MBF-705 LEGAL AND REGULATORY ASPECTS OF BANKING SUPERVISION

1. Session: SIXTEEN MBF-705LEGAL AND REGULATORY ASPECTS OF BANKING SUPERVISION OSMAN BIN SAIF

2. Agenda of this session SECTION 4 • Banking Supervision • Bank Supervision Models • Harmonization and Convergence of Bank Supervision • Supervisory Methodologies • On site Examination

3. SECTION 4BANKING SUPERVISION

4. Banking Supervision • An ineffective legal framework may result in banking system distress but, more often than not, lack of enforcement and supervision are equally at fault. 

5. Banking Supervision (Contd.) • Supervisory problems may be rooted in: • conflicting public policy goals for supervision; • political interference; • a lack of political will to deal with problems; • organizational weaknesses such as: • understaffing, • inadequate compensation, • poor leadership, and • divided supervisory responsibilities; and • the lack of a clear understanding on the role of supervision. 

6. Banking Supervision (Contd.) • Problems may also result from examination methodologies that focus on technical compliance with laws. • In some cases, problems also occur because of the lack of an early warning system and off-site surveillance capabilities. • More often than not, though, supervisory problems result from a combination of these factors.

7. Bank Supervision Models in the Industrialized Countries • Bank supervision in the industrialized countries developed in response to financial crises, economic events, and political phenomena. • Very often, the form of bank supervision reflected philosophical and social differences in the role of government and in the organization of society.

8. Bank Supervision Models in the Industrialized Countries (Contd.) •  These differences were embodied in two principal models of bank regulation and supervision: • an informal approach that relied on consultation and moral persuasion; and • a formalized approach that required active, "hands-on" verification through on-site inspection.

9. Harmonization and Convergence of Bank Supervision • Despite the differences in supervisory approaches, there is a growing consensus that bank supervision and regulation should be harmonized across national boundaries due to the ever-increasing global interdependence of financial markets.

10. Harmonization and Convergence of Bank Supervision (Contd.) • As developing countries grow and prosper, the integration of domestic financial markets with the larger international financial system will become more and more important so that distortions are minimized.

11. Harmonization and Convergence of Bank Supervision (Contd.) • In a world where financial transactions occur around the clock and banks enter into financial transactions with any number of foreign correspondents and counterparties, the global financial system may only be as strong as its weakest links.

12. Harmonization and Convergence of Bank Supervision (Contd.) • Differences in regulation can distort the financial markets as well as increase the risks for banking activities performed beyond national borders. There is also a danger that domestic institutions operating abroad may escape supervision.

13. Harmonization and Convergence of Bank Supervision (Contd.) • The failure of the West German BankhausHerstatt in 1974 due to foreign exchange and other losses had damaging effects on the international interbank market and focused attention on the need for greater international supervisory cooperation.

14. Harmonization and Convergence of Bank Supervision (Contd.) • This led to the formation of the Basel Committee later that year under the auspices of the Bank for International Settlements • Following its creation, the committee addressed the issue of supervision of financial institutions operating abroad by developing broad guidelines to ensure that no institution escaped supervision.

15. Basel Guidelines on Supervision • These guidelines are contained in the Basle Concordat," which embodied the following key principles: • (1) supervision of foreign banking establishments is the joint responsibility of parent and host authorities, • (2) no foreign banking establishment should escape supervision, 

16. Basel Guidelines on Supervision (Contd.) • (3) supervision of liquidity should be the primary responsibility of the host authorities, • (4) supervision of solvency is essentially a matter for the parent authority in the case of foreign branches and primarily the responsibility of the host authority in the case of foreign subsidiaries, and 

17. Basel Guidelines on Supervision (Contd.) • (5) practical cooperation should be promoted by the exchange of information between host and parent authorities and by the authorization of bank inspections by or on behalf of parent authorities on the territory of the host authority.

18. Basel Guidelines on Supervision (Contd.) • Other important initiatives prompted by the work of the Basle Committee include recommendations that supervision of banks' international business be conducted on a consolidated basis, so that risks can be evaluated globally, and the adoption of risk-asset based capital adequacy standards.

19. Supervisory Methodologies • The growing integration of financial markets, especially among member states of the European Community, has led to a convergence of systems of bank supervision. • It is now widely accepted that an adequate system of bank supervision should allow for both on-site examination and off-site surveillance.

20. Supervisory Methodologies (Contd.) • Supervisors' tools include on-site examinations of individual institutions and off-site surveillance from both macro and micro perspectives. • For most developing countries, on-site examinations are especially important. 

21. Supervisory Methodologies (Contd.) • This is because problems of insolvency in developing countries usually occur due to credit losses, which are best determined while within an institution. • Therefore, supervisors must concentrate on assessing asset quality and mandating provisions for bad debts and suspension of interest on nonperforming assets through on-site examination and verification.

22. Supervisory Methodologies (Contd.) • By determining asset quality and the condition of an institution, bank supervisors provide critical information to government policymakers on the health of the financial system.

23. ON-SITE EXAMINATIONS • Traditional on-site examination methodologies in many countries frequently focus on compliance with banking regulations and directives. • As a result, prudential concerns for safety and soundness are often overlooked. 

24. ON-SITE EXAMINATIONS (Contd.) •  Even in cases where supervisors attempt to address safety and soundness concerns, the examination process may only provide a "snapshot" of the institution's condition as of a given date without addressing potential risks and the management systems needed internally by the bank to control risk in a dynamic, changing environment. 

25. ON-SITE EXAMINATIONS (Contd.) •  For example, examiners may determine the condition of a bank's loan portfolio but fail to evaluate the lending policies and practices that lead to loan problems or that may give rise to future loan problems.

