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PART I:  REGULATORY ISSUES

 

1.  Regulation and the Financial Institution at the End of the Twentieth Century

Until recently, institutions that were part of the financial services sector were easily distinguished along product lines; deposits, securities, and insurance, being the three major categories. Regulation was structured along these product lines. There were regulators of deposit-taking institutions, regulators of insurance companies and regulators of firms in the securities industry.

With deregulation of the financial services sectors in most market economies, and technological innovation in communications and in the design of financial products, the historical distinction among financial institutions has become artificial. In fact, one of the largest financial institutions in the world today, GE Capital, lies outside the traditional categories to which a financial institution is usually assigned. It is not a bank, nor an insurance company, nor a securities firm. As such, it is largely unregulated, yet it is a very large "finance" company. This evolution of financial intermediaries has made the work of regulators increasingly difficult, as they must deal with financial institutions that do not fall into neat categories or that are structured so that they escape comprehensive regulation.

In this study, the focus is on institutions that are regulated as banks, financial intermediaries that have traditionally been deposit-takers and provided the liquidity that enable modern market economies to function.

Banks are only one of a number of institutions that are classified as deposit-taking institutions. There are others, such as: trust companies and credit unions in Canada; savings and loan associations and credit unions in the United States; and, building societies in the United Kingdom. In some countries, the post office operates a savings bank. These non-bank deposit-taking institutions do not, however, perform the broad range of functions that modern banks do, nor do they present regulators with the degree of complexity that banks do.

Banks are the financial intermediaries that draw the most intense public attention and the most focussed public policy discussion. They are the key players in national payments systems and international capital markets, providing the liquidity that facilitates smoothly functioning domestic economies, and the flows among these economies as well.

Contemporary banks have evolved far beyond their traditional role of taking deposits and making personal and business loans. Personal and commercial banking, in the modern bank, involve a wide range of credit, capital markets, advisory and insurance services to individuals and businesses, both domestically and internationally. Investment banking services such as loan underwriting and distribution, and financial advisory services with respect to mergers and acquisitions are also offered. Further, banks are major players in many new product markets which often involve a greater degree of customisation, than in the past, to meet client needs, such as asset based finance, asset securitisation, and derivatives.

 

2.  The Context:  Financial Intermediation and Regulation

Reduced to its basic elements, financial intermediation, what financial institutions do, is about processing information and managing risk. Financial intermediaries (FIs) channel funds from those who have more capital than is needed for immediate purposes to those who have less than is needed for immediate purposes. The income of the FI is the difference between what it pays to attract funds and what it charges for the use of those funds. The FI exists because, in general, individual lenders and borrowers would face prohibitive costs of search if each tried independently to arrange an appropriate match and to assess the risk involved in that match.

The FI specializes in gathering the information and expertise needed to match lenders and borrowers. Critical to this process is the ability to evaluate the risk involved in various loan proposals and pricing that risk accordingly. Inappropriate evaluation and pricing of the risk of loans made by an FI will entail losses to the FI and may lead to failure of the FI. In the latter case, losses and possible failures of those whose funds were being placed by the failed FI may also ensue. This could in extreme circumstances lead to widespread failures within the financial system – called systemic failure. Because of the critical importance of a sound financial system, of systemic stability, to the efficient operation of the economy, governments have established regulatory systems to oversee certain types of FIs – most notably deposit-taking institutions (DTIs).

In essence then, financial risk is related to credit and market exposures. Financial analysts have developed an extensive terminology to classify these risks – interest rate risk, general and specific; equity risk, general and specific; counterparty risk; settlement risk; large exposures risk; foreign exchange risk; and so forth. When all is said and done, however, the key questions with respect to all transactions in financial markets are: Will the terms of the contract under which the exchange was made be honoured? And, how liquid is the asset, that is, how readily can the asset involved in the contract governing the exchange of funds be converted to money?

