Chapter 5 5 Evaluating Financial Sector Supervision:Banking,Insurance, and Securities Markets This chapter looks at the legal.institutional.and policy framework needed to ensure effec tiveness of financial sector ervision.It foc on banking, ve speiboweve depend onean that provides the necessary preconditions.Those preconditions include the following: The provision and consistent enforcement of business laws-including corporate, bankruptcy,contract,consumer protection,and private property laws-and a mechanism for fair resolution of disputes .Good corporate goverance,including adoption of sound accounting,auditing and transparency procedures that carry wide international acceptance and tha promote market discipline Appropriate systemic liquidity arrangements,including secure and efficient pay- ment clearing systems that enable adequate control of risks and efficient manage. ment of liquidity ·Adequate w to minimize systemic risk.including ate levels of sys protection or safety nets and efficient procedures for handling problem institu tions The preconditions complement the legal and institutional framework governing the specific sectors of the financial system (banks,nonbank financial institutions,rural and microfinance entities,securities markets,and insurance providers)and their supervision which is discussed in section 5.1.The broader legal framework governing the p recondi. ecifically on the lega and institutional aspects of fir nancial s ector safety nets,one of the key preconditions affecting governance and stability of banking institutions.The scope and content of inter 包
101 1 I H G F E D C B A 12 11 10 9 8 7 6 5 4 3 2 This chapter looks at the legal, institutional, and policy framework needed to ensure effectiveness of financial sector supervision. It focuses on banking, insurance, and securities markets. Effective supervision, however, depends on a legal and institutional environment that provides the necessary preconditions. Those preconditions include the following: • The provision and consistent enforcement of business laws—including corporate, bankruptcy, contract, consumer protection, and private property laws—and a mechanism for fair resolution of disputes • Good corporate governance, including adoption of sound accounting, auditing, and transparency procedures that carry wide international acceptance and that promote market discipline • Appropriate systemic liquidity arrangements, including secure and efficient payment clearing systems that enable adequate control of risks and efficient management of liquidity • Adequate ways to minimize systemic risk, including appropriate levels of systemic protection or safety nets and efficient procedures for handling problem institutions The preconditions complement the legal and institutional framework governing the specific sectors of the financial system (banks, nonbank financial institutions, rural and microfinance entities, securities markets, and insurance providers) and their supervision, which is discussed in section 5.1. The broader legal framework governing the preconditions is covered in chapter 9. Section 5.2 in this chapter focuses specifically on the legal and institutional aspects of financial sector safety nets, one of the key preconditions affecting governance and stability of banking institutions. The scope and content of interChapter 5 Evaluating Financial Sector Supervision: Banking, Insurance, and Securities Markets
Financial Sector Assessment:A Handbook national standards on financial sector supervision in banking,insurance,and securities markets and the issues in assessing compliance with these standards are taken up in detai in the subsequent sections of this chapter (sections 5.3-5.5). 5.1 Legal and Institutional Framework for Financial Supervision The legal framework empowering and governing the regulator and the rules used to regulate the various markets and institutional types form the comnerstone of the orderly 5 functioning and development of the financial system.In this respect,the key laws are the law governing the central bank,banking and financial institutions,capital market laws and insurance laws,and those laws are backed by adequate provisions on the efficient and mes embedded in the ae.The key eem ncial sed already par of a broader range accounting,auditing,and disclosure,and so forth. The legal and institutional framework for financial supervision should cover (a)the identity of the supervisor(central bank or separate agency),terms of reference,powers, and authority of the supervisory agency:(b)the authority and processes for the issuance of regulations and guidance:(c)the authority and tools to monitor and verify compliance with the regulations and principles of safe and sound operations;(d)the authority and actions to remedy,enforce,take contro,and restructu and (e)the procedures to deli- ons that ca The legal fram and at nce sibilities of different er laws ips among the super visory agency,any deposit insuranc agency,and other financia sector supervisors. addition,the relationship with the Ministry of Finance needs to be clear and to provide sufficient operational autonomy to the supervisor.If a country has put in place a unified financial supervisory agency,then this arrangement needs to be laid down in a law,and its autonomy and powers need to be explicit. The legal and regulatory basis of financial supervision should also support the core components of all financial supervisory standards.Those components consist of the fol- wng categories which refers to the objec enforce. ibures tha ulate a ·Regul ctices tory practices,which refer to the practical application of laws,rules,and procedures .Prudential framework,which refers to internal controls and governance arrange ments to ensure prudent management and operations by financial firms .Financial integrity and safety net arrangements,which refer to (a)the regulatory policies and instruments designed to promote fairness and integrity in the opera- 102
