III Recent Developments in the Regulation and Supervision of Financial Markets
- International Monetary Fund
- Published Date:
- January 1991
The trends in financial flows and asset prices discussed in the preceding section occurred in the context of a continuing process of financial market internationalization and integration. This process intensified during the 1980s and has contributed to more efficient market mechanisms for the mobilization and allocation of savings, both nationally and internationally. Nevertheless, the resulting intensification of competition and pressure on profitability may, at the same time, undermine the viability of certain established institutions and market structures. Similarly, the increasing ease with which the location of financial activities may be shifted from one segment or jurisdiction to another may have adverse systemic risk implications. While there have been some instances of localized strains on financial institutions and markets, regulatory and supervisory systems have generally succeeded in containing disruptions.
The focus of this section is on international coordination and cooperation efforts in the regulation and supervision of financial markets. A central element of such regulatory and supervisory responses—developed over the last few years at the international level—has been the formulation of policies to ensure that the capital underpinning the activities of financial institutions is adequate. The risk-weighted capital adequacy requirements of the Basle Committee on Banking Supervision, analogous EC directives in this area, and related steps to extend similar treatment to nonbank securities firms provide the principal examples of such responses. To date, international policy coordination in the capital adequacy area has focused primarily on the appropriateness of capital relative to credit risk. But with increasingly active markets in a wide range of financial instruments and the blurring of institutional distinctions between various financial activities—a tendency that is likely to intensify as regulatory barriers are further eroded—increased attention has been devoted to improving the coverage of capital adequacy for market risks, particularly, risks of loss from adverse movements in exchange rates, interest rates, and equity prices.
While capital adequacy remains central to the strengthening of regulatory and supervisory practices, it is widely recognized that this approach needs to be complemented by safeguards against the excessive concentration of risk. This has been reflected, inter alia, in concern about the appropriateness of loan-loss provision practices and the degree of portfolio diversification of financial entities. Accordingly, regulators have taken steps over the past few years to strengthen provisioning requirements—particularly for developing country exposure—and, more generally, to derive guidelines for measuring and controlling credit concentration. Similarly, since the process of market integration and internationalization has also been accompanied by the emergence of financial conglomerates, regulators and supervisors are now reassessing the nature, magnitude, and effects of contagion and other risks entailed by such corporate structures. Finally, new international initiatives have also been undertaken recently to prevent financial institutions’ involvement as intermediaries in the deposit taking and transfer of funds derived from illicit activities—money laundering. This section covers the above issues in turn.
International Capital Adequacy Standards
In July 1988, the authorities of the Group of Ten countries endorsed proposals by the Basle Committee on Banking Supervision for the “International Convergence of Capital Measurement and Capital Standards.” This agreement—referred to here as the accord—provides a framework for measuring risk-weighted capital adequacy and setting minimum prudential standards for credit risks. The framework is already reflected in the national practices of several industrial countries and in the EC Directives on Solvency Ratio and Own Funds for credit institutions, which were adopted in 1989. In addition, the accord is increasingly being used as a reference point for other industrial countries and for developing countries engaged in comprehensive financial reforms.
The basic elements of the accord include the establishment of an agreed approach to defining the constituents of capital, assigning credit risk weights to various types of exposure, and setting minimum standards for the ratio of capital-to-risk-weighted assets.25 Group of Ten countries have agreed to comply fully with this framework by January 1, 1993. To facilitate implementation, transitional arrangements covering the period 1991–92 were established. In essence, the accord established a two-tier definition of capital: tier-1 capital (“core capital,” covering equity capital and disclosed reserves), and tier-2 capital (“supplementary capital,” covering other instruments, such as revaluation and undisclosed reserves, general provisions, subordinated loans, and hybrid debt-capital instruments). Several limitations are imposed on the inclusion of instruments in tier-2 capital, such as a 45 percent limit on unrealized capital gains on securities holdings and a limitation on subordinated debt equivalent to 50 percent of tier-1 capital. The accord also provided for a minimum risk-weighted capital/asset ratio of 8 percent to be achieved by the end of 1992. A transitional minimum ratio of 7.25 percent applied for the end of 1990. Assets were to be risk weighted according to five classes, carrying weights ranging from 0 percent to 100 percent.
