Foreign Bank Supervision and Challenges to Emerging Market Supervisors
Author: Inwon Song

Contributor Notes

The increased presence of foreign banks in a country's domestic banking system necessitates the development of effective cross-border prudential supervision where the consolidated supervision is the essential element. This paper presents foreign bank supervision in terms of division of responsibilities between the home and host countries, consolidated supervision, quality of home-country supervision, memoranda of understanding (MOUs), and "ringfencing" of banks. A number of challenges which foreign banks bring to emerging market banking supervisors are also discussed. The paper also provides surveys of country cases.

Abstract

The increased presence of foreign banks in a country's domestic banking system necessitates the development of effective cross-border prudential supervision where the consolidated supervision is the essential element. This paper presents foreign bank supervision in terms of division of responsibilities between the home and host countries, consolidated supervision, quality of home-country supervision, memoranda of understanding (MOUs), and "ringfencing" of banks. A number of challenges which foreign banks bring to emerging market banking supervisors are also discussed. The paper also provides surveys of country cases.

I. Introduction

Foreign banks’ operations in the emerging market banking system increased dramatically during the second half of the 1990s.2 For example, in Eastern Europe, the share of banking assets under foreign control increased from 25 percent in 1995 to 30 percent in 2000. Much the same occurred in Latin America, with almost 40 percent of total bank assets controlled by foreign banks in 2000, following a series of cross-border mergers and acquisitions. Although foreign banks have played a smaller role in Asia than in Eastern Europe or Latin America, after the Asian crisis, foreign bank control in the East Asian banking market increased from 5 percent in 1995 to 6 percent in 2000.3 Indonesia, Korea, and Thailand have raised allowable foreign equity levels in local banks to 100 percent. The Philippines now permit 60 percent foreign ownership.4

For the developed markets, foreign bank expansion had also been significant for the past decade. For example, foreign-controlled ownership in the United States increased from 8 percent in 1995 to 22 percent in 2000, primarily owing to the expansion of European banks in the United States.5

The total number of foreign banks in low-income countries more than tripled from 42 in 1995 to 144 in 2000. Foreign banks represent 18 percent of the total numbers of banks in these low-income countries in 2002, up from 5 percent in 1995.6

The growing presence of foreign-owned financial institutions, especially banks (see Box 1), raises a number of important issues. The arguments for and against foreign bank entry and foreign banks’ impact on the efficiency and stability of domestic banking systems, continue to be subjects of debate. Factors that have stimulated international banking institutions to expand into overseas markets and those that have influenced host countries’ decisions to accept foreign financial institutions are closely related to these arguments. (See Appendix I for the pros and cons of licensing foreign banks.)

Forms of Foreign Bank Entry

Each host country determines the types of foreign bank operations it will permit. Desired forms of entry may vary from bank to bank and from country to country, depending upon business-strategy considerations and host country-laws and banking structures.

Banks initially extended their services abroad in order to assist their home-country customers with international transactions. With a growing understanding of foreign markets and a more developed network of relationships with local financial institutions, some banks subsequently increased the range of their operations by adding local customers. Following this pattern, foreign banks would first establish representative offices. At a later stage, they would open branches and, eventually, establish subsidiaries.1

Today, the actual pattern of foreign bank entry depends on a wider range of factors. In particular, the profit opportunities in the destination market have become a key factor in determining the pattern of foreign bank entry. As a result, forms of foreign participation have become more varied, including full acquisition, targeted purchases of specific activities, joint ventures, alliances with local banks, and outsourcing of administrative and financial services.2

Representative offices are generally prohibited from performing any banking operations. They do, however, offer opportunities for contracts with the parent bank and its clients concerning a variety of commercial and financial business that relates to the foreign market.

A foreign branch is an overseas office of a bank incorporated in a foreign country and constitutes a higher level of commitment than a representative office. Foreign bank branches are typically involved in wholesale banking.

Bank subsidiaries are separately incorporated from the parent bank, whose financial commitment to the subsidiary consists of the capital invested. Subsidiaries are usually involved in retail banking markets. However, in some countries such as the United Kingdom, subsidiaries are often involved in wholesale investment banking operations.

Establishing an affiliate relationship or participating in a joint venture can be another way to engage in foreign expansion. This usually involves taking minority stakes in local entities, and the level of involvement in the management of the local banks by the foreign bank is normally low.

1Discussions on the forms of foreign bank entry, especially branches and subsidiaries, see Clarke, Cull, and Peria (2001), pp. 29–31.2Hawkins and Mihaljek (2001), pp. 25–26.

The increased presence of foreign banks in the domestic banking system necessitates the development of effective cross-border prudential supervision. Although the key objective of the supervisors of internationally active banks has been to ensure that no activity of these banks escapes effective supervision and that coordinated remedial action can be undertaken when necessary, several instances have occurred in which institutional structure and legal arrangements escaped effective prudential supervision.7 One of the most glaring was the failure of Bank of Credit and Commerce International (BCCI) in 1991. In the ensuing years, close cooperation between home-and host-country authorities with continuous sharing of information became far more important. Recent development of foreign banks in Argentina also could raise many supervisory issues deserving interesting discussions.

Consolidated supervision is an essential element of effective cross-border prudential supervision. This includes the ability to review both banking and nonbanking activities conducted at both domestic and foreign offices. Cooperation across markets to strengthen supervision of financial conglomerates has also been enhanced, because financial groups could pose significant international problems. Recently, the mechanisms to prevent money laundering and combat terrorism financing (AML/CFT) have become an integral part of prudential supervision. These efforts are subject to increasing standardization by the international community and also have a direct impact on the way foreign banks are supervised.

