10.1.1 Code of Good Practices

The concept of transparency of monetary and financial policies refers to an environment in which the objectives of the policy; the policy’s legal, institutional, and economic framework; the policy decisions and their rationale; the data and information related to monetary and financial policies; and the terms of agencies’ accountability are provided to the public on an understandable, accessible, and timely basis. The Code of Good Practices on Transparency in Monetary and Financial Policies (MFP Code) identifies desirable transparency practices for central banks and financial agencies in their conduct of monetary and financial policies. The MFP Code was developed by the IMF in 1999.² This document is a distillation of concepts and practices that are already in use and for which there is a record of experience. Together with the Supporting Document to the Code of Good Practices on Transparency in Monetary and Financial Policies (Supporting Document; IMF 2000b), the various guidance notes, and the specific templates, the MFP Code serves as the reference material for assessing transparency practices in monetary and financial policies.

The transparency of monetary and financial policies contributes to policy effectiveness, facilitates policy consistency, and strengthens governance. The public’s awareness of the goals and instruments of policy, as well as the authorities’ credible commitment to meeting the goals, can contribute to good policy making and can improve the effectiveness of policies. Transparency in the mandate, as well as the rules and procedures in the operations of monetary and financial agencies, helps to ensure consistency in cases where conflicts might arise between or within government units. Good governance calls for central banks and financial agencies to be accountable, particularly where the monetary and financial authorities are granted a high degree of autonomy. In the case of monetary policy, transparency about policy process—achieved by providing the private sector with a clear description of the considerations that guide monetary policy decisions—helps ensure that market expectations can be formed more efficiently and, thereby, makes the monetary policy transmission mechanism generally more effective. Through good transparency practices, the central bank can establish a mechanism for strengthening its credibility by matching its actions to its public statements. Similarly, transparency of a regulatory agency’s mandate, operations, and regulatory processes is essential in establishing the credibility and effectiveness of financial sector oversight. Although credibility is achieved by meeting the stated objectives and responsibilities, transparency may also limit self-interest on the part of the regulators and may foster increased commitment of regulated firms to regulatory compliance, prudent behavior, proper risk management, and internal control.

The MFP Code lists 17 good practices on transparency of monetary policies by the central bank and 20 good practices on transparency of financial policies, all grouped into four categories. Many of the good practices are further divided into more detailed practices. The four groups of transparency practices and a summary description of each practice are presented in Annex 10.A. The four groups are (1) clarity of roles, responsibilities, and objectives of central banks and financial agencies; (2) the processes for the formulating and reporting of monetary policy decisions by the central bank and of financial policies by financial agencies; (3) public availability of information on monetary and financial policies; and (4) accountability and assurances of integrity by the central bank and financial agencies.

10.1.2 Assessment Methodology and Assessment Experience

The objectives of MFP transparency assessments are to review the effectiveness of current practices and to recommend desirable transparency practices. The assessments, therefore, are designed to

• Allow the authorities to evaluate the transparency of their monetary policy and their financial supervisory and regulatory frameworks.

• Identify and, where appropriate, recommend desirable transparency practices for central banks and financial agencies.

• Provide input into the overall assessment of the vulnerabilities of a country’s monetary and financial system.

• Help identify the developmental needs of a country pertaining specifically to transparency issues and to assist in making informed policy decisions about the reforms needed.

• Provide input on the extent to which transparency practices contribute to policy effectiveness and to monetary and financial stability.

The MFP Code is broad and takes into account the varied institutional and legal frameworks that are found in many countries across various stages of financial development. Consequently, the ways in which transparency is applied and achieved—in terms of timing and manner of disclosure as well as the content of reports—may differ, reflecting different institutional arrangements and legal traditions. Assessments should not be conducted in a mechanistic way because practical policy considerations may require that some disclosures not be made in certain contexts.

In particular, benefits of transparency practices have to be weighed against the potential costs, and it may be appropriate to limit the extent of transparency. For example, extensive disclosure requirements about internal policy discussion on money and exchange market operations might disrupt markets, constrain the free flow of discussion by policy makers, or prevent the adoption of contingency plans. Thus, there are circumstances in which it would not be appropriate for central banks to disclose their near-term monetary and exchange rate policy implementation tactics or to provide detailed information on foreign exchange operations. Similarly, there may be good reasons for the central bank (and financial agencies) not to make public specific contingency plans, including possible emergency lending. However, the broad principles and procedures governing the decisions on emergency lending could be established and made transparent while maintaining “constructive ambiguity” about their applicability in specific situations (see chapter 5, section 5.2.1). However, limiting transparency in selected areas needs to be seen in the context of a generally transparent environment. Also, the MFP Code is not designed to offer judgment on the appropriateness or desirability of specific monetary and financial policies or frameworks that countries should adopt.

The assessment of observance of the MFP Code should draw on a wide range of information and should focus on the degree and means of disclosure to the public, as well as on the effect of disclosure practices on a policy’s effectiveness. The sources of information needed for the assessment typically include relevant laws, regulations, and instructions, as well as other documentation (reports, studies, public statements, Web sites, unpublished guidelines, directives, and assessments); counterparty agencies and officials with whom assessment-related discussions are held; meetings with other domestic authorities; any relevant government or industry associations (such as bankers’ associations, auditors, and accountants); and key market participants and analysts who draw on the information disclosed. The methodology for the assessment consists of examining, for each practice in the MFP code, the various forms of disclosure used, frequency of disclosures, quality or content of disclosure, and modes of disclosure. In addition, a fifth dimension—clarity and comprehensibility of transparency—is also examined. The content, clarity, and accessibility of the information that is disclosed are what transforms “disclosure” into “transparency.” An assessment of those five dimensions is based on a broad qualitative judgment drawing on country practices and is not based on any specified list of assessment criteria.

Illustrative country practices are summarized in the Supporting Document,³ which also provides two- or three-part explanations of each transparency practice:

• “Explanation and rationale” elaborates on what is meant and why it is desirable.

• “Application” indicates where and how the practices are implemented, with some quantification and, where applicable, with some country examples.

