Financial Regulation In South Africa

Bamber w Falkena w Llewellyn w Store

2000

FINANCIAL REGULATION IN SOUTH AFRICA

Financial Regulation in South Africa

by Hans Falkena (Chairman) Roy Bamber David Llewellyn Tim Store

Financial Regulation in South Africa

The information in this publication has been derived from sources which are regarded as accurate and reliable, is of a general nature only, does not constitute advice and may not be applicable to all circumstances. No responsibility for any error, omission or loss sustained by any person acting or refraining from acting as a result of this publication is accepted by the Policy Board for Financial Services and Regulation and/or the authors.

Copyright © 2001 by the authors All rights reserved. No part of this publication may be reproduced or transmitted in any form or by any means without prior written permission from the publisher. ISBN 1 919835 10 5 Second edition, first impression 2001 Production of this publication funded by: Bank Supervision Department of the South African Reserve Bank Financial Services Board Published by: SA Financial Sector Forum www.finforum.co.za P O Box 1148, Rivonia 2128 Fax: +27 (11) 802 3127 e-mail: [email protected] This publication is available on the Internet at: SA Reserve Bank: www.resbank.co.za Financial Services Board: www.fsb.co.za SA Financial Sector Forum: www.finforum.co.za

Set in Times New Roman/Arial 10/9 point by the SA Financial Sector Forum Printed and bound by Monty Print cc Financial Regulation in South Africa

FOREWORD Financial regulation is a topic that does not enjoy a widespread or thorough understanding. It is often regarded as obscure, arcane and yet another level of bureaucracy that has to be endured by the private sector. The importance of designing and maintaining an efficient and effective system to regulate financial markets, financial institutions and financial service providers lies at the very core of a nation’s economic wellbeing. The collapse of the banking system in many Southeast Asian countries during the closing years of the twentieth century and the economic hardships attendant on these events, are perhaps the most dramatic recent examples of how important the implementation of efficient and effective financial regulation is. The financial system in general, and the banking sector in particular, has experienced substantial structural changes since the 1980s. One of the main challenges for financial regulators has been to keep up with and adapt to these changes, which are often of an international nature. In South Africa the financial regulatory system has undergone enormous change during this period, including the transfer of responsibility for banking supervision from the Department of Finance (now known as the National Treasury) to the South African Reserve Bank in 1987, the establishment of the Financial Services Board in 1989 and the creation of the Policy Board for Financial Services and Regulation by Act of Parliament in 1993. An extract from the Mission Statement of the Policy Board reads: “The Board wishes to promote and maintain a safe and sound financial system which will be fair to investors, effective in supplying financial services to all, well structured and co-ordinated in terms of financial and regulatory matters.” It is in line with this objective that the Policy Board has commissioned this report. The report has the following aims: • To capture the current “state of the art” of financial regulation in South Africa and the world. • To catalogue and describe the underlying philosophy, guiding principles, ultimate objectives, intermediate goals, and targets associated with financial regulation. • To review experience and trends in local and international regulation. • To draw conclusions about the effectiveness of current regulation in South Africa and what still has to be done. I commend the reading of this report to all who wish to, or should, know more about financial regulation. Obviously, this has been an ambitious project that is unlikely to satisfy everyone. The report contains conceptual ideas of an exploratory nature and no recommendations should be construed as representing the final view of the authorities. Gill Marcus Chairperson of the Policy Board for Financial Services and Regulation

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PREFACE In all countries, the financial system is more regulated and supervised than are other industries. On systemic and consumer protection grounds alone, it is almost universally accepted that this should be so. Over time it has become abundantly clear that regulatory arrangements have a powerful impact on (i) the size, structure and efficiency of a financial system; (ii) the business operations of financial institutions and markets; and (iii) competitive conditions both overall and between subsectors of the system. Depending upon how the objectives of regulation are defined, and how efficiently regulatory arrangements are related to their objectives, the impact of regulation can be either benign or malignant. Some regulatory structures are more likely to contribute to the ultimate objectives than others. Accordingly, regulation has the capacity to do great harm, to be inefficient by imposing unwarranted costs on regulated institutions, and even to be perverse (i.e. to operate counter to the objectives of regulation). The skill, therefore, is to seek regulatory institutions, structures and mechanisms that maximise the explicit objectives of regulation while minimising imposed costs. This also means that effective mechanisms for supervision and enforcement need to be instituted, as these are as important as formal regulatory requirements in the overall regulatory regime. Effective regulation cannot secure its objectives in the absence of efficient supervision and enforcement. The potential costs of regulation have to be viewed in a far broader light than the actual transactions costs incurred. In particular, the impact on the economy as a whole and the cost imposed on consumers should be considered. The devising of effective regulation is comparatively easy when six “ideal conditions” are satisfied: • Competitive pressures in the financial system are weak; • the financial system is based on subsets of specialist financial institutions, each conducting a narrow range of business, so that there is a reasonably precise parallel between function and institution; • the structure of the financial system and the business operations of financial institutions are reasonably stable; • the moral suasion of the regulatory agencies is universally accepted; • the business of financial firms is predominantly domestic in nature; and • simple and limited objectives of regulation are set. The more the actual conditions move away from these “ideal conditions”, the more complex and challenging the regulatory process becomes. For regulation to be effective (in that it contributes to its objectives) as well as costefficient it has to adapt and respond to changes in institutional and market circumstances. The more these change, the more flexible the regulatory arrangements should be. Conversely, regulation becomes more demanding, and has to be more adaptable, as the objectives of regulation become more subject to change (more particularly the balance between systemic stability, efficiency and consumer protection). Moreover, as the competitive environment in the financial system becomes more intense and less stable, the business practices of financial institutions and the overall structure of the financial system in turn become increasingly subject to change. In many countries the financial system in general, and the banking sector in particular, are passing through a period of substantial structural change. The system is subjected to the combined impact of internal competition, global competitive pressures, changes in regulation, new technology and the fast-evolving strategic objectives of financial institutions and their existing and potential competitors. The past two decades resulted in major diversifications (e.g. under the pressure of deregulation and competition), and there was a decisive shift towards the emergence of financial conglomerates. Above all, the competitive environment intensified markedly as banking and other sectors of the financial system faced more inter-sector competition, increased competition from a more innovative capital market, and global competitive pressures.

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It seems that during the next decade, the challenges for regulation will remain formidable for three central reasons: (i) the process of structural change will continue, which will require regulation to adapt to, and efficiently reflect, the changing competitive and structural environment; (ii) what is required of regulation has become more extensive, and some of these requirements may be in conflict; and (iii) the environment will be particularly demanding, as each of the six “ideal conditions” noted above will become increasingly undermined. In many countries the institutional structure of regulation has recently changed or is in the process of being changed. Different models of institutional structure are available. For instance, some countries (notably the UK) have adopted the mega-regulator concept where all regulation is placed within a single, all-embracing agency. Australia, on the other hand, has adopted the “Twin Peak” approach whereby two agencies are created: a single prudential regulator for all institutions, and a single conduct of business regulator for all financial services. There is no universally accepted ideal model. Many different criteria can be applied. However, when considering the structure of regulatory institutions, a major issue is how the requirement for adaptability can be achieved. The key is how to devise a structure of regulatory institutions so that regulation has the maximum potential to adapt to changing conditions. A major issue in this dimension is the role of consultation between the regulator and regulated, and the extent of participation of the regulated in the regulatory process. The two cases are at opposite ends of a regulatory spectrum: the regulator imposing regulation with Olympian detachment, versus self-regulation with minimum external interference. In practice both extremes are untenable, though this still leaves open the issue of at what point along the spectrum the balance is to be struck. This report is directed at those interested in or affected by financial regulation and, particularly, financial regulators. The objectives of the research are to • provide comprehensive information about the theory and practice of financial regulation; • discuss, in particular, the objectives, goals, targets and instruments of regulation, as well as their alignment; • focus on the issue of the appropriate balance between statutory regulatory constraints and market incentives; • discuss international trends in regulation and how regulation evolved in South Africa; • suggest a possible future regulatory regime for South Africa and identify the key issues associated with such a regime; and • suggest areas for further investigation and research. The approach of this report will be along the following lines: Chapter 1 discusses the relationship between the overall regulatory philosophy of the government and the generally accepted regulatory objectives and principles. Chapter 2 focuses more specifically on regulatory objectives and the goals, while Chapter 3 highlights the arsenal of regulatory instruments available within the overall regulatory regime. Chapter 4 combines the instruments and objectives of regulation into an overall regulatory matrix. Chapter 5 examines financial crises, the lessons learnt and the regulatory responses. Chapter 6 describes the current regulatory structure in South Africa, discussing it in terms of financial instruments, markets and institutions. Chapter 7 views regulatory changes in South Africa over time with three snapshots: the regulatory structure in the 1980s, the structure in the 1990s and the likely structural scenario by 2010. This chapter includes an executive summary of outstanding policy issues and the priorities in South African financial regulation. Although the authors take full responsibility for the content of the report, we gratefully acknowledge the contributions of the following people: Rob Barrow; Patrick Birley; Graeme Brookes; Kevin Daly; Rinno Kuitert; Tom Lawless; Peter Redman; Bob Tucker; Bill Urmson; Philip van der Walt; Franso van Zyl and Melonie van Zyl. The task group of the Policy Board for Financial Services and Regulation Johannesburg: August 2000 vi

Financial Regulation in South Africa

CONTENTS Chapter 1: PHILOSOPHY, OBJECTIVES AND PRINCIPLES OF FINANCIAL REGULATION 1. 2. 3. 4.

Introduction General philosophy Objectives of regulation Regulatory principles 4.1 Efficiency-related principles 4.2 Stability-related principles 4.3 Conflict-conciliatory principles 4.4 Principles related to the regulatory structure 4.5 General principles 5. Conclusion Chapter 2: THE RATIONALE AND OBJECTIVES OF REGULATION 1. Introduction 2. Rationale for regulation 2.1 Systemic issues associated with externalities 2.2 Market imperfections and failures 2.3 Economies of scale in monitoring 2.4 Consumer confidence 2.5 Consumer demand for regulation 2.6 The “gridlock” problem 2.7 Moral hazard 3. Hazards in regulation 4. Objectives, intermediate goals and targets of regulation 4.1 Objectives of regulation 4.2 Intermediate goals of regulation 4.3 Targets of regulation Chapter 3: THE REGULATORY REGIME 1. Introduction 2. Alternative approaches 3. The components and instruments of the regulatory regime 3.1 Rules and regulations 3.2 Official monitoring and supervision 3.3 Intervention and sanctions 3.4 Incentive contracts and structures 3.5 Market monitoring and discipline 3.6 Corporate governance 3.7 Discipline on and accountability of the regulators 4. Instruments of regulation Financial Regulation in South Africa

1 1 1 2 3 3 5 6 7 8 10 11 11 11 12 12 13 15 15 16 16 17 17 18 18 22 26 26 26 31 31 32 32 33 34 36 37 37 vii

Chapter 4: AN INTEGRATED TARGET-INSTRUMENT APPROACH TO FINANCIAL REGULATION

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1. Introduction 2. The overall regulatory strategy matrix 3. The regulatory regime and intermediate goals 3.1 Rules and regulations 3.2 Official monitoring and supervision 3.3 Intervention and sanctions 3.4 Incentive contracts and structures 3.5 Market monitoring and discipline 3.6 Corporate governance 3.7 Discipline on and accountability of the regulators 4. Deregulation and reregulation 4.1 Deregulation 4.2 Reregulation and self-regulation 5. Summary

41 42 42 45 59 60 61 64 67 69 76 78 80 81

Chapter 5: REGULATORY RESPONSES TO GLOBAL FINANCIAL DISTRESS 1. Introduction 2. Underlying causes of financial crises 2.1 Macroeconomic causes of financial crises 2.2 Regulatory causes of financial crises 3. Global regulatory responses to financial crises 3.1 Improvements in the financial system’s infrastructure 3.2 Enhancing market discipline and sanctions 3.3 Improving the supervision, monitoring and enforcement capabilities of all players 3.4 Promoting monetary and financial stability 3.5 Regulatory arrangements 3.6 Recent trends in regulatory practice 3.7 Summary

83 83 84 86 88 88 91 92 100 103 112 114

Chapter 6: THE CURRENT REGULATORY STRUCTURE OF THE SOUTH AFRICAN FINANCIAL SYSTEM IN THE INTERNATIONAL CONTEXT 1. Regulation of financial instruments 1.1 The definition and nature of financial instruments 1.2 The regulatory regime and structure for financial instruments 2. Regulation of financial markets 2.1 Difficulties in defining a financial market 2.2 The nature of over-the-counter and regulated markets 2.3 The instruments traded on financial markets 2.4 The aggregation of financial instruments into basic markets

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116 116 116 116 118 118 121 123 125

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2.5 Types of financial markets and their regulation 2.6 The regulatory regime and structure of financial markets 3. Regulation of financial market participants 3.1 Financial market participants 3.2 The regulatory regime and structure for financial market participants Chapter 7: ASSESSMENT OF THE FINANCIAL REGULATORY REGIME IN SOUTH AFRICA 1. Introduction 2. The evolutionary trends in South African financial regulation 2.1 The socio-economic environment during the past few decades and prospects for the next decade 2.2 The regulatory regime in the 1980s 2.3 The regulatory regime of the 1990s 2.4 The expected regulatory regime in the 2000s 3. Regulatory targets and gaps 3.1 Competitive market infrastructure 3.2 Acceptable maturity and currency mismatches 3.3 Acceptable cross-market exposures 3.4 Sufficient market liquidity 3.5 Securities markets as an alternative to financial intermediation 3.6 Regulatory effectiveness, efficiency and economy 3.7 Proper risk assessment 3.8 Proper financial institutional infrastructure and suitability standards 3.9 Global institutional competitiveness and competitive neutrality 3.10 Integrity, fairness and competence 3.11 Adequate product and service competitiveness 3.12 Transparency and disclosure 3.13 Adequate access to retail financial services 3.14 Protection of retail funds 3.15 Retail compensation schemes 4. Conclusion 4.1 Summary 4.2 The way forward INDEX

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126 133 140 140 144 154 154 154 155 157 159 162 169 169 170 171 172 173 174 176 178 178 179 180 180 181 182 183 184 184 185 189

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Chapter 1 PHILOSOPHY, OBJECTIVES AND PRINCIPLES OF FINANCIAL REGULATION 1. Introduction Financial regulation can be approached from three different – albeit complementary – perspectives. Firstly, there is the perspective of general philosophy. This is essentially a discussion of the nature of regulation, and describes the rationale of regulation and the philosophical approach of a country to the regulation of financial sector activity. Secondly, there is the perspective relating to the specific objectives to be attained through the regulation of financial sector activity. Thirdly, there is the perspective concerning the broader principles to be applied when formulating regulatory arrangements and structures for the financial sector. Although these three perspectives are closely related, it makes sense to discuss each separately. From the viewpoint of the financial sector practitioner the discussion will be on the principles that are most visible and, at the operational level, that are immediately relevant.

2. General philosophy In any country the general philosophy of financial regulation is, to a considerable extent, shaped by the accepted norms and conventions of the financial community, as well as the general philosophies and ideologies supported by the political authorities. From a broader perspective, the discussion of the general philosophy can be pursued at two levels. At the higher level the discussion revolves around the ideologies regarding the role and operation of economic markets (financial markets in particular), whereas at the lower level the concern is more with the specific role assigned to the regulation of the financial sector. With regard to the higher level, the role of regulation should reflect the views of the type of economic system that is appropriate for a country. Currently, Financial Regulation in South Africa: Chapter 1

industrial countries and many developing economies place a considerable premium on a market-oriented approach. This approach assumes that the working of the market mechanism will, in general, produce the best results in terms of efficiency and the allocation of financial resources. The efficient allocation of such resources would also imply an efficient allocation of physical resources. Consequently, in most countries the general philosophy is firmly anchored on the belief that market mechanisms produce optimal decisions and resource allocation. However, it is also acknowledged that the market mechanism does not operate perfectly under all circumstances and that the role of regulation is to provide redress against identified shortcomings and market imperfections. In other words, allowance has to be made for the use of regulation to secure a high degree of overall economic efficiency, thereby compensating for the negative aspects of unfettered market activity. With regard to the lower level, the specific problems of financial markets are at issue. It is recognised that financial markets have their own unique characteristics, and that participants in these markets differ from participants in other markets in so far as their activities have a more general impact on economic activity. Accordingly, the working of financial markets as a whole should facilitate rather than impede the efficient operation of the financial system. Regulation therefore has to be both effective (in that it achieves the objectives) and efficient (i.e. is cost-effective in the use of resources). There is also an important economic dimension in that regulation should not impose unwarranted costs on the economy and consumers nor impair the efficiency of financial markets. This dimension also considers whether the objectives of regulation could be achieved in less costly ways. These considerations can be judged 1

following cost-benefit analyses of regulatory requirements. There should always be an awareness that specific regulation can inflict damage if it is either flawed or incorrectly applied. In such a case it would actually impair the working of the market mechanism and produce perverse results – i.e. counter to the objectives of regulation. It is also at this lower level that the nature of the process of regulation1 has a considerable role to play. The process of regulation consists of two basic activities: the provision of guidance and the imposition of constraints. More specific arguments in favour of regulation are that there may be a need to redress monopoly powers, to compensate for spill-over costs owing to market imperfections such as moral hazard or “gridlock” problems2, and to facilitate the dissemination of adequate market information. Regulation in finance also has a major “consumer protection” role as consumers may not always have sufficient information upon which to make judgements, and the failure of financial contracts may impose considerable hardship on consumers. To ensure fairness to consumers, the regulatory authorities have to set guidelines and operational constraints which address inter alia moral hazard problems. The general philosophy regarding the regulation of financial markets therefore implies that the regulatory authorities and the regulated parties both have an interest in the creation and maintenance of an effective and efficient system of regulation.

3. Objectives of regulation Given the general philosophy, it follows that the ultimate objective of regulation should be to achieve a high degree of economic efficiency and consumer protection in the economy. At a more practical level,

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The term regulation is used in a generic sense that encompasses regulation (the establishment of specific rules of behaviour), monitoring (observing whether the rules are obeyed), supervision (the more general observation of the behaviour of financial firms) and enforcement (ensuring the rules are obeyed). See Chapter 2, Section 2.6 for further details.

however, three specific objectives of regulation are of particular relevance: • Securing systemic stability in the economy: For any economy it is of the utmost importance that its financial markets run smoothly and are not subjected to shocks of their own doing, caused inter alia by: ineffective or inefficient trading, clearing and settlement systems; poor market infrastructures; or a major lack of market liquidity. Another major consideration in this regard would be the maintenance of the integrity of the payments system and, in financial markets, the securities delivery system3. • Ensuring institutional safety and soundness: In their efforts to promote efficiency, the regulatory authorities should exercise extreme caution not to impose – even inadvertently – regulatory obstacles or barriers that would impair the safety and soundness of financial institutions irrespective of whether or not there is a systemic dimension. Firms have to be adequately profitable, have sufficient capital to cover their overall risk exposures, be able to face global competitive forces and also have “suitable” directors, management and staff. • Promoting consumer protection: Wherever asymmetric information flows are evident, and where the consumer can potentially be exploited, there is an important “consumer protection” role for the regulatory authorities. Integrity, transparency and disclosure in the supply of financial services have to be promoted. These services have to be supplied by competent staff and consumers should have access to the full spectrum of retail financial services. In instances where consumers are wronged, there should be effective and cost-efficient compensation arrangements. Even with this limited number of objectives, conflicts can arise between them. For instance, increased competition may result in greater efficiency, but may adversely affect the stability of the financial 3

2

Called DVP – i.e. delivery versus payment

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system. Likewise consumer protection measures, such as single-capacity trading, may impact adversely on competition and hence efficiency. The more objectives that are set the more demanding the regulatory process becomes. This is especially so because the complexity of the financial system and of the business operations of institutions increases. Efficient regulation requires a multi-dimensional approach, which in turn entails an optimising process. Firstly, the approach requires a clear definition of objectives. Secondly, the impact of each regulatory or deregulatory measure on each objective needs to be measured. Thirdly, an appropriate structure of regulatory arrangements should be devised, taking the above into account. Fourthly, the fulfilment of all aspects of policy (and not only regulation) becomes more difficult as the number objectives to be satisfied increases, most especially if different policy agencies are involved. This suggests a prima facie case for a simple set of objectives. Care should be taken not to make the objectives unnecessarily sophisticated. Any move in such a direction would undermine the efficiency of regulation in contributing to its objectives. The aim should be, therefore, not to encumber regulation with a multiplicity of objectives that it is ill equipped to deliver. This is not intended to deny the legitimacy of other (perhaps social) objectives that may be secured through financial mechanisms. However, these are more appropriately attained by other means (e.g. tax incentives) rather than by regulation. An example may illustrate this point. Suppose the authorities wish to encourage a distribution of investment different from what the market mechanism – based upon the riskreward criteria of financial institutions – would achieve. In this case, rather than impose, say, prescribed asset requirements which would result in a suboptimum portfolio, a more efficient approach would be to offer tax incentives to take up such investments. A further example from the UK, relating to competition and contestability, is provided in Box 1.1 overleaf. This example is also of relevance to South Africa – see Box 1.2. Financial Regulation in South Africa: Chapter 1

Therefore, financial regulation should be restricted to a narrow range of objectives – it should not be employed as a means of achieving the wider economic and social objectives of the political authorities. This is so for three crucial reasons. Firstly, the regulation of financial institutions and markets is not the most efficient way of securing wider social objectives. Secondly, the wider the objectives, the greater the complexity of regulation as well as the potential for conflicts. Thirdly, these wider objectives are legitimately in the realm of the public accountability of the political rather than the regulatory authorities. Moreover, it is extremely hazardous to involve regulatory authorities in wider political issues. In short, the objectives of financial regulation should not be political issues.

4. Regulatory principles The third dimension of regulation refers to a set of principles to be applied when formulating regulatory policies, specific regulatory requirements and the structure of regulatory institutions. The principles are derived from the philosophy and objectives and can be grouped into five categories: (i) efficiency-related principles; (ii) stability-related principles; (iii) conflictconciliatory principles (relevant to address potential conflicts between objectives); (iv) regulatory-structure principles; and (v) general principles.

4.1 Efficiency-related principles Principles classified in this category are designed to contribute to the promotion of a high level of efficiency in the provision of financial services. Two such principles can be identified: • Promoting the maximum level of competition among market participants in the financial system; and • securing competitive neutrality between actual or potential suppliers of financial services. The reason generally advanced for promoting a maximum level of competition among market participants is that competition is likely to enhance market efficiency. Efficiency is further increased if 3

competition causes the removal of restrictive practices that impair trading in financial assets and the rationalisation of market activity. The maximum attainable level of competition requires relative freedom of entry into the financial services industry as well as relative freedom of choice regarding the financial services that any market participant chooses to provide. Taking note of the globalisation of financial markets, such freedom of entry should be allowed also in the case of foreign participants, and in turn local market participants should have (virtually) unrestricted access to global financial markets. In the financial market environment, the maximum attainable level of competition among market participants implies full competition among financial exchanges and involves all market procedures and

modes of trading. As a consequence of the relatively small size of the South African financial market, as well as the extent of the facilities being offered, market efficiency with regard to competition can only be optimised if such competition leads to maximum rationalisation in market structures and procedures. A factor militating against the optimisation of market efficiency is the fact that the South African financial markets are not fully integrated into the global markets, mainly owing to exchange control regulations. The achievement of competitive neutrality between market participants would promote a high level of efficiency. Competitive neutrality could be defined as a situation in which no party to a financial transaction would enjoy a competitive advantage as a result of regulation, and different suppliers of financial services

Box 1.1: Limiting the objectives of financial regulation: Competition and contestability1 – United Kingdom In a situation where an industry is not contestable, mergers and acquisitions (M&As) have the inherent danger that they reduce competition (at least in the domestic market). At the same time M&As may improve systemic risk management and institutional soundness and even efficiency. There is currently a debate on a recommendation that: (i) the financial regulatory authorities should become involved in M&A policy; and (ii) contestability in competition policy should be included as an explicit objective of the UK’s Financial Services Authority (FSA). There are several reasons for doubting the wisdom of this: (i) it would almost certainly create conflicts of interest within the FSA, and the FSA could defend almost anything it did by arguing that it was balancing the conflicting objectives of contestability and other objectives it is required to meet; (ii) it would therefore make the FSA’s accountability more uncertain as there would be too many escape routes; (iii) the FSA’s objectives would become too diffused and unfocused; (iv) there would be a potential danger of regulatory overload as more objectives became added; and (v) applying the “target-instrument” paradigm,2 the legitimate and very important public policy objective of sustaining and enhancing competitive conditions in all markets would be more efficiently pursued by a dedicated agency which did not have internal conflicts. Assessment and the evaluation of the effect of activities such as M&As on competition are more powerful when made by an external agency (e.g. in the UK, the Office of Fair Trading (OFT)). In addition, the resolution of conflicts, in the final analysis, may often involve judgements that have a political dimension and this should be made explicit rather than somehow resolved internally within the FSA. The UK’s approach in its Financial Services and Markets Bill (whereby the FSA is required to be conscious of the competition implications of its actions) is a more appropriate approach. The current practice (whereby the OFT is required to scrutinise the competition implications of regulatory agencies in relation to activities such as M&As) works well and is more efficient than internalising the process by establishing competition enhancement as an explicit objective of the regulator. ________________________ 1

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An industry is said to be contestable if there are low barriers to entry and exit. For instance, should M&A activity reduce competition in the domestic banking industry resulting in excess profits, there would be no barrier to the entry of foreign banks. The target-instrument approach establishes that, when each instrument differentially affects each target, all targets can be achieved simultaneously only if there are as many instruments as targets: i.e. there exists some combination of instruments that achieves the desired combination of targets (see Chapter 4 for a further discussion).

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would not have regulatory advantages. From a regulatory perspective this would involve the creation of a “level playing field” for the concluding of financial transactions. In practice this would require competitively neutral legislation as well as the avoidance of any form of functional or institutional discrimination against particular market participants (see Section 4.4 below). In addition, it is important to pursue a minimalist approach to regulation in the sense of redressing only inherent market deficiencies such as externalities4, moral hazards, imperfect competition and natural monopolies. Imperfect competition and natural monopolies could be effectively removed by abandoning regulations and such factors as would impede the necessary rationalisation of market activity.

4.2 Stability-related principles Principles in this category should contribute to the 4

Externalities would include any discriminatory imposts (i.e. taxes, levies or fees) or subsidies, which have effects analogous to regulatory differentiation between market participants, categories of market participants and types of transactions.

promotion of a high measure of stability in the financial system, and an appropriate degree of safety and soundness in financial institutions. Three such principles can be identified: • Incentives for the proper assessment and management of risk; • the use of regulatory requirements (e.g. related to capital) based, where possible, on current market values rather than historic values; and • a willingness of the regulators to take timely action to redress developments threatening the existing and future stability of financial institutions and markets. The proper assessment and management of risk requires the identification and successful handling of such risks. To the extent that the regulatory authorities do not wish to be concerned with day-to-day risk management, they should at least impose acceptable minimum prudential standards to be observed in respect of risk management by all financial sector participants. Appropriate information systems are required for the successful and timely identification of the relevant

Box 1.2: Limiting the objectives of financial regulation: Contestability and mergers and acquisitions – South Africa Late in 1999, the Standard Bank Investment Corporation (Stanbic) was on the receiving end of a hostile +R30 bn (US$5 bn) takeover bid from Nedcor Limited. Of competitive significance are the facts that Nedcor is effectively a subsidiary of the SA insurance giant, Old Mutual plc, while Stanbic also controls the large Liberty Life SA insurance company. It may be noted that the South African banking industry is not contestable because of exchange controls and constraints on foreign banks’ deposit-taking activities. Clarification is required on the responsibilities of the Registrar of Banks (SA Reserve Bank) and the Competition Commission with regard to this and future mergers. In 2000, the Courts ruled that the Minister of Finance in terms of the Banks Act should judge Nedcor’s bid. The Courts found that the Competition Act did not apply because of provisions which exempt “acts subject to or authorised by public regulation”. The ruling raises the prospect that deals in numerous sectors, such as insurance, telecommunications and liquor retailing, will fall outside the ambit of the competition watchdog. This ruling appears to explicitly assign the handling of mergers and acquisitions as an objective of the financial regulators albeit after consultation with the Competition Commission. According to the Minister of Trade and Industry, the ruling was an extreme interpretation, which ruled in favour of exclusivity, and companies would use this as a precedent. It was always the intention of the Competition Act that mergers and acquisitions should be subject to both the competition law and legislation regulating particular sectors. The Minister of Trade and Industry wishes to amend the Act to make it clear that concurrence was intended between the Competition Act and other regulatory statutes – except that the Competition Commission shall not have jurisdiction where the Minister of Finance issues a notice that the proposed merger is in the best interests of the stability of the financial system in the Republic. This matter is still under debate.

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risks. Successfully dealing with the identified risks would demand procedures for minimising risks and establishing adequate capital requirements. In financial markets, cross-market risk management is inevitable, as market participants are likely to operate in different financial markets simultaneously. Therefore, provision should be made for the offsetting of risks, for example between transactions in spot and derivative markets. Since the management of risks is to be conducted by market participants at all levels, the introduction of “fit and proper” standards for participants as well as for trading procedures should enhance financial market stability. From a stability perspective, the use of current market values is extremely important. The viability of an institution can ultimately be determined only by reference to the current (rather than historic) market values of balance sheet items. A major problem in the US, for instance, was that for much of the 1980s many Savings and Loan Associations were trading on a technically insolvent basis obscured by a failure to present accounts on a current-value basis. The continuation of trading meant that the eventual degree of insolvency, and hence the claim on the taxpayer through the deposit-insurance system, became far greater than would have been the case had initial insolvency been detected earlier. This is a controversial issue, particularly when the price of some assets on the balance sheet is prone to volatility. There is a discernable trend in accounting standards towards greater sympathy with current-value accounting concepts. Nevertheless, there are many technical accounting problems to be solved before current-value accounting can fully replace the traditional historic-value accounting. Developments threatening the existing and future stability of financial markets that might have additional disruptive consequences should be dealt with expeditiously. The regulatory authorities, in their role as the issuers of directives and in their capacity as financial market supervisors, should take or initiate the necessary corrective action whenever actual or potential market deficiencies are detected. Postponing 6

action (“forbearance”) could cause an accumulation of adverse effects and unwarranted contagion, which could exacerbate the disruption of financial market activity and consequently pose an ever greater threat to the achievement of financial market stability. Again, the US experience with Savings and Loan Associations illustrates the costs of delayed action.

4.3 Conflict-conciliatory principles As with the objectives of regulation, principles may also be in conflict with one another. Conflictconciliatory principles are designed to resolve potential conflicts between regulatory principles. These conflict-conciliatory principles would involve • following an integrated approach, aiming at the simultaneous achievement of regulatory objectives; and • pursuing a target-instrument procedure, whereby the regulatory instruments would be so selected and applied that they would facilitate the implementation of an integrated approach. The target-instrument approach establishes that, when each instrument affects each target, all targets can be achieved simultaneously only if there are as many instruments as targets: i.e. there is some combination of instruments that achieves the desired combination of targets. Therefore, the value of each instrument is set not only to have positive effects on targets, but also to neutralise the negative effects of other instruments. This analysis, therefore, indicates that, if each of the regulatory objectives is to be secured, a multiinstrument approach is required. This is an optimising approach designed to achieve satisfactory levels of competition, soundness and safety. No single instrument will suffice, and the more one objective is sought, the greater the demand on other instruments to offset the potentially negative effect upon other regulatory objectives. Therefore, a co-ordination of the various objectives and instruments is required. A good example can be found in arrangements made for the protection of the consumer. One way of dealing with potential conflicts of interest that may work against the interests of the consumer is regulation that restricts the Financial Regulation in South Africa: Chapter 1

range of allowable business. If, for any reason, such regulation is eased, it may be necessary to resort to other measures to limit the potential for conflicts of interest. Accordingly there may have to be recourse to dedicated capital, Chinese walls, rules of conduct, compliance officers, disclosure rules, etc.

4.4 Principles related to the regulatory structure A major issue in regulation, especially as financial institutions become more complex and diversified, relates to the structure of regulatory institutions and, in particular, whether regulation and supervision should be conducted on the basis of a multiplicity of specialist agencies or by a single regulatory authority. Three principles are established in this regard: • The following of a functional as well as an institutional approach to the regulation of financial market activity; • the co-ordination of regulation by different authorities and agencies in order to achieve consistency; and • a presumption in favour of a small number of regulatory agencies. The problems of official regulation and supervision multiply when a financial system develops multifunctional institutions or financial conglomerates rather than being based on clearly differentiated functional institutions. A choice has to be made whether institutions or functions are to be regulated and supervised. In a differentiated system the problem does not arise, as institutions and functions are synonymous. Therefore, as structural change entails a trend towards financial conglomerates, a choice has to be made between functional regulation or conglomerate regulation. In the former case, specialist regulators and regulatory arrangements are established to regulate and supervise clearly defined financial activities independently of which institutions are providing the service. This implies that a financial conglomerate may be subjected to the jurisdiction of several regulatory authorities. The alternative is conglomerate regulation, where a single regulatory Financial Regulation in South Africa: Chapter 1

authority is established to regulate and supervise all aspects of financial institutions’ business. Historically, the institutional approach has been dominant, largely because institutions have tended to be specialist in nature. Since the 1990s, however, more emphasis is being placed on a functional approach to regulation. The functional approach places more emphasis on regulating a specific type of activity irrespective of the type of institution involved. This is perceived to be more pervasive, and the presumption is that it would yield sounder results. In practice, however, the institutional and functional approaches need to be employed in parallel because regulatory authorities are concerned with the soundness of institutions – at both the level of the institution and at a systemic level – as well as the way in which particular services are provided. Therefore although it is institutions that become bankrupt and not functions, business practices relate to functions. Accordingly, the approaches need to be synchronised, and some common ground for such synchronisation is found in the fact that risk identification and risk management are common to both the institutional and functional approaches. In terms of the functional approach, self-regulation has adopted an important role. The co-existence of self-regulation and official institutional regulation requires proper co-ordination in order to ensure regulatory consistency. Self-regulation has always been a feature of the South African financial market control system. There is much to commend self-regulation – through recognised bodies – especially if there are built-in safeguards to protect against the obvious potential for an abuse of authority. The self-regulatory body has the required expertise and is in a position to monitor financial innovations. The participants, being members of the industry, have a professional interest in ensuring that standards and public confidence are maintained. They have an interest in ensuring that less scrupulous financial firms do not gain a “free rider”5 advantage 5

Consumers assume that others have investigated the safety and integrity of suppliers of financial services.

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based upon the public’s positive perception of the regulated industry. By eliciting the consent of the regulated, a high degree of compliance with regulations and standards can be secured. It may also be the case that self-regulation is generally concerned with standards, rather than the strict “letter of the law” which may be the case with prescriptive legislative regulation. This is particularly important when the business is very technical and, in a competitive environment, when financial innovation is an important feature of the industry. Above all, self-regulation is more likely to be flexible and adaptable to a changing market environment than regulation based upon legislatively imposed requirements. A consideration in this regard is that it can prove difficult and timeconsuming to have the law amended or revised. In terms of the functional approach, self-regulation has become all the more important – indeed the cornerstone of much financial regulation. The coexistence of self-regulation and official institutional regulation requires proper co-ordination to ensure regulatory consistency. The regulatory structure that has evolved over time could pose difficulties for the achievement of proper co-ordination, as it may prove difficult to merge the responsibilities or to reassign them more effectively. To the extent that responsibilities cannot be merged – the case of selfregulation by a financial exchange and official regulation by the statutory regulatory authorities – coordinating mechanisms need to be introduced. Such mechanisms may consist of co-ordinating boards, committees, or “lead-regulator” arrangements. Without co-ordination there is little likelihood of achieving competitive neutrality between the different financial market participants. Related to cost-efficiency is the issue of the structure and number of regulatory authorities and the relationship between them. When a financial institution, or financial activity, involves more than one regulatory authority, there has to be effective coordination and consistency between them as well as consistent rulebooks and regulatory requirements. The existence of numerous regulatory authorities 8

gives rise to the hazards of complexity, inconsistencies, overlaps, duplication and higher administrative costs. In principle, there must be a general presumption that the fewer the regulatory authorities, the fewer the problems of consistency and co-ordination. However, this consideration must be balanced against the advantage of efficiency to the extent that this requires specialist regulators, especially if there is a strong element of self-regulation. Selfregulation is more effective as the regulated activity becomes more specialised. It is a question of balance between cost-efficiency and administrative effectiveness. The issues are complex as has been demonstrated in virtually all countries with split regulatory responsibilities. The question of the distribution of supervisory responsibilities and co-ordination among different authorities has acquired greater significance in the light of the despecialisation and internationalisation of institutions. National authorities remain divided as to the merits of the centralisation of supervisory responsibilities, with views being significantly affected by the historical legal framework. There is consensus, however, on the need for further cooperation domestically and internationally in areas such as the precise allocation of responsibilities, the exchange of information and, to a lesser extent, greater consistency of supervisory methods.

4.5 General principles General principles are those that have a bearing on the general conduct of the regulatory process. With one or more regulatory instruments being employed in any specific regulatory arrangement, the following general principles may be formulated: • Every regulatory arrangement should be related explicitly to one or more of the objectives identified. • All regulatory arrangements should be justified with respect to their cost-efficiency. • The costs of regulatory arrangements should be distributed equitably. • All regulatory arrangements should be sufficiently Financial Regulation in South Africa: Chapter 1

flexible, in the sense of being amenable to changes in markets, competition and the evolution of the financial system. • Regulatory arrangements should be practitioner-based. Regulatory arrangements (especially with respect to capital) should be precisely related to the objectives they are designed to achieve. If regulatory arrangements are not related to the objectives (in the sense of being consistent with the objectives of financial regulation), negative effects would be inevitable. These negative effects would include the discouraging of competition and the stifling of financial innovation. Accordingly, it is essential that all regulatory arrangements should be applied judiciously. In the context of consumers valuing both the benefits of regulation and competition, and with regulation imposing costs both on consumers and the regulated, regulatory structures and detailed regulatory arrangements need to be based upon explicit costbenefit analysis. The requirement is that regulation should be not only effective, but also cost-efficient. Certain regulatory arrangements may be desirable in terms of the regulatory objectives but may, nevertheless, not be justified in terms of their wider costs. Because of the increased complexity and the wider range of financial services covered, the direct costs of regulation have risen. Given these costs, a judgement clearly has to be made as to how far the objectives of regulation (e.g. protection of the consumer from all possible abuse) can reasonably be pursued and what cost is reasonable to bear. Leaving aside the direct administrative costs, if the result of a totally abuse-free and safe system means a serious impairment of competition, the stifling of financial innovation and the loss of business to foreign centres, then a judgement has to be made, on cost-benefit terms, whether further regulatory imposts yield diminishing marginal returns and so cease to be cost-effective. Regulation is not a free good and the costs of an effective regulatory system and regulatory arrangements are substantial. The question arises as to who should bear such costs – two basic models are employed in most countries as follows: Financial Regulation in South Africa: Chapter 1

•

The costs are borne by a government or parastatal agency and hence by taxpayers in general. This is not necessarily inequitable as a substantial number of taxpayers are directly or indirectly the beneficiaries of an effective regulatory system. • The regulatory agency recovers its costs from the institutions which it supervises. In practice this means that the institutions pass on the costs of regulation to their customers in their pricing structures. It can be argued that this system is more equitable since it places the costs of regulation with those who benefit directly from such regulation, i.e. the customers of the regulated institutions. Neither the structure of financial systems nor the business operations of institutions are static – both evolve over time. Similarly, regulation should also evolve, and a major principle to be applied is that regulation should be a dynamic process which changes to reflect the competitive climate and market environment. If regulation moves out of step with competition, serious business distortions and inefficiencies are likely to arise. Sufficient flexibility of regulatory arrangements would ensure the necessary adaptability to changes and could assist in achieving the regulatory objectives in an optimum fashion by permitting the appropriate response to such changes. Whether they be market changes or changes in competitive positions, they emanate from the continuous process of financial innovation as well as other evolutionary forces present in the national economy. For regulatory arrangements to be practitionerbased, they need to be devised in consultation with market participants. With consultations opening the door for divulging information and responses between regulators and the regulated, the industry would contribute significantly to the development of the regulatory system. Better results would be forthcoming if such practitioner-based regulatory arrangements were employed. By creating a better understanding between the regulators and the regulated, practitionerbased regulatory arrangements would serve the additional purpose of facilitating the regulatory process itself. Overall, explicit arrangements need to 9

be made to ensure that regulated institutions and market practitioners participate in the establishment of specific regulatory requirements.

5. Conclusion Financial systems around the world are undergoing major structural changes, owing largely to increased competition. At the same time, regulatory arrangements have also changed and become more complex. In many countries a global dimension to regulation has emerged. Today the tendency is to harmonise national financial regulation with the international standards set by bodies such as the International Accounting Standards Committee (IASC), the Basel Committee on Banking Supervision (BCBS), the International Organisation of Securities Commissions (IOSCO) or the International Association of Insurance Supervisors (IAIS). In a rapidly changing market environment,

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traditional views about financial regulation should always be subject to scrutiny and challenge. It should never be taken as axiomatic that regulation is always effective and efficient and precisely related to its alleged objectives. If the ultimate purpose of regulation is to protect the consumer and serve systemic interests, then it should be subjected to the test of whether it does so effectively and costefficiently. It also requires that specific regulatory arrangements should be subjected to the same test, for arguments against particular mechanisms may not invalidate the arguments for regulation in general. The precise rationale of all regulatory arrangements and structures needs to be succinctly identified rather than taken for granted. Regulation should, therefore, be an evolving process and responsive to changes in the market environment. Indeed, regulation that remains stable irrespective of changes to the financial system will be inefficient at best and perhaps even perverse.

Financial Regulation in South Africa: Chapter 1

Chapter 2 THE RATIONALE AND OBJECTIVES OF REGULATION •

1. Introduction Financial systems are prone to periods of instability in developed and in developing countries. In recent years, bank failures around the world have been common, large and expensive. This suggests a case for more effective regulation and supervision. There seem to be three common elements in banking crises: (i) bad incentive structures; (ii) weak management and control systems within banks; and (iii) poor regulation, monitoring and supervision. Financial crises are discussed in Chapter 5. This chapter considers the economic rationale for financial regulation: why regulation has welfare benefits, and why it is rational for (particularly retail) consumers of financial services to demand (and therefore pay for) the regulation of financial services firms. It also reiterates the objectives of regulation and breaks them down into intermediate goals and further into regulatory targets. It is useful to distinguish between the rationale for regulation (why regulation is necessary if the objectives are to be achieved), the objectives of regulation (what outcome it is trying to secure) and the reasons for regulation (why in practice regulation takes place). The point of these distinctions is to differentiate between the economic rationale of regulation as opposed to why, in practice, regulation might be imposed.

2. Rationale for regulation Seven components of the economic rationale for regulation and supervision in banking and financial services are identified: • Potential systemic problems associated with externalities. • The correction of market imperfections and failures. • The need for the monitoring of financial firms and the economies of scale inherent in this activity. Financial Regulation in South Africa: Chapter 2

The need for consumer confidence, which also has a positive externality. • Consumer demand for regulation in order to gain a degree of revealed preference for assurance and lower transactions costs. • The potential for “gridlock”, with associated adverse selection and moral hazard problems. • Moral hazard associated with the revealed preference of governments for creating safety net arrangements: lender-of-last-resort, bank deposit insurance and compensation schemes. “Consumer protection” issues arise for two main reasons: the possible failure of an institution where clients hold funds, or because a firm conducts business unsatisfactorily with its customers. The failure of a financial firm may have adverse effects on systemic stability, and also cause loss to individual depositors who are regarded as being unable to look after their own interests. The impact that the failure of financial institutions has on systemic stability and the interests of consumers means that regulators are almost inevitably bound to have a prudential concern for the liquidity, solvency and riskiness of financial institutions. Such regulation must necessarily focus on institutions per se. Conduct-of-business regulation, on the other hand, focuses on the functions of financial firms irrespective of the type of firm conducting the business. Each of these seven components will be discussed in this section in greater detail. Before doing so it is worthwhile to distinguish between the two generic types of regulation and supervision, i.e. prudential regulation and conduct-of-business regulation (see Box 2.1 overleaf). The seven components of the rationale for regulation are discussed in the next two sections whereas the objectives, intermediate goals and targets of regulation are covered in the remaining sections.

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2.1 Systemic issues associated with externalities Regulation for systemic reasons is warranted when the social costs of the failure of financial institutions (particularly banks) exceed private costs and such potential social costs are not incorporated into the decision making of the firm – see Box 2.2. Financial institutions may be induced into more risky behaviour than they would if the potential costs of all risks (including those for the system as a whole) were incorporated into their pricing. Systemic issues do not apply equally to all institutions. They have traditionally been central to the regulation of banks based on four main considerations: • The pivotal position of banks in the financial system, especially in payments systems. • The systemic dangers resulting from bank runs.

•

The nature of bank (debt) contracts on both sides of their balance sheet. • Adverse selection and moral hazard associated with safety net arrangements (lender-of-last-resort facilities and deposit insurance).

2.2 Market imperfections and failures If financial services were conducted in perfectly competitive markets (i.e. if there were no information problems, externalities, conflicts of interest, agency problems, etc.) there would be no case for regulation, and any regulation that was imposed would be a net cost to the consumer. By contrast, if there are market imperfections and failures but no regulation, the consumer pays a cost because the unregulated market outcome is suboptimum. Focusing only on the accountancy cost of regulation (which can be

Box 2.1: Two generic types of regulation Two generic types of regulation and supervision are identified: (i) prudential regulation, which focuses on the solvency, safety and soundness of financial institutions, and (ii) conduct-of-business regulation which focuses on how financial firms conduct business with their customers. Prudential regulation In practice consumers are not in a position to judge the safety and soundness of financial firms. Prudential regulation is necessary because of imperfect consumer information, agency problems associated with the nature of financial institutions’ business, and because the behaviour of a financial firm – after consumers have dealt with it – affects the value of their stake in the firm. No amount of information, at the time contracts are signed or purchases made, protects against the subsequent behaviour of the firm. Leaving aside any potential systemic dimension, there is therefore a case for prudential regulation of financial firms when – • the institution performs a fiduciary role. • consumers are unable to judge the safety and soundness of institutions at the time purchases or contracts are made. • post-contract behaviour of the institution determines the value of contracts taken out by customers. • there is a potential claim on an insurance fund or compensation scheme, because the costs of the hazardous behaviour of an individual financial firm can be passed on to others (those who in the end pay the compensation). If other firms in the industry are required to pay the compensation liabilities of failed institutions, they demand certain minimum standards of behaviour which they are unable to enforce themselves without an external agency’s intervention. Conduct-of-business regulation Conduct-of-business regulation and supervision focuses upon how financial firms conduct business with their customers. It focuses upon mandatory information disclosure, the honesty and integrity of firms and their employees, the level of competence of firms supplying financial services and products, fair business practices, the way financial products are marketed, etc. Conduct-of-business regulation can also establish guidelines for the objectivity of advice, with the aim of minimising those principal-agent problems that can arise when principals (those seeking advice) and agents either do not have equal access to information, or expertise to assess it.

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Financial Regulation in South Africa: Chapter 2

measured) overstates the true cost of regulation because it does not incorporate the value of the consumer benefit if the effects of market imperfections are alleviated. The ultimate rationale for the aspect of regulation designed to protect the consumer is to correct for market imperfections or market failures, which would compromise consumer welfare in a regulation-free environment. There are many market imperfections and failures in retail financial services: • Problems of inadequate information on the part of the consumer. • Problems of asymmetric information – consumers are less well-informed than the suppliers of financial services. • Agency costs – asymmetric information can be used to exploit the consumer. • Potential principal-agent problems and issues related to conflicts of interest. • Problems of ascertaining quality at the time of purchase. • Imprecise definitions of products and contracts. • The inability of retail consumers to assess the safety and soundness of financial institutions except at inordinate cost. • Consumer under-investment in information and resultant “free-rider” problems – i.e. whereby consumers assume that others have investigated the safety and integrity of suppliers of financial services. • Consumers are not all equally equipped to assess quality, etc., because of the technicalities of some financial products.

2.3 Economies of scale in monitoring Because of the nature of financial contracts between financial firms and their customers there is a need for the continuous monitoring of the behaviour of financial firms. There are several characteristics of, at least, some financial products that require a continuous process of monitoring the suppliers of products: it is often the case that long-term contracts are involved; principal-agent problems can arise; the quality of a financial product cannot be ascertained at the time of purchase; and there is often a fiduciary role for the financial institution (see Box 2.3 overleaf). Above all, the value of a product is determined by the behaviour of the supplier after products have been purchased and contracts entered into. This is particularly significant for long-term contracts, since the consumer is unable to exit at low cost. To some extent it may also apply to bank depositors – although they can exit at low cost, depositors may not have the necessary information to make such a decision timeously. The question is who is to undertake the necessary monitoring of the behaviour of financial institutions: e.g. customers, shareholders, or rating agencies. Because most (especially retail) customers are not, in practice, able to undertake such monitoring, an important role of regulatory agencies is to monitor the behaviour of financial firms on behalf of customers. In effect, consumers delegate the task of monitoring to a regulatory agency. There are potentially substantial economies of scale to be secured through a collective authorisation (via “fit and proper” criteria), and the supervising and monitoring of financial firms.

Box 2.2: Social and individual cost of bankruptcy In the case of a bank failure the shareholders may lose all their investments in the bank concerned, which represents the private cost of failure. However, even the bankruptcy of a small bank may have serious ripple effects for other banks or even the payments and settlement system at large. The cost where people start to believe that money is safer under their mattresses than in their bank deposits is the social cost of bank failure and which is usually a multiple of the private costs. A classic example is the bankruptcy of the smallish German bank, Bankhaus Herstat in 1974 that resulted in a major contraction of credit in the Eurobond market at the time. The regulatory authorities are most concerned with the social costs of bankruptcies and their impact on systemic risks.

Financial Regulation in South Africa: Chapter 2

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Box 2.3: Nature of financial products and services Financial products and contracts are different from most other consumer goods and contracts. A central issue in the rationale for the regulation of financial services is the extent to which financial products, contracts and services differ from many other goods and services that are not regulated to the same degree. The key issue is how the consumer ascertains quality, and hence value for money, and the appropriateness of the product or service being purchased. In practice, there are significant differences between (some) financial and non-financial services and these differences are of a degree that makes a case for regulation in finance which does not apply to other goods and services. These special characteristics include the following: • Financial products are often not purchased frequently and hence the consumer has little experience or ability to learn from experience. • The consumer often lacks confidence in making purchases of financial contracts. • There is a lack of transparency – it is difficult to verify the claims being made by the seller. • The consumer frequently requires advice when purchasing financial products – this gives rise to principal-agent problems. • It is often easy for a financial salesperson to conceal relevant information and/or mislead the consumer. • It is usually difficult to detect misrepresentation at the time of purchase. • The full cost of the product may not be known at the point of purchase and it may sometimes be concealed from the consumer. • The product cannot be tested ahead of purchase. • Value is not immediately clear at the time of purchase – the consumer cannot know if a bad product is being purchased. • Value is often critically determined by the personal circumstances of the purchaser. • The value of contracts is determined by the behaviour of suppliers after purchases have been made; this creates the potential for opportunistic behaviour and gives rise to a need for monitoring. No amount of information available at the time of purchase can guard against this potential hazard. • The consumer’s future welfare often depends on the performance of the contract: a faulty product can be replaced, but a bad financial contract cannot be surrendered other than at a (sometimes substantial) cost. • There is no guarantee or warranty attached. • Faults cannot be rectified. • The value of a financial contract rises over time whereas the value of most other products declines. This lowers the net replacement cost of the latter in the event that, at some time in the future, it needs to be replaced due to a fault. • It may be a long time (if at all) before the consumer is aware of the value and faults of a financial contract. This limits the power of reputation as an assurance of good products. Even if, in the long run, reputation is damaged by bad behaviour, consumer wealth is impaired in the meantime. • The purchase often creates a fiduciary relationship with the company, which takes on the responsibility for managing the client’s investment or savings. • Information on reliability is difficult to obtain. • If the firm becomes insolvent during the maturity of the contract, the contract’s value may be lost. These characteristics mean that, in practice, the transactions costs for the consumer in verifying the value of contracts (even when this can be done at all) are high. Because of the nature of the products and contracts, producers can easily mislead the consumer and this may not be detected for many years, and sometimes not until the contract matures, by which time irreparable damage may have been done. In these circumstances, it may not be sufficient to rely on the reputation of the supplier. This means that, in some circumstances (including finance), enforceable and monitored regulation (which has a cost attached) can be justified as an alternative to high transactions costs for consumers. Put another way, the costs of regulation should not be compared with a zero cost base but with the costs imposed on the consumer by any alternative to regulation, e.g. monitoring and verification costs.

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Financial Regulation in South Africa: Chapter 2

2.4 Consumer confidence The known existence of asymmetric information can reduce consumer demand for services and contracts. In a situation where consumers know there are good and bad products or firms, but are unable to distinguish among them at the time of purchase1, the demand for some products may decline. Under some circumstances, and with known asymmetric information features, riskaverse consumers may exit the market altogether. When consumers know there are low-quality products in the market, good products and firms may become tarnished by the generalised reputation of poor products and firms. An additional role of regulation, therefore, is to set minimum standards and thus remove any “lemons” from the market. In this sense, suppliers may also have an interest in regulation that sets minimum standards and enhances confidence in the market.

2.5 Consumer demand for regulation Given that regulation sometimes fails, and has its own costs and problems, some argue the case for private self-regulation reinforced by common, commercial and contract law. One rationale for regulation is that public pressure may resist such an alternative. Although there are costs involved, the consumer may demand the degree of comfort that can only be provided by regulation, supervision and various forms of compensation mechanisms. There is an evident consumer demand for regulation and hence, irrespective of theoretical reasoning, a welfare gain (and perhaps political gain) to be secured if, within reason, this demand is satisfied. There are several reasons that it can be rational for the consumer to demand regulation: • Lower transactions costs for the consumer (e.g. saving costs in investigating the position of financial firms, or costly analysis); • Consumers’ lack of information and inability to utilise information; 1

•

a demand for a reasonable degree of assurance in transacting with financial firms; • past experience of bad behaviour by financial firms; • the value of a contract can be influenced by the behaviour and solvency of a financial firm after the contract is signed and product purchased; • the consumer may be making a substantial commitment in financial transactions; • a preference for regulation to prevent hazardous behaviour by financial institutions as an alternative to claiming redress after bad behaviour has occurred; and • to secure economies of scale in monitoring. If there is a rational consumer demand for regulatory services, the consumer would be willing to pay for them and it is economic to supply them. Regulatory agencies can be viewed as supplying regulatory, monitoring and supervisory services to various stakeholders: financial firms, consumers, government, etc. Unlike most other goods and services, they are not supplied through a market process, but are largely imposed by the regulator, although there may be a process of consultation. This leads to problems: valuable information is lost about what type and extent of regulation consumers demand, and about how much consumers are prepared to pay for regulation. Consumers are not homogeneous, and yet their different demands cannot be signalled through a market process. Above all, regulation is largely perceived as being a free good as, in the absence of a market for regulation, no market price is generated. Therefore the costs of regulation are not deadweight costs. However, there is a major limitation in that the consumer may have an illusion that regulation is a costless or free good, in which case the demand is distorted. If the perception that regulation is costless is combined with risk-averse regulators, there is a danger that regulation could become over-demanded by consumers and over-supplied by regulators.

Because of insufficient and credible information or because the quality is revealed only after the lapse of time.

Financial Regulation in South Africa: Chapter 2

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2.6 The “gridlock” problem There are circumstances when, without the intervention of a regulator, a “gridlock” can emerge. This can arise when firms know how they should behave towards customers, but nevertheless adopt hazardous strategies because they can achieve shortterm advantages and they believe that competitors may also behave hazardously. The detection of hazardous behaviour may occur only in the long run. In such a situation two problems can emerge: adverse selection and moral hazard. In the former, good firms may be driven out of business by bad firms as the latter undercut the former. A firm that behaves better towards its customers than others, and at a cost to itself, may not be able to distinguish itself from others and gain additional business. The moral hazard danger is that good firms may be induced to behave badly either because they see bad behaviour in others, or have no assurance that competitors will behave well. A role for regulation is to set common minimum standards that all firms know will be applied equally to all competitors. Regulation can have the positive and beneficial effect of breaking a gridlock by offering a guarantee that all participants will behave in accordance with certain standards.

2.7 Moral hazard The moral hazard rationale for regulation is linked to safety net arrangements: deposit insurance and lender of last resort. Deposit insurance or protection, applicable mainly to banks, creates five potential moral hazards: • Consumers may be less careful in the selection of banks and may even seek high-risk institutions on the grounds that, if the bank does not fail they will receive the higher rates of interest on offer, and if it does fail they will receive compensation. • The financial firm may be induced to take more risks because depositors are protected in the event that the institution fails. • Risk is subsidised in that, because of insurance, depositors do not demand an appropriate risk premium in their deposit interest rates. 16

•

Poorly managed banks are effectively subsidised by well-managed banks. • The existence of deposit insurance may induce banks to hold lower levels of capital. Likewise, the existence of a lender of last resort can have adverse incentive effects and induce banks to take excessive risks. With or without formal deposit insurance, ultimately governments protect depositors. This seems to be a fact of life, and no amount of theorising about the hazards involved in this is likely to change the situation. Once implemented, there is little political feasibility that deposit insurance will be removed and so, for purposes of analysis, it is taken as given. This significant revealed preference is questioned because governments do not use insurance to protect consumers from the failure of non-financial firms. In the wider financial sector there may also be moral hazards in other forms of consumer compensation arrangements, such as the UK Investors’ Compensation Scheme (ICS): • Their knowledge of such a compensation facility may induce some consumers to take less care and may, under some circumstances, even induce consumers to gravitate to risky suppliers on the grounds of a one-way option – if the contract performs well the consumer keeps the gains, whereas if the firm becomes insolvent the consumer is compensated • The costs of compensation are sometimes transferred to others who are not part of the contract. For instance, in the UK, if a financial adviser becomes insolvent and is unable to pay compensation, the financial industry as a whole is required to make payments to the ICS. The moral hazard is that behaviour may be adversely affected because the risks can to some extent be passed on to others. Overall, the moral hazard is that, when safety net arrangements are in place, financial firms are able, to some extent, to pass on risks to others, and this may adversely affect their behaviour. The moral hazard rationale for regulation is that Financial Regulation in South Africa: Chapter 2

regulation can be constructed so as to reduce the probability that the moral hazard involved with insurance and compensation schemes will be exploited. Moral hazard exists with virtually all insurance contracts (behaviour is likely to change in a way that increases the probability of the insured risk materialising) and private market insurance companies usually take measures to limit the ability of the insured to exploit it. This may take the form of prescriptions to influence the behaviour of the insured.

•

3. Hazards in regulation

To facilitate the management of objectives as well as ease of presentation, the objectives of regulation (Section 4.1) are broken down into intermediate goals (Section 4.2) and then into regulatory targets (Section 4.3). The ultimate objectives are of a broad and conceptual nature, whereas the intermediate goals derived from each objective are more manageable, practical and cover a specific aspect of the broad objective. For example, the regulators’ ultimate objective of institutional safety and soundness can be transformed into a few more specific intermediate goals. One such intermediate goal is a proper financial institutional infrastructure. Each of these intermediate goals is in turn broken down into quantifiable and measurable regulatory targets. For the abovementioned intermediate goal, one of those targets is adherence to minimum capital standards. The regulatory targets can be broken down into much more detail (e.g. capitalisation can be split into the various risk categories such as capital adequacy for market and credit risks), but this publication is aimed

Some potentially serious and economically costly hazards in regulation apply to all sectors of finance (bank and non-bank financial services), whereas others apply more specifically to non-banking. Those that apply generally include• the potential for regulators to be captured, i.e. lose their independence – especially in the case of selfregulation; • the impairment of competition and free market forces; • the extension of regulation because of conflicts and contradictions in regulation; • an asymmetric valuation of the benefits of competition and regulation by risk-averse regulators; and • the danger that regulation may have perverse effects. Three particular hazards apply to the regulation of non-banking services: • The potential for self-regulatory professions to raise members’ income by imposing barriers to entry;

the setting of minimum standards which are detrimental to the welfare of consumers who would otherwise choose to purchase cheap and lowquality services and result in an over-investment in training and the provision of high-quality services; and • “implicit contracts” between consumers and regulators (see Box 2.4).

4. Objectives, intermediate goals and targets of regulation

Box 2.4: Implicit contracts When a regulatory or supervisory authority is created and it establishes regulatory requirements, there is a danger that an implicit contract may be created between the user of financial services and the regulator. This arises when the consumer assumes that, because there is an authorised procedure, specific aspects of regulation have been established and that the supplier of financial services is in some sense authorised and supervised, and that therefore the institution is safe. The obvious danger is that an implicit contract creates the impression that consumers need not take care regarding the firms with which they deal in the area of financial services. This becomes a further moral hazard of regulation, a hazard where regulation itself creates the impression that less care need be taken. Should this occur, it would be counterproductive and one of the worse outcomes of regulation.

Financial Regulation in South Africa: Chapter 2

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at the strategic level. The regulatory targets outlined can be made operational by transforming them into quantifiable yardsticks.

4.1 Objectives of regulation The objectives of financial regulation in the context of the philosophy and principles are discussed in Chapter 1, Section 3. To summarise, the objectives are threefold, namely to sustain – • systemic stability; • the safety and soundness of financial institutions; and • consumer protection. Regulation should not be overloaded by being required to achieve other and wider objectives. This is discussed further in a later chapter.

4.2 Intermediate goals of regulation Each of the ultimate objectives can be broken down into various intermediate goals, as discussed in greater detail below. 4.2.1 The intermediate goals of systemic stability The intermediate goals for achieving systemic stability can be classified under the following headings: Competitive market infrastructure The financial system and markets reach a stage of development where sufficient information is available to allow both domestic and foreign participants to undertake borrowing, lending, trading and the concluding of obligations rapidly, at known and acceptable risks and on a level regulatory playing field. Acceptable maturity and currency mismatches The level of systemic risk management is such that the maturity mismatches of loans and currencies are “acceptable” for companies and for the nation at large. Financial firms use in-house value-at-risk models to monitor these maturity mismatches. The authorities monitor the mismatches and the greater the risk taken, the higher the resulting capital adequacy requirements. Acceptable cross-market exposures Government, the central bank and financial institutions 18

(especially banks) are aware of the cross-market and cross-border exposures on their books and are able to manage the associated risks. Sufficient market depth and liquidity Sufficient liquidity is available from the central bank and financial institutions (especially banks) to enable the free operation of the financial system and markets, especially in times of distress. The market itself is of sufficient depth to survive the impact of large or panicdriven transactions. Securities markets as an alternative to intermediation The securities markets reach a stage of development where they become a major competitor to the banking industry. This is mainly achieved through securitisation – i.e. the process that turns loans into tradable securities. More venture capital, even for small and micro enterprises, are funded – at least partially – through the securities markets. Regulatory effectiveness, efficiency and economy The financial system is guarded against demand- or supply-driven over-regulation because regulation imposes a range of costs (institutional, compliance and structural), which are ultimately reflected in the price of financial services. The authorities avoid regulation that is “excessive” (in that it exceeds what is needed to achieve its limited objectives); or that focuses upon inappropriate objectives; and has a cost that may exceed the economic costs that regulation is designed to prevent. 4.2.2 The intermediate goals of institutional safety and soundness Irrespective of the systemic aspects arising from financial institutions that are in difficulty – and the “toobig-to-fail” dilemma – individual financial institutions and financial markets should be properly structured and managed, and be competitive. The ultimate objective of regulation for safety and soundness of financial institutions is to reduce the probability of financial firms becoming insolvent. The insolvency of financial institutions can be detrimental to consumers even in the absence of system costs. The intermediate Financial Regulation in South Africa: Chapter 2

goals achieving institutional safety and soundness can be classified as follows: Adequate capital resources Banks and other financial institutions have adequate capital as an internal insurance fund to cover risks (e.g. loan defaults that cannot be externally insured). The amount of capital held reflects the risk characteristics of the financial institution. Proper risk assessment The major risk components of a financial firm (market risk, credit risk, liquidity risk, counterparty risk and operational risk) are properly assessed through the new capital adequacy regime of the Basel Committee and backed by sufficient capital. Credit risk is assessed by a standardised approach that relies on external ratings; or by an internal rating approach based on portfolio credit risk models, which provide a more accurate estimate of credit risk. Proper financial institutional and market infrastructure The infrastructure of financial institutions and markets is sound and prudent and supported by adequate national and international technological infrastructure (e.g. a reliable and secure inter-bank payment and settlement system). Suitable (fit and proper) directors and management Financial institutions are owned, directed and managed by competent staff of integrity and follow internationally recognised business codes. Global institutional competitiveness Regulation is closely co-ordinated with governments’ general competition policy to permit financial institutions to effectively compete domestically and globally in an intensifyingly competitive environment and is complicated by the advent of electronic commerce. The creative tension between the pressures of competition and regulation is managed to the benefit of consumers. It may be noted here that, given the special position of finance, and the systemic issues that apply, the question arises about the extent to which the full rigour of competition policy should be applied in the Financial Regulation in South Africa: Chapter 2

financial sector (see Box 2.5 overleaf and Boxes 1.1 and 1.2, Chapter 1, Section 3). Competitive neutrality Globalisation, the advent of the Internet and electronic commerce, and the ability to obtain and act on information rapidly has forced the levelling of playing fields and removed inappropriate and unwarranted regulation which could no longer be enforced. 4.2.3 The intermediate goals of consumer protection Consumers of financial services and participants in the financial system should be treated fairly and protected against unscrupulous or unsound financial institutions. There is a major difference between wholesale and retail business in the sense that the requirements for incorporating the international dimension into regulation are far greater in the former than the latter. To a large extent the regulation of retail business can be left mostly, if not entirely, to purely domestic jurisdictions where each country can choose its own regulatory requirements. It can be argued that, as with other products and services, the main protection for consumers of financial services lies in a combination of competition, information disclosure, reputation and legal redress. At low cost, consumers can shift their business from suppliers with doubtful reputations to their competitors because many firms deliver similar financial products. Financial firms therefore have strong incentives to maintain a reputation for honesty and fairness. However, there are several reasons for being sceptical about too much reliance on this type of reasoning: (i) shifting to other suppliers may not always be a feasible option and some financial products are not subject to repeat purchase; (ii) it may be a long time (if at all) before hazardous behaviour or that an inappropriate or weak product has been purchased becomes apparent; (iii) the consumer may not have sufficient information or capability to assess information, in order to discriminate between alternative suppliers; and (iv) in practice the nature of many long-term financial contracts is such that there may be heavy penalties when existing contracts are 19

cancelled ahead of maturity (because it is common for the total costs of the contract to be deducted from premiums paid in the first or early years). In summary, the consumer is left with the problem of being unable to distinguish between good and bad suppliers of longterm contracts. In some countries there are examples suggesting that complete reliance cannot be placed on free competition and reputation to offer an acceptable degree of consumer protection in retail financial services. There have been several costly scandals over the past two decades, e.g. consumer confidence in the integrity of financial firms has often been low; financial firms

strongly resist the disclosure of even basic information until mandatory disclosure is imposed; inadequate compliance with business conduct requirements (see Box 2.6); in addition substantial amounts of compensation have been paid to consumers. Reputation, competition and information disclosure are necessary ingredients of consumer protection. The question is whether they are sufficient ingredients. It would appear that the consumer cannot rely upon the reputation of financial institutions in all cases. It may be that the reputation effect is too diffuse in long-term contracts, because it may take a long time before any fault or misrepresentation is detected. In fact, this may

Box 2.5: Competition Although the consumer desires the benefits of both competition and regulation, in practice regulation is in part inevitably designed to limit the alleged excesses of competition. In the past, a lot of regulation has had the effect of moderating competitive pressures on the premise that “excessive competition” has the effect of increasing risk – the dilemma is that competition can add to the risk of failure, whereas attempts at avoiding such risk through regulation often have the effect of reducing competition. Competition policy in regard to financial institutions varies considerably between countries and in some the issue is by no means settled. Regulation does not replace competition. Regulation, if properly constructed, reinforces the efficiency of, rather than detracts from, market mechanisms, i.e. it does not impede competition but enhances it and, by addressing information asymmetries, make it more effective in the marketplace. Nevertheless, however well-intentioned, regulation has the potential to compromise competition and to condone, if not in some cases endorse, unwarranted entry barriers, restrictive practices and other anti-competitive mechanisms. Although regulation in finance has historically often been anti-competitive, this is not an inherent property of regulation. As there are clear consumer benefits and efficiency gains to be secured through competition, regulation should not be constructed in a way that impairs it. Regulation and competition need not be in conflict – on the contrary, if properly constructed they are complementary. Regulation can also make competition more effective in the marketplace by, for instance, requiring the disclosure of relevant information that can be used by consumers in making informed choices. It is often argued that regulation and competition are in conflict, and that regulation impedes competition. In many respects, regulation versus competition is a false dichotomy: • Properly constructed, regulation has the potential to enhance competition; • disclosure requirements enhance price competition whereas, traditionally, competition in the life assurance industry has operated via raising costs (e.g. competition in delivery mechanisms); • disclosure in all its various forms widens the dimensions in which competition operates, so there are more areas in which competition operates (e.g. contract terms); • firms are likely to emphasise the competence of their staff and this is likely to develop as part of a competitive strategy; • disclosure enables the media and financial advisers to focus on the terms offered in contracts by various suppliers of contracts; • disclosure is also likely to lead to an unbundling of contracts with the result that there will be increased competition in the various characteristics of contracts; and • given public perceptions, competition could develop in compliance standards.

