Core Principles for Effective Banking Supervision by yungtyriq


									Reserve Bank of Australia Bulletin                                                              December 1997

                 Core Principles for
            Effective Banking Supervision

                                                            leaders to call for increased international
Introduction                                                co-operation to develop globally integrated
                                                            ‘safeguards, standards, transparency and
                                                            systems necessary to monitor and contain
  The Basle Committee on Banking
                                                              The need for international co-ordination of
Supervision 1 recently released its Core
                                                            the efforts of supervisors of national financial
Principles for Effective Banking Supervision.
                                                            systems had been recognised for over twenty
This article provides some background to this
                                                            years. The collapse of Germany’s Bank
development, looks at the content of the Core
                                                            Herstatt was instrumental in the formation
Principles, how they are intended to be used
                                                            of the Basle Committee on Banking
and how Australian banking supervision
                                                            Supervision. The securities and insurance
measures up.
                                                            regulators later followed suit (the International
                                                            Organisation of Securities Commissions was
                                                            formed in 1984 and the International
Background                                                  Association of Insurance Supervisors in
                                                            1994). In 1996, these three international
                                                            groupings created the Joint Forum on
                                                            Financial Conglomerates, to consider the
  Over the past few years, national and                     supervision of groups containing banking,
international regulator y bodies have                       securities and insurance entities.
intensified their co-operative efforts to
                                                              In 1996, the International Monetary Fund
strengthen the international financial system.
                                                            (IMF), reflecting its increased interest in
Recent activity in this area was encouraged
                                                            supervisory matters, published research 2
by the Heads of Government of the G-7
                                                            which pointed to financial instability and
countries at their meeting in Halifax, Canada,
                                                            inadequate supervision of banks as important
in June 1995. The Mexican and Barings crises
                                                            determinants of economic instability. The
early in 1995 were the catalysts for the G-7
1. The Basle Committee on Banking Supervision was established by the central bank Governors of the Group of Ten
   countries in 1975. It consists of senior representatives of bank supervisory authorities and central banks from
   Belgium, Canada, France, Germany, Italy, Japan, Luxembourg, Netherlands, Sweden, Switzerland, United Kingdom
   and the United States. It usually meets at the Bank for International Settlements in Basle, Switzerland where its
   permanent Secretariat is located.
2. Lindgren, C-J., G. Garcia and M. Saal (1996), Bank Soundness and Macroeconomic Policy, International Monetary
Core Principles for Effective Banking Supervision                                 December 1997
research showed that 133 of the IMF’s 181           the sharing of information by all relevant
member countries had experienced banking            agencies.
problems in the previous fifteen years and that       Licensing and structure (Principles 2
no category of country was spared. The Board        to 5). These Principles focus on the licensing
of the IMF accepted that the soundness of           process, the ownership structure and the scope
the financial sector was essential for macro        of business of banks and banking groups. The
economic stability and that IMF surveillance        system of supervision must be based on a
could assist in identifying potential               banking licence in order to identify supervised
vulnerabilities in a country’s monetary and         institutions clearly; and the use of the word
financial systems. The IMF felt that for its        ‘bank’ in business names should be confined
surveillance to be effective its staff needed a     to these supervised institutions, to prevent
general statement of the broad principles likely    confusion amongst depositors. The licensing
to promote stable and sound financial systems.      process should include an assessment of
  At the Lyon Summit in June 1996, the G-7          ownership structure, management and
Heads of Government agreed that better              operating plans. Supervisors should be able
prudential regulation, particularly in emerging     to review major acquisitions or investments
economies, was essential for preserving             by a bank.
stability in financial markets, and urged             Prudential           regulations        and
greater efforts by national and international       requirements (Principles 6 to 15). These
agencies to achieve this goal.                      Principles emphasise the need to identify the
  In response, the Basle Committee prepared         various types of risk confronting a bank, and
a draft document setting out core principles        ways of ensuring that these risks are properly
for an effective supervisory system. In the         monitored and controlled. The development
process, it consulted widely with banking           and enforcement by supervisors of prudential
supervisors from a range of countries,              guidelines are integral parts of this process.
including Australia. The G-7 meeting in             These guidelines should relate to capital
Denver in June 1997 endorsed these principles       adequacy, loan loss reser ves, asset
and the final version was presented at the          concentrations, liquidity, risk management
annual meetings of the World Bank and               and internal controls, and can be quantitative
International Monetary Fund in Hong Kong            and/or qualitative. Internal controls should
in September.                                       include procedures which aim to prevent the
                                                    bank being used by criminal elements.
                                                      Methods of ongoing banking
The Principles                                      supervision (Principles 16 to 20). These
                                                    Principles say that both on- and off-site
                                                    supervision should be used, with the latter
                                                    including analysis of reports and returns from
  The Core Principles comprise twenty-five          banks and their affiliated entities, on a
minimum requirements that need to be met            consolidated as well as an individual basis.
for a supervisory system to be effective. The       Independent validation of data is essential and
Principles (set out in full in the Attachment       regular contact with management is necessary
to this article) are divided into seven major       to ensure that the operations of the bank are
groups.                                             fully understood.
  Preconditions for effective banking                 Information requirements (Principle
supervision. The first Principle highlights the     21). According to this Principle, each bank
need for a clear, achievable and consistent         must maintain adequate records drawn up in
framework of objectives and responsibilities        accordance with consistent accounting
for the agencies involved in banking                policies that enable the supervisor to obtain a
supervision. It notes the necessity of a suitable   true and fair view of the financial condition
legal framework for bank supervision and for        and profitability of the bank, and must publish
Reserve Bank of Australia Bulletin                                                 December 1997
regular financial statements that fairly reflect   practicable within their legal authority.
its condition.                                     Implementation of the Principles is to be
   For mal powers of super visors                  surveyed by the Basle Committee and
(Principle 22). This Principle stipulates that     reviewed at the International Conference of
supervisors must have adequate powers to           Banking Supervisors in Sydney in October
bring about corrective action if banks fail to     1998. Regional organisations of which
meet prudential standards, or the interests of     Australia is a member, such as the SEANZA
depositors are threatened.                         Forum of Banking Supervisors and the
   Cross-border banking (Principles 23 to          Executives’ Meeting of East Asia and Pacific
25). These Principles review the respective        Central Banks (EMEAP), may have a role in
roles of home and host supervisors, and stress     promoting formal endorsement of the
the need for supervision on a global               Principles and in monitoring implementation
consolidated basis and for powers to share         by their members.
information with other supervisors.

