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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)
E. Strengthening regulatory oversight of credit risk transfer
products
In light of the role that inadequate management of risks
associated with credit risk transfer products played in the
crisis, supervisors should consider various actions - on either
a national or international basis - to address these risks.
This report focuses on two prominent products for
transferring credit risk: credit default
swaps (CDS) and financial guarantee (FG) insurance.
While CDS and FG insurance share some
similar characteristics (notably, they both transfer credit risk
but give rise to counterparty credit risk, operational risk, and
risks related to a lack of transparency, among others), there
are significant differences between the two that merit unique
consideration.
As the guiding principles
presented elsewhere in this report suggest, the supervisory and
regulatory requirements applied to activities that appear to
have similar economic substance (eg transfer of credit risk via
CDS and FG insurance) should adequately reflect any similarities
and differences.
Consequently, some recommendations for
addressing gaps in oversight apply to both CDS and FG insurance,
while others are more narrowly focused on one or the other.
Many of the recommendations and options presented below
have
been discussed in other international fora or in jurisdictions.
They are reiterated in this report because the Joint
Forum seeks to provide a broad range of recommendations and
options for addressing gaps in oversight.
Moreover, the
Joint Forum welcomes efforts that have been undertaken since the
onset of the crisis and supports further international work to
address these gaps in an appropriate manner.
Some of the
recommendations and options below reiterate, for example, the
detailed recommendations in IOSCO’s September 2009 report on
Unregulated Financial Markets and Products in the areas of risk
management, transparency, and market infrastructure.
In
the context of promoting more stable and transparent markets,
reducing systemic risk, and restoring confidence,
several
central counterparties (CCP) for trading over-the-counter
derivatives - such as CDS - have been established and have begun
operation; capital requirements for the use of such instruments
have been increased for banking organisations; transparency has
been enhanced; and steps have been taken to reduce operational
and settlement risks.
Recommendation n° 13:
Supervisors should encourage or require
greater transparency for both CDS and FG insurance.
Supervisors should continue to support initiatives to store
CDS trade data in repositories (eg the Depository Trust &
Clearing Corporation’s Trade Information Warehouse).
Supervisors should encourage or require firm-level public
disclosures (to provide transparency for investors) and/or
enhanced regulatory reporting (to provide transparency for
supervisors).
Such disclosures could
include, for example, risk characteristics of instruments, risk
exposures of market participants, valuation methods and
outcomes, and, off-balance sheet exposures including investments
with unregulated entities and contractual triggers that may lead
to the posting of collateral, claims payment, or contract
dissolution.
Supervisors should promote, in the
context of wider liquidity considerations, the appropriate and
timely disclosure of CDS data relating to price, volume, and
open interest by market participants, electronic trading
platforms, exchanges, data providers, and data warehouses.
With this greater transparency, supervisors should, to the
extent feasible, monitor concentrations that could pose systemic
risks. Such disclosure should be calibrated to avoid detrimental
impact on market liquidity.
Supervisors should develop
tools to conduct enhanced surveillance of CDS markets to detect
and deter market misconduct.
Recommendation n° 14:
Supervisors should continue to work together closely to
foster information-sharing and regulatory
cooperation, across sectors and jurisdictions, regarding
CDS market information and regulatory issues.
Supervisors should cooperate and exchange information on the
potential cross-sectoral and systemic risks raised by stress and
scenario testing of FG insurers.
Recommendation n° 15:
Supervisors should continue to review prudential requirements
for CDS and FG insurance and take action where needed.
This includes:
Setting appropriate regulatory capital
requirements for CDS transactions.
Establishing minimum
capital, solvency, reserving, and liquidity requirements for FG
insurers (including requirements for the use and actuarial
approval of internal models) with appropriate levels of surplus
to policyholders factored into these requirements.
Monitoring the exposure and concentration
of risk by FG insurers with reinsurers.
Requiring
firms to undertake aggregated risk analysis and risk management,
including counterparty risk arising from exposures via CDS or FG
insurance, as well as the potential effect of special-purpose
entities and other external vehicles that could affect a FG
insurer, so the insurer is not compromised by the failure of
such vehicles.