• “Implementation considerations” deals with practical considerations—benefits and costs, intended audience, domestic versus international dimensions—where relevant. The supporting document also provides a list of references—academic studies as well as official documents—on transparency and accountability issues. The qualitative judgment of various dimensions of transparency can be informed by the supporting document, and this judgment is used to classify the degree of observance of each practice into five categories: observed, broadly observed, partly observed, non-observed, and not applicable. Detailed guidance on the procedures and practical considerations in conducting the assessments are available in the guidance note (IMF 2000) for assessing the code.

• A supplementary document providing case studies for 15 countries is under preparation.

So far, the IMF Executive Board has conducted two reviews of experiences with assessments of the MFP Code, drawing on MFP Code assessments for 57 countries.⁴ In general, the two reviews indicated a high level of observance of transparency practices among the countries reviewed. Observance was strongest with respect to the public availability of information on monetary and financial policies. Many central banks and financial agencies are making more effective use of various channels of communication to increase the public’s access to information. In banking supervision and payment system oversight, transparency was weak in practices relating to clarity of the roles, responsibilities, and objectives of the institutions.

Transparency practices with respect to the accountability and assurance of integrity of the central banks and financial agencies continue to be a challenge for many of the countries (see boxes 10.1 and 10.2). This finding also has been borne out in other Fund initiatives such as the Safeguards Assessments (IMF 2002) and in the assessments of Special Data Dissemination Standards (SDDS) (IMF 2003). Among all financial sectors, banking supervisory agencies had the most-developed transparency practices whereas insurance regulatory agencies had the least-developed transparency practices.

Standard-setting bodies have increasingly included transparency-related criteria in their individual standards and codes. The IAIS standards emphasize the need for transparency by the supervisory agency, and various transparency practices of the MFP Code are embedded in the IAIS Core Principles. The Core Principles for Systemically Important Payment Systems (see Chapter 11 for references and discussion) calls for effective oversight of such payment systems by the central bank and, consistent with the MFP code, calls for the central bank to define clearly its payment system objectives and to disclose publicly its role and major policies with respect to systemically important payment systems. The coverage of transparency issues in regulatory standards is, however, rather uneven, and there have been recent efforts to specify transparency practices of regulatory agencies in greater detail as a component of good regulatory governance of those agencies (components of good regulatory governance consist of independence, accountability, transparency, and integrity).

10.2.1 Role of the Accounting and Auditing Framework: Relevance to Development and Stability

Accounting and auditing standards of high quality provide the basis for reliable and transparent disclosure of information to relevant stakeholders. Disclosure is crucial for informed financial decisions, efficient resource allocation, and effective functioning of markets. Chapter 4 discusses the fact that they form the core of the information infra- structure needed for financial development. Accounting, auditing, and disclosure requirements of high quality for financial institutions are regarded as one of the key basic areas of financial reform necessary to prevent a financial crisis.⁵ By contributing to good corporate governance, high-quality accounting and auditing influence perceptions of risk, cost, and availability of capital, as well as foster financial stability through strengthened market discipline.

Standards such as these are not well implemented in many emerging market and transition economies, and many countries do not require the reporting of key financial data by individual institutions, including their consolidated financial exposure. This gap can hamper the ability to filter out healthy from unhealthy institutions. Moreover, the lack of appropriate information can prevent the effective monitoring of financial institutions and their risk taking.⁶ For example, insufficient or incorrect disclosures of credit risks may constrain the ability of investors to assess risks and the ability of supervisors to act in a timely manner (Mishkin 2001). Sound accounting and auditing standards and practices are also important prerequisites for financial liberalization because they form part of the proper institutional framework that places appropriate constraints on risk taking. Accounting and auditing are 2 of the 12 areas of standards that are recognized internationally as key to effective operation of domestic and international financial systems, as already outlined in chapter 1.

10.2.2 Scope and Content of International Accounting and Auditing Standards

International accounting and auditing standards have been developed respectively by the International Accounting Standards Board (IASB) and its predecessor the International Accounting Standards Committee (IASC),⁷ and by the International Federation of Accountants (IFAC).⁸ IFRSs encompass both the previously adopted—and, in some cases, amended—International Accounting Standards (IASs), as well as newly developed, IASB-issued IFRSs.

The original IASs were issued from 1973 to 2000 by the IASC, which was replaced by the IASB in 2001. The IASB has since amended or eliminated some IASs, has proposed to amend others, has proposed to replace some IASs with new IFRSs, and has adopted or proposed new IFRSs on topics for which there were no previous standards. Thus, standards are continuously changing and being upgraded to reflect the current conditions and needs of financial markets. Narrowly interpreted, IFRSs refer to the new numbered series of pronouncements that the IASB has issued, distinct from the IAS series issued by its predecessor IASC. More broadly, IFRSs refer to the entire body of IASB pronouncements, including standards and their interpretations, as well as to the IASs and their interpretation approved by the predecessor IASC. The standards issued by the IASC, many of which were revised by the IASB in 2004, will continue to be designated as IASs.

Currently, 36 effective IAS-IFRS standards, with 11 interpretations, are accompanied by documents providing the framework for the preparation and presentation of financial statements, as well as guidance on interpretation of standards. The framework defines the objectives of financial statements, identifies the qualitative characteristics that make information in the statements useful, and defines the basic elements of financial statements and the concepts in recognizing and measuring them (e.g., asset, liability, income). The framework addresses the general-purpose financial statements designed to meet the needs of shareholders, creditors, employees, government agencies, and the public at large for information about a public entity’s financial position, performance, and cash flows. Hence, it does not cover special-purpose reporting to tax and regulatory authorities. A complete set of financial statements includes a balance sheet, income statement, cash flow statement, statement of changes in equity, and notes composing the summary of accounting policies and other explanatory notes.⁹

Some of the IASs and IFRSs are particularly important in financial sector assessments. A number of the standards are more relevant for the financial institutions. For instance, IAS 32 and IAS 39 provide requirements on the recognition, measurement, and disclosure of financial instruments, and IAS 30 applies to the disclosures by banks and other similar institutions of their income statement, balance sheet, and contingencies and commitments, including other off-balance sheet items. IAS 1 is also particularly pertinent because it deals with the content of financial statements generally. Boxes 10.3, 10.4, 10.5, and 10.6, provide further details of the scope of IAS 39, IAS 32, IAS 30, and IAS 1, respectively. IAS 39, which seeks the measurement of specified assets at fair value, may have significant effect on the volatility of earnings, levels of provisioning, and various observed prudential ratios, and it has raised concerns among regulators. IAS 32 on financial instruments calls for a range of financial risk disclosures, thus seeking to improve transparency of financial risks, which may pose a challenge for some classes of financial institutions (particularly insurance companies) with traditionally weak risk disclosures. Those considerations highlight the significant challenges in aligning prudential standards with evolving accounting standards and the complexities involved in achieving convergence of national and international standards. Evolving issues in international convergence in major markets are summarized in box 10.7.

