Core Principles for Effective Banking Supervision | Bulletin – December 1997 (2024)

Introduction

The Basle Committee on BankingSupervision^[1]recently released its Core Principles for Effective Banking Supervision. This articleprovides some background to this development, looks at the content of the CorePrinciples, how they are intended to be used and how Australian banking supervisionmeasures up.

Background

Over the past few years, national and international regulatory bodies have intensifiedtheir co-operative efforts to strengthen the international financial system.Recent activity in this area was encouraged by the Heads of Government of theG-7 countries at their meeting in Halifax, Canada, in June 1995. The Mexicanand Barings crises early in 1995 were the catalysts for the G-7 leaders tocall for increased international co-operation to develop globally integrated‘safeguards, standards, transparency and systems necessary to monitorand contain risks’.

The need for international co-ordination of the efforts of supervisors of nationalfinancial systems had been recognised for over twenty years. The collapse ofGermany's Bank Herstatt was instrumental in the formation of the BasleCommittee on Banking Supervision. The securities and insurance regulators laterfollowedsuit (the InternationalOrganisation of Securities Commissions was formed in 1984 and the International Associationof Insurance Supervisors in 1994). In 1996, these three international groupingscreated the Joint Forum on Financial Conglomerates, to consider the supervisionof groups containing banking, securities and insurance entities.

In 1996, the International Monetary Fund (IMF), reflecting its increased interestin supervisory matters,publishedresearch^[2]which pointed to financial instability and inadequate supervision of banks as importantdeterminants of economic instability. The research showed that 133 of the IMF's181 member countries had experienced banking problems in the previous fifteenyears and that no category of country was spared. The Board of the IMF acceptedthat the soundness of the financial sector was essential for macro economicstability and that IMF surveillance could assist in identifying potential vulnerabilitiesin a country's monetary and financial systems. The IMF felt that for itssurveillance to be effective its staff needed a general statement of the broadprinciples likely to promote stable and sound financial systems.

At the Lyon Summit in June 1996, the G-7 Heads of Government agreed that better prudentialregulation, particularly in emerging economies, was essential for preservingstability in financial markets, and urged greater efforts by national and internationalagencies to achieve this goal.

In response, the Basle Committee prepared a draft document setting out core principlesfor an effective supervisory system. In the process, it consulted widely withbanking supervisors from a range of countries, including Australia. The G-7meeting in Denver in June 1997 endorsed these principles and the final versionwas presented at the annual meetings of the World Bank and International MonetaryFund in Hong Kong in September.

The Principles

The Core Principles comprise twenty-five minimum requirements that need to be metfor a supervisory system to be effective. The Principles (set out in full inthe Attachment to this article) are divided into sevenmajor groups.

Preconditions for effective banking supervision.The first Principle highlights the need for a clear, achievable and consistent frameworkof objectives and responsibilities for the agencies involved in banking supervision.It notes the necessity of a suitable legal framework for bank supervision andfor the sharing of information by all relevant agencies.

Licensing and structure (Principles 2 to 5).These Principles focus on the licensing process, the ownership structure and thescope of business of banks and banking groups. The system of supervision mustbe based on a banking licence in order to identify supervised institutionsclearly; and the use of the word ‘bank’ in business names shouldbe confined to these supervised institutions, to prevent confusion amongstdepositors. The licensing process should include an assessment of ownershipstructure, management and operating plans. Supervisors should be able to reviewmajor acquisitions or investments by a bank.

Prudential regulations and requirements (Principles 6 to 15). These Principles emphasise the need to identifythe various types of risk confronting a bank, and ways of ensuring that theserisks are properly monitored and controlled. The development and enforcementby supervisors of prudential guidelines are integral parts of this process.These guidelines should relate to capital adequacy, loan loss reserves, assetconcentrations, liquidity, risk management and internal controls, and can bequantitative and/or qualitative. Internal controls should include procedureswhich aim to prevent the bank being used by criminal elements.

Methods of ongoing banking supervision (Principles 16 to 20). These Principles say that bothon- and off-site supervision should be used, with the latter includinganalysis of reports and returns from banks and their affiliated entities, ona consolidated as well as an individual basis. Independent validation of datais essential and regular contact with management is necessary to ensure thatthe operations of the bank are fully understood.

