| |
Basel Committee on Banking
Supervision, The Joint Forum
Review of the Differentiated
Nature and Scope of Financial Regulation
Key Issues and
Recommendations (January 2010)
Annex 1
Acronyms
AIG American International Group
BCBS Basel Committee
on Banking Supervision
CCP Central counterparties
CDO Collateralised debt obligation
CDS Credit default
swap
DTI Debt to income
EU European Union
FASB Financial Accounting Standards Board
FG Financial
guarantee
FSB Financial Stability Board
GDP Gross
domestic product
JFRAC Joint Forum Working Group on Risk
Assessment and Capital
IAIS International Association of
Insurance Supervisors
IASB International Accounting
Standards Board
IMF International Monetary Fund
IOSCO International Organization of Securities Commissions
ITE Intra-group transaction and exposure
LTI Loan to
income
LTV Loan to value
MBS Mortgage-backed
securities
NOHC Non-operating holding company
OTC
Over-the-counter
SPE Special purpose entity
Annex 2
Fundamental analysis of the objectives of financial regulation
In order to better understand and analyse the nature of
financial regulation in each sector, the Joint Forum has
performed a comparative analysis of the key objectives of
financial regulation from an economic standpoint.
This
analysis focuses on market failures that should be addressed
through regulation.
Indeed, these elements could be seen
as key drivers of the nature of the financial regulation in each
sector.
A. The role of financial intermediation for the real economy
The aim of financial intermediation is to promote the
efficient allocation of savings and investments in the real
economy.
To this end, financial intermediaries bring
together economic agents with a surplus of funds and those with
a deficit of funds.
By supplying these services to the
real economy, financial intermediaries lower the cost of capital
for corporates and individuals and allow for the pricing and
distribution of risk.
One classical example of a
financial intermediary is a bank.
Traditionally, this
type of institution provides for its funding by taking deposits
or by borrowing on money and capital markets, while it uses
these funds to supply loans to other parties or invest in
(financial) assets.
While doing so banks generally
engage in maturity transformation, in the sense that they have
short-term liabilities while lending long-term.
As a
result, a bank might be forced to repay its creditors on a
shorter notice than that it can demand repayment of the loans
made to its debtors.
The typical risks faced by banks
are therefore credit risks from their lending activities, and
funding liquidity risk related to the mismatch between
short-term liabilities and relatively illiquid assets on their
balance sheets.
Insurance companies are another type of
financial intermediariy, particularly a risk intermediary, and
offer their policy holders protection against uncertain future
events.
Insurance offers protection against uncertain
future events.
Although this task is of
considerable
importance to the economy, usually the traditional insurance
sector is unlikely to be a source of financial instability.
Insurance provides a safety net when underlying adverse
events occur.
Insurance firms themselves are directly
affected by economic events such as interest rate movements,
which can impact asset valuation, and inflation, which can
result in policyholders cashing out policies.
Moreover,
economic distress leading to deteriorating social or economic
conditions, or obligations to pay damages as a result of
judicial rulings, can result in new liabilities and potentially
catastrophic losses.
Insurers intermediate risks
directly.
They manage these risks through
diversification and the law of large numbers.
For
example, diversification of policy liabilities can be achieved
through reinsurance.
Aside from these direct business
risks, the most significant risks to insurers are generated on
the liability side of the balance sheet.
These risks are
referred to as technical risks and relate to the actuarial or
statistical calculations used in estimating liabilities.
If these calculations are incorrect (for example, if one or
more of the assumptions on which they are based prove to be
inaccurate), the consequences for the insurer can be
significant.
In particular, premiums charged could be
inadequate to cover the risk and costs, insurers may pursue
lines of business that are not profitable, and liabilities may
be under- or over-stated, masking the true financial state of a
company.
On the asset side of the balance sheet,
insurers incur credit, market and interest rate risk from their
investments, as well as risks arising from asset-liability
mismatches.
A third type of financial intermediary are
market intermediaries, which are referred to in IOSCO principles
as generally including those who are in the business of managing
individual portfolios, executing orders, dealing in or
distributing securities and providing information relevant to
the trading of securities.
Thus, they can be investment
banks, or managing companies of (collective) investment schemes
or funds.
Examples of funds are hedge funds, money
market funds, some special purpose vehicles, or real estate
funds.
The securities sector is particularly sensitive
to market risk and liquidity risk.
For example, a loss
of confidence on the part of investors can lead to massive and
rapid withdrawal of short-term funds, producing a collapse in
asset prices.