102 Financial Sector Assessment: A Handbook 1 I H G F E D C B A 12 11 10 9 8 7 6 5 4 3 2 national standards on financial sector supervision in banking, insurance, and securities markets and the issues in assessing compliance with these standards are taken up in detail in the subsequent sections of this chapter (sections 5.3–5.5). 5.1 Legal and Institutional Framework for Financial Supervision The legal framework empowering and governing the regulator and the rules used to regulate the various markets and institutional types form the cornerstone of the orderly functioning and development of the financial system. In this respect, the key laws are the law governing the central bank, banking and financial institutions, capital market laws, and insurance laws, and those laws are backed by adequate provisions on the efficient and reliable payment system infrastructure. The provisions are sometimes embedded in the laws or else are governed by separate legislation. The key elements of sound financial sector laws are already part of the existing international standards on supervision. Effective supervision also requires certain preconditions that are embedded in a broader range of laws such as laws on bankruptcy; company laws; contracts laws; and laws governing accounting, auditing, and disclosure, and so forth. The legal and institutional framework for financial supervision should cover (a) the identity of the supervisor (central bank or separate agency), terms of reference, powers, and authority of the supervisory agency; (b) the authority and processes for the issuance of regulations and guidance; (c) the authority and tools to monitor and verify compliance with the regulations and principles of safe and sound operations; (d) the authority and actions to remedy, enforce, take control, and restructure; and (e) the procedures to delicense and liquidate problem institutions that cannot be restructured. The legal framework should clarify the roles and responsibilities of different agencies involved in financial supervision. The central bank laws, banking laws, and other laws governing financial sector supervision need to specify the relationships among the supervisory agency, any deposit insurance agency, and other financial sector supervisors. In addition, the relationship with the Ministry of Finance needs to be clear and to provide sufficient operational autonomy to the supervisor. If a country has put in place a unified financial supervisory agency, then this arrangement needs to be laid down in a law, and its autonomy and powers need to be explicit. The legal and regulatory basis of financial supervision should also support the core components of all financial supervisory standards. Those components consist of the following categories: • Regulatory governance, which refers to the objectives, independence, enforcement, and other attributes that provide the capacity to formulate and to implement sound regulatory policies and practices • Regulatory practices, which refer to the practical application of laws, rules, and procedures • Prudential framework, which refers to internal controls and governance arrangements to ensure prudent management and operations by financial firms • Financial integrity and safety net arrangements, which refer to (a) the regulatory policies and instruments designed to promote fairness and integrity in the opera-
Chapter 5:Ealating Financial Sector Supervision:Banking,Insurance,and Secrities Markets Figure 5.1.Financial Standards and Their Four Main Components Regulatory Governance' Requlatory Practices Objectives of regulation Grou -wide s nipendencenandadeagateoe EaeaiPgmp8mevoegulaoyproces Enforcement gfeationandinformationsharing Licensing,ownership transfer,and corporate dential Framework 5 Risk management Financial Integrity and Safety Netd te go Markets (financial crime) &inude8Cp2n181Gg6242经8nd2s:1cp2.3,451213,15.16.nd1:1oP89,10.1.1213 :e是品格88oa2 .2.8.ad3. discussion of specific core principles under each standard,see chapters 5.3-5.5. tions of financial institutions and markets and (b)the creation of safeguards for depositors,investors,and policyholders,particularly during times of financial dis tress and crisis Those four components are illustrated in figure 5.1.For example,in the area of regu- latory governance,Insurance Core Principles (ICPs)relating to supervisory objectives and supervisory authority require that insurance legislation include a clear statement on the m mandates of the super and give authority to issue and enforc rules by administrative means.Many of the other criteri a and core principle uch as those relating to independence and accountability-could be part of primary legislation or part of regulations and bylaws issued pursuant to the legislation. The institutional framework for supervision-and the laws that support it-needs to reflect the financial market structure and the broader institutional and policy environ- ment.The institutional fra ork should be flexible enough to adapt to the shifts market structure and in the broader environment to avoid regulatory gaps and to suppor financial innovation and development.For example,a poorly structured organizational 103
103 Chapter 5: Evaluating Financial Sector Supervision: Banking, Insurance, and Securities Markets 1 I H G F E D C B A 12 11 10 9 8 7 6 5 4 3 2 tions of financial institutions and markets and (b) the creation of safeguards for depositors, investors, and policyholders, particularly during times of financial distress and crisis Those four components are illustrated in figure 5.1. For example, in the area of regulatory governance, Insurance Core Principles (ICPs) relating to supervisory objectives and supervisory authority require that insurance legislation include a clear statement on the mandates of the supervisory authority and give authority to issue and enforce rules by administrative means. Many of the other criteria and core principles—such as those relating to independence and accountability—could be part of primary legislation or part of regulations and bylaws issued pursuant to the legislation. The institutional framework for supervision—and the laws that support it—needs to reflect the financial market structure and the broader institutional and policy environment. The institutional framework should be flexible enough to adapt to the shifts in market structure and in the broader environment to avoid regulatory gaps and to support financial innovation and development. For example, a poorly structured organizational Figure 5.1. Financial Standards and Their Four Main Components • Objectives of regulation • Independence and adequate resources • Enforcement powers and capabilities • Clarity and transparency of regulatory process • External participation Regulatory Governancea Note: This four-component framework is based on the paper “Financial Sector Regulation: Issues and Gaps” (IMF 2004a). The allocation of insurance principles into various components is based on the 2000 IAIS standard. For a discussion of specific core principles under each standard, see chapters 5.3–5.5. a. Includes BCP 1 and 19; ICP 1; IP: 1, 2, 3, 4, 5, 6, and 7. b. Includes