Chapter

V Prudential Safeguards for Bank Solvency12

Author(s):
G. Johnson, and Richard Abrams
Published Date:
March 1983
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The first line of defense for the stability of banking systems is that individual banks themselves act so as to reduce the risk of failure. Financial intermediation is inherently risky; therefore, banks must limit their risks to prudent levels.

Beyond such basic requirements as the development of techniques of credit evaluation and internal controls to limit the potential damage from incompetence or fraud, prudential standards for banks include diversification of assets and liabilities to ensure that the problems of one or a few customers of a bank cannot be critical. They also include limitations on the extent to which banks carry out maturity transformation. Perhaps most important, they include maintenance of bank capital at such a level that the bank can absorb substantial losses without becoming insolvent. In each case, there is a trade-off between prudence and profitability; the task of the banks and their supervisors is to strike a reasonable balance.

Prudential standards cannot be assessed in absolute terms, except insofar as certain risky transactions are absolutely prohibited. This section provides some broad qualitative indications of the adequacy of the standards currently in force to protect solvency in the face of problems in the international operations of banks.

Bank Capital

A fundamental safeguard of bank solvency is the capital available to meet losses. While no amount of capital can assure a bank’s solvency under all circumstances,13 the larger the capital, the larger the loss the bank can absorb. Aside from the risk of loss, however, increasing the amount of capital in relation to assets reduces bank profitability and the efficiency of financial intermediation.

In many banking systems, there was until recently a secular trend toward lower ratios of capital to assets. In the United States, for example, the average ratio for banks insured by the Federal Deposit Insurance Corporation declined from 8.12 per cent in 1964 to 5.99 per cent in 1977, while the average ratio for French banks declined from 3.94 per cent to 2.06 per cent during the same period.14 To some extent, such declines may have been a natural evolution, which does not necessarily imply any change in prudential standards. Large banks have greater scope for diversifying their assets and thus may bear less risk of catastrophic loss than small ones, so that the increase in the average size of bank balance sheets may, in a sense, have permitted lower ratios.15 The development of multinational banking itself is an example of such diversification, which leaves banks less exposed to problems in a single economy. To the extent that banks have tightened their safeguards in other areas, moreover, banks may have reduced the risks against which capital needs to be held. It has also sometimes been argued that, since the full resources of the state stand behind government-owned banks, such as most banks in France and community savings banks in the Federal Republic of Germany, explicit capital positions are incomplete measures of bank solvency for such banks. Nonetheless, the trend toward lower ratios has been less marked in recent years (Williams, Johnson, and others, 1982, p. 57).

While banks in many countries have increasingly come to recognize that their capital ratios should not be permitted to decline further, much of the pressure to maintain them has come from bank supervisors. In some countries, such as the Federal Republic of Germany and Switzerland, legal capital requirements ensured that ratios did not decline significantly in the first place; where subsidiaries abroad were not included in the requirements, however, there may have been some decline on a consolidated basis. In other countries, such as Canada and the United States, general exhortations by supervisors on capital positions have recently been replaced by explicit, albeit informal, guidelines aimed at preventing any future decline. At the same time, there has been a tendency to permit banks to have greater latitude in choosing instruments to increase their capital. Most notable, recognizing the difficulty of raising long-term capital in the depressed capital markets of recent years, some supervisors have started to permit banks to consider subordinated debt, generally with maturity in the 5–12 year range, as capital.

Two aspects of international banking that have had special implications for capital positions in recent years should be noted. One is the effect of exchange rate changes. Since banks normally maintain approximate balance between their foreign currency assets and liabilities, appreciation (relative to the home currency) of the currencies in which such items are denominated reduces capital asset ratios and increases the vulnerability of banks to losses on their foreign currency portfolio. The slowdown in the international lending of many European banks in the early 1980s partly reflected the strains on capital positions produced by the appreciation of their dollar-denominated assets. Some banks have moderated this effect by denominating some subordinated debt in foreign currency.

A second aspect of international banking that is important in relation to bank capital is the treatment of provisions for loan losses. Though practices vary from country to country, all countries grant some tax benefit for earmarking part of earnings for reserves, and some countries permit banks to create hidden reserves by writing down assets that in fact they are ultimately likely to recover.16 In many systems, however, provisions on loans to sovereign governments receive less favorable treatment, on the grounds that, unlike private debtors, sovereign debtors cannot go bankrupt; therefore, provisions for loan losses have been required only in the case of declared default or repudiation. Recently, there has been some shift in this position with respect to countries where large arrears have arisen and rescheduling negotiations have been protracted. Banks in the Federal Republic of Germany, for example, are making partial provisions (10–20 per cent) against their Polish assets, and U.S. banks have begun to take sovereign “problem loans” into account in calculating their need for provisions.