In addition to intermediating between
agents in the real economy, financial intermediaries often
engage in transactions with each other.
Transactions may
take the form of a bilateral contract between the parties, which
will be settled over-the-counter and which may give rise to the
posting of collateral.
AlthoughFinancial instruments
such as stocks, futures and options may be traded
over-th-ecounter, they are typically traded on organised trading
venues such as regulated markets and cleared via central
clearing.
In this case, a third party is involved, the
role of which is to manage and reduce counterparty risk.
When instruments are traded on an exchange and centrally
cleared there is no direct connection between counterparties
anymore.
While providers of exchange or central clearing
facilities as well as clearing and settlement systems are
generally not financial intermediaries themselves, they form an
important part of the infrastructure of financial markets and
are generally subject to regulation or supervision.
While
financial flows increasingly cross the boundaries among the
three financial sectors, these boundaries themselves have become
more blurred over time as well.
This happens either
because intermediaries from different sectors merge to form
financial conglomerates, or because intermediaries from one
sector engage in activities traditionally belonging to
another.
By now, for instance, banks can offer
insurance-like products by selling financial derivatives such as
credit default swaps (which may be used for speculative
purposes), while insurance firms can offer investment schemes
such as variable annuities, and sometimes earn more on their own
investments than on their risk pooling activities.
In
addition, many securities firms act in a bank-like manner by
financing illiquid assets with short-term debt, which can lead
to a highly leveraged balance sheet.
This ability to
take the same type of risks on balance as a typical bank,
without being regulated as such, has by now caused entities such
as hedge funds or special purpose vehicles to be considered
members of a “shadow” banking system.
This
classification underlines the fact that while they are different
from one another on a legal definition, the different types of
intermediaries can engage in similar economic activities.
B. Market failures impeding stable and efficient financial
intermediation
Economic theory has traditionally identified three types of
market failures that can justify the regulation of private
institutions.
These market failures are
i) negative externalities,
ii)
information asymmetries, and
iii) competitive
distortions. While also in the financial sector the reduction of
competitive distortions is generally implemented by the
anti-trust authorities, the need to address negative
externalities and information asymmetries can be considered the
economic rationale for the existence of financial supervision
(i) Negative externalities
When deciding upon their preferred risk profile, financial
intermediaries may not fully take into account the negative
effects their failure might have on other intermediaries or on
the economy as a whole.
This more narrow focus follows
naturally from the fact that when the intermediary becomes
insolvent, its owners only lose their claim on the future
profits of the intermediary.
What happens thereafter to
the stability and profitability of the other intermediaries and
agents in the economy is not taken into account by them.
The social cost of an intermediaries’ insolvency thus
exceeds the private costs for the owners of the intermediary
itself.
There are four reasons why this is the case.
• First, via informational contagion the insolvency of an
intermediary can cause counterparties of other intermediaries
and their clients to lose confidence in these institutions’
assets as well.
When these intermediaries rely to a
significant extent on for instance short-term funding, this loss
of confidence can lead other institutions and clients to cease
financial transactions with them and to a withdrawal of funds
with liquidity shortages as the potential outcome.
In
case the freeing of funds requires assets to be sold below book
value, the liquidity problems can even have insolvency as a
result.
• Second, illiquidity or (near-) insolvency of an
intermediary can force it to engage in a fire sale of assets so
as to adjust the size of its balance sheet to the remaining
amount of debt and equity available.
When the book value
of the assets sold is to be calculated on the basis of
mark-to-market accounting, the depressing effect that such fire
sales can have on market prices will lead to write downs also
for other intermediaries holding such financial assets.
Especially when assets are sold in illiquid markets, the price
declines and thus the write downs for other intermediaries can
be substantial.
• Third, financial intermediaries are
relatively closely interrelated, for instance because they
belong to the same financial group via mutual exposures in the
inter bank market, or through derivative trading, re-insurance,
prime brokerage services et cetera.
The insolvency of an
intermediary can thus cause it to default on many of its
obligations to other financial intermediaries, which can cause
these to suffer large losses as well.
Especially during
the immediate aftermath of the failure there can be much
uncertainty about the size of these exposures, which can again
negatively affect the liquidity of other intermediaries via the
confidence channel described above.
•
Fourth, illiquidity
or (near-) insolvency of an intermediary can force it to
restrict the supply of financial services to the real economy,
for instance by raising margins or by quantity rationing.
When this happens on a large scale and the supply of credit
and insurance is seriously reduced, economic activity will be
depressed so that personal and corporate defaults in the real
economy increase and prices of (financial) assets decline.