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never come to light. The problem is compounded when salespeople are remunerated on the basis of commission, and when movements between companies are high. Given this background to consumer protection, the following intermediate goals can be established: Integrity and fairness Effective and efficient regulation addresses the problems of failed contracts and reduces the probability of them occurring. There are five alternative dimensions to a failed contract: (i) the consumer receives bad advice – perhaps because an agency conflict is exploited; (ii) the supplying institution becomes insolvent before the contract matures; (iii) the contract turns out to be different from what the consumer was anticipating; (iv) fraud and misrepresentation; and (v) the financial institution has been incompetent. Competence Suitability and “fit and proper” standards are implemented for directors, management, staff and for the compliance office – the external auditors and regulators audit the quality of the compliance office to ensure these guardians fulfil standards themselves. Providers of financial services and products – traditional financial institutions and new entrants – are encouraged to compete freely in the provision of such services and products. Effective competition is the major component of consumer protection and the assurance of good products at competitive prices. The purpose of regulation is, therefore, not to displace competitive pressures or market mechanisms, but to correct for market imperfections and failures, which produce

suboptimum outcomes and distort consumer choice. To the extent that regulation enhances competition and, through this, efficiency in the industry, it creates a set of markets that work more efficiently and through which consumers gain (see Box 2.5). Transparency and disclosure Adequate information is available about financial services and products and the firms which provide them. The disclosure of relevant information is an essential ingredient of consumer protection. The question of whether disclosure should be mandatory, or voluntary is addressed. It may be noted that in some countries, investment and insurance companies have strongly resisted a disclosure of companies’ costs which meant that consumers were unaware of the full costs of financial products, e.g. life assurance and personal pensions. There are three main arguments in favour of mandatory disclosure requirements: • It would ease comparison between alternative products, and hence lower consumers’ transactions costs, if disclosure is made on the same basis by all firms; • standardised information could help consumers make choices – in this sense, mandatory disclosure would have a positive externality; and • the consumer is often uncertain about what is the relevant information that should be demanded when complex products are involved. Regulators do not know what information consumers require as, in some cases, what is relevant is specific to the individual. Mandatory disclosure sets out minimum disclosure requirements on a consistent and standardised basis that all firms must adhere to for

Box 2.6: Non-compliance A 1997 report by the UK Financial Services Authority (FSA) following an investigation of one of the country’s largest insurance and life assurance companies found as follows: “a deep-seated and long-standing failure in management”, and “a cultural disposition against compliance that filtered through [the firm’s] branch offices, their managers and advisers.” The FSA found “continuing and persistent breaches across major areas of its business”. The report also suggests that the company had: “an organisation structure which allowed the cost of its own compliance arrangements to take precedence over the interests of its investors.” A public reprimand was given and the company voluntarily withdrew its entire sales force for retraining.

Financial Regulation in South Africa: Chapter 2

21

all retail customers. This does not preclude giving additional information. Information imbalances were found in the UK, see Box 2.7. Adequate access to retail financial services Consumers have adequate access to financial firms, products and services without discrimination. Such access is by means of a variety of traditional and electronic access and delivery mechanisms available from financial institutions or their agents. Protection of retail funds The funds invested by retail investors in financial institutions are protected in case the firm fails. Retail compensation schemes The market conduct of financial firms is vested in one single specialist regulator for all market conduct issues. Compensation procedures are established in terms of which the client can complain about a wrong action on the part of the firm and is compensated immediately; and failing this the client can take his case to the ombudsman or adjudicator who will reconsider the case.

4.3 Targets of regulation Where the intermediate goals of regulation are in essence a transformation of the regulatory principles, the regulatory targets are empirically falsifiable magnitudes in the sense that they can be either missed or dismissed. Targets can seem very similar to instruments if they

are broken down into finer detail. However, although they seem similar, they differ conceptually. For instance, to strive for internationally acceptable accounting standards is clearly a regulatory target, but it is through monitoring and supervision (as a type of regulatory instrument) that this target is ultimately met. Alternatively stated, as an instrument of financial regulation, monitoring and supervision can be executed in terms of various minimum standards, one of them being internationally acceptable accounting standards. However, other instruments – such as enforceable compliance structures in the private sector or detailed external audit requirements – could also be used to implement this specific accounting standard. In short, targets are typically specific ratios, models, codes, manuals, systems or standards, which can be either approved or rejected by the authorities. Examples of regulatory targets are a specific capital ratio, a specific value-at-risk model, a compliance manual, a code of business conduct, a specific trading system or an accounting standard. Over time the regulatory targets are bound to change in line with the changing philosophy underpinning the regulatory regime of the nation. Tables 2.1, 2.2 and 2.3 give an overview of the various targets identified that could be aimed at by the regulatory authorities in South Africa. In Chapter 7, Section 3 most of these targets and their applicability to the regulatory regime are discussed in greater detail.

Box 2.7: Asymmetric information In a recent report, the UK Consumers Association (1998) argues as follows: “The information imbalance that has arisen between the consumer and industry has enabled the sale of substandard products which has, in many cases, cost the consumer (and the taxpayer) dear. For example, in the personal pensions mis-selling saga, hundreds of thousands of consumers fell victim to disgraceful sales practices and poor advice ... Personal pensions and life products such as endowment plans can pose particular problems because of the hidden penalties for switching, inflexibility and high charges. In many cases it is next to impossible for consumers to work out exactly what the charges are because of the euphemisms and obscure language used to disguise charges. All this has meant that there is no real competition in these markets. The lack of transparency means consumers have been unable to compare products, shop around and so in turn exert competitive pressure.”

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Table 2.1: Intermediate goals and targets supporting systemic stability 1.

• • • • • •

Competitive market infrastructure Establish a payments system that is open to all financial institutions Promote competitive trading, clearing and settlement systems Promote competitive listing requirements Stipulate minimum infrastructure standards Establish interrelated and competitive markets Establish regulatory neutrality towards foreign participants

2.

Acceptable maturity and currency mismatches • Promote accurate value-at-risk systems • Promote management of forward currency book by the private sector • Promote prudential debt-management systems in the public sector

3.

Acceptable cross-market exposures • Establish cross-market clearing and settlement facilities • Establish legally binding netting agreements between markets

4.

• • • •

Sufficient market liquidity Establish a financial stability unit at the central bank Formalise the standby facilities of the central bank Remove (tax) constraints on market turnover Promote foreign participation in local markets

5.

Securities markets as alternative to finance intermediation • Remove constraints on commercial paper issues from banking legislation • Establish a market in the bonds of SMMEs

6.

Regulatory effectiveness, efficiency and economy • Establish co-ordination agreements among domestic regulatory agencies (complex groups) • Establish harmonisation agreements between home and host regulators (complex groups and highly geared non-financial institutions) • Stipulate regulatory cost/benefit analysis • Establish ratings of national regulatory agencies

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Table 2.2: Intermediate goals and targets supporting institutional safety and soundness 1.

• • • • • 2.

• • • • • • 3.

• • • • •

24

Proper financial institutional infrastructure Adhere to minimum accounting and audit standards Adhere to minimum capital standards Adhere to corporate governance standards Adhere to compliance standards Establish an infrastructure for the verification of firms’ risk and control systems Establish an industry register of doubtful and bad debts

Suitable directors and staff • Stipulate specific minimum suitability standards for directors and senior management • Stipulate entry requirements for technical staff • Link remuneration packages to compliance standards

4.

5.

Proper risk assessment Promote accurate value-at-risk systems Stipulate consolidated supervision Appoint specific non-executive board members to supervise risk management and management systems Appoint accredited private rating agencies Promote unsecured subordinated debt as a rating tool

Global institutional competitiveness Abolish foreign exchange controls Remove regulatory limitations on e-commerce and e-money Remove regulatory limitations on foreign firms Allow remote trading Allow international listings

Competitive neutrality • Adhere to international agreements on regulatory minimum standards • Encourage functional approach to regulation • Encourage competitive neutrality between commerce and e-commerce

Financial Regulation in South Africa: Chapter 2

Table 2.3: Intermediate goals and targets supporting consumer protection 1.

• • • •

Integrity and fairness Encourage a code of corporate governance Encourage a code of business conduct Establish a policy to reduce financial crime and money laundering Encourage effective compliance manuals

2.

Competence • Stipulate “fit and proper” standards for compliance office

3.

Adequate product/service competitiveness • Remove constraints on competitive foreign products • Remove regulatory exclusions granted to parastatals or public corporations

4.

• • • • •

Transparency and disclosure Adhere to international codes of corporate governance Adhere to international codes of disclosure standards Establish government-defined benchmarks for better consumer information Inform the financial press Supply of competitive information on Internet by authorities

5.

Adequate access to retail financial services • Establish core banks in retail trading sector • Open the payments system to non-bank financial institutions

6.

Protection of retail funds • Establish Structured Early Intervention and Resolution regime • Limit the use of retail investment funds as an instrument of social engineering • Stipulate acceptable operational risk-management systems

7.

• • • •

Retail compensation schemes Stipulate ombudsmen arrangements Stipulate fidelity fund arrangements Establish bank deposit-insurance scheme Establish a single regulator for all market-conduct rulings

Financial Regulation in South Africa: Chapter 2

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Chapter 3 THE REGULATORY REGIME •

1. Introduction Essentially, regulation is about changing the behaviour of regulated institutions. Regulation can be endogenous inside the financial firm as well as exogenous. A major issue, therefore, is whether regulation should proceed through externally imposed, prescriptive and detailed rules, or by the regulators creating incentives for appropriate behaviour. A robust financial system requires three particular properties: (i) proper decision making and control within financial institutions with effective risk analysis, as well as management and control systems; (ii) an efficient regulatory and supervisory regime for financial institutions; and (iii) sound incentive structures for all parties, including regulators. This chapter considers various alternative approaches to achieving the objectives of financial regulation falling under the concept of a regulatory regime, which is far wider than the rules and monitoring conducted by regulatory agencies. The focus will be on how the components of a regulatory regime are to be combined to produce an optimum regulatory strategy for achieving regulatory objectives as opposed to particular ways of addressing specific regulatory problems. Chapter 4 develops the regulatory regime into a regulatory strategy framework based on the targetinstrument approach.

2. Alternative approaches Financial systems are changing substantially to an extent that may undermine traditional approaches to regulation, particularly to the balance between regulation and supervision, and the role of market discipline. The following issues are of particular importance: • The strong impact of globalisation on local firms; 26

the pace of financial innovation and the creation of new financial instruments; • the blurring of traditional distinctions between different types of financial firm; • the speed with which portfolios can change through trading in derivatives; and • the increased complexity of banking business. All of the above factors create a fundamentally new – in particular, more competitive – environment in which regulation and supervision are undertaken. These factors also change the viability of different approaches to regulation which, if it is to be effective, must constantly respond to changes in the market environment in which regulated firms operate. Three observations are made at the outset of the analysis and which inform the analysis that follows: • The elements of the economic rationale for regulation (discussed in Chapter 2) are relevant to a consideration of the focus of this chapter – i.e. the optimum regulatory strategy. In particular, regulation needs to be framed around, and justified in terms of, issues such as market imperfections, as such issues are the foundation for an economic rationale for regulation. • The existence of an economic rationale for regulation and a consumer demand for it do not justify everything that the regulator does. • The case for regulation in no way excludes a significant role for other mechanisms so as to achieve the desired objectives of systemic stability, institutional safety and soundness, and legitimate but limited consumer protection. The central theme of this chapter is that the various components of the regulatory regime need to be combined and balanced, and that though all are necessary, none alone are sufficient. Regulation, therefore, is not an alternative to, for instance, market discipline, but a complement to it. Indeed, a key issue Financial Regulation in South Africa: Chapter 3

to consider is the potential danger that regulation could, under some circumstances, blunt the application of other mechanisms. Internationally there is a definite shift within the regulatory regime to maximise its overall effectiveness and efficiency in the following ways: • Less emphasis is being given to formal and detailed prescriptive rules dictating the behaviour of regulated firms. • A greater focus is being given to incentive structures within regulated firms and to determining how regulation might have a beneficial impact on incentive structures. • The view is that market monitoring and market discipline of financial firms should be strengthened within the overall regulatory regime. • There is a growing recognition of the need for greater differentiation between regulated firms, different types of consumers and different types of financial business. • Greater emphasis is being placed on internal risk analysis, management and control systems. Externally imposed regulation in the form of prescriptive and detailed rules is becoming increasingly inappropriate and ineffective. More reliance should be placed on institutions’ own internal risk analysis, management and control systems. This relates not only to quantitative techniques such as value-at-risk (VaR) models, but also to the management and compliance “culture” of those who handle models and supervise. There should be a shift of emphasis towards monitoring risk-control mechanisms, and a recasting of the nature and functions of external regulation away from generalised rule-setting towards establishing incentives and sanctions to reinforce such internal control systems.1 1

For instance, the recently issued consultative document by the Basel Committee on Banking Supervision (Basel Committee, 1999) explicitly recognises that a major role of the supervisory process is to monitor banks’ own internal capital management processes and “the setting of targets for capital that are commensurate with the bank’s particular risk profile and control environment. This process would be subject to supervisory review and intervention, where appropriate”.

Financial Regulation in South Africa: Chapter 3

•

It is recognised that corporate governance mechanisms for financial firms need to be strengthened so that, for instance, owners would play a greater role in the monitoring and control of firms, and compliance issues would be identified as the ultimate responsibility of a nominated director of the main board. All of these, and other trends, are reflected in the recent Basel consultation document on new approaches to capital adequacy regulation of banks. As a simplification, there are two alternative approaches to regulation. At one end of the spectrum the regulator lays down fairly precise regulatory requirements that are applied to all regulated firms. There may be limited differentiations within the rules, but the presumption is for a high degree of uniformity. At the other end of the spectrum is what is termed contract regulation. Under this regime, the regulator sets down a clear set of objectives and general principles. It is then for each regulated firm to demonstrate to the regulator how these objectives and principles are to be satisfied by its own chosen procedures. In effect, the regulated firm self-selects its own regulation but within the strict constraints of the objectives and principles laid down by the regulator. Once the regulator has agreed with each firm how the objectives and principles are to be satisfied, a contract exists between the regulator and the regulated firm. The contract requires the firm to deliver on its agreed standards and procedures. In the case of nonperformance on the contract, sanctions would apply and the regulator would have the option of withdrawing the choice from the regulated firm (which would then have to accept a standard contract devised by the regulator). The advantage of this approach is that a regulated firm would be able to minimise its own costs of regulation by submitting to the regulator a plan that, while fully satisfying the requirements of the regulator, would best suit its own particular circumstances. The case for regulation, discussed earlier (Chapter 2, Section 2), does not mean that official regulation is to be the exclusive route through which the objectives set for regulation are met, or to imply that reliance can be 27

placed on it. On the contrary, regulation should be viewed as part of a collective regulatory strategy. Such a strategy would include official supervision, incentive structures, market discipline, rules for intervention, corporate governance arrangements and disciplining mechanisms on regulatory agencies. This is the essence of the regulatory regime and is discussed in greater detail below. Even within the purely regulation component of a broader regulatory strategy, there is a wide range of options available, and in particularly with respect to the degree of discretion exercised by the regulatory agency. When considering this wider perspective of regulation, six themes in particular emerge and need to be emphasised: • Regulation needs to be viewed and analysed not solely in the narrow terms of the rules, regulations and edicts of regulatory agencies, but in the wider context of a regulatory regime. The concept of a regulatory regime has seven components: (i) The rules and regulations established by regulatory agencies – the pure regulation component; (ii) official monitoring and supervision by regulatory agencies; (iii) intervention arrangements in the event of there being compliance failures of one sort or another; (iv) the incentive structures and contracts faced by regulatory agencies, consumers and, more particularly, by regulated firms; (v) the role of market discipline and monitoring; (vi) the role of corporate governance arrangements in financial firms; and (vii) the disciplining and accountability arrangements applied to regulatory agencies. • A regulatory strategy to achieve the objectives set for regulation should not be restricted to a view of what rules and supervision are established by a regulatory agency. A regulatory strategy is about optimising the combination of the seven components of the regime. The strategy also needs to be considered in the context that there are often 28

trade-offs to be made within the range and between the components in order to maximise the overall impact. In some circumstances the greater the emphasis on one of the components, the weaker the power of one or more of the others, even to the extent of perhaps reducing the overall impact. Equally, different combinations of the components may achieve the same degree of effectiveness in meeting the objectives but at different costs. The possibility needs to be considered that if more emphasis is given to detailed, extensive and prescriptive rules, this might weaken the role of incentive structures, market discipline and corporate governance. In other words, rules may weaken incentive structures and market discipline. • Public (and particularly academic) debate about regulation is often too polarised with too many dichotomies established – what are often posed as alternative approaches are in fact not alternatives but complementary mechanisms. It is emphasised that the skill in formulating regulatory strategy is not so much in choosing between the various options, but in combining the seven key components of the regulatory regime. The skill of the regulator in devising a regulatory strategy lies in how the various components in the regime are combined, and how the various instruments available to the regulator are used (these are listed in Section 4 below), including their potential impact on other components of the regime. So, although there may be negative trade-offs to consider, the relationship between the components of the regime may also be positive in that, for instance, regulation could itself focus on creating appropriate incentives within regulated firms. Therefore, it is not a question of choosing between either regulation or market discipline, or between regulation and supervision on the one hand and competition on the other. The concept of a regulatory strategy discussed here is that the above are not to be viewed as alternatives but components of an overall approach to achieving the objectives that are set for regulation. A key issue for the Financial Regulation in South Africa: Chapter 3

regulator to consider is how its actions not only contribute to the objectives directly, but how they impact on the other components of the regime. More particularly, the issue is how regulation affects incentive structures within firms and also the role that can be played by market monitoring and discipline. • The optimum mix of components within the regulatory regime will change over time as market conditions and structures and hence the regulatory philosophy change. It is argued that, in current conditions, there needs to be a shift in the structure of the current strategy in some respects: (i) less reliance should be placed on detailed and prescriptive rules, and more emphasis should be given to the other components (most especially market discipline); and (ii) official supervision should focus more on incentive structures, an enhanced and strengthened role for market discipline and monitoring (in ways which will be outlined below), and a more central role for corporate governance arrangements within financial firms. • Consumers, financial firms and different types of financial business are not homogeneous, which means that the optimum regulatory approach is likely to differ for different consumers, financial firms and financial business. This has been recognised by the regulatory authorities in some countries. However, it is argued that there should be more differentiation. One approach that should be considered is contract regulation, as outlined above. In effect, what is involved here is a regime of self-selecting regulatory contracts. • Given the power and discretion that the regulatory agencies have, their own accountability and disciplining mechanisms need to be constantly emphasised. When considering the above theme, the importance of trade-offs within the regulatory regime should be emphasised. In terms of regulatory strategy, a choice is to be made about the balance of the various components and the relative weight to be assigned to Financial Regulation in South Africa: Chapter 3

each. In this way, a powerful role for official regulation may be chosen with little weight assigned to market discipline, or a relatively light touch of regulation but with heavy reliance on the other components. A given degree of investor protection can be provided by different combinations of rules, supervision, market discipline, etc. and with various degrees of discretion applied by the regulator. For example, the same level of investor protection could be provided by combining a highly detailed and prescriptive rulebook and a small degree of supervisory discretion, or by combining a set of general principles and a high degree of supervisory discretion in how those principles are to be translated into action by regulated firms. The second form of trade-off is more causal in nature and relates to how the components of the regime may be causally and negatively related. For example, heavy reliance on formal regulation of a highly prescriptive nature may weaken incentives, erode market monitoring and discipline, and may have adverse effects on corporate governance arrangements. In essence, in a market that is heavily regulated for internal standards of integrity, the incentives for fair dealing diminish. Within the company culture, such norms of fair dealing as “it’s the way we do things around here” would eventually be replaced by “it’s OK if we can get away with it”. The key to optimising the effectiveness of a regulatory regime is the portfolio mix of the seven core components. To reiterate, all components are necessary but none alone are sufficient. Particular emphasis is given to incentive structures because, at the end of the day, if these are perverse or inefficient, no amount of formal regulation will prevent problems from emerging. The mix will change over time. It might be argued that the regulation of retail investment business has in many countries been highly prescriptive and detailed. It might also be argued that, given past experience and the various scandals that had been exposed, this was necessary at the outset in order to “shock” the industry into a more compliant approach to its business and the way it conducts business with 29

potentially vulnerable investors. If the norms and compliance culture of the industry change, it might become appropriate to rely less on detailed and prescriptive regulation, as far as some firms are concerned (see Box 3.1). The UK Personal Investment Authority’s (PIA) Evolution Project was designed to consider how regulatory strategy might be modified in the light of changing circumstances. Neither does it follow that the same approach and mix of components in the regulatory regime should be the same for all regulated firms, all consumers or all types of business or markets. On the contrary, given that these are not homogeneous, it would be suboptimum to apply the same approach. The key strategic issue is the extent to which variations are made between different consumers, regulated firms and business areas. However, in most countries it is argued that more differentiation is warranted than is currently allowed for.

In summary, the above amounts to emphasising an overall regulatory strategy rather than focusing on regulation per se. The central theme is that rules and regulations are an important, but only one, component of a regulatory regime designed to achieve the objectives of systemic stability, institutional safety and soundness, and consumer protection in finance. Giving too much emphasis in public debate to regulation per se has the danger of minimising the crucial importance of the other components, and most especially the role of market discipline. As part of its commitment to a flexible and differentiated approach, and the need to minimise the costs of regulation, it is to be hoped that regulators will explore how differentiated approaches and elements of choice can be extended to all areas of regulation, including the area of conduct of business. An additional advantage of allowing an element of monitored choice is that more is learnt about what

Box 3.1: Compliance culture The compliance culture within regulated firms is crucial to the success of a regulatory strategy. The regulator can have a major impact on culture through its actions and the incentives it creates. This aspect also limits how far regulatory measures which are specific to cost-benefit analysis can go in determining the ultimate value of regulation. Consequently, the main benefit may derive, not from how regulatory measure X impacts on benefit Y, but from how regulation itself enhances consumer benefits through a more general impact on the culture of the industry. Suppose an improvement is observed in consumer welfare derived through purchasing financial products. This could have been achieved through one of five ways: (i) specific regulatory rules have successfully addressed specific problems (e.g. disclosure); (ii) consumers have become more aware and more conscious of some of the potential hazards when buying complex financial products; (iii) consumers have become more sophisticated and have a greater understanding of the questions to ask, the comparisons to be made and better understand financial issues; (iv) market conditions (e.g. competition) have improved; or (v) a generally, and diffused, improved culture of compliance and competence in the industry. However, it is only in case (i) above that cost-benefit analysis (CBA) can effectively be applied even though regulation may have contributed to each of the other four. Ultimately, the general culture and standards of the industry may be a more significant to consumer benefit than the impact of specific measures. However, this will not be picked up through CBA. Put another way, the total impact of regulation may be greater than the sum of its parts. This is not intended to argue against the application of cost-benefit analysis, and other measures of effectiveness, to regulatory measures – this is always desirable. However, the limitations need to be recognised. Compliance culture is not a phenomenon restricted to finance. An example in a different area illustrates the point. Ten years ago a smoker would not feel uncomfortable about lighting a cigarette at a host’s dinner party without seeking permission. Five years ago the smoker would have asked permission. Today, if the host does not smoke, it is almost inconceivable that the guest would even consider asking permission. This is not because there is any specific regulation preventing smoking in friends’ houses, but because the culture has changed after the general message that smoking is anti-social.

30

Financial Regulation in South Africa: Chapter 3

determines good regulation. Part of the learning process is lost when a monopolist regulator imposes a uniform set of requirements.

3. The components and instruments of the regulatory regime A regulatory agency has a range of instruments available to it: rules and regulations, authorisation, mandatory disclosure requirements, creating appropriate incentives, establishing principles and guidance, monitoring, intervention, sanctions and compensation. A key choice for any financial regulator, as with any policy maker with multiple objectives, is the selection from the various instruments available in the regulatory regime, and the way they are combined to achieve the broad set of objectives. To reiterate, the skill lies not so much in the choice of instruments, but in how they are combined in the overall strategy mix. It is not a question, for instance, of rules versus market discipline, but how the full range of instruments is used to create an overall effect. The various instruments can be used in a variety of combinations, and with various degrees of intensity. As already noted, the key components of a regulatory regime are as follows: • Rules and regulations • Official monitoring and supervision • Intervention and sanctions • Incentive contracts and structures • Market monitoring and discipline • Corporate governance • Discipline on, and accountability of the regulators These components of the regulatory regime are discussed in more detail below. The following sections (3.1–3.6) discuss each of the components in turn.

3.1 Rules and regulations In prescriptive legislation, the rules for financial institutions are laid down in the actual legislation or by regulatory agencies. This form of regulation has proved inflexible and is difficult to modify within an acceptable timeframe. The trend is towards the Financial Regulation in South Africa: Chapter 3

use of enabling legislation where the power to formulate rules and regulations is given – with appropriate safeguards and in consultation with financial sector participants – to a designated regulator or “Registrar”. However the regulator is responsible for the promulgation and enforcement of the regulations. One of the roles of regulation is to authorise or “license” the suppliers of financial services. In this role there is a case for excluding companies that cannot or will not meet certain minimum standards of consumer protection. It is analogous to pollution regulation, which excludes some firms from an industry because they cannot afford production techniques that satisfy pollution standards, or car manufacturers that cannot meet minimum safety standards. There need be no difficulty with this concept of an entry barrier. Rules and regulations can be described under the following headings: • Entry and standards requirements, e.g. restrictions on the issue of financial instruments, fit and proper requirements for traders, or the various entry requirements for a firm, such as minimum capital and appropriate computer systems. • Ownership constraints, e.g. whether a firm is allowed to operate as a financial conglomerate or as a pyramid holding company. • Functional activity constraints, e.g. whether the range of allowable business of an institution is limited, and whether a firm should have “Chinese walls” (as in universal banking) or “fire walls” (as reflected in separately capitalised banking and securities business subsidiaries). • Jurisdictional constraints, e.g. whether a firm is prohibited from operating outside certain geographical areas. • Pricing constraints, e.g. whether a firm is compelled to charge a fixed brokerage. • Operational constraints, e.g. whether a firm has to operate within capital and liquidity constraints or within the constraints set by a code of conduct for investment business. 31

3.2 Official monitoring and supervision Because of the nature of financial contracts between financial firms and their customers2, there is a need for the continuous monitoring of the behaviour of financial firms. The question is who is to undertake this necessary monitoring: customers, shareholders or, for instance, rating agencies. Because most – especially retail – customers are not in practice able to undertake such monitoring, an important role of regulatory agencies is to monitor the behaviour of financial firms on behalf of customers. In effect, consumers delegate the task of monitoring to a regulatory agency, and hence that agency can be viewed as supplying monitoring services to the customers of financial firms. There are strong efficiency reasons for consumers to delegate monitoring and supervision to a specialist agency, which can act on their behalf and reduce transactions costs. The form and intensity, of supervisory requirements should differentiate between regulated institutions according to their relative portfolio risk and the efficiency of internal control mechanisms. While the objective of “competitive neutrality” in regulation is something of a mantra, this is not satisfied if unequal institutions are treated equally. One of the hazards of a detailed and prescriptive rulebook approach is that it may fail to make the necessary distinctions between non-homogeneous firms because the same rules are applied to all – i.e. it reduces the scope for making legitimate differentiations.

3.3 Intervention and sanctions There needs to be a well-defined strategy for responding to the possible insolvency of financial institutions. A response strategy in the event of financial institution distress has several possible components: • Being prepared to close insolvent financial institutions; 2

Including, for instance: potential principal-agent problems; the quality of a financial product cannot be ascertained at the point of purchase; the value of a product is determined by the behaviour of the supplier after products have been purchased and contracts entered into. See also Box 2.3 in Chapter 2.

32

•

taking prompt corrective action to address financial problems before they reach critical proportions; • closing unviable institutions promptly, and vigorously monitoring weak and/or restructured institutions; and • undertaking a timely assessment of the full scope of financial insolvency and the fiscal cost of resolving the problem. There should be a clear bias (though not a bar) against forbearance when a financial institution, especially a bank, is in difficulty. Regulatory authorities need to build a reputation for tough supervision and, when necessary, decisive action in cases of financial distress. Supervisory authorities may, from time to time, face substantial political pressure to delay action in closing hazardous financial institutions. They may also be induced to “gamble for resurrection” by allowing an insolvent (or near-insolvent) institution to make an attempt to trade out of its difficulty. There is an additional danger of regulatory capture, and that a risk-averse regulator may simply delay intervention in order to avoid blame. The need to maintain credibility creates a strong bias against forbearance, and a large number of cases of unsuccessful forbearance reinforces this conclusion. However, there are circumstances where it is appropriate to override this general presumption. Time-inconsistency and credibility problems should be addressed through precommitments and graduated responses with the possibility of overrides. In the case of banks, there is an active debate about rules versus discretion with respect to intervention in the case of distressed or insolvent banks – to what extent should intervention be circumscribed by clearly defined rules (so that intervention agencies have no discretion about whether, how and when to act) or should there always be discretion simply because relevant circumstances cannot be set out in advance? The danger of discretion is that it increases the probability of forbearance. A rules-based approach, by removing any prospect that a hazardous bank might be treated leniently, also has the advantage that it enhances the incentives for bank managers to manage their banks prudently so as to Financial Regulation in South Africa: Chapter 3

reduce the probability of insolvency. In addition, it enhances the credibility of the regulator’s threat to close down institutions. Many analysts have advocated various forms of predetermined intervention though a general policy of Structured Early Intervention and Resolution (SEIR). It has been argued that SEIR is designed to imitate the remedial action which private bond holders would impose on banks in the absence of government insurance or guarantees. In this sense it is a mimic of market solutions to troubled banks. An example of the rules-based approach is to be found in the Prompt Corrective Action (PCA) rules in the US. These specify graduated intervention by the regulators with predetermined responses triggered by capital thresholds. A major issue for the credibility, and hence authority, of a regulator is whether rules and decisions are time-consistent. There may be circumstances where a rule, or normal policy action, needs to be suspended. The priors may be that there is a strong case for precommitment and rules of behaviour for the regulator. However, there is also a case for a graduated-response approach since, for example, there is no magical capital ratio below which an institution is in danger and above which it is safe. Other things being equal, potential danger gradually increases as the capital ratio declines. This in itself suggests that there should be a graduated series of responses from the regulator as capital diminishes. No single dividing line should trigger action, but there should be a series of such trigger points where the effect of going through any one of them is relatively minor, but the cumulative effect is large. In these graduated responses no distinction should be made between losses caused by idiosyncratic or general market developments. Under a related concept (the “precommitment approach” to bank supervision) the banks’ own assessments of their capital needs3 are used as the basis of supervision. At the beginning of each period, the bank evaluates its need for capital and the bank is subsequently required to manage its risks so that its

capital does not fall below the precommitment level. Penalties are imposed to the extent that capital falls below the declared levels. There should also be a decision as to what market movements are so extreme as to merit government support to withstand them. Banks would be required to hold capital to meet shocks up to this limit in stress tests of proprietary models. However, even in a precommitment and graduatedresponse regime there may be cases where predetermined rules should be overridden. The problem is, however, that if this is publicly known, the credibility of the regulator could be seriously compromised, bearing in mind that it is to create and sustain such credibility that the precommitment rule is established in the first place. Can there be any guarantee that such an override would not turn regulation into a totally ad hoc procedure? One solution is to make the intervention agency publicly accountable for its actions and decisions not to intervene.

3

4

As determined by their own internal risk models.

Financial Regulation in South Africa: Chapter 3

3.4 Incentive contracts and structures Crises in the financial system frequently occur when there are weak incentives to act prudently. 4 A necessary ingredient of a robust and stable financial system is the creation of appropriate incentives and disciplining mechanisms for all market participants, especially for owners, managers and financial system supervisors. Laws, regulations and supervisory actions provide incentives for regulated firms to adjust their actions and behaviour, and to control their own risks internally. They can usefully be viewed as “incentive contracts” within a standard principal-agent relationship where the principal is the regulator and the agent is the regulated firm. Within this general framework, regulation involves a process of creating incentive-compatible contracts so that regulated firms have an incentive to behave in a way consistent with the objectives of systemic stability, institutional safety and soundness, and consumer protection. Similarly, there should be incentives for the regulator to set Financial crises are discussed in Chapter 5.

33

appropriate objectives, to adopt well-designed rules, not to over-regulate and to act in a timely fashion (for instance, in the face of pressure for forbearance). If incentive contracts are well designed they will induce appropriate behaviour by regulated firms. Conversely, if they are badly constructed and improperly designed, they might fail to reduce systemic risk (and other hazards regulation is designed to avoid) or have undesirable side-effects on the process of financial intermediation (e.g. impose high cost). At centre stage is the issue of whether all parties have the right incentives to act in a way that satisfies the objectives of regulation. The incentive structures and moral hazards faced by decision makers (owners and managers, lenders, borrowers and central banks) are the major issues to consider in the regulatory regime. Some analysts ascribe many of the recent financial crises to various moral hazards and perverse incentive structures, such as fixed exchange-rate regimes and anticipated lenderof-last-resort actions5.

3.5 Market monitoring and discipline Monitoring is not only conducted by official agencies which have this specialist task. In well-developed financial regimes the market also monitors the behaviour of financial firms. The discipline imposed by the market can be as powerful as any sanctions imposed by official regulatory agencies. However, in practice, the disciplining role of the markets (including the inter-bank market which in many jurisdictions is able to impose powerful discipline through the risk premium charged on inter-bank loans) was weak in the crisis countries of Southeast Asia. This was predominantly because of the lack of disclosure and transparency of banks and the fact that little reliance could be placed on the quality of the accountancy data provided in bank accounts. In many cases, standard accountancy and auditing procedures were not applied rigorously. In some cases there was wilful misrepresentation of the financial position of banks 5

Such as perceived bailouts by the IMF.

34

and non-financial companies. Overall, market discipline can work effectively only on the basis of full and accurate disclosure and transparency. Good quality, timely and relevant information disclosure should be available to all market participants and regulators so that asset quality, creditworthiness and the condition of financial institutions can be assessed. This disclosure includes the timely publication of relevant financial data on the soundness of financial institutions, and the adoption of comprehensive and well-defined accounting principles that conform to agreed international standards. The key issue is who is to undertake the monitoring. Several parties could potentially monitor the management of financial institutions: owners, depositors, clients, rating agencies, official agencies (e.g. the central bank or other regulatory body) and other firms in the market. In general, excessive emphasis has been given to official agencies. The danger is that a monopoly monitor is established with all the problems normally associated with monopoly power. There may even be an adverse incentive effect in that, given that regulatory agencies conduct monitoring and supervision on a delegated basis, the incentive for others to conduct monitoring may be weakened. The role of other potential monitors (and notably the market) needs to be strengthened in many, including well-developed, financial systems. Among other considerations, this reduces the monopoly power of a single, official supervisory agency. This in turn requires adequate information, as well as disclosure and transparency in the operations of financial institutions. There should be greater incentives for other parties to monitor firms in parallel with official agencies. Within the general framework of monitoring, a major dimension is the extent to which the market undertakes monitoring and imposes discipline on the risk taking of financial institutions. Given how the business of the financial sector has evolved and the nature of the market environment in which firms now operate, less reliance should be placed on supervision by official agencies and a greater role should be played by the market. Market disciplines need to be Financial Regulation in South Africa: Chapter 3

strengthened. The issue is not so much about market versus agency discipline, but the mix of all aspects of monitoring, supervision and discipline. The Basel Committee on Banking Supervision has recognised that supervisors have a strong interest in facilitating effective market discipline as a lever to strengthen the safety and soundness of the banking system. It argues that market discipline has the potential to reinforce capital regulation and other supervisory efforts to promote safety and soundness in banks and financial systems. Moreover, some analysts are sceptical about the power of official supervisory agencies to identify the risk characteristics of banks compared with the power and incentives of markets. They have advocated that banks should be required to issue a minimum amount of subordinated and uninsured debt as part of the capital base. Holders of subordinated debt would have an incentive to monitor the risk taking of banks. The market would apply discipline, as the markets’ assessment of risk would be reflected in the risk premium in the price of the traded debt. In particular, because of the nature of the debt contract, holders of a bank’s subordinated debt capital do not share in the potential upside gain through the bank’s risk taking, but stand to lose if the bank fails. They therefore have a particular incentive to monitor the risk profile of the bank in contrast to shareholders who, under some circumstances, have an incentive to support a highrisk profile. The merit of increasing the role of market discipline is that large, well-informed creditors (including other financial institutions) have the resources, expertise, market knowledge and incentives to conduct monitoring and to impose market discipline.6 In order to develop market discipline as a regulatory instrument, the following “directives” should be emphasised:

6

For instance, it has been argued that the hazardous state of BCCI was reflected in market prices and inter-bank interest rates long before the Bank of England closed the bank.

Financial Regulation in South Africa: Chapter 3

Regulation should not impede competition but should enhance it and, by addressing information asymmetries, make it more effective in the market place However well-intentioned, regulation has the potential to compromise competition and to condone, if not in some cases endorse, unwarranted entry barriers, restrictive practices and other anti-competitive mechanisms. Historically regulation in finance has often been anti-competitive in nature. But this is not an inherent property of regulation. Because there are clear consumer benefits and efficiency gains to be secured through competition, regulation should not be constructed in a way that impairs competition. Regulation and competition need not be in conflict – on the contrary, properly constructed they are complementary. Regulation can, therefore, enhance competition. It can also make it more effective in the marketplace by, for instance, requiring the disclosure of relevant information that can be used by consumers for making informed choices. Regulation should reinforce, not replace, market discipline, and the regulatory regime should be structured so as to provide greater incentives than those existing at present for markets to monitor financial firms Where possible, market discipline (e.g. through disclosure) should be strengthened. This means creating incentives for private markets to reward good performance and penalise hazardous behaviour. Regulation and supervision should complement and support, and never undermine, the operation of market discipline. Regulators should, whenever possible, utilise market data in their supervisory procedures The evidence indicates that markets can give signals about the credit standing of financial firms which, when combined with inside information gained by supervisory procedures, can increase the efficiency of the supervisory process. If financial markets are able to assess a firm’s market value as reflected in the market price, an asset-pricing model can in principle be used to infer the risk of insolvency that the market 35

has assigned to each firm. However, there are limitations to such an approach, hence it would be hazardous to rely exclusively on it. For instance, it assumes that the market has sufficient data upon which to make accurate assessments of firms, and it equally assumes that the market is able to efficiently assess the available information and incorporate this into an efficient pricing of firms’ securities. There should be a significant role for rating agencies in the supervisory process Rating agencies have considerable resources for and expertise in monitoring financial institutions and making assessments of risk. It could be made a requirement, as in Argentina, for all banks to have a rating which would be made public. 3.5.1 Assessment Though market discipline is potentially very powerful, it has its limitations. This means that, in practice, it is unlikely to be an effective alternative to the role of official regulatory and supervisory agencies: • Markets are concerned with the private cost of financial institution failure and reflect the risk of this in market prices. The social cost of bank failures, by contrast, may exceed the private cost and therefore the total cost of, say, a bank failure may not be fully reflected in market prices. • Market disciplines are not effective at monitoring and disciplining public-sector financial institutions. • In many countries, there are limits imposed on the extent to which the market in corporate control (the takeover market) is allowed to operate. In particular, there are frequently limits, if not bars, on the extent to which foreign institutions are able to take control of banks and other financial institutions, even though they may offer a solution to undercapitalised institutions. • The market is able to efficiently price financial institutions securities and inter-bank loans only to the extent that relevant information is available. Disclosure requirements are, therefore, an integral part of the market-disciplining process. • It is not self-evident that market participants 36

always have the necessary expertise to make risk assessments of complex, and sometimes opaque, financial institutions. • In some countries, the market in debt of all kinds (including securities and debt issued by banks) is limited, inefficient and cartelised. • When debt issues are very small it is not always economically feasible for a rating agency to conduct a full credit rating of firms. Though there are clear limitations on the role of market discipline, the global trend is appropriately leaning towards placing more emphasis on market data in the supervisory process. The contention is not that market monitoring and discipline can effectively replace official supervision, but that these have a potentially powerful role which should be strengthened within the overall regulatory regime. In addition it has been argued that broadening the number of those who are directly concerned about the safety and soundness of financial institutions reduces the extent to which insider political pressure can be brought to bear on financial regulation and supervision.

3.6 Corporate governance Ultimately, all aspects of the management of a financial institution are corporate governance issues. This means that if firms behave hazardously this is, to some extent, a symptom of weak internal corporate governance. This may include, for instance, a hazardous corporate structure for the firm, lack of internal control systems, weak surveillance by (especially non-executive) directors, and ineffective internal audit arrangements. Corporate governance arrangements were evidently weak and under-developed in banks in many of the countries in distress. Some ownership structures of financial institutions in the private sector can produce poor corporate governance. In some cases, particular corporate structures (e.g. banks being part of larger conglomerates) encourage connected lending and a weak risk analysis of borrowers. This has been found to be the case in a significant number of bank failures in the countries of Southeast Asia and Latin America. Financial Regulation in South Africa: Chapter 3

Some corporate structures also make it comparatively easy for banks to effectively conceal their losses and an unsound financial position. A key issue in the management of financial institutions is the extent to which corporate governance arrangements are suitable and efficient for the management and control of risks. Corporate governance arrangements include issues of corporate structure, the power of shareholders to exercise the right to demand the accountability of managers, the transparency of corporate structures, disclosure of the authority and power of directors, internal audit arrangements and lines of accountability of managers. In the end, shareholders are the ultimate risk takers and agency problems may induce managers to take more risks with the firm than the owners would wish. This in turn raises issues about what information shareholders have about the actions of the managers to which they delegate decision-making powers, the extent to which shareholders are represented on the board of directors of the firm and the extent to which shareholders have power to discipline managers. In essence, corporate governance arrangements should provide for the effective monitoring and supervision of the risk-taking profile of financial institutions. These arrangements would provide for, inter alia, • a management structure with clear lines of accountability; • independent non-executive directors on the board; • an independent audit committee; • the four-eyes principle for important decisions involving the risk profile of the firm; • transparent ownership structures; • internal structures that enable the risk profile of the firm to be clear, transparent and managed; and • the monitoring of risk analysis and management systems.

Financial Regulation in South Africa: Chapter 3

3.7 Discipline on and accountability of the regulators Whether they like it or not, regulators should be publicly accountable through credible mechanisms. Regulatory agencies have considerable power over regulated firms and the consumer through their influence on the terms on which business is conducted. For this reason, agencies need to be accountable and their activities transparent. In addition, public accountability can also be a protection against political interference in the decisions of the regulatory agency. Moreover, it creates incentives against forbearance. However, difficulties arise with transparency when, for example, it may be prudent for a central bank’s successful action in averting a bank failure or systemic crisis to keep specific information undisclosed. One possible approach is to create an audit agency of the regulator with the regulator being required to report on a regular basis to an independent person, or body. The report would cover the objectives of the regulator and the measures of success and failure. The audit authority would have a degree of standing that would force the regulatory agency to respond to any concerns raised. In due course, the reports of the regulator to the agency would be published.

4. Instruments of regulation The regulatory agency needs to utilise the full range of regulatory instruments at its disposal in the implementation of a regulatory regime. The alignment of the regulatory instruments with the regulatory objectives and intermediate goals is discussed in the regulatory strategic framework developed in Chapter 4. The main instruments in the components of the regulatory regime are listed in Tables 3.1 to 3.7.

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Table 3.1: Instruments of rules and regulation 1.

• • • • • • • • • • •

Entry and standards constraints accounting standards audit standards payment and settlement standards issuance standards for financial instruments fit and proper standards for individuals and firms disclosure and advice standards corporate governance standards inspection and supervision standards for financial institutions cross-border information-sharing standards financial conglomerate supervision standards financial crime and money-laundering standards

2.

Ownership constraints • cross-holdings • foreign holdings

3.

Functional activity constraints • demarcation requirements

4.

Jurisdictional constraints • domestic versus international • between regions

5.

Pricing constraints • fixed prices • price ceilings

6.

• • • • • •

Operational constraints prudential requirements market business conduct requirements trading requirements competence requirements compensation schemes requirements complaints procedures requirements

Table 3.2: Instruments of official monitoring and supervision • • • •

38

official reporting requirements periodic spot inspections permanent positioning of inspection staff regular interviews with non-executive directors

Financial Regulation in South Africa: Chapter 3

Table 3.3: Instruments of intervention and sanctions • • • •

Structured Early Intervention and Resolution regime timely assessment of risk and insolvencies timely closure of undercapitalised institutions detection of price manipulation and unfair trading practices

Table 3.4: Instruments of incentive contracts and structures 1.

• • • • 2.

• • • • • • •

Incentives for appropriate code of business conduct corporate governance compliance arrangements conflict of interest avoidance incentives gridlock avoidance incentives Incentives to encourage prudential risk exposures incentives to contain systemic risks internal risk assessment arrangements and capital adequacy (loan concentration, interconnected lending, cross-market risk assessment, fostering official oversight) incentives to contain credit risk (timely and adequate provisions against doubtful and bad debt, correct pricing of risks, correct loan and asset valuation) incentives to contain market risk (value-at-risk assessment procedures) incentives to contain operational risk (audit arrangements, forensic investigation, management control systems) incentives to contain liquidity risk (stress testing of cash-flow models)) incentives to encourage effectiveness and efficiency (incentives for regulatory cost-benefit analysis, incentives for training and consumer education, incentives for fostering competition, incentives to ensure that owners and managers lose through their failure)

Table 3.5: Instruments of market monitoring and discipline • • • • • • • • •

international accounting standards disclosure and transparency arrangements less restrictive and anti-competitive mechanisms role of external auditors ratings by private credit-rating agencies assessments by the capital market consumer and investor education fewer entry barriers remote trading by international traders

Financial Regulation in South Africa: Chapter 3

39

Table 3.6: Instruments of corporate governance • • • • • • • • • • • • • • •

leadership, enterprise, integrity and judgement appointment of board directors (executive and non-executive) strategy and values to achieve wealth creation and protect reputation company performance and business plans compliance with relevant laws communication with stakeholders accountability to shareholders relationship with stakeholders balance of power and separating roles of CEO and chairman internal procedures to ensure control performance assessment of board management appointments and development technology and competitiveness risk management annual review of future solvency

Table 3.7: Instruments of discipline on and accountability of regulators • • • •

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public accountability of the regulator (including cost of regulation) precommitment against public forbearance regulatory co-ordination and harmonisation between domestic and foreign regulatory agencies regulatory audit agency

Financial Regulation in South Africa: Chapter 3

Chapter 4 AN INTEGRATED TARGET-INSTRUMENT APPROACH TO FINANCIAL REGULATION 1. Introduction When considering regulatory strategy, an analytical framework has to be established at the outset. This framework should elucidate how the objectives and the instruments available in the regulatory regime can be aligned and potential conflicts between them eliminated. When constructing such a framework, four criteria need to be met. It should be – • coherent to those who need to use it – i.e. easily understood; • robust – based on sound economic and methodological analysis; • consistent over time – valued and relevant for different strategy exercises; and • manageable – operational and based on measurable concepts. A problem arises if some of the high-level objectives are too broad, unmeasurable and unmanageable. In such a case it is necessary to define intermediate goals

and targets that are more operational and manageable. These targets are reasonably closely related to an objective, although they are not objectives in themselves (i.e. not necessarily desired in their own right). Achieving the targets is therefore a reasonable proxy for an objective. The framework for a regulatory strategy that emerges is summarised in Diagram 4.1. It begins with a statement of objectives, i.e. what the authorities are attempting to achieve through regulatory strategy. This sets the high-level regulatory objectives, and has components within it that should be identified separately. The objectives are in turn decomposed into intermediate goals and operational targets. The components of the regulatory regime are in turn broken down into regulatory instruments. These instruments are at the disposal of the authorities and can contribute directly to achieving the targets. When implementing a regulatory strategy using such a framework, the authorities usually rely on two

Diagram 4.1: The strategy framework

Objectives (the ultimate “high-level” objectives the authorities are attempting to achieve through the regulatory strategy)

Goals and operational targets (specific and measurable regulatory targets that contribute to the ultimate regulatory objectives)

Regulatory regime and supporting instruments (what the authorities have at their command, such as rules and contracts)

Financial Regulation in South Africa: Chapter 4

41

conflict-conciliatory principles, namely that an integrated approach should be followed with regard to regulation, and that this approach should be supported by target-instrument procedures. This chapter sketches the use of these conflict-conciliatory principles in practice.

2. The overall regulatory strategy matrix The analysis to follow is based on the “regulatory regime” and the seven key components discussed in Chapter 3: • Rules imposed by regulatory agencies; • monitoring and supervision by official agencies; • intervention and sanctions by official agencies; • incentive structures; • market monitoring and discipline; • corporate governance arrangements in financial firms; and • the accountability of regulatory agencies. Table 4.1 combines in one conceptual framework – a “regulatory” matrix – the ultimate objectives and intermediate goals of regulation (as discussed in Chapter 2) and the policy instruments of regulatory regime (as sketched in Chapter 3). Placed at the top of the matrix are the three ultimate objectives of regulation (systemic stability; safety and soundness of financial institutions; consumer protection) as well as their subcomponents (i.e. the intermediate regulatory goals). On the vertical axis is shown the full regulatory regime, i.e. the seven major components or classes of financial instruments. Because of space limitations the regulatory instruments are not listed in full in the matrix – see Chapter 2, Tables 2.1 to 2.3. The intermediate goals are, in effect, a transformation of the regulatory principles outlined in Chapter 1. These intermediate goal variables relate on the one hand directly to the ultimate objectives (see Chapter 2) and on the other to the regulatory regime and its instruments (see Chapter 3). Accordingly, the regulatory instruments are employed with a view to realising the ultimate objectives. The underlying premise of this approach is that if the regulatory 42

authorities are successful in achieving their targets they will, by implication, also realise the intermediate goals and ultimate objectives. As already noted, the rationale of this paradigm is that the relationship between the ultimate objectives is too indirect and diffused.

3. The regulatory regime and intermediate goals All the instruments of financial regulation are ultimately aligned to a specific regulatory target and goal. In terms of Table 4.1, an X means that the specific instruments within a component of the regulatory regime are aligned to the intermediate target and thus support the particular ultimate objective of regulation. Although a specific regulatory instrument may support a specific target, it may also have negative side-effects. For instance, some policy instruments that support market efficiency may do so at the cost of consumer protection or may threaten to destabilise the financial system. As is evident from Table 4.1, a number of policy instruments can usually be aligned to a specific intermediate regulatory goal and target. An integrated target-instrument approach to financial regulation means that both the advantages and disadvantages of every regulatory instrument have to be taken into consideration before being employed. Therefore the Xs in table 4.1 do not indicate that a specific instrument will always be the appropriate one to address a specific target(s), but rather that it can be aligned (however defectively) to a specific target(s). For example, although official sanctioning of price cartels may reduce systemic risk, the disadvantages of such a policy are likely to outweigh the perceived advantages. In terms of Table 4.1 there are many other instruments aligned to reduce systemic risks and accordingly in terms of an integrated target-instrument approach these other instruments, rather than price fixing, should be used to reduce systemic risk. In essence, the target-instrument approach establishes that, when each instrument affects each target all targets can be achieved simultaneously only if there are as many instruments as targets: i.e. there is Financial Regulation in South Africa: Chapter 4

Financial Regulation in South Africa: Chapter 4

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X

7. Discipline/accountability of regulators

X

X

6. Corporate governance

X

X

X

X

X

5. Market monitoring and discipline

X X

X

3. Intervention and sanctions

4. Incentive contracts and structures

X

2 Official monitoring and supervision X

X

X

X

X

X

X

X

X

X

X

X

X

X

X

X

X

X

X

X

X

X

X

X

X

X

X

X

X

X

X

X

X

1.6 Operational constraints X

X

X

Fit and proper directors and staff Global institutional competitiveness

X X

Proper institutional infrastructure X

Competitive neutrality Integrity and fairness

1.5 Pricing constraints

X

1.4 Jurisdictional constraints

X

X

X

1.3 Functional activity constraints X

Sufficient market liquidity X

Securities markets as alternative to intermediation

X

X

Competitive market infrastructure Acceptable maturity and currency mismatches Acceptable crossmarket exposures X

Regulatory effectiveness, efficiency and economy Proper risk assessment

1.2 Ownership constraints

1.1 Entry and standards constraints

1. Official rules and regulations

Regulatory regime and its instruments

Regulatory intermediate goals

X

X

X

X

Competence

Consumer protection

X

X

X

X

X

Adequate product/service competitiveness

Institutional safety and soundness

X

X

X

X

X

X

Transparency and disclosure

Systemic stability

X

X

X

X

X

X

X

X

Access to retail financial services Protection of retail funds

Regulatory ultimate objectives

Table 4.1: Regulatory matrix: Alignment of regulatory instruments to regulatory goals and objectives

X

X

X

X

X

Retail compensation schemes

some optimal combination of instruments that achieves the desired combination of targets. The value (or intensity) of each instrument is aimed not only at having positive effects on particular targets, but may also be used to neutralise the negative effects of other instruments. This analysis indicates therefore that, if each of the regulatory objectives is to be secured, a multi-instrument approach is required: i.e. an optimising approach designed to achieve satisfactory levels of competition, efficiency and safety. No single instrument will suffice, and the more one objective is sought through a particular instrument, the greater will be the demand on other instruments to offset the potentially negative effects upon other regulatory objectives. Therefore a co-ordination of the various objectives and instruments is required. An example can be found in arrangements made for the protection of the consumer. One way of dealing with potential conflicts of interest that may work against the interest of the consumer is regulation that restricts a financial firm’s range of allowable business. If such regulation is eased, it may be necessary to resort to other measures to limit the potential for conflicts of interest, such as recourse to dedicated capital, Chinese walls, rules of business conduct, compliance officers and disclosure rules. As regulatory instruments generally constrain the activities of market participants (and thus may harm innovation and efficiency), the ideal should be to use the minimum number of instruments to obtain the maximum effect on the intermediate goals. Regulatory constraints are justified in that they aim to reduce market failure: i.e. asymmetric information (resulting in, for instance, insider trading), monopoly powers (often a result of high entry and/or exit barriers), and externalities (e.g. systemic risks1). Although the response of the regulators to market failure may be successful in extracting more information from the market (e.g. by way of transparency arrangements, establishing formalised markets, imposing adequate disclosures or conduct of business rules), in curtailing monopoly powers (e.g. by setting rules and outlawing restrictive trade practices) or in promoting systemic 44

stability (e.g. by harmonising regulation and by introducing capital-adequacy rules or solvency regimes), it may nonetheless fail on one or more of the following grounds: • Technological improvements and financial innovation may result in recourse to increasingly more regulations to address a specific problem (what might be termed “regulatory escalation”). What may start as a small issue, over time, may becomes a highly costly exercise which becomes totally out of proportion to the initial problem. • Regulation may create monopoly problems in its own right (e.g. the imposition of new and/or more stringent entry requirements). • Regulation may create a moral hazard (e.g. bank deposit insurance). • Regulation may result in inefficiencies, particularly when the restrictions are not related to risk. For instance, capital requirements that are not accurately based upon actuarial risks may impact adversely on an institution’s efficiency. • Regulation may deteriorate into over-regulation, which will reduce consumers’ access to cheaper products owing to the cost of excessive regulation. • Regulation may result in welfare losses as a consequence of rent-seeking efforts. Accordingly, interest groups may be induced to lobby strongly to maintain their economic rents. • Regulatory capture may occur whereby certain parties come to exploit opportunities to manipulate 1

Although in the short-run systemic stability can often be enhanced by more stringent controls, in the medium to long term such controls may endanger the stability of the financial system. From an analytical point of view a clear distinction should be drawn between the stability of the financial system and that of an individual company. In competitive markets, firms in crisis may be a symptom of “creative destruction”, as the emergence of new undertakings logically requires the demise of others which may have become obsolete. The emergence of new products, new firms and even whole new industries goes hand-in-hand with the disappearance of outdated products, the often brutal elimination of whole areas of activity and also, naturally, of individual firms. The disappearance of some production units in such a manner may lead to a higher level of efficiency and overall systemic stability, as the remaining firms adjust to a new efficiency standard and the new dynamic market conditions. Ultimately there is a natural conflict between creativity and a peaceful life.

Financial Regulation in South Africa: Chapter 4

the deployment of regulations to their advantage, which in turn results in the authorities serving the interests of the suppliers rather than consumers. • Regulation may have undesirable side-effects. For instance, transparency arrangements are usually introduced at the cost of liquidity arrangements (e.g. order- versus quote-driven market structures). Because the statutory constraints placed on the financial system can so easily backfire if not properly co-ordinated in an overall target-instrument approach, the regulatory authorities in most industrial countries have started to place greater emphasis on market discipline. This process entails a complex realignment of official rules and regulation in favour of market forces and discipline (as will be discussed in Section 4 below). The seven components of the regulatory regime, as listed in the section on the left axis of Table 4.1 and their alignment with the intermediate goals shown at the top of the table, will now be discussed.

3.1 Rules and regulations Ultimately, statutory rules and regulations aim at constraining private-sector activities. Usually these regulatory instruments are grouped under six broad headings, namely: entry and standards constraints; ownership constraints; functional activity constraints; jurisdictional constraints; pricing constraints; and operational constraints. As the subject is vast, each of these topics will be presented in a summarised format. The objective is to illustrate the methodological

approach adopted in this report, rather than to present a detailed analysis of each component. 3.1.1 Entry and standards constraints Entry and standards requirements are many and varied and often depend on a specific sector in the financial industry. By contrast, standards of probity, such as having a clean criminal record, are applicable generally. In a nutshell, the entry and standards requirements involve (i) stipulating “fit and proper” standards for individuals and for firms, (ii) the setting of disclosure and advice standards, which are particularly important in the retail market, and (iii) the setting of minimum issuance requirements for financial instruments. Each of these components will be briefly discussed below. Fit and proper standards for individuals This constraint relates to the authorisation of individuals and firms engaging in financial services. For the greater part, regulation has a bearing on the firm rather than the individual. Indeed, even the sole trader can be viewed legally as a one-man firm. Nonetheless, a few regulatory instruments are directly applicable to the individual. Of importance here are the restrictions on every financial instrument trader or principal to be “fit and proper” (meaning honest, competent and solvent). The main disadvantage of stipulating fit and proper standards for individuals is that they can be employed as a barrier to would-be competitors. Therefore, entry examinations should aim at weeding out only totally unsuitable persons. Moreover, examinations may also

Table 4.2: Impact of regulating financial individuals and instruments by minimum standards requirements Favourable

Unfavourable

• Encourages the employment of fit and proper individuals, which reduces systemic risks • Encourages ethical standards being maintained • Supports market liquidity, as trades are executed by suitable persons • Can be a cost-effective, flexible and practitionerbased way of regulation • Enhances public confidence

• Imposes an entry barrier to trade • May result in a de facto restriction • May give false security to consumers, as the usually minimum level of competence is examined only once and not on a continuous basis

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give a false sense of security to the extent that competence may be measured only once and may not be a continuous process (as is the case with, for instance, aircraft pilots). This raises the issue of whether there should be a continuous authorisation procedure. Minimum entry standards for firms Before a financial institution can be established, the authorities stipulate various entry and minimum standards requirements. In addition to its employees who have to be fit and proper, a firm has to maintain a minimum capital base at all times, and the firm’s major shareholders, its senior management and its infrastructural systems have to be satisfactory. These restrictions are primarily intended to improve systemic stability and to protect small investors (by ensuring that only firms of a minimum quality do business). In effect, these restrictions are designed to alleviate a form of market failure, namely the inability of consumers to make a proper judgement about the integrity and competence of firms (i.e. the problem of asymmetric information). In the absence of minimum standards imposed by regulatory agencies, average standards in the industry may decline due to moral hazard and adverse selection. In the former case firms are induced to behave badly because they perceive competitors making short-term gains (e.g. higher sales) because they have low standards of competence and integrity which are not transparent to ill-informed consumers. Equally, there may be adverse selection because good firms are driven out by the bad. A role of regulation, therefore, is to set minimum standards that all firms know will also be imposed universally on their competitors.

Disclosure and advice standards requirements The regulatory authorities aim at improving market transparency without sacrificing overall financial stability and efficiency. Disclosure requirements relate both to the terms of contracts and the overall financial position of a supplier of financial services. To protect small investors and to reduce the problem of asymmetric information, the authorities stipulate appropriate disclosure and minimum standards of advice (e.g. for life assurance products). Often a financial contract goes wrong because the small investor receives bad advice and is uninformed about some crucial details at the time the contract is bought so that it differs from his expectations2. It is also reasonable to allow the consumer of what are often complex financial contracts, a period of time after a contract has been signed to seek independent advice before the contract is finally enforced (i.e. a statutory “cooling-off” period to reconsider the contract). Unless there is appropriate disclosure3, the burden of responsibility shifts inevitably towards prudential supervision and the regulatory authorities. For instance, on a cost-benefit analysis basis it seems better to 2

3

In South Africa nearly one-third of all life assurance policies taken out lapse during the first few years, although this is not only because the product was inappropriate or miss-sold. There are many other reasons (e.g. a change in customer’s circumstances) why a policy may lapse. For instance, unless banks are required to make provisions against doubtful loans on a timely basis, there is a risk that losses will be understated and remain undetected. This can obscure the build-up of distress. In addition, external auditors play in an important role in a disclosure regime if they are required to report criminal evidence to the relevant authority (see e.g. the Bingham Report on BCCI).

