Regulatory Environment for Banking &

Finance (FINA 2001)

Semester 1 Year 2014/15

Lecturer: Warrick Ward

elementsofbanking@yahoo.com or e-learning
(Moodle)
Lecture 2
Simple and easy. Something that everyone can understand!

How is Regulation and Supervision Conducted?

What is the difference between regulation and supervision?

Can they be treated interchangeably?
What do you understand by risk-based supervision?
Regulation refers to the provision of rules that
define acceptable behavior and conduct for financial
institutions
Supervision refers to the enforcement of the rules.
Risk-based supervision is driven by the principlesbased philosophy of regulation and supervision
(discussed in a few minutes)

Which would you be most

concerned about?
As the regulator responsible would
you be equally concerned with the
rollout of a new ATM system and IT
framework at a medium-sized bank
or credit union or THIS?
Which would you place greater
emphasis on and why?

A small credit union

operation

Regulatory Philosophy
Principles-based vs. rules-based
May exist a temptation for the regulator to be prescriptive
in the way it regulates due to its detailed knowledge of the
industry.
In addition to stipulating outcomes, such as service levels
and prices, it also largely stipulates the methods by which
the companies operate.
Principles-based basic principles, flexible, easier and
cheap to comply with; stressed importance of governance
Consistent with efficient markets hypothesis theory
Rules-based details rules, very legalistic, little scope for
interpretation, detailed reporting requirements, higher
compliance costs.
A false dichotomy?

Regulatory philosophy:
Principles-based
Conduct their functions in a transparent and
accountable manner.
2. Act with prudence and integrity and in the best
interests of their customers at all times.
3. To maintain at all times sufficient financial
resources to meet their commitments.
4. Have in place sound corporate governance
structures.
5. Have oversight and reporting systems that allow
board and management to monitor and control all
operations.
1.

Regulatory philosophy:
Principles-based
6. Have in place internal controls that are adequate
for the nature, scale and complexity of their
operations.
7. Have risk management policies systems
appropriate to the nature, scale and complexity of
their operations.
8. Comply with any regulatory rules set down by the
financial regulator in relation to, for example,
solvency and capital adequacy, segregation of client
funds, consumer protection codes.
9. When required, to produce accurate, complete
and timely information.
10. Have high level legislation with extensive
scope for guidance

Rules-Based
Relevant measures or behaviours are pre-determined
by rules
Given the same triggering events (e.g.
transactions over a threshold), the same behaviours
apply in all situations
Compliance is achieved when pre-determined
behaviours are adopted, regardless of their suitability
(formal component)
No or little discretion in adapting the measures to the
concrete case (equal treatment of different
situations)

The rules-based approach

Advantages:
Clarity and certainty
Transparency for registrants
More operational than principles

The rules-based approach

Disadvantages:
High compliance costs
Initiative and
innovation depressed
Excessive litigation
Capital markets less
attractive to
investors

Principles-based legislation
With principles-based legislation, principles
aredrafted at a high level of generality, with the
intention that they should be overarching
requirements that can be applied flexibly to a
rapidly changing industry. They contain terms
that are qualitative not quantitative:
The use general, usually evaluative terms (fair,
reasonable, suitable) as opposed to straight
rules (within two business days, turnover of
$20m).
They are purposive, expressing the reason
behind the principle. They have very broad
application to a diverse range of circumstances.

Principles-based legislation
Largely behavioural standards more concerned
with, for example, the integrity, skill, care and
diligence and reasonable care with which
authorised firms or approved persons conduct
and organise their businesses and the fairness
with which they treat customers and manage
conflicts of interest.
Based on the idea that firms and their
management are better placed than regulators
to determine what processes and actions are
required within their businesses to achieve a
given regulatory objective.
Regulators, rather than focusing on prescribing
the processes or actions that firms must take,

Regime comparison
Type 1: Rules-Based

Principle-based

A firm must execute all

orders of under 5,000
securities instruments
within one business day

A firm must pay due regard

to the interests of its
customers and treat them
fairly

Supervisory Type

Certainty

Congruence to
supervisory
objectives

Hybrid (Rules-Principle)/Complex
Rule

A firm must execute all

orders for customers within
one business day in the
following circumstances:
[definition of customer,
definition of order, restriction
as to whether discretionary
dealing or execution only,
definition of one business
day, circumstances where
large orders may be worked
Ease of over
Application
for creative
a longerScope
period,
etc.]

