Current Legal Issues Affecting Central Banks, Volume V

Chapter 8 Comparative Banking Supervision

Robert Effros
Published Date:
May 1998
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Evolutionary trends have fundamentally altered the business of banking over the last decade or so, and, consequently, bank managers have had to adjust their practices. Technological advances, product innovation, globalization, structural changes, and deregulation have all made the world of banking ever more complex, integrated, and competitive, and overall just a much tougher place to do business.

Not surprisingly, these trends have raised major new challenges for bank supervisors as well as all across the globe. Indeed, bank supervisors have witnessed a wave of broad-scale banking problems in a significant number of countries, both large and small, industrialized and developing. In their wake, serious questions have been raised in several countries about the adequacy of bank supervisory techniques and overall performance, and about the need for fundamental changes in supervisory approaches. Further fueling the forces for supervisory change—and for closer international supervisory cooperation—have been a number of high-profile, institution-specific problems, of which Barings and Daiwa Bank are the most familiar.

This chapter has three goals. First, it describes briefly the different types of supervisory models in use among the Group of Seven countries.1 Second, it details the U.S. supervisory approach. In addition to describing the supervisory tools used in normal circumstances, it examines the U.S. approach in times of stress, such as the serious banking problems that arose in the United States in the late 1980s and early 1990s. Finally, this chapter deals with the work of the Basle Committee on Banking Supervision, including its pioneering efforts in the area of prudential risk-based capital requirements, its important work on risk management and internal controls, and its ongoing efforts to establish the principle of comprehensive consolidated supervision and to achieve close collaboration among bank supervisors and other financial regulators.

Bank Supervisory Approaches

Although supervisors around the world employ a host of different approaches in their oversight of banks, they share several common goals. In addition, the overriding objective in all cases is to maintain public confidence in their banking systems.

A full and complete discussion of supervisory models in use by the Group of Seven countries would have to focus on several dimensions. The key dimensions would include statutory authority for the bank supervisory agency, including enforcement powers; the balance between formal regulations and less formal supervisory guidance; the nature of regulatory reporting, required public disclosures, and surveillance; the role of on-site examinations; and the supervisors’ relationships with external auditors, the board of directors, and senior management.

This chapter concentrates on the latter two dimensions: the role of on-site examinations and the supervisors’ relationships with external auditors. A closer look suggests that the Group of Seven countries fall generally into two approaches but along a fairly wide spectrum.

At one end of this spectrum are supervisors who rely primarily on their own on-site examinations to determine the state of a bank’s affairs. At the other end are supervisors who rely heavily on the opinions and assessments of a bank’s external auditors rather than on their own on-site examiners. The choice as to where one fits best on that spectrum can be influenced heavily by factors such as the size and distribution of the country’s banks. In the United States, for example, there are over 9,000 commercial banks, and no one institution has more than 7 percent of the commercial banking market. In a number of other Group of Seven countries, several major banks typically dominate their national banking sector, accounting for as much as 80 percent to 90 percent of their total market.

Generally, the differences between countries are more a matter of degree than an “either/or” proposition. In addition, the commonalities are many and important. For example, in all cases bank supervisors will supplement their efforts through other supervisory tools, such as regular statistical reporting, off-site surveillance and analysis, prudential regulation, and an ongoing close dialogue with senior management. In addition, all of the Group of Seven supervisors have statutory authority to conduct on-site examinations if they see a need to do so and also have a variety of corrective and enforcement tools at their disposal.

Thus, while this chapter refers generically to two basic supervisory approaches, it should be clear that many variables are at play within each basic approach and that many overlaps exist between the two frameworks.

Examination Practices: On-Site Examiners

The Group of Seven countries that rely primarily on their own on-site bank examiners are Italy, France, Japan, and the United States. In these countries, the foundation of the oversight process is periodic visits by examiners to banks in order to evaluate overall the financial condition and operational soundness, and to ensure compliance with banking laws and regulations.

The scope of supervisory surveillance in all four countries is quite similar, reflecting their common concerns—capital adequacy, asset quality, management quality, earnings, and liquidity. Also, in each of these countries supervisors provide guidelines that limit maximum bank exposure to any single borrower or group of borrowers.

Typically, on-site examiners make use of the bank’s records and of their discussions with bank staff in order to gain a broad understanding of the bank’s operations and management systems. They also may review the work of the auditors, particularly to note any exceptions that may have been identified. Based on an in-depth analysis of a great deal of detailed information, they assess the institution’s condition. In all the countries except France, they use a structured rating system to ensure completeness and consistency in their assessments. In France, a similar, but less structured, assessment system is used.

