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	Table of Contents
p. 29 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 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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III. Financial Regulatory Structure

In recent years, there has been a growing concern regarding financial regulatory structure in individual economies and especially with regard to the appropriateness of existing arrangements in the face of globalization, the development of financial conglomerates, and the blurring of lines between traditional financial sectors (banking, insurance, and securities) and products.

Two sets of events have brought these concerns into the limelight.

First, the new Labour government in the United Kingdom, immediately after coming to power in 1997, announced two major changes: (a) formalizing the independence of the Bank of England in setting monetary policy, and (b) establishing a single financial regulatory authority, the Financial Services Authority (FSA), including removal of responsibility for banking regulation from the Bank of England. These actions were undertaken for competitive reasons (a single regulator would be more cost efficient for financial institutions to deal with); prudential reasons (a single regulator would be better able to address changing markets and institutions); and because of perceived inadequacies in the Bank of England's previous system (for example in the collapse of BCCI and Barings Bank.)

Second, in the wake of the Asian financial crisis in 1997-1998, a number of countries, notably South Korea and Japan, have reviewed their financial regulatory systems and structures in order to avoid similar situations in the future. In addition, a variety of other countries have reorganized their regulatory structures in order to address the challenges of the changing financial landscape, including Australia, the United States, Germany, France, and the People's Republic of China.

In addition, as a result of the global financial crisis, many countries are re-examining financial regulatory structure with a focus on eliminating pre-existing gaps and inconsistencies in financial regulation which played a central role in the crisis.

In most economies, the financial sector industry has undergone major changes in recent years. Deregulation, liberalization, and rapid technological innovation have allowed financial intermediaries to offer an increasing variety of financial products and services, blurring the traditional frontiers between banking, securities, and insurance sectors. Moreover, in order to remain competitive in the global market-place, financial institutions have acquired or merged with other domestic or foreign financial intermediaries, giving rise to a large number of financial conglomerates. These developments in the financial services industry pose enormous challenges to national supervisory authorities, since risks have become more difficult to monitor, not just because financial intermediaries tend to be larger and more complex, but also because they operate in an increasing number of national jurisdictions. The current global financial crisis has highlighted the risks of large complex global financial conglomerates and the need to enhance their regulation and supervision in order to reduce the likelihood of future financial crises.

In response to these challenges, countries are exploring ways to ensure adequate regulation and supervision of financial conglomerates as discussed further in Section VIII. As part of these efforts, an increasing number of countries are adopting integrated supervision by either creating a single regulator for the entire financial sector industry or by merging two of the main supervisory authorities (such as banking with insurance or, alternatively, banking with securities).

In strengthening their rules and supervisory arrangements, and exploring the possibility of restructuring or unifying their regulatory agencies, countries must carefully examine the advantages and disadvantages of any possible change, including the risks inherent in the change process itself. As the circumstances of each country are different, each will face different challenges, leading to the conclusion that integrated supervision may work well in some countries but not in others.

Moreover, a number of basic models or structures are possible, none of which can be said to be inherently better than any other. Again, the best fit depends on the particular circumstances of the country concerned. These models have been identified to be

1. Traditional sectoral model - with separate regulators for each financial sector, namely banking, securities, and insurance, often combined with strict separation or holding company structures for financial conglomerates;
2. Functional model - with separate regulators for each regulatory function, (e.g., financial stability, prudential, market conduct, and competition regulation catering to financial conglomerates and product innovation);
3. Institutional model - with regulation on the basis of financial intermediaries individually rather than on the basis of their activities; and
4. Integrated structure - with one or more sectors or functions combined in a single agency, often combined with a universal banking model for financial services provision.

There must also be an acknowledgment of the important relationship among

1. the regulatory structure (and attendant financial and human resources);
2. the financial structure (the relative importance of banking, insurance, and capital markets and the level of financial development or repression); and
3. the structure of financial institutions (e.g., strict separation of financial sectors versus universal banking).

From these lessons, a number of conclusions can be further derived.

First, financial regulatory structure is an important issue. However, the first order of consideration must be to develop the underlying infrastructure (legal and otherwise) necessary to support the development of financial markets and to develop a regulatory and supervisory capacity in line with international standards and within a system of clear objectives, independence, and accountability.

Second, a regulatory structure must be designed to coincide with an economy's financial structure. There must be full coverage of the intermediaries (especially financial conglomerates), functions, and risks inherent in a given financial system and done in a matter that coincides with the history, culture, and legal system of that economy. An additional risk involves financial structure and regulatory design ("financial and regulatory mismatch"). In this respect, the risk is that a jurisdiction's financial regulatory structure will not equate with the structure of its financial sector, i.e., financial intermediaries will be organized on a basis which is not appropriately addressed by the regulatory structure. In such circumstances, it is possible that significant risks may develop through financial intermediary operations which are not supervised by the existing structure. For example, in a strict separation financial system, informal financial groups may develop, which in turn are not regulated on a group basis, but only on a sectoral institutional basis, leaving the financial system exposed to the risks of the "group." In the current global financial crisis, this is exactly the sort of problem that the United States has had to face.

Third, coordination and cooperation is essential between all of the various authorities in an economy responsible for financial regulation.

Finally, the restructuring process itself carries risks and must be carefully considered and conducted in order to avoid worsening the current situation.

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