A recent review by the Basle Committee on the implementation of the accord indicated that as of September 1990, the capital agreement was already in force in most of the main financial centers (including Canada, France, Germany, Japan, Sweden, Switzerland, the United Kingdom, and the United States).26 Requisite legislative revisions in regulatory frameworks or binding guidelines from the supervisory authorities were already in place in those centers.27 Several of these countries (e.g., Canada, Switzerland, the United Kingdom, and the United States) require more stringent minimum standards for certain banks than specified in the accord. While some countries have moved directly to the final standards, others have taken advantage of the transitional arrangements. In general, despite developments in stock markets during 1990 adversely affecting tier-2 capital, international banks in the Group of Ten countries met or exceeded by the end of the year the transitional standard of 7.25 percent. Moreover, a majority of the large international banks reported already meeting the final 8 percent standard.
In implementing the accord during 1990, a number of technical questions arose on the interpretation of certain provisions. These were handled on a case-by-case basis by national authorities, except for instances where conflicting decisions could create significant competitive inequalities; such instances required broader agreement under the auspices of the Basle Committee. One outstanding issue concerns the treatment of general provisions or general loan-loss reserves. In February 1991, the Committee issued a consultative paper on proposals to give greater precision to the inclusion of general loan-loss reserves in the definition of capital. The Committee intends to put forth a final amendment on this issue in the second half of 1991. In its proposals, the Committee sought to make operational the general principle of separating or “cleaning” general provisions that do not reflect an identified deterioration in the valuation of particular assets and that are freely available to financial institutions, thereby qualifying for inclusion as tier-2 capital, from provisions that are set up against identified losses or an identified deterioration of particular assets, thereby not qualifying as capital. As in other areas, deliberations have had to take account of substantial differences in national accounting and regulatory environments. These include the use of different “baskets” of countries for the establishment of provisions as well as variations in the treatment of provisions for regulatory capital purposes; some countries (e.g., France) have included all provisions in regulatory capital while others (e.g., Japan) exclude such provisions.
During 1989, the EC adopted three key directives for implementation of the single banking market bearing on such matters: the Own Funds, Solvency Ratio, and Second Banking Coordination Directives (Table 8).28 The directives are now being transposed into national legislations and are to be fully in effect across the EC by January 1993. The first two directives define the requirements for capital adequacy that, with the notable exception of not allowing unrealized capital gains to count as tier-2 capital, are consistent with the Basle accord. The Own Funds Directive, adopted by the Council in April 1989, establishes standard EC definitions of capital for prudential purposes, applicable to all credit institutions. The Solvency Ratio Directive, adopted in December 1989, harmonizes the approach to solvency issues by establishing, inter alia, counterparty risk weights and rules for the treatment of collateral and guarantees. Finally, the Second Banking Coordination Directive, adopted by the Council in December 1989, harmonizes rules for the operation of credit institutions, allowing, in particular, institutions licensed in one EC country to operate throughout the Community.
|Second Banking||Harmonizes laws and rules for credit institutions; allows for institutions licensed within one EC country to operate throughout the EC||Adopted by the Council, December 1989|
|Own Funds||Establishes standard EC definitions of capital for prudential purposes||Adopted by the Council, April 1989|
|Solvency Ratio||Establishes counterparty risk weights, treatment of collateral and guarantee, and other solvency aspects||Adopted by the Council, December 1989|
|Investment Services||Harmonizes laws and rules for investment services; allows for institutions licensed in one EC country to operate throughout the EC||Under consideration by the Council|
|Capital Adequacy for Investment Firms||Harmonizes capital standard for investment firms||Under consideration by the Council|
Risk-based capital adequacy requirements have also been supplemented by other national measures seeking to place constraints on the maximum degree to which banks may lever their capital bases. In the United States, for example, a new minimum leverage ratio has been in place since the end of 1990, applicable on a consolidated basis to bank-holding companies with assets of $150 million or more.29 Banks are required to maintain minimum tier-1 leverage ratios calculated in relation to total consolidated assets (nonrisk weighted). The ratio has been set at 3 percent for institutions with a top composite rating under the system for bank-holding companies; institutions with lower ratings, as well as those experiencing or anticipating significant growth, are expected to maintain capital leverage ratios above this level.
