Financial Sector Assessment:A Handbook prioritize financial sector policies;and (e)provide a reform agenda for improving the supervisory system.Furthermore,standards assessments support the analysis in the con text of an analysis of the macroeconomic and structural risks affecting domestic financial systems. a bcp assessment involves an examination of the adequacy of the legislative and reg. ulatory framework and a determination of whether supervisors are effectively supervising and monitoring all of the important risks taken by the banks.The assessment should fol low the guidance provided in y by the Basel Committe ision (BCBS1999)To achieve full objectivity 5 nciple sed by a suitably qualified party ing of at le ance Each principle is assigned criteria that are relevant for compliance with it.Two cat egories of criteria are used:"essential criteria"and "additional criteria."The essential criteria are those elements that should be generally present in individual countries for supervision to be considered effective.Typically,essential criteria specify certain policies and procedures that supervisors are expected to follow to comply with a core principle. The additional criteria are elements that further strengthen supervision and that all coun- tries should strive to implement to improve financial stabilit Additional crite and effective supervision t to the banking organizat r may be ne led in nces re internationa local n ends to be】 highly volatil chieve full companceithcor principle.the esentia erireria gener kets t ally must be met without any significant deficiencies.There may be instances,of course where a country can demonstrate that the core principle has been achieved through dif ferent means.Conversely.because of the specific conditions in individual countries.the essential criteria may not always be sufficient to achieve the obiective of the principle. Therefore,additional criteria or other measures may also be needed for the particular principle to be considered effective a sential and additio nal d of th nt proce and e role of different criteria,conside the cas For this s principle,each subprinciple isa ssed separately. "compliant"grading for Core Principle 1,for instance,requires that the essential criteri mentioned in the methodology be met,namely,that laws are in place and that responsi bilities are clearly defined,that minimum prudential standards are in place,that defined mechanisms exist for coordination,and that those mechanisms are actually used. Furthermore,supervisors should have a role in deciding on resolution of banks,and laws should be updated as needed.Assessment of compliance with those criteria would,for instance,re uire obtaining and reading the texts of the relevant laws and including the ions in th 1 whethe re clear,ther information could be obt ained o whether agencies cooperate effec vely o wheth er turf issues aris frequently.Do annua I reports of the ground,or are they complementary?Are prudential regulations reac yaceasibc,ndd ncies cov they cover the main prudential areas?If one wishes to review which areas are essential the list of publications on the Basel Committee's Web site could be consulted to obtain an impression of which areas have been considered important.Coordination mechanisms 16
116 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 prioritize financial sector policies; and (e) provide a reform agenda for improving the supervisory system.10 Furthermore, standards assessments support the analysis in the context of an analysis of the macroeconomic and structural risks affecting domestic financial systems. A BCP assessment involves an examination of the adequacy of the legislative and regulatory framework and a determination of whether supervisors are effectively supervising and monitoring all of the important risks taken by the banks. The assessment should follow the guidance provided in the Core Principles Methodology by the Basel Committee on Banking Supervision (BCBS 1999).11 To achieve full objectivity, compliance with each principle is best assessed by a suitably qualified outside party consisting of at least two individuals with varied perspective so as to provide checks and balances. Each principle is assigned criteria that are relevant for compliance with it. Two categories of criteria are used: “essential criteria” and “additional criteria.” The essential criteria are those elements that should be generally present in individual countries for supervision to be considered effective. Typically, essential criteria specify certain policies and procedures that supervisors are expected to follow to comply with a core principle. The additional criteria are elements that further strengthen supervision and that all countries should strive to implement to improve financial stability and effective supervision. Additional criteria may be particularly relevant to the supervision of more sophisticated banking organizations or may be needed in instances where international business is significant or where local markets tends to be highly volatile. If one