Lessons worth remembering

As we continue through a year of heightened economic and geopolitical uncertainty, having a strong financial system is imperative to weather internal or externally generated shocks. 

Some lessons learned from the global financial crisis to develop and maintain a resilient financial system consistent with the principles of the Prompt Corrective Action circular issued recently by the Bangladesh Bank is based on having an effective framework for financial supervision and regulation which addresses both safety-and-soundness risks at individual institutions and macroprudential risks—that is, risks to the financial system affecting overall systemic stability.

Some of the central features of the lessons learned from the Global Financial Crisis can be broadly summarised as follows:

Corporate governance 

Sound corporate governance sustains effective risk management and confidence from key stakeholders.  The correct tone from the top and active oversight from well informed, skilled senior management and board members provide an imperative oversight process on business decisions as well as patterns of behaviours inconsistent with the culture and risk appetite of the bank.   

Arguably, a strong internal governance process with a culture of transparency and effective challenge across the financial system, would likely have created more awareness and responsibility reducing potential moral hazard during the GFC – for example, financial institutions underwrote loans with the expectation that another party would likely bear the risk of default, creating moral hazard of originating loans to borrowers without a clear ability to repay that contributed to the mortgage crisis. 

Bank failures 

More explicit recognition that the purpose of bank supervision is not to prevent bank failures but rather to reduce the probability and impact of a bank failure, so that when failure occurs, it happens in an orderly manner.  This requires supervised institutions to have credible resolution / recovery plans without the need of "bailouts" from the public sector. 

Market discipline and transparency 

Market discipline in supplementing a safe and sound banking system can be another strong guard rail to excessive risk taking.  Appropriate levels of public disclosures about the health of banks on an idiosyncratic and systemic basis can help enhance overall financial stability.

Better early warning forward looking exercises 

Since the introduction of the first supervisory stress test in 2009, as part of a more comprehensive capital adequacy assessment of systemically important financial institutions, stress tests have become an important forward-looking approach to financial stability analysis and early-warning-like exercises. 

Stress tests are a way to gauge the resilience of the system to extreme exogenous events and disentangling interconnected risks.  

Data sharing for financial stability assessments 

Good quality bank data, at borrower and transaction level, and aggregate trend data should be provided to supervisors regularly for deliberations on financial stability.  Implicit in this exercise is to strengthen banks' internal MIS systems to improve bank management's access to timely, accurate information and reports, particularly during crisis events.

Sabeth Siddique is the former Assistant Director Federal Reserve Board, Washington DC. He has also acted as the CRO of the Butterfield Bank, Bermuda. DCRO of the M&T Bank, New York, and Director of the Deloitte Touche, Washington DC. 

Disclaimer: The views and opinions expressed in this article are those of the author and do not necessarily reflect the opinions and views of The Business Standard.