Applying robust counterparty risk
management arrangements, including requirements for all
important counterparties to post collateral to secure their
obligations.
Ensuring that the corporate governance
process of an FG insurer is commensurate with its risks.
Recommendation n° 16:
Supervisors should continue to promote current international and
domestic efforts21 to strengthen market infrastructure, such as
supervised/regulated CCPs and/or exchanges.
This should include encouraging greater standardisation of
CDS contracts to facilitate more organised trading and CCP
clearing, more clearing through central counterparties for
clearing eligible contracts, and possibly an evolution to more
exchange trading.
There should also be enhanced dialogue
among supervisors of CCPs regarding applicable standards and
oversight mechanisms for CCPs.
Recommendation n° 17:
Policymakers should clarify the position of FG insurance in
insurance regulation, if this is not already the case, so it is
clear that the provision of FG insurance is captured by
regulation and is subject to supervision.
Options to be considered
Among the more specific options that supervisors are
exploring or that may be explored in the future, are:
• Ring-fencing and protecting from the
potential losses of other business lines the traditional
business underwritten by FG insurers (eg wrapping municipal
bonds) so it is separately reserved and capitalised.
•
Prohibiting or limiting exposure by FG insurers to pools of
asset-backed securities that are partly or wholly composed of
other pools.
• Requiring FG insurers to set maximum
limits for exposure to any one risk or group of risks, such as a
particular counterparty or category of obligation, by reference
either to the aggregate exposure or to capital levels;
•
Limiting the notional value of aggregate exposures, either by
counterparty or by risk factor, in relation to levels of capital
or by other appropriate measure.
Chapter 1
Key differences in regulation across the banking,
securities, and insurance sectors
I. Introduction
International financial regulation is sector-specific as
evidenced by the independent development of core principles and
standards for the banking, securities, and insurance sectors.
Indeed, the BCBS, IOSCO, IAIS have each formulated core
principles for financial supervision in their respective
sectors.
To better understand the
differentiated nature of existing regulation in the three
sectors, the Joint Forum primarily focused on the key
differences in the core principles in each sector and drew upon
some of its previous works and analyses.
This
approach was chosen because the core principles reflect
characteristics of the respective sectors and the nature of the
supervised financial institutions, products, and markets.
Each sector’s core principles provide an overview of the key
elements of the supervisory system in that sector and help
explain the key objectives of supervision.
Despite
exposures to common risk factors and growing interactions among
the sectors, the Joint Forum’s comparison of core principles
found that significant differences exist in the nature of
international financial regulation among the banking,
securities, and insurance sectors.
The Joint Forum
found:
• Some of these differences
are warranted as they reflect intrinsic characteristics of the
three financial sectors, including the scope of their respective
responsibilities.
This type of difference is
particularly evident in the IOSCO core principles, as they not
only address the supervision of securities firms but also
markets, collective investment schemes, and disclosure by
issuers.
• Other differences in the
principles governing the supervision of banking, securities, and
insurance firms also are warranted, as they reflect intrinsic
differences in the core businesses conducted by firms in each
financial sector.
For example, technical provisions play a role in the insurance
prudential framework, but not for banking and securities.
• Some differences and gaps do not have any objective
justification and should be addressed.
Differences in
regulation across sectors tend to create supervisory challenges
as well as opportunities for regulatory arbitrage. Moreover, as
evidenced by the financial crisis, problems arising in any of
the three sectors can have an impact on overall financial
stability.
Addressing these key differences in
international regulation across sectors is necessary in order to
ensure a more stable financial system in the long run.
Greater consistency at a high minimum standard would thus
contribute to the reduction of systemic risk and to the overall
stability of the global financial system.
Since 2000, the
International Monetary Fund and the World Bank have been
assessing compliance with international regulatory and
supervisory standards (eg core principles) as part of the
Financial Sector Assessment Program.
In 2009, the Financial Stability Board created the Standing
Committee on Standards Implementation to conduct peer reviews of
countries’ compliance with international regulatory and
supervisory standards.
It is therefore important to keep
the core principles updated to take into account contemporary
developments.
