Tong Zengyin
Supervising and regulating the operation of financial institutions are the important functions of the central bank. Only when the power of supervision and regulation is properly pursued and supervision and regulation duly performed can the financial sector play its role fully in macroeconomic regulation and control and monetary policy targets be smoothly realized. All central banks in the world have therefore paid much attention to supervision and regulation, established special departments, and provided enough staff for this purpose. Our central bank is no exception in that it has also laid strong emphasis on supervision and regulation.
The People’s Bank of China began its function of supervision and regulation over financial institutions with the financial reform at the end of the 1970s. The history of supervision and regulation in the past four decades can be broadly divided into three periods:
The first is from the foundation of new China in 1949 to 1978. There was one state bank throughout the country with dual functions both as the central bank and a commercial bank so as to adapt to the highly centralized planned economy. Being only a cashier to the Ministry of Finance, the People’s Bank of China was actually paralyzed in exercising its power of supervision and regulation.
The second period is from 1979 to 1983. In addition to the role of central bank, the People’s Bank of China was also responsible for some of the functions of specialized banks, due to the fact that the economy was in transition from a centrally planned economy to a planned commodity economy. In this period, the central bank was unable to fully perform its functions of supervision and regulation because it did not have an independent role.
The third period is from 1984 to the present. During this time, the People’s Bank of China has been functioning solely as the central bank and no longer handles specific banking business. It has fully played its role of supervision and regulation in accordance with state rules, regulations, policies, and guidelines. As a result, a number of positive changes have been brought about in the financial system. First, stable financial order has been maintained. Through supervision and regulation, legal business activities have been protected and illegal activities eliminated. A healthy financial order has been gradually set up in which financial institutions operate with both division and coordination in business and within the specified scope of business. Second, the financial system has been perfected. The central bank controls, according to the needs of economic development, the establishment of financial institutions in order to perfect the financial system.
Third, realization of monetary policy objectives has been secured. The central bank performs supervision and regulation in line with the objective of monetary stabilization. By examining the execution of plans and the implementation of monetary and credit policies and supervising the operations of financial institutions, the People’s Bank of China has helped facilitate the realization of macro-adjustment objectives.
The central bank ought to have corresponding power in order to supervise and regulate financial institutions. Supervisory and regulatory powers have been greatly expanded in recent years, with the deepening of economic reform and the greater role of the central bank. At present, the People’s Bank of China has responsibility not only for supervising and regulating the financial institutions with respect to their internal structure, business scope, interest rate, borrowing and lending operations, etc., but also for punishing financial institutions that break rules and regulations. The imperfection of the existing financial framework, however, has severely limited the central bank’s ability to carry out its supervisory and regulatory activities in accordance with promulgated rules and regulations. We are planning to solve these problems through accelerating legislation so that the central bank’s supervisory and regulatory functions will be ensured.
Our financial regulation system is different from that of Western countries. We have neither the Office of the Comptroller of the Currency nor the National Credit Union Administration, nor the independent financial administration units. The People’s Bank of China is fully responsible for supervising and regulating financial institutions. One of the advantages of such an arrangement is that it provides consistent supervision and regulation; a major disadvantage is the lack of various institutions to check and balance one another. Given the present framework, we are trying to strengthen supervision and regulation by enhancing the division and coordination of relevant internal departments and by the better integration of regulation and supervision; daily regulation should identify important areas for supervision; in return, supervision should identify weaknesses in the system that need stronger regulation.
With respect to the integration of supervision and regulation, the following relationship should be properly handled. (1) The relation between macro-economy and micro-economy: Supervision and regulation should, on the one hand, maintain the macroeconomic stability and, on the other, prevent microeconomic activities from being overly restricted. (2) The relationship between key institutions and other institutions: Supervision and regulation should focus on those institutions with the greater volume of business and serious managerial problems without undue ignorance of other institutions. The detailed examination of one individual institution or a group of institutions should be properly integrated with the overall supervision of the whole system. (3) The relationship between persuasion and punishment: The problems found during supervision and regulation should be treated differently in consideration of different situations. Enterprises with occasional or minor regulative problems should be persuaded to correct their behavior, while enterprises with periodic or serious problems should be punished. (4) The relationship between quantity and quality: Efforts should be made to ensure that all financial institutions are under proper supervision. Meanwhile, supervisory and regulatory experience should be periodically reviewed so that their quality will be continually upgraded.
