Diversification : Known and Unknown Risks

The new-found focus of rapid diversification started with the powers given to the banking industry in the US by the Gramm-Leach and Bliley Act which swept away divisions between commercial banking, investment banking and insurance which was a clear departure from the Glass Steagall Act of the great depression. Diversification does not absolve lenders from being prudent in their credit decisions. It is well known that many bankers have made very high-risk loans in the recent years. Obvious examples include the hundreds of billions of dollars lent to telecom and technology firms during the tech bubble, generous credit extended to energy companies like Enron and the risky enterprises in Argentina. Also, large sums of money were promised to companies through guaranteed back-up credit lines to support the issue of commercial paper and other short term instruments, often without charge at the time the credit lines were set up. When the economic downturn set in, credit became harder to find and many companies had called on their back-up facility. This has created high-risk speculation that the bankers had never contemplated when the facility was first agreed. One reason for this excessive generosity was that commercial banks were trying to wean investment-banking mandates from companies, a business traditionally dominated by investment bankers. Given the competition from commercial banks, dedicated investment banks such as Goldman Sachs and Morgan Stanley too have found it hard to remain strictly within their traditional boundaries. They too have encroached into areas which were traditionally held by commercial banks.

At the same time, other financial intermediaries like the insurance companies, have now started to take on some of the risks that were the preserve of the banking system and other market intermediaries. For example, Swiss Reinsurance and Munich Reinsurance account for about 10 percent of the credit derivatives market increasing their buying up of asset-backed securities. These activities have to be regulated not just by a single regulator but also by a group of regulators. The Asian crisis and the more recent US bank involvement in corporates indicate that the bundling of financial services is an inherently riskier business than the industry previously thought.

Nowadays, banks and financial institutions appear to put their eggs into more than one basket and even selling some eggs to investors with baskets of their own. There are several critical issues here:are they as skilled at diversifying and transferring risks, as they like to think? Are those to whom they transfer the risk capable of managing it? Do the new holders understand what risks they now bear? In short, could the shift of risks from a bank-based system to a market-based one bring new dangers of its own and how could supervisors and regulators react to these dangers? Having allowed banks to engage in investment banking and insurance and seeing the known and unknown risks, the original concept that financial system works best when banks are more focused and small is now being favoured by policy makers, specially after the Enron and WorldCom scandals.

Analysts feel that the recent fall in the bank shares cannot be taken that lightly because it affects their rating, price earning ratios, and more importantly, it has raised the risk premiums applied on banks. It has also raised issues of provisioning. Moody's believe that provisioning against bad loans could easily rise to an average of 20% for big banks as problem loans in the US and Europe, Germany in particular, have been rising. In its more recent Financial Stability Review, the Bank of England has warned that the ability of companies across Europe to service debt would be hampered by falling profits. Even if banks have been efficient at offloading risk, the Review states that "lumpy exposures can still arise for banks, partly because of the range of dealings with their largest customers, including derivatives, securities underwriting, securitisation programmes, structured transactions etc.". These have clear supervisory and regulatory implications: shouldn't big banks need closer scrutiny than before? In what ways can markets and investors can be involved in supervising banks? and what should be the appropriate supervisory structure suited for global transition?


Derivatives and the Extent of Supervision

Convergence across products and intermediaries was blurring the traditional balance between banking, securities and insurance. Derivatives are meant to reduce risks but they also lead to bigger risks. This dual role makes it hard to decide whether their impact is benign or malign. Attempts have been made to shift derivative risks around the financial system as market for derivatives is growing rapidly for futures and options, both on exchanges and in private sales which tend to be more complex and more lucrative. Banks have impressed investors and regulators with their new-found ability to transfer risk off their balance sheets by selling it usually through derivatives to other institutions and to capital markets. Even if you move these products off balance sheet, you still replace them with other instruments, such as buying distressed debt. However, if you are not smart in this game, the risk can magnify leaving the banks in exposed positions. Enron, for instance, held a lot of these derivatives booking profits straightaway ever though there was a huge question mark over their long-term profitability Many of the distortions in the functioning of the financial system arise because too much attention is paid to profits and rates of return and toe little to concomitant risks.

There is no consensus on the extent to which derivatives can be regulated nationally and internationally. The sophisticated risk quantification and management models differ greatly across financial institutions, and in most cases, risk management assessments are relatively informal. In a highly competitive and rapidly changing environment it is rather difficult to restrict the derivative trade, but how and what to regulate and where to draw the supervisory line are still debatable. Another problem is that often financial institutions give undue weight to the most recent data of clients and their investment relative to their past performances.


