5.2.1 Frameworks for Liquidity Support

Liquidity support is a key element of the financial sector safety net. Two somewhat distinct functions—one operating at normal times and another in times of crisis—need to be identified. The first is the lender-of-last-resort (LOLR) function, which typically operates in the normal course of day-to-day monetary policy operations. Nearly all central banks have the authority to provide credit to temporarily illiquid, but still solvent, institutions. This kind of support can provide an important buffer against temporary disturbances in financial markets. LOLR actions may help to prevent liquidity shortages in one bank from being transmitted to other financial institutions, for example, through the payment system. LOLR actions are not intended to prevent bank failures but, rather, to prevent spillovers associated with liquidity shortages—particularly in money and interbank markets—from interrupting the normal intermediation function of financial institutions and markets.

All central banks have a LOLR facility in place, but conditions and modalities are often not well defined.¹ Ill-defined conditions may give rise to moral hazard and forbearance, with adverse consequences for the financial system. Thus, an important component in understanding the adequacy of the financial safety net is assessing the adequacy of the central bank’s operational procedures for LOLR support.

Somewhat distinct from the normal LOLR function is central bank emergency lending. It is important for central banks to have procedures in place to provide emergency lending, with different modalities and conditions, in times of (imminent) crises. In cases of emergencies, a number of central banks have the legal authority to provide liquidity over and above what is allowed within the normal facility. Having those types of procedures available can be very useful to provide temporary support to the system in times of severe disruptions. However, the very existence of those procedures might lead to moral hazard in banks, causing them to hold less liquidity than they otherwise would do and to take other risks. As a result, the providing of emergency credit is typically at the discretion of the central bank (constructive ambiguity). Nonetheless, internal procedures and policies—a form of contingency planning—should be in place for emergency lending, which should follow sound practices. In particular, the broad principles and the procedures governing the decisions on emergency lending could be established and made transparent.

Key features of emergency lending procedures that should be considered include the following:²

• Resources should be made available only to banks that are considered solvent but are coping with liquidity problems that might endanger the entire system (e.g., too-big-to-fail cases).

• Lending should take place speedily.

• Lending should be short term; even then, it should be provided conservatively because the situation of a bank might deteriorate quickly.

• Lending should not take place at subsidized rates, but the rate also should not be penal because it might then deteriorate the bank’s position.

• The loan should be fully collateralized, and collateral should be valued conservatively. However, at times of severe crisis, it might be necessary for the central bank to relax this criterion or to organize government guarantees or to arrange government credit, even if the loan is executed from the central bank’s balance sheet.

• Central bank supervisory authorities and the Ministry of Finance should be in close contact and should monitor the situation of the bank.

• Supervisory sanctions and remedial actions should be attached to the emergency lending.

5.2.2 Deposit Insurance

A second key element of the financial safety net is a deposit insurance system (DIS). Although deposit insurance can cause excessive risk taking, a careful design of deposit insurance—complemented by a larger policy package that includes effective supervision, prompt bank resolution methods, and well-designed LOLR procedures—should provide incentives for economic agents to keep the financial system stable.³

Good practices that contribute to a proper operation of a DIS include the following:

• The DIS should be explicitly and clearly defined in laws and regulations that are known to, and understood by, the public so bank customers can protect their interests.

• If one is to reduce the probability of moral hazard in banks and to provide incentives for large depositors and counterparty banks to monitor the bank conditions, “large” deposits, including interbank liabilities, should not be covered.

• Ex ante funding schemes are preferable to ex post schemes.

• Membership should be compulsory; insurance premiums should be risk-adjusted, if possible, to moderate the subsidy provided by strong institutions to weaker ones.

• If depositors are to have confidence in the system, the DIS must pay out insured deposits promptly, and it must be adequately funded so it can resolve failed institutions firmly and without delay.

• The DIS should act in the interests of both depositors and the taxpayers who back up the fund. Consequently, it should be accountable to the public, but independent of political interference.

• The DIS should be complemented by effective supervision and well-designed LOLR policies.

• Because the roles of the LOLR, the supervisor, and the DIS are different, it is often advisable in large countries (but impractical in countries facing a shortage of financial skills) to house them in three separate agencies. Regardless, those agencies need to share information and coordinate their actions.

• If the DIS is to avoid regulatory capture by the industry it guarantees, then placing currently practicing bankers in charge of decision making is typically not advisable. However, bankers should be given the opportunity to serve on an advisory board, where they can offer useful advice.

• If a country operates insurance schemes for financial instruments other than (narrowly defined) deposits—including capital market instruments and possibly insurance—then those types of investor and policyholder compensation schemes should conform broadly to the same standards as deposit insurance, as described in this chapter.

• Although the inclusion or exclusion of foreign currency deposits in deposit insurance would depend on the features of dollarization, adequacy of foreign exchange reserves, and capacity to manage foreign exchange risks, a decision to include foreign exchange deposits should be based on a clear and transparent legal and regulatory framework that specifies who bears the exchange risk.⁴

In a systemic crisis, limited deposit insurance may become ineffective. Other measures such as an extended guarantee (blanket guarantee) could be considered in those circumstances. However, as country experience in systemic crises indicates, a blanket guarantee (a government guarantee for all depositors and certain bank creditors) should be provided only if circumstances are favorable for that guarantee to restore confidence and to stop the crisis from spreading and if there is a credible time-bound exit strategy toward limited guarantee.⁵ One crucial condition to restore confidence is that the government’s fiscal situation be sustainable.

5.2.3 Investor and Policyholder Protection Schemes

Related to the second element of safety net, deposit insurance, are investor and policyholder compensation schemes, which are designed to promote investor confidence in the functioning of financial markets and to protect policyholders from the failures of financial institutions. They are present in many jurisdictions and form one component of the range of measures adopted by industry associations, self-regulatory organizations (such as stock and futures exchanges), and national authorities. Most schemes are designed to provide some degree of compensation for investors who incur losses from the insolvency or other failure of a member firm; some schemes also provide compensation for losses arising from fraud or other malfeasance on the part of the intermediary or its employees. All schemes have a cap on claims—in absolute terms or as a proportion of the loss incurred or both.

Investor compensation schemes generally cover customer accounts in which a range of investment activities—defined in the respective licensing laws and broader regulatory regimes—take place. Compensation schemes generally do not cover losses on the part of the investor as a result of poor investment advice or management by member firms, although in some schemes, compensation may be available where a causal relationship is established between the poor investment advice or management and the inability of the firm to meet claims made by clients.

In most jurisdictions, the compensation scheme is statutory in nature; however, it may take a variety of forms. Although compensation funds are set up by contract, the obligation to set up and to be a member of one are often in statute. In some cases, schemes are constituted as nonprofit member organizations, whereas, in other cases, the scheme is arranged on the basis of a company operating a fund on behalf of an exchange, the exchange being the principal shareholder of the company. In certain jurisdictions, there are schemes in which trusts—organized on behalf of the various dealer associations and exchanges that are acting as the trust’s sponsoring organizations—provide for compensation arrangements. The compensation fund also may be established as a separate company administered by the regulator.

The majority of investor compensation schemes are tailored to individual investors and small business; in some cases, institutional investors are afforded equitable treatment under the terms of the scheme. Generally, the claims cap of the scheme is consistent with the type of investor covered by the arrangements; jurisdictions that provide for both retail and institutional claimants in their schemes have caps that are generally higher than those for compensation schemes that are targeted at retail and small business investors. Some schemes provide for a minimum level of compensation, although the majority set limits on the maximum payment in the event of a successful claim.

