Core Principles for Effective Banking Supervision

The Basle Committee on Banking

Supervision1 recently released its Core

Principles for Effective Banking Supervision.

This article provides some background to this

development, looks at the content of the Core

Principles, how they are intended to be used

and how Australian banking supervision

measures up.

Over the past few years, national and

international regulatory bodies have

intensified their co-operative efforts to

strengthen the international financial system.

Recent activity in this area was encouraged

by the Heads of Government of the G-7

countries at their meeting in Halifax, Canada,

in June 1995. The Mexican and Barings crises

early in 1995 were the catalysts for the G-7

leaders to call for increased international

co-operation to develop globally integrated

‘safeguards, standards, transparency and

systems necessary to monitor and contain risks’.

The need for international co-ordination of

the efforts of supervisors of national financial

systems had been recognised for over twenty

years. The collapse of Germany’s Bank

Herstatt was instrumental in the formation

of the Basle Committee on Banking

Supervision. The securities and insurance

regulators later followed suit (the International

Organisation of Securities Commissions was

formed in 1984 and the International

Association of Insurance Supervisors in

1994). In 1996, these three international

groupings created the Joint Forum on

Financial Conglomerates, to consider the

supervision of groups containing banking,

securities and insurance entities.

In 1996, the International Monetary Fund

(IMF), reflecting its increased interest in

supervisory matters, published research2

which pointed to financial instability and

inadequate supervision of banks as important

determinants of economic instability. The

1. The Basle Committee on Banking Supervision was established by the central bank Governors of the Group of Ten

countries in 1975. It consists of senior representatives of bank supervisory authorities and central banks from

Belgium, Canada, France, Germany, Italy, Japan, Luxembourg, Netherlands, Sweden, Switzerland, United Kingdom

and the United States. It usually meets at the Bank for International Settlements in Basle, Switzerland where its

permanent Secretariat is located.

Fund.

research showed that 133 of the IMF’s 181

member countries had experienced banking

problems in the previous fifteen years and that

no category of country was spared. The Board

of the IMF accepted that the soundness of

the financial sector was essential for macro

economic stability and that IMF surveillance

could assist in identifying potential

vulnerabilities in a country’s monetary and

financial systems. The IMF felt that for its

surveillance to be effective its staff needed a

general statement of the broad principles likely

to promote stable and sound financial systems.

At the Lyon Summit in June 1996, the G-7

Heads of Government agreed that better

prudential regulation, particularly in emerging

economies, was essential for preserving

stability in financial markets, and urged

greater efforts by national and international

agencies to achieve this goal.

In response, the Basle Committee prepared

a draft document setting out core principles

for an effective supervisory system. In the

process, it consulted widely with banking

supervisors from a range of countries,

including Australia. The G-7 meeting in

Denver in June 1997 endorsed these principles

and the final version was presented at the

annual meetings of the World Bank and

International Monetary Fund in Hong Kong

in September.

The Core Principles comprise twenty-five minimum requirements that need to be met for a supervisory system to be effective. The Principles (set out in full in the Attachment to this article) are divided into seven major groups.

need for a clear, achievable and consistent

framework of objectives and responsibilities

for the agencies involved in banking

supervision. It notes the necessity of a suitable

legal framework for bank supervision and for

the sharing of information by all relevant

agencies.

process, the ownership structure and the scope

of business of banks and banking groups. The

system of supervision must be based on a

banking licence in order to identify supervised

institutions clearly; and the use of the word

‘bank’ in business names should be confined

to these supervised institutions, to prevent

confusion amongst depositors. The licensing

process should include an assessment of

ownership structure, management and

operating plans. Supervisors should be able

to review major acquisitions or investments

by a bank.

Principles emphasise the need to identify the

various types of risk confronting a bank, and

ways of ensuring that these risks are properly

monitored and controlled. The development

and enforcement by supervisors of prudential

guidelines are integral parts of this process.

These guidelines should relate to capital

adequacy, loan loss reserves, asset

concentrations, liquidity, risk management

and internal controls, and can be quantitative

and/or qualitative. Internal controls should

include procedures which aim to prevent the

bank being used by criminal elements.

Principles say that both on- and off-site

supervision should be used, with the latter

including analysis of reports and returns from

banks and their affiliated entities, on a

consolidated as well as an individual basis.

Independent validation of data is essential and

regular contact with management is necessary

to ensure that the operations of the bank are

fully understood.

must maintain adequate records drawn up in

accordance with consistent accounting

policies that enable the supervisor to obtain a

true and fair view of the financial condition

and profitability of the bank, and must publish

regular financial statements that fairly reflect

its condition.

supervisors must have adequate powers to

bring about corrective action if banks fail to

meet prudential standards, or the interests of

depositors are threatened.

roles of home and host supervisors, and stress

the need for supervision on a global

consolidated basis and for powers to share

information with other supervisors.

The Core Principles provide a benchmark

especially in relation to emerging market

economies. Both the World Bank and IMF are

emphasising to emerging economies the

importance of sound financial systems and the

need to build effective supervision. Assistance

programs are likely to increasingly require that

systems of bank supervision be brought up to

international standards. The Principles

delineate those standards, providing an

objective target for both the agency and the

country concerned.

Bank supervisors can use the Principles both

judging the supervisory standards applying in

other countries. The latter is important when

considering applications for banking

authorities by foreign banks. Australia, like

most countries, requires that such applicants

be supervised at an internationally accepted

standard in their home countries.

Supervisory authorities around the world

are being encouraged by the Basle Committee

to endorse the Core Principles, not later than

October 1998. Endorsement will include an

undertaking to review current supervisory

arrangements against the Principles and to

initiate a program designed to address any

material shortcomings as quickly as

practicable within their legal authority.

