IMPROVING BANKING SUPERVISION

Transcription

1 IMPROVING BANKING SUPERVISION

2 Also by David G. Mayes PUBLIC INTEREST AND MARKET PRESSURES (with W. Hager, A. Knight and W. Streeck) MODERN PORTFOLIO THEORY AND FINANCIAL INSTITUTIONS (with D. C. Corner) THE EVOLUTION OF THE SINGLE EUROPEAN MARKET SOURCES OF PRODUCTIVITY GROWTH THE SINGLE MARKET PROGRAMME AS A STIMULUS TO CHANGE (with P. E. Hart) INEFFICIENCY IN INDUSTRY (with C. Harris and M. Lansbury) THE EVOLUTION OF RULES FOR A SINGLE EUROPEAN MARKET (editor) 1 Industry and Finance 2 Rules, Democracy and the Environment 3 Social and International Issues FOREIGN DIRECT INVESTMENT AND TRANSITION (editor with G. Csaki and G. Foti) THE EXTERNAL IMPLICATIONS OF EUROPEAN INTEGRATION (with others) ACHIEVING MONETARY UNION (with A. Britton) A NEW STRATEGY FOR SOCIAL AND ECONOMIC COHESION AFTER 1992 (with I. Begg) THE EUROPEAN CHALLENGE A STRATEGY FOR THE ECU (with A. Britton and Ernst & Young) SHARPBENDERS (with P. Grinyer and P. McKierman) INTEGRATION AND EUROPEAN INDUSTRY (with M. Macmillen and P. van Veen) THE EXCHANGE RATE ENVIRONMENT (with S. Brooks and K. Cuthbertson) APPLICATIONS OF ECONOMETRICS THE PROPERTY BOOM INTRODUCTORY ECONOMIC STATISTICS (with A. C. Mayes)

3 Improving Banking Supervision David G. Mayes Liisa Halme and Aarno Liuksila The views expressed in this publication are those of the authors and are not necessarily shared by the Bank of Finland

4 David G. Mayes, Liisa Halme and Aarno Liuksila 2001 Softcover reprint of the hardcover 1st edition All rights reserved. No reproduction, copy or transmission of this publication may be made without written permission. No paragraph of this publication may be reproduced, copied or transmitted save with written permission or in accordance with the provisions of the Copyright, Designs and Patents Act 1988, or under the terms of any licence permitting limited copying issued by the Copyright Licensing Agency, 90 Tottenham Court Road, London W1P 0LP. Any person who does any unauthorised act in relation to this publication may be liable to criminal prosecution and civil claims for damages. The authors have asserted their rights to be identified as the authors of this work in accordance with the Copyright, Designs and Patents Act First published 2001 by PALGRAVE Houndmills, Basingstoke, Hampshire RG21 6XS and 175 Fifth Avenue, New York, N.Y Companies and representatives throughout the world PALGRAVE is the new global academic imprint of St. Martin s Press LLC Scholarly and Reference Division and Palgrave Publishers Ltd (formerly Macmillan Press Ltd). ISBN ISBN (ebook) DOI / This book is printed on paper suitable for recycling and made from fully managed and sustained forest sources. A catalogue record for this book is available from the British Library. Library of Congress Cataloging-in-Publication Data Mayes, David G. Improving banking supervision / David G. Mayes, Liisa Halme, and Aarno Liuksila. p. cm. Includes bibliographical references and index. 1. Banks and banking State supervision Scandinavia. 2. Banking law Scandinavia. 3. Banks and banking State supervision. 4. Banking law. I. Halme, Liisa. II. Liuksila, Aarno. III. Title. HG3140.A6 M dc

5 Contents List of Tables List of Figures Preface Acknowledgements vi vii ix xiii 1 Introduction 1 2 The Financial Crisis of the Early 1990s and its Lessons 11 3 Coming Challenges to Financial Supervision 49 4 Principles of Good Financial Supervision 65 5 Corporate Governance and Financial Stability 91 6 The Rationale for a More Market-based Regime A Disclosure Regime Robust Exit Policies to Underpin Market Discipline A New Approach to Orderly Bank Exit Exit Policy Co-ordination at EU Level The Way Forward 256 Notes 269 References 286 Index 295 v

6 List of Tables 02.1 Characteristics of the Nordic financial crises Losses and provisions made by Nordic banks, Public sector support for the banking system in the Nordic countries, Banking league table Major acquisitions and mergers in Western Europe Key elements of efficient regulation Functions of financial system oversight Responsibilities in Finland Main changes to the financial system in Finland since Disclosure requirements in New Zealand Registered banks as at 30 September Llewellyn s 25 principles of good banking regulation 259 vi