In all the countries, when concerns or problems are identified, they are discussed with bank management. This can occur as part of the on-site examination process or in subsequent meetings.

The frequency of routine on-site visits varies among these countries. The Federal Reserve or other examiners in the United States visit banks at least every 12-18 months. In Japan, the banks receive full-scope examinations by the Ministry of Finance and the Bank of Japan every other year. In contrast, Italian and French examination schedules are typically less frequent. Italian banks used to be visited only every six to seven years, but this period is currently being shortened. In France, the frequency of examinations is a function of the size and condition of the bank. Smaller banks in sound condition receive a full-scope examination every four to five years, while troubled institutions might be visited annually. Larger institutions, however, are typically visited every year or two, although the examination focus will normally be targeted at specific areas, such as market risk or reserve practices.

Last and most important, supervisors in each of these four countries will conduct special on-site examinations if problems surface.

Examination Practices: External Auditors

In the second supervisory approach, the external auditors’ opinions and findings are the primary input to supervisory assessments of the financial soundness of a bank and to determinations of corrective actions that may be necessary. In special cases, the supervisors may commission experts to make assessments or may elect to make their own on-site visits. However, the scope of those visits will be quite focused.

For routine situations, banks are required to engage auditors to conduct various types of reviews specified by the supervisors, such as verifying financial controls and attesting to the financial statements of the audited bank. The auditors typically visit banks on a regular basis—annually or semiannually—and present their findings in reports that are shared with both supervisors and bank management.

In addition, the auditors may meet regularly with supervisors to discuss banking issues. In some cases, the supervisors may meet with the auditors directly, while in other cases only in conjunction with bank management. Auditors are expected to notify supervisors directly and promptly of any serious legal violations or other significant problems that are identified.

Given the importance of the role of auditors, it is not surprising that supervisors typically influence the choice of auditors. In some cases, banks may be required to choose auditors from a list preapproved by the supervisory authorities, and they may also be required to notify supervisors when they change auditors. In all cases, supervisors have the authority to remove or revoke the appointment of auditors if they believe that the auditors cannot perform their work satisfactorily, or if they have concerns as to possible conflicts of interest.

Two of the Group of Seven countries—the United Kingdom and Germany—fit the external auditors model rather closely. The United Kingdom, which has no full-time examiners and no routinely scheduled examinations, is probably the best example of this model. However, even in the United Kingdom bank supervisors will make on-site visits to banks from time to time to assess specific areas of special interest or concern. In Germany, the supervisory authorities are authorized to conduct on-site examinations but rarely do so. In normal circumstances, they, too, rely almost exclusively on the work of external auditors, although targeted examinations will be undertaken in special circumstances.

Canada seeks to strike a balance between the two basic approaches. Its examiners do, in fact, conduct annual on-site examinations, but the focus of the exams is on broader issues and process, with the transactional details left to the external auditors to verify. Thus, the Canadian authorities rely on external auditors to ensure compliance with applicable rules and regulations. The supervisors also regularly hire credit specialists to check a bank’s loan files, and other types of specialists are hired as needed.

One final point regarding these supervisory approaches is that several of the Group of Seven countries seem to be adopting practices that are moving them closer to the middle of the spectrum. For example, the United Kingdom and Germany are making on-site visits to assess and validate the internal models that internationally active banks will be allowed to use in order to compute capital charges for market risk. Also, in other countries that rely on on-site examinations supervisors are increasing their use of external auditors. For example, recent legislation in the United States requires large- and medium-sized banks to have their external auditors attest that internal controls over financial reporting are effective.2

Examination Practices: Market Discipline

There is another possible supervisory model, at least theoretically. It is the market discipline or public-disclosure-based model. Here, the notion is that extensive public disclosure, and the ensuing market discipline, will provide incentives for bank managements to take risks prudently and to ensure that their banks remain in sound financial condition. The theory is that hands-on prudential supervision should be rendered unnecessary in such cases.

While no Group of Seven country has adopted this model, one country—New Zealand—has acted to implement this approach.3 The Reserve Bank of New Zealand has eliminated most prudential regulations except capital adequacy requirements and limits on credit exposures to related parties, and replaced its regulatory reporting requirements with a new public disclosure regime. Banks must disclose on a quarterly basis detailed information, such as financial positions, asset quality and loan-loss provisions, concentrations of credit exposures, market risk exposures, capital adequacy, and information about their boards of directors. The disclosures must be signed by the banks’ boards to attest to accuracy.

