Core Principles Methodology

Transcription

1 Core Principles Methodology Basel Committee on Banking Supervision Basel October 1999

2 INDEX EXECUTIVE SUMMARY...1 CHAPTER I: INTRODUCTION...3 OBJECTIVES OF THE CORE PRINCIPLES FOR EFFECTIVE BANKING SUPERVISION...3 ENDORSEMENT OF THE CORE PRINCIPLES BY THE INTERNATIONAL COMMUNITY...3 INTERNATIONAL PRESSURE TO SWIFTLY IMPLEMENT THE CORE PRINCIPLES...3 INITIAL ASSESSMENTS OF COMPLIANCE WITH THE CORE PRINCIPLES...4 NEED FOR A HARMONISED ASSESSMENT METHODOLOGY...5 USE OF THE METHODOLOGY...5 PRECONDITIONS FOR EFFECTIVE BANKING SUPERVISION...6 CHAPTER II: SOME CONSIDERATIONS IN CONDUCTING AN ASSESSMENT...8 CHAPTER III: CRITERIA FOR ASSESSING COMPLIANCE WITH THE CORE PRINCIPLES...10 ANNEX STRUCTURE AND METHODOLOGY FOR ASSESSMENT REPORTS PREPARED BY THE INTERNATIONAL MONETARY FUND AND THE WORLD BANK...49 Introduction...49 Principle-by-Principle Assessment...49 Main Body...51 Supervisory Response...54 Executive Summary...55

3 CORE PRINCIPLES METHODOLOGY EXECUTIVE SUMMARY 1. The Core Principles for Effective Banking Supervision have become the most important global standard for prudential regulation and supervision. The vast majority of countries have endorsed the Core Principles and have declared their intention to implement them. As a first step to full implementation, there should be an assessment of the current situation of a country s compliance with the Principles. Such an assessment should identify weaknesses in the existing system of supervision and regulation, and form a basis for remedial measures by government authorities and the bank supervisors. Such assessments are typically conducted by the countries themselves or by various outside parties. 2. The Basel Committee on Banking Supervision has decided not to make assessments of its own due to a lack of necessary resources; however, the Committee is prepared to assist in other ways, inter alia by providing advice and training. Committee members may also individually participate in assessment missions conducted by other parties such as the IMF, the World Bank, regional development banks, regional supervisory organisations and private consultants. Peer reviews are also possible, whereby supervisory experts from one country assess another country and vice versa. 3. In order for the assessments to be objective and as uniform as possible, there should be harmonised standards for the fulfilment of the Core Principles. Experience has already shown that the Principles may be interpreted in widely diverging ways, and incorrect interpretations may result in inconsistencies among assessments. 4. With this in mind, at its October 1998 meeting, the Basel Committee took the initiative to have a document prepared for use in compliance assessments. The drafting was done by an ad hoc working group consisting of representatives from Basel Committee member institutions and the IMF and World Bank. The Core Principles Liaison Group, consisting of G-10 and non-g-10 senior supervisors and the IMF and World Bank, was also consulted during the drafting process. 5. The document is structured as follows: the first chapter outlines the background to the Core Principles and explains the need for their timely and effective implementation. It also describes under what conditions assessments should be made, as well as the preconditions for effective banking supervision that should be taken into account when forming an assessment. 6. The second chapter raises a few basic considerations regarding the conduct of an assessment and the compilation and presentation of the results. It notes that the assessor must have access to relevant information, without violating legal requirements for supervisors to hold certain information confidential, and to a wide range of organisations and experts. The chapter emphasises that the assessment must consider a chain of related requirements, which may encompass laws, prudential regulation, supervisory guidelines, on-site examinations and off-site analysis, supervisory reporting and public disclosures, and evidence of enforcement or

4 non-enforcement. It also emphasises the importance of the supervisory agency having the necessary skills, resources and commitment to implement the Core Principles. 7. The third chapter discusses each Core Principle in detail. All significant criteria which are relevant for compliance are enumerated. Two categories of criteria are used: essential criteria and additional criteria. The essential criteria are those elements that should be generally present in individual countries in order for supervision to be considered effective. The additional criteria are elements that further strengthen supervision and which all countries should strive to implement. The essential criteria, and to a significant degree the additional criteria, are drawn from the Core Principles document (September 1997) and related Basel Committee papers. The working group has tried not to break new ground by introducing additional concepts or interpretations, although in some cases, particularly regarding the additional criteria, the language and/or substance may be more explicit or detailed than in previous documents. 8. To achieve full compliance with a Principle, the essential criteria generally must be met without any significant deficiencies. There may be instances, of course, where a country can demonstrate that the Principle has been achieved through different 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 the additional criteria and/or other measures may also be needed in order for the aspect of banking supervision addressed by the Principle to be considered effective. 9. By way of example, the Basel Committee includes, as an appendix, the format developed by the IMF and World Bank for conducting their own assessments of the state of implementation of the Core Principles in individual countries. 10. The Committee sees the formulation of this document as an iterative process, with refinements made as experience is gained. Developments of regulatory and supervisory standards and procedures will lead to additions and revisions. Thus, there will be a need to update the document periodically. 2