Funding arrangements for investor compensation schemes rely to a large extent on levies on member firms. Where levies are imposed, they are generally calculated according to factors such as the gross revenue and net capital of member firms. Other factors may also be taken into account in assessing contributions, including the risk profile and level of activity of the firm. Some schemes set a minimum balance for the fund and have specific arrangements to ensure that the minimum balance is maintained. In some jurisdictions, the scheme does not provide for a reserve fund; rather, levies are raised according to projected costs of the scheme in a given year and calculated on an annual basis. Provisions are usually made in the scheme’s rules to ensure that additional funds can be raised in the event of a major default or likely shortfall in funds caused by increased claims.

The adequacy of investor protection measures depends on the full range of regulatory responses in place to minimize investor losses and to protect customer assets in the event of the failure of an intermediary. Those measures include (a) procedures to effect the orderly winding up of a failed intermediary, (b) provisions for the regulator to restrain conduct on the part of a failing or failed firm and to direct the appropriate management of assets held by the intermediary, and (c) capital adequacy requirements that are sufficient to facilitate the protection of customer assets in the event of a firm becoming insolvent. Adequate transparency of the regulator—with respect to the steps taken to deal with the failure of market intermediaries—can promote investor confidence.

Some of the emerging good practices of compensation schemes are noted here. Compensation schemes should be independent and transparent in their operations. They should have open and constructive relations with related agencies or functions—such as a supervisor or an ombudsman or any relevant part of the dispute resolution mechanism—and industry representatives. Compensation schemes should be industry-funded to emphasize that prudential and fiduciary responsibility lies with industry participants. The degree of government backing is likely to vary between jurisdictions, but such backing may increase moral hazard to market participants. Prefunded schemes offer greater certainty of compensation, but pay-as-you-go schemes may be perfectly adequate in disciplined markets. The latter type of scheme (and to a lesser extent, the former) may be required to borrow from time to time. The terms and conditions of this borrowing should be subject to clear limits. Funding levies are usually set at a flat percentage of income. The rate may vary from sector to sector, by size of contributor, or by the degree of financial health of the contributor.

Compensation is made on the defined event of failure or almost certain failure of a financial service provider. Compensation is typically subject to an upper limit that is appropriate for the type of product or market and commensurate with the level of funding. Compensation could be limited to retailers or small, unsophisticated commercial consumers, and the extent to which foreign consumers of domestic products should be compensated should be appropriate to the type of market. Most notably, if a market purports to offer products on an international basis, then compensation should be payable to foreign consumers. Finally, the scheme should adhere to good corporate governance practices, follow strict investment guidelines, and be subject to audit.

Policyholder protection funds act as a financial safety net, often after other avenues for redress have been exhausted (e.g., the bankruptcy process). These funds act to maintain public confidence in the industry by protecting the interest of small entities or uninformed customers and by ensuring a smooth exit mechanism for failing companies. Finally, protection funds help to level the playing field across different sectors.⁶

5.2.4 Crisis Management

A third key element of the financial sector safety net includes the policies and procedures in place to manage crises. An assessment of the adequacy of the safety net should consider the readiness of the national authorities to tackle a systemic banking crisis (ideally, to have in place a contingency plan) in case a crisis occurs. Many country authorities may view the prospects for a crisis as highly remote, and thus, assessments of readiness may help raise awareness of the need to have policies and procedures in place to address a crisis.

Some key considerations in assessing the crisis management framework include the following:

• Is the legal framework during “normal times” robust enough to ensure a smooth banking sector restructuring once a crisis has been contained? This question encompasses a wide range of areas, including the banking law, the bankruptcy procedures, the laws on foreclosing assets, and the quality of the judicial system. Adequate bank insolvency law in normal times is critical to ensure smooth bank restructuring in crisis times.

• A high-level policy committee is needed as soon as it is clear that the crisis has taken on systemic proportions. At that point, it is important to act swiftly and decisively, which requires a high-level body. This body should be at the prime ministerial level (or ministerial level) and should include the head of the central bank and the supervisory agency.

• Although it is impossible to have a contingency plan that covers all contingencies (crises come in different shapes and forms), the authorities should have some views with respect to the types of measures that could be taken to contain an emerging crisis. Time is of the essence at that point, and the measures should be of the type to show that the authorities are in control so confidence will return. Some countries occasionally organize crisis management simulations to increase awareness of potential issues and to resolve logistical impediments to the smooth handling of crises.

Additional discussion of those issues is provided in Hoelscher and Quintyn (2003), Lindgren and others (2000), and World Bank and IMF (2004), especially with respect to the legal, institutional and regulatory framework to deal with insolvent banks. See also section 5.3.5 for a more detailed discussion of bank insolvency issues.

5.3.1 Basel Core Principles—Their Scope and Coverage, and Their Relevance to Stability and Structural Development

The Basel Core Principles (BCPs) for Effective Banking Supervision, developed by the Basel Committee on Banking Supervision (BCBS), are the key global standard for prudential regulation and supervision of banks. The BCPs provide a benchmark against which the effectiveness of bank supervisory regimes can be assessed. The BCPs consist of a set of five preconditions for a robust financial system and 25 principles governing aspects of supervision (see box 5.1). The 25 core principles cover various aspects of objectives, autonomy, powers, and resources (Core Principle 1); licensing and structure (Core Principles 2–5); prudential regulations and requirements (Core Principles 6–15); methods of ongoing supervision (Core Principles 16–20); information requirements (Core Principle 21); remedial measures and exit policies (formal powers) (Core Principle 22); and cross-border banking (Core Principles 23–25).

The purpose of the BCPs is to strengthen individual banks by ensuring a sound supervisory framework. Assessments of observance of the BCPs help identify areas that need strengthening and that contribute to stability of the financial system (a) directly by improving good supervision and (b) indirectly by promoting a robust financial infrastructure. The BCPs seek to ensure that the supervisor can operate effectively and that banks operate in a safe and sound manner. The BCPs also define the necessary preconditions, including the legal, accounting, and auditing infrastructure; effective market discipline and resolution of problem banks; public safety nets; and sound macroeconomic frameworks that should be in place for effective supervision. The BCP assessments provide useful qualitative information on the risk environment, on the responsiveness of the supervisor, and on the overall effectiveness of risk management.

The BCPs highlight a set of prerequisites relating to regulatory governance and spell out principles and criteria to govern sound regulatory practices, a prudent operational framework, and financial integrity in regulated firms (box 5.1). In particular, Core Principle 1 lays down a number of prerequisites to the effective exercise of supervision such as clear and legally determined terms of reference, independence of supervisor, powers to address deficiencies, information sharing, and confidentiality and legal protection of the supervisor. What is needed to define the scope of banking supervision is a definition of banking and a licensing system to ensure that only the best-qualified institutions are 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 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 cross- border 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 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 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) 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 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.

5.3.3.2 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 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.

Table 5.1.

Observance of Basel Core Principles for Effective Banking Supervision

Source: IMF 2004a.

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 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.
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. Glotal 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.

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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 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.
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. Glotal 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.

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 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 supervisor- validated, value-at-risk (VAR) approaches using default probabilities (internal-ratings- based [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 standard. The assessment of this bifurcated standard will be made further challenging by the fact that there are several different approaches in Basel II for both credit and operational risk, as well as for several areas of national discretion in Pillar I, which could affect cross- institution and cross-country comparisons of capital regimes.

