Matching expectations with reality

Wayne Byres, Chairman - Hong Kong Monetary Authority (HKMA), Global Association of Risk Professionals (GARP) Global Risk Forum, Hong Kong

I’d like to start by thanking the HKMA’s Chief Executive, Norman Chan, for his kind introduction, and the HKMA and GARP for putting together an excellent programme for this event. Given the quality of presenters that we will hear from tomorrow, I’m very honoured to be asked to give the opening address this evening to kick off the proceedings.

When my wife and I returned to Sydney after a few very enjoyable years living in Basel, we were very conscious that our two sons had seen much more of the rest of the world than they had seen of their own country. So we resolved that, for the foreseeable future, we would take our holidays domestically. That commitment was evidenced recently when we decided to take a family car trip out to central-western New South Wales. (For those of you not that familiar with Australia, broadly it involved setting off west from Sydney, and taking a six hour, 400km road journey.) I confess we wondered about the merits of our decision when, quite shortly into the trip, the regular call from our sons in the back seat began: ‘are we almost there yet?’ and ‘how much longer?’

Holidays are meant to be about taking a break from the work environment but, for anyone involved in regulation of the financial sector, these are two questions that continually haunt you. The period since the financial crisis has seen a major overhaul of the regulatory framework:

• capital requirements have been strengthened;
• global liquidity standards introduced;
• disclosure requirements have been enhanced;
• macroprudential frameworks have been (and continue to be) developed;
• additional requirements have been imposed on systemically important financial firms; and
• the rules for derivatives markets have been substantially rewritten.

Yet there remains more to do: the FSB, Basel Committee, IAIS and IOSCO still have important pieces of work on their agenda. As each new proposal emerges, the questions are asked ‘are we almost there yet?’ and ‘how much longer?’ The answers are usually ‘not quite’ and ‘next year’. Yet work agendas do not seem to shorten, and another year rolls on ….

We are at that stage of the reform program where a great deal of time and effort is being spent on technical issues of regulatory detail: the right parameter for this, the appropriate transition timetable for that. But I sometimes think we are deciding these without enough clarity on the operating model we are ultimately working towards. My experience in Basel certainly highlighted that, when we had the greatest difficulty reaching agreement on the way ahead, it was usually because there were some underlying disagreements on the destination we were aiming for. It is like debating whether it is best to travel by car or plane on your next holiday, without first agreeing where exactly it is you plan to go.

I would suggest our task in dealing with the specifics would be easier – and we would get the work done faster - if we had a more strategic perspective on a few key issues. Those issues are the extent to which we want to design a regulatory framework founded on a degree of reliance on:

• internal models;
• supervision;
• market discipline; and
• internal governance and culture?

The reason that I highlight these issues is that all four could be said to be areas where reality has not always lived up to expectations. Yet all have the potential to act as a means of limiting the sorts of prescriptive, one-size-fits-all regulation that industry – with some justification – rails against. To put it another way, think what the regulatory framework might look like if we removed all reliance on internal models; undertook very limited supervision activities; and could not assume any form of market discipline externally, or good governance and culture internally, to act as a constraint on imprudent behaviour. The result would inevitably be a highly constraining regulatory rulebook, which assumed the lowest common denominator in all firms. Being able to relax those constraints, because there are other, better and less costly tools to help generate sound financial firms and systems, is important for ensuring regulation does not just produce financially-sound firms, but innovative and competitive ones too.

To model or not to model?

Of course, it is not as though these issues are not being discussed. Take internal models: how much the regulatory framework should make use of them is being hotly debated at present. It will also be debated in one of the sessions tomorrow, and I don’t want to be accused of front-running tomorrow’s presenters. So let me offer a couple of thoughts, which hopefully we can take up more fully in the morning.

I doubt many in this room will want to dispute the desirability of a risk-based capital framework. Aligning capital to risk is not only the best way to ensure banks have adequate capital, it is also the best way to ensure that that capital is deployed efficiently. But – and it’s an important but – risk-based capital requirements are only as good as our measure of risk.