Even so, the Reserve Bank of New Zealand authorities have retained some practices associated with the other approaches. They continue to meet with senior bank management at least once a year. Also, they have increased the frequency of statutory external audits from an annual to a semiannual basis.

New Zealand implemented the disclosure framework on January 1, 1996. Thus, it is too early to try to assess its performance. It should be pointed out however that, given its rather unique circumstances, New Zealand is a very special case. Indeed, New Zealand has only a handful of large banks, all of which are foreign owned and all of which are subject to consolidated supervision from the respective home country supervisors. In such circumstances, it is clearly easier to opt for the market-discipline approach.

From this overview of comparative banking supervision, it should be emphasized that there is no single correct approach. For example, after the problems of Daiwa Bank4 and Barings5 surfaced, supervisors in Japan, the United States, and the United Kingdom were all criticized to varying degrees for the same weakness—inadequate supervisory oversight—even though very different supervisory approaches were followed in each of those countries. Similar observations can be made regarding the many countries that encountered severe real estate problems in the late 1980s and early 1990s.

What these experiences indicate is that no one is fully satisfied with current supervisory practices. Rather, the evolutionary trends have caused not just the banking industry, but also bank supervision, to be very much in a state of flux.

Common Themes in Supervisory Practices

As bank supervisors assess and continue to learn from their past experiences, three common themes that are emerging both in the United States and elsewhere can be detected.

The first theme suggests a noticeable shifting of emphasis in supervisory practices from detailed transactional reviews to a more risk-based and process-based focus. As the banking business becomes ever more complex and model driven, supervisors must rely to an increasing extent on assessing the adequacy of each bank’s own risk-management practices and internal control systems. This shift has two implications. First, a bank’s management is, more than ever, the first line of defense, and it must bear the primary responsibility for ensuring the bank’s financial soundness. This is particularly important in today’s high-technology environment, where risk exposures and consequent losses can develop so quickly. At the same time, supervisors will have to rely to a greater extent on a bank’s own internal and external auditors to conduct detailed transactional reviews. This is likely to be increasingly true even in countries such as the United States that follow the on-site examination model.

The second emerging common theme is the trend toward broader disclosure and a greater reliance on market discipline. Banks in the Group of Seven countries, to varying degrees, are increasingly being encouraged by their supervisors to disclose publicly more detailed information, especially with respect to their risk exposures and management practices. While this trend is surely needed and to be supported, in the opinion of many observers market discipline cannot fully substitute for a hands-on independent bank supervisor, although it can play a very important complementary role. This point is elaborated on later in this chapter.

A third common theme is the welcome trend to apply common prudential standards and requirements across national boundaries. The most prominent example of this trend is the 1988 Basle Capital Accord,6 which set minimum capital requirements for banking organizations from the major countries with cross-border operations. Increasingly, these standards are being adopted by countries around the world. Even financial institutions not required to follow the guidelines are tending to do so voluntarily as a way of gaining favorable market standing.

Common standards are also being applied internationally through the identification and adoption of sound practices covering a variety of areas. Such efforts identify broad policies and procedures, leaving it up to the individual countries to determine the specifics of implementation, by taking into account their own legal, institutional, and accounting structures. A good example of common standards is found in the guidelines issued by the Basle Committee in 1997 that sets forth principles for the management of interest rate risk.7

The U.S. Approach

In examining the U.S. approach to bank supervision, this part first focuses on how U.S. bank supervisors function during “normal” times and then during times of stress. The dual banking system in the United States—under which banks can obtain either federal or state charters—has resulted in a complicated structure of bank supervision. Several official supervisory agencies are involved, including the Office of the Comptroller of the Currency, the Federal Deposit Insurance Corporation, the Federal Reserve, and 50 individual state banking authorities.8 While there are some differences in supervisory techniques, they do not vary greatly from agency to agency. Moreover, the agencies consult with each other and, under the aegis of an interagency working group, the federal agencies try to coordinate their practices and regulations. In addition, 1994 legislation required the federal agencies to develop standards for unified examinations by October 1996.9

As previously mentioned, the cornerstone to ensuring the safety and soundness of U.S. banking organizations and their compliance with laws and regulations is the on-site examination process. U.S. bank supervisors have found that a meaningful presence in a bank enables them to gain a detailed knowledge of the bank’s operations, procedures, controls, and management, which is invaluable in reaching an informed judgment about the bank’s overall condition.

