Financial Sector Assessment

Institutional Structure of Financial Regulation and Supervision1

Overview

Around the world, many countries are reconsidering the institutional structure of regula­tory and supervisory agencies in the financial sector. This reconsideration reflects the concern that the existing structures—which were often established in a markedly dif­ferent market and institutional environment than exists today—may have become inappropriate to meet the key regulatory objectives effectively. These objectives include fostering market efficiency and promoting market confidence and stability. As countries reassess and then implement changes in their regulatory and supervisory architecture, a number of issues are raised in relation to both the developmental and stability aspects of the financial sector’s evolution.

From the developmental perspective, the main question that arises is whether the existing organizational structure of the financial regulatory and supervisory function is adequate to oversee an often rapidly evolving financial sector that is characterized by new types of financial institutions and new institutional structure (such as financial con­glomerates.) It is also feasible that a poorly structured supervisory function could impede financial innovation or encourage inappropriate forms of innovation. For instance, if the structure gives rise to significant supervisory gaps—that is, differences in regulation of activities that have a similar function but that are performed by different institutional types—market participants are likely to seek opportunities for regulatory arbitrage and to engage in financial operations that are not appropriate from a regulatory perspective. This regulatory arbitrage, in turn, will lead to a developmental outcome for the financial sector that is suboptimal.

From the stability perspective, several key issues pertain to the institutional structure of regulation. The question of regulatory gaps and the implications for regulatory arbitrage is pertinent in this context also. Unsupervised, or inadequately supervised, institutions can be a primary cause of financial instability, and weak institutions will likely try to seek out the lines of least supervisory resistance and to engage in overly risky types of financial behavior. There is always a possibility that a change in supervisory structure could lead to less-optimal outcomes from the stability point of view. Such a case could be, for instance, moving responsibility for supervising banks from a strong and independent central bank to a new agency that is perceived to be less robust. Another issue that has stability implica­tions relates to the risks that arise in transitional phases. Specifically, if a country decides to change the institutional structure of its supervision, there is typically a transitional period during which responsibility is shifted from one set of supervisory bodies to another. During such a transitional phase, there is a risk that the stability of the financial system could be undermined, especially if a supervisory vacuum exists for an extended period.

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