Achieving Effective Supervision by deafeningbuzz


									Reserve Bank of Australia Bulletin
Achieving Effective Supervision                                                  December 1997

                         Effective Supervision

Talk by the Chief Manager, Bank Supervision
Department, Mr B.L. Gray, to the 10th Annual     Issues
Australasian Finance and Banking Conference,
Sydney, 5 December 1997.

                                                   As a preliminary, I should make the obvious
Introduction                                     point that the new arrangements are not
                                                 starting from scratch (or worse, starting with
                                                 a financial system which is in trouble, or a
                                                 regulatory system which is deficient). The new
  By the middle of 1998, legislation
                                                 arrangements build on a well-functioning
permitting, a new regulatory agency will come
                                                 system, but seek to adapt it to expected future
into existence. It will reflect the Wallis
                                                 developments. The task is to take over the best
Committee’s call for a more integrated and
                                                 features of the current approach, to continue
consistent approach to prudential supervision
                                                 the kind of adaptive evolution which has
and regulation, geared towards a rapid pace
                                                 occurred, and to tailor the existing institutions
of change in the financial system and an
                                                 more precisely to achieve a snug fit with the
increasing prevalence of financial
                                                 demands of a fast-changing financial sector.
conglomerates. APRA, the Australian
                                                 It is never possible to achieve perfect
Prudential Regulation Authority, will combine
                                                 congruence         between        institutional
the banking supervision functions of the
                                                 arrangements and multi-dimensional needs,
Reserve Bank with the activities currently
                                                 but there is now a new opportunity to re-align
carried out by the Insurance and
                                                 institutions and methods. The various
Superannuation Commission. On present
                                                 objectives will not flow automatically or easily,
plans, the new agency will be supplemented
                                                 however, from creating a single prudential
in the middle of 1999 by inclusion of the
                                                 regulator. So there is some point in offering
supervisory functions of AFIC (the supervisor
                                                 some thoughts, as the Bank passes on the
of building societies and credit unions). With
                                                 baton to the next runner, urging them to run
the Wallis Committee’s recommendation on
                                                 the good race. In that spirit, let me offer the
this accepted by the Government, the key
                                                 following comments.
challenge now is to put in place the new
arrangements to achieve a flexible regulatory      First, I will touch on the issue of flexibility.
system focusing on both the prudential           There can be a tendency for regulators
soundness of the financial system and,           covering a wide institutional field to become
importantly, financial system efficiency.        more highly bureaucratic than those with a

Reserve Bank of Australia Bulletin                                                 December 1997
narrow focus. A legalistic, accounting-based       feel that they do not have to be accompanied
approach to regulatory matters can emerge          by their lawyer.
over time. Why is that the case? The answer is        There is every reason to believe that this
relatively simple. Big institutions by their       objective can be achieved if it is kept in mind.
nature tend also to be complex institutions.       A noteworthy feature over the past five or so
The simplicity, flexibility and innovation that    years has, in fact, been the increasing trend
is often the hallmark of a smaller entity can      internationally towards ‘market friendly’
fade with size. This view should not be            approaches to supervision. One example of
especially controversial for it applies to most    this trend in Australia is the development of
organisations and institutions – it is why the     the on-site visit programs to banks, covering
small to medium business sector is often           first credit risk and, more recently, market risk.
viewed as the engine for growth and                Such developments can be described as
employment in the economy. It is why mergers       market friendly not because they have led to
of smaller businesses into large corporates        any easing of prudential standards, but
often fail to deliver the expected benefits.       because they reflect an approach to
   Sometimes large regulators also have large      supervision that aligns itself more to the way
rule books which are often written into            that banks themselves think about and address
legislation. The rationale is usually that this    risk. Rather than requiring banks to provide
approach is more consistent with the notion        reams of standardised statistical data on, say,
of the level playing field, with everybody in      the health of their credit portfolios, the
the market knowing the rules of the game.          approach has been to reach in to the
There is often, also, a strong sense that          information and data that the individual banks
supervisors should not be permitted to make        have developed for their own credit risk
arbitrary judgments on policies or supervisory     management purposes, and to examine the
approaches. Policy is policy and should be         systems and controls in place to measure and
applied to the letter of the law until it is       manage the risk. The same approach applies
changed. It is an approach that is                 in relation to the supervision of traded market
administratively tidy. Yet, there is also a big    risk in banks and, in theory, could apply to all
cost, for as soon as you proceed down that         other forms of risk facing financial institutions.
legalistic path, flexibility can disappear.           By taking that path, the supervisory burden
   Regulatory rule books can, of course, always    on institutions is reduced, supervisors get
be rewritten and legislation changed where         better information than could otherwise be
circumstances warrant but the time scales          obtained and, through closer interaction
involved in achieving change through that          between the bank and the supervisor, the
channel can be measured not in days or weeks       result is a much improved understanding
but sometimes in terms of years. The history       between the two parties. It should be
of the Capital Adequacy Directives in the          recognised, however, that it is also a more
European Union is compulsory and sobering          difficult approach to adopt and can make
reading for anyone who might question this         consistency of treatment across institutions
view.                                              harder to achieve. It is not as tidy as the
   In developing APRA, therefore, it will be       traditional approach. It requires supervisors
important to keep those dynamics firmly in         to know more about the businesses they
mind. The financial system of the future will      supervise. It is also an approach that, possibly,
require an increasingly flexible and               may be at odds with the natural inclination of
quick-footed approach to prudential                some supervisors or regulators to stay quite
supervision and one of the key challenges will     removed from the activities and institutions
be to ensure that the regulatory system meets      they monitor. The outcome of the preferred
that need. Financial institutions should be able   approach, however, is a much better balance
to get a quick answer when they come to the        between prudential objectives and market
regulator with a proposal. They should also        efficiency.

