Kingdom of the Netherlands
Aruba: Detailed Assessment of Compliance with the Basel Core Principles for Effective Banking Supervision

This paper discusses detailed assessment of compliance with the Basel Core Principles for effective banking supervision for the Kingdom of the Netherlands—Aruba. Aruba’s offshore banking sector is small by international standards, with only two institutions registered. The mission also recommends that the Central Bank of Aruba (CBA) meet with management to better understand their plans for their Aruban operations and their financial results. Aruba remains open to foreign investment and migrant workers, who make up 40 percent of the population and have been key contributors to economic growth.

Abstract

This paper discusses detailed assessment of compliance with the Basel Core Principles for effective banking supervision for the Kingdom of the Netherlands—Aruba. Aruba’s offshore banking sector is small by international standards, with only two institutions registered. The mission also recommends that the Central Bank of Aruba (CBA) meet with management to better understand their plans for their Aruban operations and their financial results. Aruba remains open to foreign investment and migrant workers, who make up 40 percent of the population and have been key contributors to economic growth.

Detailed Assessments of Compliance with the Basel Core Principles for Effective Banking Supervision

I. Summary, Key Findings, and Recommendations

A. Introduction

1. With the concurrence of the Central Bank of Aruba (CBA), the mission assessed compliance with the 2006 revised Basel Core Principles for Effective Banking Supervision using the Core Principles Methodology (see Table 3). Compliance with both the essential and additional criteria was assessed at the request of the CBA. The assessment was based on the CBA’s self assessment of compliance with the Core Principles, a review of the relevant laws and regulations, interviews with the staff of CBA and discussions with auditors and onshore and offshore banks. The assessors were Socorro Heysen (Consultant) and Gabriella Ferencz, Lead Financial Sector Specialist (World Bank).

Information and methodology used for assessment

2. The CBA prepared a detailed self-assessment and filled out the questionnaires in preparation for the OFC. The mission was provided with the relevant laws, regulations, policy notes, reporting forms and onsite and offsite inspection reports.

3. The assessors conducted meetings with senior supervisory staff, as well as junior supervisory staff as appropriate, as well as President of the Central Bank. The assessors also had discussions with onshore and offshore banks, the Auditor’s Association of Aruba and the RCUT, Aruba’s FIU. The work of the assessors was greatly facilitated by the thorough and candid self assessment conducted by the authorities.

Institutional and macroeconomic setting and market structure—overview

4. The banking sector in Aruba is comprised of four domestic commercial banks, bank-like financial institutions, and offshore banks. The commercial banks are mainly engaged in domestic lending. The products and services of the commercial banks are mainly in the traditional retail sector, with interest on domestic credit remaining the predominant source of income. The assets of the commercial banks are mainly funded via resident deposits and savings. Only a small percentage of the total deposits are non-resident, foreign currency.

5. Of the four commercial banks, one is a branch of a commercial bank domiciled in Curaçao, Netherlands Antilles, while the other three banking institutions are subsidiaries of banks established in Curaçao, Netherlands Antilles. Therefore, all four commercial banks operating in Aruba are also supervised on a consolidated basis by the Bank of the Netherland Antilles. Two of the Curaçao incorporated parent banks are, themselves, owned or in the process of being acquired by internationally active Canadian banks. The other two parents are owned by private interests.

6. The banking sector has been stable over the years. It is largely (80 percent) reliant on tourism and services related to tourism. The activities of the domestic commercial banks and the non-bank financial sector are mainly domestic. The main source of financial system risk remains the one-sided structure of the Aruban economy. The potential risks for commercial banks operating in a small and undiversified economy are quite high. Therefore, they must maintain sufficient reserves to absorb possible losses stemming from economic downturns. For that reason, CBA decided to increase the minimum risk-weighted capital assets ratio for banks from 10 to 12 percent, effective January 1, 2007. Branches or subsidiaries of international banks that fall under consolidated supervision are allowed to maintain a minimum risk-weighted assets ratio of 8 percent. For bank-like financial institutions and institutional investors the one-sided economy also remains the most important source of risk.

