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Time to Tackle Unfinished Business

Time to Tackle Unfinished Business

by Wayne Byres

Former Chair, Australian Prudential Regulatory Authority (APRA)

Feb 14, 2024

Thoughts

This article originally appeared in Starling Insights' “Physician, Heal Thyself” Deeper Dive.

It’s now more than a decade-and-a-half since the 2008 financial crisis. In that time, the scale of the regulatory reform agenda has been impressive: stronger capital and liquidity requirements, tougher requirements for systemically important institutions, the advent of structured macroprudential policy frameworks, and more robust recovery and resolution planning, to name just a few.

Supervisory toolkits have also been enhanced, with more attention on the identification of potential vulnerabilities through advances in stress testing, better data collection, greater attention to operational resilience, and a more systematic approach to assessing organisational governance and culture — with a particular emphasis on risk culture.1

There's no doubt that the financial system is more resilient because of these efforts. While there can, of course, never be any guarantee that such a crisis could not occur again, many of the fault lines that existed in 2008 — both in the financial system, and in its regulation and supervision — have been substantially addressed.

Yet, 15 years on, one important issue remains largely unaddressed by the international regulatory and supervisory community: establishing and reinforcing a strong supervisory mindset and culture. It would be a pity if this remained consigned to the “too-hard” basket.

Prudential supervision is needed to fulfil the goal of being anticipative and preventative.

To be clear, this is not a criticism of any individual jurisdiction or agency. As discussed below, there have been a range of domestic initiatives to promote more active and effective supervision. But the financial system is a global one, and weaknesses in supervision can impact well beyond national boundaries. It’s time for the relevant international bodies tasked with promoting good supervision to take a closer look at the issue, and to play their part in promoting a stronger supervisory culture more widely.

It has long been understood that strong regulatory foundations are necessary, but not sufficient, to deliver a stable financial system. Prudential supervision is needed to fulfil the goal of being anticipative and preventative — that is, heading off small problems before they become big ones. Importantly, good supervision is more than just checking compliance with regulation: it needs to be sceptical, questioning, forward-looking, and proactive. Indeed, ideally regulation will be framed in a manner that empowers supervisors to act in a timely and effective manner (though far too often it is not).

Because good supervision is forward-looking, it must involve a degree of judgement applied (judiciously and proportionately) in a proactive manner. It’s therefore often rightly said that supervision is more art than science. Good supervision isn’t mechanistic — it requires a blend of experience, intuition, foresight, a degree of scepticism, and a healthy dose of courage, to be effective. A supervisor obviously needs the requisite analytical tools to identify potential vulnerabilities, but identification without action achieves little.

Hence, establishing the right supervisory mindset and culture — especially a bias to action — is critical to effective supervision. That seems fairly well accepted in principle. So the relative lack of attention given to the issue by the relevant international bodies tasked with promoting good supervision (primarily the BCBS, IAIS and FSB) is perhaps somewhat surprising.

Establishing the right supervisory mindset and culture — especially a bias to action — is critical to etfective supervision.

Globally, supervisors have rightly recognised governance and culture as important contributors to the financial safety and soundness of regulated firms. More attention has therefore been given to drivers of culture, and particularly to the design of incentives for risk-taking. And yet this attention to culture within firms has not flowed into similar international efforts to strengthen the mindset and culture of financial supervisors.

Ex-post reviews of crises and periods of turmoil since 2008 have inevitably raised questions about whether supervisors did enough, and quickly enough. While hindsight is a wonderful thing, rarely has it been concluded that supervisors didn’t have enough information, or sufficient powers, to identify problems. Rather, supervisory inaction, or insufficient action, has often been called out. And yet steps to tackle this issue head-on remain, at best, piecemeal and largely left to domestic supervisors to pursue individually.

Moreover, evidence shows that organisational governance and cultural failings are not just confined to financial firms. If poor culture and governance can produce poor decisions and practices in any sort of firm, why should we not expect these issues to challenge a financial supervisor too?

Yet maybe it’s not so surprising this issue remains largely unaddressed by the international supervisory community.

Attention to culture within firms has not flowed into similar international efforts to strengthen the mindset and culture of financial supervisors.

The topic is undoubtedly a hard one. Assessing culture is a complex, and sometimes highly subjective, task. Supervisors are far from having an internationally agreed framework or the necessary skillsets for comprehensively reviewing culture within banks and other financial institutions, let alone agreeing an approach that could be applied to supervisors themselves.

The post-crisis reforms also had a strong emphasis on the incentives for risk-taking created by the design and quantum of variable remuneration in financial firms. Supervisors typically don’t use variable remuneration structures (at least of any meaningful size). A framework for the analysis of the drivers of supervisory culture and mindset would, therefore, need to begin from a substantially different starting point.

Perhaps the most challenging aspect is that, human nature being what it is, it’s always easier to judge others than it is to judge oneself. If done well, self-assessments can be uncomfortable. Any internationally coordinated response would thus require the leaders of supervisory agencies to begin by acknowledging that, ‘as leaders, we would benefit from help to do better.’

