Current Legal Issues Affecting Central Banks, Volume V

Afterword to Chapters 10 and 11

Robert Effros
Published Date:
May 1998
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Chapters 10 and 11 stress a number of trends in banking. Some of these trends—globalization, increasing diversification, and the impact of technology—have been evident for quite some time. They imply a changing view of the content of risk. There is nothing new in risk. Banks have always been in the business of risk management. The issue is one of ensuring that new risks are properly identified and properly managed. Systems of supervision need to respond to the changes within the boundaries of what is achievable and desirable. Nevertheless, risk has now taken center stage. A major underlying factor has undoubtedly been the explosive growth in the trading of derivatives and the part played in it by banks. The implications of this development are not debated here. However, the concomitant risks are and have to be in the forefront of the minds of supervisors throughout the world.1

The trends also imply that bank supervision can no longer be regarded as a purely domestic activity. Bank supervision has an international dimension, more or less important according to the nature of the bank or business concerned. There can be no question that exchange of information between supervisors is assuming ever-greater importance. As long ago as 1990, the Basle Committee on Banking Supervision was urging cooperation between supervisors,2 and moves in this direction are proceeding apace. However, a number of important policy issues arise, some of which are mentioned subsequently.

The following is a summation of the main points of Chapters 10A and 10B and Chapter 11. First, Chapter 10A describes the supervision-by-risk program introduced by the Office of the Comptroller of the Currency (OCC), which is the primary regulator of nationally chartered banks in the United States. It was described as an evolution rather than a revolution in supervisory practices. It is not a substitute for CAMEL.3 The program is notable among other things for the classification of risks for bank supervision into nine categories: credit, liquidity, interest rate, price, foreign exchange, transaction, compliance, strategic, and reputation risk. It is obvious that some of these categories are more difficult to measure than others. Nevertheless, it is right to recognize “reputation risk” as a separate category, despite difficulties in quantifying it. Ultimately, a bank’s survival depends on its reputation and the confidence that its reputation engenders in depositors.

It remains to be seen how this program will work in practice. In the long term, it is likely to be influential internationally. For example, the Bank of England announced that it will introduce a more systematic approach to risk assessment. The OCC’s evolutionary approach is also evident in the regulation of bank capital, where the U.S. authorities counseled that a bank’s own model may often be relied on. The Basle Committee adopted a models-based approach for determining capital requirements to cover market risk on securities and derivatives. Banks are permitted to use their own models to calculate market risk, subject to certain specified parameters.4

Second, the supervision of the branches of foreign banks inevitably presents particular challenges. Chapter 10B describes the supervision program used by U.S. bank supervisory agencies, including the Board of Governors of the Federal Reserve System, for the supervision of the U.S. operations of foreign banking organizations (FBOs) in the United States. He pointed out that, although there was nothing radically new about this program (which was adopted in 1995), what was significant about it was the level of coordination among the agencies involved. He described the key features of the program, including the system that emphasizes risk management, operational controls, compliance, and asset quality (ROCA) and replaces the previous rating, which focused heavily on the condition of the branch or agency’s portfolio of risk assets at a particular point in time. Again, the emphasis is on risk identification and management.

Non-U.S. observers must bear in mind the unique structure of the U.S. regulatory system. A number of factors have contributed to the structure.5 The historic separation of banking and securities business and the restrictions on interstate banking have no real counterpart in Europe. These factors, and the sheer size of the U.S. economy, have resulted in a more complex supervisory framework than exists elsewhere that is characterized by a number of different agencies, each responsible for different parts of the banking system.

Third, Chapter 11 describes the increased urgency for supervisors of financial institutions to assist one another in understanding the risks undertaken by internationally active banks and to cooperate in sharing information on those aspects of the bank’s business relevant to each supervisor. The U.S. laws dealing with the collection and disclosure of confidential financial information were addressed. There is an important issue here, namely the balancing of the desirability of the exchange of information between supervisors with the right to privacy of the supervised institutions and their customers. So far as foreign banking supervisors are concerned, the Federal Reserve Board is authorized to share information subject to certain safeguards, including confidentiality. The Board has for some time been working to develop a form of agreement that can be used as the basis for sharing information with foreign authorities in supervising cross-border operations. The point was made (which is sometimes overlooked) that there can on occasion be a downside in disclosing information unnecessarily. Disclosure may, for example, weaken a troubled institution further. In some cases, it may be necessary to balance the competing interests of sharing on the one hand and maintaining market confidence in the particular banking organization on the other.