II. Background and
approach adopted by the Joint Forum
In 2001, the Joint Forum performed a comparative analysis of
the core principles in the banking, securities, and insurance
sectors and published Core Principles, Cross-Sectoral
Comparison.
The objective was to identify common
principles and understand differences.
The Joint Forum
used an issues-based approach for this cross-sectoral comparison
because the structure and format of the core principles in each
sector are quite different.
This review identified:
• Substantial commonalities across sectors
despite the use of different formats, content and language.
• Intrinsic differences reflecting the different scope of
supervisory responsibilities in the sectors or differences in
the underlying businesses conducted by firms in each sector that
justify nonhomogeneous regulation.
• Significant
differences in regulation across sectors that do not reflect any
specific intrinsic characteristic and do not have any objective
justification.
Although each sector revised and
reissued its core principles since the 2001 review,
differences remain.
In
light of the financial crisis, the Joint Forum reassessed the
differences to determine whether they create regulatory gaps
that amplify risk to the overall financial system.
The
Joint Forum reviewed its other 2001 report, Risk Management
Practices and Regulatory Capital, Cross-Sectoral Comparison,
which confirmed some of the prudential issues identified in its
2001 core principles comparison.
While the
recommendations in this chapter focus on key differences, annex
3 summarises all changes in core principles since 2001. Annex 4
summarises key developments regarding differences in prudential
frameworks across sectors.
III. Key issues and
gaps
Commonalities in regulation across the sectors
The 2001 review of the core principles revealed substantial
commonalities across sectors, despite the use of different
formats, content, and language.
Differences have
decreased over time, reflecting the converging nature of the
businesses conducted in the three sectors.
The Joint
Forum found these commonalities:
•
Preconditions: All sectors see sound and sustainable
macroeconomic policies and well-developed public infrastructure
as preconditions to effective supervision.
•
The supervisory system: All sectors
consider customer protection and systemic stability as
objectives of the supervisory system. All sectors also recognise
the need for operational independence and adequate resources for
supervisors, and have the ability to apply supervisory
sanctions.
• The supervised entity:
All sectors require supervisors to have a regime for licensing
entities and vetting of key individuals and encourage sound
corporate governance within licensed entities.
•
Ongoing supervision: All sectors
require an effective system for monitoring, onsite inspection,
and cooperation with other supervisors.
•
Prudential standards: All core
principles describe criteria for capital adequacy, internal
controls, large exposure limits, accounting policies and
procedures, and risk management processes.
•
Markets and customers: All core
principles take some supervisory responsibility for the
prevention of financial crime.
Intrinsic differences in regulation across
financial sectors
The 2001 Joint Forum core principles comparison report noted
that some of the existing differences are warranted because they
reflect, in part, intrinsic characteristics of the three sectors
or of the firms supervised within each sector.
The 2001
report found:
• Differences in the
scope of responsibilities of supervisors in each sector, There
are many unique aspects in securities regulation reflecting the
broader scope of securities supervisors.
The
IOSCO core principles encompass the regulation and supervision
of securities firms and that of markets, exchanges, collective
investment schemes, and disclosure by issuers.
Principles that aim at preserving market integrity are only
referred to in the IOSCO core principles.
In contrast,
banking and insurance supervisors generally oversee financial
firms but not the markets themselves.
The core
principles in the banking and insurance sectors describe only
the framework needed to supervise financial institutions.
• Differences in the nature of the
underlying business activities conducted by firms within the
sectors.
This logically explains and justifies
some fundamental differences in the nature of their regulation.
One example 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 toward the valuation of technical
provisions as they are estimations of the cost of future
liabilities.
Misestimation of technical provisions can affect pricing
decisions and the overall solvency of the insurance company.
Differences that can contribute to
regulatory gaps
Because financial supervision and regulation is
sector-specific, differences have traditionally existed with
respect to the relative importance that supervisors place on
prudential or market conduct regulation across the three
sectors.
As the Joint Forum found previously, some of
these differences are not readily explained by intrinsic
differences among the sectors and have no other apparent
objective justification.
These differences pose
challenges to effective supervision and create opportunities for
regulatory arbitrage among the sectors, despite the increasingly
converging nature of the activities conducted within these
sectors.
