The views and opinions expressed in this article are those of the thought leader and not those of CeFPro.
By Bill Coen, Former Secretary General, Basel Committee on Banking Supervision & Chair, IFRS Advisory Council
Until very recently, there was a lively debate about whether standard-setting bodies and national authorities had gone too far in responding to the global financial crisis (GFC). It was in this context and based on my 20 years of experience with the Basel Committee on Banking Supervision (BCBS) that I began to gather my thoughts to express my views on the question of whether regulation has gone too far or is there still more to be done. This important question has for the moment been supplanted – but not obviated – by the coronavirus pandemic. Indeed, an already multifaceted matter of what constitutes the “right” level of regulation has been made even more complex by the economic and financial effects of the pandemic. In the following, I review how the regulatory landscape and operating environments have changed very quickly to focus on near term financial stability while longer-term considerations related to the implementation of global standards and the effects of the reforms remain central tasks for both regulators and risk managers.
A complex matter has become more complicated
On a continual basis, central bankers, bank supervisors, and risk managers seek to identify and adapt to a wide range of factors that could adversely affect or hamper the performance of the financial system or individual firms. Until very recently, the debate in many jurisdictions focused inter alia on challenges related to technology and banking; risks associated with a low interest rate environment; and a recently completed and dramatically different global regulatory framework. Banks still face “traditional” risks and now must react and adapt to challenges that are unique and novel. Moreover, the rapid onset and unimaginable impact of the coronavirus pandemic has for the moment dwarfed the considerable challenges confronting policy makers, supervisors, and financial institutions. The pandemic has compounded an already challenging environment and we are now – and seemingly overnight – trying to work out its implications for financial stability and the long-term consequences. Health care professionals, emergency workers, and all those who are working to respond to the crisis merit deep gratitude and support. From a financial stability perspective, central bankers, bank supervisors, and lenders are working hard to maintain financial stability, help ensure access to credit to those who need it, and lay the groundwork for a smooth and rapid recovery.
In response to a crisis that threatens financial stability and imperils future economic growth, authorities must take important remedial measures and national authorities have done just that. They have developed and deployed various responses expeditiously and on an impressive scale. Standard- setting bodies for their part have also responded swiftly to relax or delay the implementation of previously-agreed global standards that were necessitated by the GFC. For example, the Basel Committee on Banking Supervision (BCBS) deferred the implementation of some of the Basel III standards for one year and extended the related transitional arrangements. The quick and decisive actions of national authorities and standard setters should be applauded – as long as their remedial actions are temporary and are reversed in due course when conditions warrant. A temporary delay in implementing the regulatory revisions is understandable but stepping away from or diluting previously-agreed minimum global standards like Basel III on a permanent basis is counter to the best interests of global financial stability and is potentially unsafe and unsound for banking systems and banks. Following every financial crisis, there is a critically-important opportunity to assess which policies, practices, and activities contributed to, exacerbated the effects of, or helped to mitigate the impact of the crisis. Once financial stability has been achieved and the operating environment has returned to normal (or close to it), the effectiveness of remedial measures implemented by public authorities or firms in response to the crisis should also be evaluated. What worked and what didn’t? Were the measures deficient or inadequate? What would we have done differently and what would we do next time? This assessment will allow all relevant parties – e.g., policy makers, boards of directors, risk managers, investors – to recalibrate and adapt where necessary to better prepare for the next inevitable period of stress. This is the process that followed the GFC and that process still continues today. Once the pandemic has subsided and we are safely on the path to economic recovery, there will be plenty of time to assess the lessons learned and policy implications related to the pandemic.
The assertion that the only constant is change is especially true for risk management and financial regulation. In addition to the impact and aftermath of the coronavirus pandemic, the financial industry continues to witness monumental change, much of which is unfolding rapidly. Dealing with relatively well-understood risks like credit risk and market risk is often a daunting task but now risk managers, C-suite executives, and boards of directors must contend with and adapt to: technology-driven innovation in financial services; ongoing technological advances including the use of artificial intelligence and machine learning; more widespread use of digital assets and tokens; and persistent cyber-risk. Having a thorough understanding of emerging risks, market developments, what constitutes good governance, the regulatory perspective, and the rapidly shifting business environment are essential to effective risk management and represents a formidable set of challenges for risk managers.
Not surprisingly, my views on risk and regulation have been heavily influenced by my experience in working through or responding to financial crises. This was especially true of my career with the BCBS and my close involvement in responding to the GFC, which underscored the imperative of managing risk comprehensively and proactively (rather than reactively). In preparation for managing risk in stressful times, risk managers and regulators need to ask in advance: How do different risk types interact and combine? What could be the catalyst or the set of triggers that cause this interaction? What measures can be taken to control or mitigate the risk? What would be the impact if the risk were to materialize? Would the firm (or the financial system) be adequately equipped to weather the storm? If not, what actions would be required to restore profitability (or financial stability)?
