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Confronting Divergent Interests in Trans-Tasman Regulatory

Arrangements

Edward J. KaneBoston College

Reserve Bank Professorial Fellow

Victoria University of Wellington

March 7, 2005

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Sincere efforts to integrate the private banking markets of any two countries—in particular, those of Australia (A) and New Zealand (Z)—must also plan to integrate their private and governmental systems of banking regulation.

Regulatory integration is complicated because, even if regulatory strategies and control structures(RA, RZ) did not differ greatly between the countries, individual-country regulators are responsible to different sets of taxpayers (TA, TZ) and applicable legislation makes private and governmental regulatory officials accountable to their citizens in disparate contractual ways (CA, CZ).

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Evolving Protocols For Cooperatively Supervising Multinational Banking Organizations

1. Five-page Basel Committee “Concordat” (1975)

a. Home Country: responsible for supervising consolidated entity

b. Host Country: right to regulate local operationsc. Both Countries: share information useful to partner

regulators2. Subset of 44-Page Basel Committee “Core

Principles for Effective Supervision” (1997)3. Ongoing Operationalization of Core Principles

a. Amplifying criteria for making country-by-country assessments of “regulatory effectiveness” (FSAPs)

b. Efforts in Basel II to codify how to share information across countries to allocate capitaland diversification benefits between home and host

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The Basel Concordat and later elaborations call for contact and cooperation between host and parent supervisory authorities.

In the absence of harmonizing contact and cooperation, contractual arrangements that perfectly tied banking regulators in each country to domestic taxpayer interests would design and operate regulatory enterprises to maximize the welfare of citizens of their country.

Such maximizations and cross-border co-operation must respect constraints on powers and tools imposed by each country’s regulatory culture.

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Two Useful Metaphors For Thinking About “Contact and Cooperation”

For Contact: A bridge spanning gaps in the jurisdictions of regulators and supervisors in different nations

For Cooperation: A partnership

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Entailments of the Bridge Metaphor

• specific “structure” • process of styling the structure to serve

functions identified in advance• job of creating actual structures• job of maintaining and adaptively

renovating the structures over time.

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Theme

To coordinate cross-border flows of banking traffic effectively, authorities must focus on building not just an institutional structure, but on reconciling performance-measurement, reward systems and cultural norms to which national and supra-national financial regulatory bodies are subject.

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• Underlying “architecture of incentive conflict:” – impairs performance– delays needed maintenance, and – distorts renovation in ways that limit the ability

of the bridges to carry regulatory and supervisory traffic fairly and efficiently.

• Unresolved incentive conflicts could: – result in an inadequate program of regular

bridge inspection – burden bridge operators with an array of

conflicting goals and constraints.

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Broad Definition of Banking Regulation

Activities in which a Third Party endeavors to intervene in the shaping, pricing, and delivery of banking products in one of three ways:

• by rule-making (e.g., capital requirements); • by monitoring and enforcement; • or by identifying and resolving insolvencies

(i.e., shortages in bank-contributed net worth).

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The Principal Tasks of Individual-Country Financial Regulators Are:

• to limit risks of fraud, discrimination and contract nonperformance in financial transactions;

• to operate a safety net designed to minimize risks of fire-sale losses associated with financial-institution insolvencies and unjustified customer runs; and

• to operate the fraud controls and safety net honorably and at minimum opportunity costto taxpayers.

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• The principal tasks of banking regulation entail protecting the rest of society from excessive risk-taking and capital shortages at individual banks

• As stewards of taxpayer resources, common law implies that protective regulators owe four duties to the representative citizen:1. Vision (maintaining a capacity to recognize risk-

taking and capital shortages in timely fashion);2. Prompt corrective action (being committed to control

the value of implicit and explicit government guarantees);

3. Least-cost resolution (efficiently curing insolvencies that corrective action fails to avert);

4. Truth-telling (keeping taxpayers informed about the true opportunity costs of regulatory strategies).

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A Cooperative “Business Plan” for Operating a Bridge Would Focus On Lane Control,

Renovation, and Maintenance:

• To determine best-practice standards for preventing and resolving financial crises in individual countries;

• To create incentives for these standards to be adopted by member states, nonmember states, and other supra-national financial institutions.

• Major multinational instrument for affecting bank standards and incentives = Risk-Based Capital Requirements

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Evidence of Need for Constant Renovation

• rapid technological change• unprecedented growth in the geographic

reach, asset size, product lines, and political clout of internationally active banks.