Although the Basle capital adequacy requirements were formulated only two years ago their impact on bank balance sheets and activities are increasingly evident. In effect, resultant market pressures have encouraged banks to achieve the intended prudential adjustments before the stated deadlines. Initially, and notwithstanding some opposition to a system of risk weights that was seen imperfectly to reflect the attributes of underlying assets, this involved the replenishment of bank capital through retained earnings and the raising of equity on then-buoyant world stock markets. Thus, Japanese banks—long viewed as maintaining relatively low capital ratios—are estimated to have raised some ¥ 6 trillion of equity and equity-related finance between 1987 and 1989. The major U.K. banks are estimated to have raised £4 billion in new equity in the same period, while German and Italian banks increased their capital by 25 percent and 12 percent, respectively. Meanwhile, French banks increased their capital by 19 percent, with nationalized banks resorting to the issuance of perpetual notes and cross-equity participations with other state-controlled companies. After substantial capital-raising activities in 1987–88, new issues by U.S. banks subsequently slowed down, with the 14 largest banks reported to have increased their equity by only 4 percent in 1989. As a result of these activities, and despite continued growth in bank assets, consolidated capital/asset ratios (unadjusted for risk weighting) rose in most industrial countries during 1989 (Table A25), most markedly in Japan and Switzerland.
The substantial weakening of equity markets in 1990, combined with deteriorating bank profitability due to erosion of low-cost sources of funding and the increase in nonperforming assets, subsequently constrained additional increases in core capital. Accordingly, it appeared that banks were increasingly seeking to limit asset growth, particularly as regards those assets carrying high risk weightings, and resorting to the issuance of subordinated debt instruments as needed. Against this background, stronger emphasis was placed on ensuring an appropriate return on assets, with greater selectivity in lending being accompanied by more careful, and more risk-sensitive, pricing. The effects of such strategies were quickly reflected, inter alia, in higher margins on corporate loans and in the rationalization by some banks of their developing country loan portfolios. At the same time, major cost-cutting programs were initiated by several internationally active banks.
Progress in implementing international capital adequacy requirements for banks has been accompanied by a growing recognition of the need for similar treatment for nonbank securities firms. Policy objectives in this area include adequate investor protection, the avoidance of regulatory arbitrage between banks and nonbanks, and the promotion of fair competitive conditions in terms of a “level playing field.” The emphasis on capital ratios, as opposed to quantitative limitations, has reflected the need to strengthen the underlying financial position of firms, while minimizing nonprice distortions that may adversely affect the distribution of financial activities. To meet such objectives, regulators have placed increased stress on the need for a common framework, applied internationally, for measuring and designing appropriate capital adequacy standards for securities firms. Work in this area is being conducted under the auspices of the International Organization of Securities Commissions (IOSCO), which issued an initial report in June 1989 that proposed basic principles for such an international framework. These include risk-based requirements to take account of position and settlement risks, as well as base coverage for “non-measurable risks,” such as general management risk. The topic was addressed at the November 1990 meeting of IOSCO, on the basis of a comparative study on capital requirements in France, Japan, the United Kingdom, and the United States.30 Delegates generally recognized the need for a more detailed common framework that would allow for the establishment of harmonized regulations, and further work in this area is to proceed in the context of collaboration between securities supervisors, the Basle Committee, and the EC.
Within the European Community, a draft EC directive on capital standards for investment firms is under consideration. The directive seeks to harmonize capital standards for investment firms through the specification of risk-based capital requirements, of categories of risks to be covered, and of accounting and reporting procedures. The draft includes minimum standards for start-up and ongoing capital, as well as requirements related to business type, position risk, and foreign exchange risk. It proposes that member countries with non-segregated (“universal”) banking systems select between applying the already approved bank directives to the aggregate activities of banks, or to separate the securities activities by “carving out” the trading book and making it subject to the securities standards.
The proposed capital adequacy standards for EC investment firms would be adopted alongside the draft Investment Services Directive, which would apply to noncredit institutions the “passport” principle of the Second Banking Coordination Directive. Firms with authorization in one EC home country would not be required to obtain a separate license for operations in other EC countries and would be subject only to a notification requirement. As in the case of the draft capital adequacy directive and the banking directives, supervision would be conducted by home country authorities with information provided to other national authorities on request. Progress in finalizing the directive has been slowed by differences on a number of issues, including the extent to which securities business should be required to pass through recognized national exchanges or be allowed to take place off-market.