HISTORY MIGHTN’T REPEAT, BUT IT SURE RHYMES

Time and time again the issue of supervisory mindset and culture are prominent features of postmortems conducted in the wake of a financial failure.

More than 20 years ago, contemporaneous inquiries into the failures of two insurance companies (HIH Insurance in Australia and Equitable Life in the UK) identified similar issues. In both cases, it was found that supervisory shortcomings were not the primary cause the failures; the companies were the authors of their own demise. Yet it was noted that supervisors were overly passive in the face of identified issues and should have done more to respond to problems and to alleviate the eventual costs to policyholders and taxpayers.

Time and time again the issue of supervisory mindset and culture are prominent features of postmortems conducted in the wake of a financial failure.

In the case of HIH, a Royal Commission found that the supervisor’s performance was wanting. “It missed warning signs, was slow to act … In many instances, APRA did not react appropriately.”2 In the case of Equitable, the Penrose Report found “there was a general failure on the part of [supervisors] to follow up on issues that arose in the course of their regulation of the Society.”3 Supervisors “did identify relevant issues,” Penrose found, “but consistently these were not followed through and were allowed to evaporate.”4

Unfortunately, these lessons were not learnt more broadly. As a result, many similar findings emerged from the multitude of reviews and postmortems that followed the 2008 financial crisis. Most had their own variant of the powerful and succinct statement by the US Financial Crisis Inquiry Report: “We do not accept the view that regulators lacked the power to protect the financial system. They had ample power in many arenas and they chose not to use it.”5

And yet, despite this clear message, the problem continues to reappear.

Most recently, the US Federal Reserve published a review of its supervision and regulation of Silicon Valley Bank (the Barr Report). With echoes of the HIH and Equitable cases 20 years earlier, the Report concluded “[w]hen supervisors did identify vulnerabilities, they did not take sufficient steps to ensure that Silicon Valley Bank fixed those problems quickly enough.”6

In discussing what it needed to do better, the Report noted the Fed’s first area of focus would be to “improve the speed, force, and agility of its supervisory process … We need to develop a culture that empowers supervisors to act in the face of uncertainty. In the case of SVB, supervisors delayed action to gather more evidence even as weaknesses were clear and growing. This meant that supervisors did not force SVB to fix its problems, even as those problems worsened.”7

It would be brave to suggest this will be the last time that supervisory mindset and culture are deemed to be inadequate to the task at hand. That the issue has emerged in many different jurisdictions, each with different supervisory architecture and powers, suggests that this problem is not a product of any particular supervisory structure, approach or methodology. Yet little seems to have been done by the international community to help address the challenge.

AGENCY LEADERSHIP — THE MISSING INGREDIENT?

That’s not to say no one has sought to tackle the issue.

The IMF published an important contribution in 2010, when it set out to establish the fundamentals of good supervision. The IMF identified that, to be effective, supervisors must have both the ability to act and the willingness to act, with the latter acknowledged as the more difficult of the two dimensions to develop.

“Supervisors must be willing and empowered to take timely and effective action, to intrude on decision-making, to question common wisdom, and to take unpopular decisions.”8 The paper identified some foundational elements that would support these proclivities, including a clear and unambiguous mandate, operational independence, skilled staff and an appropriate relationship with industry.

The IMF’s paper was followed up by the Financial Stability Board, later that year, with recommendations to improve the intensity and effectiveness of the supervision of systemically important institutions.9 As with the earlier IMF paper, the FSB’s emphasis was on getting the right infrastructure for active supervision: mandates, powers, resources and analytical capabilities.

Despite repeated shortcomings being identified, relatively little has been done over the past couple decades, from an international perspective, to support the strengthening of supervisory mindset and culture towards one of action.

In both cases, however, one critical component was overlooked: the role of organisational leadership in establishing the right culture for the supervisory agency. Having the right powers and tools is a critical precondition for effective supervision, but without the right mindset — the willingness to act, in the IMF’s terminology — they will not be enough.

The Basel Committee’s Core Principles for Effective Supervision have incorporated the IMF’s foundational elements in their assessment criteria. The Principles also emphasize, in many places, the importance of supervisors acting “at an early stage” to bring about “timely corrective action” in relation to supervisory concerns.10

Yet, despite pointing to the importance of supervisory assessment of the risk culture within banks, the Principles are largely silent on the importance of establishing the right culture (as distinct from the infrastructure of frameworks and policies) within the supervisor itself. There is no discussion — and hence there will be no subsequent assessment — of the role of supervisory leaders in setting the right ‘tone from the top’ within their organisations. The International Association of Insurance Supervisor’s Insurance Core Principles are similar in their inclusions and omissions.