• diminishing entry barriers for foreign financial-services firms

• harmful gaps in national and cross-national supervision and regulation that surface in failures of multinational banks.

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It is natural for New Zealand citizens to worry about how well their interests in an evolving global banking system would be represented if they had to be filtered—via either a limited partnership or merger—through their effects on the interests of large Australian banks and Australian regulators.

Harmonization is a Hot-button Issue In Both Countries

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• Although the two countries have agreed to establish a joint Trans-Tasman Council on Banking Supervision, the hopes and fears of A and Z officials differ sharply.

• Australian Treasurer Peter Costello portrays harmonization as a process of negotiation in which a single system of “seamless” regulation—an Australian TAKEOVER—would be the most desirable endpoint.

• New Zealand Finance Minister Michael Cullen took care to label a single regulatory system as merely a “possible endpoint” (Joint Press Conference, Feb. 18, 2005), but contrary rumors abound.

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Second Metaphor: How Extensive aRegulatory Partnership Should A & Z Seek

Definition: Voluntary association of two or more parties for the purpose of managing an enterprise (control) and sharing its benefits and costs (taxpayer consequences).

Five Instructive Models of Rights and Duties:• Dancing partners (until now)• De facto partners (retain substantial exit options)• Limited Partnership (the general partner has all control)• Takeover Merger• Marriage with Pre-Nup (balanced control and sharing)

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“Divergent Perspectives”

Treasurer Costello takes it for granted that dual supervision generates only “duplication and unnecessary cost” for Australian Banks.

• My alternative view is that the excess costs are small and, especially where bank risk exposures and capital positions are hard to observe, two heads are likely to prove better than one.

• New Zealand citizens want to ensure that officials in any post-harmonization regulatory enterprise remain closely accountable for identifying and protecting Kiwi interests and especially for preventing and managing any banking crises.

• It is not for nothing that the New Testament warns of the impossibility of faithfully serving two masters.

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Incentive-Conflicted Theories of Regulation

• To reduce their exposure to different types of risk shifting, a bank’s counterparties typically: (1) strengthen self-discipline at the bank: require the bank to bond

itself in various ways to behave honestly and fairly (B); (2) negotiate a level of deterrent rights (D) that can let them

punish offensive behavior ex post; (3) monitor information on the bank’s ongoing performance and

condition.

• Bonding, policing, and monitoring are not costless. The costs vary inversely with stakeholder expertise and with the transparency of (T) provided by the accounting and disclosure regime under which the bank operates.

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Bonding for Self Discipline

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In the absence of third-party guarantees, private markets force banks known to be experiencing opportunity-cost losses to adjust promptly.

• Troubled banks must do one or all of three things: shrink their footings, raise more capital, or pay higher interest rates on their deposits and other debt.

• In monitoring, disciplining, and resolving banks, the incentives of government officials to act promptly differ from those of private creditorsin important ways. Officials cannot focus only on the economic costs and benefits of the intervention; they must also assess the political ramifications of their interventions in their respective countries.

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Setting and enforcing financial rules are infested with incentive conflict. Within a country, major conflicts exist between and among:

1. Regulators and the firms they regulate;2. Regulators and other Regulators;3. Regulators and the politicians to whom

they must report;4. Taxpayers and the politicians and

regulators they put in office.

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Each country also works out ways for watchdogs to rebalance and fill in gaps in the bonding (B), deterrent rights (D = deterrency), and transparency (T) inherent in its private contracting environment.

• Over time, the interaction of private and government watchdogs generates a regulatory culture.

• A culture may be defined as customs, ideas, and attitudes that members of a group share and transmit from generation to generation by systems of subtle and unsubtle rewards and punishments.

• A regulatory culture limits the ways in which an uncooperative or even unscrupulous individual bank can be monitored and disciplined. It comprises a matrix of attitudes and beliefs about how regulators should act. Behind these taboos and traditions are higher-order social norms that underlie a nation's political and legal environments.

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The character of a country’s Regulatory Culture is spanned by six specific components:

• Statutory Authority and Reporting Obligations• Formulation and promulgation of specific rules• Technology of monitoring for violations &

compliance• Penalties for material violations• Consultation: To guarantee fairness, regulated

parties have a right to due process which imposes substantial burdens of proof on the regulator

• Regulatee rights to judicial review: Intervened parties have an access to appeals procedures that bond the fairness guarantee.