During on-site reviews, the examiners carefully evaluate the institution in a number of critical areas.10 This review results in a formal composite rating that summarizes the bank’s overall condition. The exact components of the rating systems vary according to the type of institution being examined, whether a bank, a bank holding company, a foreign branch, or other entity. However, in each case the rating system is designed to identify significant supervisory concerns systematically and consistently.

While U.S. bank supervisors regard on-site examinations as essential to the supervisory process, they, of course, can provide only snapshots of the banking institution. In order to fill in the supervisory picture between annual examinations, U.S. bank supervisors rely heavily on regular statistical reporting and in-house surveillance and monitoring. For example, every quarter banks file what are commonly known as “call reports,” which provide extensive information on the structure and maturity of the bank’s assets, liabilities, and capital, as well as on its sources of revenue and expense.11 These reports also provide information on a bank’s non-performing and potential problem assets, its off-balance sheet activities, and its contingent liabilities.

Through the call reports and other regular reports, as well as risk-management reports made available by the largest banks, U.S. bank supervisors have access to a wealth of information that is subjected to in-house surveillance and analysis and that allows for dynamic monitoring of banks’ financial conditions throughout the year. It enables the supervisors to identify banking institutions that, while currently healthy, may be facing specific problems down the road. Surveillance techniques may also allow supervisors to spot adverse industry trends and to address more generic problems before they become critical or unmanageable.

U.S. bank supervisors typically supplement in-house surveillance with regular meetings with bank management. They want to know the banks’ managers and to be able to work closely with them. Maintaining ongoing contacts should result in fewer surprises for everyone. In the long run, effective supervision should be, and has to be, a cooperative process, although appropriate enforcement action can be resorted to if the need arises.

Not surprisingly, in situations of stress the efforts of U.S. bank supervisors become more intense. In cases of significant problems, the supervisors require banks to report additional detailed financial information on a quarterly, monthly, weekly, or even daily basis.12 In such cases, meetings with bank management also intensify; the supervisor may undertake additional examinations and may require the bank to submit a business plan to address its problems.

If the situation were to continue to deteriorate rather than to improve, the U.S. bank supervisor might well encourage, or require, the bank to take additional, and perhaps more painful, corrective actions. This close hands-on supervisory scrutiny would continue until the bank’s financial condition fundamentally changed; asset quality and any other difficulties, such as internal controls, improved; equity and reserves were restored; and there was a sustained improvement in core earnings.

Managing Bank Crises in the United States

The Federal Reserve had extensive experience in crisis management of banks, including several of the largest in the United States, in the late 1980s and early 1990s. The following is a summary of how the Federal Reserve worked with a number of these banks to resolve some serious problems. While the situation varied from bank to bank, the general approach of the Federal Reserve was quite similar.

Net charge-offs at the largest bank holding companies rose steadily throughout the 1980s. This deterioration was reflected in bank balance sheets that had been weakened by the combined effect of the less-developed countries’ debt problem; loan concentrations to troubled sectors such as energy, agriculture, and shipping; and the commercial real estate problem that surfaced in the late 1980s.

During this period, examiners at the Federal Reserve observed a sharp deterioration in asset quality, with spillover effects on earnings and capital. They also saw signs of deterioration in the internal control environment at several of the banks. In response, examiners noted their concerns in examination reports and downgraded regulatory ratings of individual banks. The initial response of bank management to the downgrades was typically one of denial. However, as the situation continued to worsen and supervisory comments intensified, most senior bank managers, to their credit, came to recognize the potential seriousness of the situation.

At the request of the Federal Reserve, the banks prepared detailed financial plans describing how they proposed to address their various problems. Reflecting both the Federal Reserve’s and their own initiatives, the plans submitted to the Federal Reserve included:

  • the raising of significant amounts of new capital;

  • the aggressive write-off of bad loans;

  • strict limitations on asset growth;

  • the sale of poorly performing assets and unprofitable business lines;

  • a sharp reduction in operating expenses, primarily through large staffing cuts;

  • the development of contingency funding plans in the event of liquidity problems;

  • the reduction or, in some cases, the total elimination of dividends;

  • more active involvement by the bank’s board of directors and, in some cases, changes in senior management; and

  • from a contingency standpoint, the consideration of possible merger candidates as a last resort.

