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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
risks’.
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
Fund.
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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
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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,
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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.
Attachment
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
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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
risks.
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
basis.
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.
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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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