Central banks and other monetary regulators worldwide need to strengthen their supervision of the domestic financial sector after the global fiscal crisis exposed widespread flaws in their role, the International Monetary Fund has said.
"The crisis demonstrated clearly that correcting weaknesses in supervision is as important as the efforts currently underway to reform financial regulation," IMF's first Deputy Managing Director John Lipsky said.
"So far, however, it appears as though most of the public's attention regarding financial sector reform – and perhaps most of official attention as well – has focused on the large regulatory agenda. Nonetheless, IMF analysis suggests that there is significant scope for improving supervision."
Besides stronger supervision, central banks also need to bolster their role in maintaining financial stability and manage capital flows into their countries, Lipsky said in a speech at a central bank conference in Moscow on Friday.
"Post-crisis analysis by IMF staff and other experts found shortcomings related to both the ability and willingness of supervisors to act in the face of institutional weakness… prior to the crisis, for instance, supervisors relied excessively on financial firms' own risk analysis and internal controls. In broad terms, they relied heavily on the self-disciplining qualities of markets. In other words, supervisors were insufficiently intrusive and skeptical," he said.
"In a rapidly changing environment spurred by financial innovation, analysis by the IMF and others suggest that in many cases supervisors did not fully understand new complex products and did not do enough to make sure that financial firms' boards and managements fully grasped the riskiness of these products. In other words, supervisors were insufficiently proactive and adaptive."
Lipsky said IMF studies had also found that supervisors tended to confine their assessments to what he termed as regulated entities and did not adequately consider risks posed from outside of the regulated system.
"Thus, supervision was insufficiently comprehensive… supervisors also often did not act quickly enough to develop their supervisory judgments. In other words, in many cases, supervision was insufficiently conclusive."
He said new IMF analysis, based on over 100 reports under the joint IMF-World Bank Financial Stability Assessment Programme, suggests that supervisory weaknesses are widespread worldwide.
While most countries are in compliance with international standards regarding the legal and institutional framework for supervision, over one-third of countries in our sample did not meet key supervision standards, he noted.
"Specifically, standards relating to the supervision of risks, consolidated supervision, adequacy of resources, operational independence, and enforcement powers were found to be lacking. More recent data suggest that deficiencies in consolidated supervision, operational independence, powers to take corrective action, and comprehensive risk management continue to be pervasive," he said.
"Looking forward, a key task will be to improve supervision. To accomplish this, the central bank's authority to conduct consolidated supervision (including over connected lending) should be strengthened, enforcement powers should be bolstered and supervisory risk management assessments should be enhanced, particularly with respect to loan provisioning and classification requirements."
Turning to financial stability, Lipsky said he expected central banks to start playing a larger role in maintaining systemic stability.
For one thing, he said, monetary policy considerations are relevant, and the crisis offers some key lessons in this regard.
"Moreover, innovative macro-prudential tools should be able to help smooth the over-the-cycle feedback between the financial sector and the real economy. It goes without saying that the crisis posed significant challenges for the conduct of monetary policy in both advanced and emerging economies," he stressed.
"I want to be very clear on one key point: Much work remains in developing systemic financial stability governance frameworks and in making macro-prudential tools operational. Nonetheless, I have no doubt that such tools will prove to make important contributions in the coming years."
In his address, Lipsky also urged central banks to play a more active role in controlling capital inflows follow the recovery in such flows over the past few quarters. He said this followed a sharp fall in 2008 and 2009 due to the crisis.
"There is little doubt, however, that the relative strength of emerging economy policy fundamentals and favourable long-term growth prospects has the potential to attract rising flows from international sources for some time to come. Of course, this is good news, as effectively channelled inflows have the potential to accelerate growth and boost economic efficiency," he said.
"In the absence of an adequate policy and institutional framework, however, it is clear that capital inflows can complicate macroeconomic management, reduce the effectiveness of monetary policy, and create systemic stress."