A. Introduction

15. In its May 2000 discussion, IMF Executive Directors⁸ noted serious weaknesses in banking supervision in many countries, especially in the areas of risk management, corrective actions, and consolidated supervision. Additional sources of weaknesses arose from deficiencies in many of the preconditions for effective banking supervision, loan valuation procedures, accounting systems, legal processes, and market discipline. The Board welcomed the positive effect of the Methodology on the quality of the assessments, and noted the value of self-assessments. Without neglecting other areas, Directors considered that TA should focus on the main weaknesses found in the review, and resources for this purpose should continue to be carefully reviewed and increased as needed. Directors welcomed the Fund’s increasingly active collaboration and dialogue with the Basel Committee and encouraged the Fund staff to contribute to the efforts of the Basel Committee to further improve the Core Principles and their implementation (see Box 2).

16. This section analyzes the main results of the assessments undertaken as of December 2001. For several reasons, it is difficult to draw conclusions about countries’ progress in implementing the BCP since May 2000, mainly because group composition has changed.⁹

17. The aggregate results of the assessments are largely indicative of the stage of development or transition of the countries. Reaching full, or a large degree of compliance is still considered a long term goal for many countries, which will require continued work on their part. Many of the areas that were signaled as weak in the 2000 review, are still relatively poorly complied with, for instance the principles on country risk and market risk, money laundering and consolidated supervision. Also non-compliance or weak compliance with supervisory independence is still relatively high. The absolute levels of weak or non-compliance have declined. In 2000, for instance, nearly 70 percent of assessed countries were non-compliant or materially non-compliant with the core principle on market risk. Now, that percentage is close to 50 percent. Weak or non-compliance on money laundering dropped from 70 percent to 50 percent.

18. Partially this “softening” of the outcomes may be explained by the relatively much larger percentage of industrialized countries that have been assessed, from one in 26, to nine in 60. Without a reassessment of countries¹⁰, no information is available on whether countries that have been assessed have improved their systems after their initial assessment. What is more relevant, however, is the relatively large number of countries that still show weaknesses on essential points such as independence of the supervisor and consolidated supervision. It would be misleading to conclude that compliance has improved across the board over the past two years.

19. As of December 2001, 60 assessments had been performed, including 15 transitional countries, 36 developing countries, and the remainder advanced economies¹¹. Assessments have taken place: (i) on a “stand alone” basis, (ii) as part of the Financial Sector Assessment Program, or (iii) as part of the OFC (Offshore Financial Center) program.¹²

Table 1.

BCP Assessments Performed

Table 1.

BCP Assessments Performed

Year13	Total	FSAP	OFC	Other s
1999 and before	12	3	-	9
2000	24	16	-	8
2001	24	19	4	1
Total	60	38	4	18

View Table

Table 1.

BCP Assessments Performed

Year13	Total	FSAP	OFC	Other s
1999 and before	12	3	-	9
2000	24	16	-	8
2001	24	19	4	1
Total	60	38	4	18

B. Main Findings¹⁴

20. Table 2 summarizes compliance with individual BCPs. The assessments¹⁵ for each BCP were aggregated across all 60 countries.¹⁶

Table 2.

Core Principles Compliance

(In percentages of 60 countries assessed)¹

^1/Source: BCP, FSAP reports, OFC reports

Table 2.

Core Principles Compliance

(In percentages of 60 countries assessed)¹

	Compliant	Largely compliant	Materially Non-compliant	Non-Compliant	Not Applicable
1. Framework for supervisory authority
1.1. Objectives	63	24	13	0	0
1.2. Independence	30	30	37	3	0
1.3. Legal framework	63	27	7	3	0
1.4. Enforcement powers	52	28	18	2	0
1.5. Legal protection	46	13	17	22	2
1.6. Information sharing	40	28	25	7	0
2. Permissible activities	63	30	5	2	0
3. Licensing criteria	38	47	12	3	0
4. Ownership	52	21	17	10	0
5. Investment criteria	28	45	22	5	0
6. Capital adequacy	28	37	33	2	0
7. Credit policies	37	23	38	2	0
8. Loan evaluation	25	46	27	2	0
9. Large exposures	32	43	22	3	0
10. Connected lending	28	30	32	10	0
11. Country risk	23	10	10	35	22
12. Market risks	23	29	35	13	0
13. Other risks	17	38	27	18	0
14. Internal control	32	36	22	10	0
15. Money laundering	28	22	20	30	0
16.On-site and off-site supervision	42	38	18	2	0
17. Bank management	48	39	10	3	0
18. Off-site supervision	35	35	28	2	0
19. Validation of information	47	33	20	0	0
20. Consolidated supervision	23	12	30	23	12
21. Accounting	35	42	20	3	0
22. Remedial measures	23	35	40	2	0
23. Global consolidation	25	17	18	12	28
24. Host country supervision	32	22	18	8	20
25. Supervision of foreign establishments	43	27	23	5	2

^1/Source: BCP, FSAP reports, OFC reports

View Table

Table 2.

Core Principles Compliance

(In percentages of 60 countries assessed)¹

	Compliant	Largely compliant	Materially Non-compliant	Non-Compliant	Not Applicable
1. Framework for supervisory authority
1.1. Objectives	63	24	13	0	0
1.2. Independence	30	30	37	3	0
1.3. Legal framework	63	27	7	3	0
1.4. Enforcement powers	52	28	18	2	0
1.5. Legal protection	46	13	17	22	2
1.6. Information sharing	40	28	25	7	0
2. Permissible activities	63	30	5	2	0
3. Licensing criteria	38	47	12	3	0
4. Ownership	52	21	17	10	0
5. Investment criteria	28	45	22	5	0
6. Capital adequacy	28	37	33	2	0
7. Credit policies	37	23	38	2	0
8. Loan evaluation	25	46	27	2	0
9. Large exposures	32	43	22	3	0
10. Connected lending	28	30	32	10	0
11. Country risk	23	10	10	35	22
12. Market risks	23	29	35	13	0
13. Other risks	17	38	27	18	0
14. Internal control	32	36	22	10	0
15. Money laundering	28	22	20	30	0
16.On-site and off-site supervision	42	38	18	2	0
17. Bank management	48	39	10	3	0
18. Off-site supervision	35	35	28	2	0
19. Validation of information	47	33	20	0	0
20. Consolidated supervision	23	12	30	23	12
21. Accounting	35	42	20	3	0
22. Remedial measures	23	35	40	2	0
23. Global consolidation	25	17	18	12	28
24. Host country supervision	32	22	18	8	20
25. Supervision of foreign establishments	43	27	23	5	2

