Supervisory Regime Research Articles

Restoring Regulatory Credibility and Preventing “Repo Runs”: A Cautionary Tale

In the aftermath of the global financial crisis (‘GFC’), policy-makers and regulators have been engaged in Herculean efforts to restore their tarnished reputations. These efforts have involved jettisoning much of their flawed ideological baggage of old, rooted in a belief about the self-correcting nature of markets and the ability of financial institutions to police themselves, and, in turn, building new, more muscular regulatory and supervisory regimes. This ongoing process is explored through the lens of a high-profile facet of shadow banking, namely the regulation of sale and repurchase agreements (so-called ‘repos’). Here, regulators have set out to address a key vulnerability associated with the maturity mismatch between the short-term liabilities of the repo borrower and its longer-term assets, which has the potential to trigger a so-called ‘repo run’. Through a review of a series of highly problematic reform options, the discussion indicates that there is a danger that regulators will repeat the mistakes of the past by substituting their misplaced faith, pre-GFC, in the self-correcting power of markets, with a misguided conviction, post-crisis, in their capacities to build regulatory regimes which can contain the risks associated with modern-day financial markets. It is suggested that such over-confidence is liable to lull us into a false sense of security about how robust these regimes really are, and to cause regulators to shirk some of the more difficult questions which remain to be addressed.

Earnings quality and external governance on banks: empirical evidence in the European context

This paper examines the relationship between external governance exerted by the national supervision and bank earnings quality, specifically earnings persistence and cash flow predictability. To test the predictions, multivariate regressions are carried out on a panel dataset of 4,443 bank-year observations from the European Union across the 2005-2014 timeframe. Results show that higher supervisory power, independence and greater stringency of capital regulation are associated to higher persistence of reported earnings. Additionally, banks under strict supervisory regimes, independent authorities and stricter capital regulation exhibit earnings that are better predictors of future cash flows. This paper has policy implications for the ongoing European debate concerning advantages and disadvantages of the new Single Supervisory Mechanisms, with specific reference to the influence of the national authorities' characteristics on bank transparency. The findings suggest indeed to adequately consider the effects of national supervisory styles on accounting quality.

Trying to Square the Circle: The ECB's Janus-Faced Character Post SSM and Its Implications for Effective Banking Supervision

The repeated pattern of politically induced lax oversight, insufficient or delayed cross-border information sharing and the obvious moral hazard problems where an ailing national banking system can rely on international aid, that for example culminated in the mutually reinforcing Spanish banking and the European sovereign debt crises in the summer of 2012, prepared the ground for one of the most ambitious regulatory projects in European history: Banking Union. While previously Eurozone Member States strongly opposed centralization in supervision and resolution of credit institutions, suddenly, they praised it as the silver bullet that would serve to internalize the externalities caused by forbearing national supervisors and to align incentives with the far-reaching mutualization of private and public debt. Following remarkable regulatory activism, only three years later the Single Supervisory Mechanism (SSM) and the Single Resolution Mechanism (SRM) had been established as the two major pillars of the new regulatory architecture. This paper emphasizes one particular and highly contentious feature of the SSM, namely installing the European Central Bank (ECB) as quasi-omnipotent pan-European watchdog. Generally, transferring oversight from the national to the supranational level constitutes a significant step forward in addressing a key impediment to transnational banking supervision – home bias. Yet, vesting this particular institution with the necessary powers to do so, may ultimately undermine, mainly as a function of conflicts of interest resulting from its henceforth two-fold mandate, the effectiveness of the otherwise relatively well-conceived supervisory regime. In fact, these concerns were already voiced when drafting the pertinent regulation, but eventually had to make way for pragmatic reasons. It is certainly true that, in theory, tasking a central bank with banking supervision can be rationalized. However, monetary policy and banking supervision pursue different, potentially colliding regulatory objectives: price stability, the ultimate target of conventional monetary policy, and financial stability, as ideally aspired by state-of-the-art banking supervision, are not fully reconcilable. The ultimate assessment, as to which extent either of the two eventually suffers from bundling both activities under one roof, depends on the adequacy of the institutional safeguards designed to isolate it from the former’s undue influence. Finding a rather mediocre arrangement, finally an alternative solution resting on the full organizational separation of both functions will be sketched.