Table 4.3: Impact of entry requirements for firms Favourable • Enforces minimum standards and so reduces systemic risk • Assists investors who are unable to judge the integrity and competence of firms • Enhances shareholders’ control over a firm’s managers • Can be a cost-effective, flexible and practitionerbased way of regulation

46

Unfavourable • Raises entry barriers • May result in a de facto trade restriction

Financial Regulation in South Africa: Chapter 4

address the potential moral hazard between tied insurance agents versus independent insurance advisers by full disclosure and a “client’s guide”, rather than to enforce a trade restriction (e.g. polarisation) that may so easily harm business efficiency. In the final analysis, regulation should never be regarded as an alternative to information disclosure. With respect to the overall position of a financial institution, the increasing opaqueness of the financial system has made appropriate disclosure to enhance transparency even more important than in the past. Today there is not only a blurring of the distinctions between different forms of financial intermediation, but also a proliferation of financial instruments, derivatives and other off-balance-sheet operations. As a result it is far more difficult to evaluate the direct risks run by a financial intermediary, and these trends also create hitherto unknown linkages (the indirect risks) between different parts of the financial industry. Though disclosure may be useful in preventing the build-up of distress, once latent distress is present,

simply revealing the underlying risk conditions may precipitate a disorderly market reaction. Accompanying stabilising measures are therefore necessary (e.g. appropriate funding capital, industryfinanced deposit insurance or guarantee schemes) as well as mutually reinforcing policies at the macroeconomic and microeconomic level with a view to ensuring financial discipline (particularly a strong long-term anti-inflation commitment inter alia to temper the fluctuations in financial asset prices). A key issue, and area of dispute, in disclosure is whether disclosure of relevant information for the consumer should be mandatory (and required by the regulator) or whether reliance can be put on financial firms voluntarily disclosure of relevant information. Some American academics, for instance, have argued against mandatory disclosure and that it may be against the consumer interest. It is argued that regulatory agencies are not able to specify universally useful disclosure rules and “may design rules that keep financial product providers from communicating effectively with consumers”. He

Table 4.4: Impact of disclosure and advice standards requirements Favourable

Unfavourable

• Reduces the problem of asymmetric information for the small investor. Without transparency, investors cannot carry out proper risk assessments • Acknowledges the right of the retail investor to know whether the intermediary or the client is at risk in respect of an investment and whether the intermediary is acting as a principal or an agent • The more information supplied to the client, the lesser the need for regulation • The longer the duration of a contract, the greater the disclosure required • Any potential moral hazard (e.g. between tied versus untied insurance agents) has to be primarily addressed by detailed disclosure requirements • Long-term contracts, such as life assurance, are not subject to “repeat order” possibilities and therefore the seller is inclined to view the sale as a once-off transaction. Accordingly more disclosure is required for these contracts

• May adversely influence the competitive neutrality between tied and untied insurance agents • Transparency arrangements are usually achieved at the cost of liquidity arrangements (e.g. order- versus quote-driven market structures) • False sense of security created • Wrong information may be mandatorily disclosed • Regulators do not know what information consumer needs • “Minimum” standards become “normal” standards

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47

suggests that, on balance, mandatory disclosure is more harmful than beneficial. There are three main arguments in favour of mandatory disclosure requirements: • Comparison between alternative products is eased, and hence consumers’ transactions costs are lowered, if disclosure is made on the same basis by all firms; • standardised information can help consumers make choices: in this sense, mandatory disclosure has a positive externality; • the consumer is often uncertain about what is relevant information to demand when complex products are involved. It is difficult to see how mandatory disclosure would be harmful to consumers unless in some way it prevented or inhibited firms from disclosing more than the stipulated minimum which they would have done in the absence of a mandatory requirement. Conceivably, it could create the impression in some consumers’ minds that, because it is mandated, this is all they need to know in order to make a decision about a product or contract. It is true that regulators do not know what

information consumers require as, in some cases, what is relevant is specific to the individual. All that mandatory disclosure does is set out minimum disclosure requirements on a consistent and standardised basis that all firms must adhere to for all retail customers. This does not preclude additional information being given. Indeed, if (as is contended by critics of mandatory disclosure) there is an incentive for firms to supply information, this will remain over and above any minima established by regulation. Minimum issue standards for financial instruments If required, the regulation of financial instruments can be increased in steps. At its lowest level the authorities can stipulate minimum issue requirements (e.g. in respect of quality, tenor, denomination or accompanying disclosure requirements). Next they can prescribe the trading procedures for specific instruments4. Lastly, the authorities can stipulate, by way of a licensing system, that recognised investment exchanges will supervise the issue of (and trade in) specific instruments, which implies that the financial 4

For example, foreign currency may only be traded by banks in South Africa.

Table 4.5: Impact of regulating financial instruments by minimum standard requirements Favourable

Unfavourable

• Reduces systemic risk by setting minimum quality standards for instruments • Creates uniformity among classes of instruments and thus promotes competitive neutrality among issuers • Enhances the supply of information to investors by stipulating specific disclosure requirements (e.g. debenture prospectus) • Enhances investors’ protection if an exchange supervises issuing and trading (for listed instruments only) • May enhance market liquidity if all instruments are traded on exchanges • Can be a cost-effective, flexible and practitionerbased way of regulation • Enhances consumer confidence

• May reduce market liquidity if regulatory restrictions become too expensive • Reduces consumer choice by eliminating poor, but also cheap, financial instruments • Reduces the supply of high risk/high return instruments for portfolio diversification • May result in the playing field not being level between the issuers of listed and unlisted instruments • May be avoided by financial engineering • “Minimum” standards become “normal” standards

48

Financial Regulation in South Africa: Chapter 4

instrument is listed (e.g. futures contracts). The listing of instruments on an exchange should preferably be done at the market’s initiative and not be enforced by the authorities. As position exposures can usually be netted for capital adequacy purposes on an exchange only, listing financial instruments may be attractive to market participants. As market efficiency often requires the deregulation of markets, the importance of regulating financial instruments and market participants has risen sharply since the 1980s.5 3.1.2 Ownership constraints When considering the ownership structure of financial institutions the issue of whether a financial institution should be allowed to operate as a multi-functional financial conglomerate is a thorny one. At stake is whether, for instance, an insurer may have a majority stake in a bank or vice versa, or whether a foreignowned bank may have a controlling shareholding in a 5

The target-instrument approach often requires greater freedom in one market and more regulation in another. For instance, to increase market liquidity and efficiency, dual capacity may be required, the resulting conflict of interest then being addressed by rules (e.g. Chinese walls).

local commercial bank6, or whether a pyramid holding company7 may be listed on the stock exchange. A major question today is whether banks, in particular, (but also other financial institutions) can be owned by non-financial companies. Regulatory restrictions in this respect are aimed at reducing the concentration of economic power (and thus enhancing competition) and systemic risk. As is evident from Table 4.6, some major disadvantages arise from constraining financial conglomerates. To some extent these restrictions could be replaced by appropriate capital standards and by encouraging international competition. However, it is mainly the underlying philosophy of society that determines whether financial conglomerates are to be allowed. If they are allowed, it is desirable that adequate 6

7

A commercial bank can be considered to be a “High Street” bank if it has a large retail customer base and is a major participant in the inter-bank payment and settlement system. A pyramid holding company is a substitute device for the issue of non-voting (or low-voting) shares so that a minority shareholder may be able to retain or establish absolute voting control without a majority of the underlying shares. Obviously, no investor is forced to take up such non-voting shares in a company, but often they are keen to do so nonetheless if the investment seems to be capable of ensuring above-average returns.

Table 4.6: Impact of regulatory restrictions on financial conglomerates Favourable

Unfavourable

• Reduces the concentration of power in the financial system • Reduces the business risk emanating from running a multi-faceted business enterprise • Reduces systemic risk, as the larger is the conglomerate, the higher are the costs to society if it fails • Simplifies bank-deposit insurance and the lifeboat facility of the central bank because the range of functions of a firm is limited • May reduce potential moral hazard within a firm. It thus reduces the cost of policing complex boundaries such as Chinese walls • Makes it easier to match functional and institutional regulation • Avoids contamination

• Reduces competition as it restricts free entry into the industry • Increases a firm’s business risk by reducing its ability to diversify its risks in other businesses • Reduces a firm’s benefits of economies of scale and scope • Obstructs the elimination of possible excess production capacity in specific activities (particularly in banking) • Limits the response to outside firms encroaching on the traditional business of a firm. The issue of growing competition between financial and nonfinancial institutions is of particular importance here • Limits the flexibility of a firm’s response to shocks to “existing” business areas

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and full (consolidated) accounting information is available for such financial conglomerates. Restrictions on foreign shareholding in a local commercial bank are normally dictated by national strategic considerations, such as the payments mechanism being controlled by local institutions. Today, this view is increasingly being challenged owing to the impact of globalisation. Pyramid companies are no longer allowed in most industrial countries because the conflicts of interest between the classes of shareholders are considered too great (see Table 4.7). 3.1.3 Functional activity constraints As with regulation related to financial conglomerates, regulation with respect to the range of allowable business that can be undertaken by financial institutions has major implications for the structure of the financial system. At stake is the structural spectrum, which is the extent to which institutions are forced to concentrate on a narrow range of business8, or whether they are allowed to conduct a wide range of financial services. This amounts to whether the structure of the financial system is based upon differential and specialised financial institutions

providing specialised services or upon institutions providing a wide range of services. In particular, the issue arises as to whether banking, insurance underwriting, securities trading and fund management may be conducted within the same firm and, if so, to what extent Chinese walls, fire walls and dedicated capital allocated to each activity are to be imposed. By restricting the functional activity of every financial institution to the four main activities of a financial system (banking, securities trading, fund management and insurance) the authorities try to ensure that there is a clearly defined relationship between institutions and functions9. To some extent regulation is simplified, as there is a precise and exclusive parallel between institution and function – if banking is to be regulated then this is focused on those unique institutions called “banks”, while the regulation of insurance focuses on insurance companies. Even if the authorities allow multi-functional financial conglomerates they may still stipulate that different functional activities shall be handled in separately capitalised subsidiaries. The premise underlying this restriction is the promotion of systemic stability (for instance, financial problems in the 9

8

For example, the Glass Steagal Act in the US has historically sought to keep commercial and investment banking separate.

The concept of financial intermediation itself has become somewhat blurred with the huge growth in financial transactions carried out more or less directly between non-financial enterprises.

Table 4.7: Impact of regulatory restrictions on pyramid holding companies Favourable

Unfavourable

• Curtails serious concentrations of economic power • Curtails corporate dynasties with absolute control and possible succession problems in future • Allows hostile takeovers (which would be impossible if a single shareholder has absolute control) • Politically attractive, as “shareholder democracy” often demands “one share, one vote”

• Restricts proven entrepreneurs from expanding their companies, without losing control, to the possible disadvantage of aggregate economic welfare • Control of the firm remains in the hands of a “longterm” player, rather than with “punter” shareholders • Need for “outside” directors to monitor and curb the power of “inside” management, as there is no longer a close link between the proprietor shareholder and management • Proprietor shareholders no longer have to preserve their reputation among investors. Accordingly, operating companies under their control may no longer be saved from possible bankruptcy

50

Financial Regulation in South Africa: Chapter 4

banking subsidiary should not contaminate the insurance subsidiary and vice versa). Unfortunately, in times of financial distress, these fire wall barriers have not proven to be particularly effective and credible, and accordingly some form of consolidated supervision is called for. Moreover, functional-activity restrictions are imposed not only on institutions, but at times also on markets. Exchanges can either be organised in terms of one of the four basic instruments (commodities, currencies, equities and debt)10, or specialise exclusively in spot market transactions (mostly the existing commodities and stock exchanges) or only in derivatives (e.g. the futures and options exchanges). In principle, regulation should allow for competing instruments and institutions and therefore competing financial markets in order to improve market efficiency. Consequently, the authorities should not shelter institutions from the impact of competition, as this may lead to a deterioration in efficiency and may even create undesirable regulatory gaps. Eventually, financial firms and exchanges that operate as monopolies will be bypassed by the impact of information and trading technology. In such a case clients’ needs will be served with different instruments from different markets or countries11. Financial engineering also has an institutional dimension, as “regulatory arbitrage” (a tendency for business to shift to less onerously regulated financial centres) may cause firms or exchanges to relocate their operations purely because of regulatory and tax considerations. The basic issues in the demarcation and diversification of financial services activities can be summarised as follows: • Extent of allowable diversification: At stake here is the extent to which regulation allows financial institutions to diversify and thus stipulates the 10

11

And thus dealing in both the underlying instruments and their derivatives. According to the old adage: “where there is a will, there is a loophole”. For instance, although swap contracts are in essence futures contracts, they are nonetheless traded in informal markets rather than on a regulated exchange (as is compulsory for futures contracts).

Financial Regulation in South Africa: Chapter 4

range of business activities allowed. In particular, regulation may limit the extent to which the same firm can mix commercial banking, securities trading and/or broking, and insurance. • Own service versus agency diversification: A financial institution may diversify (in the sense of providing a range of services to clients) either in an “own service” or “agency” manner. In the former (either by acquisition or organic growth) the institution itself provides the service: i.e. the service is provided in its own name and it is on the institution’s own balance sheet and therefore it absorbs the risk and needs appropriate capital backing. For instance, a bank can provide its own insurance services, in which case the risk lies with the bank. Agency diversification implies an institution acting as an agent: i.e. it uses its own delivery systems to sell another institution’s product or service. The advantages of an agency to a firm is that it increases efficiency as it unlocks complementary expertise, avoids some managerial problems, avoids learning costs, generates feeincome without balance-sheet constraints, and allows firms to diversify without increasing industry capacity in the new area. • Finance versus non-finance companies: Diversification can take place either within the financial sector (e.g. banks diversifying into insurance) or between commercial (i.e. nonfinancial) companies and financial institutions. This amounts to the issue of whether, for business or regulatory reasons, finance should be regarded as an exclusively specialist activity. In most countries, there is a traditional distinction between finance and non-finance companies, although to a limited extent this is breaking down. Allowing non-finance companies to own banks could offer the advantages of diversification and widen the sources of finance, such as insured deposits. It potentially widens the scope of the central bank’s lender-of-last-resort function. Also the question arises as to whether it is appropriate for unregulated and unsupervised commercial 51

companies to own banks, or that a bank within a holding company could be used to supply cheap loans to other parts of the group. In particular, the commercial company may be motivated by a desire to gain access to insured deposits. Competitors to firms who own banks might also be able to claim that the bank owner had privileged access to bank loans and even that they were being denied bank credit for competitive reasons. • Diversification versus ownership: The issue of separation versus integration relates to the range of allowable business and to the extent of interlocking ownership structures both within the finance sector (e.g. whether the bank can own an insurance company) and between financial institutions and non-finance companies. These are distinct and separate issues. For instance, while in the UK Marks and Spencer has a banking licence and sells financial services, it is open to considerable doubt at this stage whether the authorities would allow it to purchase an existing clearing bank12 or an insurance company. • Management and capitalisation: This issue, in the event that diversification into major new and

different areas is allowed, relates to the extent to which the different functional areas can be managed and capitalised in an integrated manner or whether integration by ownership is allowed while the management and/or capitalisation has to be kept separate. The latter is one way of handling the potential conflicts of interest involved in conglomeration and avoiding the risks of contamination, although by the same token it denies economies of scale in the use of capital and may impede marketing and delivery strategies. 3.1.4 Jurisdictional constraints Most restrictions on domestic jurisdiction have been eliminated over time and replaced with appropriate capital requirements (e.g. if agricultural loans are more risky than loans in the urban areas, a higher capital requirement is stipulated for such loans rather then prohibiting this type of business for certain financial institutions13). Even in the United States restrictions on 12

13

A clearing bank is generally understood to be a major participant in the inter-bank payment and settlement system. For instance, in terms of the 1965 Building Societies Act, permissible business for building societies was restricted to urban areas in South Africa.

Table 4.8: Impact of regulatory restrictions on functional activity Favourable

Unfavourable

• Simplifies supervision as institutional and functional activity merge • Creates fire walls between different functional activities and thus reduces systemic risk – ultimately it is an institution, not a function, that becomes bankrupt • Lowers regulatory costs of supervision as, for instance, the supervision of deposit-taking activities or the granting of bank-deposit insurance is clearly separated from the other activities of a financial conglomerate • One way of guarding against conflict of interest problems

• Reduces competition and business efficiency between financial institutions. Limits competition from smaller firms in particular • Benefits non-financial institutions as the regulatory constraints are often not applicable to them • Firms use capital and human resources less efficiently (every subsidiary needs its own management and capital resource) • May increase risk via enforced concentration of business • Reduces regulatory flexibility as countries have to harmonise their regulation fully in some respects (because the same client can be served from different countries) • Impedes responses to changes in business conditions • Reduces the benefits of economies of scale and scope

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interstate banking are no longer as vigorously enforced as in the past. However, in many developing countries, exchange control regulation remains a serious barrier for firms wanting to expand globally. 3.1.5 Pricing constraints Although free competition primarily implies pricing freedom, regulators may still impose pricing restrictions or condone private pricing cartel agreements (e.g. on setting interest rate ceilings by banks or fixed-brokerage charges). In these cases the authorities balance reduced price competition against reduced systemic risk, particularly in an economic environment where price competition can become “cut-throat” or “excessive”. Restricting price competition (i.e. condoning price cartels) creates economic rents (and hence either high costs or profits), which go against consumers’ interests. However, in this way business risk may be reduced to the extent that profits can be earned without moving into high-risk areas. In terms of the target-instrument approach to financial regulation, price competition should be promoted (to the benefit of the consumer), while the resulting systemic risks have to be addressed in other ways (e.g. capital-adequacy rules). 3.1.6 Operational constraints Operational constraints embrace a wide field of regulatory restrictions. In this section attention is given to the following major requirements: prudential requirements; business conduct requirements; trading requirements; and compensation scheme requirements. Prudential requirements The key to financial stability lies ultimately with the institutions themselves and in particular on their risk analysis, management and control systems. The most

effective supervision, ultimately, begins at home. For this reason the prudential requirements for capital and liquidity are considered to be the backbone of any regulatory regime. These balance-sheet constraints – which are imposed on a consolidated basis14 for a financial conglomerate – are aimed at addressing the problems emanating from increased domestic competition (banks versus non-banks, and financial versus non-financial institutions), globalisation, financial innovation and deregulation. In general, equity capital is needed for the following reasons: • To absorb operating losses while enabling the firm to stay in business; • to support the basic infrastructure of the business on the grounds that it would be inappropriate for this to be financed by borrowed funds (e.g. deposits or term loans); • to maintain public confidence through an indication that shareholders are prepared to make funds permanently available to support the business; • to enable a firm to absorb risks and sustain shocks while continuing to operate; • to enable assets to be written off while still maintaining solvency; • to provide long-term funds to mitigate the hazards of maturity transformation; • to buy time to enable an institution to adjust to changing market conditions and patterns of business. 14

This to avoid “double gearing” within a bank-insurance group. However, it is still questioned whether it is feasible to have a single consolidated capital requirement for a bank-insurance group, or whether the capital invested by the parent company (bank or insurance) in the affiliate has to be totally or partially deducted from the parent's own funds, before the calculation of the parent's capital requirement.

Table 4.9: Impact of regulatory restrictions on jurisdiction Favourable

Unfavourable

• May limit risk exposures of firms • May support national economic policies (particularly the balance of payments, but ultimately fiscal and incomes policies)

• Reduces competition and market efficiency • Increases risk as it forces a geographic concentration • Segments markets geographically

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In this framework, capital has to exhibit three essential characteristics: be permanently available; have the capacity to absorb losses and asset write-offs (hence the emphasis in regulation on equity rather than debt capital); and there should be some positive correlation between the level of capital and the degree of risk in the business15. In this last respect an institution can be burdened with too much capital as well as suffering from too little. In effect, capital is analogous to an internal insurance fund to provide cover for various non-insurable risks not covered in a firm’s pricing (i.e. unanticipated risks). Anticipated risks should always be incorporated into a firm’s pricing (i.e. in the risk premium charged). Ultimately, stronger capital standards not only improve the cushion for the absorption of losses, but 15

The capital-adequacy requirements for transactions on a regulated exchange are usually lower than for OTC transactions, as clearing and settlement systems on an exchange may be less risky than in the OTC markets.

also shift part of the burden of supervision away from the authorities onto the market. In addition to adequate capital resources, the authorities also need to ensure that financial institutions, particularly banks, are not “asset rich, but cash strapped”. Accordingly, banks are subjected to strict liquidity requirements, such as cash reserve requirements. In times of unexpected liquidity needs, banks may supplement their liquidity by means of the accommodation and lender-of-last-resort facilities of the central bank. These standby arrangements of the central bank will be discussed in greater detail in Chapter 5, Sections 3.4 and 3.5. Market conduct of business requirements The imposition of principles and core rules for the conduct of financial services business is aimed at providing an adequate level of investor protection and reducing regulatory costs. The underlying philosophy of this requirement is that the various codes of business conduct, as developed for each industry,

Table 4.10: Impact of capital adequacy requirements Favourable

Unfavourable

• Curtails excessive financial gearing, but otherwise grants greater freedom to market participants, which improves competition • Promotes a level playing field between financial institutions and between formal and OTC markets (i.e. similar capital requirements for similar risk exposures) • Seems the only way to supervise financial conglomerates such as universal banks • Reduces cross-market risk and thus enhances systemic stability • Simplifies regulatory structures and procedures, in turn reducing regulatory costs • Ensures at least some compensation out of shareholders’ funds for prejudiced investors/depositors • Supports harmonisation with internationally agreed minimum standards (IOSCO and Basel Agreements) • Imposes capital-market discipline • Enhances public confidence • Enables banks to absorb risks

• Raises the entry costs and thus may reduce competition from small firms • Raises the running cost of the business, as capital has to be serviced by dividend payments • Gives securities markets and non-financial institutions a competitive advantage over financial intermediaries • May result in suboptimal portfolios if capital ratios are not based on actuarially sound risk evaluations (e.g. public sector securities often have too low a capital ratio compared with private sector securities) • Changing capital ratios will result in portfolio adjustments, which may be swift, substantial, potentially unstable and difficult to moderate

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should provide adequate protection only, and should not be excessively cumbersome. For example, a three-tier system of conduct regulation was developed for the UK investment business as follows:

•

The first tier consists of (10) broad principles which all financial firms have to abide by. The chief executive of a firm is directly responsible for ensuring that the principles of investment business are complied with (see Table 4.12). The authorities

Table 4.11: Impact of conduct of business conduct requirements Favourable

Unfavourable

• Allows for an inexpensive and expeditious way of solving legal disputes on issues such as prejudiced investors • Supports self-regulation, which in essence centres on best ethical standards and high-quality riskcontrol techniques

• Undermines the authority of the regulator if not forcefully enforced • May involve the authorities in lengthy (and costly) legal battles

Table 4.12: Principles for the conduct of investment business (in the UK) • Integrity. A firm should observe high standards of integrity and fair dealing in the conduct of its business. • Skill, care and diligence. A firm should act with due skill, care and diligence in the conduct of its business. • Market practice. A firm should observe high standards of market conduct. It should also, to the extent endorsed for the purpose of this principle, comply with any code or standard as in force from time to time and as applied to the firm either according to its terms or by rulings made under it. • Information about customers. A firm should seek from customers it advises or for whom it exercises discretion any information about their circumstances and investment objectives which might reasonably be expected to be relevant in enabling it to fulfil its responsibilities to them. • Information for customers. A firm should take reasonable steps to give a customer it advises, in a comprehensible and timely way, any information needed to enable him to make a balanced and informed decision. A firm should similarly be ready to provide a customer with a full and fair account of the fulfilment of its responsibilities to him. • Conflicts of interest. A firm should either avoid any conflict of interest arising or, where conflicts arise, should ensure fair treatment to all its customers by disclosure, internal rules of confidentiality, declining to act, or otherwise. A firm should not unfairly place its interest above those of its customers and, where a properly informed customer would reasonably expect that the firm would place his interests above its own, the firm should live up to that expectation. • Customer assets. Where a firm has control of or is otherwise responsible for assets belonging to a customer which it is required to safeguard, it should arrange proper protection for them, by way of segregation and identification of those assets or otherwise, in accordance with the responsibility it has accepted. • Financial resources. A firm should ensure that it maintains adequate financial resources to meet its investment business commitments and to withstand the risk to which its business is subject. • Internal organisation. A firm should organise and control its internal affairs in a responsible manner, keeping proper records, and where the firm employs staff or is responsible for the conduct of investment business by others, should have adequate arrangements to ensure that they are suitable, adequately trained and properly supervised and that it has well-defined compliance procedures. • Relations with regulators. A firm should deal with its regulators in an open and co-operative manner and keep the regulator promptly informed of anything concerning the firm which might reasonably be expected to be disclosed to it.

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can discipline a firm if it does not apply the principles, but no prejudiced investor can sue a firm for not complying with a principle. • The second tier consists of (40) designated rules, which are derived from the ten principles. The designated rules have more substance than the principles, but are still more simplified than the detailed rules contained in the rulebooks. A private investor could sue his adviser if the latter breaks a designated rule. • The third tier consists of the rulebooks of the selfregulatory organisations (SROs), which have to incorporate all the designated rules (though the authorities are prepared to make exceptions). This three-tier system is less bureaucratic, less legalistic in nature, and therefore less costly. However, it assigns more responsibility to the SROs for policing their own affairs with the principles in mind. Despite being less legalistic, the system is not necessarily less effective. Indeed, it would be easier for the Financial Services Authority (FSA) to fine or to punish offenders for not complying with a principle, than for a technical infringement. Moreover, anyone who is not prepared to accept the FSA’s interpretation of the principles will have the right to take the FSA to a public court resulting in costly legal proceedings. Trading requirements Of importance in this area has been particularly the single-capacity trading requirement. In practice the benefits of single-capacity trading were closely tied to unlimited liability membership of an exchange and a fixed-brokerage system. As global competition has rendered these two restrictive trade practices increasingly impractical, single-capacity trading is likewise

disappearing. Today the issue is how to properly regulate dual-capacity trading rather than to require singlecapacity trading16. This is done, for instance, by introducing automated trading systems with good audittrail technology and surveillance programmes. Moreover, as the concentration of power becomes greater, there is more force to the argument in favour of opening up an exchange (allowing negotiable brokerage, corporate membership and ultimately dual-capacity trading). During the last decade, competition between securities exchanges in particular has grown fiercely, with major securities often quoted simultaneously on a number of exchanges. In addition, there has been intensified competition from fully automated trading systems or rival systems such as share dealing, trade settlement and information gathering. Compensation schemes requirements Compensation schemes are a useful instrument for protecting the small investor (see Table 4.14). Government can be involved in a compensation scheme either by being party to the scheme or by regulating the scheme (i.e. laying down the regulations and supervising the scheme). Compensation schemes of sufficient size are usually required for regulated exchanges to protect the interests of the small investor. Moreover, in situations where netting arrangements are not legally enforceable, the authorities can still allow offset on a regulated exchange if the overall exposure risk is covered by an approved compensation scheme. Here compensation schemes significantly 16

Only under certain explicit conditions is dual-capacity trading prohibited today (e.g. the Chicago Mercantile Exchange bans dual trading in all contract months reaching the level of "maturity liquidity" as determined by the exchange).

Table 4.13: Impact of single-capacity trading requirement Favourable

Unfavourable

• A cheap and efficient way of protecting the investor against trade manipulation provided this trading rule is rigorously applied. • Easier to guard against conflicts of interest

• Today an unnecessarily restrictive requirement, as an automated trading system can obtain the same degree of investor protection as a single-capacity trading rule • Reduces competition (e.g. a financial conglomerate can operate in dual capacity only)

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contribute to market liquidity, as without them financial gearing would be significantly lowered. Bank-deposit insurance is a form of compensation scheme. The authorities are in favour of these schemes, but during the 1980s some serious reservations developed (see Table 4.15). There is a fundamental dilemma in deposit-insurance schemes in that, where a 100% cover is offered, a moral hazard is created in two respects. Firstly, the insured institution may be induced to take excessive risk, especially when its capital position is weak. If the risk does not materialise, it gains the profits, but if the risk does materialise, the cost is passed to the insurance fund. This creates a one-way option for high-risk strategies. In addition, the institution does not need to pay a higher rate of interest to fund high-risk assets. Secondly, the depositor has less incentive to take care in the selection of institutions at which to make deposits. By contrast, if coverage is less than total, the scheme may be ineffective: for instance, depositors will withdraw funds even if they stand to lose only a small proportion of their deposits in the event of an

institution’s collapse. Central bankers are still divided over the benefits of deposit insurance. Those who have great confidence in the market process and the ability of banks to measure their risk exposures are usually against deposit insurance17, whereas those who feel that market imperfections cannot be ignored are in favour of such insurance. Private bankers often see mandatory deposit insurance as an unwanted interference with major moral hazard risks attached to it. Therefore, they feel there is no need whatsoever for deposit insurance, provided the central bank knows how to deploy its lender of last resort and lifeboat facilities. Another view is to see deposit insurance at the heart of bank regulation. This position is likely to be adopted by regulators, because they see a deposit-insurance scheme as one of two fundamental methods to determine the 17

According to the Governor of the Reserve Bank of New Zealand all that is required is: a sound monetary policy to temper fluctuations in asset prices (enforced by positive real interest rates); adequately capitalised banks (Basel Agreement); tough quarterly disclosure rules; six-monthly audits; and a rating certificate of a recognised rating agency on the front door of the bank.

Table 4.14: Impact of compensation scheme requirement Favourable

Unfavourable

• The structural and procedural aspects of investor protection are formalised, and arbitrary actions are not needed – given that the relevant aspects have been properly and adequately considered • Forces a proper risk assessment, as the compensation fund cannot accept a limitless responsibility for investor protection • Affords the government the scope for providing more or less concisely defined guarantees – given that the rules of the game are well publicised – and does not expose it (and the taxpayers) to assumed or imagined unconditional guarantees • Greater stability can be created for the financial system if investors, who do not have the capability to do adequate risk assessment, are given greater certainty about or at least an assurance of the safety of their investment

• Provides the scope for a firm to take on higher risk business (as in the case of failure the claims against it can be devolved onto the compensation fund) • Can induce moral hazards with investors, as it removes the incentive to consider the risks involved in either a certain type of investment or a specific institution • Leads to cross-subsidisation where financially stronger Institutions are continually paying for weaker institutions with respect to the guarantees (or the support) provided by the compensation scheme (i.e. the free-rider problem) • Although an upper limit is often provided, it is still an open question as to whether there is an implicit undertaking over and above that limit for the government to provide investor protection • Legal challenges can be issued to compensation schemes arising from the fact that not all projected risks are covered

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Table 4.15: Impact of bank-deposit insurance requirement Favourable

Unfavourable

• Lowers exit costs and thus may help to reduce excess capacity in banking • Affords at least some protection to retail investors • Enhances stability of banking system by reducing the likelihood of runs on healthy banks • Role of taxpayer is explicitly taken into consideration (i.e. in contrast to the lifeboat facility of the central bank) • The oligopolistic structure in banking may become monopolistic if bank failure is not avoided • Simplifies the lifeboat facility of the central bank

• Overall risk in the banking industry could increase (e.g. a 100% cover always creates a moral hazard problem) • The bank’s internal control and risk management systems (the first line of defence) may be neglected, while depositors may become indifferent to the credibility of individual banking firms • Large banks are in effect subsidising small banks • The cost-benefit can be unfavourable (e.g. the US experience). As a result of the higher cost structure of banking in general, healthy banks are bound to lose business to securities firms in the capital markets • A bank that is part of a large financial conglomerate needs no insurance, as financial assistance would be forthcoming from within the group • To run deposit insurance on sound actuarial principles is difficult in a country (such as South Africa) where a few big banks control more than 80% of the retail banking business • Financial engineering makes it difficult to draw the line at protecting some deposits and not others • Limits imposed on the extent of deposit insurance may be too low for the poor and also not prevent bank runs • Deposit insurance is a cure after a crisis – better to prevent the crisis by proper bank supervision • The local insurance capacity of the banking and insurance sectors may be too small to cover this risk (e.g. the Norwegian experience) • Creates the political dilemma of how to determine the premium (i.e. based on the size of the bank, the actuarially calculated risk value, or a fixed-price insurance) • “Creative destruction” in the sense of efficient institutions superseding obsolete ones, may be restricted

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capital adequacy of banks18. Indeed in theory, a bank’s capital need can be determined either externally or internally, i.e. either (i) by an external credit-rating agency which, in effect, sells the bank a call option that can be exercised should the bank be unable to repay its depositors out of normal cash flows;19 or (ii) by the bank’s internal risk-management models. In practice, many countries make use of both these methods, but with more emphasis on either the one or the other. Usually the better the internal risk management systems of a bank, the lesser the need to rely on rating agencies, as there is less chance that use will be made of such a deposit-insurance scheme. In the extreme, there will be no need at all for deposit insurance, provided banks have superior in-house risk management systems; the authorities impose a Structured Early Intervention and Resolution regime on banks20; and the investing public obtains sufficient and timely information about the quality and risk profiles of the banks (either from rating agencies or the central banks). However, it is mainly due to the lack of perfect and costless information that there is a need for some form of deposit insurance. If a bank runs into difficulties, e.g. through unexpected exposure to bad debt it is often difficult for the management to determine the precise borderline between a temporarily illiquid position and permanent insolvency. Likewise, the bank supervisors may have great difficulty in obtaining timeously all the relevant information about the state of solvency of a bank. Moreover, even if the bank supervisors had perfect information, they might not always be able to disclose such information to the investing public, as this may result in a run on the bank, which the authorities are trying to avoid in the first place. For depositors in general (i.e. outsiders not privy to any 18

19

20

A capital adequacy requirement flowing mainly from the inherent risks that banks run by accepting deposits from the public with the promise to redeem them on demand at par value plus interest. The call option is then hedged by the rating agency with the available funds in the deposit-insurance scheme, while the call option price – i.e. the insurance premium – is based on the actuarial risk assessment. Such a regime will discourage inter alia forbearance by the supervisory authorities.

Financial Regulation in South Africa: Chapter 4

sensitive and confidential data), obtaining reliable and timely information is often a hopeless task.

3.2 Official monitoring and supervision Financial institutions and markets have to subject themselves to inspections by the regulatory authorities. This regulatory instrument flows directly from the licensing system, which underlies the financial system. In the extreme, business licences can be withdrawn if the authorities are dissatisfied with what they see in practice. Official inspections can take various forms. For instance, financial institutions are usually requested to submit, at regular intervals, specific financial information21, which is then analysed by the regulatory authorities with a view to spotting undesirable developments, such as potential default trends. In addition, financial institutions are subjected to onsite spot inspections in which case the authorities undertake a type of external audit of the company, but with special reference to the prudential and conductof-business requirements. To enhance the link between the supervisors and the board of directors, the authorities may also engage in presentations to the board on how their firm compares with the industry at large, or to air concerns of a more general nature. Ad hoc interviews with non-executive directors may also be required, particularly if the firm has problems in the area of corporate governance. Following the development of global financial conglomerates during the 1990s, it has become virtually impossible to monitor and supervise complex groups properly on an ad hoc basis by various national specialised agencies (such as bank or insurance supervisory agencies in isolation). Accordingly the modern trend is to supervise these groups by using multi-disciplinary teams (bank, securities and insurance experts from both home and host regulators, all working in the same team) on a permanent basis and located at the financial conglomerate’s head 21

Such as the official returns, which for an average bank may run into hundreds of pages each month.

59

offices. This implies that the monitoring and supervision are undertaken by one inspection team (usually some 3–5 persons) who keep close contact specifically with the risk management department, audit department and the compliance office.

3.3 Intervention and sanctions In the banking sector, rather than using scarce regulatory resources to manage a bank depositinsurance scheme, these resources could be used, alternatively, to prevent a banking crisis by means of Structured Early Intervention and Resolution arrangements (or SEIR arrangements).22 The underlying idea of these SEIR arrangements is that the authorities have to make sure that there is always enough equity capital in the firm to repay the depositors and secured creditors in case of insolvency. The essence of a SEIR strategy is that trouble within a bank usually builds up over time rather than suddenly emerges without notice. Thus under SEIR certain trigger points (e.g. related to a banks capital adequacy levels) are established and as a bank passes through each stage, mandated corrective action is required from the supervisor. The action taken at each stage may be relatively minor in itself but cumulatively becomes significant as each stage is passed. Ultimately, the bank is closed before it has become insolvent. A major feature of SEIR proposals is that supervisory intervention is mandatory: i.e. there is no discretion. Accordingly, with this instrument the authorities subject the regulated institutions to a stringent regime of timely provisions against doubtful and bad debts. As these debts mount during the normal course of the business cycle, the credit risks are already impaired against capital, implying that shareholders would have to purchase additional ordinary shares if surplus capital is not available. If the shareholders are unwilling to invest further resources in a troubled institution, the authorities could immediately take the necessary steps, such as a prohibition on paying dividends or on 22

60

A properly Structured Early Intervention and Resolution process might imply no need for deposit insurance at all.

expanding the business by taking on more assets on to the book, or they could even close the institution. By their nature SEIR arrangements are crucially dependent on the timely assessment of risks and on the political will to close (potentially) insolvent institutions. An uncommon form of intervention in the banking industry is found in South Africa where banking legislation (section 89 of the Banks Act of 1990) contains a provision which enables the regulator, at the request of the directors of a distressed bank, to place the bank under curatorship. The main advantage of such an action is that the curator has, among his extensive powers, the ability to “freeze” deposits and halt a run on the bank while he searches for an appropriate solution in the best interests of depositors. The curatorship provisions are controversial and to a large extent untested in law. There are proposals on extensively amending the Banks Act in South Africa in this regard, and proposals have also been made to scrap the curatorship provisions altogether. The probable advent of deposit insurance in South Africa is also used as an argument for the review of the curatorship provisions. The curatorship provisions have been misunderstood and possibly misapplied in the past. However, in the situations in which they have been used, they were used effectively to prevent the inevitable run on the bank concerned from deteriorating into a “fire sale” of assets in order to meet depositors’ demands. Such fire sales result in a much worse situation for all depositors, or prejudice those depositors, usually the more unsophisticated ones, who did not react in time to the bank’s distress. Deposit insurance will not alter the situation because, in order to avoid moral hazard, deposits will never be fully insured and if depositors stand to lose even a small percentage of their deposits, they will still create a run on the bank. In the financial markets of many countries, the detection of price manipulation and unfair or insider trading practices is increasingly becoming subject to intervention by the authorities. Using the information from the trading system, legislation can give the authorities investigative powers including rights of Financial Regulation in South Africa: Chapter 4

attachment, removal of documents, interrogation and interdict and the power to institute derivative action. The authorities are able to bring civil action to bear against the transgressors so as to claim special damages from them or, in special circumstances, from their employers or principals. Persons who have suffered loss as a result of unfair trading may also be able to claim compensation.

3.4 Incentive contracts and structures Incentive structures and moral hazards faced by decision makers (bank owners and managers, lenders to banks, borrowers and central banks) are major issues to consider in the regulatory regime. Some analysts ascribe much of the recent banking crises to various moral hazards and perverse incentive structures such as fixed exchange-rate regimes, anticipated lenderof-last-resort actions, what are viewed as bailouts by the IMF, the ownership structure of banks and their corporate customers, and safety net arrangements. Incentive contracts can cover a whole range of financial activities. At the top of this list are the incentives to ensure proper corporate governance (which will be discussed in more detail in Section 3.6 below). If a firm has a good corporate governance culture, a host of other regulatory requirements will automatically fall into place, such as a proper compliance culture and adequate risk-management systems. The ultimate aim of incentive contracts is to replace, or supplement, a one-size-fits-all official dictate with a specific, tailor-made corporate contract that acknowledges the firm’s own responsibility for sound business practices. For example, the compliance manual of each individual firm can be seen as an incentive contract. In a similar vein, financial firms may be offered a choice by the authorities either to fulfil a fixed-ratios prudential requirement23, or to replace this inflexible standard with its in-house valueat-risk model to calculate its statutory capital requirement. This section will address these two issues in somewhat greater detail. 23

This is the “building block” approach, which applies to all firms without adjustments for institutional specifics.

Financial Regulation in South Africa: Chapter 4

Capital regulation should create incentives for the correct pricing of absolute and relative risk If differential capital requirements are set against different types of assets (e.g. through applying differential risk weights), the rules should be based on actuarial calculations of relative risk. If risk weights are incorrectly specified, perverse incentives can be created for firms because the implied capital requirements are more or less than those justified by true relative risk calculations. A major critique of the current Basel capital requirements for banks is that the risk weights bear little relation to the relative risk characteristics of different assets, and the loan book carries a uniform risk weight even though the risk characteristics of different loans in a bank’s portfolio vary considerably. Incentives for owners The owners of financial institutions have an important role in the monitoring of management and their risk taking. Essentially, it is owners who absorb the risks of the firm. There are several ways in which owners can be given appropriate incentives: • One route is to ensure that firms have appropriate levels of equity capital. Capital serves three main roles as far as incentive structures are concerned: (i) it commits the owners to supplying risk resources to the business, which resources they can lose in the event that the firm makes bad investments or loans; (ii) it is an internal insurance fund; and (iii) it wards off the danger that the firm may become the captive of its bad clients or debtors. In general, the higher the capital ratio, the more the owners have to lose and hence the greater the incentive for them to monitor the behaviour of managers. Low capital creates a moral hazard in that, given the small amount owners have to lose, they are more likely to condone excessive risk taking in a gamble-for-resurrection strategy. This was evidently the case during the Savings and Loan crisis in the United States. • Corporate governance arrangements should be such that equity holders actively supervise managers. • Supervisors and safety net agencies should ensure 61

that owners lose out in any restructuring operations in the event of bank failure. Failure to penalise shareholders in the restructuring of unsuccessful banks has been a major shortcoming in some rescue operations in Latin America. • In some countries (e.g. New Zealand) the incentive for owners has been strengthened by experimenting with a policy of increased personal liability for directors of firms. Incentives for management Creating the right incentive structures for the managers of financial institutions is equally as important as creating those for the owners. In fact, the two should be seen in combination. Ultimately, all aspects of the behaviour of a firm are corporate governance issues. There are several procedures, processes and structures that can reinforce internal risk control mechanisms. These include internal auditors, internal audit committees, procedures for reporting to senior management (and perhaps to the supervisors), and making a named board member responsible for compliance, risk analysis and management systems. Supervisors can strengthen the incentives for these by, for instance, relating the frequency and intensity of their supervision and inspection visits (and possibly rules) to the perceived adequacy of the internal riskcontrol procedures and compliance arrangements. In addition, regulators can create appropriate incentives by calibrating the external burden of regulation (e.g. number of inspection visits and allowable business) to the quality of management and the efficiency of internal incentives. Specific measures designed to create correct incentive structures include the following: • Strong and effective risk analysis, management and control systems in place in all financial institutions for assessing risks ex ante, and asset values ex post. For banks, this includes systems and incentives for timely and accurate provisioning against doubtful or bad debts. Many bank failures are ultimately due to weaknesses in this area. Regulatory agencies have a powerful role in promoting, and insisting upon, effective systems of internal management 62

and risk control in financial institutions through the strict accountability of owners, directors and senior management. • Managers should also lose if the institution fails. This requires a high degree of professionalism in the firm’s managers and decision makers and also penalties (including dismissal) for incompetence among managers. Remuneration packages may be related to regulatory compliance. • Subject to prudential standards being maintained, proper incentives can be created by fostering competition in the financial sector. This can be achieved, for instance, by removing restrictions on business activity, allowing the entry of foreign banks and other financial institutions, and forcing the abandoning of restrictive practices, cartels and other anti-competitive mechanisms. • Mechanisms need to be in place to ensure that loan valuation, asset classification, loan concentrations, interconnected lending and risk assessment practices reflect sound and accurate assessments of claims and counterparties. This also requires mechanisms for the independent verification of financial statements and compliance with the principles of sound practice through professional external auditing and on-site inspection by supervisory agencies. • Ownership structures that foster shareholder monitoring and oversight. These structures include private ownership of firms to strengthen the monitoring of management performance and to reduce distortions in incentives for managers. • Requiring large financial firms to establish internal audit committees. The key is that there needs to be appropriate internal incentives for management to behave in appropriate ways. And the regulator has a role in ensuring that internal incentives are compatible with the objectives of regulation. Incentives to create a sound compliance culture Regulation is often too legalistic, with too little supervision. Frequently the appropriate regulatory structure is in place, but is not backed up by adequate Financial Regulation in South Africa: Chapter 4

supervision (e.g. the BCCI and Barings cases in the UK). The supervision of wholesale investment business has to be undertaken primarily through self-regulatory organisations, while retail investment business has to be supervised more extensively by resorting to compliance procedures, adequate disclosure standards, random spot examinations, detailed reporting by external auditors and published ratings by rating agencies. To address all these issues, compliance and data examination processes are necessary. Today most industrialised countries make explicit compliance office structures a requirement for financial institutions. In terms of this arrangement, every financial institution has to submit a detailed compliance manual to the authorities for approval. This compliance manual can be seen as an incentive contract between the regulated and the regulator. Therefore it is bound to be more voluminous for more complex businesses. Typically the compliance officers have to pay specific attention to the following aspects: • Safeguarding the reputation and image of the institution. • Training and competence. • Transparency and disclosure. • Standards of advice. • Suitability of products for specific customers. • Conflicts of interest. • Fraud and money laundering. Compliance with regulations has to follow the spirit and purpose of the rules and not merely staying within the “letter” of the rules. For instance, the compliance officer of a firm should not opt for a mechanistic or a “work to rule” approach, but aim at ensuring the “best practice” application of the regulations. If effective compliance does not take place, there could be impaired judgements (e.g. underestimation of risks),

which may negatively impact on business efficiency and consumer protection. Data examination requirements increasingly demand the centralisation of data (e.g. to measure overall exposure – whether from a risk evaluation or capital adequacy point of view) and the adapting and integrating of existing computer systems. Obviously these examination requirements place a financial strain on firms. But it is a necessary expense, especially in view of the risk exposures of today’s firms. Incentives to contain systemic and business risks For over two decades risk management departments of financial institutions have mushroomed – and not without reason. Without proper risk management, no bank or securities firm can stay in business, as it would inter alia be unable to answer the many detailed questions of the supervisors about topics such as liquidity maturity ladders, repricing intervals and value-at-risk. Risk management has become a field of expertise where high finance, advanced mathematics and informatics are closely intertwined. Whether the supervisors like it or not, they have become increasingly dependent on the in-house risk management and control systems of the institutions they supervise, as the official inspection staff represents only a fraction of the firm’s risk management staff and their various technical support functions. Accordingly, there is a self-interest on the part of the authorities to encourage high quality riskmanagement assessment techniques in financial institutions on which the regulators can leverage their own monitoring and control systems. The major financial risks faced by a financial institution are the following: • Credit risk, which requires inter alia timely and

Table 4.16: Impact of compliance and data examination requirements Favourable • Improves risk management within firms • Enforces ethical standards in firms • Enhances the supply of reliable information Financial Regulation in South Africa: Chapter 4

Unfavourable • Increases entry costs and running costs of firms

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adequate provisions against doubtful and bad debt, the correct pricing of risks, and correct loan and asset valuation. • Market risk, which rests primarily on value-at-risk and earnings-at-risk assessment procedures. • Liquidity risk, which necessitates extensive stress testing of cash flow models. • Operational risk, which entails, for instance, audit arrangements, forensic investigations and management control systems. The essence of corporate risk management is the management of overall institutional risk across all risk categories and business units. Although in terms of the current Basel capital standards, the statutory capital adequacy of banks is still allowed to be determined by means of the building block approach24, the modern approach is very moving in the direction of Enterprisewide Risk Management (ERM). Financial market dynamics make it increasingly difficult to consider the various risk categories in isolation, as say a major insolvency (credit risk) may give rise to a liquidity crisis, in turn triggering a sharp fall in asset prices (market risk). As risks are at times highly correlated, the risk-management approach has to shift to a portfolio approach. The need for an integrated process for identifying, measuring and managing all risks of an enterprise (in its global context) has necessitated the ERM approach. In the end the ERM tries to address the classic risk-management problem of how to achieve (an always elusive) degree of leverage that creates an adequate return on equity without threatening default. Unfortunately the ERM approach depends on having highly skilled staff and major system backing. The ERM is therefore expensive. Supervisors cannot duplicate these systems for their inspection purposes, and neither is it in their interests to stick to the old “building block” approach of determining capital adequacy. Accordingly they have to encourage financial institutions to follow ERM modelling techniques, by means of specialised incentive contracts. 24

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Where the required capital for each risk category is considered in isolation and then summed to a grand total.

3.5 Market monitoring and discipline Besides official monitoring and supervision, the financial markets also monitor the performance of financial institutions. If markets are dissatisfied with the performance of certain financial firms, their discipline can be harsh and sudden. Usually, market discipline works through the share price, the price of subordinated debt, and willingness to trade with a firm. Particularly for banks, where trust is the basis of all business, a major fall in a bank’s reputation can be extremely painful. On balance, the markets are far more successful in enforcing a change in directors and management than are the authorities. As virtually every bank failure has had poor management as one of the underlying reasons, it is in the interest of the authorities to promote market monitoring and discipline to the maximum. Market monitoring is only possible if there are proper disclosure and transparency arrangements. Transparency is supported if financial institutions report in terms of generally accepted accounting standards and external auditors report any misgivings they may have. The rating agencies, the unsecured creditors in the capital market and the financial press are also important role players in ensuring market discipline. Each of these role players will be briefly discussed in this section. Role of external auditors There is a growing trend in financial regulation to place more responsibilities on external auditors who can potentially fulfil a valuable role in validating the financial and other information used by the regulators, and act as “whistle blowers” if they discover any irregularities in the course of their examinations of the financial institutions they audit. However, external auditors are appointed and paid by the financial institution’s shareholders and the increasing demands on them from regulators create a classic conflict of interest. Although in theory they are appointed and removed by shareholders, in practice this function is taken on by the financial institution’s management and it is often the institution’s management which external auditors are required to criticise in their reports to regulators. Financial Regulation in South Africa: Chapter 4

It is clear that in any regulatory system where additional responsibilities are assigned to external auditors, it will also be necessary to take whatever steps are necessary to avoid conflicts of interest and also to strengthen the independence of the external auditors. A number of models are available for this purpose, e.g. compulsory rotation of external auditors (as in France). Nonetheless, considering the assistance auditors could render to the supervisors by reporting criminal activities within a firm, it may be necessary to expand the areas of auditors’ responsibilities. For instance, in the UK the Bingham Report recommended that auditors should have the duty, and not just the right, to inform the authorities of adverse circumstances. Moreover, financial conglomerates should have a single, or at least the same, auditors for all the financial companies of the group25. 25

After the BCCI experience it is recommended that all companies in the conglomerate should have the same accounting date, and the head office should be in the same country as its registered office.

Official recognition of ratings by private credit-rating agencies Rating agencies help to alleviate two central problems in finance: asymmetric information and a lack of expertise in assessing information. Ratings are based not only on published information but also on information that is normally only available to the firm itself or a bank making a loan to the firm. Though rating agencies do not disclose all of the information at their disposal, it is embodied in the ratings issued. In addition, rating agencies develop considerable expertise in analysing information, especially since their reputation in this field establishes the credibility of their ratings. In essence, a rating agency offers independent opinions on the future risk of defaulting on debt securities and related fixed-income obligations. Depending on investor demand, opinions may be offered on virtually any financial instrument or obligation involving a promise to pay – such as

Table 4.17: Impact of using rating agencies by the regulatory authorities Favourable

Unfavourable

• Improves information to investors in respect of debt instruments and institutions by establishing an independent comparative scale of investment risk (“buy lists”) • Investors use ratings to assess the risk premium of a security • Good ratings enable issuers to come to the market quickly with new issues • Good ratings can result in a saving in funding costs • The existence of a pool of rated debt securities may help to create a risk-based price structure in the market • Disseminated opinions about credit provide wider access to investor capital • Good ratings counteract the effects of rumours and speculation • Credibility of bank statements is tested • An independent assessment • Strengthens market discipline (e.g. through cost of debt)

• As firms are keen to obtain a good rating, rating agencies may degenerate into “blackmail” agencies* • Rating agencies are subject to strong competition and, if they fail to provide the service for which they are paid, clients will stop using them. • Management may try to improve rating (short-term goal) at the cost of firm’s long-term profitability • Subjective analysis can lead to adverse ratings and may distort the allocation of financial resources (“run on a bank”) • Investors may abdicate the responsibility for credit risk assessment to the regulator that approves rating agencies (“moral hazard problem”) • The “accreditation” or regulation of rating agencies may create an “implicit contract” in terms of which the quality of a rating agency is no longer determined by market forces • If there is limited access to information, ratings may be subjective

* There usually are sufficient laws to prevent or to punish gross violations of conduct by the agencies, such as providing a favourable rating in exchange for a secret payment. Financial Regulation in South Africa: Chapter 4

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corporate bonds, preferred stock, commercial paper, bank deposits, structured financing and the policyholder obligations of insurance companies. Regulators in many countries require ratings of various classes of debt, for example: • Chile – all issuers of public securities have to obtain, at their own cost, ratings from at least two distinct and independent chartered rating agencies. • France – issuers of debt have to publish the rating they obtained from a specialised agency. • India – an issuer has to obtain a rating from an agency approved by the central bank. • Japan, the United Kingdom and the United States – regulators use ratings to assign values to securities held in inventory. The rationale behind the regulators’ interest in rating agencies is that a well-run rating agency system may perform a number of quasi-regulatory market functions at less cost to government – for example, by making more information available and thereby promoting prudent investment decision-making processes by investors and/or depositors. Clearly, once regulators have decided to make the rating of debt mandatory, they have to decide whose ratings are acceptable. Switzerland refers to internationally recognised agencies, the United Kingdom to authorised agencies and the United States to nationally recognised statistical rating organisations. Each country uses slightly different methods to regulate or accredit rating agencies. Assessment by the capital market Acceptance and comparative assessments of financial institutions through the international capital market can be achieved by enhancing the position of unsecured subordinated debt holders. To enhance the power of foreign creditors in banks’ risk management policy and to encourage more disclosure, the authorities may stipulate that a certain percentage of statutory capital should consist of foreign-currencydenominated unsecured subordinated debt (i.e. thirdtier capital). In principle, at least, a number advantages flow from this statutory requirement: • The yield at which these securities trade in the 66

capital market will give the authorities and depositors a good insight into the market’s confidence in a specific institution. The yield can be seen as a rating instrument. • As the holders of uninsured subordinated debt are far back in the line as creditors, they will pressure management to stay within acceptable risk parameters during their normal business and do proper risk management assessment in general. • Subordinated debt holders form a type of natural counterbalance against ordinary shareholders, who may gain from the resurrection strategies of insolvent banks, while subordinated debt holders can only lose from such high-risk strategies. • As banks have a direct interest in the market’s confidence, the issuing of subordinated debt provides a powerful incentive for banks to improve their disclosure policies and the transparency of their accounts. • Subordinated debt requirements are easy for supervisors to verify, and so they can be held accountable for verifying. In practice, official supervision and regulation cannot operate properly without any external marketderived pressure. Market signals and market penalties make government actions more credible and remove the capacity of government officials to deny that a problem exists. Whether they like it or not, financial supervisors operate in a political environment and have to be on their guard against (often well-intended) forbearance. Forbearance is a major problem in regulation, as in crisis after crisis supervisory agencies have shown that although they did not lack information, they did lack the political will to do what they were created to do26. In regulation, transparency is crucial, but in isolation it is clearly not enough. Likewise, no supervisory agency can be created in isolation that can serve as an effective substitute for market discipline. 26

Calomiris, C., “Market-based banking supervision”, The Financial Regulator, Volume 3, No 4, London: Central Bank Publications, 1999, p.34.

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A critical financial press Market discipline would be very harsh indeed if consumers were properly informed about badly managed firms or dishonest market conduct by firms (such as front running), and as a result of this insight decide to do their business elsewhere. Unfortunately, in practice, it is virtually impossible for the authorities to inform the general public without the support of the financial press and consumer bodies. In fact, the authorities would do better to focus on these interest groups exclusively and leave it to them to provide the necessary disclosure to consumers. Likewise, consumer education is best done with the assistance of the financial press and consumer bodies. Therefore it is also in the interest of the authorities to take note of the specific requirements of these interest groups and assist them, in turn, wherever possible with timely and adequate information. Fewer entry barriers The market is unable to exert discipline effectively if entry and exit barriers in the industry are too high. To promote competition, and thus market discipline, the authorities should try to lower these barriers wherever possible. Historically, regulation in finance has often been anti-competitive in nature and the regulators condoned, and in some cases endorsed, unwarranted entry barriers. Today, less restrictive regulation, particularly with respect to allowable business, and the development of information and delivery technology has lowered the entry barriers. For instance, retail financial services firms (banks, building societies, fund management institutions, insurance companies, etc.) face increasing challenges in this respect – they are losing some of their comparative advantages which have underpinned their dominant position in the financial system. In particular, as entry barriers into the industry decline, traditional financial firms are facing new types of competition from a wider range of competitors. In addition, the development of electronic banking has in some countries enabled foreign banks to enter hitherto relatively closed Financial Regulation in South Africa: Chapter 4

domestic retail banking markets. All these forces improve competition and hence market discipline.

3.6 Corporate governance If a proper corporate governance regime is in place the regulatory authorities need not be too prescriptive in their codes of business conduct, as these requirements are already “privatised” in the sense that they have become supervisory tasks of the private rather than a public sector. Corporate governance rules can be seen as a form of market discipline: i.e. their standards are set by international competitive forces. Corporate governance is essentially about leadership.28 More particularly, it is leadership for efficiency, probity, responsibility, transparency and accountability. Business efficiency is necessary to compete in the global economy. Business probity is required to obtain the trust of investors. Business responsibility is increasingly considered as including not only profitability but also legitimate social concerns. Business transparency and accountability are the essential characteristics of good leadership without which there can be no trust in the leaders. It is the responsibility of the board of directors to ensure good corporate governance. This involves a set of relationships between the management of a corporation, its board, its shareholders and other relevant stakeholders. Accordingly, the board must agree on the corporation’s purpose (what it is for), its values (what it stands for) and the strategy to achieve its purpose. It must account to shareholders and be responsible to its stakeholders. Good corporate governance requires that the board must govern the corporation with integrity and enterprise in a manner that entrenches and enhances the licence it has to operate. This licence is not only regulatory but also embraces the corporation’s interaction with its shareholders and other stakeholders. Though the board is accountable to the owners of the 27

This section is based on the following report: Commonwealth Association for Corporate Governance, CACG Guidelines, Principles for Corporate Governance in the Commonwealth, CACG Secretariat, Marlborough, New Zealand, 1999.

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corporation (shareholders) for achieving the corporate objectives, its conduct regarding factors such as business ethics and the environment, for example, may have an impact on legitimate societal interests (stakeholders) and in this way influence the reputation and long-term interests of the business enterprise. Table 4.18 summarises the 15 principles of corporate governance. These principles are not to be regarded as legal statutes that are to be followed to the letter – rather they represent standards of conduct,

which should be followed according to the spirit and intention of the guidelines. Empirical evidence seems to indicate that good corporate governance nearly always goes hand in hand with good companies and wealthy nations, whereas bad governance is virtually synonymous with poverty. This conclusion essentially confirms the old business philosophy that the basis of wealth creation is ultimately trust.

Table 4.18: Principles of corporate governance The board should do the following: • Exercise leadership, enterprise, integrity and judgement in directing the corporation so as to achieve continuing prosperity and to act in the best interest of the business enterprise in a manner based on transparency, accountability and responsibility. • Ensure that through a managed and effective process, board appointments are made that provide a mix of proficient directors, each of whom is able to add value and to bring independent judgement to bear on the decision-making process. • Determine the corporation’s purpose and values, determine the strategy to achieve its purpose and to implement its values in order to ensure that it survives and thrives, and ensure that procedures and practices are in place that protect the corporation’s assets and reputation. • Monitor and evaluate the implementation of strategies, policies, the management’s performance criteria and business plans. • Ensure that the corporation complies with all relevant laws, regulations and codes of best business practice. • Ensure that the corporation communicates with shareholders and other stakeholders effectively. • Serve the legitimate interests of the shareholders of the corporation and account to them fully. • Identify the corporation’s internal and external stakeholders and agree on a policy, or policies, determining how the corporation should relate to them. • Ensure that no one person or a block of persons has unfettered power and that there is an appropriate balance of power and authority on the board which is, inter alia, usually reflected by separating the roles of the chief executive officer and chairman, and by having a balance between executive and non-executive directors. • Regularly review processes and procedures to ensure the effectiveness of its internal systems of control, so that its decision-making capability and the accuracy of its reporting and financial results are maintained at a high level at all times. • Regularly assess the corporation’s or board’s performance and effectiveness as a whole, and that of the individual directors, including the chief executive officer. • Appoint the chief executive officer and at least participate in the appointment of senior management, ensure the motivation and protection of intellectual capital intrinsic to the corporation, ensure that there is adequate training in the corporation for management and employees and a succession plan for senior management. • Ensure that all technology and systems used in the corporation are adequate to properly run the business and keep it a meaningful competitor. • Identify the key risk areas and key performance indicators of the business enterprise and monitor these factors. • Ensure annually that the corporation will continue as a going concern for its next fiscal year.

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3.7 Discipline on and accountability of regulators Subjecting the authorities to accountability and discipline is, in essence, aimed at avoiding the danger of inadequate regulation or over-regulation (which in turn are symptoms of what is called state failure). Market failures often centre on asymmetrical information flows, monopolies and the domino effect of financial failure (which may create systemic risks), whereas state failures usually entail one or more of the following shortcomings: • Inability to enforce existing law. • Inertia about bad law. • “Regulatory capture” by industry or consumers. • “Empire building” by the authorities. • A lack of business efficiency on the part of the authorities. • Regulatory gaps. It is often the case that market failure is cheaper for the consumer than state failure. Therefore, if the authorities are unable to address state failure adequately, it is often better not to rely too excessively on statutory regulation, but instead to lean more heavily on market discipline or to follow a policy of “regulation by reputation”. Indeed, firms are sensitive to their reputation, and their fear of any adverse publicity in the media (e.g. of any fines imposed) can be an effective disciplinary instrument. Three key issues usually come to the fore in any discussion of the accountability of regulators: their governance rules, their cost efficiency and their willingness to co-operate with other regulatory bodies and thus to harmonise their standards with international best practice. Each of these issues will be discussed briefly below. Governance and the regulator The governance problem is often compounded by conflicts of interest between supervisors, investors, depositors and taxpayers. In the case of public guarantee funds, financial sector supervisors have no similar financial stake to that of shareholders, who have an equity exposure. Their compensation cannot be readily tied to performance through the tools of Financial Regulation in South Africa: Chapter 4

incentive contracts or equity ownership. Nor are supervisory agencies subject to the threat of a takeover. As a result, there is little no guarantee that supervisors will always use their best efforts in the interest of depositors, investors and taxpayers.28 When confronted with a bank in distress, supervisors may find it difficult to proceed if the bank is “too big to fail”29 or if powerful politicians are trying to protect the bank. They may be reluctant to disclose bad news, especially if the problem ought to have been discovered earlier. Moreover, supervisors may often find that friendly relations with bankers serve their long-term interests better than a strictly arm’s-length relationship. Bank supervisors have much discretion – for example, with regard to the definition of insolvency or the valuation of assets. A bank that is deemed insolvent by generally accepted accounting standards may not be insolvent in terms of the supervisors’ rules and vice versa. Supervisors may not recognise changes in the market value of assets or may not do so on a timely basis. And if it serves their interests, supervisors might delay the necessary regulatory action. The Core Principles for Effective Banking Supervision (see Box 4.1 later) have become one of the most important global standards for prudential regulation and supervision. A regulatory audit agency could assess the current situation of a country’s compliance with the Principles. Such an assessment should identify weaknesses in the existing system of supervision and regulation, and form a basis for remedial measures by government authorities and the bank supervisors. In the business of banking, time is literally money. Delayed corrective actions typically mean larger losses down the road. Troubled banks may respond to losses by taking on more speculative investments in the hope of making up for such losses. But this “desperation” risk taking often only magnifies the losses. 28

29

Indeed, the widespread failures of public deposit guarantee funds stand in stark contrast to the well-governed – and profitable – business of private sureties, which provide credit guarantees on a commercial basis. The principle of “too big to fail” is refined at times to mean that it is only the second bank in a financial crisis that is too big to fail, but never the first to collapse.

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A solution to the above problems may be found in establishing a regulatory audit agency, although international experience in this area is still limited. Governance issues for regulators will probably be improved in a piecemeal manner in years to come. For instance, of late the IMF has drawn up a Code for Transparency in the Conduct of Fiscal Policy as well as a Code for Transparency in the Conduct of Monetary and Financial (implicitly regulatory) Policies. At stake here is again the debate between “rules versus discretion”, this time on how to subject even senior officials to a code on how they should behave. Cost of regulation (cost-benefit) Correcting market failures comes at a cost, which is justified only if the social benefits of regulation exceed the social costs. If regulators ignore the cost implications of their activities,30 state failures (as opposed to market failures) seem virtually unavoidable. Accordingly, it is of great importance to subject proposed regulation to detailed cost-benefit analysis. Experience has shown that financial regulation is costly, both directly and indirectly (see Table 4.19). 30

Regulators have goals of their own, not always identical with the goals of society. Power, prestige and income are liable to be associated with the size of their agencies. All of this would raise the costs of regulation, which must be set against the cost of using the market.

Despite its high costs, it may even yield a poor return or impair the efficiency of the financial system. Curtailing regulatory costs is therefore of great importance in preserving a country’s international competitiveness. Some of the more important costreduction techniques are encompassed by the following regulatory arrangements: • Capital-adequacy standards, which in effect delegate a greater part of the risk exposure to shareholders. Indeed, capital ratios, once they are high enough, imply that a financial institution can virtually take any risk it likes. • Adequate disclosure and standards of advice, which delegate part of the investment responsibilities specifically to the investor. • Automated trading systems, which ensure the “best price” for investors at low costs. • Efficiency statement, which requires regulatory authorities to make a statement about the costeffectiveness of their measures. • Compensation schemes, as potential claims are often lower than supervisory costs (provided that the premiums of the schemes are actuarially determined to avoid moral hazards). • Professional indemnity insurance, but not to the extent that insurers de facto determine what is fit and proper for investment business.

