Bank Supervision

1. Bank Supervision Presented by Vince Polizatto Overview of Financial Sector Issues and Analysis Workshop May 28, 2002

2. Why Do Banks Fail? • Bad management!!! • Frequently evidenced by: • Poor lending practices • Concentrations of credit • Insider abuse and lending to connected parties • In combination, a dangerous mix and a prescription for failure!

3. Why Supervise? • Protect public savings • Prevent build-up of problem assets • Limit financing of speculative activities • Ensure stability of financial system • Prevent worst consequences of bank failures • Limit government’s potential liabilities

4. Cycle of Distress • Bad assets accumulate • Bank becomes insolvent • Resources are misallocated • Management speculates • Cash flows dry up • Funding rates are increased

5. Cycle of Distress • Lending rates are increased • Bad assets ratchet upwards • Cycle of distress recurs • Liquidity dries up • Bank becomes illiquid as well as insolvent

6. Good Bankers to Bad Bankers • When banks are insolvent, owners and managers have nothing else to lose - they “bet” the bank by taking huge risks • Losses are cosmetically hidden

7. Effective Supervisors Ensure: • Assets are properly valued • Losses are recognized when identified • Corrective action is taken while a bank is still solvent • Failures are promptly resolved

8. Classifying Assets • Based on borrower’s ability to repay • Assesses future as well as historic performance • Relates purpose, source of repayment, and repayment plan • Emphasizes primary sources of repayment • Not limited to loans and advances

9. Sources of Repayment • Primary sources • Cash flow • Business asset conversion cycle • Secondary sources • Refinancing • Sale of a fixed asset (collateral) • New capital

10. Criticized/Classified • Criticized • Other assets especially mentioned - more than a normal degree of risk • Classified • Substandard - well-defined credit weakness • Doubtful - high probability of loss • Loss - non-bankable and of little value

11. Supervisory Remedies • Fit and proper tests for major owners, directors, and executive management • Licensing • Change of control • Prudential controls and limits on: • Single exposures • Exposures to groups • Exposures to insiders and connected parties

12. Supervisory Remedies • Adoption of written policies and sound risk management systems • Identify risks • Measure risks • Control and manage risks • Monitor risks • Minimum capital requirements • Nominal capital • Capital adequacy

13. Supervisory Remedies Prompt corrective action: • Discretion replaced by mandatory actions • Triggered by diminution of capital • Actions include a capital restoration plan • Closure required below certain CAR level

14. Basel Core Principles 25 Basic Principles: • Preconditions for effective supervision (1) • Licensing and structure (2-5) • Prudential regulations and requirements (6-15) • Methods of ongoing supervision (16-20) • Information requirements (21) • Formal powers of supervisors (22) • Cross-border banking (23-25)

15. Preconditions for Effective Banking Supervision • Clear responsibilities and objectives • Operational independence • Adequate resources • Arrangements for sharing information

16. Preconditions for Effective Banking Supervision Suitable legal framework: • Authorization of banking establishments • Ongoing supervision • Safety and soundness • Legal protection for supervisors • Authorization to issue regulations

17. Public Policy Objectives • Prevent concentration of economic power • Promote competition • Moderate banking instability • Protect the public • Encourage operating efficiency • Promote innovation • Meet the needs of the public

18. Public Policy Objectives • Encourage efficiency and equity in the allocation of credit • Promote an equitable distribution of costs and benefits • Public policy is codified in laws, rules and regulations

19. Entry • Supervisors must have the right to set criteria for licensing banks, changes in control, mergers and acquisitions, and other corporate activities

20. Entry Considerations: • Ownership, directors and managers • Strategic and operating plans • Internal controls • Projected financial condition • Sources of capital • Effect on competition • If applicable, approval of home country supervisor

21. Permissible or Prohibited Activities • The law should define a “bank” and the business of “banking” • Permissible or prohibited activities should be clearly delineated

22. Prudential Controls or Limits • Minimum capital • nominal amount • capital adequacy ratio (simple, risk-weighted) • Exposure limits • single borrower • groups of related borrowers • aggregate of large borrowers • insiders and connected parties

23. Prudential Controls and Limits Other banking risks • Foreign exchange risk • Liquidity risk • Interest rate risk • Price risk • Operational risk

24. Supervisory Powers • Access to all bank records and information • Ability to impose adequate record-keeping • Ability to apply qualitative judgement in forming an opinion about compliance with laws and safety and soundness