Control of Country Exposure

Diversification is a basic technique for reducing the risk involved in financial intermediation. Many countries place explicit limits, expressed in relation to capital, on the exposure of banks to individual borrowers. In some systems, bank supervisors have developed similar guidelines (usually not mandatory) to encompass total lending to borrowers in a given country. The European Community’s system of capital-asset observation ratios affects exposure indirectly by weighting loans differently according to the country of the borrower. In any case, banks normally establish internal limits, adjustable over time, on their country exposures.

Banks also carry out more or less sophisticated analyses of country risk, at least for their large exposures. Supervisors consider it their responsibility to see that banks’ methods of analysis are adequate and that they make use of the best information publicly available. Supervisors do not, in general, advise banks on particular country situations, considering that banks need to take full responsibility for their own credit decisions, though recently supervisors in a number of countries have shown an increasing willingness to discuss country situations on an informal basis with their banks.

In carrying out their analyses, banks face major information problems. Data on the global debt of individual countries to banks do not become available until several months after the reporting date, and even then such data are not fully comprehensive. Information on trends and policy developments in most countries is difficult to obtain, particularly in view of the scarcity of published data. While large banks that are active in a particular country may have some idea of the true situation, others do not. Often, in fact, banks start lending to a country when they see other banks doing so, which might be just the wrong time.

This discussion suggests three areas in which improvement could be sought: (1) availability to banks of more complete and timely data on aggregate bank lending to individual countries;17 (2) provision of better information on developments in individual countries; and (3) guidelines on bank exposure that apply to changes in exposures, not just to their levels. Improvements in the international coordination of bank supervision of country exposure are also needed; as with bank capital, the recent movement toward evaluation of exposures on a consolidated basis is a step forward.

In other areas of international risk, there is little current evidence of potential threats to bank solvency. Supervisors have tightened their surveillance of foreign exchange exposure, which is now managed much more tightly in most banks than it was before the 1974 bank failures. The interest rate risk resulting from the mis-match of maturities of assets and liabilities is generally limited by floating rate provisions on bank assets. In some systems, however, banks with substantial holdings of fixed-rate international assets suffered large losses on that part of their business during the recent prolonged rise in interest rates, and individual banks in other countries have from time to time taken substantial losses from speculation on near-term interest rate developments.

The experience gained by banks and their supervisors over the years has resulted in continuously evolving standards for prudential behavior, which by and large must be considered much stronger now than in the past. Each bank failure, each new type of problem, carries lessons that can lead to modifications of prudential standards. Any system is established under a certain set of assumptions about the economic environment in which it operates, and changes in that environment can produce unexpected problems that can threaten bank solvency. The recent behavior of interest rates is a prime example: banks with large holdings of long-term assets at low fixed interest rates have been threatened by the high cost of funds in recent years. Many U.S. savings and loan associations, for example, have been technically insolvent because of their holdings of long-term mortgages at low interest rates, while many German banks have also suffered losses because of their holdings of long-term bonds and loans at fixed rates. It could be argued that such institutions and their supervisors should have considered beforehand the possibility that interest rates would rise sharply, but no set of standards can protect banks under all circumstances—no degree of diversification, for example, could preserve a bank’s solvency in the face of the simultaneous bankruptcy of a large number of its customers.

International Coordination of Bank Supervision18

A major force for improvement in supervisory standards has been the exchange of information between bank supervisors within the Contact Group of the European Community and within the Basle Committee on Banking Regulations and Supervisory Practices (also called the Cooke Committee), which functions under the auspices of the BIS.

The main thrust of the work on international coordination of bank supervision has been to try to ensure that no bank escapes supervision, and then to work toward some uniformity in supervisory standards so as to reduce incentives for banks to shop around for “easy” locations. Within the industrial world, considerable progress has been made toward these goals, though it is recognized that differences in national banking systems mean that standards will never become entirely uniform. The Group of Ten countries and Switzerland are members of the Basle Committee, and several small industrial countries are effectively brought within its purview through their membership in the European Community. For banks operating in other countries, particularly the offshore centers, only the first steps have been taken toward international coordination.