is to achieve full compliance with a core principle, the essential criteria generally must be met without any significant deficiencies. There may be instances, of course, where a country can demonstrate that the core principle has been achieved through different means. Conversely, because of the specific conditions in individual countries, the essential criteria may not always be sufficient to achieve the objective of the principle. Therefore, additional criteria or other measures may also be needed for the particular aspect of banking supervision addressed by the principle to be considered effective. Altogether, there are 227 essential and additional criteria. As an example of the assessment process and the role of different criteria, consider the case of Core Principle 1. For this principle, each subprinciple is assessed separately. A “compliant” grading for Core Principle 1, for instance, requires that the essential criteria mentioned in the methodology be met, namely, that laws are in place and that responsibilities are clearly defined, that minimum prudential standards are in place, that defined mechanisms exist for coordination, and that those mechanisms are actually used.12 Furthermore, supervisors should have a role in deciding on resolution of banks, and laws should be updated as needed. Assessment of compliance with those criteria would, for instance, require obtaining and reading the texts of the relevant laws and including the citations in the assessment report. If one is to assess whether responsibilities are, in fact, clear, then information could be obtained on whether agencies cooperate effectively or whether turf issues arise frequently. Do annual reports of various agencies cover the same ground, or are they complementary? Are prudential regulations readily accessible, and do they cover the main prudential areas? If one wishes to review which areas are essential, the list of publications on the Basel Committee’s Web site could be consulted to obtain an impression of which areas have been considered important. Coordination mechanisms
Chapter 5:Ealating Financial Sector Supervision:Banking,Insurance,and Secrities Markets should be established by a formal decision of the authorities and laid down in some form oordina for dealing with co recent bank resolutions were handled,showing,in particular,what role the supervisory authorities had played. 5.3.3.1 Key Considerations in Conducting an Assessment Consistency to the extent possible,fairness,and objectivity are key,but the primary objective of the assessment remains,not to compare a country's performance with others,but to identify and to address individual countries'stre eh and weakne ach t and e of contradic tions in assessment grading is rer rced through the use c esment methodologie and assessment guidance notes and through the review of draft assessments by other experts."Calibrating"the BCPs or modifying the assessment criteria to country-specific factors would,however,be contrary to the Basel Committee's intended objective of view ing the BCPs as a standard to be universally adopted and implemented.The quality of the assessment is enhanced when the "four eyes"approach is used-that is,the reliance thai of skill and backo helps mirigre the risk well-prepared self-a -including the sur naries of the relevant legal and regul tory texts,as well as a th rough description of the ins onal mewo supervisory practices-is essential.The assessors should meet with the autho ities,banks and other agencies and private sector counterparts.Relevant issues should be discussed not only with the supervisors but also,for instance,with other regulators,the Ministry of Finance,and the representatives from the central bank,as well as from the private sector (e.g.,bankers,insurance companies,securities market participants,external rating agen- and external auditors) Th may need to take nt the rieslevel of development while sing the sup rvis ory prerequ ore Frinc when assessing how the collateral value is accounted for in prudential regulations,asses sors will have to consider the efficacy of the legal system and whether or not enforcement of regulatory and judicial decisions is problematic.Assessors should reflect the country- specific factors in the"comment"section of the assessment template,and deficiencies can be incorporated in a forward-looking,sequenced action plan.Any considerations relating othe level of developm in the ould be reflected fully 'comments'” section of the nded a plan. 5.3.3.2 Assessment Experiencel4 A review of FSAP experience with BCP assessments reveals areas of strengths and weak nesses (see table 5.1).Notwithstanding better overall performance of industrialized 117
