Speech

Remarks by Agustín Carstens, IMF Deputy Managing Director, at the VIII Annual Assembly of Supervisors of Banks of the Americas

September 9, 2005

It is an honor to have the opportunity to address such a distinguished audience in such a beautiful city as Oaxaca. We, at the IMF follow with a great deal of detail all the work and deliberations at ASBA, and we cherish any opportunity to interact with you. This certainly should not come as a surprise, given that both the ASBA and the Fund share as an objective the strengthening of the banking system and its regulatory and supervisory framework.

In a way we could say that since the late nineties, we have seen consistent progress in this endeavor. The financial crises that took place during the last decade in Mexico, East Asia, Russia, Brazil, Argentina, Turkey, Uruguay, and the Dominican Republic triggered substantial efforts in different forums and institutions oriented to prevent renewed crises or subsequent banking crises. Work done by international bodies such as the Basle Committee, the Joint Forum and the Financial Stability Forum represent a clear example. The discussion in some instances has gone beyond the official and specialized circles, as is attested by the fact that the Basle II Capital Accord and the new International Financial Reporting Standards (IFRS) are discussed not only in forums like this one, but also by the media and political audiences in many countries. In the context of the Financial System Assessment Program (FSAP), the IMF and the World Bank have been conducting assessments of financial systems across the world, to identify their vulnerabilities and assist countries in developing plans to address them. Since May 1999, 88 such assessments have been completed and 19 are in process of completion, including assessments for 19 members of ASBA.

Countries themselves are developing action plans targeted to improve their compliance with Basle Core Principles for Effective Banking Supervision and, in the most advanced cases, to get ready to implement the Basle II Capital Accord. ASBA countries have also started to work in a coordinated way, by establishing working groups to address common vulnerabilities in the region.

However, as you know, much is yet to be done to feel confident that we have done everything in our power to prevent the next banking crisis or, at least, mitigate its effects. Making financial systems more resilient and better prepared to withstand shocks and changes in market conditions requires a comprehensive and well-coordinated effort of authorities and participants in the financial system. The task is not for bank supervisors alone, but you have a central role. Efforts in the following areas are key:

• Better macro management would help to reduce the size and likelihood of shocks affecting the financial system. Low inflation and sustainable fiscal policies are necessary to have more stable output and less pronounced business cycles. Economic authorities must bear in mind that, as we enter into a more advanced stage of the positive business cycle, a combination of several not too spectacular events might cause markets to reverse their course, and create a less hospitable environment for investors and borrowers who have become accustomed to borrowing at low interest rates.

• Structural reforms aiming at improving market infrastructure also contribute to the resilience of the financial system. Clear and strong creditor rights, an effective and consistent judicial system, high standards for market conduct and transparent information, and well-established and supervised accounting and audit professions would help to foster market discipline.

• Better risk management by financial institutions would make financial systems more resilient to shocks. While risk management is the responsibility of financial institutions, supervisors can influence banks' risk management by setting high standards and using supervisory tools to discourage risky behavior. Bank supervisors must be vigilant about the risk profile of financial intermediaries and their vulnerability to market shocks.

• Last, but not least, a well designed regulatory and supervisory framework, and good implementation of bank supervision can enhance the resilience of financial systems by controlling and deterring risky behavior, by ensuring that the financial system has adequate buffers to protect it from all risk exposures and, when necessary, by excluding undesirable players from the financial system.

The role of bank supervisors is central to improve the resilience of financial systems. I am sure that you are more than aware of the risks and vulnerabilities present in the ASBA's countries banking systems. Nevertheless, I think it is appropriate for me to present and discuss with you the two main types of challenges faced by bank supervisors in the region, as identified by the 19 FSAPs that have been conducted in your countries.

First, there are challenges arising from the need to address the main vulnerabilities, risks and exposures of the financial systems in the region. Second, there are challenges associated to the need to improve bank regulation and supervision in the region. These latter challenges were mainly identified by assessing country compliance with the Basle Core Principles for Effective Banking Supervision (BCP). At the outset I would like to acknowledge that some of the specific regional challenges that I will mention might not be applicable to all countries.

The main challenges for bank supervisors arise from key vulnerabilities and risks of the region's financial systems, such as:

• High concentration of assets: Low financial deepening and economic diversification can lead to bank portfolios that are concentrated on a few corporate clients, groups, sectors or regions. When a few correlated exposures can wipe the profitability of a bank or, worse, have a significant effect on its solvency, excessive concentration creates a high credit risk that needs to be addressed by bank supervisors, even if the bank in question is not violating any legal limits. High concentration on large exposures (including exposures to the public sector) and in some countries also related lending can be a problem. High concentration on the liability side may also add to these problems, by increasing liquidity risks.