Most recently, the Basel Committee’s Report on the 2023 banking turmoil noted that an important lesson for supervisors was the importance of exercising supervisory judgement, and that supervisors must consider “how they can effectively complement … standards by exercising judgement — and therefore intervene proactively even when specific rules have not been breached.”11

Although the Report (disappointingly) offers some justifications for a lack of supervisory action, it does suggest that “supervisory authorities could also review whether the guidance and processes given to individual supervisory teams appropriately incentivises a willingness to act early, accompanied by a clarity of process on how to do so.” This is perhaps the closest any of the guidance comes to touching on the responsibility of the leadership of supervisory agencies for establishing a culture of action.

TIME FOR ACTION

To be genuinely effective, financial supervisors need to have a bias to action, and the courage to act. Despite repeated shortcomings being identified, relatively little has been done over the past couple decades, from an international perspective, to support the strengthening of supervisory mindset and culture towards one of action. The regulatory framework has been substantially strengthened, and supervisory toolkits have been significantly enhanced. Yet, as noted above, analysis without action achieves little.

The critical role of agency leaders in establishing the right supervisory mindset and culture – especially one with a bias to action – needs to be explicitly acknowledged.

Having led a supervisory agency for over 8 years, I know well that establishing and maintaining the right supervisory culture and mindset is no easy task. It’s difficult to get right. Supervisory successes — problems averted — are largely unseen. Stakeholder priorities and expectations can shift through the economic cycle. Most of the time, the supervisor will be regularly reminded to avoid excessive regulatory burden, and to not be overly prescriptive and hands-on when it comes to how a financial firm is managed. Yet, when problems in the financial sector occur — as they are wont to do — the supervisor will often be critiqued and told it should have done more. It is the supervisor’s lot to grapple with this tricky balancing act.

More support from international bodies to help national supervisors strike this balance this would be a welcome development.

In recent years, there have been many domestic initiatives to strengthen and reinforce supervisory culture with a view to getting this balance right:

  • APRA’s Enforcement Review12 sought to create a better integration of routine supervisory activity with formal enforcement action;
  • the Expert Group Review of the European Central Bank’s Supervisory Review and Evaluation Process13 recommended greater use of empowered supervisory judgement, supported by a well-defined supervisory culture and risk tolerance framework; and
  • Canada’s Office of the Superintendent of Financial Institution’s Transformation Program14 seeks to ensure that the organisation, including its culture, is fit for the future.

But while these and other domestic initiatives are to be commended, they could usefully be supported through complementary international initiatives.

The first step needed is for the international regulatory and supervisory community to take the issue out of the “too-hard” basket. This could build on the post-crisis work of the IMF and FSB, support and reinforce work already underway in many countries at a domestic level, and help propagate good practice across the wider supervisory community. Even for those jurisdictions that are considered to already have strong and active supervisors, being able benchmark themselves more systematically against good practice and developments elsewhere should be seen as a helpful way of preserving that status.

In recognising that more can and should be done, the critical role of agency leaders in establishing the right supervisory mindset and culture — especially one with a bias to action — needs to be explicitly acknowledged. The current guidance on establishing an effective supervisory function focuses primarily on the necessary infrastructure — mandates, legal powers, skillsets, etc — but neglects any mention of the role of leaders in setting the right culture for their organisation. It’s akin to saying that, as long as a financial firm has all the right policies and frameworks, it will automatically generate prudent outcomes.

We have learnt that this emphasis on risk governance infrastructure over risk culture is insufficient in financial institutions, and it’s no different in supervisory agencies.

References
  1. The term ‘risk culture’ lacks a precise definition, but a commonly accepted reference is the Financial Stability Board’s Guidance on Supervisory Interaction with Financial Institutions on Risk Culture (April 2014), which defines risk culture as an institution’s norms, attitudes and behaviours related to risk awareness, risk taking and risk management.
  2. The failure of HIH Insurance, Report of the HIH Royal Commission, April 2003
  3. Report of the Equitable Life Inquiry, March 2004, by the Right Honourable Lord Penrose, p727.
  4. Ibid. p723.
  5. Final Report of the National Commission on the Causes of the Financial and Economic Crisis in the United States (January 2011), p. xviii
  6. Review of the Federal Reserve’s Supervision and Regulation of Silicon Valley Bank (April 2023), p ii
  7. Review of the Federal Reserve’s Supervision and Regulation of Silicon Valley Bank (April 2023), covering letter p3.
  8. The Making of Good Supervision: Learning to Say “No” (May 2010), IMF Staff Position Note.
  9. Intensity and Effectiveness of SIFI Supervision (November 2010), Financial Stability Board in consultation with the IMF.
  10. See, for example, Principle 11 in the Core Principles for Effective Supervision: Consultative Document (July 2023), Basel Committee on Banking Supervision.
  11. Report on the 2023 banking turmoil (October 2023), Basel Committee on Banking Supervision, p21.
  12. Enforcement Strategy Review (March 2019), Australian Prudential Regulation Authority. LINK
  13. Assessment of the European Central Bank’s Supervisory Review and Evaluation Process (April 2023), Report by the Expert Group to the Chair of the Supervisory Board of the ECB. LINK  
  14. A Blueprint for OSFI’s Transformation 2022 – 2025 (December 2021), Office of the Superintendent of Financial Institutions. LINK

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