The rest of this paper is structured as follows. Section II addresses foreign bank supervision in terms of the division of responsibilities between home and host country, consolidated supervision, quality of home-country supervision, a memorandum of understanding (MOU), and ring fencing of banks. Section III explores a number of challenges that foreign banks bring to emerging market banking supervisors, and Section IV concludes. Arguments for and against foreign bank entry in domestic market and country surveys are presented in the appendixes.

II. Foreign Bank Supervision

A. Home/Host Country Division of Responsibilities

Banking supervisors have long been aware of the potential problems associated with the cross-border banking activities, which have derived from the growing presence of foreign banks in many emerging markets. Of late, several instances have occurred where institutional structure and legal arrangements have escaped effective prudential supervision. This has happened even though supervisors of internationally active banks have tried to ensure that no activity of these banks escapes effective supervision, and that coordinated remedial action can be undertaken when necessary. Part of the problem is that various types of corporate structures across international borders can be used to escape regulations and effective supervision. While supervising banking institutions across borders can be difficult, the cost of not adequately supervising them can indeed be greater.

To deal with this problem, the Basel Committee on Banking Supervision has developed basic principles and standards on many aspects of supervision and regulation of cross-border banking.8 Its approach was based on two basic principles: that no foreign banking establishment should escape supervision; and that supervision should be adequate. To this end, the Basel Committee believes home and host authorities should both give their explicit permission for the setting up of an establishment abroad. Further, the Committee is of the opinion that the home authority should be able to refuse the establishment of a branch or subsidiary of a bank jurisdiction, suspected to be inadequately regulated (See Box 2 for “Minimum Standards” to reinforce the Concordat). See Appendix II for country cases on whether permission of foreign supervisor is required in licensing foreign bank branches or subsidiaries.

Improvement in the supervision of cross-border banking was made in 1996. At the International Conference of Banking Supervisors in June 1996, organized by the Basel Committee, the representatives of about 140 countries endorsed a report on the “Supervision of Cross-Border Banking” prepared by a joint working group of the Basel Committee and members of the Offshore Group of Banking Supervisors.9 The report contains a number of recommendations aimed at removing obstacles to the implementation of effective consolidated supervision. In particular, it reinforces the principle that home country supervisory authorities should have full access to necessary information, and it sets out ways in which they can conduct cross-border inspections at branches or subsidiaries owned by banks headquartered in their jurisdictions.

To be consistent with the Basel Concordat and its successors, including “The Supervision of Cross-Border Banking,” the “Core Principles for Effective Banking Supervision” set forth a number of principles regarding cross-border banking supervision in 1997. Principles 23 (Global Consolidation) and 24 (Information Exchange with Host Country Supervision) incorporate the obligations of home country supervisors, and Principle 25 (Supervision of Foreign Establishments) outlines the obligations of host country supervisors.10

“Minimum Standards” to Reinforce the Concordat

In July 1992, following the BCCI incident, the Basel Committee issued the standards that are as follows.1

  • All international banking groups and international banks should be supervised by a home country authority that capably performs consolidated supervision.

  • The creation of a cross-border banking establishment should receive the prior consent of both the host country supervisory authority and the bank’s and, if different, the banking group’s home country supervisory authority.

  • Supervision authorities should possess the right to gather information from cross-border banking establishments of the banks or banking groups for which they are the home country supervisory authority.

  • If a host country authority determines that any one of the foregoing minimum standards are not met to its satisfaction, that authority could impose restrictive measures necessary to satisfy its prudential concerns.

1Basel Committee on Banking Supervision (1992).

In May 2001, the Basel Committee on Banking Supervision reinforced its work on the international coordination of the activities of supervisory authorities. A report, “Essential Elements of a Statement of Cooperation between Banking Supervisors,” prepared by the Working Group on Cross-Border Banking, was released. The report provides a framework for agreements between supervisors to share information on the basis of mutual trust, where circumstances justify it.11 This report sets out essential elements in the area of sharing information regarding the following issues: (i) the authorization process; (ii) the ongoing supervision of their cross-border establishments; (iii) on-site inspections; (iv) protection of information; and (v) ongoing coordination (refer to Box 3).

Recently, taking into account the issues raised by the implementation of the proposed Basel Capital Accord II, the Basel Committee on Banking Supervision issued “High-Level Principles for the Cross-Border Implementation of the New Accord” in August 2003. The Basel Committee believes that fostering closer practical cooperation between home and host supervisors is essential to effectively implement the Basel Capital Accord II.12 Regarding banks’ cross-border electronic banking activities, the Basel Committee on Banking Supervision reasserted the home/host country cooperation principles by issuing “Management and Supervision of Cross-Border Electronic Banking Activities.”13

Before granting consent to the establishment of a cross-border establishment, the home and host authorities should each review their supervisory responsibilities with respect to the establishment. If either of the authorities have any concerns about the division of responsibilities, then that authority has the responsibility to initiate consultations with the other authority so that they reach an explicit understanding on which one of them is in the best position to take primary responsibility, either generally or in respect of specific activities. A similar review should be undertaken by both authorities if there is a significant change in the bank’s or banking group’s activities or structure.14

The home supervisor will need to take account of the fact that capital cannot always easily be moved from one part of a banking group to another across international borders. Host country supervisors are primarily responsible for the liquidity of foreign establishment, since they are better equipped to assess liquidity as a function of local market conditions and practices, although the home country supervisor is responsible for group liquidity.15 Host country supervisors will also be responsible for the solvency and supervision of subsidiaries, although solvency of the entire group is the responsibility of the home country (see Box 4).

Essential Elements of a Statement of Cooperation Between Banking Supervisors1/

The Basel Committee Working Group on Cross-Border Banking prepared the note in May 2001. A number of countries have suggested that there is a need for a statement setting out the essential elements of a MOU or similar document that can be used as a reference for establishing a bilateral relationship between banking supervisory authorities in different countries (and, where appropriate, between banking supervisors and other financial regulators).