5 CHAPTER I: INTRODUCTION Objectives of the Core Principles for Effective Banking Supervision 11. The Core Principles for Effective Banking Supervision, developed by the Basel Committee on Banking Supervision in cooperation with supervisors from non-g-10 countries, provide the international financial community with a benchmark against which the effectiveness of bank supervisory regimes can be assessed. 12. The need for strengthening supervision of banks has particularly been stressed as a major priority since it is now widely recognised that weaknesses in banking systems have been at the core of financial crises in many countries over the last decade. As current banking crises affect many countries, both developed and emerging economies, the monitoring of banking systems becomes both more critical and more challenging for supervisors. As a result, and in order to minimise the risk of contagion, developed and emerging countries are being strongly urged to adopt and effectively implement sound supervisory methods. Endorsement of the Core Principles by the international community 13. The Core Principles were issued by the Basel Committee in September 1997, and endorsed by the international financial community during the annual meeting of the IMF and World Bank in Hong Kong in October The report of the Working Party on Financial Stability in Emerging Market Economies endorsed the Core Principles and requested that the IMF and the World Bank play a critical role in their implementation. In October 1998, the Group of 22 countries issued its reports on the international financial architecture, and in its report on Strengthening Financial Systems, the Group endorsed several sets of internationally acceptable principles including the Core Principles and underscored the importance of their timely implementation. The International Conference of Banking Supervisors in Sydney endorsed the Core Principles and pledged to actively contribute to their implementation while requesting more comprehensive guidance from the Basel Committee. The request has resulted in this document. International pressure to swiftly implement the Core Principles 14. As a result of heightened concern about financial sector stability, the community of banking supervisors is under pressure to ensure the effective supervision of banks. In particular, this has been reflected in growing international demands for countries to implement the Core Principles. 15. The Basel Committee recognises that both financial reforms and better banking supervision require broad-ranging and intensive efforts over a long period of time. However, it is of the utmost importance that national supervisory authorities take immediate steps to: i) identify weaknesses in their supervisory system; ii) address the most urgent weaknesses; and 3

6 iii) urge public authorities to support fully all necessary measures to strengthen financial sector stability, including the implementation of the Core Principles. 16. As standard setter, the Basel Committee will remain very active in interpreting the current Core Principles, providing training to supervisors world-wide, and disseminating norms and sound practices. The Basel Committee might find it necessary to refine further the Core Principles to ensure that they are not only comprehensive, but also relevant and useful for all countries wishing to apply them. With respect to interpreting or revising the Core Principles, the Committee will be working very closely with non-g-10 countries, as well as the IMF and the World Bank, within the Core Principles Liaison Group. 17. Both the IMF and the World Bank will play an active role in the implementation process. In the context of its surveillance mandate, the IMF will encourage its member countries to comply with the Core Principles, and will work with them in assessing compliance on a case-by-case and priority basis. In the course of its regular operations, the World Bank will encourage its client countries to adopt the Core Principles and will also work with them to assess their supervisory framework against the Principles. Both the IMF and the World Bank will seek to have countries remedy identified weaknesses in their regulatory and supervisory regimes, and will provide technical assistance and training to address such weaknesses on a priority basis. To meet the increasing demands in the financial sector area, both institutions are increasing the number of staff with financial sector expertise. 18. The Basel Committee, the Core Principles Liaison Group, the IMF and the World Bank have an ongoing dialogue to i) coordinate initiatives so that common objectives in this field can be met; and ii) ensure that scarce expert resources are used in the best possible way. Given the challenging objective of strengthening banking supervision worldwide and the scarcity of resources to do so, the above groups are fully aware of the need to closely coordinate their respective activities. These organisations will also utilise resources made available by supervisors world-wide as a means to help countries that ask for technical assistance with the intention of assessing their supervisory systems against the Core Principles. Initial assessments of compliance with the Core Principles 19. While the process of implementing the Core Principles starts with the assessment of compliance, the assessment is a means to an end, not an ultimate objective in itself. Instead, the assessment will allow the supervisory authority (and in some instances the government) to initiate a strategy to improve the system of banking supervision, as necessary. Assessments of compliance have already been initiated in several different contexts. 20. The Basel Committee initiated in April 1998 a survey on compliance with the Core Principles with a view toward preparing information for consideration at the International Conference of Banking Supervisors in Sydney in October The Committee distributed a questionnaire to about 140 countries and asked that supervisors undertake a rigorous assessment of their supervisory systems to determine the extent to which the Core Principles were being implemented. More than 120 countries provided the Committee with such self assessments, but the quality of responses was uneven. 4