In Chapter 11, a compelling case is made for a model agreement governing the exchange of information. The Barings case has demonstrated how vital such an exchange can be. However, to whom is information to be disclosed? Under what circumstances? With what safeguards? These are sensitive issues that require proper analysis and, if possible, international consensus.

Before leaving this topic, it is worth mentioning that legal bars on the dissemination of banking information fall into two distinct categories. First, there are the so-called bank secrecy laws. Most jurisdictions have them in one form or another. These laws apply to the relationship between the bank and its customer. They reflect the fact that a customer is entitled to have his financial affairs kept confidential and impose upon a bank a legal obligation to do so. Second, in a different category, there are legal rules that restrict the disclosure of information about financial institutions obtained by supervisors in the conduct of their supervisory duties. These prohibitions are typically contained in statute or similar law and create duties between the financial institution and the supervisory authority. In Europe, for example, Article 12 of the First Banking Directive imposes prohibitions on the divulging of confidential information.6 Pursuant to Article 12(2), member states may conclude cooperation agreements providing for exchanges of information with the competent authorities of third countries only if the information disclosed is subject to guarantees of professional secrecy.7 A proposal to extend this provision to the nonbanking supervisory authorities of third countries is under consideration. It is into this second category that most of the legal ramifications of information exchange fall.

The Barings case, which received attention in these pages, is a classic example of the consequences of a failure of internal control. The U.K. Board of Banking Supervision, which produced a report on the affair,8 made internal controls the primary focus of attention.9 The report also indicated a number of lessons to be drawn by the Bank of England as supervisor. However, notably, nothing in the affair has diminished the Bank of England’s reputation as a supervisor.10

In brief, the Board recommended:

  • that the Bank should explore ways of increasing its understanding of the nonbanking businesses (particularly financial services businesses) undertaken by those banking groups for which it is responsible for consolidated supervision and how those businesses interrelate to one another and to such groups’ banking businesses. It should also seek to obtain a more comprehensive understanding of how the risks in those businesses are controlled by the management of the group;

  • further safeguards in relation to the solo consolidation11 of any active trading entity with the Bank;

  • close collaboration between the Bank and other regulators both in the United Kingdom and overseas;

  • that the Bank should treat the audit committee and the internal audit function as a valuable source of information. It would not be realistic to review all internal audit reports as a matter of course, but there should be an opportunity to discuss internal audit, control, and related issues;

  • that effective use should be made of reporting accountants;

  • that repeated or significant breaches of large exposures rules demanded prompt investigation;

  • that regulators should be aware of guarantees and comfort letters given by banks in respect of the obligations of other group members. While a guarantee is a legally binding obligation, the status and effect of a comfort letter is not always as clear; such letters can range from virtual guarantees to mere statements of awareness (although letters falling within the latter category should not be disregarded because they may pose a risk to the reputation of the bank issuing them); and

  • that supervisors should be subject to an independent quality-assurance group review of the supervision of banks.12

The Board also considered the desirability of increasing the level of on-site visits to bring the United Kingdom more in line with U.S. practice. It concluded that a wholesale change to the existing style of supervision was not justified. As a follow-up to the report, in October 1995 Arthur Andersen was appointed to review the effectiveness of the operation of the Bank’s Supervision and Surveillance Division. The Bank has now indicated that the various recommendations that came out of these reports will be implemented.13 The result will be the most far-reaching reorganization of the bank’s supervisory function in many years. Key elements include:

  • clarifying the standards and processes of supervision and how these are linked to the overall objectives of supervision to ensure appropriate internal focus and to promote better understanding among the banks and the public at large;

  • developing a more systematic model of risk assessment, which will then drive the supervisory program in respect of individual banks. A version of that model14 has already been prepared and tested successfully, but further modifications will be needed as it is applied throughout the banking sector; and

  • a reorganization of the Supervision and Surveillance Division into a larger number of line divisions, and the creation of an Operations Division to encompass training and other support functions.

As always, such changes carry a financial cost. An increase of staff in the Supervision and Surveillance Division from current levels of about 385 to about 486 is envisaged. The proposals imply roughly a 20 percent to 25 percent increase in total costs attributed to supervision, or £7-8 million on the current total of £35 million. However, the Bank has made it clear that there will be no radical change in its style of supervision (for example, toward the laissez-faire approach being adopted in New Zealand,15 or toward a more rule-based or inspection-based approach to supervision).

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