BCP 2, 3, 4, 6, 16, 17, 18, 20, 22, 23, 24, and 25; ICP 2, 3, 4, 5, 12, 13, 15, 16, and 17; IOP 8, 9, 10, 11, 12, 13, and 29. c. Includes BCP 5, 6, 7, 8, 9, 10, 11, 12, 13, and 14; ICP 6, 7, 9, and 10; IOP 17, 18, 20, 21, 22, 23, 25, and 27. d. Includes BCP 15 and 21; ICP 11 and 16; IOP 14, 15, 16, 19, 24, 26, 28, and 30. BCP—Basel Core Principles ICP—Insurance Core Principles of International Association of Insurance Supervisors IOP—International Organization of Securities Commission’s Objectives and Principles of Securities Regulation • Group-wide supervision • Monitoring and on-site inspection • Reporting to supervisors • Enforcement • Cooperation and information sharing • Confidentiality • Licensing, ownership transfer, and corporate control • Qualifications Regulatory Practicesc • Markets (integrity and financial crime) • Customer protection • Information, disclosure, and transparency Financial Integrity and Safety Netd • Risk management • Risk concentration • Captial requirements • Corporate governance • Internal controls Prudential Frameworkb Figure 5.1. Financial Standards and Their Four Main Components
Financial Sector Assessment:A Handbook framework for supervision could impede financial innovation or cause overregulatior that stifles development.Similarly,an inappropriate organizational structure may cause regulatory gaps and regulatory arbitrage that may allow excessive risk taking and finan cial instability.An institutional framework for financial stability is.however.quite broad and goes beyond the institutions conducting financial supervision(such as the sectoral supervisor or integrated supervisor or central bank with supervision responsibilities).It includes other institutions and policy authorities that have jurisdictions over the broader financial infra mic policies.For nd i ency regi are 5 supervis but are crit ution al framework also includes the specific coordinating arrangements to ensure information exchange and policy coordination among all these policy components-supervisory,infrastructure macroeconomic,and macroprudential-that interact to produce financial stability and financial development.In most cases,the Ministry of Finance will have the overall coor- dinating powers,and in some cases,there could be specific coordinating committees that htgCetrcrcGtmetnta onal structure of financial regulation and s per. a ma or of p and public e in several ountr .Alth many countries have moved in a uni cy for prudential eaub and supervision,the case for integrating conduct of business regulation and prudentia supervision within the same agency is less powerful and considerably less common.Also the issue of how to tailor the structure of regulation to specific features- -operationa complexities and transaction characteristics-of regulated institutions has become a pressing issue,for example,in the context of expanding access to the poor or in managing large and complex financial institutions(LCFIs).The issues in assessing the institutional cture are taken up in greater detail in appendix F(Institutional Structure of Financial 5.2 Aspects of Financial Safety Nets Financia safety nets of three main elements (a)framework y support (b)deposit insurance plus investor and policyholder protection schemes,and(c)crisis management policies.Each element of the safety net is designed to prevent situations in which the failure or potential failure of individual financial institutions disrupts the intermediation function of financial markets and,thus,the broader economic activity Facilities for liquidity support attempt to prevent liquidity difficulties in one institution (or market)from being transmitted throughout the financial system.Deposit insurance and other protection schemes s are desi med to provide confidenc to the least info deposit ors an C ors with respect to the safety of thei funds and hereb overs from n anagement policies are minim sruptio caused by widespread difficulties in the financial sector and thus avoid those difficultie from spilling over into broader economic activity.Therefore,in assessing the adequacy of the financial sector safety net,all three elements,including their legal underpinnings and their interconnections,should be considered. 104
104 Financial Sector Assessment: A Handbook 1 I H G F E D C B A 12 11 10 9 8 7 6 5 4 3 2 framework for supervision could impede financial innovation or cause overregulation that stifles development. Similarly, an inappropriate organizational structure may cause regulatory gaps and regulatory arbitrage that may allow excessive risk taking and financial instability. An institutional framework for financial stability is, however, quite broad and goes beyond the institutions conducting financial supervision (such as the sectoral supervisor or integrated supervisor or central bank with supervision responsibilities). It includes other institutions and policy authorities that have jurisdictions over the broader financial infrastructure and macroeconomic policies. For example, accounting policies, competition policies, and insolvency regimes are matters outside the jurisdiction of supervision but are critical for financial stability. The broader institutional framework also includes the specific coordinating arrangements to ensure information exchange and policy coordination among all these policy components—supervisory, infrastructure, macroeconomic, and macroprudential—that interact to produce financial stability and financial development. In most cases, the Ministry of Finance will have the overall coordinating powers, and in some cases, there could be specific coordinating committees that bring together representatives of different policy authorities. The appropriate design of the institutional structure of financial regulation and supervision has become a major issue of policy and public debate in several countries. Although many countries have moved in the direction of a unified agency for prudential regulation and supervision, the case for integrating conduct-of-business regulation and prudential supervision within the same agency is less powerful and considerably less common. Also, the issue of how to tailor the structure of regulation to specific features—operational complexities and transaction characteristics—of regulated institutions has become a pressing issue, for example, in the context of expanding access to the poor or in managing large and complex financial institutions (LCFIs). The issues in assessing the institutional structure are taken up in greater detail in appendix F (Institutional Structure of Financial Regulation and Supervision). 