A More Market Based Approach to Maintaining Systematic Stability

This paper explains how banking supervision within the EU could be improved by the implementation of greater market discipline and related changes. It draws heavily on the experience of New Zealand, where there was a major shift in this direction in the mid-1990s. Although existing EU law, institutions, market structures and practices of corporate governance restrict the scope for change, substantial improvements could be introduced in the current framework. Such changes would be particularly easy to introduce in the UK as its systems are more similar to New Zealand's. While New Zealand has many special features which make the new regime particularly suitable there, all the main principles could be applied in the context of current EU legislation. These include: ensuring the quality of corporate governance of those financial institutions wishing to be registered as banks, with high accounting and independent auditing standards; public disclosure of substantial information about the risks individual banks face so that market disciplines can be applied - including extending Value at Risk measurement to the whole of the bank's activities; placing the responsibility of the prudential operation of each bank on its directors and management, with penalties and financial liability for false statements; and avoiding putting taxpayer funds at risk, by making it clear that no bank is too big to fail and focusing the role of supervisors on ensuring that they have the power to step in and prevent adverse consequences to the system as a whole when a bank gets into difficulty. By these means, the moral hazard inherent in bank supervision and the costs of supervision could be significantly reduced.Greater market discipline, in the form of a regime of quarterly public disclosure by banks of their capital adequacy, peak exposures and risk management systems, along with improved incentives, could help to improve the prudential management of banks, enable supervisors to focus on systemic risks and help customers determine the risks they face. Banking inherently involves the taking of risks, but transparency and improved public information about them would help all concerned manage the risks more effectively and reduce the chance that the taxpayer will again be called upon to help rescue the banking system