Direct Supervisory Powers of the European Securities and Markets Authority (ESMA) in the Realm of Credit Rating Agencies – Some Critical Observations in a Broader Context

Since its establishment in 2011, the European Securities and Markets Authority (ESMA) has considerably shaped the regulation and supervision of European capital markets. Being part of the European System of Financial Supervision (ESFS ), the three European Supervisory Authorities (ESA s) – ESMA, the European Banking Authority (EBA ) and the European Insurance and Occupational Pensions Authority (EIOPA) – share its main objective: safeguarding the stability of the European financial system. ESMA however is outstanding with respect to its role as direct supervisor particularly of credit rating agencies (CRA s) in the European Union (Union). Whereas many analyses of the regulatory and supervisory regime for CRA s in the Union mainly focus on its design and effects on CRA s and the credit rating market the present paper aims to focus on ESMA as direct supervisor in this sector. The paper is organised as follows. It starts with some methodological preliminaries and remarks on the role of legal academia in the realm of financial markets regulation and supervision thereby aiming to put the paper in the broader context of the relevant legal literature. Against the backdrop of some fundamentals on rating-directed regulation and supervision it discusses the fitness of ESMA’s institutional set-up for its role as direct supervisor of CRA s in the Union. The paper then explores and assesses the performance of ESMA as direct supervisor of the CRA s in the Union since 2011. This is complemented by some observations as to ESMA’s regulatory powers and performance in the European sector of CRA s. The paper then concludes with an outlook arguing in particular that ESMA in its role as direct supervisor of CRA s in the Union might well be considered a tried and tested example of a legitimate agencification at Union level paving the way towards the concept of a single capital markets supervisor.

Reducing agency conflicts through bank dividend payout decisions: the role of opacity and ownership structure

ABSTRACTWe empirically examine whether banks’ dividend decisions are influenced by their degree of opacity and ownership structure. We find that banks with concentrated ownership structure pay lower dividends when they have high degrees of opacity, in line with the hypothesis that majority shareholders pay lower dividends to extract higher levels of private benefits. We do not observe such expropriation behaviour from managers in widely held banks. Further analysis shows that higher levels of shareholder protection and stronger supervisory regimes help to constrain opportunistic behaviour of majority shareholders. Our findings have critical policy implications for the Basel 3 implementation of restrictions on dividend payouts.

Central counterparties and sale and repurchase agreements: regulating financial markets in the light of yet another false dawn

ABSTRACTIn this article it is argued that the burgeoning faith of policymakers and regulators in the ability of central counterparties (‘CCPs’) to absorb both counterparty and collateral risk in ‘sale and repurchase agreements’ (otherwise known as ‘repos’) – and, in turn, in helping to forestall contagion in the form of so-called ‘repo runs’ – is misplaced. In developing this contention, three major claims are advanced. First, for all their benefits, CCPs exhibit a major design flaw in as much as they are unable to diversify away market-wide systemic risk when counterparty failures become correlated – as exemplified by the global financial crisis (‘GFC’). Second, this design flaw is remarkably similar to the flaw which the modern trend towards market-based finance exhibits, again, as revealed during the GFC, and as persists in its more recent ‘fund-based’ guise, and that this parallel cautions against viewing CCPs in an unduly favourable light. That is to say, in much the same way that market-based finance helped to neutralise systemic risk in good or moderately turbulent times pre-crisis, but amplified it in times of acute market turbulence, so too CCPs are liable to exhibit similar tendencies. Finally, although the UK’s new regulatory and supervisory regime applicable to CCPs has much to commend it, these measures are, in fact, likely to be of limited assistance in ensuing that CCPs are able to perform their mutualisation role, or that they do not disrupt financial markets, when things go seriously wrong.