7 List of Figures 1.1 Asset prices and credit in Sweden, Financial market liberalisation in Finland The macroeconomic picture in the Nordic countries, House prices in relation to consumer prices Real increase in lending Household savings and real after-tax lending rates Fall in GDP compared with trade share with the Soviet Union Bank lending to the corporate and household sectors in Finland Ratio of loan losses to average total assets of Nordic banks Rates of growth in bank lending in the Nordic countries Bank branches and employees per 1000 inhabitants in the Nordic countries Credit losses of deposit banks (parent companies) 45 vii

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9 Preface At the time one always tries to take the best decisions in the light of the expected future and the practicalities of the present circumstances. With the benefit of hindsight it is possible to see that different decisions might have been better and hence one always poses the question Could we have done this better even with what we knew at the time? When mistakes have been made, there is always a post-mortem and a set of changes implemented to try to make sure that history does not repeat itself. The Finnish banking crisis at the beginning of the 1990s was one of the most difficult economic challenges policy-makers have had to face since the postwar recovery. While it was clear at the time that action was needed, most of the parties involved found themselves relatively powerless to act. Where action was possible there was always the fear that it would precipitate the very crisis everybody hoped to avoid and that subsequently those who took it might be blamed for imposing unnecessary costs on society. It is easy to list what might have happened that would have made the crisis much milder. There was a general expectation that the changes in the former Soviet Union would be quite rapid and would not involve anything like as deep a downturn as has actually been experienced. Although the authorities were convinced that adherence to the exchange rate peg with the ECU was the only viable route to price stability, they had hoped that the exchange rate tensions within the European Monetary System s Exchange Rate Mechanism would be resolved much earlier and with little drama. These and other factors would have meant that fewer of the exposures of the Finnish banking system would have resulted in non-performing loans and the rapid upward valuation of liabilities. However, these ifs and maybes are not the way to look at the problem. It would be equally inappropriate to take no action if one had taken a large risk but been lucky enough to get away with it if you drive round a corner too fast but don t hit anything, you still don t drive round too fast next time. Finland had the misfortune to endure the crisis an experience from which it has not yet fully recovered. The sensible thing to do is to reflect on it and then implement a series of changes that will make the chances of repetition small. Of course, the new precautions must not themselves impose disproportionate costs on society. An efficient and effective financial system helps the economy grow faster and invest in the process of structural change. Such investment inevitably involves risks. Good management of both financial and commercial companies means managing those risks, not failing to take them. The authorities have to try to design a system that is likely to deliver the appropriate balance. ix

10 x Preface But Finland is not special in these regards. It may have endured a worse crisis than other western industrialised countries, but the ingredients of the problem and its solution are generally applicable. Unfortunately the learning process is slow. Some of the same mistakes have been made again in the run-up to the Asian crises at the end of the 1990s. It is therefore important for the authorities in Finland not just to do their best to learn themselves from the experience and implement measures in response but to help others avoid getting into similar difficulties. This book forms part of that response. The Bank of Finland has already published articles on the crisis and how it was tackled. Outsiders have, of course, done the same, drawing on different parts of the inside experience. However, the Bank of Finland has a particular responsibility not just because of its role in trying to maintain the stability and efficiency of the financial system but also because one of the responses to the crisis has been to transfer administrative responsibility for the supervision of banks and securities markets from the Ministry of Finance to the Bank of Finland an operation that is kept separate from the Bank and run by the Financial Supervision Authority. The Bank has therefore been responsible for ensuring the return of the both the banking system as a whole and all the individual banks within it to adequate capitalisation and to implementing a regime whereby good management in the future will make any repetition of the experience of the early 1990s unlikely. The early stages of this process involved detailed negotiations with the banks and very tight controls. It also involved very large injections of public money, a substantial portion of which has now been repaid. With a return to healthy banks and strong growth in the economy over a number of years expected to continue into the future we are now in a position to step back and consider a more fundamental change to the system. That is the intention of this book. The book blends law and economics to suggest how a regulatory system that provides a network of incentives for all those involved in financial markets can be put together to try to ensure that banks manage their risks prudently. Many of the ideas employed here have already been adopted in practice some in the United States, most notably in New Zealand but Europe on the whole has been slow to adopt them. There are three key messages. First of all, banks must have good corporate governance structures, proper capitalisation and be run by people of repute if they are to stand a proper chance of success. Secondly, the banks need to disclose, in public and using clear and comparable information, enough detail on their financial state and risk management practices that market participants as well as the regulators can hold an informed view of their state and prospects. Lastly we need to have a credible means of persuading banks that next time we will act early and ensure bank resolutions without public money if they become undercapitalised. Banks must come to expect that they will not be allowed to

