Description
First, it reports on the state of implementation of financial regulatory standards across banking, insurance, and securities sectors in a select group of Fund member countries.
*Prepared by an MFD team of staff and experts led by David Marston and Udaibir S. Das
INTERNATIONAL MONETARY FUND
Financial Sector Regulation: Issues and Gaps
Prepared by Staff of the Monetary and Financial Systems Department*
Approved by Stefan Ingves
August 4, 2004
Contents Page
Glossary .....................................................................................................................................3
Executive Summary...................................................................................................................4
I. Introduction and Background.................................................................................................6
II. Implementation of Regulatory Standards..............................................................................9
A. Framework for Analysis............................................................................................9
B. Implementation Overview.......................................................................................10
C. Cross-Sectoral Regulatory Weaknesses ..................................................................14
D. Factors Explaining Implementation Weaknesses ...................................................18
III. Strengthening Regulatory Standards..................................................................................23
A. Diversity of Financial Systems ...............................................................................23
B. Cross-Sectoral and Cross-Border Issues .................................................................26
C. Objectives and Design of Regulatory Standards.....................................................30
IV. Issues Going Forward........................................................................................................31
V. Issues For Discussion..........................................................................................................35
References................................................................................................................................36
Table
Regulatory Standards: Areas Posing Problems in Cross-Sector Implementation ...................23
Figures
1. Regulatory Standards: Average Implementation by Main Components .............................12
2. Regulatory Standards: Average Implementation by Country Type.....................................13
3. Rule of Law and Implementation of Standards ...................................................................21
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Boxes
1. Regulatory Standards .............................................................................................................8
2. Financial Regulation and its Four Main Components .........................................................10
3. Preconditions and Linkages with Regulation ......................................................................19
4. Regulatory Implications of Dollarization and Government Ownership..............................25
5. Regulatory Implications of Conglomeration and Internationalization ................................27
6. Cross-border Regulatory Cooperation .................................................................................29
Appendices
I. Income Level, Financial Deepening, and Standard Implementation...................................38
II. Regulatory Standards: Main Gaps and Suggested Response..............................................40
Appendix Tables
1. Correlations: Income Level, Financial Deepening, and Sector’s Implementation ..............39
2. Implementation by Regulatory Categories. .........................................................................39
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GLOSSARY
AML-CFT Anti-money Laundering-Combating the Financing of Terrorism
BCP Basel Core Principles
BCBS Basel Committee for Banking Supervision
FSAP Financial Sector Assessment Program
FSSA Financial System Stability Assessment
FSF Financial Stability Forum
GDP Gross Domestic Product
IAS International Accounting Standards
IAIS International Association of Insurance Supervisors
ICP Insurance Core Principles
IFRS International Financial Reporting Standards
IOSCO International Organization of Securities Commissions
MOF Ministry of Finance
MoU Memorandum of Understanding
OFC Offshore Financial Centers
ROSCs Reports on Observance of Standards and Codes
SROs Self-Regulatory Organizations
- 4 -
EXECUTIVE SUMMARY
This paper addresses issues in financial sector regulation from two perspectives. First, it
reports on the state of implementation of financial regulatory standards across banking,
insurance, and securities sectors in a select group of Fund member countries. Second, it
raises issues relating to the design of these three sector standards, arising from the
implementation experience and the evolving structure of financial systems. In this regard, the
paper identifies a few emerging regulatory risks and some cross-sectoral issues that may
warrant further guidance by standard setters.
The implementation of regulatory standards is broadly satisfactory, on average, but
masks underlying issues. There are also important variations in implementation across
countries. For the majority of countries, prudential rules and regulations that create an
enabling regulatory framework are in place. Significant weaknesses exist, however, in actual
regulatory practices. The variations are observed particularly in areas related to regulatory
sanctions and enforcement of laws, regulatory independence and legal protection of
regulators, and financial integrity and safety net arrangements.
Several factors help explain the implementation shortcomings. The sound policy and
operating environment required for effective regulation is not always present. A range of
non-prudential considerations, often leading to regulatory forbearance, is another factor. This
is particularly the case in financial systems with state-owned financial institutions. In several
instances, regulators face a dilemma of having to balance the objectives of prudential
regulation aimed at a safe and sound financial system, with the polices and objectives of
other initiatives. Lack of human and financial resources often leads to faulty implementation.
Ongoing structural changes in the financial sector are posing a challenge for regulators.
The Financial Sector Assessment Program (FSAP) reveals a growing integration not only
across the various types of financial institutions, but also cross-border financial integration in
Asia, Europe, and the Western Hemisphere, and in the recent period in Africa. These
developments highlight the need for closer and more systematic monitoring of cross-border
contagion risks, and of opportunities for regulatory arbitrage.
Implementation also suffers from a lack of clarity and practical guidance in some key
regulatory areas. The standard setters have been revising regulatory standards. However,
they typically focus on separate lines of financial activities, rather than on the treatment of
system-wide regulatory issues. The standards also assume the existence of legal, institutional,
and policy conditions (“preconditions”) that are not directly under the control of the
regulator, and which are often undeveloped in many countries. Differences in the treatment
of similar elements (preconditions, methods of regulation, capital, and information sharing)
among the standards also make implementation more difficult.
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To strengthen regulatory systems, countries should be encouraged to provide greater
attention to regulatory preconditions, cross-sector and cross-border information
sharing. This will enable them to bring their regulatory regime into alignment with the
evolving structure of the financial systems and the associated risks. Efforts at strengthening
regulatory regimes could be combined with periodic reviews of the regulatory objectives,
governance framework, resources, and financial infrastructure on a system-wide basis. This
is particularly important as regulatory agencies are moving towards more sophisticated risk-
based regulatory techniques.
The standards setters could support this by advancing the work on the required
preconditions, possibly incorporating them into the standards. This could be done by
taking into account the implementation experience and the emerging structural trends.
Additional guidance could also be considered on issues relating to cross-sector regulation,
regulatory governance, corporate governance, and public disclosure. Such guidance should
explicitly consider the regulatory implications of the diversity of financial systems across
countries.
The staff proposes to help address the issues identified in this paper, in close
cooperation with country authorities, standard setters, and international organizations
including the World Bank. The aim is to ensure that the regulatory framework is
implemented in a manner consistent with international practices, yet flexible enough to allow
market development and innovation. This will also help inform on issues that have general
relevance to the FSAP, and the standards and codes initiative. Specifically, consideration will
be given to strengthening the coverage of regulatory preconditions and practices in the
context of its ongoing surveillance work. This will be in line with the ongoing effort to
strengthen the coverage of financial sector issues in Fund surveillance. Staff will also
continue to distill from ongoing surveillance and technical assistance research, issues relating
to financial regulation. It proposes to provide the Board with periodic reviews on issues in
financial regulation and their effect on financial stability.
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I. INTRODUCTION AND BACKGROUND
1. Financial sector regulatory standards comprise the essential, though minimum,
principles for well-functioning regulatory systems (Box 1).
1
The assessment of the quality
of institutional and regulatory structures forms an integral part of the overall assessment of
the financial sector carried out under the FSAP, which has emerged as the main international
framework for financial sector standards implementation work.
2
The Joint Bank-Fund
international standards and codes initiative provides the overall context for the work relating
to financial sector standards.
3
Over 150 regulatory standard assessments have been
completed so far in 67 countries where the FSAP evaluation has been completed.
4
2. Good quality regulation is a key element of financial stability. Regulation,
financial stability, and macroeconomic vulnerabilities are interconnected.
5
Financial system
strengths and vulnerabilities critically depend on the design, practice, and implementation of
regulatory systems. The assessments of financial systems against standards in the FSAPs are
used to identify regulatory strengths, risks, and vulnerabilities and to assist country
authorities to prioritize policy and operational reforms.
3. The assessments are based on the internationally adopted regulatory standards
using the assessment methodologies prescribed by the standard setters. Evaluations of
regulatory systems in the FSAP involve the participation of practicing regulators from central
banks, ministries of finance, and regulatory agencies. This approach offers member countries
a “peer review” of their national regulatory systems. Fund staff has been providing periodic
feedback to the standard setting bodies on the assessment experience with individual
standards as reflected in the recent revisions to the insurance regulatory standard and the
securities standard assessment methodology.
1
Standards covered in this paper are (i) Basel Core Principles (BCP) for Effective Banking
Supervision; (ii) International Association of Insurance Supervisors (IAIS) Core Principles; and,
(iii) International Organization of Securities Commissions (IOSCO) Objectives and Principles for
Securities Regulation. The three standards are included in the 12 areas endorsed by the Board in 2001
and 2002 as being useful to the Fund’s operational work.
2
See SM/03/77 for the most recent reviews of the FSAP. Assessments of regulatory systems in
offshore financial centers (OFC) are also carried out under the OFC Program (See SM/04/92 for a
recent update).
3
See SM/03/86 for the most recent review of progress in implementing the initiative.
4
For ease of reference, the term “regulation” is understood to include supervision.
5
Some components of standards provide information on the core dimensions of financial stability.
These include regulatory infrastructure, effectiveness of regulation, and macroprudential surveillance.
In banking and insurance sectors, the assessment information is contributing indirectly to the
surveillance by informing on the reliability of reported financial soundness indicators (See
SM/03/176).
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4. This paper first reviews the implementation of financial sector regulations in
36 Fund member countries based on the findings of FSAPs completed from 2000–2003.
These are countries where regulatory systems have been assessed in three sectors—namely,
banking, insurance, and securities.
6
The second part of the paper discusses some issues
regarding the standards themselves in light of the implementation experience. It takes
into account the regulatory challenges posed by financial conglomeration and
internationalization of finance, and structural factors such as dollarization and state
ownership of financial institutions. The paper also suggests steps for further strengthening of
regulatory standards to take account of these developments and structural factors.
5. A cross-sectoral approach to the review of standards implementation has been
chosen to identify common regulatory vulnerabilities.
The need for a cross-sectoral view
is heightened by the increasingly complex ways through which financial risks are managed
by banking, insurance, and securities firms. These often erode the effectiveness of the
traditional arrangements for regulatory oversight. However, a cross-sectoral analysis should
keep in mind that standards seek to achieve similar, but not uniform objectives. Even where
sectoral lines are blurred, technical complexities remain within each sector. Thus, while
parallels may be evident in implementation weaknesses, their impact across the financial
system may differ.
7
The divergence in regulatory focus also explains, in part, the varying
relative importance of factors such as sound macroeconomic policies to the regulation of
each sector.
6. This paper is a first effort at a broader review of issues in financial regulation,
including implementation and adequacy of regulatory standards.
8
It is a work in
progress, as more experience and knowledge is gained with assessments of regulatory
systems under the FSAP. Work in this area is a cooperative endeavor involving the Fund, the
Bank, country authorities, international experts, and the standard setting bodies. Thus, going
forward, a cooperative approach will continue to be required involving all the relevant
stakeholders. The staff intends to report periodically to the Board on issues related to
6
In addition, assessments of the three sectors were also carried out in another six jurisdictions under
the OFC program. These assessments are not considered in this paper.
7
For example, prudential deficiencies and confidence in the financial condition of firms can have a
different impact on banks than on securities intermediaries and insurance companies. Moreover, for
securities regulators, the primary emphasis is on investor protection and market efficiency
considerations—relying more on disclosure, market discipline, and a sound legal and accounting
framework. In the banking and insurance sectors, regulators focus primarily on an institution’s ability
to meet its obligations to depositors and policyholders, with some attention in banking to systemic
stability.
8
Individual reviews of financial sector regulatory standards have already been reported to the Board.
These indicate substantial room for improvement in individual standards and the assessment process
itself (See SM/01/266, SM/02/121, SM/01/266, and SM/04/92).
- 8 -
financial regulation and its implications for financial stability, including developments
relating to regulatory standards.
Box 1. Regulatory Standards
Regulatory standards represent the minimum requirements for good practice in financial regulation in
individual sectors. These comprise of Basel Committee’s Core Principles (BCP) for Effective Banking
Supervision (September 1997) and the accompanying methodology (October 1999), IOSCO’s
Objectives and Principles of Securities Regulation (IOP) (September 1998) and the accompanying
methodology (September 2003), and the IAIS’s Insurance Core Principles and Methodology (ICP)
(October 2003). Each standard is accompanied by a methodology providing detailed guidance on steps
to be taken or requirements to be met which are specific enough to allow a relatively objective
assessment of the degree of observance.
The standards for the most part are written in general terms, thereby offering a degree of flexibility in
implementation to suit country circumstances. In several cases, however, the methodologies tend to be
prescriptive and set forth specific requirements. The standards’ framework also includes supporting
documents covering topics relevant to each sector, such as accounting, disclosure and transparency,
capital adequacy, information sharing, and risk management. Some of them spell out the practical
application of the standards within a more narrowly defined context—for example, the Basel
Committee's Sound Practices for Loan Accounting, IOSCO’s Operational and Financial Risk
Management Control Mechanisms for Over-the-Counter Derivatives Activities of Regulated Securities
Firms, and IAIS’s Supervisory Standards on Licensing.
As presently drafted, the primary purpose of the standards is related to the regulation covering individual
institutions. In March 2000, the Joint Forum set up a working group to compare the standards issued by
the Basel Committee, the IAIS, and IOSCO by identifying common principles and understanding
differences where they arose. Each standard provides an overview of the key elements of the supervisory
regime in that sector at the time they were written. Notwithstanding different objectives served by the
three standards, no evidence has been found of an underlying conflict or contradiction between the three
sets of standards at the highest levels. There are numerous areas of common ground (e.g., authorization,
organization of supervision, and intervention). However, in some cases variations were identified in the
application of similar principles (e.g., different capital treatment of similar risks in different sectors).
There are differences among the standards —some arising from intrinsic differences between the three
sectors and others not readily explained in this way. Variations are found in preconditions, group-wide
supervision, cooperation and information sharing, safeguarding of client assets, and application of
uniform prudential standards.
Sources: Financial Stability Forum, www.fsforum.org; The Joint Forum, 2001
- 9 -
7. The remainder of the paper is organized as follows. Section II discusses the
implementation record across sectors, focusing on the principal components of the regulatory
standards. Section III reviews the main areas for strengthening implementation; and
Section IV presents corresponding recommendations for improving implementation and
strengthening regulatory standards. Section V then lists the issues for discussion. An
accompanying Background Paper covers details of the implementation record, structural
features and trends in financial systems, and work underway by the standard setters.
9
II. IMPLEMENTATION OF REGULATORY STANDARDS
A. Framework for Analysis
8. The analysis of implementation experience focused on the main regulatory issues
relevant from a financial stability viewpoint. For this purpose, the regulatory standards were
grouped into the following four main components, broadly based on the Joint Forum
framework (2001) (see Box 2 for the list of principles included in each regulatory component):
• Regulatory governance, which refers to the capacity of the regulatory bodies to
make decisions without interference and to formulate, implement, and enforce sound
regulatory policies and practices.
10
• Prudential framework, which comprises the rules, directives, and regulatory
requirements that set forth the structure to govern the operations of financial firms.
• Regulatory practices, which refer to the practical application of the prudential
framework.
• Financial integrity and safety net arrangements, which refers to the regulatory
policies and instruments designed to promote fairness and integrity in the operations
of financial institutions and markets, and the provision of safeguards for depositors,
investors and policyholders, particularly during times of financial distress and crisis.
9
Financial Sector Regulation: Issues and Gaps—Background Paper.
10
A recent IMF staff working paper shows that regulatory governance has a significant influence on
financial system soundness (See Das, Quintyn, and Chenard, 2004).
- 10 -
Box 2. Financial Standards and their Four Main Components
Regulatory Governance 1/
• Objectives of regulation
• Independence and adequate resources
• Enforcement powers and capabilities
• Clarity and transparency of regulatory
process
• External participation.
Prudential Framework 2/
• Risk management
• Risk concentration
• Capital requirements
• Corporate governance
• Internal controls.
Regulatory Practices 3/
• Group-wide supervision
• Monitoring and on-site inspection
• Reporting to supervisors
• Enforcement
• Cooperation and information sharing
• Confidentiality
• Licensing, ownership transfer, and
corporate control
• Qualifications.
Financial Integrity and Safety Nets 4/
• Markets (integrity and financial crime)
• Customer protection
• Information, disclosure, and transparency.
1/ Includes BCP 1 and 19; ICP 1; IOP: 1,2,3,4,5,6, and 7.
2/ Includes BCP 2,3,4,6,16,17,18,20,22,23,24, and 25; ICP 2,3,4,5,12,13,15,16, and 17; IOP 8,9,10,11,12,13, and 29.
3/ Includes BCP 5,6,7,8,9,10,11,12,13, and 14; ICP 6,7,9, and 10; IOP 17,18,20,21,22,23,25, and 27.
4/ Includes BCP 15, and 21; ICP 11 and 16; IOP 14,15,16,19,24,26,28, and 30.
For this paper, the allocation of insurance principles are based on the 2000 IAIS standard.
9. Using the framework outlined above, the record was reviewed in 36 countries to
distill the level of implementation of various regulatory standards. The sample of
countries consisted of 10 industrialized countries, 12 emerging market countries, and 14
developing countries.
11
Financial systems in these countries show considerable diversity
across dimensions such as ownership, financial depth, degree of concentration, competition,
efficiency, and openness. In 12 of the sample countries, regulation across sectors was carried
out by integrated financial agencies. The arrangements ranged from a regulatory agency
overseeing all or a combination of sectors, to the central monetary authority being
responsible for cross-sector regulation. In almost all cases, however, regulation was
continuing to be carried out along sectoral lines, including the regulatory treatment of cross-
sector issues.
B. Implementation Overview
10. Drawing upon detailed data from individual assessments, indicators were
constructed measuring the level of implementation for each of the four main regulatory
components across countries and standards.
12
Although the precise terminology differs,
11
In terms of regions, there were 3 countries from Africa, 4 from Asia, 21 from Europe, 6 from the
Middle East and Central Asia, and 2 from the Western Hemisphere.
12
Additional details on the implementation record can be found in Section II of the Background
Paper.
- 11 -
all three standards classify the level of implementation of individual principles into four
categories, denoted for the purposes of this paper as compliant, largely compliant, broadly
compliant, and noncompliant. Each of the categories was assigned a numeric value from 4.0
(compliant) to 1.0 (noncompliant). A simple average of the regulatory principles was
calculated for each of the four regulatory components, implying that individual regulatory
principles were given equal weight in the resulting indicator. Simple averages were also used
to aggregate the indicators across countries and across standards.
11. Potential statistical problems with the sample need to be kept in mind while
interpreting the results. The results reflect the financial sector landscape of the assessed
countries and, while suggestions about representative behavior may be advanced, the
relatively small size of the sample has to be acknowledged.
13
Also, the potential sample
selection problems are a reason for caution. First, the FSAP is a voluntary exercise,
potentially inducing self-selection of higher performers. Second, the 36 countries included in
the sample went through assessments of all three sectors, that is, their insurance and
securities markets were deemed important enough to warrant a formal assessment along with
the banking sector.
14
12. Overall, the results show that for the majority of countries, the average level of
implementation of the four regulatory components, across sectors, is broadly
satisfactory in terms of the technical criteria under the regulatory standards.
The data
suggest that the level of implementation has been rather even across the four main
components. The average implementation of all four components falls between 2.8 and 3.3
on the above-mentioned scale (Figure 1). The prudential framework and regulatory practices
components display a slightly stronger level of implementation than regulatory governance
and financial integrity and safety net arrangements. At the same time, the implementation of
the latter two components exhibits a relatively higher degree of variation across countries.
13. Implementation of standards in industrial countries is better than in emerging
markets and developing countries (Figure 2).
15
The average implementation in industrial
countries reached 3.6, on the 1.0–4.0 scale. Industrial countries thus were relatively close to
full implementation. Emerging markets lagged behind, with average implementation slightly
over 3.0, as did developing countries (2.9). Appendix Figures 1 and 2 confirm that the overall
13
It is worth noting that the sample includes over half of the completed FSAPs.
14
These countries therefore tend to demonstrate relatively more developed financial systems. This is
irrespective of the level of economic development, which may increase the average reported level of
implementation. The latter point also likely contributed to relative over-representation of European
countries in the sample.
15
In the case of banking, data also shows that financial strength of banks is generally lower in
developing countries, and by and large this is associated with weaker implementation of the BCPs. In
several cases, though, institutions remain financially weak despite a higher degree of implementation
of banking standards.