A major step toward closing the gaps in bank supervision among industrial countries was taken by the Committee’s 1975 Concordat on international supervisory cooperation, in which it was agreed that for solvency controls there was

  • some sharing of responsibility for supervision between host and parent authorities, with the emphasis varying according to the type of establishment concerned. For foreign subsidiaries and joint ventures, primary responsibility rests with host authorities; but, in addition, parent authorities must take account of the exposure of their domestic banks’ foreign subsidiaries and joint ventures because of those parent banks’ moral commitments to those foreign establishments. For foreign branches, solvency is indistinguishable from that of the parent bank as a whole. It is therefore essentially a matter for parent supervisory authorities.19

The somewhat ambiguous phrasing of the Concordat with respect to “foreign subsidiaries and joint ventures” reflected the fact that the various national authorities were not entirely in agreement on the sharing of supervisory responsibility. Since the adoption of the Concordat, the Basle Committee has attempted to give it more precise operational definition. The most important step in this direction came in 1978, when the BIS governors endorsed the Committee’s proposal that the evaluation of the adequacy of bank capital by supervisors should be carried out on the basis of consolidation of the positions of subsidiaries, as well as of branches, with the position of the parent bank. While not diminishing the responsibility of the host authority in the case of foreign subsidiaries, this did increase the responsibility of the parental authority. Some countries whose banks are active internationally, such as the United States, have long evaluated solvency on a consolidated basis; most other countries have adopted the principle in the last few years. The major exceptions are the Federal Republic of Germany and France. Germany has not yet passed the necessary legislation, but has worked out a “gentlemen’s agreement” with its banks, under which they are reporting their capital position on a consolidated basis but are not yet formally obligated to meet prescribed standards. In France, consolidation is not considered to be as important, since a relatively small proportion of loans to final borrowers (though not to other banks) is booked outside of France.

So far, consolidation has in most cases been limited to broad balance sheet aggregates, such as bank capital. Since supervisors in most countries have only recently begun to pay detailed attention to the country exposures of their banks, consolidation in that area is applied in only a few countries. The Basle Committee has been examining the question and has endorsed consolidation of country exposure.

Supervision of bank solvency thus appears likely to be carried out increasingly on a consolidated basis. Some problems of implementation have arisen, however. The authorities in the United States, for example, feel that, even with consolidation, they still need to supervise closely the operations of foreign banks in the United States. This has led to a sort of “reverse” consolidation, in that they have requested parent banks to provide, on a continuing basis, certain information on their operations elsewhere. While this request was initially opposed by supervisory authorities in other countries (they have now acquiesced in a modified version), it does not in itself conflict with the 1975 Concordat, which is aimed at ensuring that some supervisor takes responsibility and not at avoiding multiple supervision. Another problem of implementation lies with the sharing of information among banks and their supervisors. Some national authorities limit the extent to which banks chartered in their countries can provide information to their parent bank and the parental supervisors—thus posing some obstacles to full consolidation. This issue has arisen, for example, between Luxembourg and the Federal Republic of Germany, but Luxembourg has now agreed that German bank subsidiaries can provide the information necessary for consolidation of bank capital positions. Luxembourg’s recent revision of its banking law, moreover, permits banks to give to their parent banks details of large loans. Luxembourg law does not permit inspection by foreign supervisors, though audit reports can be submitted to them through the parent bank. There are also problems in the allocation of supervisory responsibility for consortium banks or other banks where minority holdings are significant.

Differences in supervisory practices, in the interpretation of the 1975 Concordat, and in application of consolidated reporting mean that there is some variation in the strictness with which banks are supervised in industrial countries; but the gaps that remain in those countries are being closed and in any event do not appear dangerously large. The major problems for coordination of bank supervision lie with the offshore centers outside the industrial countries.

Some offshore centers are less strict in bank supervision than are the industrial countries. As most banks in these centers are branches or subsidiaries of banks headquartered in industrial countries, full consolidated supervision in headquarter countries should eventually do much to make up for any weaknesses in offshore supervision. In the meantime, gaps remain, and bank secrecy regulations in a number of centers mean that it will be some time before full information will be available to parent supervisors. Moreover, there is need for stricter supervision in the offshore centers of some banks headquartered in the offshore centers or elsewhere outside the industrial countries.

The Basle Committee has initiated contacts with offshore bank supervisors, who have now formed a coordination group that should eventually fill some of the remaining gaps. As banks of other countries, such as the rapidly growing Middle Eastern banks, become more important internationally, there will be a need for stronger supervision in those countries. The Basle Committee is sponsoring contacts with supervisors in the developing countries.

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