Achieving Effective Supervision                                                    December 1997
   As we look to the future of the financial        characteristics of the various institutions or
system, and to the development of prudential        the products they offer. APRA should work
standards over time, there is no doubt that         hard to spell out the boundaries between
this approach of utilising institutions’ own risk   financial instruments offering capital
measurement and management systems, and             guarantees and the market-linked returns
of requiring the management and Boards of           found more frequently in the superannuation
institutions to vouch for the adequacy of those     area. Those distinctions are likely to remain
systems, must be the way forward.                   over the long term. It will be important to
   As mentioned earlier, the Wallis proposals       ensure that any confusion in the mind of the
for a single prudential supervisor also turned      investing public between these product
very much on the idea that the process of           boundaries is not accentuated by the presence
financial intermediation, and financial services    of a single prudential authority covering
more generally, was blurring and becoming           banking and superannuation.
less distinct. The implication is that the            I want to say something about supervisory
supervision of different types of financial         philosophy because, ultimately, I think it is
entities should be more consistent and              the key to achieving effective supervision.
integrated within a single agency. There are a      Whether it is in relation to the style of
couple of dimensions to this. At the simplest       supervision, or the policies applied, or the
level, while the broad policies applying to what    approach to integrating supervisory
we currently define as banks and building           arrangements across different types of
societies can be reasonably aligned, the            institution, the model has to be forward
supervisory approach adopted and the                looking and innovative. I would summarise
techniques applied to an intermediary with a        all this by saying that APRA should be very
balance sheet of $150 billion will be quite         much a policy-driven, not process-oriented,
different from the situation where a balance        agency. Analytical effort is central to the task,
sheet of $50 or $100 million or less is involved.   which will require it to invest in a significant
I think that point is well understood.              financial research capability. That last point
   Integrating supervisory approaches applied       will come as a surprise to some who would
variously to deposit-takers or intermediaries,      not normally associate supervision and
traditional forms of insurance and                  regulation with a strong research focus.
superannuation will be very complex. There          Research, policy and good supervision are
is a real opportunity, however, for APRA to         inextricably linked. I would go as far as to say
smooth out some of the regulatory                   that in a dynamic financial system, supervision
inconsistencies which currently exist between       is likely to be ineffective and generate
banks and insurance companies especially.           significant financial inefficiencies unless it is
Not all of these inconsistencies will be capable    backed up by high-level research and
of being ironed out, simply because of the          analytical effort focusing on broad
nature of the different sorts of businesses         developments in the structure of the financial
conducted by banks and insurance companies.         system, trends within financial institutions,
The practical task will be to look for the areas    financial markets and the interconnections
of commonality between deposit-takers and           between them. The characteristics of emerging
insurance businesses especially, and develop        financial products and instruments need to
consistent policy where it is possible. That        be understood and leading edge work must
should be an early priority for the new             be done in the area of risk measurement and
regulatory agency.                                  management and in the modern finance
   The new framework should handle                  theories which increasingly underlie
conglomerates more neatly than at present,          developments in this field.
but bringing different institutions under one         Only by carrying out work of this nature
regulatory roof should not be allowed to            can supervisors be attuned to emerging
disguise differences in underlying                  developments in the system and be capable

Reserve Bank of Australia Bulletin                                                   December 1997
of responding accordingly. Only through an           applied to other forms of risk (credit risk,
emphasis on research, and the spreading of           operational risk, etc.) and to institutions other
the resulting work into the closely related          than the banks. APRA should have the
policy area, and then into the operational sides     capability to deal with those eventualities.
of the institution as a whole, that you can
guarantee that supervisors will be credible in
the eyes of the people they deal with day-to-        Conclusion
day – the supervised institutions. There is a
good deal of evidence to back this view. Come
the end of this year, the Reserve Bank will be
one of the few banking supervisors                      I will conclude with the thought that there
internationally to implement the internal            is now a very strong commitment within the
models approach to traded market risk. The           Australian regulatory community to APRA
reason I believe we will be in a position to do      and to ensuring that it becomes a first-rate
so links back to the research work carried out       prudential supervisor capable of handling the
on market risk, financial instruments, evolving      issues likely to be confronted within the
risk methodologies, and so forth, over the past      financial system over the next decade. Success
four or five years. Some overseas supervisory        as a prudential supervisory agency will not
agencies that have not devoted resources to          flow solely, however, from the reorganisation
market related analytical and research               of functions between the current set of
activities are lagging the field. The problem,       prudential regulators. Rather, it will be a
of course, is that the institutions they supervise   product of the development of an
are not lagging, the effect being that regulatory    appropriately flexible market-oriented
arrangements are holding back the market and         philosophy within the new authority. A
creating inefficiencies.                             dynamic, policy-driven institution, feeding off
  As I mentioned a little earlier, these             strong research capabilities which, in turn,
approaches we have applied to traded market          feed into equally robust operational areas, will
risk, involving the use of sophisticated models      achieve the objectives set for it by the Wallis
and reliance on more rigorous risk                   Committee and the Government.
management frameworks, will come to be


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