Financial Sector Governance and Banking Insolvency

1. Financial Sector Governance and Banking Insolvency V. Sundararajan Deputy Director Monetary and Exchange Affairs Department International Monetary Fund Policy Challenges for the Financial Sector in the Context of Globalization Washington DC June 5-7, 2002

2. The Governance Nexus

3. What is Governance? • Institutions and practices by which authority is exercised • Arrangements by which incentives of managers, owners, and other stakeholders are aligned: • Principal - agent • Principal - principal • Principal - stakeholders

4. This presentation: Looks at interaction between regulatory governance and corporate governance of financial intermediaries in: • Normal times • Times of distress • Times of crisis

5. 1. Corporate governance of financial intermediaries during normal times • Is essential to implement effective corporate governance over the firms in which they invest How does this happen? • Financial firms are owners and asset managers • Debt as a “controlling device”: • Insolvency regime/creditor rights • Conciliation/out-of-court restructuring • Effective loan classification/loss provisioning as a foundation for corporate restructuring • Role of capital markets • “Caveat emptor” emphasis with strong disclosure regime • Portfolio decision of asset managers/investors • Take-overs/corporate control markets

6. 1. Corporate governance of financial intermediaries during normal times • Faces problems that are different from the corporate sector, because financial intermediaries have special attributes that intensify standard corporate governance problems (opaqueness, highly regulated, government ownership)

7. 1. Corporate governance of financial intermediaries during normal times • Therefore, regulators and supervisors need to provide right incentives to instill good governance practices in financial intermediaries How does this happen? • Financial sector supervision: • Of internal controls and systems • Intervention arrangements • Voluntary “code of good corporate governance”, backed by authorities • Regulations on ownership/fit-and-proper • Listing rules, market abuse rules, market integrity regime

8. 1. Corporate governance of financial intermediaries during normal times • Disclosure, audit regime • Prudential, customer, governance disclosure • Consumer education • Managerial incentives (Other regulatory agencies) • Broader competition policy • LOLR • Deposit insurance

9. 1. Corporate governance of financial intermediaries during normal times • Good regulatory governance is important to provide • incentives to the sector in a credible manner • Components of good regulatory governance are: • Agency independence –cum- accountability • Transparency in actions and decisions • Measures to ensure integrity of agency staff • Through FSAPs, and the assessments of compliance with • financial sector standards and codes, the IMF and the World • Bank try to improve regulatory governance.

10. Regulatory Standards and RG Proper governance structure a precondition for effective regulation Operational independence Adequacy and legal protection of staff (integrity) Enforcement powers for supervisors (accountability) Clarity and transparency of regulatory process Transparency Code and RG Desirable set of transparency procedures to improve RG Accountability and its disclosure Integrity of the regulator and its disclosure Independent pursuit of regulatory policy and its transparency Regulatory operations transparency Financial Sector Standards and Regulatory Governance (RG)

11. 1. Corporate governance of financial intermediaries during normal times • Good regulatory governance is effective and sustainable only with good public sector governance • Good public sector governance implies respect of the state for the institutions that govern economic and social interactions among them: • Absence of corruption • Approach to competition policy • Effective legal environment • Effective judicial system • Government ownership • As long as political interference in the regulatory process is not costly for the politicians, regulatory governance can not be effective

12. 2. From “normal” times to “times of distress” • When under stress, incentives for good financial sector governance tend to disappear • Financial intermediaries tend to take actions that reflect poor governance, including: • attracting deposits with higher interest rates • loosening risk management • inflating collateral • Many of these actions are meant to “present a better balance sheet”, and to avoid supervisory actions or intervention

13. 2. From “normal” times to “times of distress” • In these circumstances, regulatory governance starts to • matter significantly • Danger for political (and industry) interference grows under these circumstances • Supervisors need to anticipate steps and actions • Supervisors need to enforce rules and regulations strictly • Supervisors should not apply forbearance • To withstand these threats, independence, accountability, transparency and integrity are needed

14. 2. From “normal” times to “times of distress” • In sum: • Balance of importance between market discipline and supervisory oversight shifts to the latter • Within “supervisory toolbox” emphasis shifts to intervention tools

15. 3. From “times of distress” to “crisis management” • When distress turns into a full-fledged crisis, good regulatory governance becomes even more critical • It could be argued that good governance frameworks established for “normal times” suffice for crisis management • It is certainly so that good governance frameworks will pay off in crisis times

16. 3. From “times of distress” to “crisis management” • However: • Crisis management requires exceptional measures • Crisis management requires appropriate institutional arrangements • Both requirements force us to revisit and strengthen • regulatory governance frameworks under these • circumstances

17. 3. From “times of distress” to “crisis management” • Exceptional measures: • Measures need to be innovative, creative • Outcomes unknown, unpredictable • What could be “exceptional” measures? • Emergency liquidity support, blanket guarantee, deposit • freeze, closure of unviable institutions,valuation of assets, • recapitalization, AMC’s • Accountability and transparency as leading governance • principles- Crises increase the level of uncertainty. • Transparency is needed to reduce levels of uncertainty.

18. 3. From “times of distress” to “crisis management” • Appropriate institutional arrangements: • Need for political leadership: • Budgetary impact • Burden sharing--redistribution of wealth • Breaking vested interests • Institutional structure that supersedes individual agencies temporarily • Governance structure that is independent, accountable, transparent, and with integrity, helps to: • Create credibility of crisis resolution actions • Allows speedy decision making • Avoids duplication and institutional overlap • Reduce uncertainty

19. Regulatory governance in crisis management: Exceptional measures should be formulated and implemented in a transparent manner The four components of Regulatory Governance should underpin all exceptional institutional arrangements 3. From “times of distress” to “crisis management”