Reconceptualizing regulation: Formative evaluation of an experiment with System-Based Regulation in Dutch healthcare

The Dutch Healthcare Inspectorate has recently tried out a new form of inspection: System-Based Regulation (SBR). This article explores how SBR was situated in the healthcare context through a process of ‘experimentalist governance’. A qualitative formative evaluation was undertaken involving two years of participative observation, numerous iterations between data gathering and feedback in order to orient the next steps of the process. The evaluation found that SBR could fit into the existing supervisory regime, but notwithstanding positive outcomes SBR was controversial and further implementation was delayed. The process of ‘experimentalist governance’ was strengthened by qualitative formative evaluation that documented and reflected on the process as it progressed. The evaluation also helped to translate and communicate learning so as to better understand regulation and to reform and reconceptualize SBR in today’s healthcare context.

Germany: Financial Sector Assessment Program-Fund Management: Regulation, Supervision and Systemic Risk Monitoring-Technical Notes

This paper discusses the German asset management sector and an analysis of certain key aspects of the regulatory and supervisory regime. Germany has a large and diverse asset management sector to which it applies a strong and comprehensive regulatory framework. The sector is the third-largest in Europe, as measured by all managed assets, and comprises a broad range of management companies and funds. BaFin is able to monitor developments in the asset management sector by having access to an extensive set of data shared by the Bundesbank. The data are sufficiently granular that individual exposures can be identified swiftly and accurately, allowing supervisory intervention where needed.

Reducing Agency Conflict through Bank Dividend Payout Decisions: The Role of Opacity and Ownership Structure

We empirically examine whether banks’ dividend decisions are influenced by their degree of opacity and ownership structure. We find that banks with concentrated ownership structure pay lower dividends when they have high degrees of opacity, in line with the hypothesis that majority shareholders pay lower dividends to extract higher levels of private benefits. We do not observe such opportunist behavior for widely held banks. These results suggest that there exist other corporate mechanisms in widely held banks that can induce insiders to select payout policies that reduce agency conflict in a context of high degrees of opacity. Nevertheless, the effectiveness of these mechanisms is reduced in banks with controlling shareholders. Further analysis shows that higher levels of shareholder protection and stronger supervisory regimes help to constrain opportunistic behavior of majority shareholders. Our findings have critical policy implications for the Basel 3 implementation of restrictions on dividend payouts.

Risk Control versus Risk Management in the Context of an Active Management: The Emerging Market Alternative

The regulatory environment to which financial institutions and specially banks are subjected has been evolving over the years. However, global financial sector stability has remained elusive with the global economy experiencing more financial crises in the past decade than the preceding decades. These financial tremors have had their epicenters in the advanced economies triggered by events in the banking industry. Further, economic growth in the developed economies has been very low and sometimes negative with close to 50 percent of the stock market value having been wiped out by the 2007/2008 global financial crisis. Against a backdrop of improved bank supervision and regulation courtesy of the Basel frameworks the Eurozone economies are reeling in recession. On the other hand the emerging and transitional economies have for the past close to a decade and a half showed resilient and outstanding performance with less stringent supervisory regimes enabling commercial banks to earn high profits. The profitability of the industry bolsters investment and recurrent expenditure all of which have the effect of fueling inflation and volatile exchange rates which accelerate economic growth, high interest and lending rates as well as market liquidity. These conditions provide opportunities for arbitrage trading that gives above average returns on investment as exemplified by the trend analysis. The high economic growth comes with attendant high inflation, lending rates and returns on government securities. The study set out to determine whether the high return environment within developing economies provides arbitrage investment opportunities and influences foreign investment by attracting foreign investment participation in government securities trading. The specific objectives were to demonstrate the adverse effects including the systemic vulnerabilities imposed by excess competition occasioned by thorough regulation and to empirically determine whether higher high exchange, lending, Tbill and Tbond rates attract foreign investment to developing economies with focus on Kenyan government securities. The study adopted secondary time series data analysis to establish whether or not lending rates, USD exchange rates, Tbond and Tbill rates affect foreign investment in government securities. The time series data analysis confirmed that in the long run, Tbond, USD exchange and lending rates all significantly influence the foreign investment in Kenya vide the Treasury bonds avenue. Based on these findings we conclude that emerging and transitional economies offer a perfect arbitrage investment opportunity for low return advanced economies.