There are 33 ISAs, accompanied by a “Code of Ethics for Professional Accountants” and other related engagement standards.¹⁰ The auditing standards provide requirements on a range of issues, including quality control (ISA 220), documentation (ISA 230), responsibility to consider fraud and error (ISA 240), risk assessments of internal control (ISA 400), analytical procedures (ISA 520), and the auditors report on financial statements (ISA 700).

The IASB and the IFAC’s IAASB constantly revise and update the standards to reflect current trends and issues in financial reporting and auditing, which reflect globalization, capital flows, regionalization, technology changes, and so forth. Recent events in industrialized countries relating to corporate business failures and misstatements of financial information have also raised the attention to the role and oversight of the auditing profession, the governance of standard-setting bodies, and the scope of corporate governance as it relates to reporting and disclosure. The IASB has been issuing new standards (IFRSs), and revising current IASs, while IFAC and its numerous committees and have been actively revising ISAs. For example, it recently released proposed revisions to ISA 230 on audit documentation. The IFAC’s Public Sector Committee (PSC) focuses on the accounting, auditing, and financial reporting needs of national, regional, and local governments, as well as on related agencies, and it proposes benchmark guidelines. It has also undertaken a multiyear initiative that is focusing on developing International Public Sector Accounting Standards (IPSAS) for government budget reporting that is based on IASs. It has also published a guidance paper on anti-money-laundering.

One issue of particular relevance, especially to developing and emerging market economies, is the role of small and medium enterprises (SMEs) and the need to have simplified financial reporting requirements for those enterprises. The financial reporting needs of SMEs in both developing and industrial countries are gaining greater attention by regulators. In that regard, the IASB and the IFAC have committed themselves to identifying and addressing the needs of SMEs. The IASB undertook a research project in 2001 in response to the growing call in the field to support a separate set of accounting standards for SMEs. One issue that it encountered in the process, however, was how to accurately “define” SMEs. In June 2004, it published a discussion paper on the proposal to develop separate standards and to set up an advisory panel to monitor the discussion. Going forward, IASB is expected to publish a draft of the SME versions of all existing standards.

Another important issue that arises in many countries with significant presence of Institutions Offering Islamic Financial Services (IIFS) is that the accounting standards designed for conventional types of business are not applicable to these institutions. A number of IASs and IFRSs are not suitable for Islamic financial institutions, and moreover financial statements of IIFS contain items for which there are no applicable IAS/IFRS. To address this problem, Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI) was established in 1990, as a self regulatory body of IIFS (including also some government and regulatory bodies in the governance structure) to set accounting standards that complement IAS/IFRS and at the same time recognize the specific contractual features of Islamic finance. AAOIFI has issued a number of important accounting and auditing standards for Islamic finance instruments and institutions, as well as some governance and ethics standards relating to Sharia compliance; several countries and IIFS have begun to adopt or draw these standards. For a compilation of these standards see AAOIFI (2004). With growing financial innovations in the Islamic finance industry, and the increased focus on appropriate risk measurement and disclosure in Islamic finance, the financial reporting and governance standards are continuing to evolve, and gaining increasing acceptance among countries and IIFS.

10.2.3 ROSCs and Role of the Bank and the Fund

As part of the FSAP-ROSC initiative,¹¹ the World Bank has developed a program to assist member countries in strengthening their financial reporting regimes through the implementation of IFRS and ISA. The program’s objectives are twofold: (a) an assessment and (b) the development of a country plan. Its assessment activities cover the following:

• Determine the comparability of national accounting and auditing standards with IFRS and ISA, respectively.

• Determine the extent of compliance with established accounting and auditing standards, rules, and regulations, as well as the effectiveness of enforcement mechanisms.

• Identify strengths and weaknesses of the institutional framework in supporting high-quality financial reporting.

The basic premises on which a ROSC accounting and auditing (A&A) diagnostic exercise is carried out are as follows:

• IFRS and ISA are endorsed by the Bank, the Fund, and other international institutions as the primary benchmarks for corporate financial reporting standards. IFRS and ISA should be mandated for all “public interest entities,” which are defined by the nature of their business, their size, their number of employees, or their corporate status with a wide range of stakeholders. Examples of public interest entities may include banks and financial institutions, insurance companies, investment funds, pension funds, listed companies, and other economically significant business entities.

• SMEs should be subject to a simplified financial reporting regime given their lesser degree of responsibility with respect to the public. This simplified regime for SMEs typically includes less-stringent accounting and reporting requirements.

• If one considers the distinctive responsibility of independent auditors with respect to a wide array of stakeholders, independent auditors should be subject to adequate public oversight.

• Access to the auditing profession should be limited to individuals who have demonstrated academic and professional abilities through a certification process that complies with IFAC International Educational Standards for Professional Accountants.

The assessment of A&A standards is designed (a) to focus on complying with national standards and on fostering a country-led program to make national standards comparable with international standards within a feasible time frame and (b) to develop a sufficient infrastructure to effectively adopt IFRS and ISA. The focus on assisting member countries for improving their institutional capacity to support implementation of high-quality A&A standards is consistent with the Bank’s operational activities.

The assessment process places emphasis on country involvement and on efforts to design a country-led program. The program attempts to improve A&A performance, to involve all key stakeholders, and to be linked to progress in related critical areas such as corporate governance and financial sector reform. Detailed A&A ROSCs are done on a stand-alone basis or, occasionally, as part of the FSAP. When detailed A&A assessments are not available, the focus of financial sector assessments is directed to a comparison of national standards with IAS 30, 32, 39; the legal and institutional framework for A&A; the quality of A&A of financial institutions; and a review of disclosure practices applying to financial institutions (see section 10.5).