7. Aruba’s offshore banking sector is very small by international standards, with only two institutions registered. These banks are solely engaged in banking activities to nonresidents. The two offshore banks are both affiliated with Citibank, N.A, of the US, one being a subsidiary and the other a branch, and are also supervised, on a consolidated basis, by the Office of the Comptroller of the Currency and the Federal Reserve Board, respectively. Of the two offshore banks, one is mainly engaged in intragroup financing and the financing of sovereign bonds, while the other’s activities relate to the trading and financing of Latin American sovereign risk bonds and loans, underwriting of bonds and shares for customers and other general banking services. There is no physical presence in Aruba. The management and administration is conducted by Citibank, Venezuela. They function as administrative booking offices. They originally chose to establish themselves in Aruba because of its political and financial stability, convenient location and low taxation. Note also that Citibank N.A. has decided to remain with only one offshore entity in Aruba in due time, namely Citibank Aruba N.V. In this regard, the balance sheet of Citibank N.A. Aruba Branch has been decreasing over the past few years and will continue to decrease in coming years.

8. To date, the CBA has not conducted on-site examinations of the offshore banks. The mission recommends that they carry out their plan to hire external auditors to perform an examination on a number of risk areas. The mission also recommends that the CBA meet with management as soon as possible to better understand their plans for their Aruban operations and their financial results. They should be subject to the same level of supervision as the onshore banks and should provide periodic offsite reports to the CBA. The offshore banks essentially operate as shell banks and shell banks are generally not appropriate for jurisdictions. Given that the CBA does not exercise supervision over the operations, there is reputational risk to Aruba and the CBA should problems arise. Should the offshore banks not comply with the CBA requirements, the CBA may want to consider closing them to avoid unnecessary risk.

9. The size of bank-like financial institutions is very small in terms of balance sheet total. This sub-sector consists of FCCA, AIB and Island Finance N.V. These institutions are engaged predominantly in mortgage lending to individuals, financing of social housing projects, long-term project financing and/or granting of personal loans for consumptive and home improvement purposes. Their loans represent nearly 20 percent of the housing loan market in Aruba, but their market share has fallen in recent years. These activities are financed largely through funds obtained from their parent company, other (local) financial institutions, and/or institutional investors. Bank-like institutions are not allowed to attract deposits from the public.

Overall supervisory and Regulatory Framework

10. CBA supervises banks, money transfer companies, insurance companies and company pension funds on the basis of the respective state ordinances regulating these sectors. CBA is an autonomous entity. The President of CBA, assisted by two executive directors, determines the policies of CBA. The President is appointed on the recommendation of the Supervisory Board for an indefinite period by the Governor of Aruba, who is the representative of the Queen of the Netherlands. Only the Governor, on the recommendation of the Supervisory Board, can approve the President’s dismissal. The political responsibility for the execution of CBA’s tasks lies with the Minister of Finance. No operational guidance is given to CBA by the Minister. It is fully independent in setting monetary and prudential policy.

11. CBA is also independent from the Government’s budgetary process. Its main source of income is generated from the investments of the official foreign exchange reserves of Aruba, which it holds. After financing its operations, including the supervisory activities, this source of income still leaves CBA with an annual profit, demonstrating that it has sufficient financial resources. In view of the continuous expansion and strengthening of the supervisory framework and increasing associated costs it is in the process of charging (part of) the supervision costs to the sectors supervised. At present, only insurance and money transfer sectors are charged in part for the supervisory costs incurred. It is the intention to also charge the banking and pension fund sectors in due time for the supervision costs incurred. In this respect, draft state decrees have been submitted to the government for review and approval.

12. CBA’s supervision department, which falls under the responsibility of the executive director in charge of supervision, consists of 10 staff members, supported by one secretary. The average supervisory experience is about seven years, and there is currently one vacancy for a senior staff member. Both the director and all the staff members hold university or bachelors degrees, obtained either in the Netherlands (six persons), the United States (two persons) and Aruba (two persons). The general manager is a Dutch-trained certified public accountant with a number of years of experience in auditing financial institutions while the manager of the supervision department holds a Fellow Life Management Institute title (a US degree in the area of insurance management) and is knowledgeable in supervisory regulation and policy matters. In addition, two staff members hold an ACAMS certification.

13. Given the increasing responsibilities that the CBA is taking on it should periodically reassess the adequacy of its resources and staffing to do so. A more risk based approach to supervision could result in less time as there would be better analysis of operations. Technical assistance in improving reporting forms would quicken the pace of the move toward risk based supervision.

14. The legal and regulatory framework is generally adequate for the conduct of banking supervision. There are several proposals in preparation to strengthen the supervisory laws for banking and insurance which would strengthen the ability of the supervisory authority to carry out its function. The accounting standards are good and banks are required to have an external audit annually. Disclosure needs some enhancement. There is a lack of transparency given the limited availability of financial reports. There should also be disclosure about the qualitative elements of banks’ operations, as part of their financial results.