In order to minimize the risk that an FI will be unable to generate adequate liquid funds when called upon, the FI will maintain some liquid funds in reserve. There is a cost to holding highly liquid funds however. They earn very little return. On the other hand, maintaining an inadequate stock of liquid capital on hand to meet the demands of a FI’s suppliers of capital may force the FI to dispose of relatively illiquid assets on quite unfavourable terms to the FI. There is then a trade-off to be made by the FI between the cost of holding relatively liquid assets and the cost of having to convert relatively illiquid assets to cash quickly.

With respect to the risk that the terms of the contract may not be honoured, the FI is called upon to make extremely difficult decisions about projects in which it has only a passive involvement. As with the requirement for liquidity, the FI faces a trade-off in the market for risk. It can generate a higher potential return, the more risk it is willing to take. On the other hand, the more risk it is willing to take, the higher the probability that problems will arise and that it may not realize these higher returns.

Well-designed internal credit controls, sufficient liquidity and capital, and sound internal governance will avoid most problems. Regulators focus primarily on these three factors in their oversight of FIs.

With respect to banks, the Basle Committee on Banking Supervision was established in 1975 by the central bank G-10 governors to discuss bank supervisory issues. In 1988, the Committee established minimum capital adequacy standards for international banks related to their credit risks. While viewed as a major accomplishment at the time, these capital rules are viewed as badly flawed today.

The 1988 standard tried to link capital requirements with risk by requiring different capital for different loans depending on the class of risk that the loan fell into. For example, the capital requirements for loans to corporations exceed that required for loans to governments. The "classes of risk" are much too broad however – loans to blue chip corporations are in the same class as loans to unproven corporations; loans to all banks incorporated outside the OECD are treated the same. This makes no sense.

What financial institutions do, and what regulators need to do, is to come up with an estimate of possible trading losses in an institution’s portfolio. This requires a much more sophisticated understanding of the risks involved right across a financial institution’s portfolio – including the risk associated with innovative instruments such as credit derivatives which are used to reduce the riskiness of loan portfolios. This task puts even more pressure on financial institutions and regulators to attract and keep persons skilled in risk analysis.

While recognizing that regulators will attempt to understand the complexities of the business of financial institutions, most financial institutions indicated that this was not really feasible. It was their recommendation that the regulator have a relationship not only with those actually doing risk assessment, but also at a much higher level in the organization, that is, with those senior administrators to whom the risk management units are ultimately responsible, to understand how risk is managed in the organization. Can the regulator really do any more than ensure that management is competent and honest? If the goal of the regulator is to gather adequate data to second-guess management, for example, then this will never be done. There is simply not enough time in the day and regulators do not have sufficient staff to to this. How can the regulator ever have the detailed knowledge required to understand all the intricacies of a particular trade?

Finally, there is another rationale for regulation of FIs in addition to systemic stability – the protection of consumers, and in particular, "unsophisticated" consumers. There are two aspects to consumer protection: (1) prudential regulation; that is, the protection of individual depositors should a DTI fail, and (2) conduct of business regulation; that is, issues such as full disclosure of all relevant information to a depositor or a borrower, absence of coercive selling techniques, protection of a client’s personal information held by a FI, maintenance of a level playing field among FIs and so forth.

 

3.  Moral Hazard:  A Problem for Regulators

Both the systemic stability and consumer protection rationales for regulation can create a serious problem for regulators. Is there a public perception that some banks are too big to fail (regardless of whether this is actually public policy), because the consequences of such a failure might be a general loss of confidence in the financial system as a whole leading to significant disruption to the economy. If this is public perception, then there is a problem of moral hazard; that is, institutions, expecting that they will be rescued if they get into trouble, will have an incentive to assume a greater degree of risk than they would if they did not believe they would be rescued by the government if they got into trouble.

Was Canadian bank exposure to Latin American countries in the 1980s and to Mexico in 1994-1995 a result, to some degree, of bank expectation that governments would not allow these countries to default on their loans? Or that if they did default, the banks most seriously impacted would be provided with some form of relief?

