The analytical report attempts to review the strategic issues in the differentiated financial regulation within the international banking sector and the likely future effectiveness of these approaches taken. The report also examines the existing gaps from the financial regulation scope as related to a series of financial activities, with a focus on lightly regulated or unregulated entities. Therefore, the paper will centre on the prudential regulation and supervision of banking institutions at present and their probable effectiveness in the foreseeable future.
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Prudential Regulation and Supervision of International Banking Institutions
In 2008, the leaders of G-20 agreed to review the differentiated scope and nature of prudential regulations within the banking sector. In the following year, a report entitled Enhancing Sound Regulation and Strengthening Transparency identified the financial instrumentation and institutionalisation of regulations as prerequisites for leveraging off international banking institutional bodies. These regulations were then institutionalised and adopted by the G-20 members (Williams & Conley, 2014).
Banking institutions across the globe have networks of structures and legal entities that offer a myriad of services across different multiple jurisdictions and interdependencies. The 2008-2009 financial crises showed the contribution of these banking institutions towards stabilisation of the local and global economies. As a result of their extensive economic reach and integration of a mix of unregulated and regulated entities, banking institutions have the capacity to bridge the gap among sectors (Zimmermann, 2013).
Among the notable prudential regulations activated in 2009 by the G-20 include similarity in regulation and supervision of similar markets, products and activities of the banking institutions and integration of consistent regulations at minimal legislative variances. The supervision regulations were organised to integrate potential risks, especially of systematic nature, arising in large banking instructions or through interconnectedness and interactions among financial institutions of different sizes (Selmier, 2016). In addition, the international standards implementation guidelines were merged to guarantee consistency and avoid regulatory arbitrage or competitive issues.
Current Issues and Gaps in Prudential Regulation and Supervision of Banking Institutions and Future Likely Effectiveness
Banking institutions have a significant economic function but might threaten the stability of the financial markets at global and local levels. Over the years, supervisory authorities, governments and central banks have attempted to examine the potential and actual risks of these banking institutions (Butzbach, 2016). In the process, high costs have been incurred by these bodies in mitigating the anticipated and actual impacts of these banking institutions on the general financial stability.
Since banking institutions offer a series of services such as insurance, securities and retail banking, a mix of this service charter has the potential of blurring the traditional regulatory and supervisory boundaries in other sectors (Williams & Conley, 2014). Moreover, the banking institutions are governed by a network of legal structures and entities to derive cost savings and synergies in order to take advantage of variations on supervision, taxation and regulation. Therefore, these frameworks guarantee long-term success in the regulation prudency.
Although the regulatory framework has been effective in controlling the activities of banking institutions, there is a gap in managing how unregulated institutions should be handled when computing their financial adequacy.
The variances in the definition of banking institutions, in terms of calculation of entities, create challenges for supervisory bodies in assessing risks of these institutions, their capital adequacy and consequences for entities that are regulated within the banking institution (Bakir & Woo, 2016). These variances create extensive gaps when entities that are not regulated are used in lowering the capital requirements of regulated banking institutions, reducing institutional capital adequacy obligations and blurring the distinctions at local and international levels (Selmier, 2016). This loophole may encourage internalisation of institutional structures that are opaque, complex and interdependent in the long-term.
Another variation is the computation of Intra-group Transactions and Exposures (ITEs), especially when unregulated entities are included. In the ideal implementation, the ITEs empower financial institutions to coordinate their business within their legal structures (Butzbach, 2016). This means that the ITEs have the potential of creating unintended risks and contagion at individual or group entities of financial institutions as evidenced by Lehman Brothers’ failure (Williams & Conley, 2014). The variations in regulation and supervision approaches of these ITEs may make it hard for supervisory bodies to effectively perform risk assessment associated with sustainable business models. Therefore, it is difficult to predict the likely future success from this perspective.
The unregulated entities, especially unregulated main banking institutions, have resulted in the emergence of loopholes for many financial groups at separate jurisdiction. This has the effect of hindering supervision. For instance, any unregulated parent banking institution has no obligation of providing information to unrelated parties such as foreign supervisors (Zimmermann, 2013). As a result, information produced might not be meaningful. Moreover, the existing protocols for sharing and obtaining crucial information are silent on unregulated banking entities that have higher organisational ownership hierarchy.
These variations have created situations where regulatory guidelines and oversight are not captured in all activities of banking institutions. At the same time, there are loopholes on how to deal with the costing implications of potential risks in these regulations at regional and global levels. As a result, several regulatory reforms have been put in place to address these variations (Williams & Conley, 2014). Notwithstanding, the regulatory agencies are now empowered to effectively monitor any perceived or actual risks brought about by these differences to ensure that regulated entities operate within the laid down guidelines in the short and long-term.
Step in Place to Improve Prudential Regulation of Banking Institutions
Prudent financial regulation and supervision is a sector-specific guideline characterised by proactive development of core standards and principles for effective banking. These principles take into account financial system stability and systematic risks with consistency and sustainability. However, there are variations in the value attached to market conduct supervision and prudent regulation by supervisory authorities across the banking sector.
Despite the fact that the regulatory boundaries have been blurred through international integration of the banking institution, the sector-specific prudential regulation still faces the risk of an increased number of differentiated supervision. In order to immunise this risk, a multi-agency approach has been integrated into the prudential regulation mechanisms that are currently in place.
As noted by Williams and Conley (2014), the IAIS, IOSCO and BCBS have embraced the multi collaborative review of how the core regulatory principles should be supervised to accommodate the systematic accounting risks and managed the financial system stability. For instance, several policy frameworks have been endorsed by stakeholders to update and improve consistency in the regulatory principles associated with consumer protection, conduct and prudential expectations.
