Appendix III: Materials on Financial Institution Supervision
- Robert Effros
- Published Date:
- May 1998
Appendix III 1 Basle Committee on Banking Supervision’s Core Principles for Effective Banking Supervision
SECTION I: INTRODUCTION
Effective supervision of banking organisations is an essential component of a strong economic environment in that the banking system plays a central role in making payments and mobilising and distributing savings. The task of supervision is to ensure that banks operate in a safe and sound manner and that they hold capital and reserves sufficient to support the risks that arise in their business. Strong and effective banking supervision provides a public good that may not be fully provided in the marketplace and, along with effective macroeconomic policy, is critical to financial stability in any country. While the cost of banking supervision is indeed high, the cost of poor supervision has proved to be even higher.
In drawing up these core principles for effective banking supervision the following precepts are fundamental:
the key objective of supervision is to maintain stability and confidence in the financial system, thereby reducing the risk of loss to depositors and other creditors;
supervisors should encourage and pursue market discipline by encouraging good corporate governance (through an appropriate structure and set of responsibilities for a bank’s board of directors and senior management2 and enhancing market transparency and surveillance;
in order to carry out its tasks effectively, a supervisor must have operational independence, the means and powers to gather information both on and off site, and the authority to enforce its decisions;
supervisors must understand the nature of the business undertaken by banks and ensure to the extent possible that the risks incurred by banks are being adequately managed;
effective banking supervision requires that the risk profile of individual banks be assessed and supervisory resources allocated accordingly;
supervisors must ensure that banks have resources appropriate to undertake risks, including adequate capital, sound management, and effective control systems and accounting records; and
close cooperation with other supervisors is essential, particularly where the operations of banking organisations cross national boundaries.
Banking supervision should foster an efficient and competitive banking system that is responsive to the public’s need for good quality financial services at a reasonable cost. Generally, it should be recognised that there is a trade-off between the level of protection that supervision provides and the cost of financial intermediation. The lower the tolerance of risk to banks and the financial system, the more intrusive and costly supervision is likely to be, eventually having an adverse effect on innovation and resource allocation.
Supervision cannot, and should not, provide an assurance that banks will not fail. In a market economy, failures are a part of risk-taking. The way in which failures are handled, and their costs borne, is in large part a political matter involving decisions on whether, and the extent to which, public funds should be committed to supporting the banking system. Such matters cannot therefore always be entirely the responsibility of banking supervisors; however, supervisors should have in place adequate arrangements for resolving problem bank situations.
There are certain infrastructure elements that are required to support effective supervision. Where such elements do not exist, supervisors should seek to persuade government to put them in place (and may have a role in designing and developing them)….
In some countries responsibility for licensing banks is separate from the process of ongoing supervision. It is clearly essential that, wherever the responsibility lies, the licensing process establishes the same high standards as the process of ongoing supervision which is the main focus of this paper….
The core principles of banking supervision… will provide the foundation necessary to achieve a sound supervisory system. Local characteristics will need to be taken into account in the specific way in which these standards are implemented. These standards are necessary but may not be sufficient, on their own, in all situations. Supervisory systems should take into account the nature of and risks involved in the local banking market as well as more generally the local infrastructure. Each country should therefore consider to what extent it needs to supplement these standards with additional requirements to address particular risks and general conditions prevailing in its own market. Furthermore, banking supervision is a dynamic function that needs to respond to changes in the marketplace. Consequently supervisors must be prepared to reassess periodically their supervisory policies and practices in the light of new trends or developments. A sufficiently flexible legislative framework is necessary to enable them to do this.
SECTION II: PRECONDITIONS FOR EFFECTIVE BANKING SUPERVISION
Banking supervision is only part of wider arrangements that are needed to promote stability in financial markets. These arrangements include:
sound and sustainable macro-economic policies;
a well-developed public infrastructure;
effective market discipline;
procedures for efficient resolution of problems in banks; and
mechanisms for providing an appropriate level of systemic protection (or public safety net).
1. Providing sound and sustainable macro-economic policies are not within the competence of banking supervisors. Supervisors, however, will need to react if they perceive that existing policies are undermining the safety and soundness of the banking system. In the absence of sound macro-economic policies, banking supervisors will be faced with a virtually impossible task. Therefore, sound macro-economic policies must be the foundation of a stable financial system.
2. A well-developed public infrastructure needs to cover the following facilities, which, if not adequately provided, can significantly contribute to the destabilisation of financial systems:
a system of business laws including corporate, bankruptcy, contract, consumer protection and private property laws, that is consistently enforced and provides a mechanism for fair resolution of disputes;
comprehensive and well-defined accounting principles and rules that command wide international acceptance;
a system of independent audits for companies of significant size so that users of financial statements, including banks, have independent assurance that the accounts provide a true and fair view of the financial position of the company and are prepared according to established accounting principles, with auditors held accountable for their work;
effective banking supervision (as outlined in this document);
well-defined rules governing, and adequate supervision of, other financial markets and, where appropriate, their participants; and,
a secure and efficient payment and clearing system for the settlement of financial transactions where counterparty risks are controlled.
3. Effective market discipline depends on an adequate flow of information to market participants, appropriate financial incentives to reward well managed institutions and arrangements that ensure that investors are not insulated from the consequences of their decisions. Among the issues to be addressed are corporate governance and ensuring that accurate, meaningful, transparent and timely information is provided by borrowers to investors and creditors.
Market signals can be distorted and discipline undermined if governments seek to influence or override commercial decisions, particularly lending decisions, to achieve public policy objectives. In these circumstances, it is important that if guarantees are provided for such lending, they are disclosed and arrangements are made to compensate financial institutions when policy loans cease to perform.
