Monday, January 16, 2012

Systemic oversight frameworks in LAC: current practices and reform agenda

The world financial crisis that started in the US housing market in 2008 brought into evidence deep failures of prudential oversight, linked for the most part to a failure to comprehend and handle systemic risk in a way that could prevent systemic crises. This paper summarizes the responses to the joint World Bank -ASBA survey o the state of systemic oversight in the Latin American and Caribbean financial sectors and reflects on some of the challenges identified by respondents. We found that there is broad consensus among regional financial authorities on the need to enhance the current systemic oversight framework. Improving consolidated supervision to mitigate risk-shifting in conglomerates, adjusting prudential regulations to account for the accumulation of systemic risks, redefining the role of the supervisor to make it more proactive, and improving coordination among local supervisors as well as with foreign supervisors figure preeminently in the regional reform agenda.

Systemic risk is defined as “a risk of disruption to financial services that is (i) caused by an impairment of all or parts of the financial system and (ii) has the potential to have serious negative consequences for the real economy”2. Systemically important financial institutions (SIFIs) are those impending failure, inability to operate or disorderly wind down could produce systemic effects as defined above. There are two dimensions to systemic risk; one relates to how risk is distributed in the financial system at a given point in time (“cross sectional dimension”) while the other relates to how risks evolve over time (“temporal dimension”)3. The current oversight framework focuses on individual institutions (microprudential framework) as opposed to the system as a whole (macroprudential framework).

A macroprudential approach to oversight has been proposed for some time with a view to manage systemic risk4 and is now being developed by standard setters. From a cross sectional dimension (also denominated micro-systemic risk perspective), regulation focuses on (i) removing incentives for the accumulation of risks in certain types of intermediaries, including through the extension of regulatory perimeters and the homogenization of regulations across different intermediaries to avoid regulatory arbitrage, (ii) adjusting prudential requirements to take into account the systemic risk induce by the institution, (iii) improving safety net mechanisms to reduce moral hazard pose by SIFIs that are deemed too-big-to fail5. From a temporal dimension, regulatory efforts aim at mitigating procyclicality by preventing the building up of risks in the cycle upturn and creating buffers to cushion the downturn to avoid a credit crunch. On the supervisory front, efforts are directed to monitor interconnections between participants and common risk factors. Such approach requires close coordination between financial sector supervisors and other financial sector authorities, especially monetary authorities.

The Latin America and Caribbean region (LAC), with the notable exceptions of some Caribbean countries affected by the failure of a complex insurance conglomerate, weathered the latest global financial crisis in part reflecting lessons learnt during past financial crisis as well as a somewhat different approach to oversight. Moreover, the credit cycle was not as pronounced as in the industrialized countries most affected by the crisis and public and private sector balance sheets were stronger than in past crisis episodes. However, as the region’s financial systems become more complex and more tightly integrated with those of the rest of the world, the question remains as to whether it could become exposed to similar failures caused by homebred endogenous dynamics or increased vulnerability to external turbulence.

In a framework of collaboration between the World Bank (WB) and the Association of Supervisors of Banks of the Americas (ASBA), the two institutions partnered to prepare a survey and identify the state of systemic oversight frameworks in the region. The survey also intends to understand the perception of the region on the possible need for a reform program aimed at better capturing and addressing systemic risk. This paper summarizes the responses to the survey and reflects on some of the challenges identified by respondents. The paper is organized as follows: section 2 provides a description of the survey; section 3 summarizes the main messages coming up from the survey; sections 4 to 9 provide a detailed description of the responses to the main sections of the survey; and section 10 provides some concluding thoughts.

World Bank. Author: Gutierrez, Eva; Caraballo, Patricia.Document Date: 2012/01/01.Document Type: Policy Research Working Paper.Report Number: WPS5941

Systemic oversight frameworks in LAC : current practices and reform agenda x

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