Do recent IMF actions in the Asian crisis, as many claim, simply reinforce the moral hazard problems in the international banking system? The Asian crisis has involved bank exposure to other banks and to non-banks and not exposure to sovereign risk as had been the case in 1982, when Mexico’s default was followed by virtually every country in Latin America. and in 1994 when there was a near-default by Mexico.

The existence of public deposit insurance also leads to moral hazard issues. Depositors knowing that deposits in certain institutions will be protected if that institution fails have an incentive to place their funds in institutions that are part of the safety net and to pay minimal attention to the risks assumed by those institutions. It follows then, that allowing deposit-taking institutions into new activities without supervision has the potential to lead to disaster. For example, in laws passed in 1980 and 1982, the Savings and Loan industry in the United States was given the authority to engage in business and commercial real estate lending, activities in which the thrifts had no experience. The thrifts were given this authority to help them get out of difficulties they were experiencing, at the time, with their investment portfolios. Unfortunately, they quickly ran into serious problems exercising these new powers.

The bigger a bank relative to its competitors, or the smaller the number of banks in a country, the more likely is there to be a "too big to fail" problem. In the US context, the biggest banks in the 1980s took the biggest risks and had the lowest amount of capital. A number of them ran into serious problems, Citibank, for example.

Today, a $700 billion bank (such as the proposed Citigroup) creates added problems for regulators. Whether the problems are twice that of a $350 billion bank (the size of Chase Manhattan) is unclear. What is clear is that sooner or later one of these mega-institutions will stumble, and when one does, it will be important to have a regime in place so that there will be minimal impact on systemic stability.

Some, with whom the Committee met, argued that the safety net protecting depositors should be done away with, that deposit insurance should be eliminated. This would eliminate moral hazard and market discipline could replace regulation. There are problems with this argument. First, the Committee was told that the key safety net is not deposit insurance; it is the perception that the government will not permit the big banks to go under. Second, the "too big to fail argument" aside, there is the threat of contagion, the possibility that if one bank goes under regardless of its size, that others may fail. This may lead to a run on all banks.

The desire of policymakers not to have to face a decision on whether or not to rescue a financial institution places a heavy burden on regulators to keep financial institutions from getting into serious problems in the first place.

One senior banking industry individual told the Committee that what makes a good regulator is a tradition of regulation, an obsession with stability, a focus on the important issues and an understanding of the business.

 

4.  Limiting the Risk Exposure of Banks:  Disclosure

To reiterate, a key aim of bank regulation is to limit the risk exposure of banks to a level compatible with their capital. The problem is, however, that it is very difficult for the regulator, and even senior management of a complex bank, to monitor risk exposure in a meaningful way in an environment in which:

1. many of the instruments offered by financial institutions are mathematically esoteric, and,
2. the risk exposure of a financial institution can dramatically change with a simple exchange of electronic messages.

Further, because of this potential for significant, and almost instantaneous, variation in the risk exposure of financial institutions, the usefulness of relying solely on traditional solvency regulation is diminished.

Hence, both regulators and banks:

1. focus more on the processes and procedures followed by bank’s management and boards of directors to determine the acceptable level of risk;
2. concentrate more on the ways management monitors the institution’s implementation of its risk management policies;
3. pay less attention to the particular state of risk of a given entity at a given point in time; and,
4. rely to an increasing degree on market discipline buttressed by disclosure requirements.

Questions such as the following must be asked by regulators.

• How are decisions that expose a financial institution to risk being made?
• What processes are in place to monitor risk?
• Are deposit-taking institutions using the best standards available?

It was made clear to the Committee, however, that internal monitoring processes and supervision of these processes must be taken seriously, not just set up to satisfy a regulation and then used ineffectively. The Committee was told that the problems with Barings resulted from "a clear failure of internal monitoring and of supervision." (See page 34 for more on problems of failure of monitoring.)

Regulators must rely on self-discipline by financial institutions, but clearly there is a limit to this - a lesson learned from the problems financial institutions get into from time to time by doing "stupid things" - by ignoring their own internal controls, as just noted, or having excessive concentration in their portfolio. Diversification is a key tool in any investment strategy - but one which is easily forgotten when one investment - say real estate - is doing particularly well.

