Regulatory Framework

Jeff CarmichaelChairman

Australian Prudential Regulation Authority

APRA

Topics for The Session

Contributions & risks from NBFIs

Effective regulation:

Powers

Rules & Regulations

Internal Practices & Procedures

Regulatory Structure

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Financial Services

• Payments services• Liquidity• Divisibility• Store of value• Information efficiencies• Risk pooling

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NBFI Roles

• Broaden spectrum of risks• Encourage savings and investment• Foster risk management• Enhance systemic resilience• Fill the gaps• Provide competition for banks

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Empirical Evidence

Growing evidence that:

• Financial development contributes to economic development

• Contribution is increased where NBFIs are involved

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Sources of Risk from NBFIs

1. NBFIs can circumvent the intention of banking regulation, eg Asian experience

• Thai finance companies

• Hire purchase in Malaysia

• Korean Merchant Banks & ITCs

Plus:

• Pseudo-banks in Latin America

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Sources of Risk from NBFIs

2. NBFI associations with banks through conglomerates, eg Asians again

• Korea and Indonesia

• State banks in Australia

• Latin America also

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Community Expectations

o Market conduct:

– Policemen role– Severity of penalties less important that likelihood

of being caught

o Prudential:

– Doctor role– Prevention rather than prosecution

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Characteristics of Prudential Regulation

1. Intervention is graduated:

– Breaches are a warning– Process involves cooperation

2. Regulators are not infallible:

– The process increases risk– No regulator can guarantee no failures

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The Road to Effectiveness

• Stronger powers• Stronger policies• Stronger internal practices and processes

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Powers - Conduct & Prudential• Licensing• Information• Examinations• Investigations• Standards/regulations• Administrative sanctions• Directions• Prosecution

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Prudential Powers• Ownership & Control• Appoint experts• “Whistleblower” provisions

• Statutory management/inspector• Transfers of business• Liquidation

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Australia - Prudential Powers

Banks Life Insurers

General Insurers

Pensions

Licensing Y Y Y P

Standards Y Y Y N

Appoint External Expert N Y Y N

Ownership & Control Y N Y N

Statutory Management Y Y Y Y

Directions Y Y Y N

Investigation N N N N

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Solvency Vs Risk

Australian Insurance Act 1973 – Capital set at greater of:• $2 million• 15% of OCP• 20% of Premium IncomeNew framework (2002) requires:• More capital for higher risks• Capital for asset risks

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Dangers of Over-Prescription

US Vs International Accounting standards

Same issue in Prudential Regulation

Prescription leads to:o Legalistic responseso Questions of who is responsibleo Inflexibility

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Australian Changes

• New risk-rating system• Escalation procedures• Wide circulation of high-risk assessments• Dealing with informants• Greater enforcement orientation

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Priorities

• Start with internal practices and processes• Push your laws to the limit• Never miss an opportunity to push reform• Learn from failures and from each other

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Objectives of Regulation

Ultimate Goals

• Efficiency• Fairness• Safety• Stability

Market Failures• Anti-

competitive behaviour

• Market misconduct

• Information asymmetry

• Systemic contagion

Regulatory Actions• Anti trust• Anti collusion• Disclosure• Education• Financial law enforcement• Governance• Licensing• Capital adequacy• Liquidity• Risk management• Failure management• Macro economic policy• Payment system

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Approaches to Structure

• Industry: Separate agencies for each industry group

• Pure form: One agency for each group but responsible for all 4 market failures

• Objectives: Separate agencies for each market failure

• Pure form: One agency for failure but responsible for all institutions

• Reality: Nearly all are hybrid

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The Traditional Industry Approach

Pressure from:• Convergence in financial markets and the emergence of financial conglomerates

• The need for greater regulatory neutrality

• Better use of scarce regulatory skills and resources

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Rationale for Integration

1 Aligns the regulatory structure with the industry structure

2 Resource efficiencies

3 Maximize regulatory neutrality

• Integrated regulation is objectives-based

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Choosing Among Structures

There is no single regulatory structure that is ideal for all countries and for all points in time

Ultimately a matter of judgement

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The Pure Objectives-based Model

• Case for:– Maximizes regulatory focus– Minimizes cultural clashes– Reduces confusion about safety nets

• Case against:– Still requires inter-agency cooperation– Resolution of conflicts can be a problem

• Responses:– Resolution mechanisms– Clear demarcations– Higher level of aggregation of objectives

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Combining Prudential & Conduct

• Case for combining:– One umbrella regulator for all parts of conglomerates– Bigger and more powerful agency– Can resolve regulatory conflicts internally

• Case for separation:– Cultural clashes– Loss of focus - from multiple objectives– Potential misperceptions about the safety net– Failure in one area can erode credibility in others

No definitive answer but most so far have elected to combine

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Combining Prudential & Systemic

• Case for combining:– Synergies in systemic stability regulation– Last resort lending needs knowledge of banks– Avoids crisis management by committee– C banks are more independent and better staffed

• Case for separation:– C bank with 2 objectives - loss of focus– Supervisory staff not always equal C banks– C banks lack the expertise for NBFI regulation– Cultural clashes

Most have elected not to combine so far

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Latin American Structures

COUNTRY Structure Structure No.

ARGENTINA Institutional Institutional 7

BAHAMAS Institutional Integrated 5

BARBADOS Institutional FSA 4

BOLIVIA FSA NBFI 2

BRAZIL Institutional Other 1

CHILE NBFI Total 19

COLOMBIA Integrated

COSTA RICA FSA

ECUADOR Integrated

EL SALVADOR Integrated

GUATEMALA Integrated

HONDURAS FSA

JAMAICA NBFI

MEXICO Banks & Securities

NICARAGUA FSA

PANAMA Institutional

PERU Integrated

TRINIDAD AND TOBAGO Institutional

VENEZUELA Institutional

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What Does IR Really Offer?

o Integrated regulation does not:Automatically correct regulatory failures(though it can contribute)

o Integrated regulation does:• Help with conglomerates• Reduce regulatory arbitrage• Make better use of scarce resources

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Regulatory Neutrality

• Simply putting different regulators together is not enough

• ‘Integration’ needs:• An integrated staff structure

• A harmonized set of powers and Laws

• A common approach to standards

• A common approach to analysis and inspection

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Regulation by Risk

5 Fundamental Risk Types:• Credit risk

• Market risk

• Insurance risk

• Liquidity risk

• Governance (operational) risk

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Conglomerate Regulation

• Integration eliminates “turf” wars

• Single set of definitions (controllers, affiliates etc)

• Consistent set of powers across industry groups

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Summary

NBFIs offer risks and rewards

Risks need sound regulation

NBFI regulation in the region is underdeveloped

Areas for improvement: Powers

Policies

Practices & procedures

Extracting the benefits from integration is a big challenge

Regulatory Framework

Jeff CarmichaelChairman

Australian Prudential Regulation Authority