^1/Source: BCP, FSAP reports, OFC reports

21. Table 3 shows that 32 countries are compliant with 10 or fewer BCPs. Many of these countries are still in the process of building their supervisory systems to meet BCP standards or reforming them. Only five countries were assessed as fully compliant with 25 or more of the BCPs.¹⁷

Table 3.

Country Compliance

(In number of BCPs)¹

^1/Source: BCP, FSAP reports, OFC reports.

^2/Although the BCP and the Methodology state that the Basic Core Principles comprise twenty-five Principles and requires evaluation of compliance with each Principle, the Methodology divides Principle 1 into six component parts and considers that “a more detailed assessment of Principle 1 is required, given its importance for assessing the overall potential effectiveness of the banking supervision function.” Currently, assessments are performed individually for each of the six sub-principles in BCP 1 and an overall rating for BCP1 is not always provided (only in 13 assessments out of the 60). For the initial 26 assessments discussed in the May 2000 paper a proportionately larger number of assessments had provided an overall assessment of BCP 1. Therefore, in this paper, the six sub principles included in BCP1 have been listed separately. The 24 principles plus the six sub-principles of BCP 1 together account for 30 principles.

Table 3.

Country Compliance

(In number of BCPs)¹

Number of Principles with number of countries which countries comply		Advanced economies	Transitional countries	Developing countries
26-302/	5	4	1	-
21-25	5	2	-	3
16-20	6	1	4	1
11-15	12	1	2	9
6-10	11	1	3	7
0-5	21	-	5	16
TOTAL	60	9	15	36

^1/Source: BCP, FSAP reports, OFC reports.

^2/Although the BCP and the Methodology state that the Basic Core Principles comprise twenty-five Principles and requires evaluation of compliance with each Principle, the Methodology divides Principle 1 into six component parts and considers that “a more detailed assessment of Principle 1 is required, given its importance for assessing the overall potential effectiveness of the banking supervision function.” Currently, assessments are performed individually for each of the six sub-principles in BCP 1 and an overall rating for BCP1 is not always provided (only in 13 assessments out of the 60). For the initial 26 assessments discussed in the May 2000 paper a proportionately larger number of assessments had provided an overall assessment of BCP 1. Therefore, in this paper, the six sub principles included in BCP1 have been listed separately. The 24 principles plus the six sub-principles of BCP 1 together account for 30 principles.

View Table

Table 3.

Country Compliance

(In number of BCPs)¹

Number of Principles with number of countries which countries comply		Advanced economies	Transitional countries	Developing countries
26-302/	5	4	1	-
21-25	5	2	-	3
16-20	6	1	4	1
11-15	12	1	2	9
6-10	11	1	3	7
0-5	21	-	5	16
TOTAL	60	9	15	36

^1/Source: BCP, FSAP reports, OFC reports.

^2/Although the BCP and the Methodology state that the Basic Core Principles comprise twenty-five Principles and requires evaluation of compliance with each Principle, the Methodology divides Principle 1 into six component parts and considers that “a more detailed assessment of Principle 1 is required, given its importance for assessing the overall potential effectiveness of the banking supervision function.” Currently, assessments are performed individually for each of the six sub-principles in BCP 1 and an overall rating for BCP1 is not always provided (only in 13 assessments out of the 60). For the initial 26 assessments discussed in the May 2000 paper a proportionately larger number of assessments had provided an overall assessment of BCP 1. Therefore, in this paper, the six sub principles included in BCP1 have been listed separately. The 24 principles plus the six sub-principles of BCP 1 together account for 30 principles.

22. One of the key objectives of the BCP is to contribute to international financial stability. It is clear that instability in systemically significant countries can spill over to other countries, either on a regional level or globally. Of the population of countries that have been assessed so far, only a few countries can be considered to be of systemic importance on a regional or global level: Canada, France, India, Indonesia, and South Africa. Only recently have more systemically important countries agreed to an FSAP / BCP assessment. Currently, there is no scope for analysis of the direct linkage between the level of BCP compliance and financial sector stability, as the latter depends on many other variables as well.

23. Developing countries generally show lower levels of compliance than advanced economies or transitional countries. Many of the transitional countries assessed have intermediate levels of compliance. Weaknesses in compliance in developing and transitional countries are more widely spread across the BCPs and are more interrelated.

24. Advanced economies generally possess more robust internal frameworks as defined by the preconditions. Some of the main shortcomings found include a lack of sufficiently explicit powers to require changes in the composition of bank boards and senior management or to reverse the appointment of a manager once the person has been hired (i.e. the authority to effectively address bank governance weaknesses). In some countries, supervisors lack powers to require a bank to strengthen its lending practices and levels of provisions and reserves.

25. Developing countries generally are characterized by less favorable preconditions, including unstable macroeconomic conditions, inadequacies of the laws and judicial systems, weak credit culture and accounting systems, low disclosure and incipient or nonexistent safety nets. The overriding weakness in a number of countries is the lack of bank and/or supervisory independence from political influence. This influence is most apparent with regard to the management of public banks and the handling of weak banks. Budget constraints limit staff numbers and training. The effectiveness of supervision also suffers from the lack or inadequate exercise of consolidated supervision. Weaknesses are also found in other important areas such as capital adequacy and risk management.