The note sets out essential elements in the areas of sharing information, on-site inspections, protection of information, and ongoing coordination.

  • Sharing of information

    In connection with the authorization process, and in accordance with the Core Principles:

  1. (a)The host supervisors should notify the home supervisors, without delay, of applications for approval to establish offices or make acquisitions in the host jurisdiction.
  2. (b)Upon request, the home supervisor should notify the host supervisor whether the applicant bank is in compliance with banking laws and regulations, and whether the bank may be given its administrative structure and internal controls to manage the cross-border establishment in an orderly manner. The home supervisor should also, upon request, assist the host supervisor by verifying or supplementing any information submitted by the applicant bank.
  3. (c)The home supervisor should inform the host supervisor about the nature of the regulatory system and consolidated supervision over the applicant bank. Similarly, the host supervisor should indicate the scope of its supervision and indicate any specific features that might give rise to the need for special arrangements.
  4. (d)To the extent permitted by law, the home and host supervisors should share information on the fitness and properness of prospective directors, managers, and relevant shareholders of the cross-border establishment.

In connection with the ongoing supervision of their cross-border establishments, the supervisors from the host and home country should do the following:

  1. (a)Provide relevant information to their counterpart regarding material developments or supervisory concerns in respect of the operations of a cross-border establishment.
  2. (b)Provide information on their respective regulatory systems and major changes, in particular, those which have a significant bearing on the activities of cross-border establishments.
  3. (c)Inform their counterpart of penalties imposed or enforcement actions taken, against a cross-border establishment.
  4. (d)Facilitate the transmission of any other relevant information that might be required to assist with the supervisory process.

  • On-site inspections

    The statement should recognize that cooperation is particularly useful to the supervisors in assisting each other in carrying out on-site inspections of cross-border establishments in the host country. The home supervisor should notify the host supervisor of plans to examine a cross-border establishment and to indicate the purpose and scope of the visit. The host supervisor should allow the home supervisor or its delegated agent to conduct on-site inspections. As may be mutually agreed between the parties, examinations may be carried out by the home supervisor alone or accompanied by the host supervisor. Following the inspection, an exchange of views should take place between the examination team and the host supervisor.

  • Protection of information

    The statement should recognize that mutual trust between supervisory authorities can only be achieved if exchanges of information can flow with confidence in both directions. The supervisor receiving the information must provide the assurance that all possible steps will be taken to preserve the confidentiality of the information received.

  • Ongoing coordination

    The statement should recognize that visits for information purposes and exchanges of staff may promote cooperation between supervisors.

1 See Basel Committee on Banking Supervision (2001).

Capital and Asset Maintenance Requirement on Foreign Bank Branches

Some countries apply a stringent capital requirement for foreign bank branches. The concerns are twofold: there may be some reluctance to rely on the home country regulations in some cases; and in the event of a failure of a parent bank, there is concern that any resolution might favor depositors and creditors in the home country at the expense of host country. Therefore, some host country supervisors want to rely on foreign bank branches having capital and assets in the host country to match their liabilities in the host country.

Some countries like the United Kingdom have different approaches. For example, the United Kingdom has been neutral about the way in which foreign banks operate in London. In practice, most of the large foreign banks have chosen to operate as branches, perhaps reflecting the nature of their activities within London’s wholesale markets, though subsidiaries are also used particularly for specialized activities in the retail market. Many banks operate both branches and subsidiaries. Branches are useful where a bank wants to obtain prime rates either in the interbank deposit markets, the foreign exchange market, or derivative market. If a major international bank cannot use its entire capital base, it is hampered. Moreover, by having to hypothecate capital all over the world, a major international bank loses flexibility, a problem which adds to its costs. The United Kingdom authorities have not, therefore, applied quasi-capital requirements for foreign bank branches. Thus, if a major international bank like the Citibank London branch is involved in a particular transaction, the United Kingdom authorities expect that the deal will be supported by the entire capital of Citibank and not just by the resources that Citibank may have in London at the time. However, the United Kingdom supervisors also have a category of banks from countries where they are not totally confident of the quality of supervision where they will be prepared to license, but only on condition that the bank opens a subsidiary, which can then be supervised on a stand alone basis.

The issue of foreign branches in applying exposure rules is also controversial. Where such countries with low credit ratings have allowed foreign banks to open branches, the authorities have been accused of allowing an unleveled playing field, in that foreign banks do not have to have capital in the host country and are not bound effectively by local large exposure rules. The problem is particularly acute in very small countries. In some circumstances, such countries may have a few large companies, and the local banks cannot compete because the large exposure rules keep them from offering large lines, whereas a small branch of a major international bank can offer these lines using the parent bank’s worldwide capital. Many countries have tried to level the playing field by requiring such banks to have some form of quasi-capital and sometimes limit lending to a multiple of that local quasi-capital. This of course ties the foreign bank down and restricts its ability to compete. It is often, however, ineffective because quasi-capital requirements can be met simply by a piece of bookkeeping. Foreign bank branches can try to avoid the requirements by booking some of the transactions at the offshore branches.

According to the Basel Concordat, host authorities are responsible for the foreign bank establishments in their territory, and home-country authorities are responsible for these establishments as parts of larger scale activities of banks under their supervision. Notwithstanding a certain division of responsibilities, home and host supervisory authorities should be in close cooperation.

With regard to the remedial actions against establishment abroad, the home country supervisor can require the management at the head office of branches abroad to remedy deficiencies in the branches and apply the full range of legal instruments against the head office to achieve the result. However, subsidiaries are subject to the jurisdiction of the host country, even though its home supervisor may have some influence to induce improvements.