Paul A. Volcker
It may be useful if I start out with some classifications and definitions. We are talking about supervision and regulation. Supervision and regulation for what purpose? There are at least three different purposes in the United States—and I suspect in most countries—and to some extent they overlap, but they are also distinct.
There are certain rules and regulations that are issued primarily for monetary or credit control. They are a means of carrying out the policies that we talked about yesterday. An obvious example in this area is reserve requirements. We have rather elaborate definitions of different types of deposits in the United States, partly to keep their liquidity characteristics distinct. Well, we have abandoned them. For a long time, we had interest rate ceilings on the interest rates that banks and other financial institutions could pay to depositors, and they were at least partly for monetary policy purposes.
All those kinds of regulations require writing certain rules, and while it is a fairly simple job, somebody has to make sure that the rules are in fact followed by the regulated institutions. In this case, it is typically the central bank that enforces those rules in the United States, although not always.
A second area in which we have regulation and supervision is what is thought of as so-called prudential rules, rules involved with the safety and soundness and stability of supervised institutions. The basic purpose of these rules is to make sure that institutions are strong enough to carry out their functions in the economy, while remaining solvent and adequately liquid. This area is enforced by two different kinds of approach. Sometimes, general rules and regulations are written. You may do this. You may not do that. You may not do things that are deemed to be unduly risky. You may do things that are deemed to be appropriate and safe. But a major part of this effort is done through examinations, on-site examinations of the supervised institutions, where teams of examiners from the authority go out and inspect the banks, more or less every year. The inspection is quite thorough and very detailed reports are written. Out of those reports come judgments and sometimes orders to those institutions to change their practices.
A final area of supervision and regulation encompasses what might be thought of as social concerns. They are not really necessary for monetary policy; they are not really necessary for safety and soundness, although all these things overlap. But they are incurred as a result of laws passed by the U.S. Congress, typically, to reflect certain very broad social and economic concerns that the country has. I will give two kinds of example. One is certain laws that encourage or require financial institutions to pay particular attention to the needs of certain types of consumer. These are sometimes hard to define specifically, but the supervising authorities are directed to make sure that the banks have, for instance, an adequate number of offices in poor areas of a city, where business may not be so profitable as in the rich areas of the city. That is a typical kind of approach. There are rather elaborate rules to make sure that mortgage loans for home purchases are available, to the extent consistent with safety, to the poorest sectors of the society and all races and gender and that there is no discrimination.
A quite different kind of concern in the United States is reflected in our rather long-standing rules against combining banking activity with ordinary business; we, by and large with some exceptions, have taken the view that a bank is a bank, or a bank is at least a financial institution, and it should not be directly owned by a business corporation doing ordinary manufacturing or commercial business. Nor should a bank in the United States own an industrial corporation; General Motors does not own banks and banks do not own General Motors, with some exceptions. So we are in a very complicated area, and my remarks are directed mostly toward that middle area of safety and soundness and prudential requirements, but it is more complicated than that in terms of purposes.
As Mr. Erb suggested, the United States has an extremely complicated system for supervision and regulation. I could take the time to describe this system as an object lesson for what you should not do, but I will not do so; instead, I will draw one lesson from the complications of our system, which may be generally valid.
Our system is so complicated because it involves very sensitive political and bureaucratic rivalries. The banks do not like to be supervised and regulated; they would prefer that the supervisor in most cases be as weak as possible and have as little influence as possible. There are different types of financial institutions in the United States. They are all concerned about competitive advantages against each other and about maximizing the chance of some competitive advantage. They often want their own supervisor, and they want their supervisor to be friendly to them, so that they strengthen their relative competitive position. All these pressures are brought to bear through the political system and through the U.S. Congress.
There have been proposals, over a hundred years, to simplify and strengthen the supervisory system in the United States. Despite all these proposals, the system remains more or less the same. The United States has almost 14,000 banks, and has a long tradition that a bank can be chartered by the states—the individual states—as well as the federal government. We have three or four thousand institutions, called thrift institutions, most of which historically dealt with consumers, but these days they are very much like any other kind of bank. We have tens of thousands of institutions called credit unions, which act somewhat like consumer banks for people in an individual company, or in an individual town, or in an individual association of some sort. All of these institutions may be authorized by the federal government or they may be authorized by a state government. But at the national government level, there are three different agencies supervising banks. If an institution is chartered by a state it has a state supervisory authority as well. There are two different institutions supervising the so-called thrifts. I will not speak of the credit unions, which are smaller. As you see, it is a very complicated, overlapping, confusing situation.
