Chapter 5:Ealating Financial Sector Supervision:Banking,Insurance,and Securities Markets Box 5.1 Basel Core Principles for Effective Banking Supervision The Basel Core Principle c in following: and R CP 15 set sibilities and objectives for the supervisory CP 1.4 deals with enfor ent power CP1.6 dealswith information sharing. vision Cpdeals with licensing criteria and the CP20reqre the conuct of coniated ·lnfo ks to maint ments Remedial Measures and Exit ments,For interr CP 8 sets outr orn forth rules for identifying and lim CP 24 supe tional opera for lending to (a) CP 11 require banks to have policies for identifying and managing country and rans al banks an Cp1 requires banks to have systems to mea the home-coun sure,monitor,and control market risk supervisory authority
111 Chapter 5: Evaluating Financial Sector Supervision: Banking, Insurance, and Securities Markets 1 I H G F E D C B A 12 11 10 9 8 7 6 5 4 3 2 Box 5.1 Basel Core Principles for Effective Banking Supervision The Basel Core Principles comprise 25 basic principles that need to be in place for a supervisory system to be effective. The core principles (CPs) relate to the following: • Objectives, Autonomy, Powers, and Resources – CP 1.1* deals with the definition of responsibilities and objectives for the supervisory agency. – CP 1.2 deals with skills, resources, and independence of the supervisory agency. – CP 1.3 deals with the legal framework. – CP 1.4 deals with enforcement powers. – CP 1.5 requires adequate legal protection for supervisors. – CP 1.6 deals with information sharing. • Licensing and Structure – CP 2 deals with permissible activities of banks. – CP 3 deals with licensing criteria and the licensing process. – CP 4 requires supervisors to review—and have the power to reject—significant transfers of ownership in banks. – CP 5 requires supervisors to review major acquisitions and investments by banks. • Prudential Regulations and Requirements – CP 6 deals with minimum capital adequacy requirements. For internationally active banks, the requirements must not be less stringent than those in the Basel Capital Accord. – CP 7 deals with the granting and managing of loans and the making of investments. – CP 8 sets out requirements for evaluating asset quality and the adequacy of loan–loss provisions and reserves. – CP 9 sets forth rules for identifying and limiting concentrations of exposures to single borrowers or to groups of related borrowers. – CP 10 sets out rules for lending to connected or related parties. – CP 11 requires banks to have policies for identifying and managing country and transfer risks. – CP 12 requires banks to have systems to measure, monitor, and control market risks. – CP 13 requires banks to have systems to measure, monitor, and control all other material risks. – CP 14 calls for banks to have adequate internal control systems. – CP 15 sets out rules for the prevention of fraud and money laundering. • Methods of Ongoing Supervision – CP 16 defines the overall framework for onsite and offsite supervision. – CP 17 requires supervisors to have regular contacts with bank management and staff and to fully understand banks’ operations. – CP 18 sets out the requirements for offsite supervision. – CP 19 requires supervisors to conduct onsite examinations or to use external auditors for validation of supervisory information. – CP 20 requires the conduct of consolidated supervision. • Information Requirements – CP 21 requires banks to maintain adequate records reflecting the true condition of the bank and to publish audited financial statements. • Remedial Measures and Exit – CP 22 requires the supervisor to have—and promptly apply—adequate remedial measures for banks when they do not meet prudential requirements or when they are otherwise threatened. • Cross-Border Banking – CP 23 requires supervisors to apply global consolidated supervision over internationally active banks. – CP 24 requires supervisors to establish contact and information exchange with other supervisors involved in international operations, such as host country authorities. – CP 25 requires (a) that local operations of foreign banks are conducted to standards similar to those required of local banks and (b) that the supervisor has the power to share information with the home-country supervisory authority. * CP 1 is divided into six parts. Source: BCBS (1999)