When a bank that has a branch operating in another country is closed, liquidated, or declared insolvent, the supervisory authority in the country where the branch is established must immediately be informed by the home supervisory authority. The host authority would then promptly close the branch. Unlike branches, bank subsidiaries are legally separate from the parent bank. Their assets and liabilities, in theory, remain unchanged when the parent bank closes. However, there is an increased risk of transferring assets and liabilities between the closed parent and a subsidiary, which could damage the subsidiary’s financial position.16

B. Consolidated Supervision

In many countries, banks are not stand-alone institutions but are rather a part of holding company groups. It is possible that a holding company can transfer capital, asset, and liability positions among its various entities including foreign subsidiaries, but if these positions are not treated on a consolidated basis, then they may pose considerable risks to a bank in the context of capital adequacy and liquidity. Some concerns are also voiced by complex financial institutions active in a number of jurisdictions. These concerns could easily be increased by asymmetries in information between home and host country supervisors. These potential problems can only be minimized by accounting consolidation and consolidated supervision.

An essential element of banking supervision is the ability of the supervisors to supervise the consolidated banking organization. This includes the ability to review both banking and nonbanking activities conducted by the banking organization, either directly or indirectly (through subsidiaries or affiliates), and activities conducted at both domestic and foreign offices.17 The recent emergence of financial conglomerates and ongoing development of techniques to supervise these institutions raise unique issues. Certain important aspects of supervision might include matching capital levels to the risk profiles of financial conglomerates, related cross-border insolvency of a group, effective cross-border supervision, and consolidated supervision among other things (see Box 5 for Supervision over a “Group to Which a Bank Belongs”).

Basel Core Principle 23 stipulates that banking supervisors must practice global consolidated supervision over their internationally active banking organizations, adequately monitoring and applying appropriate prudential norms to all aspects of the business conducted by these banking organizations worldwide, primarily at their foreign branches, joint ventures, and subsidiaries.

The corporate structure of a banking group should be transparent to the home and parent-level supervisors so that they are able to supervise the group effectively on a consolidated basis. Concerns are most acute when corporate complexity results not from legitimate business decisions, but on the part of the institution to thwart the supervisor’s efforts to oversee its activities.

A home country supervisory authority is responsible for supervising the global operations of a bank or banking group on the basis of consolidated, verified, and prudential information. This approach encompasses not only a bank holding company’s or parent bank’s direct branches and subsidiaries but also includes any significant nonbank companies and financial affiliates.

The home supervisory authority has a responsibility to safeguard the domestic financial system by preventing the establishment of unsupervised or under-supervised foreign banking establishment in its jurisdiction. If the bank or banking group is not subject to consolidated home supervision, or if the home supervisor does not have the capacity to perform such supervision, the host country authorities should not allow any cross- border establishment of that bank or banking group in its jurisdiction.

Special problems can be posed by so-called shell banks and parallel-owned banks.18 To be effective, no shell bank and parallel-owned banking structure, in principle, should be licensed because they conflict with the Basel Committee’s Core Principles.19 Furthermore, international AML/CFT standards have called for an explicit elimination of shell banks.20

Supervision of a Group to Which a Bank Belongs

  • A financial group incorporating banking, securities, and insurance subsidiaries and other financial intermediaries can be subject to different regulators and regulatory regimes. At the domestic level, this already poses significant problems. These problems are compounded at the international level, where the problem of coordination, information, and compliance potentially involves several regulators for each country in which the conglomerate is operating.

  • The technical issues that need to be addressed in the context of international financial conglomerates may consist of the following: (1) the supervision of financial conglomerates on a group-wide perspective; (2) techniques for assessing the capital adequacy of financial conglomerates; (3) the test on “fitness and propriety” of management; (4) a supervisory approach to large exposures and to intra-group exposures within financial conglomerates; and (5) the supervisor’s ability to intervene in structures that impair effective supervision.1

  • Countries need to urgently develop consolidated supervision practices over financial conglomerates. Several agencies, working on the basis of different legal and regulatory regimes in different jurisdictions, may be involved in assessing the risk incurred by cross-sectoral financial conglomerates. Data collection, information exchange across sectors and internationally, as well as analysis tend to be underdeveloped.

  • Recently, cooperation across markets to strengthen supervision of financial conglomerates has been enhanced. The Joint Forum on Financial Conglomerates has been working as a principal element of its efforts to enhance cooperation with securities and insurance supervisors so as to strengthen the supervision of financial conglomerates. This forum has also been pursuing practical means to facilitate the exchange of information among supervisors, both domestically and internationally, and has identified legal and other impediments to such exchanges.

  • A Task Force of the Joint Forum has been conducting an analysis of 13 international financial conglomerates in order to enhance the understanding of the ways in which such groups are managed and organized. This experience has identified structural, operational, and risk management issues within these conglomerates, and the need to strengthen relationships between supervisors from different countries, a key element in managing banking crises. In the case of parallel-owned banks, where a bank in one jurisdiction is under the same nonbank ownership as a bank in another jurisdiction, the consolidated banking supervision should be applied. If the nonbank owner has the ownership of one or more banks, the owner ought to be subjected to consolidated supervision, notwithstanding the separate responsibility of the supervisory authorities in the respective individual countries. The respective supervisors need to prevent sources of contagion by particularly stringent connected lending rules.2

1International Monetary Fund (1998), pp. 50–51.2 See Miles (2002) for supervision issues related to large complex financial institutions.

As part of practicing consolidated banking supervision, banking supervisors must adequately monitor and apply appropriate prudential standards to all operations of their banking organizations worldwide, including at their foreign branches, joint ventures, and subsidiaries. A major responsibility of the parent bank supervisor is to determine that the parent bank is providing adequate oversight, not only of its overseas branches, but also its joint ventures and subsidiaries. This parent bank oversight should include monitoring compliance with internal controls, receiving an adequate and regular flow of information, and periodically verifying the information received. See Appendix III for country cases on authority to apply regulations on a consolidated basis to cross-border establishments, joint venture, and associates of domestic banks.

