Speech for the Panel on Financial Sector Regulation at the conference to mark the 80th anniversary of the CNB - 4 April 2006, CNB, Prague

Ladies and gentlemen,

It is with great pleasure and respect that I address such a distinguished panel of speakers and audience with my remarks on financial sector regulation on behalf of the Czech National Bank. I find it particularly relevant to hold such a discussion today, on the occasion of the celebration of the 80th anniversary of our bank - FOR TWO REASONS: 1) For some time we - along with an increasing number of central banks around the world - have viewed financial stability as one of our key objectives, and 2) and perhaps even more notably, our institution became as of 1 April this year (i.e. IN FACT YESTERDAY) the sole integrated supervisor of the entire financial industry in the Czech Republic, as a result of a merger of the former SEC and offices for supervision of insurance, pension funds and credit unions into the central bank. This change - in my view - sparks the beginning of new life for the CNB and is thus a natural opportunity to pause and reflect not only on our past achievements, but even more importantly on our future vision, mission and strategy in the field of regulation and supervision. Today's conference and - in particular - the structure of this panel offers a nice background for this sort of pondering, as it brings together both central bankers and prominent representatives of the industry. I strongly believe that a constructive and grown-up dialogue is key to a successful relationship between the supervisor and the financial services industry. This dialogue is conducted not for its own sake, but to lead us:

  • to achieve our common goal of better regulation suited to the increasingly complex and global financial industry;
  • to foster mutual trust and respect for capacity of judgment; and finally
  • to explore market based collective approaches that might become a suitable alternative to the traditional top-down regulatory approach.

Our responsibilities and statutory objectives - the what and why of regulation - are clearly set by law. But in very large measure it is left to us to determine how we should regulate. And this deliberation will clearly benefit from our dialogue with the industry, because a supervisory body can - in my view - be respected only when it is sufficiently professional, transparent, accountable and able to react quickly to the development of the financial industry itself.

I would like to touch on three issues: the regulatory philosophy, harmonisation within the EU as a predominant source of new regulation and home/host issues.

Our regulatory philosophy

The decision to integrate financial market supervision into the central bank is clearly a political decision. It is, however, based on a set of practical arguments and can in a nutshell be viewed as a reflection of:

  1. the growing complexity and interdependence of the financial industry, which is leading to discussion about integration in a growing number of countries; 
  2. the unique position of the robustly independent Czech National Bank, which is well suited to combine the micro- and macro-prudential approaches to financial stability and has a rather painfully learned experience and solid reputation; and 
  3. the structure of the Czech financial market, which is bank- and bank group based (Banks = 74% of assets of fin sector in 2004, tendency towards slow decline over time; influence of bank controlled fin groups: assets of 4 largest bank groups = approx. 50% of assets of fin sector)

While I do not underestimate the importance of this institutional change for the internal functioning of the Czech National Bank, I would naturally like to concentrate on its impact on the quality of regulation and supervision and on the costs of regulation borne by market participants.

As an immediate priority following the integration I see it as necessary to ensure continuity of processes and human resources. In the medium term , our goal is to create truly integrated supervision by

  • creating a single, common institutional culture,
  • identifying and resolving unwarranted regulatory differences between the sectors,
  • balancing sector specific technical issues with consistency of the whole process so that ultimately the same activities will be supervised in the same way, thereby avoiding arbitrage opportunities as much as possible.

Regulation of the financial services industry exists because of the potential economic and social effects of major financial instability, the desirability of maintaining markets that are efficient, orderly and fair and the need to protect retail consumers in their dealings with the financial services industry. Nobody today, probably, would argue against the existence of regulation, but there is a natural debate about how regulation and supervision is conducted.

The effectiveness of any supervisor is critically influenced by the macroeconomic and institutional conditions in the country where it operates. Experience shows clearly that unstable macroeconomic conditions and/or dysfunctional legal and institutional market infrastructure (law enforcement, courts, registers, accounting rules…) significantly hinder the ability to achieve supervisory goals.

With this caveat in mind, I do believe we should aim for regulation that is:

  • risk-based;
  • cost-sensitive; and
  • principle-based as much as possible.

No regulator can eliminate all risk. Risk is inherently connected with reward and, furthermore, regulatory resources are always limited. So, any good regulator must focus resources on the areas of highest risk.

Equally important, in my view, is the need to be sensitive to the costs we impose on others. That is why we are starting to work together with the Ministry of Finance and representatives of the industry on regulatory impact methodology, and our ultimate aim should be to accompany each new regulation with a sound cost-benefit analysis. We are, however clearly not there yet.

