COMMENTARY

Peter Burgess

Why Supervising the Financial Sector Really Matters

When it comes to the role of government in regulating markets in the wake of the recent crisis, it is regulation of the financial sector that is of greatest interest. Stability is fundamental to a well-functioning financial system. But this stability does not occur naturally, argues Ravi Menon of Singapore's Monetary Authority.

While financial markets are generally efficient, they are subject to market failure and occasional bouts of instability. The global financial crisis of the late 2000s is a perfect example of that.

As the recent financial crisis has shown, stakeholder governance and market discipline can fail quite spectacularly.

Moral hazard occurs when those who make loans are not the ones who bear the risk of default — or at least, they thought they did not bear the risk. Information asymmetry occurs when debt instruments are packaged into complex products whose risks investors do not understand.

When risk is neither monitored nor understood, it gets underpriced and builds up in the system. Effective regulation and supervision of the financial sector is therefore critical to promote prudent behavior and sound risk management.

The question is how to do it without stifling the market? There are no easy answers. At Singapore's central bank, the Monetary Authority of Singapore (MAS), we try to do this in three ways. First, we set healthy prudential standards. Second, we take a risk-focused approach to supervision. Third, we leverage on the market by relying on stakeholders to complement official oversight.

Healthy prudential standards. Singapore's central bank has consistently emphasized healthy prudential standards, especially in good times. Many of these are higher than international norms:

• Banks keep a minimum 10% capital adequacy ratio, with at least 6% in Tier 1 capital.
• Banks set aside general impairment provisions of not less than 1% of net loans and receivables, so that cushions are built up ahead of loan losses.
• Housing loans are subject to an 80% loan-to-value limit. In other words, a lender has at least a 20% buffer against a reduction in collateral value.

Risk-focused supervision. The crisis has highlighted the importance of getting the supervisory approach and intensity right. MAS evaluates the relative risk posed by each financial institution. It subjects the financial institution that potentially has the largest impact on the financial system to the greatest supervisory intensity.

In Singapore, the financial institution that potentially has the largest impact on the financial system receives the greatest supervisory intensity.

MAS demands substantial information and data from financial institutions in order to review their financial situations and their risk profiles. And where there are gaps, MAS makes sure the institutions provide additional, detailed answers.

Also, rather than having a fixed view of what is an acceptable level of business risk, MAS assesses this against the institution's risk management standards. Institutions engaging in complex financial businesses must be able to demonstrate that their risk-management capabilities match their risk profiles.

A risk-focused approach allows greater business latitude for well-managed institutions while retaining higher prudential requirements or tighter restrictions for weaker ones.

Relying on stakeholders. Primary responsibility for the safety and soundness of a financial institution must lie with its board of directors and senior management. It is their job to maintain adequate risk oversight of the institution's business activities. It is neither feasible nor desirable for the regulator to do this.

The government also leverages market discipline to foster prudent behavior among financial institutions. Stakeholders — such as shareholders, creditors and counterparties — have an interest in the continued financial health of the institution.

Likewise, one can assume professionals such as rating agencies and external auditors - chastened by their experiences and failings during the past crisis - will provide an independent assessment of the risks inherent in the institution and the adequacy of internal controls.

Of course, as the recent financial crisis has shown, stakeholder governance and market discipline can fail quite spectacularly. Herd behavior and irrational exuberance can lead the market to overvalue assets or underestimate risks. This is why regulation remains necessary and important.

But it would be a mistake to substitute tighter regulation for stakeholder governance and market discipline. Rather, governments should examine how to better align market forces and private incentives with regulatory objectives. A stable financial system is better assured with a combination of robust regulation, prudent corporate governance and effective market discipline.

Stabilizing markets during a credit crisis

The other key role of governments in financial markets is stabilization. While it has been convenient to blame governments for not preventing the financial crisis, let us not forget that it was action by governments around the world that prevented a complete meltdown of markets. Consider Singapore's experience in fighting the credit crisis.

When credit conditions had recovered sufficiently, the government pulled back. Knowing when and how to exit is an important consideration in any government intervention.

When the financial crisis broke out in September 2008 in the United States, the ripple effects were felt throughout the world. A systemic seizure of credit was underway and threatened to have dire spill-over effects on the real economy if the situation was not stabilized. Trade financing dried up significantly, impacting Singapore's exporters and offshore trading companies.

Singapore's Ministry of Trade and Industry (MTI) and Ministry of Finance (MOF) got together to analyze the situation. The market failure was at two levels: the supply of credit and the price of credit. For some sectors and geographies, there was an unwillingness to provide trade financing or working capital at any interest rate.

For other kinds of loans or borrowers, banks were willing to lend but at much higher interest rates. The way out of the logjam was for the government to underwrite a sufficiently large share of the default risk to induce banks to resume lending.

But how to do this without moral hazard? The fear was that government would end up with 'lemons' — that banks would push less creditworthy loans to the government while keeping safer ones for themselves. There was real fear that the government could end up losing a lot of money without improving the access to credit for deserving firms.

In all the credit schemes drawn up by MTI and MOF, the principle that government must harness the power of the market was strictly applied. That is, the government was seeking not to replace the lending market, but to complement it.

First, the government refrained from direct lending. (Assessing credit risk is not a civil servant's area of expertise.) All government-facilitated loans were made through financial intermediaries in order to tap on their expertise in risk assessment.

Second, despite strong pressures from both banks and the industry, the government refrained from taking on 100% of the risk on any loan. For every subsidized loan, the bank assessing the loan had to have 'skin in the game.'

Singapore's credit enhancement schemes worked. When credit conditions had recovered sufficiently by early 2010, the government scaled back the credit enhancement schemes, reducing loan volumes and the risk-share. This let the market revert to normalcy, so that risk would not be mispriced over the longer term.

Knowing when and how to exit is an important consideration in any government intervention.