In turn, these effects will adversely affect the health of
other financial intermediaries as well.
The above shows
why the illiquidity or insolvency of a financial intermediary
can have such a destabilising impact also on parties that are
not its direct customers or financiers.
These effects
thus remain in place also when (some of) these intermediaries’
direct financiers are protected, for instance by explicit
guarantees for bank deposits or insurance policies.
Likewise, any indirect supervision of the intermediary by these
(professional) financiers will not sufficiently reduce these
negative effects either, since these financiers will naturally
focus
only on those risks relevant for themselves, but not on
the destabilising effects on any other parties that the
insolvency of an intermediary can bring about.
As such,
it could be argued that one objective of financial supervision
is the need to internalise these externalities, ie to make sure
that when intermediaries decide upon thei preferred risk
profile, they take the social welfare costs associated with
their own instability into account as well.
Below,
adopting a more common terminology, this objective will be
referred to as the reduction of systemic risk caused by the
intermediary
(ii) Information asymmetries
Efficient financial intermediation requires the
dissemination of relevant information to be timely and
widespread, and to be reflected in the price formation process.
Higher market efficiency improves the ability of market
participants to evaluate the risks and rewards associated with
transactions they engage in.
This statement of course
applies to transactions taking place in all sectors of the
economy, but is especially relevant to financial transactions
due to the relatively high complexity and information intensity
of the contracts involved.
When information asymmetries
exist between market parties, ie when one party involved in a
transaction has more information than the other, this not only
affects market efficiency in general, but can also lead to
adverse selection and moral hazard behaviour by the party with
the informational advantage.
Adverse selection problems
occur directly before a transaction has been agreed upon, and
happen when one party is not able to properly verify the
characteristics of the other.
A classic example of this
problem is the fact that health insurance is more likely to be
bought by people who are more likely to get sick.
A
recent example of adverse selection is the sale of securitised
mortgages to investors after the crisis had unfolded.
Since buyers were unable to verify the characteristics of the
underlying mortgages, while sellers were unable to credibly
signal the quality of their product, the prices investors were
willing to pay for these mortgages declined across the board.
After all, the only way to avoid buying a mortgage of
too low a quality at too high a price was to offer the price
that would be appropriate for the mortgage with the lowest
quality.
The information asymmetry between sellers and
buyers of securitised mortgages thus lead buyers to lose market
confidence, with a classical ‘lemons market’ being the result.
Moral hazard problems take place after the transaction has
agreed upon, and happen when one party cannot accurately verify
the actions of the other.
A classic example is that
those people having bought insurance are likely to start taking
more risks.
A recent example of moral hazard is the
making of mortgage loans to individual households during the
run-up to the crisis.
Since these mortgages and the risks
associated with them were securitised directly after they were
made, mortgage originators had an incentive to make loans to
households in riskier market segments, while monitoring them
less accurately.
In addition, the non-recourse character
of several mortgages induced moral hazard behaviour from the
part of the household, since in case of any price declines or
payment problems they could unwind their contract by returning
the house to the mortgage originator.
These households
could thus accept more risky mortgages because part of these
risks was transferred to the issuers, while the issuer could
offer more risky mortgages because part of these risks were
transferred to investors in the securitisation process.
In summary, when any information asymmetries exist in
(financial) markets, agents having the informational advantage
will not always be able or willing to credibly provide other
market participants with their information. Therefore, the
second economic justification for financial supervision is the
need to reduce any information asymmetries between financial
market participants, in so far as these hamper the fairness and
efficiency of financial markets.
Implementing this
objective will in turn also reduce systemic risks, since more
symmetry of information fosters investor confidence, and thus
reduces the probability that informational contagion will occur.
C. Evaluation of standard setters’ key objectives in light of
the market failures identified
The Basel Committee on Banking Supervision (BCBS), the
International Association of Insurance Supervisors (IAIS), and
the International Organisation of Securities Commissions (IOSCO)
each have formulated core principles for financial supervision.
These core principles describe, among other things, the key
objectives of their supervision on the three financial sectors.
In line with the discussion above, from an economic
perspective the formulation of these key objectives should start
with the observation that financial supervision aims to redress
two types of market failure: systemic risks
posed by financial
intermediaries (which are to be internalised primarily via
prudential supervision), and information asymmetries hampering
the functioning of financial markets (which are to be reduced
primarily via market conduct supervision).
Below, it is
analysed to what extent redressing these market failures is
included as a key objective in the core principles.