11 Preface xi continue trading unchanged if they fail to meet the minimum levels for prudent operation. People are always surprised that regulators would prefer not to have the opportunity to exercise discretion in favour of individual banks. If the opportunity for discretion exists everyone will tend to act in the expectation that it will be exercised in their favour. This will tend to result in people running just the sort of risks we want to avoid. In New Zealand intervention by the authorities is not only compulsory but progressive as banks become undercapitalised. If the banks involved do not act voluntarily the authorities will compel them, ultimately taking them into statutory management and out of the hands of the existing shareholders. In the United States intervention becomes mandatory if capital falls too far and the bank is then closed. The proposals in the book do not seek to attain a hypothetical world outside previous experience but to implement the best of current practice. They are deliberately a practical proposition. All of the changes advocated will involve quite substantial alterations in behaviour and indeed legislation, but these will be swimming with the tide of the modern age of transparency, and encouragement of the process of change. We can never be in a position where we can provide legislation that will cover every detailed development that can happen to financial markets in advance. However, moving towards widespread public disclosure does not mean that we will cease to pay attention to banks either individually or as a group. On the contrary, disclosure means that the process of supervision is widened. All the stakeholders in banks need to take a view and not just the regulator. Furthermore, the regulator can turn its focus more towards problems that affect the financial system as a whole and concentrate on the increasing problems of cross-border supervision. International co-ordination among authorities is becoming increasingly important as our main banks themselves become more international. The ECB Banking Supervisory Committee is focusing on what it describes as macro-prudential supervision while the European supervisors continue to develop their bilateral exchanges of information. It is likely that there will be increased pressure for wider international institutional changes as well. However, it is no good getting the microstructures right if macro-policy creates instability. Here Finland has done a lot to get away from the shocks that can destabilise a small country. Finland joined EMU in the first wave so that it now has the stability of the euro area as a whole. This entails not just a single monetary policy but prudent constraints on fiscal management as well. It is not that prudence would not have been possible in the previous independent regime but, rather, that having the peer pressure of ten fellow members and the Commission (not to mention the ECB) makes good performance seem much more likely to financial markets, price setters and hopefully to wage bargainers. Credibility may seem an overused word but it is the credibility of macroeconomic policy

12 xii Preface and financial supervision in international eyes that matters. It is no good simply believing in ourselves others have to believe us. That belief depends upon the regulatory framework, the institutional set up and the visible incentives for all those concerned to make it work. Emerging markets may find it will take some time to adopt these principles but the less the reputation of current systems the greater the benefits from making credible improvements. The international organisations are joining the chorus for prudent behaviour in both macroeconomic policy and financial sector management. It is to be hoped that this book offers food for thought on how to speed up achieving those goals. The 1990s have been a decade of hard lessons. Learning them will provide a benefit in the decades to come. Finland does not want to experience the costs of the financial crisis again and naturally would want others to avoid them as well. Helsinki DAVID G. MAYES

13 Acknowledgements We are grateful to current and former colleagues in the Bank of Finland and the Finnish Financial Supervisory Authority who have written material on financial supervision over the last ten years that we have been able to draw on in writing this book. Although, where possible, their contribution has been cited in the text, more informal influence will have been ignored. We thank in particular, Heikki Koskenkylä, for his contributions to Chapters 2 and 3, Jukka Vesala for his contributions to Chapters 3, 4 and 10, and Juha Tarkka, who suggested we write the book and provided insights into the handling of the Finnish crisis. Other colleagues have provided comments, particularly on Chapter 2. Mikko Niskanen and Markku Malkamäki were especially helpful. The Board of the Bank of Finland have been very supportive Matti Louekoski in formally releasing all the material we use and Esko Ollila, Deputy Governor, in encouraging our work. However, we must make it clear that the views we express are our own. The book draws heavily on the experience in New Zealand and Geoff Mortlock, Denys Bruce, Peter Ledingham and Bruce White of the Reserve Bank of New Zealand were helpful, both in articulating many of the original ideas and in correcting misperceptions. Senior executives in New Zealand banks willingly participated in interviews and provided helpful material for us to understand the impact of the system. Deutsche Bank, formerly through Bankers Trust, have continued to provide us with disclosure material some of which is reproduced in Chapter 7 our use of their material rather than that from other registered banks does not imply any favourable or unfavourable judgement on status and performance of any bank. We have benefited from the comments of others in a range of seminars given on parts of the book in Finland, Sweden, the United Kingdom, Estonia, New Zealand and Germany among others over the three years the work has been in the making. The Bank of England provided specific help for Liisa Halme through the Centre for Central Banking Studies and the UK Financial Services Authority for David Mayes. Jeremy Richardson was particularly helpful in his detailed scrutiny of part of the material we draw on. We thank Bill Allen, Richard Brealey, Charles Goodhart, Juliette Healey and David Swanney for their comments on Chapters 4 and 5. Kevin Dowd offered some constructive referee s comments as did David Llewellyn and Karel Lannoo. We hope they are not too disappointed by the result. Some of the work was undertaken while David Mayes was at South Bank University and has been an important contribution to the founding of its new Centre for Monetary and Financial Economics. xiii D. G. M. L. H. A. L.