Almost everyone with whom the Committee spoke, emphasised a need to turn more and more to market discipline. One suggested way of bringing market discipline to bear on financial institutions is to require mandatory subordinated debt to be issued by the financial institution. The interest paid on this debt of a financial institution will be a signal to regulators about the degree of risk that the market attaches to that institution. Investors in subordinated debt will in all likelihood rely heavily on the judgement of rating agencies before making a specific investment. Thus, the rating agencies will become quasi market "regulators." However, a few of the people the Committee spoke to questioned whether the past performance of rating agencies justifies this faith in rating them.

Another way to bring market discipline is to publicly expose the operations of a financial institution to as great a degree as possible, and to make the directors and senior officers of that institution responsible for the accuracy of the information that is made public. (As explained below, this is the approach taken in New Zealand.) This enables any market participant who is considering entrusting assets to this FI to decide whether the behaviour of this FI is consistent with the market participant`s preferences. (See page 34 for questions that one organisation suggests should be asked of all FIs.)

The Committee was impressed with the New Zealand approach which has been quite innovative in its increased use of disclosure and decreased use of costly, intrusive regulations. New Zealand set up a system to ensure that appropriate attention is paid to the management of risk by bank directors and management. The system involves an extensive regime of quarterly disclosure of the banks’ assets, liabilities and exposure to risks, backed up by attestation by all the directors that the bank is applying appropriate risk management procedures. Directors are to be liable to stiff fines and periods of imprisonment for false or misleading statements and have unlimited personal civil liability for losses incurred by others as a result of these statements being inaccurate.

Such a system, in effect, requires that the information which would normally have been disclosed in private to the supervisory authority - the end-quarter financial position, peak exposures and the attestation that the registered bank is applying all the necessary risk management - be publicly disclosed.

Because all banks have to disclose similar information, there is no competitive disadvantage, and comparison among these institutions is straightforward. The information to be disclosed is, in addition, the kind of information that banks use to ensure prudent management.

In a system of open disclosure, market discipline can operate primarily through the cost of capital. Banks should face a cost of capital that reflects the riskiness of their activities. Further, pressure on banks to run themselves well comes from the depositors, who can withdraw their money if they are uneasy about the way the bank is being run, and shareholders who invest their money in the best run institutions.

But, disclosure is not the only tool used in New Zealand. There continue to exist the wide-ranging conditions that must be met before a bank can be chartered, including capital adequacy criteria (which will be addressed further below). There is, however, relatively less reliance on costly, detailed, intrusive regulations.

Finally, should these "preventive" measures fail, and a bank does run into serious problems, the Reserve Bank of New Zealnd continues to have extensive powers to act swiftly to protect the interests of depositors.

 

5.  Key Points of the New Zealand System of Disclosures for Banks

1. There is a very extensive and detailed disclosure of a bank’s assets, liabilities, and exposures to risks on a quarterly basis;
2. The Reserve Bank works with the banks to work out exactly what is to be included in the detailed disclosure;
3. The banks also develop, for customers, a less detailed, two to three page summary of the key elements of the extensive quarterly information released that is be available in every bank branch;
4. The Reserve Bank works with the banks to work out exactly is to be included in the two to three page summary (data such as the bank’s credit rating, capital ratios, peak exposure concentration, and asset quality) and how the data are presented;
5. All directors of a bank are required to attest that the quarterly statements are reliable;
6. All directors of a bank are required to attest that the internal controls of the bank are appropriate to the nature of that bank’s business and are being properly applied;
7. Directors are subject to substantial penalties (fines, imprisonment) for making knowingly false or misleading statements;
8. Directors have unlimited personal civil liability for losses incurred by others as a result of knowingly false or misleading statements;
9. Directors are protected from penalties or from personal liability if they can prove that they acted carefully, prudently, and without negligence;
10. Foreign institutions operating in New Zealand are required to disclose the required information for their New Zealand operations (with the decision on what to disclose about global operations being left to the parent financial institution); and,
11. The Reserve Bank makes publicly available a comparison of the data provided in the two to three page summaries required of the banks.