While going through this crisis period was a difficult challenge both for the bankers and their supervisors, the program worked well. Once the bankers accepted the severity of their problems, they moved aggressively in partnership with the supervisors. By most measures—such as asset quality, capital adequacy, and earnings—these banks managed to recover in a period of just a few years.

In retrospect, perhaps the principal lesson to be learned from the U.S. experience is that when supervisors see storm clouds on the horizon, or worse yet forming directly overhead, it is imperative that they move quickly to get bank management’s full attention and their recognition of the need for prompt remedial action. History has shown time and again, in the United States and elsewhere, that the longer an institution waits to address the problem, the harder it will be to manage. Unfortunately, the temptations to try to muddle through can, at such times, be almost irresistible.

Prudential Policies

Another key element of the U.S. approach to supervision is the development and administration of prudential policies. The purpose of such policies is not to micromanage banks, but rather to ensure that the banks are operated safely and soundly and in a manner that appropriately serves the credit needs of their communities.

There are three principal areas where U.S. bank supervisors have implemented extensive prudential policies:

  • capital adequacy;13

  • asset concentrations;14 and

  • risk management and internal controls.15

Since capital policies are well known, this part focuses on the last two areas: asset concentrations and risk management.

Prudential regulation regarding asset concentrations is particularly important because credit risk concentration has been at the core of most significant banking problems encountered in the United States and else-where for a very long time. The dangers of excessive credit risk concentrations have long been recognized in U.S. banking law through a statutory limit on loans to individual borrowers (which is currently set generally at 15 percent of bank capital).16

However, concentrations can also occur in less visible, but just as dangerous, forms, such as on an industry-wide basis. For example, in the 1970s and 1980s loan concentrations to the energy, agriculture, shipping, and commercial real estate sectors resulted in significant problems in the United States. Similarly, the current Japanese banking crisis can be attributed in large measure to very heavy real estate loan concentrations, as can the banking problem in Sweden.17

Concentrations can also arise by geographic region or as a result of risks that may be common to a particular type of borrower. The financial and economic difficulties shared by many less-developed nations in the 1980s is a clear case in point. The explosive growth in leveraged buyouts and other types of highly leveraged financing in the mid-1980s also comes to mind.

While the loans were made to different firms in different industries and in different geographic areas, they were still a form of loan concentration because they shared a common vulnerability under certain economic and interest rate scenarios. When rising and potentially dangerous levels of asset concentration are detected, whatever the form, U.S. bank supervisors will act to focus bank management’s attention on the issue, encourage them to set limits to curb growth and monitor developments closely.

In the United States, recent trends involving consumer credit and capital-markets activities could give rise to new patterns of concentration not seen before. Clearly, an important task for both supervisors and bank managers alike will be to detect such potential problem areas as early as possible and to make sure that appropriate defensive measures are taken.

Turning to the Federal Reserve’s prudential policies in the risk-management area, the Federal Reserve has—along with many other supervisors around the world—increased its emphasis on sound risk-management practices and strong internal controls when evaluating the activities of banks. Such systems and controls are absolutely critical to the prevention or detection of mismanagement and fraud, and to the conduct of safe and sound banking activities. Surely, this is one of the most obvious and basic lessons to emerge from the Barings and Daiwa Bank cases.

As noted at the outset, bank supervision is not, and cannot be, a stagnant process. As the banking industry evolves, bank supervisors must continually seek ways to improve their methods and practices so as to better respond to the ongoing changes in the nature of banking. As a part of this process of review and self-appraisal, the Federal Reserve established an internal committee to conduct a comprehensive review of the financial examinations process. The committee’s task was to make recommendations to help preserve the best aspects of the existing process while identifying ways to improve its effectiveness and efficiency in the future. The committee’s basic conclusion was that the recent trend to more risk-focused and process-oriented examinations should be accelerated wherever possible. This recommendation, which is now being fully implemented, carries important implications for all aspects of the Federal Reserve’s examination process. Moreover, the international supervisory community will also be moving in this direction over time.

International Initiatives of the Basle Committee on Banking Supervision

The Basle Committee on Banking Supervision is composed of supervisors from the Group of Ten countries. The committee monitors international banking developments and trends and tries to ensure appropriate supervisory responses. The committee’s goal is to promote supervisory cooperation, to improve the quality of supervision worldwide, and to close existing gaps in supervisory coverage. Hence, the emphasis is on broad prudential issues rather than on specific supervisory techniques.