Having said all of that, I will make a few personal conclusions, growing out of American experience. They have some relevance to other countries, although particular circ*mstances differ. My first point is that a strong central bank realty needs considerable supervisory authority over the banking system. I say that partly because some of the rules and regulations necessarily flow out of those. But it is also important to a central bank to have a clear sense of the strengths and weaknesses in the financial system when it makes decisions on monetary policy, because those decisions will have different effects on the economy, depending upon the strength of the banks themselves. For instance, if the banking system is in a weak position, it may be difficult to tighten money and raise interest rates without creating more severe disturbances in financial markets.
I can tell you that a central bank, at least the American central bank, does not like to be inhibited in the conduct of monetary policy by a sense of weakness in the banks. The best way to assure to its satisfaction that those weaknesses do not exist or are minimized is to have responsibility for supervision itself. Of course, depending upon the country—but true in the United States to some extent—the central bank is entitled to have considerable supervisory authority by the mere fact that it operates very often by lending to those institutions, and if it lends to those institutions, it wants to have some assurance that it can be repaid, and that it is lending to a liquid, solvent institution. The more a central bank operates by lending to banking and other institutions, the more important it is that it has adequate supervisory authority for so-called prudential reasons, as well as for monetary policy reasons.
Let me look at the same problem from another direction. I talked about the importance to the central bank, to the strength of the central bank, of having adequate supervisory authority. I think based upon American experience, at least, it is also important to have a strong supervisor if you are going to have effective supervision. There is bound to be a contentious relationship between those that are supervised and those that supervise. If the supervisor is very weak, he will not be effective in enforcing standards of prudence, of safety, and of soundness. Therefore, you need a strong supervisor. In the United States, it is quite clear for a variety of political and other reasons that the central bank is likely to be the stronger supervisor. Its independence and stature makes it the least subject to political and other pressures that supervised institutions bring to bear to weaken supervision. That may not necessarily be true in every country, but I suspect that more often than not the central bank is in the strongest political position, in a sense, to exercise effective supervision. The alternative, at least in the United States, is the ministry of finance.
The weakest alternative, again drawing on American experience, is an agency that has no function other than to supervise a particular set of institutions. That was the case in the savings and loan industry in the United States. Savings and loans were the most important so-called thrift institutions and were important competitors of banks. They had their own supervisory arrangements and an independent supervisory authority that, as a practical matter, through the political process, the supervised institutions themselves controlled. They were in effect controlling; that is not what the law said, but that was in fact what happened. Lending by these institutions was historically directed largely toward home purchases. They took most of their deposits and put them in home mortgages. Because that is very popular politically, the U.S. Congress was willing to take a lax view toward these institutions from a supervisory standpoint. It wanted to enhance their ability to attract funds to lend to families so that they could buy a house—a very popular purpose. But through the years, supervision became quite lax in that industry and under the strains of the past decade it is not too strong to say that the industry has largely collapsed. A very large fraction of the industry is bankrupt. Their deposits were insured, so the federal government had to pick up the cost. Estimates of the cost to rescue those depositors over the next few years vary widely, but most range from $250 billion upward—an object lesson in lax supervision.
When one looks at the banks and not these thrift institutions, one can see that many of them are subject to more than one regulatory authority, but without going into great detail, the supervision is not perfect by any means. In most cases, the Federal Reserve participates in the supervision, or controls the supervision, but that is not true in all cases. The rivalry between the supervisors themselves sometimes tends to lead to easier supervision than you would otherwise have. That is understood by the supervisors, by the politicians, and by the industry; the argument then is between those that say it is a good idea to have competing supervisory agencies, so that the supervision does not get too tough and is not too detrimental to the ability of the supervised institutions to compete, and those that say we do not want them too weak. There is a constant battle, politically and otherwise, between the desire to make supervision more uniform and more unitary and the desire to keep it more dispersed. The balance goes back and forth over the years, but the system I have described, as you can see, still has a lot of competition between supervisory agencies, which means somewhat lighter supervision than otherwise would be the case. On the other hand, I would argue that in the banking area at least, supervision is rather comprehensive in the United States, and while the system is very messy it does balance two considerations: a strong supervisory authority, which is largely represented by the central bank, and an unwillingness to give too much power and too much authority to any single supervisory agency, in the interest of permitting a hundred flowers to bloom in the financial area.