- 12 -
levels of implementation across sectors and components are positively related to both income
levels and financial deepening.
14. Furthermore, the levels of implementation across sectors are correlated. On
average countries tend to display relatively similar levels of implementation in all sectors
(Appendix Table 1). Also, the variation in implementation levels is substantial and greater
for developing countries and emerging markets than for industrial countries. Thus, the
average figures mask a substantial variation in individual country performance.
Figure 1. Regulatory Standards: Average Implementation by Main Components
1/ 2/
3.32
3.26
3.06
3.09
2.76
3.25
2.96
2.91
3.23
3.01
3.31
3.05
1.0 1.5 2.0 2.5 3.0 3.5 4.0
Regulatory Governance
Regulatory Practices
Prudential Framework
Financial Integrity and Safety Net
Assessment Grade (error bars indicate minimum and maximum observations)
IOSCO
IAIS
BCP
1/ Includes 36 countries.
2/ Grades Structure: 4=Compliant, 3=Largely Compliant, 2=Broadly Compliant, 1=Noncompliant. The higher the grade,
the higher the compliance level. For core principles included in each of the four categories, see Box 2.
15. High levels of implementation are noted particularly with respect to the legal
foundation for the regulator. In the case of industrialized countries, most regulators have
adequate powers of inspection and investigation, providing for independence and
accountability of actions, and over half utilize such powers effectively. Although the level of
implementation drops in emerging and developing markets, the basic elements of an
appropriate legal structure for regulatory agencies are generally observed to be in place, with
additional needs for further strengthening of the legal and regulatory framework, particularly
in terms of independence of agencies and clarity and consistency of regulatory powers.
- 13 -
Figure 2. Regulatory Standards: Average Implementation by Country Type
1/ 2/
3.61
2.90
2.72
3.47
3.09
2.87
3.60
3.07
2.98
3.57
3.06
2.85
1.0 1.5 2.0 2.5 3.0 3.5 4.0
Industrial
Emerging
Developing
Assessment Grade (error bars indicate minimum and maximum observations)
Regulatory Governance Regulatory Practices Prudential Framework Financial Integrity and Safety Net
1/ Includes 36 countries.
2/ Grades Structure: 4=Compliant, 3=Largely Compliant, 2=Broadly Compliant, 1=Noncompliant. The higher the
grade, the higher the compliance level. For core principles included in each of the four categories, see Box 2.
16. In the prudential area, broad capital, solvency and margin requirements have
been prescribed across sectors. Financial reporting requirements have been established,
with regulatory reporting at least quarterly, and audited financial statements required on an
annual basis. Legal powers and a broad range of sanctions against problem financial
institutions exist, although banking and insurance regulators continue to have limited
discretionary powers and in many cases, the power can only be exercised by the government.
17. The licensing process and designating minimum entry standards came across as
being adequate in most countries, but more so in industrial and emerging countries. In
industrialized countries, the regulatory framework for self-regulation is also seen as having a
relatively high level of implementation. This is an indication that in most countries,
particularly those with larger and more complex markets, the regulatory regimes make
appropriate use of outside participants in the regulatory process (such as auditors, actuaries,
and Self-Regulatory Organizations (SROs)), which have some oversight responsibilities for
their respective areas of competence. However, a wide variety of operational and legal
arrangements relating to the use of third-parties makes the quality of implementation difficult
to assess.
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C. Cross-Sectoral Regulatory Weaknesses
18. The implementation record, although relatively strong in terms of technical
compliance with regulatory standards, also suggests that regulatory weaknesses exist in
several areas.
16
Implementation does vary in practice, across both standards and the four
regulatory components. Even though prudential frameworks and some aspects of regulatory
practices are well established and supported by a range of technical guidance from standard
setters, implementation of the other regulatory components is strongly conditioned by
country-specific factors. The main issues within each of the four regulatory components are
set forth below.
Regulatory governance
19. The main weaknesses relate to regulators’ independence, regulatory objectives,
and governance arrangements between the regulator and self-regulatory organizations.
• Regulatory agencies frequently lacked both formal and informal independence
from political and industry influence. In banking, one-third of the countries in the
sample had deficiencies in this area, while in one-quarter of the countries the
securities regulator lacked operational independence.
17
Similarly in insurance, lack of
independence from the Ministry of Finance (MOF) was a major issue—mainly in
developing countries, where over half of the sample countries exhibit poor
implementation.
• In many cases where formal independence had been granted to the regulator,
the accountability arrangements were ill-defined. Lack of accountability often led
to a lack of clarity and predictability in rule-making and enforcement. Accountability
and transparency are necessary corollaries to independence and affected the
credibility of the regulatory process.
• In some countries, different categories of deposit-taking institutions—
commercial and savings banks, cooperatives, and credit unions—were regulated
under different laws and often also by different regulators. This often led to
differences in the regulation of similar financial activities and instruments, resulting
16
Twenty-nine out of the 36 countries in our sample published their FSSAs and financial sector
ROSC modules. These, along with other published FSSA/ROSCs are available on the www.imf.org
webpage, and provide country specific information. See also the Background Paper (Appendix II of
Section I) for examples of some country specific weaknesses in banking area found during the FSAP
evaluation.
17
For the securities regulators, the principal issues concerned appointment and tenure of the Board of
the agency, reliance on government appropriations for funding purposes, and inability to influence the
legislative and regulatory framework pertaining to the role and responsibilities of the agency.
- 15 -
in arbitrage opportunities and competitive distortions between different types of
regulated institutions.
• Regulatory forbearance is a problem in some countries. The incidence of
regulatory forbearance or delays in adequately addressing financial system problems
suggests that there may be some negligence in the regulatory attitude or that the
regulatory governance framework is weak. The problems are compounded if the
regulators are not immune from being sued for carrying out regulatory functions and
if they fear to intervene in the absence of absolute proof.
• Despite some regulatory regimes making use of SROs, oversight responsibilities
were frequently ill-defined. The governance arrangements between the insurance
and securities SROs and the regulatory agencies show several accountability and
transparency deficiencies. Over a third of the countries were found to need more
clearly defined responsibilities for the securities SROs, as well as better arrangements
for cooperation and information exchange between the regulator and SROs. Similar
problems were found to exist in the case of the insurance sector.
• Other recurring cross-sector issues. Legal protection of regulators remains weak
(e.g., an issue in one-third of the sample countries for banking regulators). Similar
problems relate to clarity of regulatory powers, organization of the regulator, and
remedial and enforcement powers.
Regulatory practices
20. Actual regulatory practices on the ground are less robust than envisioned in the
regulatory standards, weakening the effectiveness of regulation. In most cases laws and
rules were in place. However, weaknesses were found in many cases in the conduct of
regulation, such as those relating to enforcement, consistent application of rules and laws,
and the effective and timely application of regulatory powers. These weaknesses result in risk
factors remaining unidentified or unaddressed. The main vulnerabilities across sectors relate
to the following issues:
• Consolidated supervision and regulation over all parts of a financial group—
(domestic and foreign) remain weak and ill-defined. Consolidated supervision was
not effectively implemented in broadly one-third of the countries. In particular,
consolidation of accounts and consolidated monitoring of prudential standards were
in need of improvement.
• Regulatory data and reporting shortcomings were recurrent across countries.
Financial information requirements were not comprehensive enough and, in some
cases, consolidated reporting was not a requirement. In some emerging market
countries, insufficient use was made of the data received, resulting in weaknesses in
the level and regularity of market surveillance.
- 16 -
• Powers to enforce regulations and impose sanctions were limited. Even where
powers were adequate in the emerging and developing countries, primary deficiencies
were identified in the areas of post-inspection investigation and enforcement.
Remedial measures were either not being implemented or delayed. In banking, the
ability to take effective remedial action was insufficient in around one-third of
countries. In some cases this was not as a result of weak laws and regulations, but due
to forbearance. In the securities sector almost half of developing countries
demonstrated significant weaknesses in the implementation of sound enforcement
practices.
• In the context of host country regulation of foreign institutions, cooperation
between home and host country regulators were frequently found to be
inadequate. Taxes, accounting standards, investment restrictions, or capital adequacy
requirements that differ across countries may create regulatory arbitrage opportunities
warranting cross-border collaboration. In banking, where this issue is particularly
important with a view to the implementation of Basel II, around one-fifth of countries
had insufficient arrangements in this area.
• Regulations did not fully address changes of control of regulated firms. For
instance, in around one-quarter of the countries examined, bank regulators had no
clear definition of control on which to base their assessments, and in some cases, fit
and proper criteria could not be applied to controlling shareholders.
Prudential framework
21. A strong focus on prudential regulation was evident across countries and sectors.
The objective is to ensure that prudence is exercised in assuming and managing risk. While
the regulatory focus has moved toward ensuring that financial strength and soundness of
financial firms are maintained, a few recurrent shortcomings remained:
• Substantial deficiencies were found in the monitoring and oversight of country
risk. Despite the presence of foreign banks, insurers and securities firms, and
internationally active financial conglomerates, one-third of the evaluated countries
had not fully developed regulatory systems in this area. Half of the emerging market
economies were assessed to have insufficiently implemented regulations related to
country risk.
• Regulatory requirements relating to connected lending or related party
transactions were insufficient. Approximately one-quarter of the sample countries
did not have adequate definitions of what constitutes a related party. Where legal and
definitional clarity was missing, the enforcement of financial groups was weak.
• A significant weakness across sectors relates to the prudential requirements
concerning corporate governance. This was particularly weak for the banking and
insurance sectors. In insurance, two-thirds of all the sample countries exhibited
substantial weaknesses, with emerging markets and developing countries showing
- 17 -
problems more frequently. Also in this area, weaknesses in consolidated supervision
led to deficient practices with regard to corporate governance.
• Sector specific issues: The following were also deficiencies in areas unique to each
sector:
- Credit risk management. In banking, a serious concern relates to credit risk
management. Almost half of the countries reviewed had deficiencies owing to
insufficient guidance with regard to credit risk management, loan classification
and provisioning, large exposures and country and transfer risk.
- Asset quality. In insurance, one-third of all sample countries (and the majority
of developing countries) demonstrated weak regulation of asset quality, and 60
percent of developing countries insufficiently supervised reinsurance practices of
insurance companies.
- Capital. Deficiencies with regard to the monitoring and inspection systems
ensuring compliance with capital and prudential requirements were found in
approximately one-quarter of the assessments.
- Collective investment schemes. In relation to collective investment schemes,
around one-third of securities assessments identified the need for enhancements
to the provision of information concerning scheme eligibility requirements.
18
A
similar number of assessments recommended that regulators address weaknesses
in the mechanisms in place to calculate asset valuation and pricing of units in
collective investment schemes.
Financial integrity and safety net
22. With respect to financial integrity and safety net practices, the regulatory
approaches differed greatly and largely followed sectoral lines. The implementation
levels across sectors also differed and revealed the following weaknesses:
• Content and timeliness of disclosure was a common issue across all countries. In
emerging markets, about a third of the sample countries demonstrated particular
weaknesses in continuous disclosure requirements.
18
Eligibility requirements in this context relate to the regulator’s role in imposing minimum standards
of conduct prior to commencement of marketing an investment scheme, including the honesty and
fairness of scheme operators, human and technical resources, diligence and effectiveness, and
operator-specific power and duties in the investment process. In many of the assessments, assessors
noted that several of these aspects were either lacking or needed to be enhanced through better
guidance to schemes.
- 18 -
• Protection of minority shareholder rights was another area of concern, with less
than half of all developing countries and only around two-thirds of emerging market
countries having the necessary regulatory framework in place.
• Accounting and auditing problems appeared in most countries across income
groups. In securities markets, the assessment of issuers indicated that approximately
one-third of the countries sampled had gaps in the application of International
Financial Reporting Standards or IFRS (formerly International Accounting Standards
or IAS). The audit function was also weak in at least one-quarter of countries
assessed, with assessors concluding that greater oversight of accountants and
auditors—at an independent level—was desirable.
• Procedures for orderly winding up of failed insurers and securities firms were
absent in a significant number of countries sampled. Approximately a third of
those countries were assessed as having inadequate insolvency and bankruptcy
regimes. In addition, improved mechanisms for addressing default risk and market
disruption more generally were needed in these and other jurisdictions.
• Anti-money laundering efforts were weak in many of the countries sampled
across income groups. For instance, under the banking and insurance standards, one-
quarter of the countries exhibited serious deficiencies, primarily in the so-called
know-your-customer rules.
D. Factors Explaining Implementation Weaknesses
23. The assessments suggest that several factors typically impede the
implementation of regulatory standards. This issue becomes particularly significant when
viewed in light of the fact that the regulatory standards represent the minimum requirements
of a good regulatory system.
Regulatory preconditions
24. Regulatory preconditions play an important role, and implementation problems
often arise in countries where regulatory prerequisites are weak (see Box 3). Although
not part of the formal standards framework, regulatory preconditions consist of the general
policy and environmental conditions and institutional infrastructure essential for effective
regulation. Weaknesses in regulatory preconditions can impede the regulator’s ability to
fulfill the regulatory objectives. Regulators, in general, have limited ability to change these
preconditions directly but may be able to take steps to compensate for some of the
deficiencies.
25. The sound policy and operating environment required for effective regulation is
not always present. Notably the absence of sufficiently strong legal and accounting
frameworks and resources often pose problems. While such factors may be outside the
authority of regulators, few regulators attempt to alert appropriate domestic authorities of any
- 19 -
material weaknesses. Regulators are also reluctant to prescribe enhanced requirements and
other safeguards to compensate for precondition-related weaknesses.
26. Evaluations carried out in conjunction with financial stability analysis under the
FSAP reveal several precondition-related vulnerabilities.
19
• Legal aspects such as inadequate financial legislation and bankruptcy laws and
difficulties in judicial foreclosure processes are affecting regulatory practices.
There are also other issues, such as insufficient segregation of client assets, which
should, if fully implemented, protect the clients in the event of failure of a market
intermediary, and poor enforceability of legal obligations. These inadequacies
obstruct the use of sanctions, timely corrective action, and winding up of insolvent
firms. They also affect market conduct practices.
19
In the insurance area, the IAIS has taken a significant step forward by incorporating the basic
conditions for good insurance regulation as the first principle of its recently revised regulatory
standard.
Box 3. Preconditions and Linkages with Regulation
Recent assessments of implementation of financial sector standards, as well as a survey of published financial
sector ROSCs found a number of countries that did not have the regulatory preconditions in place.
There are
important linkages between preconditions and effective regulation that are often missed. Though not part of the
formal framework, standards are premised on the existence of preconditions and a number of commonalities
exist.
• The precondition of “sound and sustainable macroeconomic policies” has the most significant impact on
the prudential elements such as the adequacy of capital, interest rate risk, foreign exchange risk and
other market risks.
• The presumption of a “well-developed public infrastructure” affects the regulatory elements related to
asset valuation, supervisory powers, enforcement, exercising rights against collateral, licensing, and
accounting frameworks.
• “Procedures for resolving problem institutions” and “appropriate levels of systemic protection or safety
nets,” have a bearing on the principles related to market disclosure, market conduct, corporate
governance, and the enforcement of corrective actions.
Where these preconditions are weak, it should not be surprising that implementation in the related area of the
standards is also compromised.
1/
For instance, major shortcomings in accounting and auditing may prevent
regulators from effectively monitoring the financial position of financial firms. Similarly, the absence of
appropriate procedures for problem bank resolution may make regulators helpless when action to restore
stability is needed. Information on the preconditions can also be derived from the assessment of other standards
(such as, accounting and auditing, and corporate governance) where available.
1/ For another discussion of the role of external circumstances similar to preconditions, such as effectiveness of
government, and control of corruption see Kaufmann, Kraay, and Mastruzzi (2003).
- 20 -
• Weak accounting standards and the absence of a high-quality audit profession
are affecting the quality of regulatory reports and disclosure. Many countries also
face a scarcity of qualified financial analysts and actuaries—a situation which often
results in unreliable regulatory and financial information.
27. The relationship between preconditions and implementation can be illustrated
by the positive correlation between the rule of law index and average implementation.
As the assessments do not provide enough information for quantitative work, the index of
rule of law compiled by Kaufmann, Kraay, and Mastruzzi (2003) was used to illustrate the
importance of preconditions in Figure 3 below.
20
The data show a clear positive relationship
between rule of law and the average level of implementation of standards. However, the level
of preconditions observance—the rule of law index as well as other governance indicators
like overall government effectiveness—is also positively correlated with the level of income
across countries.
21
Further research will be needed to disentangle the interaction between
income level and regulatory preconditions and their relevance for standards implementation
and performance of the financial sector.
Other country-specific factors
28. The level of financial development is a factor explaining uneven implementation.
Countries with very limited resources face a particularly difficult challenge in addressing
competing priorities and may not know how to build the requisite institutional and regulatory
infrastructure. Moreover, given the size and depth of the market, certain components of the
standards may have little relevance to a country’s circumstances. Both of these factors lower
the overall implementation rate. Also, regulators in such systems face very different
challenges from those in well-developed financial systems.
20
The cited reference is an update of previous work by Kaufmann, Kraay, and Zoido-Lobaton (KKZ
indices). The rule of law index includes perceptions of incidence of crime, the effectiveness and
predictability of the judiciary, and the enforceability of contracts.
21
In our sample, the correlation coefficient between the rule of law and income was 0.84 and the
same indicator for government effectiveness and income stood at 0.85.
- 21 -
Figure 3. Rule of Law and Implementation of Standards
R
2
= 0.53
2.00
2.20
2.40
2.60
2.80
3.00
3.20
3.40
3.60
3.80
4.00
-2.00 -1.50 -1.00 -0.50 0.00 0.50 1.00 1.50 2.00 2.50
Index of rule of law
L
e
v
e
l
o
f
i
m
p
l
e
m
e
n
t
a
t
i
o
n
Average implementation
Linear (Average implementation)
29. A range of “public policy considerations” to the regulatory process leads to
regulatory forbearance and impacts implementation. Assessments reveal that pursuit of
multiple regulatory objectives and public policy considerations results in a range of
regulatory forbearance practices. Some examples follow:
• Capital adequacy measures are often loosely applied to promote indigenous banks, or
are unreliable due to weak loan classification and provisioning practices.
• Breaches of large exposure limits or other asset concentration guidelines are often
tolerated, for instance, in cases of undiversified economies where there are few
creditworthy borrowers.
• Loan loss recognition may be deferred in response to problems in systemically
important institutions.
• Withdrawal of licenses are often delayed for extended periods in spite of serious
solvency problems.
- 22 -
30. Financial systems with predominantly state-owned financial institutions are
particularly susceptible to many of the weaknesses identified above. State-owned banks,
insurers, and investment firms have generally been subjected to lighter supervision than
privately owned firms. Frequently, regulators nominally have the requisite powers, but are
hindered in taking adequate action, due to government involvement in the operation of state-
owned financial institutions.
22
31. An overarching theme affecting implementation at the country level relates to
human and financial resources. Insufficient regulatory resources and, in some instances, an
acute shortage of required skills within the country—such as actuaries, accountants,
commercial lawyers, and finance professionals—often impede the adoption of good practices
and the achievement of regulatory objectives. Insufficient numbers and quality of staff often
affect not only the capacity to apply the rules as intended, but also issues such as operational
autonomy, respect of the regulator by market participants, and the ability to stay abreast of
new developments in markets.
32. In some cases, implementation has suffered due to resistance on the part of the
industry. Efforts at bringing the regulatory framework into observance with international
practices have been stalled because of institutional weaknesses, such as lack of development
of local standards in general business practice or legislation. Often it is the perceived high
regulatory burden relative to business prospects that results in industry resistance. In some
cases, industry collusion with the government or political groups impedes implementation.
The influence wielded by industry groups can be significant where there is a weak regulatory
governance framework, particularly the absence of operational independence.
Implementation guidance
33. Implementation also suffers because of a lack of clarity and practical guidance in
some key regulatory areas (Table 1). Implementation of regulatory and corporate
governance, and improvements in the quality of financial information have suffered in some
instances owing to a lack of in-depth guidance and consensus on minimum reporting and
disclosure requirements. Similar issues arise with respect to the implementation of regulatory
cooperation and coordination, which can represent channels for exchanging experiences and
comparing regulatory techniques.
