1. David C. L. Nellor International Monetary Fund May 2009 Rethinking Regulation for Financial Stability and Growth

2. 2 Outline  Financial Stability – why does it matter  Regulatory Framework – what went wrong  Specific Proposals – is there a solution  Policy Choices – confronting the trade offs  Conclusions – what does it mean for Nigeria

3. 3 Financial Stability – why does it matter Estimates of Bank Restructuring Costs

4. 4 Financial Stability – why does it matter Index - Ratio of Private Sector Credit to GDP

5. 5 2. Regulatory Framework – what went wrong?  Macro versus Micro Supervision  Regulatory and Supervisory Perimeter  Supervisory Capacity  Pro-cyclicality  Global Architecture

6. 6 Macro versus Micro Supervision  Macroeconomic developments – asset markets, macro imbalances  Regulators are micro focused and not on interlinkages across financial institutions  Basel based on bank’s own risk models  Presence of foreign intermediaries in some countries and cross-border capital flows

7. 7 Regulatory and Supervisory Perimeter  Coverage of supervision and regulation  Systemic importance of non-banks  Too big to fail – did not mean subject to prudential supervision & regulation  Reporting requirements  Information from wider range of financial institutions & off-balance sheet items  Supervisory insight – “ticking boxes” versus knowledgeable supervision

8. 8 Supervisory Capacity  Regulators/supervisors did not keep pace with developments  “Sophisticated financial engineering” - structured products & off balance sheet entities  Interlinkages across financial institutions and markets (contagion effects) - use of credit risk mitigants and contingent liabilities  Risks of under-resourced supervisory agencies

9. 9 Regulatory System Procyclical  Risk-based capital ratios - capital requirements through the cycle  Loan loss provisions – rules unrelated to expected losses through the cycle  Liquidity risk - liquidity risk management did not require stress tests sensitive to firms’ credit ratings & off-balance sheet obligations

10. 10 Global Architecture  Coordination: inability to address global imbalances or manage crisis effectively at multilateral level  Crisis framework: shortcomings in legislation dealing with cross-border bank resolution and bankruptcy  Liquidity and Financing: limitations of central bank liquidity support; reputational risk to accessing IMF support

11. 11 3. Specific Proposals – is there a solution  Turner Review  Issing Group  G 30 (Volcker)  De Larosiere

12. 12 Turner Review  Highly regulated broad-based financial sector with central bank and FSA doing macro prudential supervision  Increased capital requirements and avoiding pro-cyclicality through introduction of capital buffers  Limitations on scale of debt/leverage  No specific limitations on activities of banks

13. 13 Issing Group  Risk map – global financial intermediation (net exposures) and risk factors.  Pre-arranged link between findings and actions such as on capital requirements  Regulation of hedge funds  Systematic cooperation of regulators

14. 14 G30 (Volcker)  Redesigning the regulatory structure – overlaps, gaps, limit scope for regulatory arbitrage  Central bank take a lead responsibility on financial stability – may need to be given tools and mandate  Limit scope of bank activities – proprietary trading limited, no hedge fund operations  Prevent non-banks from taking deposits

15. 15 De Larosiere  Macro prudential supervision is essential  Macro supervision must impact the micro supervisors  Macro authority has to be at the regional (global?) level  Consistency of supervision across the region (globally?)

16. 16 4. Policy Choices – confronting the trade offs  Global versus national  The macro prudential regulator  Narrow or broad banking  Market and regulatory failure  Risk and reward preferences

17. 17 Global versus national  Internationally integrated banking system operating with national level regulatory structure – a mismatch?  Feasibility versus ideal – think globally act nationally  Challenge of building links between surveillance and actions

18. 18 The Macroprudential Regulator  Is a separate/new agency required?  Central bank independence and policy focus  Dealing with the non-bank financial sector  Analytic capacity  Could vary capital and liquidity requirements over time – discretion versus automaticity

19. 19 “Narrow” or “Broad” Banking  Where is the balance?  As deposit takers, want banks to be conservative  As allocators of capital, want banks to be flexible risk takers  Solution – regulatory overlay versus regulation plus limiting activities

20. 20 Market versus Regulatory Failure  Incentives for regulatory arbitrage will persist whatever the structure  Markets are dynamic, can regulators match that change?  Does this favor simplifying the regulatory task by moving to “narrow” banking?

21. 21 Risk and Reward Preferences  Countries at different stages of development and other reasons mean that preferences might not be the same  Global coordination does not mean that all need to be the same  But, some shared principles otherwise regulatory arbitrage will dominate

22. 22 Conclusions  Can agree  the regulatory framework failed  some areas where it failed  Can agree some principles  markets are not self regulating  investors should reap the reward and incur the losses associated with risks they take  markets are dynamic – regulatory structure must match this  Cannot agree on definitive regulatory solutions

23. 23 Conclusions  Need to secure international agreement on principles of regulation and supervision.  Countries will need to define their regulatory and supervisory structures within these international principles  Coordination within regions and internationally will be needed.

24. 24 What does it mean for Nigeria?  Develop regional frameworks and participate in international solutions  CBN as financial stability agency; advisory committee including all regulators  Consider containing scope of banking recognizing supervisory capacity  Accept somewhat greater risk recognizing development needs  A transparent and clear bank resolution framework is essential if take greater risk – bank entry and exit is a sign of a healthy system

25. 25 Thank you!