4. Sufficiently flexible powers are necessary in order to effect an efficient resolution of problems in banks. Where problems are remediable, supervisors will normally seek to identify and implement solutions that fully address their concerns; where they are not, the prompt and orderly exit of institutions that are no longer able to meet supervisory requirements is a necessary part of an efficient financial system. Forebearance, whether or not the result of political pressure, normally leads to worsening problems and higher resolution costs. The supervisory agency should be responsible for, or assist in, the orderly exit of problem banks in order to ensure that depositors are repaid to the fullest extent possible from the resources of the bank (supplemented by any applicable deposit insurance)3 and ahead of shareholders, subordinated debt holders and other connected parties.
In some cases, the best interests of depositors may be served by some form of restructuring, possibly takeover by a stronger institution or injection of new capital or shareholders. Supervisors may be able to facilitate such outcomes. It is essential that the end result fully meets all supervisory requirements, that it is realistically achievable in a short and determinate time frame, and that, in the interim, depositors are protected.
5. Deciding on the appropriate level of systemic protection is by and large a policy question to be taken by the relevant authorities (including the central bank), particularly where it may result in a commitment of public funds. Supervisors will also normally have a role to play because of their in-depth knowledge of the institutions involved. In order to preserve the operational independence of supervisors, it is important to draw a clear distinction between this systemic protection (or safety net) role and day-to-day supervision of solvent institutions. In handling systemic issues, it will be necessary to address, on the one hand, risks to confidence in the financial system and contagion to otherwise sound institutions, and, on the other hand, the need to minimise the distortion to market signals and discipline. Deposit insurance arrangements, where they exist, may also be triggered.
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LIST OF CORE PRINCIPLES FOR EFFECTIVE BANKING SUPERVISION
Preconditions for Effective Banking Supervision
1. An effective system of banking supervision will have clear responsibilities and objectives for each agency involved in the supervision of banking organisations. Each such agency should possess operational independence and adequate resources. A suitable legal framework for banking supervision is also necessary, including provisions relating to authorisation of banking organisations and their ongoing supervision; powers to address compliance with laws as well as safety and soundness concerns; and legal protection for supervisors. Arrangements for sharing information between supervisors and protecting the confidentiality of such information should be in place.
Licensing and Structure
2. The permissible activities of institutions that are licensed and subject to supervision as banks must be clearly defined, and the use of the word “bank” in names should be controlled as far as possible.
3. The licensing authority must have the right to set criteria and reject applications for establishments that do not meet the standards set. The licensing process, at a minimum, should consist of an assessment of the banking organisation’s ownership structure, directors and senior management, its operating plan and internal controls, and its projected financial condition, including its capital base; where the proposed owner or parent organsation is a foreign bank, the prior consent of its home country supervisor should be obtained.
4. Banking supervisors must have the authority to review and reject any proposals to transfer significant ownership or controlling interests in existing banks to other parties.
5. Banking supervisors must have the authority to establish criteria for reviewing major acquisitions or investments by a bank and ensuring that corporate affiliations or structures do not expose the bank to undue risks or hinder effective supervision.
Prudential Regulations and Requirements
6. Banking supervisors must set prudent and appropriate minimum capital adequacy requirements for all banks. Such requirements should reflect the risks that the banks undertake, and must define the components of capital, bearing in mind their ability to absorb losses. At least for internationally active banks, these requirements must not be less than those established in the Basle Capital Accord and its amendments.
7. An essential part of any supervisory system is the evaluation of a bank’s policies, practices and procedures related to the granting of loans and making of investments and the ongoing management of the loan and investment portfolios.
8. Banking supervisors must be satisfied that banks establish and adhere to adequate policies, practices and procedures for evaluating the quality of assets and the adequacy of loan loss provisions and loan loss reserves.
9. Banking supervisors must be satisfied that banks have management information systems that enable management to identify concentrations within the portfolio and supervisors must set prudential limits to restrict bank exposures to single borrowers or groups of related borrowers.
10. In order to prevent abuses arising from connected lending, banking supervisors must have in place requirements that banks lend to related companies and individuals on an arm’s-length basis, that such extensions of credit are effectively monitored, and that other appropriate steps are taken to control or mitigate the risks.
11. Banking supervisors must be satisfied that banks have adequate policies and procedures for identifying, monitoring and controlling country risk and transfer risk in their international lending and investment activities, and for maintaining appropriate reserves against such risks.
12. Banking supervisors must be satisfied that banks have in place systems that accurately measure, monitor and adequately control market risks; supervisors should have powers to impose specific limits and/or a specific capital charge on market risk exposures, if warranted.
13. Banking supervisors must be satisfied that banks have in place a comprehensive risk management process (including appropriate board and senior management oversight) to identify, measure, monitor and control all other material risks and, where appropriate, to hold capital against these risks.
14. Banking supervisors must determine that banks have in place internal controls that are adequate for the nature and scale of their business. These should include clear arrangements for delegating authority and responsibility; separation of the functions that involve committing the bank, paying away its funds, and accounting for its assets and liabilities; reconciliation of these processes; safeguarding its assets; and appropriate independent internal or external audit and compliance functions to test adherence to these controls as well as applicable laws and regulations.
15. Banking supervisors must determine that banks have adequate policies, practices and procedures in place, including strict “know-your-customer” rules, that promote high ethical and professional standards in the financial sector and prevent the bank being used, intentionally or unintentionally, by criminal elements.
Methods of Ongoing Banking Supervision
16. An effective banking supervisory system should consist of some form of both on-site and off-site supervision.
17. Banking supervisors must have regular contact with bank management and thorough understanding of the institution’s operations.
18. Banking supervisors must have a means of collecting, reviewing and analyzing prudential reports and statistical returns from banks on a solo and consolidated basis.
19. Banking supervisors must have a means of independent validation of supervisory information either through on-site examinations or use of external auditors.
20. An essential element of banking supervision is the ability of the supervisors to supervise the banking group on a consolidated basis.
21. Banking supervisors must be satisfied that each bank maintains adequate records drawn up in accordance with consistent accounting policies and practices that enable the supervisor to obtain a true and fair view of the financial condition of the bank and profitability of its business, and that the bank publishes on a regular basis financial statements that fairly reflect its condition.
