Effective Cross-Border Supervision: From Imperative to Implementation
Seminar on Restoring Financial Stability - The Legal Response
The International Monetary Fund
December 2, 2009
In the wake of the financial crisis, an effective framework for cross-border supervision of financial institutions has become an even more compelling imperative. Financial and technological innovation has rapidly interconnected global markets, but our supervisory infrastructure failed to keep pace. And the idea of one supranational global regulator- whether you would consider it a dream come true or a nightmare- remains only imagined. So how should we move forward as an international community? What strategies will best promote financial stability through cross-border supervision that is conducted primarily by national regulators? I believe the answer is threefold:
- Harmonization of standards, with appropriate flexibility to address local situations;
- Cooperation in examination and enforcement activities, including expanded use of supervisory colleges; and,
- Expansion of the resolution process, to provide for the orderly unwinding of systemically significant nonbank financial firms.
Before elaborating on these points, I would like to offer a few words about the dual banking system in the US and the scope of state supervision.
The Role of the States in Financial Services Regulation
The dual banking system of complementary state and federal oversight is one of the unique aspects of the US framework for financial services regulation, and directly impacts cross-border issues. This dual supervisory system may seem like a very different approach, especially if you are coming from a country with a more centralized model. But in the course of US history, we have found a unique equilibrium in dual oversight that confers the benefits of both a centralized and a decentralized structure.
Close interaction with local regulators at the state level provides benefits to financial institutions, especially those with unique business models such as community banks, private/niche banks, or foreign banking organizations that facilitate international trade. In New York, we charter just over a hundred domestic banks, and supervise these institutions in partnership with either the FDIC or the Federal Reserve. Twenty of our banks are members of the Federal Reserve System, including such industry leaders as Bank of New York Mellon, Goldman Sachs, M&T Bank, and Deutsche Bank. With this diverse supervisory perspective and a well-established partnership with the Federal Reserve Bank of New York, it is no coincidence that New York State also licenses most of the foreign banking organizations operating in the US. We supervise 137 foreign branches, agencies, and representative offices, with more than $1.6 trillion in assets- which is almost 90% of the nationwide assets held by foreign banking organizations.
The Banking Department also regulates a broad range of institutions, including commercial banks, credit unions, mortgage bankers and brokers, licensed lenders, sales finance companies, money transmitters and check cashers. And the insurance industry in the US is solely regulated at the state level. In fact, states oversee a wider mix of institutional types than even the federal government, which is primarily limited to supervision of depository institutions. This breadth gives states a distinctive perspective on market trends and reform principles that cut across the finance industry. And I say this not just as a state banking Superintendent. I started my career with the Office of the Comptroller of the Currency, and worked exclusively for national banks. I am also involved in the regulatory reform process at the national level as a member of the Congressional Oversight Panel for the $700 billion Troubled Asset Relief Program, or TARP, which issued a Special Report on regulatory reform back in January.
Substantial reforms are anticipated both in the US and internationally, but the task is so complex that we risk losing momentum. Nations and international bodies must not lose the will and urgency to reform the financial system, to move from the imperative toward the implementation of more effective supervision of international firms.
I. Harmonization of Standards
A critical first step in enhancing cross-border supervision relates to standard-setting. Greater harmonization of standards will help to eliminate both the potential for international regulatory arbitrage, in which institutions could seek the laxest regulatory environment, or be used in certain jurisdictional havens for criminal use of the financial system. The goal is laudable, but convergence in rulemaking embodies tension between the benefits of uniformity and the need for flexibility, as regulators must fulfill their responsibility to respond appropriately to local conditions. This tension can be, but need not be, an obstacle; in fact, it can even be a catalyst for progress.
The Process of Setting Uniform Standards in the US
The US experience of this tension through the state-federal dynamic has ultimately been a creative force. While progress has not been strictly linear, the trend is clear that structured flexibility of states to act at the local level, in the context of mutual accountability with state and federal partners, has improved industry standards nationwide.
