FSI Chair Speaks on Role of Regulation in Enabling Market Integration
At the IIF Market fragmentation roundtable in Washington DC, Fernando Restoy, Chairman of the Financial Stability Institute (FSI) of BIS, spoke about the relationship between regulation and market fragmentation. He highlighted that regulatory heterogeneity is not always the cause of fragmentation and it is often the consequence of a lack of market integration stemming from other factors. He also discussed the role of international standards in limiting unwarranted fragmentation.
Mr. Restoy highlighted that regulation plays a highly relevant role in facilitating market integration. The homogeneity of financial regulation across jurisdictions and the consistency of the requirements imposed on internationally active entities may provide powerful incentives for cross-border financial activities and operations. However, heterogeneous rules or any type of regulatory discrimination against foreign players in domestic markets tend to inhibit the internationalization of financial activity. He added that regulatory heterogeneity is more the consequence than the cause of the specificities prevailing in different jurisdictions. For instance, if the failure of a foreign bank's subsidiary generates a systemic impact in the host jurisdiction—without necessarily affecting the viability of the group as a whole—there is a rationale for imposing specific requirements on the local subsidiary. There is always a limit to what could be termed an acceptable degree of national regulatory specificity. In the case of ring-fencing, the limit should be set at the point where those domestic requirements started penalizing foreign subsidiaries vis-à-vis local players. In the case of proportionality, one of the limits would be to avoid overprotecting smaller institutions from legitimate competitive forces.
Mr. Restoy mentioned that the scope for (warranted) inconsistencies in relation to specific regulatory requirements for internationally active banking groups is certainly limited. The incomplete implementation of international standards in relevant jurisdictions is another major source of the regulatory inconsistencies behind market fragmentation. A significant number of jurisdictions have not met the agreed implementation timelines for specific standards in the Basel III framework and there is room for improvement in the way both supervisory colleges and crisis management groups function. Improvement in this area would certainly facilitate further consistency of prudential requirements and the establishment of sensible internal total loss-absorbing capacity requirements at the legal entity level within international groups. However, one should accept, at least hypothetically, that effective harmonization of relevant regulatory requirements for internationally active entities may require additional policy work at the international level, added Mr. Restoy. This is certainly the case for insurance regulation, where the scope of international standards is still quite limited. However, to a significant extent, it is also true in the case of banking regulation, despite the considerable effort made to develop the prudential and resolution frameworks in the context of the post-crisis reforms.
He added that Basel III still falls short of ensuring complete harmonization of the relevant prudential regulation for internationally active banks, as the procedures followed to measure regulatory capital still lack homogeneity. Valuation of assets for prudential purposes does not follow consistent criteria, given insufficient international guidance on the matter. As measuring capital is highly sensitive to asset valuations, that inconsistency diminishes the comparability of solvency indicators across jurisdictions. Specific discrepancies affect the measurement of non-performing loans and provisioning practices. Actual capital requirements are typically established by Pillar 2 capital add-ons derived from Supervisory Review and Evaluation Process analysis and/or supervisory stress tests. As of now, there is little international guidance on what criteria supervisors should follow to determine those capital add-ons. As for stress tests, an FSI study shows how authorities in selected jurisdictions design stress tests in different ways across certain key features—including the existence and level of capital thresholds; the number and severity of stress scenarios; the inclusion of feedback effects and balance sheet adjustments; and the restrictions imposed on income components over the stress horizon.
Mr. Restoy concluded that the ambition of ensuring a level playing field for internationally active entities may need to look beyond adequate implementation of existing standards, namely at additional policy work aimed to provide international guidance on high-level issues that are currently covered by widely disparate approaches. Such additional policy work will acquire even greater significance against the backdrop of rapid technological developments that have the potential to disrupt the financial industry. To this end, new common standards may be required to ensure a coordinated adjustment of the regulatory perimeter to accommodate some of the new providers of financial services and establish consistent rules to deal with financial institutions' increasing reliance on technology.
Related Link: Speech
Keywords: International, Banking, Insurance, Market Fragmentation, Basel III, Regulatory Heterogeneity, Proportionality, Stress Testing, Ring Fencing, FSI, BIS
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