"Sound Regulation as a Source of Competitive Advantage"
Speech by Mr Ravi Menon, Executive Director, Supervisory Policy Dept / Banking Dept at the Asian Banker Summit, Singapore 2001
Date: 21 Mar 2001
1.1 Thank you for inviting me to speak at the Asian Banker Summit. I propose to do three things this morning. First, I will sketch how the emerging financial landscape has intensified competition and spurred growth while spawning new risks and challenges. I will then describe how this has led to a re-orientation in MAS' framework for fostering a sound and progressive financial sector. Finally, I will share with you some of MAS' recent and ongoing initiatives on the regulatory front with respect to banking.
2 Implications of the New Financial Landscape
2.1 A new financial landscape is emerging. Five key trends are shaping this landscape:
- advance of technology;
- convergence of activities;
- consolidation of institutions;
- globalisation of markets; and
- intensification of competition all-round.
These trends have unleashed vast new opportunities for growth. But they have also accentuated risks within the financial system, posing challenges for both financial institutions and regulators.
2.2 First, advance of technology. The advent of the internet, explosion in computing power, and progress in wireless communications are revamping the ways in which financial services are produced, distributed, and consumed. They are transforming the functioning of financial markets, and introducing new modes of payment and settlement.
2.3 Second, convergence of activities. Traditional boundaries between banking, securities, and insurance are blurring. Banks sell insurance under the rubric of "bancassurance". Insurance companies provide protection for financial risks previously hedged using capital market instruments. Securities firms offer cash management services that compete with bank deposits. Financial engineers unbundle and re-package risks to create innovative hybrid products with characteristics that cut across business lines. It has become increasingly difficult for regulators to assert prudential oversight along traditional industry silos.
2.4 Third, consolidation of institutions. Financial deregulation, customer demands for integrated financial services, and shareholder pressures to enhance value have led to an unprecedented number of mergers and acquisitions, strategic alliances, and joint ventures among financial institutions globally. In the US, the number of banks has fallen by 40% since 1980; in the EU, the number has fallen by 25% since 1985. Consolidation has opened up opportunities to exploit economies of scale, diversify earnings, and create market power. But have some of these merged institutions become too large, too complex, or too diversified to effectively manage or adequately supervise?
2.5 Fourth, globalisation of markets. Falling regulatory barriers, advances in information technology, and reduced communication costs have facilitated faster and freer flow of information and capital across national boundaries, and brought financial markets closer together. Globalisation has yielded important benefits. Markets have become more efficient and liquid. Consumer choice has expanded and transaction costs have come down. Global savings are being more efficiently mobilised and allocated. But on the downside, market disturbances are now transmitted across financial markets with greater speed and virulence. Recent financial crises illustrate how rapidly instability can spread and how damaging it can be.
2.6 Finally, there is razor-sharp competition everywhere. Deregulation and technological change have allowed a variety of new players to enter the financial industry. Innovative start-up firms are challenging the franchise of established institutions, often targeting specific segments of the value chain in financial intermediation, and sometimes engaging in "loss-leader" strategies to win customers. This has forced traditional players to invest in new technologies and systems, and develop new channels of distribution or even new business models. But the downside of a more competitive environment is that it could potentially increase the appetite for risk in the system as a whole. This could happen if firms struggling to preserve their position are tempted to take ill-judged risks in an attempt to boost flagging returns.
2.7 The changes sweeping the new financial landscape have strengthened, not diluted, the need for sound regulation and supervision. While weak regulation and supervision undermines confidence and destroys credibility, overly restrictive regimes kill innovation and drive away business. Regulatory and supervisory frameworks that effectively address systemic risks without undermining the development of financial markets command a premium in the new financial landscape; they are a key source of competitive advantage.
3 Framework for a Sound and Progressive Financial Sector
3.1 MAS' mission as an integrated supervisor is to promote a sound and progressive financial sector. This means maintaining confidence in the financial system so that markets and institutions can grow and innovate. But in the new financial landscape, reliance on prudential regulation alone will not deliver the desired result. That is why MAS embarked on a fundamental reorientation in its approach three years ago. Today, I would describe our framework for a sound and progressive financial sector as one that rests on three essential pillars - self-governance, market discipline and official oversight. Let me take each of these in turn.