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A country’s regulatory culture grows out of its ethical norms and legal institutions. How much interpersonal trust and accountability a nation’s behavioral norms

generates helps:

• Dictate the structure of regulator-regulatee relationships.

• How information is collected, verified, and used by top regulatory management in making policy decisions.

• NZ’s early-warning system is that Directors are obliged to notify the RBNZ of any inability to comply with attestation requirements.

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• New Zealand’s regulatory strategy is to locate responsibility for the verification of information in the bank: requires top officials to attest convincingly that critical problems don’t exist. This creates a relationship of self-reporting and a more trustful and cooperative series of bank-regulator contacts.

• Australia asks the regulator to identify whether these same problems exists. This creates a more adversarial relationship between regulator and regulatees: one of cat-and-mouse.

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• Each Director of a registered bank in NZ must attest that he or she believes, “after due enquiry,” that:

1. Disclosure statements:a. Contain all mandated informationb. Are not false or misleading.

2. The bank continues to comply with the “Conditions of Registration.”

3. Credit exposures to connected persons were not contrary to the interests of the banking group.

4. Systems are in place to monitor and control adequately the banking group’s material risks and that these systems are being properly applied

• In practice, breaches are reported to the RBNZ immediately and a remediation plan is negotiated and implemented.

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It is Hard to Merge Entities Whose Ways of Doing Business Show as Many Differences as Those

That Exist Between APRA & RBNZ.

Examples:• Single versus multiple supervisors for differently

chartered financial institutions• Prescribed versus relatively unrestricted powers for

banks and bank ownership• Whether central bank is also a supervisory authority• Primary reliance on on-site inspections by government

examiners versus reliance on self-discipline from bank bonding of accounting reports

• Depositor preference in bank liquidations in Australia

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A country’s Regulatory Culture grows out of its ethical norms and the degree of interpersonal trust and

accountability they generate

The culture is a shaped by:a. Recognition and Response lags generated by

bureaucratic checks and balances. b. Regulatory Competition; (globalization: entry of

foreign banks brings entry by foreign regulators)c. Regulatory personnel’s exposure to influence

activity from a discipline-resistant firm’s political clout;

d. Unspoken social norms that protect fraudstersand bumblers against potentially arbitrary regulatory discipline;

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“INFLUENCE ACTIVITIES” IN THE REGULATORY CULTURE

Rules and enforcement are full of incentive conflict and are undermined ex post

and ex ante:• Ex post, by circumventive adaptations in regulatee

contracting and by the character of appeal rightsand political pressure that can be used to weaken enforcement

• Ex ante, by prior conditioning of culture by lobbyists and other advocates for interested parties.

•At all times by Fear of Public “Disapprobation”

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Do We Want Bank Regulation and Supervision to be Games of “Cat and Mouse?”

• When they can, most banks conceal from society’s watchdogs some:

1. Adverse Elements of their Condition and Performance;

2. Unhedged Elements in their Risk Management Program.

• Insolvent banks use disinformational accounting& forecasts to routinely mischaracterize sources of problems and whether they are lasting ones.

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Came in at the wrong time

Example of Adversarial Accounting: US Bankers and Field Examiners Have Different Concepts of

How to Reserve for Loan Losses

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Four cultural norms limit the speed and character of regulatory response:1. Industry-Support Norm: allows innovations

in concealment capacity to expand until their adverse effects can be proven

2. Presumption of Innocence (i.e., Bumbling):Accounting & Control Weaknesses may be tolerated even when mutual trust is evaporating

3. Mercy Norm: favors banks whose problems trace to “bad luck” as against banks that have aggressively or unethically flouted the rules

4. Aversion to failing and unwinding Large or Complex Banking Organizations (TBDA)

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Regulatory Norms, Due-Process Rights,

and Bureaucratic Pressures are

Bound to Prevent Cross-Country

Supervisors from Attacking Emerging

Insolvencies as Fiercely as NZ is Prepared to Do

Now.

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Three Principal lessons from banking crises in other countries:

• Delays in closing or Recapitalizing Economically insolvent “Zombie” Institutions Contribute Government Risk Capital to owners of these institutions;

• Zombie institutions can expand Government-Contributed Risk Capital by rapidly increasing the Size or Riskiness of their enterprise;

• Conscientious government officials responsible for the loss exposure of a deposit-insurance fund have to overcome accounting, bureaucratic, and political obstacles thrown up to “buy time” either individually or collectively for zombie firms and their managers.