7 21. In the meantime, the IMF and the World Bank initiated a review of compliance with the Core Principles in several countries at their request. Being made for the first time, these assessments provided the opportunity to test both the applicability, clarity and completeness of the Core Principles, and the degree to which an outside assessor could form a view regarding compliance. 22. The preliminary reviews of compliance conducted either through self assessments or by third parties have clearly demonstrated that a harmonised assessment methodology is desirable. Need for a harmonised assessment methodology 23. The Core Principles were designed to provide general guidance that could apply to various supervisory regimes, allowing some flexibility in the design and implementation of concrete measures. In so doing, the Basel Committee was also aware that national supervisory authorities might misinterpret the Core Principles. In the same vein, the assessment of compliance with the Core Principles by numerous interested parties (e.g., the IMF, World Bank, regional supervisory groups, regional development banks, consulting firms) is likely to result in varied interpretations and possibly inconsistent advice. Although, the results of the assessments may not be made public, it is still important that assessments be conducted in a consistent manner from country to country. 24. In order to achieve the necessary consistency, the Basel Committee pledged to develop a methodology for performing assessments, including detailed criteria for determining compliance. This methodology will not eliminate the need for both the supervisors and assessors to use their judgement in assessing compliance. Use of the methodology 25. The methodology can be used in multiple contexts: i) self-assessment performed by bank supervisors themselves, ii) peer review conducted for instance within regional groupings of bank supervisors, iii) reviews conducted by private third parties such as consulting firms, or iv) reviews performed in the context of the IMF surveillance or World Bank lending operations. 26. Whatever the context, the following factors are crucial: notwithstanding the benefits of a self-assessment, in order to achieve full objectivity, compliance against the Core Principles is best assessed by a suitably qualified outside party consisting of at least two individuals with varied perspectives so as to provide checks and balances; a fair assessment of the banking supervisory process cannot be performed without the genuine cooperation of all relevant authorities; the assessment of banking supervision by non-experts could be misleading even based on the most detailed checklist; the process of assessing each of the twenty-five 5

8 Principles requires a judgmental weighing of numerous elements that only qualified assessors with practical, relevant experience can provide. the assessment may require legal expertise in the interpretation of compliance with the Core Principles; these legal interpretations must be in relation to the legislative structure of the relevant country. Also, they may require the advice of additional legal experts which can be sought subsequent to the on-site assessment. the assessment must be in sufficient depth to allow a judgement on whether criteria are fulfilled in practice, not in just in concept. Laws and regulations need be effectively enforced and complied with. The mere existence of these does not provide an indication that the criteria are met. Preconditions for Effective Banking Supervision 27. The Basel Committee recognises that effective banking supervision requires a set of preconditions to be in place. 1 While these preconditions are largely beyond the control of the supervisory authority, weaknesses or shortcomings in these areas may significantly impair the ability of the supervisory authority to implement effectively the Core Principles. Hence, the assessors should form a view as to whether these preconditions are in place, as well as the potential problems any shortcomings might entail and whether best efforts are being made to correct these shortcomings. As discussed in the following five paragraphs, the preconditions cover a range of areas, including: (1) sound and sustainable macroeconomic policies; (2) a well-developed public infrastructure; (3) effective market discipline; (4) procedures for the efficient resolution of problems in banks; and (5) mechanisms for providing an appropriate level of systemic protection (or public safety net). 28. The macroeconomic environment and the sustainability of macroeconomic policies are major issues because of their two-way interaction with bank soundness. While the assessment focuses on the adequacy of a country s banking supervisory processes, the assessor should seek to form a view as to whether there are macroeconomic vulnerabilities and risks that have implications for the effectiveness of prudential safeguards or the stability of the financial system. Thus, the assessment of the overall effectiveness of banking supervision and compliance with individual Core Principles should give consideration to the macroeconomic environment. In this respect, it is also important that the assessment take into account the structure of the banking sector and the macroeconomic environment in which the banks operate. 29. The public infrastructure may have a profound impact on the potential to comply with the Core Principles. Perhaps the most important aspect is the existence of a proper credit culture, i.e., an environment that fosters the honouring and enforcement of financial contracts. The credit culture must be built on an adequate body of laws, covering a range of financial issues, including inter alia, contracts, bankruptcy, collateral and loan recovery. But good laws are not enough, they must be supported by a body of ethical and professional lawyers and 1 See Core Principles for Effective Banking Supervision, Section II. 6