3.2 The first pillar of self-governance recognises that primary responsibility for the safety and soundness of a bank or financial institution rests with its board of directors and executive management. They are best placed to understand and manage the risk profiles of their business. MAS has taken several initiatives over the last three years to encourage good corporate governance, rigorous internal controls, and effective risk management in our banks and financial institutions.
3.3 The second pillar of market discipline imposes external incentives on banks and financial institutions to conduct their business in a sound and efficient manner. No financial institution can be immune to the signals sent by markets in the form of bond spreads, credit ratings, and stock prices. MAS has sought to promote effective market discipline by fostering greater information disclosure and encouraging the adoption of international accounting standards.
3.4 The third pillar of official oversight is necessary because market failure can sometimes give rise to imprudent behaviour and financial instability. MAS' official oversight function comprises three limbs: regulation, supervision, and surveillance. Regulation is about establishing rules of behaviour across the industry: setting capital requirements and prudential limits, and defining permitted activities. Supervision is about monitoring and inspecting individual institutions to ensure compliance with regulation and to assess the adequacy of risk management processes and internal controls. Surveillance is about monitoring and assessing industry trends and systemic risks for the financial sector as a whole.
3.5 The three pillars - self-governance, market discipline, and official oversight - complement one another. Historically, MAS has depended heavily on official oversight, and to some extent self-governance, to promote the safety and soundness of institutions. But this cannot work well in the new financial landscape where we must allow institutions greater latitude to take well-managed risks. Thus, we are now seeking to enhance self-governance and strengthen market discipline so as to shift onto these pillars more of the burden for ensuring safety and soundness. This will allow official oversight to focus more on seeking to minimise systemic risks.
3.6 And within official oversight, we have been shifting our emphasis away from high regulatory requirements towards risk-focused supervision of institutions and surveillance of markets. "One-size-fits-all" regulation is increasingly ill-equipped to cope with the growing complexity of banks' activities and market developments. By relying less on regulation and more on supervision, we would have the flexibility to ease up on onerous requirements applied across the board and deal with weaker and poorly managed institutions on an individual basis. At the same time, we will place increased emphasis on market surveillance, to monitor systemic risks and potential vulnerabilities, in recognition of growing systemic interactions and contagion dynamics in modern financial markets.
4 Sound and Responsive Regulation
4.1 Shifting the emphasis away from regulation does not imply diminishing its importance. On the contrary, it places a higher premium on regulation being sound. Sound regulation provides the framework for risk-based supervision and surveillance; it also facilitates the effective functioning of the other two pillars of self-governance and market discipline. Indeed the irony is that it often takes additional regulation, for example increased disclosure requirements, to make market discipline work.
4.2 So what is sound regulation? First, it needs to be risk-focused. Regulatory requirements must be calibrated to address specific and well-defined risks or concerns that could have systemic implications. Second, regulation must be responsive to industry developments so that it does not inhibit innovation or undermine market functioning. Increasingly, this means a more consultative approach, with regulators and industry players working in close collaboration when developing regulatory guidelines. Third, regulation must be consistent. Similar activities carried out by different types of institutions must be subject to similar regulatory treatment, so as to create a level playing field and minimise regulatory arbitrage. Fourth, regulation must be adaptive. We must constantly benchmark to international best practices but judiciously adjust and adapt to suit domestic conditions. Finally, regulation must be clear. Clarity reduces the cost of regulation. Take the case of London and Frankfurt for example. Many observers have described London as having a rigorous but more transparent regime and Frankfurt as having a less demanding but more opaque regime. Yet, surveys consistently show that the burden of regulation is lower in London and that it remains the centre of choice for an overwhelming number of financial institutions.
4.3 I would now like to share with you MAS' thinking and recent initiatives in three key areas of regulation where we have adopted a risk-focused approach, consulted industry extensively, benchmarked to international practice, and tried to provide clarity. The three areas are: capital adequacy, prudential safeguards, and electronic finance.