Information requirements (Principle 21).According to this Principle, each bank must maintain adequate records drawn up inaccordance with consistent accounting policies that enable the supervisor toobtain a true and fair view of the financial condition and profitability ofthe bank, and must publish regular financial statements that fairly reflectit* condition.

Formal powers of supervisors (Principle 22).This Principle stipulates that supervisors must have adequate powers to bring aboutcorrective action if banks fail to meet prudential standards, or the interestsof depositors are threatened.

Cross-border banking (Principles 23 to 25).These Principles review the respective roles of home and host supervisors, and stressthe need for supervision on a global consolidated basis and for powers to shareinformation with other supervisors.

Use of the Principles

The Core Principles provide a benchmark for international agencies and groups, especiallyin relation to emerging market economies. Both the World Bank and IMF are emphasisingto emerging economies the importance of sound financial systems and the needto build effective supervision. Assistance programs are likely to increasinglyrequire that systems of bank supervision be brought up to international standards.The Principles delineate those standards, providing an objective target forboth the agency and the country concerned.

Bank supervisors can use the Principles both as a basis for self-assessment, andwhen judging the supervisory standards applying in other countries. The latteris important when considering applications for banking authorities by foreignbanks. Australia, like most countries, requires that such applicants be supervisedat an internationally accepted standard in their home countries.

Supervisory authorities around the world are being encouraged by the Basle Committeeto endorse the Core Principles, not later than October 1998. Endorsem*nt willinclude an undertaking to review current supervisory arrangements against thePrinciples and to initiate a program designed to address any material shortcomingsas quickly as practicable within their legal authority. Implementation of thePrinciples is to be surveyed by the Basle Committee and reviewed at the InternationalConference of Banking Supervisors in Sydney in October 1998. Regional organisationsof which Australia is a member, such as the SEANZA Forum of Banking Supervisorsand the Executives' Meeting of East Asia and Pacific Central Banks (EMEAP),may have a role in promoting formal endorsem*nt of the Principles and in monitoringimplementation by their members.

Australian Bank Supervision

Australia complies with almost all of the Core Principles. This is hardly surprisinggiven that its regime for supervising banks has been developed in the lightof international best practice. In the case of Principle 15, which refers tothe need for powers to combat money laundering, Australia complies, but therelevant regulatory authority is Austrac rather than the Reserve Bank.

Nevertheless, there are two areas where a literal interpretation of the Principlescould raise doubts about Australia's compliance:

• Principle 3 requires that the licensing process include (inter alia)an assessment of the bank's directors and senior management. The Basle Committee interprets this to mean that alldirectors and managers, whether appointed at establishment or subsequently,should be subject to a ‘fit and proper’ test. The aim is to ensurethat these personnel have the necessary ability, experience and integrityto operate a bank. In Australia, most local banks are large public companieslisted on the Stock Exchange, and subject to the scrutiny which comes froma broad range of shareholders (as required by our ownership rules). In thesecirc*mstances, the Reserve Bank has not sought formal powers of approval oversenior management appointments. It does, however, require prior notificationof board appointments.
• Principle 25 requires the local operations of foreign banks to be conducted to the same high standards as are required of domestic institutions. The Australian policy of allowing foreign banks tocarry out banking type operations in Australia as so-called ‘merchantbanks’ is inconsistent with this Principle. The Reserve Bank is notin a position to provide information to home country supervisors on the activitiesof these merchant banks in Australia since it neither authorises nor supervisestheir activities. In its submission to the recent Financial System Inquiry,the Bank noted that this situation, which is a hangover from the days beforeforeign banks were able to apply for banking authorities, is anomalous, andrecommended that all foreign banks operating in Australia should be requiredto seek Australian banking authorities. The Inquiry did not accept that recommendationbecause of a concern that requiring merchant banks to seek banking authoritiesmight lead to a reduction in competition. The Government has endorsed theInquiry's view on this matter.

Attachment

List of Core Principles for Effective Banking Supervision

Preconditions for effective banking supervision

1. An effective system of banking supervision will have clear responsibilitiesand 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, includingprovisions relating to authorisation of banking organisations and their ongoingsupervision; powers to address compliance with laws as well as safety andsoundness concerns; and legal protection for supervisors. Arrangements forsharing information between supervisors and protecting the confidentialityof such information should be in place.