Preconditions for effective banking supervision

15. The preconditions for effective banking supervision exist to a large extent although enhancements are needed as pointed out herein. Macroeconomic policies are generally sound. Aruba remains one of the most developed islands in the region. This is a result of its market friendly policies that have fostered a stable macroeconomic environment and a rapid expansion of the tourist sector. As important, Aruba remains open to foreign investment and migrant workers, who make up 40 percent of the population have been key contributors to economic growth.

16. The economy continues to be at risk from external factors. The economy and hence the commercial banking sector are highly dependent on tourism, mostly from the U.S. Public infrastructure is well developed and supports the conduct of banking supervision. Accounting standards are high, collateral is accessible, and the judicial system is functioning and supportive of the conduct of banking supervision. Although it is a small economy, there is effective market discipline. Market discipline would be enhanced by more disclosure of banks’ financial results as well as qualitative information about their operations.

B. Main findings

Objectives, independence, powers, transparency, and cooperation (CP 1)

17. Four of the six elements of CP 1 were found to be compliant. CP 1(4) was also found to be largely compliant. The powers to address compliance will be greatly enhanced by the passage of the draft law granting the CBA the authority to levy fines, sanctions, and/or administrative penalties to banks, management and board members in the event of noncompliance. CP 1(5) was found to be largely compliant. There is no explicit mention in the law of protection of supervisory staff. The CBA sought legal advice from the Dutch Central Bank on this matter. According to their advice, the Dutch legal system, on which Aruban laws are based, the employer is responsible for the actions of its employees.

Licensing and structure (CPs 2-5)

18. These criteria were found to be compliant. Licensing criteria are sufficiently broad. No new licenses have been granted for years although there are periodic inquiries. The law adequately defines significant ownership and controlling interest. Although the legal requirements to obtain supervisory approval for proposed changes in ownership and control are adequate, they would benefit from clarification regarding multiple acquisitions below the threshold that could in sum total in excess of the thresholds for notification. The CBA has adequate criteria for reviewing major acquisitions or investments by banks.

Prudential regulation and requirements (CPs 6-18)

19. Some prudential regulations and requirements are adequate and others need improvement. Implementation needs improvement in a number of areas as well.

  • CP 6 regarding capital adequacy was found to be largely compliant. The CBA sets the minimum regulatory capital for banks at 12 percent and they all meet or exceed the minimum. However, while the CBA contends that market risk is not an issue for onshore banks it is believed that the offshore banks have trading desks and therefore are exposed to market risk. Market risk needs to be supervised by the CBA at the offshore banks.

  • CP 7 regarding risk management was found to be materially non compliant. Supervision continues to be largely compliance based. The CBA needs to enhance its ability to conduct risk based supervision and it must work closely with banks so that they incorporate risk management into their operations.

  • CP 8, credit risk, was found to be largely compliant. The supervisory approach to credit risk oversight is generally appropriate for the largely retail loan portfolios of commercial banks. It would be greatly enhanced by improved data and reporting from banks. This would enable the CBA to perform more meaningful financial analysis.

  • CP 9 on problem assets, provisions and reserves was found to be largely compliant. While the focus on number of days a loan is past due is generally adequate for retail portfolios, classification of commercial loans should be more proactive and take into account qualitative factors as well.

  • Large exposure limits, CP 10, was found to be compliant.

  • Exposures to related parties, CP 11, was found to be largely compliant. The law should clarify that loans to companies where insiders have significant interests should be granted on no more favorable terms than other loans.

  • CP 12, country and transfer risk, was found to be largely compliant. Even though the CBA considers these risks to be minimal, it should receive reports more frequently than once a year.

  • CP 13, market risk was found to be noncompliant. The CBA states that this risk is small and it would be covered by the 12 percent capital charge. Market risk needs to be supervised in the offshore banks.

  • CP 14, liquidity risk was found to be largely compliant. The required liquidity ratios and liquidity reporting requirements are in proportion to the liquidity risks in the Aruban banking sector. The industry and supervisory oversight would benefit from more proactive liquidity risk management which would address funding and contingency plans.

  • CP 15, operational risk, was found to be largely compliant. Certain areas that pose operational risk to banks are examined for onsite but the CBA needs to provide banks with additional guidance in this area and examine for it in greater depth.

  • CP 16, interest rate risk, is rated materially non compliant. Interest rate risk may be small in Aruba given that loan terms regarding interest are often stated to be fixed until further notice by the bank. Some corporate loans are at fixed rates. The CBA needs to be more proactive in its supervision of interest rate risk and reporting needs to capture interest rate risk in banks to allow for a meaningful GAP analysis.