                                                   Australian Bank Supervision
Use of the Principles

                                                      Australia complies with almost all of the
  The Core Principles provide a benchmark          Core Principles. This is hardly surprising given
for international agencies and groups,             that its regime for supervising banks has been
especially in relation to emerging market          developed in the light of international best
economies. Both the World Bank and IMF are         practice. In the case of Principle 15, which
emphasising to emerging economies the              refers to the need for powers to combat money
importance of sound financial systems and the      laundering, Australia complies, but the
need to build effective supervision. Assistance    relevant regulatory authority is Austrac rather
programs are likely to increasingly require that   than the Reserve Bank.
systems of bank supervision be brought up to          Nevertheless, there are two areas where a
international standards. The Principles            literal interpretation of the Principles could
delineate those standards, providing an            raise doubts about Australia’s compliance:
objective target for both the agency and the       • Principle 3 requires that the licensing
country concerned.                                     process include (inter alia) an assessment of
  Bank supervisors can use the Principles both         the bank’s directors and senior management.
as a basis for self-assessment, and when               The Basle Committee interprets this to
judging the supervisory standards applying in          mean that all directors and managers,
other countries. The latter is important when          whether appointed at establishment or
considering applications for banking                   subsequently, should be subject to a ‘fit
authorities by foreign banks. Australia, like          and proper’ test. The aim is to ensure that
most countries, requires that such applicants          these personnel have the necessary ability,
be supervised at an internationally accepted           experience and integrity to operate a bank.
standard in their home countries.                      In Australia, most local banks are large
  Supervisory authorities around the world             public companies listed on the Stock
are being encouraged by the Basle Committee            Exchange, and subject to the scrutiny
to endorse the Core Principles, not later than         which comes from a broad range of
October 1998. Endorsement will include an              shareholders (as required by our
undertaking to review current supervisory              ownership rules). In these circumstances,
arrangements against the Principles and to             the Reserve Bank has not sought formal
initiate a program designed to address any             powers of approval over senior
material shor tcomings as quickly as                   management appointments. It does,