Finally, relying more and more, wherever practical, on general principles rather than detailed rules has many advantages. It provides better quality regulation and it provides flexibility for firms to decide how to comply, so long as they deliver the result, and thus allows for necessary heterogeneity of the financial sector, which in my view makes the sector as a whole more resilient to external shocks and the constantly changing global environment. The capital requirements directive is a good example of what I mean here - creating more alignment between how managers view the economics and risks of their business and the regulatory capital needed to support that business. I strongly believe that it is managements' job to organise, manage and control their businesses in a way which meets a set of general principles determined by the regulator necessary to safeguard the interests of customers and secure the safety and fairness of markets. Sometimes it is necessary to underpin those principles with detailed rules (such as, say, a definition of regulatory capital), but it should not be the regulators' job to tell management how to run their business.

That brings me to a second topic - the EU

It is a reality of all EU-based regulators that the source of our regulation is almost exclusively in Brussels and that the domestic legislative process has been transformed into implementation of EU directives. My so far short experience with insider debates on the future of regulation in the EU signals to me that there is a serious preoccupation of policy makers with the lack of progress on integration of financial markets across the EU, in particular in retail financial services. Some people think that without the detail of regulation being the same in each member state, we will not foster the emergence of a truly single market in financial services. While I can understand the theoretical basis of this argument, I believe that regulation must also be sympathetic to the particular characteristics of different markets and resist what the Chairman of the British FSA Callum McCarthy recently described in one of his speeches as ' mindless box ticking" 1)

The only way to balance this conundrum is to strive for lighter regulation, based on principles rather than detailed prescriptions as much as possible.

I would also argue that in the retail financial services market, issues of taxation, social security systems, pensions mobility, language and culture are all more important in preventing the operation of a single market than (the lack of) regulation. Let us not be led into believing that regulation alone can facilitate the emergence of a single market for the retail customer. Neither can or should regulation alone foster the development of relatively under-represented parts of the Czech financial sector (such as life insurance, the stock market etc.)

Home/host issues and financial services regulation in Europe

A particular feature of the Czech banking sector is the high share of assets under foreign control: banks represent three-quarters of the financial sector and approximately 97% of the assets of banks are owned by non-residents (vs. 23% in 1997); the owners come mainly from the EU-15 and are geographically very diversified. The issue of the optimal structure of financial regulation in Europe and in particular of the so-called home/host relationship is thus quite topical for us.

I think that there is no magic wand here to resolve this complex problem easily, but our position on it can be summarised as follows:

  • We support the current Lamfalussy framework. But it should be recognised that there are limitations to what the CESR, CEBS and CEIOPS can achieve.
  • At the same time we see as misplaced - at least under the current circumstances - the debate about further shifting supervisory responsibilities to home country supervisors, for the following reasons:
    • legitimacy: supervisory responsibilities are always delegated to the supervisor by a particular jurisdiction;
    • accountability: supervisors are accountable to the domesticpublic for securing financial stability;
    • limited resources: they lead everybody to rely on a risk-based (proportional) approach; in our case this would mean that - with some exceptions - all our dominant players would be supervised as unimportant institutions by home country supervisors.

The debate about the regulatory landscape should not in my view be about institutional realignment for the sake of it, but should be about better regulation - that is, whether any proposal would provide more efficient andmore effective regulation than the current structure.

So, rather than spending time on the centralisation debate I would argue for trying to set up clear rules and procedures for the existing supervisors on information exchange and crisis management. Sounds mundane, but it could do the trick much better….

Ladies and Gentlemen, I am very grateful for the opportunity to set out some thoughts on the important topic of financial regulation and supervision. I believe that now, while standing at a crossroads after the domestic institutional change and being also able to influence the debate in Europe from within, we have a great opportunity to get it right by doing what makes sense for business, while securing the fairness of markets, protecting the interests of consumers and achieving the ultimate objective of a stable financial sector and sustainable economic growth supported by it. Finding the right balance between ensuring the stability and safety of the financial system on the one hand and cultivating a competitive, innovative and diversified environment on the other hand, will in my view be one of the major tasks of integrated financial market supervision in the Czech Republic for the years to come.

Thank you for your attention.

 

1)  e.g. occupational pension funds should not be introduced in the Czech Republic and the respective directive should not be applied to our existing funds, which are not occupational in nature.