2 Supervisory review and recommendations
2.7 Supervisory implications of global banking trends .1 Overview of assessment
2.7.2 Global changes and supervisory implications and responses
Building on the analysis completed the review of global forces and trends, nine specific changes in banking are examined below in terms supervisory implications and responses:
Ø blurring of financial markets;
Ø consolidation;
Ø intensified competition from non-bank financial institutions;
Ø increasing market volatility;
Ø economic integration with Mainland China;
Ø information systems and new technologies;
Ø product complexity;
Ø risk management capabilities; and
Ø remote and cross-border processing.
Blurring of financial markets
Changes in the global nature of financial markets as banks expand beyond their traditional banking business. Financial supermarkets are emerging in response to competition.
Supervisory implications
Ø Creation of complex organisational structures, that go beyond legal entity and product line boundaries, could result in regulatory gaps69 or duplicative supervisory reviews. Supervisors need to understand and remain vigilant to the organisational structures used and closely co-ordinate their oversight.
Ø Increased cross-border activities require closer co-ordination with foreign supervisors.
Supervisory responses
Ø Increased supervisory cooperation and harmonisation of polices and procedures across functional areas, including, at the extreme, adoption of the super-regulator concept.
Ø Transition away from legal entity focus towards emphasis on line of business risk.
69 Situation where an activity is not subject to supervisory oversight.
Ø Strengthening of consolidated supervision programmes, including home/host country roles.
Ø Development of bilateral memoranda of understanding between cross-border and same-country financial sector supervisors (banking, securities, insurance and NBFIs).
Ø Establishment of prudential norms governing capital, large exposures, financial statement disclosures, etc.
Ø Evolution of principles of on-going or continuous supervision, rather than point-in-time judgements.
Consolidation
Banks are consolidating with other financial service providers to augment products and services. Increasing pressures are being placed on Hong Kong local banks to seek these types of alliances, to enable them to provide complete product lines.
Supervisory implications
Ø An increased number of banking groups, which operate different licences (e.g.
banking, securities) in different subsidiaries, will require supervisors to focus on the impact of consolidation on the resulting entity, including legal implications and financial results, as well as management capabilities.
Supervisory responses
Ø Supervisory agency reorganisation or resizing to respond to the composition and complexity of the industry.
Ø Development of specialised and sophisticated large bank supervision programmes, including advanced risk management procedures, continuous supervision and deployment of resident teams of examiners to large/complex institutions.
Ø Recruitment of persons with industry and functional expertise directly into the supervisory organisation, rather than historical process of internal resource development.
Intensified competition from non-bank financial institutions
The number of financial service providers, insurance and securities firms, offering products that were traditionally offered only by banks is increasing. Several of the DTCs and RLBs in Hong Kong are also owned by non-bank financial institutions.
Supervisory implications
Ø The increased possibility that traditional institutions will enter new markets to meet competition requires the supervisor to appropriately evaluate new product developments, risk management processes and resulting financial performance.
Supervisory responses
Ø Increased supervisory monitoring of financial performance as pressures on margins and quality intensify.
Ø Greater focus on judging bank management capacity to respond to competitive pressures.
Ø Focus on legal and regulatory means to enhance “banking company”
competitiveness, balanced against safety net issues.
Increasing market volatility
Since the Asian crisis started, global markets and Hong Kong are experiencing increasing volatility in interest rates, although this has subsided in recent months in Hong Kong.
Supervisory implications
Ø Narrower spreads increase the need to monitor interest rate risk, particularly basis risk. Supervisors must be able to increase scenario modelling or sensitivity analysis to changes in interest rates.
Ø Increases in sophistication of financial risk management models used by individual institutions will necessitate increased knowledge within the supervisory staff to evaluate such models.
Supervisory responses
Ø Emphasis on proactive, real-time exchange of information between the supervisor and significant financial institutions.
Ø Changes in reporting requirements and use of on-line feeds of financial data and transactions.
Ø Increased use of stress-testing and scenario modelling in forecasting the impact or influences of market volatility.
Economic integration with Mainland China
As Mainland China emerges as a global economic power, the geographic proximity and same country status make Hong Kong the acknowledged gateway to Mainland China.
