Implications For Regulatory Structure

In considering institutional structures for financial regulation it is necessary to assess alternative models in terms of economies of scope, regulatory parity (the 'level playing field') and (in respect of prudential regulation) what might loosely be termed 'prudential logic'. Prudential logic refers in particular to the importance of aligning the remit of the regulator with the risk management function of the regulated organization, so that in the case of centralized risk management of diversified activities, the regulator's perspective is the same as that of management. A mismatch between the regulator's unit of assessment on the one hand, and management's on the other, is likely to lead to trouble (as suggested in Section 3 above).

In the traditional segmented financial structure described in Section 2 a regime of functionally specialized prudential regulators makes sense because different sets of regulatory objectives, techniques and targets are associated with different financial activities. For instance, a traditional-style regulatory framework covering the main areas of activity is summarized in Table 20.4.

Within this segmented industry structure there are no obvious economies

The regulation of international banking Table 20.4 Traditional-style regulatory framework





Investment firms Insurance companies Investor protection Consumer protection


Systemic stability Neutralize moral hazard Depositor protection

Lender of last resort/ deposit insurance Capital requirements (going concern basis) On-site examinations Central bank/bank regulator

Liquid capital mark-to-market valuation (liquidation basis)

Actuarial solvency

Securities regulator Insurance regulator of scope to be gained, nor is there any prudential logic, in combining specialized prudential regulatory functions within a single regulatory agency. Furthermore, regulatory parity is not a serious issue. On the other hand, conduct of business regulation is concerned primarily with fair treatment of retail depositors, investors and savers. Because in this case regulatory objectives and techniques are similar across different categories of financial activity, there is an arguable case for a single conduct of business regulator in terms of both efficiency and regulatory neutrality - regardless of the structure of the financial services industry.

Within the new market environment described in Section 3 above, very different considerations apply. Regulation may in this context be divided up in a number of ways, the most important alternative models being as follows:7

1. functional regulation;

2. institutional regulation;

3. systemic versus non-systemic institutions;

4. regulation by objective; and

5. wholesale versus retail.

Under a functional regulation regime, specialist regulators focus on the type of business undertaken irrespective of which institutions are involved in that business. Individual institutions might then be subject to several regulatory agencies; there would very likely be a mismatch between regulators' disaggregated approach to risk assessment and the centralized risk management adopted by financial firms; and consolidated supervision becomes problematical. New Zealand (see Figure 20A.5 in the appendix) may be viewed as an example of functional regulation but problems of regulatory overlap are minimized because of the authorities' emphasis on market forces and strong internal governance incentives as a substitute for detailed official supervision.

A more effective form of functional regulation might be envisaged, however, if regulators were to mandate a corporate structure for diversified firms that seeks to segregate risks associated with different financial activities. Financial conglomerates could be required to operate through a financial services holding company which would conduct its business through specialized operating subsidiaries separated by 'firewalls'. Those subsidiaries could then be subject to functional regulation by specialized regulatory agencies. An element of institutional regulation could then be superimposed in the form of consolidated supervision of the holding company. This model has now been adopted in the US following passage of the Financial Services Modernization Act in 1999 which repealed key provisions of the Glass-Steagall Act. The new US regulatory regime combines umbrella supervision of the consolidated group by the Federal Reserve, regulation of banks by their primary bank regulators and financial regulation of affiliated non-bank entities by their respective specialized regulators (see Figure 20A.5c in the appendix). However, the main drawback to such an approach, apart from potential regulatory confusion, is that attempts to segregate risks within specialized entities may well prove ineffective and are in direct conflict with the observed trend towards centralized risk management (see, generally, Dale, 1992).

Institutional regulation, in contrast to functional regulation, demands that regulation be directed at financial institutions irrespective of the mix of business they undertake. It has been argued that under this regime 'each institutional regulator would need to apply the business rules appropriate for every function - which would be hugely inefficient in terms of regulatory resources' (George, 1996; cited in Goodhart et al., 1998, Chapter 8). However, this view may be overstated: in the context of a single megaregulator (such as the UK now has - see Figure 20A.1 in the appendix) all regulation is institutional in the sense that the diversified activities of each institution/group fall within the regulatory remit of a single agency which is also responsible for consolidated supervision. On the other hand, in a regime of multiple regulatory agencies specialized by function, 'pure' institutional regulation becomes impossible for the simple reason that institutions are no longer synonymous with functions (although an element of institutional regulation may be introduced through the appointment of a 'lead regulator' for diversified groups).

A third possible regulatory divide is between institutions which give rise to systemic risk and those which do not. Since banks are generally viewed as systemically sensitive this might involve a simple distinction between banks and non-banks. However, as explained in Section 3, changes in the market environment have blurred the risk characteristics of banks and non-banks. An alternative approach would be to identify those institutions, whether banks or non-banks, which are of such a size that their default would pose a systemic threat. The difficulty here is that the failure of even small institutions can in some circumstances have systemic consequences. More generally, given the complexity and fluidity of the present market environment it is impractical to identify systemic risk with some specified subset of financial institutions. On the contrary, the interconnectivity between both institutions and markets means that a systemic threat may originate almost anywhere and be transmitted through a variety of institutional channels.