Risks in Non-performing Loans

A realistic valuation of the financial institution's/bank's assets is essential to measure its networth; but it is extremely difficult to get such a valuation in instances of severe corporate and financial distress, like the world economic downturn in 2001 or in a world of transition. The valuation of non-performing loans (NPL) is particularly hampered by the lack of clear market values and continuously changing economic conditions. The management of NPL and other value impaired bank assets is one of the most critical aspects of bank supervision. A widely accepted method is to hive-off the NPL of banks to a separate asset management company. Countries have taken different views on the role of asset management companies. Indonesia, Korea and Malaysia have opted for centralized public asset management companies that buy assets from private banks to help them clear their balance sheets. Thailand has aggressively liquidated the impaired assets of closed banks and financial institutions through a central agency but does not permit public sector purchases of impaired assets from private banks. They also encourage each bank to establish its own asset management company. The key to successful asset management companies is the realistic valuation of assets but it should not be a tool for the indirect bailout of existing shareholders. Sri Lanka's banking industry too is hampered by an average of 16% NPL. To clear balance sheets of banks/financial institutions, a significant amount of public resources would be necessary which is best avoided through detailed regulatory procedures.

As evidenced in the Asian crisis a few years ago, and now in the US, the problems of banks also reflect the profound problems of the corporate sector. Hence, resolving banking problems should go hand ii hand with corporate debt restructuring. Widespread corporate insolvencies and weaknesses are much more difficult to solve and it is time consuming. The same is true for Sri Lanka's state banks which an saddled with large public enterprise debts. The supervisory authorities alone cannot restructure banks. Bankruptcy laws, appropriate judicial systems and institutional structures are needed for this task. Until the corporate restructuring is done, there is no meaning to restructuring o insolvent banks because the complexities of the corporates would inevitably filter into banks' books. Banking industry worldwide still believes that they are better run than in previous crises as their capital bases are stronger and their earnings are more diversified. Yet, the supervisor and regulators cannot be complacent as the aftermath o corporate failures can become far more complex than one thinks.


Estimation of System-wide Risks and Regulatory Capital

When the banking industry is in global transition, it is hare to understand the level of risk and predict how much of it is transferred out of the banking sector and on to the rest of the entire financial system Regulators and banking institutions no doubt are better in judging the relative risks of different institutions, instruments and counter parties than the system-wide total risk. Nowadays, a technology-related or asset price-related bubble can bring wide risks, which are not directly within the ambit of the supervisors and regulation. It is difficult to know with certainty the extent to which the financial system is exposed by the bubble. The economic cycle would encourage lenders to lend too much at good times and cut back too much at bad times and downturns, perhaps making things worse. According to BIS, one way out of this is to require banks to set higher amounts of capital during economic booms and lower amounts during downturns thus making risk taking more pro-cyclical, which is one of the key guidelines included in Basle II principles.

In determining regulatory capital, Basle II gives an important role to external credit rating although many regulators question the usefulness of such ratings. The alternative would be to encourage banks to have their own internal ratings. Here too, there are misgivings about the use of quantitative credit risk models to set regulatory capital. Value at risk (VAR) models estimate how much capital a bank would lose in a day against a portfolio of marketable securities and the amount of capital that needs to be set aside. More subtly, financial liberalization and worldwide deregulation have allowed VAR to become more important on economic activity and business fluctuations. However, VAR models are said to be of little help in estimating the frequency with which bad days can occur. The proposed remedy for this is the stress test with imaginary storms, although modeling and estimating credit risks in this manner is an uphill task for banks and indeed, for supervisors.


Consolidation of Banks

The consolidation in the banking sector has also increased the risks of the financial system in several ways. Banking institutions would seek to merge and consolidate with the aim of achieving economies of scale, diversifying risk, investing in cutting edge technology and offering customers a one-stop integrated financial service.

But the larger and the more complex the institution is, the larger would be the systemic risks. Consolidation would cut down the number of big market participants. For example, in the US, the 20 big banks that existed in 1995 have been reduced to 13 in 2001. The bigger banks are increasingly using internal risk management systems. These are sensitive to movements in the market and tend to reduce liquidity. Less liquid markets may be more prone to financial crises. The task of assessing the magnitude of this danger would also fall on the already constrained supervisory authority.

The diversification of banking into related financial services has also raised a number of supervisory concerns in respect of financial reporting. The recent experiences have driven the message home that even the most advanced systems are not immune from deficiencies of financial reporting. The lack of transparent and reliable accounts, for instance, contributed to the build-up of financial imbalances and to the aggravation of the Asian crisis. The growing capacity for financial engineering and innovation in today's financial system demands the application of principles, standards and codes. Often, detailed rules and codes have led to irresponsible financial reporting aided by accounting. That's why the regulators are compelled to emphasise on qualitative oversight rather than quantitative rules. The way to achieve the qualitative and quantitative balance is obviously a prime concern for supervisors but a difficult one.


Closure of Financial Institutions

Regulators and supervisors are conscious of financial system stability. This would call for closing of most insolvent institutions as early as possible. No doubt, the closure of non-viable institutions would certainly provide a way to allow loss sharing with creditors, remove excess intermediation capacity and build up resources to deal with the remaining institutions. However, closing of financial institutions and sharing of losses with private sector creditors is an extremely difficult task to manage. A well-managed information campaign to explain and support the policy and to reassure the public, staff and the unions must accompany it. In essence, the process involves necessary legal, institutional and policy frameworks for completing tasks. These are complex and multi-year processes, which require substantial financial and human resources. Above all, the authority responsible must take full control of the implementation from start to finish. This requires a group of dedicated, skilled and committed personnel, which is hard to find.

