that of markets, exchanges, collective investment schemes, and
disclosure by issuers.
This broader scope of the IOSCO
core principles reflects unique and intrinsic aspects of
securities regulation and supervision. Core principles in the
banking and insurance sectors describe only the framework needed
to supervise financial institutions, not markets.
• Differences in the nature of the businesses being conducted by
firms within each sector also explain and justify some
fundamental differences in the nature of their regulation.
An example of this differentiated nature of businesses
of firms across sectors is the key role assigned to technical
provisions by insurance regulation, but not by banking and
securities regulation.
Insurance companies offer protection against uncertain future
events.
As a consequence, much regulatory and
supervisory effort in the insurance sector is directed towards
the valuation of technical provisions as they are estimations of
the cost of future liabilities.
However, as already noted
by the Joint Forum in 20018, key differences remain among the
regulatory frameworks of the banking, securities, and insurance
sectors that have no objective justification.
Furthermore, the relevance of some of
these differences has been emphasised by the financial crisis,
as noted by the G-20 in its report on Enhancing Sound Regulation
and Strengthening Transparency.
As a general and
overarching matter, the Joint Forum believes that there is room
for greater consistency among each sector’s core principles, as
well as the standards and rules applied to similar activities
conducted in different sectors.
Such improvements would
reduce opportunities for regulatory arbitrage and contribute to
greater efficiency and stability in the global financial system.
Also, the financial crisis evidenced the lack of a
coordinated approach to assess the implications of systemic
risks and of the necessary policy options to address them.
The core principles for each sector should appropriately
reflect the extent to which systemic risk and financial
stability play a role in the development of supervisory policies
and approaches.
More specifically, despite exposures to
common risk factors and growing interactions and risk transfer
across the three sectors, there are areas treated differently
for the purposes of prudential regulation of financial firms
under each sector’s supervisory system:
•
This is notably the case with regard to the supervision and
regulation of financial groups.
The emphasis placed on supervision on a group-wide basis
varies dramatically and the principle is applied in very
different ways in the three sectors.
While the Basel
framework has always placed much focus on consolidated
supervision, the IAIS only started requiring group-wide
supervision (in addition to supervision of individual entities)
in 2003.
IOSCO’s core principles do not require
securities firms to be supervised on a group-wide basis.
•
Differences exist regarding a global uniform capital framework
within each sector.
A uniform framework exists only in the banking sector,
whereas different frameworks still coexist within securities and
the insurance sectors at the international level.
•
Prudential regulations across sectors also remain largely
different from both a conceptual and a technical point of view.
Although these largely reflect significant differences in
underlying business activities, some of these differences create
supervisory challenges as well as opportunities for regulatory
arbitrage.
•
The extent to which regulation of the different sectors deal
with business conduct and consumer or investor protection also
vary.
The Joint Forum believes that addressing these
inconsistencies in supervisory frameworks across the banking,
securities, and insurance sectors is necessary in order to
ensure a sounder financial system in the future.
In
addition to considering the legal or regulatory framework for
evaluating differences in prudential regulation across sectors,
it is also important to consider how supervisors implement these
regulations.
Differences at the implementation level are
important as they may impede fair and effective supervision and
assessment of the financial sector in general.
Although
how supervisors implement regulations was beyond the scope of
this work, the Joint Forum wishes to emphasise that partial or
inconsistent implementation of even nearidentical prudential
regulation can result in significant differences in practice.
Basel Committee on
Banking Supervision, The Joint Forum
Review of the Differentiated
Nature and Scope of Financial Regulation
Key Issues and
Recommendations (January 2010)
Conglomerates
- Part 1:
Introduction, Mandate, Focus and guiding principles of this study,
Key issues and gaps
Conglomerates - Part 2:
Supervision and regulation of financial groups. Mortgage
origination. Hedge funds
Conglomerates - Part 3:
Recommendations and options for effective and consistent
financial regulation across sectors. Reducing key regulatory
differences across the banking, securities, and insurance sectors.
Strengthening supervision and regulation of financial groups.
Promoting consistent and effective underwriting standards for
mortgage origination. Broadening the scope of regulation to hedge
fund activities
Conglomerates - Part 4:
Strengthening regulatory oversight of credit risk transfer
products. Key differences in regulation across the banking,
securities, and insurance sectors.
Background and approach adopted by the Joint Forum. Key issues
and gaps
Conglomerates - Part 5:
Recommendations to reduce key differences in regulation across
the banking, securities, and insurance sectors. Supervision and
Regulation of Financial Groups. SPEs. Key issues and gaps.
Recommendations to strengthen supervision and regulation of
financial groups
Conglomerates - Part 6:
Mortgage Origination. United Kingdom, United States, Spain,
Canada, Germany. Key issues and gaps. Recommendations to promote
consistent and effective underwriting standards for mortgage
origination
Conglomerates - Part 7:
Hedge Funds. Key issues and gaps
Conglomerates - Part 8:
Recommendations and policy options to broaden the scope
of regulation to hedge fund activities.
Credit Risk Transfer Products.
Key issues and gaps common to both CDS and FG insurance (CDS -
Credit default swaps, FG - Financial guarantee)
Conglomerates - Part 9:
Key issues and gaps specific either to CDS or FG insurance.
Recommendations and policy options to strengthen regulatory
oversight of credit risk transfer products
Conglomerates - Part 10:
Annex 1-9
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