• Financial conglomerates in some countries have legal and corporate structures that complicate control and supervision. Examples are, un-supervised parent or holding companies and parallel banks, many of them constituted in foreign countries, and protected by secrecy laws. In this context, under-pricing and transfer of risks and contagion across members of financial conglomerates create vulnerabilities for the conglomerate and, often, for the financial system as a whole, that cannot be properly assessed by bank supervisors.

• Financial systems that are partially dollarized tend to be exposed to higher solvency and liquidity risks. Unique solvency risks result from mismatches of borrowers' balance sheets, including currency, maturity and interest rate mismatches. The most widespread of these mismatches, albeit not the only one, results in foreign currency induced credit risk for financial institutions. Added liquidity risk in dollarized financial systems stems from the potentially limited backing of bank's dollar liabilities. These added risks create scope for a more active approach to prudential regulation and supervision.

• Growing regional financial integration-as is happening in Central America- exposes financial systems to higher cross border contagion risks. While financial integration has numerous positive effects, including the capacity to exploit scale economies, the benefits of diversification and other synergies within the region, it also increases risks of cross border contagion. Addressing these risks requires a more integrated and homogeneous regulatory and supervisory framework. Cooperation of supervisors to exchange information and to allow on site examinations of the home country supervisor is just the beginning. To reduce the scope for regulatory arbitrage created by differences in prudential regulation requires that countries work together towards a regulatory and supervisory framework that is more homogeneous and consistent with international standards. As a result of the recently finalized Central America Financial Sector Regional Project (FSRP), the IMF has supported an initiative aiming at achieving effective consolidated supervision of regional financial conglomerates in Central America. This could be regarded as a first step towards the more ambitious objective of having a more integrated framework.

• Exposure to cross border contagion arises in some countries, not only because of internationally active financial conglomerates but also because of the large share of operations with non-residents in their financial systems and because of the perception of investors and creditors-well founded or not-that financial systems within a region share common risks. For instance, a large concentration of operations with residents of a foreign country may expose a financial system to shocks originated abroad, as Uruguay learned the hard way in 2001.

• In some countries, these risks may be aggravated by a weak credit culture and weak market conduct. Weak creditor protection and precedents of government interference, to grant some type of debt relief to problem debtors, are often evidence of a weak credit culture. In a weak credit culture environment, market discipline is eroded, as there is no incentive for banks and borrowers to prudently manage their risks. On the contrary, bankers and debtors are more likely to collude to obtain debt relief from the government. Weak credit culture may also develop when credit is rapidly expanding into new retail segments, as new borrowers with no financial experience, obtain access to credit. In this type of environment, competition leads banks to lower their credit standards and take higher risks. Weak market conduct aggravates these risks, as banks may not have transparently informed borrowers of all the terms and conditions of their loan contracts. As overborrowing leads to default, it may also lead to a common perception that loan contracts were unfair, and lobbies and pressures to obtain debt relief may emerge.

A second group of challenges arises from the need to strengthen the regulatory and supervisory framework of the financial system. The Basle Core Principles assessments done in the context of FSAPs point toward six challenges that are common to a large number of ASBA member countries (from 9 to 13 out of 19-based on the number of countries not compliant or materially not compliant with the corresponding BCPs):

• Consolidated supervision (BCP 20-13 countries): In many countries supervisors are not able to effectively supervise banking groups on a consolidated basis. The absence of legislation granting the powers to conduct consolidated supervision of financial conglomerates, or lack of a comprehensive regulation including key prudential requirements on a consolidated basis, are not the only problems. When speaking about consolidated supervision, the devil is in the details. Issues of coordination among domestic and foreign supervisors, scope for regulatory arbitrage and difficult conglomerate structures tend to arise. And it is generally because of a combination of these that countries cannot effectively supervise their conglomerates on a consolidated basis. A well-designed framework for consolidated supervision has to address all these issues.

• Minimum capital requirements (BCP 6: Capital adequacy (11): In many countries, the minimum capital requirements do not meet international standards. While lower weights for some asset categories or differences in the components of capital can cause this problem, there are two more likely reasons for this result. In some countries it is the absence of capital requirements on a consolidated basis and in others it is the existence of some form of regulatory forbearance that affects effective capital requirements.

• Supervision of banking risks (BCP 12- Market risks (11 countries); BCP 13- comprehensive risk management and supervision of other risks (10 countries); BCP 11-country risk (9 countries): Many countries lack regulatory requirements on comprehensive risk management and on managing specific risks, such as credit, market, liquidity, operational or country risk. Capacities to effectively supervise these risks also need to be developed.

• Internal control and audit (BCP 14-10 countries): Absence of an independent internal control system and audit hamper internal control in many countries.

