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International Financial Regulation
GLOBAL
Because asymmetric information problems in
the banking industry are a fact of life
throughout the world, financial regulation in
other countries is similar to that in Canada.
Financial institutions are chartered and
supervised by government regulators, just as
they are in Canada. Disclosure requirements
for financial institutions and corporations
issuing securities are similar in other devel-
oped countries. Deposit insurance is also a
feature of the regulatory systems in most
other countries, although its coverage is dif-
ferent than in Canada and is intentionally not
advertised. We have also seen that capital
requirements are in the process of being
standardized across countries with agree-
ments like the Basel Accord. Accounting and
financial reporting are also in the process of
being standardized across countries by mov-
ing to IFRS, a set of global standards devel-
oped by the IASB.
Particular problems in financial regula-
tion occur when financial institutions operate
in many countries and thus can readily shift
their business from one country to another.
Financial regulators closely examine the
domestic operations of financial institutions
in their country, but they often do not have
the knowledge or ability to keep a close
watch on operations in other countries,
either by domestic institutions foreign affili-
ates or by foreign institutions with domestic
branches. In addition, when a financial insti-
tution operates in many countries, it is not
always
clear
which
national
regulatory
authority should have primary responsibility
for keeping the institution from engaging in
overly risky activities.
The difficulties inherent in international
financial regulation were highlighted by the
collapse
of
the
Bank
of
Credit
and
Commerce
International
(BCCI).
BCCI,
which was operating in more than 70 coun-
tries including the United States and the
United
Kingdom,
was
supervised
by
Luxembourg, a tiny country unlikely to be up
to the task. When massive fraud was discov-
ered, the Bank of England closed BCCI
down, but not before depositors and stock-
holders were exposed to huge losses.
Cooperation among regulators in different
countries and standardization of regulatory
requirements provide potential solutions to
the problems of international financial regu-
lation. The world has been moving in this
direction through agreements like the Basel
Accord and oversight procedures announced
by the Basel Committee in July 1992, which
require a bank s worldwide operations to be
under the scrutiny of a single home-country
regulator with enhanced powers to acquire
information on the bank s activities. Also, the
Basel Committee ruled that regulators in
other countries can restrict the operations of
a foreign bank if they feel that it lacks effec-
tive oversight. Whether agreements of this
type will solve the problem of international
financial regulation in the future is an open
question.
deposit insurance, the government was guaranteeing that the deposits were safe,
so depositors were more than happy to make deposits in the Canadian Commercial
and Northland banks with the higher interest rates.
As already noted, the managers of Canadian Commercial and Northland did
not have the required expertise to manage risk in the permissive atmosphere of
western Canada. Even if the required expertise was available initially, rapid credit
growth may have outstripped the available information resources of the banking
institution, resulting in excessive risk taking. Also, the lending boom meant that the
activities of Canadian Commercial and Northland were expanding in scope and
were becoming more complicated, requiring an expansion of regulatory resources
to monitor these activities appropriately. Unfortunately, regulators of chartered
banks at the Inspector General of Banks (the predecessor of the Office of the
Superintendent of Financial Institutions) had neither the expertise nor the resources
that would have enabled them to sufficiently monitor the activities of Canadian
Commercial and Northland. Given the lack of expertise in both the banks and the
Inspector General of Banks, the weakening of the regulatory apparatus, and the
moral hazard incentives provided by deposit insurance, it is no surprise that
Canadian Commercial and Northland took on excessive risks, which led to huge
losses on bad loans.
In addition, the incentives of moral hazard were increased dramatically by a his-
torical accident: the combination of sharp increases in interest rates from late 1979
until 1981 and a severe recession in 1981 1982, both of which were engineered by
the Federal Reserve in the United States to bring down inflation. The sharp rise in
interest rates produced rapidly rising costs of funds for the banks that were not
matched by higher earnings on their principal asset, long-term residential mort-
gages (whose rates had been fixed at a time when interest rates were far lower).
The 1981 1982 recession and a collapse in the prices of energy and farm products
hit the economy of Alberta very hard. As a result, there were defaults on many
loans. Losses for Canadian Commercial and Northland mounted and the banks had
negative net worths and were thus insolvent by the beginning of 1985.
At this point, a logical step might have been for the regulators
the Bank of Canada
and the Inspector General of Banks
to close the insolvent banks. Instead, the reg-
ulators adopted a stance of
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