A key component of consolidated supervision is establishing contact and information exchange with the various other supervisors involved, including host country supervisory authorities as indicated in Basel Core Principle 24. This contact should commence at the authorization stage when the host supervisor should seek approval from the home supervisor before issuing license.21 In many cases, bilateral arrangements exist between supervisors. These arrangements can prove helpful in defining the scope of information to be shared and the conditions under which such sharing would normally be expected.

Home country supervisors have the right to gather information from their cross-border banking establishments. In order for home country supervisors to practice consolidated supervision effectively, the host country supervisor must share information about the local operations of foreign banks. Host authorities also should be able to obtain any necessary information from the home authority. This ability to gather information should be a condition for giving consent for the cross-border establishment of a bank.

The information to be shared should encompass both qualitative and quantitative aspects. The information should permit the supervisors to calculate the bank’s (or banking group’s) capital adequacy ratios, large exposures or legal lending limits, and funding and deposit concentrations on a consolidated basis. However, home and host authorities need to acknowledge that prudential standards and supervisory practices may differ between countries.

Authorities of the host state should permit on-site inspections by the home supervisor of a prudential nature of establishments of internationally active banks within its jurisdictions. Together with the free flow of data, such inspections are a necessary corollary of effective consolidated supervision. To conduct on-site inspections in the territory of another state requires the consent of the country receiving the inspection team. Any legal barrier against such on-site inspections would need to be removed, for instance, by concluding agreements between countries on the conduct of such inspections. See Appendix IV and V for country cases on authority to have contacts and exchange supervisor information with, and allow on-site inspection by, foreign financial supervisory agencies.

C. Quality of Home-Country Supervision

Difficulties at the parent bank could raise questions about the fortunes of the local affiliate, even if its position is fundamentally sound. Since difficulties at a parent bank could quickly create doubts about the viability of local branches or subsidiaries, the capabilities of home country supervisors to perform effective supervision is crucial.

A host state should be able to ascertain whether the home state can “capably perform home country consolidated supervision” as a condition for permitting a foreign bank entry to its territory.22 If a host supervisory authority is in any doubt in this respect, it should either refuse entry or stipulate that the establishment shall be supervised on a strict independent basis.

The quantity and quality of available resources to supervise the foreign operations of a home country should be assessed, as well as its supervisory techniques, frequency of inspections, and any other similar methods of supervision. These items should provide the basis for a judgment as to whether the home supervisory authority is capable of performing consolidated supervision. It is also important to establish the track record of the home supervisory authority in taking effective supervisory action against banks, especially those with overseas subsidiaries or branches. To facilitate this process, a system of routine personal contacts should be developed between supervisors of the host and home countries.23

In the case of the U.S. banking supervisory authorities, the review of home country supervision quality has been strengthened since 1991. The Foreign Bank Supervision Enhancement Act (FBSEA) of 1991 gave the Federal Reserve System (FRS) enhanced supervisory and regulatory authority over foreign banks operating in the United States.24

Since 1992, the FRS has only been able to approve an application from a foreign bank to establish an office in the United States if it is able to conclude that the bank is subject to comprehensive consolidated supervision by its home country supervisor.25 In 1996, the Congress amended the regulations regarding comprehensive consolidated supervision to allow somewhat more flexibility. The FRS has the authority to close or restrict the activities of existing branches and agencies if consolidated supervision is missing, it but has not yet considered it necessary to exercise this power.

In keeping with its enhanced authority, the FRS has worked with other supervisory agencies to develop the Foreign Banking Organization Supervision Program. This program focuses on incorporating into supervisory procedures a common understanding of a given foreign bank in its entirety, including policies and practices in the foreign bank’s home country, as well as the overall condition of the foreign banking organizations combined in U.S. operations.26

The program calls for coordinated development and common use of five new products. Two of these programs are referred to as “country reports.” One country report is to provide information about the financial system and supervisory and government policies in the foreign bank’s home country, and the other is to provide information about significant accounting policies and practices in the home country.

A third product, the Strength-of-Support Assessment (SOSA), to be based on the country reports and other financial data, will provide analysis and a ranking to reflect the U.S. supervisors’ judgment about the foreign banking organization’s ability to provide its U.S. operations necessary financial and managerial support. These assessments are to be used along with other information for reaching decisions regarding the scope and frequency of exams and for other supervisory and enforcement matters.

A fourth product, the Summary of Condition and Combined Rating, is designed to provide the management of foreign banking organizations and U.S. supervisors with an overall assessment of the their U.S. operations. The last new supervisory product is an annual comprehensive examination plan. This examination plan is to be developed from information in the SOSA, the results of individual prior examinations, and the overall assessment of the foreign bank’s combined U.S. operations.27

D. Memoranda of Understanding With Home-Country Supervisors

A critical component of consolidated supervision is establishing contact and information exchange with various other supervisors involved, including host country supervisory authorities. This contact should commence at the authorization stage when the host supervisor seeks the approval from the home supervisor before issuing a license. In many cases, bilateral arrangements between supervisors can prove helpful in defining the scope of information to be shared and the conditions under which such sharing would normally be expected. A number of countries have concluded a bilateral exchange of letters of signed Memoranda of Understanding (MOUs). As indicated in Box 3, “Essential Elements of a Statement of Cooperation between Banking Supervisors” set out key ingredients of MOUs between countries.

MOUs facilitate supervision by setting out the commonly agreed upon terms of understanding between countries and clarifying in advance any assumptions and procedures. MOUs do not set limits on the relationships and interaction between supervisory authorities. They are neither legal documents, nor should any exchange or procedure be prevented because the MOU did not discuss the topic nor because it defined a procedure in a detailed manner. Although there is a high degree of commonality between MOUs, notwithstanding the differences that reflect national discretion and diversity, there is no single model for an MOU. Over time, changing circumstances, for example, an increase of cross-border alliances in banking, may mean that supervisory interaction develops ahead of the texts of the MOUs.

