Flawed compensation practices have encouraged excessive risk taking - Deputy Governor

Ramani KANGARAARACHCHI

An effective enforcement mechanism is vital for timely identification of sources and the degree of risks to ensure stability in the financial sector, Central Bank of Sri Lanka Deputy Governor Dharma Dheerasinghe said.

Delivering the keynote address on "Building supervision resilience after crisis" at the 13th SEACEN Conference of directors of supervision of the Asia-Pacific region at the Central Bank auditorium yesterday, he said it is necessary to build supervision resilience, a proper assessment of supervision methodologies that are practised in countries.

The recent financial crisis has proven that all these supervisory reforms and improvements have not been able to deliver desired results to avoid the crisis and the results were unbearable.

Extremes in the economic cycle of asset booms and busts, excessive leverage and risk taking with inadequate risk management tools and techniques, inferior quality of capital, failures in regulation and supervision were the main contributors for this crisis.

Referring to changes suggested to regulation Dheerasinghe said many international financial conglomerates lacked adequate capital and liquidity to protect themselves as well as the financial system as a whole. In response, internationally attempts have been made for significantly stronger standards by way of both quantity and quality standards. He said that to address weaknesses in liquidity, risk management in financial institutions, new approaches, such as liquidity stress testing and quantitative liquidity standards those similar to capital adequacy, have been proposed with the objective of ensuring liquidity needs of financial institutions even during the times of severe market instability. However, stress testing as an important technique for assessing the tail-end risks needs appropriate attention from the regulators.

The flawed compensation practices in financial institutions that encourage excessive risk taking have also contributed to the crisis. Compensation not only at the top but throughout a banking organization, should be linked to performance while providing sound incentives as people always respond to incentives in place.

One of the fundamental elements of regulations is to protect customers from unfair and deceptive products and practices. However, the crisis gave an opportunity to learn the relationship that exist between such unfair and deceptive products and practices and the safety and soundness of financial institutions.