Miguel Mancera
First, let me tell you that my comments on this topic should not be understood to be applicable to banks only but to financial intermediaries generally. If I do not refer expressly to all of them, it is merely for the sake of simplicity.
Bank regulation and supervision play three important roles. The first of these is promoting the soundness of banks to protect depositors. The second is encouraging economic efficiency in financial intermediation. The third is ensuring that banks comply with monetary policy measures and do not circumvent or, even worse, ignore them. As is well known, the average person does not usually have the ability to assess the soundness of a bank. To determine whether or not a bank is healthy requires specialized knowledge and detailed information. This is the reason why most countries have a bank supervisory authority. Whether it is a department of the central bank, of the ministry of finance, or a separate agency, its role is fundamentally the same, that is, to ensure the soundness of the banking system.
Laxity with regard to the soundness of banks is extremely dangerous because, among other reasons, insolvency is highly contagious. Poorly managed banks may appear to be successful for a time. In a number of cases, they may show a high rate of growth. This apparent success puts pressure on other banks who do not wish to forfeit their market share to the faster growing banks. Thus, banks will often compete among each other by paying higher interest rates to attract deposits; at the same time, they may relax their lending standards. If this process goes uncorrected, an undesirable situation develops where banks may display one or more of the following negative features: low quality loan portfolios, growing current losses, or negative net worth. These danger signs may go unnoticed for a long time, making correction increasingly difficult to achieve.
Poor or irresponsible management is the main reason for bank insolvency. But a bank’s unsoundness is also fostered by inappropriate regulations or insufficient bank supervision. For instance, imposing high and inadequately remunerated reserve requirements or forced lending to priority sectors of the economy at below market interest rates may seriously debilitate banks. Also, a legal framework that unduly protects borrowers makes loan recovery difficult. In addition, if banks are not subject to appropriate disclosure rules, problems cannot be tackled in a timely fashion.
Since bank insolvency may easily become widespread, it can damage the economy for various reasons. (1) If the public perceives banks to be insolvent, depositors will withdraw their funds from banks, inflicting a severe blow to the saving-investment process. Moreover, since banks are major depositories of financial assets, when savers move out of banks, capital flight from the country cannot be ruled out. (2) Resources will be misallocated, as troubled banks often lend to borrowers of dubious solvency as these are usually willing to pay higher interest charges. (3) Since bank deposits will be perceived as risky, interest rates will be subject to upward pressure. (4) If the government subsidizes banks to prevent depositors and other bank creditors from losing money, public finances will deteriorate, thereby weakening monetary control. (5) As numerous banks fall into precarious situations, they cannot be expected to be effective vehicles for implementing monetary policy. (6) The widespread existence of bad loans implies a deteriorating economic morality. People may believe that not fulfilling credit obligations is socially acceptable, which would hinder economic progress.
Under these circ*mstances, the financial system’s development is seriously jeopardized as trust, the most important of its pillars, erodes. For these reasons, bank regulation and supervision should aim primarily at establishing preventive measures, so that “bank diseases” do not arise or, should they appear, be immediately remedied.
Foremost among preventive measures is the development and enforcement of good accounting standards. Without them, it is virtually impossible to know where a bank stands; it is also impossible to establish comparisons among banks. Supervisory authorities should determine that the information provided by the accounts is reliable, in this respect, there is a very difficult, albeit crucial, task: to ensure that the information in the loan portfolio provides a fair and truthful report on the quality of the respective assets. Provisions for doubtful loans should be mandatory. The same should apply to write-downs or write-offs of credits that have been partially lost and for those that cannot be recovered.
Other preventive measures concern entry into the financial market. In this regard, it is important to keep in mind that meeting the minimum capital requirement to establish a bank should not by itself be enough to obtain a banking license. The human capital, that is to say, the moral and professional quality of the bank’s prospective management, is in fact more important than its capital base. No deposit-taking institution should be allowed to be established when the prospective management is not entirely satisfactory to the licensing authorities.