Capital Adequacy Requirements for Market Risks Assumed by Banks
Following the progress achieved in harmonizing capital requirements in terms of credit risk, increasing attention is now being devoted by bank supervisors to ways of improving the treatment of market risks when assessing overall capital adequacy. Three types of market risks, in particular, are being considered: foreign exchange risk (the risk of loss from adverse exchange rate movements), interest rate risk (the risk of loss from adverse interest rate movements), and position risk in traded equity securities (the risk of loss from movements in the market price of equities). Banks’ exposure to such risks has increased in recent years, in line with the deregulation of interest rate and the lifting of capital controls, the broadening of the range of bank activities into the securities field, and increasingly active markets in a wide range of financial instruments.
The Basle Committee, in collaboration with IOSCO members, has been a major forum for international deliberations on this issue. As with the treatment of credit risk in the accord, the approach thus far emphasizes the use of minimum capital requirements as the appropriate regulatory instrument to achieve international convergence on the treatment of market risks. The Committee’s work in this regard has highlighted numerous conceptual and technical difficulties in defining and measuring market risk and taking account of offsetting risk positions. This is particularly the case in the area of interest rate risk where important methodological questions have arisen, for example, regarding the treatment of indefinite maturity assets and liabilities, and the extent and stability of negative covariance between short and long maturities, and different instruments and currencies. In regard to position risk in equities—where the Committee is advocating a two-tier approach based on the quality of the issuer and the bank’s net exposure to movements in the equity market as a whole—difficulty has emerged on the definition of equity, the offsetting of positions in different national markets, and the treatment of variations in the degree of liquidity associated with different securities. Work on setting capital requirements on banks’ open foreign currency positions has focused on the measurement of single currency exposure, the measurement of risks inherent in a mix of long and short positions in different currencies, and the determination of appropriate capital ratios. As with capital requirements on credit risks, the formulation and implementation of capital requirements on market risks may be expected to induce financial institutions to adjust their on- and off-balance sheet positions. The nature and extent of such adjustments would depend, inter alia, on the importance of interest and exchange rate operations, with U.K. and U.S. institutions accounting for an important portion of such operations, and on the extent to which the use of hedging techniques is considered in setting capital requirements.
At the national level, the introduction of new regulations in the various areas of market risk has been generally limited to date, reflecting, in part, anticipation of international initiatives on the issue. The German authorities, however, recently introduced specific capital requirements for off-balance sheet items. With effect from October 1, 1990, the Federal Banking Supervisory Office amended its principles concerning bank capital to take supervisory account of the dynamic trend in the off-balance sheet transactions of German banks that underlie forward contract positions in the broadest sense. The volume of such transactions grew from 29 percent of on-balance sheet operations at the end of 1986 to 56 percent at the end of 1989, with a relatively large dispersion around these average estimates. The new regulations limit, in quantitative terms, the risks arising from off-balance sheet transactions through expanding the general counterparty risk principle beyond credit risk and laying down capital-related ceilings for open positions. Thus, banks are required to include, in their capital coverage, risks arising from financial swaps, forward contracts and options rights. In accounting for these risks, banks may use either the original-exposure method (which involves multiplying the nominal amount of the transactions by a maturity-related percentage weight) or the marking-to-market method (involving aggregating the current replacement cost and an add-on). Total price risks are to be limited to 60 percent of banks’ liable capital, with disaggregated limits for individual risk categories.
Issues in Monitoring Large Credit Exposures
During the recent past, increasing attention has been devoted to the harmonization of monitoring and control practices governing large credit exposure and encouraging the spreading of risks through portfolio diversification. This attention is likely to increase in the context of the more acute financial difficulties facing selected groups of borrowers. The October 1990 International Conference of Banking Supervisors discussed the issue on the basis of a report prepared by the Basle Committee.31 The report advocates a limit on bank exposures to nonbank private borrowers of 10–40 percent of capital on a fully consolidated basis, with 25 percent as the preferred central point, and stresses the need to pay careful attention to loans to “connected borrowers.” It was agreed that this report should form the basis of a “best practices guide,” which was issued by the Basle Committee in January 1991. The guide concludes that a sound supervisory system requires a range of supervisory elements to prevent excessive concentration, with an overall limit on individual private sector nonbank exposures of not more than 25 percent of total capital.
