International Financial Architecture - Modern Banking

The Meaning of International Financial Architecture

Though the term ‘‘international financial architecture’’ is relatively new, institutions such as the Basel Committee have been working towards a common system of regulating global banks for over two decades. National bodies concerned with containing national crises, such as Sweden’s central bank and the Bank of England, have been around for centuries. However, the agenda for international financial architecture is much broader, bringing together the various organisations dealing with international finance in an attempt to regulate banks, other global financial institutions and the financial system as a whole. The objectives are to design a global financial structure, and a means of regulating and coordinating institutions within that structure, to minimise the probability of a major financial crisis occurring. Also, to have in place methods for dealing with a crisis, should it occur.

Table above shows the key global institutions concerned with preserving the stability of the international financial system. These organisations focus on the international coordination of regulations in a particular area, including banking, securities, insurance and accounting. The exception is the Financial Stability Forum, which is trying to ensure the effective implementation of all these rules. For example, at its September 2003 meeting, the FSF identified a number of areas which, in their view, required close monitoring and/or action. The issue of credit risk transfer (CRT) from the banking sector to non-banking financial areas, notably the insurance sector, which is arising from the use of credit derivatives. It reported that a work plan had been set up to investigate the issue and address concerns about financial stability posed by CRT. The need for greater transparency in the reinsurance industry was also discussed, as was the role of offshore financial centres in an increasingly integrated global financial market. It looked forward to stronger arrangements by these centres in the areas of supervision, information exchange and regulation. Other areas considered were corporate governance and auditing standards.

There are other organisations which also focus on the broader picture, including the IMF and the World Bank. The International Monetary Fund (IMF) was created by the 1944 Bretton Woods Agreement. With a membership of 182 countries, its primary concern is with the balance of payments, exchange rate and macro stability, with a responsibility for economic surveillance around the world. Member countries are encouraged to meet

International Organisations Concerned with Financial Stability

International Organisations Concerned with Financial Stability

macroeconomic targets. Also, since the 1980s, the IMF has been involved in rescheduling loans/facilitating new ones in the event of major problems (e.g. default or requests by sovereign countries to reschedule debt repayments). If a country is having problems repaying its external debt (private, public, or both), it puts pressure on lenders to extend financing in exchange for the Fund increasing its lending; and on problem debtor countries to implement macroeconomic adjustment programmes including meeting inflation targets and reducing the size of government debt relative to GDP.

The World Bank was also created by the 1944 Bretton Woods Articles of Agreement.

The Bank is a development agency, arranging external finance for developing and emerging markets with little or no access to private lending. The external finance consists of project finance or loans, granted on condition that certain structural adjustments, etc. be made. It also encourages private foreign direct investment.

Both institutions have expanded their financial policy departments and are concerned with financial stability, but mainly at the macro level. The Financial Sector Assessment Programme (FSAP) is a joint programme run by the IMF and the World Bank. Introduced in 1999, it signalled that these institutions were intending to play a greater role monitoring and trying to preserve global financial stability. By April 2003, approximately 95 countries (both developed and emerging market) have either been, or are about to be, assessed. The assessments cover the macroeconomy, identification of points of vulnerability in the financial systems, arrangements for managing financial crises, regulation, supervision and soundness of the financial structure. There is a direct link with the Basel Committee and the WB/IMF through the Core Principles Liaison Group: its remit is to draw up methods for assessing different aspects of the financial sector and for setting up new capital standards. In its most recent public statement (IMF, 2003), concern was expressed that the programme is turning out to be costly, stretching IMF/World Bank resources. Though these reports are thorough, there is a question about their necessity, especially among the G-10 countries, which are reported on by the organisations such as the OECD and produce their own extensive statistics and analyses.

Ongoing Issues Related to International Bank Supervision

International coordination of banking regulation and supervision has come a very long way since the formation of the Basel Committee in 1975. However, there continue to be a number of outstanding issues to be addressed.