26. Weakness in compliance with preconditions is difficult and time-consuming to address, and often relates to areas outside the jurisdiction of the supervisory authorities. Improvements in the accounting, legal and judicial systems are medium to long-term issues, which cannot be remedied easily. Supervisory independence may require changes in the Banking and Central Bank Laws as well as constitutional law. These issues may need to be addressed in a longer term, well-coordinated, technical assistance program. Specifically, research supports that supervisory independence plays a key role in achieving financial stability.¹⁸

27. Countries in transition generally have made more progress in establishing macroeconomic stability and implementing institutional and structural reforms. However, banking culture and corporate governance have not yet been fully developed and legal and judicial systems still suffer deficiencies. Fuelled by their will to become members of the European Union, many Central and Eastern European countries are in the process of implementing new prudential regulations. The review of compliance with BCPs has shown that supervisory agencies have invested in human resources, but there still remains a need for more experienced supervisors and more training in areas such as credit risk analysis, market risk and consolidated supervision.

C. Specific Areas of Concern

28. The following paragraphs review the preconditions and principles of which compliance has tended to be weakest, in terms of the percentage of countries receiving a compliance rating of “materially non-compliant” or “non-compliant” for that particular BCP.¹⁹ Within the BCBS, and within the group of assessors, discussions have taken place on the relative importance of individual core principles, but it was concluded that the relative importance is very difficult to measure, and differs from country to country. Also, any type of weighting of the core principles would be extremely difficult to achieve. In practice, assessors will group interrelated core principles in their analysis, for instance on the key issues of credit risk management, connected lending, and effective on-site supervision, but also here these groupings may differ from country to country. Assessors should take these interlinkages into account and report on them in the assessment.

Preconditions for effective banking supervision:²⁰

29. Overall, the findings of this survey suggest that compliance with the BCP is positively correlated to compliance with the preconditions and the stage of development of the financial sector.

30. The preconditions are not formally a part of the BCP, as they are largely outside the jurisdiction of the supervisory authorities. Thus, the BCP Methodology does not develop specific criteria for the assessment of compliance with the preconditions. However, the Introduction to the Methodology does mention the preconditions, i.e. sound and stable macroeconomic policies, good public infrastructure, efficient bank resolution procedures, and appropriate safety nets. These elements are not explicitly covered in the assessments, but a more structured approach to their evaluation could improve the analysis of the BCPs. It could furthermore enhance the discussion within an FSAP of linkages between the macro economy, the condition of the banking sector and the effectiveness of supervision. This is in part the argument for including the BCP assessments into the FSAP, in order to better illustrate the linkages between the soundness of the banking system and the macro economy.

31. The most frequent weaknesses found in the set of preconditions are:

• Unstable macroeconomic conditions: many supervisors have not developed sufficient analytical frameworks to take into account the implications of macroeconomic conditions in their banking systems, in many cases due to the lack of accurate data and insufficient IT resources.

• Obsolete bankruptcy laws, long judicial delays in loan collection and procedures for collateral foreclosure (due to overloaded courts or courts subject to undue influence) hamper the development of a proper credit culture. Weak accounting standards, lack of reliable and meaningful information in financial reports, long lags in the publication of the annual accounts and the absence of a high quality audit profession are also frequently found.

• Inefficient resolution of bank problems: Supervisors lack the ability or the resolve to step in early in the process and see to the prompt and orderly resolution of problem banks. Furthermore, there is, in some countries, a widespread presumption that the authorities would not allow any bank to fail. In many countries, deposit insurance arrangements are not in place or are in the process of being set up.

32. Another issue that is not addressed explicitly in the preconditions or the BCPs (although closely related with BCP 2) is the treatment of non-bank financial entities and other deposit-taking companies, in light of the vulnerabilities they may represent for the banking system. The scope of banking supervision is not uniform in countries around the world. For instance, different approaches are applied to the mutual credit sector across countries. In several countries, the numerous credit unions are only partially covered or not covered at all by the Core Principles, while in others they are subject to full supervision (usually less intense than for “banks”). Another case involves the supervisory approach to the “informal sector” made up of micro-finance institutions or individuals, which in some countries, has become a significant sector.

BCP 1 on the framework for supervisory authority.

33. Almost half of the assessed countries are compliant with most of the elements of BCP 1, and have the framework for effective banking supervision broadly in place. In light of the relevance for effective supervision, it should be noted that of the six components of BCP 1, the independence of the supervisory authority (BCP1.2) shows the lowest level of compliance. Table 2 indicates that in 40 percent of assessed countries supervisory independence is still considered a major problem. On this point, supervisory agencies need a firmer legal and institutional basis, as well as adequate financial and human resources that allow them to take prompt remedial action when needed, also against weak state-owned banks. Lack of trained supervisors is seen as a major weakness since it impacts the observance of many other principles.

34. Weak observance is also found in another two components of BCP1. Legal protection for supervisors (covered by BCP 15; almost 40 percent non-compliant or materially non-compliant ) varies widely across countries. Efficient action against problem banks is often reversed by a weak court system. Furthermore, in only about a third of countries, formal arrangements have been established for sharing information with domestic supervisors of other financial sectors and with banking supervisory agencies abroad (BCPs1.6, 24 and 25.). This is especially relevant in light of the fact that foreign banks have an increasingly significant presence in many countries. Even when the arrangements are in place, the exchange of information is infrequent and not sufficiently informative. The existence of bank secrecy provisions many times prevents information sharing between supervisors.

BCPs 7 and 10 on credit policies and connected lending.