The
key objective of bank supervision, as described in the 2001 BCBS
core principles, is “to maintain stability and confidence in the
financial system, thereby reducing the risk of loss to
depositors and other creditors” (p. 8).
In the revised
version in 2006, the objective is somehow broadened as it is
indicated that a “high degree of compliance with the Principles
should foster overall financial system stability.”
According to the 2003 IAIS core principles, the main goal of
insurance supervision is “the maintenance of efficient, fair,
safe, and stable insurance markets for the benefit and
protection of policyholders” (p. 9).
In practice, this
implies that the main goal of insurance supervision is to ensure
that the interests of the insured are adequately safeguarded and
the laws applicable to the operation of insurance business are
observed.
According to the 2008 IOSCO core principles,
“the three core objectives of securities regulation are (1) the
protection of investors, (2) ensuring that markets are fair,
efficient, and transparent, and (3) the reduction of systemic
risk” (p. 5).
As noted by the IOSCO, there may be
significant overlap in the policies that securities regulators
adopt to achieve each of these objectives.
For example,
regulations that help to ensure fair, efficient, and transparent
markets also help to reduce systemic risk.
(i) Reduction of systemic risk
Although their core principles reflect that all standard
setters consider reduction of systemic risks to be a key
objective, substantial differences exist with respect to how
this objective is made explicit.
This issue was already
raised by the Joint Forum in 200195: “traditionally, the broad
objective of supervisors and regulators of the three sectors has
been to protect customers, whether these were depositors,
investors or policyholders.
Over time, as firms have
become larger and more entwined with other market participants,
supervisors have in some cases also been concerned to limit the
potential implications of the sudden failure of a financial
institution on the financial system and the economy.”
However, “the extent to which concerns over ‘systemic risk’
currently do or should play a role in the development of
supervisory policies in each sector is not completely clear.
Supervisors in some jurisdictions place more emphasis on
these concerns than others, even within the same sector, so it
is hard to make generalisations across the sectors”
The above citation underlines that the objective of customer
or stakeholder protection is not equivalent to the objective to
reduce systemic risks.
On the one hand, protecting
customers may help to reduce systemic risk by for instance
preserving market liquidity, while on the other this might
increase systemic risks by undermining market discipline.
To have financial supervisors put more emphasis on the
objective of systemic risk reduction, the G-20 recommends in its
2009 report on Sound Regulation and Strengthening Transparency
that “as a supplement to their core mandate, the mandates of all
national financial regulators, central banks, and oversight
authorities, and of all international financial bodies and
standard setters (IASB, BCBS, IAIS and IOSCO) should take
account of financial system stability.”
The BCBS states
most clearly in its core principles that it aims to maintain
overall stability of the financial system.
Traditionally, especially distress in the banking sector and
instability in the macroeconomic environment have been perceived
as reciprocally linked.
Therefore, concerns about the
importance of banks to the overall economy, including their use
as a tool in the implementation of monetary policy, are
reflected in the historic tendency of many
governments to
support their banking sectors during times of crisis. Because of
the strong linkage between the banking sector and the macro
economy, banking supervisors - many of which are (or were) also
central bankers - have placed a great deal of emphasis of
maintaining systemic stability.
The IAIS focuses more
specifically on promoting a stable insurance market for the
benefit and protection of policyholders, while putting somewhat
less emphasis on the objective of reducing systemic risks in
general.
Although promoting a stable insurance market
will contribute to overall systemic stability as well, the core
principles put less emphasis on reducing systemic risks than
for instance the principles underlying banking supervision.
This difference can to some extent be rationalised by
noticing that insurers generally are not very dependent on short
term debt financing, and therefore are less sensitive to
instability caused by confidence effects and liquidity
shortages.
The systemic risk posed by insolvency of an
insurer is therefore not usually at the same level of severity
or speed as that associated with the failure of a typical bank.
The IOSCO explicitly aims to reduce systemic risk as well,
to the extent that the financial or operational failure of a
provider of investment services (or of a market infrastructure
such as an exchange, a clearing house, or a clearing and
settlement system) does not significantly impair the proper
functioning of the broader markets and the economy.
In
this respect the IOSCO core principles thus predominantly
consider risks involving the market intermediary, and IOSCO
principles include principles relating to capital adequacy
aiming at the following:
• allowing a firm to absorb some
losses, particularly in the event of large adverse market moves,
and to achieve an environment in which a securities firm could
wind down its business over a relatively short period without
loss to its customers or the customers of other firms and
without disrupting the orderly functioning of the financial
markets ;
• requiring firms to maintain adequate
financial resources to meet their business commitments and to
withstand the risks to which their business is subject.