In practice, bilateral arrangements can include such issues as establishment of a branch/notification, exchange of information, inspection, and remedial or punitive actions against cross-border establishments by home and host authorities. In an MOU, operational aspects of cross-border inspections would typically need to be agreed upon in advance by both authorities. The findings of inspections should be shared between the supervisory authorities of both countries as well as with the institutions involved.

When inspections or other information would indicate the need for remedial or punitive action, this may be complicated by differences in legal arrangements. Supervisory authorities in different countries, therefore, conclude arrangements in the MOU to make supervisory action in the foreign state possible, if the need should arise. These arrangements could also include providing assistance in accessing local nonsupervisory information, for example, on the legal system on shareholder’s activities.

With the implementation of the Second Banking Coordination Directive of the European Union (EU), many member countries of the EU began to negotiate MOUs in order to facilitate supervisory cooperation in the context of changed supervisory responsibilities28 brought about by the Directives. Although not all member countries of the EU have signed a full set of MOUs, the work is almost complete, and where agreements have not been concluded, this means a lack of cross-border establishments between member countries. For example, the United Kingdom and the Finnish authorities concluded an MOU in 1994, while the Dutch and Finnish authorities agreed on an MOU in 1996. On the other hand, although Iceland has signed MOUs with Denmark, Finland, Norway, and Sweden, no cross-border establishments existed in Iceland as of July 2002.29

In the case of the Slovak Republic, the National Bank of Slovakia signed the Agreement on Banking Supervision with the Czech Republic, Germany, and Hungary as of end-June 2002. In the case of Estonia, the Bank of Estonia was preparing a series of MOUs with several foreign bank supervisory authorities in 1998. They had signed an MOU with Finland in 1995 and had finalized MOUs with Latvia and Russia in 1999. In the case of Albania, the Governors of the Bank of Albania and the Bank of Greece entered into an agreement for “Cooperative Banking Supervision” with reference to branches of Greek banks operating in Albania. The Finnish Financial Supervision Authority had signed MOUs concerning the supervision of financial institutions with twelve countries as of March 2004. Recently, the Financial Supervisory Commission (FSC) and Financial Supervisory Service (FSS) of Korea have begun entering into MOUs with foreign supervisory authorities to promote consolidated supervision. In the banking supervision areas, FSC/FSS has signed with the following supervisory authorities: Financial Services Authority of the United Kingdom (1999), Financial Supervisory Agency of Japan (2001), Federal Banking Supervisory Office of Germany (2001), France, Vietnam, and China as of February 2004.

E. Ring Fencing of Banks

Recently, a number of banking groups seem to utilize “ring-fencing” arrangements, although international best practices do not exist for these arrangements. Supervisors should be aware of ring-fencing arrangements and their implications in the cross-border supervision.

“Ring-fencing” involves isolating the bank from other companies in the group by taking several actions, for instance: (i) prohibiting or placing severe limits on the financial exposure of the bank vis-á-vis other companies in the group; (ii) restricting the volume of funding the bank receives from companies in the group; and (iii) ensuring that directors and management of the bank can operate the bank independently of the group management. Such precautionary measures could be welcome by supervisors in cases where they have serious concerns about a bank’s owners or its positions with a group, although ring-fencing is not established as an international best practice. Ring-fencing could be used in the case of a bank that is part of a mixed activity group but remains essential in the case of a bank that, for example, is a subsidiary of a bank or a branch of a bank incorporated in a country where the bank supervisors do not practice effective consolidated supervision.

Risks carried by local offices may have limited implications for internationally active banks if they are separate legal entities and ring-fenced from the parent group. As a subsidiary being a legally distinct entity from the parent, in case of a subsidiary, the parent’s losses in a subsidiary would be, in principle, no larger than its equity stake. On the other hand, in the case of a branch, the parent is not typically legally distinct from the branch so that branch closure may not shield the parent from losses.30

In certain instances, ring-fencing can also affect the obligations of the local branches of major international banks. In Asia, some banks, which were “ring-fenced,” argue that the imposition on capital outflow could limit the ability of their branches to make payments on foreign exchange-related transactions. In some derivative products, various parent banks inserted the ring-fencing clauses into their confirmation documentation to specify the conditions under which the parent would not be responsible for the payments of the onshore branch and to make the pricing of a transaction more transparent.

Other banks have argued that ring-fencing is not just a pricing issue but has broader systemic implications because it will alter the degree of support that parent banks will offer their on shore branches and subsidiaries during crisis periods.

In some cases, other obligations are ring-fenced by law. For example, under the Federal Reserve Act and also the New York Banking Law, all deposit liabilities of foreign branches of U.S. banks are already ring-fenced, if the local authorities take actions that prevent the local branch from making payment (such as the imposition of capital controls).31 The issue may be more complex where these are de facto ring-fencing restrictions that make deposits payable only at the local branches and not at branches in other countries. A number of banking groups seem to apply restrictions of this nature.32

This ring-fencing practice could raise some concerns related to transparency in the current system. There is the issue of whether market participants are fully aware of the nature of the ring-fencing contracts. In addition, markets could operate in a very different way during crisis periods due to these ring-fencing contracts. Supervisors should also be aware of some concerns related these contracts.

