Explainer: Twin peaks regulation

MUCH talk has been made in recent weeks about a "twin peaks" regulatory model for Jamaica as the country's financial sector is set to undergo changes over the next 18-24 months, driven chiefly by the fraud-hit securities dealer Stocks and Securities Limited (SSL) and the lapse in regulatory oversight by its regulator, the Financial Services Commission (FSC). But what is this twin peaks model and how is it envisioned to work?

First, the need for Jamaica to create a new financial regulatory system has been a glaring one for years. This as the sectoral regulatory model (we'll get back to this later) that has been in place for the better part of the last two decades was being increasingly challenged by the fact that 90 per cent of the financial assets in Jamaica were controlled by a few conglomerates with both deposit- and non-deposit-taking institutions.

In essence, the traditional dividing lines between financial sectors were being blurred as the sectors converge, with commercial banks combining banking activities, such as lending and deposit-taking, with securities activities, such as offering investment funds and underwriting securities offerings. Meanwhile, banks and insurers are allowed to operate as part of financial conglomerates.

Because of the blurring of the dividing lines between financial sectors, cross-sector models of supervision have emerged. There are two main cross-sector models of supervision — a functional (or twin peaks) model and an integrated model.

As a reminder, deposit-taking institutions are the commercial banks, building societies and merchant banks which take customers deposits. These are regulated by the Bank of Jamaica. Non-deposit taking institutions are insurance companies, pension funds, and securities dealers, which do not take deposits from customers. These are regulated by the Financial Services Commission (FSC).

The separated regulation, the BOJ regulating one sector and the deposit-taking entities, with the FSC regulating the non-deposit taking entities, is what is called sectoral regulation. The regulation takes place depending on the sector in which the entity falls, which is why it is called sectoral regulation.

Now Jamaica is pushing towards a "twin peaks" regulatory model.

In the twin peaks model there are separate supervisors for each of the supervisory objectives. The first peak would be prudential supervision focusing on the health and soundness of all financial firms. Finance Minister Dr Nigel Clarke outlined recently that this type of supervision has become necessary as financial firms have become increasingly interwoven. The BOJ is expected to take over these functions when the reforms are completed.

The second peak would be a strong market conduct and consumer protection supervisor. This supervisor would solely focus on the proper functioning of markets and fair treatment of consumers. The role is expected to be taken over by the FSC, which will have the ability to levy fines on financial institutions if they are found to be in breach.

In the integrated model there is a single supervisor for banking, insurance and securities combined or, put differently, one supervisor who oversees both prudential supervision and market conduct supervision.

There are potential conflictS of interest between prudential supervision and market conduct and consumer protection supervision relating to the different nature of their objectives. The two types of supervision generally require different mindsets and skills, and occasionally conflict with each other. For example, in times of financial crisis, or to avert a crisis, the imperative of financial stability can be so overwhelming that authorities might neglect some market conduct duties in order to help firms satisfy prudential requirements — such as, authorities might close their eyes to questionable commercial practices if these help a bank to increase its profitability and capital.

The prudential supervisor will be interested in the soundness of financial firms including profitability, while the conduct-of-business supervisor will focus on the interests of those firms' clients. Mixing up the responsibilities of financial stability and market conduct and consumer protection could create incentives for the supervisor to prioritise one objective over the other. By separating the supervisory functions the market conduct and consumer protection supervisor is ideally situated to supervise possible conflicts of interest between a financial institution and its clients because it will focus only on the interests of the clients. Furthermore, the stability objective is consistent with preserving public confidence and may require discretion and confidentiality, which could be counter-productive to the transparency objective.

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