Supervisory implications
Ø Increased direct and indirect credit exposures to Mainland China will expose Hong Kong banks to concentrations of credit, and place pressures on credit management skills. Supervisors must be vigilant in ensuring that appropriate underwriting standards and sufficient credit risk management systems exist in each institution to deal with the increased exposure.
Ø Different accounting rules and disclosures, and unfamiliar legal and regulatory frameworks also increase country risk. Supervisors must consider country risk as a factor in their risk assessment frameworks.
Supervisory responses
Although other regulators have not experienced this specific impact, some have met similar regional challenges. Their responses have included:
Ø coordination with professional organisations such as legal and accounting bodies to develop better transparency standards among countries;
Ø creation of internal guidelines and public documents emphasising the possible impact that differing accounting standards, legal documents and business regulations have on cross-border business risks;
Ø monitoring agreed exposure limits;
Ø ensuring that prudent lending policies have been adopted; and
Ø ensuring that lending is in accordance with established rules and practices.
Information systems and new technologies
Technological advances are changing the way banks do business. New technologies are also leading to increasing operational risks.
Supervisory implications
Ø Supervisors will need to have sufficient internal expertise to evaluate the adequacy of information systems during on-site examinations and in conjunction with outside auditor reviews.
Ø New delivery channels will increase operational risk as a result of data security and protection issues. This will require placing greater emphasis on operational risk management systems.
Ø Increased use of sophisticated risk management and decision tools such as credit scoring, asset-liability management (“ALM”) models and automated trading
systems will require sufficient knowledge of these tools on the part of the supervisor in order to assess their effectiveness.
Supervisory responses
Ø Recruitment and retention of staff capable of understanding and judging risks of bank information and risk management technology.
Ø Incorporation into the supervisory process the review of sophisticated management decision tools such as value at risk models, derivative black box methodology, automated trading systems and credit scoring systems.
Ø Identification and supervisory response to technology risk (e.g. Year 2000, smart cards and internet banking).
Product complexity
Local banks are expanding their products in response to customer demands.
Supervisory implications
Ø The speed of product innovation will require the supervisor to remain alert to the development of new products or financial activities, and to assess the vulnerabilities to current market conditions.
Ø The supervisor’s focus must be on reviewing how bank management recognises the risk in new products in addition to their risk management capabilities.
Supervisory responses
Ø Use of specialised expertise to evaluate non-traditional banking products and associated risks.
Ø Greater focus on bank risk management processes relating to new and complex products.
Ø Supervisory focus on those products that represent the greatest risk.
Risk management capabilities
Changing and increasing risks is one of the most important trends in banking. Risk management systems and processes must keep pace with the complexity of a bank’s products. In the course of our study we have noted that risk management capabilities vary considerably among banks in Hong Kong.
Supervisory implications
Ø Institutions are likely to establish new organisational structures and risk management systems that will need to be evaluated by the supervisor.
Supervisory responses
Ø Implementation of risk management and supervision by risk examination objectives and procedures, moving away from the historical compliance-based approach.
Ø Supervision programmes geared to be proactive rather than reactive.
Ø Development of customised programmes of supervision for large and complex institutions, including ongoing supervision and, in some cases, the use of resident and specialist teams.
Ø Resource deployment geared to meet the greatest elements of risk in individual banks and banking sector.
Ø Implementation of supervisory tools that facilitate supervision by risk, by enabling examiners to efficiently record supervisory findings and later access and correlate those findings in reaching conclusions about identified and emerging risks, both on an individual institution basis and across the sector.
Remote and cross-border processing
Due to economic efficiencies, many banks are relocating operational functions. A number of Hong Kong banks are considering this option to reduce costs.
Supervisory implications
Ø The possibility for internal control breakdowns increases as operations are moved away from local management control. This will require supervisors to focus on internal audit capabilities within institutions, to better assess operational risks.
Ø In addition, it may give rise to data security and confidentiality issues. Cross-border processing will therefore require closer co-operation with foreign supervisors and clearer policies on the review of operational risk. This may require additional resources to review this activity, particularly if it is not subject to the host country supervisor’s oversight.
Supervisory responses
Ø Greater understanding and focus on operations risk, including data security and protection.
Ø Implementation of risk-based supervision programmes that stress operations risk and evaluate internal bank programmes (including internal audit) to manage such risks.
Ø New approaches to support the integrity and safety of payment systems (e.g. use of FED WIRE across international boundaries).