Table 4.19: Direct and indirect costs of regulation Direct costs

Indirect costs

• Supervisory structure expenses (e.g. the cost of running the SA Financial Services Board) – “lead regulator” arrangements can overcome duplication and double reporting to a limited extent only • Rulebook expenses • Computer system expenses • Human resource expenses (particularly compliance office staff) • Contributions to compensation schemes (particularly the fund management portion) • Legal fees

• Reduces competition (particularly by regulatory capture) • Stifles innovation, as “best practice” in terms of rulebooks will be amended only after a delay • Loss of business to less regulated countries • Opportunity costs of enforcing fit and proper standards • Regulatory burden on consumers (e.g. price of products) • May reduce consumer choice • Interest of regulator served at expense of industry and consumer • Risk-averse regulators

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•

Code of business conduct, which in turn allows for less costly rulebooks. • One self-regulatory authority for all retail investment business (i.e. banking, insurance and fund management) that improves fragmented rulemaking and weak regulatory standards. Although cost-benefit analysis of specific regulatory measures may not always be practical or may be very difficult at times, ultimately the onus is on the authorities to show that their regulation will improve social welfare. Regulatory co-ordination and harmonisation between domestic and foreign regulatory agencies To reduce systemic risks31 and ensure a level playing field among financial institutions, the harmonisation of international regulatory arrangements has been assigned a high priority. The likely degree of regulatory harmonisation between countries depends on the degree of interaction and integration among these countries. For instance, immobile transactions are usually left to the local 31

Systemic risks are raised internationally as a result of increased cross-border flows and large-scale securities trading in a variety of financial centres, as well as advances in technology.

regulators, as is mostly the case with retail trade. Those regulations that address major cross-border flows or systemic risks can be harmonised between countries either by negotiation and/or regulatory competition. Negotiations have the disadvantage that they may involve lengthy discussions in which the vested interests of lobby groups have to be bridged. Regulatory competition may work more quickly but may result in a lowering of standards. In order to avoid “competition in laxity” between regulatory regimes it is of great importance to set minimum international standards, leaving sufficient room for countries to fine-tune the arrangement by imposing tougher criteria. Generally the issue of regulatory co-ordination entails two major issues: (i) cross-market regulation (for instance between spot and derivative exchanges); and (ii) regulation between banking and non-banking financial institutions. (i) Regulatory co-ordination between markets To implement emergency measures during periods of financial crises (e.g. the global stock markets crash in October 1987) and to avoid gaps in the regulatory structure, it is crucial that regulation should be properly co-ordinated between the various regulatory

Table 4.20: Impact of harmonising regulatory arrangements Favourable

Unfavourable

• Ensures an internationally accepted minimum standard in local markets and thus avoids competition in laxity, which in turn would result in a lowering of standards in regulatory regimes • Enhances competition and efficiency by creating a level playing field between major players in different countries • Avoids complicated bilateral rules and promotes international co-operation in a world increasingly characterised by globalisation (e.g. regulatory authorities can share in the experiences of counterparties abroad) • Reduces the authorities’ exposure to lobby-group pressure • Lowers the country’s sovereign risk and thus its credit costs

• International standards may not be suitable for the local financial system, as fundamentally different systems cannot converge (e.g. with regard to ownership arrangements) • Reduces regulatory competition and results in reduced consumer choice (e.g. between regulated and offshore markets) • International standards are difficult to amend owing to the complexities of multinational arrangements

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authorities, both locally and abroad. For instance, the rulebooks of the exchanges should be carefully coordinated to avoid situations where, for example, the spot market closes down, while the futures market continues to trade. To respond effectively and on a co-ordinated basis to market disorder, the following recommendations have been made by the Brady Commission (Executive Summary, 1988, p. vii): • One agency should co-ordinate the few, but critical, regulatory issues that have an impact across the related market segments and throughout the financial system. This agency should have expertise in the interaction between markets, and not simply experience in regulating specific market segments. Moreover, it should have a broad perspective on the workings of the financial system as a whole, both domestic and foreign, as well as being independent and responsive. • Clearing systems should be unified across marketplaces to reduce financial risk. • Margins should be made consistent across marketplaces to control speculation and financial leverage. • Circuit-breaker mechanisms (such as price limits and co-ordinated trading halts) should be formulated and implemented to protect the market system. • Information systems should be established to monitor transactions and conditions in related markets. Since the Brady Commission Report, considerable discussion has taken place worldwide on the merits (and drawbacks) of a single regulatory authority. Detailed investigations were launched by the major exchanges, but the regulatory structure based on the multi-functional

approach has remained more or less intact. Research seems to indicate that the fundamental causes of the 1987 crash were largely related to market congestion and information lags. The fact that the regulatory structure was of a multi-functional nature aggravated the problem, particularly when the spot and derivative markets moved increasingly apart during the crash. The key advantage of a single regulatory authority is that it explicitly addresses cross-market risks, as the spot and derivative transactions are concluded on the same exchange.32 The major disadvantage of a single regulatory authority is the temptation to over-regulate, as competition between spot and derivative markets may be reduced. In addition, regulatory co-ordination between markets has become complicated owing to the unbundling of traditional exchange activities, particularly since the late 1980s. Ultimately, it is of secondary importance by whom, how and where a trading service is delivered. By contrast, it is of the utmost importance for exchanges to promote market transparency and a central marketplace. Improved technology and the freedom of international capital flows have resulted in keen competition between the traditional stock exchanges and the new derivative exchanges, OTC markets and foreign securities markets. International competition has already pulled the primary and secondary markets apart, and as a result exchanges are rapidly losing their most profitable activities to competitors (“cherry picking”). This is partly because competition is eroding the potential to “cross-subsidise”. 32

In terms of this regulatory structure, financial hybrids (such as the ELFI bond) will be traded on the same exchange as the underlying instrument

Table 4.21: Impact of a single regulatory authority for markets Favourable • Addresses cross-market risk explicitly and thus reduces systemic risk • Links spot and derivative instruments in the four basic markets more closely together • Facilitates netting between spot and derivative instruments (e.g. novation) 72

Unfavourable • May result in regulatory competition • May result in over-regulation • Bureaucratic • Unwieldy

capture

and

less

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Although the increased competition eliminates economic rents (as reflected in high costs and/or high profits), it may also result in increased systemic risks. In this competitive environment the regulatory authorities have to ensure primarily that no competition will take place in regulatory laxity (e.g. by stipulating similar surveillance and listing requirements), and that securities firms meet appropriate capital, liquidity, system and other prudential requirements. In fact, promoting competition and full disclosure may even bring about less need for regulation.

(ii) Regulatory co-ordination between banking and non-banking financial institutions A single regulatory authority to supervise and regulate banks and non-banking financial institutions has some major advantages, although the problems of such a structure should not be underestimated either (see Table 4.22). Like the issue of ownership, this issue is greatly influenced by the regulatory philosophy of a country.

Table 4.22: Impact of a single regulatory authority for banking and non-bank financial institutions Favourable

Unfavourable

• Combines institutional and functional approaches to regulation • Enhances the supervision of complex groups • Reduces the problem of a multiplicity of regulatory authorities • Enhances competitive neutrality between the suppliers of financial services • Enhances economies of scale in the use of resources in regulation • Reduces potential conflicts over jurisdiction and authority when the authorities have to adapt to changing market conditions • Creates greater transparency for the public and may add to the credibility of the supervisory and regulatory process • Consistent approach to rule-based supervision • Accountability easier • Lower cost for firms • Consistent authorisation procedures • Consistent enforcement and discipline

• May result in a bureaucratic and unwieldy regulatory organisation • May increase the concentration of power and complicate issues related to accountability • May create problems associated with uniformity and a monopoly of wisdom • Reduces competition between regulatory authorities and thus may adversely impact on the balance between regulation and competition in financial services • Conflicts of culture internally

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Box 4.1: List of core principles for effective banking supervision 1.

An effective system of banking supervision will have clear responsibilities and objectives for each agency involved in the supervision of banking organisations. Each such agency should have operational independence and adequate resources. A suitable legal framework for banking supervision is also necessary, including provisions relating to the authorisation of banking organisations and their ongoing supervision; powers to address compliance with laws as well as safety and soundness concerns; and legal protection for supervisors. Arrangements should be in place for sharing information between supervisors and protecting the confidentiality of such information.

Licensing and structure 2. The permissible activities of institutions that are licensed as banks and subject to supervision must be clearly defined, and the use of the word "bank" in names should be controlled as far as possible. 3. The licensing authority must have the right to set criteria and reject applications for establishments that do not meet the standards set. The licensing process, at a minimum, should consist of an assessment of the banking organisation’s ownership structure, directors and senior management, its operating plan and internal controls, and its projected financial condition, including its capital base; where the proposed owner or parent organisation is a foreign bank, the prior consent of its home country supervisor should be obtained. 4. Banking supervisors must have the authority to review and reject any proposals to transfer significant ownership or controlling interests in existing banks to other parties. 5. Banking supervisors must have the authority to establish criteria for reviewing major acquisitions or investments by a bank and ensuring that corporate affiliations or structures do not expose the bank to undue risks or hinder effective supervision. Prudential regulations and requirements 6. Banking supervisors must set prudent and appropriate minimum capital-adequacy requirements for all banks. Such requirements should reflect the risks that the banks undertake, and must define the components of capital, bearing in mind their ability to absorb losses. At least for internationally active banks, these requirements must not be less than those established in the Basel Capital Accord and its amendments. 7. An essential part of any supervisory system is the evaluation of a bank’s policies, practices and procedures related to the granting of loans and making of investments and the ongoing management of the loan and investment portfolios. 8. Banking supervisors must be satisfied that banks establish and adhere to adequate policies, practices and procedures for evaluating the quality of assets and the adequacy of loan loss provisions and loan loss reserves. 9. Banking supervisors must be satisfied that banks have management information systems that enable management to identify concentrations in the portfolio and supervisors must set prudential limits to restrict bank exposures to single borrowers or groups of related borrowers. 10. In order to prevent abuses arising from connected lending, banking supervisors must have in place requirements that banks shall lend to related companies and individuals on an arm’s-length basis, that such extensions of credit are effectively monitored, and that other appropriate steps are taken to control or mitigate the risks. 11. Banking supervisors must be satisfied that banks have adequate policies and procedures for identifying, monitoring and controlling country risk and transfer risk in their international lending and investment activities, and for maintaining appropriate reserves against such risks.

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12. Banking supervisors must be satisfied that banks have in place systems that accurately measure, monitor and adequately control market risks; supervisors should have powers to impose specific limits and/or a specific capital charge on market-risk exposures, if warranted. 13. Banking supervisors must be satisfied that banks have in place a comprehensive risk-management process (including appropriate board and senior management oversight) to identify, measure, monitor and control all other material risks and, where appropriate, to hold capital against these risks. 14. Banking supervisors must determine that banks have in place internal controls that are adequate for the nature and scale of their business. These should include clear arrangements for delegating authority and responsibility; separation of the functions that involve committing the bank, paying away its funds and accounting for its assets and liabilities; reconciliation of these processes; safeguarding its assets; and appropriate independent internal or external audit and compliance functions to test adherence to these controls as well as applicable laws and regulations. 15. Banking supervisors must determine that banks have adequate policies, practices and procedures in place, including strict "know-your-customer" rules, that promote high ethical and professional standards in the financial sector and prevent the bank being used, intentionally or unintentionally, by criminal elements. Methods of ongoing banking supervision 16. An effective banking supervisory system should consist of some form of both on-site and off-site supervision. 17. Banking supervisors must have regular contact with bank management and a thorough understanding of the institution’s operations. 18. Banking supervisors must have a means of collecting, reviewing and analysing prudential reports and statistical returns from banks on a solo and consolidated basis. 19. Banking supervisors must have a means of independent validation of supervisory information either through on-site examinations or the use of external auditors. 20. An essential element of banking supervision is the ability of the supervisors to supervise the banking group on a consolidated basis. Information requirements 21. Banking supervisors must be satisfied that each bank maintains adequate records drawn up in accordance with consistent accounting policies and practices that enable the supervisor to obtain a true and fair view of the financial condition of the bank and the profitability of its business, and that the bank publishes on a regular basis financial statements that fairly reflect its condition. Formal powers of supervisors 22. Banking supervisors must have at their disposal adequate supervisory measures to bring about timely corrective action when banks fail to meet prudential requirements (such as minimum capital-adequacy ratios), when there are regulatory violations, or where depositors are threatened in any other way. In extreme circumstances, this should include the ability to revoke the banking licence or recommend its revocation. Cross-border banking 23. Banking supervisors must practise global consolidated supervision over their internationally-active banking organisations, adequately monitoring and applying appropriate prudential norms to all aspects of the business conducted by these banking organisations worldwide, primarily at their foreign branches, joint ventures and subsidiaries. 24. A key component of consolidated supervision is establishing contact and exchanging information with the various other supervisors involved, primarily host country supervisory authorities. 25. Banking supervisors must require the local operations of foreign banks to be conducted to the same high standards as are required of domestic institutions and must have powers to share information needed by the home country supervisors of those banks for the purpose of carrying out consolidated supervision.

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4. Deregulation and reregulation As a general principle of financial regulation, regulatory structures have to be adaptable. Without flexibility it is difficult to address challenges such as ongoing technological improvements, financial innovation, increased global competition and other evolutionary forces present in the economy. Typically, periods of increased formal regulation are followed by periods of deregulation and vice versa. In practice, pure deregulation is quite rare, as the giving of more powers to self-regulatory authorities for instance, usually goes hand in hand with greater reliance on other regulatory instruments such as market forces.33 As the financial system becomes more complex and sophisticated, it also becomes more difficult to regulate in terms of statutory rules and regulations. As a consequence, there is a process of deregulation as well as reregulation. Usually, less emphasis is now placed on official constraints, but in its place more market monitoring and discipline are introduced to ensure that the ultimate objectives of regulation are met. Table 4.23 gives an overview of what the process of deregulation – which started in the early 1980s – has meant in practice. In the area of official rules and regulation there has generally been a significant reduction in the number of constraints placed on ownership, functional activity, jurisdiction and pricing. As a result, price competition has increased sharply hand in hand with the emergence of global financial conglomerates. These conglomerates are typically involved in all the major financial functions, operating in all the major jurisdictions with strongly interrelated ownership structures. However, to make this deregulation process possible – i.e. without endangering the objectives of regulation – greater emphasis had to be placed on minimum standards (e.g. accounting standards) and initially, at least, more operational constraints, particularly in the fields of prudential requirements, code of conduct requirements and anti-cartel arrangements. But even in these areas 33

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of operational constraints the tide has been changing since the mid 1990s in favour of more market-related instruments such as specific incentive contracts and private sector structures to support prudential risk exposures (e.g. value-of-risk modelling) and codes of business conduct (e.g. as reflected in the corporate governance structures). As is evident in Table 4.23 the deregulation of some key statutory rules and regulations (indicated by a “–” symbol) implied major reregulation in areas such as supervision, incentive structures, reliance on market discipline, early structured intervention regimes and corporate governance (indicated by a “+” symbol). The employment of this large array of regulatory instruments was required not only to compensate for lesser official constraints, but also to offset any possible negative impact of the new, more marketrelated instruments. Today, the regulatory regime in industrial countries is more flexible to allow adjustment to unexpected changes. It is also more market related than, say, two decades ago. At the same time the regulatory regime has become far more complex and integrated. For instance, where risk control and compliance functions were rather elementary in the 1970s, these functions are today major departments in any large financial institution, involving not only senior management, but increasingly the board of directors as well. In contrast to the imposition of rules and regulations (discussed in full in Section 3.1), regulatory arrangements do not necessarily imply restrictions on the activities of market participants. Regulatory arrangements aim at improving the regulatory structure by inter alia deregulating financial markets, resorting to more self-regulation, harmonising regulation with that in other countries, limiting the number of regulatory agencies, or co-ordinating the roles of various regulatory agencies, and utilising privatesector parties (such as external auditors and rating agencies) in supervising capacities. A few of these aspects will be discussed briefly below.

Entailing in turn reregulation in areas such as disclosure requirements, transparency rules, minimum standards of advice, or conflicts-of-interest avoidance arrangements.

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77

+

3. Intervention and sanctions

+

6. Corporate governance

7. Discipline/accountability of regulators

+

5. Market monitoring and discipline

4. Incentive contracts and structures

+

2 Official monitoring and supervision +

+

+

+

+

+

+

+

+

+

+

+

+

+

+

+

+

+

+

+

+

+

+

+

+

+

+

+

+

+

+

+

–

+

1.6 Operational constraints +

–

+

Fit and proper directors and staff Global institutional competitiveness

– +

Proper institutional infrastructure +

Competitive neutrality Integrity and fairness

1.5 Pricing constraints

–

1.4 Jurisdictional constraints –

–

+

1.3 Functional activity constraints

–

Securities markets as alternative to intermediation

–

–

Competitive market infrastructure Acceptable maturity and currency mismatches Acceptable crossmarket exposures Sufficient market liquidity +

Regulatory effectiveness, efficiency and economy Proper risk assessment

1.2 Ownership constraints

1.1 Entry and standards constraints

1. Official rules and regulations

Regulatory regime and its instruments

Regulatory intermediate goals

+

+

+

+

Competence

Consumer protection

+

+

+

+

Adequate product/service competitiveness

Institutional safety and soundness

+

+

+

+

+

Transparency and disclosure

Systemic stability

+

+

+

+

+

–

Access to retail financial services Protection of retail funds

Regulatory ultimate objectives

Table 4.23: Regulatory matrix: The impact of deregulation in the context of the total regulatory regime

+

+

+

–

Retail compensation schemes

4.1 Deregulation Deregulation has created an environment of greater freedom. Firstly, controls on prices, quantities and cross-border capital movements have been lessened or even removed in full. Secondly, as a result of institutional despecialisation and the opening of domestic markets to foreign competition, financial enterprises have been given much greater freedom to choose lines of business, location, area of operation and financial structures. Deregulation intensifies the competitive environment, particularly in the early stages of major adjustments to portfolio composition. It may lead to a redistribution of income from the suppliers to the users of financial services and thus increase the fragility of the financial system. Moreover, the oligopolistic structure of the financial industry frequently pressurises firms into moving together (the “herd

instinct”), which in turn results in “overshooting” a longer-run equilibrium position. Deregulation is necessary to create scope for financial innovation (see Table 4.24) and to accommodate the increasing pressures emanating from globalisation. Today the deregulation of financial markets seems unavoidable, although it should be handled with care. Cognisance should be taken of the important policy lessons learned over the past few years in respect of the deregulation process: • Deregulation should proceed rapidly but at a pace that gives market participants sufficient time to prepare themselves for the new environment in terms of internal controls, restructuring and adjustments to their business strategies, training of staff and so on. • A proper balance should be struck between deregulation in different segments of f i n a n c i a l

Table 4.24: Impact of financial innovation Favourable

Unfavourable

• Increases the variety of financial instruments available to both borrowers and lenders by combining different standard characteristics in different instruments ("spectrum filling") • Improves the liquidity of the system to the extent that tradable assets and markets are created (securitisation) – innovation thus enhances portfolio management • Encourages competition between banks (assetliability transformation) and securities firms (securitisation) • Facilitates the pricing and transferring of particular risks (unbundling) • May give borrowers access to markets from which they had previously been excluded • Lowers the cost of finance or the transactions costs involved in accomplishing what is already possible • Allows participants to attain previously impossible goals, and provides new sources of finance to some borrowers • Accelerates international financial integration, resulting in more competitively neutral legislation • Allows some risks to be managed and shifted

• Puts a premium on the efficiency and soundness of clearing and settlement arrangements (in view of the spectacular surge in financial transactions and its impact on the payment system) • Complicates the evaluation of financial institutions' risk exposures, which in turn may lead to overregulation • May result in shareholders obtaining insufficient financial information, particularly about off-balancesheet risk exposures • Results in specific financial instruments being created primarily to evade the regulatory control system (e.g. "daylight" funds) • Securitisation results in an increased opaqueness of the financial system where an off-balance-sheet commitment may become an on-balance-sheet item, and vice versa • Complicates macroeconomic management owing to large-scale disintermediation and re-intermediation • Risks may not be fully understood in complex instruments

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•

•

• • •

markets to ensure that competition among them is not grossly distorted. The right time for deregulation may be best defined in terms of the wrong time, which is when the economy is in or moving into a powerful boom. Deregulation should be accompanied by a strengthening of supervision so as to establish rules of the game (the Basel capital-adequacy standards are a good example) and by appropriate macroeconomic policy, especially monetary policy. Transparency and disclosure should accompany the deregulation process. Banks should develop adequate risk analysis, management and control systems. Effective and transparent corporate governance arrangements should be created within banks.

•

Market discipline arrangements should be strengthened. A distinction needs to be drawn between the stockadjustment effect of moving from one regulatory regime to another, and the steady-state characteristics of a deregulated environment. Substantial changes to the regulatory regime may be very destabilising during the period in which institutions adjust to the new regime. New behavioural characteristics may need to be learned and institutions have the problem of handling increased uncertainty when new regulatory regimes and market conditions are created. Mistakes may be made in this stock-adjustment phase. However, this does not mean that the resultant instability is a characteristic of the new deregulated steady-state condition. The conditions created, when moving from

Table 4.25: Impact of deregulation of financial markets Favourable

Unfavourable

• Creates an environment of greater freedom and enhances more active competition and a more level playing field between financial institutions • Encourages competitively neutral legislation, particularly between financial and non-financial institutions (allows for more diversification) • Allows companies to arbitrage between less efficient and more efficient national financial systems (globalisation) • Allows for more self-regulation – at least if all participants are adequately capitalised and subject to appropriate disclosure standards • Reduces over-regulation that often imposes a “tax” on financial institutions and thus raises the supply price of services, which in turn impairs competitiveness • Lowers regulatory costs (as competition takes the place of rules) • Allows for the creation of new regulatory structures enforced by competitive forces • Exposes unsound risk arrangements (e.g. the stipulation of unlimited liability for exchange members does not enhance systemic stability, as members may keep their wealth in private trusts) • Improves international competition

• Necessitates more institutional and functional regulation to mitigate the impact of deregulation • Necessitates that the nature and form of local regulation are not out of step with the international regulatory regime (as the same client can be serviced from different countries or different markets) • Results in greater competition and lower profitability and thus encourages diversification into new businesses with potentially increased systemic risks • Increases entry costs (e.g. if fixed commissions fall away, this will ultimately harm small undercapitalised firms) and may result in higher costs for retail investments (as internal cross-subsidising will be eliminated) • May result in portfolio adjustments that are swift, substantial, potentially unstable and difficult to moderate • The overall risk characteristics of the industry may increase owing to greater competition

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one regime to another, indicate nothing about the new steady-state regime when all transitory adjustments have been made. 4.2 Reregulation and self-regulation Self-regulation entails two elements: the primary policy makers within the recognised self-regulatory organisation (SRO) are themselves practitioners, and the organisation is funded by the market rather than with public funds. In most countries there are significant elements of self-regulation in finance. The main issues relate to the effectiveness, durability, acceptability and credibility of self-regulation as a principle. Self-regulation through recognised bodies has much to commend it, especially if there are built-in safeguards to protect against the obvious potential for an abuse of authority (see Table 4.26). However, there is the obvious danger of the regulators being “captured” by the industry – in fact by themselves, for they are the industry! Self-regulation rests substantially on the acceptance of the regulated

and, unless there are powerful sanctions, this may not always be guaranteed. There is the question whether it is possible to rely on self-regulatory bodies always serving the public interest as the public defines this (rather than the industry). The issue centres on the optimum combination of self-regulation and externally imposed regulatory requirements. Though there must be a powerful element of selfregulation, there should also be checks and balances built in so as to maximise the benefits of selfregulation while limiting its potential hazards. The distinction between self-regulation and statutory regulation is to some extent artificial: the debate is ultimately about the balance to be achieved between the industry, the state and consumers in the implementation of the law. It is necessary to have safeguards against the potential hazards of exclusive self-regulation, while securing the maximum benefits of practitioner input into the regulatory process. It forms the regulatory process through experience and specific expertise of the industry and its practices. Generally self-regulation is more appropriate for

Table 4.26: Impact of self-regulatory organisations (SROs) on regulation Favourable

Unfavourable

• Regulation is carried out by acknowledged experts in the market • The regulators' standing in the market is likely to enhance the consent and compliance of the regulated • The SRO is fully aware of innovations and their implications and can adapt accordingly • The SRO is likely to be less legalistic and dogmatic in its decisions • It is in the self-interest of the SRO to maintain standards and retain the public's confidence in the market • The SRO is better positioned to detect abuses of the regulatory system (e.g. free-riders) • The SRO can operate with greater flexibility, speed and effectiveness than direct regulation

• Regulatory capture by the SRO becomes a major threat • The creditability of the SRO may be questioned by the public • Regulation may be used to protect the industry rather than clients in the case of difficulties ("fair weather" regulation) • Regulation may degenerate into an anti-competitive device designed to protect a cartel – accordingly competition may be stifled • The industry's view of public interest may dominate, to the detriment of the client (i.e. who defines the public interest?) • The SRO may operate as a self-maintained organisation, which does not smoothly co-operate with other regulatory agencies • The SRO may not have sufficient sanctioning and investigative powers to enforce flexible selfregulation (e.g. to subpoena witnesses)

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wholesale investment business than retail business34. It is interesting, for instance, that the principle of self-regulation does not apply to banking. In practice, the issue relates to the optimum combination of self-regulation and externally imposed regulatory requirements.

5. Summary Evaluating the scope of regulatory instruments makes it evident that some regulatory instruments are more favourable than others. In a world dominated by free capital flows, globalisation and sharply increased competition, there is little scope for restrictions on ownership, jurisdiction, pricing and trading capacity. For similar reasons, the following regulatory instruments have gained in importance during the last few decades: stipulating minimum entry requirements and standards; capital and liquidity constraints; corporate governance rules, adequate disclosure and standards of advice requirements; and an enforceable code of business conduct. In respect of regulatory arrangements the regulatory structure in many countries has been strengthened by the deregulation of financial markets (usually going hand in hand with stricter regulation of market participants and financial instruments), more self-regulation for wholesale investment business, international regulatory harmonisation and better co-ordination between regulatory authorities and private sector supervisors (such as external auditors and rating agencies). Regulatory instruments that are somewhat contentious today are restrictions on functional activity and the whole issue of how to ensure competitive neutrality, particularly between financial and nonfinancial institutions. The most important world trends in regulation may be summarised as follows: Ethos of regulation • Increased emphasis on enhancing competition in finance; • enhanced role for market mechanisms; 34

Typically SROs at the retail business level are as much involved in supervision as regulation.

Financial Regulation in South Africa: Chapter 4

•

increased priority given to efficiency in finance; competitive neutrality between competing subsectors of the financial system. Deregulation • Wider business opportunities to institutions; • greater price flexibility (e.g. interest rates); • self-imposed restrictive practices competed away and removed by regulatory changes; • less direct control over prices and allowable business; • less direct credit control mechanisms. Structure of regulation • A tendency towards integrated supervisory agencies; • wider range of financial services subject to regulation; • international co-ordination mechanisms. Methods of regulation • Regulation has become more interventionist and detailed, with regulatory authorities developing comprehensive rulebooks governing the way financial services are supplied; • more formal and explicit “business conduct” rules in the context of distinctions between types of financial institutions being eroded; • regulation and supervision are increasingly based on functional rather than institutional criteria (e.g. the consolidation requirements for banks and securities business); • greater emphasis on capital requirements – rules on the allowable definitions of capital structure and capital adequacy; • information and disclosure requirements extended. While there is an overwhelming case for regulation in financial services, there are certain danger factors: the benefits of regulation should not be exaggerated; false expectations in consumers’ minds should not be encouraged; and the potential moral hazard of implicit contracts should be guarded against. It is necessary that expectations should be not raised to unrealistic levels, that it be clear that regulation has only a limited role, that regulation and supervision can fail, and that under no circumstances should regulatory

•

81

arrangements be created that reduce the incentive for users of financial services to exercise due care. In the final analysis, regulation is never an alternative to

82

adequate information and the intelligent use of what information is available. Not all risks are covered, and neither could, or should they be.

Financial Regulation in South Africa: Chapter 4

Chapter 5 REGULATORY RESPONSES TO GLOBAL FINANCIAL DISTRESS 1. Introduction The realignment of policy instruments to ensure their optimum economic effectiveness and cost-efficiency is increasingly becoming an international process. For example, the global policy responses to financial crises over the past few decades have become more uniform as regulators started to learn from past mistakes and even begun to harmonise their regulatory structures with international “best standards”. As a result the national regulatory structure is becoming increasingly a reflection of global standards with relatively minor country-specific differences. As discussed in Chapter 3, the concept of a regulatory regime is considerably wider than the prevailing set of prudential and conduct of business rules established by external regulatory agencies. It is widened to include the nature of the incentive structures operating within financial institutions, the role of monitoring and supervision (by private and official agencies), the disclosure regime and the role of market discipline, and corporate governance arrangements. It also includes the arrangements for official intervention in the event of distress in the financial system. Just as the causes of financial crises are multidimensional, so the principles of an effective regulatory regime must also incorporate a wider range of issues than just externally imposed rules on the behaviour of financial institutions. A central theme is that, while external regulation has a role in fostering a safe and sound financial system, this role is limited. Equally and increasingly important are the incentive structures faced by private financial institutions, particularly banks, and the efficiency of the necessary monitoring and supervision of financial institutions by official agencies and the market. External regulation is only one component of regimes to create a safe and sound financial system. Financial Regulation in South Africa: Chapter 5

In this chapter, Section 2 sketches the underlying causes of recent financial crises, as a background for Section 3, which in turn looks at the global policy responses to those financial crises. Although financial crises are still not fully understood (and therefore appear unexpectedly), the major lessons learnt from past experience seem to indicate that the structure of financial regulation can be improved in a number of ways. Firstly, by stipulating minimum infrastructure requirements for institutions as well as markets (e.g. accounting, audit, capital adequacy, corporate governance). Secondly, by setting in place specific supervisory structures to monitor complex financial groups in their totality. Thirdly, by enhancing the securities markets as a stable source of finance and an alternative to financial intermediation. Fourthly, by avoiding the build-up of major asset price imbalances (particularly currency, equity and realestate prices that no longer represent “fundamental” value). And lastly, by creating new regulatory arrangements in respect of safety nets and by making the regulators themselves more accountable for their actions (or lack thereof, e.g. in respect of forbearance).

2. Underlying causes of financial crises From a regulatory viewpoint, financial crises fall (roughly) into two major classes: (i) those that have primarily a macroeconomic character and for which monetary, financial and fiscal policies seem the appropriate economic instruments; and (ii) those that have a more explicit financial regulatory component. It has to be emphasised immediately, however, that there is a strong interrelationship between financial instability and macroeconomic instability. Accordingly it may be difficult in practice always to distinguish clearly between these two classes. A recent IMF study of banking crises around the 83

world begins as follows: “A review of the experiences since 1980 of the 181 current Fund member countries reveals that 133 have experienced significant bankingsector problems at some stage during the past fifteen years (1980–1995)”1 (Lindgren, 1996). Crises in the banking sector (in both developing and industrial countries) are clearly not random, isolated events. Around the world, banks in many countries have had very high levels of nonperforming loans, there has been a major destruction of bank capital, banks have failed and massive support operations have been necessary. This represents a greater failure rate among banks than at any time since the great depression of the 1930s. They have involved substantial costs. In around 25 percent of cases the cost has exceeded 10 percent of gross national product (for example, in Spain, Venezuela, Bulgaria, Mexico, Argentina and Hungary). The main causes of recent crises have been those that have always attended commercial banking problems: poor risk analysis by banks, weak internal credit-control systems, connected lending, insufficient capital, ineffective regulation, weak monitoring and supervision by regulatory agencies, and weak internal governance. These factors have frequently been aggravated by a volatile conduct of economic policy and structural weaknesses in the macroeconomy. In other words, the origins of crises are both internal to banks and external. To focus myopically on one side misses the essential point that systemic crises have both macro and micro origins. Almost always and everywhere banking crises are a complex interactive mix of economic, financial, and structural weaknesses. While each banking crises has unique and country-specific features, they also have a lot in common. Several conditions tend to precede most systemic banking crises: • Rapid growth in bank lending within a relatively short period. • Unrealistic expectations and euphoria about economic prospects in the economy. 1

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Lingren, G.J., G. Garcia, and N. Saal, Banks Soundness and Macroeconomic Policy, Washington, DC: IMF, 1996.

•

•

• •

• •

•

A sharp and unsustainable rise in asset prices (part of euphoria speculation), leading to unrealistic demands for credit and willingness of banks and other lenders to supply loans. Concentrated bank portfolios often with a high property content (that is, while project risks may be properly assessed, portfolio risk is often not). Excessive interconnected lending within banking groups. Government involvement in loans and loan decisions, which may have the effect of weakening incentive structures, eroding discipline on lenders (an implicit guarantor), and involving undue political influence or insider relationships. Inappropriate risk premia being charged in lending interest rates. Insufficient attention being given to the value of collateral, most especially if rapid balance-sheet growth occurs in a period of asset-price inflation. Weak conduct of monetary policy in a context of a high and volatile rate of inflation.

2.1 Macroeconomic causes of financial crises Macroeconomic changes are more quickly reflected in markets than in institutions. However, all changes in macroeconomic policy impact directly on the balance sheet of the banking industry, and therefore macroeconomic instability is quickly transformed into financial instability. An important reason that it may be useful to distinguish between the macroeconomic causes of a financial crisis versus failures in the regulatory regime itself, is that the financial regulatory authorities usually have little direct influence on macroeconomic policy. For instance, even though there is usually a close interaction between the banking supervisors and the central bank, bank supervisors have no say in monetary policy. From the financial regulators’ point of view, financial crises caused by macroeconomic mismanagement are more or less a given. Accordingly, financial institutions need sufficient capital and other types of reserves to withstand such exogenous Financial Regulation in South Africa: Chapter 5

headwinds. Alternatively, should the financial crisis be particularly severe, macroeconomic support may have to be provided in the form of, for instance, lower real interest rates (i.e. additional liquidity) by the central bank. To what extent the policy makers should use their discretion in such situations is still a highly debatable issue among central bankers. Judging by economic developments over the past few decades, it seems that the following macroeconomic factors have contributed in a major way to financial distress: • Macroeconomic volatility: This can derive from several sources – both external and domestic. External factors include, for instance, large fluctuations in the terms of trade, relatively low export diversification, volatile international interest rates (and the induced effect on private capital flows) and real exchange-rate volatility. On the domestic side, economic growth and inflation rates are both often highly volatile. As a result, economies are at times exposed to massive overconsumption (e.g. Mexico 1995), too high levels of domestic investments (e.g. the Asian crises of 1997), too large internal debt levels (e.g. Japan, 1990s), or unserviceable external debt levels (e.g. Russia, 1998). • Exchange rate regimes: Fixed exchange-rate regimes have been criticised for increasing the fragility of the banking system as regards external adverse shocks, because such shocks so easily lead to a balance-of-payment deficits, a decline in the money supply and higher domestic interest rates. A recent example was Argentina’s response to the large liquidity shock to the banking system that followed the Mexican crises in early 1995. The central bank of Argentina had to perform a delicate balancing act and ensure sufficient liquidity to prevent a contagious bank crisis, but not provide so much liquidity as would extend the exchange-rate commitment. It has also been argued that fixed exchange rates (governments’ alleged commitment to an exchange-rate level) can create moral hazard by inducing banks to fund high interest-rate loans Financial Regulation in South Africa: Chapter 5

in domestic currency with low interest-rate foreign currency liabilities. The unmatched foreign currency position can cause a bank to become insolvent in the event that the domestic currency is devalued (e.g. Thailand). • Lending booms, asset price collapses and surges in capital inflows: Excessive credit extension and unsound financing during the expansion phase of the business cycle can cause banking crises – a crisis is triggered when the bubble bursts. Usually banks find it harder to discriminate between good and bad credit when the economy is expanding rapidly: borrowers are at least temporarily very profitable and liquid. Moreover, sharp swings in real-estate and equity prices intensify these crises because of high loan concentration, whereas asset price declines depress the market value of collateral. Examples are the stock market crash of 1987, the bond market collapses in 1958 and 1994, Venezuela 1994–1997, or the difficulties with highly leveraged companies such as Long Term Capital Management in 1998. From a monetary policy viewpoint, the big question today is whether the monetary authorities should recognise that “if trouble emerges, it usually comes unexpectedly and from a clear blue sky” and pay explicit attention to asset price developments (particularly when associated with rapid credit extension) or whether they should concentrate exclusively on domestic inflation. • Contagion across markets and countries: Even if a specific market or country is well regulated and financially sound, it may be adversely affected by distress elsewhere in the region. For example many of the “Asian tiger” countries were badly mauled by the financial crisis of 1987 in Thailand (and soon thereafter Malaysia and Indonesia). Usually contagion spreads quickly through a region by means of two channels: firstly, a general lack of investor confidence in that specific region, with resulting reallocation of capital to other parts of the world; and secondly, an exchange rate fear among these investors that countries in the region will have to devalue their currencies in tandem simply 85

to remain trade competitive. Different countries may react differently to the impact of contagion. For instance, during the Asian crisis, Taiwan devalued its currency, despite its huge foreign exchange reserves, to remain price competitive in the region. In contrast Hong Kong left its exchange rate unchanged, but then had to increase its interest rates sharply, which in turn resulted in a major fall in equity and property prices. In the absence of devaluation, the result was price deflation and a worsening of the downturn. • Lack of market liquidity: A sudden hardening of monetary policy may have major liquidity consequences for markets and even countries. Usually, a liquidity crisis is reflected in higher domestic interest rates and a weaker currency with major consequences for business confidence and price stability. To a limited extent the authorities can trade-off interest-rate hikes against exchangerate devaluation. Indeed, if foreign investors lose confidence in a country they have to pass two hurdles: they first have to change their investments into local currency (thus trading in the equity or bond markets), and thereafter they have to change local cash into say dollars (i.e. trade in the foreignexchange markets). The quicker the authorities raise their interest rates, the faster the fall in domestic asset prices. If foreign investors feel they are in a bear trap, they may not sell their assets immediately and wait for a price recovery in the domestic asset markets. Accordingly, major selling pressure is taken off the forex market (at least temporarily). Once business sentiment has changed for the better, the authorities can increase the liquidity in the financial system again.

2.2 Regulatory causes of financial crises Where the macroeconomic causes of financial crises usually affect markets, the microeconomic causes of financial distress are virtually, as a rule, related to institutions. However, in practice the interaction between market and institutional failures may be so great that it is practically impossible to distinguish 86

between them properly. Nonetheless, the following causes of financial distress can be identified in this area (see also Diagram 5.1 which in essence emphasises that trouble can easily emerge from a clear blue sky): • Weaknesses in the accounting, disclosure and legal framework: Many banks in emerging markets engage in “evergreening”, i.e. making bad loans look good by lending more money to troubled borrowers, or by “rescheduling” arrears. If nonperforming loans are systematically understated, loan loss provisions will be inadequate, and the reported measures of bank net income and bank capital will be systematically overstated (e.g. Chile and Colombia in the early 1980s). • Increasing bank liabilities with large maturity and currency mismatches: A large unhedged debtor position in foreign exchange not only makes banks and their customers more vulnerable, but also makes it harder to deal with a banking crisis once it occurs (because an easier monetary policy will be much less effective when debts are denominated in foreign currencies). Similarly, the risks of maturity mismatches are typically higher in the emerging markets, because they have less access to sources of longer term funding (on the liability side) and receive less assistance from securities markets for increasing liquidity and spreading risk (on the asset side) than do banks in the industrial world. An example in this category is Mexico during 1989–94. • Heavy government involvement: The loan decisions of state-owned banks are much more likely to be subjected to explicit or implicit government direction than those of privately owned banks. All too often, the creditworthiness of borrowers does not receive sufficient weight in the credit decision, with the result that the loans of state banks can become a vehicle for extending government assistance to ailing industries. Moreover, because these banks are shielded from competition, have their losses covered by the government and are sometimes protected from Financial Regulation in South Africa: Chapter 5

closure on constitutional grounds, they tend to have lower incentives to innovate, to promptly identify problem loans at an early stage and to control costs. Overstaffing and overextended branch networks are also more prevalent. Moreover, their loan/loss performance is usually inferior to that of their private sector counterparts. Examples in this area are Argentina, Brazil, China, India and Indonesia. • Loose controls on connected lending: The risks of “connected lending” are more common among universal banks and are primarily due to a lack of objectivity (sometimes even fraud) in credit assessment and undue concentration of credit risk. Key problems in the Spanish banking crises of the 1980s were connected lending and slack corporate governance. • Inadequate preparation for financial liberalisation: Regulatory reforms inevitably present institutions with new risks. For example, when interest rates are liberalised, banks may lose the protection they previously enjoyed. Generally the volatility in interest rates tends to rise, at least during the transition period of financial liberalisation. Rapid rates of credit expansion have often, paradoxically, coincided with high real interest rates in the wake of financial liberalisation. Lifting restrictions on bank lending often releases pent-up demand for credit in the liberalised sectors (e.g. real-estate, securities activities). Lowering reserve requirements permits banks to accommodate increased loan demand – as does the inflow of foreign capital, which is often attracted by reforming economies. However, bank credit managers reared in an earlier controlled financial environment may not have the expertise needed to evaluate new sources of credit and market risk. Likewise, unless the supervision framework is strengthened before the liberalisation of financial markets, bank supervisors may have neither the resources nor the training needed to do their jobs properly. Examples of inadequate preparation for financial liberalisation are Brazil, Chile, Indonesia, Mexico and several Nordic countries. The situation Financial Regulation in South Africa: Chapter 5

outlined above is exacerbated in countries which have large disparities in the size of banks, i.e. a few large banks and many small banks. In many countries, and particularly at present in South Africa, there is a view that a proliferation of small banks represents a threat to financial stability in that such banks are far more vulnerable to liquidity risk than their larger competitors. While no bank on its own is “too big to fail”2 there is a considerable degree of interdependence, firstly via the inter-bank market and secondly through public perception which tends to regard the failure of one small bank as the forerunner of the failure of other small banks. The proponents of this view draw the conclusion that the policy of “free entry, free exit” on the part of the licensing authorities in the banking industry is inappropriate and would recommend that the authorisation of new (and therefore probably small) banks should be severely restricted as was the case in the past in South Africa. Opponents of this view would argue that: (i) the admission of new entrants is an essential element to stimulate competition in the banking industry; (ii) the threat of new entrants creates competitive pressure on incumbent banks; (iii) there are a number of examples on record of new small banks growing into large and highly successful competitors (e.g. Investec and Rand Merchant Bank in South Africa); and (iv) though smaller banks are undoubtedly more vulnerable to liquidity risk than larger banks, this is a situation that can be and has been successfully managed by the regulatory authorities. • Distorted incentives for bank owners, managers, 2

“Too big to fail” may be synonymous with “too important to fail”. However, “fail” does not necessarily mean going out of business, as the authorities may wish to keep a troubled bank as a going concern, inter alia to protect depositors or maintain confidence in the market. Note, that this does not mean that shareholders or management will be protected, as the authorities are likely to change the management of the bank, restructure it, place it under curatorship (as in South Africa), or even nationalise it. Further, the principle of “too big to fail” is refined at times to mean that it is only the second bank in a financial crisis that is “too big to fail”.

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bank depositors and supervisors: These main actors in any financial drama have to be properly discouraged from engaging in excessive risk taking, and encouraged to take corrective action at an early stage. Moreover, they each need to “have something to lose” if they fail to act in a manner consistent with their mandate. Bank owners should lose enough capital to make them think twice about engaging in high-risk activities3 and senior managers should lose their jobs if a bank needs fundamental restructuring. Bank depositors should only be bailed out if they are small, unsophisticated investors, whereas wholesale creditors should lose in a case of bank failure. Finally, bad supervisors, like managers, should be replaced with better ones irrespective of the political pressures such a step usually entails. Alternatively, their powers should be reduced by placing more emphasis on disclosure, market discipline and sanctions. Last but not least, it should be emphasised that all the financial crises discussed above have not come cheaply. As shown in Diagram 5.2, the fiscal costs (i.e. to the taxpayer) of a banking crisis can easily exceed 10% of gross domestic product. In the past two decades, more than 130 countries suffered major bank failures4, and not surprisingly the authorities worldwide are keen to promote financial stability and to strengthen the financial system.

3. Global regulatory responses to financial crises Having analysed the causes of financial crises, the regulatory authorities’ responses have been generally to concentrate their efforts in five areas, namely: • Efforts to improve the infrastructure of markets and institutions, particularly in harmonising minimum 3

4

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Banking is an inherently risky business. Nonetheless, banks have unusually high leverage. In non-bank firms a debt-equity ratio of 1 to 1 is considered high and a ratio of 4 to 1 reckless. But in a bank a ratio of say 10 to 1 is considered prudent. Caprio, G. and D. Klingebiel, Episodes of systemic and borderline financial crises, World Bank, Washington, 1999 and Leechor, C., “Banking on Governance”, Public policy for private sector, World Bank, Washington, December 1999.

(international) standards and guidelines. Corporate governance, compliance structures, proper incentives, adequate transparency and clear accountability are of particular importance here. • Greater reliance on market-led processes to provide the discipline required to encourage prudent and stabilising behaviour. Reliance on market processes also implies that the authorities forcefully support the development of securities markets as an alternative to formal financial intermediation. • Reinforcing market discipline with official integrated monitoring and supervision activities, particularly in complex financial groups. • Promoting financial stability (in addition to monetary stability) by “leaning against the wind” during the financial cycles, particularly in areas such as credit expansion and financial gearing. • Improving regulatory arrangements and competitive neutrality as well as avoiding regulatory arbitrage by explicitly acknowledging the international dimension of financial regulation. In essence the above approach tries to counteract all the factors causing financial distress as identified in the previous section. In terms of the regulatory matrix (see Table 4.23 in Chapter 4), it implies a massive repositioning of the available policy instruments in the regulatory regime: i.e. less emphasis on official rules and regulation and more reliance on market forces, which in turn entails a huge shift in the overall regulatory architecture. This section will discuss each of these five initiatives in greater detail.

3.1 Improvements in the financial system’s infrastructure The infrastructure of markets and institutions is usually improved by: (i) harmonising domestic regulatory standards with minimum international standards (including capital-adequacy standards); (ii) emphasising the importance of corporate governance rules; and (iii) by ensuring that institutions and markets are subjected to appropriate compliance procedures. As the last two items are discussed in Financial Regulation in South Africa: Chapter 5

Diagram 5.1: Factors behind 29 bank insolvencies MACROECONOMIC FACTORS Capital flight Dutch disease Asset bubble Recession Terms of trade drop

2 4 7 16 20

MICROECONOMIC FACTORS Weak judiciary Fraud Lending to state enterprises Connected lending Political interference in lending Deficient bank m anagement Poor supervision & regulation

2 6 6 9 11 20 26 0

5

10

15

20

25

30

1. As indicated above, bank insolvencies are at times due to bad luck (e.g. capital flight or bank runs), or bad shocks (e.g. recession or adverse terms of trade). 2. Source: G.Caprio and D.Klingebiel "Bank Insolvency: Bad luck, Bad policy, or Bad banking" in M. Bruno and B Pleskovic (eds), Annual World Bank Conference

Diagram 5.2: Cost of banking crises Ghana, 1982-89 United States, 1984-91 Sweden, 1991-94 Russian Fed., 1998 Norway, 1987-93 Czech Rep., 1989-91 Brazil, 1994-96 Philippines, 1983-87 Malaysia, 1997-present Spain, 1977-85 Mexico, 1995-present Japan, 1990s Venezuela, 1994-97 Cote d'Ivoire, 1988-91 Rep. of Korea, 1997-present Thailand, 1997-present Chile, 1981-83 China, 1990s Indonesia, 1997-present Argentina, 1980-82 0

5

10

15

20

25

30

35

40

45

50

55

60

Fiscal costs as a percentage of GDP

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Chapter 4, attention will only be given in this section to the various international minimum standards. Today the international approach is mainly to improve the financial system incrementally5. Accordingly, changes to the infrastructure are brought about in a piecemeal policy solution fashion, i.e. a consistent “bottom up” approach. So far the following international standards have been worked out: • International Accounting Standards (IAS) by the International Accounting Standards Committee in co-operation with Basel Committee on Banking Supervision and IOSCO and endorsed by IOSCO in May 2000. • International Standards on Auditing (ISA) by the International Federation of Accountants through its International Auditing Practices Committee. • Core Principles for Systemically Important Payment Systems, by the BIS Committee on Payment and Settlement Systems (CPSS) and issued in December 1999. • Core Principles for Effective Banking Supervision by the Basel Committee on Banking Supervision (BCBS) and endorsed by the IMF and World Bank in October 1997. • Objectives and Principles of Securities Regulation by the International Organisation of Securities Commissions (IOSCO) in September 1998. A detailed self-assessment methodology was completed in 2000. • Insurance Supervisory Principles by the International Association of Insurance Supervisors (IAIS), issued in September 1997, while its Core Principles Methodology is expected to be completed in 2000. 5

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To impose on the world financial markets an international superregulator or even “A New International Financial Architecture” is still rejected, because the causes and consequences of financial crises are still inadequately understood; the national legislators are not yet ready for such an enormously powerful supernational regulatory body; the tasks of oversight and supervision are a virtually unmanageable task for such a single agency; and the huge shortage of skilled resources in both domestic and international institutions.

•

Supervision of Financial Conglomerates by the Joint Forum on Financial Conglomerates in collaboration with the BCBS, IOSCO and IAIS, issued in February 1999. • Ten Key Principles on Information Sharing by the Group of Seven Finance Ministers in May 1998 and endorsed by the Joint Forum on Financial Conglomerates in February 1999. • The Forty Recommendations of the Financial Action Task Force in respect of Financial Crime and Money Laundering issued in April 1990 and modified in 1996. • Principles of Corporate Governance by the Organisation for Economic Co-operation and Development (OECD) and the World Bank and endorsed by the OECD Ministerial Meeting in May 1999. • The Specific and General Data Dissemination Standards (SDDS and GDDS) by the IMF and approved by the IMF Executive Board in respectively March 1996 and December 1997. • Model Law on Cross-Border Insolvency by the United Nations Commission on International Trade Law in May 1997. • Orderly and Effective Insolvency Procedures issued by the IMF in 1999. Note that nearly all these standards date from the second half of the 1990s. The standards are de facto enforced by means of the following (i.e. piecemeal, bottom up) policy procedures: • The establishment of the various core principles and minimum standards by international technical committees. • Establishment of specific liaison groups to ensure that the codes are implemented smoothly. • Peer pressure among industrial countries (and later developing countries) to fulfil these codes. • Ensuring increasing regulatory co-ordination and harmonisation through international bodies such as the IMF, World Bank and the Financial Stability Forum. • Regulatory monitoring of compliance with the codes (e.g. the IMF’s Article IV consultation). Financial Regulation in South Africa: Chapter 5

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Penalties by private-sector institutions on those countries deemed not to conform to the core principles (mainly by means of higher credit interest rates). • Official “denying rights of establishment” in major financial centres unless core principles are implemented. • Higher statutory capital requirements in the home country for credit given to debtor countries that do not fulfil the core principles. Besides these core principles and minimum standards, the Bank for International Settlements has established three powerful Standing Committees of national experts, namely: • The Basel Committee on Banking Supervision (BCBS) • The Committee on the Global Financial System (CGFS), and • The Committee on Payments and Settlement Systems (CPSS). These Standing Committees attempt to prevent financial crises and make policy recommendations on how to structurally improve systemic stability on a global scale. In addition, the IMF and World Bank are currently developing new guidelines for nations (e.g. a manual of best practices in sovereign debt and risk management using a balance sheet framework). The ultimate aim of all these guidelines and standards is to improve the minimum infrastructure of institutions and markets. The supervisory agencies (e.g. the central bank supervision function and the financial services supervisor, or an integrated supervisory agency) have an important responsibility for ensuring that these minimum infrastructure requirements are indeed fully implemented and enforced.

3.2 Enhancing market discipline and sanctions The discipline and sanctions of the market can be enhanced in a number a ways. The key concepts in this respect are competition and disclosure.

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3.2.1 Encouraging competition between financial intermediaries and securities markets Competition among financial institutions has the advantage of lowering the costs of finance for the public and removing inefficient institutions from the marketplace (called “creative destruction”) which in turn may reduce systemic risks in the long term. The regulatory authorities have an obligation to encourage competition to the highest degree as long as systemic risks are within accepted boundaries. The cutting edge of competition between the banks and the securities markets is probably at the short end of the yield curve: i.e. money-market funds (retail investors) and the commercial paper market (wholesale investors). Usually the complaints of banks are that this competition in the money market is “excessive”, “unnecessary”, and even “unfair” to the unsophisticated small investor. However, this need not be the case for the following reasons: • With the development of financial conglomerates, competition is not really between banks and securities firms, as both are divisions in same group. Any undue competition is therefore within the group, and managements themselves can determine the degree of participation in these markets at the ruling price levels. “Excessive” competitive pricing need not be followed, if such prices are unsustainable in the medium or longer term. What may happen is a reduction in the profit margin as a result of healthy competition between banks and the securities markets. Neither the authorities nor the consumers are likely to object to this competitive element. • To reason that there is no need for money-market funds because bank deposits can fulfil this task equally as well, is incorrect from a risk/return point of view. Some investors with a low risk preference may favour bank deposits, but others may feel they can easily accept the implicit market risks of a money-market fund provided they are accordingly compensated with a higher yield. • For the truly unsophisticated retail investor, 91

money-market funds are an unlikely investment avenue, as the minimum investment in these funds is often higher than the amount these people normally save. Moreover, even if the minimum investment threshold was low enough for them, financial advisers (and their compliance officers!) are bound to discourage such investments. • Similar arguments are applicable to commercial paper issues. Clearly, a competitive market in commercial paper will reduce the interest margin on corporate bank business, but such competition is an advantage rather than a problem for the regulatory authorities and the investing public. Today, the regulatory authorities worldwide are encouraging the development of their securities markets, mainly for reasons of financial stability policy and to improve the cost-efficiency of their financial systems. As technology and financial engineering improve, the relative importance of banks and their role in the financial system becomes smaller. The banks’ answer to this development is to transform themselves progressively into financial conglomerates, which service their clients over the full spectrum of financial products and services. 3.2.2 Promoting direct financing through the securities markets for higher risk business Considering the fact that the essence of banking is the accepting of deposits (that are redeemable on demand at par value plus interest) from the general public, there is a relatively low risk threshold for deposit-taking institutions. In contrast to securities firms, banks have money-certain liabilities but uncertain (even unmarketable) assets on their balance sheets. Therefore if a sudden financial crisis hits the banks it is far more serious for them than for the securities markets, as banks have firm commitments to depositors. In fact, the higher the market risks, the more attractive the capital markets. The big advantage of the securities markets is that its investors know, and have decided so themselves, where their money is invested, but bank depositors are not informed about the asset 92

management strategies of their banks. Therefore, one possible solution is to finance very risky investment projects such as venture capital projects or microlending schemes for upcoming entrepreneurs through the capital markets6. This financing can either take the form of equity or bond financing. From a regulatory viewpoint it is crucial that the securities markets should be placed on a competitive footing vis-à-vis the banking industry. If investors are more prepared to accept the implicit market, credit and liquidity risks of their investments, the financial system will be more stable. Moreover, during periods of financial distress, systemic risks are usually better secured if the financial system rests on two strong pillars, namely financial intermediation and securities markets. The central bank can play a powerful role in the development of securities markets. It can do so mainly by removing the regulatory constraints that limit their development, and also by encouraging competition both between various types of financial institutions and between local and foreign suppliers. For example, the definition of deposit taking in banking legislation should not be so constraining that it adversely effects the development of the commercial paper market. Likewise, the regulatory constraints placed on moneymarket funds should not make these investments a priori uncompetitive vis-à-vis bank deposits.

3.3 Improving the supervision, monitoring and enforcement capabilities of all players In contrast to popular belief, the authorities are not solely responsible for the supervision, monitoring and enforcement of good corporate governance rules, minimum standards and official regulation. Financial market participants also play a major role in this respect. For example: directors of financial institutions have to ensure that corporate governance rules are enforced in their organisations; management has to see 6

War bonds, not bank lending, were the instrument used in the past. Likewise, the financing of micro-lenders may also be achieved by means of bond financing than, for instance, by coercing the banks or pension funds to invest in such projects.

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to it that compliance takes place; internal and external auditors have a great responsibility for monitoring and enforcement; the markets reflect the risk characteristics of banks through the pricing of subordinated debt capital; last but not least, the financial press has the important task of ensuring sensible disclosure and reporting. 3.3.1 Enforcement Even if the regulatory regime of a nation is well structured and supported by supervisory agencies of a high calibre, regulation will still be less effective if the rules and regulations are not properly enforced. This was again painfully true towards the end of the 1990s, particularly after the financial crises in the Far East. In principle, enforcement operates at various levels, involving ultimately all the abovementioned role players in the market. Firstly, market sanctions discipline individuals and institutions. However, to be effective the markets need disclosure, as the healing impact (through competition) of markets is only possible if wrongdoings are known. For instance, the requirement that generally accepted accounting policies are to be followed is a powerful disclosure rule (and enforced by the auditors). The financial press also plays an important role in supporting market sanctions, again through their ability to disclose wrongdoings. Secondly, corporate governance rules force directors to take effective steps if regulations are breached. If they do not, investors can sue them in their personal capacity7. Thirdly, compliance officers have to ensure that the spirit and letter of the regulations are enacted throughout the organisation. Fourthly, auditors (particularly external auditors, because they can be sued for compensation) have a role in ensuring that regulations are enforced in line with boards’ instructions. Furthermore, the audit committee not only monitors the firm, but also plays a part in monitoring the board itself.8 7

8

In practice, to sue directors in their personal capacity is still a very rare event, but there is no obvious reason why this may not change in future. This is one of the reasons that the Chair of the Board is not allowed to be a member of the Audit Committee – at best the chair can attend as an observer.

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A major difficulty in enforcement starts when the board of directors and senior management are not “suitable”. In essence, the underlying question is: “who guards the guards?” Although the authorities would prefer a market solution to this problem (i.e. market sanctions), they cannot close their eyes to the fact that they have granted the licence to undertake, say, banking business. The regulatory authorities have to ensure that directors and management are suitable before they can issue such a banking licence, but at what level of incompetence do they interfere? The problem becomes even greater if there is, or was, an ideological (political) link between the ruling government party and bank directors (e.g. Indonesia, 1998). Close links between political power groups and bank directors can create serious systemic risks for many years to come,9 as bank staff appointments may be to some extent based on party loyalty rather than on competitive financial skills. If management cannot distinguish between good and bad credit during the good times, the central bank will have to do so during the bad times (i.e. either with lender-of-last-resort facilities or even lifeboat assistance to avoid systemic failure). The key question remains, however, at what level of incompetence do the regulatory authorities revoke the licence of a firm or require a major change in the composition of the board of directors? 3.3.2 Consolidated supervision of financial conglomerates10 This regulatory challenge was extensively researched by the BIS De Swaan Committee in 1995.11 In this section attention will only be given to the typical regulatory concerns in respect of financial conglomerate structures and the possible options the regulators have regarding how to cope with these concerns. 9

10

11

After the ruling party has been replaced, bank management may be subjected to “unusually stiff” competition, as the “normal”, easy business from friends in government is no longer forthcoming. Based on Falkena, H.B. et al., An inquiry into the regulation and supervision of financial conglomerates, Pretoria: The Policy Board for Financial Services and Regulation, 1998, pp. 1–9. Tripartite Group of Bank, Securities and Insurance Regulators, The supervision of financial conglomerates, Basel: Bank for International Settlements, July 1995. 93

Regulatory concerns In the regulation of financial conglomerates, the authorities are primarily concerned with (i) contagion, (ii) transparency and (iii) autonomy. The key issues with respect to each of these topics are summarised below: (i) Concerns about contagion Without appropriate regulation at group level, the problems of liquidity or solvency throughout a conglomerate will be magnified if market participants are allowed to do the following: • Regulatory arbitrage: Without a lead-regulatory structure, the total risk exposure of a group (local as well as abroad) can be disguised (e.g. as happened in the case of BCCI). • Granting excessive credit lines to selected third parties: Without a limit on credit exposure to clients, the diversification requirement – which is the basis of credit risk management – is seriously undermined. • Granting excessive loans to connected parties:12 Connected parties are often in a position to influence the policies and decisions of financial institutions. Accordingly, large loans to connected parties may be particularly risky. • Executing high-risk business within low-risk institutions: This is easier in financial groups than in specialist financial institutions. For instance, the management of a specialised low-risk financial institution (say a building society) is unlikely to handle high-risk business (such as the financing of venture capital projects). • Double gearing of capital between financial institutions: For example, if bank deposits are used to fund a long-term loan to an insurance undertaking, which in turn follows up a rights issue of that same bank, the double gearing of regulatory capital is bound to occur (such an arrangement is usually handled indirectly through a non-financial company in order to bypass the restrictions of banking regulation). Eliminating this double12

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Connected parties may include shareholders, other group entities, the directors and managers of all group entities, and perhaps other of the business interests of those directors and managers.

counting of a group’s capital may result in the net capital of the group being less than the sum of the capital of the individual institutions. This double gearing of capital creates a serious potential contagion problem. • Invalid assumptions about the mobility of capital: Surplus regulatory capital in one subsidiary is used to cover a capital shortage in another subsidiary, despite the fact that the capital is not mobile. As a result the group’s net capital is insufficient. (ii) Concerns about transparency The complexity inherent in financial conglomerates, particularly if they conduct international business, often diminishes transparency. The key supervisory concern in this regard is transparency: i.e. supervisors should be comfortable with their understanding of the corporate and managerial structure. Structures where it is not clear which shareholders (either legal entities or individuals) and which managers exercise control over a conglomerate and its component entities and which parties have financial responsibility for the component regulated entities, should be prohibited or discouraged. Typical problems encountered by the regulatory authorities in this area are: • Lack of public disclosure: A financial group makes it difficult for rating agencies or the securities markets to evaluate an institution (e.g. the extensive use of off-balance-sheet financing structures). • Use of bearer shares: Ultimate ownership of a financial institution is disguised by way of bearer shares or similar vehicles (e.g. nominee company structures). • Insufficient disclosure to supervisors: A financial group reports to various supervisory authorities on a “solo” basis only and not on a consolidated group basis. • Non-standardised accounting rules: Different accounting rules are used within a group (particularly between local and foreign branches). • No lead-auditors: Different external audit firms are used within a group and may even report on different year-end dates (i.e. no lead-auditor structure and no accounting uniformity). Financial Regulation in South Africa: Chapter 5

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Arbitrage between different regulatory accounting principles: These principles may differ between local and foreign supervisors, and institutions can exploit these differences to their advantage (e.g. in areas such as provisions, valuations, deferrals and treatment of off-balance-sheet items). (iii) Concerns about autonomy A regulator has to ensure that the legal and moral duties of directors and managers of each entity in a group are clear and are carried out. Management has to act fairly in situations involving conflicts of interest (of which there are potentially more in a conglomerate structure). The following arrangements are particularly difficult in this context: • Low Chinese walls: Directors and senior management do not respect the Chinese wall structures. If these walls are too low (even middle management can peer over them), this may not only encourage insider trading (where, for instance, information of the credit division is shared with the investment division), but could also result in serious systemic risk exposures (e.g. Barings Bank had no proper Chinese wall between the trading room and the back office). • Obscure mixed-activity groups: In financial groups where the parent company is a non-financial institution abroad the supervisory authorities may have great difficulty in determining the ultimate line of de facto authority and responsibility. • Connected parties receiving credit at artificially low rates: Where credit is granted by a financial institution to a connected party at below market rates, a serious conflict of interest will often arise. • Significant change in business mix: After authorisation has been obtained, the business mix of a group changes substantially, resulting in major changes in, for instance, ownership and management. Regulatory options To address the abovementioned concerns, the regulators have a number of basic options available. In essence they have a choice between consolidated, separate or “solo plus” regulation. Each of these regulatory options will be briefly discussed. Financial Regulation in South Africa: Chapter 5

(i) Consolidated versus separate regulation In principle, regulatory authorities have a choice of two basic models of regulating financial conglomerates. Either they select consolidated regulation, which implies that regulation is applicable to all group members engaged in financial activities, or separate regulation, which tries to insulate (ringfence) the regulated entity from other group members, and each activity is regulated separately. Generally bank supervisors have been in favour of consolidated regulation, while investment and insurance regulators favour the separate regulation option. The preference of bank regulators for consolidated regulation is not accidental. In contrast to investment and insurance regulators, bank regulators are heavily involved in payments systems and the implementation of monetary policy. Accordingly, bank regulators want explicit authority over entities closely related to banks. Moreover, contagion is regarded as such a grave concern in banking that it justifies the extension of regulation on a groupwide basis to include, for example: capital-adequacy requirements; large creditexposure limits; foreign-exchange position limits; shareholder, director and senior manager suitability standards; and regulatory reporting and public disclosure standards. Separate regulation is usually preferred by investment and insurance supervisors, as this option is based on the principle of some activities best being regulated (e.g. dealings with retail customers), with other activities best being left unregulated. Under a separate regulation regime the concerns about contagion, transparency and organisational structure are addressed by requiring additional capital (often in an amount equal to the exposure itself), establishing limits (or other restrictions) on exposures and type of transactions, and setting suitable standards for shareholders and management. In practice, time and place will influence the ultimate choice of regulating a financial conglomerate. Although both options have their advantages and disadvantages (see Table 5.1), the greater sophistication of financial markets makes it 95

increasingly difficult to insulate a regulated entity within a group. Moreover, contagion can result from the public perception of an exposure. Even a wrong perception by the public can result in a liquidity crisis or a crippling loss of business for a regulated entity, initiated by events elsewhere in a group. (ii) “Solo plus” regulation “Solo plus” regulation13 tries to obtain a middle position between the (theoretical) extremes of consolidated and separate regulation. Under “solo plus” regulation there is no need to have a single prudential regulatory agency, but instead use is made of lead regulators (which is already the norm in many countries)14. The lead regulator would be responsible for taking a groupwide perspective of the risk profile of a financial conglomerate and for co-ordinating the process of supervision, both on a regular basis and in a crisis. A lead regulator would also be responsible for assessing the capital adequacy of a group as a whole, 13

14

As supported by the Basel Committee, IOSCO and EU Commissioners. The lead regulator (convenor) would usually be the regulator of the parent company of the financial conglomerate.

transmitting and requesting relevant information to and from other supervisors, and generally coordinating any necessary actions involving more than one supervisory agency. Under the “solo plus” regulatory approach, capital requirements are related to the balance sheet positions of each component of a group (the “solo” component) after which adjustments are made with a view to the conglomerate as a whole (the “plus” component). This would eliminate, for instance, any double-counting of capital within a group. (iii) The concepts of “consolidated supervision”, “accounting consolidation” and “solo plus” The term “consolidated supervision” means a qualitative assessment of the overall strength of a group to which a supervised institution belongs and the evaluation of the potential impact that other group companies may have on the authorised institution. Consolidated supervision also takes into account the activities of group companies which are not included in the consolidated returns, for example industrial or insurance companies which would be excluded because the nature of their assets would not make their

Table 5.1: Advantages and disadvantages of consolidated regulation and separate regulation Advantages

Disadvantages Consolidated regulation

• Addresses consistently the concerns of contagion in a financial conglomerate • Fully harmonises the approaches of consolidated supervision and consolidated accounting • Enhances transparency and public disclosure • Addresses the risk characteristics of the institution as a whole

• May be burdensome and even create competitive disadvantages for otherwise unregulated entities • Requires extensive co-ordination and even modification of responsibilities among regulatory agencies

Separate regulation • Harmonises fully with the functional approach to financial regulation, and therefore enhances the efficiency of separate financial entities • Supports explicitly the autonomy concerns of different regulated functional entities • Lessens co-ordination and authority concerns among regulatory agencies

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• Results in transparency problems • Has difficulty in detecting problems in overall organisational and management structures • Addresses contagion problems in a fragmented way

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inclusion meaningful. In exercising consolidated supervision, the activities of group companies are taken into account to the extent that they have a material bearing on the reputation and financial soundness of the supervised institution in the group. The purpose of consolidated supervision is not to supervise all the companies in the group to which the supervised entity belongs, but to supervise the supervised entity as part of the group. A distinction must be made between consolidated supervision and accounting consolidation. The latter implies the preparation of consolidated accounting returns covering a group or part of a group. Accounting consolidation may be the basis for applying prudential requirements to the group, although accounting consolidation is not a precondition for the application of consolidated supervision as there are alternative techniques (solo-plus measures), which may also be applied. Solo-plus measures may be applied to group members which are not included in the consolidation in order to monitor and/or control the exposure of the supervised entity to such entities. The tools applied in consolidated supervision may include any of the following: • Impairment of capital for intra-group exposures and/or holdings in other supervised entities; • limitations on holdings in other supervised entities; • the calculation of capital requirements to cover market risks on a groupwide basis; • calculation of capital requirements which may be based on consolidated figures, through aggregation of the capital requirements of the different group members, or through deduction methods; • groupwide application of limits on large exposures in the banking book and the capital requirements against large exposures in the trading book; • review of intra-group transactions; • assessment of the adequacy of internal control mechanisms on a groupwide basis (especially control over the information which will be relied upon for the application of consolidated supervision); Financial Regulation in South Africa: Chapter 5

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access to information and power of inspection in all areas of prudential supervision, applicable to supervised and to unsupervised group members; • regulation of group structures, ensuring that the group structure does not prevent effective supervision; • assessment of distribution of capital among group members within a group. 3.3.3 The supervision of complex groups Complex groups are large financial conglomerates that operate in various functions and in various jurisdictions. For example in the UK and US the regulators have classified their largest financial institutions as “most complex”. In the UK these firms include about 50 institutions (including all big clearing banks, and the major banks and investment banks from the US, Europe and Japan), while in the US they include the 30-plus internationally active banking giants. In various countries, notably Australia, Canada, the Nordic countries, the UK and the US, complex groups are now supervised by dedicated teams of (between two and twelve) supervisors, who concentrate entirely on one financial conglomerate. Once a financial conglomerate begins to look at its risk on a global, groupwide basis, the balance sheet of one part of the group becomes progressively less important. For a large globally active bank, a typical trading book could contain half a million open positions. A trade made in one market may be hedged in another market halfway across the world. Similarly, management lines may cross continents. The upshot of this is that regulators have recognised that they can only scrutinise a complex financial conglomerate’s operations by using the firm’s own systems and data. The level of resources dedicated to risk management and control processes is large in a complex group, particularly compared to that of the official supervisory staff (which is usually tiny and may only total 3 man-years for a particular complex group). As a result the focus of supervision is shifting away from individual spot inspections to verifying the group’s own risk-management systems. The emphasis in the 97

supervision of complex groups has started to centre on the following type of questions: • Is top management up to the job? • Are the group’s risk management systems of sufficiently high quality? • Are the group’s control systems acceptable? • What standing do control and compliance people have in the organisation? • Is the degree of disclosure acceptable (notably to creditors)? • Why are risk exposures, and thus profits, shifted between components of the group (notably between banking and insurance)? Once the supervisors are happy with the attitude of top management and confident about the quality of internal audit, compliance and risk management, they have a basis for leveraging off what the group is doing and to use the output of the group’s management and control systems. As financial conglomerates become more globalised, more integrated with financial markets, and place greater emphasis on centralised risk-management and economies of scale, the supervisors can no longer rely on lead supervision structures. For instance, the UK has moved to “enhanced” lead supervision, which entails that the solo regulators of each wing of a financial institution should agree on a co-ordinated programme of supervision. This supervisory structure is designed to concentrate resources on the group’s most risky activities. Accordingly, the supervisors in banking, insurance, securities trading and fund management are combined into a single team, creating essentially a bespoke micro-regulator, dedicated fulltime to one institution. The UK regulatory authorities have also moved towards risk-based regulation and supervision whereby differentiations are made between financial firms according to their risk characteristics, and supervisory resources are concentrated more on those institutions judged to be most at risk. Although “enhanced” lead supervision creates a single point of contact with the regulator it also entails the danger that the supervisory teams will lose 98

objectivity and begin to see the world through the conglomerate’s eyes, or that the supervisors will have too much concentration of power. To address these two potential dangers it is important that (i) examiners are rotated at least, say, every three years, that (ii) group supervision teams are carefully monitored by a quality control team and that (iii) there are sufficient checks and balances in place to avoid misuse of power (e.g. appeal to tribunal). 3.3.4 Highly geared off-shore institutions and liquidity risk Fluctuations in market liquidity are of considerable systemic concern to the authorities, given the increasing role of the securities markets for funding, liquidity management and asset sales by banks. Today banks and other financial institutions are often heavily involved in the issuance of, and trading in, securitised assets. Some of the major securities markets’ participants are even non-financial institutions with highly leveraged positions. Should such institutions be confronted with a sudden collapse in market liquidity, the external effects could be similar to a bank crisis. Securities markets are prone to episodes of illiquidity and market failure. A liquidity crisis can be triggered by a sudden rerating of sovereign risk, as was the case for instance after the Russian debt moratorium in 1998. As a result, the effective exchange rate of the rouble depreciated sharply, while equity and bond prices worldwide were badly affected. The perceptions about credit risk worsened suddenly, in turn resulting in an extreme liquidity preference and a general unwillingness to deal in corporate bonds. As liquidity plunged, price volatility rocketed, implying an even higher premium on liquidity. Consequently spreads in the securities markets widened abruptly, which combined with the natural herd instinct of dealers, caused a flight to quality securities at the cost of higher-risk and/or lower-liquidity assets. For an unregulated hedge fund such as Long Term Capital Management (LTCM), with a leveraged position of 50:1 across a diversified range of financial markets, such a liquidity shock proved too much in 1998. Financial Regulation in South Africa: Chapter 5

Private-sector banks, under the guidance of the US Federal Reserve, had to undertake a rescue operation to preserve orderly market conditions. Although markets, unlike banks,15 may become illiquid but cannot become insolvent, the end-effect of a liquidity crisis, with the massive impact of forced leveraged sellers, is still similar to a bank failure.16 If LTCM had not been rescued, a process similar to a contagious bank run could have ensued,17 with first the institution itself and then the most exposed creditors being starved of liquidity and forced to sell assets in a “fire sale” manner18. Given an underlying weakness in market liquidity, this would have exacerbated the effects of the simultaneous closure of positions would have prompted severe market disruptions. As traditionally uncorrelated markets became highly correlated in the wake of a liquidity crisis, the market, liquidity and credit risks became far more correlated. In these circumstances, market makers are no longer willing to quote doubles for fear being caught at the opposite side of the market. Accordingly the market makers adopted a defensive approach which aggravated the liquidity crunch. It is difficult to regulate hedge funds from a financial stability viewpoint, because they are usually nonfinancial institutions positioned in offshore financial centres. Accordingly hedge funds are extremely mobile internationally and fall outside the regulatory regime normally applicable to financial institutions. Nonetheless, considering their size and the fact that a securities market collapse can so easily lead to a 15

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Unlike sight deposits at banks, there is no guarantee of a fixed rate at which securities can be liquidated immediately, although short-term high-quality debt securities approximate to this. Sharp declines in liquidity may lead to cash-flow difficulties owing to inability to sell, or increased difficulties in obtaining credit due to the lower value of collateral. Moreover, the process of securitisation has entailed a much greater reliance on securities markets by a range of institutions. Had LTCM been put into default, its 75 counterparties would have rushed to “close-out” hundreds of billions of dollars of positions, causing massive illiquidity and price shifts, harming both the counterparties and other market participants Davis, E.P., “Russia/LTCM and market liquidity risk” in The Financial Regulator, Vol.4, No.2, London: Central Banking Publication , 1999.