In its 2001 cross-sector comparison, the Joint
Forum identified key prudential
differences that could not be readily characterized as intrinsic
differences among the sectors.
These differences
related to preconditions, cooperation and information sharing,
safeguarding of client assets, group-wide supervision, and
prudential standards for capital adequacy.
For this
report, the Joint Forum focused on two of these differences -
group-wide supervision and prudential standards for capital
adequacy - because these differences can lead to supervisory
gaps that can amplify systemic risk.
This report does not address all of the differences in core
principles and prudential standards that exist between the
sectors.
The Joint Forum believes that more work is
needed to identify and assess differences that can lead to
inconsistent supervisory approaches or
regulatory gaps.
Strengthening core principles
and prudential standards, with the aim of establishing
consistently high standards of comparable quality across
sectors, could reduce opportunities for regulatory arbitrage and
contribute toward a more stable financial system.
It is
also important to consider how supervisors implement key
principles and supervisory frameworks.
Differences at
the implementation level may impede fair, consistent, and
effective supervision and assessment of the financial sector in
general.
The implementation of a supervisory framework
can be influenced by a variety of factors, including differences
in the style or culture of supervision across sectors and
jurisdictions.
Although implementation was beyond the
scope of this review, the Joint Forum emphasises that partial or
inconsistent implementation of even near-identical prudential
standards of regulation and supervision can result in
significant differences in practice.
Strengthening the emphasis on financial
system stability in the core principles
The formulation of each sector’s core principles should
start with the observation that financial supervision and
regulation aims, in part, to maintain financial stability by
reducing the systemic risk posed by financial institutions,
markets and products.
The Joint Forum reviewed the core
principles to determine to what extent maintaining financial
stability and reducing systemic risk were taken into account in
each sector.
Although the core principles indicate that
supervisors from each sector consider the reduction of systemic
risk to be a key objective, differences exist with respect to
how this objective is made explicit 27
•
The 2006 BCBS principles state that
supervisors should “develop and maintain a thorough
understanding of the banking system as a whole” and the
“stability of the banking system.”
Further, they
state that “a high degree of compliance with the principles
should foster overall financial system stability.”
•
The 2008 IOSCO core principles state that
“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.”
IOSCO further notes that 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.
•
The 2003 IAIS core principles state that
“the key objectives of supervision promote the maintenance of
efficient, fair, safe, and stable insurance markets for the
benefit and protection of policyholders.”
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.
The principles recognise the financial
convergence of the sectors, and state that “supervisors and
regulators should understand and address financial and systemic
stability concerns arising from the insurance sector as they
emerge.”
Further, the 2008 IAIS by-laws explicitly state
that “the objectives of the Association are… to contribute to
global financial stability.”
The
relevance of financial stability was made apparent by the
financial crisis, as noted by the G-20 in its report Enhancing
Sound Regulation and Strengthening Transparency.
“As a
supplement to sound micro-prudential and market integrity
regulation, national financial regulatory frameworks should be
reinforced with a macro-prudential overlay that promotes a
system-wide approach to financial regulation and oversight and
mitigates the build-up of excess risks across the system.
In most jurisdictions, this will require improved
coordination mechanisms between various financial authorities,
mandates for all financial authorities to take account of
financial system stability, and effective tools to address
systemic risks.”
Each set of core principles draws
a link between financial stability and systemic risk.
The principles, however, do not expand on what is meant by
systemic risk and they do not make clear to what extent systemic
risk and financial stability play a role in the development of
regulatory frameworks and supervisory policies in each sector.
The Joint Forum concurs with the G-20 recommendation and
encourages the BCBS, IOSCO and IAIS to review and revise, as
necessary, their core principles to ensure that they
appropriately focus on a coordinated approach to reducing
systemic risk and maintaining the overall stability of the
financial system.
Reducing key prudential differences across financial sectors
This report analyses two key differences identified in 2001
that can lead to regulatory gaps and contribute to systemic
risk. They are:
• Differences in
group-wide supervision, and
• Differences across and
within sectors in applying capital standards.