The GFC reinforced some essential elements of effective risk management. This includes, for example, the roles of the board of directors, board risk committees, senior management and the control functions, including the CRO and internal audit. The GFC was a stark reminder of the hazards of placing excessive reliance on individual risk management tools (e.g., external credit ratings or internal models) and dispelled the notion that bank capital is in all cases a suitable and exclusive backstop to absorb losses.
From a regulatory perspective, the GFC underscored the need for the BCBS and others to formulate policies by means of a process which is inclusive, transparent, and well-informed. The process must include a mechanism for engaging with and receiving comments from all interested stakeholders on the proposed policies. These consultations must be accompanied by a careful assessment of the quantitative impact that is based on quality data. Quantitative impact studies are an important element – but not the sole driver – of the policy-making process.
Developing and implementing global standards
One of the most important lessons learned from the GFC was this: the global standard-setting process is seriously undermined and impaired if the standards are not implemented in a full, timely, and consistent manner by those who agreed the standards. This is irrespective of how rigorous and inclusive the process may be and regardless of how robust and well-designed the standards are that are produced by the process. Faithful implementation of the globally-agreed standards into rules, regulations, or directives at the national or jurisdictional level within a reasonable timeline with appropriate transitional arrangements where necessary is crucial.
Today many jurisdictions are confronted with the unhappy prospect of implementing the revised global minimum standards in a time of financial crisis and this leads to another important lesson: in a time of crisis, public authorities must do “whatever it takes” to respond to pressing and immediate financial stability imperatives and this may very well mean the temporary suspension or delay of previously-agreed standards. During “normal” times, delays in putting the reforms in place or diluting the global minimum standards distort a level playing field. This engenders doubt and mistrust as to the soundness of a jurisdiction’s banks and banking system. In the long term, delays and dilution are a risk to the financial system. The long-term importance of implementing the full range of the reforms on a timely and consistent basis is critical but one must also recognize that, during a crisis, all bets are off and authorities’ primary objective is to maintain or restore financial stability and facilitate economic recovery.
Taking stock of regulatory reform and its consequences
Taking stock of regulatory reform is a critical step in the standard-setting process. Have the minimum standards been implemented within the timeframe and manner in which they were agreed? Are the reforms producing the expected outcome? Are there unintended consequences (versus fully intended consequences)? If so, are modifications warranted? The importance of looking forward cannot be overstated. Before the pandemic, one of the topics that dominated discussion among regulators and bankers was the role of non-bank fintech firms in the banking space. It remains to be seen to what extent technology-driven innovation in financial services – or fintech – will continue to exert such an extraordinary influence on financial services and represent a significant source of competition for banks that will be affected by the pandemic.
The question of whether these unregulated firms should be subject to the same regulations as traditional banks will re-emerge and it is important to distinguish between supervisory oversight and regulation. In my view, the focus should be on supervisory oversight. Fintech can lead to faster, more inclusive, more convenient, and overall improved delivery of financial services that is beneficial to end users. It also represents a potential opportunity for firms that can deliver the services in a cost-efficient manner while effectively managing the attendant risks. This is an expensive proposition so fintech’s impact on a bank’s business strategy and profitability should be a key focus for senior management and the board.
For their part, standard setters, supervisory authorities, and regulators should continue to monitor closely banks’ management of the risks associated with fintech. This includes strategic and profitability risks; operational risk, including cyber risk; compliance risk; and outsourcing and the use of third- party vendors. From a broader perspective, the official sector must also be attentive to any financial stability implications stemming from developments in fintech. The official sector must also continue to examine how best to take advantage
of technological advances (i.e., suptech) in order to carry out supervisory responsibilities as efficiently and effectively as possible.
Authorities must proceed cautiously when it comes to the regulation of fintech firms and their activities to avoid stifling innovation or unduly obstructing the benefits they confer. This is not to say that authorities have no role. They do and they could even facilitate innovative technologies and business models for financial services. Authorities have an opportunity to provide a safe environment for banks to test newly developed products through, for example, innovation hubs, accelerators, and regulatory sandboxes.
Regulators and risk managers have been confronted with a range of game-changing challenges that have already altered the status quo. These conditions have disrupted many banks’ profitability if not their prospects for long-term viability. An already difficult operating environment and set of challenges have now been exacerbated by the coronavirus pandemic. Longer-term objectives, such as implementing reforms like Basel III, can become subordinate to existential goals of achieving and maintaining financial stability and paving the way for sustainable economic recovery. This does not mean implementing already-agreed regulatory reforms have become irrelevant but that they need to be prioritized in pursuit of more immediate imperatives.