The most recent example relates to consumer protection and the scope of federal preemption, as federal law may override state law in certain circumstances. The federal chartering agency, the Office of the Comptroller of the Currency (OCC), took an overly broad interpretation of preemption in 2004 that exempted the largest banks in the country from complying with higher state consumer protection and anti-predatory lending laws. It has taken action by the US Supreme Court, which I anticipate will be further clarified by legislation, to restore balance.
But this aberration in state-federal relations that was provoked by the OCC’s sweeping preemption policy is the exception that proves the rule: there is an appropriate zone for local authorities to set standards above a national floor, and those local standards, once tested, may in turn become the model for a new national baseline. The states were correct in detecting the emerging subprime mortgage problem and were the first to take action through anti-predatory lending laws and landmark settlements. And state leadership on consumer protection issues over decades has led to improved national standards for the financial services industry in product disclosure and protection of home equity. Results like this demonstrate that it is worth the effort of engaging in this dialectic process, whether it is state-federal or among international partners.
The Process of Setting International Uniform Standards
On the international stage, a compelling example of the benefits as well as the practical limitations of harmonizing standards is in the implementation of the Basel II capital framework. I thoroughly support the effort to establish international capital standards, but progress on this issue comes in stages. If we take two steps forward but one step back, we are still making progress. And in the case of Basel II, the financial crisis has made clear that the FDIC was correct in taking one step back and insisting on retention of the leverage ratio for the US. What was sometimes misinterpreted as intransigence has now become an occasion for refining Basel II. Far from frustrating international progress, this appropriate use of regulatory discretion by a national supervisor actually reinvigorated the work of creating even more effective international capital standards, helping to ensure that we will reach our shared goal of a more stable banking system.
The Relationship between Standards and Risk ReductionWhen entering into international agreements, the ultimate question for jurisdictions with high standards is the degree to which a partial relaxation of those standards in the adoption of a uniform baseline would contribute to a local increase in safety and soundness, through the reduction of risks stemming from other jurisdictions where uniformity would result in increased rigor. In other words, if more and less robust regulatory regimes meet somewhere in the middle in setting a new common supervisory framework, is it still a net gain in terms of risk reduction for those who agree to technically lower the bar? The question of whether the US should abandon the leverage ratio for the sake of greater uniformity in the adoption of Basel II is a timely case in point.
The issue is further complicated by the fact that determining whether such a net gain in risk reduction is produced involves a qualitative and not just a quantitative judgment. The same supervisory standards on paper could be more or less effective in reducing risk and promoting stability depending upon the quality of execution. The right standards need to be paired with robust examination and enforcement activities that are coordinated among home and host supervisors.
II. Cooperation in Examination and Enforcement Activities
And here we return to a concept I mentioned earlier- mutual accountability. Effective home-host supervision, as with intra-national coordination, is dependent upon it. In the US, the flexibility that states have to create, examine, and enforce local laws and rules affecting the finance industry is structured through mutual accountability to other states and to federal regulatory counterparts. This structure does not imply that any of the individual supervisors held within this covenant of accountability is inadequate or incapable of the task of sole supervision. Rather, it is an affirmation that multiple regulators bring a needed diversity of perspectives to complex issues in a rapidly evolving financial services marketplace. Multiple regulators yield better results in setting a robust framework for the examination process, just as multiple judges are used in the Olympics to achieve a fair score.
Accountability among Regulators in the US
In the US, state-chartered depository institutions are dual-regulated by the either the Federal Reserve or the FDIC. Independent non-depository institutions such as mortgage bankers and brokers are solely supervised at the state level. But the states cooperate in setting licensing and examination standards for this diverse sector through the Conference of State Bank Supervisors (CSBS). There is something akin to positive peer pressure in this collegial gathering of state regulators that is very effective, and effective especially in the sense of accountability in the implementation of agreed principles.
