Banking Soundness and Monetary Policy


Charles Enoch, and J. Green
Published Date:
September 1997
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In response to Tommaso Padoa-Schioppa’s excellent presentation and his insightful reflections on the developments of banking practices in the last twenty-two years. I would like to say how grateful I am to him for his historical perspective on the work of the Basle Committee on Banking Supervision, which he chairs.

During the first of many seminars that the IMF held on banking issues in 1982, Peter Cook, Padoa-Schioppa’s predecessor, described the purpose of the Concordat and the work of the Basle Committee. It is interesting to note how much the agenda and work of the Committee have grown during this long span of time. In listening to Padoa-Schioppa, it is only with appreciation that we can look back at extensive accomplishments made in the international sphere by this committee in order to set standards on banking practices and develop an international forum for exchange of information among the revered leaders of the profession. The International Monetary Fund and certainly the Monetary and Exchange Affairs Department (MAE) are very much in the business of dissemination of data, information, standards, and certainly policies. In a sense, MAE is a clearinghouse of best practices in central banking; in this context the MAE department follows the work of the Committee and the work program that Padoa-Schioppa has set forth with keen interest. As part of this process, MAE is most interested in continuing to work to make these practices and standards available to other IMF member countries in the course of our surveillance and consultation.

I have followed Padoa-Schioppa’s arguments in great detail on the direction in which the work of the committee will progress in the next few years. He also uses some analogies in his presentation that deserve comment here. In particular, he alludes to the analogy of bank supervision with the medical profession and how much medicine can be prescribed to patients (banks) and what preventive measures the patient should take himself. In his presentation, he also referred to antibodies that the patients can develop as distinct from antibiotics that doctors have to prescribe. This analogy is an appropriate one to use to bring out one of the main messages of his presentation—that bank supervision has to get closer to the market to ensure that banks know how to manage their risk. This is a very important development and needs further discussion. Certainly, supervision must evolve over time, although, at least as fast as the markets and institutions themselves are progressing. The move to review a bank’s internal controls and risk assessment system is a necessary step in this direction. In this regard, I am in full agreement with Padoa-Schioppa that banks should be encouraged to develop “antibodies,” or protective measures, against taking excessive risk.

Bank supervisors are basically in the position of approving what class of antibiotics, or safeguards, are effective against certain types of risk, and in that context must be prepared to do the necessary research on appropriate safeguards to take and advise bank management on the best selection available to banks. While certain global safety standards for antibiotics can be established, they should be reasonably general—more general than in medicine, due to the fact that the divergences in national laws and regulations far exceed the differences in human chemistry and anatomy. What is appropriate for one particular institution in one particular setting may not be appropriate for another institution or the same institution in a different environment.

Playing the role of the doctor in this situation, bank supervisors must recognize that while virtually all patients (banks) would agree with the importance of avoiding excessive risk, they also have certain clear incentives not to be ideal patients who continue to take their medicine (banking safeguards) as prescribed. That is particularly the case in light of competitive pressures, when it is believed that the medicine may interfere with optimal performance. Moreover, if a bank is uncertain that other competitors are following their own preventive regimes rigorously—or if a bank is ignorant of its regulatory regime, whether it be foreign or domestic competitors, there will be an even greater temptation to rationalize indifference (or negligence). This is where supervision is like the doctor who ensures that the patient continues to take the appropriate medicine on a regular basis. Scheduled and random spot tests will probably both be needed. In this regard, regulators also must work to harmonize and disclose standards of behavior, communicate with each other, and work to develop a common language. Indeed, one patient (bank) may have more than one doctor (supervisor)—either because the bank operates in more than one jurisdiction or operates in more than one line of business. In such a case, the various medications (safeguards) must be, at least, compatible and ideally, complementary.

At the same time, there is the question of how to arrive at a balance, again, using the medical analogy, between allowing the body to develop antibodies and the prescription of antibiotics by the doctor. There is a delicate balance in this case of banks being allowed to develop their own regimen to assess their risk over a period of time so that the strength of the patient (bank) can progress to the point that it can accommodate the exogenous shocks of the system. There is a tradeoff between that time before a bank can weather shocks, which is often too long, and when the doctor (bank supervisor) should make an early prescription of antibiotics. This particular trade-off is somewhat judgmental. This is critical to one’s assessment in that the supervisors, in judging the bank’s own internal controls and corrective mechanisms, are also prescribing and observing how those antibodies will develop in the banking system. At the same time, an early prescription of antibiotics, without allowing the symptoms to develop, could be a move that perhaps would prevent banks from functioning efficiently.

This elicits a second consideration: should banks—and the markets—be allowed to correct the inefficiencies, or can the regulators and supervisors prevent such inefficiencies from developing? Padoa-Schioppa makes a very strong case that intervention is necessary to the extent that the prescriptions have to be there. But also in his paper he alludes to the fact that over time, as the market develops antibodies, there is less need for supervision. This does not necessarily mean that one day banks could do without supervision. In my view, banks will continue to have primary responsibility for overseeing the payments system, a characteristic that will remain unchanged, while the supervisors will still have an important role. Perhaps twenty years from now, it is interesting to speculate on how a similar seminar would address the concerns of a bank supervisor. Should we leave everything to the market forces, or will there still be a role for supervisors?

Third is the question of capital adequacy. In the last twenty-two years, as he mentioned, the Basle Accord together with the capital charged by banks has been the central focus of the work of the Basle Committee. It would be interesting to know how this issue will be reconciled with the question of allowing the supervisors to move toward market forces. Will the banks view their credit operations as a possible charge against their capital? There is no question of the importance of capital as a commercial bank’s only major component of the balance sheet against which there are no external claims—for example, no deposit withdrawals. But in examining a bank’s balance sheet so as to find the item of capital somewhere other than as an entry on the balance sheet is difficult. Capital, of course, cannot be viewed as an item of cash available to cushion banks in case of an emergency. But, nonetheless, this is how banks themselves often consider their capital. It is well to examine whether they see their taking risks in the marketplace as a charge against capital, or whether they look at some other criterion, such as their ability to raise funds at competitive rates? What are the main factors that affect banks’ behavior?

Finally, in consideration of outside banking system supervisors, he mentions correctly the increasing banking activities of nonbanks. In such an environment, it is critical to see how far the Basle Committee can go in collaborating with the other supervisory agencies. After all, as Padoa-Schioppa mentions, there is not much point in looking at the market risks that banks are carrying if they can conveniently book them as off-balance-sheet items—assets somewhere outside the balance sheet within the consolidated balance sheets of the conglomerate.

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