The evolution of the Basel framework has, until recently, followed the industry in employing greater sophistication and science in the measurement of risk. The use of internal models was introduced into the Basel framework for market risk in 1996, opening the door to the use of credit and operational risk models a decade later in Basel II. At this point, models reigned supreme, and were seen as the regulatory future. Regulators even calibrated the framework to provide significant incentives for banks to invest in models for regulatory purposes, given they were seen to be at the heart of advanced risk management.

Not long after models reached that pinnacle, the financial crisis hit. Discussion quickly turned from a future built on models, to their failure: models went, to put it simply, from the penthouse to the doghouse. Regulators’ reliance on advanced risk models – coupled with capital concessions for banks for building them – all of a sudden seemed a questionable strategy. Then, an additional criticism emerged: models stood accused of being too complex. That led to a line of argument, characterised by Andy Haldane’s ‘The Dog and the Frisbee’[1] speech, that the regulatory community would be better placed relying on simple rules of thumb rather than complex mathematical models of dubious reliability.

So did Basel II send us in the wrong direction, as some have suggested?

My own view is it did not. Directionally, Basel II was on the right path. Seeking to improve the risk sensitivity of Basel I was a necessary and entirely sensible objective. What we might now reflect on, and which I hope we might explore tomorrow, is whether we were seduced by the science, and embraced complexity without sufficient regard to other objectives such as transparency and comparability. If so, it does not mean we need to completely retrace our steps. We just need to find a better balance, recognising that models can certainly help improve our assessment of risk when used judiciously.

Nevertheless, we now find ourselves at a fork in the road. To model or not to model is the question being debated. For my part, I support continuing with the use of internal models as part of the regulatory framework, albeit there needs to be:

• a stronger set of constraints;
• more consistency in modelling practices;
• a greater degree of conservatism; and
• a recognition that some risks are beyond the ability of even the most clever quants to reliably measure.

And while we are at it, we might reasonably debate the extent to which the largest banks in the world need sizeable incentives to invest in advanced risk management techniques: surely it is in their interests to do so, without the need for significant regulatory subsidies? But equally, I am happy to concede that regulators will not be able, particularly in an international agreement such as the Basel framework, to always produce better measures of risk than individual banks. We should not ignore all that models have to offer, just because some aspects have not lived up to expectations thus far.

The under-appreciated art of supervision

Let me turn now to the respective roles of regulation and supervision.

‘Regulation’ is often thought of as the sum of statute, standards and associated guidance material that determine the rules by which financial firms must operate, and ‘supervision’ as the process by which we seek to ensure that firms stay within the rules. Under such a definition, the rules are the key, with supervision acting in a supporting role to police them.

The immediate response to the failings of the financial crisis was that we needed a stronger set of rules. There was a less emphatic reaction when it came to supervision. Indeed, in some cases it was judged that it was not so much the rules that failed, but the people tasked with policing them. As with models, supervision was seen as not living up to expectations, so more prescription, and less supervisory discretion, was largely the order of the day.

In my view, this downplaying of supervision was far from ideal. Good supervision is an under-appreciated art, and it has lacked sufficient attention and investment in the post-crisis response. Furthermore, the ‘supervisors police the rules’ philosophy is likely to tend towards a compliance-based approach: “if something is not prohibited by the rules, it’s OK.” I would argue that such an approach is unlikely to be forward-looking, responsive, assertive or, ultimately, effective.

An alternate philosophy recognises that no set of rules can adequately and efficiently deal with something as complex as a financial system. This philosophy views supervision as the primary means by which we can promote long-term safety and soundness of financial firms, and regulation is a tool that supports and empowers supervision. Such an approach can be tailored and take account of nuances and subtleties in individual and national circumstances in a manner a rulebook cannot, and will be more flexible and responsive than a ‘regulation first’ philosophy. And done well, supervisors can and should be one of the best countercyclical tools at our disposal.