22
In response to a recent Fund staff survey, regulators indicated that they could only “draw attention
to problems in a bank and try to find a solution in consultation with the government which (is the
only authority which) could take corrective action,” while many stated that they would “take minor
action while leaving stronger action to the government.”
- 23 -
Table 1. Regulatory Standards: Areas Posing Problems in Cross-Sector Implementation
Cross-Sector Regulatory Areas Areas Where Guidance is Needed
• Preconditions
• Definitions of different types of cross-sector
products and services
• Risk management
• Group-wide internal controls
• Capital adequacy
• Sanctions
• Cross-sector and cross-border information sharing
between regulators.
• Corporate governance within regulated firms.
• Exit policies, winding up and insolvency of
financial conglomerates
• Asset classification and provisioning
• Measuring adequacy of regulatory resources
• Accounting, auditing and actuarial requirements
• Cooperation and information sharing: legal
authority, nature of relationship, topics on which
information should be shared.
34. The focus on the formal existence of regulatory arrangements rather than on
implementation poses a challenge to the evaluation of the effectiveness of regulatory
systems. This is particulalry so when regulatory deficiencies are integrated with the analysis
of financial stability in the FSAP. Assessment of implementation also requires a high level of
cooperation on the part of the regulatory bodies, both domestically and internationally; often,
confidentiality gets in the way. Lack of full information makes it difficult to form an in-depth
judgment on the effectiveness of implementation, leading to disagreements on the
assessments, interpretation, and appropriate actions to strengthen implementation.
III. STRENGTHENING REGULATORY STANDARDS
35. The above review of implementation of good regulation brings out a number of
issues related to the regulatory standards themselves.
23
The challenges are arising mainly
due to three factors: (i) the diversity of financial systems; (ii) growing cross-sectoral and
cross-border issues; and (iii) the objectives and design of regulatory standards.
A. Diversity of Financial Systems
36. Financial systems are showing considerable diversity. The FSAPs are highlighting
differences across several dimensions such as ownership, the role of government in financial
intermediation, financial depth, concentration, competition, efficiency, currency composition,
and openness. Diversity also exists in relation to intermediation patterns, such as with respect
to the scope of financial services (savings facilities, credit facilities, contractual savings and
hedging). Aggregate balance sheet structures also vary across different financial (banks,
insurance) and nonfinancial sectors (corporate, household, public sector), and highlight key
linkages among balance sheet components.
23
See Appendix II for an overview of the main gaps in regulatory standards.
- 24 -
37. The diversity of financial systems poses challenges for the uniform applicability
of the current sectoral standards across financial systems. Some of the regulatory
standards recognize elements that distinguish mature and developing financial systems.
24
This approach helps to enhance the universal applicability of regulatory standards. However,
scope exists for further enhancing the inclusiveness of regulatory standards. Four broader
issues observed in some countries deserve particular attention. These are: (i) regulatory
preconditions; (ii) governance issues; (iii) treatment of financial systems with state-owned
financial institutions; and (iv) prudential issues created by dollarization (see Box 4).
25
Preconditions
38. Implementation can be strengthened with additional guidance on the role and
importance of preconditions. Current standards have been formulated from the viewpoint
of relatively developed and market-based financial systems. A number of their underpinning
features are either not immediately available in some countries or these features are anchored
to a different paradigm.
26
39. While mentioning the importance of preconditions, the standards provide little
or no guidance on the impact on implementation if weaknesses relating to preconditions
exist.
27
The links between specific preconditions and particular elements of the standards are
unspecified, leaving considerable room for judgment in assessing the regulatory implications.
24
This is done in the assessment methodologies. The banking and insurance standards distinguish the
essential assessment or implementation criteria from the more advanced criteria.
25
For a detailed discussion of financial stability in dollarized economies, see SM/03/112. In a recent
discussion of this paper, the directors agreed that the dollarization of bank liabilities and bank loans
poses unique challenges and generally agreed that the range of policy responses observed at the
country level and recommended by standard-setting bodies often remain insufficient, particularly in
the most highly dollarized economies (BUFF/03/77).
26
For example, a legal framework built on approaches of arbitration and consensus may be no less
effective that one where litigation is the principal means for dispute resolution.
27
This limitation has been recognized in the 2003 revisions to the IAIS Insurance Core Principles,
which now require an assessment of preconditions important for insurance regulation. The revised
supervisory standard explicitly incorporates preconditions as an element of the standard. It also
provides implementation guidance, and states that, where these conditions do not yet sufficiently
exist, the supervisor could have additional powers to address the weaknesses. However, no guidance
is provided on how precondition-related weaknesses should be taken into account when evaluating
implementation.
- 25 -
State-owned financial institutions
40. Regulatory standards need to take into account the phenomenon of state-owned
financial institutions and policy-based financial activities. In many countries, the financial
system structure is characterized by the prevalence of state-owned financial firms. This is
particularly so in banking, where despite several privatization initiatives over the last decade,
public sector banks still account for a significant portion of total banking sector assets.
41. State ownership of financial firms raises several regulatory issues. These include:
(i) weak corporate governance structure and management; (ii) political interference with
business decisions; (iii) conflicts of interest, such as preferential lending to state-owned
enterprises or investing assets in other state-owned firms without prudent due diligence;
(iv) difficulties in implementing and enforcing any remedial measures; and (v) absence of
market discipline. The current regulatory standards do not adequately address the numerous
regulatory issues raised by state ownership of financial institutions.
Dollarization
42. Prudential issues raised by dollarization could also be explicitly addressed by
standards. An increase in de facto dollarization has been observed in many developing and
emerging market economies. While it has not affected all countries equally, it is widespread
and increasing (Reinhart, Rogoff, and Savastano, 2003, and De Nicoló, Honohan, and Ize,
2003). Dollarization can have important regulatory implications for stability of financial
Box 4. Regulatory Implications of Dollarization and Government Ownership
Risk Factors Regulatory Issues
Dollarization • Higher balance sheet (solvency)
risk, both due to direct (net open
foreign exchange position) and
indirect risk arising from unhedged
credit exposure to the corporate
sector.
• Diminished role of central bank as
the lender-of-last-resort.
• Higher vulnerability of deposits to
runs, with diminished scope of
interest rate defense.
• Adjustment of prudential
rules to limit risks.
• Bank soundness as well as
transparency critical to
prevent banking instability.
Government ownership
of financial institutions
• Weak governance and political
interference in business decisions.
• Conflicts of interests for
supervisors and resulting
forbearance.
• Absence of market discipline.
• Introduction of proper
governance structures and
minimization of conflicts of
interest.
• Uniform treatment of
financial institutions by
regulations and supervision,
irrespective of ownership.
- 26 -
systems. Balance sheet effects of asset and liability valuations and the diminished role of
central banks as lenders of last resort are usually mentioned among the main risks. Although
it is usually suggested that financial dollarization entails not only risks but also benefits
(Baliño et al., 1999), the exposure to solvency, unhedged credit and liquidity risks might
make financial systems inherently more fragile. Since dollarization is prevalent in developing
and emerging market countries, more detailed international guidance on its regulatory
implications would be helpful.
B. Cross-Sectoral and Cross-Border Issues
43. Cross-sectoral and cross-border linkages in the financial sector are growing.
These include ownership and transactional linkages among banks, insurers, pension funds,
and securities firms through conglomeration.
28
Conglomeration and risk transfer among
different sectors increases contagion risks as cross-sectoral linkages in the financial sector
mature. Also, as cross-border capital movements become liberalized and exchange rate
controls are abolished or reduced, financial systems are becoming increasingly integrated.
The substantial volume of financial transactions recorded in the offshore financial centers is
another indication of significant internationalization of financial flows. Thus, the
conglomerate phenomenon is being amplified by increasing internationalization of financial
sectors across countries, resulting in new forms of risk transfer. These developments
transcend regulatory frameworks provided by sectoral standards and call for strengthened
guidance on cross-sectoral and cross-border regulatory issues (see Box 5).
44. There are also specific vulnerabilities to financial system stability in countries
that are major international financial centers or operating offshore financial centers.
Many financial institutions have established themselves in such markets, often under more
favorable tax regimes.
29
They provide services to nonresidents and are often subsidiaries or
branches of major internationally active (and often cross-sector) groups. The business
objectives and incentives for cooperation with the regulator are generally different for those
institutions operating primarily in the domestic market. The standards do not explicitly
identify and address any additional vulnerability to financial stability that may arise in an
international or offshore financial center.
45. In countries with cross-sector financial groups, the prudential framework must
cover risks pertaining to each group as well as additional risks due to the cross-sector
interlinkages. Financial legislation is often drafted on an institutional basis alone and,
particularly where regulation of the financial sector is shared among several agencies, gaps
are possible, leaving entities or activities that may pose risks to financial stability
28
See Section I of the Background Paper. Also, other sectors not considered here may offer
substantial potential for regulatory arbitrage. These include banking activities of various kinds of
nonbank financial institutions, leasing and factoring companies, and pension funds.
29
The scope for regulatory arbitrage by these institutions using offshore centers is being minimized
through the OFC and similar initiatives.
- 27 -
insufficiently regulated.
30
Standards need to emphasize that all relevant firms operating in the
financial system, particularly those that may entail systemic risk, should be under regulatory
review.
Box 5. Regulatory Implications of Conglomeration and Internationalization
Risk Factors Regulatory Issues
Increased conglomeration and
risk transfer
• Higher contagion risks.
• Regulatory and supervisory
arbitrage.
• Conflicts of interests.
• Implicit extension of financial
safety nets.
• Exposure of parts of the financial
sector to complex risk transfer
instruments.
• Effective tools and political
mandate to regulate large
conglomerates.
• Adequate expertise to supervise
complex structures.
• Harmonization of regulation
and supervision of similar
products to avoid arbitrage.
• Coordination among different
regulatory agencies.
Significant and growing
internationalization
• Higher transmission of financial
sector shocks across borders.
• Cross-border coordination and
information sharing.
• Adjustments to laws,
regulations, and deposit
insurance systems to reflect
cross-border issues.
46. Risks common across sectors are not dealt with consistently across standards.
This situation poses risk-assessment problems and creates arbitrage opportunities. The Joint
Forum has noted that the regulatory standards treat risks in different ways: banking specifies
several risks on the asset side, while the insurance standard places more emphasis on the
liability side “insurance risks.” The securities standard stresses market risks. Recently,
standard setters have begun to emphasize a broader set of risks. The insurance standard now
includes more risks on both sides of the balance sheet, while the Basel Committee has
focused more strongly on liquidity and other liability-side risks. The securities regulatory
standard expressly references the need to address all risks faced by the firm—including
market, credit, and liquidity.
47. Definitions and calculations of capital requirements differ among the sectors and
across borders. To be effective, capital must be adequate both on a group or consolidated
level and on a single entity “solo” level. However, proper monitoring is complicated by
differences in the definitions and calculations of both actual and required capital among the
30
The securities standard states that where responsibilities are shared for securities regulation, there
should be no inequities of regulation. However, this does not address inconsistencies between the
various sector supervisors.
- 28 -
sectors and across borders. For instance, some countries’ regulations accept the inclusion in
capital of unrealized gains on financial or real estate assets. Others may be flexible in
accepting various forms of collateral for reducing risk weights when calculating capital
adequacy ratios. As a result, the same nominal capital adequacy level of financial firms in
different countries may provide different levels of resilience against adverse developments.
48. There is a lack of convergence stemming from the different focus of sector
regulators. Accounting rules are not fully harmonized—either among the sectors or across
borders—and similar transactions may thus affect a group’s capital differently depending on
where within the group they are carried out.
• In banking, the Basel Committee standard on capital is adequately comprehensive
but its application needs to be underpinned by a harmonized approach to loan
classification and provisioning.
• In insurance, the most important characteristics of a capital adequacy and solvency
regime are covered at a fairly high level in the standard. Therefore, a wide range of
approaches to capital adequacy and solvency are in use, some of which may be
deficient in their ability to identify and require capital for significant risks to financial
stability or the solvency of an insurer.
31
• There is no international standard for capital for securities firms. The lack of a
common standard could lead to financial stability concerns if lower standards in one
jurisdiction lead to failures and the problems spill over into other jurisdictions.
However, this problem is somewhat ameliorated by the dual objectives of minimum
capital under the securities standard. Rather than focusing solely on maintaining
solvency, it also has the objective of enabling a firm to wind down its operations
over a relatively short period of time without loss to its customers and without
disrupting the orderly functioning of the financial markets. If the local standards
meet this latter objective, the chances of contagion are slim.
49. Notwithstanding these country nuances, other cross-country issues exist in the
area of the preconditions and governance. The prevalence of complex financial
organizations has increased the need for good corporate governance of financial institutions.
Overall, the coverage of corporate governance in the standards is limited. Although the
insurance standard explicitly addresses corporate governance, the banking standard does not
explicitly recognize the role and importance of good corporate governance. The securities
standard does not address corporate governance in a systematic way, although the importance
31
The capital required by an insurer under the index-based solvency regime currently used in the
European Union and various other jurisdictions does not depend on the composition of its investment
portfolio. The IAIS and other organizations are working to strengthen and bring convergence to
standards in this area, although much remains to be done.
- 29 -
of good corporate governance at public companies, collective investment schemes and
market intermediaries is generally recognized.
50. Cross-sectoral and international financial intermediation also requires more
active and extensive coordination and cooperation among supervisory authorities
across sectors and borders. Several countries have opted to either consolidate the
regulatory authorities, or set up other forms of institutional arrangements that secure
adequate exchange of information and cooperation among regulators. Regulatory standards
outline frameworks for dealing with cross-border operations, and coordination and
cooperation between national authorities. In practice, the degree and effectiveness of
coordination and information sharing vary across countries. As suggested by IMF (2002e)
cross-border information sharing and cooperation between regulators tend to be stronger
when formalized arrangements are in place (such as, Memoranda of Understanding or
MOU). Overall, information sharing requirements among regulators should be strengthened
(see Box 6).
Box 6. Cross-Border Regulatory Cooperation
A recent Fund staff study of cross-border regulatory cooperation issues reveals the following
characteristics:1/
• While channels for cooperation and information exchange are being established, they are far
from being effective.
• Although there are historical differences in emphasis in the objectives of cooperation and
information exchange in the different sectors—banking and insurance were focused on
solvency while securities focused on enforcement investigation—anti-money
laundering/combating the financing of terrorism (AML/CFT) customer due diligence
requirements and conglomeration in the financial services industry are bringing the
requirements closer together.
• There is a spectrum of instruments that facilitates cooperation including informal contacts and
MOUs. Many countries rely on informal and flexible arrangements, although in the absence of
legal gateways, informal contacts may not be adequate for civil and criminal proceedings.
• It is essential that national laws provide the basic gateways and do not impede cooperation and
information exchange. It is important that an appropriate balance be achieved between the
public interest in obtaining and using information and protection of civil rights.
To enhance cooperation, the following suggestions have been put forward by some regulators:
• Standard setters should consider making information on contact persons more readily available
to relevant agencies.
• National authorities should consider publishing information on contacts, gateways, and
requirements indicating “how” to communicate with them, including their statistics on
information sharing as well as unsolicited transmission.
1/ IMF Conference on Cross-Border Cooperation and Information Exchange held in Washington D.C., July 7–8, 2004.
- 30 -
C. Objectives and Design of Regulatory Standards
51. The objectives of regulation and regulatory components could be more expressly
linked to the goal of system-wide financial stability.
32
The standards are useful to
regulators charged with assessing the strength of regulated entities within each sector.
However, their use in addressing system-wide stability issues is limited, partly because they
were not written for this purpose. The standards take little account of structural issues, or of
interlinkages among different types of financial firms and markets.
33
52. Guidance is needed on the interrelationships among key components of the
regulatory standards. Several components of the standards are dependent on each other and
the standard setters should provide explicit guidance on how these interdependencies should
be addressed during implementation and assessment. For example, if the minimum
requirements on regulatory information sharing are not fully implemented, then it is very
unlikely that other elements, such as regulation of conglomerates, which are dependent upon
the existence of a well-functioning information-sharing framework, will be effectively
implemented.
53. Additional guidance on the applicability of different regulatory approaches
would be helpful. Depending on legal tradition and culture of compliance, highly detailed
and explicit legislation and regulations may be required in some countries. In other cases,
countries can manage with overriding principles, for instance “managers must ensure the safe
and sound conduct of the firm,” which are then interpreted by the regulator based on
institution-specific factors. Guidance would be useful on the conditions under which detailed
and prescriptive regulation, as opposed to flexible and discretionary regulation, is desirable.
54. The standards should be strengthened in the area of information disclosure and
made more explicit in dealing with the integrity of financial reporting. For market
discipline to work effectively, the requirements regarding public disclosure by market
participants and the applicable accounting and auditing standards need to be comparable
across firms, yet the current standards do not address this point in sufficient detail. Also, the
32
The standard setters could articulate the direct or indirect link between principles and financial
stability wherever applicable. This would help address some of the important practical issues
involved in the FSAP assessments, including an evaluation of the actual regulatory practices on the
ground, and linking the assessment outcome with the financial stability analysis.
33
Both banking and insurance standards do mention financial stability as an objective of regulation
but do not provide guidance on how the various elements of the standards are linked to that goal. In
the securities areas, this is not traditionally thought of as something that securities regulators are
involved in, with a focus mainly on investor protection. However, given the number of integrated
regulators, the need for more cohesive guidance on cross-sector regulation, and the overall role of
regulation for ensuring market stability, financial stability objective could be integrated within the
elements of various standards.
- 31 -
standards could deal with issues affecting the integrity of financial reporting more
comprehensively. The need for robust accounting, auditing and actuarial standards, together
with the existence of skilled professionals and quality control mechanisms, is critical. Given
the growing emphasis on financial and risk measurement and disclosure (such as Pillar 3 of
Basel II, or the EU Solvency standards for insurers), the importance of express standards in
this area is increasing.
55. In banking, there are currently no specific requirements on banks’ disclosures to the
general public, with the exception of an annual financial statement.
34
In insurance, public
disclosure by insurers of relevant information on a timely basis is required. The criteria that
such disclosures must meet are comprehensive, but quite high-level. The financial statements
of insurers are often difficult to understand and open to manipulation, for example, through
the modification of actuarial methods and assumptions. Disclosure requirements in a
jurisdiction could be assessed as observing this principle, without ensuring the existence of
clear and meaningful disclosure of the financial positions and risk exposures of its insurers.
As regards securities, there are extensive public disclosure and transparency expectations
that apply to public companies, securities supervisors, collective investment schemes and
organized markets. However, public disclosure of the financial condition of market
intermediaries is not addressed directly.
35
36
IV. ISSUES GOING FORWARD
56. The analysis in Sections II and III indicates the need for improving
implementation and adopting regulatory standards. The staff proposes to continue
working closely with country authorities, standard setters, and international experts and
organizations, including the World Bank, to enhance implementation and help in adapting
regulatory standards to the challenges identified in the paper. The aim shall be to ensure that
implementation takes place in a manner that is consistent with international practices while
flexible enough to reflect countries’ particular stage of market development.
34
The Basel II framework will introduce detailed requirements on disclosures.
35
This gap only applies to privately owned securities firms, as firms with public shareholders are
subject to extensive disclosure requirements.
36
The Fund staff, in collaboration with the standard setters, is undertaking a stock taking of barriers,
gateways, and practices on the basis of an expanded survey and information from FSAP and OFC
assessments. The stock taking could include a comparison of the standards’ principles on information
exchange to identify common elements and differences and ways to help facilitate compliance with
the standards.
- 32 -
Country authorities
57. At the country level, the following steps could help strengthen implementation:
• Provide greater attention to meeting regulatory preconditions. Countries should
have adequate supporting legal and financial infrastructures, and could undertake a
review of how well the regulatory system is aligned to the operating environment.
The state of regulatory preconditions may influence the design of the regulatory
approach, and in specifying the regulatory priorities and goals.
• Carry out periodic reviews of the governance framework of regulatory bodies.
Periodic review could assist the countries in identifying issues related to the adequacy
of the legal protection of regulators, their operational autonomy, and the adequacy of
supervisory and supporting judicial resources. In this context, the accountability
framework should also be examined. A strong governance framework will help
countries make timely interventions in problem institutions, and help establish a clear
institutional framework among regulators for crisis management.