In the period before implementation, national authorities are beginning to examine more closely the various options, as well as the necessity and possibility of applying them. National authorities are also under pressure from the banks in their jurisdictions to refrain from taking actions that would raise capital requirements or increase costs for the system; the banking supervisors are worrying about the lack of capacity to deal with the technical issues in the new Basel framework. International banks face the possibility of being subject to multiple capital regimes through national requirements in different jurisdictions, the resolution of which will require the development of effective systems for cooperation between home and host country supervisors. In contrast, local banks in developing countries are apprehensive about competitive concerns because they fear that foreign banks could gain advantage from using the more advanced approaches that could lower groupwide capital requirements.

Effective implementation of the new capital framework will promote better risk-management practices, more risk-focused bank supervision, and stronger market discipline. However, the framework has been written with the internationally active G-10 banks in mind. Many jurisdictions may not find the proposals easy, or even relevant, to implement. Further, there are other supervisory priorities to be addressed in many countries, and weak implementation may not provide the required comfort but, instead, may divert scarce supervisory and other resources. For this reason, a good level of compliance with the BCPs is considered to be a precondition to considering Basel II implementation.

The Fund, together with the Bank and other international donors, would develop technical assistance programs for countries that seek assistance to implement some or all parts of the new Basel framework within the constraints of available budgets. Finally, countries will not be assessed under the BCPs on the basis of whether or not they have chosen to implement Basel II, but will be assessed against the standard that they have chosen to apply, be it Basel I or Basel II.

5.3.5 Bank Insolvency Procedures: Emerging Bank-Fund Guidelines

Effective bank insolvency procedures form an essential part of the supervisory framework and are also part of a proper financial safety net. Effective procedures help in reducing moral hazard. An analysis of the effectiveness and appropriateness of bank insolvency procedures and exit policies is an important part of BCP assessment. Experience indicates that, in many countries, those types of procedures are weak, opening the door to interference and forbearance.

The World Bank and the IMF have developed a (draft) document titled “Global Bank Insolvency Initiative,” (IMF and World Bank 2004),¹⁵ which documents practices around the world in the area of insolvency procedures. Although not a “best practices” document (given the diversity of judicial approaches around the globe, it is premature to develop best practices), this document could certainly be used to check country practices and to provide advice.

When authorities face problem banks, the general principle is that the authorities should take prompt action to restore them to health. The supervisors should have the authority to identify unsafe and unsound banking practices and then to require that those practices be halted. Supervisors should be able to apply a series of corrective measures and penalties with increasing severity. If deterioration continues, supervisors should close, merge, or otherwise resolve issues in troubled banks expeditiously before they become insolvent. Increasingly, countries are basing supervisory corrective action on a legal obligation to take specific actions (“prompt corrective action” specifically identified in the law) against a bank as capital levels fall below values established in the law. Prompt action reduces the likelihood that a failing bank will engage in risky and potentially expensive gambles for redemption.

Supervisors need good information on the condition of individual banks so they can take appropriate action. Appropriate disclosure of information to the public would support market discipline. These general issues should come out of the BCP assessment, particularly in Core Principle 22. However, the core principles do not deal specifically with insolvency proceedings other than in the preconditions. That is where the Bank- Fund document on bank insolvency (IMF and World Bank 2004) becomes useful. When making an assessment, assessors should bear in mind that legal and judiciary systems and traditions differ widely among countries. When a bank develops severe financial difficulties, it will have to be either restructured or liquidated. The legal and institutional features that should be in place to allow for orderly restructuring or liquidation are discussed in appendix G (Bank Resolution and Insolvency) and are summarized next. The broader legal environment for effective insolvency procedures is outlined in Annex 5.A.

A special bank insolvency regime, or suitable modifications of a general corporate insolvency regime, is needed to reflect the potential systemic effects of bank failures that call for prompt actions, effective protection of bank assets, and the key role of the banking authorities in bank insolvency proceedings. A typical immediate first step is to have an official authority assume direct managerial control of an insolvent bank (insolvent either in a regulatory sense or in a balance-sheet sense) with the goal of protecting its assets, assessing the true condition, and arranging or conducting either restructuring or liquidation. Official administration continues until the institution has been restored or placed in liquidation. The key principles governing official administration, bank restructuring, and bank liquidation are further discussed in appendix G. One of the key principles is that the authorities should choose the bank resolution option that costs the least. In particular, the cost of bank restructuring should be viewed in terms of net outlays on recapitalization and other assistance operations after deducting the proceeds from reprivatization and asset recoveries. When restructuring is not feasible or when it involves spinning off the viable operations of the bank and, thus, leaving behind only the nonviable part, then the bank will have to be liquidated.

In this process, the supervisory (licensing) agency should have the authority to withdraw a bank’s license on the basis of clearly defined criteria. Such criteria include (a) noncompliance with the conditions under which the license was initially granted (in particular, when management is no longer fit and proper), (b) failure to meet prudential requirements, (c) failure to make payments, (d) following of unsafe and unsound banking practices, and (e) criminal activities by the bank. The supervisor could also be given the responsibility to establish the list of qualified liquidators.

Unless the supervisory authorities or some other government agency (such as a deposit insurance fund) is responsible for resolving the problems of insolvent banks, the liquidator will be appointed by the courts, which oversee liquidation. Any deficiency in the court process that could impede bank liquidation should be identified. The authorities should have contingency plans to deal with the emergence of systemic banking problems or large-scale bank closures. Plans should include ways to protect the payments system and to maintain basic banking services. The authorities should also have an idea of how to organize the restructuring efforts, including which institutions would be charged with guiding the restructuring efforts. In addition, the authorities should evaluate the legal framework for bank supervision and regulation to ensure that the authorities have the necessary powers to act quickly and efficiently in the face of a systemic crisis.

5.3.6 Large and Complex Financial Institutions¹⁶

The activities of large and complex financial institutions (LCFIs)¹⁷ raise issues of cross- sectoral and cross-border transfer of financial risks that are especially relevant to a comprehensive assessment of the strengths and weaknesses of financial systems and their supervision. An LCFI is likely to have the following characteristics:

• An LCFI will be an important player in both wholesale and retail financial markets and in substantial international operations, regionally or globally. In some cases, these operations could dwarf its business in the country under consideration.

• The group may have its headquarters in the country or may be based abroad. In the latter case, it will have a significant local presence in the form of branches or locally incorporated subsidiaries (perhaps including local holding companies). The legal form of its local presence may have important implications for the way it is regulated.¹⁸

• The group’s international and domestic business will span a number of financial activities including commercial banking and other lending, such as the origination and securitization of credit; securities trading, dealing and underwriting, mergers and acquisitions, and other capital market activity; life and general (property and casualty) insurance; and custody and asset management. In some cases, the operations of the wider group may include significant industrial and other nonfinancial activities.

• The group is likely to be prominent in the local payments, clearing, and settlements structure.

As a consequence of the characteristics of an LCFI, the group’s liabilities will reflect very diverse sources of local and cross-border funding and reserves, while its assets will include a full range of marketable and nonmarketable financial instruments held locally and abroad. Off-balance sheet items are likely to be particularly prominent and to reflect complex funding, plus hedging and speculative trading strategies, all of which are carried out in both over-the-counter (OTC) markets and on organized exchanges. The group is likely to comprise many different legal entities, and the link between those entities and its internal management structure may appear complicated or even opaque. Complexity or opaqueness in organizational structures could be a potential source of risk, as well as raising issues for supervisory and central bank coordination.

