Study Group on the Evolutions of Supervision and Regulation

ISBN 1-56708-101-0

July 1997

Executive Summary

The threat of serious disruption to the international financial system is small, but is nonetheless a serious concern. Shocks sufficient to disrupt the international financial system may arise in individual countries or from the institutions, markets or the clearing and settlements mechanisms that link them. Rapid changes occurring in the international financial system have resulted in new sources of, and transmission mechanisms for, systemic shocks.

The institutions active in international markets are becoming larger and more complex. A rapidly growing volume of transactions and an expanding array of new products are moving across borders at ever faster speeds. New entrants to the system, often from outside the G-10 countries, are less well known to the international financial community and may be weakly supervised or not supervised at all. Indeed, the global operations of major financial institutions and markets have outgrown the national accounting, legal and supervisory systems on which the safety and soundness of individual institutions and the financial system rely.

There have also been positive developments: expanded use of netting and collateral; improvements in measuring risk; greater disclosure of off-balance-sheet risk; substantial increases in equity capital of many major financial institutions; financial sector consolidation; and the growth of securitization. Yet despite these improvements, substantial uncertainty remains over the level and direction of risk in the system and the effectiveness of measures to control it.

When shocks have occurred in the past, central banks, often in collaboration with market participants, have managed to prevent gridlock in the payments system and more serious disruption through skillful ad hoc crisis management. But the changes occurring in the international financial system are also likely to make improvised crisis management increasingly difficult in the future. And even if crisis management were completely reliable, it would be more efficient and sensible to establish policies and procedures to prevent and contain crises in the first instance. Much remains to be done to ensure the safety and efficiency of the international financial system.

• Large, internationally active commercial banks, the major participants in large-value payment systems, along with the largest investment banks, which are key participants in the clearing and settlement systems for globally-traded securities, represent the core institutions in the international financial system. It is essential that they are well capitalized and have management systems that are global in scope and of a high standard.

• Market participants must have the means to judge the financial condition, risk exposures and risk controls of major counterparty firms, which information may be difficult to obtain at present.

• Government supervisors, who must ensure the safety and soundness of complex global firms currently operating within and beyond their borders, have difficulty achieving a global view of these firms because of the limits of national jurisdiction and supervisory charters. Although international cooperation among supervisors has helped considerably, global surveillance remains a challenge.

For all these reasons, this report proposes a global initiative that will aim to: encourage consistently high standards of risk management; improve market transparency; and promote more effective supervision of core institutions. Our conclusions:

Management. Core financial institutions must shoulder the burden of strengthening their own management and the market infrastructure through which they do business. Their agenda:

• Establish a standing committee to develop a global framework for comprehensive and effective management controls. Such a framework would cover all aspects of risk monitoring, risk management and internal controls and would provide the basis for evaluating a firm's own operations and those of major counterparties. The framework would be developed in cooperation with international groupings of supervisors and national supervisors and would be subject to periodic review and revision.

• Submit their worldwide operations to an independent external global audit of both financial performance and management controls and agree upon more consistent and meaningful disclosure of financial and risk information on a global, consolidated basis.

Supervisors should pursue stronger international coordination and greater consistency in supervisory requirements. The agenda for national and functional supervisors:

• Agree on a lead coordinator for global firms, apply the global framework for comprehensive and effective management controls in reviewing all parts of a financial group and agree upon consistent reporting requirements for global firms.

• Establish performance criteria and risk management guidelines for exchanges, clearing houses and settlement systems to strengthen the underpinnings of the entire international system.

Legislatures should provide a reliable legal framework for international transactions by strengthening national laws governing netting, contract enforceability and insolvency of financial institutions.

Recommendations:

Areas for voluntary action by industry:

1. Create a standing committee to promulgate and review an industry framework for comprehensive and effective management controls including: the full range of management control functions; the full range of risks in a global firm; the efficacy of risk-reduction strategies; the type, format and location of information to be maintained by all institutions; etc.

2. Subject their worldwide operations to expanded review by a single, independent, external audit firm or firm group, and agree upon more consistent and meaningful disclosure of financial and risk information on a global, consolidated basis.

3. Support efforts to agree upon uniform accounting standards internationally.

Areas for action by global auditors:

4. Work with global firms, audit-standards bodies and supervisors to achieve an agreed upon approach to financial-statement audits and other information for portraying risk.

5. Work with global firms, designated audit-standards bodies and regulators to specify the appropriate criteria for reporting on internal accounting and risk-management controls over global financial and operational risks.

Areas for action by supervisors:

6. Agree upon a lead coordinator for all global financial institutions.

7. Work with global firms in reviewing a global framework for comprehensive and effective management controls, use the framework in the supervisory review process, and provide incentives for adoption of strong controls.

8. Formulate standards for exchanges, clearinghouses and settlement systems, including risk management and financial stability; protection of customer assets, funds and positions; and netting, contract enforceability and insolvency.

9. Agree on a standard international approach to the number and basic content of supervisory reports, with modifications or appendices to meet specific supervisory needs.

10. Improve the capabilities of supervisory agencies to understand complex financial products, assess sophisticated risk management systems, and deal with crisis management in global markets.

Areas for action by legislatures:

11. National legislatures should provide a reliable legal framework for international transactions by strengthening laws regarding:

• enforceability of netting
• enforceability of collateral contracts
• speedy and sure insolvency procedures
• protection of customer assets, funds and positions on exchanges.