• Undertake and update self-assessments of implementation of regulatory
standards. Using the methodologies prescribed by the standard setters, this exercise
could be undertaken periodically. Since financial structures are not static, regulatory
regimes would need to adapt and adjust. A process of self evaluation would help
monitor the progress. Publication of such assessments and any follow-up actions
would provide information to other regulators and stakeholders on emerging
regulatory practices and could lead to convergence of regulatory views.
• Discuss mechanisms with relevant constituents for cross-sector, cross-border
regulatory coordination and information-sharing. Consideration could be given to
establishing and maintaining regular contacts with the most relevant authorities and
making a joint effort to understand each others’ systems, while working towards an
international arrangement or an institutional mechanism for improving domestic and
international regulatory coordination and exchange of information. This will facilitate
the regular monitoring of potential contagion and regulatory arbitrage risks. It would
also facilitate the sharing of information regarding the linkages between banks and
the nonbanks operating as part of complex groups on a cross-border basis.
• Augment regulatory oversight with a focus on system-wide issues. Enhanced
research and supervisory capacity is needed on regulatory issues, especially relating
to the interlinkages between financial regulation and financial stability. Regulatory
responses could be swifter and more focused if a better understanding exists at the
country level of the interrelationships in the financial system. Issues such as the
nature of systemic exposures among banking, insurance, securities sectors, and other
sectors not analyzed in this paper, including leasing, factoring, nonbank financial
institutions, and pension fund managers deserve attention.
- 33 -
Standard setters
58. The standard setters have adopted a pro-active stance of critically reviewing the
regulatory standards and assessment methodologies.
37
The IAIS has recently completed
its revisions of the insurance standards, while the Basel Committee has begun a review of the
banking standard. IOSCO has issued its first implementation methodology. Based on the
above review of the actual implementation practices, however, the opportunity exists to make
the regulatory standards more reflective of the structural shifts and diversity across financial
systems. A more consistent approach also appears possible on issues that commonly arise in
all sectors. Specific areas of further work could include the following:
38
• How might regulatory standards best recognize the diversity of financial
systems, including financial systems in an early stage of development, dollarized
financial systems, and those where state-owned financial institutions are
significant? Standard setters could provide guidance on trade-offs between different
regulatory approaches and how regulation might be adapted to different types of
financial systems.
• Consideration should be given to including preconditions as a component of the
standards framework. To the extent possible, preconditions should be harmonized
across sectors, and the links between preconditions and the elements of standards
elaborated.
• Regulatory principles relating to cross-sectoral and cross-border issues could be
laid out in a comprehensive and consistent manner. Consideration should be given
to issuing a separate set of standards or guidance for addressing cross-sectoral
regulatory issues and their interdependencies.
• More extensive and harmonized guidance on regulatory governance
requirements would be helpful. Also, developing more specific guidance in the
areas of corporate governance and public disclosure could be considered.
• Standard setters could work with country authorities on information exchange
arrangements. The aim would be to provide practical support for formal
arrangements for improving domestic and international regulatory coordination and
exchange of information, while fostering informal contacts and communication.
59. The recommendations made by the Joint Forum in 2001 on the issue of greater
coordination and harmonization among standard setters could be revisited. Consistency
37
Ongoing work by standard setters is reviewed in Section III of the Background Paper.
38
The main areas for strengthening standards and suggested responses are detailed in Appendix II.
- 34 -
among regulatory standards might be achieved at two levels: (i) in the content and design of
regulatory standards (definitions and terminology, cross-referencing, and uniform
mechanisms for keeping the standards current with new guidance); and (ii) consistency in the
implementation process (assessment grading, self-assessment tools, assessment
methodologies and procedures, and linkages with formal stability analysis). However,
harmonization and coordination among standards must leave room for addressing aspects
that are unique to each sector, and how regulation might be adapted to different types of
financial systems.
Fund staff
60. To assist the above steps, the Fund staff could play the following supporting role:
• Consider undertaking together with other relevant bodies and the standard
setters, a study of different types of regulatory systems. This will help to
determine how well the individual regulatory standards apply across the financial
sectors (such as, how well do the banking standards apply to the securities-like
operations of banks) The study could specifically have a cross-sector and cross-
border focus, and look into the depth and intensity of regulation based on different
environments.
• Give priority to the coverage of regulatory preconditions and regulatory
practices in the context of ongoing financial sector surveillance work. In assessing
and conducting surveillance of regulatory systems, devote more attention to the
underlying infrastructure (i.e., the preconditions) and the adequacy of the regulatory
approach given the stage of development and particular challenges facing the country.
• Continue working with standard setters in a cooperative manner in providing
further guidance on implementation of good regulatory practices, and laws and
regulations. In this regard, a framework could be developed on what constitutes a
well-regulated financial system, including a consistent set of metrics to evaluate
regulatory performance and implementation practices. This will also help to focus
technical assistance more sharply on regulatory strengthening in areas where the main
vulnerabilities exist.
• Continue to provide technical assistance to help countries strengthen regulatory
systems, in close cooperation with FIRST, the World Bank, and other donors.
• Build on the existing research agenda and include financial regulation, financial
stability and linkages with macroeconomic stability. Based on this work, the Fund
staff will provide the Board periodic reviews on issues in financial regulation and
their effect on financial stability.
- 35 -
V. ISSUES FOR DISCUSSION
61. Do the suggested approaches in Section IV seem appropriate towards
strengthening implementation and fostering stronger practices in financial regulation?
Specifically:
• Is there a need for stakeholders (e.g., countries, standard setters, and staff) to pay
closer attention to the adequacy of regulatory preconditions?
• Given the importance of cross-sectoral and cross-border issues in regulation, should
the Fund, in collaboration with standard setters, conduct a stock-taking of barriers,
gateways, and practices, in order to identify common elements and differences and
ways to improve domestic and international coordination and exchange of
information?
• As the standards are applied mainly on a sectoral basis within a country, is there a
need for overarching guidance on the regulation of financial operations with cross-
sectoral and cross-border features?
• Should regulatory standards better recognize the diversity of financial systems,
including financial systems in an early stage of development, dollarized economies,
and counties where state-owned institutions are significant?
• Is the envisaged role of Fund staff in the right direction and in line with the call by the
Board for strengthening the coverage of financial sector issues in Fund surveillance
across all member countries?
- 36 -
REFERENCES
Baliño, Tomás J.T., Adam Bennett, and Eduardo Borensztein, 1999, “Monetary Policy in
Dollarized Economies,” IMF Occasional Paper No. 171. (Washington: International
Monetary Fund).
Bank for International Settlements, 2001, “The Banking Industry in the Emerging Market
Economies: Competition, Consolidation, and Systemic Stability,” BIS Papers,
Number 4 (August) (Basel).
Bank for International Settlements Joint Forum, 2001, “Core Principles: Cross-Sectoral
Comparison,” (November) (Basel).
Barth, J., G. Caprio, and R. Levine, 2001, “The Regulation and Supervision of Banks Around
the World: A New Database,” (Washington: World Bank).
Das, Udaibir, S., Marc Quintyn, and Kina Chenard, 2004, “Does Regulatory Governance
Matter for Financial System Stability? An Empirical Analysis,” IMF Working Paper
04/89 (Washington: International Monetary Fund).
De Nicoló Gianni, Patrick Honohan, and Alain Ize, 2003, “Dollarization of the Banking
System: Good or Bad?” IMF Working Paper 03/146 (Washington: International
Monetary Fund).
International Monetary Fund, 2001, Experience with the Insurance Core Principles
Assessments Under the Financial Sector Assessment Program, Washington (August)
SM/01/266 (Washington: International Monetary Fund).
International Monetary Fund, 2001, “International Capital Markets: Developments,
Prospects, and Key Policy Issues,” (Washington: International Monetary Fund).
______, 2001b, “Regulatory Issues in the Consolidation of the Banking, Insurance, and
Securities Industries: A Literature Survey,” MAE Technical Note 01/3 (October),
(Washington: International Monetary Fund).
______, 2002, “The Financial Market Activities of Insurance and Reinsurance Companies,”
in: Global Financial Stability Report (Chapter 3), (June), (Washington: International
Monetary Fund).
- 37 -
______, 2002b, Implementation of the Basel Core Principles for Effective Banking
Supervision, Experiences, Influences, and Perspectives, SM/02/310 (October)
(Washington: International Monetary Fund).
______, 2002c, Experience with the Assessments of the IOSCO Objectives and Principles of
Securities Regulation Under the Financial Sector Assessment Program, SM/02/121
(April), (Washington: International Monetary Fund).
______, 2002d, “Large Complex Financial Institutions (LCFIs): Issues to be Considered in
the Financial Sector Assessment Program,” MAE Operational Paper 02/3 (March),
(Washington: International Monetary Fund).
______, 2002e, “Consolidated Supervision: Managing the Risks in a Diversified Financial
Services Industry,” MAE Operational Paper 02/5 (September) (Washington:
International Monetary Fund).
______, 2003, “Regulatory and Supervisory Challenges and Initiatives” Chapter II,
Appendix I in Global Financial Stability Report (September), (Washington:
International Monetary Fund)
______, 2003a, “Offshore Financial Centers—The Assessment Program—A Progress Report
and the Future of the Program,” (August) (Washington: International Monetary
Fund).
______, 2003b, “Financial Stability in Dollarized Economies,” SM/03/112, (April)
(Washington: International Monetary Fund).
______, 2004, “Risk Transfer and the Insurance Industry,” Chapter III in Global Financial
Stability Report, (April) (Washington: International Monetary Fund).
Kaufmann, Daniel, Aart Kraay, and Massimo Mastruzzi, 2003, “Governance Matters III:
Governance Indicators for 1996–2002,” (unpublished; Washington: the World Bank),
also available at the Internet: www.worlbank.org
Reinhart, C., K. Rogoff, and M. Savastano, 2003, “Addicted to Dollars,” NBER Working
Paper 10015 (Cambridge, Mass.: National Bureau of Economic Research).
The Joint Forum, 2001, “Core Principles: Cross-Sectoral Comparison,” (November) (Basel:
Bank for International Settlements).”
- 38 - APPENDIX I
Income Level, Financial Deepening, and Standard Implementation
Appendix Figure 1. Income Level and Implementation
Log Y vs. PGRAL
0
10,000
20,000
30,000
40,000
50,000
60,000
2.3 2.5 2.7 2.9 3.1 3.3 3.5 3.7 3.9 4.1 4.3
PGRAL
Y
Appendix Figure 2: Financial Deepening and Implementation
Log CREDIT vs. PGRAL
0.00
0.20
0.40
0.60
0.80
1.00
1.20
1.40
1.60
1.80
2.3 2.5 2.7 2.9 3.1 3.3 3.5 3.7 3.9 4.1 4.3
PGRAL
C
R
E
D
I
T
Notes:
Y = GDP Per Capita, Credit=Credit to the Private Sector by Banks/GDP,
PGRAL=Average level of compliance across sectors and components.
- 39 - APPENDIX I
Appendix Table 1. Correlations: Income Level, Financial Deepening, and Sector’s
Implementation
GDP Per Capita Credit/GDP BCP 1/ IAIS 1/ IOSCO 1/
GDP Per Capita 1.000 0.617 0.664 0.543 0.587
Credit/GDP 1.000 0.458 0.214 0.242
BCP 1.000 0.481 0.474
IAIS 1.000 0.560
IOSCO 1.000
1/ BCP, IAIS, IOSCO are the grades of implementation with standards in each sector: 4=complaint, 3=largely
complaint, 2=broadly compliant, 1=non-compliant.
Appendix Table 2. Implementation by Regulatory Categories
Regulatory
Governance
Regulatory
Practices
Prudential
Framework
Financial Integrity
and Safety Net
BCP
Industrial 3.729 3.650 3.567 3.700
Emerging 3.194 3.107 2.968 2.964
Developing 3.179 3.153 2.824 2.750
Average 3.367 3.303 3.120 3.138
IAIS
Industrial 3.100 3.563 3.400 3.550
Emerging 2.923 3.148 2.986 2.714
Developing 2.364 3.122 2.625 2.708
Average 2.796 3.277 3.004 2.991
IOSCO
Industrial 3.586 3.600 3.733 3.593
Emerging 3.153 2.952 3.230 3.031
Developing 3.074 2.667 3.102 2.698
Average 3.271 3.073 3.355 3.107
Grades of implementation: 4=complaint, 3=largely complaint, 2=broadly complaint, 1=non-complaint.
-
4
0
-
A
P
P
E
N
D
I
X
I
I
Regulatory Standards: Main Gaps and Suggested Response
Regulatory
Component
Main Gaps
Suggested Response
Regulatory
Preconditions
• A framework for preconditions for effective regulation and its
implementation is not expressly included in the standards.
• Interlinkages between specific preconditions and principles of good
regulation are unclear. Guidance is missing on how preconditions affect
the macro-financial situation, the crisis management framework, and
overall implementation.
• Strong reliance is placed on regulatory judgment on how weaknesses in
preconditions can be compensated for.
• Preconditions could be made an integral component of the
standards framework. (Insurance has incorporated
preconditions in 2003 which could benefit from
strengthening.)
• Interlinkages between legislative and the judicial processes
and effective regulation (enforcement, sanctions and
remedial action) could be covered in detail.
• Evaluation of implementation should require an assessment
of the application of “rule of law” and of “debtor discipline”
by the judicial system.
• Specific guidance could be provided on how preconditions
affect implementation of other regulatory components.
Regulatory
governance
• Focus is mainly on regulatory independence. Implementation guidance is,
however, missing on defining and evaluating regulatory independence in
some common situations.
• Other components of regulatory governance (accountability, transparency
and integrity) are not adequately covered by the governance-related
requirements in all sectors.
• Regulatory surveillance of macro-financial issues and monitoring overall
financial stability is not an expressly-stated objective for regulators. The
objective of reducing systemic risk is noted, but the term is undefined and
applied differently across sectors.
• Standards adopt a segmented, or ‘silo’ approach toward regulation. Thus
the issue of regulatory overlap is not explicitly dealt with.
• Regulatory governance requirements could be expanded,
harmonized, and made applicable to all types of regulatory
bodies (solo or integrated). Guidance could be provided on
the pros and cons of different approaches to regulation
(individual versus integrated, and prescriptive versus
reliance-based).
• Guidance could also be provided to facilitate the assessment
of regulatory governance components, particularly
independence.
• The concept of systemic risk could be clarified and the
monitoring and reduction of such risk could be included as a
regulatory objective.
-
4
1
-
A
P
P
E
N
D
I
X
I
I
Regulatory
Component
Main Gaps
Suggested Response
• The standards framework should facilitate regulation of
all types of financial activities, without gaps and
overlaps, while promoting a fair and equitable
competition.
• Guidance is required on assessing the adequacy of
regulatory resources.
Regulatory
Practices
• Cooperation and information sharing are mentioned but the focus is more
on the ability to share information rather than on the actual practice and
effective mechanisms of information sharing on conglomerates.
• The standards lack guidance for regulators on how to develop techniques
to adequately address the risks posed by financial conglomerates and
cross-sectoral products and services, including regulatory vulnerabilities
arising from on and offshore financial activities. Guidance is also absent
on how regulators should identify the systemically important cross-
border, cross-sector firms.
• Requirements could be tightened on effective exercise of
powers within an accountable framework (“ladder of
intervention”), and for monitoring sectoral and cross-
sectoral risks and not just institution-specific risks.
• Regulatory authorities, in cooperation, should have powers
to monitor all relevant activities of conglomerates, including
those of affiliated unregulated entities and the different
categories of financial institutions within a sector.
• Regulatory cooperation could be suggested in the
monitoring of risks arising from less-regulated parts of the
financial system, especially where market participants are
not part of a financial conglomerate.
• More guidance could be provided on the identification of
vulnerabilities to financial stability in a range of situations,
e.g., in an international financial center or a jurisdiction
where government-owned entities are prevalent. The need
for proper oversight by both parent organizations and home
country supervisor(s), with relevant information being
accessible to the host regulators, could be emphasized.
Prudential
Framework
• Risks common across sectors are not being dealt with consistently.
Operational and reputational risks are mentioned but not comprehensively
addressed.
• A common categorization of risks and their regulatory
treatment could be incorporated within the standards, and
the extent to which these risks are relevant to each sector.
-
4
2
-
A
P
P
E
N
D
I
X
I
I
Regulatory
Component
Main Gaps
Suggested Response
• A lack of consistency exists in the capital adequacy treatment for some
financial products and services across sectors. Emphasis is lacking on
ensuring that capital must be adequate, both on a group or consolidated
level and on a single entity or individual level.
• Implementation guidance on risk management requirements, including
corporate governance, internal controls, and management of risk
concentration is not fully dealt with. In securities, this is particularly the
case with respect to market intermediaries and collective investment
schemes.
The focus of the prudential framework is at the firm level, and not at the
level of the system as a whole. In securities, the coverage of secondary
market issues does not expressly cover all possible types of securities
markets, such as the over-the-counter (OTC) market (interbank
derivatives trading and sovereign debt market).
• Further cross-sectoral work could be undertaken to achieve
greater harmonization in both the acceptable forms of
capital and the level of capital required in respect of
particular risks. While cross-sectoral harmonization at a
detailed level (such as that of Basel II) may be both
unnecessary and unachievable, harmonization at the level of
the regulatory standards may well be possible.
• Stress testing by financial firms could be suggested across
sectors, at the legal-entity level and on a group-wide basis.
Regulators should review the results and use the information
as part of their own analyses of sectoral and cross-sectoral
risks.
• More consistent and comprehensive guidance could be
provided on corporate governance and internal control as
key elements of prudential framework.
Financial
Integrity and
Safety Net
Consumer protection
• The banking standard does not explicitly recognize consumer protection
as a regulatory objective. The focus is on risks to the bank and less on
depositors or other counterparts. Insurance standard does not explicitly
address the role of the regulator in the review and approval of products
and premium rates, which may affect solvency, consumer protection and
market stability. With securities, a stronger focus is placed on protecting
investors and ensuring fair and efficient markets. However, deficiencies
relating to regulation of secondary markets lead to lower requirements of
integrity and fairness.
Financial safety net
• Both the concern relating to “moral hazard” and the role of “lender-of-
last-resort” need to be integrated within the standards framework. For
cross-sector groups, the safety net arrangement must be able to deal with
“ring-fencing” and protecting a part of the group from problems in other
• Standards should highlight the importance of maintaining
the confidence of consumers in the fairness and integrity of
the financial system. The tools used to achieve this could be
appropriate disclosures, and business conduct and conflict of
interest rules. In banking, explicit mention could be made to
consumer protection as an objective of regulation and the
requirement for a mechanism for handling consumer
complaints.
• In insurance, the regulatory review of products and premium
rates, where it exists, must be transparent, timely, and fair. It
should not impede market innovation and unduly
compromise solvency (through premium rate caps) nor
significantly distort pricing.
• In securities area, requirements relating to secondary
markets should be the same as for other organized markets.
-
4
3
-
A
P
P
E
N
D
I
X
I
I
Regulatory
Component
Main Gaps
Suggested Response
parts. The same applies to cross-border groups. In insurance, criteria for
assessing the appropriateness of policyholder protection funds are
missing.
Disclosure of information
• Different approaches are adopted across standards. In banking, the focus
is on regulatory reporting and less on public disclosure. In insurance,
emphasis is placed on public disclosure by insurers but at a high level. No
uniform requirements exist for disclosure of the financial positions and
risk exposures of insurers. In securities, public disclosure of the financial
condition of market intermediaries is not directly addressed.
• Financial safety net issues that arise with respect to cross-
sector and cross-border groups could be explicitly
addressed. Harmonized criteria for assessing the
appropriateness of financial safety net arrangements could
be established.
• Financial safety net issues that arise with respect to cross-
sector and cross-border groups could be explicitly
addressed. Harmonized criteria for assessing the
appropriateness of financial safety net arrangements could
be established.
• Further development work on disclosure requirements
might be accelerated on a cross-sectoral basis.
Responsibility of regulators should include reviewing the
manner in which regulated firms are implementing
disclosure requirements, so as to ensure that meaningful
information regarding their financial position and risks is
disclosed. In banking, an explicit requirement for disclosure
should be included, while the securities standards should
require disclosure of the financial condition of market
intermediaries.
• For market discipline is to work effectively, requirements
regarding public disclosure by market participants and the
applicable accounting and auditing standards need to be
made comparable across sectors. Standard setters should
continue to provide inputs to the developers of such
standards and might coordinate their efforts in doing so.
doc_263878893.pdf
First, it reports on the state of implementation of financial regulatory standards across banking, insurance, and securities sectors in a select group of Fund member countries.