5.2 Aspects of Financial Safety Nets Financial safety nets consist of three main elements: (a) a framework for liquidity support, (b) deposit insurance plus investor and policyholder protection schemes, and (c) crisis management policies. Each element of the safety net is designed to prevent situations in which the failure or potential failure of individual financial institutions disrupts the intermediation function of financial markets and, thus, the broader economic activity. Facilities for liquidity support attempt to prevent liquidity difficulties in one institution (or market) from being transmitted throughout the financial system. Deposit insurance and other protection schemes are designed to provide confidence to the least-informed depositors and investors with respect to the safety of their funds and thereby avoid spillovers from runs. Crisis management policies are established to minimize the disruption caused by widespread difficulties in the financial sector and thus avoid those difficulties from spilling over into broader economic activity. Therefore, in assessing the adequacy of the financial sector safety net, all three elements, including their legal underpinnings and their interconnections, should be considered
Chapter 5:Ealating Financial Sector Supervision:Banking,Insurance,and Secrities Markets 5.2.1 Frameworks for Liquidity Support Liquidity support is a key element of the financial sector safety net.Two somewhat dis tinct functi ne operating at normal times and another in times of crisis identified.The first is the lender-of-last-resort(LOLR)function,which typically operates in the normal course of day-to-day monetary policy operations.Nearly all central banks have the authority to provide credit to temporarily illiquid,but still solvent,institutions This kind of support can provide an important buffer against temporary disturbances in financial markets s.LOLR actions may elp to prevent in one bank from be nsmitted to other finar throu gh the payment system.LOLR actions are not intended to prevent bank failures but,rather,to prevent spillovers associated with liquidity shortages-particularly in money and interbank mar kets-from interrupting the normal intermediation function of financial institutions and markets All central banks ha ea LOLR facility in place,but conditions and modalitiesare often no vell defined.Ill-defined conditions may giver to moral ha azard and forbear ance,with adverse consequences for the financial system.Thus,an important component in understanding the adequacy of the financial safety net is assessing the adequacy of the central bank's operational procedures for LOLR support. Somewhat distinct from the normal LOLR function is central bank emergency lend. is important fo cntabanks to have procedures in place to provide emergen lending,with different modalities and conditio s,in times of (imminent)crises.In of emergen cies,a numb of central banks have the legal authority to provide liquidity over and above what is allowed within the normal facility.Having those types of proce dures available can be very useful to provide temporary support to the system in times of severe disruptions.However,the very existence of those procedures might lead to moral hazard in banks,causing them to hold less liquidity than they otherwise would do and to take other risks.As a result,the providing of en of the central bank ( ve ambiguity s and a form of contingency planning-shoul be in place for emergency lending,whic should follow sound practices.In particular,the broad principles and the procedures gov- eming the decisions on emergency lending could be established and made transparent. Key features of emergency lending procedures that should be considered include the following: ·Resources should be ade available only to banks that are considered solvent but are coping w vith liquidity problems that might endanger the entire system (e.g. too-big-to-fail cases). Lending should take place speedily. .Lending should be short term;even then,it should be provided conservatively because the situation of a bank might deteriorate quickly. .Lending should not take place at subsidized rates,but the rate also should not be then deter orate the bank's po Thehoolren de valued sonerva tively.However,at times of severe crisis,it might be necessary for the central bank 105
105 Chapter 5: Evaluating Financial Sector Supervision: Banking, Insurance, and Securities Markets 1 I H G F E D C B A 12 11 10 9 8 7 6 5 4 3 2 5.2.1 Frameworks for Liquidity Support Liquidity support is a key element of the financial sector safety net. Two somewhat distinct functions––one operating at normal times and another in times of crisis––need to be identified. The first is the lender-of-last-resort (LOLR) function, which typically operates in the normal course of day-to-day monetary policy operations. Nearly all central banks have the authority to provide credit to temporarily illiquid, but still solvent, institutions. This kind of support can provide an important buffer against temporary disturbances in financial markets. LOLR actions may help to prevent liquidity shortages in one bank from being transmitted to other financial institutions, for example, through the payment system. LOLR actions are not intended to prevent bank failures but, rather, to prevent spillovers associated with liquidity shortages—particularly in money and interbank markets—from interrupting the normal intermediation function of financial institutions and markets. All central banks have a LOLR facility in place, but conditions and modalities are often not well defined.1 Ill-defined conditions may give rise to moral hazard and forbearance, with adverse consequences for the financial system. Thus, an important component in understanding the adequacy of the financial safety net is assessing the adequacy of the central bank’s operational procedures for LOLR support. Somewhat distinct from the normal LOLR function is central bank emergency lending. It is important for central banks to have procedures in place to provide emergency lending, with different modalities and conditions, in times of (imminent) crises. In cases of emergencies, a number of central banks have the legal authority to provide liquidity over and above what is allowed within the normal facility. Having those types of procedures available can be very useful to provide temporary support to the system in times of severe disruptions. However, the very existence of those procedures might lead to moral hazard in