35. About 40 percent of countries show weak compliance with these principles. Losses from credit risk remain the largest threat to sound banking systems. They are often the consequence of “name lending,” connected and government-directed lending, lax management controls and poor credit risk management techniques. Banks and supervisors often rely on lagging indicators of loan performance. Loans are frequently granted based exclusively on the existence of collateral, insufficiently taking into account actual cash flow needed to service the loans. Bank supervisors need to insist more on banks making loans based on the lender’s capacity to repay the loan and on improvement of lending policies and procedures. Where collateral is taken, it must be conservatively valued to reflect current fair value. Especially in the absence of effective consolidated supervision, identification of connected and related borrowers can be extremely difficult. Often, complex governance, ownership and corporate group structures are used to hide connected exposures from banks and supervisors. Furthermore, regulations in regard to connected lending differ widely among countries, and are often not implemented sufficiently rigorously.

BCP 8 on loan evaluation. ²¹

36. About 30 percent of countries show weak compliance with this related principle. In many countries, the guidelines for loan loss classification and provisioning show serious deficiencies: lenient classification of problem loans, excessively generous treatment of collateral and valuation of foreclosed assets, weak treatment of restructured operations and unfavourable tax treatment of provisions. In many countries, even when formal loan classification and provisioning regulations are adequate, the actual verification by the supervisor of banks’ reports on asset quality may be weak. Frequently, the supervisors rely excessively on banks’ internal and external audit systems to verify the accuracy and completeness of such reporting. Furthermore, underlying asset valuation, particularly in distressed bank situations, has been found to be repeatedly suspect. Inaccurate asset values, inadequate loan provisioning, and improper income recognition on non-performing assets overstate income and therefore misstate capital positions and adequacy, all of which are used by the market place as key bank performance indicators. Even though many supervisory agencies have improved their guidelines and capacity to evaluate asset quality, many still require further development and enforcement capacity. Many supervisory agencies need to adopt a more effective on and offsite processes to verify banks’ asset classification, valuation, and provisioning policies and practices and the accuracy therein. In particular, this requires more active onsite evaluation of loan quality and reporting verification.

BCP 11,12, and 13 on country risk, market risk and other risks.

37. Nearly half of the countries assessed show weak compliance with these principles. Monitoring of these risks is at an early stage in many countries, as risk levels may be minimal, with the exception of liquidity risk. Currently, country risk is often not considered an issue and is frequently not addressed. Many supervisors have not developed their own techniques for the supervision of banks’ liquidity and interest rate risk. In many transitional and developing countries supervisors often lack expertise in these areas. However, looking forward, and depending on the state of development of the economy and the markets, supervisory authorities may need to develop mechanisms to address these risks.

BCP 15 on money laundering.

38. As many as 50 percent of countries show weak compliance with this principle. Most member countries of the Financial Action Task Force (FATF) and many outside the FATF are in the process of issuing or have already issued laws and regulations complying with AML/CFT standards set up by the FATF. However, “know-your-customer” requirements are not always sufficiently detailed and tested in practice. The involvement of bank supervisors under BCP 15 is typically limited to monitoring whether banks have put appropriate systems in place for the implementation of know your customer rules, reporting of unusual transactions, staff awareness training, and appropriately disseminated policy statements against money laundering. The supervisors are usually also under an obligation to report any signs of money laundering in supervised institutions to the law enforcement authorities.

BCP 20 on consolidated supervision.

39. More than half of the countries assessed show weak compliance with this principle and 30 percent with BCP 23 on global consolidation. Many countries are in the early stages of implementing the necessary legal scope to conduct consolidated supervision and to require consolidated accounting and regulatory reporting. Certainly in transition countries, internationally accepted accounting standards have only recently been introduced and are in the early stages of being implemented. Also other weaknesses, such as poor administration of company formation and shareholder registration, make supervision on a consolidated basis difficult to implement. Without accurately consolidated accounts and adequate supervisory capacity, supervisors will not be able to form a complete view of a bank’s risk profile and governance structure. Lack of consolidated accounts and prudential reports impedes the understanding of true bank solvency and of aggregated risk exposures of the subject conglomerate as banks can transfer risk to unconsolidated subsidiaries. Also, compliance with other prudential standards such as asset diversification, large exposures, and connected parties becomes difficult to monitor.

40. Especially in light of the emergence of large and complex financial institutions that operate across borders, countries need to urgently develop their consolidated oversight capabilities. Several agencies working on the basis of different legal and regulatory regimes in different jurisdictions may be involved in assessing the risks incurred by a cross-sector financial services group. Data collection, information exchange across sectors and internationally, as well as analysis tend to be underdeveloped. Especially relatively young supervisory agencies which are still building up their supervisory capacity, may be at a serious disadvantage when confronted with complex financial groups.

BCP 22 on remedial measures.

41. Slightly more than 40 percent of countries show weak compliance with this principle. In this area, supervisory agencies often lack enough independence, have weak legal protection for supervisory staff and weak judicial back-up of supervisory actions. In some emerging countries, authorities are unable to follow up on conclusions reached during the supervisory process because the courts have suspended their decisions.These circumstances undermine effective remedial action. In many countries, weak arrangements exist for the judicial enforcement of corrective action; moreover, the array of remedial measures does not address conditions leading up to insolvency and is too limited. It may not be possible, for instance, to impose fines on managers and board members individually.

Other Principles: Observations related to other principles include:

• About a third of reviewed countries show weaknesses in capital adequacy (CP 6). Capital ratio requirements are applied extensively, but in many cases only toward credit risk. In many countries they are still calculated and applied on a non-consolidated basis. In some cases, banks are allowed to operate with inadequate capital for long periods of time, and no corrective actions are taken.

• About a third of reviewed countries have weaknesses in internal controls (CP14). Not many countries have formulated detailed guidance on internal controls, though generic references in the law are quite frequent. Moreover, a comprehensive review of bank internal controls is not always an integral part of the examination process. Clear criteria to evaluate the composition of the board and management board and, consequently, legal powers to require changes in case the criteria is not met, are not well established.

• Slightly less than a third show deficiencies in off-site supervision (CP18). Some supervisory systems are in the process of establishing off-site surveillance units, upgrading their computer equipment and are developing analytical tools and technical analysis. A frequent weakness is the lack of financial statements and prudential returns submitted on a consolidated basis.