*Prepared by an MFD team of staff and experts led by David Marston and Udaibir S. Das
INTERNATIONAL MONETARY FUND
Financial Sector Regulation: Issues and Gaps
Prepared by Staff of the Monetary and Financial Systems Department*
Approved by Stefan Ingves
August 4, 2004
Contents Page
Glossary .....................................................................................................................................3
Executive Summary...................................................................................................................4
I. Introduction and Background.................................................................................................6
II. Implementation of Regulatory Standards..............................................................................9
A. Framework for Analysis............................................................................................9
B. Implementation Overview.......................................................................................10
C. Cross-Sectoral Regulatory Weaknesses ..................................................................14
D. Factors Explaining Implementation Weaknesses ...................................................18
III. Strengthening Regulatory Standards..................................................................................23
A. Diversity of Financial Systems ...............................................................................23
B. Cross-Sectoral and Cross-Border Issues .................................................................26
C. Objectives and Design of Regulatory Standards.....................................................30
IV. Issues Going Forward........................................................................................................31
V. Issues For Discussion..........................................................................................................35
References................................................................................................................................36
Table
Regulatory Standards: Areas Posing Problems in Cross-Sector Implementation ...................23
Figures
1. Regulatory Standards: Average Implementation by Main Components .............................12
2. Regulatory Standards: Average Implementation by Country Type.....................................13
3. Rule of Law and Implementation of Standards ...................................................................21
- 2 -
Boxes
1. Regulatory Standards .............................................................................................................8
2. Financial Regulation and its Four Main Components .........................................................10
3. Preconditions and Linkages with Regulation ......................................................................19
4. Regulatory Implications of Dollarization and Government Ownership..............................25
5. Regulatory Implications of Conglomeration and Internationalization ................................27
6. Cross-border Regulatory Cooperation .................................................................................29
Appendices
I. Income Level, Financial Deepening, and Standard Implementation...................................38
II. Regulatory Standards: Main Gaps and Suggested Response..............................................40
Appendix Tables
1. Correlations: Income Level, Financial Deepening, and Sector’s Implementation ..............39
2. Implementation by Regulatory Categories. .........................................................................39
- 3 -
GLOSSARY
AML-CFT Anti-money Laundering-Combating the Financing of Terrorism
BCP Basel Core Principles
BCBS Basel Committee for Banking Supervision
FSAP Financial Sector Assessment Program
FSSA Financial System Stability Assessment
FSF Financial Stability Forum
GDP Gross Domestic Product
IAS International Accounting Standards
IAIS International Association of Insurance Supervisors
ICP Insurance Core Principles
IFRS International Financial Reporting Standards
IOSCO International Organization of Securities Commissions
MOF Ministry of Finance
MoU Memorandum of Understanding
OFC Offshore Financial Centers
ROSCs Reports on Observance of Standards and Codes
SROs Self-Regulatory Organizations
- 4 -
EXECUTIVE SUMMARY
This paper addresses issues in financial sector regulation from two perspectives. First, it
reports on the state of implementation of financial regulatory standards across banking,
insurance, and securities sectors in a select group of Fund member countries. Second, it
raises issues relating to the design of these three sector standards, arising from the
implementation experience and the evolving structure of financial systems. In this regard, the
paper identifies a few emerging regulatory risks and some cross-sectoral issues that may
warrant further guidance by standard setters.
The implementation of regulatory standards is broadly satisfactory, on average, but
masks underlying issues. There are also important variations in implementation across
countries. For the majority of countries, prudential rules and regulations that create an
enabling regulatory framework are in place. Significant weaknesses exist, however, in actual
regulatory practices. The variations are observed particularly in areas related to regulatory
sanctions and enforcement of laws, regulatory independence and legal protection of
regulators, and financial integrity and safety net arrangements.
Several factors help explain the implementation shortcomings. The sound policy and
operating environment required for effective regulation is not always present. A range of
non-prudential considerations, often leading to regulatory forbearance, is another factor. This
is particularly the case in financial systems with state-owned financial institutions. In several
instances, regulators face a dilemma of having to balance the objectives of prudential
regulation aimed at a safe and sound financial system, with the polices and objectives of
other initiatives. Lack of human and financial resources often leads to faulty implementation.
Ongoing structural changes in the financial sector are posing a challenge for regulators.
The Financial Sector Assessment Program (FSAP) reveals a growing integration not only
across the various types of financial institutions, but also cross-border financial integration in
Asia, Europe, and the Western Hemisphere, and in the recent period in Africa. These
developments highlight the need for closer and more systematic monitoring of cross-border
contagion risks, and of opportunities for regulatory arbitrage.
Implementation also suffers from a lack of clarity and practical guidance in some key
regulatory areas. The standard setters have been revising regulatory standards. However,
they typically focus on separate lines of financial activities, rather than on the treatment of
system-wide regulatory issues. The standards also assume the existence of legal, institutional,
and policy conditions (“preconditions”) that are not directly under the control of the
regulator, and which are often undeveloped in many countries. Differences in the treatment
of similar elements (preconditions, methods of regulation, capital, and information sharing)
among the standards also make implementation more difficult.
- 5 -
To strengthen regulatory systems, countries should be encouraged to provide greater
attention to regulatory preconditions, cross-sector and cross-border information
sharing. This will enable them to bring their regulatory regime into alignment with the
evolving structure of the financial systems and the associated risks. Efforts at strengthening
regulatory regimes could be combined with periodic reviews of the regulatory objectives,
governance framework, resources, and financial infrastructure on a system-wide basis. This
is particularly important as regulatory agencies are moving towards more sophisticated risk-
based regulatory techniques.
The standards setters could support this by advancing the work on the required
preconditions, possibly incorporating them into the standards. This could be done by
taking into account the implementation experience and the emerging structural trends.
Additional guidance could also be considered on issues relating to cross-sector regulation,
regulatory governance, corporate governance, and public disclosure. Such guidance should
explicitly consider the regulatory implications of the diversity of financial systems across
countries.
The staff proposes to help address the issues identified in this paper, in close
cooperation with country authorities, standard setters, and international organizations
including the World Bank. The aim is to ensure that the regulatory framework is
implemented in a manner consistent with international practices, yet flexible enough to allow
market development and innovation. This will also help inform on issues that have general
relevance to the FSAP, and the standards and codes initiative. Specifically, consideration will
be given to strengthening the coverage of regulatory preconditions and practices in the
context of its ongoing surveillance work. This will be in line with the ongoing effort to
strengthen the coverage of financial sector issues in Fund surveillance. Staff will also
continue to distill from ongoing surveillance and technical assistance research, issues relating
to financial regulation. It proposes to provide the Board with periodic reviews on issues in
financial regulation and their effect on financial stability.
- 6 -
I. INTRODUCTION AND BACKGROUND
1. Financial sector regulatory standards comprise the essential, though minimum,
principles for well-functioning regulatory systems (Box 1).
1
The assessment of the quality
of institutional and regulatory structures forms an integral part of the overall assessment of
the financial sector carried out under the FSAP, which has emerged as the main international
framework for financial sector standards implementation work.
2
The Joint Bank-Fund
international standards and codes initiative provides the overall context for the work relating
to financial sector standards.
3
Over 150 regulatory standard assessments have been
completed so far in 67 countries where the FSAP evaluation has been completed.
4
2. Good quality regulation is a key element of financial stability. Regulation,
financial stability, and macroeconomic vulnerabilities are interconnected.
5
Financial system
strengths and vulnerabilities critically depend on the design, practice, and implementation of
regulatory systems. The assessments of financial systems against standards in the FSAPs are
used to identify regulatory strengths, risks, and vulnerabilities and to assist country
authorities to prioritize policy and operational reforms.
3. The assessments are based on the internationally adopted regulatory standards
using the assessment methodologies prescribed by the standard setters. Evaluations of
regulatory systems in the FSAP involve the participation of practicing regulators from central
banks, ministries of finance, and regulatory agencies. This approach offers member countries
a “peer review” of their national regulatory systems. Fund staff has been providing periodic
feedback to the standard setting bodies on the assessment experience with individual
standards as reflected in the recent revisions to the insurance regulatory standard and the
securities standard assessment methodology.
1
Standards covered in this paper are (i) Basel Core Principles (BCP) for Effective Banking
Supervision; (ii) International Association of Insurance Supervisors (IAIS) Core Principles; and,
(iii) International Organization of Securities Commissions (IOSCO) Objectives and Principles for
Securities Regulation. The three standards are included in the 12 areas endorsed by the Board in 2001
and 2002 as being useful to the Fund’s operational work.
2
See SM/03/77 for the most recent reviews of the FSAP. Assessments of regulatory systems in
offshore financial centers (OFC) are also carried out under the OFC Program (See SM/04/92 for a
recent update).
3
See SM/03/86 for the most recent review of progress in implementing the initiative.
4
For ease of reference, the term “regulation” is understood to include supervision.
5
Some components of standards provide information on the core dimensions of financial stability.
These include regulatory infrastructure, effectiveness of regulation, and macroprudential surveillance.
In banking and insurance sectors, the assessment information is contributing indirectly to the
surveillance by informing on the reliability of reported financial soundness indicators (See
SM/03/176).
- 7 -
4. This paper first reviews the implementation of financial sector regulations in
36 Fund member countries based on the findings of FSAPs completed from 2000–2003.
These are countries where regulatory systems have been assessed in three sectors—namely,
banking, insurance, and securities.
6
The second part of the paper discusses some issues
regarding the standards themselves in light of the implementation experience. It takes
into account the regulatory challenges posed by financial conglomeration and
internationalization of finance, and structural factors such as dollarization and state
ownership of financial institutions. The paper also suggests steps for further strengthening of
regulatory standards to take account of these developments and structural factors.
5. A cross-sectoral approach to the review of standards implementation has been
chosen to identify common regulatory vulnerabilities.
The need for a cross-sectoral view
is heightened by the increasingly complex ways through which financial risks are managed
by banking, insurance, and securities firms. These often erode the effectiveness of the
traditional arrangements for regulatory oversight. However, a cross-sectoral analysis should
keep in mind that standards seek to achieve similar, but not uniform objectives. Even where
sectoral lines are blurred, technical complexities remain within each sector. Thus, while
parallels may be evident in implementation weaknesses, their impact across the financial
system may differ.
7
The divergence in regulatory focus also explains, in part, the varying
relative importance of factors such as sound macroeconomic policies to the regulation of
each sector.
6. This paper is a first effort at a broader review of issues in financial regulation,
including implementation and adequacy of regulatory standards.
8
It is a work in
progress, as more experience and knowledge is gained with assessments of regulatory
systems under the FSAP. Work in this area is a cooperative endeavor involving the Fund, the
Bank, country authorities, international experts, and the standard setting bodies. Thus, going
forward, a cooperative approach will continue to be required involving all the relevant
stakeholders. The staff intends to report periodically to the Board on issues related to
6
In addition, assessments of the three sectors were also carried out in another six jurisdictions under
the OFC program. These assessments are not considered in this paper.
7
For example, prudential deficiencies and confidence in the financial condition of firms can have a
different impact on banks than on securities intermediaries and insurance companies. Moreover, for
securities regulators, the primary emphasis is on investor protection and market efficiency
considerations—relying more on disclosure, market discipline, and a sound legal and accounting
framework. In the banking and insurance sectors, regulators focus primarily on an institution’s ability
to meet its obligations to depositors and policyholders, with some attention in banking to systemic
stability.
8
Individual reviews of financial sector regulatory standards have already been reported to the Board.
These indicate substantial room for improvement in individual standards and the assessment process
itself (See SM/01/266, SM/02/121, SM/01/266, and SM/04/92).
- 8 -
financial regulation and its implications for financial stability, including developments
relating to regulatory standards.
Box 1. Regulatory Standards
Regulatory standards represent the minimum requirements for good practice in financial regulation in
individual sectors. These comprise of Basel Committee’s Core Principles (BCP) for Effective Banking
Supervision (September 1997) and the accompanying methodology (October 1999), IOSCO’s
Objectives and Principles of Securities Regulation (IOP) (September 1998) and the accompanying
methodology (September 2003), and the IAIS’s Insurance Core Principles and Methodology (ICP)
(October 2003). Each standard is accompanied by a methodology providing detailed guidance on steps
to be taken or requirements to be met which are specific enough to allow a relatively objective
assessment of the degree of observance.
The standards for the most part are written in general terms, thereby offering a degree of flexibility in
implementation to suit country circumstances. In several cases, however, the methodologies tend to be
prescriptive and set forth specific requirements. The standards’ framework also includes supporting
documents covering topics relevant to each sector, such as accounting, disclosure and transparency,
capital adequacy, information sharing, and risk management. Some of them spell out the practical
application of the standards within a more narrowly defined context—for example, the Basel
Committee's Sound Practices for Loan Accounting, IOSCO’s Operational and Financial Risk
Management Control Mechanisms for Over-the-Counter Derivatives Activities of Regulated Securities
Firms, and IAIS’s Supervisory Standards on Licensing.
As presently drafted, the primary purpose of the standards is related to the regulation covering individual
institutions. In March 2000, the Joint Forum set up a working group to compare the standards issued by
the Basel Committee, the IAIS, and IOSCO by identifying common principles and understanding
differences where they arose. Each standard provides an overview of the key elements of the supervisory
regime in that sector at the time they were written. Notwithstanding different objectives served by the
three standards, no evidence has been found of an underlying conflict or contradiction between the three
sets of standards at the highest levels. There are numerous areas of common ground (e.g., authorization,
organization of supervision, and intervention). However, in some cases variations were identified in the
application of similar principles (e.g., different capital treatment of similar risks in different sectors).
There are differences among the standards —some arising from intrinsic differences between the three
sectors and others not readily explained in this way. Variations are found in preconditions, group-wide
supervision, cooperation and information sharing, safeguarding of client assets, and application of
uniform prudential standards.
Sources: Financial Stability Forum, www.fsforum.org; The Joint Forum, 2001
- 9 -
7. The remainder of the paper is organized as follows. Section II discusses the
implementation record across sectors, focusing on the principal components of the regulatory
standards. Section III reviews the main areas for strengthening implementation; and
Section IV presents corresponding recommendations for improving implementation and
strengthening regulatory standards. Section V then lists the issues for discussion. An
accompanying Background Paper covers details of the implementation record, structural
features and trends in financial systems, and work underway by the standard setters.
9
II. IMPLEMENTATION OF REGULATORY STANDARDS
A. Framework for Analysis
8. The analysis of implementation experience focused on the main regulatory issues
relevant from a financial stability viewpoint. For this purpose, the regulatory standards were
grouped into the following four main components, broadly based on the Joint Forum
framework (2001) (see Box 2 for the list of principles included in each regulatory component):
• Regulatory governance, which refers to the capacity of the regulatory bodies to
make decisions without interference and to formulate, implement, and enforce sound
regulatory policies and practices.
10
• Prudential framework, which comprises the rules, directives, and regulatory
requirements that set forth the structure to govern the operations of financial firms.
• Regulatory practices, which refer to the practical application of the prudential
framework.
• Financial integrity and safety net arrangements, which refers to the regulatory
policies and instruments designed to promote fairness and integrity in the operations
of financial institutions and markets, and the provision of safeguards for depositors,
investors and policyholders, particularly during times of financial distress and crisis.
9
Financial Sector Regulation: Issues and Gaps—Background Paper.
10
A recent IMF staff working paper shows that regulatory governance has a significant influence on
financial system soundness (See Das, Quintyn, and Chenard, 2004).
- 10 -
Box 2. Financial Standards and their Four Main Components
Regulatory Governance 1/
• Objectives of regulation
• Independence and adequate resources
• Enforcement powers and capabilities
• Clarity and transparency of regulatory
process
• External participation.
Prudential Framework 2/
• Risk management
• Risk concentration
• Capital requirements
• Corporate governance
• Internal controls.
Regulatory Practices 3/
• Group-wide supervision
• Monitoring and on-site inspection
• Reporting to supervisors
• Enforcement
• Cooperation and information sharing
• Confidentiality
• Licensing, ownership transfer, and
corporate control
• Qualifications.
Financial Integrity and Safety Nets 4/
• Markets (integrity and financial crime)
• Customer protection
• Information, disclosure, and transparency.
1/ Includes BCP 1 and 19; ICP 1; IOP: 1,2,3,4,5,6, and 7.
2/ Includes BCP 2,3,4,6,16,17,18,20,22,23,24, and 25; ICP 2,3,4,5,12,13,15,16, and 17; IOP 8,9,10,11,12,13, and 29.
3/ Includes BCP 5,6,7,8,9,10,11,12,13, and 14; ICP 6,7,9, and 10; IOP 17,18,20,21,22,23,25, and 27.
4/ Includes BCP 15, and 21; ICP 11 and 16; IOP 14,15,16,19,24,26,28, and 30.
For this paper, the allocation of insurance principles are based on the 2000 IAIS standard.
9. Using the framework outlined above, the record was reviewed in 36 countries to
distill the level of implementation of various regulatory standards. The sample of
countries consisted of 10 industrialized countries, 12 emerging market countries, and 14
developing countries.
11
Financial systems in these countries show considerable diversity
across dimensions such as ownership, financial depth, degree of concentration, competition,
efficiency, and openness. In 12 of the sample countries, regulation across sectors was carried
out by integrated financial agencies. The arrangements ranged from a regulatory agency
overseeing all or a combination of sectors, to the central monetary authority being
responsible for cross-sector regulation. In almost all cases, however, regulation was
continuing to be carried out along sectoral lines, including the regulatory treatment of cross-
sector issues.
B. Implementation Overview
10. Drawing upon detailed data from individual assessments, indicators were
constructed measuring the level of implementation for each of the four main regulatory
components across countries and standards.
12
Although the precise terminology differs,
11
In terms of regions, there were 3 countries from Africa, 4 from Asia, 21 from Europe, 6 from the
Middle East and Central Asia, and 2 from the Western Hemisphere.
12
Additional details on the implementation record can be found in Section II of the Background
Paper.
- 11 -
all three standards classify the level of implementation of individual principles into four
categories, denoted for the purposes of this paper as compliant, largely compliant, broadly
compliant, and noncompliant. Each of the categories was assigned a numeric value from 4.0
(compliant) to 1.0 (noncompliant). A simple average of the regulatory principles was
calculated for each of the four regulatory components, implying that individual regulatory
principles were given equal weight in the resulting indicator. Simple averages were also used
to aggregate the indicators across countries and across standards.
11. Potential statistical problems with the sample need to be kept in mind while
interpreting the results. The results reflect the financial sector landscape of the assessed
countries and, while suggestions about representative behavior may be advanced, the
relatively small size of the sample has to be acknowledged.
13
Also, the potential sample
selection problems are a reason for caution. First, the FSAP is a voluntary exercise,
potentially inducing self-selection of higher performers. Second, the 36 countries included in
the sample went through assessments of all three sectors, that is, their insurance and
securities markets were deemed important enough to warrant a formal assessment along with
the banking sector.
14
12. Overall, the results show that for the majority of countries, the average level of
implementation of the four regulatory components, across sectors, is broadly
satisfactory in terms of the technical criteria under the regulatory standards.
The data
suggest that the level of implementation has been rather even across the four main
components. The average implementation of all four components falls between 2.8 and 3.3
on the above-mentioned scale (Figure 1). The prudential framework and regulatory practices
components display a slightly stronger level of implementation than regulatory governance
and financial integrity and safety net arrangements. At the same time, the implementation of
the latter two components exhibits a relatively higher degree of variation across countries.
13. Implementation of standards in industrial countries is better than in emerging
markets and developing countries (Figure 2).
15
The average implementation in industrial
countries reached 3.6, on the 1.0–4.0 scale. Industrial countries thus were relatively close to
full implementation. Emerging markets lagged behind, with average implementation slightly
over 3.0, as did developing countries (2.9). Appendix Figures 1 and 2 confirm that the overall
13
It is worth noting that the sample includes over half of the completed FSAPs.
14
These countries therefore tend to demonstrate relatively more developed financial systems. This is
irrespective of the level of economic development, which may increase the average reported level of
implementation. The latter point also likely contributed to relative over-representation of European
countries in the sample.
