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 governments 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 borrowers 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 banks
  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
• Accords 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

• Banks risk appetite
• Banks record in managing risk
• Nature of the banks 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 banks 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.