  • CP 17, internal control and audit, and CP 18, abuse of financial services, are compliant.

Methods of ongoing banking supervision (CPs 19-21)

20. These CPs were found to be largely compliant. The supervisory approach is generally appropriate for the size and complexity of the size of the economy and the portfolios of the commercial banks. The CBA would benefit from better data from the banks to improve the information about risks in banks. Supervisory techniques are generally broad but additional analytical depth is needed. Supervisory reporting needs to be enhanced to provide more risk oriented information.

Accounting and disclosure (CP 22)

21. This CP is largely compliant. Legislative proposals are being prepared to require the CBA’s prior approval in the change of its external auditors and requiring banks to publish their annual audited financial statements.

Corrective and remedial powers of supervisors (CP 23)

22. This CP is largely compliant as there are draft amendments to the banking law granting the CBA the authority to impose a tiered system of administrative fines on banks and individual managers and board members.

Consolidated and cross-border banking supervision (CPs 24-25)

23. CP 24 is not applicable as local banks to not have foreign branches or subsidiaries. CP 25 was found to be compliant.

Table 1.

Aruba: Summary Compliance with the Basel Core Principles—Detailed Assessments

article image
article image
article image
Aggregate: Compliant (C) - 12, Largely Compliant (LC) - 14, Materially Non-Compliant (MNC) - 2, Non-Compliant (NC) - 1, Not Applicable (N/A) - 1

Recommended action plan and authorities’ response

Recommended action plan
Table 2.

Aruba: Recommended Action Plan to Improve Compliance with the Basel Core Principles

article image
article image

Authorities’ response to the assessment

24. The authorities indicated that although on certain issues their views differ slightly from those of the mission, they are of the opinion that such reports are well balanced and give a detailed view of the areas that need further improvement. They were also pleased that the report acknowledged the progress made since the last assessment and the ongoing efforts to strengthen the legal framework and supervisory practices. The authorities stressed their intention to follow up swiftly on the recommendations made in the report and, in this regard, a detailed action plan for furthering compliance with the BCPs will be prepared on short term, also taking into account the action plan recommended in the assessment. The authorities also indicated that they intend to submit a request for technical assistance of the Dutch Central Bank in the areas that need further strengthening, particularly on risk management and risk based supervision. They also noted that they would appreciate receiving Fund technical assistance to conduct a stress test on the resilience of the financial system.

II. Detailed Assessment

A. Principle-by-principle assessment

25. The assessment of compliance of each principle was made based on the following four-grade scale: compliant, largely compliant, materially noncompliant, and noncompliant.

  • Compliant—A country will be considered compliant with a Principle when all essential criteria applicable for this country are met without any significant deficiencies. There may be instances, of course, where a country can demonstrate that the Principle has been achieved by other means. Conversely, due to the specific conditions in individual countries, the essential criteria may not always be sufficient to achieve the objective of the Principle, and therefore other measures may also be needed in order for the aspect of banking supervision addressed by the Principle to be considered effective.

  • Largely compliant—A country will be considered largely compliant with a Principle whenever only minor shortcomings are observed which do not raise any concerns about the authority’s ability and clear intent to achieve full compliance with the Principle within a prescribed period of time. The assessment “largely compliant” can be used when the system does not meet all essential criteria, but the overall effectiveness is sufficiently good, and no material risks are left unaddressed.

  • Materially non-compliant—A country will be considered materially non-compliant with a Principle whenever there are severe shortcomings, despite the existence of formal rules, regulations and procedures, and there is evidence that supervision has clearly not been effective, that practical implementation is weak, or that the shortcomings are sufficient to raise doubts about the authority’s ability to achieve compliance. It is acknowledged that the “gap” between “largely compliant” and “materially non-compliant” is wide, and that the choice may be difficult. On the other hand, the intention has been to force the assessors to make a clear statement.

  • Non-compliant—A country will be considered non-compliant with a Principle whenever there has been no substantive implementation of the Principle, several essential criteria are not complied with or supervision is manifestly ineffective.

26. In addition, a Principle will be considered not applicable when, in the view of the assessor, the Principle does not apply given the structural, legal and institutional features of a country.

Table 3.

Aruba: Detailed Assessment of Compliance with the Basel Core Principles

article image
article image
article image
article image
article image
article image
article image
article image
article image
article image
article image
article image
article image
article image
article image
article image
article image
article image
article image
article image
article image
article image
article image
article image
article image
article image
article image
article image
article image
article image
article image
article image
article image
article image
article image
article image
article image
article image
article image
article image
article image
article image
article image
article image
article image
article image
article image
article image
article image
article image