Designing a System of Financial
Regulation
Howard Davies
Director - London School of Economics
Executive Public Policy Training Programme
Beijing
20 June, 2006
Five Steps to Reform
1. Assess the strengths and weaknesses of the financial system
2. Determine the desired future shape of the system
how flexible?
how open?
3. Assess compliance with international standards
4. Review the structural options
5. Map them against local market conditions
1. The Strengths and Weaknesses
of the Financial System
Global Financial Stock 2004 (%)
China is becoming a significant part of the global system
16.5
23
4.5
Eurozone
UK
Japan
China
Rest of World
6
15
Source: McKinsey Global Institute, 2006
Financial Depth – Financial Stock as %
of GDP 2004
China’s financial system is already well-developed
450
400
350
(%)
300
250
200
150
100
50
0
Japan
US
UK
Eurozone
China
India
Source: McKinsey Global Institute, 2006
Bank Deposits as % of Financial Stock
But it is very heavily dependent on banks
70
Percent (%)
60
50
40
30
20
10
0
US
Eurozone
India
China
Source: McKinsey Global Institute, 2006
Chinese Share of Global Financial Stock
(%) 2004
And the capital markets are relatively small
Percent (%)
10
8
6
4
2
0
Private Debt
Government
Debt
Equities
Bank Deposits
Source: McKinsey Global Institute, 2006
2. The Desired Future Shape of the
System
• Meet WTO commitments
• Strengthen competitive pressures: greater
flexibility
• Expand capital markets as a source of finance for
growth
» equities
» private sector bonds
• Improve financial services for lower income
families, and in remote areas
3. Compliance with International
Standards
The International Financial Architecture
G7
Finance Ministers
International
Monetary
Fund
Financial Sector
Assessment
Programmes
World
Bank
ICFC
Global Financial
Stability Report
Financial
Stability
Forum
ADB IADB EBRD etc
A. Banking Supervision
Bank of International
Settlements
Basel Capital
Accord
G10 Governors
+ Heads of
Supervision
Basel Committee
G10 + Spain, Luxembourg
EC
ECB
Central Banks and Supervisors
B. Securities Regulation
IOSCO-
Core Principles
Multilateral MOU
C. Insurance Regulation
IAIS -
Solvency Standards
D. International Accounting Standards
4. Review the Structural Options
Four main models in operation elsewhere
• ‘3 pillars’:
banking, securities and insurance
separately regulated
• ‘Twin Peaks’: separation of prudential and
conduct of business regulation
• ‘Hybrid’:
where two or more sectors are
regulated together
• ‘Integrated’:
a single regulator covering most
or all of the financial sector.
There is no clear consensus about
which model is ‘best’.
Structure of Supervision in 77 Countries, 2002
Agency supervising two types of financial intermediaries
Indicator
Countries
Single supervisor for
Banks and
Banks and
Securities firms
Multiple
the financial system
securities firms
insurers
and insurers
supervisors
Austria, Bahrain,
Dominican
Austria, Belgium,
Bolivia, Chile
Argentina, Bahamas,
Bermuda, Cayman
Republic, Finland,
Canada, Colombia
Egypt, Mauritius,
Barbados, Botswana,
Islands, Denmark,
Luxembourg,
Ecuador, El
Slovakia, South
Brazil, Bulgaria, China,
Estonia, Germany,
Mexico,
Salvador,
Gibraltar, Hungary,
Switzerland,
Guatemala,
Greece, Hong Kong
Iceland, Ireland,
Uruguay
Kazakhstan,
(China), India,
Japan, Latvia,
Malaysia, Peru
Indonesia, Israel, Italy,
Maldives, Malta,
Venezuela
Jordan, Lithuania,
Africa, Ukraine
Cyprus, Egypt, France,
Nicaragua, Norway,
Netherlands, New
Singapore, Rep. of
Zealand, Panama,
Korea, Sweden,
Philippines, Poland,
United Arab Emirates
Portugal, Russia,
United Kingdom
Slovenia, Sri Lanka,
Spain, Thailand,
Turkey, United States
% of
counties
29
8
13
9
38
in the
sample
Source: Luna Martinez and Rose (2003)
There is a trend towards integrated
regulation for a number of reasons
- growth of financial supermarkets
- risk transfer between sectors
- attractions of ‘one-stop shopping’
Main Reasons for Adopting Integrated Supervision
(agencies indicating any one of the following reasons
Reasons
Number of
Agencies
Percentage of all
agencies
Improve the supervision of a financial system
moving towards universal banking
14
93
Maximise economies of scale and scope
12
80
Solve problems resulting from poor
communication and lack of cooperation among
existing supervisory agencies
4
27
Minimise gaps in the regulation and supervision
of financial intermediaries
3
20
Facilitate operational restructuring of regulatory
agencies (in particular, after a financial crisis)
3
20
Overcome other weaknesses in the overall
quality of financial regulation and supervision
2
13
But there are also important
variations between integrated
regulators
- scale
- scope
- powers
Powers of the Integrated Supervisory Agencies
over Banks
Regulatory and supervisory agencies
Number of
agencies
% of all agencies
Conduct on-site examinations
15
100
Conduct off-site examinations and surveillance
15
100
Impose sanctions and fines for non-compliance with
rules and regulations
15
100
Set prudential regulation on market, credit, operational,
and liquidity risks
12
80
Set accounting rules and information disclosure
requirements
11
73
Set rules on the composition of capital
11
73
Approve and revoke a license to a financial intermediary
11
73
Set minimum capital requirements
10
66
Set licensing requirements
9
60
Consumer protection (assist to resolve claims for abuses
against users of financial services)
9
60
Source: Luna Martinez and Rose (2003)
How the Centres Rank in Terms of their
Regulatory Environment
Market participants tend to favour integrated regulation
Average Score
20
18
16
14
12
10
8
6
4
2
0
London
New York
Paris
Frankfurt
Source: Z/Yen, 2005
5. Map options against local market
conditions
China now operates a ‘3 pillar’ model, but
with banking supervision outside the central
bank
• suitable where there is little ‘cross-sectoral’
activity
• also where a single agency might be seen to be
‘too powerful’
• and where sheer scale makes effective
management difficult.
Regulatory Reform in China is under way
- 3 commissions: CBRC, CSRC, CIRC
- International Advisory Councils
- Training
- Culture of challenge
- Overarching body to resolve inconsistencies
and promote co-operation
An integrated regulator might be more
appropriate if
• banks are allowed to undertake other
activities: universal banking
• derivatives markets develop, allowing risks
to be transferred between sectors
• multi-functional overseas firms enter the
markets on a large scale
Designing a System of Financial
Regulation
Howard Davies
Director - London School of Economics
Executive Public Policy Training Programme
Beijing
20 June, 2005