Capital Adequacy: The Accord

The single most important contribution of the Basle Committee to date is the Basle Capital Accord.18 This agreement sets out in detail a frame-work for measuring capital adequacy on a risk-weighted basis and a set of minimum standards that would be applied consistently to all major international banks in the Group of Ten countries. The goal was to create a consensus framework that was both reasonable and prudent, and that would provide competitive equality among internationally active banks.

Initially, the Basle Capital Accord focused on capital adequacy solely in relation to credit risk. However, it was understood from the beginning that other types of risk, particularly market risk, would eventually be incorporated into the capital standards as banking institutions developed their trading businesses and their exposure to market risks expanded.

Dealing with market risk was a major challenge but, in January 1996, the Basle Committee finally approved a proposal to incorporate this risk into the risk-based capital framework.19 Under the proposal, which was implemented at year-end 1997, capital charges will be applied to cover the risk of losses in both on- and off-balance-sheet positions emanating from market price changes. An exciting feature of this amendment, and a precedent-setting innovation in supervisory practices, is that it will allow banks to compute their capital charges using their own internal market risk-measurement models. The amendment reflects extensive consultations with the industry and its concerns that a standardized measurement framework, as initially proposed,20 would not be sufficiently compatible with the banks’ own measurement systems, would be costly to implement, and might retard risk-management innovation in the industry.

Looking to the future, with the ink now dry on the market-risk proposal, consideration is being given in some quarters to the question of how to approach total capital over the longer term. Some intriguing ideas have been put forward by researchers, basically putting more of the onus on individual banks to determine prudent amounts of capital and to be penalized in some way for misjudgments. These ideas are now just in their infancy. However, they are indicative of supervisor awareness and acceptance of the evolutionary nature of the supervisory process.

Accounting Standards: International Harmonization

The Group of Ten supervisors are discussing the need to work toward a harmonizing of international accounting standards. This is an area where the Federal Reserve thinks that much useful work needs to be done. It is important work because without such harmonization it is far from clear how successful bank supervisors have been in achieving a level playing field regarding international capital requirements. For example, if international banks are using disparate accounting methods for key capital elements, such as for determining loan loss provisions, past due loans, and income and expenses, it is unlikely that the capital ratios derived will afford a reasonable basis for comparison across countries.

Thus, ultimately, a common set of accounting conventions is needed to make sure that bank supervisors and the market are not comparing apples and oranges, and are able to make meaningful financial assessments of firms and useful comparisons from their public disclosures. No one should have illusions as to the magnitude of this task. Achieving international harmonization of accounting practices is likely to be a very slow and tedious process because there are many participating countries and entities with different traditions, laws, priorities, and concerns. However, participants must not back away from this challenge. Without greater convergence, the full potential benefits of the Basle Capital Accord will not be fully realized.

Consolidated Supervision

Increased globalization of banking is also bringing to the forefront the critical importance of consolidated supervision. As cross-border activities grow, it is essential that no internationally active banking establishment escape supervision and that the supervisory oversight be on a comprehensive and consolidated basis. Failure to achieve this can have disastrous consequences, such as those that occurred with the Bank for Credit and Commerce International.21

To achieve this objective, the relative roles and interrelationships between supervisors in the home country (that is, the jurisdiction where the parent is organized) and the host country (where the local activity to be supervised is conducted) need to be defined clearly.

In June of 1992, the Basle Committee addressed this issue in a paper, setting forth “Minimum Standards for the Supervision of International Banking Groups and Their Cross-Border Establishments.”22 Four key standards were agreed upon at that time.

  • First, it was agreed that all international banking groups and international banks should be supervised by a home country authority that capably performs consolidated supervision. To this end, the host supervisor was responsible for determining that the home supervisor had the capability to perform consolidated supervision, taking into account the home supervisor’s statutory powers, past supervisory experience, and the scope of its administrative practices.

  • Second, it was agreed that, before commencing operation, cross-border banking establishments should receive the prior consent of both the host and home supervisors. The Basle Committee saw the authorization process as an ideal opportunity for home and host supervisors to share information and establish a foundation for future information exchange and supervisory coordination. Furthermore, they recognized the authorization process itself as the supervisory cornerstone in preventing the establishment of questionable banking operations deemed likely to cause trouble.