9 judges, and a reasonably efficient court system whose decisions are enforceable. An adequate infrastructure also requires that accounting standards approach international best practices, so investors and supervisors can properly evaluate the financial condition of the banks, and the banks can monitor the health of the institutions to which they lend. Accurate financial data requires a professional body of accountants and auditors. Other key considerations in evaluating the public infrastructure are the effectiveness of supervision in other financial sectors and markets, as well as the risks inherent in the payment system. 30. Effective market discipline is based on financial transparency and effective corporate governance; however, the process can be undermined by government efforts to influence commercial decisions, particularly lending operations. Hence, any influence government policies have on lending operations should be as transparent as possible, with government policies published and government guarantees clearly disclosed. 31. Supervisors should have a sufficient and flexible range of procedures to achieve the efficient resolution of problems in banks. The Core Principles note the need for such a range of powers, including responsibility for, or ability to assist in, the prompt and orderly resolution of problem banks. 32. There is a need to ensure that an appropriate public safety net is in place. The key aspects of this safety net may include a lender of last resort facility and/or formal deposit insurance arrangements. While minimum standards for a public safety net have not been agreed, shortcomings in the safety net have implications for banking supervisory practices. 7

10 CHAPTER II: SOME CONSIDERATIONS IN CONDUCTING AN ASSESSMENT 33. While the Basel Committee does not have a specific role in setting out detailed guidelines on the conduct, preparation and presentation of assessment reports, it believes there are a few considerations that assessors should take into account when conducting an assessment and preparing the assessment report. In addition, the Committee is providing in the annex, by way of example, the proposed format to be used by the IMF and World Bank in their assessments. Other potential assessors (e.g., regional development banks, regional supervisory groups) may want to consider using this format in their work although this format is just one way of conducting an assessment. 34. First, when conducting an assessment, the assessor must have free access to a range of information and interested parties. The required information may not only include published information such as the relevant laws, regulations and policies, but also more sensitive information, such as any self-assessments, operational guidelines for supervisors, and, where possible, supervisory assessments of individual banks. This information should be provided as long as it does not violate legal requirements for supervisors to hold such information confidential. The assessor will need to meet with a range of individuals and organisations, including the banking supervisory authority or authorities, other domestic supervisory authorities, any relevant government ministries, bankers and bankers associations, auditors, and other financial sector participants. Special note should be made when any required information is not provided, as well as what impact this might have on the accuracy of the assessment. 35. Second, the assessment of compliance with each Core Principle requires the evaluation of a chain of related requirements, which, depending on the Principle, may encompass law, prudential regulation, supervisory guidelines, on-site examinations and offsite analysis, supervisory reporting and public disclosures, and evidence of enforcement or non-enforcement. It also requires assessing whether the supervisory authority has the necessary skills, resources and commitment to implement the Core Principles. Further, the assessment must ensure that the requirements are put into practice. 36. Third, the primary objective of an assessment should be the identification of the nature and extent of any weaknesses in the banking supervisory system and compliance with individual Core Principles. The assessment should not focus solely on deficiencies but also highlight the achievements. This approach will provide a more accurate measure of the overall compliance with the Principles. The results of such assessments should not be used to grade or rank a supervisory system but rather to develop an action plan that prioritises the improvements needed to achieve full compliance with the Core Principles. It should also indicate the actions and timetable undertaken to address any shortcomings and where a follow-up assessment may be warranted. 37. Fourth, in order to achieve full compliance with a Principle, the essential criteria generally must be met without any significant deficiencies. There may be instances, of course, where a country can demonstrate that the Principle has been achieved through different 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 the 8

11 additional criteria and/or additional measures may also be needed in order for the aspect of banking supervision addressed by the Principle to be considered effective. 38. Fifth, there are certain jurisdictions where non-bank financial institutions, that are not part of a supervised banking group, conduct some bank-like activities, which represent a significant portion of the total financial system and may be largely unsupervised. Since the Core Principles deal specifically with bank supervision, they cannot be applied to these nonbank financial institutions. However, the assessment report should, at a minimum, mention the activities where non-banks have an impact on the supervised banks and the potential problem situations which may develop as a result of the non-bank activities. 9

12 CHAPTER III: CRITERIA FOR ASSESSING COMPLIANCE WITH THE CORE PRINCIPLES The following set of criteria for each of the 25 Core Principles are listed under two separate headings: essential criteria and additional criteria. The essential criteria are those elements that should be present in order to demonstrate full compliance with a Principle. The additional criteria are elements that further strengthen supervision and are recommended for improved financial stability and effective supervision. They may be particularly relevant to the supervision of more sophisticated banking organisations or may be needed in instances where international business is significant or where local markets tend to be highly volatile. The individual criteria are largely based on materials provided in the full Core Principles document (September 1997) and in related Basel Committee papers on sound practices. Where appropriate, the documents have been cited. It should be noted that, while many of the criteria refer to supervisors having the authority to conduct such activities as setting certain standards and requirements for banks, these can also be contained in laws and regulations. Conversely, where it is mentioned that laws and/or regulations are in place on certain issues, the same effect can, in some circumstances, be achieved through guidelines. 10