Financial sector assessment a handbook permitted into the market.The public needs to be aware of which financial institution are banks and that,as banks,they are subject to supervision.Consequently,the use of the word "bank"needs to be limited to licensed institutions.Those issues are dealt with in Core Principles 2 and 3. The quality and integrity of the bank's owners and management are crucial elements in longer-term safety and soundness of the bank,and they need to be vetted by the super visory authorities.Without clear insight into the structure of the group to which a bank belongs and its acquisitions of inter ests in other companies.su visors may not be able to ade onitor the risks.Core Principles3,4. nd 5add sthose stions.Core 5 res tha banks be subje ct t ules regulating the buffer against risk in the asset portfolio,a key requiremen tfor safe and sou Core Principles 7-11 broadly relate to the quality of lending procedures,the adequacy of provisions (without which capital adequacy figures are overstated),the concentration risks,the risks in lending to connected parties against which contract enforcement may be difficult,and the risks in lending abroad.Core Principles 12 and 13 relate to risks with respect to open positions in securities,currencies,and fixed-income instruments.Good internal systems to monitor and manage risks,as required in Core Principle 14,are also of key importance because bank mar ment is primarily responsible for the stability of ds to be able to own info nd c Core Principles 16-20 relate to ontrol、 au reliable ormation on th oonring and timely crtive action ars not p ope financial condi ble. Related this need,but with a broader objective of informing the markets and the public,is the requirement in core principle 21 to disclose audited consolidated annual financial state ments that are prepared according to internationally acceptable accounting standards The supervisory authority must have the means to preempt threats to the stability of financial institutions through timely corrective actions,as envisaged in Core Princ ple 22.The remaining Core Principles 23-25 relate to the effective monitoring of grou risks,the erview of the financial nditio group and the trnpurenf -borde policies can ontribute to is not expli good transparency practices are covered in IMF Code of Good Practices on Transparency in Monetary and Financial Policies (IMF 2000).Supervisory policies and their imple mentation need to be disclosed to the public,for instance,through annual reports of the supervisory agency or through dedicated chapters in central bank annual reports. Web sites of sun rvisory agencies can be used to disseminate annual reports and other periodicals and repository for banking laws and regulations.For additional rence is to thes ME Codef产Tnspren时one d Pol Good BCP observance has a clear and positive effect on financial sector stability because it helps toensure that the risks in the banking system-which,in many countries is by far the most important component of the financial system-are adequately monitored and that tools are in place to manage the risks.If the BCPs are properly implemented and
112 Financial Sector Assessment: A Handbook 1 I H G F E D C B A 12 11 10 9 8 7 6 5 4 3 2 permitted into the market. The public needs to be aware of which financial institutions are banks and that, as banks, they are subject to supervision. Consequently, the use of the word “bank” needs to be limited to licensed institutions. Those issues are dealt with in Core Principles 2 and 3. The quality and integrity of the bank’s owners and management are crucial elements in longer-term safety and soundness of the bank, and they need to be vetted by the supervisory authorities. Without clear insight into the structure of the group to which a bank belongs and its acquisitions of interests in other companies, supervisors may not be able to adequately monitor the risks. Core Principles 3, 4, and 5 address those questions. Core Principle 6 requires that banks be subject to rules regulating the adequacy of their capital buffer against risks in the asset portfolio, a key requirement for safe and sound banking. Core Principles 7–11 broadly relate to the quality of lending procedures, the adequacy of provisions (without which capital adequacy figures are overstated), the concentration risks, the risks in lending to connected parties against which contract enforcement may be difficult, and the risks in lending abroad. Core Principles 12 and 13 relate to risks with respect to open positions in securities, currencies, and fixed-income instruments. Good internal systems to monitor and manage risks, as required in Core Principle 14, are also of key importance because bank management is primarily responsible for the stability of the institution and needs to be able to rely on its own information and control systems. Core Principles 16–20 relate to the need for the supervisory authority to have reliable and comprehensive information on the operations and financial condition of a bank. Without this information, monitoring and timely corrective action are not possible. Related to this need, but with a broader objective of informing the markets and the public, is the requirement in Core Principle 21 to disclose audited consolidated annual financial statements that are prepared according to internationally acceptable accounting standards. The supervisory authority must have the means to preempt threats to the stability of financial institutions through timely corrective actions, as envisaged in Core Principle 22. The remaining Core Principles 23–25 relate to the effective monitoring of groupwide risks, the creation of an overview of the financial condition of the group as a whole, and the associated cross-border supervisory cooperation. Transparency of supervisory framework and policies can contribute