Going Beyond the Rules

Some countries with similar financial and regulatory systems fared differently during this crisis. What are the reasons for this? And what made some financial institutions with similar business models, and in the same country, better equipped to deal with the virulence of the crisis?To find the answers, we need to ask the following question: How well did the four key components of a sound financial system―good regulation, effective supervision, robust risk management, and credible resolution mechanisms―perform?

A lot of attention has been paid to improving regulation, the first key component. Sweeping changes are being proposed through new and enhanced rules of the game, such as higher capital, loan loss provisions, liquidity buffers, and limits on executive compensation. I believe that corresponding changes are also needed in the other three components if a crisis of this magnitude is to be avoided in the future.

-Comprehensive approach to resolution will have preventive elements such as requiring derivatives to be traded through centralized counterparties (photo: Chris Hondros/Getty Images)

The second key component is the quality of financial sector supervision. Supervisors monitor both how well regulations are implemented and the quality of internal risk management systems in regulated firms. If deemed inadequate by the supervisors, firms must be required to take corrective action. For this to work, supervisors need clear mandates, operational independence underscored by public accountability, adequate resources, and first-hand knowledge of their firms. Their approach must include a sufficient degree of on-site and off-site work. In addition to firm-specific vulnerabilities, they should also capture systemic risks―distinguishing the forest from the trees. They must have the authority to bring about a wide range of remedial actions. These actions should be primarily rule based, so that supervisors can withstand pressures to “forbear,” but the rules should also allow for the exercise of supervisory judgment.

The third key component, risk management systems in financial institutions, should identify emerging vulnerabilities. Supervisors should test the quality of these systems and provide guidance on how they expect risks to be managed. They have to follow up by periodically drilling deep into the firm’s risk management functions to test their effectiveness. Even with these systems in place, the primary responsibility for ensuring robust risk management systems rests with the boards of directors of financial institutions, which are the foundation of firms’ internal defense mechanism. The board should determine the risk appetite of the firm, nurture the appropriate risk culture with internal incentives, and assure that the firm does not take on excessive risk―a role that many boards have not played well in this crisis.

Orderly breakup

The fourth key component is the resolution mechanism to deal with nonviable firms, particularly those that are deemed systemically important and insolvent. A comprehensive approach to resolution will have several elements. The first would be a ”preventive” element that ensures a more robust infrastructure, such as requiring derivatives to be traded through centralized counterparties to limit the consequences of financial institution failures. A second element would be the requirement by systemically important institutions to develop a plan for an orderly breakup and dismantling of group structures. This is called a “living will.”  A third element would be a ”special resolution regime” applicable to regulated institutions whose failure could have systemic implications. These elements become even more important when systemically important institutions have a cross-border presence. Harmonizing resolution internationally could well be the last bastion to fall in this battle.

In my view, the policy agenda needs to target each of these four key components if a balanced outcome is to be achieved. If any one of the four is weak, then the foundation on which the global financial system stands becomes inherently unstable. While much of the emphasis so far has been on improving regulation, I am convinced that we need to be mindful of the other three components to keep instability at bay.

Originally published at iMFdirect and reproduced here with the author’s permission.