In recent years, supervisory authorities have devoted much attention—and rightly so—to the capital adequacy of banks. At a certain stage, particularly in some countries, commercial banks became too leveraged. Although it is virtually impossible to establish scientifically what the optimum capitalization of a bank should be, it is clear that the higher the leverage, the more vulnerable a bank tends to be. (The recommendations of the Cooke Committee of the Bank for International Settlements (BIS) reflect a consensus among knowledgeable people on how to judge the capital adequacy of commercial banks.)
Concentration of lending is a main source of bank instability. This is the reason most countries have rules to prevent it. Nevertheless, pressure continuously arises for banks to lend disproportionately to a single customer. In some cases, this is because the customer happens to be a shareholder of the bank or a member of its management, or because the customer is somehow related to them. In other instances, concentration may arise because the customer is able to apply political pressure to the bank in question. Since concentration of lending is a common cause of bank failures, supervisory authorities should be especially keen to prevent it. If the supervisory authorities are to be effective, they must be empowered to impose appropriate—even harsh—sanctions for the infringement of regulations. Otherwise, they risk not being taken seriously.
When banks become insolvent, or better, when they are on the way to insolvency, supervisory authorities should act as quickly as possible. If they do not, losses usually grow geometrically. Moreover, there is the risk of passing on the insolvency of one bank to others. Remedial action may involve two kinds of measures. One of them is the rehabilitation of the weak bank, and the other is its liquidation. Rehabilitation is generally preferable to liquidation. The latter provokes a general distrust about banking institutions and thus impairs the future development of the financial system. For this reason, liquidation should be seen as a measure of last resort.
Rehabilitation may be achieved by various means, such as new shareholder capital appropriations, mergers, or acquisitions. But usually, the key factor in a successful bank rehabilitation is a change or, at least, a strengthening of its management. In fact, except in the rather infrequent cases in which bank failures are attributable to macro-economic factors or to extremely poor regulation, insolvencies are due to mismanagement. Bank mismanagement not only damages the particular banks involved and the banking system generally but also impairs the efficiency of the overall economy. This is because poor management usually implies that savings channeled to investment through the respective banks are not applied to good projects. This is demonstrated by the preponderance of low quality loans in the portfolios of those institutions.
In most countries, central banks play an important role in bank regulation and supervision, but they are not the only regulatory and supervisory authority. It seems to me that the issue of regulations required for the implementation of monetary policy should be a responsibility exclusive to the central bank. Otherwise, the risk arises that competing authorities may distort the objectives of the central bank, jeopardizing the effectiveness of monetary policy. If you recall the distinction between monetary and credit policy that I made in the first session, it seems that there is some scope for other authorities (the ministry of finance, for example) to regulate some aspects of credit operations, such as determining the features of the credits granted by development banks. The best arrangement for the coordination of policy measures, however, may well be that the central bank regulates all or most banking activities. Nevertheless, the ministry of finance or other authorities could have a say in the formulation of central bank policies through their participation in the governing bodies of the bank.
Bank supervision may be seen as a different task from that of regulation. The purpose of supervision is to verify that existing regulations are complied with and to impose sanctions when they are not. The supervisory function can be carried out by a department of the central bank. This arrangement has certain advantages. Since the central bank has close contact with the market, it can detect violations more easily than other agencies. Moreover, when someone is in charge of enforcing regulations, he may be in the best position to design them as well.
On the other hand, bank supervision may be such a time-consuming responsibility that it could distract the central bank official from crucial monetary policy matters. This may be a good argument for entrusting bank supervision to an agency separate from the central bank. Should this be the case, it is essential that the central bank have a strong presence in the governing bodies of the supervisory agency.
Achieving efficiency in the financial system, as in the rest of the economy, is, or should be, a key objective in every country. The question is how best to promote efficiency in the financial system. In my view, the most effective way is through competition. The degree of competition in the financial system does not only depend on the number of banks but also on how able they are to compete with one another and on the number and capabilities of nonbank institutions, which may also form part of the financial system. Moreover, the degree of competition may also depend on the diversity of financial instruments used by the various financial intermediaries.
The more financial intermediaries encourage the generation of saving and the better they are at allocating such saving to highly productive projects, the more efficient the financial system will be. Ultimate efficiency is attained when financial intermediaries are able to stimulate saving and fund good investment projects while charging narrow spreads between deposit and lending rates and still remain profitable.
To encourage saving, the financial system should be able to offer a wide choice of instruments to current or potential clients, so that their particular needs can be adequately met. The same can be said about lending instruments. There should be a variety of them so that the financial support for investment projects can be appropriate to the features of each of them.