The Committee recognises that, under the existing regime in Canada, in which important information remains confidential, the regulator has more discretion in its dealings with banks than the regulator has in systems with extensive disclosure like that in New Zealand. In certain circumstances the regulator in a more discretionary (and confidential) regulatory system like Canada’s may be more "flexible" in its dealings with a bank than a strict interpretation of the rules might call for. This in turn may prevent a minor problem from escalating into a major one.

There are, however, other considerations. How can we ensure that all institutions in similar predicaments will be treated in the same manner? Does the fact that "behind-the-scenes" flexibility is possible create incentives that may lead banks into situations that full disclosure would not?

The Committee recognises that there is a tradeoff between full disclosure and the flexibility that confidentiality permits, but is persuaded that the case for a regime with greater disclosure is strong. Institutions that are aware that their behaviour will be subject to public scrutiny will make certain that all decisions taken adhere to established processes and procedures. They will not rely on "behind-the-scenes" forbearance from the regulator to shield them from the consequences of mistakes.

The Committee is further aware that the usefulness of disclosure is a function of the quality of the data available. Committee members were told, by almost every regulator with whom they met, that the effectiveness of disclosure is hampered to some degree by existing accounting practices. There are no harmonised international accounting standards making comparisons of financial institutions across regulatory environments difficult. Efforts are, however, underway by the International Accounting Standards Committee, representing 88 countries, to remedy this problem. (See page 36 for more discussion of this issue.) The success of this initiative is critical to the link between disclosure and market discipline.

It is interesting to note that, in July,1998, the U.S. Office of the Comptroller of the Currency (OCC) announced that regulators would, for the first time, go directly to bank directors to identify specific risky loans and lending practices. It was the view of the OCC that one of the contributing factors to the Savings and Loan Industry problems in the United States was a lack of vigilance by directors. This new policy will put more pressure on directors to take their oversight responsibilities seriously; they will not be able to claim they were unaware of problem areas.

It is the view of the Committee that greater responsibility should be placed on directors and senior officers of a bank for decisions taken by the bank, and that there should be greater disclosure of the bank’s financial condition. Directors would be protected from personal liability with a due diligence defence.

It is further the view of the Committee that there is a tradeoff between a regulatory system with more openness and the "intrusiveness" of regulations. Because directors and senior bank officers will assume more responsibility and because there will be more disclosure, the regulator should no longer impose as onerous regulations as are imposed in a regime with greater confidentiality.

 

Recommendations

1.  The Committee recommends that Canada adopt a system of disclosure similar to that of New Zealand, adapted to make it appropriate to the Canadian legal and institutional framework.

 

6.  Limiting the Risk exposure of Banks:  Capital

As noted earlier, the Basle criteria have been found to be unsatisfactory due to their arbitrariness. The Committee heard about a number of initiatives that attempt to move away from detailed regulatory approaches that are inappropriate in the current environment. These are discussed in the individual country studies in the Appendices

The Committee also heard, however, that the risk profile of an institution can change dramatically with an exchange of electronic messages. What then is the point of even trying to measure risk in a FI`s portfolio? First, it was made clear to the Committee that the regulator must get some idea of a FI`s risk exposure in a dynamic sense and not at a specific point in time. Second, without some idea of the risk exposure, how can the institution or the regulator determine minimum capital standards?

It is the capital maintained in reserve that provides assurance to a FI`s depositors and others to whom it has made financial commitments, its counterparties, that the FI will be able to honour its commitments in the face of "acceptable" losses from on- or off-balance sheet-related transactions.

Consequently, the FI and the regulator must have some idea of the risk involved in all the FI`s activities.

 

2.  The Committee strongly supports ongoing OSFI participation in current initiatives among regulators world-wide to explore routes to setting capital that put more emphasis on the risk across the entire portfolio of a bank and on approaches that provide incentives for management to commit the appropriate levels of capital.