42. An important underlying limitation in many countries is that supervisory practice often tends to be “compliance-oriented” with over-reliance on rules and regulations, versus “risk-oriented” supervision where a more forward looking, incisive type of supervision needs to be exercised, and enforcement action also needs to capture unsafe and unsound banking practices.

A. Financial Market Developments

49. Developments in financial markets: Three main developments in the financial markets since 1997 need to be taken into consideration in a review of the BCPs and the Methodology: continued internationalisation of financial markets, the blurring of boundaries between the traditional financial sub-sectors banking, insurance and securities, and acceleration of financial sector consolidation.²⁵ All these changes demonstrate an increasing need for cooperation and coordination in regulations and practices between domestic and international financial supervisory agencies to establish a consistent group-wide supervisory framework. This would comprise supervisors from different sectors and countries, which can effectively supervise a multinational financial conglomerate.²⁶

50. Emergence of Large and Complex Financial Institutions (LCFIs): Although also a more recent development in financial markets, the emergence of LCFIs and the ongoing development of techniques to supervise these institutions, needs to be mentioned separately, in view of the unique issues and problems associated with it. The potential impact of LCFIs on financial system stability (see Box 7) will require review of the relevant BCPs and their Methodology. The BCPs already emphasize the need for effective supervision of a group at both individual entity and consolidated levels and the need for effective consultation and informationsharing between the domestic and foreign supervisors of the entities within the group. Certain important aspects of supervision of LCFIs might call for further enhancement of the BCP, for instance: how to better match capital levels to the risk profiles of LCFIs; how to address the unsupervised components of the group; how to address issues related to cross-border insolvency of a group, how to further develop effective cross sector and cross border supervision, and the extent to which coherent and transparent accounts can be produced for such groups on a consolidated basis.

B. Developments in Banking supervision

51. Development of financial soundness indicators: Increased awareness of the linkages between the cyclical movements in the macro economy and the health of the banking sector has led to the continued refinement of a system of financial soundness indicators.²⁷ The use of financial soundness indicators implies a more system-wide approach to banking supervision. Financial soundness indicators can help signal deteriorating conditions in the economy that can impact the banking sector at a later stage. They fit into the shift in perspective that is gradually taking place among supervisory agencies towards complementing the micro-prudential perspective with the increased awareness of the macro-prudential linkages. The ultimate objective of this is to limit the likelihood of failure, and the associated cost, of significant portions of the financial system. Thus, an expansion of focus is taking place not only to concentrate on depositor protection, but also to consider and to safeguard systemic stability.²⁸

52. Development of anti-money laundering and combating the financing of terrorism (AML/CFT) standards: Future FSAPs will need to devote increased attention to AML/CFT measures by banks and to supervisory monitoring of these measures. From a banking supervisory viewpoint the main risks of AML/CFT are to the integrity and reputation of banks that are contaminated by these activities. Terrorist financing is not explicitly mentioned in BCP 15. In light of the recently enhanced scope and comprehensiveness of the assessment of countries’ AML/CFT policies and practices, coordination between BCP 15 and these assessments will need review. The draft AML/CFT Methodology significantly expands the number of criteria that countries need to meet (see Box 8).

53. Dealing with weak banks, bank intervention and bank insolvency: As work continues on developing techniques to deal with weak banks ²⁹and bank intervention³⁰ there may be a need to revisit the relevant BCPs and Methodology. The challenges that cross border bank resolution and liquidation pose to supervisors need to be taken into account. Remedial measures and intervention are in many cases difficult to take as a result of weak

judicial systems, insufficient independence of the supervisory authority, or a culture of forbearance. A correct balance between rigid prompt corrective actions and a more flexible framework for supervisory intervention needs to be sought.

54. Need for further international guidance on loan classification and provisioning: Increased awareness of the need for sound practices on loan classification and provisioning³¹ has highlighted the need for more international guidance. To support the new capital accord, it is necessary to develop more precise guidance on accurate loan classification and provisioning, without which capital calculations are seriously flawed. In many banking crises, asset classification and valuation was found to be especially weak and misleading. Although the BCBS has started work on this issue, in particular in the document “Sound Practices for Loan Accounting and Disclosure,”³² more specific guidance is needed in many countries, for instance on provisioning levels, and the use of collateral and its valuation.

Also, the relationship between the internal ratings based approach under Basel II, which takes loss experience into account, and the traditional approach to dealing with expected losses through loan classification and provisioning, needs to be examined.

55. The role of state-owned banks: The past years have brought increased awareness of the risks and problems associated with state owned banks. In many member countries, long ignored problems in state owned or controlled banks are causing major quasi fiscal and credit allocation problems. Often they operate under preferential supervisory regimes, thus distorting competition and hiding losses. The role of these institutions will need to be taken into consideration when reviewing the BCP and the Methodology. One way to address this issue could be to bring the current Appendix 1 to the BCP into the main body of the document, and to include it in the assessment exercise.

56. Enhanced awareness of the importance of good external auditors in the supervisory process: ³³ In many countries, the external audit process does not reliably perform its intended role, i.e. of verification of the quality of the financial statements of an institution. Furthermore, supervisors often rely on external auditors to perform on site inspections, certify prudential returns on a periodic basis, certify the annual statements of banks, and provide opinions on internal administrative systems of banks. Good accounting and auditing is also crucial for sound lending decisions of banks, the preparation of consolidated statements and prudential returns, as well as for accurate asset valuation, capital calculation, prevention of circumvention of prudential standards, and for better quality information to the markets and the public. Assessors should also review whether and under what conditions banks’ external auditors have the authority to report directly to the supervisors, and whether these powers are actually used. In light of these conditions, assessments may need to cover the quality of the accounting profession in that country, based for instance on the availability of training, requirements for entry into the profession, and the independence of external auditors, which are generally contracted and paid by the banks. In this context, BCPs 17, 18 and 19 and the associated Methodology criteria may need adjustment.