Formal Powers of Supervisors
22. Banking supervisors must have at their disposal adequate supervisory measures to bring about timely corrective action when banks fail to meet prudential requirements (such as minimum capital adequacy ratios), when there are regulatory violations, or where depositors are threatened in any other way. In extreme circumstances, this should include the ability to revoke the banking licence or recommend its revocation.
23. Banking supervisors must practise global consolidated supervision over their internationally-active banking organisations, adequately monitoring and applying appropriate prudential norms to all aspects of the business conducted by these banking organisations worldwide, primarily at their foreign branches, joint ventures, and subsidiaries.
24. A key component of consolidated supervision is establishing contact and information exchange with the various other supervisors involved, primarily host country supervisory authorities.
25. Banking supervisors must require the local operations of foreign banks to be conducted to the same high standards as are required of domestic institutions and must have powers to share information needed by the home country supervisors of those banks for the purpose of carrying out consolidated supervision.
Appendix III: 2 Tripartite Group of Bank, Securities, and Insurance Regulators’ Report: The Supervision of Financial Conglomerates
1. The deregulation of domestic financial markets over the past decade together with the internationalisation of financial markets has led to new ways and means of doing business in the highly competitive, integrated world economy of the 1980s and 1990s. One notable development has been the emergence of financial conglomerates, often with significantly large balance sheets (and off-balance-sheet positions), providing a wide range of financial services in a variety of geographic locations.
2. Over the past several years, a number of supervisory and regulatory groups within the international financial community have sought to explore the ways in which some of their concerns relating to the supervision of financial conglomerates could be addressed. Those groups have approached the subject from the perspective of a particular sector—the supervision of banks, or of securities firms, or of insurance companies. This report brings together the efforts of a Tripartite Group of bank, securities and insurance regulators, who are acting in a personal capacity but are able to draw on the experience of their respective institutions. The Tripartite Group was set up at the beginning of 1993 specifically to consider ways of improving the supervision of financial conglomerates.
3. The Tripartite Group agreed that, for its purposes, the term “financial conglomerate” would be used to refer to “any group of companies under common control whose exclusive or predominant activities consist of providing significant services in at least two different financial sectors (banking, securities, insurance)”. It was recognised that many of the problems encountered in the supervision of financial conglomerates would also arise in the case of “mixed conglomerates” offering not only financial services (perhaps restricted to just one of the three sectors mentioned above), but also non-financial or commercial services. However, the primary focus of this report is on financial conglomerates.
4. The present situation with regard to the supervision of conglomerates was clarified through the medium of a questionnaire (Appendix II to this report analyses the responses). This provided valuable information on the types of financial conglomerates in existence and their different structural features, many of which are largely a reflection of national laws and traditions. From the responses to the questionnaire, it was also possible to compare approaches to the overall supervision of financial conglomerates.
Identification of issues
5. Subsequently, building on previous work in other forums, the Tripartite Group identified a number of problems which financial conglomerates pose for supervisors, and discussed ways in which these problems might be overcome. Among the issues discussed were the overall approach to the supervision of financial conglomerates; the assessment of capital adequacy and ways of preventing double gearing; contagion, in particular the effect of intra-group exposures; large exposures at group level; problems in applying a suitability test to shareholders and a fitness and propriety test to managers; transparency of group structures; the exchange of prudential information between supervisors responsible for different entities within a conglomerate; rights of access to information about non-regulated entities; supervisory arbitrage; and mixed conglomerates.
Overall approach to supervision
6. The rapid growth of financial conglomerates which cut across the banking, securities and insurance sectors raises questions as to whether the traditional approach to prudential supervision—whereby each supervisor monitors institutions in one constituency without much contact with supervisors responsible for other parts of the group—is still appropriate. Fundamentally, the Tripartite Group agreed that supervision of financial conglomerates cannot be effective if the individual components of a group are supervised on a purely solo basis. The solo supervision of individual entities continues to be of primary importance, but it needs to be complemented by an assessment from a group-wide perspective.
7. Banks, insurance companies and securities firms are subject to different prudential requirements, and accordingly supervisors face a difficult problem in determining whether there is adequate capital coverage. The Tripartite Group discussed this issue in some depth and concluded that the desired group-wide perspective can be achieved either by adopting a consolidated type of supervision, or by a “solo-plus” approach to supervision.2 For the purposes of this report, the following working definitions were agreed upon:
Consolidated supervision—This supervisory approach focuses on the parent or holding company, although individual entities may (and the Tripartite Group advocates that they should) continue to be supervised on a solo basis according to the capital requirements of their respective regulators. In order to determine whether the group as a whole has adequate capital, the assets and liabilities of individual companies are consolidated; capital requirements are applied to the consolidated entity at the parent company level; and the result is compared with the parent’s (or group’s) capital.
Solo-plus supervision—This supervisory approach focuses on individual group entities. Individual entities are supervised on a solo basis according to the capital requirements of their respective regulators. The solo supervision of individual entities is complemented by a general qualitative assessment of the group as a whole and, usually, by a quantitative group-wide assessment of the adequacy of capital. There are several ways in which this quantitative assessment can be carried out (see below).
8. Recognising the different starting points of the solo-plus and consolidated supervision approaches, the Tripartite Group discussed a range of techniques available to supervisors for making a quantitative assessment of capital adequacy in a financial conglomerate. The Group recognised the value of accounting-based consolidation (involving a comparison, on a single set of valuation principles, of total consolidated group assets and liabilities, and the application at parent level of capital adequacy rules to the consolidated figures) as an appropriate technique for assessing capital adequacy in homogeneous groups. This is the technique commonly used by bank supervisors in respect of banking groups; under European legislation, it is also a technique applied to groups made up of banks and securities companies.
