Evolving risk based supervision in a globalised banking market 

Closing Seminar of the Eurosystem Cooperation Programme with the Bank of Russia on Banking Supervision and Internal Audit
Moscow, 30 March 2011
Dr. Jukka Vesala
Deputy Director General, Finnish Financial Supervisory Authority

Introduction

It is a tremendous honour for me to take part in this closing seminar of the Eurosystem Cooperation Programme with the Bank of Russia. The Programme has been a prime example of excellent international cooperation on banking regulation and supervision.

Authorities around the world have been seeking ways to improve the resilience of the banking system after the devastating experiences from the global financial crisis.  I would like to present today my views on what are the main lessons from the crisis to improve our future supervisory approach.

Sound business models need to be re-established by banks

I think it is well recognised that it was the negative evolution of banks’ business models that was at the heart of the emergence of the financial crisis. The first problem was the expansion of the “originate and distribute” banking model that made risks difficult to see and understand through complex securitisation transactions. The second was excessive reliance by banks on very short-term funding in financing long-term assets (i.e. extreme maturity transformation) and low level of core equity capital to absorb future losses (i.e. very high leverage).

Much has been done to contain unsound banking models through new and tougher regulation. Securitisation has been considerably reduced also for regulatory reasons, and the new Basel III rules will deal with the problems of excessive maturity transformation and too low level of core equity in banks. The extensive regulatory reforms are very much needed – but they only provide half of the answer, I think.

We need to focus on supervision as well

I would like to stress that effective supervision can be even more important in preventing financial crises than regulation and should receive more attention in the international debate. Regulation cannot guarantee sound behaviour by financial firms, for instance competent risk management. Ever tighter banking regulation can also encourage regulatory arbitrage by banks as well as sifting of risks into the unregulated parts of the financial system – the so-called shadow banking sector.  Supervisors will have a major challenge in keeping eye on the regulatory arbitrage such that the new regulation will actually become enforced.

The focus on adequate internal risk management and capital allocation on various risks was already one key element in the Basel II reform in its second Pillar. Having a comprehensive approach on all three Pillars of the Basel II reform in the Cooperation Programme on Banking Supervision with the Central Bank of Russia has in my view been a very useful one and has brought practical supervisory aspects into the scope of the cooperation as well. One of the key goals of the Programme has been to facilitate a move towards more risk-based supervision within the Central Bank of Russia.

What is good supervision?

Some answers to the key question – What is good supervision? – might be found by looking at the practices prior to the financial crisis and trying to learn from those mistakes. I think three shortcomings can be identified in the past supervisory practices.

The first was the “principle-based” or “light-tough” supervisory model adopted by some supervisors. One feature of this model was to guide in advance very little what banks do in practice and intervene in banks only after something went wrong. Another feature was limited ongoing monitoring of risks – e.g. by means of regular financial reporting. Costly supervisory and reporting burden was to be avoided. Not all supervisors followed the “light-tough” model and those that did are revising their strategies. In countries such as Canada, Italy, France and also Finland, I think supervisory controls were more effective already prior to the financial crisis and the worst was avoided.

The second shortcoming was failure to institute sound governance in banks. It turned out that some major institutions did not have effective view of the risks they took – let alone a clear choice of the desired level of risk taking and effective risk management to keep risks within desired limits. Different business operations were managed largely as independent profit units, without capability to consolidate the risks taken at the level of the entire group. Individual traders and business units may also have relied too much on complex models to price and manage risks. Stress tests were far from adequate and did not capture the major risks involved.

The third shortcoming was limited attention by supervisors on business and strategic risks. We were quite skilled in analysing single risk-types and the required capital charges under Basel II like credit and market risks, but we failed to see the risks involved in the entire business model.

I think that in a good supervision model there is much focus on on-site inspections, where supervisors actually verify what is stated in firms’ documentation and that governance and risk management arrangements are effectively put in operation. Supervisors need to intervene in a proactive way to provide guidance on sound arrangements and to limit major risks from building-up in advance. This would not mean taking over the responsibility of the management, but enforcing good governance.

The supervisory practices I have been talking about are quite challenging for supervisory authorities. They require ability to make judgements, for instance to analyse business and strategic risks and effectiveness of risk management. More sophisticated reporting and analyses are also needed – as well as high-quality staff in supervisory agencies. Attracting top-quality staff is maybe the biggest and the most important challenge of all.

Effective international cooperation needs to take place in supervisory colleges.

Another major challenge for supervisors has been the internationalisation of banks and the growth of the large cross-border financial groups that span several countries. Supervision would not work if authorities from different countries would operate in isolation.

Supervisory colleges are the tool to institutionalise the necessary cooperation. I would even like to talk about single supervision of the cross-border group in question by the college. The different home and host supervisory authorities need to have clear responsibilities, but much can be achieved through actually conducting supervisory activities jointly – such as joint on-site inspections and joint assessment of risks and capital adequacy of the group and its different entities. Nordic cooperation in the supervision of Nordea Group has longer than 10 years of experience and has demonstrated the benefits of seamless work together on a day-to-day basis in the context of a supervisory college.

The Committee of European Banking Supervisors (CEBS) – a body that preceded the new European Banking Authority (EBA) – has done a lot of work to develop the work of the European supervisory colleges. The latest piece of work was the detailed guidance on Joint Risk and Capital Adequacy Assessment published in January 2011. EBA will need to continue the development of the practical functioning of the colleges. Similar efforts are also underway at the global level.

International good supervisory practices should be developed

The new European Supervisory Authorities should assume responsibility to develop and enforce good supervisory practices. This requires avoiding exclusive focus on regulatory development, and sufficient resources and independence to foster good supervision. Global standards will also play a useful role in developing supervisory practices. The G20 and the Financial Stability Board have recently talked about improving supervision, which is a welcome development.

Well-functioning micro-macro cooperation also needed

One of the main lessons from the financial crisis was also that we will have to pay much closer attention to the risks taken in the macro-economic expansion phase and make sure that, at the same time, adequate financial buffers are created to withstand the risks and sound banking models are maintained.  Supervisors will also have to look at the developments at the level of the entire financial system. One institution may look all right in relation to others, but the whole industry may be accumulating huge concentrated risk positions.

The crisis has shown that central banks’ macro-prudential supervision has lacked tools to mitigate systemic risks. In practice, the most important avenue for macro-prudential concerns to result in corrective action is to work through micro-prudential regulatory and supervisory standards. Conversely, macro-prudential analysis can be of great significance for micro-prudential supervisors.

Hard separation of the two functions might lead to a situation in which neither central banks nor supervisory authorities would be able to perform their functions satisfactorily. Having the prudential supervision of banks and other institutions conducted within or closely linked with central banks would overcome this separation. At the European level, very close cooperation with the newly created European macro- and micro-prudential bodies – the European Systemic Risk Board and the European Supervisory Authorities – needs to be established.

Learning from each other

I hope I have been able to highlight in my remarks today the importance of focusing adequately on good supervisory practices and avoiding exclusive focus on regulation. In this area international work to develop standards and practices should be stepped-up at European and global levels in my view.

We should learn not only from the past mistakes in supervision that contributed to the recent financial crisis, but also learn progressively from each other. Much can be learned by for example comparing on-site inspection practices with supervisory colleagues from different countries. This Cooperation Programme has also been in essence – I think – learning from each other.

Thank you for your attention and I wish the best continuation of your work here at the Bank of Russia. And thank you for hosting this excellent event today.

 

20.5.2011