10.2.4 Focus of A&A Assessments

Assessments of A&A standards address financial reporting by public interest entities, which are defined as such because of their business, size, and number of employees or because their corporate status is such that they have a wide range of stakeholders. Public interest entities include credit institutions, insurance companies, investment firms, pension funds, and listed companies. The assessments cover the following four areas:

• Institutional Framework—The ROSC A&A focuses on the current state of the institutional framework and, accordingly, provides policy recommendations for strengthening it. The goal is to enable the framework to promote high-quality A&A practices. The framework assessment includes (a) the laws and regulations¹² (quality of the design of the framework), (b) the history and current state of the A&A profession, (c) the strengths and weaknesses of accounting education and training, (d) the A&A standard-setting process, and (e) the arrangements for ensuring compliance with A&A requirements (enforcement mechanisms).

• Comparability of National and International Standards—One key benefit of conformity of any country’s A&A standards to IFRS and ISA is the promotion of sound financial reporting that facilitates cross-border usage. Generally, the standards and regulations of different countries have reached various levels of conformity. The methodology for this examination, which helps to identify gaps, is based on IFRS and ISA.

• Compliance with National Standards—Enforcement of the standards is a key underpinning of a sound financial reporting environment. Efficient and effective enforcement is also important because corporate stakeholders depend on access to high-quality financial information.

• Action Plan—To strengthen the corporate financial reporting regime, the ROSC’s A&A module identifies areas for improvement. Those findings serve as the basis for working with policy makers and other stakeholders to develop an action plan to improve A&A practices.

10.2.5 ROSC A&A Methodology

The World Bank has developed a diagnostic tool to gather and analyze pertinent information for preparing A&A ROSCs. This tool consists of a set of questionnaires under each of the following four components: (a) A&A environment, (b) national accounting standards in relation to IASs, (c) actual accounting practices in relation to national standards, and (d) auditing standards and practices. The process adopts a highly participatory approach, with strong involvement of policy makers and other country stakeholders, and culminates in the creation of a country action plan. The information gathered from the diagnostic tool is supplemented with a due diligence exercise to capture primary experiences of practitioners and other facts on professional accounting and auditing practices in the country. The details of the assessment process, the diagnostic tools and questionnaires, and the ROSC preparation procedure are further discussed in Annex 10.B.

10.2.6 Assessment Experience

By the end of December 2004, 38 A&A ROSCs had been completed, 28 of which have been published, and this process has contributed to progress in implementation. A regional breakdown shows that 15 were completed in the Central and Eastern Europe region, 7 in the Middle East, 7 in Latin America and the Caribbean, 5 in Africa, 2 in East Asia, and 2 in South Asia. The majority (29) of the assessments were conducted in middle-income countries whereas only 7 were done in low-income countries and 2 in high-income countries. It is anticipated that the A&A assessments will be conducted in an increasing number of low-income countries. The program has provided a body of experience that has informed the work of standard-setting bodies and that has facilitated reforms in several countries.

The experience gained in implementing the A&A ROSC program thus far suggests a few key issues and lessons to consider in moving forward:

• Adoption of IFRS and ISA as applicable standards is crucial in all countries, particularly when business entities contribute materially to the economy, the public interest, or both. However, if efficient and effective monitoring and enforcement mechanisms are lacking—which creates an environment of noncompliance—then adoption of the standards is not sufficient. This situation is most often the case in developing countries and emerging markets. Similarly, wholesale adoption of the standards without simultaneously developing the necessary legal and institutional infrastructure and without improving professional skills in auditing and accounting may be an inappropriate solution.

• In many developing and emerging market countries, observance of A&A standards is constrained by (a) the lack of access to the standards and related publications by students and professionals; (b) the non-availability of standardized implementation guidelines and practice manuals in a country context; (c) the lack of proper training on the practical application of both standards and the code of ethics for professional accountants and auditors; and (d) a rudimentary academic environment that is illustrated by deficient curriculum, lack of appropriate academic literature, and a shortage of well-trained instructors.

• A greater participation of developing countries in the process of developing and revising the standards is critical to facilitate the design and implementation of standards that reflect the realities in developing countries.

• Reaching an international consensus on a common framework of principles for the regulation and supervision of the A&A profession is important.

10.3.1 Introduction to Credit-Reporting Systems

Credit or consumer reporting firms and other types of public credit information registries provide rapid access to accurate and reliable standardized information on credit history and financial condition of potential borrowers, be they individuals or firms, and help to support a well-functioning credit market. Credit reporting addresses a fundamental problem of credit markets: asymmetric information between borrowers and lenders, which leads to adverse selection and moral hazard. Credit information sharing allows lenders to more accurately evaluate risk and to avoid adverse selection. Similarly, credit-reporting mechanisms strengthen incentives for borrowers to repay and thus reduce moral hazard because late or nonpayment with one institution can result in sanctions from many others. Credit reporting expands access to finance, especially for lower income consumers, micro-enterprises, or small businesses. Credit reporting can also play a key role in improving the efficiency of financial institutions by reducing loan processing costs, as well as the time required to process loan applications.

Some empirical work has been done to provide evidence of the importance of credit registries in credit markets. For example, Jappelli and Pagano (2001) analyze the effect of credit registries—both private and public—and find a positive effect on the volume of bank lending (as a percentage of GDP) and a decrease in credit risk. Barron and Staten (2003) show that greater availability of information reduces default rates and improves access to credit. Kallberg and Udell (2003) demonstrate that data from Dun and Bradstreet Corporation, a private credit information firm, have greater predictive power in calculating probability of default than a firm’s financial statements. Galindo and Miller (2001) argue that firms in countries with better credit information are less credit constrained because they rely less on internal funds. Overall, theoretical and empirical analyses show that banks’ sharing of information on borrowers helps to curtail the effects of adverse selection and moral hazard, reduces credit risk, improves access to credit markets, and strengthens the stability of the banking system.

10.3.2 Elements of a Robust Credit-Reporting System

Good practices of a robust credit-reporting system are presented in this section to provide broad guidance on issues to consider in establishing a new credit-reporting system and in identifying areas for the improvement in, or the assessing of, an existing credit-reporting system. This section describes several fundamental elements with respect to the structure of a sound credit-reporting system. It is not a comprehensive and complete illustration but a general guideline. The appropriate design of the system in any particular economy may largely vary by its size, the level of penetration of financial services, the degree of competition, and the legal framework. The implementation of Basel II may also affect the design and operation of the systems (see section 10.3.3).

