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

In combination, a dangerous mix and a
prescription for failure!
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

Bad assets accumulate
 Bank becomes insolvent
 Resources are misallocated
 Management speculates
 Cash flows dry up
 Funding rates are increased
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

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:

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
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

Primary sources
– Cash flow
– Business asset conversion cycle

Secondary sources
– Refinancing
– Sale of a fixed asset (collateral)
– New capital
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

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 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 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
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

Clear responsibilities and objectives
 Operational independence
 Adequate resources
 Arrangements for sharing information
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

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 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

Supervisors must have the right to set
criteria for licensing banks, changes in
control, mergers and acquisitions, and other
corporate activities
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
The law should define a “bank” and the
business of “banking”
 Permissible or prohibited activities should
be clearly delineated

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
Other banking risks
 Foreign exchange risk
 Liquidity risk
 Interest rate risk
 Price risk
 Operational risk
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 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 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 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

Menu of options
 Corrective rather than punitive
 Progressively stronger
 Used against both the bank and individuals
 Address unsafe and unsound behavior
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 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

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 Methodologies

Offsite surveillance
– Individual banks - trends and peers
– Banking system
– Main sectors of the economy
– Economic environment (local, national,
regional, global)
Typical Supervisory
Weaknesses

Political interference / lack of political will
 Inadequate staffing and budget
 Poor legal framework
 Lack of timely recognition of problems
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
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

Certain risks not addressed
 Crude measure of risk
 Arbitrage between true risk and risk
measured under the Accord
 Discourages risk mitigation techniques
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

Minimum capital requirements
 A supervisory review process
 Effective use of market discipline
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
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

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
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
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
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
Existing risks covered
 Credit risk
 Market risk
Proposed additions
 Interest rate risk
 Operational risk
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
Supervisors must identify and intervene in
banks when falling capital levels raise
concerns about the bank’s ability to
withstand business shocks.
Market Discipline

Encourage high disclosure standards
 Enhance role of market participants
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
An effective supervisor, sound legal system,
and strong accounting and auditing
framework are essential to healthy banking
systems and a robust economy.