9. As a means of applying accounting-based consolidation in respect of heterogenous groups, the Tripartite Group considered a technique referred to as “block capital adequacy”, which envisages the classification and aggregation of assets and liabilities according to the type of risk involved (rather than according to the institution to which they pertain), and the development of harmonised standards for assessing a conglomerate’s capital requirement. However, this technique was not thought to be a practical possibility for heterogenous groups in the immediately foreseeable future.
10. Instead, the Tripartite Group concluded that three techniques—the “building-block prudential approach” (which takes as its basis the consolidated accounts at the level of the parent company), a simple form of risk-based aggregation and risk-based deduction—are all capable of providing an accurate insight into the risks and capital coverage. It is suggested that these three techniques might form the basis of a set of minimum ground rules for the assessment of capital adequacy in financial conglomerates and that some form of mutual recognition of their acceptability would be eminently desirable. The Group also agreed that “total deduction” might be recognised as a fourth technique, which deals effectively and conservatively with double gearing but one which does not in itself seek to provide a full picture of the risks being carried by the conglomerate. The type and structure of the conglomerate in question may determine which of these four techniques is most appropriate for supervisory use.
11. Detailed consideration was given to the way in which supervisors should regard a parent institution’s participation of less than 100% in a financial subsidiary for the purposes of assessing group capital adequacy. It was agreed that simple minority shareholdings over which the group has neither control nor significant influence (i.e. less than 20% of the shares or voting rights owned) should not be taken into account for group capital adequacy purposes. They would normally simply be regarded as portfolio investments and would be treated by the parent’s supervisor in accordance with the relevant solo rules. Only in exceptional circumstances would supervisors expect to integrate such shareholdings in an assessment of capital adequacy from a group perspective.
12. Where the group has what is deemed to be a “significant influence” (i.e. ownership of between 20% and 50% of the shares or voting rights) over a subsidiary undertaking, a pro-rata approach is advocated with regard to the inclusion of capital in the group-wide assessment. As far as subsidiary undertakings which are not wholly-owned, but over which the group has effective control (i.e. more than 50% of the shares or voting rights), are concerned, most members of the Tripartite Group agreed that the full extent of any deficit should be attributed to the group. However, there was less of a consensus as to the appropriate treatment for any capital surplus in such a subsidiary. Some members favoured attributing such surpluses in full to the parent group for capital adequacy purposes, while others considered a pro-rata approach to be more appropriate. A few members were inclined towards an asymmetric approach, under which any capital deficit would be attributed to the group in full but surpluses would only be attributed pro-rata.
13. The suitability and availability of capital surpluses for transfer from subsidiary to parent, and from one subsidiary to a sister company, were other issues considered by the Tripartite Group. The divergent definitions of capital from sector to sector, make it necessary for supervisors to examine both the distribution and structure of capital across a financial conglomerate in order to ensure that excess capital in one group entity, which is used to cover risks in another, is suitable for those purposes. The Group agreed that the simplest approach would be to assess the extent and nature of any excess in a dependant by reference to the capital requirements of that dependant; but to admit any excess for the purposes of the parent only to the extent that the excess capital elements are suitable according to the rules applied to the parent (or other regulated entity). The supervisors of the parent and the dependant would clearly need to liaise closely over the acceptability and admission of different forms of capital.
14. As far as availability is concerned, some members of the Tripartite Group, recognising various obstacles to the free movement of capital surpluses around a group, are in favour of applying a test before accepting that surpluses in individual group entities are available at parent/group level. Other members of the Group, however, view a financial conglomerate as a single economic unit and, from a “going concern” perspective, they are prepared to assume that capital surpluses in individual entities are available to the group as a whole. It did not prove possible to reach consensus on this point.
15. A difficult problem occurs when a group includes substantial nonregulated entities, either at the ownership level or downstream. The Tripartite Group is of the view that, notwithstanding moral hazard, supervisors should be able to obtain prudential information about the unregulated entities in a group in order to supervise the regulated parts effectively, and to be able to conduct a group-based risk assessment. Most members of the Group take the view that unregulated entities whose activities are similar to those of regulated entities should be included in group-wide assessments of capital adequacy through the application of notional capital requirements derived from the analogous regulated activity.3 A small minority of the Group, on the other hand, have a preference for the establishment of qualitative standards aimed at the regulated entities (rather than notional capital requirements for the unregulated ones) wherever they appear in the group structure. Most members also advocate that unregulated holding companies at the top of the group structure and intermediate holding companies should be encompassed in the group-wide assessment of capital adequacy.
16. Contagion is recognised as one of the most important issues facing supervisors in relation to conglomerates. Psychological contagion—where problems in one part of a group are transferred to other parts by market reluctance to deal with a tainted group—is difficult for supervisors to guard against. However, contagion resulting from the existence of extensive intra-group exposures can, in principle, be contained and the Tripartite Group believes that, at the very minimum, it is essential for supervisors to be informed on a regular basis of the existence and nature of all such exposures.
17. The Group takes the view that the potential problems of intra-group exposures are best tackled as an element of solo supervision, not least because the parent regulator’s perspective is likely to be quite different from that of a subsidiary’s regulator. Solo regulators should ensure that the pattern of activity and aggregate exposure between the regulated entity for which they are responsible and other group companies is not such that failure of another group company (or the mere existence of such intra-group transactions) will undermine the regulated entity. Solo supervisors also need to liaise closely with other group supervisors when uncertainties arise; they need powers to limit or prohibit intra-group exposures when necessary; and they should be particularly concerned about situations where funds are being invested by a subsidiary in securities issued by a parent, or are being deposited directly with a parent.
Large exposures at group level
18. Wide differences between the large exposure rules pertaining in the banking, securities and insurance sectors provide ample scope for regulatory arbitrage, and the differences are such that it is difficult to envisage the gaps being bridged in the foreseeable future. The Tripartite Group agreed that a combination of large exposures to the same counterparty in different parts of a conglomerate could be dangerous to the group as a whole and a group-wide perspective is therefore considered necessary. One practical way of proceeding might be to develop a system whereby the parent or lead regulator is furnished with sufficient information to enable him to assess major group-wide exposures to individual counterparties; this would provide valuable information on gross exposures. It might be possible to identify suitable “trigger points” of concern which, when reached, would trigger discussions on a case-by-case basis between the supervisors involved on the nature of any perceived problems and on any proposed action to be taken.