57. Increased awareness of the importance of good governance and transparency: Increased awareness of the need for governance and transparency standards for banks and supervisory agencies³⁴ will need to be taken into consideration for a new generation of BCP and the Methodology. Sound governance objectives are indicated across many of the existing Core Principles. Raising the importance of sound bank governance by making it more clearly defined and more explicit within the context of the Principles will help facilitate the increasing emphasis on risk based supervision (and thus bank board and management responsibilities and accountability). Nonetheless, sound governance and the ability to address such through the supervisory process will further enhance the effectiveness of bank oversight. Furthermore, good governance in supervisory agencies can promote better policies in banks as supervisors gain enhanced credibility.³⁵ Greater transparency of banking supervision policies can be expected to contribute to the education of the public on banking sector and supervisory issues and contribute to more effective market discipline and greater stability.

58. The shift from compliance oriented supervision to risk-based supervision: In many countries, a shift is underway from solely compliance based supervision to a more risk oriented form of oversight. This shift is likely to be reinforced when countries implement the new Basel Capital Proposals, and under the impact of financial innovations. The BCP and the associated Methodology may need review, in order to assess whether the current BCP and Methodology are sufficiently flexible to accommodate this shift to a more qualitative aspect of banking supervision.

59. The new Basel Capital Accord (Basel II): ³⁶ Although still a consultative document and subject to change, the proposals for a new Basel Capital Accord to replace the 1988 Accord will have a major impact on the formulation of the BCP. The current Basel Capital Accord was finalized in 1988 and developments in banking and regulation, a number of which are described above, have made it necessary to update the Accord. The present Accord only focuses on a limited number of risk categories and risk weights. Basel II takes a more “holistic” approach to banking supervision than the 1988 Capital Accord. It will encompass most of the core aspects of general banking regulation and supervision as well as elements of disclosure and market discipline.

A. Implications for the Standard-Setting Body

60. The key role of the BCP as the accepted global standard for effective banking supervision has reinforced the place of the BCBS as the authoritative standard setter in this area.

61. In order to maintain the relevance of the assessment process, the BCP and the assessment methodology must be reviewed periodically to incorporate the experience of the assessment process as well as new market and prudential developments. At the same time, standards should not be revised so frequently as to become “moving targets,” which many countries may not be able to implement in time. There should be a trade-off between setting “state of the art” international standards, and the avoidance of “regulatory fatigue” in countries that need to implement these standards.

62. Guidance issued by the BCBS needs to balance the need for universally acceptable standards against the need for standards that accommodate different backgrounds and systems. The joint IMF-World Bank document entitled “Technical Review on Strengthening the Assessment of Financial Sector Standards”³⁷ emphasizes that calibrating the BCP, or modifying the assessment criteria to fit the specific circumstances of countries, would be contrary to the Basel Committee’s intended objective of viewing the BCP as the standard aimed at universal adoption and implementation. The risk of imposing unachievable standards is mitigated by the policy of the BCBS to closely involve non G-10 countries through the Core Principles Liaison Group, which has been instrumental in the definition of both the Core Principles and the Assessment Methodology.

Review of the Basel Core Principles and the Methodology

63. The BCP prove to have been well formulated, and to stand up well in the face of the new challenges. However, a review will be needed to assess to what extent the issues raised above can be accommodated into the current principles or whether additional principles are advisable. The Methodology may also need to be reviewed. New assessment criteria may be needed in some cases, while in others, a shift from “additional” criteria to “essential” may be enough. A third element in ensuring that the BCP continue to address current issues can be the issuance of additional detailed technical guidance papers by the BCBS.

64. As the review of compliance and the assessment process has shown, the preconditions can have a profound impact on the potential to comply with the BCPs. Therefore, more methodological guidance on their evaluation is advisable. Although in some cases new international guidance has been issued since the publication of the BCP³⁸ or experience has highlighted the main aspects that such guidance should cover, there are others where further work needs to be done, for instance, on the linkages between the macro-economy and the banking sector. Preconditions might be addressed in two non-mutually exclusive ways: first, assessors would review in more detail certain infrastructure elements comprised by the preconditions and which support effective supervision, and, second, assessors would review what actions regulators and supervisors might undertake to countervail the negative impact of the lack of such preconditions on safe and sound banking and on effective supervision. Such a review might require that additional expertise, for instance in the legal or accounting area, be added to assessment teams. Furthermore, coordination will be needed when some of the preconditions are also relevant to other standards, as is likely to be the case for—for instance—the IAIS or IOSCO standards.

65. In some countries, the assessors may determine that the preconditions are not complied with. Although this will severely impact the overall level of compliance, also in these cases the BCP assessment should continue, as the assessments have been found very useful by the countries involved, as well as by the Fund and the Bank. Second, it is desirable to avoid an interruption of the program. Third, future assessments will also need to deal with other events that have an impact on the level of compliance, such as the introduction over time of a new generation of BCPs.

66. Furthermore, additional guidance is needed on several principles. For instance, there is a need to consider possible ways to strengthen supervisory independence (BCP 1.2), in particular ensuring appropriate governance arrangements for supervisory agencies—clear mission statements, adequate arrangements to support accountable decision-taking processes, effective channels of communication to ensure that staff and supervised institutions fully understand the policies and procedures, or ways to address conflicts of interest. Principle 8 on loan classification and loss provisioning should be complemented with more precise guidelines on loan evaluation, income recognition, collateral valuation, establishment of loan loss allowances, and credit risk disclosure.³⁹ Furthermore, a number of other principles need more methodological guidance, such as the supervisory regime for state banks, credit risk management and connected lending and large exposures, management of other risks, consolidated supervision, corporate governance for banks, information requirements, remedial measures and cross border banking. In some cases, as the BCBS⁴⁰ has already issued guidelines covering some of these issues, the only need will be to update accordingly the BCPs or the Methodology.