  • Third, it was agreed that home supervisors should possess the right to gather information from the cross-border banking establishments of their banks. This information gathering could be done either through on-site examinations or by other means satisfactory to the home supervisor—presumably based on the particular supervisory approach that was being followed.

  • Fourth, the Basle Committee agreed that if a host supervisor determines that any one of the foregoing minimum standards is not being met to its satisfaction, it could impose restrictive measures as necessary to satisfy its prudential concerns, including a prohibition on the creation of new banking establishments.

It may seem that these are fairly straightforward standards that appeal to both common sense and reason. In fact, while virtually everyone agreed in principle to the minimum standards, implementation has not been easy.

The crux of the problem is that consolidated supervision requires the free flow of relevant information between host and home country supervisors. For a variety of reasons, information has not been flowing as freely in either direction as one might have hoped.

Why have supervisory authorities been reluctant to share information? In many cases, host authorities have faced the major constraint of a lack of resources, particularly staff resources, to gather properly supervisory information. In some cases, the host authority may be uncertain as to what information would be relevant and useful to home supervisors, perhaps because of meaningful differences in supervisory practices and approaches.

Home supervisors, on the other hand, find it difficult to share information with host supervisors at times when their banks are experiencing serious financial difficulties. At such times, the focus of the home supervisors inevitably will be on trying to find a viable solution to their banks’ problems. In such circumstances, home supervisors will almost certainly be reluctant to share information on a bank’s condition with a significant number of host supervisors and thereby risk precipitating the very crisis that they are trying to prevent.

All of these problems can be very real, but by far the most significant information-sharing obstacle that bank supervisors have had to contend with is the bank secrecy laws that continue to exist in some jurisdictions.23 While limitations on disclosure of customer information are usually directed at deposit balances—an item that is normally not of major interest to supervisors—some banking centers extend their secrecy requirements to asset information as well. Moreover, some bank secrecy laws even prevent home country supervisors from performing any on-site examinations of local offices of banks for which they are the consolidated supervisor. Such laws are totally at odds with the principle of consolidated supervision that bank supervisors have been attempting to implement.

To address this problem, a joint working group was formed of members from the Basle Committee on Banking Supervision and the Offshore Group of Banking Supervisors, the latter primarily representing a group of countries that are not members of the Organization for Economic Cooperation and Development, and many of which have some form of bank secrecy law. The joint group has produced a paper that, among other things, establishes three important principles.24 First, home country supervisors should be able to conduct on-site examinations of over-seas offices of their banks, and bank secrecy laws that interfere with their ability to do so should be changed. Second, home country supervisors should be able to gain access to depositor account information at over-seas offices of their banks if needed for safety and soundness purposes, including the pursuit of suspicions of serious criminal activity by banks or their customers. Third, evidence of serious violations of home country criminal laws uncovered during such on-site examinations can be passed by the home country supervisor to the home country’s law enforcement authorities as may be required by the home country’s laws. The paper was endorsed by bank supervisors of 130 countries at the International Conference of Bank Supervisors in 1996. Fully implementing these principles will take considerable time and effort, but, given the need for changes in local laws and local customs, getting the principles agreed to and on paper is a critical first step toward making comprehensive, consolidated supervision a global reality.

A description of consolidated supervision would be incomplete without a few words on the current efforts of the Basle Committee to coordinate their efforts with supervisors of other financial institutions, such as securities and insurance firms. The blurring of distinctions between banks, securities firms, and insurance companies has given rise to a proliferation of global financial conglomerates that offer a wide variety of financial services. The concerns expressed with respect to the supervision of cross-border activities of banks are fully applicable to financial conglomerates as well and make it increasingly necessary that supervisory collaboration between all relevant financial supervisors be improved. This effort has been under way for some time.

In June 1995, the finance ministers of the Group of Seven countries, at a meeting in Halifax, Canada, took note in their official communique of the growing importance of increased supervisory collaboration between banking and securities supervisors.25 In response, the Basle Committee and the International Organization of Securities Commissions (IOSCO) have affirmed their common goal of improving the quality of supervision worldwide and responding to financial market developments in a timely, effective, and efficient manner.26 In pursuit of closer collaboration, the Basle Committee and IOSCO have engaged in ongoing efforts to achieve more consistent regulatory treatment in cases where banks and securities companies are participating in similar types of activities.