Fit and proper test for managers
19. Most supervisors already have the power to check the fitness and propriety of the managers of the firms for which they are responsible. The problem facing supervisors in applying such tests is that, as the banking, insurance and securities businesses become more and more integrated, it is possible that decision-making processes will be shifted away from individually-regulated entities to the parent or holding company level of the structure, enabling managers of other (perhaps unregulated) companies in the group to exercise control over the regulated entity. Because of this, the Tripartite Group believes that, in applying the fit and proper test to managers, supervisors should be able to “look through” a conglomerate’s legal structure and focus on the people who are actually managing the supervised entity, regardless of exactly where they feature in the group’s organigram.
20. The Tripartite Group is of the view that the way in which a conglomerate is structured is crucial to effective supervision. It believes that supervisors need powers, at both the authorisation stage and on a continuing basis, to obtain adequate information regarding managerial and legal structures, and, if necessary, to prohibit structures which impair adequate supervision. Where supervision is impaired, supervisors should be able to insist that financial conglomerates organise themselves in a way that makes adequate supervision possible.
Suitability of shareholders
21. The Tripartite Group is of the view that shareholders who have a stake in a financial conglomerate (enabling them to exert material influence on a regulated firm within it) should meet certain standards, and that supervisors should endeavour to ensure that this is the case by applying, on an objective basis, an appropriate test, both at the authorisation stage and on an ongoing basis. Responsibility for applying such a test clearly rests with the supervisors of individually regulated entities, but the Tripartite Group advocates close cooperation between supervisors and a sharing of information on shareholders in this respect.
Access to information
22. In the case of a financial conglomerate, intensive cooperation between supervisors is essential and supervisors should have the right to exchange prudential information. There was general support for the idea of appointing a lead supervisor or “convenor”, who would be responsible for gathering such information as they require in order to have a perspective on the risks assumed by the group as a whole (including information on non-regulated entities). Using this data, a convenor would make an assessment of the capital adequacy of the group and would also be responsible for ensuring that the supervisors of individual entities are made aware of any developments which might affect the financial viability of the group. In addition, when supervisory action involving more than one regulated entity is called for, the convenor would be responsible for the coordination of this action. This would not interfere with the power of the solo supervisor to obtain information regarding the group and to act individually when necessary. In all probability, the convenor would be the supervisor of the dominant operational business entity in a group. The Tripartite Group also believes that the precise role of the lead regulator or convenor, and indeed the responsibilities of all individual supervisors involved in a financial conglomerate, could be defined and agreed upon effectively through the establishment of Memoranda of Understanding or Protocols between the relevant supervisors, particularly when a financial conglomerate has a complex structure. Where the relevant supervisors are located in the same country, however, more informal information sharing arrangements may be sufficient. External auditors are recognised as another valuable source of information for supervisors.
23. Although many of the problems associated with the supervision of financial conglomerates also arise in the case of “mixed conglomerates” (groups which are predominantly industrially or commercially oriented but contain at least one regulated financial entity), the latter also raise some rather different issues for supervisors and can demand a fundamentally different approach. For example, there are difficult issues to be tackled in ascertaining the suitability of the shareholders of the regulated entities and the fitness and propriety of the managers responsible for running the regulated businesses. Intra-group exposures are another problem area and it is essential that supervisors establish that such business is conducted at “arm’s length” (i.e. at the terms prevailing in the market in general at the time). Clearly, there is scope for supervisory discretion in this area, but supervisors must be satisfied that, as a rule, intra-group business is not being conducted at rates or on terms which significantly differ from those prevailing generally.4
24. At the heart of the problem with regard to mixed conglomerates is the difficulty for supervisors in assessing overall group capital adequacy because supervisory rules and practices cannot be extended to commercial and industrial entities in the same way as they can to non-regulated financial entities. The Tripartite Group believes that, ideally, supervisors should be able to insist on the establishment of an intermediate holding company to provide a legal separation of the regulated financial parts of a mixed conglomerate from the non-financial parts; this would enable supervision to be carried out in the same way as for other financial conglomerates.
25. In summary, considerable progress has been made in identifying broad areas of agreement between supervisors in the three disciplines and a number of recommendations have been made as to ways in which the supervision of financial conglomerates could be improved. However, any further progress that can be made by the Tripartite Group seems certain to be restricted by the informal nature of the group. It is hoped that this paper will provide a sound basis for any further work that may be undertaken in this regard.
Appendix III 3 Joint Report on the Supervision of Cross-Border Banking
II. Summary of conclusions and recommendations
1. Improving the access of home supervisors to information necessary for effective consolidated supervision
(i) In order to exercise comprehensive consolidated supervision of the global activities of their banking organisations, home supervisors must be able to make an assessment of all significant aspects of their banks’ operations that bear on safety and soundness, wherever those operations are conducted and using whatever evaluative techniques are central to their supervisory process.2
(ii) Home supervisors need to be able to verify that quantitative information received from banking organisations in respect of subsidiaries and branches in other jurisdictions is accurate and to reassure themselves that there are no supervisory gaps.
(iii) While recognising that there are legitimate reasons for protecting customer privacy, the working group believes that secrecy laws should not impede the ability of supervisors to ensure safety and soundness in the international banking system.
(iv) If the home supervisor needs information about non-deposit operations, host supervisors are encouraged to assist in providing the requisite information to home supervisors if this is not provided through other supervisory means. The working group believes it is essential that national legislation that in any way obstructs the passage of non-deposit supervisory information be amended.
(v) Where the liabilities side of the balance sheet is concerned, home supervisors do not routinely need to know the identity of individual depositors. However, in certain well-defined circumstances, home supervisors would need access to individual depositors’ names and to deposit account information.