If these benefits exist, why does the ‘regulation first’ philosophy seem to hold sway? I suspect there are a few reasons:

• First, supervisors did not see, at least any better than anyone else, the complex build up of risks that led to the financial crisis, and so did not intervene actively or early enough. (Of course, when many were working within the constraints of a ‘regulation first’ philosophy, that may be a little unfair.)
• In the context of a global crisis, collective action was needed. It is much easier for the rest of the world to observe that Norman has strengthened the banking regulatory framework here in Hong Kong than it is for us to judge the extent to which the quality and quantity of his supervisory experts and approach have been enhanced.
• And then there is also the not-so-small problem that supervisors also have to be paid for, year in and year out, whereas new regulations, once on the statute books, have no direct cost to the Government's budget.

Indeed, it is tempting to see regulation as the low cost option. But we all know regulation is not costless. To give an example, we recently made a change to risk weights in Australia, raising the risk weight for mortgages under the IRB approach to an average of around 25 per cent, from the previous 16 per cent. In very rough terms, this added A$10 billion to the capital requirements of the banking system. If one assumes that the banks’ cost of equity is roughly around 10 per cent, the additional cost from this one change is in the order of 15-20x the total operating cost of my organisation’s banking supervision activities each year. Against that backdrop, a few more supervisors are not that costly at all!

A lack of willingness to place more faith in supervision has in my view been a major contributor to the pipeline of international regulation that continues to flow. Giving some greater thought to the relative benefits of regulatory and supervisory approaches, and devoting some time to strengthening the latter as well as the former, might allow us to not only draw a line under current rule-making efforts, but also to achieve our objectives in a lower cost manner.

Disclosure and market discipline – a fickle friend

The next question I wanted to pose is: how can we better enlist market discipline to aid our cause? Underlying the concept of Pillar 3 - which has its origins in Basel II but is now an important component of insurance regulation as well - is a view that markets should be supported to act as a disciplining device on wayward financial institutions. Unfortunately, this is another area where expectations have yet to be matched by reality. As an ally for the supervisor, market discipline has tended to be a fickle friend.

Of course, we always knew there were limits to this form of discipline. Retail depositors, even if not protected by deposit insurance or other similar arrangements, cannot be expected to actively monitor the credit quality of their bank, and inevitably rely on the (explicit or implicit) backstop of the government. And at the other end of the spectrum, we have learnt the hard way that sophisticated investors may well have undertaken more complex analysis but, at least for the largest institutions, reached the same conclusion - that by virtue of these firms being 'too-big-to-fail', they too could rely on the backstop of the government. This meant, during the pre-crisis good times, investors - debt as well as equity - seem to perversely reward banks on the basis of 'capital efficiency' (ie minimisation) ahead of 'capital sufficiency'.[2]

The expectation of a government backstop has been one area where, unfortunately but necessarily, expectation has been matched by reality. Some governments were even forced to bail out the holders of capital instruments. And by allowing over-leveraged banks to strengthen their balance sheets by shedding assets and constraining lending, rather than being more forcefully recapitalised, we have seen shareholders effectively bailed out too. If this remains the prevailing expectation, then we have an even bigger problem than we thought: not only will markets fail to adequately act as a disciplining device, but they will continue to encourage and reward excessive risk-taking. The costly misallocation of credit will again be the result.

A key issue to be resolved is therefore the extent to which we can engineer a world in which disclosure, and the resulting market discipline, can help in banking regulation. If we can, there may be instances in which disclosure might work better than, or at least as well as, more regulation. We cannot expect markets to appropriately monitor financial institutions and correctly price their underlying risk if there is no incentive to do so. Having instruments that investors truly understand and expect will bear loss if a financial institution is failing is critical to market discipline working as intended. Some further discussion on what else we might do to promote the right environment for market discipline to work effectively could well be a worthwhile investment.

Culture – the final frontier

The final question we need to ask is: how the regulatory framework should be shaped by the industry’s culture? To be blunt, how can we avoid just assuming the worst?