117 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 should be established by a formal decision of the authorities and laid down in some form of decree or similar instrument. This decree should also define the mechanics of coordination, the exchange of information, the procedures for dealing with confidentiality issues, and similar issues. The authorities should provide to the assessors descriptions of how recent bank resolutions were handled, showing, in particular, what role the supervisory authorities had played. 5.3.3.1 Key Considerations in Conducting an Assessment Consistency to the extent possible, fairness, and objectivity are key, but the primary objective of the assessment remains, not to compare a country’s performance with others, but to identify and to address individual countries’ strengths and weaknesses. Consistency—defined as a uniform approach to assessments and avoidance of contradictions in assessment grading—is reinforced through the use of assessment methodologies and assessment guidance notes and through the review of draft assessments by other experts. “Calibrating” the BCPs or modifying the assessment criteria to country-specific factors would, however, be contrary to the Basel Committee’s intended objective of viewing the BCPs as a standard to be universally adopted and implemented. The quality of the assessment is enhanced when the “four eyes” approach is used—that is, the reliance on two experts with a mix of skills and backgrounds—because it helps mitigate the risk of individual bias. A well-prepared self-assessment—including the summaries of the relevant legal and regulatory texts, as well as a thorough description of the institutional framework and supervisory practices—is essential. The assessors should meet with the authorities, banks, and other agencies and private sector counterparts. Relevant issues should be discussed not only with the supervisors but also, for instance, with other regulators, the Ministry of Finance, and the representatives from the central bank, as well as from the private sector (e.g., bankers, insurance companies, securities market participants, external rating agencies, and external auditors).13 The assessor may need to take into account the countries’ level of development while assessing the supervisory prerequisites (Core Principle 1). Differences in prerequisites are likely to have a bearing on the detailed principle-by-principle assessment. For example, when assessing how the collateral value is accounted for in prudential regulations, assessors will have to consider the efficacy of the legal system and whether or not enforcement of regulatory and judicial decisions is problematic. Assessors should reflect the countryspecific factors in the “comment” section of the assessment template, and deficiencies can be incorporated in a forward-looking, sequenced action plan. Any considerations relating to the level of development and country-specific circumstances should be reflected fully in the “comments” section of the assessment templates and in the “recommended action plan.” 5.3.3.2 Assessment Experience14 A review of FSAP experience with BCP assessments reveals areas of strengths and weaknesses (see table 5.1). Notwithstanding better overall performance of industrialized
Financial Sector Assessment:A Handbook Table 5.1.Observance of Basel Core Principles for Effective Banking Supervision Issues raised by assessors 1.1rerisruhorty/Frm:ncear role fxur 1.2.Independence 13.Legal framework pfcoghassforcooperaioanandintormafionexchange,asownhforoign 1.4.Enforcement powers 5 15.Legal protection 1.6.Information sharing acotlealhatnortoemalagrements;tigidconidentialityconstraints,MoUsnot 2.Permissible activities of the wo 4.Ownership 6.Capital adequacy policies 7.Credit policies gfi8sio5ta所nfGientsupevisoymonioin, 8.Loan evaluation na p 10 ateral included. 9.Large exposures 10.Connected lending 12.Market risk 13.Other risks 15.Anti-Money laundering nadequate or no legal framework. 16.On-site and off-site supervision 17.Contcts with bank manm requency,no clear pro 18Off-ite supervision 8n8aaaaeae0aooidetcaee8poPtgmewotnotsatbysupeveo 19.Validation of information hegten2yofeSecRareakaucdsnocotrolovoranernalaudinors,insufcient lo Rooiteegnno2ering 18
118 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 Table 5.1. Observance of Basel Core Principles for Effective Banking Supervision Core principle (number and main topic) Issues raised by assessors 1.1 Framework for supervisory authority/ objectives Fragmented responsibilities; unclear role of external auditors 1.2. Independence Political interference in licensing and remedial measures; forbearance; insufficient legal protection; weak autonomy; insufficient staffing. 1.3. Legal framework Insufficient basis for cooperation and information exchange, also with foreign supervisors. 1.4. Enforcement powers Legal basis inadequate or overly rigid; forbearance, court intervention, need to consult political authorities. 1.5. Legal protection Rules on legal protection not explicit, inadequate or absent; no rules on legal expenses; accountability concerns. 1.6. Information sharing Lack of legal basis or formal agreements; rigid confidentiality constraints, MOUs not implemented in practice. 