Global Banking: Paradigm Shift - Managing Transition

Speech by Mr Malcolm D Knight, General Manager of the BIS, at the Federation of Indian Chambers of Commerce and Industry (FICCI) - Indian Banks' Association (IBA) Conference, Mumbai, 12 September 2007.

Abstract

There are three important issues in the context of globalisation and the move towards global banking. First, market participants need to understand the changing nature of risk in the context of the increasing use of innovative and complex instruments that can be traded across markets and borders. In particular, credit risk transfer and liquidity risk management need to be looked at from a fresh perspective. Second, disclosures need to keep pace with market developments. The enhanced disclosures under international financial reporting standards (IFRS) and Basel II will strengthen market discipline and contribute to the soundness of the international financial system. Third, good governance is important for supervisory agencies and central banks. It lends credibility to their actions and enhances their legitimacy as public policy institutions.

Full speech

1. It is a pleasure to be here in Mumbai once again to address the participants of the FICCI-IBA Conference. This is the fourth occasion on which I have had the opportunity to participate. I believe that, as in the past, the theme of the conference aptly reflects the need of the hour - that of "managing transition" in an increasingly global world. The global financial system is in the process of transition because of two important initiatives: the implementation of the Basel II regulatory framework for ensuring stability and strong risk management in banking institutions and the move towards harmonised international accounting standards. Managing these transitions effectively will contribute to the success of both these initiatives and help to address the challenges involved.
2. Before I proceed with my talk today, let me take a few minutes to mention the increasingly important role of the emerging market economies (EMEs) and the Asian region in the global economy. Over the last few years, a significant contributor to global growth has been the expansion of real GDP in the EMEs, which has remained above 7% a year.¹ Among the EMEs, India has been one of the fastest-growing economies, maintaining a growth rate of more than 9% per annum for the last two years. India's track record in managing its progression to a liberalised and globalised economy has been impressive.
3. The Bank for International Settlements (BIS) has been strengthening its already deep relations with the Asian region. To facilitate deeper interaction and cooperation with Asia, the BIS set up its Representative Office for Asia and the Pacific in Hong Kong in 1998. In 2001, the Asian Consultative Council - composed of the Governors of all the BIS member central banks in the Asia-Pacific region - was established to facilitate communication between the central banks of the region and the BIS Board of Directors on matters of mutual interest. Dr Y V Reddy, Governor of the Reserve Bank of India, currently chairs the Asian Consultative Council. Additionally, in 2006 the BIS launched a focused programme, the "BIS Asian Strategy", to further deepen and enhance BIS outreach to the region by fostering more intensive regional economic research, providing more extensive banking services from our Hong Kong Office, and addressing capacity-building needs among financial sector supervisors in the region through the Financial Stability Institute of the BIS.
4. Let me now turn to the two important initiatives that require the effective management of the transition process. The Basel II regulatory and supervisory framework for banking institutions, which is now in the process of being implemented by most jurisdictions in both advanced and emerging market economies, has important change management implications for banks and supervisory agencies alike. The framework requires implementation of three "pillars". Pillar 1 aligns a bank's holding of regulatory capital with the underlying risks in its specific business. Pillar 2 requires each bank to operate a comprehensive internal capital allocation process and the supervisors to review banks' methodologies for risk management. Pillar 3 fosters transparency and public disclosures by banks that are intended to promote market discipline. Basel II implementation requires, inter alia, improvements in banks' risk management systems, enhancement of data management and IT capabilities, and upgrading of human resource skills. Each jurisdiction should determine its schedule for Basel II implementation over the next few years, based on a consideration of all the relevant factors. In order to ensure adequate preparedness on the part of all stakeholders and to facilitate a smooth transition to Basel II, India has extended the time frame for its implementation. Indian banks that have a foreign presence and foreign banks that operate in India will implement Basel II by March 2008, while all other Indian banks will do so no later than March 2009.
5. The adoption of international financial reporting standards (IFRS) also has change management implications for firms, analysts, investors, auditors and other stakeholders. International accounting standards are being harmonised to ensure common reporting, consistent understanding of financial information, and comparability of financial statements across firms and jurisdictions. The standards will also ensure that information and disclosures provided by a firm are comprehensive, and reflect its financial position and performance more accurately than at present. The transition to IFRS may require legal or regulatory amendments in some jurisdictions. I understand that in order to better align Indian accounting practices with international standards, the Institute of Chartered Accountants of India is initiating steps to ensure adoption of IFRS by 2011.
6. I would also like to mention an initiative that is currently engaging the attention of policymakers worldwide - that of building more inclusive financial systems. Financial inclusion is all about ensuring that everyone has access to appropriate financial services. Many countries are addressing the issue of how best to broaden the reach of financial services to include the "unbanked" or "underbanked" segments of society. To create an awareness of this initiative, in recent years the Financial Stability Institute of the BIS organised two conferences on microfinance and financial inclusiveness in cooperation with the World Bank and the Consultative Group to Assist the Poor (CGAP). The Basel Committee on Banking Supervision has also initiated a new work stream to assess how the growing area of microfinance fits into the existing supervisory frameworks. In the Indian context, I understand that the Reserve Bank of India has stepped up efforts to promote financial inclusiveness. Banks in India are now making available basic "no frills" banking accounts with low or minimal balances, and - in partnership with non-governmental organisations and self-help groups - improving their outreach. In the future, these measures will lead to major social and economic benefits.
7. I will now talk about three themes that I think are especially important in the context of globalisation and the move towards global banking:
1. Understanding the changing nature of financial risk and the need for fresh perspectives in risk management.
2. Encouraging the use of enhanced disclosures for effective market discipline.
3. Promoting good governance in supervisory agencies and central banks.