10.3.2.2 Credit-Reporting Institutional Arrangements

Institutional forms for credit-reporting arrangements around the world include both public credit registries administered by central banks and private credit-reporting firms of varied ownership structure. A survey conducted by the World Bank between 1999 and 2001 covers both private firms that specialize in credit data from banks and other financial intermediaries as well as firms that specialize in trade credit, which is typically the most important source of external finance for small businesses. The survey reveals that public and private credit registers are present in a large number of developed and emerging market economies throughout the world (see Miller 2003). Forty-one countries have public credit registers, 44 countries have private credit bureaus, and many have both types. Table 10.1 summarizes the pros and cons of different types of private credit registries and public registries.

Table 10.1.

Institutional Arrangements for Private Credit Registries

Source: Miller (2003).

Table 10.1.

Institutional Arrangements for Private Credit Registries

Institutional Type	Pros	Cons
Private firm with no bank ownership	All types of data Independence	No automatic access to data
Private firm with bank ownership	All types of data Special access to specific bank data	Independence may be questioned
Bank association	Access to bank data Integrity	Only bank data and bank access
Chamber of Commerce	Retail and nonbank data Broad cover Historical record	No bank data Limited funds for modernization
Commercial and credit insurance firms	In-depth data on commercial sector	Limited coverage High cost per entry
Industry-specific databases	In-depth data on single sector	Limited scope—cannot cross-check data
Public ownership such as a central bank	Automatic access to credit data	Only bank data

Source: Miller (2003).

View Table

Table 10.1.

Institutional Arrangements for Private Credit Registries

Institutional Type	Pros	Cons
Private firm with no bank ownership	All types of data Independence	No automatic access to data
Private firm with bank ownership	All types of data Special access to specific bank data	Independence may be questioned
Bank association	Access to bank data Integrity	Only bank data and bank access
Chamber of Commerce	Retail and nonbank data Broad cover Historical record	No bank data Limited funds for modernization
Commercial and credit insurance firms	In-depth data on commercial sector	Limited coverage High cost per entry
Industry-specific databases	In-depth data on single sector	Limited scope—cannot cross-check data
Public ownership such as a central bank	Automatic access to credit data	Only bank data

Source: Miller (2003).

10.3.3 Credit Registries, Efforts to Strengthen Credit Risk Measurement, and New Basel Capital Accord (Basel II)

Credit registries possess enormous potential as a key tool in the hands of supervisory authorities that would enable those authorities to face the challenges of implementation of Basel II.¹³ Moreover, effective use of the information contained in credit registries, whether public or private, will enable credit institutions to improve the identification and control of their banking risks, thereby helping to pave the way for more advanced risk and capital measurement approaches envisaged in Basel II.

As already explained, credit registries facilitate the sharing of information among lenders and with supervisors—subject to adequate safeguards—on credit history loan characteristics and specified characteristics of borrowers (households and firms separately), which enables each bank to assess the quality of its credit assets and enables the supervisors to monitor credit risk in the entire system. The access to credit information by banks helps to impose discipline on borrowers and fosters greater transparency, as well as more competition.

Information from credit registries can be used to support both onsite and offsite supervision, as well as to facilitate macroprudential surveillance. Because supervisors have access to the entire population of loans granted by each credit institution, they can use this information to construct a range of financial soundness indicators for individual banks, peer groups, and the system as a whole. The information can be used to select samples for more detailed examination in onsite inspection. Also, comparison of the information reported by different credit institutions can help those conducting offsite surveillance to detect the potential of any one bank’s systematic overvaluation of credit worthiness of its borrowers or a deterioration in the credit quality of a bank’s loan portfolio relative to the rest of the system. The information from credit registries can help when analyzing the dynamics of aggregate credit risk—and bank-specific risks—and its macroeconomic and institutional determinants. Finally, information in credit registries—together with other information outside the registries—can help when estimating (or validating bank estimates for) probability of default of different borrowers, when providing input into estimating loss given default (LGD), and when verifying the bank’s estimate of exposure at default.

Credit registries can be a useful tool to validate the bank’s own internal ratings and internal assumptions about credit risk modeling. The statistical techniques to verify borrower rating systems are well developed, and it is relatively easy to discriminate among the relative positions of obligors. However, the validation of probabilities of default associated with each rating is more difficult because data are scarce, particularly on defaulted obligors and on the correlation among defaults, which is hard to quantify. In this context, a rating system for borrowers—developed by supervisors and based on data on the entire population of all credit institutions—could provide a yardstick with which to compare and validate ratings and probabilities used by individual institutions. This approach would require credit registries to be managed by supervisors and to contain a certain minimum quantity of information so an overall rating system could be developed.

The estimation of LGD is typically based on market prices of defaulted loans and bonds or on a credit institution’s own data on discounted cash flows—revenues and expenses—following default so best estimates of loan losses can be obtained (using both internal and external data). Little progress has been made on the techniques to validate LGD. Information from credit registries can be used to estimate the key determinants of LGD (by means of a regression model), and the possibility of using credit registries to document loan losses offers a realistic option to develop estimation and validation procedures for LGD. Similar observations apply to exposure at Default (EAD). In addition, the transition matrix for the entire credit system, as well as the sectoral and geographic differences in credit quality, can all be monitored using the credit registries. Finally, the broad recognition of credit risk mitigation techniques in Basel II calls for the credit registries to carry precise information on loan characteristics so they can be used to estimate the value of guarantees, collateral, and other risk mitigants accurately.

If they are to harness the potential of credit registries, their information structure should have adequate information to estimate the value of Probability of Default (PD), EAD, LGD, maturity, risk mitigation factors, and loan loss provisions so various parameters of credit risk models can be estimated by banks and validated by supervisors. For this purpose, required minimum information that should be included in the data structure of credit registries should be evaluated so credit registries can contribute to effective implementation of Basel II.

10.3.4 Role of Credit Rating Agencies in Financial Stability and Development

Credit Rating Agencies—or External Credit Assessment Institutions, as referred to in the New Basel Capital Accord—provide independent, forward-looking “opinions” to investors on the credit worthiness—or ability and willingness to service debt in full and in time—of an obligor (debt issuer) with respect to a specific financial obligation, or a class of financial obligations, or a specific financial program such as a commercial paper issuance. Those opinions are expressed in the form of (a) a credit rating for various financial instruments and transactions such as corporate bonds (both financial and non-financial institutions); (b) obligations issued by sovereign (central governments) and sub-sovereign (state and local governments) borrowers, other public institutions, and supra-nationals (multilateral and regional institutions); and (c) structured finance transactions (e.g., asset-backed securities, project finance transactions, collateralized debt obligations).