Harmonisation of national supervisory arrangements

Increasingly, bilateral meetings are being used to improve harmonisation between supervisors of different countries. They are used to exchange information and draw up memoranda of understanding (MOU). The MOU broadly defines the areas in which the information exchange takes place, dealing with ongoing financial issues and firms. For example, Evans (2000) reports the UK’s FSA has over 100 MOUs with other supervisors. Keeping the lines of communication open in the event of serious cross-border problems is very important, and requires contact and communication at both the formal and informal level.

Improved compliance

Improved compliance with agreed standards set by bodies such as the Basel Committee. The traditional approach has been the assumption that once a standard (e.g. the Basel risk assets ratio) has been agreed upon, the members of the group would implement the new standard. However, there are problems with this method:

  • Failure to apply the rules.
  • Different interpretation of the rules (e.g. tier 2 capital – Basel 1).
  • In the case of Basel, a membership limited to developed countries, though this is changing.
  • For organisations such as IOSCO and IAIS, the membership is so large and the secretariat so small (6 and 5, respectively with 91 and 80, respectively country members) that the rules are impossible to enforce, even if these organisations saw enforcement as part of their remit, which they do not.
  • Basel and IOSCO have attempted peer review but abandoned it for lack of resources, issues related to confidentiality (e.g. how much information does a member pass to the peer member conducting the review?) and a reluctance on the part of one member to pass judgement on another because it could upset bilateral relationships. The IMF and World Bank may be able to monitor compliance to standards laid down by the international supervisors because they have the expertise and resources, and already have detailed knowledge of most countries’ financial sectors. The FSAP is a good example, though these bodies are already concerned that the assessments are stretching their resources. There is a more fundamental issue about whether the IMF/World Bank can be policy advisors/assessors and also act as neutral intermediaries, should a sovereign nation encounter problems repaying their external debt.
  • Incentives could be put in place to encourage countries to cooperate with a compliance assessment and make the results public. Incentives could include using the assessments to reinforce attempts at financial reform by a government, getting better ratings from external agencies and the markets, obtaining lower risk weights for government and bank borrowing in a given country, and being given better access to IMF and World Bank loans. Finally, the market would form a poor opinion of countries that did not publish their reports.

Improved disclosure

Improved disclosure by financial firms is an important component of effective international supervision because it can improve market discipline. The disclosure can be direct, provided by the firms themselves (e.g. pillar 3 of Basel 2) or indirect, where the ratings published by independent rating agencies are used. A more radical suggestion is to use spreads on subordinated debt as an indicator of the health of a financial firm. The Federal Reserve Bank of Chicago has provided some evidence that these spreads are a significant indicator of the creditworthiness of banks but to date, there is no serious move to use them for supervisory purposes.

The Financial Stability Forum (2001) reported the results of a working group looking at disclosure by banks, hedge funds, insurance firms and securities firms. The purpose of the exercise was to issue recommendations on an improved regime of disclosure and the incentives needed to ensure firms participate. The main recommendations called for timely disclosure (at least semi-annual and preferably quarterly) of financial data drawn from a firm’s risk management practices. In addition to data on market risk, credit risk, liquidity risk, etc. qualitative information should be provided. The report also called for more information on intra-period disclosures or issues such as the methodology behind the production of statistics.

However, it is important to bear in mind the costs and benefits of disclosure. For example, supervisors rarely disclose the overall assessment of the riskiness of a particular bank because of the effect it might have on the markets if a bank is pronounced ‘‘high’’ risk. This in turn would adversely affect the incentives of the bank to fully disclose its position to the supervisors, and/or to go for broke in the hope of getting the bank out of a problem before the supervisor finds out.