Risk management: fresh perspectives

• In this era of financial globalisation, risks transcend all borders. It is now possible to originate, repackage and distribute various financial risks across investors, markets and borders. Effective risk management, therefore, requires a better understanding of risks by market participants, supervised entities and supervisory agencies. In this regard, I will highlight some issues relating to (i) credit risk transfer and (ii) liquidity risk management.
• Simple credit risk transfer instruments such as loan sales and loan syndications have been used by banks for many years. But securitisation and credit derivative transactions that are assuming increasingly complex structures have now gained in popularity. Both the overall transaction volumes and the number of market participants have been increasing. I understand that the Reserve Bank of India has decided to allow market participants to deal in credit default swaps as part of the gradual process of financial sector liberalisation. This will open up the credit derivatives market in India.
• Credit risk transfer instruments enable trading in credit risk, which allows for its valuation or pricing by the market. Banks can offload credit risk in the market without impairing their relationship with the borrowers. The traditional "originate and hold" strategy of banks involved originating loans and holding them on the balance sheet until they were repaid or written off. The "originate and distribute" strategy, on the other hand, allows banks to distribute the underlying risk of the originated loans to final investors such as pension funds, insurance companies, hedge funds, mutual funds and other banks. This unbundling and repackaging of credit risk enables market participants to assume credit risk exposure in accordance with their risk appetites and their capacities to bear risk. The resulting diversification of risk can contribute to the efficiency and stability of the financial system.
• However, it is important that both the originating and the investing firms understand the risks in transactions relating to credit risk transfer. In a benign macroeconomic environment, it is easy for investors to be lured by "return", losing sight of the fact that "return" forms only one part of the equation; the other part relates to "risk". The "originate and distribute" strategy may lead, and indeed probably has led, to reduced incentives for banks to undertake adequate assessment of credit risk at the time of origination, since the risk is to be offloaded later. Moreover, the markets for credit risk transfer are especially vulnerable whenever there is impaired market liquidity.
• This brings me to the issues relating to liquidity risk.² Liquidity facilitates the smooth functioning of financial institutions and markets. Institutions require liquidity to carry out "business as usual", execute business strategies over the medium and long term, and sustain the confidence of clients, counterparties and stakeholders. Markets require liquidity to function efficiently. Liquidity imparts resilience to the markets to absorb shocks, and can help prevent imbalances from spreading from one segment of the market to another.
• Liquidity risk has assumed greater significance in the light of the increasing cross- border operations of banks and corporations, the complexity of the activities undertaken, the growing interdependencies among markets, and the emergence of innovative off-balance sheet instruments and products with embedded optionality. While individuals and firms are now able to trade complex assets in markets of increasing breadth and depth, it is important that this ability to trade continues under stressful market conditions, as well as in normal times.
• The Basel Committee on Banking Supervision, hosted by the BIS, issued a paper on Sound practices for managing liquidity in banking organisations in February 2000. The Committee is currently taking a fresh look at liquidity risk in the context of banks' growing reliance on market liquidity to distribute risk, and their associated vulnerability to market liquidity shocks. Some of the areas being reviewed - which have been much in the news lately - include the growing links between market and funding liquidity, the use of stress testing exercises, and the impact of "originate to distribute" strategy on the funding liquidity of institutions. A stocktaking of the current regulatory frameworks for liquidity risk management is also being undertaken. Based on the findings, the Committee will identify issues that may need to be addressed.

