Designing a System of Financial Designing a System of Financial RegulationRegulation

Howard Davies

Director - London School of Economics

Executive Public Policy Training ProgrammeBeijing

20 June, 2006

Five Steps to Reform

1. Assess the strengths and weaknesses of the financial system

2. Determine the desired future shape of the system

how flexible?

how open?

3. Assess compliance with international standards

4. Review the structural options

5. Map them against local market conditions

1. The Strengths and Weaknesses of the Financial System

Global Financial Stock 2004 (%)Global Financial Stock 2004 (%)China is becoming a significant part of the global system

Source: McKinsey Global Institute, 2006

23

16.5

4.5

156

EurozoneUKJapan ChinaRest of World

Financial Depth – Financial Stock as % Financial Depth – Financial Stock as % of GDP 2004of GDP 2004China’s financial system is already well-developed

Source: McKinsey Global Institute, 2006

0

50

100

150

200

250

300

350

400

450

Japan US UK Eurozone China India

(%)

Bank Deposits as % of Financial StockBank Deposits as % of Financial StockBut it is very heavily dependent on banks

Source: McKinsey Global Institute, 2006

0

10

20

30

40

50

60

70

US Eurozone India China

Per

cent (%

)

Chinese Share of Global Financial Stock Chinese Share of Global Financial Stock (%) 2004(%) 2004And the capital markets are relatively small

Source: McKinsey Global Institute, 2006

0

2

4

6

8

10

Private Debt GovernmentDebt

Equities Bank Deposits

Per

cent

(%

)

2. The Desired Future Shape of the System• Meet WTO commitments• Strengthen competitive pressures: greater

flexibility• Expand capital markets as a source of finance for

growth» equities

» private sector bonds

• Improve financial services for lower income families, and in remote areas

3. Compliance with International Standards

G7

Finance Ministers

International Monetary

Fund

World Bank

Global Financial Stability Report

Financial Stability Forum

ADB IADB EBRD etcICFC

The International Financial Architecture

Financial Sector Assessment Programmes

A. Banking Supervision

Bank of International Settlements

G10 Governors + Heads of Supervision

Basel Committee

Basel Capital Accord

G10 + Spain, LuxembourgECECBCentral Banks and Supervisors

B. Securities Regulation

IOSCO- Core Principles

Multilateral MOU

C. Insurance Regulation

IAIS - Solvency Standards

D. International Accounting Standards

4. Review the Structural Options

Four main models in operation elsewhere• ‘3 pillars’: banking, securities and insurance

separately regulated• ‘Twin Peaks’: separation of prudential and

conduct of business regulation• ‘Hybrid’: where two or more sectors are

regulated together• ‘Integrated’: a single regulator covering most

or all of the financial sector.

There is no clear consensus about which model is ‘best’.

Structure of Supervision in 77 Countries, 2002 Agency supervising two types of financial intermediaries

Indicator Single supervisor for Banks and Banks and Securities firms Multiple

the financial system securities firms insurers and insurers supervisors

Countries Austria, Bahrain, Dominican Austria, Belgium, Bolivia, Chile Argentina, Bahamas,

Bermuda, Cayman Republic, Finland, Canada, Colombia Egypt, Mauritius, Barbados, Botswana,

Islands, Denmark, Luxembourg, Ecuador, El Slovakia, South Brazil, Bulgaria, China,

Estonia, Germany, Mexico, Salvador, Africa, Ukraine Cyprus, Egypt, France,

Gibraltar, Hungary, Switzerland, Guatemala, Greece, Hong Kong

Iceland, Ireland, Uruguay Kazakhstan, (China), India,

Japan, Latvia, Malaysia, Peru Indonesia, Israel, Italy,

Maldives, Malta, Venezuela Jordan, Lithuania,

Nicaragua, Norway, Netherlands, New

Singapore, Rep. of Zealand, Panama,

Korea, Sweden, Philippines, Poland,

United Arab Emirates Portugal, Russia,

United Kingdom Slovenia, Sri Lanka,

Spain, Thailand, Turkey, United States

% of

counties 29 8 13 9 38

in the

sampleSource: Luna Martinez and Rose (2003)

There is a trend towards integrated regulation for a number of reasons

- growth of financial supermarkets

- risk transfer between sectors

- attractions of ‘one-stop shopping’

Main Reasons for Adopting Integrated Supervision (agencies indicating any one of the following reasons

Reasons Number of Agencies

Percentage of all agencies

Improve the supervision of a financial system moving towards universal banking

14 93

Maximise economies of scale and scope 12 80

Solve problems resulting from poor communication and lack of cooperation among existing supervisory agencies

4 27

Minimise gaps in the regulation and supervision of financial intermediaries

3 20

Facilitate operational restructuring of regulatory agencies (in particular, after a financial crisis)

3 20

Overcome other weaknesses in the overall quality of financial regulation and supervision

2 13

But there are also important variations between integrated regulators

- scale

- scope

- powers

Powers of the Integrated Supervisory Agencies over BanksRegulatory and supervisory agencies Number of

agencies% of all agencies

Conduct on-site examinations 15 100

Conduct off-site examinations and surveillance 15 100

Impose sanctions and fines for non-compliance with rules and regulations

15 100

Set prudential regulation on market, credit, operational, and liquidity risks

12 80

Set accounting rules and information disclosure requirements

11 73

Set rules on the composition of capital 11 73

Approve and revoke a license to a financial intermediary 11 73

Set minimum capital requirements 10 66

Set licensing requirements 9 60

Consumer protection (assist to resolve claims for abuses against users of financial services)

9 60

Source: Luna Martinez and Rose (2003)

How the Centres Rank in Terms of their Regulatory Environment

Market participants tend to favour integrated regulation

02468

101214161820

London New York Paris Frankfurt

Average Score

Source: Z/Yen, 2005

5. Map options against local market conditions

China now operates a ‘3 pillar’ model, butwith banking supervision outside the centralbank• suitable where there is little ‘cross-sectoral’

activity• also where a single agency might be seen to be

‘too powerful’• and where sheer scale makes effective

management difficult.

Regulatory Reform in China is under way

- - 3 commissions: CBRC, CSRC, CIRC

- International Advisory Councils

- - Training

- Culture of challenge

- Overarching body to resolve inconsistencies and promote co-operation

An integrated regulator might be more appropriate if

• banks are allowed to undertake other activities: universal banking

• derivatives markets develop, allowing risks to be transferred between sectors

• multi-functional overseas firms enter the markets on a large scale

Designing a System of Financial Designing a System of Financial RegulationRegulation

Howard Davies

Director - London School of Economics

Executive Public Policy Training ProgrammeBeijing

20 June, 2005