The group’s activities may be subject to numerous different national legal and insolvency, accounting, tax, and regulatory regimes, which will influence the management of its business and balance sheet. The group may or may not have an overall lead supervisor monitoring its activities on a consolidated basis. At the host country level, responsibility for supervision of an LCFPs local affiliates may reside within a single regulator or several functional regulators. The size of the group and of its geographical diversification has the potential to threaten financial stability in several countries and markets. Its operations will thus be of concern both to its many financial regulators and also to the central banks and guarantee agencies that could be involved in providing or facilitating liquidity or other official financial support.

The presence of foreign-owned LCFIs in the domestic financial market may not raise particular issues for local financial stability, when their share of local banking, securities, and insurance markets is small and when the nature of their local business is straightforward. While local and foreign affiliates of wider LCFI groups may well be counterparties in foreign exchange and OTC derivatives transactions of local financial institutions, this need not warrant any special analysis, absent any significant concentrations of exposure. Conversely, there may be cases where an internationally active institution has such a large share of the local market or is such a significant counterparty of local financial institutions that its failure could constitute a serious local systemic risk. In such instances of high concentration, an understanding of the wider operations of the group, its reputation, and the risks of its business should be important in assessing potential threats to financial stability.

In relation to LCFIs, there are clearly limits to the scope of assessments at the level of individual countries. Country assessments can be expected to cover only part of the activities of LCFIs, given the international nature of such. Even if local supervision of an LCFI is effective in identifying and mitigating local risks as far as possible and if there is good cooperation with the LCFI’s home regulator(s), a host country is unlikely fully to escape the effects of a failure. The assessment process should focus mainly on those aspects over which the countries’ authorities can reasonably be expected to exert an influence.

An examination of LCFIs can be approached in three stages, followed by a summary of the main risks identified and recommendations to the authorities:

• Stage I involves the identification of the scope and scale of LCFIs’ activities within the local financial system. An assessor will want to seek data on market shares of prominent, internationally active, financial institutions to determine if a focus on LCFI activities is warranted. Where one or more LCFIs have been identified as having particular significance for local systemic stability, more detailed firm- specific information on the legal entity and organizational structures, the nature of intra-group exposures, the main sources of earnings, and so forth may then be needed to provide a sufficiently detailed map of their activities to identify the main channels of systemic risk. For some internationally prominent LCFIs, it may be possible to draw on information gathered from other assessments conducted for other countries.

• Stage II involves an assessment of the major systemic risks arising from the activities of LCFIs. Emphasis should be placed on the extent and nature of both intra- group transactions and the exposures of other domestic institutions to LCFIs. Key concerns will be not only potential direct losses in the event of an LCFI failure but also contagion risks. The approach suggested here is that this assessment be built up by considering credit, technical,¹⁹ liquidity, market, and operational risks from the different businesses of the group. LCFIs’ participation in local payment and settlement systems should also form a significant part of the analysis. Drawing on the preceding qualitative identification of risks, the assessor may also want to quantify the risks by considering further stress testing or scenario analyses.

• Stage III involves an assessment of the effectiveness of the authorities’ policies and practices in addressing the risks. This stage should include a review of group capital adequacy, the regulation of large exposures and of intra-group transactions, and the extent and effectiveness of information sharing between local and foreign supervisors. Oversight of the role of LCFIs in local payment and settlement systems should also be considered.

Given the potential of LCFIs to be a conduit in the transmission of internal and external shocks, the authorities’ approach to surveillance—the identification of potential systemic risks from the activities of LCFIs—should be a prominent part of the assessment. The assessment team may want to assess the effectiveness of stress testing and scenario analyses that are conducted by the authorities and that may be complemented by work conducted by the team itself as part of Stage II. The state of preparedness for managing a crisis arising from a domestically headquartered LCFI that is in difficulties or from the failure of a major foreign, internationally active institution that threatens local financial stability is an important issue for supervisors to consider.

5.3.7 Consolidated Supervision

Consolidated supervision is a supervisory tool that was developed in response to the growing trend in financial institutions of diversifying their activities across national borders and sectoral boundaries through ownership linkages. The creation of diversified financial groups raises additional supervisory concerns, including contagion, conflicts of interest, lack of transparency, and regulatory arbitrage. Supervisory and regulatory arrangements are geared at mitigating those concerns to ensure that risks are properly managed and that they do not threaten the safety and soundness of the financial system.

Consolidated supervision may be broadly defined as a qualitative and quantitative evaluation of the strength of a financial group that consists of several legal entities under common ownership or control. The objective of consolidated supervision is (a) to ensure the safety of the financial system through monitoring and evaluating the additional risks posed to the regulated financial institutions by the affiliated institutions in the financial group and (b) to assess the strength of the entire group. Consolidated supervision should have both quantitative and qualitative elements:

• Quantitative consolidated supervision focuses on issues such as asset quality, capital adequacy, liquidity, and large exposures that are measured on a consolidated basis. There is clearly a requirement that the group be able to produce (a) comprehensive on-balance sheets and off-balance sheet data and (b) counterparty information. This input should be in a form sufficient for reliable capital adequacy, liquidity, and exposure concentration calculations to be made. Because different entities in the group may be subject to different accounting regimes, the results of accounting consolidation may need to be treated with caution.

• Qualitative consolidated supervision is closely identified with comprehensive risk-based supervision, which is designed to assess how well management identifies, measures, monitors, and controls risks in a timely manner. This supervision will involve an assessment of the wider risks posed by other group companies in terms of their effect on the regulated entity. This assessment is likely to involve the identification of significant activities or business units and an understanding not only of their role within the group but also of the risks to the group posed by their activities.

Some of the key issues and principles governing consolidated supervision are summarized in Annex 5.B.

5.3.8 Unique Risks in Islamic Banking

Islamic banking can be defined as the providing of and use of financial services and products that conform to Islamic religious practices.²⁰ Islamic financial services are characterized by a prohibition against the payment and receipt of interest at a fixed or predetermined rate. Instead, profit-and-loss-sharing (PLS) arrangements or purchase and resale of goods and services form the basis of contracts. In PLS modes, the rate of return on financial assets is not known or fixed before undertaking the transaction. In purchase - resale transactions, a markup is determined on the basis of a benchmark rate of return, typically a return determined in international markets such as LIBOR (London interbank offered rate). Islamic banks are also prohibited from engaging in certain activities such as (a) financing production or trade in alcoholic beverages or pork and (b) financing gambling operations. A range of Islamic contracts is available, depending on the rights of investors in project management and the timing of cash flows. Special risks in Islamic banking arise because of the specific features of Islamic contracts and the weak environment for effective risk management, thereby reflecting the absence of risk-management tools that are Sharia compatible. Box 5.2 contains further details.

5.4.1 Relevance to Stability and Development

Sound and effective regulation and supervision is important in sustaining a sound operating sector that protects and maintains the confidence of policyholders and, therefore, plays an effective role in overall economic development. Supervision of the insurance sector is not an end in itself. Rather, insurance supervision, when properly conducted, plays a critical role in facilitating that sector’s contribution to the effective management of risks for the wider economy; the mobilization of long-term savings, particularly in the life insurance sector; and the allocation of investment in long-term fixed interest and equity markets, as well as in infrastructure and venture capital.