15
In the case of banking, data also shows that financial strength of banks is generally lower in
developing countries, and by and large this is associated with weaker implementation of the BCPs. In
several cases, though, institutions remain financially weak despite a higher degree of implementation
of banking standards.
- 12 -
levels of implementation across sectors and components are positively related to both income
levels and financial deepening.
14. Furthermore, the levels of implementation across sectors are correlated. On
average countries tend to display relatively similar levels of implementation in all sectors
(Appendix Table 1). Also, the variation in implementation levels is substantial and greater
for developing countries and emerging markets than for industrial countries. Thus, the
average figures mask a substantial variation in individual country performance.
Figure 1. Regulatory Standards: Average Implementation by Main Components
1/ 2/
3.32
3.26
3.06
3.09
2.76
3.25
2.96
2.91
3.23
3.01
3.31
3.05
1.0 1.5 2.0 2.5 3.0 3.5 4.0
Regulatory Governance
Regulatory Practices
Prudential Framework
Financial Integrity and Safety Net
Assessment Grade (error bars indicate minimum and maximum observations)
IOSCO
IAIS
BCP
1/ Includes 36 countries.
2/ Grades Structure: 4=Compliant, 3=Largely Compliant, 2=Broadly Compliant, 1=Noncompliant. The higher the grade,
the higher the compliance level. For core principles included in each of the four categories, see Box 2.
15. High levels of implementation are noted particularly with respect to the legal
foundation for the regulator. In the case of industrialized countries, most regulators have
adequate powers of inspection and investigation, providing for independence and
accountability of actions, and over half utilize such powers effectively. Although the level of
implementation drops in emerging and developing markets, the basic elements of an
appropriate legal structure for regulatory agencies are generally observed to be in place, with
additional needs for further strengthening of the legal and regulatory framework, particularly
in terms of independence of agencies and clarity and consistency of regulatory powers.
- 13 -
Figure 2. Regulatory Standards: Average Implementation by Country Type
1/ 2/
3.61
2.90
2.72
3.47
3.09
2.87
3.60
3.07
2.98
3.57
3.06
2.85
1.0 1.5 2.0 2.5 3.0 3.5 4.0
Industrial
Emerging
Developing
Assessment Grade (error bars indicate minimum and maximum observations)
Regulatory Governance Regulatory Practices Prudential Framework Financial Integrity and Safety Net
1/ Includes 36 countries.
2/ Grades Structure: 4=Compliant, 3=Largely Compliant, 2=Broadly Compliant, 1=Noncompliant. The higher the
grade, the higher the compliance level. For core principles included in each of the four categories, see Box 2.
16. In the prudential area, broad capital, solvency and margin requirements have
been prescribed across sectors. Financial reporting requirements have been established,
with regulatory reporting at least quarterly, and audited financial statements required on an
annual basis. Legal powers and a broad range of sanctions against problem financial
institutions exist, although banking and insurance regulators continue to have limited
discretionary powers and in many cases, the power can only be exercised by the government.
17. The licensing process and designating minimum entry standards came across as
being adequate in most countries, but more so in industrial and emerging countries. In
industrialized countries, the regulatory framework for self-regulation is also seen as having a
relatively high level of implementation. This is an indication that in most countries,
particularly those with larger and more complex markets, the regulatory regimes make
appropriate use of outside participants in the regulatory process (such as auditors, actuaries,
and Self-Regulatory Organizations (SROs)), which have some oversight responsibilities for
their respective areas of competence. However, a wide variety of operational and legal
arrangements relating to the use of third-parties makes the quality of implementation difficult
to assess.
- 14 -
C. Cross-Sectoral Regulatory Weaknesses
18. The implementation record, although relatively strong in terms of technical
compliance with regulatory standards, also suggests that regulatory weaknesses exist in
several areas.
16
Implementation does vary in practice, across both standards and the four
regulatory components. Even though prudential frameworks and some aspects of regulatory
practices are well established and supported by a range of technical guidance from standard
setters, implementation of the other regulatory components is strongly conditioned by
country-specific factors. The main issues within each of the four regulatory components are
set forth below.
Regulatory governance
19. The main weaknesses relate to regulators’ independence, regulatory objectives,
and governance arrangements between the regulator and self-regulatory organizations.
• Regulatory agencies frequently lacked both formal and informal independence
from political and industry influence. In banking, one-third of the countries in the
sample had deficiencies in this area, while in one-quarter of the countries the
securities regulator lacked operational independence.
17
Similarly in insurance, lack of
independence from the Ministry of Finance (MOF) was a major issue—mainly in
developing countries, where over half of the sample countries exhibit poor
implementation.
• In many cases where formal independence had been granted to the regulator,
the accountability arrangements were ill-defined. Lack of accountability often led
to a lack of clarity and predictability in rule-making and enforcement. Accountability
and transparency are necessary corollaries to independence and affected the
credibility of the regulatory process.
• In some countries, different categories of deposit-taking institutions—
commercial and savings banks, cooperatives, and credit unions—were regulated
under different laws and often also by different regulators. This often led to
differences in the regulation of similar financial activities and instruments, resulting
16
Twenty-nine out of the 36 countries in our sample published their FSSAs and financial sector
ROSC modules. These, along with other published FSSA/ROSCs are available on the www.imf.org
webpage, and provide country specific information. See also the Background Paper (Appendix II of
Section I) for examples of some country specific weaknesses in banking area found during the FSAP
evaluation.
17
For the securities regulators, the principal issues concerned appointment and tenure of the Board of
the agency, reliance on government appropriations for funding purposes, and inability to influence the
legislative and regulatory framework pertaining to the role and responsibilities of the agency.
- 15 -
in arbitrage opportunities and competitive distortions between different types of
regulated institutions.
• Regulatory forbearance is a problem in some countries. The incidence of
regulatory forbearance or delays in adequately addressing financial system problems
suggests that there may be some negligence in the regulatory attitude or that the
regulatory governance framework is weak. The problems are compounded if the
regulators are not immune from being sued for carrying out regulatory functions and
if they fear to intervene in the absence of absolute proof.
• Despite some regulatory regimes making use of SROs, oversight responsibilities
were frequently ill-defined. The governance arrangements between the insurance
and securities SROs and the regulatory agencies show several accountability and
transparency deficiencies. Over a third of the countries were found to need more
clearly defined responsibilities for the securities SROs, as well as better arrangements
for cooperation and information exchange between the regulator and SROs. Similar
problems were found to exist in the case of the insurance sector.
• Other recurring cross-sector issues. Legal protection of regulators remains weak
(e.g., an issue in one-third of the sample countries for banking regulators). Similar
problems relate to clarity of regulatory powers, organization of the regulator, and
remedial and enforcement powers.
Regulatory practices
20. Actual regulatory practices on the ground are less robust than envisioned in the
regulatory standards, weakening the effectiveness of regulation. In most cases laws and
rules were in place. However, weaknesses were found in many cases in the conduct of
regulation, such as those relating to enforcement, consistent application of rules and laws,
and the effective and timely application of regulatory powers. These weaknesses result in risk
factors remaining unidentified or unaddressed. The main vulnerabilities across sectors relate
to the following issues:
• Consolidated supervision and regulation over all parts of a financial group—
(domestic and foreign) remain weak and ill-defined. Consolidated supervision was
not effectively implemented in broadly one-third of the countries. In particular,
consolidation of accounts and consolidated monitoring of prudential standards were
in need of improvement.
• Regulatory data and reporting shortcomings were recurrent across countries.
Financial information requirements were not comprehensive enough and, in some
cases, consolidated reporting was not a requirement. In some emerging market
countries, insufficient use was made of the data received, resulting in weaknesses in
the level and regularity of market surveillance.
- 16 -
• Powers to enforce regulations and impose sanctions were limited. Even where
powers were adequate in the emerging and developing countries, primary deficiencies
were identified in the areas of post-inspection investigation and enforcement.
Remedial measures were either not being implemented or delayed. In banking, the
ability to take effective remedial action was insufficient in around one-third of
countries. In some cases this was not as a result of weak laws and regulations, but due
to forbearance. In the securities sector almost half of developing countries
demonstrated significant weaknesses in the implementation of sound enforcement
practices.
• In the context of host country regulation of foreign institutions, cooperation
between home and host country regulators were frequently found to be
inadequate. Taxes, accounting standards, investment restrictions, or capital adequacy
requirements that differ across countries may create regulatory arbitrage opportunities
warranting cross-border collaboration. In banking, where this issue is particularly
important with a view to the implementation of Basel II, around one-fifth of countries
had insufficient arrangements in this area.
• Regulations did not fully address changes of control of regulated firms. For
instance, in around one-quarter of the countries examined, bank regulators had no
clear definition of control on which to base their assessments, and in some cases, fit
and proper criteria could not be applied to controlling shareholders.
Prudential framework
21. A strong focus on prudential regulation was evident across countries and sectors.
The objective is to ensure that prudence is exercised in assuming and managing risk. While
the regulatory focus has moved toward ensuring that financial strength and soundness of
financial firms are maintained, a few recurrent shortcomings remained:
• Substantial deficiencies were found in the monitoring and oversight of country
risk. Despite the presence of foreign banks, insurers and securities firms, and
internationally active financial conglomerates, one-third of the evaluated countries
had not fully developed regulatory systems in this area. Half of the emerging market
economies were assessed to have insufficiently implemented regulations related to
country risk.
• Regulatory requirements relating to connected lending or related party
transactions were insufficient. Approximately one-quarter of the sample countries
did not have adequate definitions of what constitutes a related party. Where legal and
definitional clarity was missing, the enforcement of financial groups was weak.
• A significant weakness across sectors relates to the prudential requirements
concerning corporate governance. This was particularly weak for the banking and
insurance sectors. In insurance, two-thirds of all the sample countries exhibited
substantial weaknesses, with emerging markets and developing countries showing
- 17 -
problems more frequently. Also in this area, weaknesses in consolidated supervision
led to deficient practices with regard to corporate governance.
• Sector specific issues: The following were also deficiencies in areas unique to each
sector:
- Credit risk management. In banking, a serious concern relates to credit risk
management. Almost half of the countries reviewed had deficiencies owing to
insufficient guidance with regard to credit risk management, loan classification
and provisioning, large exposures and country and transfer risk.
- Asset quality. In insurance, one-third of all sample countries (and the majority
of developing countries) demonstrated weak regulation of asset quality, and 60
percent of developing countries insufficiently supervised reinsurance practices of
insurance companies.
- Capital. Deficiencies with regard to the monitoring and inspection systems
ensuring compliance with capital and prudential requirements were found in
approximately one-quarter of the assessments.
- Collective investment schemes. In relation to collective investment schemes,
around one-third of securities assessments identified the need for enhancements
to the provision of information concerning scheme eligibility requirements.
18
A
similar number of assessments recommended that regulators address weaknesses
in the mechanisms in place to calculate asset valuation and pricing of units in
collective investment schemes.
Financial integrity and safety net
22. With respect to financial integrity and safety net practices, the regulatory
approaches differed greatly and largely followed sectoral lines. The implementation
levels across sectors also differed and revealed the following weaknesses:
• Content and timeliness of disclosure was a common issue across all countries. In
emerging markets, about a third of the sample countries demonstrated particular
weaknesses in continuous disclosure requirements.
18
Eligibility requirements in this context relate to the regulator’s role in imposing minimum standards
of conduct prior to commencement of marketing an investment scheme, including the honesty and
fairness of scheme operators, human and technical resources, diligence and effectiveness, and
operator-specific power and duties in the investment process. In many of the assessments, assessors
noted that several of these aspects were either lacking or needed to be enhanced through better
guidance to schemes.
- 18 -
• Protection of minority shareholder rights was another area of concern, with less
than half of all developing countries and only around two-thirds of emerging market
countries having the necessary regulatory framework in place.
• Accounting and auditing problems appeared in most countries across income
groups. In securities markets, the assessment of issuers indicated that approximately
one-third of the countries sampled had gaps in the application of International
Financial Reporting Standards or IFRS (formerly International Accounting Standards
or IAS). The audit function was also weak in at least one-quarter of countries
assessed, with assessors concluding that greater oversight of accountants and
auditors—at an independent level—was desirable.
• Procedures for orderly winding up of failed insurers and securities firms were
absent in a significant number of countries sampled. Approximately a third of
those countries were assessed as having inadequate insolvency and bankruptcy
regimes. In addition, improved mechanisms for addressing default risk and market
disruption more generally were needed in these and other jurisdictions.
• Anti-money laundering efforts were weak in many of the countries sampled
across income groups. For instance, under the banking and insurance standards, one-
quarter of the countries exhibited serious deficiencies, primarily in the so-called
know-your-customer rules.
D. Factors Explaining Implementation Weaknesses
23. The assessments suggest that several factors typically impede the
implementation of regulatory standards. This issue becomes particularly significant when
viewed in light of the fact that the regulatory standards represent the minimum requirements
of a good regulatory system.
Regulatory preconditions
24. Regulatory preconditions play an important role, and implementation problems
often arise in countries where regulatory prerequisites are weak (see Box 3). Although
not part of the formal standards framework, regulatory preconditions consist of the general
policy and environmental conditions and institutional infrastructure essential for effective
regulation. Weaknesses in regulatory preconditions can impede the regulator’s ability to
fulfill the regulatory objectives. Regulators, in general, have limited ability to change these
preconditions directly but may be able to take steps to compensate for some of the
deficiencies.
25. The sound policy and operating environment required for effective regulation is
not always present. Notably the absence of sufficiently strong legal and accounting
frameworks and resources often pose problems. While such factors may be outside the
authority of regulators, few regulators attempt to alert appropriate domestic authorities of any
- 19 -
material weaknesses. Regulators are also reluctant to prescribe enhanced requirements and
other safeguards to compensate for precondition-related weaknesses.
26. Evaluations carried out in conjunction with financial stability analysis under the
FSAP reveal several precondition-related vulnerabilities.
19
• Legal aspects such as inadequate financial legislation and bankruptcy laws and
difficulties in judicial foreclosure processes are affecting regulatory practices.
There are also other issues, such as insufficient segregation of client assets, which
should, if fully implemented, protect the clients in the event of failure of a market
intermediary, and poor enforceability of legal obligations. These inadequacies
obstruct the use of sanctions, timely corrective action, and winding up of insolvent
firms. They also affect market conduct practices.
19
In the insurance area, the IAIS has taken a significant step forward by incorporating the basic
conditions for good insurance regulation as the first principle of its recently revised regulatory
standard.
Box 3. Preconditions and Linkages with Regulation
Recent assessments of implementation of financial sector standards, as well as a survey of published financial
sector ROSCs found a number of countries that did not have the regulatory preconditions in place.
There are
important linkages between preconditions and effective regulation that are often missed. Though not part of the
formal framework, standards are premised on the existence of preconditions and a number of commonalities
exist.
• The precondition of “sound and sustainable macroeconomic policies” has the most significant impact on
the prudential elements such as the adequacy of capital, interest rate risk, foreign exchange risk and
other market risks.
• The presumption of a “well-developed public infrastructure” affects the regulatory elements related to
asset valuation, supervisory powers, enforcement, exercising rights against collateral, licensing, and
accounting frameworks.
• “Procedures for resolving problem institutions” and “appropriate levels of systemic protection or safety
nets,” have a bearing on the principles related to market disclosure, market conduct, corporate
governance, and the enforcement of corrective actions.
Where these preconditions are weak, it should not be surprising that implementation in the related area of the
standards is also compromised.
1/
For instance, major shortcomings in accounting and auditing may prevent
regulators from effectively monitoring the financial position of financial firms. Similarly, the absence of
appropriate procedures for problem bank resolution may make regulators helpless when action to restore
stability is needed. Information on the preconditions can also be derived from the assessment of other standards
(such as, accounting and auditing, and corporate governance) where available.
1/ For another discussion of the role of external circumstances similar to preconditions, such as effectiveness of
government, and control of corruption see Kaufmann, Kraay, and Mastruzzi (2003).
- 20 -
• Weak accounting standards and the absence of a high-quality audit profession
are affecting the quality of regulatory reports and disclosure. Many countries also
face a scarcity of qualified financial analysts and actuaries—a situation which often
results in unreliable regulatory and financial information.
27. The relationship between preconditions and implementation can be illustrated
by the positive correlation between the rule of law index and average implementation.
As the assessments do not provide enough information for quantitative work, the index of
rule of law compiled by Kaufmann, Kraay, and Mastruzzi (2003) was used to illustrate the
importance of preconditions in Figure 3 below.
20
The data show a clear positive relationship
between rule of law and the average level of implementation of standards. However, the level
of preconditions observance—the rule of law index as well as other governance indicators
like overall government effectiveness—is also positively correlated with the level of income
across countries.
21
Further research will be needed to disentangle the interaction between
income level and regulatory preconditions and their relevance for standards implementation
and performance of the financial sector.
Other country-specific factors
28. The level of financial development is a factor explaining uneven implementation.
Countries with very limited resources face a particularly difficult challenge in addressing
competing priorities and may not know how to build the requisite institutional and regulatory
infrastructure. Moreover, given the size and depth of the market, certain components of the
standards may have little relevance to a country’s circumstances. Both of these factors lower
the overall implementation rate. Also, regulators in such systems face very different
challenges from those in well-developed financial systems.
20
The cited reference is an update of previous work by Kaufmann, Kraay, and Zoido-Lobaton (KKZ
indices). The rule of law index includes perceptions of incidence of crime, the effectiveness and
predictability of the judiciary, and the enforceability of contracts.
21
In our sample, the correlation coefficient between the rule of law and income was 0.84 and the
same indicator for government effectiveness and income stood at 0.85.
- 21 -
Figure 3. Rule of Law and Implementation of Standards
R
2
= 0.53
2.00
2.20
2.40
2.60
2.80
3.00
3.20
3.40
3.60
3.80
4.00
-2.00 -1.50 -1.00 -0.50 0.00 0.50 1.00 1.50 2.00 2.50
Index of rule of law
L
e
v
e
l
o
f
i
m
p
l
e
m
e
n
t
a
t
i
o
n
Average implementation
Linear (Average implementation)
29. A range of “public policy considerations” to the regulatory process leads to
regulatory forbearance and impacts implementation. Assessments reveal that pursuit of
multiple regulatory objectives and public policy considerations results in a range of
regulatory forbearance practices. Some examples follow:
• Capital adequacy measures are often loosely applied to promote indigenous banks, or
are unreliable due to weak loan classification and provisioning practices.
• Breaches of large exposure limits or other asset concentration guidelines are often
tolerated, for instance, in cases of undiversified economies where there are few
creditworthy borrowers.
• Loan loss recognition may be deferred in response to problems in systemically
important institutions.
• Withdrawal of licenses are often delayed for extended periods in spite of serious
solvency problems.
- 22 -
30. Financial systems with predominantly state-owned financial institutions are
particularly susceptible to many of the weaknesses identified above. State-owned banks,
insurers, and investment firms have generally been subjected to lighter supervision than
privately owned firms. Frequently, regulators nominally have the requisite powers, but are
hindered in taking adequate action, due to government involvement in the operation of state-
owned financial institutions.
22
31. An overarching theme affecting implementation at the country level relates to
human and financial resources. Insufficient regulatory resources and, in some instances, an
acute shortage of required skills within the country—such as actuaries, accountants,
commercial lawyers, and finance professionals—often impede the adoption of good practices
and the achievement of regulatory objectives. Insufficient numbers and quality of staff often
affect not only the capacity to apply the rules as intended, but also issues such as operational
autonomy, respect of the regulator by market participants, and the ability to stay abreast of
new developments in markets.
32. In some cases, implementation has suffered due to resistance on the part of the
industry. Efforts at bringing the regulatory framework into observance with international
practices have been stalled because of institutional weaknesses, such as lack of development
of local standards in general business practice or legislation. Often it is the perceived high
regulatory burden relative to business prospects that results in industry resistance. In some
cases, industry collusion with the government or political groups impedes implementation.
The influence wielded by industry groups can be significant where there is a weak regulatory
governance framework, particularly the absence of operational independence.
Implementation guidance
33. Implementation also suffers because of a lack of clarity and practical guidance in
some key regulatory areas (Table 1). Implementation of regulatory and corporate
governance, and improvements in the quality of financial information have suffered in some
instances owing to a lack of in-depth guidance and consensus on minimum reporting and
disclosure requirements. Similar issues arise with respect to the implementation of regulatory
cooperation and coordination, which can represent channels for exchanging experiences and
comparing regulatory techniques.