4.4 First, improving the capital adequacy framework. Capital plays a critical role in the regulatory tool kit. When a bank experiences difficulties, capital serves as a buffer to absorb losses and reduce the risk of spillover to other banks. Currently, we require a 12% capital adequacy ratio, or CAR, meaning we require banks incorporated in Singapore to set aside $12 in capital for every $100 of risk-weighted assets. This is significantly higher than the 8% CAR promulgated by the Basel Committee for Banking Supervision. We took this position in recognition that Singapore banks operated in a more volatile and risky region, and hence required a larger capital cushion than other international banks. We have, however, adjusted the Tier 1 or equity capital component in recent years from 12% to 8%, while keeping the overall ratio at 12%, so as to allow our banks greater flexibility in their capital management. We have also expanded the definition of Tier 1 capital to include innovative capital instruments with strong equity-like features, up to 15% of Tier 1 capital. To provide greater clarity on the requirements for the issuance of such innovative Tier 1 capital instruments, MAS has been consulting the industry on a set of draft guidelines. These guidelines are aimed at ensuring the loss-absorption and subordination qualities that are necessary for instruments to qualify as Tier 1 capital. We will issue them in about a month's time.
4.5 MAS will continue to review the capital adequacy framework, taking account of our banks' risk management capabilities, industry innovations in risk mitigation techniques, and regulatory developments globally. In this regard, the most significant international regulatory development on the horizon must surely be the Basel Committee's second consultative paper on a new capital accord. MAS welcomes the proposed changes in the New Basel Accord. We will adopt the key broad initiatives proposed, namely to (a) better align regulatory capital requirements with underlying risks and provide capital relief for effective risk mitigation; (b) place greater emphasis on supervisory review of the risk profile of individual banks and introduce supervisory CARs where appropriate; and (c) facilitate market discipline to help ensure that banks maintain adequate capital.
4.6 The New Basel Accord proposes two main approaches for the maintenance of capital for credit risks. Under the revised standardised approach, risk weights for capital charge will be determined by credit ratings by external rating agencies. This is a significant improvement over the present risk weighting system based on a country's OECD membership status. The second approach is the internal ratings based, or IRB, approach, which allows the more sophisticated banks to use their internal ratings systems as the basis for setting capital charges for credit risks, subject to supervisory approval. Our banks will not be disadvantaged by either approach. For a start, they will certainly attract a lower capital charge on their inter-bank borrowings. It is also very unlikely that they would be required to hold more capital than they do currently.
4.7 The more pertinent issue is: which approach to adopt? The IRB approach is superior in aligning regulatory capital with banks' underlying economic capital. But it is more complex, and requires sophisticated risk assessment technology and adequate historical information for successful implementation. The revised standardised approach is simpler but the lack of a ratings culture in the region and in Singapore is a strong drawback. It is also not as finely calibrated to underlying risks as the IRB approach. MAS' preference is that our banks adopt the IRB approach, which will provide them stronger incentives to refine and upgrade their credit risk management techniques. The IRB approach will also motivate banks to have a higher quality asset portfolio because it penalises poor assets more severely than the revised standardised approach.
4.8 The deadline for the implementation of the New Basel Accord is 2004. To successfully implement the IRB approach, both MAS and the banks need to enhance their respective capabilities and resources. Our banks are currently in various stages of implementing their risk rating systems. But gaps in data availability with respect to historical default experiences and recovery rates are a constraint. MAS has been working closely with the banks to explore ways of getting around this constraint. To promote market discipline in line with the direction set by the New Accord, MAS will issue a detailed set of mandatory and best practice guidelines on the disclosure of risk management practices and risk profiles. These are currently being finalised in consultation with the banks.
4.9 A second area of recent and ongoing regulatory work involves finetuning our prudential safeguards to make them more focused on addressing relevant risks while allowing banks greater latitude in their operations. By way of illustration, let me touch on MAS' policy on banks' investments in private equity and venture capital.
4.10 As Singapore gears up to become a knowledge-based economy, there will be growing demand for private equity and venture capital funding. Indeed, Singapore already ranks fifth in the world for venture capital invested as a share of GDP. About 18% of the private equity and venture capital funds in Singapore is provided by banks. If well-managed, the private equity and venture capital business presents good growth opportunities for banks. But the risks of these investments are high. MAS has approached the matter flexibly to address the prudential concerns without unduly stifling enterprise. We are proposing to exempt banks' investments in private equity and venture capital from a new MAS rule requiring portfolio equity investments in non-financial businesses to be limited to 10% of the investee company's capital. This rule is not practical for the private equity and venture capital business as the investor frequently takes a major stake and may be involved in the business directions of the investee company. Instead, investments in private equity and venture capital would be governed by a set of separate guidelines tailored to meet the business realities as well as risks of such investments.