Regulation, Supervisiin and Accounting Conservatism in Banks

The main purpose of this article is to evaluate the effects of the three pillars of Basel II, i.e. bank regulation, supervision and market discipline, on the timeliness of loan loss provisioning by banks. In particular, we analyze explicitly how regulatory and supervisory regimes interact with the market discipline measures, such as listing status, ownership and market concentration. Using a sample of 14,651 bank-year observations covering 54 countries over the period 1997-2009, we provide empirical evidence suggesting that a) the stringency of the regulatory and supervisory regimes is positively associated with accounting conservatism; b) unlisted banks and commercial banks are more conservative than listed entities and savings banks, respectively; and c) banks operating in more concentrated markets exhibit a lower degree of timeliness in loan loss recognition. In addition, our results suggest that strong capital requirements mitigate the effect of market concentration and governance on accounting conservatism, whereas strict regulatory regimes tend to reinforce the effect of both variables on early loan loss recognition.

Bank ownership structure, lending corruption and the regulatory environment

We empirically examine whether bank lending corruption is influenced by the ownership structure of banks, a country’s regulatory environment and its level of economic development. We find that corruption in lending is higher when state-owned banks or family-owned banks provide a higher proportion of credit to the economy, in both developed and developing countries. A stronger regulatory environment, either through a stronger supervisory regime or a higher quality of external audits, helps to curtail bank lending corruption if induced by family-controlled ownership, but not if induced by state-controlled ownership. We further find that controlled-ownership of banks by other banks contributes to reduce corruption in lending; the same applies to widely-held ownership of banks, but only for developed countries.

Bank Ownership Structure, Lending Corruption and the Regulatory Environment

We empirically examine whether bank lending corruption is influenced by the ownership structure of banks, a country's regulatory environment and its level of economic development. We find that corruption in lending is higher when state-owned banks or family-owned banks provide a higher proportion of credit to the economy, in both developed and developing countries. A stronger regulatory environment, either through a stronger supervisory regime or a higher quality of external audits, helps to curtail bank lending corruption if induced by family-controlled ownership, but not if induced by state-controlled ownership. We further find that controlled-ownership of banks by other banks contributes to reduce corruption in lending; the same applies to widely-held ownership of banks, but only for developed countries.

South Africa: Financial Sector Assessment Program-Detailed Assessment of Observance on the Insurance Core Principles

This paper discusses key findings of the Detailed Assessment of Observance on the Insurance Core Principles on South Africa. Insurance regulatory and supervisory regime in South Africa is in transition. Currently, the Financial Services Board (FSB-SA) regulates the nonbanking financial services industry, including the insurance sector, in South Africa. With the goal of achieving a safer financial sector to serve South Africa better, the government has proposed major changes in the financial sector. The four policy objectives are: financial stability, consumer protection and market conduct, financial inclusion, and combating financial crime. Market realities in the insurance sector pose significant regulatory challenges, which are well recognized by the authorities.

Prudential Policy at Times of Stagnation: A View from the Trenches

In the euro area, macroprudential policy can be a powerful complement to monetary policy. However, its coordination with microprudential policy is a particularly delicate task. The coexistence of two supervisory regimes that rely on similar tools to pursue different objectives may at times give rise to conflicting decisions, or create uncertainty on the logic of the prudential framework. These risks are structurally greater in bank-based economies with highly concentrated banking sectors, and may be heightened in the contractionary phase of the cycle, when policymakers face a short-run trade-off between the resilience of the financial sector and the speed of economic recovery. This makes the micro/macro coordination problem a top priority for European supervisors today. In order to address it, supervisors must agree to rank their policy objectives and examine their interventions from a general equilibrium perspective. We remain agnostic as to how much capital European banks should ultimately be required to hold. Instead we stress that, irrespective of the target, supervisors should achieve it over the appropriate time span, minimizing any negative spillovers on credit supply and protecting the credibility of the newly-launched countercyclical macroprudential framework with all available means.