22
In response to a recent Fund staff survey, regulators indicated that they could only “draw attention
to problems in a bank and try to find a solution in consultation with the government which (is the
only authority which) could take corrective action,” while many stated that they would “take minor
action while leaving stronger action to the government.”
- 23 -
Table 1. Regulatory Standards: Areas Posing Problems in Cross-Sector Implementation
Cross-Sector Regulatory Areas Areas Where Guidance is Needed
• Preconditions
• Definitions of different types of cross-sector
products and services
• Risk management
• Group-wide internal controls
• Capital adequacy
• Sanctions
• Cross-sector and cross-border information sharing
between regulators.
• Corporate governance within regulated firms.
• Exit policies, winding up and insolvency of
financial conglomerates
• Asset classification and provisioning
• Measuring adequacy of regulatory resources
• Accounting, auditing and actuarial requirements
• Cooperation and information sharing: legal
authority, nature of relationship, topics on which
information should be shared.
34. The focus on the formal existence of regulatory arrangements rather than on
implementation poses a challenge to the evaluation of the effectiveness of regulatory
systems. This is particulalry so when regulatory deficiencies are integrated with the analysis
of financial stability in the FSAP. Assessment of implementation also requires a high level of
cooperation on the part of the regulatory bodies, both domestically and internationally; often,
confidentiality gets in the way. Lack of full information makes it difficult to form an in-depth
judgment on the effectiveness of implementation, leading to disagreements on the
assessments, interpretation, and appropriate actions to strengthen implementation.
III. STRENGTHENING REGULATORY STANDARDS
35. The above review of implementation of good regulation brings out a number of
issues related to the regulatory standards themselves.
23
The challenges are arising mainly
due to three factors: (i) the diversity of financial systems; (ii) growing cross-sectoral and
cross-border issues; and (iii) the objectives and design of regulatory standards.
A. Diversity of Financial Systems
36. Financial systems are showing considerable diversity. The FSAPs are highlighting
differences across several dimensions such as ownership, the role of government in financial
intermediation, financial depth, concentration, competition, efficiency, currency composition,
and openness. Diversity also exists in relation to intermediation patterns, such as with respect
to the scope of financial services (savings facilities, credit facilities, contractual savings and
hedging). Aggregate balance sheet structures also vary across different financial (banks,
insurance) and nonfinancial sectors (corporate, household, public sector), and highlight key
linkages among balance sheet components.
23
See Appendix II for an overview of the main gaps in regulatory standards.
- 24 -
37. The diversity of financial systems poses challenges for the uniform applicability
of the current sectoral standards across financial systems. Some of the regulatory
standards recognize elements that distinguish mature and developing financial systems.
24
This approach helps to enhance the universal applicability of regulatory standards. However,
scope exists for further enhancing the inclusiveness of regulatory standards. Four broader
issues observed in some countries deserve particular attention. These are: (i) regulatory
preconditions; (ii) governance issues; (iii) treatment of financial systems with state-owned
financial institutions; and (iv) prudential issues created by dollarization (see Box 4).
25
Preconditions
38. Implementation can be strengthened with additional guidance on the role and
importance of preconditions. Current standards have been formulated from the viewpoint
of relatively developed and market-based financial systems. A number of their underpinning
features are either not immediately available in some countries or these features are anchored
to a different paradigm.
26
39. While mentioning the importance of preconditions, the standards provide little
or no guidance on the impact on implementation if weaknesses relating to preconditions
exist.
27
The links between specific preconditions and particular elements of the standards are
unspecified, leaving considerable room for judgment in assessing the regulatory implications.
24
This is done in the assessment methodologies. The banking and insurance standards distinguish the
essential assessment or implementation criteria from the more advanced criteria.
25
For a detailed discussion of financial stability in dollarized economies, see SM/03/112. In a recent
discussion of this paper, the directors agreed that the dollarization of bank liabilities and bank loans
poses unique challenges and generally agreed that the range of policy responses observed at the
country level and recommended by standard-setting bodies often remain insufficient, particularly in
the most highly dollarized economies (BUFF/03/77).
26
For example, a legal framework built on approaches of arbitration and consensus may be no less
effective that one where litigation is the principal means for dispute resolution.
27
This limitation has been recognized in the 2003 revisions to the IAIS Insurance Core Principles,
which now require an assessment of preconditions important for insurance regulation. The revised
supervisory standard explicitly incorporates preconditions as an element of the standard. It also
provides implementation guidance, and states that, where these conditions do not yet sufficiently
exist, the supervisor could have additional powers to address the weaknesses. However, no guidance
is provided on how precondition-related weaknesses should be taken into account when evaluating
implementation.
- 25 -
State-owned financial institutions
40. Regulatory standards need to take into account the phenomenon of state-owned
financial institutions and policy-based financial activities. In many countries, the financial
system structure is characterized by the prevalence of state-owned financial firms. This is
particularly so in banking, where despite several privatization initiatives over the last decade,
public sector banks still account for a significant portion of total banking sector assets.
41. State ownership of financial firms raises several regulatory issues. These include:
(i) weak corporate governance structure and management; (ii) political interference with
business decisions; (iii) conflicts of interest, such as preferential lending to state-owned
enterprises or investing assets in other state-owned firms without prudent due diligence;
(iv) difficulties in implementing and enforcing any remedial measures; and (v) absence of
market discipline. The current regulatory standards do not adequately address the numerous
regulatory issues raised by state ownership of financial institutions.
Dollarization
42. Prudential issues raised by dollarization could also be explicitly addressed by
standards. An increase in de facto dollarization has been observed in many developing and
emerging market economies. While it has not affected all countries equally, it is widespread
and increasing (Reinhart, Rogoff, and Savastano, 2003, and De Nicoló, Honohan, and Ize,
2003). Dollarization can have important regulatory implications for stability of financial
Box 4. Regulatory Implications of Dollarization and Government Ownership
Risk Factors Regulatory Issues
Dollarization • Higher balance sheet (solvency)
risk, both due to direct (net open
foreign exchange position) and
indirect risk arising from unhedged
credit exposure to the corporate
sector.
• Diminished role of central bank as
the lender-of-last-resort.
• Higher vulnerability of deposits to
runs, with diminished scope of
interest rate defense.
• Adjustment of prudential
rules to limit risks.
• Bank soundness as well as
transparency critical to
prevent banking instability.
Government ownership
of financial institutions
• Weak governance and political
interference in business decisions.
• Conflicts of interests for
supervisors and resulting
forbearance.
• Absence of market discipline.
• Introduction of proper
governance structures and
minimization of conflicts of
interest.
• Uniform treatment of
financial institutions by
regulations and supervision,
irrespective of ownership.
- 26 -
systems. Balance sheet effects of asset and liability valuations and the diminished role of
central banks as lenders of last resort are usually mentioned among the main risks. Although
it is usually suggested that financial dollarization entails not only risks but also benefits
(Baliño et al., 1999), the exposure to solvency, unhedged credit and liquidity risks might
make financial systems inherently more fragile. Since dollarization is prevalent in developing
and emerging market countries, more detailed international guidance on its regulatory
implications would be helpful.
B. Cross-Sectoral and Cross-Border Issues
43. Cross-sectoral and cross-border linkages in the financial sector are growing.
These include ownership and transactional linkages among banks, insurers, pension funds,
and securities firms through conglomeration.
28
Conglomeration and risk transfer among
different sectors increases contagion risks as cross-sectoral linkages in the financial sector
mature. Also, as cross-border capital movements become liberalized and exchange rate
controls are abolished or reduced, financial systems are becoming increasingly integrated.
The substantial volume of financial transactions recorded in the offshore financial centers is
another indication of significant internationalization of financial flows. Thus, the
conglomerate phenomenon is being amplified by increasing internationalization of financial
sectors across countries, resulting in new forms of risk transfer. These developments
transcend regulatory frameworks provided by sectoral standards and call for strengthened
guidance on cross-sectoral and cross-border regulatory issues (see Box 5).
44. There are also specific vulnerabilities to financial system stability in countries
that are major international financial centers or operating offshore financial centers.
Many financial institutions have established themselves in such markets, often under more
favorable tax regimes.
29
They provide services to nonresidents and are often subsidiaries or
branches of major internationally active (and often cross-sector) groups. The business
objectives and incentives for cooperation with the regulator are generally different for those
institutions operating primarily in the domestic market. The standards do not explicitly
identify and address any additional vulnerability to financial stability that may arise in an
international or offshore financial center.
45. In countries with cross-sector financial groups, the prudential framework must
cover risks pertaining to each group as well as additional risks due to the cross-sector
interlinkages. Financial legislation is often drafted on an institutional basis alone and,
particularly where regulation of the financial sector is shared among several agencies, gaps
are possible, leaving entities or activities that may pose risks to financial stability
28
See Section I of the Background Paper. Also, other sectors not considered here may offer
substantial potential for regulatory arbitrage. These include banking activities of various kinds of
nonbank financial institutions, leasing and factoring companies, and pension funds.
29
The scope for regulatory arbitrage by these institutions using offshore centers is being minimized
through the OFC and similar initiatives.
- 27 -
insufficiently regulated.
30
Standards need to emphasize that all relevant firms operating in the
financial system, particularly those that may entail systemic risk, should be under regulatory
review.
Box 5. Regulatory Implications of Conglomeration and Internationalization
Risk Factors Regulatory Issues
Increased conglomeration and
risk transfer
• Higher contagion risks.
• Regulatory and supervisory
arbitrage.
• Conflicts of interests.
• Implicit extension of financial
safety nets.
• Exposure of parts of the financial
sector to complex risk transfer
instruments.
• Effective tools and political
mandate to regulate large
conglomerates.
• Adequate expertise to supervise
complex structures.
• Harmonization of regulation
and supervision of similar
products to avoid arbitrage.
• Coordination among different
regulatory agencies.
Significant and growing
internationalization
• Higher transmission of financial
sector shocks across borders.
• Cross-border coordination and
information sharing.
• Adjustments to laws,
regulations, and deposit
insurance systems to reflect
cross-border issues.
46. Risks common across sectors are not dealt with consistently across standards.
This situation poses risk-assessment problems and creates arbitrage opportunities. The Joint
Forum has noted that the regulatory standards treat risks in different ways: banking specifies
several risks on the asset side, while the insurance standard places more emphasis on the
liability side “insurance risks.” The securities standard stresses market risks. Recently,
standard setters have begun to emphasize a broader set of risks. The insurance standard now
includes more risks on both sides of the balance sheet, while the Basel Committee has
focused more strongly on liquidity and other liability-side risks. The securities regulatory
standard expressly references the need to address all risks faced by the firm—including
market, credit, and liquidity.
47. Definitions and calculations of capital requirements differ among the sectors and
across borders. To be effective, capital must be adequate both on a group or consolidated
level and on a single entity “solo” level. However, proper monitoring is complicated by
differences in the definitions and calculations of both actual and required capital among the
30
The securities standard states that where responsibilities are shared for securities regulation, there
should be no inequities of regulation. However, this does not address inconsistencies between the
various sector supervisors.
- 28 -
sectors and across borders. For instance, some countries’ regulations accept the inclusion in
capital of unrealized gains on financial or real estate assets. Others may be flexible in
accepting various forms of collateral for reducing risk weights when calculating capital
adequacy ratios. As a result, the same nominal capital adequacy level of financial firms in
different countries may provide different levels of resilience against adverse developments.
48. There is a lack of convergence stemming from the different focus of sector
regulators. Accounting rules are not fully harmonized—either among the sectors or across
borders—and similar transactions may thus affect a group’s capital differently depending on
where within the group they are carried out.
• In banking, the Basel Committee standard on capital is adequately comprehensive
but its application needs to be underpinned by a harmonized approach to loan
classification and provisioning.
• In insurance, the most important characteristics of a capital adequacy and solvency
regime are covered at a fairly high level in the standard. Therefore, a wide range of
approaches to capital adequacy and solvency are in use, some of which may be
deficient in their ability to identify and require capital for significant risks to financial
stability or the solvency of an insurer.
31
• There is no international standard for capital for securities firms. The lack of a
common standard could lead to financial stability concerns if lower standards in one
jurisdiction lead to failures and the problems spill over into other jurisdictions.
However, this problem is somewhat ameliorated by the dual objectives of minimum
capital under the securities standard. Rather than focusing solely on maintaining
solvency, it also has the objective of enabling a firm to wind down its operations
over a relatively short period of time without loss to its customers and without
disrupting the orderly functioning of the financial markets. If the local standards
meet this latter objective, the chances of contagion are slim.
49. Notwithstanding these country nuances, other cross-country issues exist in the
area of the preconditions and governance. The prevalence of complex financial
organizations has increased the need for good corporate governance of financial institutions.
Overall, the coverage of corporate governance in the standards is limited. Although the
insurance standard explicitly addresses corporate governance, the banking standard does not
explicitly recognize the role and importance of good corporate governance. The securities
standard does not address corporate governance in a systematic way, although the importance
31
The capital required by an insurer under the index-based solvency regime currently used in the
European Union and various other jurisdictions does not depend on the composition of its investment
portfolio. The IAIS and other organizations are working to strengthen and bring convergence to
standards in this area, although much remains to be done.
- 29 -
of good corporate governance at public companies, collective investment schemes and
market intermediaries is generally recognized.
50. Cross-sectoral and international financial intermediation also requires more
active and extensive coordination and cooperation among supervisory authorities
across sectors and borders. Several countries have opted to either consolidate the
regulatory authorities, or set up other forms of institutional arrangements that secure
adequate exchange of information and cooperation among regulators. Regulatory standards
outline frameworks for dealing with cross-border operations, and coordination and
cooperation between national authorities. In practice, the degree and effectiveness of
coordination and information sharing vary across countries. As suggested by IMF (2002e)
cross-border information sharing and cooperation between regulators tend to be stronger
when formalized arrangements are in place (such as, Memoranda of Understanding or
MOU). Overall, information sharing requirements among regulators should be strengthened
(see Box 6).
Box 6. Cross-Border Regulatory Cooperation
A recent Fund staff study of cross-border regulatory cooperation issues reveals the following
characteristics:1/
• While channels for cooperation and information exchange are being established, they are far
from being effective.
• Although there are historical differences in emphasis in the objectives of cooperation and
information exchange in the different sectors—banking and insurance were focused on
solvency while securities focused on enforcement investigation—anti-money
laundering/combating the financing of terrorism (AML/CFT) customer due diligence
requirements and conglomeration in the financial services industry are bringing the
requirements closer together.
• There is a spectrum of instruments that facilitates cooperation including informal contacts and
MOUs. Many countries rely on informal and flexible arrangements, although in the absence of
legal gateways, informal contacts may not be adequate for civil and criminal proceedings.
• It is essential that national laws provide the basic gateways and do not impede cooperation and
information exchange. It is important that an appropriate balance be achieved between the
public interest in obtaining and using information and protection of civil rights.
To enhance cooperation, the following suggestions have been put forward by some regulators:
• Standard setters should consider making information on contact persons more readily available
to relevant agencies.
• National authorities should consider publishing information on contacts, gateways, and
requirements indicating “how” to communicate with them, including their statistics on
information sharing as well as unsolicited transmission.
1/ IMF Conference on Cross-Border Cooperation and Information Exchange held in Washington D.C., July 7–8, 2004.
- 30 -
C. Objectives and Design of Regulatory Standards
51. The objectives of regulation and regulatory components could be more expressly
linked to the goal of system-wide financial stability.
32
The standards are useful to
regulators charged with assessing the strength of regulated entities within each sector.
However, their use in addressing system-wide stability issues is limited, partly because they
were not written for this purpose. The standards take little account of structural issues, or of
interlinkages among different types of financial firms and markets.
33
52. Guidance is needed on the interrelationships among key components of the
regulatory standards. Several components of the standards are dependent on each other and
the standard setters should provide explicit guidance on how these interdependencies should
be addressed during implementation and assessment. For example, if the minimum
requirements on regulatory information sharing are not fully implemented, then it is very
unlikely that other elements, such as regulation of conglomerates, which are dependent upon
the existence of a well-functioning information-sharing framework, will be effectively
implemented.
53. Additional guidance on the applicability of different regulatory approaches
would be helpful. Depending on legal tradition and culture of compliance, highly detailed
and explicit legislation and regulations may be required in some countries. In other cases,
countries can manage with overriding principles, for instance “managers must ensure the safe
and sound conduct of the firm,” which are then interpreted by the regulator based on
institution-specific factors. Guidance would be useful on the conditions under which detailed
and prescriptive regulation, as opposed to flexible and discretionary regulation, is desirable.
54. The standards should be strengthened in the area of information disclosure and
made more explicit in dealing with the integrity of financial reporting. For market
discipline to work effectively, the requirements regarding public disclosure by market
participants and the applicable accounting and auditing standards need to be comparable
across firms, yet the current standards do not address this point in sufficient detail. Also, the
32
The standard setters could articulate the direct or indirect link between principles and financial
stability wherever applicable. This would help address some of the important practical issues
involved in the FSAP assessments, including an evaluation of the actual regulatory practices on the
ground, and linking the assessment outcome with the financial stability analysis.
33
Both banking and insurance standards do mention financial stability as an objective of regulation
but do not provide guidance on how the various elements of the standards are linked to that goal. In
the securities areas, this is not traditionally thought of as something that securities regulators are
involved in, with a focus mainly on investor protection. However, given the number of integrated
regulators, the need for more cohesive guidance on cross-sector regulation, and the overall role of
regulation for ensuring market stability, financial stability objective could be integrated within the
elements of various standards.
- 31 -
standards could deal with issues affecting the integrity of financial reporting more
comprehensively. The need for robust accounting, auditing and actuarial standards, together
with the existence of skilled professionals and quality control mechanisms, is critical. Given
the growing emphasis on financial and risk measurement and disclosure (such as Pillar 3 of
Basel II, or the EU Solvency standards for insurers), the importance of express standards in
this area is increasing.
55. In banking, there are currently no specific requirements on banks’ disclosures to the
general public, with the exception of an annual financial statement.
34
In insurance, public
disclosure by insurers of relevant information on a timely basis is required. The criteria that
such disclosures must meet are comprehensive, but quite high-level. The financial statements
of insurers are often difficult to understand and open to manipulation, for example, through
the modification of actuarial methods and assumptions. Disclosure requirements in a
jurisdiction could be assessed as observing this principle, without ensuring the existence of
clear and meaningful disclosure of the financial positions and risk exposures of its insurers.
As regards securities, there are extensive public disclosure and transparency expectations
that apply to public companies, securities supervisors, collective investment schemes and
organized markets. However, public disclosure of the financial condition of market
intermediaries is not addressed directly.
35
36
IV. ISSUES GOING FORWARD
56. The analysis in Sections II and III indicates the need for improving
implementation and adopting regulatory standards. The staff proposes to continue
working closely with country authorities, standard setters, and international experts and
organizations, including the World Bank, to enhance implementation and help in adapting
regulatory standards to the challenges identified in the paper. The aim shall be to ensure that
implementation takes place in a manner that is consistent with international practices while
flexible enough to reflect countries’ particular stage of market development.
34
The Basel II framework will introduce detailed requirements on disclosures.
35
This gap only applies to privately owned securities firms, as firms with public shareholders are
subject to extensive disclosure requirements.
36
The Fund staff, in collaboration with the standard setters, is undertaking a stock taking of barriers,
gateways, and practices on the basis of an expanded survey and information from FSAP and OFC
assessments. The stock taking could include a comparison of the standards’ principles on information
exchange to identify common elements and differences and ways to help facilitate compliance with
the standards.
- 32 -
Country authorities
57. At the country level, the following steps could help strengthen implementation:
• Provide greater attention to meeting regulatory preconditions. Countries should
have adequate supporting legal and financial infrastructures, and could undertake a
review of how well the regulatory system is aligned to the operating environment.
The state of regulatory preconditions may influence the design of the regulatory
approach, and in specifying the regulatory priorities and goals.
• Carry out periodic reviews of the governance framework of regulatory bodies.
Periodic review could assist the countries in identifying issues related to the adequacy
of the legal protection of regulators, their operational autonomy, and the adequacy of
supervisory and supporting judicial resources. In this context, the accountability
framework should also be examined. A strong governance framework will help
countries make timely interventions in problem institutions, and help establish a clear
institutional framework among regulators for crisis management.