Sound regulation and supervision can also guard against the consequences of insurer failure for policyholders. The traditional focus of supervision on policyholder protection is increasingly giving way to broader financial stability concern as activities of insurers in financial markets expand. Failure can have catastrophic consequences for the individual policyholder, particularly because the choice of insurer may not be subject to market forces in all cases (e.g., third-party claimants) and may not be easily diversified. Some insurance contracts are not suitable for the insured party to take out contracts with several providers—in the same way that many hold deposits with several institutions. The ICPs seek to protect policyholders, both as a group (by focusing on the institutional integrity of the insurance companies) and individually (by promoting good marketing practices, adequately disclosing information about contracts to customers and potential customers, and handling consumer complaints). At the same time, the increasing financial market activities of insurers, including a growing role in credit risk transfer, has raised a question about the implications for financial stability arising from insurer’s failures and the implications for insurance supervision (see IMF 2002, 2004b).

Insurers have a role to play in guarding against fraud, money laundering, and terrorism financing. The ICPs recognize this role through a comprehensive set of requirements and good practices in the custody and management of assets, corporate governance, and internal controls. Specific obligations with respect to the fitness and propriety of those who act as custodians (in a legal sense or otherwise) of the community’s savings are recognized as critical to the maintenance of a sound insurance sector.

5.4.2 The Structure of the ICPs

The ICPs consist of 28 principles in total, grouped into seven categories.²¹ The principles cover all aspects of a supervisory framework—from licensing to closure of activities. The seven groupings reflect commonality of purpose among the principles in each group, ranging from preconditions to prudential requirements and market conduct. See Annex 5.C for a summary of the scope of each of the principles.

The first ICP addresses the general conditions needed for effective supervision and is similar in nature to the BCP “preconditions.” This ICP addresses elements that are most usually not the direct responsibility of the insurance supervisory authority. The elements relate to the overall policy settings for the financial sector, as well as the infrastructure of financial markets and their efficient operation. Effective policy settings are critical to the supervisors’ task because they provide the backdrop against which the institutional risk is assessed. Infrastructure in markets includes not only the broader financial policy aspects but also the legal and professional services that enable the supervisory process to function. The role of accounting, auditing, and actuarial professions shows examples of particular relevance to insurance supervision. The efficiency of financial markets influences the extent to which institutions are exposed to liquidity risk and market risk, as well as the options they have to address those risks. The first ICP is also concerned with the extent to which companies are able to access statistical data to enable those data to assess market risks and liability risks.

The second group of ICPs (ICPs 2–5) deals with the organizational structure and governance aspects of the supervisory authority. Those ICPs cover the objectives of the supervisor, the legal standing of the supervisory authority, the independence, the confidentiality requirements, and the existence of a transparent supervisory process. Information sharing is also covered in this group of ICPs, which makes it consistent with the issue of confidentiality.

The third group of ICPs (ICPs 6–10) focuses on the establishment and operations of the insurance companies as supervised entities. The fundamental licensing obligation and the effective stewardship of the organization under the continuing control of owners with integrity is emphasized through tests for fitness and propriety, as well as through control of changes in ownership and transfers of portfolios.²² Overall policies and obligations with respect to corporate governance and internal controls also form part of this group.

Ongoing supervision is the focus of the fourth group of ICPs (11–17). The principles in this group set out the process for supervision and its key components at a high level and then elaborate on key elements of the supervisory process. First, to establish the basis for sound assessment of individual institutions and prompt supervisory actions, ICP 11 stresses the role of an overall analysis of the market and identifies the potential risks and vulnerabilities that affect insurance firms and markets²³ and that arise as a result of the overall environment in which they operate. The ICPs that follow cover the reporting obligations of companies, including the regular and ad hoc information requirements; the assessment of returns received by the supervisor; the conduct of onsite inspections; the taking of action through preventative measures; the active enforcement and sanction powers; and, if necessary, the closeout of the insurer. In particular, ICP 12, which focuses on reporting, also establishes the main obligations with respect to external audit and accounting standards. ICP 12 largely focuses on the content and completeness of supervisory reporting²⁴ and includes a substantive role of offsite supervisory assessment as one of the criteria. ICP 16 includes the definition of insolvency, or at least the point at which intervention is obligated to protect policyholders, and ICP 17 addresses the assessment of groupwide risks.

The group of insurance core principles that cover “prudential requirements” (ICPs 18–23) focuses on insurers’ obligations with respect to the key areas of sound risk management, which includes understanding the nature of insurance risks, liabilities, assets, risk instruments, and capital. However, there is no internationally uniform capital requirement or set of rules for assets and liabilities in the insurance sector at this stage. The most important characteristics of a capital adequacy and solvency regime are covered at a fairly high level in the standard. Therefore, a wide range of approaches to capital adequacy and solvency are in use, some of which may be deficient in their ability to identify and require capital for significant risks to financial stability or to the solvency of an insurer. For example, capital required under the regime used in the EU and other jurisdictions does not depend on the composition of the investment portfolio. The IAIS and other organizations are working toward greater uniformity of capital adequacy standard.²⁵ The ICPs within this group emphasize the need for a sound assessment of risk and adequate resources to meet the risks assessed. The IAIS had already issued other supervisory standards that are relevant and related to these ICPs. Because the ICPs themselves were being revised, the supervisory standards available at the time were incorporated into the ICPs; some guidelines and issue papers were also under preparation at the time of the issuance of ICPs, and those, too, would be relevant for the assessment.²⁶

The remaining two groups (ICPs 24–28) deal with markets and consumers (the oversight of insurance intermediaries, customer protection, disclosure to the wider market, and fraud prevention) and with AML–CFT. The oversight of intermediaries (most commonly, insurance agents and brokers) is an important element of insurance sector soundness that does not always have a direct equivalent in other sectors. The failure of an intermediary can have a direct effect on those customers who have dealt with the insurer through the intermediary. The fitness and the propriety of intermediaries are also an important element in the maintenance of a sound system that preserves public confidence in the sector. Customer protection goes beyond the customer’s dealings with intermediaries to include (a) the requirements for information disclosure to explain the product and services to the customer and (b) the manner by which a customer may seek to have complaints resolved. Complaint resolution needs to be accessible, to be timely, and not to impose an undue cost, recognizing that customers have relatively limited financial and technical resources available. In some jurisdictions, this role is played by self-regulatory organizations (SROs). In others, it is played by companies with supervisory oversight or even by the supervisors themselves. Wider market disclosure focuses on broader and less-specific disclosure than is involved with individual customers and their individual products. The intent of this wider disclosure is to impose market discipline on companies. Again, it can be more or less effective and needs to reflect the market structures as the system needs to consider all companies, not just those that are publicly listed.

Claims fraud is a key issue in the insurance sector and is addressed in the newly introduced ICP 27. Claims fraud, wherein customers might submit inflated or invalid claims, has an insidious effect on companies and can ultimately bring the solvency of a company into question. As one addresses this issue, the diligence and integrity of the company is emphasized, as well as the linkages between the supervisory and prosecuting authorities.

The principles themselves have been deliberately drafted at a general level, and those principles should be interpreted according to the additional explanation provided for each principle. Each principle is elaborated with an explanatory note and followed by a set of criteria. The explanatory note is intended to provide elaboration and clarification, setting out the rationale for the particular principle and sometimes referring to specific examples. The criteria are divided between the so-called “essential criteria” and “advanced criteria.” Essential criteria are considered necessary for all markets to be fully functional and effective. Advanced criteria are considered either for particularly advanced and complex markets or, more likely, to provide a sense of direction for further improvement as markets and practices evolve.