Risk may result from the activities of unlicensed and off
balance sheet affiliates and regulation should consider the need
for information about the activities of these affiliates.
It also needs to be mentioned that the IOSCO offers an
important contribution to reducing systemic risks by reducing
information asymmetries and enhancing investor confidence.
This objective will be discussed in more detail below.
(ii) Reduction of information asymmetries
There also exist differences between the standard setters
with respect to the inclusion of reduction of information
asymmetries as a key objective in the core principles.
In general reducing information asymmetries fosters market
confidence and contributes to financial stability.
Such
transparency strengthens perceptions of regulatory
predictability and contributes to supervisory accountability,
which in turn facilitate normal market functions and improve the
credibility of the enforcement process.
However, when
problems emerge in a particular financial intermediary a
supervisory dilemma arises.
This was noted already by
the Joint Forum in 2001: “Supervisors in all three sectors must
take into account the balance of advantage in making public any
supervisory action that has been taken to prevent or remedy
problems in supervised firms”.
Hence, especially in
times of financial instability the objectives to reduce both
systemic risks and information asymmetries might be difficult to
reconcile.
Bearing the above in mind, the core principles
of the BCBS do not explicitly mention the reduction of
information asymmetries or customer protection as a key
objective.
This was already noticed by the Joint Forum
in 2001: “This leads banking supervisors in many jurisdictions
to avoid or postpone public disclosure of banks’ problems
because of the importance of maintaining confidence in the
banking system.
Public confidence is essential to ensure
stable funding. Loss of confidence in the banking sector can
create financial instability by resulting in a run on banks by
depositors, with a subsequent systemic drain on liquidity”
Nonetheless, the BCBS core principles stipulate the
need for intermediaries to adequately disclose relevant
information on their financial position to market participants
in general.
The IAIS core principles reflect the need to
reduce information asymmetries by referring to the objective of
promoting customer protection.
This objective is filled
in by the requirement that intermediaries treat policyholders
and investors fairly, while they adequately provide them with
relevant information.
Nonetheless, in practice the
trade-off between this objective and the need to maintain the
stability of the intermediary exists here as well, as was
mentioned by the Joint Forum in 2001: “Insurance supervisors are
concerned that disclosure to the public of regulatory actions
being taken could cause policyholders or others to take actions
that could worsen the situation the supervisor was trying to
remedy.
Furthermore, the public awareness of
difficulties of individual companies might affect public
confidence in the insurance sector as a whole.”
To
address this issue, however, “in at least some jurisdictions, a
distinction is made between supervisory actions related to
prudential issues, which tend not to be made public, and those
related to conduct of business issues, where disclosure is more
common” (p. 11).
The IOSCO most explicitly refers to the
objective of reducing information asymmetries, by stating that
markets should be fair to the extent that they do not unduly
favour some market participants over others, that they should be
efficient in the sense that relevant information is necessary
for investors to make informed investment decisions on an
ongoing basis and should be is timely disseminated, and that
they should be transparent in the sense that information about
trading itself is publicly available on a real-time basis.
Securities supervisors generally also disclose enforcement
actions, reflecting that in the securities sector, supervisory
transparency and accountability are linked to the maintenance of
confidence in the markets, which is vital for the maintenance of
orderly markets.
Besides, with regard to the secondary
market, the core principles state that “systems for clearing and
settlement of securities transactions should be subject to
regulatory oversight, and designed
to ensure that they are
fair, effective and efficient and that they reduce systemic
risk.”
D. Observations on the objectives of financial regulation
Traditionally, differences exist with respect to the
relative importance attached to prudential and market conduct
regulation by supervisors across the three financial sectors.
This is a reflection of the sectoral approach to
financial supervision, with separate principles for banks,
insurance companies, and securities firms.
Indeed, this
approach comes at the risk of more differentiated financial
supervision between sectors, even though the boundaries between
financial sectors have become increasingly blurred over time.
In contrast, in times of financial instability the
boundaries between prudential and market conduct supervision
tend to become more explicit, since during such times a
trade-off can arise between the reduction of systemic risks and
the reduction of information asymmetries.
Nonetheless,
under a sectoral approach to financial supervision, standard
setters’ need to keep in mind both these key objectives of
financial supervision in formulating their core principles.