With most branches of foreign banks in the US being state-licensed, intra-state coordination is critical to minimize overlap and reduce burden for foreign banking organizations with activities that cross state lines. For over ten years, the states through CSBS have had in place agreements, both between states and state-federal, for nationwide coordination in the supervision and examination of foreign banking organizations. These agreements are important in streamlining the oversight process, but more could be done to reduce burden for foreign banks operating in multiple states.
I could envision additional flexibility for state-licensed foreign branches to operate under “home state rules,” similar to the arrangements given to domestic banks chartered in another state. While national legislation would be required to implement this fully, there is much that the states can do through CSBS and on their own initiative. I am already in discussions with California, another state with a large foreign bank presence, to explore opportunities to harmonize our licensing procedures.
Accountability among International Regulators: Supervisory Colleges
The same type of cooperation that we are striving for in the US between states and between states the federal government should hold true on the international level: we need to strengthen accountability mechanisms for operational efficiency and vigilant supervision. That is precisely what nations are doing under the auspices of the G-20 and the IMF. And on the front lines of bank examinations we need to more fully realize the potential of supervisory colleges in enhancing the quality of supervision.
Functions of a Supervisory College
Supervisory colleges are working groups composed of the relevant regulators of an international banking organization, coordinated by the home country supervisors. Key functions of a supervisory college include information sharing, assessment of cross-border risk exposures, and coordinated inspections and examinations. This supervisory cooperation is increasingly important as banking organizations continue to organize their operations by business lines, with the result that risk management for a New York activity may be located in the home office.
While supervisory colleges cover institutions with a range of risk profiles, this cross-border market surveillance is particularly significant in identifying and responding to emerging systemic risks.
The existence of the supervisory college does not eliminate the need or prevent individual regulators within the college from establishing parallel mechanisms for cooperation, such as bilateral agreements and memorandums of understanding. In New York, we have close to twenty agreements in place with regulators from around the world, and have developed very strong supervisory relationships with those home countries. In fact, supervisory colleges may be formed as an outgrowth of such bilateral agreements, and the college then - creates an additional forum in which subgroups of supervisors can form new international connections and focus on concerns common to their markets. This flexibility is one of the benefits to the supervisory college structure.
Supervisory Colleges as an Immediate Response Mechanism for Emerging Issues
The flexibility of supervisory colleges and similar voluntary oversight bodies is well-suited as a first response mechanism to evolving challenges in supervision. Areas in which formal oversight is yet to be fully established, such as the over-the-counter (OTC) derivatives market, benefit from this oversight structure which can be implemented immediately. The process of developing a formal supervisory structure for the “shadow banking” system also benefits from early learnings that will emerge from new voluntary oversight structures.
Currently, 41 supervisory bodies from 15 countries participate in the OTC Derivatives Regulators Group. The Group is discussing how to regulate central counterparties and data repositories, including what information should be requested of data repositories to assist in regulating the market or market participants. Data repositories for credit default swaps and trades will bring more transparency to the market and help to assess counterparty exposures. Subgroups have also been formed to focus on issues of particular relevance to the individual supervisors’ missions. I am proud of the early lead New York has taken in chartering one of the first clearinghouses and the trade repository for credit default swaps, and our participation in the OTC Derivatives Regulators Group will further inform our mission as well as the movement to promote standardization and disclosure for this diverse market.
Supervisory colleges are also the appropriate approach for coordination among jurisdictions with disparate legal and supervisory structures that would hinder more formal and binding approaches to cross-border supervision. For example, I considered it critical to attend the supervisory college in China in person earlier this month.- New York has recently licensed branches of the Industrial and Commercial Bank of China, China Merchants Bank, and China Construction Bank. These are the first branches of banks from mainland China to open in the US in over 17 years, and reflect the growing trade between our countries and New York’s role as a hub for global finance.