banks, causing them to hold less liquidity than they otherwise would do and to take other risks. As a result, the providing of emergency credit is typically at the discretion of the central bank (constructive ambiguity). Nonetheless, internal procedures and policies––a form of contingency planning––should be in place for emergency lending, which should follow sound practices. In particular, the broad principles and the procedures governing the decisions on emergency lending could be established and made transparent. Key features of emergency lending procedures that should be considered include the following:2 • Resources should be made available only to banks that are considered solvent but are coping with liquidity problems that might endanger the entire system (e.g., too-big-to-fail cases). • Lending should take place speedily. • Lending should be short term; even then, it should be provided conservatively because the situation of a bank might deteriorate quickly. • Lending should not take place at subsidized rates, but the rate also should not be penal because it might then deteriorate the bank’s position. • The loan should be fully collateralized, and collateral should be valued conservatively. However, at times of severe crisis, it might be necessary for the central bank
Financial Sector Assessment:A Handbook to relax this criterion or to organize government guarantees or to arrange govern. ment credit,even if the loan is executed from the central bank's balance sheet. .Central bank supervisory authorities and the Ministry of Finance should be in close contact and should monitor the situation of the bank. .Supervisory sanctions and remedial actions should be attached to the emergency lending. 5.2.2 Deposit Insurance 5 A second key element of the financial safety net is a deposit insurance system (DIS) Although deposit insurance can cause excessive risk taking,a careful design of deposit insurance-complemented by a larger policy package that includes effective supervision, prompt bank resolution methods,and well-designed LOLR procedures-should provide ncentives for economic agents to keep the financial system stable.3 Good practices that contribute toa proper operation of a DIS include the following .The DIS should be explicitly and clearly defined in laws and regulations that are known to,and understood by,the public so bank customers can protect their inter ests. If one is to reduce the probability of moral hazard in banks and to provide incen- tives for large depositors and counterparty banks to monitor the bank conditions. "large"depe sits,including interbank liabilities,should not be covered. ·Ex ante fund g s emes are preferable toex post scheme .Membership should be compulsory;insurance premiums should be risk-adjusted,if possible,to moderate the subsidy provided by strong institutions to weaker ones. If depositors are to have confidence in the system,the DIS must pay out insured deposits promptly,and it must be adequately funded so it can resolve failed institu- and without delay ·The e DIS should act in the interests of both depe ors and the taxpayers who back up the fund.Consequently,it should be accountable to the public,but independent of political interterence. The DIS should be complemented by effective supervision and well-designed LOLR policies .Because the roles of the lolr.the supervisor,and the DIS are different,it is often advisable in eo(but impractical financial skills)to house them in three separate agencies.Regardless,those agen. cies need to share information and coordinate their actions. If the DIS is to avoid regulatory capture by the industry it guarantees,then placing currently practicing bankers in charge of decision making is typically not advisable. Howev er bankers should he s given the opportunity e on an advisory board. where they can offer useful advic .Ifa country operates insurance schemes for financial instruments other than (nar rowly defined)deposits-including capital market instruments and possibly insur ance-then those types of investor and policyholder compensation schemes should 106
106 Financial Sector Assessment: A Handbook 1 I H G F E D C B A 12 11 10 9 8 7 6 5 4 3 2 to relax this criterion or to organize government guarantees or to arrange government credit, even if the loan is executed from the central bank’s balance sheet. • Central bank supervisory authorities and the Ministry of Finance should be in close contact and should monitor the situation of the bank. • Supervisory sanctions and remedial actions should be attached to the emergency lending. 5.2.2 Deposit Insurance A second key element of the financial safety net is a deposit insurance system (DIS). Although deposit insurance can cause excessive risk taking, a careful design of deposit insurance—complemented by a larger policy package that includes effective supervision, prompt bank resolution methods, and well-designed LOLR procedures—should provide incentives for economic agents to keep the financial system stable.3 Good practices that contribute to a proper operation of a DIS include the following: • The DIS should be explicitly and clearly defined in laws and regulations that are known to, and understood by, the public so bank customers can protect their interests. • If one is to reduce the probability of moral hazard in banks and to provide incentives for large depositors and counterparty banks to monitor the bank conditions, “large” deposits, including interbank liabilities, should not be covered. • Ex ante funding schemes are preferable to ex post schemes. • Membership should be compulsory; insurance premiums should be risk-adjusted, if possible, to moderate the subsidy provided by strong institutions to weaker ones. • If depositors are to have confidence in the system, the DIS must pay out insured deposits promptly, and it must be adequately funded so it can resolve failed institutions firmly and without delay. • The DIS should act in the interests of both depositors and the taxpayers who back up the fund. Consequently, it should be accountable to the public, but independent of political interference. • The DIS should be complemented by effective supervision and well-designed LOLR policies. • Because the roles of the LOLR, the supervisor, and the DIS are different, it is often advisable in large countries (but impractical in countries facing a shortage of financial skills) to house them in three separate agencies. Regardless, those agencies need to share information and coordinate their actions. • If the DIS is to avoid regulatory capture by the industry it guarantees, then placing currently practicing bankers in charge of decision making is typically not advisable. However, bankers should be given the opportunity to serve on an advisory board, where they can offer useful advice. • If a country operates insurance schemes for financial instruments other than (narrowly defined) deposits—including capital market instruments and possibly insurance—then those types of investor and policyholder compensation schemes should