Do Asymmetric Information and Ownership Structure Matter for Dividend Payout Decisions? Evidence from European Banks

We empirically examine whether banks' dividend decisions are influenced by their degree of opacity and ownership structure. We find that banks with concentrated or dispersed ownership structure pay lower dividends when they have high degrees of opacity. These results would be consistent with the entrenchment behavior hypothesis, with insiders (managers or majority shareholders) paying lower dividends to extract higher levels of private benefits when banks' opacity is high. Higher levels of shareholder protection and stronger supervisory regimes help to constrain entrenchment behavior of majority shareholders. Our findings have critical policy implications for the Basel 3 implementation of restrictions on dividend payouts.

THE NUMBER OF FINANCIAL REGULATORY AUTHORITIES AND FINANCIAL STABILITY: CROSS-COUNTRY EXPERIENCES

This paper attempts to provide evidence whether or not the unification of regulatory institutions for different types of financial sector creates challenges for financial stability. From a sample of 91 countries that provide data on the financial unification index and the central bank involvement index, the empirical results reveal that higher financial unification index or the convergence toward a single supervisory institution outside the central bank, in order to control three different sectors (banking, insurance, and securities), is detrimental for financial stability. However, this finding only holds for developed countries, but dissapears for less developed countries. In parallel, the central bank involvement in financial sector supervision has no impact on financial stability in both developed and less developed countries. Keywords: Supervisory Regimes, Financial Sectors, Financial Stability JEL Classification: G18, G21, G28

Supervisory Stress Tests

We describe the background, design choices, and particular details of stress tests used as part of an overall supervisory regime, that is, their formal integration into the ongoing prudential supervision of banks and other large financial institutions. We then describe how the US Comprehensive Capital Analysis and Review (CCAR) and Dodd-Frank Act stress testing (DFAST) regime is designed and what that means for the macroprudential versus microprudential nature of US supervisory exercises. We argue that routine stress tests have the potential to substantially change the nature of the supervisory process. We also argue that a great deal depends on the philosophy underpinning modeling decisions, which has not received as much attention as scenario design, disclosure, or other stress test design choices.

Housing Finance in Canada: Looking Back to Move Forward

The Canadian system of housing finance proved to be resilient and efficient during the global financial crisis and its aftermath. The system's effectiveness is the result of a rigorous prudential regulatory and supervisory regime coupled with targeted government guarantees of mortgage insurance and securitisation products. In the post-crisis period, household debt levels and house prices have risen, owing, in part, to accommodative monetary conditions necessary to support the economic recovery. These vulnerabilities were mitigated by tightening macroprudential policy, specifically mortgage insurance rules, and strengthening mortgage-underwriting standards. Looking ahead, the housing finance framework needs to be adjusted and strengthened by rebalancing the risk exposures away from the government towards the private sector participants in the housing finance market. Although some measures have already been taken for this purpose, more adjustments may be needed to create the right incentives and achieve a sustainable rebalancing in risk exposures. Measures should also be considered to promote a liquid private-label mortgage securitisation market in Canada.

Financial Supervision and Bank Profitability: Evidence from East Asia

The growing fragility of the financial system has led to the increasing importance of financial supervision's role. In particular, the financial supervision regime is expected to promote bank performance and maintain financial stability. Unfortunately, studies on the relationship between banking supervisory regimes and bank performance are still limited. To address this issue, this paper focuses on the following four aspects of banking supervision:(i) the structure of supervisory frameworks, (ii) the independence of supervisory institutions (iii) the scope of supervisory role; and (iv) the authority of central banks in the banking sector. We use country-specific data for seven East-Asian countries and data for 39 individual banks in those countries over the period of 2006–2011 to examine how different financial supervision regimes in the region influence bank performance. The results show strong evidence that the existence of a single bank supervisor, instead of multiple, will enhance bank profitability. Mean while, there is a mixed result regarding the role of central bank independence in improving bank profitability. Furthermore, the authority of central banks in the banking sector and the scope of bank supervision do not show strong relationship with bank performance.