Did banks adopt the FDR Framework model of bank supervision?

The Financial Times ran an article on the Institute of International Finance, a lobbying organization of some of the largest financial institutions in the world, in which the IIF indicated that banks are willing to accept effective regulation.

The IIF defined effective regulation not as rules based but instead as combining the provision of all the useful, relevant data by the banks with the ability of the party that receives the data to transform it into information for promoting financial stability.

As regular readers know, market participants like competitors and credit and equity market analysts are better at transforming this data into information than the regulators (a point that regulators like the Bank of England's Andrew Haldane and the Irish Central Bank's Patrick Honohan have made).

As regular readers know, market participants like competitors and investors can provide a significant assist to regulators in promoting financial stability.  Market participants promote financial stability through the exercise of market discipline.

Market discipline takes the form of market participants adjusting the price and amount of their exposure to any bank based on its current risk profile.  Market discipline applies brakes to bank's risk taking by increasing a bank's cost of funds and the lower its access to funds as it becomes riskier.  Market discipline encourages banks to reduce their risk profile by lowering a bank's cost of funds and increasing its access to funds as it becomes less risky.

What the IIF says it wants as effective regulation is exactly what is provided under the FDR Framework.

Tougher supervision of banks is critical to financial stability but could easily descend into box-ticking and laundry lists of new rules that will do little good, a global banking industry group has warned. 

The Institute of International Finance, which represents 400 groups in 70 countries, said in a report issued on Tuesday that its members support and are willing to pay more for tougher oversight by experienced regulators. In the wake of the financial crisis, the group also said it accepted the duty of regulators to challenge risky business models and impose additional capital and control requirements where necessary. 

“Well-run firms have every reason to welcome strong and effective supervision . . . Regulation alone cannot create a safer financial system — good regulation must to be matched by improved industry practices and stronger supervisory systems,” said Peter Sands, chief executive of Standard Chartered and chairman of the IIF’s special committee on effective regulation.

As everyone knows the strongest and most effective supervision is when all market participants have access to the curent asset and liability-level data.  Those market participants with a financial exposure to the banks, this includes the regulators who have a financial exposure through deposit guarantees, have a strong incentive to analyze this data and to adjust both the price and amount of this exposure based on what the analysis shows is the riskiness of the banks.

But the IIF warned that the supervisory process could become unnecessarily contentious and rule-based. 

“There is a significant risk that increased activity and the imposition of more requirements will themselves be mistaken for more effective supervision,” the report said. “Supervision should not be about shadow-running firms or second-guessing all decisions.” 

Financial groups have a role to play in improving supervision as well, the IIF said. Not only must they provide relevant data, but groups should be open with their regulators about their risks and challenges and interact with authorities on a “no surprises” basis. 

“Banks should be fully transparent and give the supervisors the information they need,” said Kerstin af Jochnick, who chaired the IIF committee behind the report. “If you have good supervision you can rely on your counterparties in the market.”

When the supervisors include all the market participants, the IIF is embracing the FDR Framework.

It is a very important point that when a bank has the current asset and liability-level data on its counter-parties, the bank can rely on these counter-parties (the bank will not do business with a counter-party that poses an unacceptable risk).

The IIF, which tends to be dominated by the very largest banks, also warned against creating a special supervisory regime for global groups. The Financial Stability Board, a worldwide regulatory body, is due to consider additional capital requirements for the largest, systemically important banks later this year. 

“There is no case for adopting fundamentally different approaches to groups of firms that may be judged to be systemic,” the report said.

When all financial firms have to disclose their current asset and liability-level data, there is no reason for different approaches to groups of firms.  Market discipline will act to reduce the risk of the very largest banks.

The group also said the banking industry would prefer to pay a higher levy for more and better regulators to a more general tax on financial activities.

The higher levy is the cost of making their curent asset and liability-level data available to all market participants in an appropriate, timely manner.