(vi) It should not normally be necessary for the home supervisor to know the identity of investors for whom a bank in a host country is managing investments at the customer’s risk. However, in certain exceptional circumstances, home supervisors would need access to individual investors’ names and to investment account information subject to the safeguards in paragraph 10.
(vii) The working group recommends that host supervisors whose legislation does not allow a home supervisor to have access to depositor information use their best endeavours to have their legislation reviewed and if necessary amended to provide for a mechanism whereby in exceptional cases a home supervisor, with the consent of the host supervisor, will gain access to depositor information subject to the same conditions as outlined in (viii) below.
(viii) In order to provide legitimate protection for bank customers, it is important that the information obtained by home supervisors, especially that relating to depositors’ or investors’ names, is subject to strict confidentiality. The working group recommends that those host jurisdictions whose legislation allows foreign supervisors to have access to banks’ depositor or investor information should subject such access (at the host country’s discretion) to the following conditions:
- the purpose for which the information is sought should be specific and supervisory in nature;
- information received should be restricted solely to officials engaged in prudential supervision and not be passed to third parties without the host supervisor’s prior consent;3
- there is assurance that all possible steps will be taken to preserve the confidentiality of information received by a home supervisor in the absence of the explicit consent of the customer;
- there should be a two-way flow of information between the host and home supervisors, though perfect reciprocity should not be demanded;
- before taking consequential action, those receiving information will undertake to consult with those supplying it.
(ix) If a host supervisor has good cause to doubt a home supervisor’s ability to limit the use of information obtained in confidence solely for supervisory purposes, the host would retain the right not to provide such information.
(x) Subject to appropriate protection for the identity of customers, home supervisors should be able at their discretion, and following consultation with the host supervisor, to carry out on-site inspections in other jurisdictions for the purposes of carrying out effective comprehensive consolidated supervision. This ability should include, with the consent of the host supervisor and within the laws of the host country, the right to look at individual depositors’ names and relevant deposit account information if the home supervisor suspects serious crime…. If a host supervisor has reason to believe that the visit is for non-supervisory purposes, it should have the right to prevent the visit taking place or to terminate the inspection.
(xi) It would avoid potential misunderstandings if a standard routing were laid down for conducting cross-border inspections along the lines recommended in Annex A.
(xii) In those countries where laws do not allow for on-site inspections by supervisors from other jurisdictions, the working group advocates that host supervisors use their best endeavours to have their legislation amended. In the meantime, host supervisors should, within the limits of their laws, be willing to cooperate with any home supervisor that wishes to make an inspection. The working group believes that the host supervisor should have the option to accompany the home supervisor throughout the inspection.
(xiii) It is important that the confidentiality of information obtained during the course of an inspection be maintained. Home supervisors should use their best endeavours to have their legislation modified if it does not offer sufficient protection that information obtained for the purposes of effective consolidated supervision is limited to that use.
(xiv) In the event that a home supervisor, during an on-site inspection in a host country, detects a serious criminal violation of home country law, the home supervisor may be under a strict legal obligation to pass the information immediately to the appropriate law enforcement authorites in its home country. In these circumstances, the home supervisor should inform the host supervisor of the action he intends to take.4
(xv) In order to carry out effective comprehensive consolidated supervision, home supervisors also need information on certain qualitative aspects of the business undertaken in other jurisdictions by branches and subsidiaries of banking organisations for which they are the home supervisor. All members of the working group agree that it is essential for effective consolidated supervision that there are no impediments to the passing of such qualitative information to the home supervisor.
2. Improving the access of host supervisors to information necessary for effective host supervision
(xvi) In the case of information which is specific to the local entity, an early sharing of information may be important in enabling a potential problem to be resolved before it becomes serious. The home supervisor should therefore consult the host supervisor in such cases and the latter should report back on its findings. In particular, it is essential that the home supervisor inform the host supervisor immediately if the former has reason to suspect the integrity of the local operation, the quality of its management or the quality of internal controls being exercised by the parent bank.
(xvii) A home supervisor should have on its regular mailing list for relevant material all foreign supervisors which act as hosts to its banks.
(xviii) While the working group agrees that home supervisors should endeavour to keep host supervisors appraised of material adverse changes in the global condition of banking groups, the Group recognises that this will typically be a highly sensitive issue and that decisions on information-sharing necessarily will have to be made on a case-by-case basis.
3. Ensuring that all cross-border banking operations are subject to effective home and host supervision
(xix) The working group has formulated a set of principles of effective consolidated supervision (see Annex B) which could be used by host supervisors as a checklist to assist in determining whether a home supervisor is meeting the Minimum Standards.
(xx) Regional group procedures might be used to support the implementation of the Minimum Standards, as the Offshore Group is now doing.
(xxi) The working group recommends that other regional groups consider the possibility of using a checklist similar to the one used by the Offshore Group (see Annex C) as a means of establishing which of their members might be certified as meeting certain general criteria.
(xxii) The Basle Committee encourages its member countries to assist the Offshore Group or another regional group in the fact-finding verification process, but any decision-making regarding membership of a regional group should be left to that group alone. The Committee has asked its Secretariat to maintain a list of competent persons (for example, retired supervisors) who are available to undertake exercises of this nature.
(xxiii) The supervisor that licenses a so-called shell branch has responsibility for ensuring that there is effective supervision of that shell branch. No banking operation should be permitted without a license, and no shell office should be licensed without ascertaining that it will be subject to effective supervision. In the event that any host supervisor receives an application to license a new shell branch that will be managed in another jurisdiction, that supervisor should take steps to notify both the home supervisor and the appropriate host supervisor in the other jurisdiction in order to establish that there will be appropriate supervision of the branch before approving the application.
(xxiv) Home supervisors should not authorise their banks to establish or acquire offices in any host jurisdiction without satisfying themselves in advance that such offices will be subject to appropriate supervision.
