Prudential Discipline for Financial Firms: Micro, Macro, and Market Structures

Risk taking is an essential part of the financial system that contributes to economic growth around the world. Risk taking in the financial system is also crucial for the efficient allocation of risk within our societies. But this risk bearing should take place in the context of sound risk management. Individual firms must prudentially manage their own risks, and financial supervisors must prudently manage the risks posed by the financial system to society.

The consequences of inadequate risk management can be a financial crisis that spills over into the real economy. Several East Asian countries experienced the consequences of significant breakdowns in risk management at both the individual firm level and at the supervisory level in the late 1990s. Many Asian countries drew the conclusion from this experience that rapid increases in asset prices and/or debt may endanger financial stability. Subsequently, many supervisory authorities in Asia―including those in Hong Kong, China; India; Republic of Korea; and Thailand—tightened regulatory restrictions on residential mortgage lending to forestall rising price and debt levels (Vanikkul 2009).

The consequences of inadequate risk management are again being felt in recent years with the current global financial crisis. This time, the weaknesses were primarily in the risk management of firms in some developed countries, with the Asian financial sector having little direct exposure. However, just as the affected policymakers in Asia drew lessons from the Asian financial crisis, so too will policymakers in countries currently struggling with weakened financial systems draw lessons from the global financial crisis. Moreover, the lessons they draw from the current problems are likely to have an especially large impact on international standards, given that the crisis is occurring in the countries whose financial sophistication has led them to be leaders in such standard settings.

The purpose of this paper is to identify some of the breakdowns that occurred and evaluate some possible policy changes intended to strengthen financial sector risk management. The paper considers some alternatives to strengthen both micro- and macroprudential supervision. It also considers ways to strengthen market discipline at financial firms.

The paper's analysis of microprudential regulation notes that financial regulators are typically assigned responsibility for more than one policy goal. When these goals have conflicting policy implications, the policy option that is followed depends on the structure of the regulatory agencies and each agency's view of its primary mission. If avoidance of financial crises is a top priority, it is important that this be reflected in the overall structure of financial regulatory agencies, and it is especially important that the primary goal of the microprudential supervisor be prudential regulation.

The discussion of macroprudential supervision finds that macroprudential supervision was weak or absent in some of the key players. Many of the problems that arose could have been detected at an earlier stage by a macroprudential supervisor that conducted end-toend reviews of systemically important markets, starting with the initial underwriting and continuing through to the ultimate risk holders. In at least some cases, it may have been possible to take supervisory action that would have reduced the ultimate extent of financial instability. However, this section also makes the point that we should not expect too much of macroprudential supervision. As Cho (2009) noted, an agency with a broad mandate to deal with systemic risk issues is unlikely to be able to maintain political independence. By the time it is clear that market developments are moving to create significant risks of financial instability, it is likely that these development moves are also providing substantial benefits to politically important constituencies. These constituencies are unlikely to quietly accept the judgment of an agency that is not subject to political review. Yet if political considerations are brought into the discussion, prudential concerns will not always be the highest priority. Thus, this section concludes that macroprudential supervisors should be bold in seeking to understand the risks in the financial system and modest about promising an end to financial instability.

Both the micro- and macroprudential discussions also highlight the potential benefits of greater cross-border cooperation among supervisors. Such cooperation is essential if prudential supervisors are to have an adequate understanding of financial institutions and markets that operate across borders.

Although the structure and powers of the micro- and macroprudential supervisors are important, sound risk management starts at the firm level. A prerequisite for sound risk management at the financial institution level is that the institution's owners and managers bear the costs of bad management and receive the benefits of sound management. If the government bears most of the risk of loss, not only will the managers lack adequate incentive to manage the risk, but the government is likely to insist on playing a major role in the firm's risk management. The problem with having the government take over risk management is that many efficiency gains that arise from a market-based economy will ultimately be lost if risk management is outsourced to the government.

Unfortunately, the recent crisis is likely to have the exact opposite effect on private incentives to manage risk. The recent experience has been that governments will step in to provide bailouts if the troubled firm is sufficiently large or interconnected. The problem of how to reverse both the perception and reality that the government is bearing the risk is a difficult problem. The analysis in this section considers a number of alternatives, including deposit insurance reform, special resolutions, financial institution-prepared “shelf bankruptcy” plans, and contingent capital. It concludes that all these alternatives are likely to have a role to play in restoring market discipline.

The paper is organized as follows: The first section discusses the importance of financial regulatory structure; the second and third sections discuss micro- and macroprudential regulatory structures, respectively; the fourth section discusses issues in establishing effective market discipline structures; and the last section concludes the paper.