As mentioned earlier, the worldwide trend of banks engaging in non-traditional commercial banking such as, investment and insurance activities raises the pertinent issue of the nature of the supervisory framework, i.e., single or multiple regulatory system. The US still defends its multiple regulatory system despite considerable duplication. A single regulator like the Financial Services Authority (FSA) in the UK is said to be bureaucratic, intrusive and insensitive. The UK commercial banks blame that it does not have the central banking touch, which they enjoyed for centuries. The debate of single vs. multiple regulators is on in Sri Lanka too. One needs to be practical and sensible in deciding the appropriate system for its financial services industry. The size of the country, the track record of supervisory authorities and more importantly, the close interaction between the supervisory authority and the institutions to be supervised, are important considerations. The transition from traditional banking to a wide array of operations could bring in unexpected and sometimes undetected risks. Perhaps, continuous and close surveillance would always help in understanding these risk and their early prevention.

Behind every sophisticated markets are good regulations whether by government agency or organized by market participants. The need of today is to get regulators to converge around common international standards. This process is by no means complete particularly for investment products sold to personal investors. Given the diversification of the industry, it is not possible to have a single regulator Competition among regulators has some benefits. For example, who regulates the global operations of the Citigroup or the HSBC group? The FSA in the UK is able to regulate only the Citigroup's British activities The Central Bank of Sri Lanka supervises Citibank's and HSBC's Colombo branch operations. But there is no way national regulators can have any control on Citigroup or HSBC group's global activities.

When global banking is widely spread with cross border transactions, ideally, information among national regulators and supervisors should flow regularly and more efficiently. Although multinational institutions such as the IMF, World Bank, BIS and the Stability Forum continue to pass relevant information to national regulators, what matters most is the bilateral communication between regulators. What is possible, however, is for all national regulators to be informed of the health of the group on a worldwide basis. The global financial system is yet to develop an efficient system for exchange of information. Until then, the national regulators should exchange information as much as possible to keep an eye on global conglomerates.

Given the banking and financial crisis in the recent past, it is also a challenge for regulators to decide, "how much failure should a regulatory system allow?" One school of thought is that it should be more than zero. The US regulators also reckon that there should be small-scale problems to keep everybody aware of risks. There need to be jerks to test the system from time to time to enable the supervisors and regulators to revisit the system's checks and balances and improve on them.

In a world of banking transition, the old approach to supervision has to be changed. Following the deviation of banking from its traditional operations, the regulators also have to deviate from the old approach in supervision, which was based on stringent admission policy, high prudential requirements and rigorous enforcement. The aim was to minimize failures and protect depositors and investors. Many countries have achieved a reputation for prudence and stability alongside rapid growth in the banking industry. Singapore, despite its well-illustrated and successful adoption of the old approach with widespread benefits, is rapidly changing for a new supervisory approach.


Conclusions

Let me now conclude. Central Banks and other regulators are aware that the complexity of the financial system imposes practical limitations on what they can do. Increasingly, central banks are relying on the private sector to assist them in supervisory tasks. Supervisors cannot simply look into every transaction of a bank to determine accumulated risks in their transactions. This is where regulators rely heavily on external auditors and credit rating agencies. The auditing profession is under great scrutiny in the light of recent corporate collapses but auditing is not the responsibility of the regulator. If a bank fails, regulators are the first to be blamed, but the complexities and challenges faced by supervisors are often underestimated.

The experience of the crisis-hit countries in Asia and elsewhere illustrates once more the importance of prompt and decisive action to deal with banking problems that emerge in transition. Often, supervisors are aware of the dangers of waiting for the problem to solve itself. Of course, prevention is always superior to cure, particularly in preventing weaknesses from building up. This requires the adoption of new approaches to supervisory procedures.

Regulators the world over have played an important role in developing prudential guidelines, particularly by encouraging risk disclosures as a means of enhancing market discipline. Under the new international financial architecture, the international institutions are encouraging the adoption of best practices and codes on a worldwide scale. In keeping with these trends, more recently, the Central Bank of Sri Lanka led a task force on corporate governance for the financial sector which issued specific guidelines for banks, which are expected to be adopted by consensus rather than coercion.

As my remarks have made clear, the challenges involved in strengthening bank supervision and regulation underscores today's context of complex banking transactions. Establishment of accurate and timely financial reporting is the key to off-site and off-site supervision and hence lead to sounder and more stable financial system. Effective supervision coupled with comprehensive financial reporting, assisted by technological advances could bring about a better balance between markets and official regulation, which is now the accepted and the more effective form of regulation. To be in line with these trends, the Central Bank has embarked on a systematic upgrading of bank supervision aided by a close and confidential consulting process. As unregulated financial systems are prone to market failure, it is in everybody's interest to evolve an efficient and consultative prudential supervisory system.