In summary, the above analysis shows that:
•
The BCBS
core principles already put quite a large emphasis on the
objective to reduce systemic risks, but do not explicitly state
as a key objective the adequate disclosure of information to
market participants and the public and the fair treatment of
customers (although Pillar 3 of the Basel capital adequacy
framework shows that supervisory practice might be somewhat
ahead of supervisory principles in this case).
•
For
IOSCO, the key objective of investor protection is mainly met by
the reduction of information asymmetries, including the indirect
contribution thereof to financial stability, while the objective
of reducing systemic risks directly receives substantially less
attention.
• The IAIS core principles reflect both
objectives, although they have a relatively strong focus on
risks for direct policy holders rather than on risks for the
financial system in general.
Annex 6
Core principles related to group-wide supervision
Core principles established by the BCBS and IAIS set minimum
standards for group-wide supervision, although there are
variations between these standards.
Principles on group/consolidated supervision
The BCBS core principle on consolidated supervision
specifies that where corporate ownership of banking companies
(eg unregulated or lightly regulated holding companies) is
permitted, the supervisor should have the power to:
•
review the activities of parent companies and to determine the
safety and soundness of the bank
• establish and enforce
fit and proper standards for owners and senior management of the
(less regulated) parent.
The IOSCO core principles refer
to group supervision in the context of supervisory cooperation.
The IAIS core principle on group-wide supervision specifies
that where an insurer is part of a conglomerate, the assessment
of the risk exposures of the insurer would take into account the
operations of other group companies, including applicable
holding companies.
It also notes that at a group level
there should be adequate supervisory oversight of:
•
the
group structure and inter-relationships, including ownership and
management structure,
• capital adequacy, reinsurance and
risk concentrations, and intragroup transactions;
•
internal control mechanisms and risk management processes,
including reporting lines and fit and proper testing of senior
management.
The IAIS has also published the following
papers:
• Guidance paper on the role and responsibilities
of a group-wide supervisor – October 2008,
• Guidance
paper on the use of supervisory colleges in group-wide
supervision – October 2009, and
• Principles on
group-wide supervision – October 2008 These principles include:
1. The assessment of capital adequacy on a group-wide basis
2. The assessment of the fitness and propriety of the board,
senior management and significant shareholders on a group-wide
basis
3. The assessment of risk management and internal
controls on a group-wide basis
4. Supervisors should have
appropriate skills and authority to supervise on a groupwide
basis
5. Cooperation and exchange of information among
supervisors of the group to allow efficient and effective
supervision
The IAIS is also developing further papers
including:
• a Group-wide Supervision Framework (GSF)
• a guidance paper on the treatment of unregulated entities
in group-wide supervision, and
• a guidance paper on
establishing criteria for supervisory recognition in group-wide
supervision.
Unregulated entities
The BCBS core principles require banking supervisors to have
a means of collecting, reviewing and analysing prudential
reports and statistical returns from banks on an individual
entity and consolidated basis.
This should include
information on off-balance sheet activities.
The core
principles also state that an essential element of banking
supervision is the ability of supervisors to supervise the
banking group on a consolidated basis.
The supervisor
should have the ability to review nonbanking activities and
should take into account that nonfinancial activities of a bank
or group may pose risks to the bank.
Banking supervisors
are also required to practice global consolidated supervision
over their internationally active banking organisations and to
apply prudential norms to all aspects of the business including
foreign branches, joint ventures and subsidiaries.
The
IOSCO core principles note that risk may result from the
activities of unlicensed and offbalance sheet affiliates and
that regulators should consider the need for information about
the activities of these affiliates.
The IAIS core
principles require supervisors to require insurers to submit
information about their financial condition and performance on
both an individual and a group-wide basis.
They should
also request and obtain financial information on any subsidiary
of the supervised entity and require insurers to report any
off-balance sheet exposures.
Insurance supervisors should
also require that the structures of the financial groups
containing potential controlling owners of insurers be
sufficiently transparent so that supervision of the insurance
group will not be hindered.
The core principles of the
BCBS, IOSCO and the IAIS expect exchange of cross-border
information between supervisors within the same sector.
Information sharing
The BCBS core principles state that arrangements for sharing
information between supervisors and protecting the
confidentiality of such information should be in place.
This requires a system of interagency cooperation and sharing of
information among the various official agencies, both domestic
and foreign, responsible for the safety and soundness of the
financial system.
Other BCBS core principles provide that
a key component of consolidated supervision is establishing
contact and information exchange with the various other
supervisors involved, primarily host country supervisory
authorities, but also refer to the sharing of information with
home country supervisors.
