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    FSI Chair Speaks About Proportionality in Regulation and Supervision

    May 08, 2019

    Fernando Restoy, Chairman of the Financial Stability Institute (FSI) of BIS, spoke at the BIS/IMF policy implementation meeting on proportionality in financial regulation and supervision. Drawing from the analytical work at FSI and at other international bodies, he examined the application of proportionality at the global level, along with the associated policy challenges. "In the wake of the post-crisis reforms, applying proportionality begins with a more humble endeavor: knowing your regulated firms in a manner that allows for a sensible tiering of regulation, supervision, and resolution," he concluded.

    Mr. Restoy described the concept of proportionality and outlined the conditions that, he believes, sound proportionality regimes should, ideally, meet. He pointed out that the proportionality strategies used to tailor regulatory requirements vary markedly across jurisdictions, including the criteria used to differentiate institutions, the scope of application, and the methods used to apply proportionality. These differences may reflect a lack of international guidance on how to apply proportionality. Next, he discussed the worldwide application of proportionality in the areas of prudential regulation, supervision, and resolution. All Basel standards are applicable for "internationally active banks"—a term that has "purposely never been defined by the BCBS"—and there is no commitment for prudential authorities to extend their application to other banks operating in their respective jurisdictions. Evidence suggests that the concept of proportionality is most often applied to the market risk framework, the quantitative liquidity standards, the large exposures regime, and the disclosure and reporting obligations. Most adjustments in regulation aim to reduce complexity without necessarily diminishing stringency.

    However, in non-BCBS member jurisdictions—which are under no commitment to adopt Basel standards and where the vast majority of locally incorporated banks are unlikely to be internationally active—the differences in how proportionality is applied are more widespread. A forthcoming FSI paper—based on a survey of 16 BCBS and non-BCBS jurisdictions—indicates that all surveyed authorities apply proportionality, which demands various degrees of supervisory judgment. He added that, to facilitate a proportionate approach in supervision, some authorities rely more on principles-based approaches that emphasize a holistic assessment of a firm. By contrast, others have developed more structured methodologies, which are referred to as "guided discretion." The key takeaway, he adds, is that the use of proportionality in supervision is not a choice; it is an intrinsic part of supervision that allows supervisory resources to be better allocated to firms that pose the greatest risks. Further, it also helps supervisors to better align a bank's risk profile with its financial buffers and the quality of its risk management/governance arrangements. These issues simply should not, and cannot, be dealt with by regulation alone.

    The FSI Chair also discussed the policy challenges associated with the application of proportionality. He added that it is unlikely that all proportionality approaches taken in various jurisdictions could deliver the same outcomes with respect to the objective of ensuring a level playing field while protecting financial stability. In this context, he illustrated the differences in application of this principle to certain aspects of Basel III in U.S. and EU. These vastly different approaches, while well within each jurisdiction's purview, illustrates the need to achieve a common understanding of the pros and cons of the varied proportionality approaches that have been taken or are being considered. "Against this background, consideration could be given to adopting a categorization (or tiering) approach, where banks are grouped into several classes (defined by various criteria); and these categories are used as the basis for differentiating requirements. Indeed, this is the approach followed in countries such as Brazil and Switzerland (Castro Carvalho et al (2017), and it is the one that the United States is planning to adopt soon (US Federal Reserve (2018)). Ideally, the defined categories could be used not only to establish specific prudential rules but also supervisory criteria and resolution planning requirements," advocates Mr. Restoy. 

    He added that, to the extent that less complex rules imply less risk-sensitivity, authorities may consider introducing certain regulatory requirements and supervisory policies to mitigate the potential incentives for firms to take on excessive risks. There could be merit in imposing more stringent regulatory requirements for banks that are subject to simpler obligations, as an explicit trade-off for adopting less risk-sensitive methodologies. One example of such an approach is the currently proposed community bank leverage ratio framework in the United States. He suggests that the ability to apply proportionality in financial regulation and supervision—without pushback from rating agencies, institutional investors, and other market participants—seems to favor the economies that have "exorbitant privilege" in the structure of the global financial system. For economies that do not benefit from this privilege, additional work at the international level to identify good proportionality practices could serve as a reference for the supervisory community. These references may be particularly valuable for emerging market economies, as these economies will need to ensure that their regulatory framework—particularly if it deviates in some respects from Basel standards for small and non-complex institutions—is still perceived internationally as being sufficiently rigorous.

     

    Related Link: Speech

     

    Keywords: International, Banking, Insurance, Basel III, Proportionality, Regulation and Supervision, Resolution Planning, FSI, BIS

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