The nonbinding but still effective mechanism of the supervisory college is the best practical fit for engaging with supervisors from jurisdictions with legal systems and other dynamics that are very different from those in the US, such as China.
Supervisory Colleges as a Complement to Increased EU Cooperation
I appreciate that some believe this nonbinding nature of the supervisory college is the primary weakness of the concept, its Achilles heel. Views on the efficacy of supervisory colleges are also relevant to the debate in Europe on the creation of expanded EU-level authority. But I do not believe it is an either-or choice; supervisory colleges can provide a complement to increased cooperation through EU regulatory bodies. Proposals to develop EU-wide supervision, to go beyond existing bodies which focus on coordination, also amount to a dual banking system and raise issues that are similar to state-federal concerns in the US. Harmonization of rules and consistency in supervisory approach across the EU will need to be accomplished while recognizing the responsibility of member countries to protect their residents.
When diverse economies need to work together for the good of the region, some form of dual oversight seems to be the natural outcome. We can learn from each other in finding the optimal balance.
III. Resolution Authority
Another area in which an optimal structure is needed is the resolution process for international firms. I would like to focus on the issue of creating a resolution authority in the US for systemically significant nonbanks.
Proposals to Expand US Resolution Authority
When faced with the failure of Lehman Bros. last fall, the government found itself without the regulatory structure to ensure the orderly unwinding of the firm. The market uncertainty provoked by the Lehman bankruptcy is still evident. Bankruptcy proceedings simply do not provide a sufficient means to ensure interim operations, thus triggering call provisions that upend contractual arrangements that could otherwise have remained in place and exacerbating market destabilization.
The Obama Administration and members of Congress are supporting various proposals to expand resolution authority for systemically significant institutions, such as bank holding companies, insurance companies, and other nonbanking financial organizations. While the process of regulatory reform in the US covers many fronts, the resolution authority issue is one of the most central. It is a key to approaching the thorny problems of moral hazard, “too big to fail,” and the interconnectedness of international financial conglomerates.
Detractors characterize expanded resolution authority as a permanent bailout approval for large firms, with the attendant moral hazard concerns. The opposite is true; a proper resolution method demonstrates that large firms will be allowed to fail. It also would provide a way to assess firms that are outside the FDIC deposit insurance program for a new form of insurance premiums commensurate with the external risks they present to the financial system, thus providing additional protections against the need to put taxpayers dollars at risk. This is far superior to an ad hoc use of public funds in times of economic distress, and helps to counter pro-cyclical trends.
Some have suggested “living wills” as a solution to the resolution of systemically significant firms. In a living will, the firm outlines how it would orderly unwind its operations. Such an exercise has value for a firm as a compliance discipline, especially in identifying and aggregating counterparty risk and other contingent liabilities. While I support the concept of a living will as part of a firm’s contingency planning, much like the liquidity contingency planning I mentioned previously, it is an insufficient safety net in the event of a systemic financial panic.Conclusion
Having been asked to describe effective cross-border supervision from the domestic perspective, and coming from a state like New York with a broad international presence, I would offer the following conclusions.
First, the progress of regulatory reform, including the creation of new or expanded authorities to manage systemic risk, is critical- but architecture is not a panacea. There are no structural shortcuts to effective oversight. Countries with diverse regulatory frameworks were all deeply impacted by the current financial crisis.
Second, there is a continuing role for nonbinding regulatory bodies. Strengthening the quality of these mechanisms should be our primary focus, given the reality of diverse legal structures among jurisdictions which can hinder more formal associations. Structures such as supervisory colleges have great potential as market surveillance tools and as stepping stones to closer international ties and greater convergence in standards and supervisory protocols.
And finally, no system, no protocol will result in quality oversight of the diverse and increasingly interconnected global financial markets apart from mutual accountability and trust between supervisory partners. I am pleased to be part of this dialogue today at the IMF, which is an important opportunity to further these international relationships.