In the banking sector in
particular, the supervisory approach has been for home and host
supervisors to share information but the swiftness of the
financial system crisis exposed this approach as being somewhat
two dimensional.
The international standards also
provide little emphasis on the exchange of information between
supervisors in different sectors.
IOSCO requires the
sharing of both public and non-public information with domestic
and foreign counterparts, the establishment of information
sharing mechanisms and the provision of assistance to foreign
regulators. Specifically in relation to financial conglomerates,
the IOSCO core principles refer to the exchange of information
with other regulators in the banking and insurance sectors.
The IAIS core principles require supervisors to cooperate
and share information with other relevant supervisors subject to
confidentiality requirements.
Information to be
exchanged includes but is not limited to specific information
gathered from the entity, relevant financial data and objective
information on individuals.
Consultation should take
place between insurance supervisors before action is taken and
there are obligations on both home and host supervisors to
provide information to each other if such action would have an
effect in the other’s jurisdiction.
A comparatively
recent development in cooperation and information exchange
between supervisors is the establishment of Multilateral
Memoranda of Understanding (MMoU), namely those established by
IOSCO and the IAIS.
In broad terms, the IOSCO MMoU is
based around potential enforcement action by securities
supervisors and the information expected to be exchanged under
it by signatories relates to transactions, and market abuse,
insider dealing and other fraudulent activity in relation to
those transactions.
In order to become a signatory to
the MMoU a supervisor must be able to obtain information from a
person who is not regulated (for example, an unregulated entity
or a member of the public).
The IAIS MMoU is concerned
with facilitating cooperation and the exchange of information
for insurance supervision generally.
Information
disclosed under the MMoU must have a valid purpose and relate to
licensing, fit and proper criteria, ongoing supervision,
enforcement, winding up or other supervisory concerns.
The MMoU is, therefore, not specifically directed at
transactions.
Ownership structure
The BCBS core principles require banking supervisors to have
the authority to review and reject any proposals to transfer
significant ownership or controlling interests in existing banks
to other parties.
The original ownership structure
should be assessed at the licensing stage and, when the proposed
owner is a foreign bank, the consent of the home country
supervisor should be obtained.
The IOSCO core principles
state that regulation should provide for minimum entry standards
for market intermediaries. Changes of control or material
influence should be made known to the supervisor and the
supervisor should be empowered to withdraw a licence where a
change in control results in a failure to meet relevant
requirements.
The IAIS core principles require that
supervisors approve or reject proposals to acquire significant
ownership or any other interest in an insurer that results in
that person, directly or indirectly, alone or with an associate,
exercising control over the insurer.
The term
“control”
is described as a defined shareholding, voting rights or the
power to appoint and remove directors.
Insurance
supervisors are therefore required to approve any change in
ownership which comes above the regulated entity in the
ownership structure.
However, a change of control within
any other entity in the group will not necessarily need to be
notified to the supervisor even though that entity may have an
effect on the risk exposure of the whole group.
There is
therefore a requirement that the supervisor has the authority to
refuse or revoke a licence if the group structure is not
sufficiently transparent so that the supervision of the group is
not hindered.
Insurance supervisors are also required to
apply a fitness and propriety test to prospective controllers
including an assessment of both their financial and
non-financial resources.
Typically, jurisdictions define
controllers who are beneficial owners as having a minimum
shareholding in a regulated entity and information on such
owners is required by the supervisor in order to assess fitness
and propriety prior to licensing an entity and prior to any
change of controller after licensing.
With regards to
senior management, individuals are often required to complete a
personal questionnaire, which includes details of employment
history together with personal details, which allows the
supervisor to carry out due diligence on such individuals.
Supervisors require appropriate statutory powers in order to
ensure that the core principles described above can be applied
in their jurisdiction.
Annex 8
Case study: American International Group
In 2008, American International Group (AIG)
was a global
financial conglomerate with sigificant insurance operations and
operates in more than 130 countries and has about 116.000
employees.
For the year 2007, AIG reported earnings of
USD 6.2b. Its balance sheet amounted to more than USD 1 trillion
and the group was the world’s largest insurance group.
AIG in 2009 provides a very different picture. AIG’s total
assets now stand at USD 860b and its 2008 earnings are a record
loss of USD 100b. In the fourth quarter of 2008 alone, AIG made
a loss of USD 60b.
Its stock fell from around USD 50 in
the beginning of 2008 to around USD 1 in 2009.