The application of credit exposure limits necessitates a clear specification of both the credit coverage and the counterparty. In defining credit exposure, the Basle Committee favors a comprehensive definition that includes not only standard bank loans but also all on- and off-balance sheet positions subject to the counterparty default risk (e.g., securities participation and off-balance sheet contingencies). The counterparty is also defined in a broad manner in order to ensure that related borrowers are treated as constituting a single exposure. The latter reflects the recognition that institutional and operational linkages (e.g., through common ownership, management, or cross-guarantees) may imply a large contagion risk within bank portfolios. When applied in isolation of other portfolio monitoring instruments, quantitative credit exposure limits run the risk of ignoring sizable single exposures that, while important in the aggregate, are individually not large enough to exceed exposure limits. Such “clustered” loan portfolios are more vulnerable to potential credit risk than more diversified ones, as are portfolios with heavy concentration in certain geographic regions, economic sectors, or industries. Citing difficulties of definition and other constraints, the Basle Committee report stresses the need for close monitoring of these issues by supervisory authorities rather than the application of quantitative rules.
Supervision of Financial Conglomerates
Market integration has been accompanied in recent years by a tendency toward greater institutional concentration in financial systems. The main contributing factors have been the need to maintain or expand market shares and take advantage of perceived economies of scale. Resulting tendencies toward concentration have taken a number of forms, including (a) mergers among banks in the same country (e.g., ABN-AMRO and NMB-Postbank in the Netherlands; Provinsbanken, Danske Bank, and the Copenhagen Handelsbank in Denmark; PK Banken and Nord Banken in Sweden; Mitsui and Taiyo Kobe banks in Japan); (b) cross-border bank mergers and acquisitions (e.g., Deutsche Bank (Germany) and financial institutions in Italy, Portugal, and Spain; Crédit Lyonnais (France) and institutions in Belgium and Germany; and Barclays and National Westminster banks (U.K.) and institutions in France, Italy, and Spain); and (c) mergers and “strategic alliances” between bank and nonbank financial institutions (e.g., banks moving to acquire securities companies in France, Canada, and the United Kingdom). Some banks have also increased their participation in nonfinancial enterprises, most notably in France. This tendency toward the creation of financial conglomerates is expected to persist as a result, in part, of the erosion of regulatory-induced separations between different financial services. Such erosion is most evident in Canada, Japan, and the United States, which had long maintained a formal segmentation between banking and securities markets.
Draft legislation was submitted in late September in Canada, which proposed allowing various types of financial institutions to engage directly or indirectly in one another’s business, with the main exception of retail insurance. The proposed measures complement a process of structural reform, initiated in 1987, which began modifying traditional regulatory barriers between four broad categories of financial institutions (the “four pillars”)—banks, securities companies, trust companies, and insurance companies. The first step was to allow federally regulated banks, trust companies, and insurance companies to take an ownership interest of up to 100 percent in securities firms. The newly proposed steps would, if approved, allow for (i) banks to own trust companies; (ii) banks and trust companies to own insurance companies; (iii) insurance companies to own trust companies; and (iv) any widely held financial institutions to own “schedule-2” banks.32 “Significant” changes in ownership would be subject, inter alia, to the approval of the ministry of finance. In addition to providing additional opportunities for diversification, the proposals allow for expanded business functions within established institutional structures. For example, insurance companies would have enhanced abilities to make consumer and commercial loans, while trust companies would be granted the same in-house opportunities as banks. The proposed changes would also be accompanied by new prudential measures to discourage self-dealing. The federal Superintendent of Financial Institutions would be provided with new powers to receive additional information on the operation of financial institutions. At the same time, industry self-regulatory mechanisms would be strengthened, and institutions would be required to put in place internal procedures to manage conflicts of interest within the expanded structures.