compliance

Rules

High

Low

High

High

Principles

Dependent

High

Dependent

Low

Complex Rule

High

High

Low

High

PARADOXES
7 paradoxes of principle-based legislation:
1. THE INTERPRETIVE PARADOX:
Principles can be general yet precise
2. THE COMMUNICATIVE PARADOX:
Principles can facilitate communication but can also hinder it
3. THE COMPLIANCE PARADOX:
Principles provide scope for flexibility in compliance yet can lead to
conservative and/or uniform behaviour by regulated firms
4. THE SUPERVISORY AND ENFORCEMENT PARADOX:
Principles need enforcement to give them credibility but overenforcement can lead to their demise

Paradoxes
5. THE INTERNAL MANAGEMENT PARADOX:
Principles-based regulation can provide flexibility for internal
control systems to develop but can overload them
6. THE ETHICAL PARADOX:
Principles-based regulation can facilitate a more ethical approach
but it could result in an erosion of ethics
7. THE TRUST PARADOX:
Principles-based regulation can give rise to relationships of trust,
mutuality and responsibility but these are the very relationships
which have to exist for it to be effective.
Source:
Forms and Paradoxes of Principles Based Regulation by Julia Black
LSE Law, Society and Economy Working Papers 13/2008

Hearing problems
What Regulator
Says:
Capital adequacy, lower
leverage, solvency ratios,
Market dominance
concerns

What
Registrants
Hear:

Registra
nt

Blah, blah, blah,

money, blah, blah,
blah, blah, blah

Regulat
or

Conversations in a reconfiguration to Gary Larsons What

Building the Toolkit

Given the scale of resources at the most regulators, a
leaning towards principles-based seems logical..BUT
A regulator should not institutionally dominated by a
conduct of business or market conduct ethos, causing it
to lose focus on prudential and financial stability
issues.NOR
Expand the toolkit and does not use the tools
To be effective in such a situation, a regulatory
framework needs to be enforced appropriately. In
addition to an effective inspection regime, this requires
regulators to use their sanctions (ranging from
conditions attached to licences, to financial penalties,
or even revoked licences) in a manner that will most
benefit the functioning of the market and therefore
ultimately the consumer.

Lax Financial Regulation

(Have the
tools but do not use them or does not know
how to use them!!)

Supervisory requirements
Effective regulation of financial
institutions requires:
Risk-based regulation
Integrated supervision
Higher standards for corporate
governance

Risk-Based Regulation
What do we mean by Riske-Based Regulation?

Risk Based Framework

Know your Customer (KYC)
Capital Adequacy
On-site Programmes
Legislation

Risk-Based Framework

Assess nature, scale and complexity of entities seeking to be based in

Barbados, their related risk and level of sophistication of clients involved

Apply progressively higher levels of scrutiny and more requirements

when higher risk profile/exposure determined (e.g. financial, operational,
reputational risk)

Need to develop an internal risk management structure that allows

regulators to identify and manage the risks that exist

Risk-Based Regulation
Move focus away from detailed rules.
Transparency to ensure institutions understand
risks and how they will be dealt with.
Each institution is risk rated, advised of risk
level, areas of particular risk so they can begin
to take measures to reduce risk.

Risk-Based Regulation
Risk based supervision monitors risks and aims to
reduce risk where necessary
Greater focus is paid on corporate governance
Corporate governance and risk-based supervision
are mutually reinforcing. Both are ways of
managing and controlling risk
Monitor risks: A view to prevent problems from occurring
rather than attempting to fix problems that have happened
Problem avoidance a more effective public policy than
problem rectification
Also more efficient because allocate resources only where
risks are high

Risk-Based Framework
Behaviours differ from case to case, depending
on the risk
Given the same triggering events, situations
may be treated differently (different treatments
for different situations)
Compliance means exercising discretion in
determining the most appropriate measures in light
of the risk
Compliance is achieved when the risk is tackled
appropriately; examples set out in the rules are not
exhaustive (substantial component)
High-level legislation; extensive scope for
guidance

Corporate Governance Partnership

in Regulation
Principles-based legislation
Every insurer that authorizes one or more agents to act on behalf of the
insurer shall establish and maintain a system that is reasonably designed to
ensure that each agent complies with the Act and the regulations.
This clearly makes the company responsible for maintaining the suitability
of its own agents
By means of benchmarking, the regulator determines the risk levels based
on observed net risk situations.