AIG was
an extremely complex operation which had many subsidiaries and
was basically able to choose its supervisor.
Its
consolidated supervisor is, thus, the Office of Thrift
Supervision (OTS). AIG’s problems stemmed not from its insurance
companies but are located at the holding level and its
non-insurance subsidiaries.
The backbone of AIG’s
insurance business was used to shore up its unregulated
financial products trading business which specialised in the
trading of credit default swaps (CDSs).
CDSs were, unlike
insurance, not regulated and were traded over-the-counter.
AIG insured more than USD 500b of debt against default by
the use of CDSs.
They insured credit events on
super-senior tranches of financial obligations (normally AAA or
equivalent tranches).
This includes asset backed
securities (ABS). AIG Financial Products Corp. (AIGFP), based in
London (United Kingdom), is a very small unit within AIG (about
400 employees).
Counterparties include major banks, hedge
funds, money managers, sovereign wealth funds and other
institutional investors.
At least some of them may have
sought to buy protection from AIG in order to reduce their
regulatory capital requirements.
AIG did not expect the
CDSs to be executed which probably was one of the motivations
behind its massive use.
Historical data did not indicate
default levels high enough to seriously threaten AIG’s business
and the perceived risk seemed to be low and the unit contributed
substantially to AIG’s profits for some years.
However,
this strategy eventually appeared to be flawed and AIGFP amassed
heavy losses in 2007 and 2008.
A CDS portfolio of more
than USD 60b on CDOs existed with RMBS as underlying including
subprime mortgages.
This caused write-downs but also
made it necessary to post cash collateral as the CDOs reduced in
value.
Another issue AIG had to face came from its
securities lending programme.
AIG’s insurance
undertakings essentially lent securities via this programme to
other financial institutions outside the AIG group in exchange
for cash collateral.
This money was then used by AIG
Investments for investments in RMBS and other debt obligations.
News on the weakening state of AIG caused increasing
numbers of lenders to return the securities and to regain their
money from AIG.
This caused further liquidity
difficulties for AIG.
Both activities contributed to a
strong need for additional liquidity at AIG in September 2008.
Also, downgrades by credit rating agencies forced AIG to
post further collateral and contributed to the worsening state
of the group. Eventually, just after the breakdown of Lehman
Brothers, the Federal Reserve and the United States government
decided to bail out AIG and to provide it with a lending
facility given by the Federal Reserve Bank of New York (AIG was
provided with much needed liquidity as well as with equity).
This was to prevent further damages from the world economy
as a whole and the world’s insurance industry.
In order
to service this debt, AIG committed itself to an orderly
wind-down of its financial products unit and to sell parts of
its insurance businesses.
A new “AIG” will concentrate on
its core business, which is insurance. This will also help to
reduce the complexity of its group structure.
Annex 9
Related initiatives and reports
Joint Forum
• Supervision of Financial
Conglomerates, February 1999
• Core Principles,
Cross-sectoral Comparison, November 2001.
• Risk
Management Practices and Regulatory Capital, cross-sectoral
comparison, November 2001
• Credit Risk Transfer, March
2005
• Regulatory and market differences: issues and
observations, May 2006
• Customer suitability in the
retail sale of financial products and services, April 2008
• Credit Risk Transfer, developments from 2005 to 2007, July
2008
• Stocktaking on the use of credit ratings, June
2009
• Report on Special Purposes Entities, September
2009
BCBS
• Core
Principles for Effective Banking Supervision, October 2006
• Enhancements to the Basel II framework, July 2009
•
Report and Recommendations of the Cross-Border Bank Resolution
Group, September 2009
IAIS
• Insurance Core Principles and Methodology, October 2003
• Guidance paper on the role and responsibilities of a
group-wide supervisor, October 2008
• Principles on
group-wide supervision, October 2008
• Guidance Paper on
the Use of Supervisory Colleges in Group-Wide Supervision,
October 2009
IOSCO
•
Objectives and Principles of Securities Regulation, February
2008
• Role of Credit Rating Agencies in Structured
Finance Markets, May 2008
• Report on the subprime
crisis, May 2008
• Hedge Fund Oversight: Final Report,
June 2009
• Unregulated Financial Markets and Products,
September 2009
G-20 Working Group 1
• Enhancing
Sound Regulation and Strengthening Transparency, March 2009
IMF-BIS-FSB
• Guidance
to Assess the Systemic Importance of Financial Institutions,
Markets and Instruments: Initial Considerations, report and
background paper, November 2009
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
|
| |