In the United States, increasing attention is being devoted to reforming laws and regulations separating commercial and investment banking and limiting interstate banking, in the context of efforts to improve the competitiveness and stability of financial institutions and markets. Proposals to this end are included in the U.S. Treasury Department’s study for modernizing the U.S. financial system released in early February 1991 and summarized in the following section of this report. That study reflects growing pressure for reform of the U.S. financial system, both in the wake of problems in the deposit insurance system and in view of the efficiency costs imposed by existing structures. The legal segregation between different providers of financial services has also come to be seen as inhibiting appropriate risk diversification on both sides of intermediaries’ balance sheets. The relative loss of market shares and competitive standing of U.S. banks, for example, as well as the relatively high incidence of financial disruptions in the United States, is indeed often partly attributed to the geographical and functional segmentation of financial services. The case for relaxing, in particular, legislative restrictions on interstate banking and on bank involvement in securities activities has been strengthened by their gradual effective erosion through the actions of state governments and the liberal interpretation of federal regulations. For example, the Federal Reserve has been increasingly permissive in its interpretation of the legal requirement that banks may not “principally engage” in securities activities (Section 20 of the Glass-Steagall Act). In 1989 and 1990, this relaxation was reflected in regulatory decisions to (i) increase (from 5 percent to 10 percent of total revenue) the allowable contribution of securities activities to a bank’s total earnings;33 (ii) authorize two U.S. bank-holding companies to act as agents in the private placements of bonds; (iii) approve, subject to “firewall” conditions, the applications of five U.S. and three foreign bank-holding companies to underwrite all types of debt and equity securities; and, (iv) allow, also subject to restrictions, four banks to underwrite and deal in U.S. corporate stocks. In early 1991, the Federal Reserve Board granted three additional banks, two of which are foreign, approval to underwrite and deal in U.S. corporate equities.
Analogous work is proceeding in Japan on the reform of regulations separating banking and securities activities (Article 65 of the Securities and Exchange Law). The Japanese financial system is characterized by a large degree of specialization and segmentation. The separation of banking and securities markets, for example, is supplemented by a split within the banking market between long-term, short-term, and trust activities. In July 1990, the Financial System Research Council (affiliated with the Banking Bureau of the Ministry of Finance) issued a second interim report on the reform of the Japanese financial system, following up on an earlier study published in May 1989.34 While the earlier study had identified five possible structures for the organization of banking and securities activities, the new report focuses on two of these alternatives. Under the first of these, both banks and securities houses would be able to set up separate subsidiaries to carry out either banking or securities activities. Alternatively, a multifunctional unit approach would allow a range of banking and securities activities under one roof at the whole sale level. Another study was published a month earlier by the Fundamental Research Committee of the Securities and Exchange Council (affiliated with the Securities Bureau of the Ministry of Finance).35 The report emphasized that if banks were to be allowed into the securities business, then it would need to be through separate subsidiaries, and effective firewalls would have to be put in place to limit problems related to conflict of interest and contagion.
The trend toward the emergence of financial conglomerates raises major regulatory and supervisory challenges. These include (i) identifying the risks inherent in financial conglomerates; (ii) assessing the magnitude of contagion effects and the effectiveness of firewalls (i.e., the extent to which problems in one area of a conglomerate will erode prudential capital underpinning other areas or affect agent confidence in other areas); (iii) avoiding conflicts of interest and insider trading, while limiting the dispersion of management control; (iv) establishing efficient monitoring mechanisms that accommodate the need for remedial action in chronic loss-making areas of conglomerates that are effectively subsidized by profit centers elsewhere; and (v) avoiding the de facto extension of public safety nets. Potential difficulties in these areas are compounded by substantial variation in the nature and evolution of the structure of financial conglomerates, both within and across national borders, and by the fact that holdings may include both supervised and unsupervised entities. This, in turn, has led regulators to seek a broad menu of policy responses.
An important element in the specification of appropriate policy responses is consolidated supervision of conglomerates to the fullest extent possible. At the national level, increased cooperation between bank supervisors and regulators of other types of financial institutions has recently been more prevalent. The form of such cooperation has tended to vary, encompassing (i) formally consolidating supervisory powers (e.g., in Nordic countries where the supervision of insurance activities has been integrated with that of banks under the auspices of the central bank); (ii) establishing formal though not fully integrated coordination mechanisms between regulators (e.g., the “collegiate system” in the United Kingdom where interested supervisors meet as a committee chaired by the agency responsible for the most important element of the conglomerate); and (iii) increasing contacts between the main supervisors, with formal deliberations sometimes supplementing informal consultations (e.g., in the United States).