Rules-based legislation
Prior to the issuance of a license to an insurance salesman the
applicant must meet certain suitability criteria enforced by the
regulator.
Results in filings, correspondence between the regulator
and the applicant.

Comparison of Traditional, Compliance Based

with Corporate Governance, Risk Assessment
Based
Rules-based
Known globally as an army of
compliance checkers
Proliferation of rules
In fast changing environment (such
as financial services), many rules no
longer make sense, some may be
contrary to public interest.

Principles based
Fewer personnel but higher calibre
Few behaviour, more corporate
governance rules

Expensive

Stipulate public policy intent,

board and senior management put
in place systems to meet
compliance can be a matter of
competitive advantage

stifles competition, destroys

initiative, discourages innovation

Encourages innovation, competition, and initiative

Key Success Factors in the Regulatory

Framework
Culture
Rigorous challenge of risk models and governance
Require firms to explain why business models are safe before approved

Focus

Pro-active oversight of whole financial system

Forward looking assessment of potential risks (not backward looking
legalistic rules)
Firms should address conflicts of interest and consumers need for timely,
accurate and intelligible information

Philosophy

Macro-prudential systemic risks and controlling externalities

Firms should act honestly, fairly and professionally in best interest of
customers
Exercise of supervisory judgement based on discretionary powers

Legislation can influence culture, focus

and philosophy
Need to set clear objectives
Effectively allocate powers and responsibilities
Establishes appropriate system of accountability
of regulatory bodies

The Optimal Regulatory Regime How Well are

Regularors Doing?

Ex-ante tools Impact Assessment

Impact Assessment (IA) is a tool which aims to

ensure that regulatory proposals are subject to a
transparent, publicly accountable and rigorous
analysis to determine if they are a proportional
means of meeting regulatory objectives.
Used effectively, they help ensure the burden of
regulation is not unnecessarily increased by
answering the questions:
Should a new regulation be introduced?
Should an existing regulation be abolished?
Are there better ways of achieving the objective
rather than regulation?
Do the benefits justify the costs?

The Optimal Regulatory Regime

How Well Are We Doing?
Ex-post tools post implementation review
Further to the analysis of the administrative costs
imposed by regulation, post-implementation review
involving the full range of estimates and assumptions on
which the regulatory framework was based. This
requires the regulator to consult with the relevant
stakeholders, and allows more consideration of the more
indirect policy costs as well as wider industry issues.

Though often neglected, this process is key to

ascertaining if the stated objectives of regulatory
frameworks are being met, if there is scope to further
reduce the regulatory burden, and if specific regulation
is proving effective or should perhaps even be removed.

Key Considerations for

Captives
Application for Captive Registration in
Barbados:
Companies apply as Exempt Insurance
Companies
Application fee is US$250.00
Minimum Start Up Capital of US$125,000 is
required

Annual License Fee:

US $10,000.00

Key Considerations for

Captives
Solvency Requirements:
The value of the assets in the first financial year must
always exceed the value of the liabilities by a minimum of
US$125,000.
After the first financial year, if the premium income of the
company is between US $750,000 and US$5 Million, then to
be solvent the assets of the company must exceed the
liability by an amount equivalent to one fifth (1/5) of the
premium income.
If the premium income exceeds US$5 Million, then to be
solvent the assets of the company must exceed the liabilities
by an aggregate of US$1 Million and one tenth (1/10) of the
premium income in excess of US $5 Million.

Key Considerations for Captives in Barbados

Statutory Reporting Requirements:

1.

Audited financial statements submitted annually.

2.

Annual actuarial certificate evaluating the companys

reserves and liabilities.

3.

Auditors certificate indicating the licensees compliance

with the prescribed solvency requirements.

4.

Quarterly financial statements. These could take the

form as management accounts and will be used by the
regulator as a means of conducting on-going supervision.