Another way of dividing up the regulatory function is according to regulatory objective. As noted in Section 2, the relevant prudential objectives in this context are systemic risk, moral hazard and consumer protection, while to these must be added consumer protection in the conduct of business sense as well as market integrity. In assessing the merits of this structural model it is important to stress that there has been a convergence of prudential regulatory objectives (in that systemic risk and moral hazard have become a feature of financial activities other than banking) as well as a convergence of prudential regulatory techniques (reflecting the new supervisory emphasis on value at risk models and internal management controls for all types of financial business). Therefore there is much greater congruence than previously in the prudential regulatory function as it is applied to banks, investment firms, insurance companies and so on. The implication is that there are important potential economies of scope to be gained from combining the prudential regulatory function under one regulatory agency. Furthermore, a single prudential regulator embracing all financial business is consistent with centralized risk management practised by diversified firms and the matching principle of consolidated supervision. Prudential logic therefore points to the desirability of a single prudential regulator which would also be in a position to apply consistent rules across institutions and activities, thereby ensuring regulatory neutrality.

The above is, broadly speaking, the 'Twin Peaks' approach advocated by Taylor which would divide regulatory responsibilities between a single prudential regulator (Financial Stability Commission) and a single conduct of business regulator (Consumer Protection Commission) (see Taylor, 1995). It may be objected that a single prudential regulator would be dealing with three different objectives, namely systemic stability, which calls for a higher degree of risk restraint than the market would provide even without an official safety net; moral hazard which requires regulators to simulate the self-regulatory constraints that would exist in the absence of an official safety net; and consumer protection which is one of the causes of moral hazard. However, since these objectives imply different intensities of prudential regulation, rather than different regulatory techniques, and since systemic risk and moral hazard permeate many areas of financial activity, it would seem neither efficient nor practicable to allocate the objectives to separate regulatory agencies.

It may also be objected that a single prudential regulatory agency would not offer efficiency gains because as a matter of practical necessity there would have to be specialist divisions within the unified agency. Such internal divisions (see for instance the Financial Services Authority's (FSA's) 'functional' divisions in Figure 20A.1 in the appendix) might involve internal transactions costs equivalent to those incurred by separate agencies. While there is no doubt some force in this argument, the key point is that where prudential responsibility lies clearly with a single authority the regulatory function and the group managerial function are much more closely aligned. In other words the scope of these two functions is precisely matched, even though the regulatory and managerial objectives may diverge.

Following publication of the findings of the Wallis Committee of Inquiry, Australia has adopted a regulatory structure that closely resembles the Twin Peaks model described above (Financial System Inquiry, 1997). However, the Reserve Bank of Australia retains responsibility for systemic stability and is specifically responsible for safeguarding the payments system. Similarly, following the establishment in the UK of a single megaregulator, the Bank of England retains responsibility for systemic stability.

A key question that arises in this context is whether a central bank that is deprived of prudential regulatory powers (except, perhaps, in respect of the domestic payments system) can meaningfully be responsible for systemic stability - other than in the narrow sense of crisis management. In any event, the supervisory interface between the central bank and the prudential regulatory authority under such a regime assumes great importance (see Memorandum of Understanding between the FSA and the Bank, summarized in the appendix).

Finally, regulatory responsibilities may be divided according to whether the financial activity concerned is wholesale or retail, on the grounds that retail users of financial services are in greater need of regulatory protection. The differentiation is particularly relevant for conduct of business regulation but since this distinction, too, relates more to the intensity of regulation than to differences in regulatory technique, there would appear to be efficiency gains in combining wholesale and retail business under one regulatory roof.


It has been suggested that the convergence of prudential regulatory objectives and techniques relating to previously distinct financial activities has created potential economies of scope in the regulation of such activities. Furthermore, a single prudential regulatory agency is better equipped to conduct consolidated supervision that matches the consolidated risk management practised by diversified financial firms. Finally, regulatory neutrality and consistency are best assured under a unified prudential regulator.

The housing of conduct of business and market integrity regulation within a single conduct of business regulatory agency similarly offers efficiency benefits. However, there is no obvious case for combining the prudential and conduct of business regulatory functions within a single all-purpose regulatory agency given that the techniques and skills required for those functions are very different.

Whether the central bank should be the single prudential regulatory for all financial activities is a different issue altogether (Taylor, 1997). There have been various inconclusive analyses of the appropriate role of central banks in the regulatory process (see Goodhart and Schoenmaker, 1993). However, if, as is increasingly the case, the monetary authority is divested of its prudential regulatory role yet retains responsibility for systemic stability, the ability to exercise that responsibility depends very heavily on the central bank's working relationship with the prudential regulatory authority.

The argument in favour of a single prudential regulator must be modified to the extent that some financial systems, typically in emerging markets, retain the traditional institutional and functional distinctions between banking, securities business, insurance and so on (see Taylor, 1998). Furthermore in those systems where regulators seek to separate and sub-sidiarize such activities carried on within diversified financial groups, there may be a case for preserving the traditional structure of regulation based on specialized agencies. Nevertheless, the predominance of the specialized regulatory agency model (see Table 20.5) does suggest that regulatory structures have yet to adapt to recent and ongoing changes in financial markets.

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