 

7.  Limiting the Risk Exporsure of Banks:  Rules-based Regulation versus Judgement-based Regulation

With respect to the content of regulations, the Committee heard diametrically opposite views during its European trip and its American trip. The "judgement-based" approach of the Europeans in theory involves setting relatively "broad brush" regulations and then letting the regulator adapt them to each issue that arises in a manner that the regulator deems appropriate for the situation at hand. The rules-based approach of the Americans, on the other hand, involves a relatively strict application of very detailed regulations.

In practice, the approaches used in both Europe and the US did not fit these simple characterisations. While the European approach is certainly less rule-oriented than the American approach, the rules are not so general that institutions can custom design their own regime. And the rules in the United States are not so detailed that regulators have no flexibility in adapting them to the particular circumstances of a specific bank but they have much less flexibility than European regulators.

Many of those with whom the Committee met in Washington and New York did say that, in an "ideal" world, they would choose a more flexible approach to deal with safety and soundness issues and a rules-based approach for consumer protection and disclosure. They argued, however, that because of the large number of institutions in the US, the judgement-based approach is simply not feasible. In addition, the American regulators pointed out the moral hazard issues inherent in the latter and the incentive for forbearance on the part of regulators. In a rules-based environment, it is easier for the regulator to be tough when toughness is called for.

If discretion is to be used, it must be with transparency. In the US when there is a failure, the regulator must provide an explanation of exactly what steps were taken and when to try to avoid the failure. The report goes to the General Accounting Office and to Congress. Basically, what the Committee heard was that institutions and regulators in the United States prefer a rules-based system where the regulator is not "straight-jacketed" by the rules. It appears that the US will be moving toward a more judgement-based approach for the "big" institutions.

There are a number of valuable lessons to be learned from the two approaches. Regulated institutions must clearly understand how the regulations will be applied in situations that are not unique, and they must clearly understand, when a decision is made, what the rationale for that decision is. Further, there must be consistency in the interpretation and application of the regulations to a specific institution, as well as across institutions. If an institution’s request of a regulator is rejected, an explanation should be provided.

It is the view of the Committee that the Canadian situation is somewhat closer to the American approach than the European approach, and that OSFI has struck an appropriate balance between the two. The Europeans have a much longer tradition of using the informal, consultative approach than the Americans who are more accustomed to a confrontational, often litigious, approach. The Committee sees considerable merit in spelling out the rules relatively precisely, while not placing either the institutions or OSFI in regulatory straightjackets.

 

The Committee recommends:

3. That OSFI have the power to use a combination of regulatory approaches; that OSFI have the discretion to decide the best approach to regulation to be used in particular circumstances; that is, the power to adopt detailed codes which prescribe appropriate conduct and disclosure in particular industries or to allow the industry to develop such codes;

4. That OSFI do a cost-benefit analysis of proposed regulations as part of its consultation process with stakeholders;

5. That, when a decision is made, OSFI provide a clear explanation of what the rationale for that decision is, and that, if an institution’s views are rejected, an explanation be provided to that institution.

 

While the regulator monitors the risk management practices of banks, there is no ongoing monitoring of the supervisory practices and procedures of the regulator. Internal audit units generally focus on the details of specific situations and not on broader questions such as consistency of standards.

In the United Kingdom, the Financial Services Authority (the new integrated financial institutions regulator) is creating a quality assurance function to ensure that standards are being adhered to by examiners and to foster the spreading of best practices. The goal is quality assurance, improving the consistent application of operating standards and not to second guess the decisions of individual supervisors. Such a function is an important management tool that can clearly assist in the continuous improvement of supervisory practices and procedures.

 

The Committee recommends:

6. That OSFI establish a quality assurance function to improve the consistent application of operating standards. The scope of this function should cover technical aspects of supervision and wider management issues such as staff development and training.

 

8.  Corporate Governance and OSFI

The Committee was persuaded by what it heard from FSA officials and by Federal Reserve Bank of New York officials about the value of a board of directors for the regulator. These boards act as oversight bodies, not enforcement bodies, and provide the regulator with individuals knowledgeable about the regulated sector, individuals who can bring a private sector perspective to the processes implemented by the regulator to fulfil its mandate, and individuals able to communicate the views of the regulator to the public.