2. Permissible activities No authority to act against unauthorized banks; laws unclear on licensing requirements; no protection of the word “bank.” 3. Licensing criteria Reputation of managers not tested; inadequate fit and proper tests, refusal to grant license can be appealed at Ministry of Finance; foreign supervisors not contacted; political interference. 4. Ownership Prior supervisory approval not required; no fit and proper test for shareholders; no definition of significant ownership, nor qualitative criteria to determine ownership. 5. Investment criteria No approval authority; inadequate definitions of investments requiring approval; no criteria for impairment of supervision resulting from acquisitions. 6. Capital adequacy policies No calculation on a consolidated basis; no market risk charges, inadequate risk weightings, inappropriate capital components. 7. Credit policies Insufficient supervisory guidance on credit policies; no rules on arm’s length lending; unclear board and management responsibility for credit policies; no dissemination of policies to staff; insufficient supervisory monitoring. 8. Loan evaluation Insufficiently rigorous loan classification and provisioning rules, insufficient monitoring, no cash flow based assessment, rules too lenient on use of collateral, restructured or evergreened loans, no tax deductibility for specific provisions, off–balance sheet items not included. 9. Large exposures Exposures not reported/monitored on a consolidated basis, inadequate and/or overly rigid criteria to establish group connections. 10. Connected lending Regulations absent or without sufficient legal basis; inadequate/overly rigid definitions of connectedness. 11. Country risk Absence of regulations, usually because banks have little or no exposure. 12. Market risk Absence of regulations, or inconsistency with Basel guidance, usually because banks have little or no exposure; no supervision on a consolidated basis, weak or no enforcement. 13. Other risks Absence or inadequacy of rules on risk management, absence of guidelines on interest rate, liquidity and operational risk; inadequate supervisory capacity. 14. Internal control Inadequate or no standards, unclear responsibilities of management for internal controls, examination mandate inadequate, no rules on corporate governance. 15. Anti-Money laundering Inadequate or no legal framework. 16. On-site and off-site supervision Inadequate frequency of visits, staff shortages, insufficient skills, no risk-based supervision, unclear objectives. 17. Contacts with bank management Insufficient frequency, no clear procedure to maintaining contact. 18. Off-site supervision No supervision on a consolidated basis, reporting framework not set by supervisor, non-bank affiliates not covered, inaccurate reporting. 19. Validation of information Inadequate response to weak audits, no control over external auditors, insufficient frequency of inspections. 20. Consolidated supervision No requirements on consolidation or consolidated supervision, no legal basis to require consolidated reporting, scope of consolidation too limited, e.g., not covering non-bank affiliates, no reporting of related interests
Chapter 5:Ealating Financial Sector Supervision:Banking,Insurance,and Securities Markets Table 5.1.(continued) Issues raised by assessors 21.Accounting stdarteionotampywith1a5,supenvisorhasnoahoriyostbank 22.Remedial measures 3 Global authority t 24.Host country supervision paeegloTaeneiateoeorenmiaetewithhomesupevisors,Imecontactin urfcenteeangeotintormation,insufidientMoUs,noinspetionauthortytor 5 in relative strengthsand weaknesses all counry incom groups (ind trialized,dev eloping,and emerging).It is significant to note that,in al countries,the broad area of credit risk management has relatively low rates of compliance Principles relating to the overall foundation for supervision (i.e.,the legal and regulatory framework,licensing,and supervisory practices)are relatively well observed when com- pared with the principles on credit policies,loan evaluation,and risks related to country market,and other variables.These are areas that affect banks'condition most directly, and their relatively low observance is a matter of concern. Two crucial areas that are also relatively weak are those of capital adequacy and con- solidated supervision.The two areas arec nected because,in a n mber of ca apital ere mp lequa was n calculated on con olid ated basis. ential other prudenti meaningful if supervision is no onthe basis of a ards,are much les ed reports,accounts and implementation of remedial action.The principle on anti-money-laundering is also among those that are insufficiently implemented in many countries. The experience of assessments to date indicates that developing countries generally show lower levels of compliance with the bcps.whereas many transition countries have intermediate levels of compliance.Advanced economies generally satisfy the precondi. tions more robustly and achieve the highest level of compliance overall.Compliance with the BCPs is positively correlated with observance of the preconditions and the stage of development of the financial sector al the ma s of akness identified by ents of observ ce of the visory independence,for and info to the principl practices relating to loan c and provisioning,also appears to be low.Consolidated supervision,especially for large complex financial institutions,is another area of weakness that has been identified in 119