• Remedial actions (BCP 22-9 countries): In many countries supervisors do not have at their disposal adequate supervisory measures to bring about timely corrective action when banks fail to meet prudential requirements or take risks that endanger the interests of depositors, including in extreme circumstances the ability to revoke the banking license. The inability to impose timely remedial measures is often related to the existence of regulatory forbearance or another type of political interference. But also some countries have incomplete or inadequate resolution frameworks, with very limited tools to resolve weak institutions or with explicit or implicit government guarantees to creditors of weak banks.

• Independence of bank supervisors (BCP 1.2 - Operational independence and adequate resources and BCP 1.5 - Legal protection for bank supervisors (9 countries): In many countries bank supervisors lack operational independence and legal protection to do their job. Lack of independence could be de jure or de facto; de jure, when the legal framework does not grant independence to bank supervisors; de facto, when, in spite having legal independence, there is evidence of political interference or industry capture. As we have seen in previous points, political interference or lack of independence affect the capacity of supervisors to do their job, including their capacity to require an adequate minimum capital to cover banks' risks and to impose timely remedial actions, whenever deemed necessary. I don't have to elaborate much about the need for legal protection. Many of you have first-hand experience on being subject to prosecution and legal suits as a result of doing your job.

It is fair to say that many countries have undertaken corrective actions, or are in the process of doing so, often with the help of the Fund. At the same time, achieving full compliance with Basle Core Principles is not sufficient to keep up with an evolving international standard setting. As discussed by previous speakers, additional challenges are posed by the implementation of newly developed standards, such as the forthcoming changes in the Basle Core Principles for Banking Supervision, the new International Financial Reporting Standards and the Basle II Capital Accord.

An underlying theme of the preceding discussion is that financial sector soundness, and ultimately the sector's efficiency, are likely to be better protected where the supervisory and regulatory authority has adequate independence. This protection is afforded by both the institutional arrangements to provide supervisory and regulatory independence, and the political consensus that supports it.

An analogy can be drawn with the Latin American experience of reducing inflation and establishing independent central banks. Much of Latin America was plagued by very high and volatile inflation during the 1970s and 1980s. In response, a consensus emerged on the importance of establishing price stability and strengthening the institutional arrangements to carry out this task, such as granting independence to the central bank. The building of a strong intellectual, political and social consensus to fight inflation translated into the endowment of central banks with a greater degree of autonomy to pursue the clearly focused mandate of price stability (together with a provision to assure the resources that are necessary to comply with the mandate). The result has been lower and more stable inflation, with inflation expectations better anchored around inflation objectives. By the end of 2004, most Latin American countries were characterized by low rates of inflation.

Banking crises are extremely costly in terms of output and employment contraction, and can contribute significantly to an increase in public debt. The welfare impact of an increase in debt due to banking crises (transfer of wealth to unproductive uses) can be far worse and regressive than that of an increase in debt due to tax cuts or spending on social issues or infrastructure. In addition, this increase in public debt can accumulate over a very short period of time, a feature that in itself magnifies the social cost of banking crises.

So, there is an urgent need for society to embrace the need to preserve financial stability. Going forward, a concerted effort is needed to build public understanding of the need for effective regulation and supervision, and consensus on the institutional arrangements needed to support these objectives. In particular, the supervisory authority needs to have an unambiguous mandate to support financial soundness, the autonomy and the resources (including the human capital) to carry it out.

Delegating the authority of regulation and supervision to an independent agency not only contributes to policy credibility, but it would also be proof of good governance in the public sector. In this connection, the independent authority should be accountable vis-à-vis those who delegated the responsibility, namely, the government and the legislature, but also vis-à-vis the public at large. In turn, accountability is easier to implement when the agency has a clearly defined and measurable objective. Transparency is a vehicle to safeguard independence and integrity and is a key instrument to make accountability work.

To conclude, I would like to underline that much progress has been achieved in recent years on crisis prevention and on enhancing bank regulation and supervision in the ASBA region. Your governments have put a lot of attention to improve the regulatory framework of the financial system. Nevertheless, and looking forward, additional steps are needed to ensure that the financial systems of the region fulfill their role as a vehicle for growth in a stable environment. To add one more challenge to your long list, it is essential that bank supervisors work hard to obtain the legislative and political support necessary to strengthen the institutional arrangement of their agencies, to achieve independence and legal protection. It is in the interest of Central Banks and Ministries of Finance to also join forces to help build the necessary political consensus to achieve independence of bank supervisors. Multilateral institutions and supervisory associations, such as the IMF and ASBA, also have a role to play, for instance, by spreading information on good practices, by targeted technical assistance and by organizing outreach activities where politicians hear from their peers in countries where bank supervisors are independent and from bank supervisors in these countries. All this hard work would pay by strengthening financial systems in the region and preventing and mitigating banking crisis.