13 Principle 1: An effective system of banking supervision will have clear responsibilities and objectives for each agency involved in the supervision of banks. Each such agency should possess operational independence and adequate resources. A suitable legal framework for banking supervision is also necessary, including provisions relating to authorisation of banking establishments and their ongoing supervision; powers to address compliance with laws as well as safety and soundness concerns; and legal protection for supervisors. Arrangements for sharing information between supervisors and protecting the confidentiality of such information should be in place. Note: Principle 1 is divided into six component parts. Four of the component parts are not repeated elsewhere in the Core Principles. However two parts (3 & 4) are developed in greater detail in one or more of the subsequent Principles. For these two, since the criteria will be developed further elsewhere, this section identifies only the most fundamental and crucial ones. 1 (1): An effective system of banking supervision will have clear responsibilities and objectives for each agency involved in the supervision of banks. 1. Laws are in place for banking, and for (each of) the agency (agencies) involved in banking supervision. The responsibilities and objectives of each of the agencies are clearly defined. 2. The laws and/or supporting regulations provide a framework of minimum prudential standards that banks must meet. 3. There is a defined mechanism for coordinating actions between agencies responsible for banking supervision, and evidence that it is used in practice. 4. The supervisor participates in deciding when and how to effect the orderly resolution of a problem bank situation (which could include closure, or assisting in restructuring, or merger with a stronger institution). 5. Banking laws are updated as necessary to ensure that they remain effective and relevant to changing industry and regulatory practices. Additional criteria 1. The supervisory agency sets out objectives, and is subject to regular review of its performance against its responsibilities and objectives through a transparent reporting and assessment process. 2. The supervisory agency ensures that information on the financial strength and performance of the industry under its jurisdiction is publicly available. 11

14 1 (2): Each such agency should possess operational independence and adequate resources. 1. There is, in practice, no significant evidence of government or industry interference in the operational independence of each agency, and in each agency s ability to obtain and deploy the resources needed to carry out its mandate. 2. The supervisory agency and its staff have credibility based on their professionalism and integrity. 3. Each agency is financed in a manner that does not undermine its autonomy or independence and permits it to conduct effective supervision and oversight. This includes, inter alia: salary scales that allow it to attract and retain qualified staff; the ability to hire outside experts to deal with special situations; a training budget and program that provides regular training opportunities for staff; a budget for computers and other equipment sufficient to equip its staff with tools needed to review the banking industry; and a travel budget that allows appropriate on-site work. Additional criteria 1. The head of each agency is appointed for a minimum term and can be removed from office during such term only for reasons specified in law. 2. Where the head of an agency is removed from office, the reasons must be publicly disclosed. 1 (3): A suitable legal framework for banking supervision is also necessary, including provisions relating to authorisation of banking establishments and their ongoing supervision. Note: This component of Principle 1 is amplified considerably in the Principles dealing with Licensing and Structure (2 to 5), Prudential Regulation and Requirements (6 to 15), Methods of Ongoing Banking Supervision (16-20), and Information Requirements (21). 1. The law identifies the authority (or authorities) responsible for granting and withdrawing banking licences. 2. The law empowers the supervisor to set prudential rules administratively (without changing laws). 12

15 3. The law empowers the supervisor to require information from the banks in the form and frequency it deems necessary. 1 (4): A suitable legal framework for banking supervision is also necessary, including powers to address compliance with laws as well as safety and soundness concerns. Note: This component of Principle 1 is amplified in Principle 22 which addresses Formal Powers of Supervisors. 1. The law enables the supervisor to address compliance with laws and the safety and soundness of the banks under its supervision. 2. The law permits the supervisor to apply qualitative judgement in forming this opinion. 3. The supervisor has unfettered access to banks files in order to review compliance with internal rules and limits as well as external laws and regulations. 4. When, in a supervisor s judgement, a bank is not complying with laws and regulations, or it is or is likely to be engaged in unsafe or unsound practices, the law empowers the supervisor to: take (and/or require a bank to take) prompt remedial action; impose a range of sanctions (including the revocation of the banking licence). 1 (5): A suitable legal framework for banking supervision is also necessary, including... legal protection for supervisors. 1. The law provides legal protection to the supervisory agency and its staff against lawsuits for actions taken while discharging their duties in good faith. 2. The supervisory agency and its staff are adequately protected against the costs of defending their actions while discharging their duties. 1 (6): Arrangements for sharing information between supervisors and protecting the confidentiality of such information should be in place. 1. There is a system of cooperation and information sharing between all domestic agencies with responsibility for the soundness of the financial system. 13