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liquidity crisis for banks, the regulatory authorities (BIS) decided to tighten up the capital requirements for banks granting credit lines to hedge funds. This latest measure is likely to reduce the financial gearing of hedge funds to a significant extent, and so contribute to greater financial stability in general. 3.3.5 The financial press and information disclosure One of the cornerstones of the regulatory regime is disclosure. Or as the saying goes: “Sunlight is the best antiseptic!” In the financial markets the financial press is an extremely important role player as well as a bridge between consumers and producers. For consumers to sift sensible from rather useless financial information is often a hard or even impossible task. The small print on financial contracts is often too small, too legalistic and too long to be of much help to consumers. In this type of “information overload”, the authorities and the press can be of great assistance to consumers by digesting the information supplied and summarising the results in a user-friendly form. Better information and disclosure also reduce the moral hazard of the authorities and are a powerful antidote to forbearance. In this respect, a number of countries are experimenting with some new ideas: • Competitive prices for similar financial products can be placed on an Internet site on a daily basis. This information should be supplied, through the compliance office, by all product providers. The financial press now immediately possesses a powerful database on which it can base its advice to the public. The FSA in the UK is working along these lines today. • The credit rating of financial institutions can be enhanced by the official ratings of the regulatory authorities. Although certain information supplied to the supervisors is classified, this need not prevent the authorities from doing a general evaluation of regulated institutions and publishing the results of such research. In fact, the financial industry together with the authorities can work out for public consumption a rating analysis based on 99

the official returns. In the US banks are already rated in five classes by the authorities and this information is made public. • Consumers may want to give their business to financial institutions that support their social preferences, even if the returns on their investments may be slightly less attractive. Some consumers, for instance, may want to support only those banks that sponsor sport, while others may feel that their support should go to banks that support the social upliftment of their local communities. How much of a bank’s spending is done on sport and how much on social goals? The public (i.e. in effect the press) wants to know, and the authorities can be of help by simply collecting the available data. • Consumers may want to know, on a competitive basis, the quality of financial advice given by evaluating, for instance, the lapse rates of longterm insurers, or they may want to know the claim/ payout rate of short-term insurers. Before signing a financial contract it is helpful for the consumers to receive a short summary of the essentials of the contract (called a “health warning”). In the UK this is known as the “Key Features” of a contract on a product and must be given to the consumer before a purchase is made. But even before they consider such a “warning” on contents, consumers should also be aware of the competitiveness of that contract in the broader market. With the technology of the Internet available, the authorities can do a lot more than they currently do to make markets more competitive and transparent. In this regard, the FSA in the UK plans to issue comparisons between similar products issued by different firms.

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3.4 Promoting monetary and financial stability

3.4.1 The conventional view that central banks should limit themselves to monetary stability only

Recognising that regulatory provisions can have systemic implications with macroeconomic effects raises two questions: • Should central banks have a role in designing regulatory regimes? 100

Should central banks have some advisory role when it comes to enforcement? The precise role of the central bank in the promotion of financial stability still seems subject to a significant degree of uncertainty. Recent experience has taught (painfully) that credit risk, liquidity risk and market risk are not separable and additive, but instead have proved highly interactive.19 If the central bank is at the heart of liquidity management, how do other regulators manage credit-risk and market-risk exposures in isolation? The key question in central banking today is therefore whether monetary policy should respond to asset price and exchange rate movements. For instance, should the central bank try to prick an asset price bubble in the stock market with a more stringent monetary policy stance (e.g. higher discount rates) or higher prudential requirements (e.g. higher capital requirements for banks) in the hope that this will enhance overall financial stability in the long term. The answer to this question is also of critical importance for the regulatory architecture of a country. If the central bank has, in addition to monetary stability, the responsibility for financial stability, it will then virtually and implicitly become the key institutional regulator, in addition to being the monetary authority. In fact, in such a regulatory architecture the central bank is likely to be the lead institutional regulator, particularly for complex financial institutions. To date, no consensus has been reached among central bankers on this important matter. The aim of this section is to summarise the train of thought on this topic and to hint at a possible direction of development in this area.

There are strong arguments why central banks should 19

Credit risk causes liquidity to disappear, in turn generating price movements significant enough to have effects on perceptions of market risk.

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focus exclusively on price stability. The main reasons are as follows: • Price stability is the best protection against financial instability. There is a close long-term relationship between inflation and asset prices. Accordingly, monetary policy should only respond to asset prices to the extent that they provide information about future inflation. • Fundamental value is extremely hard to assess. No central banker can be certain whether a jump in asset prices reflects an increase in productivity or a bubble.20 • Ill-designed safety nets (notably the central banks’ lender-of-last-resort facilities and public-sector sponsored deposit-insurance schemes) can exacerbate instability. According to this view, central banks should not involve themselves with deposit insurance (it should be a private sector arrangement, if required at all), while its lender of last resort arrangements should be limited to collateral lending (implying that only illiquid, but solvent banks can make use of this distress facility21). • Sudden withdrawal of liquidity or a sharply reduced scope for gearing can result in even more fragile balance sheets for banks. Therefore central banks should not actively interfere in the liquidity supply of institutions or markets (i.e. after it has set broad prudential requirements in this respect). • Even if a central bank wishes to prevent a financial imbalance from building up, by the time it forms a firm judgement about the existence of an imbalance, it would be too late. Trying to prick a bubble in its later stage risks precipitating the financial instability it is intended to avert. 20

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Central banks always deal with uncertainties of one kind or other. If they do make estimates about the potential output gap in their inflation forecast, they can make projections about fundamental asset prices and exchange rates as well. Indeed, the uncertainty about the valuation of asset prices is arguably no greater than the uncertainty about potential growth rates and hence the size of the output gap which is at the heart of most central banks’ inflation forecasts. By contrast, insolvent banks should approach the Treasury, as taxpayers’ money will unavoidably be involved in the bail of an insolvent bank.

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The response of asset prices to monetary policy is highly unpredictable and dependent on market sentiment. A pre-emptive monetary tightening may even boost asset prices if it strengthens the market participants’ sense that the central bank has inflation well under control. • As no monetary authority can say with confidence that an asset price movement is a bubble and not a reflection of fundamental values, it becomes difficult to persuade the investment public that interest rates have to rise to resist surging equity prices. In the end, bubbles are popular among investors and particularly so if the authorities support the markets during a “crash”, and do not interfere during the boom (and thus let bubbles burst on their own account). The markets love this kind of asymmetrical asset price interference, and even more so if paid for by others – such as taxpayers. • The more the central bank becomes involved in financial stability policy, the greater the likelihood that it may lose some of its independence from politicians, which in turn may adversely affect its goal of price stability (as nowadays reflected in a defined inflation target). The above arguments are powerful indeed, but doubts remain. 3.4.2 Arguments why central banks should also be involved in establishing financial stability Over the past twenty years the world’s financial system has been subjected to major changes which has also changed the traditional character of central banking. Financial systems today are market-led rather than government-led. Most important, financial liberalisation and innovation has not only resulted in cheaper financial products and more choice, but has also provided the means for increased liquidity and the potential for leverage. In fact, the current system has structurally increased liquidity and the potential for financial gearing with major consequences for financial stability (one of them being that there is now far more fuel for the fire). All these changes imply 101

greater reliance on market forces, with resulting “creative destruction” of institutions and markets. And yet relying on market discipline alone to ensure the necessary degree of financial stability, may no longer be possible. The major reasons for the central banks’ possible involvement in financial stability centre on the following arguments: • Central banks, by their very nature, are heavily involved in systemic risk management, and cannot close their eyes to the fact that there is a close correlation between monetary and financial stability. Increased market volatility often results in financial instability, which in turn results in institutional distress, increased credit risks, more insolvencies in general, later systemic distress, and ultimately greater demands for liquidity through the central bank’s lender-of-last-resort facilities. Moreover, the implied option value of deposit insurance rises during periods of financial instability. The costs of the central bank’s safety net arrangements are closely associated with the phase of the financial cycle and thus financial stability. To keep the costs of the safety net arrangements within reason, the central bank has a direct interest in financial stability, and should react accordingly. • Central banks face a major moral hazard in respect of asset price movements, because they should not interfere in an asymmetrical fashion in the financial markets. If they are expected to supply extra liquidity during a market crash (e.g. during the 1987 “melt- down”), they should also be able to reduce liquidity deliberately at the height of financial cycles. • Market liquidity has a dangerous binary side – it is either “on” or “off”. By contrast, the central banks’ liquidity policy could be one of “leaning against the wind”. Liquidity policy is the key instrument in any financial stability arrangements and the central bank (not the Treasury) possesses these important policy instruments. By taking more account of asset prices, central banks can reduce the long-term variability of inflation and output. 102

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Financial markets are usually very sophisticated in assessing relative risks, particularly in respect of instruments, debtors and counterparties. However, markets are far less skilled in assessing absolute risks, i.e. the phase of the business cycle and the overall position of the financial environment. Usually the central bank is in a better position here than the markets, and it should use this information for the benefit of national welfare. • Even if the central bank is uncertain whether the high level of asset prices is a reflection of improved economic fundamentals or whether it is a bubble, the monetary policy implication is not much different: i.e. it should be tightened anyway. Indeed, if it is a bubble, then a tightening of monetary policy would help to contain it. If it is instead a reflection of a stronger rate of productivity growth, then the real equilibrium interest rate would increase as investment opportunities expand. 3.4.3 The current status of the debate whether central banks should be involved in active financial stability policy The economy as a whole has a pressing need for both monetary and financial stability. In essence, the current financial system has two major weaknesses. Firstly, risks tend to accumulate rapidly in the upswing of the financial cycle (in line with increased levels of business optimism), but during the unavoidable recessions that follow such booms, these risks start to materialise quickly. Damage is then done to the financial system and it seems that the regulatory authorities cannot rely on market discipline alone in this respect. Secondly, the policy anchors for monetary and financial stability are no better than the ground in which they are secured. Inadequate perceptions of risk and inflated asset values lead to serious distortions in the financial system. If the authorities do not address these distortions, the policy anchors are secured in quicksand. Moreover, particularly in developing countries, the regulatory infrastructure is often still too weak to rely on market Financial Regulation in South Africa: Chapter 5

forces alone. It seems that the impact of the above arguments imply the following: • There is a school of thought, if the central bank is to be responsible for broad definitions of financial stability, it must be a position to set, or have a major influence on, capital requirements and hence leverage of banks. In particular a more extreme view argues that the central bank, in the interest of financial stability, should set capital requirements on a counter-cyclical basis. • Globalisation has extended financial linkages across institutions, markets and countries with resulting capital flows. These often volatile flows need the attention of the central bank, as even a small change in the portfolio composition of fund managers in the industrialised countries (the core) can have a major impact on capital flows to developing countries (the periphery). The exchange rate value and hence price stability in the medium term are directly influenced by these institutional portfolio adjustments and this requires international institutional co-operation, particularly between international institutions such as the IMF and developing countries. In such agreements the role of central banks cannot be ignored. • Financial stability rests on the three pillars of the financial system, namely proper infrastructure, sound markets and robust financial institutions. Whereas monetary stability depends ultimately on the interest rate, financial stability depends primarily on prudential requirements and financial gearing. It seems that the central bank has a key role to play in reinforcing each of these three pillars of the financial system. • Central banks are involved in systemic distress management, whether such distress flows across sectors, across borders or over time. Usually distress results from misalignments in macroeconomic magnitudes such as consumption and investments patterns, which in turn impact on credit risks and insolvency. In a nutshell, if central banks were to accept the responsibility for targeting two ultimate goals, namely Financial Regulation in South Africa: Chapter 5

monetary and financial stability, they would be de facto heavily involved in financial regulation as well. It then becomes crucial to distinguish clearly between regulation and supervision (as discussed in the next section). If financial stability is an objective, the important policy instrument will be the setting of prudential requirements for banks and investment firms in order to constrain credit expansion and financial leverage. In such a case the prudential requirements would potentially have major implications for the discount rate (i.e. the key instrument of monetary policy) to ensure the harmonisation of medium- and long-term price stability. Accordingly, the latest efforts of the Financial Stability Forum (BIS) go to the very heart of central banking, as its recommendations centre on the central bank’s ultimate objectives.

3.5 Regulatory arrangements 3.5.1 “Enhanced” lead regulation versus functional regulation Traditionally the supervision of banks and non-bank financial institutions was clearly distinguished and separated. Bank supervision was seen as a central bank function. There were a number of powerful reasons for this policy approach: • The supervision of banks needed specialised staff, which were more easily found in the central bank than outside it. • Combining oversight with the monetary policy functions offered distinct advantages, especially within an open and liberalised economy. • The safety net arrangements of the central bank were closely intertwined with the responsibilities of the bank supervision department. Before the central bank could decide on a lifeboat facility, it depended on the bank supervision department for a due diligence investigation. • Banking supervision, crisis management and lender-of-last-resort facilities were and still are closely intertwined, particularly because: (i) there is a lack of (perfect) information, making it 103

difficult at times to know for sure whether a bank is insolvent or illiquid; (ii) there are systemic implications for other banks if a bank in distress is not bailed out; and (iii) even if part of the banking system is allowed to fail, the authorities may find it is difficult to achieve their macroeconomic objectives (because of a major loss of confidence, i.e. the social costs of a bank failure22). Financial distress management sooner or later involves the central bank because of its key role in the payments system and ultimately its role as lender of last resort. The bank supervision department plays a crucial role in supplying the required information to the central bank. • The (confidential) information about banks that the central bank possessed and still possesses is also used by the bank supervision department for routine in-house operations. However, since the mid 1990s a change in philosophy has occurred vis-à-vis the role of the central bank in bank supervision: • Bank supervision and enforcement policies are conceptually quite different from regulatory policies. For instance, the central bank may change the prudential requirements for banks, but the monitoring, supervision and enforcement of such regulatory changes are not necessarily a central bank function. • The creation of new financial instruments (owing to the unbundling and rebundling of services) and the offering of these financial hybrids by different types of financial institutions have made integrated regulation more necessary than in the past. • As globalisation progresses worldwide, national supervisors are likely to become less able to assess the soundness of banks or the risks of systemic contagion, because of their national orientation towards supervision and regulation. For similar reasons cross-border co-ordination is unlikely to 22

Expressed in social costs, a major bank failure cannot be handled in isolation by an autonomous supervisory agency, as it also involves the monetary authorities and often the Treasury as well – inter alia because taxpayers’ money may have to be used to bail out the bank.

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fill these gaps, as the sharing of responsibilities between home and host supervisors has proved difficult. What ultimately is required are multinational supervisory agencies that include home and host country representatives of the banking and the non-banking financial institutions. The lender-of-last-resort facility was never intended to be limited to banks, as the central bank may need to supply liquidity to any institution experiencing difficulties that may create systemic problems more specifically payments system problems.23 The emergence of complex financial groups has resulted in integrated financial-sector supervisory agencies, which are combining banking, securities and insurance supervision. Such an integrated supervisory approach cannot be operated effectively and efficiently by one specific department of the central bank. Building supervisory capacity on an integrated basis achieves important synergies and economies of scale. Not only are the career progression prospects in such a super-regulatory agency attractive, but such a larger unit may reap important benefits of economies of scale in areas such as joint administrative and information technologies. A larger unit also facilitates the more effective deployment of staff. The establishment of currency blocs (and notably the euro-currency bloc) implies a radical split between policy making and supervision. In the EU the national central banks handed over their monetary policy to a super-national body (i.e. the European Central Bank or ECB). However, the supervision of financial institutions still remains a national affair. For example the 11 EU countries all have their supervisory agencies at national level, whereas the ECB takes full responsibility for monetary (and perhaps financial) stability. Some countries have established super-regulatory A recent US example (in 1998) was the support given to Long Term Capital Management, a highly leveraged non-financial institution, by the Federal Reserve through the American banking system. The support was required given the large exposures of banks to Long Term Capital Management. Financial Regulation in South Africa: Chapter 5

agencies (such as the FSA in the UK). This implies that bank supervision has to be taken out of the central bank, to enable this function to be integrated inter alia with insurance supervision. • Consolidated supervision implies that banking and securities business supervision become fully integrated. In a complex financial group, the bank supervision function probably becomes the lead supervisor in respect of securities business and insurance supervisors. Nonetheless, the traditional boundaries between banking, securities and insurance are becoming increasingly blurred. • In complex financial groups there is a general strategy to position the war chest of the group (i.e. the surplus capital and reserves available for takeovers and acquisitions) in the insurance company, as this type of business is less risky and more leniently regulated. Although jurisdictions and functions may differ in the various strategic business units of a complex group, the financial risks (e.g. credit, currency or market risks) remain the same. What is important is that, by means of derivatives these risks (and therefore profits) can be transferred throughout the group. Supervisors have a better overview of such risk transfers if the supervision is done on an integrated basis. • A tendency is developing among governments to allow central banks only to assist in bank bailouts to the extent that such institutions are solvent. Liquidity assistance is therefore on a strictly collateral basis, and the final decision in this respect depends on the governors of the central bank, not the head of the bank supervision department. In an effort to blend the advantages and disadvantages of a super-regulatory agency, the following structures are now developing in some of the major industrialised countries: • More and better-integrated autonomous supervisory agencies are being created. These agencies are, administratively, strongly connected to the central bank, sharing for instance its support infrastructure (e.g. data collection or administrative support). Financial Regulation in South Africa: Chapter 5

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The supervisory agencies tend to follow a multidisciplinary approach: i.e. across functions and across jurisdictions. • The integrated agencies are politically transparent, as any directives given to it by the responsible minister are open to public scrutiny. • The supervisory agency actively co-operates with the central bank to provide professional expertise on issues such as financial market stability and the payment and settlement systems. • While some supervisory agencies have become more rules bound, central banks have often been granted greater degrees of discretion (e.g. to ensure financial stability). • An integrated agency makes it possible to have a single coherent financial services statute under which financial conglomerates can be regulated. • To integrate its own staff, the integrated supervisory agency has to rotate the various professional skills between the various functions (e.g. banking and insurance supervisors may have to change jobs after some time). Given all the above arguments, a final note of warning is in order – particularly for developing countries where skilled resources are usually scarce. Many developing countries struggle with problems with retaining skilled labour in government departments, inter alia because these resources are relatively scarce in the first place and secondly because the private sector is able to skim off the cream by offering more attractive remuneration packages. By contrast, an independent central bank falls outside the public sector’s remuneration policies and accordingly can compete head-on with private banks for more expensive personnel. Any transfer of bank supervisors to an integrated supervisory agency would have to be undertaken with the greatest care, as it may easily result in a reduction in banking supervisory capacity. Indeed, the professional staff may opt to leave rather than to lose the pay and status usually associated with being a central bank employee. But then again, personnel issues should not cloud the overall strategic direction of the 105

authorities in the long run.24 Moreover there are of course also the political implications of transferring power from one authority to another (see Box 5.1, which lists some of these aspects). 24

Some countries are appointing retired senior managers from the private sector on an occasional basis to assist the supervisors in their monitoring and enforcement tasks. This scheme seems to operate very satisfactorily, because the appointed staff have much in-house knowledge and experience, no great problems with limited career prospects, and can be employed on a selective basis as they do not want to be involved full-time anyhow.

3.5.2 Safety net arrangements The safety net arrangements of the monetary authorities (including the Treasury) embrace, in principle, three components. Firstly, there is the lender-of-last-resort facility of the central bank for illiquid, but solvent, financial institutions. Secondly, retail depositors may be compensated from a depositinsurance scheme if a bank becomes insolvent. Lastly, insolvent financial institutions may be supported for systemic reasons by the central bank or the Treasury.

Box 5.1: The political dimension of transferring bank supervision from the central bank Transferring bank supervision outside the central bank has an important political dimension. For one, it implies a lower institutional barrier between the politicians and the financial regulators. A balance of power as a counter to populist day-to-day party politics demands a separation of powers*. For instance, in the South African context, the State President appoints the governors of the central bank on a fixed five-year contract, while the independence of the central bank is enshrined in the Constitution. By contrast, the National Treasury is a straightforward government department headed by a political appointee (i.e. the Minister of Finance), who may leave his office at any time (e.g. after a Cabinet reshuffle). Further, the central bank is of great importance in any country because of the legal right to create money. One of the important issues arising from this right is whether this function should fall under the ultimate control of the executive branch of government or whether parliament should leave this responsibility to an independent, autonomous institution run by unelected people. The traditional argument in favour of an independent central bank is that the power to spend money should be separated from the power to create money. Numerous episodes in the world’s economic history testify to a government’s potential abuse of its power to create money and a resultant increase in inflation (e.g. many governments have given way to the temptation to reduce interest rates ahead of elections). Central bankers normally operate on a longer-term time scale than politicians and therefore do not face the same temptation to relax policy to achieve short-term objectives (in fact, the Governor of the SA Reserve Bank has suggested that increasing the governors’ terms of tenure from the five-year political cycle would improve the autonomy of the Bank). By delegating decisions about interest rates and other monetary matters to such an independent institution, with a clearly defined mandate, society can hope to achieve a better inflation outcome over the longer term. Generally in old established democracies, where effectively the “middle-class” rules, and where there is a distinct separation of powers, the lowering of the political barriers may be less problematic – particularly in a federal constitutional set-up as found in the US and now increasingly in the EU – than in developing countries where the young democracies effectively represent the poor and often the unemployed. Accordingly, the envisaged efficiency gains of a one-regulator structure in industrial countries may well turn out to be inappropriate for developing countries, as short-term political opportunism may take its toll (note for instance the recent experiences in Indonesia and Zimbabwe). Although private bankers may prefer (on a basis of principle) that the structure of their regulators should mirror as closely as possible their own organisational structures, a trade-off has to be made between the economic and political interests of society. These country-specific dilemmas are one of the reasons that the one-regulator structure of the UK cannot simply be copied by developing countries such as South Africa. In fact, not even the UK is of the opinion that their current regulatory arrangement of a mega-regulator is an ideal export product. ________________________________ * For instance, the trias politica and upper and lower houses in parliament are just a few of the instruments used to ensure a balance of power in the state and go back at least until the times of Montesquieu.

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Lender-of-last-resort facility25 Similar to the current debate about whether the monetary authorities should use discretion or rules in financial stability policy (see Section (iv) below), there is a debate whether the central bank should use discretion in granting lender-of-last-resort (LOLR) assistance to illiquid institutions or whether it should stick to predetermined rules in such operations. LOLR policies have typically three primary objectives: • To protect the integrity of the payments system. • To avoid runs that spill over from bank to bank and develop into a systemic crisis. • To prevent illiquidity at an individual bank from leading unnecessarily to its insolvency.26 Countries approach the issue of discretion or rules in LOLR operations in different ways. For example, in the US the Federal Reserve Act (i.e. the 1991 amendment) severely limits the Fed’s discretion to lend to undercapitalised institutions, and if such lending would cause losses, the Fed needs reimbursement from the Federal Deposit Insurance Corporation. By contrast, the European Central Bank (ECB) is almost exclusively focused on monetary policy and its role vis-à-vis the national European central banks is one of ambiguity. Being largely based on the German central bank system, the ECB would most likely consider LOLR assistance if such operations only take place on a strictly collateral basis against good quality paper. In the German monetary system the LOLR functions are the responsibility of the Liquidity Consortium Bank (in which the Bundesbank holds a 30 per cent interest), while the Bundesbank itself focuses exclusively on price stability. In the UK the Bank of England (BoE) will grant LOLR facilities to institutions on a discretionary basis, but only against good collateral. In the case where an 25

26

This section is based on Prati, A., and G. Schinasi, “Will the European Central Bank be the lender of last resort in EMU?” in Artis, M., A. Weber and E Hennessy (editors), The Euro, A challenge and opportunity for financial markets, London: Routledge, 2000. By contrast, the primary objective of a deposit-insurance scheme is to prevent self-fulfilling runs on deposits and to provide a safe asset to small savers.

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illiquid financial institution drifts into insolvency, funds have to be supplied by the Treasury, which then also wants control over how these funds are to be used.27 In South Africa the SA Reserve Bank (SARB) has discretion in granting LOLR assistance but only against collateral (this assistance has, at times, been supplied by the authorities at virtually zero cost). As in the UK, the SARB has to look for financial assistance from the Treasury if it wants to bail out an insolvent financial institution. This section will briefly evaluate the various approaches to LOLR operations by firstly emphasising the underlying principles of LOLR assistance, secondly by distinguishing between the “marketoperation” and “banking-policy” approaches to LOLR assistance, and lastly by considering the relative advantages and disadvantages of discretion or rules in LOLR operations. (i) The principles of LOLR operations Bagehot (1873) set out the benchmark for LOLR operations more than a century ago. The application of his doctrine would require a central bank to – • make LOLR facilities available to the whole financial system, but lend only to illiquid institutions that are solvent; • let insolvent institutions fail; • lend speedily; • lend only for the short term; • charge penalty interest rates; • require good collateral; and • announce these conditions well in advance of any crisis, so that the market would know exactly what to expect. These best practices are generally still considered valid as an ideal. Strict adherence to the Bagehot rules has three major advantages. Firstly, as a loan is only granted to solvent institutions, the central bank is not confronted with the moral hazard of bailing out institutions that do not deserve such assistance (but may have to obtain it nonetheless for systemic 27

With potential negative implications in terms of time delay and political interference – indeed, “he who pays the piper calls the tune”.

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reasons). Secondly, as lending takes place against good collateral, the central bank’s balance sheet position is not necessarily adversely effected. Thirdly, because the lending is only for short periods, the inflationary consequences of LOLR intervention are limited. However, in practice a number of factors complicate the implementation of the Bagehot’s principles: • In the midst of a crisis, information about the degree of solvency is not readily available. Perfect information does not exist, neither is it easy to distinguish between “good” and “bad” collateral in the case of an insolvent bank. • To avoid systemic implications, the authorities have a tendency to bail out insolvent “systemically important” institutions to prevent the failure or even collapse of the financial system (called the “too-big-to-fail” argument). • Even if part of the banking system is allowed to fail, the authorities may find that it becomes far more difficult to achieve their macroeconomic objectives (including price stability, financial stability and fiscal stability), owing in part to a loss of confidence and the unavailability of alternate funding, which alter the private sector’s behaviour. • Banks find it difficult to redeem LOLR loans, and the penalty rates imposed by the central bank impact negatively on their solvency. All these factors can interact and worsen a crisis and complicate crisis management. In essence the more imperfect the information and the greater the premium placed by politicians on a rapid solution to a financial crisis, the greater is the moral hazard for the central bank. Considering the high and costly information requirements, it is doubtful whether central banks can always justify their LOLR assistance, as their intervention costs may well exceed the benefits. There are two broad approaches to addressing this problem: (i) the “market-operation” approach which wants to do away with LOLR assistance; and (ii) the “banking policy” approach which aims to refine current LOLR operations. (ii) The market-operation approach According to this approach, the central bank should 108

only provide liquidity to the market and focus exclusively on providing liquidity to the system against well-defined collateral (e.g. government securities). Accordingly, the central bank should supply emergency liquidity to the financial markets (not individual institutions) through its open-market operations, with government securities as underlying assets. Under this approach the allocation of liquidity is left to market participants. In essence, this school of thought believes that the costs of LOLR assistance28 are greater than the benefits and that central banks should therefore only be involved in monetary stability. Moreover, it (conveniently) assumes that financial stability would naturally follow monetary stability. In fact the market-operation approach does not address systemic or contagion risks. It usually considers large insolvent financial institutions as being “too big to rescue”, rather than “too big to fail”. In many respect the ECB framework reflects the market-operation approach as the Bank has a “narrow” monetary stability mandate; has no mandate as a LOLR; can only smooth interest rate movements by using open-market operations; and may provide liquidity only against penalty rates and against strictly defined collateral (the Lombard facility).29 As a result of these restrictions the ECB, like the Bundesbank in the past, has to rely heavily on either Treasury or private-sector support. However, Treasury standby arrangements have the disadvantages that their resources (i.e. the emergency liquidity funds) have a limit and a sizeable opportunity cost, and that the use of these funds requires parliamentary approval which may be a time-inconsistent emergency solution. Likewise, private-sector support – e.g. in the form of deposit-insurance schemes, German-style liquidity 28

29

These costs include the cost of supervision and regulation; the moral hazard cost flowing from imperfect information; the cost of reduced peer monitoring among market participants owing to the central banks’ LOLR role; and the cost of potential monetary policy errors. Another example of the use of the market-operation approach was the general, unrestricted assistance given by the Fed to banks at the discount window during the 1987 stock market crash to avoid gridlock in the US payments system.

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consortia or pools of solvent banks – may be timeinconsistent during a financial crisis. (iii) The banking-policy approach This approach favours a more interventionist financial stability role for central banks, on the assumption that there is a strong relationship between achieving and maintaining monetary and financial stability. Four arguments are usually advanced to support this approach: • Market failures may preclude the fast and reliable channelling of liquidity to illiquid, solvent institutions. • Widespread failures of financial institutions could affect the confidence and the behaviour of the private sector. • Central banks can reasonably contain the moral hazard implications by following the practice of “constructive ambiguity”. • Central banks are likely to be involved in most banking crises (including insolvent institutions), because they are generally the only source of immediate (not necessarily ultimate) funds.30 The banking-policy approach is favoured by institutions such as the US Federal Reserve and the Bank of England both of which have, for instance, considerable leeway in selecting eligible collateral and counterparties. They may even make loans available at a subsidised rate. On balance the banking-policy approach rests on two assumptions: • Central banks are in a better position to assess the solvency of illiquid institutions than the market is31. • Central banks contribute to an orderly resolution of such crises with a limited and tolerable impact on moral hazard and monetary (price) stability. (iv) Rules versus discretion Speed is increasingly becoming a critical factor in the handling of financial crises. Firm rules, worked out ex 30

31

If the central bank is the immediate provider of liquidity for LOLR operations and the Treasury the ultimate provider of funds, then in practice the central bank needs Treasury guarantees on LOLR operations. At least in a crisis situation in which there is the potential for farreaching systemic implications.

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ante on how to operate during distress periods, improve speedy solutions. The regulatory arrangement of LOLR should therefore be evaluated in particular against its time-consistency. From the point of view of speed, the central bank has major advantages over private sector LOLR arrangements or Treasury assistance. Indeed, the private sector is less likely to consider the social cost of financial distress and instead concentrate more on direct costs to privatesector participants, which is likely to result in very slow payouts (e.g. deposit-insurance schemes are slow providers of liquidity assistance). Likewise, the Treasury is bound to be slow with its assistance, as it first has to obtain parliamentary approval. Only the central bank is an immediate provider of liquidity when required and its key role in financial distress management seems natural if speed is of the essence. However, even if the central bank accepts its role as LOLR, the following arguments should be considered: • If obtaining perfect information in the shortest possible time is aimed at during a banking crisis, it is probably better that the bank supervision function should be an integral part of the central bank. • If financial distress and systemic risks flow primarily from large financial conglomerates, it is better that bank supervision should be part of a larger supervisory body. The supervision of complex groups is increasingly a task for an integrated supervisory agency, implying that bank supervision should be outside the central bank and be integrated with inter alia securities and insurance supervision. • If supervision is performed by an integrated supervisory body outside the central bank, it becomes crucial that an adequate and reliable Memorandum of Understanding (MoU) should be signed between the central bank and the supervisory agency. • If ultimate funds for LOLR are recovered by the central bank from the Treasury, again a MoU would have to be in place ex ante to the financial crisis. 109

•

If the approach of MoUs between the three key institutions (central bank, supervisors and Treasury) proves in practice too complicated and too slow to allow for a rapid assessment of the systemic implications of a crisis, then the secondbest solution would probably be to have bank supervision remaining part of the central bank, although this solution seems suboptimal. • If the central bank uses “constructive ambiguity” to reduce its moral hazard in LOLR operations, prudence would require, nevertheless, that there should be no ambiguity among policy makers about the mechanisms that can be used to manage crisis situations. In a nutshell, the sharing-of-information provisions between the central bank and the supervisory agency are crucial in an efficient and effective LOLR operation.32 The aim of MoUs is to create a more rules-based approach to LOLR operations, without which co-operation between the central bank, the supervisors and the Treasury would be difficult to achieve. Deposit-insurance scheme The lender-of-last-resort facility is not an alternative to deposit insurance. Deposit insurance should only be activated after the bank has become insolvent. The ultimate aim of deposit insurance is to facilitate the liquidation of insolvent banks without the need for bailouts and to contribute to the stability of the financial system (e.g. by avoiding runs on banks). It does so by quickly paying the many small and unsophisticated depositors. This means that depositors are shielded from the costs associated with bank insolvency. To improve the deposit-insurance scheme and to limit the moral hazard, the following are essential: • The level of insurance cover must be relatively low and clearly specified so that bank depositors and 32

For example in the UK the MoU between the Bank of England and the FSA (paragraph 9) stipulates that: “the FSA and the Bank will establish information sharing arrangements, to ensure that all information which is or may be relevant to the discharge of their respective responsibilities will be shared fully and freely. Each will seek to provide the other with the relevant information as requested”.

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other creditors can be in no doubt about the insured or uninsured status of their claims. • In order to sustain depositor confidence in the guarantee fund, compensation must be available quickly. • Participation in the deposit-insurance scheme for banks should be mandatory, to avoid adverse selection. • The uninsured deposits and other liabilities should be “credibly uninsured”. There should be no false hopes of official support in the event of a bank’s insolvency. • The insurance premium should be market-related, and thus risk-related. The risk premium on credibly uninsured subordinated debt could be used as an indicator to determine a market-related insurance premium, provided the bond market is sufficiently efficient and effective. Unfortunately, bond markets are normally not so efficient, and this limits the practical use of yields on unsecured subordinated bank debts as a regulatory instrument. • The insurance scheme should be funded ex-ante rather than ex-post. • Some form of co-insurance (i.e. depositors are expected to share a portion of the losses within the coverage limits) is recommended. • If a bank fails, shareholders, managers and unsecured creditors should lose, not taxpayers. • The deposit-insurance scheme must insist on a strong institutional infrastructure (e.g. accounting, disclosure, compliance and corporate governance standards). As an ill-designed deposit-insurance scheme can do more harm than good, the authorities should be careful about practical implementation.33 The lifeboat facility and exit policy As a financial institution in distress drifts (often not so slowly) from being illiquid to insolvent, the operations of the central bank may shift from LOLR to lifeboat 33

The relationship between the curatorship function and deposit insurance could also be emphasised. For instance, in South Africa the curator can freeze the deposits in a failed bank and thus prevent bank runs.

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operations (i.e. the financial institution is kept afloat) and ultimately to exit policies (i.e. the institution is scuttled). The ultimate aim of an exit policy is to ensure that shareholders, managers and unsecured creditors (particularly subordinated debt holders), but not taxpayers, will pay for the failure. If the social cost of failure exceeds the private cost of a bankruptcy, Treasury emergency funds could justifiably be used, but the government may then decide to nationalise the financial institution and to resell it during better times. This policy was followed in Scandinavia, when the Government of Sweden, for instance, nationalised most of the country’s big banks during the 1990–92 financial crises. The average costs, in the form of guarantees and capital injections from the budget, amounted to 5,9 percent of GDP. This cost was totally recovered by the Swedish Government on the sale of the appreciated shares of the now-profitable stateowned bank (i.e. Nordbanken) in 1994–1996. An alternative to nationalisation is ensuring that the exit of failed financial institutions takes place through the market process. This implies that a rules-based exit policy is in place prior to a financial crisis. Generally a rule-based exit policy guarantees the prompt and orderly closure of insolvent institutions and ensures that at least part of a bank failure is borne by owners/ shareholders, managers and perhaps creditors. One mechanism to make this operational is through the SEIR proposals (Structured Early Intervention and Resolution) first suggested by academics in the United States. Under this regime it is outlined in advance what official intervention action will be triggered as and when a bank’s financial position deteriorates beyond specified levels. The United States and Japan are examples of where rules require supervisors to take prompt action when an institution’s capital ratio falls below a specified level. A more radical example is the market-based regulation in New Zealand (1996) that requires banks to disclose publicly information that in other countries is normally viewed as the “proprietary” information of the authorities. The objective of the reforms is to limit regulatory forbearance by passing some of the responsibility for supervising the banking system to the Financial Regulation in South Africa: Chapter 5

markets, and to reduce moral hazard by changing the incentives of bank managers. Together with full disclosure, these reforms increase the frequency of external audits and credit ratings, eliminate official deposit insurance, and make financial institutions’ managers personally liable and accountable. Once the rules of the exit policy have been announced, the authorities have to credibly commit themselves to such rules. The worst possible scenario would be where the government announced its intention not to provide emergency credit assistance in the future, but the banks believed that in fact it would. In this case, if a liquidity problem arose, banks would not have prepared for it by holding sufficient capital and by arranging lines of credit. If the government remained true to its policy, widespread insolvency could prevail. Ultimately the exit policy of the authorities for failed financial institutions is only one particular instrument in an array of policy instruments available on how to restructure systemically the financial, and more specifically, the banking industry. As is evident from Table 5.2, the restructuring tools available to the regulatory authorities embrace structural and financial measures, with the closure of failed banks being only one of the structural possibilities. In practice, the authorities use an average of about eight different instruments to address the issue of systemic bank restructuring.34 Successful reform requires, as a first step, that solvency should be restored. This is usually the easy part of the restructuring programme; far more difficult is the restoring of sustainable profitability, which always means that management deficiencies have to be addressed promptly and head-on. Achieving profitability without exception requires painful operational restructuring, which is not only difficult but also time-consuming (generally, the central bank can be supportive but not operationally involved). For this reason alone, the authorities should ideally anticipate the need for reforms and carry them out in times of relative financial calm. 34

Dziobek, C. and C. Pazarbasioglu, “Lessons from Systemic Bank Restructuring”, Economic Issues, No. 14, Washington: International Monetary Fund, p. 4.

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3.6

Recent trends in regulatory practice

intermediation becomes excessive; regulation imposes an unnecessary tax on banks with the result that financial intermediation business may switch to unregulated firms; and banks may respond by seeking to cover the higher costs through more risky business with a higher expected rate of return. On the other hand, if capital ratios are set too low the cost of financial instability is likely to rise. Because of this trade-off, unnecessary costs are imposed if regulatory capital (capital-adequacy requirements imposed by regulation) is not aligned with economic capital (what is needed on the basis of actuarial calculations of a bank’s risk). When judging the efficiency and effectiveness of capital-adequacy regulation, four basic criteria should be applied: • Does it bring regulatory capital into line with economic capital? • Does it create the correct risk-management incentives for owners and managers of banks? • Does it produce the correct internal allocation of capital as between alternative risk assets and therefore the correct pricing of risk? • To what extent does it create moral hazard? BIS approach to capital adequacy It is well established that there are many problems with the current BIS capital-adequacy regime (1988 Accord). In particular: • The risk weights applied to different assets and contingent liabilities are not based on actuarial calculations of absolute and relative risk. This in turn creates incentives for banks to misallocate the

Space precludes a detailed review of how regulatory arrangements have been evolving. However, in some areas substantial changes have been made and others are in the pipeline. This section briefly considers some of the trends that are emerging with respect to the international approach to the prudential regulation and supervision of banks. When setting capital-adequacy standards on banks, the regulator confronts a negative trade-off between the efficiency and costs of financial intermediation on the one hand, and financial stability on the other. Although it is a complex calculation – absent the Modigliani-Miller theorem (which does not, in any case, apply to banks with deposit insurance) – as the cost of equity exceeds the cost of debt (deposits) the total cost of financial intermediation (measured, for instance, by the banks’ interest margin) rises as the equity-assets ratio rises. If the regulator imposes an unnecessarily high capital ratio (in the sense that it exceeds what is warranted by the risk profile of the bank), an avoidable cost is imposed on society through a high cost of financial intermediation. On the other hand, a high capital ratio reduces the probability of bank failure and hence the social costs of financial instability. It also means that a higher proportion of the costs of a bank failure are borne by specialist risk takers rather than depositors. This means that regulatory capital requirements can either be too high or too low and both involve costs. If capital-adequacy requirements are set too high three potential costs arise: the cost of financial

Table 5.2: Tools available for systemic bank restructuring Structural measures • • • • • • • • 112

Central bank as sole restructuring agency Central bank liquidity support Loan workout units (public- or bank-based) Closure of insolvent banks Merger of insolvent banks Privatisation (where applicable) Enterprise restructuring to improve creditors Twinning with foreign banks

Financial measures • • • •

Bonds (e.g. in exchange for bad loans) New equity (e.g. bought by government) Depositor-based instruments Owners, management, market incentives

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internal distribution of capital and to choose an uneconomic structure of assets. It is also liable to produce a mis-pricing of risks. There is, for instance, an incentive to choose assets whose regulatory risk weights are low relative to the economic (true) risk weights even though, in absolute terms, the risk weights may be higher than on alternative assets. The distortion arises not because of the differences in risk weights but to the extent that differentials between regulatory and economic risk weights vary across different asset classes. • The methodology involves the summing of risk assets and does not take into account the extent to which assets and risks are efficiently diversified. • No allowance is made for risk-mitigating factors such as hedging strategies within the bank. • All loans carry a risk weight of unity whereas the major differences within a bank’s overall portfolio exist within the loan book. • Banks are able to arbitrage their regulatory capital requirements in a way that lowers capital costs without any corresponding reduction is risk. • The current Basel Accord only applies to credit and market risk. Although national regulatory and supervisory authorities have discretion about how the Accord is to be applied (subject to certain minima), and therefore the distortions may not be as serious in practice as the Accord might suggest, the fact remains that the Accord is seriously flawed. Partly because of these weaknesses, the Basel Committee on Banking Supervision has recently proposed a new framework for setting capitaladequacy requirements, (Basel Committee, 1999). It has issued a substantial consultation document which, if adopted, would represent a significant shift in the approach to bank regulation. This is not discussed in detail here other than to note that it is based on three pillars: minimum capital requirements, the supervisory review process and market discipline requirements. The proposed new approach can be viewed in terms of the regulatory regime paradigm: • Substantial emphasis is to be given to the importance Financial Regulation in South Africa: Chapter 5

•

•

• •

•

•

• •

of banks developing their own risk analysis, management and control systems, and it is envisaged that incentives will be strengthened for this. The Committee’s consultative paper stresses the important role of supervision in the overall regulatory process. This second pillar of the capital-adequacy framework will: “seek to ensure that a bank’s capital position is consistent with its overall risk profile and strategy and, as such, will encourage early supervisory intervention”. In an attempt to bring regulatory capital more into alignment with economic capital, it is proposed to widen the range of risk weights and to introduce weights greater than unity. A wider range of risks is to be covered including operational risk. Capital requirements are to take into account the volatility of risks and the extent to which risks are diversified. Although a modified form of the current Accord will remain as the “standardised” approach, the Committee believes that for some sophisticated banks, use of internal and external credit ratings should be incorporated, and also that portfolio models of risk could contribute towards aligning economic and regulatory capital requirements. The Committee recognises that use of internal ratings is likely to incorporate information about customers that is not available either to regulators or external rating agencies. In effect, in some respect this would involve asking banks themselves what they believe their capital should be. This is a form of precommitment. The object is to bring the regulatory process more into line with the way banks undertake risk assessment. A major aspect of the proposed new approach is to ask banks what they judge their capital should be. Any use of internal ratings would be subject to supervisor approval – this is an element of, what earlier was termed, contract regulation. Allowance is to be made for risk-mitigating factors. Greater emphasis is to be given to the role of 113

market discipline. The third pillar in the proposed new approach is market discipline. It will encourage high standards of transparency and disclosure standards and “enhance the role of market participants in encouraging banks to hold adequate capital”. It is envisaged that market discipline should play a greater role in the monitoring of banks and the creation of appropriate incentives. The Committee has recognised that supervisors have a strong interest in facilitating effective market discipline as a lever to strengthen the safety and soundness of the banking system. It argues: “market discipline has the potential to reinforce capital regulation and other supervisory efforts to promote safety and soundness in banks and financial systems. Market discipline imposes strong incentives on banks to conduct their business in a safe, sound and efficient manner”. • The proposals also include the possibility of external credit assessments in determining risk weights for some types of bank assets. This would enhance the role of external rating agencies in the regulatory process. The Committee also suggest there could usefully be greater use of the assessment by credit rating agencies with respect to asset securitisations made by banks. • The consultation document gives some emphasis to the important role that shareholders have in monitoring and controlling banks. Overall, the new approach being proposed envisages more differentiation between banks, a less formal reliance on prescriptive rules, elements of choice for regulated institutions, elements of contract regulation, an enhanced role for market discipline, a greater focus on risk analysis and management systems, some degree of precommitment, and a recognition that incentives for prudential behaviour have an important role in the overall approach to regulation.

3.7 Summary To ensure good governance in finance regulation and to 114

improve the efficiency and effectiveness of supervisors, three key building blocks have to be in place.35 Proper incentives These incentives have to ensure that the following are in place: • Bank insiders should have a significant equity stake in the banking business. • Banks’ accounting policies need to reflect market risks and borrowers’ credit risks. • Bank directors need to be accountable. • Connected lending and ownership of banks by commercial interests need to be prohibited or tightly controlled. • A limited and explicit role for public deposit insurance. • Protection of the interests of minority shareholders, especially among banks that are closely held. • A duty of loyalty should be imposed on controlling shareholders who also serve as bank directors. • Independent directors and the use of audit committees to deter insider abuse. • The interests of banking supervisors should be aligned with those of taxpayers. Ensuring transparency Usually the coverage and standards of banks’ disclosure leave too much scope for discretion. In order to ensure proper transparency, the following information should be disclosed: • Besides the normal financial statements, banks should publish their capital-adequacy ratio, peak exposure concentration, lending to related parties and to members of the board, and any conflicts of interest. • Disclosure should follow marked-to-market procedures and thus reflect the effects of exchange rates, interests rates and commodity prices. • Bank directors should attest that their disclosures are not false or misleading. • Banking information should be given to the markets to a greater extent, rather than exclusively to the authorities. The aim should be for market35

Leechor, C., “Banking on Governance?”, Public Policy for the Private Sector, The World Bank Group, Washington, December 1999, pp. 45–48.

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based disclosure on a quarterly basis, informing depositors, their agents and outside shareholders. • Likewise, banking supervisors should be more transparent. They should be required to disclose regulatory opinions on official forbearance or corrective actions. • The authorities should disclose the risk exposure of public guarantee funds. • Supervisors, like directors, should be requested to attest that their disclosures are not false or misleading. Clarifying accountability Along with better disclosure, competition in the banking business can make bankers more accountable. The following points arise: • To attract funds, banks would have to rely more on investment merits, including good governance and creditworthiness. • There should be adequate sanctions against abusive practices, particularly for a breach of rules of disclosure. • Bank insiders should have unlimited liability for abusive practices. • Minority shareholders and taxpayers should have access to judicial remedies against insider abuse.

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•

Banking supervisors should have clearly defined performance criteria and a governing body accountable to the taxpayers. • Supervisors should set targets for the risk exposure of public funds, explain any deviations from the targets and provide a clear plan of corrective actions. • Supervisors, like directors, should face significant sanctions for breach of duty. • A regulatory audit agency could help in investigating official misconduct. • An independent and aggressive media can play a critical role in the enforcement of supervisory standards. All of this amounts to a rebalancing between the different components of the regulatory regime and, in particular, greater emphasis should be given to effective supervision by official agencies; a clearer focus on the incentive structures faced by all stakeholders in regulation; an enhanced role for market discipline; effective corporate governance arrangements in banks; clearly defined and credible rules for the intervention in the case of deteriorating banks; and proper accountability of regulatory and supervisory agencies.

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Chapter 6 THE CURRENT REGULATORY STRUCTURE OF THE SOUTH AFRICAN FINANCIAL SYSTEM IN THE INTERNATIONAL CONTEXT This chapter endeavours to describe the current structural framework of financial regulation in South Africa. Any financial system consists of three major components: (i) financial instruments; (ii) markets in which these instruments trade; and (iii) market participants1. This analysis is divided into similar sections. Section 1 examines the current regulation of financial instruments. Section 2 outlines the regulation of financial markets and Section 3 analyses the regulation of financial market participants. In each section the regulatory regime is highlighted by means of a regulatory matrix.

1.2 The regulatory regime and structure for financial instruments

Ultimately any financial instrument can be broken down into cash (money) and/or options. Therefore cash and options provide the basic building blocks for “financial engineering”, which facilitates the continuous creation of new financial instruments. Simultaneously, competition ensures the demise of commercially unviable instruments. In fact, not all newly created financial instruments survive in the long run, as some new instruments are often not liquid enough, too complicated, too difficult to capture in existing management control systems, or simply have fulfilled their tasks. Diagram 6.1 gives an overview of major financial instruments in the spot and derivative markets.

Since financial innovation enhances competition, the regulatory authorities are reluctant to interfere unnecessarily in the creation of new instruments, some of which can be used to mitigate risk. The issuing of and trading in many financial instruments are therefore subjected by and large to market disciplines only. For instance, swap contracts – despite their large amounts and often sophisticated nature – are unconstrained in terms of official regulation2 in South Africa. In contrast, the authorities do regulate the issue of company shares and debt instruments, as well as the derivatives on these instruments. For instance, in the interests of systemic stability the authorities prescribe minimum standard requirements for the issuing of money- and capital-market instruments and/or the way they should be traded. The issuing of money- and capital-market instruments is regulated by general legislation, specific prescriptive legislation and/or specific enabling legislation. Those money- and capital-market instruments can be created by a wide variety of issuers and are usually regulated in terms of general legislation. For instance, the Bills of Exchange Act and the Companies Act stipulate in detail the issuing and processing requirements of bankers’ acceptances, trade bills, promissory notes, corporate debentures and equities. In cases where the issuer is established in terms of specific prescriptive legislation (e.g. in the case of a public business enterprise) such legislation usually contains stipulations about the issuing requirements

1

2

1. Regulation of financial instruments 1.1 The definition and nature of financial instruments

Such as lenders, borrowers, financial intermediaries, brokers, fund managers, financial advisers and trustees.

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The market may however constrain trading operations by applying self-imposed regulation.

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and processing of the relevant instruments. For example, the Exchequer Act controls the issuance of Treasury bills and government bonds, the South African Reserve Bank Act the issuance of SARB debentures, the Banks Act the issuance of NCDs, the Land Bank Act the issuance of Land Bank bills and Land Bank debentures, whereas the acts establishing various public corporations and local authorities regulate the issuance of public corporation and local authority bonds. Fiduciary money is also a financial instrument, as it represents a claim on the government3. The issuance of coin and banknotes is regulated in terms of the South African Reserve Bank Act. The issuance of foreign exchange vests of course in foreign authorities, but trade in such currencies within the South African jurisdiction is subjected to strict regulation by the exchange control authorities. In South Africa the financial and commodities exchanges (i.e. formalised investment markets) are regulated in terms of enabling legislation. The Stock Exchanges Control Act regulates the operations of the 3

In low-inflation countries government income flowing from seignorage is some 2–3% of government revenue, but in highinflation countries it may be over 10% of government revenue (see BIS, Policy Papers No. 1, 1996).

Johannesburg Stock Exchange4 (JSE), and the Financial Markets Control Act regulates the activities of the Bond Exchange of South Africa (BESA) and the South African Futures Exchange (SAFEX). These exchanges not only supervise trade in financial instruments – such as listed equities and corporate debentures and options5 on these (JSE); bonds and options on bonds6 (BESA); and futures and options contracts on these futures (SAFEX) – but also prescribe minimum listing requirements for these instruments. In this way the issuance of equities, debentures and bonds is regulated by both general and specific legislation. In the case of futures and option contracts, an exchange can even act as the creator of these derivative financial instruments. For instance, SAFEX places itself as a “middleman” in every trade,7 4 5

6

7

Now named the JSE Securities Exchange. An option on an individual share is also called a warrant. Today the JSE’s trade in derivatives is de facto limited to warrants. Although the BESA is permitted to regulate bond options, most of the bond derivative market in South Africa is over-thecounter (i.e. not formalised). The process involved here is novation, i.e. where two parties to a contract agree to enter into a new contract putting an end to an original liability and substituting a new liability in its place. Novation takes three forms: i) extinguishing an existing debt and substituting a new debt in its place; ii) substituting a new debtor; and iii) substituting a new creditor.

Diagram 6.1: Types of financial instruments Cash

Options

Financial instruments

Spot market instruments (spot settlement)*

Currencies

Derivative market instruments (forward settlement)

Equities

Debt

Forward contracts

Option contracts

Futures contracts

Other derivative contracts

* “Spot” settlement in South Africa is currently 2 days (T+2) in the currency market, 3 days (T+3) in the bond market and up to 7 days in the equity market.

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i.e. the exchange is either a buyer or seller of futures and option contracts with all its clients. As reflected in the regulatory matrix (see Table 6.1), financial instruments as such are fairly leniently regulated in South Africa. In essence the regulatory authorities only want to ensure that the rights and obligations represented by those instruments (e.g. the underlying credit soundness) are secure. It is instead the financial markets or the users of financial instruments who are regulated. The major statutory constraints applicable to the issuance of financial instruments are the following: • Minimum quality standards: Usually when new financial instruments are created they are relatively free of quality requirements. However, over time there is a tendency to standardise, if only to improve the liquidity of such instruments. For example, one important reason for the standardisation of forward contracts into futures contracts is the higher degree of market liquidity that goes hand in hand with such standardisation. A second reason for standardisation is to regulate minimum quality standards (e.g. in respect of disclosure and fairness) as set by the authorities and/or the exchange. For example the issue of equities is constrained by the Companies Act and the listing requirements of the JSE. • Operational constraints: Financial instruments may not be misleading, neither should their issuance result in conflicts of interest. The pricing of financial instruments should be transparent and fair. Accordingly, the issuance of corporate debentures requires the issuing of a prospectus with detailed disclosure requirements. • Market monitoring and discipline: Competitive forces ensure that only the most effective and costefficient financial instruments survive over time. The stability of financial markets is enhanced by the elimination of those instruments that either lack a sufficient degree of liquidity or that are not (globally) competitive. Besides the legal minimum standards and operational constraints placed on the issue of instruments, the market itself effectively 118

ensures the quality of financial instruments. This market discipline in turn promotes integrity and transparency to an even higher extent than often can be enforced by the regulatory authorities. Diagram 6.2 gives a structural overview of how financial instruments are regulated in South Africa. As noted, financial instruments issued and/or traded outside the equities, bond and futures markets are usually subjected to market discipline and marketmonitoring mechanisms only. For instance, option contracts written in the informal market (e.g. on residential property) are unregulated. Likewise most products of financial engineering (usually complex off-balance-sheet instruments) are unregulated at the time of their creation.

2. Regulation of financial markets The regulation of financial markets is more complicated than that of instruments owing inter alia to the complex nature of markets. For instance, markets can: trade in one or more basic financial instruments; be of an informal or formal nature; embrace spot and/or derivative instruments; be subdivided into various smaller market segments each with its own character (e.g. primary issue and secondary trading markets); and be regulated by one or more regulatory authorities. Moreover, financial markets show a high degree of interdependence. These issues will be addressed in this section under the following headings: • Difficulties in defining a financial market • The nature of over-the-counter and regulated markets • The instruments traded on financial markets • The aggregation of financial instruments into basic markets • Types of financial markets and their regulation • The regulatory regime and structure of financial markets

2.1 Difficulties in defining a financial market So long as a financial market trades in only one Financial Regulation in South Africa: Chapter 6

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7. Discipline/accountability of regulators

6. Corporate governance

5. Market monitoring and discipline

4. Incentive contracts and structures

3. Intervention and sanctions

2 Official monitoring and supervision

1.6 Operational constraints

1.5 Pricing constraints

1.4 Jurisdictional constraints

1.3 Functional activity constraints

1.2 Ownership constraints

1.1 Entry and standards constraints

1. Official rules and regulations

Regulatory regime and its instruments

Regulatory intermediate goals Competitive market infrastructure Acceptable maturity and currency mismatches Acceptable crossmarket exposures X

X

Sufficient market liquidity X

X

X

X

X

Competitive neutrality Integrity and fairness

Fit and proper directors and staff Global institutional competitiveness

Proper institutional infrastructure

Regulatory effectiveness, efficiency and economy Proper risk assessment

Securities markets as alternative to intermediation

Consumer protection

Competence

Institutional safety and soundness

X

X

Adequate product/service competitiveness

Systemic stability

X

X

Transparency and disclosure

Regulatory ultimate objectives

Access to retail financial services Protection of retail funds

Table 6.1: Regulatory matrix: Financial instruments

Retail compensation schemes

specific financial instrument, it can usually be defined in terms of the instrument being traded. For instance, the bond market can be defined as a place or facility8 where trade in bonds takes place. However, the grouping of different types of financial instruments into a single financial market usually results in problems of definition. A few examples illustrate this point. The money market is usually defined as the spot market for short-term “securities”9. But what is short term? For some dealers the demarcation between the money market and bond market in South Africa is three years because, they argue, it is only then that 8

9

It used to be a trading floor, but today most financial markets are electronic. Bond markets have generally been the last to embrace electronic trading technology, with corporate bond markets being last of all. Securities may be notional or fictitious.

bonds obtain their statutory liquid-asset status. However, most dealers, both in South Africa and abroad, define the money market as a market that trades in instruments with a maximum tenor of only one year. Apart from the issue of the tenor of money-market instruments, there are some additional problems of definition. The distinction between the spot market and the forward market is unclear at times. It is normal practice to consider some repurchase agreements (e.g. valid for a few days only) as money-market instruments, despite the fact that a repurchase agreement is in essence a forward agreement and therefore belongs to the forward market. Even if participants aim at spot settlement in the money market, this may not always be possible because of problems related to market practices,

Diagram 6.2: Regulation of financial instruments Legislation in respect of financial instruments

General legislation

Companies Act Bills of Exchange Act

Corporate debentures Equities Bankers’ acceptances Trade Bills Promissory notes

Specific prescriptive legislation

Exchequer Act SA Reserve Bank Act Banks Act Land Bank Act Enabling acts of: - Local authorities - Public corporations

Coins and banknotes Treasury bills Landbank bills SARB debentures Land Bank debentures NCDs Capital project bills Bridging bonds Bonds: - Local authorities - Public corporations - Government

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Specific enabling legisltion

Financial Markets Control Act Stock Exchanges Control Act

Exchanges: - BESA - JSE - SAFEX

Listed instruments: - Debt/bonds - Company debentures - Equities - Futures - Options

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clearing procedures and the physical delivery of assets. Consequently the definition of the money market as the spot market in short-term debt instruments (tenor no longer than one year), with settlement within one or two days, could be regarded as being somewhat arbitrary. The problems of definition do not end here, as a spot position can be simulated either by buying the asset outright (i.e. a long instrument) or by means of a synthetic position (in this case a long call plus short put both at the same strike price)10. Are synthetic spot positions part of the spot market? For investors and speculators the difference is often academic, as they can make or lose as much money on an outright spot position as on a synthetic spot position. However, most money-market dealers see this issue in a different light, regarding the spot market and derivative market as two distinct markets. Because markets are so difficult to define, it is obviously also difficult to say where one market ends and another begins. Until the early 1980s the distinction between the forward and futures markets was well understood and defined. Futures contracts were seen as standardised forward contracts traded on an exchange. However, this distinction has faded with the rapid development of forward (or future) rate agreements (called FRAs), which can be defined as over-the-counter futures contracts. Banks in the major financial centres of the world create very liquid markets in FRAs, effectively operating as market makers for such instruments. Moreover, two traditional markets can easily merge into a new market, creating new problems of definition. For example, how to legislate (if that is desirable at all) for a “swoption” market, which is a combination of the activities of the traditional swap and options markets? In conclusion, the concept “market” should be used with care and circumspection, particularly in 10

Different instruments may be used to do the same thing, which raises the question of whether regulation should focus on function or instrument. The same issue arises between functions and institutions when demarcations between institutions are eroded.