Core Principles for Effective Banking Supervision                                          December 1997
  however, require prior notification of board                 supervises their activities. In its submission
  appointments.                                                to the recent Financial System Inquiry, the
• Principle 25 requires the local operations of                Bank noted that this situation, which is a
  foreign banks to be conducted to the same high               hangover from the days before foreign
  standards as are required of domestic                        banks were able to apply for banking
  institutions. The Australian policy of                       author ities, is anomalous, and
  allowing foreign banks to carr y out                         recommended that all foreign banks
  banking type operations in Australia as                      operating in Australia should be required
  so-called ‘merchant banks’ is inconsistent                   to seek Australian banking authorities. The
  with this Principle. The Reserve Bank is                     Inquir y     did     not      accept      that
  not in a position to provide information                     recommendation because of a concern that
  to home country supervisors on the                           requiring merchant banks to seek banking
  activities of these merchant banks in                        authorities might lead to a reduction in
  Australia since it neither authorises nor                    competition. The Government has
                                                               endorsed the Inquiry’s view on this matter.

List of Core Principles for Effective                           standards set. The licensing process, at a
Banking Supervision                                             minimum, should consist of an
                                                                assessment of the banking organisation’s
Preconditions for effective banking supervision
                                                                ownership structure, directors and senior
1. An effective system of banking                               management, its operating plan and
    supervision will have clear responsibilities                internal controls, and its projected
    and objectives for each agency involved                     financial condition, including its capital
    in the super vision of banking                              base; where the proposed owner or parent
    organisations. Each such agency should                      organisation is a foreign bank, the prior
    possess operational independence and                        consent of its home country supervisor
    adequate resources. A suitable legal                        should be obtained.
    framework for banking supervision is also
                                                          4.    Banking supervisors must have the
    necessary, including provisions relating to
                                                                authority to review and reject any
    authorisation of banking organisations
                                                                proposals to transfer significant
    and their ongoing supervision; powers to
                                                                ownership or controlling interests in
    address compliance with laws as well as
                                                                existing banks to other parties.
    safety and soundness concerns; and legal
    protection for supervisors. Arrangements              5.    Banking supervisors must have the
    for sharing information between                             authority to establish criteria for reviewing
    super visors and protecting the                             major acquisitions or investments by a
    confidentiality of such information should                  bank and ensuring that corporate
    be in place.                                                affiliations or structures do not expose the
                                                                bank to undue risks or hinder effective
Licensing and structure                                         supervision.
2. The permissible activities of institutions
                                                          Prudential regulations and requirements
    that are licensed and subject to
    supervision as banks must be clearly                  6. Banking supervisors must set prudent
    defined, and the use of the word ‘bank’                   and appropriate minimum capital
    in names should be controlled as far as                   adequacy requirements for all banks.
    possible.                                                 Such requirements should reflect the risks
                                                              that banks undertake, and must define the
3. The licensing authority must have the
                                                              components of capital, bearing in mind
    right to set criteria and reject applications
                                                              its ability to absorb losses. For
    for establishments that do not meet the
                                                              internationally active banks, these
Reserve Bank of Australia Bulletin                                                 December 1997
      requirements must not be less than those         management process (including
      established in the Basle Capital Accord.         appropriate board and senior
7.    An essential part of any supervisory             management oversight) to identify,
      system is the evaluation of a bank’s             measure, monitor and control all other
      policies, practices and procedures related       material risks and, where appropriate, to
      to the granting of loans and making of           hold capital against these risks.
      investments and the ongoing                  14. Banking supervisors must determine that
      management of the loan and investment            banks have in place internal controls that
      portfolios.                                      are adequate for the nature and scale of
8.    Banking supervisors must be satisfied that       their business. These should include clear
      banks establish and adhere to adequate           arrangements for delegating authority and
      policies, practices and procedures for           responsibility; separation of the functions