16 2. There is a system of cooperation and information sharing with foreign agencies that have supervisory responsibilities for banking operations of material interest to the domestic supervisor. 3. The supervisor: may provide confidential information to another financial sector supervisor; is required to take reasonable steps to ensure that any confidential information released to another supervisor will be treated as confidential by the receiving party; is required to take reasonable steps to ensure that any confidential information released to another supervisor will be used only for supervisory purposes. 4. The supervisor is able to deny any demand (other than a court order or mandate from a legislative body) for confidential information in its possession. 14

17 Principle 2: The permissible activities of institutions that are licensed and subject to supervision as banks must be clearly defined, and the use of the word bank in names should be controlled as far as possible. 1. The term bank is clearly defined in law or regulations. 2. The permissible activities of institutions that are licensed and subject to supervision as banks are clearly defined either by supervisors, or in laws or regulations. 3. The use of the word bank and any derivations such as banking in a name are limited to licensed and supervised institutions in all circumstances where the general public otherwise might be misled. 4. The taking of proper bank deposits 2 from the public is reserved for institutions that are licensed and subject to supervision. 2 An example of a proper bank deposit is one that is not subject to security law disclosure requirements. 15

18 Principle 3: The licensing authority must have the right to set criteria and reject applications for establishments that do not meet the standards set. The licensing process, at a minimum, should consist of an assessment of the banking organisation s ownership structure, directors and senior management, its operating plan and internal controls, and its projected financial condition, including its capital base; where the proposed owner or parent organisation is a foreign bank, the prior consent of its home country supervisor should be obtained. 1. The licensing authority has the right to set criteria for licensing banks. These may be based on criteria set in law or regulation. 2. The criteria for issuing licences are consistent with those applied in ongoing supervision. 3. The licensing authority has the right to reject applications if the criteria are not fulfilled or if the information provided is inadequate. 4. The licensing authority determines that the proposed legal and managerial structures of the bank will not hinder effective supervision. 5. The licensing authority determines the suitability of major shareholders, transparency of ownership structure and source of initial capital. 6. A minimum initial capital amount is stipulated for all banks. 7. The licensing authority evaluates proposed directors and senior management as to expertise and integrity (fit and proper test). The fit and proper criteria include: (1) skills and experience in relevant financial operations commensurate with the intended activities of the bank and (2) no record of criminal activities or adverse regulatory judgements that make a person unfit to uphold important positions in a bank. 8. The licensing authority reviews the proposed strategic and operating plans of the bank. This includes determining that an appropriate system of corporate governance will be in place. 9. The operational structure is required to include, inter alia, adequate operational policies and procedures, internal control procedures and appropriate oversight of the bank s various activities. The operational structure is required to reflect the scope and degree of sophistication of the proposed activities of the bank. 10. The licensing authority reviews pro forma financial statements and projections for the proposed bank. This includes an assessment of the adequacy of the financial strength to support the proposed strategic plan as well as financial information on the principal shareholders of the bank. 11. If the licensing authority and the supervisory authority are not the same, the supervisor has the legal right to have its views considered on each specific application. 16

19 12. In the case of foreign banks establishing a branch or subsidiary, prior consent (or a statement of no objection ) of the home country supervisor is obtained. 13. If the licensing, or supervisory, authority determines that the licence was knowingly based on false information, the licence can be revoked. Additional criteria 1. The assessment of the application includes the ability of the shareholders to supply additional financial support, if needed. 2. At least one of the directors must have a sound knowledge of each of the types of financial activities the bank intends to pursue. 3. The licensing authority has procedures in place to monitor the progress of new entrants in meeting their business and strategic goals, and to determine that supervisory requirements outlined in the licence approval are being met. 17

20 Principle 4: Banking supervisors must have the authority to review and reject any proposals to transfer significant ownership or controlling interests in existing banks to other parties. 1. Law or regulation contains a clear definition of significant ownership. 2. There are requirements to obtain supervisory approval 3 or provide immediate notification of proposed changes that would result in a change in ownership or the exercise of voting rights over a particular threshold or change in controlling interest. 3. The supervisor has the authority to reject any proposal for a change in significant ownership or controlling interest, or prevent the exercise of voting rights in respect of such investments, if they do not meet criteria comparable to those used for approving new banks. Additional criteria 1. Supervisors obtain from banks, either through periodic reporting or on-site examinations, the names and holdings of all significant shareholders, including, if possible, the identities of beneficial owners of shares being held by custodians. 3 Supervisory approval may consist of either explicit prior approval or non-objection to a prior notification. 18

21 Principle 5: Banking supervisors must have the authority to establish criteria for reviewing major acquisitions or investments by a bank and ensuring that corporate affiliations or structures do not expose the bank to undue risks or hinder effective supervision. 1. Laws or regulations clearly define what types and amounts (absolute and/or in relation to a bank s capital) of acquisitions and investments need supervisory approval Laws or regulations provide criteria by which to judge individual proposals. 3. Consistent with the licensing requirements, among the objective criteria that the supervisor uses is that any new acquisitions and investments do not expose the bank to undue risks or hinder effective supervision. The supervisor determines that the bank has, from the outset, adequate financial and organisational resources to handle the acquisition/investment. 4. Laws or regulations clearly define for which cases notification after the acquisition or investment is sufficient. Such cases should primarily refer to activities closely related to banking and the investment being small relative to the bank s capital. 4 See footnote 3. 19