It is worth noting that the collaborative efforts are spreading to insurance supervisors as well. In July 1995, the Tripartite Group of Bank, Securities, and Insurance Regulators issued a report suggesting several areas for further study.27 Among other things, they agreed that supervisors needed to assess the capital adequacy of diversified financial conglomerates on a consolidated basis.28 However, they also recognized the usefulness of a “solo-plus” approach that looks both at the individual entities as well as at the group as a whole.29

The Tripartite Group’s report also stressed the importance of close cooperation between the various supervisors responsible for the different components of a financial conglomerate and the need to exchange prudential information among themselves.30 To this end, they suggested consideration of the appointment of a “lead supervisor” or “convener,” whose responsibility it would be to gather all relevant information, including information on the group’s nonregulated entities, and to pass that information, as appropriate, to other concerned supervisors.31

To maintain the momentum generated by the initial work of the Tripartite Group, a new group composed of banking, securities, and insurance supervisors was appointed and designated the “Joint Forum.”32 The work of the Joint Forum is ongoing and, among other things, it seeks to develop proposals for better collaboration, including the possibility of adopting a lead-supervisor approach. It also plans to establish a code of principles for effectively supervising financial conglomerates, including such issues as how to measure group capital, control intragroup exposures, and limit the potential for contagion within a group. Obviously, this is an ambitious agenda and is sure to result in an active and extended dialogue. Difficult issues remain to be tackled and resolved, particularly with respect to the proposal for a lead supervisor. A number of questions arise in this regard. For example, which financial firms should be covered by the proposal? What criteria should be used to decide which supervisor should be designated as the “lead?” Should the lead supervisor’s role be confined to receiving and sharing information, or should the role be more broadly defined? Which host supervisors should be included in the information-sharing network? What information should be shared? And, crucially important, how will this be done without creating new bureaucratic problems?

Everyone involved in the Joint Forum’s work recognizes that much give and take will be needed if meaningful progress is to be achieved. However, success at the end of day is likely. A way must be found to supervise effectively global financial market participants if the challenges posed by the major global trends currently under way in the financial industry are to be met.


It is clear that the role of the bank supervisor is under examination in many countries and that there will no doubt be important changes, as individual countries continue to adapt their supervisory approaches. The role of capital requirements, the contribution of external auditors, and the importance of market discipline will all evolve further. Whatever happens, it will be clear to all that none of these alternatives can fully substitute for the role played by the bank supervisor.

The basis for this conclusion is that the firm’s management, the marketplace, and the official supervisor, each in its own way, has something special to offer. There are unique comparative advantages of each. As previously noted, a firm’s own board of directors and senior management—and the checks and balances they build into their organizations through internal controls, limits, internal audits, and progressive levels of review by independent functions—are the first and most important line of defense. Media headlines have illustrated the fate that awaits institutions that fail to heed this lesson. At the market level, oversight takes the form of what is typically referred to as market discipline. Undeniably, efforts to achieve better public reporting and disclosure and more consistent international accounting standards would help considerably to enhance market discipline. Greater transparency can enable market participants to make more informed judgments about those with whom and to what extent they are prepared to do business. All steps in this direction should be strongly supported. However, firm- and market-driven supervision are simply not enough.

Bank supervisors possess their own special and unique comparative advantages. First and foremost, bank supervisors are far better positioned and more inclined to focus attention on systemic risk and other important and longer-term public policy issues than the individual firm or the broad marketplace that focuses necessarily on shorter-run financial performance.

Second, bank supervisors have undeniable advantages in obtaining and assessing certain types of information. For example, they have more extensive and more timely access to sensitive information than markets are ever likely to have. By virtue of their supervisory authority, they have direct and immediate access to proprietary information on all the banks that they supervise, including their management information systems and internal control environments. In addition, bank supervisors have the unique ability to compare any bank’s management and control processes, as well as its financial performance, against that of its peers. The work that bank supervisors have done recently on internal models in connection with the market-risk proposal33 is a good case in point.

Third, experience strongly suggests that bank supervisors are also needed to enforce compliance with applicable laws and regulations both in good times and in bad.

Finally, only bank supervisors have the requisite knowledge and clout to ensure that prompt corrective actions are taken when serious financial or other problems are identified. The critical role that can be played by a supervisor in problem cases—both through public enforcement actions and through other far less visible means—cannot be overstated.

While both firm and market-level oversight should be strongly encouraged and supported, there continues to be a prominent role for bank supervisors as well. The challenge for bank supervisors is to continue to adjust quickly in response to the evolutionary trends affecting the banking industry. Much has been done on both the domestic and international fronts, and more efforts are currently under way.

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