Participation and cooperation by developing countries/emerging markets

All of the key international bodies concerned with prudential supervision have their memberships dominated by the industrialised countries, while the developing nations are normally the recipients of aid and loan packages by the IMF, World Bank, etc. However, greater participation of the emerging market countries is vital if international financial stability is to be achieved, and this is beginning to happen. For example, 13 emerging market central banks are members of the Bank for International Settlements, in contrast to its predominantly western focus at the time of its establishment. The Basel Core Principles Liaison Committee has members drawn from developing nations.

Harmonisation of accounting standards

There are significant differences in the application of accounting standards, even among industrialised countries. In the United States, pre-Enron, the standards were used to ensure that those looking at a firm’s accounts would get a ‘‘true and fair view’’ of the firm. The result was a proliferation of accounting rules which, in Europe, are regarded as too onerous. Also, many non-Anglo Saxon countries view firms’ accounts as serving a different purpose, such as providing information to creditors and employees. For example, in Germany, methods (e.g. for depreciation) using published accounts must be approved by the tax authorities because tax is determined from the published profits. By contrast, tax authorities in Anglo Saxon countries do not use these accounts to assess tax. In the USA, the Sarbanes–Oxley Act (2002) introduced new, stricter rules designed to prevent a repeat of the poor accounting practices discovered after the spectacular problems uncovered at the bankrupt Enron and WorldCom. External auditors for a firm may no longer offer consulting services, and there are strict new corporate governance rules which apply to all employees and directors of a company. CEOs and CFOs must certify the health of all reports filed with the Securities and Exchange Commission, and face stiff fines/prison sentences if they certify false accounts. A new independent board is to oversee the accounting profession. While the US experience prompted authorities in other countries to re-examine their laws, no country has introduced new laws similar to Sarbanes–Oxley.

There has been significant progress in the resolution of differences, and a convergence of global standards in accounting. In May 2000, IOSCO agreed to allow the International Accounting Standards Committee (IASC) to produce a set of 30 core accounting standards, that would apply globally. After some debate over structure, the International Accounting Standards Board (IASB) was formed in 2001, with 14 members, from 9 countries: 5 from the USA, 2 from the UK, and 1 member each from, respectively, Australia, Canada, France, Germany, Japan, South Africa and Switzerland.47 A Standards Advisory Council (SAC) was established to advise the IASB. The IASB has produced one set of international accounting standards (IAS) so that a transaction in any country is accounted for in the same way. A firm meeting these standards could list themselves on any stock exchange, including, it is hoped, the New York Stock Exchange.

In June 2002, the European Commission (EC) agreed that all EU firms listed on a regulated exchange would prepare consolidated accounts in accordance with the IAS from 2005 onwards. In October 2002, it was announced that the IASB and the US Financial Accounting Standards Board (FASB) were committed to achieving convergence between their respective standards by 2005. Should convergence be achieved, the Securities and Exchange Commission (SEC) could accept financial statements from non-US firms which use IAS – they would not have to comply with the US GAAP (Generally Accepted Accounting Principles).

However, the issue of whether foreign firms operating in the USA will have to conform to Sarbanes–Oxley remains unresolved – many countries are seeking to have their companies exempted. A separate dispute has arisen over two standards, IAS 33 and 39, which the European Commission is refusing to accept. The rules are concerned with the treatment of financial assets and liabilities, currently reported on the accounts at book value. In earlier periods when few bank assets and liabilities (e.g. loans, deposits) were traded, holding them at book value was not controversial. IAS 39 would make accounting statements more transparent with respect to derivatives – many of the markets for futures, options, etc. are large and liquid due to the growth of derivatives and securitisation. The IASB proposes to replace book value with ‘‘fair value’’ – the market price of the financial instrument. European banks and insurance firms, especially the French, have objected on two grounds. Not all financial instruments are traded in liquid markets, so obtaining a market value is difficult. For options, futures, etc. that are traded frequently, the concern is that fair value would lead to more volatile accounts. In the USA, the SEC will not allow European firms to use international rules unless there is greater transparency. The FSAB has threatened to halt its efforts to converge GAAP and international standards.

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