119 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 countries, similarities in relative strengths and weaknesses exist across all country income groups (industrialized, developing, and emerging). It is significant to note that, in all countries, the broad area of credit risk management has relatively low rates of compliance. Principles relating to the overall foundation for supervision (i.e., the legal and regulatory framework, licensing, and supervisory practices) are relatively well observed when compared with the principles on credit policies, loan evaluation, and risks related to country, market, and other variables. These are areas that affect banks’ condition most directly, and their relatively low observance is a matter of concern. Two crucial areas that are also relatively weak are those of capital adequacy and consolidated supervision. The two areas are connected because, in a number of cases, capital adequacy systems were considered noncompliant or materially noncompliant because capital adequacy was not calculated on a consolidated basis. Also, other prudential standards, such as those related to loan quality and other prudential standards, are much less meaningful if supervision is not exercised on the basis of consolidated reports, accounts, and implementation of remedial action. The principle on anti-money-laundering is also among those that are insufficiently implemented in many countries. The experience of assessments to date indicates that developing countries generally show lower levels of compliance with the BCPs, whereas many transition countries have intermediate levels of compliance. Advanced economies generally satisfy the preconditions more robustly and achieve the highest level of compliance overall. Compliance with the BCPs is positively correlated with observance of the preconditions and the stage of development of the financial sector. In general, the main areas of weakness identified by assessments of observance of the BCPs relate to supervisory independence, legal protection for supervisors, and information sharing with other supervisors. Compliance with respect to the principles on credit policies and connected lending, as well as the practices relating to loan classification and provisioning, also appears to be low. Consolidated supervision, especially for large complex financial institutions, is another area of weakness that has been identified in Table 5.1. (continued) Core principle (number and main topic) Issues raised by assessors 21. Accounting Standards do not comply with IAS, supervisor has no authority to set bank accounting standards. 22. Remedial measures Insufficient legal basis, enforcement ineffective, forbearance, limited range of measures, proactive action not possible, court intervention. 23. Global consolidation Scope too limited, no supervision on a consolidated basis, insufficient authority to oversee foreign banks, insufficient information exchange and MoUs. 24. Host country supervision No formal arrangements for contacts with home supervisors, little contact in practice, confidentiality constraints. 25. Supervision of foreign establishments Insufficient exchange of information, insufficient MoUs, no inspection authority for foreign supervisors. Source: IMF 2004a
Financial Sector Assessment:A Handbook assessments performed to date.The ruleson anti-money-laundering and combating the financing of terrorism (AML-CFT)need to be more strongly implemented,as do prompt and effective remedial measures.Finally,systems for managing country risk and market risk were identified as needing improvement in many countries that were assessed. 5.3.4 Basel ll The 1988 Capital Accord (Basel I)introduced capital adequacy measures for credit risk that were based on risk weights assigned to different classes of bank exposures.It was 5 originally intended to be applicable to internationally active banks in the G-10 and other member countries (Belgium,Canada,France,Germany,Italy,Japan,Luxembou Switzerland,United K m,and nited States) Committee on Banking Supervision How ever,the framework was qui kly adopted by national supervisors almost universally,making it an international standar Subsequently,a capital measure for market risk introduced in 1996 has alsc o met with wide acceptance,though it has not been as widely implemented.Nevertheless,signifi cant deficiencies began to surface in the application of basel l.The use of a uniform 100 percent risk weight for all commercial credits regardless of the risk profile of individual exposures led to distortions.Similarly,the treatment of cross-border and interbank claims technology, ng the incre sing d strum recognized.The factors were among those that led to the e development of a new capita accor The New Capital Framework (Basel II)represents a significant improvement over the original