(xxv) Where the home authority wishes to inspect on-site, they should be permitted to examine the books of the shell branch wherever they are kept. The working group believes that in no case should access to these books be protected by secrecy requirements in the country that licenses the shell branch.
(xxvi) The working group recommends that home or host supervisors be vigilant to ensure that parallel-owned banks (where a bank in one jurisdiction has the same ownership as a bank in another jurisdiction, where one is not a subsidiary of the other) become subject to consolidated supervision, if necessary by enforcing a change in group structure as indicated by the Minimum Standards.
(xxvii) Any home supervisor that licenses a banking entity has a responsibility to monitor its operations on a worldwide basis.
(xxviii) No entity should be allowed to use the word “bank” in its name if it is not conducting banking activities and being supervised as a bank.
(xxix) The working group believes the Basle Committee should advise all host countries to be extremely cautious about approving the establishment of cross-border operations by banks incorporated in under-regulated financial centres, and even more cautious about accepting other financial institutions conducting banking activities from those centres.
Standard procedures for cross-border inspections
The working group recommends that the following routine should be followed in cases where the home supervisor wishes to undertake a cross-border inspection:
(i) The home supervisor should contact the host supervisor to let the latter know of an intention to make a visit to a specified branch/subsidiary within the host supervisor’s jurisdiction;
(ii) The home supervisor should be prepared to explain to the host supervisor the purpose of the visit and what aspects of the branch or subsidiary it would wish to explore;
(iii) The host supervisor should be able to obtain an undertaking from the home supervisor that information obtained in the course of the visit will be used for specific and supervisory purposes and, to the maximum extent possible under applicable laws, will not be passed to third parties without the host supervisors’ prior consent…. ;
(iv) The host supervisor should identify to the home supervisor any areas where access to information is normally restricted (e.g. information on individual customers), and the home supervisor should indicate where exceptions are needed;
(v) The host supervisor should have the option, but not the duty, to accompany the home supervisor during the inspections;
(vi) Where relevant, the host supervisor should advise the home supervisor of procedures necessary to comply with local/host country legislation and, where necessary or appropriate, assist in ensuring that these procedures are correctly followed to expedite the examination.
Effective consolidated supervision
1. Under the first of the four Minimum Standards, it is required that all international banks be supervised by a home country authority that capably performs consolidated supervision. The purpose of this Annex, and in particular the checklist in paragraphs 6 and 7 below, is to provide examples of some of the principles and factors that could be taken into account in making a judgement about effective consolidated supervision.
2. There can be no single set of criteria to determine whether or not a home supervisor is performing “effective consolidated supervision”, since supervisory techniques differ from country to country, due to institutional, historical, legal or other factors. The concepts of consolidated supervision can, however, be defined, namely as a group-wide approach to supervision whereby all the risks run by a banking group are taken into account, wherever they are booked. In other words, it is a process whereby a supervisor can satisfy himself about the totality of a banking group’s activities, which may include non-bank companies and financial affiliates, as well as direct branches and subsidiaries.
3. One of the prime reasons why consolidated supervision is critical is the risk of a damaging loss of confidence if an associated enterprise gets into difficulties. This so-called risk of contagion goes well beyond legal liability. Consolidated supervision helps protect the integrity of, and confidence in the group, both supervised and unsupervised elements. More directly, the purpose of consolidated supervision is essentially threefold:
- to support the principle that no banking operation, wherever located, should escape supervision altogether;
- to prevent double-leveraging of capital; and
- to ensure that all the risks incurred by a banking group, no matter where they are booked, are evaluated and controlled on a global basis.
4. It is important to draw a distinction between accounting consolidation, which is a mechanical process, and the concept of consolidated supervision, which is qualitative as well as quantitative. The drawing up of consolidated accounts facilitates consolidated supervision but is not necessarily sufficient. Consolidated accounting may, for example, be inappropriate when the nature of the business or the nature of the risks are markedly different, but that does not mean that the risks should be ignored. Moreover, some risks need to be monitored at local levels too. Liquidity concerns, for one, can be considered on a market-by-market (or currency-by-currency) basis, though a group liquidity spectrum would need to include at least the main funding centres. Market risk is another risk that the supervisor may decide should not necessarily be consolidated: that decision would depend on whether the bank manages its market risks centrally or regionally. Moreover, if a bank is operating in jurisdictions subject to controls on capital flows, offsetting of market (and other) risks through consolidation would not necessarily be prudent.
5. In reaching a decision as to the effectiveness of the consolidated supervision conducted by a home supervisor, the host supervisor will also need to take account of his own supervisory capabilities. If he has limited resources, greater demands will be placed on the home supervisor than if host supervision is strong. The host also has to judge the extent to which its supervision complements that of the home supervisor, or whether there are potential gaps. Accordingly, one host supervisor may decide that a given country is conducting effective consolidated supervision, whereas another host supervisor with different capabilities may decide that it is not. Nonetheless, there are certain common factors on which host supervisors will base their decisions. The checklist below is designed to assist in that decision-making process.
Checklist of principles for effective consolidated supervision
A. Powers to exercise global oversight
6. Does the home country supervisor have adequate powers to enable it to obtain the information needed to exercise consolidated supervision, for example:
- does the bank in question have its own routine for collecting and validating financial information from all its foreign affiliates, as well as for evaluating and controlling its risks on a global basis?
- does the home supervisor receive regular financial information relating both to the whole of the group, and to the material entities in the group (including the head office) individually?
- is the home supervisor able to verify that information (e.g. through inspection, auditors’ reports or information received from the host authority)?
- is there access to information on intra-group transactions, not only with downward affiliates but also if appropriate with sister companies or non-bank affiliates?
- does the home supervisor have the power to prohibit corporate structures that deliberately impede consolidated supervision?
B. Exercise of consolidated supervision
7. Which of the following procedures does the home country supervisor have in place to demonstrate its ability to capably perform consolidated supervision:
- adequate control of authorisation, both at the entry stage and on changes of ownership?