Finally, a word on the role of profit in the financial system. If profit does not come from monopolistic situations, it should be welcome. Such profit indicates that the respective firm is efficient. It seems to me that aiming at profit in a competitive environment is particularly advisable in countries where banks belong to the state. In such circ*mstances, the absence of profit implies the need for budgetary appropriations in order to capitalize banks. This imposes an additional burden on public finances, which are usually already strained. Apart from that, and perhaps of more concern, the absence of profit may be an indicator of an inefficient allocation of resources.
Jean Godeaux
Regulation and supervision of the banking system or, more appropriately, of the financial institutions are a traditional responsibility of banks. For brevity’s sake, the words “supervision” and “banks” will be used to describe the exercise of this responsibility and its field of application.
Supervision covers two distinct categories of activity. The first is the macroeconomic control that is designed to influence the conditions under which monetary policy can be made effective, or more effective: such as the power to impose reserve requirements on various ratios. Quite naturally this power should be vested in the central bank, and it is so vested in most countries.
The second is the ensuring and monitoring of the soundness of financial institutions and the financial system. Obviously, these two supervisory activities are interconnected, even complementary. I shall hereafter speak mostly of the second, generally called prudential control.
My considered opinion, and that of all central bankers, is that prudential control is more necessary than ever. On account of the internationalization of capital markets, on account of the spread of financial innovations, and on account of a general movement of deregulation of financial markets, one has to accept the view that the risk of unstable international financial markets has increased, and there exists now, more than in the past, what may be called systemic risk, namely, that the whole system itself might be endangered by a difficulty encountered by one institution in one country.
Now, as regards the way in which this prudential control is being exercised, there are basically in Europe two ways at the institutional level. One is to have this prudential control vested in the central bank; as everybody knows that is the case with the Bank of England, the Bank of Italy, the Bank of Spain, and the Bank of the Netherlands. The other is to have prudential control vested in a separate institution; that is the case in the Federal Republic of Germany and in my country, where prudential control is entrusted to the banking commission. France is a special case. There is a separate institution, but this institution is run by the Bank of France, so that in practice the supervisory activities as regards prudential control are exercised in effect by the Bank of France.
Whatever the institutional setup, there must be, as Mr. Mancera pointed out, a close involvement of the central bank in prudential supervision. Whenever there is a separate institution, there must be a strong presence of the central bank in that institution or, at least, a close liaison. In my country, for instance, a banking commission was created in 1935 (the central bank had been created in 1850). Two of the six members of the commission are appointed from a list of candidates proposed by the central bank. And one of the appointees has, by tradition, always been a member of the board of the central bank, often the deputy governor.
I may pass briefly over the methods by which this prudential control is exercised. As in most countries, it is a combination of the monthly transmission of detailed statements, on-the-spot examinations, either occasional or continuous, and—what is feasible in a small country with few institutions—regular contacts of the supervisory authority with top management.
A short historical account of the evolution of concepts, preoccupations, and methods at the international level may be more interesting. The first, and probably most important, episode in this history was the creation of the bank supervisors’ committee in Basle, in the framework of the Group of Ten (G-10) countries. This committee was chaired originally by Mr. Blundon and then by Mr. Cooke, both of the Bank of England, and now by Mr. Muller of the Netherlands Bank. The committee of bank supervisors was called into existence by the G-10 Governors in the wake of the first large “bank accident,” the Herstatt affair, as some of you may remember. The first result of their activities was the conclusion of an agreement, the so-called Basle Concordat. It was designed to make sure that no banking institution in the G-10 countries and progressively in a wider circle would escape supervision. The Basle Concordat established the principle of “home country control,” namely, that the supervising authorities in the country of the parent company would be responsible for control over all subsidiaries and branches of the bank, whatever their location.
A second moment in this history of international cooperation on prudential control was the creation, again by G-10 Governors, of a special working party, chaired by Mr. Cross, First Vice President of the Federal Reserve Bank of New York. This working party was commissioned to write a report on financial innovations in international banking and their consequences on prudential control. The Sam Cross report was for a time a “best seller,” except that it was not sold but freely distributed by the BIS. It was almost required reading for every banker. An updated version would probably be very useful but would require a great deal of work.
A third step was the conclusion, in 1988, if I am not mistaken, again at the G-10 level, of an agreement on minimum rules with regard to capital adequacy.