to effective supervision. Although the transparency of supervision is not explicitly covered in the BCPs, good transparency practices are covered in IMF Code of Good Practices on Transparency in Monetary and Financial Policies (IMF 2000). Supervisory policies and their implementation need to be disclosed to the public, for instance, through annual reports of the supervisory agency or through dedicated chapters in central bank annual reports. Web sites of supervisory agencies can be used to disseminate annual reports and other periodicals and can serve as a repository for banking laws and regulations. For additional suggestions and guidance on transparency practices, reference is made to the “Supporting Document” of the IMF Code of Good Practices on Transparency in Monetary and Financial Policies (IMF 2000). Good BCP observance has a clear and positive effect on financial sector stability because it helps to ensure that the risks in the banking system—which, in many countries, is by far the most important component of the financial system—are adequately monitored and that tools are in place to manage the risks. If the BCPs are properly implemented and
Chapter 5:Ealating Financial Sector Supervision:Banking,Insurance,and Secrities Markets h supervisory authorities have the means to rem system. ugh risk o preempt mor anking institui ns I external shocks (e.g.,libera lization-induced credit oooms or a foreign exchange crisis) good BCP observance can help manage the effect of the shocks by constraining excessive buildup of exposures to risk factors. The links between observance of the BCPs and financial development are complex and multifaceted.at one level.the preconditions for observing the bces (discussed in section 5.3.2)are also conditions that facilitate financial stability and help to promote financial development.Beyond the preconditions,the observance of best practices of and regulation prom ce and better risk ma nage. ment,as well a generate mor effic ture.In t urn,this rengthening of institutions can elp promo sustained economi growth.However,the precise mechanism through which this effective operation can occur is far from clear because it also can be the case that developments in the regulatory infrastructure arise in response to financial development.This situation can arise when market participants see that the public good aspects of financial stability outweigh the compliance costs of a stronger regulatory framework so a constituency in favor of a strong regulatory framework emerges The key area in supervision that is directly relevant to the ability of banks to contribute th relate tation of tal adeq ng policie s.The rule on capita adequacy in a jurisdiction the relati onship between bar and their loan and investment portfolios and,therefore,limit the amount of loans and investments banks can make against the amount of regulatory capital they hold.When provisions for losses on assets are not adequate,a bank will overstate its capital and thus its capacity to intermediate funds.When a correction needs to be made,the action will instantly decrease the intermediation function of the institution.If this dynamic occurs on a large scale.for instance.as a result of more widespread banking sector problems in my.then the sult can be a credit crunch,which can have fiscal co sequence soluti cludine prote al fe nking sys ed to be taken into acc in applying the BCPs and in designing regulatory policies For example,increasingly,the presence of LCFIs with significant international operations requires an analysis of cross border exposures to risks and an integrated management of risks across business lines.Ir some countries,state-owned commercial banks play an important role in the countries financial systems.In many cases.the weak profitability.governance.and efficiency of those institutions become a cause for concern.The factors may not immediately pose a risk to the banking sector insofar as the implicit guarantee of their liabilities serves to maintain confidence.but thew distort i tive structures and can slow dowr the al ha more rigorou tisk. nanagement p ng un dards borrower to the ben of the overall quality the assets portfo the ba nce between the scope of discipline would vary among countries.The approaches and tools to observe the BCPs 113
113 Chapter 5: Evaluating Financial Sector Supervision: Banking, Insurance, and Securities Markets 1 I H G F E D C B A 12 11 10 9 8 7 6 5 4 3 2 if the preconditions are satisfied, then supervisory authorities have the means to remove weak institutions from the market and to preempt more extensive damage to the banking system. Although risks in banking institutions may also arise from macroeconomic and external shocks (e.g., liberalization-induced credit booms or a foreign exchange crisis), good BCP observance can help manage the effect of the shocks by constraining excessive buildup of exposures to risk factors.7 The links between observance of the BCPs and financial development are complex and multifaceted. At one level, the preconditions for observing the BCPs (discussed in section 5.3.2) are also conditions