5.4.3 Assessment Methodology and Assessment Experience

ICP assessments are based on a set of essential and advanced criteria, as well as on an assessment methodology that has been issued as part of the document.²⁷ The methodology is intended to assist the assessor in his or her goal to be both fair and objective. The document itself speaks of the assessments being “comprehensive, precise, and consistent” (IAIS 2003a). In practice, the methodology and the ICPs themselves include some key nuances that should be understood in carrying out the assessment and in interpreting the results. The following subsections highlight these key issues, without elaborating on every feature of the ICPs and their assessment.

5.5.1 IOSCO Core Principles—Relevance to Stability Considerations and Structural Development

The Objectives and Principles of Securities Regulation (the IOSCO core principles) of the International Organization of Securities Commissions is the key global standard for securities market regulation. The IOSCO bylaws state that the organization’s members (a) will exchange information about their experiences so they can foster the development of domestic markets, (b) will work together to establish standards and improve market surveillance of international transactions, and (c) will provide mutual assistance to promote market integrity. IOSCO adopted the core principles in September 1998, and they have been identified by the Financial Stability Forum as one of the 12 key international standards. The IOSCO core principles provide evidence of “IOSCO’s commitment to the establishment and maintenance of high regulatory standards for the securities industry” (IOSCO 2003b, 2). Over the years, IOSCO has produced many resolutions and numerous technical reports relating to different aspects of securities market regulation. However, before the development of the IOSCO core principles, the organization had never produced a framework statement covering the fundamental aspects of securities regulation.

The purpose of the core principles is to strengthen securities markets by enhancing the regulatory framework. As noted above, the core principles set out three objectives on which securities regulation is based: (a) promoting investor protection; (b) ensuring that markets are fair, efficient, and transparent; and (c) reducing systemic risk. Although each of the principles is presented as equally important, the document underscores the statement in the IOSCO bylaws that IOSCO members should be guided at all times by their concern for investor protection. Investors are to be protected from misleading, manipulative, and fraudulent practices. The most important means for doing so is full disclosure. Regulation should also promote fair and efficient markets with the highest levels of transparency, defined to include both pretrade and posttrade transparency. Finally, the core principles call for regulators to reduce systemic risk. Although regulators cannot prevent firms from failing, the regulations should contain the risks and mitigate the impact of any such failures. The core principles then set out 30 principles of securities regulation that are intended to give “practical effect” to the objectives. Each of the 30 principles is elaborated and explained in significant detail. Because the three objectives are overlapping, it is impossible to link each principle to a specific objective. However, certain principles promote one or two of the objectives in particular.

The IOSCO objectives and core principles (IOP) are stated at a general level—as is the case with other regulatory standards—and permit considerable flexibility in implementation. Each of the 30 principles is supplemented by narrative discussion, illustrating how the objective of the principle might be achieved while simultaneously recognizing that the nature of a particular market will necessarily dictate how the principle is implemented. “The particular manner in which a jurisdiction implements the objectives and principles described in this document must have regard to the entire domestic context, including the relevant legal and commercial framework” (IOSCO 2003b, 3). In addition, the IOSCO core principles were drafted with the recognition that markets change over time and that regulators must have the flexibility to adapt their supervision to changing market conditions. The document notes that there is not a single approach for implementing the principles and that multiple approaches, often depending on the broader legal and regulatory system, may be effective.

The IOSCO core principles also reflect the broad scope of responsibilities possessed by most securities regulators. Securities regulators are responsible for a much broader array of activities than banking supervisors. Like banking supervisors, securities regulators supervise the activities of market intermediaries. However, they also supervise securities markets, collective investment schemes, investment managers or advisers, and issuer disclosure. Some securities regulators also have responsibility for enforcing company law. The core principles thus cover a large range of issues. The 30 core principles, therefore, are grouped into eight subject areas as illustrated in Annex 5.D. Principles 1–5 relate to the regulator and to its powers, resources, independence, and accountability. Principles 6–7 relate to self-regulatory organizations and their supervision. Principles 8–10 relate to enforcement, and Principles 11–13 relate to cooperation, including international cooperation for enforcement and regulatory purposes. Principles 14–16 relate to issuers and the disclosure of information. Principles 17–20 relate to collective investment schemes and their operation. Principles 21–24 relate to the supervision of market intermediaries, and Principles 25–30 relate to how a jurisdiction’s overall regulatory structure ensures the integrity of secondary markets, including through robust clearance and settlement function that is addressed in Principle 30.³⁴

Because of securities regulators’ broad responsibilities for the effective functioning of the markets, the links between (a) observance of the IOSCO core principles and (b) market development and stability are fundamental. As the core principles themselves note, securities markets are vital to the development and strength of national economies. They not only support “corporate initiatives, finance the exploitation of new ideas, and facilitate the management of financial risk” (IOSCO 2003b, 1) but also—with the growth of collective investment schemes—have become increasingly important to individual wealth and retirement planning. Sound domestic markets are important to domestic financial development; with globalization, they have become increasingly important to the strength and stability of the global economy. Indeed, much work has been done to show (a) that financial diversification and development outside of the banking system enhances efficiency, as well as encourages development and promotes stability and (b) that an alternative source of intermediation may help strengthen the banking sector, which, again, will enhance financial development and stability.³⁵ Improving the quality of regulation and enhancing the supervision and surveillance promotes investor confidence, better risk management, and more efficient and robust institutions and markets. These actions, in turn, will promote economic growth. In addition, the preconditions for a strong securities market, including a well-functioning legal system and observance of contract and property rights, are the institutional factors that promote both financial stability and financial development.

5.5.2 Preconditions for Effective Securities Market Regulation

Effective securities regulation depends on the existence of a number of “preconditions.” The IOSCO core principles recognize that “securities law and regulation cannot exist in isolation from the other laws and the accounting requirements of a jurisdiction” (IOSCO 2003b, 8). In particular, the principles note that “there must be an appropriate and effective legal, tax and accounting framework within which the securities markets can operate” (IOSCO 2003b, 8). The preconditions are not formally part of the core principles because they are outside the jurisdictional authority of most securities regulators. IOSCO identifies in an annex to the core principles certain elements of the legal framework that are particularly important for effective securities regulation. These elements include (a) company law; (b) a commercial code or established contract law, including recognition and enforcement of property rights; (c) clear and consistent tax laws, especially with respect to the treatment of investments and investment products; (d) bankruptcy and insolvency laws; (e) competition law; (f) banking law; and (g) a fair and efficient judicial system or other dispute resolution system in which orders can be enforced and illegal behavior sanctioned (IOSCO 2003b, annex III).

Weaknesses in the preconditions can have a significant deleterious impact on the effectiveness of securities regulation and on market development. Investor protection must be grounded in a legal framework for investors to have confidence in the markets. For example, without an effective bankruptcy law, investors will be reluctant to risk investing in a company that may fail because they will be without any legal recourse. Similarly, investors would be reluctant to leave assets in accounts with a securities firm or an asset management company if bankruptcy and property law did not support a clear separation of client assets from the general assets of a firm. Without uniform accounting standards, companies will not be able to present a consistent and meaningful financial picture to investors. The absence of a fair and impartial judicial system that can mediate disputes or enforce sanctions will weaken the credibility and effectiveness of securities regulation.