1.1 Importance of Regulatory Structure

Most of the current debate about regulatory structure has focused on the issue of whether to consolidate financial regulatory agencies into fewer agencies, or possibly only one agency. Čihák and Podpiera (2006) pointed out several possible advantages of integrating financial sector supervision, including greater supervisory efficiency, economies of scope, improved accountability, elimination of duplication and turf wars, and a more level playing field. They also noted some possible disadvantages of integration, including diseconomies of scope, the potential for losing key staff, and objectives that are poorly communicated or not wellspecified.

One possible explanation for many of the breakdowns in financial supervision in the United States (US) is that its fragmented financial regulatory system led to duplication in some areas and a lack of coverage in others. An obvious implication of this sort of analysis is that countries should adopt a single regulatory body, at least for the purposes of prudential supervision. However, Hsu and Liao (2009) pointed out that the structure of the microprudential regulators is not necessarily the central issue because the unified regulatory structure of the United Kingdom (UK) also encountered serious problems.

An alternative approach is to recognize that a hierarchy of objectives of the financial supervisor is even more fundamental to financial regulation than was suggested by Čihák and Podpiera (2006). Financial supervisors are typically assigned multiple goals, which may include some combination of prudential oversight, adequate disclosure, “fair” treatment of all consumers, and allocation of resources to favored sectors of the economy. These different goals will often have conflicting implications for the financial regulatory system. For example, policies intended to encourage credit flows to favored sectors may result in some financial firms becoming more risky. Horvitz (1983) argued that the structure of the financial regulatory system plays a crucial role in resolving these conflicts.

Wall and Eisenbeis (1999) discussed two general methods of dealing with conflicting goals: internal and external resolution. Internal resolution arises when the conflicting goals are assigned to a single regulatory agency. In such cases, the conflict is addressed based on the priorities of the agency head, suggesting that the conflict will be resolved in favor of whatever the agency believes to be its primary mission. For example, if an agency believes that its primary responsibility is to support credit allocation, its policy decisions are very likely to favor credit allocation policies over that agency's prudential goals.

Internal resolution can lead to the wrong outcomes if the regulatory agency does not place sufficient priority on prudential regulation. One example comes from the UK in a recent report by the House of Lords Select Committee on Economic Affairs (2009a, 2009b). The report discussed the dual responsibility for conduct-of-business supervision and microprudential supervision of the Financial Services Authority. The chairman of the Financial Services Authority, Lord Turner, noted that “it is broadly speaking true to say that in retrospect we focused too much on the conduct of business and not enough on prudential” (House of Lords, Select Committee on Economic Affairs 2009b: 177). The House of Lords report (2009a: 34) concludes the discussion this way:

Regulatory bodies are subject to conflicting political pressures. There is a danger that, when a single institution has responsibility for conduct-of-business and prudential supervision, one will be emphasised at the expense of the latter. Institutional arrangements in the future must be designed so as to minimise this danger.

In pointing out this conflict, the House of Lords committee was rediscovering a fundamental concern with the structuring of regulatory agencies of all types.

External resolution arises when the conflicting goals are assigned to different regulatory agencies. If a conflict arises, the agencies may either quietly reach an agreement on the relative priorities of the two goals or publicly disagree and seek support from the political authorities. An example from the US policy debate over bank loan loss provisioning illustrates external resolution when appeals were made to the political authorities. The US Securities and Exchange Commission (SEC) is charged with setting accounting policies to help investors make informed decisions. The SEC believes that reported net income in each period should fairly reflect the results of the firm's operations in that period. The federal bank regulatory agencies, which are responsible for the prudential supervision of commercial banking organizations, believe that banks should build up loan loss reserves during good periods to cover losses that are likely to be incurred during weaker economic conditions. US banks in general―and in particular SunTrust, a large regional bank―were caught between the two regulators when the SEC ordered SunTrust to restate its prior years' financial statements to reduce its loan loss provisions. The bank regulatory agencies publicly protested the SEC's action, but SunTrust was effectively forced to obey the SEC. So far, the result has been that Congress has told the SEC to consult with the banking regulators on some accounting decisions, but has left ultimate power over US accounting rules in the hands of the SEC.¹

Viewing agency structure through the prism of goal conflicts suggests two questions that are especially important in designing supervisory structure: Which goal conflicts should be subject to internal resolution and which to external resolution? And, in the case of internal resolution, how to make sure that the regulatory agency follows the right priorities in resolving goal conflicts?² The answers to these questions will determine the extent to which the most important goals are achieved.

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