Financial Regulation in South Africa: Chapter 6

legislation11. Accordingly, legislation mostly addresses issues relating to the structure of a market, the types of instruments traded in a market, the participants in such a market and the activities taking place in the market. Imposing a structure on the market – without actually putting forward a concise definition of the market concerned – therefore effectively dispenses with the question of the definition of a market.

2.2 The nature of over-the-counter and regulated markets 2.2.1 The over-the-counter (OTC) market In any country most trade takes place in informal (or over-the-counter) markets. Buyers and sellers meet over a counter (e.g. shop or bank counter), in a marketplace (e.g. flea market or trading floor), or via a computer screen (e.g. most securities markets nowadays). OTC markets may be totally free of official supervision or be subject to regulation imposed by the authorities in terms of general legislation only (e.g. the licensing of trade). Most new financial markets start as OTC markets, and some develop into regulated markets with the passage of time. 2.2.2 The regulated market Regulated markets (or exchanges) are governed by specific enabling legislation as well as the rules of selfregulatory organisations (SROs), which are established in terms of this legislation. Exchanges usually specialise in only a limited range of products (e.g. bonds, equities or futures), and make specific allowance for trading with small, retail investors. Trading on an exchange has to take place in accordance with the exchange’s rules, which are aimed at reducing the financial risks of executing on-market transactions (i.e. risks relating to 11

The difficulty in correctly applying the terms “market” and “exchange” is illustrated in the Financial Markets Control Act 1989, where, for example, an exchange is required to apply for a financial market licence prior to undertaking business. However, the financial market itself (comprising buyers and sellers of financial instruments) exists independently of the exchange and would continue to operate in the absence of a formal regulated structure.

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counterparty, open positions, large exposures and settlement). This emphasis on risk reduction also extends to the minimisation of undesirable practices such as front-running, insider trading and price manipulation. 2.2.3 Some differences between OTC and regulated markets As regards the type of product or the type of market participant, OTC markets and regulated markets differ in four major respects: • Not every kind of merchandise can be listed, because standardisation, as required for dealing on an exchange, is possible only in the case of a limited number of products. OTC trading will therefore always constitute a very large and important market segment. • International markets (including offshore centres) are usually OTC markets. For example the foreignexchange market or the eurobond markets are running very efficiently as OTC markets and, being of an international nature, difficult to regulate by one national regulatory authority even if it wanted to. • As explained in greater detail below, membership of a regulated exchange is usually restricted in terms of a rulebook, but in an OTC market entry is restricted by conventions of the participants. • Systemic risk is usually lower in a regulated exchange than in the OTC market owing to prudential requirements on members and sophisticated clearing and settlement systems. For instance, in an OTC market there is no formal exchange to “stand good” for trade settlement, whereas the participants in the formal market are often subjected to “fit and proper” requirements (such as examinations). In short, an exchange is a formalised market segment, which can never fully replace the OTC market in all its targets. 2.2.4 The transformation of an OTC market into a formal market There is no specific economic need to transform OTC markets – which are essentially wholesale markets –

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into formal markets. OTC markets have great flexibility and, with modern technology, they can compete very effectively with formal markets. For instance, markets such as the euro currency, swap, forward and securitised-asset markets can easily compete with any exchange in terms of liquidity and trading sophistication. Moreover, most major financial innovation takes place in the OTC markets, because the formalisation of trade in specific new instruments can occur only subsequent to their creation. It seems that the transformation of an OTC market into an exchange usually takes place for one or more of the following reasons: • The management of risk. The authorities may regard the general legislation governing OTC markets as insufficient from a risk management point of view, and so supplement it by the rules and regulations of an exchange. A very successful OTC market may therefore eventually invite regulation by the authorities, since the more successful it becomes, the greater the consequences of default (i.e. systemic failure) and therefore the likelihood that the authorities will prescribe more detailed risk-management procedures within the framework of an exchange. The establishment of the BESA is an example in this regard. • Counterparty risk management. In contrast to OTC markets where participants carry counterparty risk, an exchange guarantees settlement (i.e. the exchange stands good for the counterparty risk). • The netting of trading positions. The partial offsetting of long against short trading positions for capital-adequacy purposes is usually only done if the risk exposure is supervised by an exchange which guarantees settlement12. • The need for greater liquidity. Although an OTC 12

However, it should be borne in mind that several OTC markets have adopted relatively sophisticated trading, margining and settlement systems, often under the auspices of an industry association of some sort e.g. the International Securities Markets Association. In the United States, the Government Securities Clearing Co-operation (GSCC) manages a sophisticated risk-management system for all bond trades concluded in the OTC market. Netting of positions is permitted and is a strong feature of the GSCC.

Financial Regulation in South Africa: Chapter 6

market can be very liquid (e.g. the currencies markets), this may not necessarily be the case. For instance, establishing an exchange can often increase liquidity in the equities markets, as this facilitates participation by small investors who are usually barred from the OTC markets. Generally, if a market has a great potential for retailing, the choice usually falls on a formal market structure, though a typical wholesale market often prefers an OTC market structure. • The avoidance of monopolistic pricing. Fair competition could be endangered if a few big players in the OTC market were to acquire oligopolistic powers. At stake here is the issue of central price discovery. To avoid the underlying market being squeezed, or even cornered by the use of derivatives, the authorities may prescribe that all trade in derivatives should be effected through a formal derivative exchange. Ultimately the way in which financial markets are structured depends mainly on place and time, as their structures are determined inter alia by the historical development of a market, its custom, underlying market liquidity and competitive forces. All of these may differ materially between countries. In fact, international evidence indicates that there are no hard and fast rules for the organisational structure of a market.

2.3 The instruments traded on financial markets 2.3.1 Spot markets In the spot market, exchanges concentrate on specific securities which are approved by the particular exchange for listing purposes (e.g. the Johannesburg Stock Exchange trades mainly in equities). By contrast, unlisted financial instruments (e.g. currencies, shares in private companies, bankers’ acceptances) are traded in OTC markets. However, even listed shares can be bought or sold away from an exchange – for instance by “private treaty”. Although there may be a formal market for a specific security, buyers and sellers may not always wish to use such a market. Particularly between large participants, private treaty deals are attractive inter alia to avoid disclosure, to trade at non-market related prices (i.e. transferpricing techniques), or to save on commission payments. Usually the authorities try to limit the offmarket trading of listed instruments. However, if such a trade occurs, it is usually compulsory to disclose to the exchanges the volume and prices of such offmarket trades13. Diagram 6.3 depicts the structure of the spot market. 13

At present, off-market equity trades are not currently reported to the JSE. However, on enactment of the Investment Services Act this will become a requirement (probably in 2001).

Diagram 6.3: Listed and OTC spot-market instruments

Spot market

Regulated exchange

Listed commodities

OTC market

Listed securities

Debt instruments

Financial Regulation in South Africa: Chapter 6

Commodities

Currencies

Debt instruments

Equities

Equities

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2.3.2 Derivative markets The structure of the derivative instruments market is analogous to that of the spot market (see Diagram 6.4). Derivative instruments are “derived” from the basic assets of spot markets (namely commodities, currencies, equities and debt instruments). As with spot market instruments, derivative instruments can be traded either on an OTC basis (e.g. forward contracts) or on an exchange (e.g. futures contracts). They differ from spot market products primarily because the final settlement of the contract is deferred to some future date.14 In a narrow conceptual sense, derivative instruments (i.e. “instruments B terme”) embrace only forwards and futures, though in a broader sense they also include options (incorporating the concept of option premiums with forward settlement). By volume, trade

in derivative instruments probably takes place mostly in the OTC markets. Highly standardised securities that are not traded on an exchange – such as a forward rate agreement (FRA) – can be considered a hybrid between instruments traded in the formal and OTC markets. Abroad, the FRAs market is huge, which indicates the capacity of OTC markets if supported by powerful financial intermediaries.

14

15

In the formal futures markets, cash settlement takes place daily on a marked-to-market basis (i.e. the “margin call”) until the contract finally matures at some future date.

2.3.3 The relationship between spot and derivative markets As noted previously, a spot market position can be replicated by means of a synthetic position.15 This fact implies that spot and derivative markets have the potential to be in competition with one another.16 Depending on additional considerations such as

16

For example, a short spot position by way of a long put and short call, both at the same strike price. This is the crux of the Arrow/Debreu contingent claim analysis.

Diagram 6.4: Listed and OTC derivative market instruments

Derivative market

Regulated exchange (standardised with clearing)

Listed option contracts

OTC market (customised without clearing)

Futures contracts

Forward contracts

OTC option contracts

yyyyyyyy Derivative market instruments in the narrow sense*

Derivative market instruments Co in the broadiiimmiodities sense

Commodities

Currencies

Financial assets

Debt instruments

Equities

* Derivative instruments used here as a translation for instruments à terme

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taxation, market liquidity, brokerage and transactions costs as well as voting rights (e.g. a synthetic equity position does not grant voting rights, as does an outright spot position), the investor may prefer either a spot or a synthetic position. Although competition among exchanges is desirable from a cost-efficiency point of view, it could nevertheless impair systemic risk management. Competing exchanges may harm one another, for example, through reduced liquidity (if both exchanges were to trade slightly different products) and by complicating risk-management procedures (a circuit breaker applied on one exchange should immediately be effective for another exchange trading that same or similar products). Generally the authorities actively supported the emerging derivatives exchanges during the 1970s, although today competition among exchanges is very much anchored in market discipline. The authorities prefer to address the resulting problems of market liquidity and systemic risks with technological solutions such as fully automated trading systems and linking the information flows among exchanges. Anyhow, with the rapid development of Internet stockbroking the authorities are forced more or less to rely increasingly on market discipline, market incentives as well as corporate governance rules to ensure orderly markets.

2.4 The aggregation of financial instruments into basic markets The problem of determining which financial instruments should logically be combined in one financial market is more complicated than it may seem at first glance. One criterion is to select common characteristics. Another is to ask whether the product can be replicated (or simulated) in another market. If this is the case, the markets concerned should be combined into a larger market. Based on this lastmentioned criterion, only four basic markets can be theoretically distinguished, namely: • Commodities markets • Currencies markets • Equities markets • Debt instruments markets As in the case of the two basic building blocks of financial engineering, namely cash and options, it is possible to draw up a simple two-dimensional classification matrix for these four basic markets. This matrix, with the spot markets and options markets on the two axes, is shown in Table 6.2 (where a futures contract represents no more than a synthetic option position). Table 6.2 reflects the four basic spot markets in the first column. Options (or their synthetic positions such as futures and swaps) on these four basic spot markets

Table 6.2: Spot and options markets matrix Options markets Commodities

Currencies

Equities

Debt instruments

Spot markets Commodities

Options/futures on e.g. gold

Currencies

Equities

Debt instruments

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Options/futures on e.g. the rand exchange rate Options/futures on equities Options/futures on bonds

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are shown in columns 2 to 5. The diagonal of combinations shown in Table 6.2 represents “pure” instruments (in contrast to hybrid instruments) in the sense that the derivatives are linked directly to the underlying spot market. In the case of the hybrid instruments, two of the four basic spot markets are combined.17 For instance, an Equity Linked Fixed Interest (ELFI) stock was a hybrid instrument, as it was based on a debt instrument in the spot market with an equity-linked option attached to it.

2.5 Types of financial markets and their regulation Financial markets can be conceptually divided into various components or forms depending on the criteria employed. For instance, on the criterion of whether new or existing securities are being traded, a distinction can be drawn between the primary- and secondary-securities markets, whereas the way prices are determined on a market will result in order- or quote-driven markets. Moreover, the trading mechanism used may result in a classification based on floor, screen or automated-trading markets. Lastly, markets can also be classified in terms of the capacity in which traders may trade (i.e. single or dual capacity). All these issues and their regulatory aspects are briefly discussed in this section. 2.5.1 Primary and secondary securities markets Depending on the criteria of whether new or existing capital is at stake, the securities market can be divided into two components: a primary market dealing in the creation or redemption of securities, and a secondary market engaged in the trading of existing securities. The primary securities market Transactions in the primary-securities market affect the size of the securities market. The pool of money invested in the primary-securities market can change 17

This interdependence of financial markets implies that a single transaction may involve several markets and instruments simultaneously. The regulatory authorities cannot therefore focus solely on one market or instrument.

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only if the amount of scrip18 changes, which can occur only with transactions such as new issues or listings, rights issues, the winding-up of existing companies and the buying back of their own shares by companies. The secondary securities market Transactions in the secondary-securities market affect the money flow through the market. For instance, the buying and selling of existing securities are secondarymarket transactions. If investors decide to turn their paper wealth into cash, someone else has to be willing to turn cash into paper wealth. Transactions in the secondary market impact on securities prices, and thus market capitalisation.19 They also impact on market liquidity, but do not affect the size of the securitiesmarket pool. Indeed, changes in securities prices are needed to make sure that there is a buyer for every seller. In short, transactions in the primary market affect the pool of money invested in securities, whereas transactions in the secondary market affect perceived wealth or market capitalisation. The regulatory response to primary and secondary markets Inherent in the nature of the primary market, the regulation of newly created securities is mostly enforced by the legislation governing financial instruments (see Section 1.2) and the listing requirements for those instruments on exchanges.20 In the secondary OTC markets, the authorities rely mainly on market monitoring and disciplines, incentive structures and corporate governance rules, but that portion of the secondary market that is “exchange18

19 20

The term scrip is used here in a broad sense, as securities can be immobilised or dematerialised through central depository mechanisms. For instance, bonds in South Africa have been immobilised since 1994. That is, the value of the total stock of securities outstanding. A distinction should be drawn between primary market activities in the equity and bond markets. In the government bond markets, securities can be issued by private placing, on a tap basis or via auctions. The latter method is used by the National Treasury to allot tranches of key benchmark bonds to a panel of primary dealers appointed by the department. These institutions, which have an obligation to bid for a minimum allotment at each weekly auction, then sell the bonds so acquired into the secondary market. These benchmark bonds are, however, already listed on BESA.

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regulated” is subjected to additional and extensive selfregulation in terms of the exchange’s rulebook. 2.5.2 Auction-, quote- and order-driven securities markets The trade in commodities and financial instruments can conceptually be divided into three classes: auctiondriven markets, quote-driven markets and order-driven markets. The auction-driven markets are usually classified according to the different institutional rules governing markets, which determine the bidding incentives and therefore the terms and the efficiency of a market. It has become standard now to distinguish between the following primary types of auction markets: Auction-driven markets • English auction. The auctioneer starts at a low price and would-be buyers bid higher and higher prices till the auctioneer is unable “to knock down” an even higher price. The advantage of this auction type is that the buyer has a second chance to change his pricing strategy, while the seller can announce a reserve price (provided the auction house allows this). Examples of these markets are found in livestock markets of the United States or the wool markets in Australia. • Dutch auction. Under this procedure, the auction starts at a somewhat higher price than buyers are willing to pay, and the auctioneer decreases the price in decrements until a buyer shouts “mine”. The major advantage of this type of auction is that any form of trade collusion or conspiracy (such as bid “ramping”) is impossible, as leaked information is not feasible. Examples are the cutflower markets in the Netherlands and the fish markets in the UK. True Dutch auction procedures are rare in financial markets. • First-price auction. This is the common form of “sealed” or written-bid auctions, in which the highest bidder is awarded the item at a price equal to the amount bid. For about fifty years the US used this method to trade its weekly primary auction of short-term US Treasury securities. In South Africa this method is used for the sale of Treasury bills Financial Regulation in South Africa: Chapter 6

and Treasury bonds and has in the past been utilised for one-off gold sales, e.g. by the IMF. • Second-price auction. Here the highest bidder is awarded the item at a price equal to the bid of the second-highest bidder. This method of auctioning was used for many years by the US Treasury to sell its long-term bonds. In South Africa this method is used for the sale of inflation-linked government bonds, which are sold at the auction price that clears the market requirement (which may be the second price or even lower). • Tâtonnement auction. This auction model “fixes” a price equilibrium between the quantity offered and purchased for a specific item, irrespective of whether the market participants operate as buyers or sellers (i.e. sellers become buyers if the proposed price is below the equilibrium price). The London Bullion Market uses this method of auctioning to fix its prices. The attributes that auction markets have in common are that they aim for the maximum number of buying and selling orders possible by limiting the number of trading hours and, unless sellers have reserve prices, the realised market prices are not known prior to the auction. Many permutations of the auction-market model are possible, as for instance each model can be used either in single-object (e.g. one specific commodity or security) or multiple-object (e.g. the auction of slave families in the past) unit auctions. In auction-driven exchanges such as the London Bullion Market, trade takes place at the “standard” (or single) price (i.e. the buying and selling prices are the same). The standard price is the price at which the greatest possible turnover takes place in the market and is based on numerous buy and sell orders. Once the standard price is fixed, it is generally valid for the day of trading. The concentration of orders makes the auction-driven exchanges particularly suitable for illiquid markets. However, if the market is characterised by uneven supply and major economic power concentration, the auction-driven market may be open to abuse, since established groups may manipulate the price-forming process. (Unless of 127

course the Dutch auction method is used, but this method has other inherent shortcomings, such as greater price volatility if trading volumes are low). Quote-driven markets In sharp contrast to the auction-driven markets, trade in the quote-driven markets can take place throughout the day. As buyers and sellers know prior to their trade at what price they are willing to deal, there can be no unhappy surprises. However, liquidity may be poor in these markets if strongly capitalised market makers do not support trade. Two major types of quote-driven markets dominate: • Market-maker market. Here customer orders are transacted with market makers – who are dualcapacity traders (see Section 2.5.4 below) – who specialise in the trading of specific securities and who quote firm prices all times. True market makers are committed to these quotes to buy or sell, and the spread between buying and selling can become expensive if trade is either thin or volatile. Examples are the London Stock Exchange and BESA21 in South Africa. • Quote-driven dealership market. Customers’ buying and selling orders are directly “matched” on the exchange with the assistance of brokers. Brokers in turn are supported by “jobbers” – who are single-capacity traders trading exclusively with brokers or for their own account and who provide inter-broker services by quoting two-way price spreads (but are not committed to their quoted prices for large volumes). In essence, the jobber plays the role of an auctioneer in a quote-driven market. An example of such a market was the London Stock Exchange prior to the Big Bang in 1986. In the aftermath of “big bangs” on exchanges around the world, dual-capacity trading has become the norm and the jobber function

redundant. Exchanges now operate a market-maker market or an order-driven market. As in the auction-driven markets, various permutations are possible in the quote-driven markets. These, subtle, differences may have a significant impact on market liquidity. For example, the dealership model can operate on single or multiple dealerships, which impacts on trading methods22. Moreover, in the United States, dealers and market makers are not obliged to offer all customers’ orders to the market if they can net them off in their own trading books. The result of this trading practice is that many American dealers are operating like a “microexchange” in their own right, although strictly speaking no exchange functions are executed but merely a large scale offsetting of various buying and selling orders in the trader’s own book. The market-maker market is used by the BESA in South Africa. These markets are relatively new and primarily wholesale markets. The advantages and disadvantages of the market-maker markets are summarised in Table 6.3. Order- or order-book-driven markets Trade in the order-driven markets can also take place throughout the day. As in the quote-driven markets, buyers and sellers know prior to their trade at what price they are willing to deal. Again, liquidity may be poor in these markets if strongly capitalised market makers do not support trade. In an order-driven market, customers’ buying and selling orders are directly “matched” on the exchange with the assistance of brokers or by an ATS. Incoming orders are offset against standing orders previously submitted to the market or are placed in the order book until such time an offsetting order is submitted. As no spread has to be paid (except the brokerage), this method of trading is cheaper for market users than a market-maker method,

21

22

In BESA customer orders are not necessarily routed to the primary dealers (market makers) as a matter of routine, but are executed in the market if they can be. If not, then the primary dealers are requested to quote. Primary dealers are not obliged to display continuous doubles (buy and sell quotes) to the market, but have to quote on request. In this respect they are not true market makers.

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Today, nearly a third of all retail orders placed for equities in the US are routed through the Internet. In essence the Internet is merely a new medium of communication. Orders placed through the Internet are generally funnelled into an order/time priority engine, which is linked via the brokerage firm directly to an exchange’s trading system. Therefore the Internet interface can be seen as a “funnel” channelling trades into the regulated markets.

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but if market liquidity is low it may take time to execute orders. This is the method now used by Tradepoint in the UK and also since inception by the JSE23. The trend appears to be towards order-driven systems. Where automated-trading systems are used, there is no need for an intermediary at all, as the computer system will do the “matching” of orders. However the JSE, like most exchanges, requires orders to be submitted through brokers. South Africa has a tradition of equity trading which differs from that of the London Stock Exchange in that it has never had recognised “jobbers”. Even today, financial securities are traded on the South African exchanges either in the form of a market-maker market (usually referred to as a “quote-driven market”) or an order-driven market. However, the primary markets for Government bonds and Treasury bills in South Africa are based on the auction-market methods discussed above. The order-driven market is still used by the JSE.24 It has operated satisfactorily over the years. Table 6.4 summarises the advantages and disadvantages of such an order-driven market.

The regulatory response in respect of auction-, quote- and order-driven markets Generally the regulatory authorities worldwide leave it to market participants to decide for themselves whether they will use either auction-, quote- or order-driven pricing systems, provided the interests of the general public are not impaired (i.e. consumer protection issues). As the BESA, SAFEX and the OTC markets in South Africa are primarily wholesale markets, the authorities had no objections to the use of the market-maker method in these markets, while the use of the order-driven market method on the JSE is to a large extent based on the relatively large retail component in this traditional market. However, as the retail component of the stock market is increasingly giving way to unit trust managers, portfolio managers and the like (i.e. the retail component on the stock market becomes increasingly wealthy and knowledgeable individuals), the need for consumer protection is decreasing. In essence all financial exchanges are today wholesale markets, which in turn is likely to influence regulatory structures in time to come.

23

2.5.3 Trading systems of securities markets Irrespective of whether a market is order- or quotedriven, it can employ various trading modes to effect transactions. The following major trading systems can be

24

Today, on the JSE’s ATS (i.e. the JSE Electronic Trading system or JET) price and quantity are fixed prior to the order being submitted, whereas in the former “open outcry” system, only the price was fixed. On the JSE orders are now electronically matched and executed on the JET system.

Table 6.3: Quote-driven market system Advantages • Promotes continuous price quotation • Promotes liquidity in the market

Financial Regulation in South Africa: Chapter 6

Disadvantages • Expensive to operate (market makers may have to be paid for their services) • May stall in times of great market volatility when market makers are reluctant to quote two-way prices • Market transparency is less than in the order-driven markets (market makers may demand time delays in information dissemination to unwind big deals) • Extensive rulebooks are required to provide protection to investors • Less tradable shares tend to become even less so as market makers are reluctant to make price commitments (or spreads become excessive)

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distinguished: floor trading; telephone/screen-quotation trading; screen trading; and fully automated trading. Floor-trading system Dealing on a floor market is done by way of “open outcry”, i.e. traders meet each other face to face and “shout” their buying and/or selling prices out loud. Inherently, floor trading usually implies trading on a regulated market. The major advantages and disadvantages of floor trading are summarised in Table 6.5. Of the major exchanges today, only the New York Stock Exchange and three futures exchanges in Chicago still do floor trading. However, it seems that even these exchanges are bound to change over to electronic trading in the next few years (as competition from other exchanges – particularly Nasdaq – is proving too great). Telephone/screen-quotation trading system In essence, this is a telephone market in which buyers and sellers negotiate a financial transaction over the telephone. The screen (usually a Reuters or Bloomberg information screen) is used only to advertise prices, but these prices are not, strictly speaking, binding. For

instance, a trader can always avoid being “hit” at his quoted price by saying that he has just traded at that price and now wishes to give a “new” quote. Telephone/screen-quotation trading usually takes place in OTC markets, although it is still used on an exchange for the larger trades (e.g. at the BESA and SAFEX)25. However, from a supervisory point of view this system is unsatisfactory, as its audit-trail technology is poor. Screen-trading system Under this trading system, firm quotes are made on an electronic trading screen (usually good for a specific amount) and transactions are finalised by telephone. Screen trading requires a central clearing-house and usually (but not necessarily) an exchange that is quote-

25

SAFEX prescribes the use of its ATS for all trades, although large block trades and structured transactions may be concluded off-ATS provided they are booked through the ATS within 24 hours. BESA permits the use of its ATS alongside more traditional quotation/trading mechanisms such as vendor quote systems, inter-dealer broker (IDB) screens and telephones.

Table 6.4: Order-driven market system Advantages

Disadvantages

• Less expensive for market users (e.g. no price spread to be paid) • Less need to commit capital • More transparent than the market-maker market • Less costly to supervise than the market-maker market • Can be more easily automated

• Execution of orders may take time

Table 6.5: Floor-trading system Advantages

Disadvantages

• Access to the market for participants at all times (e.g. no power-failure impact) • Personal contact of the trader with the market • All misdemeanours are visible to other traders, who could report to exchange management

• Expensive operations in terms of building and skilled staff • Surveillance is difficult • Open to abuse such as trade rigging • Alienation of remote participants • Inflexible with regard to future physical market growth and product growth • Perception of an exclusive club

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driven. A screen market usually has the following characteristics: • All trade (buying and selling) has to be recorded on the screen system of the exchange. • The screen should always show the best price quoted in the market. • All transactions have to be reported by participants on the exchange within a few minutes. • All telephone conversations of market makers have to be recorded. • The front-end clearing system should operate as a central checking system independent of the exchange’s automated quote system. The major advantages and disadvantages of screen dealing are shown in Table 6.6. Although the screen system is a major improvement on the telephone/screen-quotation trading system, it is nonetheless often seen as an interim step between floor and fully automated trading systems. Automated-trading system (ATS) Under the ATS all the routing of orders and trading is fully automated using a screen, i.e. buyers and sellers perform their transactions using only the central automated-trading system that shows the prices and no telephone is required. The ATS can be used in the formal and informal markets, although it is more often used by exchanges.

The idea behind an automated routing and trading system is that a central marketplace, in which prices and volumes of trading for each instrument are transparent, best serves investors. Large investors (who may be exchange members) can therefore deal on their own behalf and are no longer dependent on brokers to find the “best price”. By contrast, small investors, who are not exchange members, have to deal with a broker, as they have no direct access to the ATS. Compared with floor and screen trading, the ATS offers some major advantages, as reflected in Table 6.7. A significant advantage of the ATS is the ability to build in many pre-trade compliance checks, in this way reducing the costs of surveillance of the marketplace. Checks to ensure the appropriate qualification of traders, fairness of pricing, appropriate client registration, authority to trade and availability of funds before the transaction is completed, are commonplace features of ATSs and lead to a much reduced need for post-trade analysis26. 26

Inter-dealer broker systems (IDBs) are a feature of global financial markets, particularly active in bond, currency and derivative markets. An IDB operates as a “matching engine” either on a name-give-up or no-name-give-up basis. IDBs utilise a voice box or screen-based system for putting exchange members or OTC market participants in contact with one another. Alternatively, an IDB may stand in the middle of each transaction (as buyer and seller) thereby “protecting” the names of the two counterparties. In the South African bond market, four IDBs are active and all are members of BESA.

Table 6.6: Screen-trading system Advantages

Disadvantages

• High technology, which makes the geographic spread of participants possible, even on a globalised 24-hours a day basis • Virtually instantaneous dissemination of information, which facilitates supervision • Relatively inexpensive to operate (requiring fewer staff and less space) • Availability of information on market depth, e.g. showing the best price at all times, which makes trade rigging more difficult • Higher efficiency (less paperwork) with fewer transcription errors • Lower transactions costs

• Reliance on electronic communication systems, which may fail at critical times • No visible presence of market • Dealers may decide not to answer incoming telephone calls • Deferred reporting of large trades to forestall “piggybacking”

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A drawback of the ATS is that it is less appealing in a quote-driven market where large participants prefer to negotiate directly with the market maker rather than deal at the price quoted on the screen. To date, only one fundamental problem has been identified with ATSs using the quote-driven system (e.g. on the LSE in the UK), namely that of handling pre-arranged deals (i.e. deals negotiated on the telephone and then executed on the ATS within seconds).27 The BESA, JSE and SAFEX all have automatedtrading systems, and all allow major deals to bypass the system as traders are fearful of submitting firm prices to the system for large volumes. Moreover, nearly all option contracts, except those on SAFEX, are traded on a telephone/screen basis in South Africa, as option strategies are typically too complex and nonstandardised for automated systems. The regulatory response to trading systems With the development of the ATS, there is a tendency worldwide for the authorities to prefer ATS trading, as it has superior audit-trail technology (which ensures investor protection) and pre-trade compliance procedures, and also facilitates dual-capacity trading.

Most regulatory authorities seem willing to accept the problem of pre-arranged deals on an ATS because: (i) wholesale clients (doing “block” trades) may well demand a different price from retail clients; (ii) costbenefit analysis has indicated that the closure of this “loophole” would be too expensive; and (iii) these practices exist with other trading systems as well. The South African regulatory authorities leave the choice of the specific trading system to market participants. By encouraging competition among exchanges, market discipline will ultimately enforce the most effective and cost-efficient system. However, there are two major problems where two, especially domestic, exchanges are in direct competition (i.e. the same securities are listed on both exchanges): (i) the reduction or splitting of market liquidity; and (ii) the difficulty and cost of monitoring activity across two exchanges.28

27

28

This can be overcome by allowing “report only” trades through the ATS. This is not a problem with the order-driven mechanism (as used, for instance, by the JSE).

2.5.4 Single- and dual-capacity trading on exchanges Single-capacity trading, in the pure sense of the word, means that exchange members may trade as brokers or jobbers only, whereas dual-capacity trading allows The South African playing field is not very level – e.g. SA companies can only list overseas with Ministerial approval, whereas overseas companies are free of any form of exchange control.

Table 6.7: Automated-trading system Advantages

Disadvantages

• Major cost saving in comparison with floor trading – thus ATS leads to competitive advantages • Strict pre-trade compliance procedures have to be fulfilled which ensure compliance even before the trade is done • Superior audit-trail technology compared with floor and screen trading • Anonymity of trading parties is possible (but still secures price transparency) • Guarantees methodical order matching by mechanical application of price and time priorities • Guarantees efficient price formation by immediate and automatic display of executed orders, not only on trading screen, but also on public vendor screens

• Reliance on electronic communication systems, which may fail at critical times • Excludes the possibility of negotiating a price directly with the market maker • Pre-arranged trades are difficult to prevent • Loss of personal contact

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exchange members to trade for clients and for their own accounts. The aim of a single-capacity trading rule is to avoid any conflicts of interest (e.g. frontrunning). However, a liquid market often depends on active market makers, which in turn may necessitate dual-capacity trading. Traditionally, stock exchanges required members to trade in single capacity and as a natural persona (i.e. with unlimited liability). This implied that members of the exchange had to be either brokers or jobbers. Dualcapacity trading, as existed in the OTC markets, used to be prohibited on exchanges, as this was thought to be bound to lead to front-running.29 However, with the development of ATS trading, there is no longer a need for single-capacity trading rules, as the audit trail of these electronic systems is superior to that of any other 29

That is, buying for own account first and only thereafter for client account during a bull market – and mutatis mutandis during a bear phase – ensuring virtually risk-free profits for the broker at the expense of the client.

trading system. Accordingly market making – and thus dual-capacity trading – became a possibility on exchanges as well. The advantages and disadvantages of single- and dualcapacity trading are summarised in Tables 6.8 and 6.9. The regulatory response to single- and dualcapacity trading In principle the regulatory authorities generally prefer dual-capacity trading to single-capacity trading because dual-capacity trading improves competition and efficiency. Since the late 1980s, the necessity for single-capacity trading has virtually disappeared in practice, as ATS trading can cope with most trading problems that in the past would have necessitated a single-capacity rule.

2.6 The regulatory regime and structure of financial markets The regulation of markets should be conceptually differentiated from the regulation of market

Table 6.8: Single-capacity trading rule Advantages

Disadvantages

• Avoids conflict of interest for exchange members • Inexpensive form of consumer protection from a regulatory point of view • Particularly suitable for illiquid markets

• May harm market liquidity, as this rule makes market making impossible • Should brokers be undercapitalised, this rule also requires unlimited liability for exchange members (and thus the exclusion of corporate exchange membership) • An exchange operating under this rule will find great difficulty in facing competition from (foreign) dualcapacity exchanges and informal markets

Table 6.9: Dual-capacity trading rule Advantages

Disadvantages

• Allows for both single- and dual-capacity trading at the choice of exchange members • More competitive than single-capacity exchanges

• Under this rule traders have to be well capitalised, which in turn may result in powerful securities firms ousting small broking firms • Requires sophisticated audit trail technology to protect investors • Requires a sufficient degree of market liquidity from the outset

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participants, which are by nature individuals or institutions. For example, a formal exchange is subjected to stringent entry (licensing) requirements, which differ significantly from those applicable to exchange members. Likewise, although exchange members are subjected to corporate governance rules, the markets themselves are usually not. The regulatory regime impacts on the markets primarily in areas such as entry and standards requirements (e.g. licensing conditions); ownership constraints (e.g. until the Big Bang on the JSE in 1995, membership of the exchange was limited to juristic persona with a minimum of 10 such persons); functional constraints (e.g. the JSE may not trade in futures); jurisdictional constraints (e.g. the JSE’s jurisdiction is limited to South Africa); pricing constraints (e.g. until 1995 trading on the JSE was allowed only at prescribed brokerage fees); and operational constraints (e.g. trade may only be done with exchange members). Besides these formal rules and regulations, markets are also subject to market discipline and monitoring. It is primarily the competition among exchanges that ensures that trading, clearing and settlement systems use the latest technology. It is also competition that results in the demise of unsuccessful (expensive) exchanges. In short, markets have to prove to other (often foreign) competing markets that they are well capitalised, safe and sound. Market discipline in the OTC markets is not necessarily less stringent than in the exchanges but because formal markets are also involved in retail trade, their consumer protection rules are more extensive than those found in the (typically wholesale) OTC markets. The conceptual regulatory matrix is shown in Table 6.10, and is discussed in somewhat more detail below. 2.6.1 The OTC market In terms of turnover, the foreign exchange and money markets are both large. For example in 1999 turnover on the JSE amounted to R448 billion, compared with R2 375 billion in the South African forex market. Usually the entry requirements in the OTC markets depend on the balance sheet strength of the participant, 134

since trading, clearing and settlement procedures are done directly between market participants. In the foreign-exchange market use is made mostly of the Reuters or Bloomberg information systems, while clearing and settlement is done through local or overseas clearing banks (using the SWIFT confirmation and instruction system). Cross-market exposures are controlled in the forex market by integrating all spot, forward and option positions of members in one overall risk exposure. Ultimately the net forex exposure of South Africa is limited by the available credit lines of foreign participants. In respect of the money market, no crossmarket risk management takes place as all contracts are entered into between two specific counterparties, who will see each other as ultimate credit risk takers. Two pieces of legislation are particularly important for the OTC markets, namely the Companies Act and the Currency and Exchange Act (1933). It is the Harmful Business Practices and the Consumer Affairs (Unfair Business Practices) Acts that ultimately determine issues such as fair trading, while the Currency and Exchange Act gives rise to South Africa’s regime of exchange control. However, most of the powers of the Exchange Control Department of the SA Reserve Bank are focused on the market participants rather than the forex market as such (see Section 3.2.1 below). For example, Exchange Control stipulates that local residents, except authorised forex dealers, are not allowed to trade foreign exchange. Likewise, the rand/dollar futures contract traded on SAFEX is limited to foreigners and the authorised forex dealers in South Africa. 2.6.2 The formal market Exchanges are subjected to far more formal rules and regulation than the OTC markets. The most important constraints are the Companies Act, the Insider Trading Act, the Stock Exchanges Control Act (SECA), the Financial Markets Control Act (FMCA), the Currency and Exchange Act, the Directives of the Registrar of (non-bank) Financial Institutions, and the self-imposed rules of the exchanges in areas such as advertising and Financial Regulation in South Africa: Chapter 6

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135

7. Discipline/accountability of regulators

6. Corporate governance

5. Market monitoring and discipline X

X

3. Intervention and sanctions

4. Incentive contracts and structures

X

2 Official monitoring and supervision X

X

X

X

X

X

X

X

X

X

X

X

X

X X

X

X

X

X

X

X

X

X

X

1.6 Operational constraints X

Proper institutional infrastructure

X X

X

Fit and proper directors and staff Global institutional competitiveness

1.5 Pricing constraints

1.4 Jurisdictional constraints

X

X

1.3 Functional activity constraints X

Sufficient market liquidity X

Securities markets as alternative to intermediation

X

X

Competitive market infrastructure Acceptable maturity and currency mismatches Acceptable crossmarket exposures X

Regulatory effectiveness, efficiency and economy Proper risk assessment

1.2 Ownership constraints

1.1 Entry and standards constraints

1. Official rules and regulations

Regulatory regime and its instruments

Regulatory intermediate goals Competitive neutrality Integrity and fairness

Consumer protection

X

X

X

X

X

Competence

Institutional safety and soundness

X

X

Adequate product/service competitiveness

Systemic stability

X

X

X

X

X

Transparency and disclosure

Regulatory ultimate objectives

X

X

X

X

X

Access to retail financial services Protection of retail funds

Table 6.10: Regulatory matrix: Financial markets

X

X

X

X

X

Retail compensation schemes

sponsorship. Since the Big Bang on the JSE in 1995, the traditional constraints on ownership and pricing have fallen away on the JSE, and the aim of the authorities is now to consolidate the SECA with the FMCA into a new act (probably named the Investment Services Act). The entry and standards constraints for an exchange largely centre on the licensing requirements, riskmanagement systems and guarantee or fidelity funds. The functional constraints are that the securities traded on an exchange may only be listed securities (e.g. not the shares of a private company – “(Pty) Ltd”). Moreover, the rules and regulations of the exchange stipulate in detail which securities may be traded on the exchange. The jurisdictional constraints limit exchanges’ operations to South Africa (so far as they apply to listed securities30), although efforts are being made to extend this to the Southern African Development Community (SADC) region. The operational constraints are not only the familiar prudential requirements and code-of-conduct requirements (such as appropriate capital adequacy and the avoidance of conflicts of interest), but also contain conditions that trading must be limited to exchange members only. Official monitoring and supervision are undertaken by both the Financial Services Board and the inspectorates of the exchanges and is aimed at enhancing the institutional infrastructure, and at avoiding insider trading and fraud. Despite all these formal regulations, market discipline remains crucial to ensure effective and costefficient trading on exchanges. Local exchanges have to compete successfully with foreign exchanges such as the London Stock Exchange to remain in business. Remote trading31 by foreign members of the exchange 30

31

The exchanges in South Africa are free to make their systems and services available to the OTC markets or to markets offshore, which activities would fall outside the ambit of their financial market licences and constitute a separate line of business. A problem experienced with exchange rationalisation in South Africa was due to the mix of retail and wholesale business – SAFEX and BESA are wholesale and employ clearing or settlement members whereas the JSE does not. Remote trading means that foreign participants can also use the exchange facilities by means of electronic networks.

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increases local liquidity, but also increases foreign competition.32 Moreover, there is keen competition between the underlying market (e.g. the equities quoted on the JSE) and the derivative market (i.e. options and futures on those equities or indices based on them on SAFEX). It is primarily the forces of competition that lead to innovation and technological enhancements. 2.6.3 The structure of the market regulators The regulatory structure is unique for every market and every country, as no two countries have identical legislative structures. Different circumstances often demand different structures in order to ensure effective and cost-efficient regulation. In principle there are three basic models: • A single regulatory authority for each basic market, in which case one regulatory authority regulates all relevant activity in one basic market (e.g. in the currencies markets). • More than one specialised regulatory authority for activities within basic markets, implying that parts of one basic market are regulated by various specialist regulatory authorities. This structure is found in South Africa where spot and derivative instruments in the same basic market (e.g. equities market) are supervised by different self-regulatory organisations. • A separate entity for the three basic functions33 of an exchange: (i) execution; (ii) clearing and risk management; and (iii) settlement and delivery. In terms of such a model the exchanges will concentrate exclusively on their execution functions, while the clearing of all their trades will be done by a

32

33

Remote trading currently occurs at SAFEX, and at some future date this may also happen at the BESA or the JSE. In the South African bond market, foreigners participate in one of two ways: either via direct trading with member firms (known as nonresident trading) or directly among themselves (e.g. two foreignbased entities) in the OTC market. This turnover represents some 35% of the exchange’s overall annual turnover. Remote membership of a local exchange will have a significant impact, particularly in the bond market, as the “foreign” primary dealers have invested significantly in setting-up local operations to comply with National Treasury requirements. Also referred to in the market as “platforms”.

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separate specialist institution or even a few competing clearing-houses (e.g. like Euroclear and Clearstream in the currency markets). The settlement of trade can be done by either that same clearing company or by a separate settlement company.34 The single regulatory authority for each basic market In terms of Table 6.2 (Section 2.4), a single regulatory authority for each basic market implies that the matrix should be read in rows. In this case, supervision centres on only four basic markets (namely commodities, currencies, equities and debt instruments), each embracing both spot and derivative instruments. Control over hybrid financial instruments is relegated, virtually by definition, to the underlying spot market. The advantages emanating from the regulation of one basic market by one single regulatory authority for each basic market35 can be summarised as follows: • Reduced risk profile between markets. Since one regulatory authority supervises both the spot and derivative markets in a specific instrument, the potential for a squeeze in the underlying market36 is substantially reduced. • Recognising explicitly the markets’ interdependence. The spot, futures and options markets, though often physically separated, have actually become so closely intertwined as to effectively constitute one market. Spot market instruments can easily be replicated in derivative markets by way of synthetic spot positions. In fact, derivative markets can attribute their existence almost solely to differing views (expectations) held about the spot market price.37 • Assigning regulatory responsibilities more clearly. If a single regulatory authority accepts responsibility for the safety and soundness of one basic market, 34

35 36

37

Other functions of an exchange, e.g. listing requirements and, for equity exchanges, corporate actions (e.g. financial statements to shareholders) would remain within the core exchange. That is, a single self-regulatory organisation or SRO. Arising from demanding the physical delivery of large short positions created in the derivatives market. In “pure” theory, derivative markets are not considered, as such theoretical constructions assume perfect market information.

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quick action can be taken to address possible difficulties. Splitting the responsibility, and hence the regulatory authority, for one basic market can undermine orderly and regulated market structures. • Avoiding harmful competition between exchanges. The commercial success of any market is highly dependent on market liquidity, although derivative markets are even more dependent on liquidity than spot markets38. If two exchanges offer similar, or virtually similar, products in competition with each other, market liquidity in both markets would be impaired and costs increased. • Legalising the process of netting and novation. To reduce their capital-adequacy requirements, firms want to offset (or net) their long/short trading positions in the underlying market against short/ long positions in the derivatives market. Although the regulatory authorities are willing to allow such offsets in formal and in OTC markets, the legislator (in the case of bankruptcy) only allows netting and novation under specific conditions39. • Greater agreement with historical precedence. One of the oldest derivative markets is the forward currency market. This basic market operates as a single entity, embracing both spot and forward transactions. Specialist regulatory authorities for activities within basic markets One basic market can be supervised by various regulatory authorities, each specialising in a specific activity of that market. For instance, in most countries – including South Africa – the futures market is regulated as a separate market, independent from the 38

39

Accordingly, derivative markets are quick to remove illiquid products from their exchange. Novation is the introduction of two new trades both with same central counterparty (which trades replace the original one between the two ultimate counterparties). By definition, novation can only take place on one exchange. By contrast, netting the exposures in underlying and derivative instruments across counterparties can be achieved even though the instruments are traded on different markets (a complex process though). In South Africa, the Insolvency Act specifically recognises (in section 35A) that the netting processes of an exchange have legal standing and furthermore the Act binds liquidators to observe these practices. 137

underlying spot market. This regulatory arrangement is often favoured for the following reasons: • Increased business efficiency. Although systemic risk management may favour a single-regulatory authority, trading all futures on one exchange may nonetheless enhance business efficiency (economies of scale and scope). • Evading the single-capacity trading constraint. Traditionally exchanges operating the spot markets were based on single-capacity trading. As corporate participants were often not allowed to participate in these exchanges, they created a separate market where they could trade the synthetic equivalent of the underlying spot market, without encountering the trading constraints of spot markets. Specialist platforms for exchange execution, clearing and settlement functions This regulatory arrangement entails that the basic functions of an exchange are unbundled first and then aggregated again across markets per platform. For instance, the three existing exchanges, BESA, JSE and SAFEX, could compete in terms of their execution skills (basically trade in information assimilation), but share the same clearing and risk-management platform and/or even the same settlement and delivery platform. In essence this approach tries to maximise the benefits of both the single regulatory authority model by aggregating the clearing and settlement functions across markets, and the specialist regulatory authority model by promoting competition between the various spot and

derivative markets. As discussed in Chapter 7 (Section 2.4.2) in greater detail, this model would also be able to harmonise the OTC markets with the formal markets. 2.6.4 The structure of the South African regulatory authorities The regulatory structure in South Africa has developed in an evolutionary way. It followed rather than initiated the developments in the financial system. Particularly during the 1980s, major changes took place. For instance the Office of the Registrar for Banks and Building Societies was transferred from, at that time, the Department of Finance to the Reserve Bank in 1987 and the Office of the Registrar of Financial Markets was established as a statutory body, namely the Financial Services Board, in 1989. The regulatory structure is currently still in a transitional stage and some major changes may still occur. For example it is still undecided whether South Africa should follow the British example, by creating one super-regulatory agency such as the Financial Services Authority. As a matter of principle, the Registrar of Financial Markets has elected not to force market structures on exchanges, which are self-financed. Instead, he has elected, by and large, to accept the historical (evolutionary) development of the regulation of the financial system, which in South Africa was of a specialist nature (see Table 6.11). In essence, change in the structure of exchanges has to be brought about by increased competition rather than regulatory directives.

Table 6.11: Listed financial instruments and their markets Exchange BESA

JSE

SAFEX

Listed instrument Equities

x

Warrants on individual equities

x

Bonds

x

Futures

x

Options on futures

x

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Today, the JSE, as a self-regulatory organisation, accepts the responsibility for regulating all trade in listed equities and warrants on individual equities. SAFEX regulates all futures contracts (i.e. on commodities, currencies, equities and debt instruments) and options on these futures, and the BESA regulates trade in listed bonds. All options on bonds are traded in the OTC market. The current regulatory structure may be attractive from a business efficiency point of view. For instance, trading all futures on one exchange would generate important economies of scale. However, the prevailing regulatory structure also creates some major problems. Firstly, to ensure proper risk-management procedures, the rulebooks of the three exchanges have to be synchronised to avoid situations where trade in one specific instrument is effectively terminated on one exchange, but continues on another. In an emergency, the current structure is complicated and may even involve the authorities unnecessarily. In effect, the price paid for greater business efficiency in the private sector is the increased complexity of systemic riskmanagement procedures for the regulatory authorities. For instance, the rulebooks for all these exchanges have to be carefully synchronised, not only in terms of

emergency management (e.g. possible circuit breakers) but also for addressing any dispute between those exchanges trading in similar products (e.g. procedures on how to confront a squeeze or corner). Secondly, the historical approach to the structure of the regulatory authorities has had the result that the JSE reports to the Registrar of Stock Exchanges and is subject to the Stock Exchanges Control Act, whereas SAFEX and the BESA report to the Registrar of Financial Markets and are regulated in terms of the Financial Markets Control Act (see Diagram 6.5)40. It is expected that this issue will be addressed in 2001, when the Stock Exchanges Control Act, the Financial Markets Control Act, the Insider trading Act and the Custody and Administration of Securities Act are consolidated into the proposed Investment Services Act. 40

The same person currently performs the functions of Registrar of Stock Exchanges and Registrar of Financial Markets. To minimise regulatory arbitrage between the exchanges, particularly with respect to the application and monitoring of capital-adequacy requirements, the three exchanges in South Africa have concluded agreements in terms of which exchange members must elect a lead regulator for the reporting and monitoring of capital-adequacy. Where such a member is also a member of the other exchanges, those exchanges rely on reports received from the lead regulator as to the quality and quantity of the member’s capital.

Diagram 6.5: Regulatory structure of exchanges*

Financial Markets Control Act

Stock Exchanges Control Act

Minister of Finance

Registrar of Financial Markets

Rulebook: Bond Exchange of South Africa

Rulebook: SA Futures Exchange

Registrar of Stock Exchanges

Rulebook: Johannesburg Stock Exchange

* The diagram depicts relationships in terms of the Acts and not organisations

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3. Regulation of financial market participants Particularly because financial markets are so difficult to demarcate and therefore to regulate, the authorities place great emphasis on the regulation of financial participants41. In effect the deregulation of markets often goes hand in hand with the reregulation of financial firms. Two issues are addressed in this section: (i) financial market participants in both the OTC and regulated markets; and (ii) the regulatory regime and structure for market participants.

3.1 Financial market participants 3.1.1 Participants in OTC markets In an OTC market, buyers and sellers trade of their own volition. If these buyers and sellers trade in securities, they could be ultimate lenders, ultimate borrowers or financial intermediaries (see Diagram 6.6). In turn, financial intermediaries can operate as banks, institutional investors or investment firms, though those in this last category can again operate as brokers, principal traders or market makers42 or act in a combination of these capacities. Traditionally exchanges were associations of exchange members (i.e. mutual associations). In terms of the proposed Investment Services Act an exchange may now be a corporate body with share capital. In future an exchange may therefore be self-listed. Moreover, provision is also being made in the proposed Act that exchanges do not need to have any members at all. This necessitates the emergence of the “authorised 41

42

Participants in the financial markets are primarily financial institutions. However, large corporates (such as Eskom, Transnet and Telkom) are also important participants in the regulated markets. They even make a market in their own bonds. In the South African markets, the South African Reserve Bank has withdrawn from active involvement in the bond market. Instead, the National Treasury has appointed a panel of primary dealers (the major banks which comply with certain minimum capital and other criteria) which are obliged to bid for a minimum amount of the department’s weekly auction of government bonds. Furthermore, these institutions are required to make markets in these benchmark securities and serve as buyers of last resort in the event of market disruption.

140

user”. All these changes are required to increase professionalism and keep pace with global development. Financial advisers are also a type of financial market participant, but they are not financial intermediaries. Usually broking and advice goes hand in hand though, as good advice results in attractive broking opportunities. Each of these major participants will now be briefly discussed. Banks and institutional investors Banks and institutional investors (i.e. insurers and fund managers) play various roles in the financial system, the most important being their willingness to match the differing needs of lenders and borrowers and to assume such credit, liquidity and market (or price) risks that ultimate borrowers and ultimate lenders are unwilling to assume and wish to dispose of. Therefore banks and institutional investors position themselves between ultimate lenders and ultimate borrowers. They accept primary securities from ultimate borrowers (such as trade bills or government stock) and issue indirect securities (such as NCDs or annuities) to ultimate lenders (see Diagram 6.6). Since financial intermediaries are exposed to various financial risks, they require a sufficiently large capital base. Investment firms and traders Traders and market makers buy and sell traded securities for their own account with the aim of making a profit. While assuming an investment risk in the process, traders do not create indirect securities. They only “warehouse” securities (both primary and indirect securities)43 for comparatively short periods of time. In doing so they generate liquidity in the market, but their ability to add liquidity to the market is restricted by the extent of their capital resources. A securities firm is a type of investment firm (usually a medium- or higher-risk firm) that trades on an exchange and can be seen as a large-scale market maker. However, the securities firm does more than merely “warehouse” securities. It can also operate as an informal market maker in the OTC markets for certain securities and so powerfully support financial 43

Warehousing also includes placing the scrip in a central depository.

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markets in their role of bringing ultimate lenders and ultimate borrowers together. Indeed, lenders and borrowers who cannot always meet each other in terms of credit exposure, liquidity and market risks can still compromise by utilising the securities market rather than financial intermediaries. For instance, lenders may “securitise” their debt instruments by standardising them in small nominations and issuing them for relatively short periods, simultaneously allowing for predetermined rollover dates and having these issues underwritten by a financial institution (often a bank and/or a securities firm). These securitised instruments (the most popular being commercial paper and note-issuance facilities) are often supported by securities firms, which – with the help of computerised trading systems – create highly liquid markets in these instruments.

Increasingly, credit-rating agencies are undercutting banks’ comparative advantage in the screening of borrowers so that today there is a large and sophisticated pool of investors who are capable of diversifying risks directly in the capital markets. In effect, the financial markets themselves address, to a large extent, the specific requirements of lenders and borrowers, which have traditionally been accommodated by financial intermediaries. Accordingly keen competition is emerging between the traditional intermediation role of banks – which at times displayed significant monopolistic trends in their lending and deposit-taking business – and the securitisation of new financial instruments by securities firms. Owing to significant investment risk and the de facto need to support market liquidity in certain securitised instruments, securities firms (like banks) need a relatively large capital base.

Diagram 6.6: Financial intermediation versus direct financing money

money Banks indirect securities

Institutional investors

primary securities

money

money Investment firms primary securities

Traders

Ultimate lenders

primary securities Ultimate borrowers

money

Brokers (direct financing)

primary securities

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The development of capital markets has an important advantage in reducing systemic risk, as financial systems are likely to be more stable if based on the two pillars of (i) intermediated credit and relationship banking, and (ii) strong securities markets. This is the essential reasoning behind current efforts to develop bond markets in many developing countries. To strengthen the financial system the authorities must cover each of the system’s main pillars, namely institutions (particularly banks), markets (particularly the bond market) and the market infrastructure (particularly corporate governance). Brokers Brokers do not assume any trading risks – nor do they issue indirect securities. They operate solely as agents on behalf of their clients (see Diagram 6.6).44 They sell or buy financial instruments on behalf of their clients, thereby earning a fee (commission). Brokers perform an intermediary function, as they merely bring buyers and sellers together. They also offer services additional to that of the trading function, such as: trading experience; speed of execution; finding buyers and sellers; client privacy/anonymity; research; and standing good for a client in case of default. Though the requirements of lenders and borrowers are rather standard, the pure broking function is increasingly being taken over by automated-trading systems. However, the broker still plays an important role in respect of non-standardised financial products. As agents do not assume any financial risk themselves, they require limited capital resources of their own. In an OTC market, participants can operate as both traders and brokers. For example, large corporates are not only involved in funding, but may also speculate on a large scale (jobbing) or conduct broking business. As the OTC markets are less strictly regulated, participants are free to choose their type of business, and consequently large players are often involved in

more than one trading capacity. The only criterion for participation in an OTC market is acceptance by other players, which effectively implies an acceptable credit rating. The OTC markets are therefore often wholesale markets, subject at times to sudden shakeouts particularly if credit risk increases. Financial advisers After extensive discussions with interested parties for nearly a decade, the regulation of financial advisers will probably commence with the proclamation of the Financial Advisory and Intermediary Services Act in 2001. For a long time a pressing need has been felt by the authorities to bring financial advisers into the regulatory net, because advisers and intermediaries services suppliers are acting as “an indispensable link in the chain when fraud is being perpetrated on the public”.45 In terms of the proposed Act, financial advisers and the intermediaries of financial services suppliers will be subjected to various market-conduct rules, the most important being: • Minimum fit and proper standards for professional advisers. • Minimum quality standards for the suppliers of financial products and their representatives. • Subjection of the industry to a code of business conduct. • Reporting and disclosure rules. • Complaints and compensation procedures. • Compliance officer requirements. • Dispute resolution by an ombudsman. With the power of this new Act, the authorities hope to be able to better protect the interests of the consumer against the inherent problems of asymmetric information flows46. However, the regulation of financial advisers will not only rely on market-conduct rules. The new Act also contains some strong elements of regulation by reputation. Rather than trying to depend on too-detailed

44

45

JSE stockbrokers are not “pure” brokers as they can trade with clients or among themselves for own account. Most trades with clients are, however, on an agency basis because inter alia commission cannot be charged on trades with clients on a principal basis.

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46

The Nel Commission of Inquiry, Nov. 1997, p.104. Asymmetrical information problems are one of the major reasons that small investors do not always fully understand the financial products they are buying.

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regulation,47 reliance on a firm’s own self-interests often works more effectively and efficiently. Regulation by reputation usually entails the following elements: • Reliance on firms’ self-interest. • Firms take responsibility for staff training and minimum competence standards. • Firms take responsibility for the blacklisting of rogue advisers on their products. • The authorities take responsibility for the enhancing of competition (particularly foreign competition). • Extensive education and information flows to the media. • Publication in the media of fines and misconduct. In essence, regulation by reputation is based on the assumption that the sale of most financial products is not fundamentally different from the sale of other (complex) retail goods such as motor vehicles or computers. Only those few financial products that are indeed uniquely complex need additional statutory regulation (e.g. authorisation and registration requirements). 3.1.2 Participants in the regulated market An exchange is in essence a regulated marketplace, operating under its own rules. These rules usually stipulate trading, clearing and settlement procedures, as well as risk-management procedures. Membership of such an exchange often entails entry restrictions48 and is subject to certain requirements such as minimum capital reserves, certification of certain skills and levels of experience, business integrity and an acceptable degree of legal accountability. Exchange members are usually categorised into three major types: brokers; principal traders; and market makers.49

47

48

49

Which always carries with it the danger of over-regulation and cost-inefficient regulation – i.e. state failure. Internationally, membership of an exchange is often limited to investment firms. In South Africa exchange membership is based on mixed criteria. For the JSE, membership is limited to securities firms, but the BESA and SAFEX also allow the membership of banks, insurers and even non-financial institutions. Securities firms which are members of the JSE may be subsidiaries of other financial institutions, e.g. banks. In South Africa these roles are often mixed.

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Each has a specific role to play on an exchange. Brokers (or agents). Brokers operate solely as agents for buyers and/or sellers. They facilitate direct financing between ultimate lenders and ultimate borrowers and/or financial intermediaries. They do not speculate on price movements in the market and concentrate solely on their role as agent for which they receive a commission. Brokers often assume full responsibility for the retail business. • Principal traders (or dealers). Principal traders operate on the exchange for their own account only. They take a view on possible price movements and buy or sell for their own portfolio. They perform the role of wholesalers on the exchange, often buying and selling large quantities of securities from and to brokers. • Market makers (or specialists). Market makers are specialists in certain securities traded on an exchange. They create liquid markets in certain securities by continuously quoting buying and selling prices – thereby ensuring the existence of a two-way market. As market liquidity is asymmetrical (it is high in a bull market, but may be very thin in a bear market), market makers are in need of sufficiently large capital resources. They often have to buy large quantities of securities during a bear market phase, which they off-load (or are supposed to off-load) at a later stage. Market making may therefore be very costly (or even unprofitable) during a bear run. Exchanges normally grant certain privileges to market makers, such as deferred reporting and executing large orders away from the exchange’s trading facilities (called “block” trading). These privileges are granted to attract market makers with sufficiently large capital resources in order to increase market liquidity. Although not every OTC market participant may trade on an exchange, exchange members are usually allowed to trade in an OTC market in securities not regulated by the exchange. •

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Diagram 6.7: Financial market participants

Financial markets

Investment exchanges (formal with eg automatedtrading systems)

OTC market (informal with eg telephone/ screen-quotation trading systems)

BESA SAFEX

JSE

Investment firms*

Banks Insurers Fund managers Investment firms

Ultimate borrowers and ultimate lenders

Brokers

Principal traders

Market makers

* Investment firms that are members of the JSE may be subsidiaries of other financial institutions, e.g. banks.

3.2 The regulatory regime and structure for financial market participants Usually financial institutions are functionally divided into three broad classes: banks, insurers and investment firms. The essence of banks is that the cost of their liabilities is fairly certain, but that the return on their (illiquid) assets is uncertain (mainly owing to the credit risk on their unmarketable loans); insurers have mutatis mutandis uncertain liabilities (i.e. as reflected in the actuarial risk) and certain (mainly marketable) assets; whereas investment firms have certain (marketable) assets and also liabilities (i.e. they are exposed predominantly to market risks). These three classes of financial institutions can be 144

subdivided again. Banks can be classified as commercial banks, merchant banks and mutual banks; insurers can provide long-term (life assurance) or short–term insurance; and investment firms can be split into fund managers, securities traders and brokers. This section highlights some of the regulatory differences between these various types of institutions, with the emphasis on private-sector financial institutions. The contrast between public-sector financial institutions and their private sector equivalents is stark but relatively simple. For all practical purposes, financial institutions in the public sector are exempted in full from the usual statutory requirements (as imposed on private-sector institutions), as their risk Financial Regulation in South Africa: Chapter 6

exposures are backed by the National Treasury. However, this type of generosity on the part of the National Treasury is not without inherent problems. Firstly, it distorts the level playing field concept and thus competitive neutrality as a regulatory goal, because public-sector financial institutions do not incur any of the implicit costs of prudential requirements. Secondly, this organisational structure implies that the taxpayer, rather than shareholders or clients, pay for potential mismanagement. Thirdly, it creates major conflicts of interest in that these institutions operate under an implied free-of-charge lifeboat facility. Fourthly, the lack of profit yardsticks makes it very difficult to measure the true effectiveness, cost-efficiency and economy of such institutions. Be that as it may, the following public-sector bodies operate under their own Acts of Parliament: (i) the Postbank is exempted from all the provisions of the Banks Act (in terms of the Post Office Act); (ii) the Corporation for Public Deposits is a subsidiary of the SA Reserve Bank and does not fall under any banking legislation; (iii) the Land and Agricultural Bank of South Africa is exempt from the provisions of any other law, especially those governing banks (in terms of the Land Bank Act); and (iv) the Public Investment Commissioners (PIC) are not subjected to the Pension Fund Act (in terms of PIC Act). In all these publicsector institutions, it is their founding legislation that describes the regulatory arrangements. Accordingly, there is no external monitoring and supervision by the Financial Services Board or the Bank Supervision Department of the SA Reserve Bank for such institutions. Moreover, incentive contracts with such institutions are unknown, neither are these institutions subjected to market discipline, structured early intervention arrangements or corporate governance rules. In essence, these public financial institutions are autonomous bodies backed, if need be, by the National Treasury. In contrast, financial institutions in the private sector are extensively regulated in South Africa. The rules and regulations usually operate at four distinct levels. Firstly, there is the general legislation usually Financial Regulation in South Africa: Chapter 6

applicable to all companies (such as the Companies Act). Secondly, financial institutions are subjected to specific prescriptive legislation applicable only to their functional business (e.g. the Banks Act). Thirdly, the respective registrars apply the rules in terms of their specific directives (e.g. the rules issued in terms of the Banks Act by the Registrar of Banks). Fourthly, the industry is bound by the self-imposed rulings of industry associations (e.g. the Banking Council). In addition to rules and regulations, the regulatory authorities impose a monitoring and supervision regime on private financial institutions (mainly through the inspectorates of the Financial Services Board and the Bank Supervision Department). As financial institutions are increasingly becoming big, complex and even opaque in their overall risk exposures, the regulatory authorities are attempting to take the first steps in the direction of incentive contracts. For example, banks can now choose between being capitalised in terms of preset fixedcapital ratios or in terms of their own in-house valueat-risk (VaR) models. Obviously, such VaR models have to be approved, and certain risk parameters in the model are also set by the authorities (including an absolute minimum capital level), but after that the institution itself determines its capital-adequacy level in terms of its risk profile. By their nature, private financial institutions are extensively exposed to the harsh discipline of the marketplace. The market also monitors financial institutions and may in future even influence their capital-adequacy requirement. It could do so in a number of ways, for example the credit ratings of private-sector rating agencies (local and international) could be used by the authorities as a parameter for their risk-assessment procedures. Similarly, the stock market ratings in terms of the price-earnings ratio could be used for prudential requirements. Internationally a new trend is developing in which banks are asked to issue part of their capital as subordinated (tradable) debt in the bond market. The interest rate on that debt is then in turn used as a key parameter in the capital-adequacy regime. 145

The new provisions in the amendment to the Banks Act (2000) entail an important first step on the road to a structured early intervention regime, as for instance, substandard, doubtful or bad debts50 have to be impaired against capital by ratios of respectively 20%, 50% and 100%. Last but not least, all financial institutions in the private sector are subjected to the corporate governance regime. The regulatory matrix for financial market participants (see Table 6.12) is briefly discussed below. 3.2.1 Rules and regulations Entry and standards constraints In order to ensure a sound business infrastructure, all financial institutions (at least those in the private sector) have to fulfil the general requirements of the Companies Act, the Inspection of Financial Institutions Act,51 the Financial Institutions (Investment of Funds) Act,52 or the Co-operatives Act (if applicable). All these Acts endeavour to ensure that a public company meets the requirements with regard to directors, management, financial procedures, accountability, etc. In addition there are the specific requirements of the Banks Act, the Long-term and Short-term Insurers Acts, the Pension Funds Act, the Friendly Societies Act, the Unit Trusts Control Act or the Participation Bonds Act. These specific Acts set out in great detail the minimum entry and standards requirements. Moreover, each of these Acts provides for a Registrar who can issue additional directives to ensure that minimum standards are met in respect of institutional soundness and “suitable” directors, management and systems. Ownership constraints Particularly during the last two decades, the development of global financial conglomerates has resulted in a more liberal view by the authorities about ownership constraints. Internationally the trend is to lift any ownership constraints on foreigners and/or 50 51

52

Bank loans are considered bad if the loan becomes uncollectable. In contrast to all other financial institutions, banks are not subjected to this Act. Banks are subjected to this Act only in respect of their trust goods.