Chapter 5:Ealating Financial Sector Supervision:Banking,Insurance,and Securities Markets conform broadly to the same standards as deposit insurance,as described in this chanter .Although the inclusio or exclusion of fo ance would lepend on the features of dollarization,adequacy of foreign exc reserves,and capacity to manage foreign exchange risks,a decision to include foreign exchange deposits should be based on a clear and transparent legal and regulatory framework that specifies who bears the exchange risk. In a systemic crisis,limited deposit insurance may become ineffective.Other measures such as an extended guarantee (blanket guarantee)could be considered in those circum. stances.However,as country experience in systemic crises indicates,a blanket guarantee 5 (a government guarantee for all depositors and certain bank creditors)should be provided mstances are favorable for that guarantee to restore confidence and to s the crisis fro spre time.bo ward li sustainable 5.2.3 Investor and Policyholder Protection Schemes functioning of financial markets and to protect policyholders from the failures of financial institutions.They are present in many jurisdictions and form one component of the range of measures adopted by industry associations,self-regulatory organizations (such as stock and futures exchanges),and national authorities.Most schemes are designed to provide some degree of compensation for investors who incur losses from the insolvency or other failure of a member firm:some schemes also provide compensation for losses arising from fraud or other malfeasance on the part of the intermediary or its employees.All sche me a proportion of thelo rred or both. or compens ustomer which ang of investm efined in t respective l en ng laws and e place.C mpen ation schemes generally do not cover although in some sch mes,compensation may be available where a causal relationship is established between the poor investment advice or management and the inability of the firm to meet claims made by clients. In most jurisdictions,the compensation scheme is statutory in nature:however,it may take a variety of forms.Although compensation funds are set up by contract,the obliga tion to set up and to be a member of one are often in statute.In some cases.schemes are constituted as nonprofit member organizations,whereas,in other cases,the scheme on the b ng a fund behalf of an cha ng prin any.In cer tain j ictio the are schemes in which trusts exchanges that are ac ting as the trust's sponsoring organizatio tion arranger .The compensation fund also may be established as a separate company administered by the regulator
107 Chapter 5: Evaluating Financial Sector Supervision: Banking, Insurance, and Securities Markets 1 I H G F E D C B A 12 11 10 9 8 7 6 5 4 3 2 conform broadly to the same standards as deposit insurance, as described in this chapter. • Although the inclusion or exclusion of foreign currency deposits in deposit insurance would depend on the features of dollarization, adequacy of foreign exchange reserves, and capacity to manage foreign exchange risks, a decision to include foreign exchange deposits should be based on a clear and transparent legal and regulatory framework that specifies who bears the exchange risk.4 In a systemic crisis, limited deposit insurance may become ineffective. Other measures such as an extended guarantee (blanket guarantee) could be considered in those circumstances. However, as country experience in systemic crises indicates, a blanket guarantee (a government guarantee for all depositors and certain bank creditors) should be provided only if circumstances are favorable for that guarantee to restore confidence and to stop the crisis from spreading and if there is a credible time-bound exit strategy toward limited guarantee.5 One crucial condition to restore confidence is that the government’s fiscal situation be sustainable. 5.2.3 Investor and Policyholder Protection Schemes Related to the second element of safety net, deposit insurance, are investor and policyholder compensation schemes, which are designed to promote investor confidence in the functioning of financial markets and to protect policyholders from the failures of financial institutions. They are present in many jurisdictions and form one component of the range of measures adopted by industry associations, self-regulatory organizations (such as stock and futures exchanges), and national authorities. Most schemes are designed to provide some degree of compensation for investors who incur losses from the insolvency or other failure of a member firm; some schemes also provide compensation for losses arising from fraud or other malfeasance on the part of the intermediary or its employees. All schemes have a cap on claims—in absolute terms or as a proportion of the loss incurred or both. Investor compensation schemes generally cover customer accounts in which a range of investment activities—defined in the respective licensing laws and broader regulatory regimes—take place. Compensation schemes generally do not cover losses on the part of the investor as a result of poor investment advice or management by member firms, although in some schemes, compensation may be available where a causal relationship is established between the poor investment advice or management and the inability of the firm to meet claims made by clients. In most jurisdictions, the compensation scheme is statutory in nature; however, it may take a variety of forms. Although compensation funds are set up by contract, the obligation to set up and to be a member of one are often in statute. In some cases, schemes are constituted as nonprofit member organizations, whereas, in other cases, the scheme is arranged on the basis of a company operating a fund on behalf of an exchange, the exchange being the principal shareholder of the company. In certain jurisdictions, there are schemes in which trusts—organized on behalf of the various dealer associations and exchanges that are acting as the trust’s sponsoring organizations—provide for compensation arrangements. The compensation fund also may be established as a separate company administered by the regulator