As part of the IOSCO assessment, it is important to gain an understanding of the relevant preconditions in a particular country, which will require access to information from a wide variety of other sources, including assessments of other financial sector components. Information will be needed from country authorities other than the securities regulator and from market participants. Assessments of the legal system and accounting standards would provide information on shortcomings, if any, that might affect securities regulator’s activities. In addition, when considering actions to enhance securities regulation, country authorities will need to determine whether the preconditions themselves should be addressed first to ensure that the proposed action will achieve its objective.

5.5.3 Assessment Methodology and Assessment Experience

The core principles were initially adopted as a stand-alone document, without an accompanying methodology for implementation. When IOSCO adopted the core principles, they were intended as an incentive document, expressing the commitment of IOSCO members “insofar as it is within their authority to use their best endeavors within their jurisdiction to ensure adherence to those principles” (IOSCO 2003b, 3). At the same time, IOSCO also recognized that the core principles could serve as a benchmark or, as IOSCO put it, a “yardstick against which progress towards effective regulation can be measured” (IOSCO 2003b, 2). Therefore, IOSCO began the development of detailed questionnaires to help securities regulators assess the extent to which they were implementing the core principles. The questionnaires included a “high-level” questionnaire and five additional questionnaires that focused on specific areas of securities regulation.

The Methodology for Assessing Implementation of the IOSCO Objectives and Principles of Securities Regulation (IOSCO 2003a; hereinafter, the Methodology) has been developed as a tool to provide guidance on assessing the level of implementation of the IOSCO core principles. The core principles were themselves helpful as a starting point for assessing securities market regulation; however, they were drafted at a broad conceptual level to accommodate differences in the laws, regulatory framework, and market structures among IOSCO members. They, therefore, provided little or no guidance to assessors as to how to assess whether they were implemented in practice. Although the self-assessment questionnaires could be used by third-party assessors, they were a cumbersome tool, particularly for those assessors who were less familiar with the market and the regulatory system that they were assessing. As an alternative, the World Bank and the International Monetary Fund developed a guidance note for use by assessors as they worked with the IOSCO core principles. Although helpful, this note was quite general, and IOSCO members believed that more detailed and comprehensive guidance could be of greater assistance. In response, IOSCO set up a task force that was specifically mandated to develop a methodology that could be used by both self-assessors and third-party assessors such as the Bank and the Fund. The task force consisted of IOSCO member regulators from both developed and emerging markets. Staff members from the Bank and the Fund also participated. The Methodology built on the self-assessment questionnaires and the guidance note that were already in existence.

IOSCO developed the Methodology for its own use and for use by third-party assessors. IOSCO intended all along for the Methodology to be used as a tool for conducting self-assessments. At the same time, IOSCO recognized that the Methodology would be used by third-party assessors, some of whom might not be securities regulators. Thus, IOSCO members tried to achieve multiple objectives in drafting the Methodology. To reflect the complexity of regulating a wide variety of types of markets in different stages of development, IOSCO sought to ensure that the Methodology was sufficiently multifaceted. IOSCO also wanted to be sure, however, that the Methodology—and assessments based on the Methodology—would reflect the high standards of regulation that the core principles embodied and would not be watered down or diluted for different markets. IOSCO also sought to ensure a degree of consistency in assessments across different markets. Consequently, the Methodology is a long and complex document, with numerous “key issues” and “key questions” for assessors to draw on and a rather strict benchmarking system. The benchmarking system is intended to add consistency and objectivity to an inherently subjective assessment process while allowing for some flexibility.

The organization of the Methodology follows the format of the core principles. The Methodology groups each of the principles into the eight subject areas used in the presentation of IOSCO core principles. Each grouping of the principles is introduced with an introductory note. It then introduces each individual principle and sets forth that principle’s “key issues” and associated “key questions.” These descriptions are followed by an elaborate benchmarking system through which IOSCO essentially indicates the relative importance of different aspects of the principles. The benchmarking system recognizes five levels of observance of each principle: “fully implemented,” “broadly implemented,” “partly implemented,” “not implemented,” and “not applicable.” An explanatory note may accompany these levels. (Annex 5.E illustrates the structure and use of the Methodology for one of the core principles.)

The work of the IOSCO task force reflected the experience being gained in the context of Bank-Fund assessments and country self-assessments. For example, in the Methodology’s benchmarking system, IOSCO initially had not included a “broadly implemented” category. However, IOSCO concluded that the benchmarks should be expanded to reflect those situations in which the regulatory system or regulator had implemented nearly all aspects of a particular principle, though not every detail. To reflect this situation, IOSCO incorporated the new category “broadly implemented” into the benchmarking system. Similarly, as a result of feedback from assessors that the application of benchmarks was too rigid, explicit language was included in the instructions to the Methodology to make clear that the benchmarks were intended to be applied in a flexible manner that would take account of the specific regulatory context.

The Methodology represents a compendium of all of IOSCO’s work and provides a comprehensive framework for analyzing implementation of the principles. It references in one place many of IOSCO’s technical reports, resolutions, statements of good practice, and other relevant materials on securities regulation. It thus is a tremendous resource, giving an assessor the tools to access more in-depth material on a given topic. In addition, the Methodology serves an effective diagnostic and action-planning function. The Methodology is especially strong in establishing the market and regulatory context for the various principles. By organizing the core principles into key issues and key questions and by providing detailed criteria for each topic, the Methodology not only provides a vehicle for analyzing a securities regulatory regime across the entire range of securities regulation but also provides a measure of consistency across markets.

5.5.4 Key Considerations in Conducting an Assessment

An assessment generally begins with an overview of the structure and state of development of securities markets and key institutions in a particular country. Although an in-depth assessment of this information is generally beyond the scope of the assessment of IOSCO core principles, the assessor must understand the effect of the information gathered on the effectiveness of securities regulation in the country being assessed.³⁶ The nature of the market being assessed and its legal framework must be comprehended fully for the assessment to be well-founded. For example, “markets with a single or a few issuers, that are totally domestic in nature, or that are predominantly institutional, will pose different questions and issues as to the sufficiency of application of the Principles, and as to the potential vulnerabilities likely to arise from their non-application” than markets that feature different characteristics (IOSCO 2003a, 6). In addition, any weaknesses or shortcoming in the preconditions and the effect they have on securities regulation must be considered. Assessors obtain much of this information through the use of a securities markets questionnaire, which seeks data on the structure and performance of securities markets and on the legal and regulatory framework for supervision in the country being assessed (for an example of the sort of quantitative information analyzed, see appendix B, table B.9).

An assessment of securities regulation requires the assessor to be familiar with all the relevant laws and regulations, as well as with other key documents and practices. As noted earlier in the discussion of preconditions, effective securities regulation not only is based on the securities law but also is integrally connected to company law. In addition, accounting and audit standards, investment fund law, bankruptcy law, and other parts of the legal framework are critical. In many countries, codes of conduct and other policy documents that may or may not have the force of law may also be important. Consequently, an assessor must be familiar with a wide range of relevant laws and regulations, as well as with other types of government and nongovernment guidance.