 

The Committee recommends:

7. That OSFI have a board of seven directors to oversee the exercise of its statutory powers and that at least 2/3 of the board be independent (to be defined following public consultation and hearings as described in recommendation 8);

8. That issues such as selection of board members, selection of the chairman, term of board members, compensation of board members, be developed by the government based on extensive public consultation, including hearings before the Senate Banking Committee;

9. That the OSFI board operate with the powers of a corporate board except that it not have the power to hire and fire the Superintendent;

10. That the Superintendent be chosen from a list of nominees submitted to the Minister by the board (similar to the procedure used to select the Governor of the Bank of Canada); and,

11. That the Senate Banking Committee annually hold hearings to review OSFI’s performance based on its objectives as set out in legislation and on its corporate governance processes.

 

9.  Consumer-related Issues

The Committee heard from regulators in every country involved in the study that more needs to be done to educate the public about the financial services sector and about what consumers should expect from the regulator and from the deposit insurer. Of particular concern is that many individuals believe that the deposits they hold in financial institutions are protected by public or private plans, when, in fact, they are not protected. There is confusion about the role of financial institutions and about the types of deposits offered by these institutions. In the United Kingdom, the FSA will have a public education role to deal with these concerns.

 

The Committee recommends:

12. That the government develop public education programs about the financial services sector, about the nature of risks involved in transactions with banks, about which institutions are federally regulated and what that means, and about what protection is available to those dealing with banks;

13. That OSFI establish a process to formally incorporate consumer input into any consultations that OSFI undertakes about proposed regulatory changes;

14. That the government review disclosure requirements for retail financial products to ensure that they provide information that enables comparison among products. This information should:

1. be comprehensible and sufficient to enable a consumer to make an informed decision relating to the financial product; and
2. be consistent with that for similar products regardless of which institution offers them;

15. That the government monitor regularly the effectiveness of disclosure requirements using complaints data and user testing.

 

10.  OSFI's Ability to Carry Out Its Mandate

The Committee heard repeatedly from regulators, from banks, and from analysts about the critical importance of having a regulator with the quality of staff and support, particularly in the area of information technology, that will enable it to carry out its responsibilities.

The regulator must have people on its staff who can validate the models used by financial institutions to deal with risk. While there is no universal model, there is a universal goal - to measure value at risk (VaR). The regulator is not there to advise the bank on what model to use to manage risk, but may advise the bank to bring in a consultant if it feels the bank’s model for estimating risk is not adequate,

As new financial instruments are developed, the risk attributes of a bank’s activities change. The regulator must, therefore, keep upgrading the knowledge base of its examiners. (They do have the advantage of evaluating, not creating - the latter being a more difficult task.)

The pay gap between regulators and the private sector in terms of salaries for employees is large. The Federal Reserve and the OCC in the United States, and the FSA in the United Kingdom, do have pay scales that permit higher salaries than in the civil service, but the salaries are not comparable to those in the private sector. This leads to an increasingly difficult personnel task.

The regulators have been able to attract people with the capability needed if not the experience to be bank examiners. The major problem is keeping the experienced people. The regulator serves as a training ground for private sector financial institutions (which some argued was an appropriate function of government), which then adds the "frontier" skills needed to do risk monitoring in a complex organisation. The skills developed by a regulator are almost completely transferable to the private sector.

OSFI should be able to draw upon the examination fees paid by regulated institutions to pay salaries that will enable it to attract and keep high quality personnel. This implies that OSFI should be exempt from public service regulations.

 

The Committee recommends:

16. That OSFI be provided with adequate resources and authorities needed to

1. attract and keep the quality of staff needed to regulate institutions in the increasingly complex environment OSFI works in;
2. provide the ongoing training needed to enable staff to be able to understand the rapidly changing developments in the financial services sector; and
3. make that level of IT investments that will enable OSFI to deal with its increasingly complex tasks.

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