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competitors. This trend is also visible in South Africa. For example the Big Bang on the JSE removed the requirement that exchange members had to be South African nationals.53 Nonetheless a number of important constraints are still on the law books. Insurers may not own more than 49% of a specific banking institution without the approval of the Registrar of Banks, and a person cannot hold an interest in excess of 25% in any insurance company without the approval of the Registrar of Insurance. Moreover, the names of intended shareholders in a bank have to be registered (implying that covert ownership is illegal), and the Registrar of Banks or the Minister of Finance has to give approval if a shareholder of a bank has shares exceeding a certain percentage of the total shares issued. In case of foreign-exchange brokers, the owner has to be a South African company registered in terms of the Companies Act. Non-resident companies are not allowed to be foreign-exchange brokers. By virtue of the requirement that the foreign-exchange broker has to be independent of an authorised dealer, it follows that a bank may not have ownership interests in a foreign-exchange broker. Functional activity constraints Demarcation lines between the various types of financial institutions used to be drawn fairly sharply in South Africa. The aim of restricting the activities of specific financial institutions to specific functions was to promote competitive neutrality between functionally different institutions, or to avoid “excessive” competition (whatever this may mean today). Ideally, functional constraints should allow for a more focused approach to business. However, these demarcation lines are now increasingly fading in a financial conglomerate.54 In terms of the Banks Act, a bank is restricted in its business to the taking of deposits and the making of loans and investments. The Long-term Insurance Act limits the business of long-term insurers to the issuing 53

54

The fact that even permanent residents were barred from the JSE prior to 1995 was of course plainly a trade restriction. However, in a universal bank, the banking and insurance businesses may still be strictly ring-fenced.

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X X

X

6. Corporate governance

7. Discipline/accountability of regulators

X

5. Market monitoring and discipline X

X

X

3. Intervention and sanctions

4. Incentive contracts and structures

X

2 Official monitoring and supervision X

X

X

X

X

X

X

X

X

X

X

X

X

X

X

X

X

X

X

X

X

X

X

X

X

X

1.6 Operational constraints

X

1.4 Jurisdictional constraints

X

X

X

X

1.3 Functional activity constraints

Proper institutional infrastructure X

Fit and proper directors and staff Global institutional competitiveness

1.5 Pricing constraints

X

X

Sufficient market liquidity

1.2 Ownership constraints

Securities markets as alternative to intermediation

X

X

Competitive market infrastructure Acceptable maturity and currency mismatches Acceptable crossmarket exposures X

Regulatory effectiveness, efficiency and economy Proper risk assessment

1.1 Entry and standards constraints

1. Official rules and regulations

Regulatory regime and its instruments

Regulatory intermediate goals Competitive neutrality Integrity and fairness

Consumer protection

X

X

X

X

X

Competence

Institutional safety and soundness

X

X

X

X

Adequate product/service competitiveness

Systemic stability

X

X

X

X

X

X

Transparency and disclosure

Regulatory ultimate objectives

X

X

X

X

X

X

X

X

Access to retail financial services Protection of retail funds

Table 6.12: Regulatory matrix: Financial market participants

X

X

X

X

X

Retail compensation schemes

of long-term policies (e.g. life-assurance policies, endowment policies and retirement annuities) – with a strict demarcation being applied between such assurance business and other business of a long-term assurer. Moreover, the Registrar of Insurers may impose restrictions on the business of issuing policies and may prohibit the removal of certain assets from the country. Accordingly, insurers may only issue specific financial instruments, such as endowment policies, whereas only banks may create NCDs. However, an endowment policy of, say, one day becomes de facto a deposit, and a one-year fixed deposit can be simulated perfectly by option contracts in the derivative markets. In essence, financial engineering is undermining this functional demarcation, a process aggravated by the development of multi-product financial conglomerates. Likewise the Short-term Insurance Act limits the business of a short-term insurer to short-term business, i.e. the issuing of indemnity-type insurance policies. And again, the Registrar of Insurance may impose additional restrictions on the business of issuing policies. In a similar way the activities of reinsurers, medical aid schemes, pension funds, friendly societies, fund managers, unit trust schemes, participation mortgage bond schemes and trustees are functionally constrained. Finally, in terms of the National Payment System Act, only banks or their agents may process payment instructions and only banks may settle payment obligations across accounts held at the SA Reserve Bank. The aim of this constraint is to achieve a high level of payment system integrity and reduce systemic risk. Jurisdictional constraints This field of legislation is dominated by the Currency and Exchange Act, which subjects any cross-border financial transactions to exchange controls. The ultimate aim of exchange control is to protect the country’s currency, and by implication its foreignexchange reserves. The requirement that certain financial institutions must maintain a covered position (i.e. local currency liabilities have to be covered with local currency assets) is primarily a prudential 148

requirement (namely the elimination of currency risk), but is used simultaneously as a tool to avoid unwanted capital outflows. Exchange control stipulates that only banks can be authorised dealers in foreign exchange, and that foreign-exchange brokers are not permitted to conduct any business other than foreign-exchange broking. The Banks Act restricts the business of deposit taking to South Africa, with special provisions in place that provide scope for the establishment of subsidiaries outside South Africa as well as for the establishment of representative offices of foreign banks inside the country. Likewise, insurers are subjected to exchange control, particularly in respect of cross-border insurance premiums and benefit payments as well as their offshore investment holdings. Moreover, the prudential requirements of the Insurance Act and the Pension Funds Act stipulate a covered domestic position of 85% for such institutions. The stated policy of the Minister of Finance is to relax exchange control regulations gradually in the years to come. Accordingly, the covered domestic position requirements may well be reduced further in future. Pricing constraints The pricing of financial products and services is, with only a few exceptions, unconstrained in South Africa. The exceptions are the Usury Act, which limits the financial charge rates to a maximum of 25% p.a. generally, or ten times the prime rate for specific industries such as microlenders, as well as the commission fees of insurance brokers. As banks’ lending rates are usually well below the ceiling rate set by the Usury Act, this Act applies mainly to microlenders and related types of non-bank business. It is expected that the commissions payable to insurance brokers will be fully deregulated during 2001. A bill in this respect is likely to go before Parliament towards the end of 2000. Operational constraints Operational constraints usually fall into two major categories: prudential requirements and market business conduct requirements. Once again, these Financial Regulation in South Africa: Chapter 6

requirements can be imposed in terms of general legislation, specific legislation, external agency regulation, self-regulation, self-imposed regulation or moral suasion. General legislation. The most important Acts are the Credit Agreements Act (which compels banks to follow the prescriptions on credit agreements); the Harmful Business Practices Act (financial activities should be so conducted as to meet the restrictions under the statue); the Maintenance and Promotion of Competition Act (which prohibits cartel arrangements that affect pricing);

and the Insider Trading Act (which prohibits insiders from profiting by trading on insider knowledge). Specific legislation. At this next level there are specific Acts applicable to specific types of financial institutions. Usually these Acts prescribe in detail the minimum capital and liquidity requirements, and guide institutions on conducting their business in a desired manner and on desisting from certain practices and/or actions (see Diagram 6.8). For example, insurers may not pledge or encumber their assets, whereas unit trusts must be sold for cash (with restrictions being

Diagram 6.8: Operational constraints placed on market participants (expected structure in 2001)

Institutional regulation of capital-adequacy standards

Capital-adequacy standards in terms of the Banks Act

Capital-adequacy standards in terms of the Insurance, Pension Fund and Unit Trust Acts

Capital-adequacy standards in terms of the Investment Services Act*

Registrar of Banks

Registrar of Insurance/ Pension Funds/Unit Trusts

Registrar of Financial Markets

Banks

Insurers/Pension funds Unit trusts

Investment firms

Functional regulation of market activity

OTC markets

Central securities depositories

Self imposed trading rules

Money and capital market participants

Forex market participants

Regulated exchanges

Authorised rulebooks

OTC derivatives market participants

BESA members

JSE members

SAFEX members

* This Act will probably be promulgated in 2001.

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imposed on loans against security of units). The most important pieces of specific institutional legislation are the following acts: the Banks Act, the Mutual Banks Act,55 the Long and Short-term Insurance Acts, the Pension Funds Act, the Friendly Societies Act, the Unit Trusts Control Act, the Participation Bonds Act, the Financial Institutions (Investment of Funds) Act and the National Payment System Act. Diagram 6.8 sketches the expected supervisory structure divorcing institutional regulation from functional market activity in respect of capital-adequacy rules. In terms of the existing Safe Deposit of Securities Act and the (proposed) Investment Services Act, a central securities depository is supervised in a similar vein to exchanges (and accordingly has to be licensed). The proposed Investment Services Act will eventually set the capital-adequacy standards for all investment firms. However, for the time being the Investment Services Act only tries to consolidate the Financial Markets Control Act, the Stock Exchanges Control Act, the Custody and Administration of Securities Act, the Insider Trading Act and specific sections of the Companies Act (particularly those dealing with public interest, the transfer of shares, debentures and prospectuses), but ultimately the Investment Services Act should also cover the capital requirements for investment firms operating solely in the OTC markets. The institutional and functional aspects of regulation are co-ordinated by the Policy Board for Financial Services and Regulation for all financial institutions and markets (see Diagram 6.9). The issue of whether the Financial Services Board (FSB) and the Bank Supervision Department (BSD) should merge into a larger single regulatory authority (like the Financial Services Authority in the UK) has not been finally resolved in South Africa. The Melamet Committee (1993) recommended the consolidation of the Offices of the Executive Officer of the Financial Services 55

The Mutual Banks Act (1993) is similar to the Banks Act (1990) but differs on two points: firstly, a mutual bank is of course exempted from the requirement that a bank has to be a limited company; and secondly, its minimum capital requirements is R50 million, whereas for banks this requirement is going to be increased to R250 million.

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Board and the Registrar of Banks at some stage in future in order to strengthen the holistic approach to financial regulation in South Africa. In 1999 a Round Table Conference consisting of the Minister of Finance, the executives of the FSB and the BSD, as well as foreign experts, reaffirmed this conclusion, but to date no concrete steps have been taken to implement these recommendations. External agency regulation emanates from specific legislation and allows the registrars of these Acts to set additional constraints. The registrars have the statutory power to issue guidelines (in the form of circulars as to how the provisions of the Acts are to be applied and interpreted) and directives based on the provisions of the Acts for certain (more detailed) activities and how these are to be conducted. Self-regulation. Self-regulatory authorities are unknown for financial institutions in South Africa (except those, like the JSE, found in the regulated markets). Self-imposed regulation. Industry associations such as the Banking Council or the Life Offices Association (LOA), impose binding rules on their members. Usually these constraints are in the area of codes of conduct, advertising rules and sponsorship rules. However, the insurance industry is generally more prescriptive with its members than other industry associations. For example the LOA issues quite detailed operational constraints with rulings such as the Benefit Illustration Agreement, Dread Disease Benefits, Deferred Compensation Policy, and various registries (e.g. in respect of life, intermediaries and claims). Likewise, the South African Insurance Association lays down operational constraints for its members, such as the Earthquake Agreement, the SA Knock-for-knock Agreement, the Application of pro rata Average Agreement, or the War and Civil Risks Agreement. The reinsurance industry in turn is constrained by the following self-imposed rules: reinsurance may not be for a greater amount or for a longer period than the original insurance; and the original insurance cannot be altered without the consent of the reinsurer. Moral suasion is seldom used nowadays as a Financial Regulation in South Africa: Chapter 6

regulatory instrument. In the past the governors of the central bank were not too shy to urge (which necessarily contains an element of compulsion) banking institutions to conduct business in a desired manner. However, with the emergence of global banks and financial conglomerates, moral suasion has lost most of its powers and influence. 3.2.2 Official monitoring and supervision All financial institutions in South Africa are monitored and supervised by their respective registrars in terms of prudential and code-of-conduct requirements. This supervision is increasingly performed according to minimum international standards (see Chapter 4, Section 3.2).

3.2.3 Intervention and sanctions Structured Early Intervention and Resolution measures were introduced into the regulations of the Banks Act in 2000. Today banks have to impair their capital as per a provision matrix which defines the status of their loans. Of course, market manipulation, insider trading, unfair trading practices and money laundering are criminal offences in South Africa, and the sanctions thereon are sufficiently stiff to at least discourage such practices. Moreover, in 2000 the Financial Stability Unit was established at the SA Reserve Bank and is aimed at addressing all issues of systemic risk management, including structured early intervention rules, the timely closure of insolvent financial institutions and the replacement of those directors and senior staff who

Diagram 6.9: Statutory regulation of financial intermediaries and advisers indicates advisory functions indicates executive functions

Minister of Finance

Policy Board for Financial Services and Regulation

Department of Trade and Industry

Financial Services Board

Advisory Committees

South African Reserve Bank

Banks Office of the Registrar of Companies

Office of the Executive Officer and Registrar of Financial Institutions*

Financial markets Long-term insurers Short-term insurers Pension funds Unit trusts

Office of the Registrar of Banks

Appeal Boards

Insurers Pension funds Friendly societies

Financial markets: BESA JSE SAFEX

Unit trusts Participation bond managers Portfolio managers

Financial advisors

Banks

* The Office of the Registrar of Financial Institutions encompasses the registrars of all non-bank financial institutions, i.e. the Registrars of: Stock Exchanges; Financial Markets; Insurers; Pension Funds; Unit Trusts and Friendly Societies. Responsibilities under the Usury Act lie with the Department of Trade and Industry. Responsibilities under the National Payment System Act lie with the SA Reserve Bank.

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proved plainly unfit for their positions. Much work still has to be done in this area of regulation (particularly for non-bank financial institutions) and no concrete visible results should be expected within the next few years. 3.2.4 Incentive contracts and structures This important segment of the regulatory regime is still relatively underdeveloped in South Africa. Incentive contracts are currently written between the regulator and the regulated in two areas, namely in compliance and risk management for banks. In terms of the regulations of the Banks Act, banking institutions have to appoint a compliance officer, but every bank is free to compile its own compliance manual which has to be approved by the board of directors and the registrar. This compliance manual is likely to be significantly more complex and detailed for a banking conglomerate than for, say, a mutual bank. Accordingly the compliance manual can be viewed as a type of incentive contract, which is more or less tailored for the specific firm. A bank can also elect to evaluate its risk exposures by means of its own value-at-risk models (VaR), provided such models are approved by the Bank Supervision Department. The advantage of the VaR modelling approach is that banking firms can use their own in-house models and data to measure risks (rather than use the fixed capital ratios embodied in the regulations of the Banks Act). The aim is again to avoid “one size fits all” capital requirements for fundamentally different type of banks. It is expected that in future even more emphasis will be placed on “contract banking”56 particularly in respect of complex bank conglomerate structures. 3.2.5 Market monitoring and discipline Ultimately, competitive forces ensure that only the most effective and cost-efficient financial institutions 56

In “contract banking” a bank defines the components of the services it wishes to offer and decides which are to be supplied internally and which subcontracted. In effect, a series of contracts is established by a contracting bank with internal and external suppliers.

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survive. Sooner or later weak firms are taken over by stronger institutions or forced to close down. This “market law of the survival of the fittest” supports the stability of the financial system, provided the (unavoidable) bankruptcies are not themselves systemic in nature. From a regulatory point of view, the prudential requirements should never be so stringent that they eliminate bank failures under all possible circumstances, as such a cost-inefficient regulatory regime would be bound to eliminate all possible forms of financial innovation and in addition make the cost of credit too high for optimal economic growth. Today the international approach emphasises that financial regulation should actively support competition, but this trend is still relatively undeveloped in South Africa. In part this is because of two important factors. Firstly, during the years of financial isolation (until 1994) foreign product providers were viewed with suspicion, while local producers were expected to serve the “national interest”. Secondly, in South Africa financial legislation was always highly functional in nature. Financial conglomerates, operating in many different functions simultaneously in both the local and foreign markets, were unknown until the 1990s in South Africa. As a result the South African regulators were exposed to all types of unwanted “captures”, particularly in functional “border disputes” between banks and insurers, or between local and foreign institutions. Generally consumers and investors want evergreater choice, which in turn entails competitive choices. So long as the interests of the consumer are not endangered and provided that no excessive systemic risks are created, the regulatory authorities should in principle actively support competition between local and foreign firms and between the various markets. By not doing so, the financial system could be seriously impaired (as the healthy impact of competition on effectiveness and cost-efficiency would be weakened). Internationally acceptable minimum standards can be introduced by (gradually) opening the markets to international competition. Therefore existing rules and Financial Regulation in South Africa: Chapter 6

regulations should be carefully checked for any (unintended) restrictive and anti-competitive mechanisms57. Competition policy will also be enhanced by focused disclosure and transparency arrangements hand in hand with consumer and investor education programmes. Last but not least, entry barriers to the industry should be lowered wherever possible so as to promote competition. The transition from a regulatory approach that confronts “excessive” competition to one that powerfully supports such foreign and inter-industry competition will not be an easy one, neither can it be done overnight. However, if South Africa wants to retain the quality of its financial services, it has little choice but to give serious attention to letting market disciplines work in favour of the ultimate objectives of regulation. For example in respect of banks, the capital-market could increasingly be used as a rating agency. The major advantage of such a regulatory measure is that private financial institutions have to prove their quality first and foremost to the markets, while the regulatory authorities will also obtain valuable insights from this market evaluation process. Moreover, it is always difficult for the authorities to replace unsuitable directors once they are fully established. Here, too, market forces could be of great help to the authorities. 3.2.6 Corporate governance Usually the operational constraints imposed by the regulatory authorities are blended with corporate governance requirements. Again, acceptable international standards are crucial here, as a lack of corporate governance deters foreign investors. 57

For instance, foreign banks may currently only accept deposits in excess of R1 million.

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Accordingly, corporate governance not only improves the integrity and transparency of financial institutions and markets, but also powerfully supports market stability, liquidity and international competitiveness. Some of the major issues in corporate governance that still have to be addressed in South Africa are the following: • Pyramid companies and non-voting shares (which makes potential misuse by the major shareholders all too easy). • Disclosure rules (e.g. on executive remuneration – particularly share-option schemes). • Related-party transactions and exposures. • Segmental corporate reporting (e.g. geographic and business segments). • Capacity to investigate and prosecute commercial crimes. 3.2.7 Discipline on and accountability of financial regulators On this topic, one can be fairly brief. In South Africa there are currently no effective rules which can discipline the regulators, neither are there routine procedures on public accountability. Of course, gross misconduct will ultimately be disciplined by Parliament, but more refined methods still have to be worked out. It is likely that South Africa will follow international trends in this respect, rather than initiate them. Currently, exchange members and persons aggrieved by a decision of the exchange’s governing committees can take such decisions on appeal to the Appeal Tribunal established in terms of the FMCA and SECA. Decisions of the Registrar can be similarly taken on review. The introduction, in due course, of the “ombudsman” under the Investment Services Act will be a further review mechanism strengthening the accountability process.

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Chapter 7 ASSESSMENT OF THE FINANCIAL REGULATORY REGIME IN SOUTH AFRICA 1. Introduction The boom in the global financial industry over the past few decades has been fuelled by an explosive combination of economic growth, demographic changes, technology and financial innovation. In this rapidly changing world1 the optimal alignment of regulatory instruments has become a complex and highly dynamic process. Not surprisingly, even tested approaches to standard regulatory challenges now require some serious reconsideration. Indeed, “change is the only constant”. Not only South Africa, but also the industrialised countries are faced with fundamental changes in their socio-economic environment. For example, the following structural changes are evident: the decreasing powers of the national state in a world consisting of offshore financial centres2 and “e-citizens”; the attainment of the upper limits of the social welfare state; pressures for lower (global) taxes and thus a smaller state; the massive migration of refugees from one nation to another; and the ageing of the population in the West. In the South African context the socio-economic challenges may even be greater than those faced in the industrialised countries, because of the country’s underlying dualistic nature3 and the problems caused by nearly half the population being undereducated, and as such unemployable, in what are today known as the “knowledge economies”. Section 2 emphasises the evolutionary trends in 1

2

3

The shape of financial markets is set by factors such as financial engineering, computer technology, e-commerce, volatile international capital flows and powerful global financial conglomerates. “By some estimates more than half of the world’s stock of money passes through offshore centres, about 20% of total private wealth is invested in those centres and about 22% of banks’ external assets are invested offshore.” See Francis, J. “The Bahamas perspective”, in The Financial Regulator, Vol. 4, No. 4, London: Central Bank Publications, 2000, p. 27. As reflected, for instance, in a highly sophisticated financial sector in what is basically a lower-income developing country.

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South African financial regulation. In this section the following basic questions are posed: “What is so different today on the regulatory front compared with, say, a decade or two ago? And what is to be expected in regulation during the next decade?” To address such issues an effort is made to identify the engines of sociopolitical change and to evaluate, against this background, whether the use of the regulatory instruments was appropriate. The projection of the South African economy during the next decade is based on a supply-driven econometric model that ultimately is driven by available production factors such as fixed capital stock, skilled labour and multifactor productivity. Thereafter, a rough guess is made to see whether the financial system is able to confront these economic challenges with a degree of confidence. Against the socio-economic background of Section 2, Section 3 attempts to identify existing regulatory gaps, and thus set the regulatory targets,4 in the current financial system. The emphasis is on three issues, namely institutions, markets and infrastructure. The last section sets out a few possible guidelines for the South African regulatory regime in the years ahead.

2. The evolutionary trends in South African financial regulation Regulation takes place in a specific socio-economic environment. Although it is not the aim of this section to sketch in any detail the socio-political developments of the past, nonetheless note has to be taken of this environment in the overall assessment process. Accordingly, a short summary is first given of the socio-economic background, and then the regulatory issues are addressed in greater detail. 4

Regulatory targets are usually aimed at improving the regulatory instruments – irrespective of whether the authorities or the markets use these instruments.

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2.1 The socio-economic environment during the past few decades and prospects for the next decade Table 7.1 summarises some of the key variables and characteristics of the South African economy and the role that the financial sector plays in it. The aim of the table is not to present yet another economic projection. The aim is rather to present a conservative scenario, which highlights possible future trends and emphasises some of the major constraints placed on the economy. Obviously, the scenario presented may prove unrealistic, but from a planning point of view “stress testing” of the regulatory environment has to be done. The scenario assumes world economic growth of some two per cent per annum and stable terms of trade for South Africa. The following remarks can be made: • Demographic developments: After the population had grown at an average rate of 2,3% p.a. during the past two decades, it is expected to flatten out from 2007 onwards. The population may even fall from 2010 onwards, mainly owing to the impact of diseases (e.g. Aids, TB and malaria), as well as better birth-control measures. In fact, during the next 15 years some 12 million people may die from Aids and the population is likely to peak at some 50 million at the end of this decade. The average life expectancy of South Africans may even drop to a mere 40 years by 2015. The financial sector will be affected in a number of ways as a result. For instance, retail banks may experience no real growth in credit extension, bad debts on mortgage finance may rise sharply (another consequence of Aids), and there may also be major claims on medical aid schemes and insurance in general. The term structure of the banks’ loan books is likely to become shorter, which may have an adverse effect on long-term fixed investments. • Households: Without any material increase in real savings, households will struggle to reduce their debt to more acceptable levels. The impact of Aids will make this reduction even more difficult. People will spend less on normal consumption items, but significantly more on health care. Being Financial Regulation in South Africa: Chapter 7

already heavily taxed, households are expected to make no material contribution to the national savings and thus fixed investments in the foreseeable future. At best they will remain neutral, even though this sector accounts for as much as 63 per cent of GDP. In this environment it will be very difficult for the government to encourage microlending to disadvantaged communities. • Corporate sector: This sector is likely to be the sole engine of economic growth in the immediate future. To support long-term economic growth of say some 1,5 per cent per annum, the nation’s gross capital formation has to be some 18 percent of GDP (it is currently around 16 per cent). Net foreign capital inflows have financed about 15 per cent of South Africa’s gross capital formation since the end of 1994 and, on the basis of net capital formation5, they amounted to over 70 per cent. This dependence on foreign savings to finance local investments will remain the Achilles heel of the South African economy until the government and private households start saving seriously again. For a relatively open economy6 such as South Africa, import protection has progressively fallen away in recent years. Moreover, in the years ahead, as Aids takes its toll, the corporate sector may have to rely increasingly on highly skilled, imported labour (particularly in the securities markets). Although profit margins in corporate banking are already thin, competition in this sector is likely to remain stiff as foreign banks may start to operate more aggressively in this market segment. A shakeout of cost-inefficient banks is to be expected in future, which in turn may require the involvement of the central bank in a number of ways. • Government sector: The finances of the state are overstretched on nearly all fronts, as reflected in the general government’s dissaving since the early 1980s. From the government’s point of view, its 5

6

Net capital formation is equal to gross capital formation minus the depreciation of existing capital stock. Total imports and exports account for around half of the nation’s output.

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Table 7.1: Socio-economic indicators of the South African economy Demographics 1980-1989 Birth rate %change pa 3,0% Death rate % change pa 0,9% Aids deaths number pa Normal death number pa 284 926 Total population millions 32,4 Total population growth % change pa 2,5 Labour market 1980-1989 Highly skilled labour/total employment ratio % 10,2 Highly skilled labour/total employment ratio % change pa 3,2 Real output per worker % change pa 0,7 Real wages % change pa 1,0 Capital/labour ratio % change pa 1,9 Total labour force growth % change pa 2,6 Unemployment rate % 24,1 Saving 1980-1989 Net household saving/disposable income % 5,9 Net corporate saving/corporate profits % 23,3 Net government saving/government revenue % -8,5 Total gross domestic saving/GDP % 23,5 Fixed investment 1980-1989 Gross fixed capital formation % change pa -3,6 Gross fixed capital formation/GDP % 21,8 Net capital formation/GDP % 6,0 Real capital stock % change pa 2,5 Gross foreign direct investment/GFCF % Net foreign direct investment/GFCF % 0,0 Net capital inflow/net capital formation % -21,5 Net capital inflow/gross capital formation % -5,8 Debt exposures 1980-1989 Household debt/disposable income % 47,4 Government debt/GDP % 33,0 Foreign debt (non-monetary private sector)/GDP % 6,2 (85-89) Foreign debt/export earnings % 100 (85-89) Output 1980-1989 Actual GDP growth % change pa 1,4 Potential GDP growth % change pa 1,5 Government sector 1980-1989 Total government consumption expenditure/current income % 73,7 Total government fixed investment/GFCF % 6,9 Total taxes/GDP % 22,2 Total tax on imported goods and services total/imports % 7,8 Monetary sector 1980-1989 Real prime rate % 1,6 Real effective exchange rate % change pa -0,7 Real domestic credit extension % change pa 2,0 Headline inflation rate % change pa 14,7 Financial sector 1980-1989 Real financial sector output/GDP % 14,8 Real financial sector capital formation/GFCF % 21,6 Financial sector imports/total imports % 6,0

1990-1994 1995-1999 2000-2004 2005-2015 2,9% 2,7% 2,4% 2,1% 0,8% 1,0% 1,6% 2,4% 10 231 105 650 426 846 828 488 305 600 323 571 337 440 344 096 35,8 39,9 45,4 50,5 2,3 2,2 1,8 0,9 1990-1994 1995-1999 2000-2004 2005-2015 12,7 14,3 16,0 17,5 2,1 3,0 1,6 1,0 1,5 3,7 1,5 1,5 0,8 3,8 1,5 1,5 2,1 3,4 2,0 2,4 2,6 2,7 2,5 2,3 33,3 39,6 42,8 41,6 1990-1994 1995-1999 2000-2004 2005-2015 3,1 1,2 0,7 1,3 24,0 19,8 16,9 15,8 -21,0 -14,8 -9,8 -9,4 17,3 15,1 15,2 16,4 1990-1994 1995-1999 2000-2004 2005-2015 -1,7 3,0 3,7 1,9 16,1 15,9 16,1 17,9 1,7 3,5 3,6 4,5 0,6 1,6 1,9 2,0 0,8 6,9 7,0 5,5 -3,1 -0,7 -0,5 -1,0 -48,5 70,7 31,3 15,9 -5,2 15,0 7,0 4,0 1990-1994 1995-1999 2000-2004 2005-2015 52,5 59,7 58,3 57,8 42,0 49,2 52,9 60,9 3,8 5,0 6,0 7,5 91,0 102,7 105 108 1990-1994 1995-1999 2000-2004 2005-2015 0,2 2,0 1,3 1,1 1,5 2,0 2,0 1,5 1990-1994 1995-1999 2000-2004 2005-2015 79,0 73,4 72,5 73,8 13,9 11,9 12,2 12,0 24,1 25,2 25,9 25,7 8,7 4,8 4,2 4,5 1990-1994 1995-1999 2000-2004 2005-2015 5,8 11,3 8,6 7,9 2,1 -4,2 -1,9 -1,0 0,4 7,8 1,0 1,0 11,9 7,2 5,2 5,5 1990-1994 1995-1999 2000-2004 2005-2015 16,1 17,2 17,5 17,0 22,9 23,1 23,5 23,0 3,7 3,0 3,2 3,0

Note: GFCF = Gross fixed capital formation

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major concern remains the possibility of a fiscal debt trap. Although the structure of government finances has improved materially since the mid1990s, the impact on government debt of a structurally lower inflation rate and a more competitive open economy has not yet fully worked through the public accounts. Because government has committed itself to a high level of consumption expenditure for socio-political reasons, virtually no funds remain for public fixed investments. Privatisation is one possible solution in this context. Although the level of government debt is currently not too far out of line with international standards, the interest costs of servicing this debt are nonetheless placing a severe burden on the state’s finances. The management of government debt will be a major challenge in the years ahead. • Total economic output: The sustainable growth rate of real output of the South African economy is likely to be some 1,5 per cent per annum for the medium term. This relatively low growth rate is due to the impact of Aids, a low level of fixed investments, the scarcity of highly skilled labour and relatively low productivity. In this depressed macroeconomic environment, the financial sector may try to support its historical growth performance by progressively investing abroad. This scenario implies that local financial institutions would aim to become global conglomerates, which in turn would have some major consequences for local regulators.

2.2 The regulatory regime in the 1980s The 1980s were a period when the first hesitant steps were taken by the authorities to free the economy from over-regulation. A generation ago the regulatory world was quite different from what it is today. For instance, during that period: regulators hardly looked beyond the national frontiers (despite rapid growth in crossborder business); capital requirements were based on simple gearing ratios of capital to total assets; offbalance-sheet items were virtually disregarded Financial Regulation in South Africa: Chapter 7

(derivatives were unheard of); consolidated supervision was an unknown concept; country risk was little heeded (because “countries don’t go bust”); the financial sector components – banks, insurance and the capital markets – were regarded as separate species nationally; regulators seldom spoke to one another; international contacts were just beginning; and supervisory co-operation at an international level (not to mention co-ordination or standardisation) was still only a pipe dream7. Owing to its politically isolated position, South Africa followed these international trends rather sluggishly in the 1980s. In fact, co-operation with foreign regulators was nearly non-existent, and as a result the regulatory structure became progressively out of line with international best standards. In South Africa, the process of deregulation only started to gain momentum in the 1990s. These local developments will be analysed now by looking at the three pillars of the financial system in somewhat greater detail, namely financial institutions, markets and infrastructure. 2.2.1 Financial institutions The true forces of competition arrived only recently in the South African financial sector. For instance, banks have started to compete on price (i.e. interest rates) only since early 1983 (i.e. with the abolishment of the Register of Co-operation). Building societies had favourable funding benefits from the government that effectively resulted in controlled lending and deposit rates until the mid-1980s. Price competition between banks and building societies started in earnest on the asset side on their balance sheets in 1984 (when Standard Bank came into the bond market) and on the liability side in 1998 when the phasing-out of the tax privileges on building societies “shares” began8. A level playing field between banks and building 7

8

Cooke, P., “The future of financial regulation”, The Financial Regulator, Vol. 4, No.1, London: Central Banking Publications, 1999, p. 23. Building societies were immediately forced to start competing on a level playing field for deposit funding, even though they continued to benefit from the endowment factor of the taxprivileged share funding for another 5 years.

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societies materialised only with the Deposit-taking Institutions Act of 1990 (renamed the Banks Act in 1996). Money-market funds were not yet available as an alternative to bank deposits. Owing to South Africa’s politically isolated position until 1994, competition from foreign banks was very limited in the 1980s. Foreign banks were exclusively active in the corporate market, often concentrating solely on their home clients’ businesses in Africa. In fact, some of the major overseas shareholders (e.g. Standard Chartered, Barclays and ABN AMRO) disinvested their South African bank holdings for political reasons in the mid-1980s. Local financial companies picked up these shares cheaply, which resulted in even higher levels of financial power in the local market. By 1994 the four largest banks granted more than 80 per cent of all local credit. Competition among the long-term insurance companies was (and still is) limited due to “industry agreements”. The fiscal aspects of life assurance contracts were co-ordinated effectively by the Life Offices Association (LOA). Most insurance companies and associated bodies toed the line of the LOA in respect of illustrative values, replacement of life assurance contracts and disclosure policies. Likewise, competition between assurance intermediaries (agents and brokers) was based mainly on the “quality of services” rendered and only to a limited extent on price. Insurance commissions paid to intermediaries are still statutorily capped and not disclosed to the paying consumer, implying that usually the maximum commissions are charged. As the 1970s and 1980s were characterised by low, and often negative, real interest rates and high inflation, the insurance industry was in a preferential competitive position vis-à-vis the banking sector. Another major factor that benefited insurers was the preferential tax treatment of income (on the basis that the insurer was treated and taxed as the “trustee” for the policyholders). This resulted in an uneven playing field, and the Sixth Schedule of the Income Tax Act was subsequently amended in the early 1990s in an attempt to restore this imbalance (it was eventually 158

replaced by measures in the Insurance Act9). Moreover, the fiscal regime was particular attractive to insurers as the government turned a blind eye to the long-term contractual impact of inflation. This favourable competitive position of the insurance industry was reflected in the rapid growth of its market share during the 1980s. 2.2.2 Securities markets Seen from an international perspective, the development of the South African securities and investment institutions and business was seriously delayed, mainly because of uneven playing fields for the various financial institutions. For instance, banks were in an unfavourable competitive position vis-à-vis the insurance industry, and the development of the securities market was effectively constrained by the lack of competition on the Johannesburg Stock Exchange (JSE). Price competition on the stock market only arrived after the Big Bang on the Johannesburg Stock Exchange in 1995. Prior to this date, stockbrokers competed solely on their “quality of service”. They could not trade as principals with their clients (but could with other brokers) and had to rely on their limited personal resources for capital purposes. As a result, stockbroker investment in the exchange’s trading, clearing and settlement systems was neglected (which only became particularly evident towards the end of the 1990s). Considering all the trading restrictions imposed by the JSE on its members10 prior to the Big Bang, the opening of the futures market (SAFEX) in 1989 was a welcome sign of somewhat greater price competition in the securities markets. Initially this competition was limited to futures on equity indexes. Futures on individual shares had not yet been developed or approved. In South Africa the bond market started very 9

10

Insurance companies (long- and short-term) were regulated by means of a single Act, namely the Insurance Act 27 of 1943. This act was separated only in 1998 into Long- and Short-term Insurance Acts. For instance, single-capacity trading, fixed commissions, no corporate membership, floor trading and unlimited liability structures.

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informally and rigidly in the late 1960s when institutions began purchasing bonds directly from the, then, Department of Finance (now the National Treasury). Eskom (the electricity parastatal) started to make markets in its own stock as well as government bonds in the late 1980s. Statutorily the JSE was the only formal bond market until 1996, because bonds were a form of security as defined in terms of the Stock Exchanges Control Act, 1985. However, an active informal bond market existed outside the JSE, particularly among well-capitalised merchant banks. It was only in the early 1990s that bond brokers became proper financial intermediaries between institutions and the government (and other issuers) in both the primary and secondary markets. In 1989 the informal and formal bond markets were combined into the Bond Market Association (BMA), which in turn was transformed into a formal exchange, the Bond Exchange of South Africa (BESA) in 1996. 2.2.3 Financial infrastructure The financial sector’s infrastructure was rather rudimentary in the 1980s. Incentive structures between the regulator and the regulated were unknown at that time, and transparency and accountability were generally poorly developed. Industry codes of business conduct and ombudsmen procedures to address consumer complaints were established under the auspices of voluntary industry arrangements in 1985 for life assurance and in 1989 for short-term insurance respectively, but not for banks and financial advisers. The disclosure regime in the 1980s clearly left room for improvement. Banks at that time were not subjected to certain provisions of the Companies Act, which implied, for instance, that their (secret) reserves were not disclosed. With some of the key data missing from the banks’ balance sheets, the creditworthiness of banks was difficult for investors to judge. In fact, creative accounting and the non-reporting of major offbalance-sheet positions were standard practices in banking at the time. The disclosure requirements for insurers were even less demanding. In essence, the chief actuary, in line with the stipulations of the Financial Regulation in South Africa: Chapter 7

Insurance Act and LOA policies, took responsibility for disclosure, and the policy always seemed “the least said the better”. Last but not least, various corporate structures – e.g. nominee companies, non-voting shares and pyramid company structures – obscured ownership and effective control in South Africa in the 1980s. At this time, companies were not required to comply with formal corporate governance rules.

2.3 The regulatory regime in the 1990s To face the challenges of financial innovation, capital mobility and global financial conglomerates, the ethos of regulation changed rapidly after the late 1980s. The structure of regulation moved strongly in the direction of deregulation, with significantly more reliance on market forces. More important was that the consumer moved more to centre stage and that for the first time the authorities took consumer protection issues more seriously. As a result, corporate governance rules, disclosure, transparency and accountability became key concepts in regulation. During this period, international experience was broadly along the following lines: • Financial regulators and supervisors started to meet regularly in national and international groupings; • national financial regulatory regimes were edging closer together, producing much greater international cohesion; • core principles of supervision for banks were developed and widely adopted, if not yet effectively implemented universally, and similar efforts were made for the capital markets; • basic concepts for capital-adequacy measures were agreed upon; • fundamental concepts of the management of risk and associated emphasis on effective management control systems were becoming increasingly accepted as the cornerstones of supervisory practice; and • in a world increasingly dominated by complex international financial groups, supervisors were striving to devise effective global arrangements.11 11

Cooke, op. cit., p.23.

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Until the early 1990s South Africa somewhat lacked these international developments, but after its political isolation came to an end in the mid-1990s, the country quickly adjusted to international standards. 2.3.1 Financial institutions Today banking in South Africa is a highly competitive industry. In the span of a decade, with the exception of the few constraints on foreign banks,12 competitive constraints on banks have been removed. However, competition between banks and the securities market is not yet on a level playing field, owing to a range of restrictions on the issue of commercial paper and corporate bonds.13 Despite initial opposition from the banking industry, money-market funds14 as a competitive alternative to bank deposits, appeared on the financial scene in 1997. During the 1990s not much happened on the securitisation front in South Africa, but considering international parallels, the next decade could see some massive changes. In fact, to encourage the financing of inter alia housing or small business through the securities markets, securitisation may be a key concept in future. Initially the banks resisted securitisation as their attention was focused on growing their interest income and holding the assets on their balance sheets. 12

13

14

For example, foreign banks may currently not accept deposits of less than R1 million from the general public. For instance, commercial paper to obtain operating capital may only be issued by a listed company with net assets exceeding R100 million. In addition, commercial paper has to be issued in denominations of R1 million or more, unless – • the paper is listed on a recognised financial exchange. • the paper is endorsed by a bank. • the paper is issued for a period longer than five years. • the paper is issued or backed by the government. Moreover, only the following persons may be ultimate borrowers of the money obtained from the general public against the issue of commercial paper: • The issuer. • Subsidiaries and holding companies of the issuer. These restrictions make it utterly impossible at present to use the securities markets as a competitive alternative force for small business finance. These funds are managed as a subdivision of the unit trust industry and are today an important section of the market.

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However, during the second half of the 1990s, banks started to reassess their policies of holding all assets on the balance sheet, because of higher capital requirements (particularly for developing countries), increased compliance costs in banking, the entry of new niche and foreign banks, and the need to eliminate cross-subsidisation to ensure long-term profitability. The favourable competitive position of the insurance industry established in the 1980s continued into the 1990s. In 1980 the insurance industry output was 27 per cent of the value added in the financial sector, and its contribution in 1995 had grown to 42 per cent. 2.3.2 Securities markets The Big Bang on the Johannesburg Stock Exchange took place in 1995, heralding price competition, corporate membership and dual-capacity trading. The previous lack of stockbroker investment in the exchange’s trading, clearing and settlement systems was now evident and even massive investment since Big Bang has not succeeded in resolving all the outstanding issues. Even today, settlement on the JSE is an activity that requires a degree of patience, as it is carried out on a fixed basis only once a week15. Compared to the levels of competition faced by exchanges in the industrialised countries today, South African securities markets are still sheltered16 against the competitive gales blowing abroad. Nonetheless, South African’s exchanges are not immune to foreign competition. For instance, international participation is about half of the turnover on SAFEX, and a third on both the BESA and the JSE. Because the JSE adjusted so late to international competitive forces, it now trails behind these international developments, with shortcomings in its organisational structure (perceived to be expensive), clearing and settlement systems (unacceptably out of date) and listing requirements (not yet fully comparable to international requirements). 15

16

Settlement is non-contractual and for no fixed date, it takes place from every Tuesday, but can be extended at times for weeks if there is any problem with the scrip delivery. Mainly by the protection offered by existing exchange-control regulations.

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The situation is exacerbated by a perception of high transactions costs. Of course, there are reasons for this state of affairs. For example, the JSE is involved in expenses that are not faced to the same extent by SAFEX and the BESA, such as the supervision of securities firms’ capital-risk adequacy17, an education programme for the general public18, control systems to police insider trading (a requirement of the Insider Trading Act) and the costs of assisting the Securities Regulation Panel (SRP). Despite its high operating costs, the JSE will be protected from serious competition from abroad (or locally) as long as the securities traded are not fully dematerialised and foreign-exchange controls remain in place. During this period, despite strong opposition from the JSE, the activities of SAFEX were extended to futures on individual shares in 1997 (although they only became accepted a few years later). The JSE successfully countered this shortly afterwards by introducing warrant instruments on individual shares. Meanwhile the Bond Market Association established itself. OTC trading in bonds was phased out slowly from 1989 and totally eliminated with the formal implementation of the Bond Exchange of SA (BESA) in 1996. Prior to licensing, the BESA implemented an electronic trade matching, clearing and settlement system (delivery versus payment). The commercial paper and corporate bond markets are poorly developed in South Africa, because of the constraints imposed by the Banks Act (see Section 2.3.1 above). These restrictions could be lifted, in principle, when Parliament has approved the proposed Collective Investment Schemes Control Bill, the Investment Services Bill and the amendments to the Companies Act. However, in the absence of this legislation, the Registrar of Banks is hesitant to deregulate this market, as small investors need protection against the abuses still possible under

2.3.3 Financial infrastructure The first corporate governance rules were published by the King Commission in 1994; risk-based capital requirements, in line with the EU directives, were introduced for banks in 1991 and for securities firms in 1995; banks (not other financial institutions!) were required to report in terms of the generally accepted accounting rules in 1996; and consolidated accounting rules for financial conglomerates (and therefore the avoidance of double counting of regulatory capital) were made mandatory for banking groups in 2000. In rapid succession, minimum international standards were introduced, for example in respect of capital adequacy, accounting and audit, and disclosure. Of the 25 Core Principles set by the Basel Committee19, South Africa has implemented today 80 per cent fully and 12 per cent partially, though 8 per cent are not addressed at all. The outstanding areas are mainly related to items such as loan classification, concentration within portfolios, intra-group exposures, country risk management, money laundering, consolidated supervision and timely corrective action against banks which fail to meet prudential requirements (e.g. the revocation of their banking licences). After the implementation of the new Regulations under the Banks Act (probably later in 2000), South Africa will fulfil some 95 per cent of these Core Principles and partially fulfil the remaining 5 per cent. Statutory formalised adjudicator offices were established during the late 1990s for banks and pension funds, and draft legislation on the recognition of voluntary schemes in the insurance industry20 is currently being prepared. Despite the initial opposition of the industry, the

17

19

18

For banks the Bank Supervision Department of the SA Reserve Bank carries this expense. Most securities firms are de facto supervised in terms of their capital adequacy by the JSE and not by the BESA or SAFEX or even the FSB. Strictly speaking, public education is not an exchange task – not even the education of the investing public.

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current legislation (as was evidenced in the Masterbond and Supreme Bond debacles during the early 1990s).

20

For details of the principles see the Bank for International Settlements’ Website at: http://www.bis.org/publ/bcbs30a.htm During the 1990s Short- and Long-term Insurance Ombudsmen were appointed voluntarily by the respective South African insurance associations, which pay their remuneration and the administrative expenses.

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authorities started to improve the infrastructure of the insurance industry during the mid-1990s. Early in 2000, significant progress had already been made, as reflected inter alia in a detailed disclosure regime for consumers (i.e. the Policyholder Protection Rules in accordance with the Long- and Short-term Insurance Acts). Financial advice and the intermediary services will be subjected to regulatory requirements soon (with the promulgation of the Financial Advisory and Intermediary Services Act expected later in 2001). Moreover, the development of the different codes of business conduct and ombudsmen procedures will become more and more important and could even become a statutory requirement.21 In fact, South African insurers today fulfil substantially 13 of the 17 core principles set by the International Association of Insurance Supervisors (IAIS)22, and partially fulfil the remaining four core principles. Most of the shortcomings are in the area of corporate governance, internal controls, transparency of reinsurance and conduct of business (i.e. investor protection). Likewise, major strides were made in the securities markets by 2000 to improve the financial infrastructure of markets. All exchanges are moving towards fully automated trading, clearing and settlement systems – ideally all seamlessly interconnected.23 The JSE is undergoing a major restructuring process, mainly aimed at improving listings requirements to ensure greater competitiveness with overseas bourses and better investor protection. This entails inter alia that listed companies should comply with generally accepted accounting practices, more disclosure and transparency, suitability standards for directors, a rise in the minimum public float, and a higher and longer profit history before listing will even 21

22

23

With the exception of the Pension Funds Adjudicator, none of the ombudsmen are “statutory”. They are all voluntary and at best there is a contractual obligation on the institution. In time to come it is likely that the various industry codes and adjudicators will run in tandem with the statutory codes of conduct and adjudicators. For detail of the principles see the IAIS’s Website at: http://www.iaisweb.org/framesets/pas.html Floor trading on the JSE was abolished in 1996 and eventually on the BESA in 1998.

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be considered. It is expected that the majority of these changes will be implemented on the JSE in October 2000. Of the 30 Core Principles of securities regulation set by IOSCO24, South Africa complied fully with 24 and partially with 6. Shortcomings were mainly in the area of investor protection, too much informal oversight, not enough enforcement powers, inadequate clearing and settlement systems, and issues related to financial fraud and money laundering. With the proclamation of the Financial Advisory and Intermediary Services Act, South Africa will fulfil all IOSCO’s Core Principles except for some specific measures against financial fraud, money laundering and clearing and settlement standards.

2.4 The expected regulatory regime in the 2000s Obviously the future is and will always remain unknown. Nonetheless an indication of possible future developments has to be given for regulatory planning purposes. Based on the projections given in Section 2.1 above, the socio-economic scenario a decade from today may be rather depressing. Of course, better socioeconomic conditions may materialise in reality, but regulators are by nature more interested in the downside potential. The power of “negative” thinking cannot be ignored in this context25. Accordingly, consideration must be given to an economic environment dominated by the impact of Aids, a lack of domestic savings, a high dependence on foreign capital flows, increased globalisation of local companies and even greater poverty among the uneducated part of the population. The optimal regulatory regime has to be designed against this background. Based on current trends in net capital formation, the supply of highly skilled labour and multi-factor productivity, the South African economy has an output growth potential of some 3 per cent per annum at best. This optimistic scenario assumes no impact 24

25

For details of the principles see IOSCO’s Website at: http://www.iosco.org/download/pdf/1998-objectives-eng.pdf Indeed, even luxury ocean-going sailing yachts, exclusively used for recreation, should be able to withstand gales.

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from Aids. However, if no affordable defence against, or cure for, Aids is found, sustainable GDP growth may be reduced to some 1,5% p.a. by 2005, implying that actual GDP could be some 10% lower in 2010 than it would have been without Aids. So, within a decade, the country may be faced not only with a marginal decline in its population, but also with stagnant economic output. Moreover, Aids will be expensive in terms of its opportunity costs. Medical expenses, lower productivity, sick leave, early retirement (but with insufficient retirement funds), and the expensive retraining of new staff (for relatively short periods) may result in a massive increase in bankruptcies among small companies that are by nature highly dependent on a few key persons. Moreover the social problem of a potential 2 million orphans will place a heavy burden on the government’s social expenditure budget. With more than a quarter of the South African workforce potentially affected by Aids by 2005, large companies are likely to soften the blow by greater automation. As domestic savings are already low, larger companies will have to rely increasingly on retained earnings to finance these investments. As the monetary authorities are inter alia responsible for systemic stability, the capital-adequacy rules for financial institutions and other infrastructural requirements will have to be reconsidered in the light of all this. To secure the foreign financing of domestic fixed investments, the authorities have to ensure that foreign creditors deal with local financial institutions that are sound and safe, despite all the potential macroeconomic setbacks. No doubt these prudential requirements will be harsh for South African financial institutions, but as the county is so dependent on foreign finance, the attitude overseas may be more or less along the lines of “beggars can’t be choosers”.

by falling into two broad categories – global financial conglomerates and specialised local financial institutions. In future the large South African banks are bound to become truly complex financial groups with a sharp international focus to their business. In South Africa, their main focus is the corporate and government sectors as well as relatively wealthy households, but the delivery of financial services to the poor and small business sectors may become an “unprofitable sideline” activity (i.e. mainly for socio-political reasons). With their corporate clients borrowing and investing around the globe, banking has become a 24 hour-aday business with major trading operations in the different time zones. Ultimately, these global banks will cluster in only a few financial centres like London and New York where they can source the important parts of their business – particularly their most skilled and highly priced employees. Business in Johannesburg may become no more than an important branch for such South African-owned global banks. For these institutions, national boundaries become increasingly unimportant, inter alia because it is becoming difficult to define a domestic market (as reflected in for instance remote trading26). Global banks will be under severe competitive pressures to reduce costs and thus try to eliminate cross-subsidisation wherever possible. By contrast, financial services to the poor in South Africa are likely to be supplied by more specialised financial institutions, such as core banks (see Section 3.13 below), mutual banks which specifically foster community banking and various types of savings cooperatives27. These institutions are very small compared to the few large global banks in South Africa, but have the advantage that they are in much 26

2.4.1 Financial institutions In a stagnant economic environment, the existing socio-economic dichotomy of South African society may increase even further in the years ahead. In fact, local financial institutions may follow a similar trend Financial Regulation in South Africa: Chapter 7

27

Commercially the distinction between “international” and “domestic” has disappeared. Only the regulators and the tax authorities still have to hold on to these concepts, as the state, in contrast to companies, is dependent upon the taxes it levies. These various legal entities, e.g. village financial services cooperatives, credit unions, microlenders, start-up venture capital providers and stokvels all operate on an effective exemption basis under the Banks Act, 1990 (rather than being legitimised by it).

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closer contact with their supporting communities28. Considering the type of lending they are involved in, their dependence on skilled personnel is far less critical than for complex financial groups. The challenges facing the banking industry in the years ahead seem twofold. Firstly, how to ensure that the financial sector remains systemically stable in an environment of rapid technological change and sharply increased competitive conditions. And secondly, how to ensure that banking services are delivered to the broad community which includes the poor. These challenges entail, in essence, two conflicting regulatory goals and accordingly different instruments would have to be used to address them simultaneously. In Section 3 below, three specific regulatory targets and regulatory instruments are proposed in this context: increasing global competition in the local financial markets (Section 3.1); the development of the commercial paper and corporate bond markets in South Africa (Section 3.5); and the establishment of core banks (Section 3.13). 2.4.2 Securities markets Since the securities markets are almost totally dominated by wholesale transactions, they are exposed even more than the banks and insurers to the influences of technology and globalisation. As technology improves, the competitive position of the securities markets becomes enhanced virtually automatically vis-à-vis the traditional financial intermediaries. And, as exchanges become more global in nature (typically starting with remote trading), the competition displays an increasingly international character. Already South African securities are traded simultaneously in Johannesburg, London, New York, Frankfurt and Zurich. The local bond market is a very liquid market with major

foreign participation. There is a potential, over the next few years, for new large markets to develop quickly in South Africa. These new markets in commercial paper, corporate bonds and securitised assets are bound to have a major impact on the financial system in general and the banking industry in particular (see Section 3.5 below). In future the government bond market may shrink somewhat owing to the proceeds from privatisation and greater fiscal discipline, but private enterprises (including banks) are expected to make increasing use of the securities markets. The end result of this type of enhanced competition from the securities markets will be lower interest margins and reduced loan business for banks. In fact, some of the undercapitalised banks in South Africa may be forced to look for assistance in the securitised asset markets, inter alia as a means to fulfil their capital adequacy requirements29. The South African securities markets will probably face a period of increased consolidation in the years ahead. This consolidation process is an international phenomenon and it is unlikely that South Africa can distance itself from it. Consolidation in the securities markets is driven by factors such as the following: • Consolidation processes in the United States and particularly in the European Union (with the euro creating new financial markets) are bound to have major side-effects in South Africa. • Deregulation and freer trade are helping to consolidate international firms into a handful of international financial centres. • Technology, particularly in clearing and settlement systems, will support economies of scale and thus the consolidation of various exchange activities. • The tendency of capital to look for low costs, highquality skills and lenient regulation, results in the

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A close tie with the local community is extremely important in the South African context because the government cannot always ensure law and order in the townships and rural areas. As a result, the large banks have hesitated to lend in these areas as the operational risks were considered simply too great.

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If a bank is undercapitalised and its shareholders are unwilling to support it in a rights issue, one alternative for the bank would be to securitise part of its assets (usually mortgage loans and instalment credits) and so reduce the size of its asset book in line with its available capital.

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consolidation of finance into a few financial centres with international efficiency30. • The international wave of mergers in finance is shaking up entrenched businesses. These mergers are, as a rule, across borders, as securities firms, banks and fund managers build their global businesses. • To improve their risk-management systems, particularly operational risks and thus human resource management31, there is a strong pull towards centralisation in a firm. • The financial industry likes to cluster because clusters create innovative – and therefore competitive – businesses32. There is little doubt that the securities markets in South Africa will become even more international in the years ahead. Similar to the banks that have already established major treasury operations in their overseas branches, the securities markets (exchanges) may start to reallocate part (or even all) of their operations abroad. Such a development would imply that all securities traders in the local market could become remote traders. An international trading platform for the South African securities markets would have a number of powerful advantages. These are for example: the full integration of local operations with the international capital markets; strongly capitalised institutional traders; access to a large pool of highly skilled labour and expertise; and a level playing field between local and overseas brokers. Liquidity, the Achilles heel of the securities markets, will be further enhanced if the traditional exchanges 30

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Around the world no self-respecting politician lacks plans to turn his/her city into a capital of finance. For most cities this is simply a pipe dream. Drawbacks in South Africa are, for instance, that the country is not a net exporter of capital and is a long distance from industrialised countries. Anyhow, the promotion of a financial centre is not a regulatory task, but primarily a responsibility of the central bank. Major losses have occurred in the past because human management was too dispersed (e.g. Barings, UBS, NatWest and Daiwa). Of course, a “rough neighbourhood” will chase the muses away. And without the arts (particularly artful business lunches), the skilled staff of the banking industry cannot be truly happy. A financial centre simply cannot blossom on a “sports” culture.

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could be broken down into three separate (but seamlessly connected) operations: (i) execution; (ii) clearing and risk management; and (iii) settlement and delivery systems. In essence, an exchange proper only trades in information. Accordingly the execution of trades could be conducted in future on many different platforms simultaneously. Execution specialists could be the traditional exchanges (or various competing exchanges), Internet exchanges, or any other form of electronic community network (ECNs). The clearing and risk-management operations of a market could well, in future, be taken over by the large primary dealers, such as J.P. Morgan, Merrill Lynch, Morgan Stanley and ABN AMRO. These firms have first-class trading names internationally, extensive capital resources and expertise. The clearing-house for South African securities could, in such a scenario, become part of an international clearing system such as Euroclear (which is operated by J.P. Morgan). In future the execution of securities trades could well be performed on various platforms, predominantly from abroad. Clearing could be carried out domestically by a large international specialist in this field. Traders would have a choice of more than one of these clearing systems33 as they would be compatible. Because separately operating clearing and riskmanagement systems can simultaneously deal effectively with many different execution channels, competition in trade as well as cross-market risk management will improve. Such systems also allow for better netting of trading positions, both in the spot and derivative markets. Finally, the settlement and delivery system (including a central depository) could be operated as a separate local activity, although it could be provided by the same institutions running the clearing systems (as already happens with Euroclear). If South African securities markets develop roughly along the abovementioned lines, the local market could well split into two tiers. The first tier would consist of blue-chip multinationals that are likely to have their 33

In the international securities markets there is, for example, the choice between Euroclear, Clearstream and Clearnet.

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primary listings on the London Stock Exchange and their secondary listings on the JSE. Their internal governance and prudential standards would be world class and accordingly have immediate access to the international capital markets and no exchange controls. The foreign home regulators would do the regulation of these companies, while South Africa would become in essence a host regulator. The South African National Treasury could also be part of this first-tier market. It is in the government’s interest to have a notable slice of its bonds listed abroad (i.e. either as eurorand bonds or international bonds). The reasons for an overseas presence by the Treasury are the familiar ones, such as enhancing liquidity standby facilities, securing capital inflows or simply raising the government’s profile abroad. Already commodities and currencies are trading around the globe, so it is probably only a matter of time before bonds and equities will do likewise. The basic problem seems to be that global capitalism is not matched by a “global society”. The second tier in the securities market would consist mainly of local companies, with local clients and local personnel. The local authorities would be the home regulator for this market segment. The standards for this second-tier market may be close to but not necessarily the same as those of the first tier, because of some country specifics. As the top 25 companies on the main board of the JSE account for some 80 per cent of market turnover, the second-tier market will be relatively small in turnover and therefore less profitable for broking firms. Today, the exchanges in the major financial centres cross borders with ease. This in turn results in sharply increased competition and remote trading. The exchanges are under huge pressure to reduce costs and to consolidate in strategic critical areas so that they stay competitive. To facilitate this transformation, exchanges are changing their ownership structures from mutual to shareholder-owned organisations. An exchange owned by shareholders, rather than its trading members, has the advantage that it avoids conflicts of interest, which in turn enhances quicker and cleaner decision making. Once this change in 166

ownership structure is complete, the exchanges look critically at their execution, clearing and settlement structures. These fundamental functions in turn can be consolidated or split off. For instance, clearing and risk management can be consolidated with other exchanges (e.g. embracing both spot and derivative exchanges) or cross-border (e.g. consolidating local and foreign clearing systems), and execution functions can be placed on a highly competitive basis (e.g. traditional broking vis-à-vis electronic broking channels). To date, international experience indicates that alliances between exchanges are more popular than full-scale mergers. Although the ultimate aim of the exchanges may be to create a “virtually integrated market”, a “network of networks” seems, for the time being, to be more probable than such a single integrated network. In short, the immediate aim is a large expansion of remote trading. No doubt, from a regulatory perspective, the securities markets will become a major focus point in future, not only because of the expected dynamic growth in this market segment, but primarily because the new and changing aspects require the regulatory framework to keep pace. In summary, some of the issues that the regulators have to address are the following: • Commercial paper and corporate bond markets: The development of these markets seems only a matter of time, and South Africa clearly lags behind international trends here. How are the regulators to support these developments without compromising consumer protection goals? • Securitised asset markets: Seen from an international perspective, like the commercial paper market, this market is grossly underdeveloped in South Africa. One of the reasons might be that the underlying regulation is still dominated too much by banking legislation. • Clearing and settlement systems: Particularly worrying here are the outdated settlement systems of the JSE. Globalisation of the execution activities in the equity market (either the JSE or a new competitive exchange) are a possibility. Financial Regulation in South Africa: Chapter 7

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Remote trading and foreign competition: Electronic trading is bound to change the structure of the local securities markets fundamentally. The key issue for the regulators is the impact of remote trading on systemic risk management. The regulatory example for the authorities could be the foreign-exchange markets, where the market itself is free of regulation, but not its participants34. Competition from e-exchanges: Although it is still early days, the regulators have to now consider carefully the possible consequences of the execution of trades through inter alia the Internet. Liquidity management and systemic support: As the securities markets grow in size, their importance in systemic risk management growths proportionally. The authorities face here the fundamental question of under what conditions they are willing to support these markets during a liquidity crunch.35 Circuit breakers and super-regulation: The superregulation of markets becomes of crucial importance if one market stops trading36 and other markets continue trading in similar instruments or their derivatives. Should the authorities impose circuit breakers on exchanges? And, if so, should these circuit breakers be applied automatically to other exchanges as well (local and abroad) in times of a liquidity crisis? The current trend is for exchanges to move away from the use of circuit breakers. Cross-market risk management and netting: Typically, the questions faced here by the regulators are whether effective cross-market risk can be managed properly if every exchange manages in isolation only the risk exposures of its own members, or whether trading positions in different exchanges may be netted for prudential requirements.

In the foreign-exchange markets, brokers use one another’s systems (e.g. Reuters), trade at the same price and exchange the same legal contracts. In fact, during crisis management, the authorities are always confronted with the trade-off between the provision of liquidity and the implied moral hazard. For whatever reason: e.g. computer failure or a liquidity crisis.

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Supervisory structures: Currently the capital adequacy of banks is supervised by the SA Reserve Bank, whereas that of brokers by the exchanges (predominately the JSE) themselves. The regulators have to consider whether it is better, from both a competitive and prudential viewpoint, to supervise the prudential requirements of all securities firms (i.e. exchange members as well as OTC firms) centrally using systems similar to Euroclear. How the authorities decide to deal with each of the above issues will have a major impact on the competitive position of the South African securities markets during the next decade. Clearly, the securities regulators face “interesting times”.

2.4.3 Financial infrastructure In recent years, major progress has been made with improving the infrastructure of the South African financial system. However, it is unlikely that the speed of change will slacken in the years to come. In order to support the three pillars of the financial system (i.e. institutions, markets and infrastructure), three sets of incentive systems (i.e. internal governance, supervision and market discipline) have to be developed rapidly. These incentive systems have both a private and a public-sector dimension. Private-sector incentive arrangements • Corporate governance rules: As a matter of urgency South Africa’s corporate governance rules have to be adjusted to best international standards. • Accounting and audit rules: Generally accepted accounting rules have to be made compulsory for the financial reporting of any company in order to enhance transparency. The Companies Act requires an urgent amendment in this respect. Likewise, audit rules have to be improved to international best standards, particularly for global financial conglomerates. • Disclosure and transparency: Many adjustments have been made in this area since the mid1990s, but there is still plenty of scope for providing better information to the financial press. An example would be far more useful 167

information on competitive structures and investors’ support profiles. • Market monitoring and discipline: As the securities markets become increasingly placed in a competitive position, it becomes easier for the market to monitor and discipline traders and financial intermediaries. The authorities have to support this market process wherever possible and generally give the markets greater responsibilities. • Private-sector ratings: The authorities, for prudential requirements, have to recognise more explicitly the ratings of private-sector agencies, particularly their ratings of financial institutions and securities market instruments. • Capital-adequacy rules and value-at-risk systems: Although the authorities stipulate an absolute minimum capital standard based on risk-weighted assets, they should encourage the use of in-house value-at-risk systems in financial institutions, as such systems explicitly take the inter-relationships of portfolio compositions into consideration. Public-sector incentive arrangements • Supervision of complex groups: A draft Financial Conglomerates Review Bill has been drawn up by the FSB, but much work has still to be done on this topic. This situation exists despite the fact that the nation’s largest insurer (the Old Mutual Group) already operates as a large global financial conglomerate from the UK. • Competitive neutrality vis-à-vis global financial conglomerates: From an internationally competitive perspective it is crucial that the authorities ensure a level playing field by reconsidering, for instance, their transaction taxes on securities trade. • Home and host regulatory arrangements: The regulation of complex groups implies a far greater degree of co-operation between home and host regulators than is currently the case. • Super-regulatory agency: Ideally the supervisory structure follows the structure of the supervised institution. Accordingly, complex groups have to be supervised by a multidisciplinary agency or 168

arrangement (i.e. embracing both banking and insurance specialists). Moreover, such a supervisory team may consist of home and host regulators. Research on this issue has only just commenced in South Africa. • Safety net arrangements: Deposit insurance, and its link with the lender-of-last-resort facilities of the central bank, is currently under investigation in South Africa, and the implementation of new policies may have a major impact in years to come. • Financial stability policy: In 2000 a Financial Stability Unit was established at the SA Reserve Bank to address all questions of a systemic nature. Much work has still to be done in this area. • Co-operation between non-bank supervisors and the central bank: As the public sector lacks the discipline of the profit motive, it is far more difficult to ensure co-operation than in the private sector. A Memorandum of Understanding has been drafted between the FSB and the Registrar of Banks to ensure effectiveness and efficiency, but more detailed work still needs to be done. • Financial fraud and money-laundering control systems: The government has still to decide whether the SA Reserve Bank or the National Treasury is going to undertake this regulatory responsibility. • Exchange controls: Considering that there are an estimated R20 billion in blocked rands still outstanding and a mismatched forward currency book of some US$10 billion, exchange controls cannot be lifted immediately in a Big Bang fashion. Nonetheless, internationally competitive forces make it essential to remove this constraint as soon as possible. • Regulatory accountability: In the end any sensible accountability of the authorities can only be ensured if a regulatory audit agency is established by Parliament. Nothing has yet been done in this respect in South Africa. From the issues stated above it is clear that the South African regulatory agencies confront a challenging agenda for the next decade. Time is clearly not on their Financial Regulation in South Africa: Chapter 7

side. In fact there is a distinct danger that a regulatory failure may badly affect South Africa’s competitive position in years to come.