that facilitate financial stability and help to promote financial development. Beyond the preconditions, the observance of best practices of supervision and regulation can also promote strong governance and better risk management, as well as generate more efficient and robust institutions, markets, and infrastructure. In turn, this strengthening of institutions can help promote sustained economic growth. However, the precise mechanism through which this effective operation can occur is far from clear because it also can be the case that developments in the regulatory infrastructure arise in response to financial development. This situation can arise when market participants see that the public good aspects of financial stability outweigh the compliance costs of a stronger regulatory framework so a constituency in favor of a strong regulatory framework emerges. The key area in supervision that is directly relevant to the ability of banks to contribute to sustainable economic growth relates to implementation of capital adequacy standards and appropriate loan evaluation, as well as provisioning policies and practices. The rules on capital adequacy in a jurisdiction determine the relationship between banks’ capital and their loan and investment portfolios and, therefore, limit the amount of loans and investments banks can make against the amount of regulatory capital they hold. When provisions for losses on assets are not adequate, a bank will overstate its capital and thus its capacity to intermediate funds. When a correction needs to be made, the action will instantly decrease the intermediation function of the institution. If this dynamic occurs on a large scale, for instance, as a result of more widespread banking sector problems in an economy, then the result can be a credit crunch, which can have fiscal consequences related to costs of bank resolution, including deposit protection. Specific institutional features of the banking system need to be taken into account in applying the BCPs and in designing regulatory policies. For example, increasingly, the presence of LCFIs with significant international operations requires an analysis of crossborder exposures to risks and an integrated management of risks across business lines. In some countries, state-owned commercial banks play an important role in the countries’ financial systems. In many cases, the weak profitability, governance, and efficiency of those institutions become a cause for concern. The factors may not immediately pose a risk to the banking sector insofar as the implicit guarantee of their liabilities serves to maintain confidence, but they can distort incentive structures and can slow down the growth of a viable commercial banking sector with more rigorous risk-management policies. Better risk-management policies with strong underwriting standards also impose discipline on banks’ borrowers to the benefit of the overall quality of the assets portfolio. Also, the balance between the scope of official supervision and the extent of market discipline would vary among countries. The approaches and tools to observe the BCPs
Financial Sector Assessment:A Handbook may be strongly influenced by the extent to which the overall policy environment and the supervisory policies themselves tend to harness market forces and bring about good governance of banks.For an analysis of the importance of bank supervisory and regula tory policies that facilitate market discipline,see Barth,Caprio,and Levine(2004).In addition,the appropriate balance between official supervision and market discipline could change over time,depending on the extent of stress in the banking system,which might affect the incentives for risk taking. 5 5.3.2 Preconditions for Effective Banking Supervision The BCP include five for effective they are normally beyond the es or shortcomings in these area nay impair the ability of the supervisory authority to implement effectively the Core Principles"(BCBS 1999),the preconditions are as follows: .Sound and sustainable macropolicies (the precondition that has the most signifi- cant effect on risk exposures and capital adequacy) .A well-developed public infrastructure that covers contract enforcement,a general insolvency regime,an accounting framework,and a corporate governance (all of which affec ment) iplin that is b on transparency and disclosure (which affects the q uali y of prudential fram ework) .Procedures for effective resol tion of problem banks Mechanisms for providing either an appropriate level of systemic protection or a public safety net (which,along with the preceding precondition above.affects supervision of market conduct and enforcement of corrective actions) The 2002 evaluation of the experience with the Financial Sector Assessment Program (FSAP)in 60 countriess drew attention to the importance of effective preconditions for bank ervision rec ent banking crises.In many of the countries experiencing precon met s also not ed that the BCP is p ited to ons and the of development of the financial sector"(IMF and 2002b). developing countries generally are characterized by less favorable preconditions,including unstable macroeconomic conditions,inadequacies of the laws and iudicial systems,weak credit culture and accounting systems,low disclosure,and incipient or nonexistent safety nets. In view of these arguments.the evaluation emphasized the need for assessing the pre ss and the BCp ontinued ore plicitly in the ntext of an FSAP ured app could e analysis of the BCPs.It could furth rmore enhanc ion within an FSAP of linkages between the macroeconomy.the the banking sector and the effectiveness of supervision. Although an in-depth assessment of some of the preconditions may be bevond the scope of a BCP assessment,an effort should be made to present not only the weaknesses 114
