At the Westminster Business Forum in London, the FSI Chairman Fernando Restoy spoke about the application of proportionality in banking regulation. He reviewed the concept, motivation, and the constraints associated with the proportionality principle and compared the different approaches in various jurisdictions, while using some work that has been recently done at the FSI of BIS.
He believes that it may make sense to adjust the regulatory requirements applied to smaller and/or less complex institutions to alleviate the excessive regulatory burden that they would otherwise face. However, the design of such a proportionality regime will need to meet a number of conditions. First, it should not dilute institutions' capacity to absorb losses or face liquidity shocks. A proportionality regime must focus on reducing complexity without undermining the fundamental prudential safeguards to avoid compromising financial stability. Second, the proportionality regime should not overprotect small or medium-size institutions against competitive forces. In particular, proportionality should not generate spurious incentives for banks to remain small or simple if there are competitive forces that promote consolidation, potentially leading to a more efficient banking industry. Technological developments and overcapacity in some jurisdictions are examples of competitive forces that help to shape market structure.
He explained that the results of an FSI study showed the approaches to tailoring regulatory requirements to different classes of institutions vary markedly across jurisdictions. They could be broadly classified into the categorization approach and the specific standard approach. Under the categorization approach, which is followed in Switzerland and Brazil, banks are classified into a few categories according to their size or complexity and a specific set of rules is applied for all banks within each category. Under the specific standard approach, which is being used in EU and to some extent the United States—exceptions are applied to each relevant regulatory obligation (for example: liquidity, market risk, or reporting requirements) for banks meeting specific criteria. The categorization approach is certainly simpler and more transparent. However, the specific standard approach permits a finer adjustment of the requirements to the characteristics of the supervised institutions; it allows exemptions or simpler versions of specific requirements to be adopted only for banks for which the original rules are considered unnecessarily complex from a prudential point of view.
The study also shows that, in most jurisdictions, the proportionality regime affects a variety of regulatory requirements. Within Pillar 1, the standards on market and liquidity risk are the ones most often tailored to specific institutions. Within Pillar 2, proportionality often affects stress testing requirements and procedures for the supervisory review process. Proportionality regimes also typically include simpler reporting and disclosure requirements for small firms. The analysis shows that proportionality does not normally imply reduced minimum capital ratios for smaller or less complex institutions. Yet the application of some simplified approaches to assess the solvency, liquidity, and risk profile of the institutions and the reduced reporting and disclosure requirements may collectively have prudential relevance. The reduced frequency of reporting requirements for small institutions—which is allowed in some jurisdictions and is a subject of discussion in EU—may hamper the ability of supervisors to properly monitor emerging risks.
In view of these prudential considerations, some jurisdictions are considering the possibility of accompanying the application of simplified requirements to some institutions with the introduction of a more demanding coverage of risks. A case in point is the recent legislation passed by the US Congress in which institutions with a balance sheet below USD 10 billion may be exempted from meeting standard minimum risk-based capital ratios if they keep their leverage ratios—whose calculation is simpler—substantially above the ones required under the Basel standards. This combination of simplicity with additional stringency would seem to be a promising formula for the calibration of proportionality regimes and one that might be well worth exploring in other jurisdictions.
Related Link: Speech
Keywords: International, Banking, Proportionality, Basel III, Reporting, FSI
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