- adequate prudential standards for capital, credit concentrations, asset quality (i.e. provisioning or classification requirements), liquidity, market risk, management controls, etc?
- off-site capability, i.e. systems for statistical reporting of risks on a consolidated basis and the ability to verify or to have the reports verified?
- the capability to inspect or examine entities in foreign locations?
- arrangements for a frequent dialogue with the management of the supervised entity?
- a track record of taking effective remedial action when problems arise?
Offshore group of banking supervisors on-site examination checklist
1. What number, types of banks etc. are licensed in the jurisdiction? Is there any differentiation in the type of banking licence issued, or the conditions imposed and, if so, why? What legislation is in place, when was it last updated, and does it provide for the Basle Committee’s minimum standards to be met?
2. What resources are available to the supervisory authority, with regard to the background and experience of the supervisory team, and what training programme is in place?
3. What are the requirements which banks/banking groups have to fulfil in order to become authorised in the jurisdiction? What measures are in place to ensure that banks/banking groups are managed and controlled by fit and proper persons?
4. What is the process of authorisation - what objective criteria and what type of background checks are used? What arrangements are in place to ensure the approval of the home supervisor? What regular links are there with other supervisory authorities?
5. What steps are taken to ensure that banks/banking groups are subject to effective consolidated supervision?
6. What financial and prudential information is collected from banks/banking groups in the jurisdiction, and how frequently is the information collected? By what means is the reliability of this information confirmed?
7. Are on-site inspections of banks/banking groups undertaken? If not, what are the alternative arrangements? If so, who carries them out, what is their scope and what is their frequency? Is the home supervisory authority informed of examination findings?
8. What measures are taken to supervise the overseas operations of any banks/banking groups for which the Supervisory Authority is the home supervisor? Are financial conglomerates allowed? If so, what are the arrangements for supervising the operations of non-bank subsidiaries?
9. What limits are applied with regard to the extent to which a bank or banking group can lend to:
(a) any one customer (including any arrangements for treating groups of borrowers as one risk);
(b) companies or persons connected with the bank/banking group itself; and
(c) particular sectors (e.g. real estate)?
10. What rules are in place to monitor:
(b) asset quality;
(c) country risk exposure;
(d) liquidity control systems;
(e) foreign exchange positions;
(f) off-balance-sheet activity;
(g) ownership and organisation structure;
(h) derivatives activities?
What is the frequency of report on each of the above?
11. What arrangements are in place to ensure that banks/banking groups maintain adequate accounting and other records, and adequate systems of control?
12. What measures and actions can be taken if the banks/banking groups in the jurisdiction fail to comply with prudential requirements or any other factors that are a cause for concern?
13. Are internal auditors from the parent bank or head office entitled to inspect the banks in the jurisdiction? Are internal auditors required to meet with/report to the host/home supervisor?
14. Are the home supervisory authorities of banks/banking groups entitled to conduct on-site inspections?
15. What powers does the supervisory authority have to provide or share information with other supervisory authorities? What kind of information may be provided or shared? What restrictions or constraints are there (if any) on the provision or sharing of information with other supervisory authorities? What statutory or other protection is available for information passed to the supervisory authorities by other authorities?
16. Have the Basle Commmittee’s capital convergence proposals been adopted?
17. What legislation, rules, etc. are in place to control money-laundering activities and to provide for the implementation of the FATF’s forty recommendations?
18. Are locally incorporated subsidiaries required to publish annual audited accounts? Are all banks subject to external audit and, if so, in what form? What is the criteria for appointing/approving external auditors and do they have to be the same as the auditors of the parent/group?
This text is reproduced with permission from the Basle Committee on Banking Supervision. It is an excerpt from Basle Committee on Banking Supervision, Core Principles for Effective Bunking Supervision (September 1997).
This document refers to a management structure composed of a board of directors and senior management. The Committee is aware that there are significant differences in legislative and regulatory frameworks across countries as regards the functions of the board of directors and senior management. In some countries, the board has the main, if not exclusive, function of supervising the executive body (senior management, general management) so as to ensure that the latter fulfils its tasks. For this reason, in some cases, it is known as a supervisory board. This means that the board has no executive functions. In other countries, by contrast, the board has a broader competence in that it lays down the general framework for the management of the bank. Owing to these differences, the notions of the board of directors and the senior management are used in this document not to identify legal constructs but rather to label two decision-making functions within a bank.
Text of footnote omitted.
This text is an excerpt from The Supervision of Financial Conglomerates (July 1995), a report by the Tripartite Group of Bank, Securities and Insurance Regulators.
Some members consider that a quantitative assessment of group-wide capital could be inappropriate if its usefulness in terms of improved risk assessment for a regulated entity would be less than its potential drawbacks in terms of moral hazard or real or apparent extension of a safety net to include affiliates of the regulated entity. This situation could arise, for example, if the regulated entity were very small relative to the overall group, and there were strong legal restrictions on the relationships and nature of allowable business transactions between the regulated entity and its affiliates. In such cases, a quantitative assessment of capital adequacy for the overall group would have little value in assessing the risks for the regulated entity. If such an approach were construed as bringing the affiliates within the supervisory structure applicable to the regulated entity, the overall effect could be negative.
In determining these notional needs, some supervisors might also refer to the requirements established by the market for firms to obtain high credit ratings and ready access to low cost funding.
It is recognised that, in certain circumstances, it might be perfectly reasonable to expect a parent to provide support at off-market conditions to its subsidiaries. Supervisory authorities might actually require such support on occasions.
This text is an excerpt from The Supervision of Cross-Border Banking (October 1996), a report by a working group composed of members of the Basle Committee on Banking Supervision and the Offshore Group of Banking Supervisors.
Cross references to paragraphs of the report are omitted.
Text of footnote omitted.
Some members of the working group strongly believe, as is required by their laws, that the home supervisor should be expected to obtain approval from the host country supervisor before informing the home country law enforcement authorities of any suspected violations of home country law.