67. Regarding the new Capital Accord: Many components of Basel II may be addressed in the present BCPs, since they are parts of generally accepted international standards for effective supervision. However, some important new aspects are not dealt with, or only briefly mentioned by the current BCPs. The new Accord will only become operational at the beginning of 2007, and its proposals are not currently a part of the accepted standards for effective banking supervision. Nevertheless, the proposals cast their shadow ahead, and will impact thinking on the revision of the current BCPs. The following paragraphs are aimed to briefly describe only the most important implications for the content of the BCPs:

• For Pillar I of the proposals, the BCPs do not seem to imply major changes. They are sufficiently broadly formulated, and seem able to incorporate banks’ more risk oriented capital adequacy systems, also using the internal ratings-based (IRB) approach. The Methodology may require additional criteria, for instance, to facilitate assessment of supervisory capacity to judge and potentially reject banks’ IRB systems,⁴¹ or the acceptability of rating agencies and export credit agencies as sources of input for the standardized approach. More specificity may be needed in the BCPs and the Methodology to support prudential standards in newly prominent areas such as credit risk mitigation, interest rate risk, operational risk, and securitization.

• Pillar II implies significant additional responsibilities for supervisors, including, for instance, evaluating banks’ internal capital assessment processes or selecting which credit rating agencies are acceptable. Possibly more emphasis will be needed on BCP 1, i.e., addressing the ability of the supervisory authority to do its job, particularly in terms of having sufficient discretionary powers balanced with a suitable framework for transparency and accountability, and an adequate staff. Stronger formulation may be needed for the legal protection of supervisory officials in this more discretionary environment that Basel II envisages. More emphasis may be needed on encouraging supervisory arrangements that allocate resources and design regulatory programs that take into account banks’ systemic importance, for instance focusing more intensely on those banks whose risk profile or operational experience warrants such attention or categorizing banks with regard to their capital ratio and requiring a certain level of capital in order for a bank to engage in certain activities or to make certain acquisitions. More explicit language may be needed on appropriately frequent and effective interaction between supervisors and banks, an area, which Pillar II emphasizes and which is not always well developed.

• Pillar III puts increased emphasis on market discipline and requires banks to disclose more information. Supervisors will need adequate powers to ensure that banks’ management disclose appropriate and accurate information. In the present BCP little mention is made of the need for public disclosure of banks’ financial information. The current text of BCP 21 is too limited to support Pillar III requirements.

68. As shown above, there will be room for differences in country implementation. However, differences should not lead to regulatory arbitrage. In order to improve supervisory convergence, the BCBS has established an Accord Implementation Group, where bank regulators from different countries will exchange their experiences on applying Basel II. The conclusions of this forum, and also any future interpretations of Basel II by the BCBS itself, will also have an impact on the interpretation of the BCPs and of the assessment criteria.

69. Other developments in financial markets and banking supervision, as indicated in the previous chapter, affect the BCP in several ways and they will need to be taken into account when reviewing the BCP, for instance, the effectiveness of the supervisory arrangements and the ability of the supervisors to exercise oversight over LCFIs. More guidance is advisable on dealing with weak banks that takes into account the progress of the work that is underway. More specific guidance on loan classification and provisioning needs to be provided. State owned banks tend to play a problematic role in many developing country financial sectors that may need specific mention in the BCP. More attention needs to be paid to issues of bank and supervisory agency governance and transparency. An underdeveloped area that requires more prominence in assessments of supervisory practices is that of international cooperation between financial sector supervisors.

70. Coordination with other standard-setting bodies: Moreover, standards on securities, insurance, payment system oversight, corporate governance, and transparency of monetary and financial policies, will need to be taken into account⁴² in keeping the BCP and the assessments up to date. A revision of the BCP should take into account the need for coordination with the CPs of other sectors, without weakening the BCP.

71. Standards on accounting and auditing practices are especially relevant to the BCP. Supervisors should have an interest in the quality of accounting standards and encourage their effective implementation, in view of their importance for the proper measurement of banks’ capital and profitability.⁴³ More emphasis should be given to the importance of such standards, and the role of the supervisors, working closely with the banking industry and the accounting profession, in encouraging their implementation. Furthermore, the role of the auditor’s work in the supervisory review process will need to be reviewed.

72. Especially any standards to be issued by the newly created International Association of Deposit Insurers (IADI)⁴⁴ will be relevant to the BCP, as in many countries deposit insurance agencies have substantial roles in banking supervision or interact closely with the banking supervision authority. New BCPs will need to take issues of deposit insurance into account, or carve these issues out, and leave them for the IADI to deal with. Issues could specifically arise with regard to remedial actions against non-compliant banks.

B. Implications for Assessed Countries

73. The adoption in 1997 of the BCP has shaped the agenda of many supervisory authorities worldwide. Because of this effect, many supervisory authorities have taken concrete steps aimed at upgrading their regulatory and supervisory systems with a view to achieving compliance. Furthermore, the assessment process, based on the BCP and the Methodology, supports further convergence of individual country standards with the international standard, thus promoting financial stability.

74. The assessment of compliance with the BCPs is not an end in itself. Some jurisdictions may have given too much prominence to being rated favorably since their main concern was to obtain a “good assessment” especially relative to peers. Arguably, a distorted assessment, which would not have thoroughly revealed actual weaknesses, would compromise the goal of developing an action plan to correct shortcomings. Although it has been specified that all countries are to be assessed⁴⁵ against the “essential criteria,” it is likely that many of the “additional criteria” will be considered essential in an updated version of BCP, which provides a roadmap for supervisory authorities to take action in anticipation of the “upgrading” of these criteria.