Disclosures and market discipline - the Basel II and IFRS perspectives

• Market discipline reinforces the incentives for the management of banking enterprises to manage them along sound lines. It operates on the basis of disclosures and other information available in the market. Periodic and meaningful disclosures by banks relating to their capital, risk exposures and risk management techniques enable market participants to make an assessment of a bank's risk profile. Bond spreads or stock prices quoted in the markets provide information that may indicate changes to the risk profile. This information can be used by the supervisors to initiate appropriate supervisory responses, if required.
• For market discipline to be effective, creditors, investors and other stakeholders should analyse the disclosed information, understand its meaning and have incentives to act. Markets are effective in identifying outliers, ie a risky institution in an otherwise healthy financial system. Markets, however, find it more difficult to identify and limit excessive exposure to risk in the financial system as a whole.³ In this context, monitoring the macroprudential aspects of financial stability by the supervisory agencies and central banks becomes important.
• Enhanced, high-quality disclosures are mandated in IFRS from an accounting perspective and in Basel II from a prudential perspective. While IFRS disclosures focus on assessing the current financial position of an enterprise, Basel II disclosures are more forward-looking. Given the different focus of accounting and prudential standard setters, it is to be expected that the disclosure requirements under the two standards differ in some respects. IFRS disclosures are made in the financial statements by all enterprises that prepare and submit financial statements. On the other hand, disclosures under Pillar 3 are required to be made only by banks that are implementing Basel II. Moreover, Pillar 3 disclosures need not necessarily be made in the financial statements.
• IFRS and Basel II disclosures do, however, complement as well as supplement each other in several ways. Both require a firm or corporation to provide information on its capital, the risks it is exposed to, and how it manages these risks. Disclosures are required to be made "through the eyes of the management". This enables the user of information to view and assess a firm in the same way as its management would. While material information should be disclosed, confidential information need not be. Disclosures under both IFRS and Basel II include a good mix of quantitative and qualitative aspects.
• Consistent, comprehensive and comparable disclosures contribute to effective market discipline. IFRS and Basel II disclosures try to ensure that this goal is met. There is potential for achieving synergies in disclosures under IFRS and Basel II by defining risk parameters in a common way, and developing common processes and data collection methodologies. This could lead to a consistent basis for internal reporting to the management of the enterprise and external reporting to the supervisors or regulators and other stakeholders.

Good governance in supervisory agencies and central banks

• Good governance facilitates the emergence of more efficient and robust institutions, whether they are in the private or public sector, whether they are central banks, governments, supervisory agencies or international financial institutions. I will highlight some important issues relating to good governance in supervisory agencies and central banks.
• There is no specific code of governance for supervisory agencies.⁴ However, three elements are important for their good governance. First, a supervisory agency needs to have operational independence, adequate legal powers, and the ability to take decisions without external influence. It should have the necessary financial, IT and other resources and the ability to attract and retain suitable qualified staff. Second, the agency needs to be transparent in the exercise of its functions. It should engage in a consultative process with the supervised entities in formulating supervisory policies, and make efforts to ensure that regulation and supervision are understood by those entities. Third, the agency needs to be accountable for the discharge of its duties. It should periodically explain its performance vis- à-vis the objectives to the stakeholders and wider public, thereby building understanding and support among them.
• Do institutional arrangements for financial sector regulation and supervision have an impact on good governance? In this regard, I will mention the results of a survey that the Financial Stability Institute of the BIS undertook in 2006. The survey focused on the current institutional arrangements for financial sector supervision globally. The results indicate that there is a variety of approaches through which financial sector supervision can be structured. Across jurisdictions, banking supervision is carried out by either the central bank, a government department or a separate supervisory agency. There are also differences in the level of integration of supervisory functions across the banking, insurance and securities sectors. Each jurisdiction has to determine which institutional arrangement for financial sector supervision is best suited for its financial system. Good governance must be ensured whatever the institutional arrangements for financial system supervision.
• In recent years, there has been a growing interest in the governance of central banks. The principles of operational independence, transparency and accountability that I referred to earlier apply equally to central bank governance. However, in view of the unique functions performed by central banks, the focus of governance is also on their institutional and organisational setting for the pursuit of monetary and exchange rate policies, reserve management and financial stability functions. For many years, the BIS has been facilitating discussions and the exchange of views on central bank governance. More recently, in 2005, the Central Bank Governance Forum was set up by the BIS to foster the good governance of central banks and to compile, analyse and disseminate timely and accurate information on central bank governance matters.

Conclusion

• Let me conclude by summarising the issues that I have talked about today. First, financial market participants need to develop a better understanding of various risks that are inherent in the increasing use of innovative and complex instruments that can be traded across markets and borders. Second, disclosures need to keep pace with market developments. Over time, the enhanced disclosures under IFRS and Basel II will strengthen market discipline and contribute to the soundness of the international financial system. Third, good governance in supervisory agencies and central banks lends credibility to their actions and enhances their legitimacy as public policy institutions. Discussions and the sharing of views will lead to an increased awareness of the various options available for their sound governance.
• I am happy to be at this conference and wish you every success in your deliberations.

¹ 77th Annual Report, 1 April 2006-31 March 2007, Bank for International Settlements, Basel, Switzerland.

² Two dimensions of liquidity risk are well known: funding liquidity risk and market liquidity risk. Funding liquidity risk relates to a firm not being able to efficiently meet both expected and unexpected current and future cash flow and collateral needs without affecting either the daily operations or the financial condition. Market liquidity risk relates to the difficulty a firm has in offsetting or eliminating a position without significantly affecting the market price because of inadequate market depth or a market disruption. The same factors could trigger both types of liquidity risk. The management of liquidity risk in financial groups, Joint Forum Report, Bank for International Settlements, May 2006.

³ M Knight, "Three observations on market discipline", in C Borio et al (eds), Market discipline across countries and industries, MIT Press, 2004.

⁴ The OECD Principles of Corporate Governance, issued by the Organisation for Economic Co-operation and Development, have become an international benchmark for assessing the effectiveness of corporate governance in different entities. The Basel Committee on Banking Supervision has issued guidance on Enhancing corporate governance for banking organisations.