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In 2009, the G-20 endorsed the need for a collaborative partnership among the standard setters and international banking institutions to accommodate the stability of global and regional financial systems. This has the impact of reducing any systematic risk while improving the stability of the financial systems within the core prudential regulation principles. The empowerment of trendsetters, such as IAIS, IOSCO and BCBS, has empowered these supervisory authorities to continuously revise and review their core supervision principles to monitor the stability of the financial system (Selmier, 2016).
As a result, these trendsetters have made it clear to banking institutions about their role instability of the overall financial system through adherence to the overarching principles. The actions of increasing the consistency in the core principles have contributed to reducing structural regulatory gaps. For instance, the trendsetters have laid down strategies for strengthening the core principles’ consistency associated with consumer protection and market conduct. At present, there are enough core principles on customer protection and market conduct to enhance confidence and benefits of customers in the banking sector. This assurance has reduced the magnitude of regulatory arbitrage with regards to financial products and their distribution at local and international levels.
Another significant improvement in prudent regulation of the institutional banking risk is an expansion of the minimum capital adequacy within the banking sector to lower regulatory arbitrage at regional and international levels. In 2011, there was a unanimous declaration among the G-20 members to create a uniform minimum capital standard for security products within the banking institution to facilitate effective prudential regulation of cross-border banking institutions.
For instance, the BCBS’s primary supervision principles incorporate guidelines for a consistent and similar risk-based minimum capital standard to minimise inequalities associated with competition at the regional level to safeguard the stability of a financial system. As noted by Butzbach (2016), the IAIS and IOSCO have guiding principles empowering supervisors to broaden capital requirements within the G-20 member states banking institutions.
Over the years, the IAIS, IOSCO and BCBS have incorporated their mandate and working guidelines to establish uniform cross-regional standards that are appropriate to ensure that similar rules apply to the same activities. As a result, there has been a decline in the regulatory arbitrage opportunities and increased stability of the financial system in their areas of supervision (Bakir & Woo, 2016). As observed by the G-20, “in order to avoid regulatory arbitrage, there is a need for greater consistency in the regulation of similar instruments and of institutions performing similar activities, both within and across borders” (Butzbach, 2016, p. 242).
Over the last five years, there has been a consistent trend in developing replicable and high-quality cross-regional standards to reduce regulatory arbitrage opportunities by ensuring that similar banking activities are subjected to the same rules.
The previous global financial meltdown has inspired increased concern and collaboration in an attempt to create standard cross-regional banking principles. At present, variances in the regional regulatory principles must be justified unlike before. For instance, policymakers have proposed deliberate actions to regulated banking institutions that provide services beyond their home country by capturing their spectrum of risks and activities (Pal & Clark, 2015).
As noted by Butzbach (2016), the lessons observed from the 2008 financial crisis and cost implications in the near-failure or failure of banking institutions have confirmed the significance of prudent regulation of these financial groups. As evidenced by the impact of the 2008 financial crisis, the assumed risks by unregulated banking institutions may affect an entire banking sector, including those entities that are regulated (Selmier, 2016). In order to remain effective, the supervisory activities have been transformed into a framework that treats and captures all the entities and risks within the banking sector at the group-wide regulation level.
The IAIS successfully underscored the significance of effective supervision of banking institutions through the creation of a taskforce in 2009 with a mandate of reviewing the benefits of creating a common prudential regulation framework (Pal & Clark, 2015). Over the years, the recommendations of this committee has resulted in progressive improvement towards supervision and strengthening of financial systems of banking institutions.
Recommendations to Improve the Future Likely Success
Banking institutions that are active past their home county boundaries should be subjected to regulation and supervision capable of capturing the full spectrum of risks and activities. Due to inconsistency in the regulatory guiding principles, some banking institutions, especially in underdeveloped financial systems, are subjected to supervisory principles that are silent on potential or significance of risks associated with costs.
In order to make the prudent banking institution regulation more multifaceted and systematic, there is a need for development and endorsement of a consistent and clear framework for regulation that covers all financial risks and activities at local and international levels (Woo, 2016). In order to make the current regulatory principles sustainable and effective in long-term, these frameworks should define the responsibilities and powers of supervisory authorities in addition to supplementing the applicable regulations at individual and regional banking activities. Since there is no global standard set for capital adequacy within the banking sector, the IAIS, IOSCO and BCBS have limited mandate to their region of operations.
As a result, there are competitive inequalities within different jurisdictions, regulatory arbitrage and instability in some banking systems across the globe (Selmier, 2016). Therefore, there is a need to strive at setting a uniform global minimum capital standard to improve the present prudential standards and make the financial system more stable and predictable on the foreseeable future.
As a result of diversity in the regional and cross-border regulatory and supervisory frameworks for banking institutions, there is a need to improve the region-wide prudential supervision through implementing and practicing regulation at regional level.
Therefore, there is a need to update and review the 1999 joint forum guidelines on regulation of financial conglomerates. In 1999, the guiding principles issued by the joint forum covered prudent and sound management, capital adequacy, risk concentration and intra-group exposures and transactions among others (Tiernan, 2015). However, the current dynamics within the banking sector are more complex than the way they were in 1999. Therefore, the proposed review may focus on information access, oversight and standardised formula for computing capital adequacy. These principles should be adjusted to ease a more effective process of monitoring risks and activities within a banking institution at cross-border level.
The prudential regulation and supervision of the banking institutions has improved following the 2008 financial crisis. Several trend setters are currently empowered to regulate the minimum capital requirement, risks, disclosures and level of customer satisfaction. Although these trend setters operate in different jurisdiction, there is a common agreement across the globe to strengthen these banking institutions to guarantee stability in the financial system. Although the current regulatory frameworks are effective, there is a need to improve on their scope and uniformity to minimise differences associated with variations in banking policies.
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