Regulating financial institutions: the value of opacity.

• Author: Anand, Anita I.

Introduction I. Financial Institution Regulation: Rationales and Structural Characteristics II. Optimizing Administrative Design A. Insulation B. Transparency and Opacity C. Combining Insulation and Opacity III. Regulating Financial Institutions IV. Policy Implications Conclusion Introduction

The global financial crisis highlighted profound difficulties in the banking sector, which in turn cast attention on differing regulatory approaches across countries. (1) Drawing on the administrative law literature, we examine the characteristics of a regulatory agency that oversees financial institutions and ask how these characteristics influence the strength of its oversight. In particular, we analyze the agency's insulation from political control and the opacity in its operations. (2) We discuss both the value of these characteristics in the regulation of financial institutions themselves and also how these characteristics interact--when are they complements and when are they substitutes?

In order to ground the theoretical discussion, we examine the regulator of Canadian financial institutions, which is called the Office of the Superintendent of Financial Institutions (OSFI). Canada's financial institutions weathered the crisis well relative to their international peers, an outcome that has been attributed at least in part to the presence of an effective regulator. (3) The academic literature points to Canada's regulatory structure as a factor that discouraged banks from taking excessive risks. Ratnovski and Huang, for example, examine the performance of the seventy-two largest commercial banks in OECD countries during the financial crisis, analyzing the factors behind Canadian banks' relative resilience at this time. (4) They identify two main causes, one of which is regulatory factors that reduced banks' incentives to take excessive risks. (5) This view of the efficacy of banking regulation permeated Canada's own government. For example, OSFI was not subject to regulatory reform following the crisis, and the government in fact relied on the structure of OSFI, and new guidelines that OSFI proposed, to stave off an international bank tax. (6)

Building on the existing literature, this article assumes that OSFI played a role in ensuring the stability of Canadian financial institutions relative to their international peers during the financial market meltdown of 2008. (7) Of course, we do not mean to exclude factors other than Canada's regulatory structure that likely contributed to the stability and performance of Canadian financial institutions, such as: Canada's oligopolistic market (consisting of rive big banks); (8) macroeconomic policies emanating from the Bank of Canada; the historical structure of the banking system; the approach to regulating the Canadian mortgage market; and, a generally conservative approach that pervades the banking sector. (9) Given the international interest in the structure and role of OSFI, however, we examine whether there are characteristics of Canada's financial institution regulator that may be worth emulating.

OSFI's efficacy may at first be surprising. It is the primary regulator of Canada's rive big banks (which account for approximately 85 percent of Canada's banking sector). (10) Its power to overcome the possibility for rent seeking or capture by these institutions depends on its rule making and enforcement processes, and forms of accountability for its actions. That is, if not sufficiently independent, regulated institutions might seek rules that favour their profitability at the expense of consumers. Yet on many important issues, including capital adequacy requirements, OSFI relies on guidelines rather than regulations. OSFI creates these guidelines through a largely opaque process in which the regulated parties have early input. Other parties (such as consumers) not only face considerable collective action problems but are limited to a stunted notice and comment process. The comment process thereby potentially privileges the views of regulated institutions. Further, in addressing compliance with regulations or guidelines, OSFI attempts to work informally with regulated parties, ultimately rendering it unnecessary for it to take formal enforcement action. This structure seems to point more towards capture by the large (albeit regulated) players. To aid in the discussion of the appropriate institutional structure for banks, we examine whether Canada's financial institutions--and banks in particular--have been successful because of, or despite, the presence of OSFI.

OSFI is an independent federal agency whose role is to supervise financial institutions and pension plans. (11) Its specific mandate is to determine whether these institutions are in sound financial condition and whether they meet minimum plan funding requirements, governing law, and supervisory requirements. OSFI must advise these bodies if there are material deficiencies, and if there are, it is to require management and boards of directors to take necessary corrective measures expeditiously. OSFI must also advance and administer a regulatory framework that promotes the adoption of policies and procedures designed to control and manage risk. It must also monitor and evaluate system-wide or sectoral issues that may negatively impact institutions. (12) OSFI functions within a web of other bodies discussed below. (13)

We argue that OSFI exhibits two traits in particular that are connected to its efficacy: it is both insulated and opaque. Insulation refers to its separation from elected officials in key respects. This separation can be seen, for example, in the appointment and removal requirements for OSFI members, the lack of control by elected officials over the structure and procedures of OSFI, and the weak powers of elected officials to review or issue directives to the body.

OSFI's opacity--or lack of transparency--exists in the processes for establishing rules and guidelines. While the federal cabinet makes regulations that OSFI must administer, OSFI itself develops and implements other forms of regulation, such as guidelines and policy statements. There is no prescribed process, no mandated public consultation, no necessary stakeholder input or cost-benefit analyses required with regards to the formulation of either policy statements or guidelines. (14) The process by which OSFI's capital adequacy guideline is developed is a particularly striking example of opacity. The guideline seeks to provide a framework "within which the Superintendent assesses whether a bank ... maintains adequate capital pursuant to the acts." (15) In the guideline, the superintendent establishes two minimum standards: assets to capital multiple and risk-based capital ratio. The guideline indicates that OSFI may also issue further "notes" to clarify "expectations on compliance with the technical provisions of the internal ratings approach" set out in the guideline. (16) While OSFI is actively engaged in international discussions around appropriate standards for financial regulation, such as for the Basel III standards, OSFI is not mandated to adopt these standards. For our purposes, the key point is that in an area of crucial importance to the stability of financial institutions, OSFI is able to pass and implement guidelines without Cabinet approval or an open process. Rather, they are established by a relatively insulated body through a partially opaque process.

Despite its insulation and opacity, however, OSFI is almost universally viewed to be an effective regulator. (17) In this article, we ask: What is it about institutional insulation and opacity that may lead to effective regulation of banks? Part I examines the purposes of financial institution regulation. Part II then discusses the characteristics of administrative agencies, and particularly the relationship between transparency (or opacity) and insulation. We build on the growing body of administrative law literature that rigorously examines the impacts of transparency, insulation, and related administrative processes. (18) We argue that there are certain benefits associated with an opaque and insulated structure, including the ability to regulate unfettered by partisan politics and majoritarian preferences. Our conclusions regarding the value of opacity cut against generally held views about the benefits of transparency in regulatory bodies.

The article then uses OSFI to illustrate the theoretic discussion of financial regulation and administrative structures. Part III outlines the administrative structure, accountability, and functioning of OSFI--to whom it is accountable and how it works--paying particular attention to its level of transparency and insulation. Part IV explains why insulation and opacity may be positive attributes that enable OSFI to function effectively. We argue that OSFI operates in a "black box" of sorts relative to both the government and financial institutions. It encourages co-operation between itself and financial institutions by protecting information about its policy agenda and formation. We argue that OSFI profits from its informational advantage by weakening the ability of regulated entities to collude amongst themselves or rent-seek. We conclude by drawing out the lessons for the institutional form of financial institutions regulation.

1. Financial Institution Regulation: Rationales and Structural Characteristics

   Regulation governing financial markets generally seeks to address macro- and microprudential issues. (19) Macroprudential regulation focuses on the financial system as a whole, seeking to minimize system-wide distress in order to avoid reductions in aggregate output (which may be measured by GDP). By contrast, microprudential regulation seeks to minimize distress in individual institutions in order to protect depositors. In short, macroprudential regulation focuses on common exposures across financial systems and...