These two prudential issues were explored in more detail in the
2001 Joint Forum report Risk Management Practices and Regulatory
Capital,Cross-sectoral Comparison.
Annex 4 of this
report summarises the main differences identified in that
report, as well as the key developments in those areas since
2001.
Differences in group-wide supervision
Effective group-wide supervision better enables supervisors
to capture and assess risks within a financial group
irrespective of the sector and entity, regulated or unregulated,
in which those risks arise.
In 2001, the Joint Forum
noted that the principles of group-wide supervision varied
dramatically in the three sectors and were applied in different
ways.
For example, only the BCBS core principles
emphasised the importance of group-wide supervision.
The
2001 report also noted that group-wide supervision was not
generally required in the insurance sector and that the IOSCO
core principles did not prescribe consolidated supervision.
It is important to recognise that,
since this comparative analysis was performed, the IAIS in 2003
introduced, among other things, the requirement that the
supervision of insurers be conducted on both an individual and a
group-wide basis.
Several aspects regarding
group-wide supervision indicate not only
actual inconsistencies in application of and emphasis on the
principle across the financial sectors.
They also
raise the issue of the supervisory challenges related to
assessing risks and activities conducted outside the perimeter
of regulation.
For example, the
existence of unregulated entities within financial group
structures pose significant challenges to the effectiveness of
supervision (such as with respect to the treatment of
unregulated holding companies).
Since the 2001
report was issued, developments in the financial markets have
highlighted the need for effective group-wide supervision
irrespective of whether groups conduct banking, securities, or
insurance activities or are well-diversified financial
conglomerates.
Furthermore, lessons
learned from the financial crisis have highlighted the key
importance of supervisors having a full view of all risks of and
entities within financial groups.
The complex
challenges relating to group-wide supervision, including the
supervisory gaps arising from the existence of unregulated
entities or unregulated activities within financial groups, are
explored and discussed in greater detail in Chapter 2 of this
report, together with associated recommendations for needed
improvements.
Differences - across and within sectors - in applying capital
standards
The Joint Forum’s 2001 core principles comparison noted that
the core principles of all three sectors specify that
supervisors should set capital requirements for supervised
entities.
However, differences in
capital frameworks exist in two respects.
First,
differences in capital requirements exist
within sectors, resulting in different rules being applied
across jurisdictions for entities undertaking similar
activities.
International capital standards are
expected to reduce the competitive
inequalities and pressures across countries and thereby the
possibilities for regulatory arbitrage.
The 2001
report noted that the BCBS has established an international
capital standard (the Basel Accord).
IOSCO and IAIS, by contrast, expect supervisors to promulgate
capital requirements, but they do not have a single
international capital framework for their respective sectors.
Only the BCBS core principles incorporate the requirement
for a uniform risk-based capital standard to reduce competitive
inequalities across countries and to safeguard financial
stability.
The IAIS has developed a set of high-level
standards and guidance papers on solvency assessment.
Despite developments in prudential regulation since 2001 (eg,
Basel II in banking, joint work by the BCBS and IOSCO on risks
arising from trading book activities, the development of the
Solvency II Directive for insurance
in the European Union, the IAIS Cornerstone project), the
observations made in 2001 by the Joint Forum with respect to
differences in prudential frameworks within sectors generally
remain the same: a uniform global framework exists only in the
banking sector, whereas different frameworks still coexist in
the securities and the insurance sectors at the international
level.
Second, differences in
capital requirements also exist across sectors, resulting in
similar risks being subject to different capital treatments in
each sector.
The BCBS and IOSCO core principles
expressly state that capital requirements should be risk-based.
The IAIS core principles state that insurance
supervisors are expected to take into account the size and
complexity of insurance companies, in addition to the risks
undertaken, in setting capital
requirements.
The Joint
Forum recognises that more consistency in prudential frameworks
for financial firms across sectors is desirable due to the
increasing exposure of financial groups to similar risk factors
and increasing transfer of risks across sectors.
However,
as a starting point to achieve more consistency across sectors
where needed, such as capital frameworks, it would be necessary
to first achieve more convergence of prudential frameworks
within financial sectors.
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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