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Forbearance: Regulatory Cultures Set Limits on Examination and Enforcement

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• Regulatory officials must focus on the quality of regulatee information flowsand dealmaking activity.

• To establish even limited control over a universe of individual regulatees, a regulator must establish, enforce, and readapt protocols for verification, disclosure, truth-telling, promise-making, promise-keeping, and conciliation.

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Regulatory Culture Must Fit into Dimensions of Private Contracting Environment

Transparency: Measures the ease with which accounting and disclosure standards let outsiders track changes in value of bank capital and loss exposures

Bonding: Measures Protection provided by:- Reputation and capital of the bank - A country’s cultural and professional standards forbankers and financial watchdogs- A country’s informal and legal penalties for fraud and misrepresentation.

Regulatory Accountability:- In the absence of effective bonding, Regulators and Supervisors must continually adapt their rules, monitoring, penalties, and administrative procedures to overcome clients’ political clout and innovations in bank concealment capabilities.

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Regulatory Cultures of A and Z Generate Sharply Different Incentives with Respect to

Regulatory “Forbearance.”

It does not pay watchdogs in NZ:• to keep runs by Keynoters “Silent” • to underdiscipline troubled banks• to deny danger and pray for good luck or

at least a “clean getaway”

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US Has Moved Toward the NZ Culture

1. Sarbanes-Oxley requires attestations2. New US Regulatory Norms: Increase Transparency

and Accountability to Promote Prompt Corrective ActionBeginning in 1993, U.S. regulators have made themselves accountable for delays in exercising appropriate discipline by making forbearance decisions transparent.Efforts to hold supervisors Accountable in post-1993 “Material Loss Reviews” (MLRs) for the size of the insolvencies experienced extract the supervisory lessons learned from the accounting tricks, delays, and forbearances supervisors countenanced in notable bank failures. These MLRs are published on agency websites.

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COMMON FEATURES in MLR’sStrategic Sources of Failure

Rapid and concentrated growth in a risky and often innovativeactivity or strategy

Deficient Risk Management: Severe Underdiversification of Risk accompanied by weaknesses in Verification and underwriting Procedures

Aggressive or Fraudulent Accounting Not just Nonresponsive, but downright pugnacious managementExtravagant CEO compensation

Assessment of Examiner and Enforcement Performance- Inadequate in some important respects

Recommendations for Change:Make “Strategic Sources of Failure” into Red Flags for extended follow-up examinations and strong enforcement actions.

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Lessons from MLR for Hamilton Nat'l Bank (10% to 13% Loss Rate)

Relatively Traditional Patterns of Loss Generation and Loss Concealment:

--High-growth concentration of risky loans in Latin America--New Capital injected yearly over 1997-2000, but capital weakness

concealed by overstating loan quality & under-reserving for loan losses

--CEO compensation extravagant.11 years of conflict with examiners: In 1991, cited poor underwriting

practices; in 1995, deficiencies in credit files; in 1998, criticized country concentrations and surge in adversely classified assets.CAMELS composite mistakenly rose to 1 after 1997 IPO, but fell to 2 in 3-98, 3 in 11-98, 4 in 12-99 and 5 in 11-01 failed 1-02.

Efforts to reclassify bank as: “PCA-undercapitalized” begun in 3-01; delayed 3 mos. by “Request for Hearing.”

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It is interesting to speculate on how differently the NAB’s FX options scandal might have unfolded in a culture that incentivizes self-reporting and transparency instead of hide-the-cheese.

In the scandal, A$360 million in bank funds was lost and covered up by four poorly supervised options traders.

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APRA’s report (23 March 2004) on this scandal blames the inadequacies in supervision exclusively on the corporate culture of NAB, and not at all on its own examiners nor on the regulatory culture APRA has established.

• The corporate culture of regulated banks is a policy instrument in that the supervisor is responsible for working out the bank control structure jointly with top bank management.

• APRA implicitly acknowledges this in its regulatory response to the scandal by not firing board members and mandating a series of detailed changes in particular processes of oversight.

• Even with the benefit of hindsight, APRA proposes to fix what it explicitly defines as a cultural problem by re-engineering examiners’ tick boxes.

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In NZ, if the scandal had gone so far, the bank’s directors and top executives would have been held responsible:• Their reputations would be ruined.• Legal proceedings against them would be quickly

underway.

New directors would be tasked with:• Figuring out how to protect themselves and other

bank stakeholders from a repeat situation in the future• Meeting the burden of convincing the RBNZ that the

reforms they propose were adequate to that task.