26. ON-SITE EXAMINATIONS (Contd.) • Indeed, in many cases, bank examiners fail to identify and quantify the extent and severity of problem and major failure. Even when problems are identified, supervisors may lack the powers to require provisions and write-offs or other necessary actions.

27. ON-SITE EXAMINATIONS (Contd.) • To correct these weaknesses and improve the effectiveness of their on-site examination activities, supervisors need to move away from checking compliance with laws to assessing risk and assisting banks in managing risk.

28. ON-SITE EXAMINATIONS (Contd.) • To accomplish this, bank supervisors should embrace a top-down approach that places emphasis on the direction and policies formulated by the board of directors and executive management.

29. ON-SITE EXAMINATIONS (Contd.) • It is not enough to quantify problems-although this is certainly a necessary step. The causes of problems must also be understood and preventive action taken to reduce the likelihood of their recurrence.

30. ON-SITE EXAMINATIONS (Contd.) • As part of the examination process, on-site examiners should verify the accuracy of prudential reports submitted to the supervisory agency and analyze those aspects of a bank that cannot be adequately monitored by off-site surveillance. Examiners should focus on the banks' main activities and on the potential problems identified by offsite surveillance. 

31. ON-SITE EXAMINATIONS (Contd.) • In particular, they should assess the quality of assets, management, earnings, capital, and funds management, as well as the bank's internal control, audit, management information, and accounting systems.

32. ON-SITE EXAMINATIONS (Contd.) • In evaluating asset quality, the examiner should review the bank's lending policies, written or implied, to determine whether they are reasonable and complete.

33. ON-SITE EXAMINATIONS (Contd.) •  Minutes of meetings of the credit committee and the board of directors should be reviewed. • The examiner should also evaluate the bank's procedures for writing off bad debts, and determining an adequate loan loss provision.

34. ON-SITE EXAMINATIONS (Contd.) • Bank supervisors should also review the business and strategic plans of individual banks and assess the capabilities of management to fulfill objectives. • They should check that management systems in place are sufficient to ensure compliance with policies and proper functioning. 

35. ON-SITE EXAMINATIONS (Contd.) • Bank supervisors should also encourage banks to establish and strengthen their own internal management systems as the first lines of defense against unsound, unsafe, or illegal banking practices.

36. ON-SITE EXAMINATIONS (Contd.) • Management systems should include written policies and procedures, formalized planning and budgeting, management information systems, internal loan review, compliance systems, internal and external audit activities, and internal controls.

37. ON-SITE EXAMINATIONS (Contd.) • The development of management systems should be encouraged in both large and small banks, although their sophistication and complexity may differ.

38. ON-SITE EXAMINATIONS (Contd.) • Since the ongoing task of bank supervisors is typically to ensure the safety and soundness of the financial system-as opposed to individual banks-and to protect depositors, not the shareholders of banks, supervisory activities should focus on the areas of greatest risk to the system.

39. ON-SITE EXAMINATIONS (Contd.) • Within individual banks, efficient use of scarce supervisory resources should be made by targeting examination efforts to the areas of greatest risk, for example, asset quality, interest rate risk, foreign exchange activities, and so on.

40. ON-SITE EXAMINATIONS (Contd.) • Examination activities should also avoid the examination of each and every branch office or operating subsidiary of an institution. • Instead, the examination should focus on the condition of the consolidated institution by examining those units that have a significant impact on the institution's overall position. • The remaining units should be evaluated on a sample basis.

41. ON-SITE EXAMINATIONS (Contd.) • The failure to follow up on problems and to enforce corrective action is a common weakness in the supervisory process.

42. ON-SITE EXAMINATIONS (Contd.) • This occurs for many reasons including weak leadership, political influence, temerity in dealing with problems, organizational weaknesses, and a lack of appropriate enforcement tools. • However, it also occurs because examination results and the type of corrective actions needed are not adequately communicated to the bank's board of directors and senior management. 

43. ON-SITE EXAMINATIONS (Contd.) • It is extremely important that examination results are clearly communicated to the bank through a written examination report and meetings with the board of directors and executive management.

44. ON-SITE EXAMINATIONS (Contd.) • In most developing countries, written examination procedures are less than adequate, or lacking altogether, so that the examiner must rely totally on his or her experience, knowledge, and skills. • This leads to a lack of uniformity and consistency in the conduct of on-site examinations from one examiner to the next. 

45. ON-SITE EXAMINATIONS (Contd.) •  As a result, the head of bank supervision can never be sure which bank functions were reviewed and the manner in which the examination was performed.

46. ON-SITE EXAMINATIONS (Contd.) • The lack of written examination procedures also deprives new staff of an essential training tool. • Therefore, to ensure consistency and uniformity, and to provide a training tool for new examiners, written examination procedures and questionnaires should be developed for use in on-site examinations.

47. ON-SITE EXAMINATIONS (Contd.) • A complementary aspect to written examination procedures is the documentation of work performed and the maintenance of working papers. • These are necessary to demonstrate that the actions recommended by the examiner are not arbitrary but are based on valid concerns and criticisms. • This documentation may also be necessary to support legal enforcement actions proposed by the supervisors.

48. ON-SITE EXAMINATIONS (Contd.) • Over the long run, bank supervisors can use the on-site examinations process as a catalyst for changing the fundamental ways in which banks operate by recommending actions for financial institutions to upgrade their operations.

49. ON-SITE EXAMINATIONS (Contd.) • This usually involves the strengthening of management systems in banks, including written policies and procedures, formalized planning and budgeting, internal controls and audit procedures, management information, and loan review. 

50. Summary of this session SECTION 4 • Banking Supervision • Bank Supervision Models • Harmonization and Convergence of Bank Supervision • Supervisory Methodologies • On site Examination