25. Supervisory Powers • Ability to independently evaluate a bank’s policies, practices and procedures related to the granting and ongoing management of loans and investments • Ability to ensure adequate policies, practices and procedures for evaluating the quality of assets and adequacy of reserves • Ability to require additional provisions and direct the write-off of bad assets

26. Supervisory Powers • Ability to assess adequacy of internal controls and audit activities and access to audit reports • Ability to impose “know your customer” rules and safeguards against money laundering and criminal activities • Ability to require submission of reports and prudential returns

27. Supervisory Powers • Ability to examine all affiliates and to supervise on a consolidated basis • Ability to require prompt remedial action and/or impose a range of sanctions • Ability to share information with other supervisors

28. Enforcement Measures • Menu of options • Corrective rather than punitive • Progressively stronger • Used against both the bank and individuals • Address unsafe and unsound behavior

29. Enforcement Measures • Moral suasion • Monetary fines • Restrictions on banking activity • restrictions on the payment of dividends • prohibitions on branch expansion • limitations on asset growth

30. Enforcement Measures • Suspension or removal orders • “Prompt Corrective Action” • Memorandum of understanding • Formal agreement or cease and desist order • Forced acquisition or merger • Revocation of license and placement in receivership

31. Supervisory Methodologies • Onsite examination • Top-down and forward-looking • Appraisal and assessment - not an audit • CAMELS ratings • Regular contact with management • Regular contact with auditors, security analysts, bank rating agencies, etc.

32. Supervisory Methodologies • Offsite surveillance • Individual banks - trends and peers • Banking system • Main sectors of the economy • Economic environment (local, national, regional, global)

33. Typical Supervisory Weaknesses • Political interference / lack of political will • Inadequate staffing and budget • Poor legal framework • Lack of timely recognition of problems

34. Typical Supervisory Weaknesses • Weak governance in banks • Weak risk management systems in banks • Weak accounting and auditing • Inability to promptly force exit and resolve bank failures

35. A New Capital Adequacy Framework - Basel Accord II Objectives: • Improve the way regulatory capital requirements reflect underlying risks • Better address financial innovation (e.g., asset securitization) • Recognize improvements in risk measurement and control

36. Weaknesses of the Current Capital Accord • Certain risks not addressed • Crude measure of risk • Arbitrage between true risk and risk measured under the Accord • Discourages risk mitigation techniques

37. Supervisory Objectives • Promote safety and soundness • Enhance competitive equality • Address risks in a comprehensive way • Focus on internationally active banks

38. Three Pillars of New Framework • Minimum capital requirements • A supervisory review process • Effective use of market discipline

39. Minimum Capital Requirements • Modified version of existing Accord remains the “standard” approach • Internal credit ratings and portfolio models allowed for some sophisticated banks • Accord’s scope extended to fully capture risks in banking groups

40. Minimum Capital Requirements Minimum capital requirements consist of: • A definition of regulatory capital • Measures of risk exposures • Rules specifying the level of capital in relation to those risks

41. Extending the Scope • Risks in banking groups & individual banks • External credit assessments • New risk weighting for asset securitization • 20% credit conversion for certain types of short-term commitments

42. Banking Groups The Accord will clarify the application of the capital standard and capture risks at every tier within a banking group: • Bank holding companies • Banking groups • Individual banks within the group

43. Treatment of Non-Banks The Accord will also clarify capital treatments for banks’ investments in: • Other areas of financial activity (e.g., securities and insurance) • Significant minority-owned entities • Majority-owned investments in commercial entities

44. Alternative Approaches For some sophisticated banks • An internal ratings-based approach • Portfolio credit risk modeling Credit risk mitigation • Credit derivatives • Collateral guarantees • On-balance-sheet netting

45. Capital Charges for Risks Existing risks covered • Credit risk • Market risk Proposed additions • Interest rate risk • Operational risk

46. Supervisory Considerations • Bank’s risk appetite • Bank’s record in managing risk • Nature of the bank’s markets • Quality, reliability and volatility of earnings • Adherence to sound valuation and accounting standards

47. Intervention Supervisors must identify and intervene in banks when falling capital levels raise concerns about the bank’s ability to withstand business shocks.

48. Market Discipline • Encourage high disclosure standards • Enhance role of market participants

49. Disclosure Banks should disclose all key features of the capital held as a cushion against losses, and the risk exposures that may lead to losses.

50. Summary An effective supervisor, sound legal system, and strong accounting and auditing framework are essential to healthy banking systems and a robust economy.