accord and seeks to provide more risk-sensitive methodologies to align capi tal requirements with riskiness of banks assets.Under Basel Il.the risk weights can be determined using different approaches based on ratings either assigned to bank exposures by external agencies(standardized approach)or internally assigned through supervisor validated,valu eat-risk (VAR)a aches using default p appr ches)Ex uidance has also be their app as o d th zation ar specialized lending.The methodology for market risk kept almost unchanged while a new capital charge for operational risk has been intro. duced.Apart from laying out different approaches of varying degrees of sophistication, the basel ll framework also provides for a high degree of national discretion.In addition to laying out methodology to compute minimum capital requirements (Pillar I),the new Basel framework also incorporates guiding principles on the supervisory review of bank risk management (Pillar I1)and promotes market discipline through enhanced disclosure ots (Pillar I). Membe countries of the Basel Co are expected to implement the Basel framew eginning a ne end .Both the kisting and new systems l be rur in parallel for a year.While most European Union(EU)countries are expected to imple ment Basel Il in full for their banking systems,many other countries can be expected to implement a mixture of Basel I and Basel II for different parts of their banking systems. Thus,after 2007,assessors can expect banking systems to be applying a bifurcated stan- 120
120 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 assessments performed to date. The rules on anti-money-laundering and combating the financing of terrorism (AML–CFT) need to be more strongly implemented, as do prompt and effective remedial measures. Finally, systems for managing country risk and market risk were identified as needing improvement in many countries that were assessed. 5.3.4 Basel II The 1988 Capital Accord (Basel I) introduced capital adequacy measures for credit risk that were based on risk weights assigned to different classes of bank exposures. It was originally intended to be applicable to internationally active banks in the G-10 and other member countries (Belgium, Canada, France, Germany, Italy, Japan, Luxembourg, the Netherlands, Spain, Sweden, Switzerland, United Kingdom, and United States) of the Basel Committee on Banking Supervision. However, the framework was quickly adopted by national supervisors almost universally, making it an international standard. Subsequently, a capital measure for market risk introduced in 1996 has also met with wide acceptance, though it has not been as widely implemented. Nevertheless, significant deficiencies began to surface in the application of Basel I. The use of a uniform 100 percent risk weight for all commercial credits regardless of the risk profile of individual exposures led to distortions. Similarly, the treatment of cross-border and interbank claims also caused biases in credit allocation. Moreover, rapid changes in risk-management technology, including the increasing use of credit risk transfer instruments, needed to be recognized. The factors were among those that led to the development of a new capital accord. The New Capital Framework (Basel II) represents a significant improvement over the original accord and seeks to provide more risk-sensitive methodologies to align capital requirements with riskiness of banks assets. Under Basel II, the risk weights can be determined using different approaches based on ratings either assigned to bank exposures by external agencies (standardized approach) or internally assigned through supervisorvalidated, value-at-risk (VAR) approaches using default probabilities (internal-ratingsbased [IRB] approaches). Extensive guidance has also been provided on the expanded credit risk mitigation techniques and their application, as well as on the treatment of securitization and specialized lending. The methodology for market risk capital has been kept almost unchanged while a new capital charge for operational risk has been introduced. Apart from laying out different approaches of varying degrees of sophistication, the Basel II framework also provides for a high degree of national discretion. In addition to laying out methodology to compute minimum capital requirements (Pillar I), the new Basel framework also incorporates guiding principles on the supervisory review of bank risk management (Pillar II) and promotes market discipline through enhanced disclosure requirements (Pillar III). Member countries of the Basel Committee are expected to implement the Basel framework beginning at the end of 2006. Both the existing and new systems will be run in parallel for a year. While most European Union (EU) countries are expected to implement Basel II in full for their banking systems, many other countries can be expected to implement a mixture of Basel I and Basel II for different parts of their banking systems. Thus, after 2007, assessors can expect banking systems to be applying a bifurcated stan-