      evaluating the quality of assets and the         that involve committing the bank, paying
      adequacy of loan loss provisions and loan        away its funds, and accounting for its
      loss reserves.                                   assets and liabilities; reconciliation of
9.    Banking supervisors must be satisfied that       these processes; safeguarding its assets;
      banks have management information                and appropriate independent internal or
      systems that enable management to                external audit and compliance functions
      identify concentrations within the               to test adherence to these controls as well
      por tfolio and supervisors must set              as applicable laws and regulations.
      prudential limits to restrict bank           15. Banking supervisors must determine that
      exposures to single borrowers or groups          banks have adequate policies, practices
      of related borrowers.                            and procedures in place, including strict
10.   In order to prevent abuses arising from          ‘know-your-customer’ rules, that promote
      connected lending, banking supervisors           high ethical and professional standards in
      must have in place requirements that             the financial sector and prevent the bank
      banks lend to related companies and              being      used,     intentionally       or
      individuals on an arm’s-length basis, that       unintentionally, by criminal elements.
      such extensions of credit are effectively    Methods of ongoing banking supervision
      monitored, and that other appropriate
                                                   16. An effective banking supervisory system
      steps are taken to control or mitigate the
                                                       should consist of some form of both
                                                       on-site and off-site supervision.
11.   Banking supervisors must be satisfied that
                                                   17. Banking supervisors must have regular
      banks have adequate policies and
                                                       contact with bank management and
      procedures for identifying, monitoring
                                                       thorough understanding of the
      and controlling country risk and transfer
                                                       institution’s operations.
      risk in their international lending and
      investment activities, and for maintaining   18. Banking supervisors must have a means
      adequate reserves against such risks.            of collecting, reviewing and analysing
                                                       prudential reports and statistical returns
12.   Banking supervisors must be satisfied that
                                                       from banks on a solo and consolidated
      banks have in place systems that
      accurately measure, monitor and
      adequately control market risks;             19. Banking supervisors must have a means
      supervisors should have powers to impose         of independent validation of supervisory
      specific limits and/or a specific capital        information either through on-site
      charge on market risk exposures, if              examination or use of external auditors.
      warranted.                                   20. An essential element of banking
13.   Banking supervisors must be satisfied that       supervision is the ability of the supervisors
      banks have in place a comprehensive risk         to supervise the banking organisation on
                                                       a consolidated basis.
Core Principles for Effective Banking Supervision                                   December 1997
Information requirements                              Cross-border banking
21. Banking supervisors must be satisfied that        23. Banking super visors must practise
     each bank maintains adequate records                 global consolidated supervision over
     drawn up in accordance with consistent               their internationally-active banking
     accounting policies and practices that               organisations, adequately monitoring and
     enable the supervisor to obtain a true and           applying appropriate prudential norms to
     fair view of the financial condition of the          all aspects of the business conducted by
     bank and the profitability of its business,          these banking organisations worldwide,
     and that the bank publishes on a regular             primarily at their foreign branches, joint
     basis financial statements that fairly reflect       ventures and subsidiaries.
     its condition.                                   24. A key component of consolidated
                                                          supervision is establishing contact and
Formal powers of supervisors
                                                          information exchange with the various
22. Banking supervisors must have at their                other supervisors involved, primarily host
    disposal adequate supervisory measures                country supervisory authorities.
    to bring about timely corrective action
                                                      25. Banking supervisors must require the
    when banks fail to meet prudential
                                                          local operations of foreign banks to be
    requirements (such as minimum capital
                                                          conducted to the same high standards as
    adequacy ratios), when there are
                                                          are required of domestic institutions and
    regulatory violations, or where depositors
                                                          must have powers to share information
    are threatened in any other way. In
                                                          needed by the home country supervisors
    extreme circumstances, this should
                                                          of those banks for the purpose of carrying
    include the ability to revoke the banking
                                                          out consolidated supervision.
    licence or recommend its revocation.


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