The ratings are based on current information obtained from the obligors and other sources that the rating agencies consider reliable. Judging credit quality involves analyzing a broad scope of relevant risk factors, often subjective, which are unique to particular industries, issuers, and countries. For a discussion of what methodologies are used in assessing country credit ratings, what the sources of possible biases are in those assessments, and how the rating methodology has evolved in recent years, see Bhatia (2002). Credit ratings may be of long-term or short-term duration, depending on the maturity of the instrument. Rating agencies differentiate the ability to service foreign and local currency debt in their analysis and issue separate ratings by currency. They may be subject to downgrade or upgrade should a rating agency consider that material changes in the financial condition of an issuing entity warrant a rating review.¹⁴

10.4.1 Rationale for Good Corporate Governance?

A good corporate governance regime is central to the efficient use of capital. First, it promotes market confidence; helps to attract additional long-term capital, both domestic and foreign; and fosters market discipline through good disclosure and transparency. Second, good corporate governance helps to ensure that corporations take into account the interests not only of a wide range of constituencies but also of the communities within which they operate and that their boards are accountable to the company and the shareholders. Those actions, in turn, help to ensure that corporations operate for the benefit of society as a whole.

The experiences of economic transition and the financial crises in many developing and emerging market economies have confirmed that good corporate governance practices can strongly contribute to financial market development and financial stability. Good corporate governance helps to bridge the gap between the interest of those who run a company and the shareholders who own it, thereby increasing investor confidence and making it easier for companies to raise equity capital and to finance investment. Good corporate governance also helps ensure that a company honors its legal commitments and forms value-creating relations with stakeholders, including employees and creditors (OECD 2003).

Empirical evidence¹⁷ suggests that good corporate governance will do the following:

• Increase the efficiency of capital allocation within and across firms.

• Reduce the cost of capital for issuers.

• Help broaden access to capital.

• Reduce vulnerability to crises.

• Foster savings.

• Render corruption more difficult.

10.4.2 OECD Principles of Corporate Governance

In response to a call by the OECD council meeting at the ministerial level on April 27-28, 1998, to develop a set of corporate governance standards and guidelines, the OECD issued in 1999 the OECD Principles of Corporate Governance after extensive consultations. Since then, the principles have formed the basis for corporate governance initiatives in both OECD and non-OECD countries alike. Hence, they represent the minimum standard that countries with different traditions could agree on, without being unduly prescriptive. In particular, they are equally applicable to countries with a civil and common-law tradition, different levels of ownership concentration, and models of board representation. Moreover, they have been adopted as one of the 12 key standards for sound financial systems by the Financial Stability Forum. They have been endorsed by the Bank and the Fund executive boards, and they form the basis of the corporate governance component of the World Bank-IMF ROSCs.

The OECD principles were reviewed and revised by the OECD Steering Group on Corporate Governance under a mandate from OECD ministers in 2002. This review and the subsequent revisions were supported by a comprehensive survey of corporate governance practices and by information on practices outside the OECD area derived from regional corporate governance round tables. The revised OECD principles were issued in April 2004.

The OECD principles have been devised with four fundamental concepts in mind: responsibility, accountability, fairness, and transparency. The OECD principles allow for diversity of rules and regulations and are primarily concerned with listed companies. A set of 32 principles is organized into six sections that ensure the following: (a) the basis for an effective corporate governance framework, (b) the rights of shareholders, (c) the equitable treatment of shareholders, (d) the role of stakeholders in corporate governance, (e) the disclosure and transparency, and (f) the responsibilities of the board. The scope of the OECD principles is summarized in box 10.8.

The recent revisions to the principles covered four main areas: (a) a new set of principles on the development of regulatory framework to underpin corporate governance framework and mechanisms for implementation and enforcements; (b) additional principles to strengthen the exercise of informed ownership by shareholders, particularly those calling on institutional investors to disclose their corporate governance policies and those strengthening the rights of shareholders to choose Board members; (c) strengthened principles to reinforce Board oversight and enhance Board members’ independent judgment; and (d) new and strengthened principles to contain conflicts of interest through enhanced disclosure and transparency (e.g., on related party transactions), thus making auditors more accountable to shareholders and promoting auditors’ independence.

The principles have been framed to keep in mind primarily non-financial firms, but the core principles apply equally well to financial firms. However, additional safeguards and controls apply to financial institutions’ governance as reflected in various financial supervisory standards. The key issues in financial sector governance are highlighted in Annex 10.C.

10.4.3 World Bank ROSC Corporate Governance Assessments

As part of the ROSC initiative, the World Bank has established a program to assist its member countries in strengthening their corporate governance frameworks. The objectives of this program are to accomplish the following:

• Benchmark the country’s corporate governance framework and company practices against the OECD Principles for Corporate Governance.

• Assist the country in developing and implementing a country action plan for improving institutional capacity with a view to strengthening the country’s corporate governance framework.

• Raise awareness of good corporate governance practices among the country’s public and private sector stakeholders.

Participation in corporate governance ROSC assessments is voluntary, and the World Bank conducts the assessments at the invitation of country authorities, sometimes in the context of an FSAP assessment. The World Bank has developed a template to gather pertinent information for preparing the Corporate Governance ROSC as a diagnostic instrument. The template gathers both quantitative and qualitative information on ownership and control structure of listed companies, capital market structure, legal and institutional factors affecting corporate governance, rights and obligations of listed companies, intermediaries and investors in a given country, relevant disclosure practices, and functions and responsibilities of governing bodies of the corporation. Although the assessments are relevant to all countries, they are particularly pertinent in middle-income countries seeking to build strong capital markets. They are also a useful instrument for transition economies, where mass privatization has created a large pool of listed companies with thousands of shareholders, and for low-income countries seeking to attract international portfolio investors.

The assessments are also a tool for communication between policy makers and domestic and international investors to reach a common understanding in an environment where countries are grappling with the establishment of a market for corporate control and are competing to attract capital. Assessments do not advocate a single model of corporate governance but do promote choice for issuers and investors.