At the international level, the Basle Committee on Banking Supervision has established formal mechanisms for consultations with securities regulators and is in the process of doing so with insurance regulators. Discussions with securities regulators have covered the need for, and implications of, partial relaxation of constraints on the freedom of regulators to pass on prudential information to other regulators at home and abroad. Key issues in these discussions involve important differences in regulatory approaches to various financial activities, approaches that reflect historical, institutional, and industry-specific “cultural” differences. The basic characteristics of supervised activities tend to differ across sectors. In the case of securities firms, for example, most assets are marketable and therefore subject to observable price fluctuations, which result in similar fluctuations in a firm’s net worth. Since firms have to meet losses as they occur, regulators typically place considerable emphasis on liquidity. This may be contrasted with the experience in the banking sector, where—in the case of relatively narrow banks—regulators typically focus less on short-term changes in asset values and more on the underlying solvency positions through capital requirements.
The supervisory challenges posed by the growth of financial conglomerates was one of the main issues discussed at the October 1990 International Conference of Banking Supervisors. In its review of supervisory issues, the conference noted the clear trend in many financial centers toward enterprises comprising mixed financial functions across banking, securities, and insurance sectors. In view of the complexity and diversity of the associated risks, it endorsed the need for a “combination of approaches” that is flexible enough for national supervisors to apply to unique corporate structures. To render such approaches effective, the conference stressed the need for cooperation between the regulators and supervisors of the component parts of individual groups.
Recent Initiatives Against Money Laundering
In an increasing number of countries, money laundering, which may be described as the attempt to convert or dispose of resources derived from illegal activities in such a way as to conceal their illicit origin, has been criminalized. While most efforts to prevent the criminal use of the financial system for such purposes have been undertaken nationally, increasing attention has recently been focused on furthering international cooperation and developing common standards in this area. The trend reflects the international dimension of certain criminal activity, in particular narcotics trafficking, as well as the possibility that efforts to combat money laundering internally may be frustrated by the channeling of transactions through overseas channels. In such cases, the ability of national authorities to trace the final placement of illicit proceeds risks being frustrated by divergent national reporting standards or by restrictions on the cross-border sharing of information. Moreover, while the general trend toward liberalization of capital controls internationally may be expected to have positive effects on the efficiency of domestic and international capital markets, concern has arisen that the removal of internal and cross-border controls may have the undesirable effect of facilitating the clandestine channeling and placement of illicit proceeds.
International efforts to combat money laundering have generally involved (a) establishing common minimal standards for customer identification; (b) establishing criteria for detecting and reporting suspicious transactions; (c) improving means for international cooperation by facilitating greater information sharing by competent national authorities; and (d) establishing means for cross-border collaboration on the freezing and confiscation of assets related to criminal activity. Various international organizations, including the Council of Europe, Interpol, the Mutual Assistance Group between customs administrations, and the Customs Cooperation Council have devoted considerable attention to these goals. The issue of money-laundering has also been addressed in several international forums and through initiatives to convene specialized task forces.
The United Nation’s “Vienna Convention against Illicit Traffic in Narcotic Drugs and Psychotropic Substances” (the “Vienna Convention”), adopted on December 20, 1988, deals with drug trafficking in general but contains specific provisions related to the laundering of drug money. It creates an obligation for signatories to criminalize money laundering related to drug trafficking, contains provisions to facilitate international investigations, and extends extradition practices to money-laundering cases. It also sets out the principle that banking secrecy should not interfere with international cooperation related to criminal investigations. The Convention became an official body of international law on November 11, 1990 when the required minimum of 20 countries acceded to or completed ratification of the treaty. By the end of 1990, 32 countries, including five industrial countries36 had ratified the Convention.
