The working group formed at the behest of the G20 leaders to review the ongoing economic crisis has recommended that the financial regulatory framework within each country should use a system-wide approach to improve oversight and mitigate excess risks that are built over a period.
The group, which was headed by Reserve Bank of India Deputy Governor Rakesh Mohan, pointed out that such a system-wide approach will have to supplement a sound micro-prudential and market integrity regulation.
“For rolling out effective mechanisms, most jurisdictions will have to improve coordination mechanisms between various financial authorities,” it said. The group also called for bringing together national financial authorities on an effective global platform to jointly assess systemic risks across the world’s financial system and coordinate policy responses.
“The scope of regulation and oversight should be expanded to include all systemically important institutions, markets and instruments. This will require enhanced information for financial authorities on all financial institutions and markets, including private pools of capital,” the group said.
It stressed that the proposed regulatory framework should strive to treat similar institutions and activities consistently, placing greater emphasis on functions and activities with less emphasis on legal status.
Dwelling on the weakness in the system, the group said that the credit quality of loans, which were transferred to other entities through the securitisation process, was not adequately assessed. Also, there was a lack of oversight of systemic risks.
“The build-up of leverage and the under-pricing of credit risk were recognised in advance of the turmoil. But their extent was under-appreciated and there was no coordinated approach to assess the implications of these systemic risks and policy options to address them. There was also insufficient recognition of the ‘interconnectedness’ of risks within both regulated and unregulated markets,” it added.
| WEAKNESSES THAT DRIVE THE FINANCIAL CRISIS |
| * Weaknesses in underwriting standards |
| * Lack of oversight of systemic risks |
| * Lack of oversight of unregulated pools of capital |
| * Weak performance by credit rating agencies |
| * Shortcomings in risk management practices |
| * Financial innovation outpacing risk management |
| * Lack of transparency in various OTC markets |
The group also observed that unregulated and lightly regulated pools of capital, such as hedge funds and private equity funds, grew rapidly in importance during the period preceding the crisis.
“Regulatory arbitrage pushed risks outside the regulatory framework and, in many jurisdictions, oversight of these markets and entities consisted – to a large extent – of indirect oversight through the supervision of counterparties and market discipline. Also, there was a significant acceleration of financial innovation in the years leading up to the crisis that far outpaced the ability of firms to manage risks and that of regulators to effectively monitor them,” the group said.
The group felt that the weaknesses in public disclosures by financial institutions damaged market confidence during the turmoil.
“Public disclosures by financial institutions did not always make clear the type and magnitude of risks associated with their on- and off-balance sheet exposures,” it said.
Referring to improving capital standards, the group’s report said that, once conditions in the financial system recover, global standards for capital and liquidity buffers should be enhanced. “The building of capital buffers and provisions in good times should be encouraged so that capital can absorb losses and be drawn down in difficult times,” it added.