114 Financial Sector Assessment: A Handbook 1 I H G F E D C B A 12 11 10 9 8 7 6 5 4 3 2 may be strongly influenced by the extent to which the overall policy environment and the supervisory policies themselves tend to harness market forces and bring about good governance of banks. For an analysis of the importance of bank supervisory and regulatory policies that facilitate market discipline, see Barth, Caprio, and Levine (2004). In addition, the appropriate balance between official supervision and market discipline could change over time, depending on the extent of stress in the banking system, which might affect the incentives for risk taking. 5.3.2 Preconditions for Effective Banking Supervision The BCPs include five preconditions for effective supervision. Although preconditions are not formally part of the BCPs because they are normally beyond the jurisdiction of bank supervisors, “weaknesses or shortcomings in these areas may significantly impair the ability of the supervisory authority to implement effectively the Core Principles” (BCBS 1999), the preconditions are as follows: • Sound and sustainable macropolicies (the precondition that has the most significant effect on risk exposures and capital adequacy) • A well-developed public infrastructure that covers contract enforcement, a general insolvency regime, an accounting framework, and a corporate governance (all of which affect supervisory powers and enforcement) • Effective market discipline that is based on transparency and disclosure (which affects the quality of prudential framework) • Procedures for effective resolution of problem banks • Mechanisms for providing either an appropriate level of systemic protection or a public safety net (which, along with the preceding precondition above, affects supervision of market conduct and enforcement of corrective actions) The 2002 evaluation of the experience with the Financial Sector Assessment Program (FSAP) in 60 countries8 drew attention to the importance of effective preconditions for bank supervision during recent banking crises. In many of the countries experiencing crises, these preconditions were not sufficiently met. It is also noted that “compliance with the BCP is positively correlated to compliance with the preconditions and the stage of development of the financial sector”(IMF and World Bank 2002b). It was stated that developing countries generally are characterized by less favorable preconditions, including unstable macroeconomic conditions, inadequacies of the laws and judicial systems, weak credit culture and accounting systems, low disclosure, and incipient or nonexistent safety nets. In view of these arguments, the evaluation emphasized the need for assessing the preconditions for effective banking supervision more explicitly in the context of an FSAP process and the BCP assessment. It continued to explain that a more structured approach to their evaluation could improve the analysis of the BCPs. It could furthermore enhance the discussion within an FSAP of linkages between the macroeconomy, the condition of the banking sector and the effectiveness of supervision. Although an in-depth assessment of some of the preconditions may be beyond the scope of a BCP assessment, an effort should be made to present not only the weaknesses
Chapter 5:Ealating Financial Sector Supervision:Banking,Insurance,and Secrities Markets and shortcomings with respect to those onditions but also the effect they n may have cthefoltheo of he inancal sytm.Emphs Although the ssessment of macroeconomic policies remains in the purview of the broader surveillance,the assessor can focus on identifying vulnerabilities and risks associated with macroeconomic policies both for the financial system and for the effectiveness of bank supervision.Assessors should note whether supervisors have the capacity to assess those vulnerabilities and risks and to what extent the risks can be controlled by supervisors or by banks. .To assess the adequacy of public infrast re the BCP asses 5 conclus ssments c ial infras ructure nere formation,the assesso uld note weaknesses in the crec level ofredior protection,the effectivees of the udicasystem,the bankrupcy procedures,the accounting standards,the auditing profession,and the level of information disclosure to the public. .An assessment of the strength of market discipline needs to consider(a)issues of transparency,including