Microprudential Structure

An agency with microprudential supervisory responsibility will affect the extent to which a number of public policy goals are obtained. For example, microprudential regulation will affect the ease with which new financial firms can enter the market and, thus, have an effect on competition. In deciding among these conflicts, there is a strong case for making prudential supervision the primary goal: Financial firms that are not operated in a prudent manner put at risk their capability to support society's other goals for the financial sector. This is not to suggest that a microprudential supervisor should not consider other goals when structuring prudential regulation. There is often more than one way to accomplish the goals of prudential regulation, and this choice should take into account the impact of alternative regulations on other goals. However, if forced to choose between what is required for effective prudential supervision and some other goal, prudential supervision generally should take priority.³

Microprudential supervisors may be assigned narrow or broad responsibilities across two dimensions: the number of goals assigned to the agency and the number of subsectors assigned to the agency. Both the set of goals and the set of firms may have a significant influence on the effectiveness of prudential supervision.

2.1 Set of Goals

An agency that is assigned a large number of goals may find that these goals distract it from effective prudential supervision. However, the assignment of responsibility for a large number of goals will not necessarily distract the agency from prudential supervision. The key is that if the agency is to be an effective prudential supervisor, it must view prudential supervision as its primary mission. Moreover, the assignment of responsibility for many goals allows the prudential supervisor to adopt a consistent set of policies and avoid having firms be told to follow mutually inconsistent policies by different supervisors. Instead, the cost may take the form of the other financial goals becoming subordinated to prudential regulation.

Although the assignment of other goals is not necessarily inconsistent with effective prudential supervision, assigning an agency with both prudential supervision and promoting a sector of the financial service industry is inviting trouble. A staff report of the US Senate Committee on Governmental Affairs (1977) discussed a common fundamental conflict when a regulatory agency is charged with both promoting and regulating an industry. The report argues that the goal of promotion typically dominates other policy goals, a tendency that can have undesirable outcomes. Many analysts believe part of the reason that the losses in the US thrift industry in the 1980s were so large because the industry's prudential supervisor, the Federal Home Loan Bank Board, was also charged with promoting the housing industry.

Structures that subject prudential supervisors' operational decisions to political review are also likely to result in prudential goals becoming subordinated to other goals. The political authorities rarely owe their power primarily to promises to give prudential supervision priority over all other goals. Thus, for prudential supervision to take priority, it is necessary for this goal to be assigned to an agency that is operationally independent, even as it remains accountable to the political system. Indeed, this is so important that the Basel Committee on Bank Supervision (1997) identified operational independence as a precondition for effective supervision.⁴

Although it is important that the agency with microprudential responsibility have prudential supervision as its primary mission, it is also important that this mission not be defined too narrowly. In particular, assigning the microprudential supervisor an overriding goal of “no failures” is likely to prove costly and counterproductive. A microprudential supervisor with a goal of no failures is incentivized to impose draconian regulations that limit risk taking in an effort to prevent its financial firms from failing. Yet, risk taking is an inherent part of an efficient economy. Financial firms exist in large part to help allocate resources to their best use and to help manage society's risk. A financial sector that is overly limited in its capability to take risk not only cannot help society manage its risk, but also forces that risk into other parts of the economy. For example, if a financial institution's capability to lend to finance purchases is overly constrained due to concerns about credit risk, that may force such lending onto the books of suppliers, even when suppliers are less able to manage credit risk. Thus, it is important that prudential supervisors be tasked with making sure that firms are managing their risks in a prudent way, not with preventing financial firms from taking risks.⁵

2.2 Set of Firms

Prudential supervisors may be assigned broad responsibility for most or all financial firms, as is the case with the Australian Prudential Regulatory Authority and the Japan Financial Services Authority. Alternatively, they may be assigned responsibility for a particular sector of the financial services industry. The advantage of assigning only one industry sector to an individual prudential supervisor is that the supervisor can build substantial depth in the types of risks being taken by that industry.

Significant problems exist with a microprudential regulator being assigned responsibility for a small subsector of the financial services industry, however. The microprudential regulator's size, power, and prestige depend upon that single subsector. If that industry encounters financial problems, both the industry and its prudential supervisor are threatened. If the supervisor openly acknowledges the problem, there is a risk that policymakers will restructure the industry and eliminate the need for the regulator. As such, the agency will be tempted to exercise forbearance and hope that the problem is cured over time. If the problem can no longer be hidden, the regulator has an incentive to support high-risk investments by the industry as it “gambles for resurrection.”⁶

The assignment of authority over a broad portion of the financial services industry has two additional advantages. First, it allows for the sharing of information and expertise among supervisors of different sectors of the financial services industry. Second, it facilitates the sharing of information between supervisors in different countries. Mismatches in responsibility across countries may reduce communications across countries and the ability of supervisors in each country to fully appreciate what they are learning from cross-border exchanges.

The set of firms may also be too narrow in one other important dimension: All the affiliates in a group should be subject to consolidated prudential supervision. Wall (1986) and Mayes, Nieto, and Wall (2008) noted that the parents of large financial groups do not operate groups such as mutual funds, in which each holding is managed separately. Instead, the primary purpose of forming such groups is to exploit economies of scale and scope that could not be obtained by arms-length bargaining. As such, groups operate as integrated entities sharing such vital services as information technology, risk management, and liquidity management. In many groups, there are few subsidiaries that could operate independently of their affiliates. Thus, in order to understand the risk management and exposure of individual subsidiaries, such as insured commercial banks, it is essential that the prudential supervisor have consolidated authority over the entire group.⁷

Milo (2007) discussed the benefits of consolidated supervision for the Philippines. She noted that the Philippines has a long history of permitting universal banking and has nine universal banks that constitute a large share of its banking system. The bank supervisor, Bangko Sentral ng Pilipinas, has moved in the direction of consolidated supervision of banking groups. However, Milo (2007: 11) noted that “its application is still rudimentary because existing laws preclude its full implementation.”

The importance of consolidated supervision of an entire group raises the difficult problem of the foreign operations of domestic groups and the domestic operations of foreign groups. The home country supervisor can obtain some information from the group about its foreign operations. However, there is also much that the home supervisor can learn about the foreign subsidiaries from the host country supervisors. The host supervisor will typically be even more dependent upon the foreign supervisor for an understanding of the condition of the parent corporation. The dependence of home and host supervisors has a variety of implications, some of which are discussed in the following sections. One important implication for domestic supervisory structure is that any agency overseeing prudential supervision must view prudential supervision as its primary responsibility. An agency that engages in prudential supervision as a secondary priority is likely to not only fail in its domestic obligations, but also in its international obligations to assist in the prudential supervision of financial firms operating across borders.

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