Catalog

	Table of Contents
p. 25 of 58 BACK | NEXT Purpose and Structure of the Toolkit Part One: Introduction and Overview Part Two: Preconditions and Infrastructure for Financial Sector Development Part Three: Financial Regulation and Supervision I. Financial Stability, Development and Institutional Design A. Design of the Financial Safety Net B. Roles and Responsibilities of Financial Authorities II. Financial Regulation: General Principles III. Financial Regulatory Structure IV. Banking Regulation V. Bank Insolvency and Depositor Protection VI. Securities and Derivatives Regulation VII. Insurance and Pensions Regulation VIII. Regulation of Financial Conglomerates Part Four: Regional Financial Integration Part Five: ADB's Intervention in the Financial Sector Bibliography Glossary and List of Abbreviations Acknowledgements

Financial Sector Legal and Regulatory Toolkit : Part Three: Financial Regulation and Supervision

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I. Financial Stability, Development and Institutional Design

A number of important elements support financial stability and financial development:

• A competitive market structure in the financial services industry, populated by well- managed firms with good governance practices and sound risk-management systems.
• A well-designed financial safety net that prevents the system from collapsing due to market failures.
• An effective regulatory and supervisory structure to minimize any moral hazard associated with the existence of the official safety net.
• A framework that deals with the inevitable failures of economic entities, both in normal and in crisis times, i.e., effective restructuring and bankruptcy procedures for banks, non-bank financial institutions, companies and sovereign governments.

In considering financial regulation, at the outset, the overriding concern should be the overall design of the financial regulatory system (sometimes called the "financial safety net"). Financial safety nets are, in general terms, a set of institutions, laws, and procedures that strengthen the ability of the financial system to withstand bank runs and other systemic disturbances.

The objectives of the establishment of a financial safety net include

• the reduction of macroeconomic costs,
• the control systemic risk, and
• the protection of consumers.

Good corporate governance and sound risk management of individual financial institutions, effective market discipline, and frameworks for strong prudential regulation and supervision can mitigate moral hazard. These elements are most effective when used in concert.

A well-designed financial safety net has four major advantages:

• It helps to ensure that the incentives facing market participants are not unduly distorted, e.g., by a widespread expectation that all financial institution liabilities ultimately have state underpinning;
• It provides clear guidelines for the type of action to be taken in the event of a particular contingency which help to limit forbearance;
• It can reduce the need for ad hoc, ex post actions which, even if effective in dealing with an immediate crisis, may, through "moral hazard," significantly distort incentives for the future; and
• A clear ex ante procedure reduces uncertainty and can thus have the additional advantage of limiting loss of confidence.

As a general rule, the design and ongoing operations of a financial safety net should be guided by the following principles:

• Safety nets should strengthen rather than supplant private capital, monitoring, and closure mechanisms.
• Safety nets should take into account both aggregate and idiosyncratic risk.
• The design of the net should tie securely into the characteristics of the particular financial system and economy in which it is embedded.
• Safety nets should be designed to impose a margin of loss on financial claimants.
• Authorities should be explicit in describing the nature and extent of the safety net and implement appropriate supervisory and regulatory policies. This will reduce the risk of an indiscriminate extension of public guarantees.
• A complete standard would require authorities to develop and regularly review strategic plans for managing financial crises and to train their staff in the use of crisis-management protocols.

Effective financial regulation and supervision is essential to the proper operation of the financial safety net. These issues are discussed below in greater detail.

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