The assessment team works closely with stakeholders and makes recommendations that can lead to a country action plan. The World Bank publishes the ROSC report on its Web site with permission of the country authorities.¹⁸ The published reports are accessible at http://www.worldbank.org/ifa/rosc_cg.html. The procedures and format of the corporate governance assessments are further explained in box 10.9.

The format of the assessments allows for systematic benchmarking across countries and regions. It is divided into five parts: (a) an executive summary, (b) a report on key corporate governance issues and major recommendations, preceeded by a capital markets profile, (c) a table of assessment ratings by principle, (d) a principle-by-principle review, and (e) a set of specific technical recommendations.

Each OECD principle is evaluated on the basis of quantitative and qualitative standards. “Observed” means that all essential criteria are met. “Largely observed” means that only minor shortcomings are observed—deficiencies that do not raise any questions about the authorities’ ability and intent to achieve full observance within a reasonable period of time. “Partially observed” means that, although the legal and regulatory framework may be fully compliant with the OECD principle, practices and enforcement diverge. “Materially not observed” means that, despite progress, the shortcomings are sufficient to raise doubts about the authorities’ ability to achieve observance. “Not observed” means that no substantive progress toward observance has been achieved.

The assessments are complementary to private sector rating activities in this field. The World Bank assessments focus on country analysis, whereas some rating agencies have started to focus on corporate governance of companies. Standard & Poor’s and Moody’s have begun rating companies in emerging markets. Other similar exercises are carried out by specialized firms such as Pensions Investment Research Consultants in the United Kingdom or Deminor in Belgium and France. New rating companies for corporate governance have emerged in Russia and South Korea.

10.4.4 Key Findings from Country Assessments

The work of Fremont and Capaul (2002) reviews the lessons of corporate governance assessments and its findings are discussed in this section. None of the assessed countries comply with the OECD principles in all respects. Yet all countries surveyed have undertaken or are currently undertaking reforms to bring their legal and regulatory frameworks in compliance with the OECD principles. In most countries surveyed, there is a growing interest toward improving corporate governance practices. A large number of countries, including Brazil, Croatia, the Philippines, and Romania have developed their own corporate governance codes of best practice. The World Bank corporate governance assessments also have been a catalyst to trigger interest and reform.

Some of the key policy issues that have arisen in corporate governance assessments include the following:

• A Code of Corporate Governance should be developed at the country level to provide more detailed guidelines to complement existing laws and regulations, and foster good practices.

• Director-training facilities should be promoted.

• Further legal reforms are needed to ensure additional rights to shareholders, particularly protection of minority shareholders, and to promote more comprehensive governance policy, including effective exercise of voting rights by institutional investors acting in fiduciary capacity.

• Institutional framework for corporate governance requires further strengthening to avoid duplication and overlap (and to promote better coordination) among multiple regulators with oversight responsibilities for listed companies (e.g., overlap and coordination issues could arise among agencies overseeing company law enforcement, securities regulatory agencies, and other law enforcement and regulatory agencies).

• Enforcement of corporate Governance Laws needs to be strengthened in several areas, including listing rules, content of disclosure, shareholders’ rights and equitable treatment of shareholders.

In most countries surveyed, business transactions have traditionally taken place on the basis of personal relationships and trust, and little attention has been paid to publicly available information. Corporate governance reform is a way to extend this trust to all market participants by enforcing shareholders’ rights, as well as other rules and practices underlying good corporate governance. The OECD principles assume that countries have an efficient legal and regulatory framework in place and that securities regulators have the means and capabilities to enforce the rules and regulations of their capital markets. However, experience from the countries surveyed demonstrates that this assumption is often not the case. Typically, courts are underfinanced, unmotivated, unclear as to how the law applies, unfamiliar with economic issues, or even corrupt. Moreover, securities regulators have little direct power to enforce penalties. Enforcement of prevailing rules and regulations is mostly the responsibility of the courts, which consequently leads to poor enforcement of the rules and regulations underlying corporate governance. In countries with weak judicial enforcement, concentrated enforcement through the market regulators may be preferable to enforcement through the courts.

The legal framework and corporate governance arrangements should recognize various forms of organizing companies when incorporating and policy makers should offer issuers different corporate governance options (in terms of disclosure and governance standards). This “menu of options” approach to corporate governance standards would facilitate reforms and enhance the relevance of the OECD principles for developing countries and transition economies. This approach provides a means for issuers and investors to choose the markets and the companies that are most appropriate to their specific risk profile. At the same time, standardization of options is desirable to lower transaction costs for issuers and investors alike.

10.5.1 Current Practices and Evolving Standards

Public disclosure practices of banks are typically governed by banking laws in some countries and by the listing requirements for publicly traded companies under the countries’ securities regulations and the applicable company laws. This type of disclosure of financial information on banks and other financial institutions helps to enforce prudential standards and to protect investors and creditors by promoting market discipline. Market discipline is an effective tool to limit excessive risk taking by banks, particularly in countries with a generous government safety net.¹⁹ Market discipline becomes even more fundamental because supervisory approaches are increasingly shifting from hard prudential limits toward a more risk-based supervisory review. In this framework, banks establish their own policies with respect to risk tolerance and risk management while supervisors validate those policies and procedures, supported by harnessing market forces to foster sound risk management policies. In support of enhanced market discipline, additional disclosure requirements are being introduced as one of the pillars (Pillar III) in the New Capital Accord (Basel II).²⁰

The New Basel Capital Accord (Basel II) provides a new international standard on disclosure practices for banks, although elements of it are already covered in the IFRS, in the national listing requirements, and to some extent in Basel Core Principles (e.g., Core Principle 21). The Basel Core Principles, however, do not explicitly require disclosure of banks’ financial information.²¹ Nevertheless, disclosure practices consistent with the spirit of the principle should be taken into account in BCP assessment. For example, the New Zealand financial supervisory framework relies to a large extent on market discipline, with only a limited recourse to prudential limits and onsite inspections. Therefore, the effectiveness of mandatory disclosure requirements was considered and taken into account in the assessment of several core principles.²²

