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Monday, 17 March 2014 12:04

The G20 agenda for financial regulatory reform in 2014

Written by Daniel Mminele

At the time of the Brisbane G20 Summit in November 2014, four core financial reform deliverables will be assessed which ties in with the FSB focus for the upcoming year on “completing the job”. The policy priorities needed to “complete the job” are: building the resilience of financial institutions; ending too-big-to-fail; transforming shadow banking; and making derivatives markets safer. The FSB will also undertake a review of its governance structures and submit a final report to the G-20 Leaders Summit.

I will address each of these policy priorities separately, without going into too much detail, in particular in those areas I have already touched on such as the OTC derivatives market.

Building the resilience of financial institutions
The outstanding reform issues revolve around the Basle III capital framework and include the finalisation of the LCR, the NSFR, capital requirements for the trading book and addressing the various methodologies followed to determine risk weighted assets. South Africa fully implemented the risk-based capital component of the Basel III framework on 1 January 2013, with the exception that the capital charge for credit valuation adjustment (CVA) risk on banks’ exposures to ZAR-denominated OTC derivatives and non-ZAR OTC derivatives transacted purely between domestic entities, was zero-rated for 2013, which exemption has been extended to 2014.

The CVA exemptions have been a necessity because of the lack of a domestic CCP and a similar carve out in larger jurisdictions like Europe.

Another focus area is to improve the comparability across banks of the risk weights that they use in their internal risk models. A high degree of convergence and harmonisation should be reached so as to level the playing fields.

Ending too-big-to-fail (TBTF)
Only a few jurisdictions (most notably the US and the EU) have made the necessary legislative reforms to implement the Key Attributes of Effective Resolution Regimes, which all G20 jurisdictions are expected to fully implement in substance and scope by the end of 2015.

The earlier mentioned Financial Sector Regulation Bill establishes the Bank as the Resolution Authority for domestic SIFIs and market infrastructures, and affords certain resolution powers to the Bank. During 2012/13 the Bank focused on the development of recovery and resolution plans (RRPs, also called “living wills”) by all banks registered in South Africa. A Resolution Policy Working Group (RPWG) was established, consisting of representatives from National Treasury, the Financial Services Board and the Bank, which is to draft the Resolution Bill taking cognisance of the requirements of the Key Attributes. We hope to have this Bill finalised by the end of 2014.

Strengthening oversight and regulation of shadow banking entities
The shadow banking industry has grown tremendously in recent years. The FSB’s 2013 report indicated that non-bank financial intermediation grew by US$5 trillion in 2012 to reach US$71 trillion. The assets in the shadow banking system expanded in most jurisdictions in 2012, helped by a general increase in valuation of global financial markets, while bank assets stagnated. Globally the assets of Other Financial Intermediaries (OFIs) represents on average about 24 per cent of total financial assets, about half of banking system assets and 117 per cent of GDP.

A broad regulatory policy framework for strengthening oversight and regulation of shadow banking entities was endorsed by all G20 members. The framework addresses five policy areas: mitigation of risks in banks’ interactions with shadow banking entities; reducing the susceptibility of money market funds (MMFs) to runs; improving transparency and aligning incentives in securitisation; dampening pro-cyclicality and other financial stability risks in securities financing transactions such as repos and securities lending; and, assessing and mitigating financial stability risks posed by other shadow banking entities and activities. Peer reviews by IOSCO of implementation on the regulation of money market funds will start in 2014.

A particular issue for South Africa is that the definition of shadow banking namely, “credit intermediation involving entities and activities outside the regular banking system” – has different implications in different countries. In the case of advanced economies, it is primarily applicable to such entities as money market funds, hedge funds and private equity funds which play a large role in the financial systems of these countries. In the case of EMDEs like South Africa, these entities are less prominent and although we agree with the intent to bring unregulated or under-regulated activities into mainstream regulation, there could again be unintended consequences that require careful consideration during implementation.

In South Africa the definition of shadow banking as currently stated would cover credit-extending institutions that address the financial needs of individuals and SMEs who are not adequately integrated into the traditional banking sector. Some of these institutions play an important role in deepening our financial system and advancing financial inclusion. A careful balance therefore needs to be struck between creating an enabling environment on the one hand, and ensuring appropriate market conduct provisions, protection of consumers and guarding against irresponsible and exploitative lending practices on the other.

FSB Governance Review
As part of the process to enhance trust and confidence in the financial system, the FSB has proposed a review of its governance structure to ensure a comprehensive approach to representation in the FSB across all levels. South Africa recognises the value of having the widest possible participation when developing global solutions to regulation in a highly globalised financial system and supports the principle of equal and balanced representation. The development of global financial standards, principles and processes require coordination between central banks, prudential and market conduct regulators, as well as policy making institutions such as the Ministries of Finance. A representative member body, in which each participant is able to contribute effectively, will improve the FSB’s ability to develop standards and rules that are responsive to the needs of key stakeholders in the global regulatory community, and will lead to greater compliance with global financial standards.

Before I conclude, let me say that completing the four remaining core reforms is quite an ambitious agenda which if rushed through could result in compromises being made and create its own challenges in the future. The fact that the leading global regulators have not reached sufficient agreement to issue joint regulations is causing divergences and market fragmentation between them. It is also having a big impact on efficiency and financial stability and is increasing the business costs for both the providers and the users of financial services.

South Africa is suffering direct and indirect consequences from this situation. More impetus and direction to address the current situation of fragmentation and arbitrage and push for a higher level of coordination is required. In the past, we have stressed the importance of national discretion and flexibility and we should continue in this vein. However, the scope, substance and spirit of the global regulatory objective should still be met and demonstrated at all times.

In conclusion, the task of global regulatory reform is complicated by the fact of blurring lines between banking, insurance and capital markets. Interconnectedness of markets within and across countries requires an element of harmonisation without neglecting country-specific circumstances. The other challenge is that ‘we are making our way as we go’, because the crisis is not over yet, and we are working on the basis of preliminary lessons without being able to fully assess the likely consequences.

This calls for a collaborative effort between regulators to minimise uncertainty for financial institutions and markets, so as to allow them to structure their risk management processes, price products and embark on long-term planning.

Similarly, financial market participants and institutions need to take responsibility for being responsive to, accepting and communicating to their other stakeholders the need for and benefits of regulatory reform. Standards such as Basel III will not address good day-to-day risk management within banks, or the lack thereof, including strategic risks that banks undertake in pursuit of return on equity demands from shareholders who often have a short term view of the world. And of course Basel III only covers banks and therefore the financial system as a whole will remain vulnerable until we have regulations in place for the system as a whole.

The above is an extract from The G20 agenda for financial regulatory reform in 2014, from:  Keynote address by Mr Daniel Mminele, Deputy Governor, South African Reserve Bank, at the Risk and Return Conference in Cape Town on 'South Africa in the global regulatory context: progress, challenges and opportunities'.

See a related paper: The BRICS and the International Development System: Challenge and Convergence?, Institute of Development Studies, March 2014.

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