Concluding comments regarding supervisory options
As the above discussion indicates, a recent trend in financial sector supervision has been the creation of super-regulators. The new models, initiated in the UK, Denmark, Australia, South Korea and Singapore70, are the results of an acknowledgement that the borderlines between different types of financial service providers are indistinct. The complexity of global markets, the increasing rate of change within industries and the diversification of firms into financial supermarkets for financial services placed an enormous strain on systems with multiple and overlapping regulatory structures. Each of the super-regulator initiatives is still in the implementation stage, as none were created more than a little over a year ago. It will be some time before their success and overall impact on the financial sectors of the respective countries can be properly assessed.
Generally, countries where there has been a convergence of functions performed by financial institutions, stock brokerage firms, and insurance companies are adopting the super-regulator model. In countries where the divisions between different types of institutions are maintained by legislation, the case for a single regulator is undoubtedly less strong. According to survey results, market views regarding the concept of a super-regulator in Hong Kong are mixed. While 43% of respondents believe the current regulatory arrangement (with different authorities regulating particular types of institutions) is the best system for Hong Kong, 43% also felt that Hong Kong needs a super-regulator in the next five years.
In theory, a super-regulator provides a number of benefits that must be considered within the country’s economic and legislative context. Briefly, a super-regulator is a single point of contact for all regulated firms and consumers, which can reduce the confusion, duplication and overlap that make multiple regulatory systems so cumbersome. Under the latter, for example, buyers of services can be shuffled among various agencies trying to identify the most appropriate forum to vent their complaints or resolve their problems. Having a super-regulator should also result in a single entity administering a single set of laws, principles and rules, thus ensuring that all market participants engaged in like activities are treated equally, based on their risk characteristics and the markets in which they operate. Similarly, a single regulator should provide for consistent treatment in authorizations, enforcement and discipline.
One of the singular challenges in the creation of the new super-regulator is developing a new organisational structure and staffing it properly. Care must be taken to avoid an
70 The Monetary Authority of Singapore can be regarded as a super-regulator since 1984, when the securities industry was placed under its supervision.
overly bureaucratic entity, or one that maintains previous turf barriers. In most countries, the initial staff for the super-regulator have been transferred from a combination of its regulatory predecessors. Such staff bring with them considerable experience in their fields. However, there are also traditional biases that might need to be overcome in the new environment. A strong change management process and creation of a new organisational culture is needed for the staff to integrate properly and promptly.
Another challenge is funding the new regulator. As the new entity is essentially a start-up body, funding must be carefully considered to assure that appropriate budgets can be established to allow it to run efficiently and employ qualified staff. In many countries, the funding schemes of the previous regulatory entities are varied. Establishing a single assessment or fee structure merits carefully consideration to assure that no supervised group is unduly affected.
In most countries, changes to the regulatory structure require legislative action and extended time frames. Barriers created by law or convention, such as privacy laws and jurisdictional issues, may also need to be addressed before the new super-regulator can initiate operations.
Finally, from an operational standpoint, accounting and disclosure standards must be considered. The lack of common reporting within all industries on items such as investment valuation, bad debt provisioning and fee income recognition can create inconsistencies in information across functions. Also, regulatory returns must be evaluated to assure that information across functions is consistent and comprehensive to assess the financial condition of the combined entity.
It is therefore clear that the decision to establish a super-regulator is one that requires careful consideration of organisational, legal and financial issues, even in countries where the convergence of financial services participants exist. The purpose of our comments is to briefly identify the benefits and challenges of such a structure. It is not within the scope of our study to evaluate the feasibility of or make specific recommendations on the creation of a Hong Kong super-regulator. We do not therefore express an opinion on the advisability of a super-regulator. However, we encourage the HKMA to continue to monitor the integration and implementation process in the super-regulator countries, to further assess what lessons from such an approach can be applied in Hong Kong. The recommended starting point is to assess if there are presently any supervisory gaps/overlaps in existing arrangements, and the options to address these. A super-regulator is only one option.
Similarly, while not developing specific recommendations, we encourage the HKMA to continue to:
Ø assess the risks associated with longer-term integration with Mainland China;
Ø improve communication between supervisors/regulators; and
Ø work towards improved international standards for sector-level financial information and market disclosure.