Licensing and structure

2. The permissible activities of institutions that are licensed and subject to supervisionas 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 applicationsfor establishments that do not meet the standards set. The licensing process,at a minimum, should consist of an assessment of the banking organisation'sownership structure, directors and senior management, its operating plan andinternal controls, and its projected financial condition, including its capitalbase; where the proposed owner or parent organisation is a foreign bank, theprior consent of its home country supervisor should be obtained.
4. Banking supervisors must have the authority to review and reject any proposals totransfer significant ownership or controlling interests in existing banksto other parties.
5. Banking supervisors must have the authority to establish criteria for reviewing majoracquisitions or investments by a bank and ensuring that corporate affiliationsor structures do not expose the bank to undue risks or hinder effective supervision.

Prudential regulations and requirements

6. Banking supervisors must set prudent and appropriate minimum capital adequacy requirementsfor all banks. Such requirements should reflect the risks that banks undertake,and must define the components of capital, bearing in mind its ability toabsorb losses. For internationally active banks, these requirements must notbe 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 investmentsand the ongoing management of the loan and investment portfolios.
8. Banking supervisors must be satisfied that banks establish and adhere to adequatepolicies, practices and procedures for evaluating the quality of assets andthe adequacy of loan loss provisions and loan loss reserves.
9. Banking supervisors must be satisfied that banks have management information systemsthat enable management to identify concentrations within the portfolio andsupervisors must set prudential limits to restrict bank exposures to singleborrowers or groups of related borrowers.
10. In order to prevent abuses arising from connected lending, banking supervisors musthave in place requirements that banks lend to related companies and individualson an arm's-length basis, that such extensions of credit are effectivelymonitored, and that other appropriate steps are taken to control or mitigatethe risks.
11. Banking supervisors must be satisfied that banks have adequate policies and proceduresfor identifying, monitoring and controlling country risk and transfer riskin their international lending and investment activities, and for maintainingadequate reserves against such risks.
12. Banking supervisors must be satisfied that banks have in place systems that accuratelymeasure, monitor and adequately control market risks; supervisors should havepowers to impose specific limits and/or a specific capital charge on marketrisk exposures, if warranted.
13. Banking supervisors must be satisfied that banks have in place a comprehensive riskmanagement process (including appropriate board and senior management oversight)to identify, measure, monitor and control all other material risks and, whereappropriate, to hold capital against these risks.
14. Banking supervisors must determine that banks have in place internal controls thatare adequate for the nature and scale of their business. These should includeclear arrangements for delegating authority and responsibility; separationof 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 externalaudit and compliance functions to test adherence to these controls as wellas applicable laws and regulations.
15. Banking supervisors must determine that banks have adequate policies, practices andprocedures in place, including strict ‘know-your-customer’ rules,that promote high ethical and professional standards in the financial sectorand prevent the bank being used, intentionally or unintentionally, by criminalelements.

Methods of ongoing banking supervision

16. An effective banking supervisory system should consist of some form of both on-siteand off-site supervision.
17. Banking supervisors must have regular contact with bank management and thorough understandingof the institution's operations.
18. Banking supervisors must have a means of collecting, reviewing and analysing prudentialreports and statistical returns from banks on a solo and consolidated basis.
19. Banking supervisors must have a means of independent validation of supervisory informationeither through on-site examination or use of external auditors.
20. An essential element of banking supervision is the ability of the supervisors tosupervise the banking organisation on a consolidated basis.

Information requirements

21. Banking supervisors must be satisfied that each bank maintains adequate records drawnup in accordance with consistent accounting policies and practices that enablethe supervisor to obtain a true and fair view of the financial condition ofthe bank and the profitability of its business, and that the bank publisheson a regular basis financial statements that fairly reflect its condition.

Formal powers of supervisors

22. Banking supervisors must have at their disposal adequate supervisory measures tobring 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 circ*mstances,this should include the ability to revoke the banking licence or recommendits revocation.

Cross-border banking

23. Banking supervisors must practise global consolidated supervision over their internationally-activebanking organisations, adequately monitoring and applying appropriate prudentialnorms to all aspects of the business conducted by these banking organisationsworldwide, primarily at their foreign branches, joint ventures and subsidiaries.
24. A key component of consolidated supervision is establishing contact and informationexchange with the various other supervisors involved, primarily host countrysupervisory authorities.
25. Banking supervisors must require the local operations of foreign banks to be conductedto the same high standards as are required of domestic institutions and musthave powers to share information needed by the home country supervisors ofthose banks for the purpose of carrying out consolidated supervision.