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Bank Supervision. Presented by Vince Polizatto Overview of Financial Sector Issues and Analysis Workshop May 28, 2002. Why Do Banks Fail?. Bad management!!! Frequently evidenced by: Poor lending practices Concentrations of credit Insider abuse and lending to connected parties

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bank supervision

Bank 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 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
cycle of distress
Cycle of Distress
  • Bad assets accumulate
  • Bank becomes insolvent
  • Resources are misallocated
  • Management speculates
  • Cash flows dry up
  • Funding rates are increased
cycle of distress1
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
good bankers to bad bankers
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
effective supervisors ensure
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
classifying assets
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
sources of repayment
Sources of Repayment
  • Primary sources
    • Cash flow
    • Business asset conversion cycle
  • Secondary sources
    • Refinancing
    • Sale of a fixed asset (collateral)
    • New capital
criticized classified
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
supervisory remedies
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
supervisory remedies1
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
supervisory remedies2
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
basel core principles
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)
preconditions for effective banking supervision
Preconditions for Effective Banking Supervision
  • Clear responsibilities and objectives
  • Operational independence
  • Adequate resources
  • Arrangements for sharing information
preconditions for effective banking supervision1
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
public policy objectives
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
public policy objectives1
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
entry
Entry
  • Supervisors must have the right to set criteria for licensing banks, changes in control, mergers and acquisitions, and other corporate activities
entry1
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
permissible or prohibited activities
Permissible or Prohibited Activities
  • The law should define a “bank” and the business of “banking”
  • Permissible or prohibited activities should be clearly delineated
prudential controls or limits
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
prudential controls and limits
Prudential Controls and Limits

Other banking risks

  • Foreign exchange risk
  • Liquidity risk
  • Interest rate risk
  • Price risk
  • Operational risk
supervisory powers
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
supervisory powers1
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
supervisory powers2
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
supervisory powers3
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
enforcement measures
Enforcement Measures
  • Menu of options
  • Corrective rather than punitive
  • Progressively stronger
  • Used against both the bank and individuals
  • Address unsafe and unsound behavior
enforcement measures1
Enforcement Measures
  • Moral suasion
  • Monetary fines
  • Restrictions on banking activity
    • restrictions on the payment of dividends
    • prohibitions on branch expansion
    • limitations on asset growth
enforcement measures2
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
supervisory methodologies
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.
supervisory methodologies1
Supervisory Methodologies
  • Offsite surveillance
    • Individual banks - trends and peers
    • Banking system
    • Main sectors of the economy
    • Economic environment (local, national, regional, global)
typical supervisory weaknesses
Typical Supervisory Weaknesses
  • Political interference / lack of political will
  • Inadequate staffing and budget
  • Poor legal framework
  • Lack of timely recognition of problems
typical supervisory weaknesses1
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
a new capital adequacy framework basel accord ii
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
weaknesses of the current capital accord
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
supervisory objectives
Supervisory Objectives
  • Promote safety and soundness
  • Enhance competitive equality
  • Address risks in a comprehensive way
  • Focus on internationally active banks
three pillars of new framework
Three Pillars of New Framework
  • Minimum capital requirements
  • A supervisory review process
  • Effective use of market discipline
minimum capital requirements
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
minimum capital requirements1
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
extending the scope
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
banking groups
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
treatment of non banks
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
alternative approaches
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
capital charges for risks
Capital Charges for Risks

Existing risks covered

  • Credit risk
  • Market risk

Proposed additions

  • Interest rate risk
  • Operational risk
supervisory considerations
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
intervention
Intervention

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

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

summary
Summary

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