Implementation of the Principles is to be

surveyed by the Basle Committee and

reviewed at the International Conference of

Banking Supervisors in Sydney in October

1998. Regional organisations of which

Australia is a member, such as the SEANZA

Forum of Banking Supervisors and the

Executives’ Meeting of East Asia and Pacific

Central Banks (EMEAP), may have a role in

promoting formal endorsement of the

Principles and in monitoring implementation

by their members.

Australia complies with almost all of the

Core Principles. This is hardly surprising given

that its regime for supervising banks has been

developed in the light of international best

practice. In the case of Principle 15, which

refers to the need for powers to combat money

laundering, Australia complies, but the

relevant regulatory authority is Austrac rather

than the Reserve Bank.

Nevertheless, there are two areas where a

literal interpretation of the Principles could

raise doubts about Australia’s compliance:

The Basle Committee interprets this to

mean that all directors and managers,

whether appointed at establishment or

subsequently, should be subject to a ‘fit

and proper’ test. The aim is to ensure that

these personnel have the necessary ability,

experience and integrity to operate a bank.

In Australia, most local banks are large

public companies listed on the Stock

Exchange, and subject to the scrutiny

which comes from a broad range of

shareholders (as required by our

ownership rules). In these circumstances,

the Reserve Bank has not sought formal

powers of approval over senior

management appointments. It does,

however, require prior notification of board

appointments.

allowing foreign banks to carry out

banking type operations in Australia as

so-called ‘merchant banks’ is inconsistent

with this Principle. The Reserve Bank is

not in a position to provide information

to home country supervisors on the

activities of these merchant banks in

Australia since it neither authorises nor

supervises their activities. In its submission

to the recent Financial System Inquiry, the

Bank noted that this situation, which is a

hangover from the days before foreign

banks were able to apply for banking

authorities, is anomalous, and

recommended that all foreign banks

operating in Australia should be required

to seek Australian banking authorities. The

Inquiry did not accept that

recommendation because of a concern that

requiring merchant banks to seek banking

authorities might lead to a reduction in

competition. The Government has

endorsed the Inquiry’s view on this matter.

1. An effective system of banking supervision will have clear responsibilities and objectives for each agency involved in the supervision of banking organisations. 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 organisations 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.

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.

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.

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.

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.

6. Banking supervisors must set prudent

and appropriate minimum capital

adequacy requirements for all banks.

Such requirements should reflect the risks

that banks undertake, 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 Basle Capital Accord.

7. An essential part of any supervisory

system is the 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.

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 loan loss reserves.

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.

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.

11. Banking supervisors must be satisfied that

banks have adequate policies and

procedures for identifying, monitoring

and controlling country risk and transfer

risk in their international lending and

investment activities, and for maintaining

adequate reserves against such risks.

12. Banking supervisors must be satisfied that

banks have in place systems that

accurately measure, monitor and

adequately control market risks;

supervisors should have powers to impose

specific limits and/or a specific capital

charge on market risk exposures, if warranted.

13. Banking supervisors must be satisfied that

banks have in place a comprehensive risk

management process (including

appropriate board and senior

management oversight) to identify,

measure, monitor and control all other

material risks and, where appropriate, to

hold capital against these risks.

14. Banking supervisors must determine that

banks have in place internal controls that

are adequate for the nature and scale of

their business. These should include clear

arrangements for delegating authority and

responsibility; separation of the functions

that involve committing the bank, paying

away its funds, and accounting for its

assets and liabilities; reconciliation of

these processes; safeguarding its assets;

and appropriate independent internal or

external audit and compliance functions

to test adherence to these controls as well

as applicable laws and regulations.

15. Banking supervisors must determine that

banks have adequate policies, practices

and procedures in place, including strict

‘know-your-customer’ rules, that promote

high ethical and professional standards in

the financial sector and prevent the bank

being used, intentionally or

unintentionally, by criminal elements.

16. An effective banking supervisory system

should consist of some form of both

on-site and off-site supervision.

17. Banking supervisors must have regular

contact with bank management and

thorough understanding of the

institution’s operations.

18. Banking supervisors must have a means

of collecting, reviewing and analysing

prudential reports and statistical returns

from banks on a solo and consolidated

basis.

19. Banking supervisors must have a means

of independent validation of supervisory

information either through on-site

examination or use of external auditors.

20. An essential element of banking

supervision is the ability of the supervisors

to supervise the banking organisation on

a consolidated basis.

21. Banking supervisors must be satisfied that

each bank maintains adequate records

drawn up in accordance with consistent

accounting policies and practices that

enable the supervisor to obtain a true and

fair view of the financial condition of the

bank and the profitability of its business,

and that the bank publishes on a regular

basis financial statements that fairly reflect its condition.

22. Banking supervisors must have at their

disposal adequate supervisory measures

to bring about timely corrective action

when banks fail to meet prudential

requirements (such as minimum capital

adequacy ratios), when there are

regulatory violations, or where depositors

are threatened in any other way. In

extreme circumstances, this should

include the ability to revoke the banking

licence or recommend its revocation.

23. Banking supervisors must practise

global consolidated supervision over

their internationally-active banking

organisations, adequately monitoring and

applying appropriate prudential norms to

all aspects of the business conducted by

these banking organisations worldwide,

primarily at their foreign branches, joint

ventures and subsidiaries.

24. A key component of consolidated

supervision is establishing contact and

information exchange with the various

other supervisors involved, primarily host

country supervisory authorities.

25. Banking supervisors must require the

local operations of foreign banks to be

conducted to the same high standards as

are required of domestic institutions and

must have powers to share information

needed by the home country supervisors

of those banks for the purpose of carrying

out consolidated supervision.