The regulatory framework of banking governance

La banking governance, i.e. the processes and bodies set up for their direction and control, is a crucial issue for the stability of the financial system. The banking scandals of recent decades have highlighted the importance of a solid regulatory framework in this area.

The regulatory authorities have therefore gradually reinforced requirements for improving practices of governance. New international and European standards have supplemented national legislation to provide a framework for banking governance.

In this article, we will take an overview of the main regulatory reforms that govern bank governance.

A thing is certain:he shareholders, managers, directors and supervisors of banks now face increased requirements in terms of internal control, risk management and monitoring. These regulatory advances aim to ensure the sustainability of the banking system.

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???? What are banking regulations?

First of all, it is necessary to distinguish prudential regulation of regulation or supervision which constitute banking regulations.

The first is to define the operating rules, while the second is to enforce them and potentially to sanction breaches. It is therefore a governance mechanism.

By definition, banking prudential regulations is the set of measures that reduce or better assume the risks generated by the various components of the banking system.

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To speak of the regulatory framework of banking governance is to speak of regulation and supervision. There banking regulation and supervision therefore appear as essential elements to integrate in order to ensure the sustainability of the institution.

Regulation contributes in part to solving the problems of informational asymmetry between borrowers and lenders which create problems of adverse selection and moral hazard.

The regulatory framework of banking governance requires compliance with prudential regulations. Prudential regulation allows:

to harmonize the conditions for exercising banking competition, in order to preserve the stability and solidity of the system;

To strengthen banking security by establishing standards for own funds and their use;

to adapt the operation of banks to market developments.

???? Banking regulators

Compliance with prudential standards is ensured by certain actors whose roles are essential. It is :

 ✔️ The Basel Committee 

Its mission is to strengthen safety and reliability of the financial system. To establish minimum standards in terms of prudential supervision; disseminate and promote best banking and supervisory practices and promote international cooperation in prudential supervision.

✔️ The Financial Markets Authority 

Its role is to ensure the protection of savers in the context of companies calling on public savings. As part of the introduction of financial instruments on the financial markets, it ensures the regularity of the information given to the players.

✔️ The Advisory Committee on Financial Legislation and Regulation 

Its mission is to give an opinion on all draft normative texts of general scope relating to the banking, financial and insurance fields, upon referral by the Minister of the Economy.

✔️ The Commission Bancaire became the Prudential Supervisory Authority in January 2010

This commission is responsible for monitoring compliance with the legislative and regulatory provisions applicable to them and for penalizing any breaches noted. It also ensures compliance with the rules of good conduct of the profession.

???? Sources of Bank Governance Failures

The regulatory framework of banking governance seeks reduce failures. In fact, market imperfection is one of the factors explaining bank failures.

The nature of the market causes imperfections that create dysfunctions that can lead to a financial crisis. This is information asymmetry.

It characterizes any situation where two (or more) individuals must make important decisions concerning the same event. But do not have the same quantity and quality of information on this event. It may or may not be voluntary.

Information asymmetry leads parties to make adverse selections and moral hazard.

✔️ Adverse selection

Adverse selection or anti-selection is a statistical and economic phenomenon. It's a form of agency conflict. In an agency relationship, this problem is essentially based on uncertainty about the type of agent, unlike moral hazard.

This problem of adverse selection is even more accentuated in banking companies where the relationship is at several levels.

In an ideal world, à la Arrow-Debreu where the information is perfect and free, the bank can predict the actions of the borrower and set an interest rate at a level corresponding to the risk of the project.

In this case, the classical theory assumes that an increase in risk will result in an increase in the interest rate since uncertainty is characterized by imperfect and asymmetric information between the different actors.

✔️ Moral hazard or moral hazard

By definition, moral hazard designates a perverse effect which can appear in certain risk situations, in a relationship between two agents or two contracting parties.

Moral hazard first appeared in insurance and banking. It was the possibility that an insured increase your risk taking, compared to the situation where he would fully bear the negative consequences of a claim.

In banking enterprises, an increase in interest rates may encourage borrowers, after obtaining their loan, to undertake more risky projects than expected to increase their earnings.

Thus, moral hazard corresponds to a situation where the incompleteness of information comes from unobservable actions and behaviors. It's a shape post-contractual opportunism which occurs when the actions implemented cannot be discerned.

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To deal with these problems of moral hazard and adverse selection, financial intermediation turns out to be the more efficient in solving problems incentives that affect the credit market in the context of asymmetric information.

???? Financial intermediation as a solution to information asymmetry problems

✔️ Transaction costs

A transaction cost is a cost linked to an economic exchange, specifically a market transaction. This cost is not taken into account in the context of pure and perfect competition. It can be direct (stock market commission) or indirect.

All the costs induced by these actions form the transaction costs that Carl J. Dahlman (1979) groups into three categories:

Research and information costs : prospecting, comparison of the quality/price ratio of the various services offered, market research, etc. It is also aboutnegotiation and decision costs : drafting and conclusion of a contract etc.

Monitoring and enforcement costs : quality control of the service, verification of the delivery, etc.

This concept makes it possible to explain, according to Coase, why all transactions are not market transactions, and, therefore, the existence of companies or firms, which can effectively limit these costs by imposing cooperation between employees. .

Thus, we understand why transaction costs are a first explanatory factor for the presence of financial intermediaries. These costs represent the reason of being » the activity of intermediaries (Descamps and Soichot, 2002).

When dealing with small savers and borrowers, the cost of research is prohibitive.

The existence of banks is justified by their ability to mobilize savings. This savings is at the service of long-term investment, while simultaneously preserving the liquidity of depositors and the sustainability of financing.

✔️ Portfolio diversification

The notion of diversification refers to the diversity of securities that make up a portfolio. A portfolio containing only one security is not diversified. Diversification is therefore a method of managing the risk of capital loss.

The diversification of the portfolio should make it possible to protect against the risks associated with holding a limited number of securities.

That's what I'm looking for financial intermediation. All approaches to financial intermediation agree on the need to mitigate the risks of direct contact between borrowers and lenders.

The ability to diversify portfolios is another important function of financial intermediation which explains their pre-eminence in the financing of the economy.

Financial theory teaches that part of portfolio risk can be neutralized by asset diversification it contains.

Differentiated risk aversion also makes the presence of financial intermediaries essential, for whom risk is an inherent part of their business, whereas non-financial agents only accept it by demanding premiums. too large for the lender.

Non-financial agents will transfer risks to financial intermediaries in return for a reduction in their earnings.

✔️ Information costs

Granting credit is a decision that is both irreversible and risky. The return on investment depends on a future and a more or less detailed analysis of the present situation.

The future being uncertain, in most cases the lender does not have enough information on his or her borrowers, which sometimes generates colossal costs. It's information costs.

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