3. Regulatory targets and gaps The essence of regulatory targets is that they can be quantified, i.e. targets can either be hit or missed. The authorities should be able to state – i.e. after a specified time period – whether they were successful in the stipulation or establishment of, say, minimum standards, or whether their support of or encouragement for specific private-sector initiatives did bear fruit. A regulatory gap37 is likewise quantifiable, but of course avoided wherever possible. This section summarises the various regulatory targets that support the regulatory intermediate goals as identified in Chapter 2. Most of these targets are refinements of existing regulatory instruments, i.e. by improving their regulatory instruments the authorities hope to better target their intermediate goals (see Chapter 4). The various intermediate goals are addressed in the same order as they appear in Table 4.1 (see Chapter 4). Accordingly, Sections 3.1 to 3.6 below aim at supporting the objective of systemic stability; Sections 3.7 to 3.9 focus on institutional safety and soundness objective, while Sections 3.10 to 3.15 support the objective of fairness and consumer protection. The approach in this section is along the following lines: to begin with, a short overview is given of the issues at stake for each intermediate goal, and thereafter the specific regulatory targets are identified38.

3.1 Competitive market infrastructure The South African financial sector has a great concentration of economic power. In terms of value 37

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Often these gaps result from regulatory failure – either in regulatory structure or plain mismanagement. Once the major targets are identified, they could be grouped in a number of similar classes and be handed over to specific task groups for investigation and execution. The successful attainment of targets could imply that these targets would be dropped from the list of future targets. However, this is unlikely in practice, as targets are hardly ever completely finished (e.g. fulfilling minimum accounting standards is a moving target as these standards themselves change over time).

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added, the four largest banks represent some 75 per cent of all the industry’s business, while the four largest assurers have a 65 per cent market share. Likewise, securities trading on the financial exchanges is dominated by about five large (mainly foreign) companies. Limited competition is one of the reasons for this state of affairs. For instance, the existing statutory limitation that foreign banks may not accept from the general public deposits of less than R1 million rand excludes them effectively from the retail market, while the stipulation that foreign insurers have to establish a local subsidiary (rather than a branch) to write insurance has severely limited foreign competition. Likewise, the dominant position of foreign primary dealers in local securities trading is primarily a direct result of South Africa’s dependence on foreign capital inflows as well as too protective a regulatory policy on undercapitalised stockbrokers for too long39. In-house rules may also limit competition. The members of the JSE for example cannot easily start a competing local exchange as they are only allowed to hold membership of BESA and SAFEX within South Africa. To ensure that the South African financial industry can perform satisfactorily in the long term – i.e. under the pressures of globalisation, liberalisation, financial innovation and deregulation – the authorities have to create a competitively neutral environment between local and foreign financial services providers. The authorities themselves cannot actively guide the financial industry in the new world of, for instance, e-money, e-commerce and electronic broking (whose services are directly available through any computer linked to the Internet). Technology continuously lowers the barriers of entry and distance. Internationally networked computers distribute information with great speed that undermines traditional local operations. These technological developments are bound to change the competitive conditions fundamentally in South Africa, and at best the authorities can assure that the 39

Clearly, the Big Bang on the JSE should have occurred far earlier than 1995.

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most efficient players in the local market win in this game. As a “referee” the authorities should be concerned with the “rules of the game”, rather than whether a local or foreign player wins in this game. The regulator should be concerned primarily with the risk exposures of firms (e.g. sufficient capital and management skills), irrespective of whether these resources are financed by local or foreign investors. In short, in an increasingly globalised industry, it is neither effective nor cost-efficient to behave in a protective nationalistic manner. In order to increase competition in the local banking industry, the South African authorities could conduct an investigation similar to that of the Cruickshank Commission in the UK, whose final report became available in March 2000. This Commission found that British banks: (i) were making monopolistic (cartel) profits from the payments system; (ii) were too often allowed to write their own rules in the name of systemic soundness; (iii) were granting too few loans to small businesses (because of local monopolistic powers, but also because the entrepreneur lacked the necessary risk capital to support the bank loan and the government failed in its “loan guarantee” programme); and (iv) were not supplying sufficient useful information to consumers. Moreover, the Commission recommended that a core banking account should be made available to the public by the government, which should call for tenders from the banks to provide that service on behalf of the government. Considering that the South African banking industry is more concentrated than the British industry and less subject to international competition, it would be beneficial if these same issues were scrutinised in the local market. To promote a competitive market infrastructure in future, the South African authorities could focus on the following regulatory targets: • Establish a payments system open to all financial institutions: The authorities should license access to the payments system and remove unnecessary entry barriers and any uncompetitive practices between banks40. Obviously opening the payments system should not result in more settlement risk, 170

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and competition has to take place on a level playing field (i.e. in terms of capital requirements, settlement accounts with the central bank and cash reserves). In addition, new entrants should share, on a fair basis, the costs of the infrastructure that supports the existing payments system. Promote competitive trading, clearing and settlement systems: Without effective and efficient operational systems, systemic risk management is seriously impaired. Promote competitive listing requirements: Unless local listing requirements meet minimum international standards, local companies may find it difficult to obtain international finance. Stipulate minimum infrastructural standards: Corporate governance, accounting, audit, transparency and disclosure rules are of particular importance in addressing major operational risks. Establish interrelated and competitive markets: Financial engineering enforces a close interrelationship between new and different markets, which in turn improves efficient pricing and thus competitive market conditions. Establish regulatory neutrality towards foreign participants: Only through foreign competition can the authorities combat possible local cartel structures in finance and ensure that the industry remains globally efficient. Foreign competition encourages domestic banking practices to approach international best standards.

3.2 Acceptable maturity and currency mismatches Systemic risk management emphasises that the maturity mismatches of loans and currencies should be “acceptable” for both companies and the nation at large. In financial firms their in-house value-at-risk models ultimately check these maturity mismatches. The greater the risk taken, the higher the resulting 40

This step is not simplistic and may have consequences for the availability and distribution of money, the accommodation policy, the lender-of-last-resort function and the SA Reserve Bank’s regulatory responsibilities for the payment system.

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capital adequacy requirements. However, the government does not subject itself to such prudential requirements, which creates serious problems at times (e.g. Russia, 1998). Once currency and maturity mismatches have built up, particularly relative to long-term debt, they become very difficult to resolve. The Asian crises in the late 1990s emphasised this point. Asian banks were financing their lending with short-term (often call) deposits, and preferred rolling over their short-term loans (permitting market liquidity and corporate creditworthiness). As Asian corporates had no access to long-term financing in the domestic markets, they turned to the international markets with the resulting currency-risk exposures. As this borrowing was done on an uncovered basis, major currency risks soon built up. A hardening in macroeconomic policy brought this house of cards down eventually. The solution to this type of dilemma lies in the development of a long-term debt market in the local currency. By its nature this is a time-consuming exercise. South Africa withstood the Asian crisis relatively well, mainly owing to the quality of its financial regulation and supervision. Nonetheless, inherent problems are easy to spot in the South African currency book. To obtain long-term foreign capital during the lengthy episode of political and financial isolation, the South African government aggressively supported any foreign borrowings of local companies by granting forward cover at subsidised costs until the late 1980s41. Owing to this long historical legacy of massive crosssubsidisation, South Africa is today saddled with a poorly structured currency book. Repositioning this book will take many years, as the government will have to buy foreign currency during periods of rand strength and then use these proceeds to reduce the forward oversold position of some US$10 billion. Accordingly, the rand will remain an inherently weak

currency at least until the forward book is more balanced, and ideally handed over to the private sector. To promote a better-structured loan and currency book in the years to come, the South African authorities could focus on the following regulatory targets: • Promote accurate value-at-risk systems: Without VaR modelling techniques it is impossible for the authorities to define “acceptable” mismatches. • Promote the management of the forward currency book by the private sector: On the basis of principle, the government (i.e. in practice the central bank) should not be responsible for the dayto-day running of this exposure and it should be handed over to the private sector as soon as possible. • Promote prudent debt-management systems in the public sector: In order to promote an active bond market and to avoid the build-up of systemic pressures, the government should ensure that its public debt is managed professionally42.

3.3 Acceptable cross-market exposures Cross-market exposures are still poorly regulated in South Africa. If trade on one exchange halts for whatever reason, it is still unclear how other exchanges would react to this. Co-operation among the exchanges is difficult to enforce in view of their underlying competitive nature. South Africa does not apply circuit breakers on exchanges43 and accordingly these mechanisms are not integrated into the overall risk-management systems of markets. A fundamental problem may be the existing structure of local exchanges which do execution, clearing and settlement on an integrated basis per exchange, rather than breaking these functions up and integrating the clearing and settlement functions across exchanges. Today the spot and derivative markets have become

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In the past, foreign borrowing has tended to be sporadic and ad hoc, with confused roles between the private and public sectors. Government should consider a regular programme of foreign borrowing and the establishment of a reliable market for South African paper in the international markets.

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43

For example, one of the EU fiscal yardsticks is that the government debt/GDP ratio should not exceed 60 per cent. Whether such circuit breakers are desirable in the South African context is a different question. Preliminary investigations, carried out by Quant Financial Research, seem to indicate that such structures are undesirable.

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so intertwined, that the risk management thereof is probably best performed by one entity rather than having this function split among different exchanges. To enhance competition between exchanges and to face the expected competition from e-exchanges (which are likely to be outside South Africa’s jurisdiction), it is probably better that the local exchanges should start concentrating solely on their execution functions. Such a structure implies that the risk management, clearing and settlement systems would be left to more specialised and better capitalised institutions. To support the intermediate goal of better crossmarket risk management, the following regulatory targets can be identified: • Establish cross-market risk management, clearing and settlement facilities: Without such facilities major risk exposures can fall into the cracks between the various markets. • Establish legally binding netting agreements between markets: Risk management requires offsetting positions in different markets to be fully taken into consideration in the overall risk assessment. Ideally all markets could use the same legal contracts for netting purposes.

3.4 Sufficient market liquidity Liquidity in the securities markets usually ebbs and flows with the movements of the business cycle. Liquidity-enhancing instruments are fundamental to securities markets. For instance, one of the reasons that futures contracts were developed alongside forward contracts was their liquidity-enhancing qualities. Likewise, dual-capacity trading is encouraged on exchanges to support the liquidity-enhancing qualities of well-capitalised market makers. The large international investment banks usually perform the function of market makers and they prefer to operate on the large exchanges in the international centres. In any case, large exchanges attract more liquidity than small exchanges. The more liquid the market, the less the “impact” cost of conducting large trades. Investors avoid small exchanges as they have small trading volumes and therefore prices may move against them 172

when they make big trades. This is the fundamental reason for the monopolistic nature of exchanges: trading always gravitates to whichever market has the biggest share of liquidity in a specific security. And it is inter alia for this fundamental reason that competition among exchanges has to be promoted wherever possible by the authorities, as only competition can ensure the lowest costs to the consumer. South African markets are competing with foreign exchanges for liquidity. For locally traded securities this competition can be faced without any great difficulties, but for South Africa’s large multinational companies this competition is fierce. As noted earlier, fund managers (and particularly foreign fund managers) go to the market with the least impact cost, and if that market is found on the London Stock Exchange, the JSE will fight a losing battle to compete, at least for its most liquid internationally quoted shares. Beside impact cost arguments, a financial centre’s attractiveness depends crucially on the tax regime. Withholding taxes or transaction taxes imposed unilaterally by the government can result in a massive shift in funds, and can even cause the demise of a financial centre. The conditions under which the authorities are expected to assist the securities markets during a liquidity crunch have become, recently, a hot topic among the monetary authorities. The tendency seems to be towards less support by the authorities and more reliance on the market mechanism to detect in good time any drainage of market liquidity.44 To promote liquid markets as an intermediate goal, the South African authorities could focus on the following regulatory targets: • Establish a financial stability unit at the central bank:45 Such a unit should monitor liquidity conditions particularly in the securities markets as 44

45

For instance during the crisis around Long Term Capital Management in 1998, the US Federal Reserve arranged a privatesector rescue package rather than easing its monetary policy stance. At this time (August 2000) this unit is in the process of being implemented.

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any crunch here quickly flows over to the banking sector and the foreign-exchange markets. • Formalise the standby facilities of the central bank: The financial markets need, at times, assistance from the monetary authorities, and the basis of such assistance has to be published ex ante in great detail46. • Remove (tax) constraints on market turnover: To maintain a level playing field internationally and improve the attractiveness of local markets, the tax authorities should think twice before imposing transaction taxes and stamp duties on the securities trade. Currently the JSE is subjected to a 0,25 per cent transaction tax (i.e. the Marketable Securities Tax), which, for instance, does not apply in the UK. To avoid paying this indirect tax, foreign investors would obviously prefer the London market. Moreover, bankers’ acceptances, fixed-rate deposits and promissory notes attract stamp duty of 0,05 per cent and listed instruments a duty of 0,25 per cent. These tax differentials between nations and local markets create price distortions between closely integrated markets and drain liquidity from the local markets. • Promote foreign participation in local markets: Only the large foreign investment banks and fund managers have the capital resources and the expertise to support liquidity in the local markets on a daily basis. With the increased globalisation of finance, it is probably a better regulatory strategy to take foreign competition kindly by the arm, than to challenge it permanently on all fronts.

3.5 Securities markets as an alternative to financial intermediation47 Securitisation – i.e. the process that turns loans into tradable securities – has the major advantage that it removes the need for borrowers to stay close to 46

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See for instance: Bank Supervision Department, Annual Report, Pretoria: The South African Reserve Bank, 1999, pp. 4–19. Currently the external funds provided to non-financial businesses in South Africa are comprised roughly as follows: 46% bank loans, 32% equity, 18% bonds and 4% other sources.

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lenders. In contrast to banks, bond lenders rely on credit-rating agencies to rate the securities in terms of the borrowers’ creditworthiness. Usually the lenders’ exposure to one specific private borrower in the securities markets is small, as their assets are spread much wider than bank loans. Moreover, lenders in the securitised asset markets have tradable paper that makes their ability to adjust their risks easier, which in turn lowers the cost of borrowing. Current legislation in South Africa in respect of securitisation is still influenced by banking legislation, but over time these constraints are likely to be lifted. Once this occurs the securities markets will rapidly grow and become a major competitor to the banking industry. Although access to credit can always be improved, generally banks have advanced extensive credit to small, medium and micro-enterprises (SMMEs), provided these enterprises were adequately capitalised and had the necessary managerial skills. The basic problems in South Africa’s microlending industry are the inadequate capitalisation of these businesses and the high risks attached to the granting of this type of venture capital. The demand for credit is aggravated by the fact that unemployment is running at excessively high levels and that the credit institutions were unable to provide risk capital at the bottom end of this market on a sustainable basis. In essence, these loans cannot be made part of the normal commercial and prudential activities of the banks. Perhaps in the years ahead, more venture capital, even for small and micro-enterprises, could be funded – at least partially – through the securities markets. When it comes to the granting of credit the securities markets can compete effectively with banks, and they may be even more cost-efficient in this higher risk area. Anyway, the supply of credit is not exclusive to banking. Many institutions (both financial and non-financial) grant credit. The needed investment funds for SMMEs (or housing finance for that matter) can in principle be generated through the securities markets on a competitive basis vis-à-vis the banks. The advantages of this type of funding are the following: 173

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In contrast to banks, securities markets cannot become insolvent but only illiquid. As a result they are able to accept more market risk than banks. Historically the financing of risky business always took place primarily in the capital markets (i.e. equities or bonds)48. • Direct financing through securities markets implies a direct knowledge link between ultimate lenders and SMME funds. Accordingly investors can have a direct say in how their investments are to be utilised. • The rating of SMME funds, i.e. in terms of the quality of their paper, can be done by private rating agencies and the investing public can select funds according to their desired risk profile. • By stipulating that SMME bonds should be traded on a regulated investment exchange (e.g. the BESA), standard investor safety features can be secured. • By making SMME bonds negotiable, investors can obtain a relatively liquid investment instrument that directly reflects the markets’ sentiment and in turn disciplines the lending operations of SMME funds. • Foreign development agencies, trade unions, local communities, etc. may be more inclined to invest directly in socially acceptable projects. • By increasing the competition between banks and securities markets, prices for debt are likely to reflect better relative scarcity. • From the viewpoint of systemic stability the strength of the financial system is improved if the securities markets are comparable in size to financial institutions. However, there are a number of disadvantages to this approach. Financing SMMEs partially through the securities markets will have the natural setbacks of any instrument traded in these markets, such as: • The market for SMME bonds may lack sufficient 48

Indeed, wars can be financed by selling war bonds, but not by demanding war deposits! The upliftment of the poor in South Africa is no less a battle than a major war, in terms of effort and dedication.

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liquidity because the investing public shows too little interest. • The yield on SMME bonds may fluctuate too sharply during periods of financial instability. • Financing through the securities markets requires a higher degree of financial sophistication on the part of investors than a plain bank deposit. • Particularly if the investing public is uneducated, disclosure rules and a critical financial press are of crucial importance. However, all these disadvantages are not of a principle nature and the authorities can address them by promoting the securities markets in general. Accordingly, to support the intermediate goal of promoting the securities markets as an alternative to financial intermediation, the following regulatory targets can be identified: • Remove constraints on commercial paper and corporate bond issues from the Banks Act: The authorities can only consider this step after pending legislation to improve consumer protection has been passed by Parliament. • Promote the engineering and implementation of an SMME bond instrument: This instrument should be designed and developed by the private sector, but its initiation, development and the establishment of a market need to be supported actively by the authorities.

3.6 Regulatory effectiveness, efficiency and economy The UK is an example of a country where the quality of regulation is one of the major strengths of its financial system. For instance, wholesale business in the UK is leniently regulated to ensure international competitiveness, but retail business is tightly controlled in order to protect the British consumer. By contrast, the Securities and Exchange Commission (SEC) in the US does not differentiate as efficiently and effectively as the UK between wholesale and retail business, which in turn so easily results in the over-regulation of wholesale markets. In fact, the undifferentiated regime in the Financial Regulation in South Africa: Chapter 7

US is one of the reasons that their major investment banks49 operate largely from the UK. As trading in foreign markets becomes increasingly indistinguishable from domestic trading, the competition between regulatory agencies heats up correspondingly. Although South Africa is still somewhat isolated in this respect, it is unlikely to stay in this position for much longer because its top companies are rapidly diversifying abroad. Some of South Africa’s blue chip companies have already obtained primary listings in the UK recently, and the JSE struggles to remain competitive with the London market in terms of its ability to raise financial and human capital more cheaply. Exchange controls and the location of corporate head offices in “rough neighbourhoods” are other hinderances for South African companies with major foreign operations. During the period 1998–2000 the JSE lost about a third of its primary listing market capitalisation (i.e. if companies with secondary listings are excluded from the JSE market capitalisation). Although the JSE is obviously not pleased to see its best equity counters listed on competitive exchanges, there is ultimately not that much that the JSE, or the government, can do about it. Indeed, any South African company with major interests abroad could split off its foreign operations in a separate company abroad, if permission to list abroad were to be withheld by the National Treasury. To avoid competition in regulatory laxity (i.e. the “dive to the bottom” in regulation), two different approaches have been developed in the European Union. The first device is “harmonisation” in terms of which national regulators adhere to certain minimum standards, and the second device is the “mutual recognition” of one another’s regulatory regimes (and their differences). This mutual recognition results, in turn, in concepts such as the “single passport”, “home”

and “host” regulators, and “remote trading” regimes. The single passport implies that any financial institution can deliver its services throughout the EU without incurring regulation from different jurisdictions. The home regulator keeps an eye on the soundness of, say, a bank, while the host regulator is concerned with the bank’s business practices. Host regulators must recognise the competence of home regulators in the EU. Remote trading is an extension of the home versus host regulatory regime. Again the home country regulates the remote trader, while the host country must allow remote electronic foreign participation on its exchanges. Outside the EU the host country can of course refuse to recognise the home country as the prudential regulator, but this becomes difficult if the home country is the US, France, Germany or the UK which have sound financial systems 50. Accordingly, internationally, the tendency is increasingly to deregulate the exchanges in full (and thus to regulate them more or less like the OTC markets) and instead to concentrate more on institutions such as banks, securities firms and fund managers. The argument is that with the development of professional fund management firms, the need to protect the retail client on the stock exchange has largely fallen away. Nonetheless the inherent danger of such a development is that the equity markets may split into a first tier of blue chip companies and a second tier of low-capitalised companies. These smaller companies would struggle more to generate capital on such “formalised OTC” stock markets. To support the intermediate goal of regulatory effectiveness, efficiency and economy the following regulatory targets can be identified: • Establish co-ordination agreements among 50

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The large US investment banks, e.g. Merrill Lynch, Goldman Sachs and P.J. Morgan, already operate as truly international companies, rather than US firms. Positioning their head offices in London rather than New York would not be a big issue of principle (except for tax reasons).

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One way to deal with the issue of the quality of the home regulator is to subject the national regulators and supervisors to a rating procedure. For instance, host regulators could be asked to compile a checklist on how they determine the competence of home supervisors. The BIS has already formally declined to be involved in such a rating process, but the IMF may still decide to do so.

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domestic regulatory agencies: unless such agreements are in place, the authorities may be confronted with regulatory gaps in the supervision of complex financial groups. Establish harmonisation agreements between home and host regulators: without harmonisation in this area it would be difficult to effectively supervise global financial conglomerates and hedge funds in offshore financial centres. Stipulate regulatory cost-benefit analysis: the danger of over-regulation can only effectively be addressed if the authorities do detailed cost-benefit analyses. Establish a regulatory audit agency: such an agency would go a long way towards ensuring that appropriate accountability takes place on the part of the regulators. In most countries, parliamentary scrutiny and accountability require more attention: i.e. the select parliamentary committees have not reached their full potential yet. Establish ratings of national regulatory agencies: international bodies, like the IMF or the World Bank, could perform this task.

3.7 Proper risk assessment The major risk components of a financial firm are market risk, credit risk, liquidity risk, counterparty risk and operational risk. The aim of the new capital-adequacy regime of the Basel Committee is to back all these risks with sufficient capital by 2001. The original Basel capital accord of 1988 mainly addressed counterparty risk, and was aimed primarily at: stopping the sharp fall in the capital adequacy of internationally active banks; reducing the competitive inequalities among countries; and establishing minimum standards (though this minimum soon became a universal standard). In 1995 the capital agreement was extended to include market risk. The proposed new capital accord tries to addresses all the other risk exposures of banks in greater detail. To evaluate credit risk, two approaches are proposed by the Basel Committee: a standardised approach that 176

is reliant on external ratings51 or an internal ratings approach for qualifying banks.52 Obviously the industry believes that internal ratings offer the right way forward (as bankers think they know their own business better than agencies). Banks hope that portfolio credit-risk models, which promise a more accurate estimation of credit risk than the standardised approach, will soon be acceptable for regulatory capital purposes. There are however two major hurdles to be overcome: data limitations and the lack of credible back testing. Over the medium term these issues will, no doubt, be addressed as better default and loss data are accumulated. A more serious problem over the long term is the absolute level of capital required for banks. Rewarding good risk management and a more differentiated calibration of credit risks are likely to result in an absolute decrease in the overall level of regulatory capital in the banking system. The Basel Committee thinks that this is undesirable, it would rather see the capital standard raised to 10 or even 12 per cent of risk-weighted assets.53 Regulators want to factor in something – in their minds if not in their models – for the unexpected. The justification for an arbitrary minimum capital requirement emanates directly from this need to cover the unexpected. Accordingly, they propose an explicit charge for other banking risks that at the moment are taken into account only implicitly, particularly interest rate risk arising from the banking 51 52

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By credit rating agencies such as Standard & Poor’s or Moody’s. However, both these methods rely on the opinions of parties who may have an incentive to underestimate that risk exposure. By contrast, the advantage of the prescription of subordinated debt as a form of regulatory bank capital would be that these opinions are replaced by market forces and thus a reliance on private agents’ behaviour. The potential use of subordinated debt is to bring market forces to bear on the operations of large financial institutions and to protect the deposit-insurance funds. See Evanoff, D.D. and L.D. Wall, “Subordinated debt as bank capital: a proposal for regulatory reform”, in Economic Perspectives, Federal Reserve Bank of Chicago, second quarter 2000, pp. 40–53. The current minimum capital requirement for large internationally active banks of 8 per cent of risk-weighted assets may be too low for South African retail banks, which are relatively small and operate primarily in a developing country environment.

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book, and operational risk such as computer-related or legal risk. However, the industry has many concerns about such “add-ons”. Moreover, it is still not clear how the internal rating approach could be made comparable across countries that have different banking legacies as well as different bankruptcy and accounting regimes. To ensure that the new capital regime does not give a competitive edge to non-banks, the Joint Forum54 has to investigate the impact thereof on the banks’ counterparts in the securities and insurance businesses. Sound risk-management systems require close cooperation between the regulator and the regulated. Ideally the regulatory framework should be as simple as possible, though managements’ own control superstructure can be as complex as they wish to make it, subject to its being open to supervisory scrutiny. Good management and good regulators seldom have reason to fall out. The latest discussions on credit risk models between the Basel Committee and the industry are progressing satisfactorily in this philosophical context. Proper risk management for systemic purposes does not stop with financial institutions though. Also of importance are the risk exposures of hedge funds. After the US Federal Reserve had to launch a largescale rescue operation for the largest hedge fund in the world, Long Term Capital Management, the riskmanagement procedures of hedge funds and their impact on financial stability came under the regulatory spotlight in 1998. Hedge funds are by their very nature highly geared, non-financial offshore institutions. This makes them very difficult to regulate directly. In 2000 the Financial Stability Forum at the BIS recommended that hedge funds should not be placed under direct regulatory supervision, but that more disclosure should be demanded from both them and their bankers (who 54

The Joint Forum (formerly known as the Joint Forum on Financial Conglomerates) was established in early 1996 by the Basel Committee on Banking Supervision (Basel Committee), the International Organization of Securities Commissions (IOSCO) and the International Association of Insurance Supervisors (IAIS), to take forward the work of a predecessor group, the Tripartite Group, in examining supervisory issues relating to financial conglomerates.

Financial Regulation in South Africa: Chapter 7

usually grant the credit to them and thus largely allow their high degree of gearing). As a result, many bankers have compelled their hedge fund clients to use value-at-risk models, which in turn resulted in a massive de-gearing of those funds. As market liquidity started to fall in line with less credit being made available, the largest of the hedge funds, after showing significant trading losses in 1999, withdrew from the market in 2000. In quick succession some of the larger funds, such as Tiger Fund, Quantum Fund and Quota Fund, closed for business. The danger of such a development is that it may cause a vicious circle: as banks provide less liquidity, markets become more volatile, forcing them to make further cuts in the amount of capital they devote to trading, making markets even less liquid, and so on. In the end, the hedging of open positions is becoming increasingly difficult. Although the South African regulatory authorities are not really engaged with hedge funds (exchange controls prohibit this type of bank lending), the recommendations of the Financial Stability Forum are to be implemented nonetheless. To support the intermediate goal of proper risk management, the following regulatory targets can be identified: • Promote accurate value-at-risk models: Ideally, all risk exposures within a firm have to be quantified on a fully integrated basis. The building of such enterprise-wide risk management (ERM) simulation models needs to be supported by the authorities. • Stipulate consolidated supervision: Without proper accounting consolidation, the double counting of regulatory capital is bound to take place. • Appoint specific non-executive board members to supervise risk management and management control systems: Ultimately the authorities would like to make one specific director at board level responsible (and perhaps even accountable in a private capacity55) for the firm’s risk-management procedures. 55

This policy is currently enforced in New Zealand.

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Appoint accredited private rating agencies: Paper traded in the securities markets has to be rated for risk-management purposes. This task can be left to the private sector but the ratings need to be recognised by the authorities for regulatory purposes. • Promote unsecured subordinated debt as a rating tool: Bank risk-management is structurally improved if the interests of subordinated debt creditors are closely aligned with those of the bank supervisors.

3.8 Proper financial institutional infrastructure and suitability standards A proper financial infrastructure is one of three major structural pillars of a stable financial system56. From a regulatory point of view, improvements in the financial infrastructure usually go hand in hand with raising the minimum standards. These standards, in turn, entail accounting, audit, capital, governance and compliance standards. As the process of international standard-setting is one based on mutual agreement, it can only be on the basis of consensus. Such a common approach is based on a “bottom-up”, rather than a “top-down” approach, which by its nature will be an evolutionary process. In recent years major progress has been made: e.g. international accounting standards were endorsed by IOSCO in 2000, the OECD is currently considering more uniform governance rules for industrial countries, while the BIS is working on a new capital accord. In the South African context, segments of financial infrastructure, need urgent attention. For example: the transparency of the OTC markets (particularly off-market trade) and nominee companies; internal governance in relation to pyramid companies and nonvoting shares; and capacity for investigating commercial crime and prosecuting offenders effectively in the justice system. To support the intermediate goal of a proper financial infrastructure, the following regulatory targets can be identified: 56

The other pillars are sound financial institutions and liquid markets.

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Adhere to minimum accounting and audit standards: There cannot be proper disclosure without proper accounting and audit standards. Adhere to minimum capital standards: Competition in regulatory laxity emerges if no international minimum standards are set in this area. Adhere to corporate governance standards: These standards promote high-quality leadership in firms. Adhere to compliance standards: With increased reliance on market discipline and monitoring, the compliance function within firms becomes crucial in ensuring proper in-house supervision. Establish an infrastructure for the verification of a firms’ risk and control systems: Verification, as a type of auditing process, has to ensure that the simulation models and control systems used, will live up to expectations. Establish an industry register of doubtful and bad debts: To improve credit risk-management procedures, the creation of a credit register – where bank loans are classified in terms of size and rated by independent rating agencies on an industry-wide basis – is recommended. Stipulate suitability standards for directors and senior management: Unless top management is knowledgeable, battle-hardened and generally “fit and proper” no company can face the global competitive forces head-on in today’s financial world for long.

3.9 Global institutional competitiveness and competitive neutrality A basic problem faced by all global firms is that their activities are constrained by national regulation. In the absence of a global government, how are regulators to create a system of mutually interdependent and reliant supervisors in which companies can compete on a level playing field? Too much self-regulation may result in regulatory laxity or regulatory capture, while too much official regulation from the top may stifle competition. In the end the relationship between the supervised and the supervisor is symbiotic, and so it is vital to encourage industry leaders to help develop the Financial Regulation in South Africa: Chapter 7

appropriate standards, including codes of conduct and prudential standards. On the competitive front the Internet, hand in hand with digital cash, is bound to have a strong influence in future. From a regulatory perspective the Internet is often seen as just another form of media. Although, in a narrow sense, this is logically correct, the Internet nonetheless undermines current regulation and practices. One reason is that electronic documents are different from their paper equivalents57. More fundamental are the problems of jurisdiction (e.g. investment advice given in London may be read in Johannesburg, which in turn impacts on local legislation covering investment advice) and home country supervision (will foreign investors using a website in, say, the United States have recourse to US law for redress?). Financial scams are another potential problem on the Internet. Because information on the Internet is cheap to distribute and therefore reaches a vast number of people, even a small response makes it an ideal medium for “get-rich-quick” schemes (e.g. pyramid selling). Ultimately consumers can directly control their regulatory environment simply by “voting with their feet” for the jurisdiction they like. Without geographic barriers, consumers can elect the type of protection they need by choosing their preferred Internet regulator. This implies that unpopular regulation, even with good intentions, will be difficult, if not impossible to enforce in the long run. It seems, accordingly, that the regulator of the Internet will be no more than the well-informed consumer. The regulatory response to all these Internet challenges still needs to be worked out by international task groups. It will be a daunting task, particularly considering that national sovereignty, and thus pride, is at stake. Therefore no quick answers can be expected. Even as a minimum involvement, South African regulators will have to follow these international developments closely. Most of the basic issues underlying global

competition have already been discussed in one way or another above. Generally, South African companies are globally competitive, but it is worth repeating that exchange control regulations are still a major hindrance as capital mobility has increased so much in the last two decades. Therefore, to support the intermediate goal of global competitiveness and competitive neutrality, the following regulatory targets are of particular importance: • Abolish foreign exchange controls as soon as possible: The free flow of capital underlies competitive forces in the global economy. • Adhere to international agreements on regulatory minimum standards: These standards aim at avoiding competition in regulatory laxity. • Encourage a functional approach to regulation: With the emergence of global financial conglomerates it is of crucial importance that functional regulation across various financial sectors should be properly co-ordinated with traditional institutional regulation. • Encourage competitive neutrality between commerce and e-commerce: The Internet may well prove to be the vehicle that makes the “caveat emptor” approach in regulation more sustainable.

3.10 Integrity, fairness and competence Within the firm the compliance office deals with the day-to-day issues of suitability. In the end it is the compliance officer’s responsibility to ensure that only people with integrity are appointed (called the “gatekeeper’s” function), that the clients are dealt with fairly and that staff is competent to do the work. However, who guards the guards? To date, no mechanisms for systematically assessing compliance procedures have been developed58. To support the intermediate goal of integrity, fairness and competence the following regulatory targets can be identified: 58

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For instance, typical problems are that Web pages change too quickly; are easy to browse, but difficult to read; while “small print” can be skipped too easily through the use of hypertext links.

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At the national level the IMF and the World Bank have put together compliance assessment teams to conduct financial assessment programmes. The national supervisors may have to do the same at the corporate level.

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Encourage a code of corporate governance: The major responsibilities in this area rest with the board of directors. Encourage a code of business conduct: Industry associations usually compile this code. It is already in place in South Africa for the local banking, insurance and unit trust industries. Establish a policy to reduce financial crime and money laundering: Without such a policy South Africa could become an undesirable business place. Cabinet approval of the Financial Intelligence Centre Bill, which deals with money laundering control, is being awaited. Encourage effective compliance manuals: These manuals can be seen as an incentive contract between the regulator and the regulated and may accordingly differ among financial firms. The quality of the compliance manuals may have to be certified by the external auditors of the firm in consultation with the regulator. Stipulate “fit and proper” standards for the compliance office: The external auditors and regulators have to audit the quality of the compliance office to ensure these guardians fulfil standards themselves.

3.11 Adequate product and service competitiveness Protective feelings on the part of the authorities often mean that they want to protect both their home turf and their colleagues in the public sector. The result is trade restrictions of various kinds against foreigners and the exclusion of standard regulations for the public sector. Both policies can prove extremely expensive in the long term. Public involvement in the financial sector can create socio-economic benefits. For instance, a government bank, like the Postbank, can provide effective competition at the cutting edge in a market dominated by private banks. Likewise, the Land Bank can assist where the private sector may hesitate, because of its longerterm commitment to agricultural development. However, it would for a number of reasons be bad policy to 180

exclude such enterprises from the standard prudential requirements (like capital adequacy or disclosure) or even from the industry’s code of conduct requirements (including the code of corporate governance policies). Firstly, even if the government stands behind its enterprises through thick and thin, the political election cycle is far shorter than the average life cycle of a public enterprise. A newly elected government may not want to inherit over-stretched public sector budgets for political aims they did not subscribe to, or face the legal consequences of the bad financial advice given by public servants. Secondly, efficiencies in the public enterprises can only be measured between competing entities on a level playing field. For example, the fact that the Land Bank has a zero-cost capital base, is untaxed and has a preferential creditor status to compete in the commercial markets, results in serious market distortions. Thirdly, without prudential requirements the taxpayer may once again be asked to bail out, whereas winding-down would have been the logical policy. Lastly, the financial regulator should be careful when dealing with general government, as historical evidence shows time and again that state failure is far more expensive and painful to society than market failure (see Chapter 4, Section 3.7). To support the intermediate goal of product competitiveness, the following regulatory targets can be identified: • Remove constraints on competitive foreign products: True competition usually only flows from different countries, different cultures, different languages and different regulatory regimes. • Remove regulatory exclusions granted to parastatals or public corporations: Only by placing the enterprises of the state on a equal footing with private-sector equivalents can inefficiencies and unacceptable risk exposures be detected.

3.12 Transparency and disclosure Disclosure and profitability do not necessarily always sit comfortably together. For instance, a company may obtain valuable marketing benefits by giving the impression of being ethically involved in “socially responsible investments” (SRI), while in reality its Financial Regulation in South Africa: Chapter 7

expenses in this area are primarily for advertising. Ultimately, all predation is based on the fine differentiation between the apparent and the real, and the hunt for profit is no exception. In the end, investors want to know how much of their funds is used for SRI corporate goals. In order to make this type of information more transparent, specific disclosure rules should be considered. For instance, in July 2000, the British made it compulsory for pension funds to disclose whether they take account of the environmental, ethical and social impact of their investments. The aim of this regulation is not so much to interfere in the investment patterns of pension funds, but rather to ensure proper information flows to investors and policy holders. It is crucial for the authorities and industry associations to make information, which is sufficiently benchmarked, available to the press. Ultimately the link between financial markets and consumers is the financial press. The press plays a critical role in any financial system and has to be educated and supplied with relevant and updated information about market conditions, investment patterns and the relative importance of the various classes of investors and borrowers. Questions like “who is really supporting small businesses?” and “how much of the funds are employed for SRI projects?” are not only of interest to pressure groups and politicians, but also to market participants in a broader sense. Disclosure is a powerful instrument, provided it used properly – i.e. no information overflow. The disclosure of selected benchmarked information is the key to success. To support the intermediate goal of transparency and disclosure, the following regulatory targets can be identified: • Adhere to an international code of corporate governance: Disclosure and transparency are in essence components of internal governance. Although every nation may have different ideas about what appropriate disclosure means, it is helpful for international investors if at least the minimum standards are met in this respect. • Establish government-defined benchmarks for Financial Regulation in South Africa: Chapter 7

better consumer information: Often consumers find it difficult to compare prices because of a lack of standardisation. Officially agreed benchmarks, including the cost of a “basic bank account”, will better address consumer grievances. The regulatory authorities, including the industry associations, can do more to enhance the supply of competitive information, inter alia via the Internet. • Inform the financial press. The regulatory authorities should establish a practical, mutually effective, working relationship with senior financial journalists in order to promote better communication with the public at large.

3.13 Adequate access to retail financial services As emphasised by the Cruikshank Commission in the UK, the uncompetitive behaviour of banks is often a result of too-high capital charges for new entrants as well as the banks’ cartel position in the payments system. Likewise, for example, the practice where banks charge non-clients significantly more for the use of cash machines is perceived as a lack of competitiveness. To lower entry barriers, the authorities could consider establishing different types of banks, and participation in the payments system should be opened, in principle, to any financial institution materially involved in payments. In the past, specific licences were granted in South Africa to different classes of banks such as commercial banks, savings banks, general banks and building societies (which were effectively mortgage banks). Over the years all these distinctions were eliminated because the functional borderlines between these institutions became increasingly blurred. In terms of the 1990 Banks Act only one definition for a bank remained.59 However, to assist the “unbanked” the authorities could define a “core 59

The Mutual Banks Act (1993) is similar to the Banks Act (1990) except on two points: (i) a mutual bank is of course exempted from the requirement that a bank has to be a limited company; and (ii) its minimum capital is R50 million, but for a bank it is proposed that it should be increased to R250 million.

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bank”, being a bank that accepts deposits from the general public and invests all its assets in moneymarket paper of top quality (i.e. a core bank has no credit risk). Core banks would have a lower capital requirement than other, more universal banks because their risk profile would be fundamentally lower. In essence, a core bank’s deposit rates would be determined by money-market rates minus operating expenses. Retailers that currently provide limited banking services could then be granted a full corebanking licence and direct membership of the national payments system (rather than as a bank’s agent), which in turn would be bound simultaneously to increase financial services to the poor and improve competition in the banking sector. A basic problem in the South African context remains the conflicts of interest faced by the authorities in ensuring prudential regulation and compliance with international standards, and the interests of Parliament in providing banking services to the entire population. The danger of maintaining international standards in a developing country is that local banks participating in the international markets may find that the costs of capital demanded by those standards are just too high for the returns that can be earned in the low-income markets. So the local banks tend to contract out of the very markets that Parliament would like to see them expanding into. To support the intermediate goal of adequate access to retail financial services, the following regulatory targets can be identified: • Establish core banks in the retail trading sector: A one-size-fits-all banking structure is unlikely to be satisfactory to both wealthy and poor retail clients. • Open the payments system to non-bank financial institutions: Core banks can only really compete with established banks if there is a level playing field in the inter-bank market and in the national payment system60.

3.14 Protection of retail funds The issue of protecting retail funds is closely related to the issue of financial soundness and financial stability in general (as discussed in Chapter 5, Section 3.5.2). In essence it implies that the authorities ensure proper risk-management systems in firms (e.g. in respect of operational risks) and maintain macroeconomic stability. In this context the emphasis is increasingly being placed on the market monitoring and discipline61. Generally, investments made by the public at large are poorly protected in South Africa. If an investment fund should go under as a result of, for instance, gross negligence, usually no compensation is paid to the investors.62 In respect of bank deposits, the authorities are currently investigating the possibility of an investor protection scheme that will pay limited compensation to depositors. Besides the Reserve Bank’s investigation into bank-deposit insurance, the FSB is currently investigating whether other retail investment funds should receive similar protection. No doubt this is a challenging investigation, as the current situation can be roughly summarised as follows: to date no official protection against operational or default risks is given by the private sector (whether they are banks, insurance, pension or unit trust funds), and most of the public contributions to the public sector’s funds have long since disappeared. For instance, the Department of Labour is responsible for the Unemployment Insurance Fund and the Workmen’s Compensation Fund. Both these funds are effectively bankrupt. The Department of Transport is responsible for the Road Accident Fund. The actuarial shortfall of this fund runs into billions of rands. The Department of Health is responsible for 61

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Subject of course to the earlier observations of level playing fields, settlement risk and contribution to the costs of the existing infrastructure.

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One of the regulatory reforms that powerfully support market discipline is a greater role for subordinated debt as a form of bank capital. The official excuse is usually along the lines of “let the buyer beware”, despite the fact that investors often lack even the most basic information. Moreover some of these investments are made compulsory like the Road Accident Fund or the Unemployment Insurance Fund.

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medical aid schemes63. The majority of these schemes are in dire straits, although a few of them are still actuarially sound. Considering the possibly huge medical costs of Aids, TB and malaria, medical aid schemes are probably one of the most risky forms of insurance at present. The only exception in the public sector seems to be the SA Special Risk Insurance Association (SASRIA) managed by the National Treasury that accumulated a massive surplus of some R8 billion, more or less by mistake.64 The dilemma faced by government is that most of these investment funds are used as instruments of social engineering, though in a truly free market any cross-subsidising between fund members is impossible. Furthermore, prudential considerations require that “the wishbone should never replace the backbone”. Accordingly, these public sector funds have to be appropriately financed for the benefit of their paying members. To promote better protection of retail funds in future, the South African authorities could focus on the following regulatory targets: • Establish a Structured Early Intervention and Resolution regime: Without timely and adequate provisions, firms may fail in appropriate credit-risk management. • Stipulate acceptable operational risk-management systems: Major computer system failure and/or fraud are an important reason for bankruptcy in the financial industry. • Limit the use of retail investment funds as an instrument of social engineering: Even with the best social intentions, the investment funds will face ruin in South Africa unless payouts are based on actuarial principles.

63

64

This regulatory arrangement came about in 1975 when the supervision of medical aid schemes was transferred from the, then, Department of Finance to the Department of Health. Considering the current financial problems of medical aid schemes and the dynamic interaction with medical insurance in general, it seems that this arrangement has probably passed its due date. As the Government was the sole underwriter of the SASRIA scheme, it took the lion’s share of the surplus from this fund by means of the Conversion of SASRIA Act, 1998.

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3.15 Retail compensation schemes Compensation to a wronged investor should not be viewed as a type of generosity on the part of the financial institution (as so often happens in practice), but rather as a basic right of such a client. Compensation can flow through various channels and can be triggered by various means. The easiest case is where the client complains about a wrong action on the part of the firm and is compensated immediately as a consequence thereof. If the firm refuses to compensate, the client can take his case to the industry’s ombudsman who will reconsider the case. If the client is still unhappy about the rulings of the industry’s adjudicator, the case can be brought before a court of law. Since the late 1990s market conduct regulation has been improved significantly in South Africa. Today, banks have a strict code of market conduct; an effective and independent redress mechanism for customers; and an industry adjudicator (operative effectively since early 2000). Similar developments are eventually envisaged for the insurance industry, but as yet they have not materialised. In the securities business, the compensation of wronged investors ultimately flows from the exchanges’ fidelity or guarantee funds. The compensation is usually limited though. In the case of banks, the adjudicator can demand compensation up to R500 000, but the compensation of the long-term insurance ombudsman is limited to R250 000. The Guarantee Fund of the BESA limits payouts to a maximum of R100 million for all clients of defaulting members; the Guarantee Fund of the JSE compensates to a maximum of R5 million per client, and the Fidelity Fund of SAFEX limits itself to R1 million per client65. One fundamental problem remaining in South Africa is that not all market conduct is vested in one single specialist regulator for all market-conduct issues. Currently the Department of Trade and Industry, rather than the National Treasury, deals with issues such as the investor protection provisions of the Companies

65

In the case of SAFEX its clearing members accept full responsibility for the credit risks of its clients.

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Act, corporate governance standards and possible claims arising from the Usury Act. Ensuring coordination among the various government departments has proven difficult in practice and is clearly not to the advantage of the wronged consumer. To support the intermediate goal of adequate compensation schemes, the following regulatory targets can be identified: • Stipulate ombudsmen arrangements: This is one of the most cost-efficient and effective ways to compensate wronged investors. • Stipulate fidelity fund arrangements: A necessary arrangement if brokers are operating in an individual capacity and are therefore relatively thinly capitalised. • Establish a bank deposit-insurance scheme: Although not without inherent problems (mainly conflicts of interest and moral hazard issues), these schemes usually operate as compensation schemes for small depositors only. In effect they only replace implicit compensation contracts with an explicit contract. • Establish a single regulator for all market-conduct rulings: Only by centralising the regulation of market conduct activities can oversight and responsibility be enhanced in this area. Better compensation mechanisms will result from a better organisational structure.

4. Conclusion 4.1 Summary The dualistic underlying nature of the South African economy is very evident in its financial sector. On the one hand there is a highly sophisticated financial industry serving the daily needs of inter alia multinational companies, the government and wealthy households, while on the other hand this same industry is unable to assist in a meaningful way upcoming small businesses and poorer households. For a lower-middle-income country66 South Africa’s 66

Based on the World Bank’s classification.

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financial industry is clearly one of its crown jewels. The industry assists in a major way to bridge the national savings gap by ensuring adequate capital inflows from abroad. Any attempts to pluck this goose extensively will affect its health, and in turn the international investor confidence that is so crucial for supporting sustainable economic growth in South Africa. International competition forces the big banks to focus on high-yielding business and stringent cost controls (and thus the elimination of crosssubsidising). However, international competition still does not exclude the possibility of a lack of sufficient competition in the domestic markets. To service the financial needs of the small business sector and lowerincome households, the authorities may have to consider a number of fundamental steps to increase competitiveness in local markets. For example: the deregulation of the commercial paper and corporate bond markets; removal of the regulatory barriers against foreign banks; opening the national payment system to non-bank financial institutions; and the creation of core banks. Likewise, the authorities could increase the degree of competition in the local insurance market. It could do so, for instance, by allowing foreign insurers to sell their policies in South Africa on a branch basis, rather than forcing these insurers to establish local subsidiaries.67 When considering the long-term economic prospects for South Africa in an Aids scenario, the regulatory authorities cannot close their eyes to its socioeconomic impact in the next few years. The consequential costs of Aids may badly affect the local banking and insurance businesses. How badly is still an open question, because this uncertainty cannot be properly quantified with current value-at-risk models (as there is simply no meaningful local data or backtracking possibilities). However, to cope with this higher degree of uncertainty, the authorities may consider decreasing the financial gearing of financial 67

In such a case South African insurance regulators would become host regulators to such foreign insurers, implying that the local authorities would have to be satisfied with the standards of the home regulators.

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institutions in general. The banks’ and securities firms’ capital ratios may have to be increased from 8 per cent to 10 or even 12 per cent of risk-weighted assets. Similarly, the insurance regulator may have to reevaluate the implied financial gearing of insurers. South Africa’s current financial infrastructure is quite good, but not so good that it fulfils all the prudential principles set by the Basel Committee, IOSCO and IAIS. Implementing more fully all these international minimum standards (or principles) may take a few more years. The Policy Board for Financial Services and Regulation, the South African Reserve Bank and the Financial Services Board are fully aware of the work still to be done in this area. Likewise, the King Commission has started its second report on corporate governance in South Africa. The Commission’s recommendations on how to harmonise local governance issues with international minimum standards are expected later in 2001. The optimal regulatory architecture is a topic that needs urgent attention in South Africa. The cooperation and co-ordination among the various domestic regulators and between home and host regulators has to be investigated more carefully. In a similar vein, co-ordination between the various markets (both formal and OTC) in terms of their cross-market risks needs to be addressed. Last but not least, the regulatory authorities have to ensure that retail investment funds are properly protected against abuse and actuarially sound, which in turn involves close interaction with other government departments. To ensure that the authorities themselves operate efficiently and effectively, consideration should also be given to the establishment of a regulatory audit agency. Particularly in a world likely to be increasingly dominated by e-commerce, consumers have to be fully aware that they operate in this area exclusively on a caveat emptor basis. To ensure integrity, fairness and competence in these e-markets, disclosure and transparency are of crucial importance to consumers. The authorities have to assist the consumer and the financial press by benchmarking the flood of financial information. Moreover, even if the decapping of Financial Regulation in South Africa: Chapter 7

insurance commissions proves difficult in the medium term, consumers have to be aware of these commission payments (i.e. the plain disclosure of service fees). Capped insurance commissions are not controlled prices, but simply maximums. The authorities should encourage price negotiations, competition and possibly lower commissions. In line with the recommendations of the Basel Committee, the South African Reserve Bank has established a Financial Stability Committee (and Unit) that will closely investigate the interaction between macroeconomic policy, macroprudential and microprudential requirements. Of particular importance will be the precise roles of the central bank as lender of last resort, and its de facto role as forwardcoverer of last resort and guarantor of the payments system. Much work still has to be done in this new area. For instance, the involvement of the central bank in financial stability policy may require a new look at the traditional regime of fixed minimum capital requirements for banks. To stabilise liquidity conditions in the markets over the business cycle – and thus avoid possible asset bubbles, property crashes and the like – the monetary authorities may well have to adjust the minimum capital ratios during different stages of the business cycle. Liquidity management may also involve fiscal policy; as for instance the current transaction taxes levied on securities trade undermine the competitiveness of the local markets vis-à-vis overseas markets. In fact, the interaction between monetary policy and financial regulation is likely to become even closer in future, particularly considering the outstanding issues of exchange controls, lender-of-last-resort facilities, banks’ exit policies, Structured Early Intervention and Resolution regimes, and possibly cyclically adjusted minimum capital standards that all impact in a major way on the financial regulatory regime.

4.2 The way forward All the above issues are incorporated into the targets developed in Section 3. As these targets are intended to address South African financial regulation for the 2000s 185

it may be necessary to make an early start in allocating these targets to task forces for further investigation. For example, one such task force could investigate those targets that are associated with competition.68

All the targets identified in Section 3 are summarised in Table 7.2. 68

This task force could conduct similar research to that of the Cruickshank Commission in the UK.

Table 7.2: Summary of regulatory targets for the 2000s Systemic stability 1. Competitive market infrastructure • Establish a payments system open to all financial institutions • Promote competitive trading, clearing and settlement systems • Promote competitive listing requirements • Stipulate minimum infrastructural standards • Establish interrelated and competitive markets • Establish regulatory neutrality towards foreign participants 2. Acceptable maturity and currency mismatches • Promote accurate value-at-risk systems • Promote the management of the forward currency book by the private sector • Promote prudent debt-management systems in the public sector 3. Acceptable cross-market exposures • Establish cross-market risk-management, clearing and settlement facilities • Establish legally binding netting agreements between markets 4. Sufficient market liquidity • Establish a financial stability unit at central bank • Formalise the standby facilities of central bank • Remove (tax) constraints on market turnover • Promote foreign participation in local markets 5. Securities markets as an alternative to financial intermediation • Remove constraints on commercial paper and corporate bond issues from the Banks Act • Promote the engineering and implementation of an SMME bond instrument 6. Regulatory effectiveness, efficiency and economy • Establish co-ordination agreements among domestic regulatory agencies • Establish harmonisation agreements between home and host regulators • Stipulate regulatory cost-benefit analysis • Establish a regulatory audit agency • Establish ratings of national regulatory agencies

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Table 7.2: Summary of regulatory targets for the 2000s (continued) Institutional safety and soundness 7. Proper risk assessment • Promote accurate value-at-risk systems • Stipulate consolidated supervision • Appoint specific non-executive board members to supervise risk-management and management control systems • Appoint accredited private rating agencies • Promote unsecured subordinated debt as a rating tool 8. Proper financial institutional infrastructure and suitability standards • Adhere to minimum accounting and audit standards • Adhere to minimum capital standards • Adhere to corporate governance standards • Adhere to compliance standards • Establish an infrastructure for the verification of firms’ risk and control systems • Establish an industry register of doubtful and bad debts • Stipulate suitability standards for directors and senior management 9. Global institutional competitiveness and competitive neutrality • Abolish foreign exchange controls as soon as possible • Adhere to international agreements on regulatory minimum standards • Encourage a functional approach to regulation • Encourage competitive neutrality between commerce and e-commerce

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Table 7.2: Summary of regulatory targets for the 2000s (continued) Consumer protection 10. Integrity, fairness and competence • Encourage a code of corporate governance • Encourage a code of business conduct • Establish a policy to reduce financial crime and money laundering • Encourage effective compliance manuals • Stipulate “fit and proper” standards for the compliance office 11. Adequate product/service competitiveness • Remove constraints on competitive foreign products • Remove regulatory exclusions granted to parastatals or public corporations 12. Transparency and disclosure • Adhere to an international code of corporate governance • Establish government-defined benchmarks for better consumer information • Inform the financial press 13. Adequate access to retail financial services • Establish core banks in retail trading sector • Open the payments system to non-bank financial institutions 14. Protection of retail funds • Establish a Structured Early Intervention and Resolution regime • Stipulate acceptable operational risk-management systems • Limit the use of retail investment funds as an instrument of social engineering 15. Retail compensation schemes • Stipulate ombudsmen arrangements • Stipulate fidelity fund arrangements • Establish a bank deposit-insurance scheme • Establish a single regulator for all market-conduct rulings

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Financial Regulation in South Africa: Chapter 7

INDEX access to retail financial services, 22, 182 accountability, 115 accountability of financial regulators, 153 accounting consolidation, 96 accounting rules, 167 adverse selection, 11, 16 agency diversification, 52 agents, 143 asset price collapses, 85 asymmetric information, 22 auction-driven markets, 127 audit agency, regulatory, 69 audit rules, 167 automated-trading system, 131, 132 autonomy, 95 bank supervision, 103 core principles, 74 political dimension, 105 bank-deposit insurance requirement, 58 banks, 140 basic markets, 125 brokers, 142, 143 building blocks, 116 business conduct requirements, 55 capital adequacy, 54, 112, 168 capital inflows, 85 causes of financial crises, 84, 86 circuit breakers, 167 clearing systems, 166 commercial paper, 160 commercial paper market, 166 compensation scheme requirement, 57 competence, 21 competition, 20 competitive market infrastructure, 18 financial intermediaries and securities markets, 91 global institutional, 19 neutrality, 19 competition and contestability, 4 competitive neutrality, 19, 168, 178 complex group supervision, 97 complex groups, 97, 168 compliance, 30 and data examination requirements, 63 culture, 30 incentives, 62 non-compliance, 21 Financial Regulation in South Africa: Chapter Index 7

components and instruments of the regulatory regime, 31 conduct of business regulation, 12 conduct of business requirements, 55 conduct of investment business, 55 conflict-conciliatory principles, 42 connected lending, 87 connected parties, 94 consolidated regulation, 95, 96 consolidated supervision, 93, 96 consumer confidence, 15 consumer demand for regulation, 15 consumer protection, 2, 11, 19, 25 competence, 21 integrity and fairness, 21 protection of retail funds, 22 retail compensation schemes, 22 transparency and disclosure, 21 contagion across markets and countries, 85 contestability, 3, 4, 5 contestability and merger and acquisitions, 5 contract regulation, 27, 113 corporate bond market, 166 corporate governance, 36, 40, 67, 68, 153, 167 and the regulator, 69 cost of regulation, 70 credit rating capital market assessment, 66 recognition of agencies, 65 credit risk, 64 cross-market exposures, 171 cross-market netting, 167 cross-market risk management, 167 dealers, 143 deposit-insurance scheme, 110 deregulation, 76, 78, 79, 81 deregulation and reregulation, 76 derivative markets, 124 direct and indirect costs of regulation, 70 discipline on and accountability of regulators, 37, 40, 69 discipline on financial regulators, 153 disclosure. See transparency disclosure and advice, 46, 47 diversification, 51, 52 double gearing of capital, 94 dual capacity, 132 dual-capacity trading rule, 133 Dutch auction, 127 189

economic regulation, 1 economies of scale in monitoring, 13 e-exchanges, 167 effective banking supervision, 74 effective regulation, 1 efficient regulation, 1 enforcement, 93 English auction, 127 enhanced lead regulation, 103 Enterprise-wide Risk Management, 64 entry and standards constraints, 45, 146 entry barriers, 67 entry requirements, 46 entry standards, 46 ethos of regulation, 81 exchange controls, 168 exchange rate regimes, 85 execution, clearing and settlement functions, 138 exit policy, 110 exposures, cross-market, 18 external auditors role, 64 externalities, 12 failure, institutional. See financial crises financial advisers, 142 financial conglomerates, 49 financial crises asset price collapses, 85 capital inflows, 85 contagion, 85 exchange rate regimes, 85 financial liberalisation, 87 incentives, 87 liquidity, 86 macroeconomic causes, 84 macroeconomic volatility, 85 regulatory causes, 86 regulatory responses, 88 social and individual cost of bankruptcy, 13 financial distress. See financial crises financial engineering, 116 financial fraud, 168 financial infrastructure, 159, 161, 167 financial innovation, 78 financial institutions, 157, 160, 163 financial instruments, 116 definition and nature, 116 issue standards, 48 regulatory matrix, 119 regulatory regime, 116 190

financial intermediation, 141, 173 financial market participants, 140, 144 accountability of regulators, 153 banks, 140 brokers, 142 corporate governance, 153 financial advisers, 142 incentive contracts and structures, 152 institutional investors, 140 intervention and sanctions, 151 investment firms, 140 market monitoring and discipline, 152 official monitoring and supervision, 151 OTC markets, 140 regulated market, 143 regulatory matrix, 147 regulatory regime, 144 rules and regulations, 146 traders, 140 financial markets, 118 auction driven, 127 basic markets, 125 defining, 118 derivative markets, 124 formalising OTC markets, 122 instruments traded, 123 order driven, 128 OTC markets, 121 primary markets, 126 quote driven, 128 regulated markets, 121 regulation, 126 regulatory matrix, 135 regulatory regime, 133 secondary markets, 126 single/dual-capacity trading, 133 spot markets, 123 trading systems, 129 financial press, 67, 99 financial products and services, nature of, 14 financial stability, 100, 101 financial stability policy, 102, 168 financing through securities markets, 91 first price auction, 127 fit and proper standards, 45 for individuals, 45 suitable directors and management, 19 floor-trading system, 130 formal market, 134 Financial Regulation in South Africa: Chapter Index 7

functional activity constraints, 50, 146 functional activity restrictions, 50 functional approach, 7 functional regulation, 103 generic types of regulation, 12 global financial distress. See financial crises global institutional competitiveness, 19 governance and the regulator, 69 gridlock, 11, 16 harmonising regulatory arrangements, 71 hazards in regulation, 17 highly geared off-shore institutions, 98 home regulatory arrangements, 168 host regulatory arrangements, 168 implicit contracts, 17 incentive contracts and structures, 33, 39, 61, 152 incentives, 61, 114 incentives for management, 62 incentives for owners, 61 incentives to contain systemic and business risks, 63 incentives to create a sound compliance culture, 62 infrastructure financial institutional infrastructure, 19 financial system, 88 international standards, 90 institutional approach, 7 institutional competitiveness, 178 institutional failure. See financial crises institutional infrastructure, 178 institutional investors, 140 institutional safety and soundness, 2, 18, 24 instruments of regulation, 37 accountability of regulators, 40 corporate governance, 40 incentive contracts and structures, 39 intervention and sanctions, 39 market monitoring and discipline, 39 official monitoring and supervision, 38 rules and regulations, 38 integrity, fairness and competence, 21, 179 intermediate goals of regulation, 18, 23, 42 intermediation competition with securities markets, 91 securities markets as an alternative, 18, 173 international regulatory standards, 90 international standards, 90 intervention and sanctions, 32, 39, 60, 151 investment firms, 140 issuance standards, 48 Financial Regulation in South Africa: Chapter Index 7

jurisdiction, 53 jurisdictional constraints, 52, 148 lack of market liquidity, 86 lead regulation, 103 lender of last resort, 107 lending booms, 85 lifeboat facility, 110 liquidity management, 167 liquidity risk, 64, 98 listed financial instruments, 138 macroeconomic volatility, 85 market depth and liquidity, 18 market discipline, 34, 91 assessment, 35 market imperfections and failures, 12 market infrastructure, 169 market liquidity, 172 market maker market, 128 market makers, 143 market monitoring and discipline, 34, 39, 64, 152, 168 market regulators, 136 market risk, 64 market specialists, 143 maturity and currency mismatches, 18, 86, 170 merger and acquisitions, 5 methods of regulation, 81 minimum standards, 46, 48 monetary stability, 100 monitoring capabilities, 92 economies of scale, 13 moral hazard, 11, 16 nature of financial products and services, 14 non-compliance, 21 novation, 72, 117, 137 objectives of regulation, 2, 18 objectives, intermediate goals and targets of regulation, 17 official monitoring and supervision, 32, 38, 59, 151 offshore institutions, 98 operational constraints, 53, 148 operational risk, 64 order book driven markets, 128 order driven market system, 130 order driven markets, 128 over the counter (OTC) market, 121, 134 own service diversification, 51 ownership constraints, 49, 146 philosophy of regulation, 1 191

platforms execution, clearing and settlement functions, 138 pricing constraints, 53, 148 primary securities markets, 126 principal traders, 143 principles of regulation, 3 conflict-conciliatory, 6 efficiency related, 3 general, 8 regulatory structure, 7 stability related, 5 product competitiveness, 180 protection of retail funds, 182 prudential regulation, 12, 54 pyramid holding companies, 50 quote driven dealership market, 128 quote driven markets, 128, 129 rating agencies, 65 ratings, 168 rationale for regulation, 11 regulated market, 121 regulatory accountability, 168 regulatory arbitrage, 94 regulatory architecture basic function authorities, 137 market regulators, 136 single authority per basic market, 137 South Africa, 139 specialised authorities, 137 regulatory audit agency, 69 regulatory co-ordination, 71 regulatory effectiveness, efficiency and economy, 18, 174 regulatory gaps, 169 regulatory instruments. See instruments of regulation regulatory matrix, 42 alignment of instruments to goals, 43 financial instruments, 119 financial market participants, 147 financial markets, 135 impact of deregulation, 77 regulatory objectives, 2, 18 intermediate goals of regulation, 18 regulatory philosophy, 1 regulatory principles, 3 regulatory regime, 26, 42, 154 accountability of regulators, 37, 69 alternative approaches, 26 components and instruments, 31 corporate governance, 36, 67 192

financial instruments, 116 financial market participants, 144 formal markets, 134 incentive contracts and structures, 33, 61 intervention and sanctions, 32, 60 market discipline, 91 market monitoring and discipline, 34, 64 official monitoring and supervision, 32, 59 OTC markets, 134 rules and regulations, 45. See rules and regulations structure of financial markets, 133 regulatory regime in South Africa, 154 alternative to intermediation, 173 compensation schemes, 183 competitive neutrality, 178 cross-market exposures, 171 disclosure, 180 in 1980s, 157 in 1990s, 159 in 2000s, 162 fit and proper standards, 178 global competitiveness, 178 integrity, fairness and competence, 179 market infrastructure, 169 market liquidity, 172 maturity and currency mismatches, 170 product and service competitiveness, 180 regulatory effectiveness, 174 retail funds protection, 182 risk assessment, 176 service access, 181 targets and gaps, 169 the way forward, 185 regulatory regime paradigm, 113 regulatory strategy, 26, 28, 41 strategy matrix, 42 regulatory targets, 22, 169, 186 remote trading, 167 reregulation, 76, 80 reregulation and self-regulation, 80 retail compensation schemes, 183 risk incentives to contain systemic and business risks, 63 risk assessment, 19, 176 rules and regulations, 31, 38, 45, 146 entry and standards constraints, 45 entry and standards requirements, 31 functional activity constraints, 31, 50 jurisdictional constraints, 31, 53 Financial Regulation in South Africa: Chapter Index 7

operational constraints, 31, 53 ownership constraints, 31, 49 pricing constraints, 31, 53 safety net arrangements, 106, 168 deposit-insurance scheme, 110 lender of last resort, 107 lifeboat, 110 sanctions, 91 screen-trading system, 131 secondary securities markets, 126 second price auction, 127 securities markets, 91, 92, 158, 160, 164, 173 Securities Regulation Panel, 161 securitised asset markets, 166 self-regulation, 80 self-regulatory organisations (SROs), 80 separate regulation, 95, 96 settlement systems, 166 single capacity, 132 single regulatory authority, 73, 137 single-capacity trading requirement, 56 single-capacity trading rule, 133 social and individual cost of bankruptcy, 13 socio-economic environment, 155 solo plus, 96 solo plus regulation, 96 South African financial system, 116 specialist regulatory authorities, 137 spot markets, 123

Financial Regulation in South Africa: Chapter Index 7

stability, 2, 18, 23 and central banks, 101 externalities, 12 financial, 100 monetary, 100 stock adjustment, 79 strategic framework for regulation, 41 goals and operational targets, 41 objectives, 41 regulatory regime, 41 strategy matrix, 42 structure of financial markets, 133 structure of regulation, 81, 136 Structured Early Intervention and Resolution arrangements, 60 suitability standards, 178 super-regulatory agency, 168 supervision capabilities, 92 systemic bank restructuring, 111 systemic stability. See stability target-instrument approach, 41, 42 targets of regulation, 22, 186 tâtonnement auction, 127 telephone/screen-quotation trading system, 130 traders, 140 trading requirements, 56 trading systems, 129 transparency, 22, 97, 114, 167, 180 value-at-risk systems, 168 warehousing securities, 140

193