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Rethinking financial sector regulation

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The recent case of ReNaissance Merchant bank alleged financial misconduct this year (2011) and the previous 2003/4 banking crises have placed the financial sector regulation debate to the fore of financial sector policy discussion.

In a statement to Parliament recently, the Finance minister considered moving towards a single mega regulator for the financial sector.

This article is an extract of a research paper I presented at the Zimbabwe Global Diaspora Conference in December 2007 which contributes to this debate.

Traditionally, regulators have employed the silo approach in regulating the financial system which is sector based (banking, insurance and securities).

The emergence of financial conglomerates has challenged traditional demarcations between regulatory agencies and has made regulation more complex.

Whilst there is evidence of moving from the silo-based approach, there is inconclusive evidence on the best regulatory structure any country should follow.

The choices range from a single agency in the form of a mega regulator or middle of the road approach such as twin peaks or partially integrated regulatory system is being adopted depending with a country’s circumstances and development of the financial system.

The Reserve Bank of Zimbabwe (RBZ) is responsible for banking sector regulation including registering and supervision of banks.

The securities industry is regulated by the Securities and Exchange Commission while the Insurance Commission regulates the insurance sector and pension funds.

The first limitation with the silo approach is inconsistency when regulating a financial group. A financial group that operates in all three industries has three different regulators.

Tighter regulation is generally imposed on the banking sector relative to others due to its vulnerability.

This provides space for regulatory arbitrage by financial groups. Institutions may reduce the required aggregate capital by spreading risks where capital requirements are lower such as in the securities and or insurance sectors.

The second limitation that arises is aggregation. Each institution may be viewed as a separate entity from its holding company because of the different regulators.

For risk purposes, the risk that may be assumed by a financial group may be larger or smaller than the sum of its subsidiaries.

Mega regulator approach follows a single regulator approach for all the three industries in the financial sector. The single agency is responsible for systemic, prudential and conduct of business regulation.

This has been adopted in the UK with the Financial Services Authority as the single regulator for all firms in the sector.

The major advantage of this method is its ability to regulate financial conglomerates and assess the various risk levels as a whole entity. It brings together all financial sector institutions under one mega regulator.

The major limitation is that it relies heavily on the availability of financial regulation expertise in a country.

Twin Peaks approach favours two different regulators, prudential supervisor and conduct of business regulator. It has mainly been adopted in Australia where there is one prudential regulator (Australian Prudential Regulatory Authority) for the whole of the financial sector.

Australian Securities and Investments Commission is responsible for consumer protection and market integrity regulation while the Reserve Bank of Australia is left with systemic regulation of banks alone.

This approach eliminates regulatory duplication and overlap as it creates regulatory bodies with clearly defined roles. Similar to the mega regulator system, the twin peaks approach also requires skilled personnel to be involved in the prudential regulation of the financial sector.

Partial integration is adopted by South Africa for the financial services sector. An integrated body, the Financial Services Board is responsible for the conduct of business and prudential regulation of insurance and the securities industries.

The South African Reserve Bank is involved with systemic and prudential regulation of banks. The conduct of business supervision is under the ambit of the Banking council in a self regulatory system.

Zimbabwe may lack the necessary expertise to follow the single regulator approach as in the UK. It may also be costly to form a mega regulatory agency with limited funding from the fiscal envelope.

The starting point is to centralise regulation through forming a committee from the three existing regulators.

The committee can work towards modalities of harmonising the supervision of the financial sector in light of the existence of financial groups.

RBZ alluded to the idea of a Financial Stability Committee in 2005 but is yet to be implemented in practice.

A financial sector committee would design a memorandum of understanding among the regulators which would define their operations.

The exchange of information regularly would provide regulators with all required information to assess the stability and soundness of individual institutions and the entire financial system.

Gardner Rusike is an economist based in Cape Town, South Africa. He can be contacted on: gardyrusike@yahoo.com

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