Bank SupervisionBank Supervision

Presented by Vince Polizatto

Overview of Financial Sector Issues and Analysis Workshop

May 28, 2002

Why Do Banks Fail?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!

Why Supervise? Why Supervise?

Protect public savingsPrevent build-up of problem assetsLimit financing of speculative activitiesEnsure stability of financial systemPrevent worst consequences of bank

failuresLimit government’s potential liabilities

Cycle of DistressCycle of Distress

Bad assets accumulateBank becomes insolventResources are misallocatedManagement speculatesCash flows dry upFunding rates are increased

Cycle of DistressCycle of Distress

Lending rates are increasedBad assets ratchet upwardsCycle of distress recursLiquidity dries upBank becomes illiquid as well as insolvent

Good Bankers to Bad BankersGood 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

Effective Supervisors Ensure:Effective Supervisors Ensure:

Assets are properly valuedLosses are recognized when identified Corrective action is taken while a bank is

still solventFailures are promptly resolved

Classifying AssetsClassifying Assets

Based on borrower’s ability to repayAssesses future as well as historic

performanceRelates purpose, source of repayment, and

repayment planEmphasizes primary sources of repaymentNot limited to loans and advances

Sources of RepaymentSources of Repayment

Primary sources– Cash flow– Business asset conversion cycle

Secondary sources– Refinancing– Sale of a fixed asset (collateral)– New capital

Criticized/ClassifiedCriticized/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

Supervisory RemediesSupervisory 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

Supervisory RemediesSupervisory RemediesAdoption 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

Supervisory RemediesSupervisory Remedies

Prompt corrective action:Discretion replaced by mandatory actionsTriggered by diminution of capitalActions include a capital restoration planClosure required below certain CAR level

Basel Core PrinciplesBasel 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)

Preconditions for Effective Preconditions for Effective Banking SupervisionBanking Supervision

Clear responsibilities and objectivesOperational independenceAdequate resourcesArrangements for sharing information

Preconditions for Effective Preconditions for Effective Banking SupervisionBanking Supervision

Suitable legal framework:Authorization of banking establishmentsOngoing supervisionSafety and soundnessLegal protection for supervisorsAuthorization to issue regulations

Public Policy ObjectivesPublic Policy Objectives

Prevent concentration of economic powerPromote competitionModerate banking instabilityProtect the publicEncourage operating efficiencyPromote innovationMeet the needs of the public

Public Policy ObjectivesPublic 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

EntryEntrySupervisors must have the right to set

criteria for licensing banks, changes in control, mergers and acquisitions, and other corporate activities

EntryEntryConsiderations: 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

Permissible or Prohibited Permissible or Prohibited ActivitiesActivities

The law should define a “bank” and the business of “banking”

Permissible or prohibited activities should be clearly delineated

Prudential Controls or LimitsPrudential 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

Prudential Controls and LimitsPrudential Controls and Limits

Other banking risksForeign exchange riskLiquidity riskInterest rate riskPrice riskOperational risk

Supervisory PowersSupervisory Powers

Access to all bank records and informationAbility to impose adequate record-keepingAbility to apply qualitative judgement in

forming an opinion about compliance with laws and safety and soundness

Supervisory PowersSupervisory 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

Supervisory PowersSupervisory PowersAbility 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

Supervisory PowersSupervisory 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

Enforcement MeasuresEnforcement Measures

Menu of optionsCorrective rather than punitiveProgressively strongerUsed against both the bank and individualsAddress unsafe and unsound behavior

Enforcement MeasuresEnforcement Measures

Moral suasionMonetary finesRestrictions on banking activity

– restrictions on the payment of dividends– prohibitions on branch expansion– limitations on asset growth

Enforcement MeasuresEnforcement Measures

Suspension or removal orders“Prompt Corrective Action”Memorandum of understandingFormal agreement or cease and desist orderForced acquisition or mergerRevocation of license and placement in

receivership

Supervisory MethodologiesSupervisory Methodologies

Onsite examination– Top-down and forward-looking– Appraisal and assessment - not an audit– CAMELS ratings

Regular contact with managementRegular contact with auditors, security

analysts, bank rating agencies, etc.

Supervisory MethodologiesSupervisory Methodologies

Offsite surveillance– Individual banks - trends and peers– Banking system– Main sectors of the economy– Economic environment (local, national,

regional, global)

Typical Supervisory Typical Supervisory WeaknessesWeaknesses

Political interference / lack of political willInadequate staffing and budgetPoor legal frameworkLack of timely recognition of problems

Typical Supervisory Typical Supervisory WeaknessesWeaknesses

Weak governance in banksWeak risk management systems in banksWeak accounting and auditingInability to promptly force exit and resolve

bank failures

A New Capital Adequacy A New Capital Adequacy Framework - Basel Accord IIFramework - Basel Accord II

Objectives:Improve the way regulatory capital

requirements reflect underlying risksBetter address financial innovation (e.g.,

asset securitization)Recognize improvements in risk

measurement and control

Weaknesses of the Current Weaknesses of the Current Capital AccordCapital Accord

Certain risks not addressedCrude measure of riskArbitrage between true risk and risk

measured under the AccordDiscourages risk mitigation techniques

Supervisory ObjectivesSupervisory Objectives

Promote safety and soundnessEnhance competitive equalityAddress risks in a comprehensive wayFocus on internationally active banks

Three Pillars of New Three Pillars of New FrameworkFramework

Minimum capital requirementsA supervisory review processEffective use of market discipline

Minimum Capital Minimum Capital RequirementsRequirements

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

Minimum Capital Minimum Capital RequirementsRequirements

Minimum capital requirements consist of:A definition of regulatory capitalMeasures of risk exposuresRules specifying the level of capital in

relation to those risks

Extending the ScopeExtending the ScopeRisks in banking groups & individual banksExternal credit assessmentsNew risk weighting for asset securitization20% credit conversion for certain types of

short-term commitments

Banking GroupsBanking Groups

The Accord will clarify the application of the capital standard and capture risks at every tier within a banking group:

Bank holding companiesBanking groupsIndividual banks within the group

Treatment of Non-BanksTreatment 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 entitiesMajority-owned investments in commercial

entities

Alternative ApproachesAlternative Approaches

For some sophisticated banksAn internal ratings-based approachPortfolio credit risk modeling

Credit risk mitigationCredit derivativesCollateral guaranteesOn-balance-sheet netting

Capital Charges for RisksCapital Charges for Risks

Existing risks coveredCredit riskMarket risk

Proposed additionsInterest rate riskOperational risk

Supervisory ConsiderationsSupervisory Considerations

Bank’s risk appetiteBank’s record in managing riskNature of the bank’s marketsQuality, reliability and volatility of earningsAdherence to sound valuation and

accounting standards

InterventionIntervention

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

Market DisciplineMarket Discipline

Encourage high disclosure standardsEnhance role of market participants

DisclosureDisclosure

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

SummarySummary

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