For all the weaknesses in regulation, supervision and market discipline, we know there were internal failings within firms that were at the heart of the financial crisis. Standards of collective governance, and individual behaviour, fell a long way short of expectations. Initial attempts to correct this came in the form of executive compensation standards established by the FSB, followed up by efforts to strengthen standards of governance by both the standard-setters and groups like the G30. But increasingly these are recognised as helpful adjuncts to the main game: that is, tackling the underlying culture within financial firms. It is, to a large degree, the final frontier in the post-crisis response.

I don't think anyone on the regulatory side of the fence would be naïve enough to think they can regulate a good culture into existence. Ultimately, the financial sector will collectively determine the values it wants to uphold, and the behaviours it wants to display. Regulators and supervisors can only do so much.

I recently met with the CEO of one of the larger G-SIBs, and we spent some time talking about the efforts underway in his institution to strengthen the bank's culture. There was certainly a major program of activity underway but, to be frank, none of it was particularly innovative or unusual. That prompted me to ask two questions:

• why was it not done before?
• what is to stop it being forgotten again once the current program has been rolled out?

I have had similar discussions and asked similar questions of a range of banks I have met with, and I am yet to get a really convincing answer. But I think it boils done to the fact that ‘doing the right thing’ has not, at least until more recently, been seen as strategically important. And, coming back to the role of market discipline, managers were not being rewarded for putting long-standing principles ahead of short-term profit.

The challenge for the industry is therefore to show genuine leadership and commitment on this issue, and not put it in the too hard basket. I do not pretend this is an easy task, and fully acknowledge that standards of behaviour are far more difficult to define than standards of capital adequacy. However, it is critical to establishing confidence – amongst regulators, let alone the wider community – that the current focus on establishing a strong, ethical culture across the industry is not just a passing fad. That will be the case when, amongst other things, developing and maintaining the right culture is seen as a core part of the organisation's strategy, and critical for its long-term success. If that occurs, then it is more likely reality will match expectations.

Summing up

Let me now sum up. There's no doubt the journey of regulatory reform that we embarked upon in the immediate aftermath of the financial crisis was absolutely essential. Unfortunately, we are still not there yet, but our destination - a more resilient financial system characterised by, amongst other things, better capitalised, more liquid and well managed banks, reduced perceptions of implicit support, countercyclical tools to help limit the extent of future excesses, and an enhanced toolkit for dealing with problems when they arise - is undoubtedly a desirable one.

One might argue that a rationale for the strong emphasis on regulation in taking us to that destination has been that we had a naïve expectation that people, models and markets would all work better than they did. In short, we have depended on a largely regulatory response to the crisis because we lacked faith in those other means to get us to where we want to go.

Even if that’s the case, we should not give up on making them work better. Models can help us, even though they have their limits. We should certainly be exploring how and when supervision can be more effective, at lower cost, than more regulation. We need to seek better ways to harness market discipline to aid our task. And the industry needs to clearly demonstrate how it will put – and more importantly keep – its own house in order. If we are going to match expectations with reality, we have a choice: to lower our expectations in these areas, or to improve what happens in practice. I prefer the latter.

Footnotes

1. See paper titled 'The dog and the frisbee' by the Bank of England’s Andrew Haldane and Vasileios Madouros at the Federal Reserve Bank of Kansas City’s 36th economic policy symposium, "The changing policy landscape", Jackson Hole, Wyoming, August 2012. For those interested, my (far less prominent) rejoinder can be found in a speech titled 'Regulatory reforms - incentives matter (can we make bankers more like pilots?)' to the Bank of Portugal conference on "Global Risk Management: Governance and Control", Lisbon, October 2012.
2. This was contrary to the Basel Committee’s stated objective: 'Market discipline imposes strong incentives on banks to conduct their business in a safe, sound and efficient manner, including an incentive to maintain a strong capital base ….' (emphasis added). See BCBS Working Paper No 7 (September 2001).