Evolving bank supervision

The BIS came into being during the period of great depression. The negotiations which began in Paris on February 11, 1929, and continued in Baden Baden and Brussels finally concluded in the Hague on January 20, 1930. The first meeting of its board was held on May 12, 1930. Initially, its focus was confined to a small group of countries of Europe. Gradually, its circle of participants widened; between 1950 and 1960 the central banks of Iceland, Ireland, Portugal, Turkey and Spain became members of BIS. This was because BIS assumed the functions for the European Payments Union. The BIS provided a forum for cooperation among the central banks. First, the cooperation assumed the form of providing opportunity to governors of central monetary developments. Secondly, consultation could also be held on the adoption of practical measures, either domestically or internationally, and their possiblerepercussions. Thirdly, in certain exceptional circumstances meetings at the bank may culminate in the joint action and occasionally in the provision of financial assistance when deemed necessary to deal with emergency.

Earlier, the BIS was largely European in character but with creation of G-10 in 1963, the United States, Canada and Japan were drawn into its meetings on regular basis. In 1970, Bank of Canada and Bank of Japan became members followed by the central banks of Australia and South Africa. Though its membership extended over five continents, its focus was again limited to the rich countries. The BIS took a lead in suggesting policy measures to promote (a) macro-economic stability and (b) financial stability. Its greater concern has been to ensure financial stability as there is a belief that once the financial stability is achieved, the macro economic stability is relatively easy to handle through various policy measures.

Because of several crises in the 1990s and their global reach, the BIShas hosted regular meetings of central bank governors of the principal industrial and emerging market countries. Among the issues, these meetings discussed the problems relating to the current account in the balance of payments, exchange rate adjustments, the pack of bank restructuring in emerging markets, and the risks and challenges posed by asset price inflation amidst deflationary pressure in the goods market.

On issues relating to financial stability, the bank constituted and provided secretariat for a number of standing committees, namely, the Basle Committee on Banking Supervision, Committee on the Global Financial System (formerly the Euro-currency Standing Committee) and Committee on Payment and Settlement System (CPSS). The first two committees are concerned with safe functioning of the banking sector and the markets involved in the international financial system. The third focuses on the infrastructure which links institutions and supports the orderly functioning of the financial markets throughthe payments and settlement system.

Basle Committee on Bank Supervision

This committee has focussed its attention on the Basle Capital Accord which stipulated the capital structure for the banks. The Accord of 1988 classified bank lending into three broad categories: (a) the loans which do not require any capital to be set aside, this is, sovereign bonds of OECD countries, (b) the loans which require capital to the extent of 1.6 per cent. This capital requirement is applicable to the loans extended to the banks in OECD countries, and (c) all other loans extended to corporates and individuals, and these required provisioning of capital at 8 per cent. The main criticism of the accord is that the three-way classification is somewhat arbitrary and does not take into account the riskiness of the loan. The requirement of 8 per cent of capital is uniform whether the loan extended is to a first rate corporate entity or to a company with junk grade rating. The absence of the linkage between the riskinessand the loan has in some cases led the banks to overextend their exposure with a view to earn higher profits. Though in some countries such as in USA, the banks had their own internal system, the feeling was that when riskiness is taken into account, the provisioning for capital could go much beyond 8 per cent and even to the extent of 30 per cent. As a result, some of the banks especially in the USA chose the route of securitisation whereunder bank loans were converted into tradeable financial instruments. The accord was originally meant for the rich countries but when the loans of the banks in USA and UK to emerging market economies ran into difficulties, the countries of the emerging markets were encouraged to join BIS. The functioning of the accord during the last 11 years is being reviewed with the main objectives in the revision being:

i) Promotion of safety and soundness of the financial system,

ii) Enhancement of competitive equity,

iii) Comprehensive approach towards risks,

iv)Continued focus on internationally active banks.

The revision in the accord will place strong emphasis on the market discipline, and supervisory review will become essential components in addition to the minimum capital requirement, and introduce a system of rating credit risk. With this, BIS will be widening the role of Basle Committee beyond its rich G-10 members, and would work closely with non-G10 supervisors. The committee will force co-ordination with IMF and World Bank to strengthen the supervision over financial system generally and banks in particular. In other words, the Basle Committee would develop relationship with and among supervisors from all parts of the world, and will encourage banks from developing countries to maintain capital structure and other requirements in the wake of globalisation.

Committee on Global Financial System

Following the Asian crisis, the committee focussed on monitoring and analysing the developments in international financial markets, and conductexamination of the issues having a bearing on stability of the financial system and possibly make suggestions on policy responses. The main areas in which this committee would monitor and analyse are:

a) Potential improvements in transparency.

b) Behaviour of international capital flows.

c) The effectiveness of international support operations, and

d) The management of country risk exposures by internationally active banks.

Initially, the committee began examination of the use of information involved in the decisions of the banks lending to the emerging market economies, and now it is trying to strengthen its monitoring mechanism of developments in the global financial system and individual countries in order to identify potential vulnerabilities in the financial system.

Committee on Payment and Settlement Systems

In order to strengthen financial market infrastructures and reduce systemic risk, a Committee on Payment and Settlement Systems (CPSS) which has beencontinually increasing its co-operation with other international institutions and is also involving non-GI0 central banks has been set up. This committee has started monitoring several private sector groups involved in the design and enhancement of schemes to reduce foreign exchange settlement risk. The intensification of this work in the foreign exchange area started, following the report released in July 1998 on foreign exchange settlement risk. The committee is also engaged in cooperation with International Organisation of Securities Commissions (IOSCO) to promote greater transparency in settlement arrangement of securities through disclosures and grater transparency.

Finally, in the process of economic growth that is sustainable and steady, one needs to have macro economic stability and financial stability. Both are necessary but financial stability is crucial. The recent crisis have driven home the fact that lack of financial stability, particularly, of the banks is at the root of crises witnessedrecently in several countries of the world. Basically, the work of these three committees mentioned above is directed towards strengthening of the financial structure and ensuring financial stability on the understanding that root cause of instability in the real sector especially, production and prices emanate from the absence of strong and enduring financial system. Measures taken by the BIS to strengthen the supervisory and surveillance mechanism in order to achieve financial stability globally would go a long way in promoting macro economic stability and thereby provide stimuli to the growth process. With rapid movements of capital across countries induced by the technological developments, the steps now taken in the financial sector should usher in the next millennium a phase of faster economic growth. Allan Greenspan, chairman of Federal Reserve has mentioned that we are using the 19th Century instruments to cope up with the problems of the 20th Century in matters relating to surveillance andsupervision of the financial system. If the spirit of this statement is taken, there is a need to foresee the 21st Century developments in the financial sector and create the use of instruments for surveillance and supervision of the 21st Century if not of the next century.

The author is research director with Mega Ace Consultancy Ltd, Mumbai