Financial Sector Assessment

Assessing Institutional Structure and Regulatory Arbitrage

The appropriateness of the institutional structure for supervising OFIs should consider the overall institutional framework for financial supervision and the scope of the OFIs’ activities within that framework. The number and size of OFIs (individual and aggregate), as well as their links to banks and other players in the financial system, are major fac­tors influencing the appropriate institutional structure for supervising OFIs. The stage of financial development, the legislative environment generally, and the range of regulators’ skills available would also affect the appropriate institutional structure for supervising OFIs.

An institutional structure that is sectorally focused rather than focused on the nature of functions to be regulated may result in gaps in the regulation of OFIs. In some country circumstances, therefore, bringing the regulation and supervision of all types of financial institutions, including OFIs, under a unified supervisory framework would help reduce the possibilities of regulatory arbitrage and regulatory gaps and allow for more-efficient oversight. A unified structure facilitates the adoption of a common set of standards for institutions with the same profile of risk—for instance, uniform application of conduct of business and financial integrity regulations, and adjustments in the scope of prudential regulations according to risk profile. However, under a structure with more than one regulatory body involved in institutional regulation and supervision, special attention should be given to the definition of the legal power of responsible bodies, the identifica­tion of conflicting areas of jurisdiction, and the extent of regulatory duplication. This sectorally focused structure is a source of inconsistencies and ambiguities that have cre­ated weaknesses in the regulatory and supervisory process in many countries. For instance, this structure’s inability to undertake “fit-and-proper” tests and impose minimum capital requirements or other specific guidelines creates loose regulatory and supervisory regimes that allow OFIs to develop their business recklessly and get involved in banking activi­ties.

In countries with separate, sectorally focused regulators, the assessment should focus on verifying the differences in the types of risk posed by various categories of service providers, since the application of different rules to products and services that are func­tionally equivalent can give rise to increased incentives for regulatory arbitrage (OECD 2002). For instance, institutions assuming the main banking functions should be con­sidered banks and regulated and supervised as such. In some countries, OFIs became an important segment of the financial system as a result of efforts to circumvent prudential norms and exploit loopholes in the banking sector.

Table 6.1 compares the regulatory features of banks and OFIs. Raising the following four questions when completing table 6.1 can help regulators verify the differences in the rules applied to different group of institutions (Carmichael and Pomerleano 2002):

• Can institutions subjected to different regulation provide similar products?

• Is a financial institution capable of choosing among different regulators by altering its corporation form, regulatory jurisdiction, or institutional label? For example, is a parent institution able to reduce its regulatory burden by shifting business into an unregulated subsidiary?

• Can new OFIs offer banking-type products under a different banner to remain outside the jurisdiction of the main regulator?

• Is there a regulatory structure in which at least one regulator has overall responsi­bility for financial conglomerates?

In a unified supervisory structure where the number of OFIs is significant but OFIs operate independently from the main players in the financial sector (i. e., banks and insurance companies), establishing a separate department that is exclusively dedicated to the supervision of OFIs is a common practice. In such structure, there are cases where the same regulators are responsible for both onsite supervision and offsite supervision for a group of OFIs, or cases where there is separation between the responsibility for onsite and offsite functions. On the one hand, having the same regulators be responsible for both onsite and offsite functions helps ensure continuity in monitoring events in the sector, as well as coherence in supervision. On the other hand, separating offsite and onsite func­tions provides a certain degree of specialization in the related processes and procedures. In either case, the regulators’ skill levels should be adequate to avoid having inexperienced and unqualified regulators be systematically assigned to supervising OFIs.

In a unified structure where the links between OFIs and banks are significant through investment and ownership, regulators with responsibility for a group of related institu­tions (including banks and OFIs) help monitor development in related sectors in a con­solidated manner. Moreover, specialization helps enhance the regulation and supervision of OFIs. Regulators in charge of supervising banks can usually supervise OFIs, provided they receive adequate training and guidance to specifically deal with OFIs. As stressed in the Basel Core Principles (BCPs) for Effective Banking Supervision, an essential element
of banking supervision is regulators’ ability to supervise the banking organization on a consolidated basis, which includes their ability to review both banking and non-banking activities conducted by the bank.