A critical foundation of a third-party assessment is a self-assessment completed by the regulator. The availability of a thorough and candid self-assessment is critical to enable a third-party assessor to complete a fair and accurate assessment. A well-prepared self- assessment that includes the summaries of the relevant legal and regulatory texts and a thorough description of the institutional framework and supervisory practices is essential. As noted earlier, before the development of the Methodology, IOSCO members completed a series of self-assessment questionnaires, including a so-called “high-level” assessment and additional assessments covering specific aspects of securities regulation. Those questionnaires are highly informative and, though cumbersome to use, have been helpful to the third-party assessors, especially since IOSCO developed a concordance key to cross-reference specific items in the questionnaires to the Methodology. However, with the adoption of the Methodology, IOSCO members may undertake updated self-assessements directly pursuant to the Methodology. A number of IOSCO members have already started to do so, and some are undergoing “assisted self-assessments” in which they obtain the assistance of other IOSCO members to help them complete the self-assessment. A comprehensive and candid self-assessment prepared pursuant to the new Methodology would serve as a good foundation for developing a complete profile of the market and for assessing how it is regulated, as well as for identifying strengths and weaknesses for further consideration.

Third-party assessors must conduct in-depth discussions with the securities regulator, other relevant authorities, and market participants on the relative strengths and weaknesses of the securities regulator. Assessors should meet with authorities, securities firms, exchanges, SROs, industry groups, depositories, and other agencies and must share the draft assessment with the regulator and discuss comments.

An IOSCO self-assessment and an FSAP assessment follow similar formats. Both types of assessments begin with a discussion of the institutional and market structure of securities regulation in the country being assessed. The information and the methodology used for the assessment are then set forth, followed by a discussion of the sufficiency of the preconditions for effective securities regulation. The heart of the assessment is the principle-by-principle assessment, which contains a detailed discussion of each principle, noting relevant factual information, actual practices that are followed, and effectiveness of oversight. Comments by the assessor are important to document how the assessor arrived at his or her conclusions. Thus, this information should be described in reasonable detail, with reference to the supporting authority as necessary. The assessment concludes with recommended actions and the securities regulator’s response.

An assessment must take into account what is actually taking place in practice. The IOSCO methodology explicitly recognizes that there is a significant difference in terms of effective securities regulation between laws and rules that may look good on paper and those that are enforced in practice. The Methodology specifically states that it envisions that assessors will conduct their assessments from two perspectives: first, whether the laws and rules are sufficient and the programs or procedures intended to implement those laws and rules are effective and, second, whether the laws, rules, and programs and procedures are actually implemented in practice. It can be challenging for assessors to gain a realistic understanding of how securities regulation operates in practice, requiring candid discussions with regulators, market practitioners, investor representatives, and others.

5.5.5 Assessment Experience

As of the end of April 2004, 54 IOSCO assessments had been completed in the FSAP process. This number is approximately one-half of the 105 assessments that had been completed or were under way or planned. Not all FSAP assessments include an IOSCO assessment. In April 2002, Bank and Fund staff members issued a report reviewing the experience with the assessment of the IOSCO core principles (see IMF and World Bank 2002a).

Assessors have had some difficulty in applying the Methodology’s benchmarks in practice. As the Methodology was being completed, the Bank and the Fund conducted a testing program in which they undertook eight IOSCO assessments pursuant to the Methodology. The eight assessments took place across all geographic regions and in both industrialized and emerging market economies. The assessors comprised World Bank staff members, IMF consultants, and experts nominated by IOSCO. Uniformly, the assessors found that the benchmarking system set forth in the Methodology made it difficult to apply the Methodology with the flexibility they believed IOSCO had intended. Members of IOSCO who had conducted self-assessments pursuant to the Methodology had a similar reaction.

As a result, IOSCO has drafted new instructions on the use of the Methodology to clarify that the Methodology contemplates “the exercise of disciplined flexibility” in the benchmarking process. Assessors are expected to use their discretion in arriving at a rating but must document their conclusions, particularly to the extent they may depart from the benchmarking parameters. Thus, for example, in assessing under Principle 2 whether a securities regulator operates independently from the Ministry of Finance, an assessor must consider whether the regulator must consult with the government ministry on particular matters of regulatory policy. If the circumstances of such consultation include any decision making on day-to-day matters, then under the benchmarking as strictly applied, the regulator would receive a “not implemented” on this principle. However, the assessor may conclude that the matters on which the regulator must consult do not impair the independence of the regulator. In that case, the assessor may give the regulator a higher rating, as long as the reasons for this assessment are well documented. By maintaining the benchmarks but permitting them to be applied with discretion, IOSCO is hoping that the benchmarks will be able simultaneously to bring objectivity to, and a measure of consistency across, assessments while allowing for the flexibility necessary to ensure that the resulting assessment is appropriate for the regulatory system assessed.

Several key conclusions on securities market regulatory practices have emerged from the assessments so far.³⁷ Weaknesses in the implementation of many of the principles were evident across the range of jurisdictions assessed, although the most marked concerns related to assessments of developing and emerging markets. The assessment experience also highlighted the difficulties in drawing clear connections between the weaknesses identified in the regulation of securities market and financial sector vulnerabilities.

An analysis of completed IOSCO assessments indicates that there are specific areas of weakness in the implementation of the IOSCO principles. Weaknesses in implementation are particularly evident with respect to principles for enforcement of securities regulation (Principles 8–10) and principles for issuers (Principles 14–16). Overall, assessors found that regulators had a lack of authority to investigate; had limited access to time-sensitive data needed for surveillance purposes; had insufficient resources for inspection, surveillance, and investigation; and often had a limited enforcement mandate. With respect to issuers, there is a clear need for more efficient methods to disseminate information to the public and to improve the quality of the information being released. In addition, there is a need to improve the legislative and policy framework relating to the treatment of shareholders, a need to enhance the regulatory regime for auditors, and a need to address the lack of harmonization between international and domestic accounting and auditing standards. Improvements in those preconditions would help improve securities regulation.

In turn, the principles that have relatively higher levels of full and broad implementation are the following: (a) Principles 18–19 (regulation of collective investment schemes, (b) Principles 21 and 25 (regulation of market intermediaries and the secondary market), and (c) Principles 1 and 4–5 (activities of the regulator). Some common deficiencies noted by the assessors in terms of the issues relating to the regulator include the following: a lack of operational independence; limited enforcement powers; and inadequate resources, which thus hamper the ability to perform regulatory functions efficiently and effectively. The lack of operational independence raises particular questions as to control of resources (both human and financial). The lack of a clear mandate—or the lack of clear regulatory powers—also inhibits regulatory functions such as licensing, access to necessary (sometimes confidential) data, and so forth. Other common deficiencies include the need for appropriate regulations dealing with collective investment schemes, the need to expand the scope of the regulator’s responsibilities, the need to improve licensing requirements for trading systems, and the need to increase the scope of trading arrangements.

Although assessors are not able to readily consider preconditions, the comments in specific assessments do, nevertheless, allude to the poor state of legal and accounting systems in many jurisdictions. For example, many assessments note the inadequacy of the accounting framework—both in terms of standards and professional arrangements—as being linked to weaknesses in the implementation of the principles for issuers. Likewise, audit issues are commonplace, and aspects of the oversight of auditors feature prominently in many assessments. The insolvency regime is, not surprisingly, often cited as requiring attention in those jurisdictions that exhibit lower levels of implementation of the principles related to market intermediaries. An efficient court system, a highly skilled legal profession, and a set of well-designed administrative review processes would no doubt support strengthening the enforcement of laws in the countries that have been assessed as not having fully implemented the principles relating to enforcement and cooperation (Principles 8xyy10 and 11–13). (See section 5.5.6 and Annex 5.F for a further discussion of enforcement issues.)

5.5.6 Special Topics in Securities Market Development and Regulation

Three key topics in securities market regulation and development are discussed in this section: (a) demutualization of stock exchanges, (b) creation of integrated regulator or supervisor, and (c) enforcement and exchange of information.