The challenges of financial regulation and supervision

Financial crises are endemic. As soon as the last one is curtailed, the next springs up. With money came speculation; with speculation, financial crises became part of our lives. Central banks exist in part because of these crises. Take the Federal Reserve. America had no central bank until 1907 when series of events including an earthquake, a market scam and an investment bubble led to a banking collapse that proved that the American economic system was fragile and prone to failure. A bank to prop up all the others in times of stress was needed and so the Fed came into being. Today, central banking structure is a global trend. Financial regulation now flows down from the Bank of International Settlement (the bank that sets Capital Adequacy Requirements) to its member central banks and then to the private banks in each country.

It is well documented that recessions that are associated with banking crisis tend to have much more severe macroeconomic impact – they tend to last twice longer, be twice intense, and account for four times cumulative output loss. This underscores why the financial industry stability is now a priority of every government. The fundamental weaknesses in the functioning of the financial market such as information asymmetries, moral hazard and principal agency problems are well known. However, the main ingredients of banking crises are bad banking, inadequate market discipline, weak banking regulation and supervision, and inadequate macroeconomic policies relating to financial liberalization.

In theory, central banks should use regulatory and supervisory authority to stamp out excesses in specific market while leaving monetary policy to take care of inflation and employment. According to an IMF staff position note, “To have the ability to act, bank supervisors must possess sufficient legal authority and resources, a clear strategy and strong working relationship with other regulators. To have the willingness to act, supervisors must have a clear mandate, operational independence, accountability, skilled staff and a healthy relationship with the banking industry that is still distant enough to avoid regulatory capture (in which the regulator identifies more strongly with the regulated than the public interest).” History suggests this is easier said than done. The recent financial crisis has shown that widespread regulations often fail to prevent systemic risk despite the obvious advantages of the regulators; the resources of the state, the backing of the law, access to confidential information and moral authority.

The big question is: do central banks really have the instruments to address the mandate of financial stability? Several factors limit their regulatory and supervisory effectiveness, especially in the developing world. Many regulators are worse paid and in some cases less qualified than the elite professionals they are supposed to regulate. In most countries, the compensation structure of national bank examiners and supervisors are in adherence to civil service and public servants pay structure that is often characterized with low salary, no bonus and small rewards for doing a good job. It is a common adage that ‘the smartest people go where the money is’. In this case, it is the banks and not the agencies who regulate them that attract the best brains. The implication is that for banking regulation to get better, the problems of flawed incentives in the public sector, especially in regulatory institutions, need to be addressed. Unfortunately, it is impossible to raise public sector salaries to the level of the private sector.

Nearly all banking rules are subject to and heavily reliant upon informed judgment by the supervisors. Even the much-touted Risk Based Supervision (RBS) approach relies heavily on the ability of both bank supervisors and risk managers at individual banks to make sound judgment. Determining whether, when and what action should be taken remains necessarily a discretionary process. The paucity of this sound judgment in the face of the complex realities of the present-day financial industry explains the reason why effective banking supervision has remained elusive. Unfortunately, curtailing supervisory discretion is not feasible unless policymakers are willing to raise minimum capital and liquidity requirements to the extent that it would have dire consequences for credit intermediation and job growth.

Policies are made by real people with political and personal interest to protect. Anytime the effectiveness of a profession is hinged on its ability and willingness to exercise sound judgment, the likelihood that vested interests – the industry, politicians, and the regulatory authority itself – can influence the decision-making process is high.

When central banks are subject to political control, they are unable to demand prompt corrective action and there is greater leniency for violating Banking Supervision Core Principles such as the prudential requirements. This lax supervision ultimately paves the way for weak banks to remain in the system thereby imposing systemic risk to the industry. It is an open secret that sometimes supervision fails not because the rules were flawed but simply because the regulators are captured. It is therefore not uncommon to see the best regulatory framework replaced with the second best because of the baffling world of politics.

Supervisors are prone to capture because they interact with the banks on daily basis. Chances are therefore high that they would either empathize with the performance pressure that these banks continually face or collude with them for personal gratification in the course of the supervision. Unfortunately, the harsh economic reality in most developing countries has greatly reduced the ability of their regulators to resist corrupt practices.

When there is a regulation, there is evasion. Human beings have a remarkable talent for getting around rules – including the rules they try to impose upon themselves. As technology advances, new opportunities for cheating are also created. And the banking industry is a market leader in technology deployment. The industry is equally notorious for fraudulent financial statements and all forms of market manipulations.  Bankers are known to be capable of working their way around the best laid rules. Madoff’s case in America illustrates the limit of laws in banking regulation.

In the developing nations, even the top executives in the private sector often lack detailed information they need to rein in their own trade. Regulators will struggle to do any better. Missing, inaccurate or insufficient data are realities in this industry. This means that there is a fundamental problem in relying on policy decisions formulated from these data. This may leave the industry with rules that everyone knows cannot be met given the changing macroeconomic landscape. The unintended consequence is the creation of the culture of non-compliance and its associated regulation failure.

Globalization has made most economies more exposed to external shocks as their rising openness to trade and financial flows creates wider channels for cross-country spillovers of shocks. It is much harder now for a central bank to use monetary policy instruments such as interest rate changes to attain domestic objectives. The recent financial crisis has demonstrated the difficulties of macroeconomic management in a globalising world. Even as government and central banks acted with an unusual show of policy force, they were unable to get the situation under control because of the interconnectedness of the financial system and the effects, positive or negative, of external developments on domestic policy actions. Slack oversight by one country can spread chaos across countries. All these forces have culminated to increase the burden on monetary policy which ultimately weakened the effectiveness of central banks.

A good policy comes from an intuition honed by working with both the simple theoretical models and the big models. However, we know with 100 percent certainty that we cannot know everything. Given that the financial system’s fallibility is not in doubt, its regulation is also bound to be fallible. Consequently, many causes of financial system breakdown will continue to remain beyond the reach of any reform. The specific event that triggers financial crisis will remain unpredictable.

Ejike Nwolisa