Financial Sector Assessment:A Handbook The majority of investor compensation schemes are tailored to individual investors and small business;in some cases,institutional investors are afforded equitable treatment under the terms of the scheme.Generally,the claims cap of the scheme is consistent with the type of investor covered by the arrangements;jurisdictions that provide for both retail and institutional claimants in their schemes have caps that are generally higher than those for compensation schemes that are targeted at retail and small business investors. Some schemes provide for a minimum level of compensation.although the maiority set limits on the maximum pa yment in the event of a successful claim Funding for in estor ation schemes re to a la 5 levies on me ns.Where levies a y are genera y calcul to factors such as the gross revenue and net capital of mem er firms Othe ma also be taken into account in assessing contributions,including the risk profile and level of activity of the firm.Some schemes set a minimum balance for the fund and have spe cific arrangements to ensure that the minimum balance is maintained.In some jurisdic tions,the scheme does not provide for a reserve fund;rather,levies are raised according to projected costs of the scheme in a given year and calculated on an annual basis.Provisions are usually made in the scheme's rules to ensure that additional funds can be raised in the event of a major default or likely shortfall in funds caused by increased claims. The of in pends on the full of re o losses and customer assets in h to pr ure or an ite rmediary.T se measures incl e(a）proc ures to effe the orderly winding up of a failed intermediary,(b)provisions for the regulator to restrain conduct on the part of a failing or failed firm and to direct the appropriate management of assets held by the intermediary,and (c)capital adequacy requirements that are sufficient to facilitate the protection of customer assets in the event of a firm becoming insolvent Adequate transparency of the regulator- -with respect to the steps taken to deal with the failure of market intermediaries an promote investor confidence Some of the em ractices of compensation schemes are noted here should be nde. ns.Th structive relati s with rela sor function as a superv or an ombudsman or any relevant part of the disp and industry representative schemes should be industry-funded to emphasize that prudential and fiduciary responsibility lies with industry participants. The degree of government backing is likely to vary between iurisdictions.but such back. ing may increase moral hazard to market participants.Prefunded schemes offer greater certainty of compensation,but pay-as-you-go schemes may be perfectly adequate in dis. ciplined markets.The latter type of scheme(and to a lesser extent,the former)may be ired to borrow fron besubjecttocdearlimits.F me.The terms and conditions of this borrowing should of in e.Th ary fon sector to sector,by size of contributor,or by the degree of financ Compensation is made on the defined event of failure or almost certain failure of a financial service provider.Compensation is typically subject to an upper limit that is appropriate for the type of product or market and commensurate with the level of funding. Compensation could be limited to retailers or small,unsophisticated commercial consum- 108
108 Financial Sector Assessment: A Handbook 1 I H G F E D C B A 12 11 10 9 8 7 6 5 4 3 2 The majority of investor compensation schemes are tailored to individual investors and small business; in some cases, institutional investors are afforded equitable treatment under the terms of the scheme. Generally, the claims cap of the scheme is consistent with the type of investor covered by the arrangements; jurisdictions that provide for both retail and institutional claimants in their schemes have caps that are generally higher than those for compensation schemes that are targeted at retail and small business investors. Some schemes provide for a minimum level of compensation, although the majority set limits on the maximum payment in the event of a successful claim. Funding arrangements for investor compensation schemes rely to a large extent on levies on member firms. Where levies are imposed, they are generally calculated according to factors such as the gross revenue and net capital of member firms. Other factors may also be taken into account in assessing contributions, including the risk profile and level of activity of the firm. Some schemes set a minimum balance for the fund and have specific arrangements to ensure that the minimum balance is maintained. In some jurisdictions, the scheme does not provide for a reserve fund; rather, levies are raised according to projected costs of the scheme in a given year and calculated on an annual basis. Provisions are usually made in the scheme’s rules to ensure that additional funds can be raised in the event of a major default or likely shortfall in funds caused by increased claims. The adequacy of investor protection measures depends on the full range of regulatory responses in place to minimize investor losses and to protect customer assets in the event of the failure of an intermediary. Those measures include (a) procedures to effect the orderly winding up of a failed intermediary, (b) provisions for the regulator to restrain conduct on the part of a failing or failed firm and to direct the appropriate management of assets held by the intermediary, and (c) capital adequacy requirements that are sufficient to facilitate the protection of customer assets in the event of a firm becoming insolvent. Adequate transparency of the regulator—with respect to the steps taken to deal with the failure of market intermediaries—can promote investor confidence. Some of the emerging good practices of compensation schemes are noted here. Compensation schemes should be independent and transparent in their operations. They should have open and constructive relations with related agencies or functions—such as a supervisor or an ombudsman or any relevant part of the dispute resolution mechanism—and industry representatives. Compensation schemes should be industry-funded to emphasize that prudential and fiduciary responsibility lies with industry participants. The degree of government backing is likely to vary between jurisdictions, but such backing may increase moral hazard to market participants. Prefunded schemes offer greater certainty of compensation, but pay-as-you-go schemes may be perfectly adequate in disciplined markets. The latter type of scheme (and to a lesser extent, the former) may be required to borrow from time to time. The terms and conditions of this borrowing should be subject to clear limits. Funding levies are usually set at a flat percentage of income. The rate may vary from sector to sector, by size of contributor, or by the degree of financial health of the contributor. Compensation is made on the defined event of failure or almost certain failure of a financial service provider. Compensation is typically subject to an upper limit that is appropriate for the type of product or market and commensurate with the level of funding. Compensation could be limited to retailers or small, unsophisticated commercial consum-