• Undertake and update self-assessments of implementation of regulatory
standards. Using the methodologies prescribed by the standard setters, this exercise
could be undertaken periodically. Since financial structures are not static, regulatory
regimes would need to adapt and adjust. A process of self evaluation would help
monitor the progress. Publication of such assessments and any follow-up actions
would provide information to other regulators and stakeholders on emerging
regulatory practices and could lead to convergence of regulatory views.
• Discuss mechanisms with relevant constituents for cross-sector, cross-border
regulatory coordination and information-sharing. Consideration could be given to
establishing and maintaining regular contacts with the most relevant authorities and
making a joint effort to understand each others’ systems, while working towards an
international arrangement or an institutional mechanism for improving domestic and
international regulatory coordination and exchange of information. This will facilitate
the regular monitoring of potential contagion and regulatory arbitrage risks. It would
also facilitate the sharing of information regarding the linkages between banks and
the nonbanks operating as part of complex groups on a cross-border basis.
• Augment regulatory oversight with a focus on system-wide issues. Enhanced
research and supervisory capacity is needed on regulatory issues, especially relating
to the interlinkages between financial regulation and financial stability. Regulatory
responses could be swifter and more focused if a better understanding exists at the
country level of the interrelationships in the financial system. Issues such as the
nature of systemic exposures among banking, insurance, securities sectors, and other
sectors not analyzed in this paper, including leasing, factoring, nonbank financial
institutions, and pension fund managers deserve attention.
- 33 -
Standard setters
58. The standard setters have adopted a pro-active stance of critically reviewing the
regulatory standards and assessment methodologies.
37
The IAIS has recently completed
its revisions of the insurance standards, while the Basel Committee has begun a review of the
banking standard. IOSCO has issued its first implementation methodology. Based on the
above review of the actual implementation practices, however, the opportunity exists to make
the regulatory standards more reflective of the structural shifts and diversity across financial
systems. A more consistent approach also appears possible on issues that commonly arise in
all sectors. Specific areas of further work could include the following:
38
• How might regulatory standards best recognize the diversity of financial
systems, including financial systems in an early stage of development, dollarized
financial systems, and those where state-owned financial institutions are
significant? Standard setters could provide guidance on trade-offs between different
regulatory approaches and how regulation might be adapted to different types of
financial systems.
• Consideration should be given to including preconditions as a component of the
standards framework. To the extent possible, preconditions should be harmonized
across sectors, and the links between preconditions and the elements of standards
elaborated.
• Regulatory principles relating to cross-sectoral and cross-border issues could be
laid out in a comprehensive and consistent manner. Consideration should be given
to issuing a separate set of standards or guidance for addressing cross-sectoral
regulatory issues and their interdependencies.
• More extensive and harmonized guidance on regulatory governance
requirements would be helpful. Also, developing more specific guidance in the
areas of corporate governance and public disclosure could be considered.
• Standard setters could work with country authorities on information exchange
arrangements. The aim would be to provide practical support for formal
arrangements for improving domestic and international regulatory coordination and
exchange of information, while fostering informal contacts and communication.
59. The recommendations made by the Joint Forum in 2001 on the issue of greater
coordination and harmonization among standard setters could be revisited. Consistency
37
Ongoing work by standard setters is reviewed in Section III of the Background Paper.
38
The main areas for strengthening standards and suggested responses are detailed in Appendix II.
- 34 -
among regulatory standards might be achieved at two levels: (i) in the content and design of
regulatory standards (definitions and terminology, cross-referencing, and uniform
mechanisms for keeping the standards current with new guidance); and (ii) consistency in the
implementation process (assessment grading, self-assessment tools, assessment
methodologies and procedures, and linkages with formal stability analysis). However,
harmonization and coordination among standards must leave room for addressing aspects
that are unique to each sector, and how regulation might be adapted to different types of
financial systems.
Fund staff
60. To assist the above steps, the Fund staff could play the following supporting role:
• Consider undertaking together with other relevant bodies and the standard
setters, a study of different types of regulatory systems. This will help to
determine how well the individual regulatory standards apply across the financial
sectors (such as, how well do the banking standards apply to the securities-like
operations of banks) The study could specifically have a cross-sector and cross-
border focus, and look into the depth and intensity of regulation based on different
environments.
• Give priority to the coverage of regulatory preconditions and regulatory
practices in the context of ongoing financial sector surveillance work. In assessing
and conducting surveillance of regulatory systems, devote more attention to the
underlying infrastructure (i.e., the preconditions) and the adequacy of the regulatory
approach given the stage of development and particular challenges facing the country.
• Continue working with standard setters in a cooperative manner in providing
further guidance on implementation of good regulatory practices, and laws and
regulations. In this regard, a framework could be developed on what constitutes a
well-regulated financial system, including a consistent set of metrics to evaluate
regulatory performance and implementation practices. This will also help to focus
technical assistance more sharply on regulatory strengthening in areas where the main
vulnerabilities exist.
• Continue to provide technical assistance to help countries strengthen regulatory
systems, in close cooperation with FIRST, the World Bank, and other donors.
• Build on the existing research agenda and include financial regulation, financial
stability and linkages with macroeconomic stability. Based on this work, the Fund
staff will provide the Board periodic reviews on issues in financial regulation and
their effect on financial stability.
- 35 -
V. ISSUES FOR DISCUSSION
61. Do the suggested approaches in Section IV seem appropriate towards
strengthening implementation and fostering stronger practices in financial regulation?
Specifically:
• Is there a need for stakeholders (e.g., countries, standard setters, and staff) to pay
closer attention to the adequacy of regulatory preconditions?
• Given the importance of cross-sectoral and cross-border issues in regulation, should
the Fund, in collaboration with standard setters, conduct a stock-taking of barriers,
gateways, and practices, in order to identify common elements and differences and
ways to improve domestic and international coordination and exchange of
information?
• As the standards are applied mainly on a sectoral basis within a country, is there a
need for overarching guidance on the regulation of financial operations with cross-
sectoral and cross-border features?
• Should regulatory standards better recognize the diversity of financial systems,
including financial systems in an early stage of development, dollarized economies,
and counties where state-owned institutions are significant?
• Is the envisaged role of Fund staff in the right direction and in line with the call by the
Board for strengthening the coverage of financial sector issues in Fund surveillance
across all member countries?
- 36 -
REFERENCES
Baliño, Tomás J.T., Adam Bennett, and Eduardo Borensztein, 1999, “Monetary Policy in
Dollarized Economies,” IMF Occasional Paper No. 171. (Washington: International
Monetary Fund).
Bank for International Settlements, 2001, “The Banking Industry in the Emerging Market
Economies: Competition, Consolidation, and Systemic Stability,” BIS Papers,
Number 4 (August) (Basel).
Bank for International Settlements Joint Forum, 2001, “Core Principles: Cross-Sectoral
Comparison,” (November) (Basel).
Barth, J., G. Caprio, and R. Levine, 2001, “The Regulation and Supervision of Banks Around
the World: A New Database,” (Washington: World Bank).
Das, Udaibir, S., Marc Quintyn, and Kina Chenard, 2004, “Does Regulatory Governance
Matter for Financial System Stability? An Empirical Analysis,” IMF Working Paper
04/89 (Washington: International Monetary Fund).
De Nicoló Gianni, Patrick Honohan, and Alain Ize, 2003, “Dollarization of the Banking
System: Good or Bad?” IMF Working Paper 03/146 (Washington: International
Monetary Fund).
International Monetary Fund, 2001, Experience with the Insurance Core Principles
Assessments Under the Financial Sector Assessment Program, Washington (August)
SM/01/266 (Washington: International Monetary Fund).
International Monetary Fund, 2001, “International Capital Markets: Developments,
Prospects, and Key Policy Issues,” (Washington: International Monetary Fund).
______, 2001b, “Regulatory Issues in the Consolidation of the Banking, Insurance, and
Securities Industries: A Literature Survey,” MAE Technical Note 01/3 (October),
(Washington: International Monetary Fund).
______, 2002, “The Financial Market Activities of Insurance and Reinsurance Companies,”
in: Global Financial Stability Report (Chapter 3), (June), (Washington: International
Monetary Fund).
- 37 -
______, 2002b, Implementation of the Basel Core Principles for Effective Banking
Supervision, Experiences, Influences, and Perspectives, SM/02/310 (October)
(Washington: International Monetary Fund).
______, 2002c, Experience with the Assessments of the IOSCO Objectives and Principles of
Securities Regulation Under the Financial Sector Assessment Program, SM/02/121
(April), (Washington: International Monetary Fund).
______, 2002d, “Large Complex Financial Institutions (LCFIs): Issues to be Considered in
the Financial Sector Assessment Program,” MAE Operational Paper 02/3 (March),
(Washington: International Monetary Fund).
______, 2002e, “Consolidated Supervision: Managing the Risks in a Diversified Financial
Services Industry,” MAE Operational Paper 02/5 (September) (Washington:
International Monetary Fund).
______, 2003, “Regulatory and Supervisory Challenges and Initiatives” Chapter II,
Appendix I in Global Financial Stability Report (September), (Washington:
International Monetary Fund)
______, 2003a, “Offshore Financial Centers—The Assessment Program—A Progress Report
and the Future of the Program,” (August) (Washington: International Monetary
Fund).
______, 2003b, “Financial Stability in Dollarized Economies,” SM/03/112, (April)
(Washington: International Monetary Fund).
______, 2004, “Risk Transfer and the Insurance Industry,” Chapter III in Global Financial
Stability Report, (April) (Washington: International Monetary Fund).
Kaufmann, Daniel, Aart Kraay, and Massimo Mastruzzi, 2003, “Governance Matters III:
Governance Indicators for 1996–2002,” (unpublished; Washington: the World Bank),
also available at the Internet: www.worlbank.org
Reinhart, C., K. Rogoff, and M. Savastano, 2003, “Addicted to Dollars,” NBER Working
Paper 10015 (Cambridge, Mass.: National Bureau of Economic Research).
The Joint Forum, 2001, “Core Principles: Cross-Sectoral Comparison,” (November) (Basel:
Bank for International Settlements).”
- 38 - APPENDIX I
Income Level, Financial Deepening, and Standard Implementation
Appendix Figure 1. Income Level and Implementation
Log Y vs. PGRAL
0
10,000
20,000
30,000
40,000
50,000
60,000
2.3 2.5 2.7 2.9 3.1 3.3 3.5 3.7 3.9 4.1 4.3
PGRAL
Y
Appendix Figure 2: Financial Deepening and Implementation
Log CREDIT vs. PGRAL
0.00
0.20
0.40
0.60
0.80
1.00
1.20
1.40
1.60
1.80
2.3 2.5 2.7 2.9 3.1 3.3 3.5 3.7 3.9 4.1 4.3
PGRAL
C
R
E
D
I
T
Notes:
Y = GDP Per Capita, Credit=Credit to the Private Sector by Banks/GDP,
PGRAL=Average level of compliance across sectors and components.
- 39 - APPENDIX I
Appendix Table 1. Correlations: Income Level, Financial Deepening, and Sector’s
Implementation
GDP Per Capita Credit/GDP BCP 1/ IAIS 1/ IOSCO 1/
GDP Per Capita 1.000 0.617 0.664 0.543 0.587
Credit/GDP 1.000 0.458 0.214 0.242
BCP 1.000 0.481 0.474
IAIS 1.000 0.560
IOSCO 1.000
1/ BCP, IAIS, IOSCO are the grades of implementation with standards in each sector: 4=complaint, 3=largely
complaint, 2=broadly compliant, 1=non-compliant.
Appendix Table 2. Implementation by Regulatory Categories
Regulatory
Governance
Regulatory
Practices
Prudential
Framework
Financial Integrity
and Safety Net
BCP
Industrial 3.729 3.650 3.567 3.700
Emerging 3.194 3.107 2.968 2.964
Developing 3.179 3.153 2.824 2.750
Average 3.367 3.303 3.120 3.138
IAIS
Industrial 3.100 3.563 3.400 3.550
Emerging 2.923 3.148 2.986 2.714
Developing 2.364 3.122 2.625 2.708
Average 2.796 3.277 3.004 2.991
IOSCO
Industrial 3.586 3.600 3.733 3.593
Emerging 3.153 2.952 3.230 3.031
Developing 3.074 2.667 3.102 2.698
Average 3.271 3.073 3.355 3.107
Grades of implementation: 4=complaint, 3=largely complaint, 2=broadly complaint, 1=non-complaint.
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Regulatory Standards: Main Gaps and Suggested Response
Regulatory
Component
Main Gaps
Suggested Response
Regulatory
Preconditions
• A framework for preconditions for effective regulation and its
implementation is not expressly included in the standards.
• Interlinkages between specific preconditions and principles of good
regulation are unclear. Guidance is missing on how preconditions affect
the macro-financial situation, the crisis management framework, and
overall implementation.
• Strong reliance is placed on regulatory judgment on how weaknesses in
preconditions can be compensated for.
• Preconditions could be made an integral component of the
standards framework. (Insurance has incorporated
preconditions in 2003 which could benefit from
strengthening.)
• Interlinkages between legislative and the judicial processes
and effective regulation (enforcement, sanctions and
remedial action) could be covered in detail.
• Evaluation of implementation should require an assessment
of the application of “rule of law” and of “debtor discipline”
by the judicial system.
• Specific guidance could be provided on how preconditions
affect implementation of other regulatory components.
Regulatory
governance
• Focus is mainly on regulatory independence. Implementation guidance is,
however, missing on defining and evaluating regulatory independence in
some common situations.
• Other components of regulatory governance (accountability, transparency
and integrity) are not adequately covered by the governance-related
requirements in all sectors.
• Regulatory surveillance of macro-financial issues and monitoring overall
financial stability is not an expressly-stated objective for regulators. The
objective of reducing systemic risk is noted, but the term is undefined and
applied differently across sectors.
• Standards adopt a segmented, or ‘silo’ approach toward regulation. Thus
the issue of regulatory overlap is not explicitly dealt with.
• Regulatory governance requirements could be expanded,
harmonized, and made applicable to all types of regulatory
bodies (solo or integrated). Guidance could be provided on
the pros and cons of different approaches to regulation
(individual versus integrated, and prescriptive versus
reliance-based).
• Guidance could also be provided to facilitate the assessment
of regulatory governance components, particularly
independence.
• The concept of systemic risk could be clarified and the
monitoring and reduction of such risk could be included as a
regulatory objective.
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A
P
P
E
N
D
I
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I
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Regulatory
Component
Main Gaps
Suggested Response
• The standards framework should facilitate regulation of
all types of financial activities, without gaps and
overlaps, while promoting a fair and equitable
competition.
• Guidance is required on assessing the adequacy of
regulatory resources.
Regulatory
Practices
• Cooperation and information sharing are mentioned but the focus is more
on the ability to share information rather than on the actual practice and
effective mechanisms of information sharing on conglomerates.
• The standards lack guidance for regulators on how to develop techniques
to adequately address the risks posed by financial conglomerates and
cross-sectoral products and services, including regulatory vulnerabilities
arising from on and offshore financial activities. Guidance is also absent
on how regulators should identify the systemically important cross-
border, cross-sector firms.
• Requirements could be tightened on effective exercise of
powers within an accountable framework (“ladder of
intervention”), and for monitoring sectoral and cross-
sectoral risks and not just institution-specific risks.
• Regulatory authorities, in cooperation, should have powers
to monitor all relevant activities of conglomerates, including
those of affiliated unregulated entities and the different
categories of financial institutions within a sector.
• Regulatory cooperation could be suggested in the
monitoring of risks arising from less-regulated parts of the
financial system, especially where market participants are
not part of a financial conglomerate.
• More guidance could be provided on the identification of
vulnerabilities to financial stability in a range of situations,
e.g., in an international financial center or a jurisdiction
where government-owned entities are prevalent. The need
for proper oversight by both parent organizations and home
country supervisor(s), with relevant information being
accessible to the host regulators, could be emphasized.
Prudential
Framework
• Risks common across sectors are not being dealt with consistently.
Operational and reputational risks are mentioned but not comprehensively
addressed.
• A common categorization of risks and their regulatory
treatment could be incorporated within the standards, and
the extent to which these risks are relevant to each sector.
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2
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P
P
E
N
D
I
X
I
I
Regulatory
Component
Main Gaps
Suggested Response
• A lack of consistency exists in the capital adequacy treatment for some
financial products and services across sectors. Emphasis is lacking on
ensuring that capital must be adequate, both on a group or consolidated
level and on a single entity or individual level.
• Implementation guidance on risk management requirements, including
corporate governance, internal controls, and management of risk
concentration is not fully dealt with. In securities, this is particularly the
case with respect to market intermediaries and collective investment
schemes.
The focus of the prudential framework is at the firm level, and not at the
level of the system as a whole. In securities, the coverage of secondary
market issues does not expressly cover all possible types of securities
markets, such as the over-the-counter (OTC) market (interbank
derivatives trading and sovereign debt market).
• Further cross-sectoral work could be undertaken to achieve
greater harmonization in both the acceptable forms of
capital and the level of capital required in respect of
particular risks. While cross-sectoral harmonization at a
detailed level (such as that of Basel II) may be both
unnecessary and unachievable, harmonization at the level of
the regulatory standards may well be possible.
• Stress testing by financial firms could be suggested across
sectors, at the legal-entity level and on a group-wide basis.
Regulators should review the results and use the information
as part of their own analyses of sectoral and cross-sectoral
risks.
• More consistent and comprehensive guidance could be
provided on corporate governance and internal control as
key elements of prudential framework.
Financial
Integrity and
Safety Net
Consumer protection
• The banking standard does not explicitly recognize consumer protection
as a regulatory objective. The focus is on risks to the bank and less on
depositors or other counterparts. Insurance standard does not explicitly
address the role of the regulator in the review and approval of products
and premium rates, which may affect solvency, consumer protection and
market stability. With securities, a stronger focus is placed on protecting
investors and ensuring fair and efficient markets. However, deficiencies
relating to regulation of secondary markets lead to lower requirements of
integrity and fairness.
Financial safety net
• Both the concern relating to “moral hazard” and the role of “lender-of-
last-resort” need to be integrated within the standards framework. For
cross-sector groups, the safety net arrangement must be able to deal with
“ring-fencing” and protecting a part of the group from problems in other
• Standards should highlight the importance of maintaining
the confidence of consumers in the fairness and integrity of
the financial system. The tools used to achieve this could be
appropriate disclosures, and business conduct and conflict of
interest rules. In banking, explicit mention could be made to
consumer protection as an objective of regulation and the
requirement for a mechanism for handling consumer
complaints.
• In insurance, the regulatory review of products and premium
rates, where it exists, must be transparent, timely, and fair. It
should not impede market innovation and unduly
compromise solvency (through premium rate caps) nor
significantly distort pricing.
• In securities area, requirements relating to secondary
markets should be the same as for other organized markets.
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3
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P
P
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N
D
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I
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Regulatory
Component
Main Gaps
Suggested Response
parts. The same applies to cross-border groups. In insurance, criteria for
assessing the appropriateness of policyholder protection funds are
missing.
Disclosure of information
• Different approaches are adopted across standards. In banking, the focus
is on regulatory reporting and less on public disclosure. In insurance,
emphasis is placed on public disclosure by insurers but at a high level. No
uniform requirements exist for disclosure of the financial positions and
risk exposures of insurers. In securities, public disclosure of the financial
condition of market intermediaries is not directly addressed.
• Financial safety net issues that arise with respect to cross-
sector and cross-border groups could be explicitly
addressed. Harmonized criteria for assessing the
appropriateness of financial safety net arrangements could
be established.
• Financial safety net issues that arise with respect to cross-
sector and cross-border groups could be explicitly
addressed. Harmonized criteria for assessing the
appropriateness of financial safety net arrangements could
be established.
• Further development work on disclosure requirements
might be accelerated on a cross-sectoral basis.
Responsibility of regulators should include reviewing the
manner in which regulated firms are implementing
disclosure requirements, so as to ensure that meaningful
information regarding their financial position and risks is
disclosed. In banking, an explicit requirement for disclosure
should be included, while the securities standards should
require disclosure of the financial condition of market
intermediaries.
• For market discipline is to work effectively, requirements
regarding public disclosure by market participants and the
applicable accounting and auditing standards need to be
made comparable across sectors. Standard setters should
continue to provide inputs to the developers of such
standards and might coordinate their efforts in doing so.
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