The Basel Committee has issued several papers with guidelines for supervisors to enhance disclosure and has described best practices in disclosure of specific banks’ activities such as lending and derivatives.²³ In addition, the BIS survey of disclosure practices by banks contains a detailed list of disclosures and provides a benchmark for comparing the practices of domestic banks in the different categories (e.g., disclosure of capital elements, asset quality, derivative activities). The benchmark provided is the level of disclosure in those areas by international banks.²⁴ Given that the survey looks only at the type of items that are disclosed, conclusions with respect to the comprehensiveness of domestic banks’ practices—as compared with those of international banks—should be qualified to take into account the adequacy of the underlying accounting practices.²⁵

Countries adopting risk-based supervision frameworks should considerably enhance the disclosure of banks’ risk exposures and risk management techniques in line with the new accord requirements. A detailed example of a rather comprehensive disclosure requirement on banks’ risk exposures is the requirements imposed on bank holding companies by the U.S. Securities and Exchange Commission (SEC).²⁶ The recommended disclosure templates of Pillar III (see section 10.5.2) are more detailed in several areas and more focused on specific types of risks, and they complement the SEC requirements. In addition, supervision could become more effective if national authorities disclose aggregate information on the level and trends in risk exposures of the system.²⁷

10.5.2 Pillar III and Market Discipline

Pillar III (market discipline) of the New Basel Capital Accord is intended to complement the minimum capital requirements laid out in Pillar I and the supervisory review (of capital) process laid out in Pillar II of the New Basel Capital Accord.²⁸ This development is an important one because it recognizes the role of market discipline in supplementing the efforts of supervisors in monitoring the safety and soundness of banks. It also places the responsibility for promoting transparency, hitherto largely in the ambit of accounting and corporate governance standards, into the formal framework of banking supervision.

Disclosure under Pillar III, however, is limited in scope to those items that have a direct bearing on the computation of capital adequacy of the institution. Thus, under Pillar III, a bank would have to disclose information material using the approach that it has adopted under Pillar I. However, this limitation in scope does not limit the amount of information that is required to be disclosed, and the suggested disclosures are still substantial and comprehensive, as discussed below.

To facilitate disclosure, Pillar III provides 13 templates. They cover the following: (a) scope of application, (b) capital structure, (c) capital adequacy, (d) credit risk (general), (e) credit risk (standardized approach), (f) credit risk (IRB approach), (g) equity (banking book) positions, (h) credit risk mitigation, (i) securitization, (j) market risk (standardized approach), (k) market risk (internal models approach), (1) operational risk, and (m) interest rate risk in the banking book. Each template, in turn, breaks up the disclosure requirements into (a) quantitative and (b) qualitative disclosure. For example, under credit risk (standardized approach), banks are required to disclose not only the percentage of a bank’s outstandings in each risk bucket that is covered by each agency’s ratings but also the names of the rating agency and the agency’s role.

Pillar III disclosure is to apply only to the top consolidated level of the banking group to which Pillar I applies. Hence, individual banks within the banking group need not separately meet those requirements. However, the Total and Tier I capital ratios of individual banks within the group are to be disclosed separately by the Pillar III entity in the template on capital adequacy.

The disclosure has to be detailed at the portfolio level, where applicable. Thus, for example, if the bank implements a foundation internal ratings-based approach, then in the template for credit risk, it should disclose for each of the five portfolios a broad overview of the model approach with a description of the definitions of the variables and with methods for estimating and validating the variables as part of the quantitative disclosure. For the quantitative disclosure, it should disclose for each of the portfolios exposures across different probability of default (PD) grades and should supplement this information with (a) historical data on actual loss experience in the preceding period for each portfolio, (b) analysis of how these data differ from past experience, and (c) a discussion of the factors that affected the loss experience.

The purpose of such detailed disclosure is to enable concerned market participants to make their own assessments of the risk exposures and risk assessment processes and, hence, to develop a truer picture of the capital adequacy of the institution. The structured presentation will allow for a consistent framework across institutions, which will enhance comparability. This development is particularly important because, under some approaches in Basel II, banks would be using internal methodologies and data sources for computing capital instead of supervisor-defined risk weights, as in the past.

The frequency of the Pillar III disclosures is intended to be generally semiannual, though an underlying expectation is that all material information should be published as soon as practicable. Further, there is also an expectation that all large internationally active banks and the significant banks would disclose information on their Tier I and total capital adequacy ratios and their components on a quarterly basis. Similarly, all information on risk exposure that is prone to rapid change should also be disclosed quarterly. However, qualitative disclosures of a general nature, which are not subject to this frequency of change (e.g., those that deal with risk management objectives and policies), need to be reported only on an annual basis.

The incentive, location, and manner of disclosure are left to the jurisdictions. An important consideration in the design of the disclosure has been that the framework does not conflict with the requirements under the accounting standards, which are much broader in scope. Hence, the medium and location of the disclosure could vary and would also depend on the method used by supervisors to effect the disclosure. Thus, the disclosure could be affected by making it mandatory under the accounting regime or the listing requirements. In other cases, it could be built into a supervisory regulation or reporting requirements. In some cases, it may be influenced by pure moral suasion or may be voluntarily adopted to maintain competitive equality. Further, in some cases (e.g., credit risk mitigation techniques and credit derivatives, asset securitization, and internal ratings), the incentive for disclosure is provided by virtue of its being a qualifying criterion for the recognition or use of those techniques under the New Basel Capital Accord.

There is a presumption of validation built into the disclosure, especially where the disclosure forms part of the accounting requirements, which are generally audited because they should be consistent with the audited statements. In case the disclosures are part of the supervisory reporting requirements that are subsequently made public, there is a presumption that the information is reliable. When it is published by the bank on a standalone basis or on the bank’s Web site, then banks should ensure that this information has undergone some verification before being posted.

However, Pillar III stops short of requiring that the disclosure be audited by an external or independent party, unless, of course, this step automatically forms part of the regime under which the disclosure is made. The additional reporting burden is a clear disincentive for banks to voluntarily adopt Pillar III. Supervisors will have to find effective means of ensuring reliability of disclosure, especially in circumstances where this disclosure takes place outside their purview. Nevertheless, it can be expected that the markets would be quick to penalize any incorrect disclosure ex post. While one is interpreting the disclosure, care will have to be exercised to take into account the different items of national discretion that have been applied in the particular jurisdiction because this information could affect comparability across countries.