III. Challenges to Emerging Market Banking Supervisors

The growing presence of foreign banks in many emerging markets has increased the complexity of the tasks facing supervisory authorities. As the presence of foreign banks increases, the domestic supervisory authorities are more likely to upgrade the quality and increase the size of their staff, in order to supervise the more sophisticated activities and new products that are usually introduced by foreign banks. This effect has been observed, for example, in Brazil and Hungary. Before they gain sufficient skills, however, supervisors may have some difficulties in supervising highly sophisticated foreign bank operations, not knowing how to deal with sophisticated operations. This is a particular concern in the cases where foreign commercial banks expand their operations rapidly in the area of nonblank33 financial services, such as insurance, portfolio management, and investment banking. Given the complex structure of many internationally active banks, it is also a challenge to supervisors to know how to improve governance structure of these banking institutions. Good internal governance may have a better chance of providing early warning signals than would external supervisors on their own, helping to manage operational and reputational risks. Integral issues within foreign banks are increasingly being shown to be of potential systemic significance. These policy issues include cross-border supervision and regulation on a consolidated basis, banking system concentrations and systemic risks, and governance of foreign banking institutions and integrity of financial market among other things.

One of the first problems facing bank supervisors is the issue of licensing policy for foreign banks. Domestic supervisory authorities in emerging economies often have strong views on their choice of licensing policy for foreign banks. Many Asian supervisory authorities note that branches have the advantage of being backed by the full strength of their parent institution. They also point out that, under the proposed Basel Capital Accord II, branches of banks incorporated in less risky countries will be able to obtain less expensive funds because they will be subject to lower capital weights, whereas subsidiaries will be covered by the ratings of their host country. Countries that favor subsidiaries stress their ability to better regulate, supervise, and ring-fence subsidiaries in periods of distress. There are some arguments that branches are more difficult to sell to third parties when problems arise.3435 In emerging countries, the licensing policy for foreign banks is subject to political considerations. Political interference in the licensing process of foreign banks could appear on the basis of wider inter-governmental agreement rather than on strict prudential criteria. Procedures should be put into place to shield supervisory decisions on licensing foreign banks from political influence or interference. The supervisory authorities in emerging countries should not unnecessarily delay the approval of foreign bank entry into new markets or products, in order to allow domestic banks sufficient time to gain a foothold in such new activities. The supervisors in emerging markets might have some difficulties in implementing effectively fitness and propriety test of management and owners of foreign banks, especially in case where owners come from a complex holding company or investment funds for which home supervisors are ambiguous.

The second problem facing supervisors in emerging markets is the issue of how to monitor the local establishments of large international banks. These supervisors need to know the financial positions of not only the local branches or a subsidiary of major international banks but also the parent bank. Indeed, difficulties at the parent bank could raise questions about the fortunes of the local affiliate, even if its position is fundamentally sound. Since difficulties at one of these parent banks could quickly create doubts about the viability of local branches or subsidiaries, the stability of emerging market financial systems has become increasingly dependent on the qualities of prudential supervision in mature markets. Nevertheless, emerging markets’ supervisors will still need to develop the expertise to monitor a new range of activities and instruments that are likely to be used by the local establishment of large complex banking organizations.36

The third issue confronting supervisors is that foreign banks entering local markets tend to offer a variety of new financial products, including derivatives, in order to expand their market share in the local market.37 These new derivative products can allow market participants far better hedging opportunities and, thereby, can be a source of considerable benefit. However, they can also be used as a way of avoiding prudential regulations. Derivatives have also been used to take on what have proven to be excessive risks, especially in weak financial and accounting systems. The emergence of financial conglomerates that provide a wide range of products and services also complicates prudential supervision and regulation. Therefore, it is evident that, as foreign banks enter emerging markets, supervisors need to upgrade their capacity to acquire information on the growing use of financial products, including derivatives and to be able to analyze their implications. In addition, the host country supervisors should have closer contact with the home supervisors because control of derivatives are usually conducted by the home country supervisors. The presence of financial conglomerates could also raise the issue of how the regulatory agencies overseeing banks, securities, and insurance companies should be structured.38

The fourth issue supervisors need to be familiar with is to have an understanding of when and to what extent parent-banking organizations will support their local operations in terms of difficulties or crisis. A number of factors are likely to influence both the likelihood and extent of a parent bank’s support for its foreign establishment. Both legal and reputational issues are involved in determining the parent bank’s support. In the case of a crisis situation, the parent central bank/supervisor support for various elements of dealing with crisis could be needed in addition to the need for close information sharing between authorities.

From a narrow legal perspective, a bank subsidiary is a stand-alone entity with its own capital, and the parent’s formal obligation to support its subsidiary is generally limited to the amount of invested capital.39 Legally, the parent bank may have an option to sell off or close down an insolvent or illiquid subsidiary. However, reputational or strategic issues may be considered in the case of reputable international banks in dealing with any loss-making subsidiaries.40 In contrast, a branch has no independent legal personality distinct from that of its parent, and claims on branches actually constitute claims on the parent. From a supervisory perspective, foreign bank branches have some advantages. They are less likely to engage in connected lending; they are subject to additional oversight by foreign supervisors on a consolidated basis; and they may be subject to more rigorous accounting, disclosure, and reporting requirements.41

Other factors also influence both the likelihood and extent of a parent bank’s support for its foreign establishment. A parent bank which experiences weak profitability and capital position may have little capacity to recapitalize a large, troubled foreign subsidiary. While the parent bank will typically have a strong incentive to remedy problems created by weak internal controls, it may have a much smaller incentive to support its local establishment if force majeure events prevent the local entity from making payments. It is also evident from recent episodes of ring-fencing of the local branches of some international banks in Asia that there are clear limits on the extent of parental support for these local operations and their obligations.42

The fifth issue relates to country cases, where the majority of the banking market is dependent on foreign banks, the supervisory authority tends to face different kinds of challenges. If almost all of the major banks are supervised on a consolidated basis by home supervisors, host supervisors should ensure that the home supervisors are aware of the risks and take them into account for supervision. Under this situation, increasingly, managers responsible for systems or controls of foreign banks may not be available in the host supervisors because the functions are usually centralized in the home country with the modern technology. There always exist political barriers to exchange information between home and host supervisors. Legal and tax issues could be involved and, sometimes, MOUs are regarded as of little practical help. Under these situations, foreign banks tend to behave like branches, even where they entered as subsidiaries. However, under this situation, branches are best for host supervisors since a foreign bank is less likely to walk away from a branch than from a subsidiary.