4.11 These guidelines are now ready for industry consultation, and have been placed on the MAS website. We have sought to align the guidelines to industry best practices, allowing flexibility while maintaining prudential standards. Rather than setting too many regulatory requirements, the guidelines seek to complement a minimal number of quantitative limits with qualitative requirements of banks' internal risk management policies and practices. For example, instead of imposing a single investment limit on such investments, we will require banks to satisfy MAS that they have adequate diversification policies and notify MAS on their risk management policies for such investments. To address potential concentration risks arising from a build-up of such high-risk investments, we propose to cap the aggregate amount of private equity / venture capital investments at 10% of the bank's capital funds.
4.12 The capital treatment for banks' private equity / venture capital investments will also be more finely calibrated to motivate banks to exercise internal discipline when making investment decisions. Many leading private equity professionals in the international banks set aside capital, dollar for dollar, to absorb potential losses in such investments. We will require that such investments be subject to a 50% capital charge where the aggregate investments are less than 5% of the bank's capital funds. Where the aggregate investments are above 5% of the bank's capital funds, a 100% capital charge will be applied on the excess. This will force banks to be more disciplined in investing and managing their deal flow and focus their attention on the required returns. We will continue our dialogue with banks and private equity / venture capital professionals to stay abreast of industry developments and ensure that our guidelines remain relevant.
4.13 The third area I would like to touch on is providing flexibility for electronic finance. Indeed, e-finance poses some of the most difficult challenges for regulators as they strive to address and contain risks without inhibiting growth and innovation in the new financial landscape.
4.14 The key challenge lies in determining whether e-finance merely accentuates some existing prudential risks or poses risks of a fundamentally different magnitude or nature. This is a matter still being debated in international regulatory circles. According to some, e-finance merely employs a different medium of delivery, with the underlying business model remaining essentially unchanged. Those who subscribe to this "old wine in new bottles" theory believe that e-finance does not pose fundamentally different risks and the existing regulatory paradigm was sufficient to address any aggravation of existing risks. However, there are others who believe that the "new bottles" or delivery channels are so significantly different that they are capable of transforming the "wine" within or the underlying business itself and thereby posing fundamentally new risks. But e-finance is evolving so rapidly that no one can say with certainty which view is valid, and few regulators, if any, have put in place alternative regulatory frameworks for e-finance.
4.15 MAS has taken the pragmatic approach of evaluating specific e-finance activities on their own merits and risk considerations before formulating appropriate responses. For example, in the case of internet banking, the underlying business is fundamentally unchanged, although the mode of delivery helps to reduce costs and improve the quantity and quality of product and service offerings. Therefore, in formulating its internet banking guidelines, MAS took the view that the risks in internet banking are not fundamentally different from those in traditional banking, although the magnitudes of each specific risk type may vary across both modes of banking. In particular, MAS recognised that security, technology, operational, and liquidity risks may be accentuated and has required banks to focus on monitoring and managing these risks.
4.16 MAS has prepared in consultation with the industry a detailed set of guidelines on the management of technology risks in Internet banking. The guidelines to be released shortly will require banks to: (a) establish a sound and robust technology risk management process; (b) strengthen system security and recovery capability; and (c) deploy strong cryptography to protect consumer data and transactions.
4.17 MAS will seek to allow scope for industry innovation in e-finance but cannot do so without regard for the soundness of the institution and the interests of depositors and customers as well as the impact on Singapore's financial sector stability. This is why we have precluded the admission of new internet-only bank start-ups with weak capital, negative earnings, and poor parent company support. The somewhat chequered experience worldwide of internet-only banks seems to have borne out our balanced appraoch.
4.18 In other e-finance cases, where MAS is satisfied that the risks of introducing a new activity are well-managed or if the new activity is not a regulated activity, we have imposed little if any regulatory burden. For example, we have allowed online or email payment solutions as part of banks' internet banking offering. In other words, banks can use the internet alongside existing EFTPOS networks to effect debit transactions. We hope this will encourage reputable international banks to make greater use of Singapore as an incubator or test bed for payment innovations.
5.1 Let me now conclude. The new financial landscape has thrown up exciting opportunities. But to exploit these opportunities and manage its risks, we need to re-orientate prudential oversight while strengthening the pillars of self-governance and market discipline. MAS will continue to adapt and develop its frameworks for regulation, supervision, and surveillance so as to facilitate innovation and dynamism without compromising the safety and soundness of the financial system. This must necessarily be an ongoing, dynamic process as markets and institutions themselves change. But it is a process that is critical for developing a resilient, competitive, and innovative banking industry.