22 Principle 6: Banking supervisors must set minimum capital adequacy requirements for banks that reflect the risks that the bank undertakes, and must define the components of capital, bearing in mind its ability to absorb losses. For internationally active banks, these requirements must not be less than those established in the Basel Capital Accord. 1. Laws or regulations require all banks to calculate and consistently maintain a minimum capital adequacy ratio. At least for internationally active banks, the definition of capital, method of calculation and the ratio required are not lower than those established in the Basel Capital Accord. 2. The required capital ratio reflects the risk profile of individual banks, in particular credit risk and market risk. Both on-balance-sheet and off-balance-sheet risks are included. 3. Laws or regulations, or the supervisor, define the components of capital, ensuring that emphasis is given to those elements of capital available to absorb losses. 4. Capital adequacy ratios are calculated and applied on a consolidated bank basis. 5. Laws or regulations clearly give the supervisor authority to take measures should a bank fall below the minimum capital ratio. 6. Regular (at least semi-annually) reporting by banks to the supervisor is required on capital ratios and their components. Additional criteria 1. For domestic, as well as internationally active banks, the definition of capital is broadly consistent with the Basel Capital Accord. 2. The supervisor clearly sets out the actions to be taken if capital falls below the minimum standards. 3. The supervisor determines that banks have an internal process for assessing their overall capital adequacy in relation to their risk profile. 4. Capital adequacy requirements take into account the conditions under which the banking system operates. Consequently, minimum requirements may be higher than the Basel Accord. 5. Capital adequacy ratios are calculated on both a consolidated and a solo basis for the banking entities within a banking group. 6. Laws or regulations stipulate a minimum absolute amount of capital for banks. (Reference document: International convergence of capital measurement and capital standards - July 1988) 20

23 Principle 7: An essential part of any supervisory system is the independent evaluation of a bank s policies, practices and procedures related to the granting of loans and making of investments and the ongoing management of the loan and investment portfolios. 1. The supervisor requires, and periodically verifies, that prudent credit-granting and investment criteria, policies, practices, and procedures are approved, implemented, and periodically reviewed by bank management and boards of directors The supervisor requires, and periodically verifies, that such policies, practices and procedures include the establishment of an appropriate and properly controlled credit risk environment, including: a sound and well-documented credit granting and investment process; the maintenance of an appropriate credit administration, measurement and ongoing monitoring/reporting process (including asset grading/classification); and ensuring adequate controls over credit risk. 3. The supervisor requires, and periodically verifies, that banks make credit decisions free of conflicting interests, on an arm s-length basis, and free from inappropriate pressure from outside parties. 4. The supervisor requires that a bank s credit assessment and granting standards are communicated to, at a minimum, all personnel involved in credit granting activities. 5. The supervisor has full access to information in the credit and investment portfolios and to the lending officers of the bank. Additional criteria 1. The supervisor requires that the credit policy prescribes that major credits or investments, exceeding a certain amount or percentage of the bank s capital, are to be decided at a high managerial level of the bank. The same applies to credits or investments that are especially risky or otherwise not in line with the mainstream of the bank s activities. 5 This paper refers to a management structure composed of a board of directors and senior management. The Committee is aware that there are significant differences in legislative and regulatory frameworks across countries as regards the functions of the board of directors and senior management. In some countries, the board has the main, if not exclusive, function of supervising the executive body (senior management, general management) so as to ensure that the latter fulfils its tasks. For this reason, in some cases, it is known as a supervisory board. This means that the board has no executive functions. In other countries, by contrast, the board has a broader competence in that it lays down the general framework for the management of the bank. Owing to these differences, the notions of the board of directors and senior management are used in this paper not to identify legal constructs but rather to label two decision-making functions within a bank. 21

24 2. The supervisor requires that banks have management information systems that provide essential details on the condition of the loan and investment portfolios. 3. The supervisor verifies that bank management monitors the total indebtedness of entities to which they extend credit. (Reference document: Principles for the Management of Credit Risk July 1999.) 22