The Statement of Principles of the Basle Committee on Banking Supervision (the “Basle Statement of Principles”), agreed to on December 12, 1988, applies to banks and recommends that they should make reasonable efforts to identify their customers, refuse knowingly to assist money-laundering operations and cooperate with law enforcement officials to the extent permitted by local regulations relating to confidentiality. Although the statement is not a binding legal document, member countries of the Basle Committee have used various formulas to bind banks under their national jurisdiction to detailed and precise norms in these areas. The statement has also received support from supervisory authorities not represented on the Committee, including members of the Offshore Supervisors Group.
At the July 1989 economic summit meeting in Paris, the heads of state or government convened a Financial Action Task Force, consisting of representatives from summit participants and other interested countries. The mandate of the Task Force was to assess the results of cooperation already undertaken to prevent money laundering through the financial system and to consider additional preventive measures. The Report of the Task Force, issued in April 1990, noted that in order to prevent drug traffickers from exploiting discrepancies between national measures to fight money laundering, minimum standards should be adopted to build upon and enhance the Basle Statement of Principles. It recommended that the suggested measures be applied to nonbank financial institutions that would be permitted or required to play a more active role in bringing suspicious activities to the attention of law enforcement officials. It also recommended that countries consider the establishment of universal reporting of all cash transactions above a fixed amount. Furthermore, the report called on countries to improve their capacity to respond expeditiously to requests from authorities of other countries for information relating to suspicious transactions, persons, or corporations. The findings of the Task Force were endorsed at the Houston economic summit of industrial countries in July 1990, and the Task Force was reconvened for the purpose of assessing and implementing the various recommendations. All OECD and financial center countries subscribing to the Task Force’s recommendations were invited to participate.
These international coordination efforts have been accompanied by several regional initiatives. In December 1990, the finance ministers of EC member countries agreed to recommend to their respective governments that legislation making money laundering a criminal offense be introduced into their respective national legal codes. In April 1990, representatives of the 32 members of the Organization of American States met in Ixtapa, Mexico to discuss the drug issue and related problems, including money laundering. Over half of the participants (18 countries) joined in the signing of the “Declaration of Program of Action of Ixtapa,” which recommended the criminalization of money laundering, the enactment of laws to facilitate tracking and seizure of assets related to drug trafficking, and efforts to improve cooperation among signatories in combating money laundering. They also convened an inter-American group of experts to draft model legislation in these areas. Finally, in May and June 1990, representatives of more than twenty Caribbean nations and territories as well as north, central, and south American countries met in Aruba to form the Caribbean Financial Action Task Force.37 The participants agreed to recommend to their governments that laws criminalizing money laundering and permitting the confiscation of assets related to drug trafficking be introduced and that regulations governing bank licensing, record keeping, and reporting of currency transactions be strengthened.
For a detailed description of the accord, refer to International Monetary Fund, International Capital Markets (1989).
In other EC countries, the agreement was to be implemented in parallel with their adoption of related EC Directives. Nevertheless, their existing practices already complied with the requirements of the accord.
For a description of the directives refer to Section IV of International Monetary Fund, International Capital Markets (1990).
For bank-holding companies with consolidated assets below this amount, the guidelines are applied on a bank-only basis unless the parent bank-holding company is engaged in nonbank activities involving significant leverage on the parent company or the parent company has a significant amount of outstanding debt that is held by the general public.
Banks in Canada are classified into two groups: schedule-1, which are broadly held (i.e., subject to an individual shareholding limit of 10 percent), and schedule-2, which can have dominant shareholders. Historically, the domestic banks have been schedule-1 banks and the foreign banks schedule-2. That distinction is now less firm, for example, one domestic bank (Laurentian Bank of Canada) is now a schedule-2 bank.
In 1987, the Federal Reserve Board had determined that securities activities by an affiliate of bank-holding companies do not violate Section 20 provided earnings from those activities are less than 5 percent of the affiliate’s total revenues.
Canada, France, Italy, Spain, and the United States.
Antigua, The Bahamas, Barbados, Bermuda, British Virgin Islands, Colombia, Costa Rica, Dominica, Grenada, Guatemala, Honduras, Mexico, Jamaica, Montserrat, Netherlands Antilles, Panama, St. Lucia, St. Vincent and the Grenadines, Trinidad and Tobago, Venezuela, and the United States and the U.S. Virgin Islands.