Designing a System of Financial Regulation Howard Davies Director - London School of Economics Executive Public Policy Training Programme Beijing 20 June, 2006

Five Steps to Reform 1.Assess the strengths and weaknesses of the financial system 2.Determine the desired future shape of the system how flexible? how open? 3. Assess compliance with international standards 4. Review the structural options 5. Map them against local market conditions

1. The Strengths and Weaknesses of the Financial System

Global Financial Stock 2004 (%) Global Financial Stock 2004 (%) China is becoming a significant part of the global system Source: McKinsey Global Institute, 2006

Financial Depth – Financial Stock as % of GDP 2004 Financial Depth – Financial Stock as % of GDP 2004 China’s financial system is already well-developed Source: McKinsey Global Institute, 2006 (%)

Bank Deposits as % of Financial Stock Bank Deposits as % of Financial Stock But it is very heavily dependent on banks Source: McKinsey Global Institute, 2006

Chinese Share of Global Financial Stock (%) 2004 Chinese Share of Global Financial Stock (%) 2004 And the capital markets are relatively small Source: McKinsey Global Institute, 2006

2. The Desired Future Shape of the System Meet WTO commitments Strengthen competitive pressures: greater flexibility Expand capital markets as a source of finance for growth »equities »private sector bonds Improve financial services for lower income families, and in remote areas

3. Compliance with International Standards

G7 Finance Ministers International Monetary Fund World Bank Global Financial Stability Report Financial Stability Forum ADBIADBEBRD etc ICFC The International Financial Architecture Financial Sector Assessment Programmes

A. Banking Supervision Bank of International Settlements G10 Governors+ Heads of Supervision Basel Committee Basel Capital Accord G10 + Spain, Luxembourg EC ECB Central Banks and Supervisors

B. Securities Regulation IOSCO-Core Principles Multilateral MOU C. Insurance Regulation IAIS-Solvency Standards D. International Accounting Standards

4. Review the Structural Options Four main models in operation elsewhere ‘3 pillars’: banking, securities and insurance separately regulated ‘Twin Peaks’: separation of prudential and conduct of business regulation ‘Hybrid’: where two or more sectors are regulated together ‘Integrated’: a single regulator covering most or all of the financial sector.

There is no clear consensus about which model is ‘best’.

Structure of Supervision in 77 Countries, 2002 Agency supervising two types of financial intermediaries Indicator Single supervisor for Banks and Banks and Securities firmsMultiple the financial system securities firms insurers and insurerssupervisors CountriesAustria, Bahrain, Dominican Austria, Belgium, Bolivia, ChileArgentina, Bahamas, Bermuda, Cayman Republic, Finland,Canada, Colombia Egypt, Mauritius,Barbados, Botswana, Islands, Denmark, Luxembourg,Ecuador, El Slovakia, SouthBrazil, Bulgaria, China, Estonia, Germany, Mexico,Salvador, Africa, UkraineCyprus, Egypt, France, Gibraltar, Hungary, Switzerland,Guatemala,Greece, Hong Kong Iceland, Ireland, UruguayKazakhstan,(China), India, Japan, Latvia,Malaysia, PeruIndonesia, Israel, Italy, Maldives, Malta,VenezuelaJordan, Lithuania, Nicaragua, Norway,Netherlands, New Singapore, Rep. ofZealand, Panama, Korea, Sweden,Philippines, Poland, United Arab EmiratesPortugal, Russia, United KingdomSlovenia, Sri Lanka, Spain, Thailand, Turkey, United States % of counties in the sample Source: Luna Martinez and Rose (2003)

There is a trend towards integrated regulation for a number of reasons - growth of financial supermarkets - risk transfer between sectors - attractions of ‘one-stop shopping’

Main Reasons for Adopting Integrated Supervision (agencies indicating any one of the following reasons ReasonsNumber of Agencies Percentage of all agencies Improve the supervision of a financial system moving towards universal banking 1493 Maximise economies of scale and scope 1280 Solve problems resulting from poor communication and lack of cooperation among existing supervisory agencies 427 Minimise gaps in the regulation and supervision of financial intermediaries 320 Facilitate operational restructuring of regulatory agencies (in particular, after a financial crisis) 320 Overcome other weaknesses in the overall quality of financial regulation and supervision 213

But there are also important variations between integrated regulators - scale - scope - powers

Powers of the Integrated Supervisory Agencies over Banks Regulatory and supervisory agenciesNumber of agencies % of all agencies Conduct on-site examinations15100 Conduct off-site examinations and surveillance15100 Impose sanctions and fines for non-compliance with rules and regulations Set prudential regulation on market, credit, operational, and liquidity risks 1280 Set accounting rules and information disclosure requirements 1173 Set rules on the composition of capital1173 Approve and revoke a license to a financial intermediary1173 Set minimum capital requirements1066 Set licensing requirements960 Consumer protection (assist to resolve claims for abuses against users of financial services) 960 Source: Luna Martinez and Rose (2003)

How the Centres Rank in Terms of their Regulatory Environment Market participants tend to favour integrated regulation Source: Z/Yen, 2005

5. Map options against local market conditions China now operates a ‘3 pillar’ model, but with banking supervision outside the central bank suitable where there is little ‘cross-sectoral’ activity also where a single agency might be seen to be ‘too powerful’ and where sheer scale makes effective management difficult.

Regulatory Reform in China is under way commissions: CBRC, CSRC, CIRC - International Advisory Councils - - Training - - Culture of challenge - Overarching body to resolve inconsistencies and promote co-operation

An integrated regulator might be more appropriate if banks are allowed to undertake other activities: universal banking derivatives markets develop, allowing risks to be transferred between sectors multi-functional overseas firms enter the markets on a large scale

Designing a System of Financial Regulation Howard Davies Director - London School of Economics Executive Public Policy Training Programme Beijing 20 June, 2005