quality,timeliness,and clarity of the information available to the public:(b)issues of co ment in the fin ancial systen nd the set of ing ntives that The adequacy of ss pro lem banks and the effec iveness of the safety net fall within the scope of the BCP assessment and should be examined while assessing Core Principles I and 22.In this regard,the assessor should focus on whether supervisors have a sufficient and flexible range of procedures to achieve the efficient resolution of problems in banks,including the capacity to conduct an orderly resolution with respect to problem banks.For the assessment of the safety net examiners should focus on the existence and design of the deposit insurance and lender-of-last-resort facilities In many cases,assessing the weaknesses and sho s in the e preconditions for difficult,dema codionofamtemeamaetemnc effective bank sup ling a high degree ssues o priorities and sequencing arise when trying to prepare a road map to address weaknesses in prudential aspects and preconditions for effective supervision.The question of whether shortcomings in preconditions should be addressed before addressing prudential weak. nesses is not a trivial one.Coordination,prioritization,and sequencing of various reform of infrastructure,supervision,and market and institutional development require careful onsideration of the stability and the technical rlinka ong various reform components that affect implementation. 5.3.3 Assessment Methodology and Assessment Experience BCP assessments are a for of peer review that helps to(a)identify regulatory streng (b)assess e level of observance of financial sector stand (c)ascertain the financial sector's developmental and technical assistance needs;(d)
115 Chapter 5: Evaluating Financial Sector Supervision: Banking, Insurance, and Securities Markets 1 I H G F E D C B A 12 11 10 9 8 7 6 5 4 3 2 and shortcomings with respect to those preconditions but also the effect they may have on the effectiveness of supervision and on the soundness of the financial system. Emphasis could be placed on the following issues: • Although the assessment of macroeconomic policies remains in the purview of the broader surveillance, the assessor can focus on identifying vulnerabilities and risks associated with macroeconomic policies both for the financial system and for the effectiveness of bank supervision. Assessors should note whether supervisors have the capacity to assess those vulnerabilities and risks and to what extent the risks can be controlled by supervisors or by banks. • To assess the adequacy of public infrastructure, the BCP assessors can draw from the conclusions of assessments of financial infrastructure, where available. Using that information, the assessors could note weaknesses in the credit culture, the level of creditor protection, the effectiveness of the judicial system, the bankruptcy procedures, the accounting standards, the auditing profession, and the level of information disclosure to the public. • An assessment of the strength of market discipline needs to consider (a) issues of transparency, including quality, timeliness, and clarity of the information available to the public; (b) issues of corporate governance; and (c) the role of the government in the financial system and the set of incentives that may weaken market discipline. • The adequacy of procedures to address problem banks and the effectiveness of the safety net fall within the scope of the BCP assessment and should be examined while assessing Core Principles 1 and 22. In this regard, the assessor should focus on whether supervisors have a sufficient and flexible range of procedures to achieve the efficient resolution of problems in banks, including the capacity to conduct an orderly resolution with respect to problem banks. For the assessment of the safety net, examiners should focus on the existence and design of the deposit insurance and lender-of-last-resort facilities. In many cases, assessing the weaknesses and shortcomings in the preconditions for effective bank supervision may be time consuming and difficult, demanding a high degree of coordination of different agencies and branches of the government. Important issues of priorities and sequencing arise when trying to prepare a road map to address weaknesses in prudential aspects and preconditions for effective supervision. The question of whether shortcomings in preconditions should be addressed before addressing prudential weaknesses is not a trivial one. Coordination, prioritization, and sequencing of various reforms of infrastructure, supervision, and market and institutional development require careful consideration of the effect on financial stability and the technical interlinkages among various reform components that affect implementation.9 5.3.3 Assessment Methodology and Assessment Experience BCP assessments are a form of peer review that helps to (a) identify regulatory strengths, risks, and vulnerabilities; (b) assess the level of observance of financial sector standards; (c) ascertain the financial sector’s developmental and technical assistance needs; (d)