The supervisory authority could also face challenges in a situation where the systemic importance of subsidiaries/branches of banks from specific countries at regional levels exist, for example, Spanish banks in Latin America, French banks in West Africa, and Australian banks in New Zealand. If the operations are all foreign controlled, the host supervisors are relegated to “secondary” supervisors since some of the risk-management responsibilities is taken away from domestic management. There is a need for greater coordination with the home supervisor, particularly on crisis management issues.

The sixth problem confronting supervisors in the emerging markets is that of systemic risk associated with cross-border banking. Systemic risk potentially can either increase or decrease as a result of a growing foreign presence in the banking system. If a foreign bank entry leads to consolidation in the banking system and contributes to create a more efficient, smaller set of larger institutions, this may reduce systemic risks. A diversified portfolio of foreign banks can also reduce systemic risks. However, failure of large institutions can be a source of more severe systemic risks. Weakened parent banks could quickly worsen the liquidity situation of local subsidiaries and, thereby, diminish stability in the local market.43

A seventh difficulty that supervisors must be aware of in many emerging markets is that many banks are not necessarily stand-alone institutions but are rather part of a holding company group. Even when banks are of a relatively modest size, the existence of these groups raises issues about what level of consolidation should occur when evaluating bank capital adequacy or liquidity. It is possible that a holding company can transfer capital, asset, and liability positions among its various entities, but if these positions are not treated on a consolidated basis, they may pose considerable risk to a bank in the context of capital adequacy and liquidity. Distorting capital and liquidity requirements could lead to misrepresenting holding company financial positions and, thereby, the risk of abuse of financial markets could increase. On the other hand, support to the bank holding company during a period of crisis period will either directly or indirectly assist the rest of the group. These potential problems can only be minimized by consolidated supervision at the group level. In addition, the host country supervisors should ensure which supervisory authority is the main home supervisor for a holding company group. In a crisis situation, problems could be aggravated in case it is not certain who is the main supervisor for the holding company group in the home country. The appropriate prudential supervision and enhanced mechanism for preventing money laundering and terrorism financing should also be incorporated to prevent potential problems associated with the entry of a foreign bank as a part of the holding group.44

Some concerns are voiced over the multiple challenges to supervision raised by complex financial institutions active in a number of jurisdictions. These concerns could easily be increased by imbalances in information between home and host country supervisors. Even among those who support increased foreign ownership, many argue that the degree and sequencing of such openness to foreign banks is critical, and that it should follow the consolidation and strengthening of the domestic financial system and the development of necessary financial infrastructure, including supervision.45 In addition, bank supervisors should be aware of the importance of good corporate governance of these complex financial institutions as well as the main supervisor of them.

Finally, the entry of foreign banks can increase concentration within the banking system, both on the international and domestic fronts. In some countries, such as Chile, this issue arose when the parent institutions of two local banks merged. The entry of foreign banks can also create pressures on local banks to merge to remain competitive. The process of financial sector consolidation in emerging markets raises a number of policy issues, including how to create sufficient market discipline and official supervision for institutions that are “too big to fail.” Supervisors should be prepared for the possibility of increasing concentration in the local banking industry, spurred by the expansion of large international banks into the local market.46 There are concerns that such concentration could create monopoly power that would reduce banking system efficiency. If governments are more likely to protect large banks because they are regarded as “too big to fail,” then mergers stimulated by foreign bank entry could increase the implicit costs associated with maintaining the official safety net.

Integrated operations of consolidated financial institutions possibly imply increased operational risks. Integration reduces transparency and increases the potential for risk management errors. Integration also tends to make the risks of consolidated institutions harder for supervisors to measure, since risk transfer techniques become more complex and create new interdependencies in group risk profiles. These same risk transfer techniques could also increase the risk of abuse of financial markets. Moreover, consolidation can considerably complicate the resolution of an institution in the event of insolvency. The complexity of unwinding an integrated risk management strategy increases the risk that the resolution process could become disorderly. This is clearly the case for larger institutions that are more dependent on risk transfer markets, including interbank and derivative markets, especially when an institution is large enough to be systematically significant. Transnational consolidations increase the complexity of handling a distressed firm since multiple regulatory authorities and differing national safety net provisions must be reconciled. Cross-border consolidation can increase the potential for systemic problems in one financial system to spill over into another.47 Dealing with these problems will involve strengthening prudential supervisory capacity to monitor activities of large complex financial institutions and establishing clear entry and exit rules and prompt corrective action for distressed institutions.

IV. Conclusion

As the presence of foreign-owned banks grows, the complexity of the tasks facing supervisory authorities increases. The challenges for emerging market supervisors include: (i) choosing of licensing policy and fitness and propriety test for management and owners of a complex holding company or investment funds; (ii) effectively monitoring the local establishment of large international banks or complex financial institutions; (iii) upgrading their supervisory capacity to oversee complicated financial products of foreign banks; (iv) dealing with the issue of the parent bank support in case of difficulties of a branch or subsidiary in normal as well as systemic crisis situations; (v) handling consolidated supervision in the event the market is heavily dependent on foreign banks; (vi) effectively exchanging information with the home supervisors in the case of bank holding companies or other complex financial institutions; (vii) dealing with increasing concentration in the banking system by foreign banks; and (viii) improving the governance structure of complex international banking groups while, among other things enhancing the integrity standards in the financial markets. These challenges should be resolved through more enhanced cooperation between home-and host-country supervisory authorities, as well as development of additional international best practices.