25 Principle 8: Banking supervisors must be satisfied that banks establish and adhere to adequate policies, practices and procedures for evaluating the quality of assets and the adequacy of loan loss provisions and reserves. 1. Either laws or regulations, or the supervisor, sets rules for the periodic review by banks of their individual credits, asset classification and provisioning, or the law/regulations establish a general framework and require banks to formulate specific policies for dealing with problem credits. 2. The classification and provisioning policies of a bank and their implementation are regularly reviewed by the supervisor or external auditors. 3. The system for classification and provisioning includes off-balance-sheet exposures. 4. The supervisor determines that banks have appropriate policies and procedures to ensure that loan loss provisions and write-offs reflect realistic repayment expectations. 5. The supervisor determines that banks have appropriate procedures and organisational resources for the ongoing oversight of problem credits and for collecting past due loans. 6. The supervisor has the authority to require a bank to strengthen its lending practices, credit-granting standards, level of provisions and reserves, and overall financial strength if it deems the level of problem assets to be of concern. 7. The supervisor is informed on a periodic basis, and in relevant detail, concerning the classification of credits and assets and of provisioning. 8. The supervisor requires banks to have mechanisms in place for continually assessing the strength of guarantees and appraising the worth of collateral. 9. Loans are required to be identified as impaired when there is reason to believe that all amounts due (both principal and interest) will not be collected in accordance with the contractual terms of the loan agreement. 10. The valuation of collateral is required to reflect the net realisable value. Additional criteria 1. Loans are required to be classified when payments are contractually a minimum number of days in arrears (e.g., 30, 60, 90 days). Refinancing of loans that would otherwise fall into arrears does not lead to improved classifications for such loans. 2. The supervisor requires that valuation, classification and provisioning for large credits are conducted on an individual item basis. (Reference document: Sound Practices for Loan Accounting and Disclosure July 1999.) 23

26 Principle 9: Banking supervisors must be satisfied that banks have management information systems that enable management to identify concentrations within the portfolio and supervisors must set prudential limits to restrict bank exposures to single borrowers or groups of related borrowers. 1. A closely related group is explicitly defined to reflect actual risk exposure 6. The supervisor has discretion, which may be prescribed by law, in interpreting this definition on a case-by-case basis. 2. Laws or regulations, or the supervisor, set prudent limits on large exposures to a single borrower or closely related group of borrowers. Exposures include all claims and transactions, on-balance sheet as well as off-balance sheet. 3. The supervisor verifies that banks have management information systems that enable management to identify on a timely basis concentrations (including large individual exposures) within the portfolio on a solo and consolidated basis. 4. The supervisor verifies that bank management monitors these limits and that they are not exceeded on a solo and consolidated basis. 5. The supervisor regularly obtains information that enables concentrations within a bank s credit portfolio, including sectoral and geographic exposures, to be reviewed. Additional criteria 1. Banks are required to adhere to the following definitions: 10 percent or more of a bank s capital is defined as a large exposure; 25 percent of a bank s capital is the limit for an individual large exposure to a private sector non-bank borrower or a closely related group of borrowers. Minor deviations from these limits may be acceptable, especially if explicitly temporary or related to very small or specialised banks. (Reference document: Measuring and controlling large credit exposures January 1991.) 6 The definition can include not only legally related companies but also financially related companies, e.g., with common ownership. Also physical persons are considered as being parts of closely related groups, e.g. when they have large economic interests at stake in the groups (for instance, when they are large shareholders). 24

27 Principle 10: In order to prevent abuses arising from connected lending, banking supervisors must have in place requirements that banks lend to related companies and individuals on an arm s-length basis, that such extensions of credit are effectively monitored, and that other appropriate steps are taken to control or mitigate the risks. 1. A comprehensive definition of connected or related parties exists in law and/or regulation. The supervisor has discretion, which may be prescribed in law, to make judgements about the existence of connections between the bank and other parties. 2. Laws and regulations exist that exposures to connected or related parties may not be extended on more favourable terms (i.e., for credit assessment, tenor, interest rates, amortisation schedules, requirement for collateral) than corresponding loans to nonrelated counterparties The supervisor requires that transactions with connected or related parties exceeding specified amounts or otherwise posing special risks are subject to approval by the bank s board of directors. 4. The supervisor requires that banks have procedures in place to prevent persons benefiting from the loan being part of the preparation of the loan assessment or of the decision itself. 5. Laws or regulations set, or the supervisor has the mandate to set on a general or caseby-case basis, limits for loans to connected and related parties, to deduct such lending from capital when assessing capital adequacy or to require collateralisation of such loans. 6. The supervisor requires banks to have information systems to identify individual loans to connected and related parties as well as the total amount of such loans, and to monitor them through an independent credit administration process. 7. The supervisor obtains and reviews information on aggregate lending to connected and related parties. Additional criteria 1. The definition of connected or related parties established in law and/or regulation is broad and, generally, includes affiliated companies, significant shareholders, board members, senior management, key staff as well as close family members, corresponding persons in affiliated companies, and companies controlled by insiders and shareholders. 7 An exception may be appropriate for beneficial terms that are part of overall remuneration packages (e.g., employees receive credit at favourable rates.) 25