But the most important development, in my view, occurred in the EEC. For a long time the method of European unification was “harmonization” of rules and regulations and administrative practices. This attempt at complete harmonization led to lengthy procedures, “somber” procedures as Jacques Delors once called them, and consequently to intolerable delays.
On the proposal of the European Commission and in the framework of the European Act—the first important amendment to the Treaty of Rome—the tiresome attempt at complete harmonization was replaced by the acceptance of two principles: “mutual recognition” and “minimum harmonization.” Once a minimum level of “commonality” of regulation or administrative practice had been reached, countries of the EEC would accept that their respective rules would be sufficient. In the field of banking control it would mean, for instance, that a license to operate a bank in any one country of the Community would be valid in all other countries of the Community. By this method we could speed up the attainment of two factors that we consider essential for achieving “the great integrated market”: freedom of establishment of financial institutions and freedom of provision of financial services.
Against this background of mutual recognition and minimum harmonization, the authors of the Delors Report considered unanimously that the mandate and functions of the future European System of Central Banks should comprise the four following elements: (1) It would be committed to the objective of price stability; (2) it should support, subject to the foregoing, the general economic policy set at the Community level by the competent bodies; (3) it would be responsible for the formulation and implementation of monetary policy, exchange rate and reserve management, and the maintenance of a properly functioning payment system; and, (4) it would participate in the coordination of banking supervision policies of the supervisory authorities. We see thus that responsibility for a “properly functioning payment system” and “participation” in the coordination of supervision policies are viewed by all as essential elements of the functions of central banks. This leads me to answer with a clear yes the question: Is it necessary that the central bank should have an important authority in the field of prudential control of financial institutions?
Summary of Discussion
Richard D. Erb
Let me take a few moments to comment on some of the main points that were made during the course of this morning’s discussion. First, during the discussion of the purposes of supervision and regulation, there was strong consensus on the importance of regulation and supervision for monetary control and for the safety and soundness of the banking system. Mr. Volcker indicated that there may also be social concerns that require supervision and regulation. Mr. Mancera talked about the need to encourage efficiency in financial intermediation; this was perhaps related to what Mr. Tong was saying when he indicated that the central bank should promote development of financial intermediation. Mr. Godeaux introduced the international dimension with respect to the purposes of supervision and regulation. As Mr. Volcker said, this may not be of immediate concern to China but certainly within the near future it will have special relevance, as the economy opens up further.
Then there was discussion of the question of who should supervise and regulate. As each speaker indicated, practices differ across countries and have also differed over time. One conclusion that we can draw from this is that the issue of supervision and regulation is dynamic and must always be kept under review and examination to be sure it is keeping up with the times. There was strong consensus, not surprisingly, that the central bank should play a key role in supervision and regulation, or, at a minimum, the central bank should have responsibility for the regulation and supervision that is key to the implementation of monetary policy.
To the extent that there are separate supervisory agencies, the central bank should have a strong presence. But the point was also made that whoever supervises should be strong and also independent, independent of political pressure and independent of the institutions being supervised. Mr. Mancera indicated that it was implicit in the statements of the other speakers that the broader environment has an impact on the scope and effectiveness of supervision. For example, the legal system: to what extent does it protect—overprotect—borrowers. There may also exist political pressure and laws that require forced lending to priority sectors at low, market interest rates. Accounting practices and standards may also influence the safety and soundness of banks.
Then there is the more general question of changes in the financial markets that may come about in the course of financial deregulation. Mr. Godeaux mentioned that these changes could be technological changes in communications, and computers, etc. Mr. Volcker, when talking about the changes in international banking, commented that there will be growing economic and financial integration across countries. Beyond that, the experience exists in many countries that enterprises are often very imaginative in finding ways of responding to limitations. It is often hard to stop innovation.
Mr. Mancera had said in his statement that poorly managed banks may appear very successful for a time, and when a dangerous situation goes on for a period of time corrections are difficult to achieve. Negative systemic consequences, he indicated, can occur if there is widespread insolvency. I think that is a pattern in many countries: when problems arise in an individual bank, or even across a number of banks, everyone is often caught by surprise. This leads to the question of the usefulness of preventive measures, good accounting standards, for example, provisions for bad loans, adequate capital standards, minimum entry standards; these are ways of providing some protection, some preventive assistance.