75. External BCP Assessments or Self Assessments: Countries should feel encouraged to request BCP assessments. While the BCP assessments conducted as a part of the FSAP/OFC program provide an external, independent view of country compliance, countries should also perform their own assessment of compliance based on the BCBS guidance document. Fund and World Bank assistance can always be requested for this process. The assessments will help define an agenda for further improvement of the subject supervisory systems, serve as a basis for identifying TA needs, and promote convergence of standards and practice.

76. Need to develop an agenda for regulatory and supervisory reform: Once an assessment is completed, countries often need to amend their legal and regulatory framework. This requires convincing lawmakers that amendments or more fundamental reform is needed, particularly in the case that preconditions require reinforcing. In many instances, the objective of attaining full compliance may also necessitate upgrading of IT systems and internal procedures and provision of training. Moreover, better banking supervision or the introduction of legal and regulatory reform is often slowed by a shortage of qualified human and financial resources. Thus, not all the expected benefits from the FSAP and BCP assessment process have been obtained. Countries can be more pro-active in requesting technical assistance from donor organizations or bilaterally.

77. Emerging countries might reject a revision of the BCP, especially regarding the incorporation of Basel II, because they are just in the process of implementing some of the recommendations included in the 1997 BCP. Furthermore, implementing new amendments will require, in many countries, significant investments in more resources and training. However, this fact should not prevent the revision, as the BCP document states⁴⁶ “banking supervision is a dynamic function that needs to respond to changes in the marketplace. Consequently, supervisors must be prepared to reassess periodically their supervisory policies and practices in the light of the new trends or developments. A sufficiently flexible framework is necessary to enable them to do this.”

C. Implications for the Fund, Bank and Other Agencies

78. The assessment process will tend to mirror the evolution of banking supervision as reflected in the BCP. Assessments will need to cover more areas and will require a broader range of expertise, in order to assess a wider variety of banking supervision systems, as countries use the options in the Basel II framework. These developments raise a number of issues. Maintaining the relevance of the assessment effort will also require these agencies to review what changes in assessment procedures, as well as assessment follow-up, are needed.

79. Consistency of assessments: As shown during the November 2001 Technical Review meeting, the consistency of the assessments is a concern of many countries participating in the program. The publication of many assessments invites cross-country comparison. As indicated above, a number of actions have already been taking by the assessor agencies to address the issue of consistency.

80. Currently all assessments must be carried out on the basis of the agreed-upon Methodology, which comprises very specific criteria (more than 200) that greatly facilitate the conduct of assessments as well as dialogue between assessors and those countries receiving the assessment. The risk of inconsistency is also mitigated by the development of additional assessment tools by the assessing agencies, and outreach meetings to provide an opportunity for countries to comment on the assessment process and compare experiences. The “four-eyes-principle” is applied as much as possible, implying that two assessors are deployed, each from a different supervisory tradition. Furthermore, initiatives have been taken to prepare guidance notes, standardized assessment templates, and briefing notes for experts and participating countries. However, at the Paris Technical Consultations in November 2001, assessors also pointed out that the combination of two different supervisory traditions could give rise to friction and lengthy debates within the team and/or with the country authorities.

81. Cross-sector assessments: A related issue is how to coordinate the assessors’ work across sectors. Since an increasing number of countries are beginning or have already integrated supervision across the various financial sectors (typically banking securities, and insurance or a combination thereof), the assessment process should likewise reflect this configuration.

82. Technical assistance: One of the key objectives of any BCP assessment is to identify any technical assistance needs the country may have to implement its post-assessment reform program. In order to improve systematic and coordinated TA follow-up procedures, the FIRST was developed. This initiative envisages systematic delivery of follow-up technical assistance to countries that have been assessed, and thus also creates incentives to volunteer for an assessment. FIRST will seek to provide support in implementing recommendations emanating from the assessment reports. It will also provide support for countries strengthening their financial systems and implementing standards and codes prior to formal inclusion in the ROSC/FSAP programs. There is no “one-size-fits-all” model for supervising banks, and TA may differ in content.

83. In this context, a key issue that will need further discussion is how to incorporate weaknesses identified in the preconditions, that in many cases are beyond the supervisors’ domain, into the prioritized action plan at the end of the assessment and, therefore, into focused and well coordinated TA.

84. Dissemination: Once standards have been adopted, ensuring proper dissemination to all supervisory authorities is key to their adoption going forward. Aside from the Bank and the Fund, the task of disseminating Basel standards is also assigned to the Financial Stability Institute (FSI). This institution also serves as the training arm of the BCBS. It organizes workshops and seminars on the latest developments in banking supervision, with input from other agencies, including the Bank and the Fund. The FSI also facilitates dialogue and experience-sharing among supervisors, through meetings and seminars. Also the FSF has been advocating the dissemination of the results of BCP assessments and other standards as a means of improving the quality of decisions and/or behavior of market participants, which in turn should contribute to enhancing stability of the global financial system.

85. Training and Resources: The introduction of Basel II, and other new elements in banking supervision, will require that assessors may need training to be fully up to date on developments, in order to be able to perform a proper assessment. There will be a need to train Bank and Fund staff in new supervisory techniques, as they will frequently be playing a coordinating role in the assessment process. As the scope of assessments widens, additional assessment staff may be required to join assessment missions. There will be a need for training and pre-mission guidance on how to assess the practical implementation of the BCP.

86. The BCP and the Financial Action Task Force (FATF): As the AML/CFT standards evolve and become more specialized, and the assessment methodology specifically for AML/CFT is finalized, the issue arises as to how to align the assessment of BCP 15 with the use of AML/CFT methodology. The BCP assessors had, until recently, worked without the benefit of close ties with the FATF and the Bank/Fund AML/CFT experts. But, with the objective of adopting adequate AML/CFT policies, strengthening coordination and cooperation among BCBS, IOSCO, IAIS, World Bank, IMF, FATF and the Egmont Group⁴⁷ has become an absolute necessity. The AML methodology being drafted by the Fund and the Bank has greatly benefited from input provided not only by FATF but also by other standard setters, including the Basel Committee.⁴⁸