Chapter 5:Ealating Financial Sector Supervision:Banking,Insurance,and Secrities Markets ers of domestic products should be compen of market.Most nota ably if a market purports to offer products on an international basis,then compensation should be payable to foreign consumers.Finally,the scheme should adhere to good corporate governance practices, follow strict investment guidelines,and be subject to audit. Policyholder protection funds act as a financial safety net,often after other avenues for been exhausted (the bankruptcy pro cess).These funds act to main tain public confidence in the industry by protecting of all entitieso uninformed customers and by ensuring a smooth exit mechanism for failing companies Finally,protection funds help to level the playing field across different sectors. 5 5.2.4 Crisis Management A third key element of the financial sector safety net includes the policies and procedures in place to manage crises.An assessment of the adequacy of the safety net should con- sider the readines s of the national authorities to tackle a syste nic banking crisis (ideally to have in place a contingency plan)in case a crisis occurs.Many country autho oritie may view the prospects for a crisis as highly remote,and thus,assessments of readiness may help raise awareness of the need to have policies and procedures in place to address a crisis. Some key considerations in assessing the crisis management framework include the following: ·Is the legal framework during“normal times”robust enough to ensure a smooth banking sector restructuring once a crisis has been contained? This question encompasses a wide range of areas,including the banking law,the bankruptcy procedures,the laws on foreclosing assets,and the quality of the judicial system Adequate bank insolvency law in normal times is critical to ensure smooth bank rest cturing in crisis times A high-level policy committee is ne eded as soon as it is clear that the cri sis ha taken on systemic proportions.At that point,it is important to act swiftly and decisively,which requires a high-level body.This body should be at the prime ministerial level (or ministerial level)and should include the head of the central bank and the supervisory agency. ·Although it is ir possible to hav cy plan that c ers all conting encies (crises come in different shapes and forms),the horities should have some view with respect to the types of measures that could be taken to contain an emerging crisis.Time is of the essence at that point,and the measures should be of the type to show that the authorities are in control so confidence will return.Some coun. tries occasionally organize crisis management simulations to increase awareness of ents to the smooth handling of Additional discussion of thos issues is provic in Hoelscher and Quintyn (2003) Lindgren and others (2000),and World Bank and IMF(2004),especially with respect to
109 Chapter 5: Evaluating Financial Sector Supervision: Banking, Insurance, and Securities Markets 1 I H G F E D C B A 12 11 10 9 8 7 6 5 4 3 2 ers, and the extent to which foreign consumers of domestic products should be compensated should be appropriate to the type of market. Most notably, if a market purports to offer products on an international basis, then compensation should be payable to foreign consumers. Finally, the scheme should adhere to good corporate governance practices, follow strict investment guidelines, and be subject to audit. Policyholder protection funds act as a financial safety net, often after other avenues for redress have been exhausted (e.g., the bankruptcy process). These funds act to maintain public confidence in the industry by protecting the interest of small entities or uninformed customers and by ensuring a smooth exit mechanism for failing companies. Finally, protection funds help to level the playing field across different sectors.6 5.2.4 Crisis Management A third key element of the financial sector safety net includes the policies and procedures in place to manage crises. An assessment of the adequacy of the safety net should consider the readiness of the national authorities to tackle a systemic banking crisis (ideally, to have in place a contingency plan) in case a crisis occurs. Many country authorities may view the prospects for a crisis as highly remote, and thus, assessments of readiness may help raise awareness of the need to have policies and procedures in place to address a crisis. Some key considerations in assessing the crisis management framework include the following: • Is the legal framework during “normal times” robust enough to ensure a smooth banking sector restructuring once a crisis has been contained? This question encompasses a wide range of areas, including the banking law, the bankruptcy procedures, the laws on foreclosing assets, and the quality of the judicial system. Adequate bank insolvency law in normal times is critical to ensure smooth bank restructuring in crisis times. • A high-level policy committee is needed as soon as it is clear that the crisis has taken on systemic proportions. At that point, it is important to act swiftly and decisively, which requires a high-level body. This body should be at the prime ministerial level (or ministerial level) and should include the head of the central bank and the supervisory agency. • Although it is impossible to have a contingency plan that covers all contingencies (crises come in different shapes and forms), the authorities should have some views with respect to the types of measures that could be taken to contain an emerging crisis. Time is of the essence at that point, and the measures should be of the type to show that the authorities are in control so confidence will return. Some countries occasionally organize crisis management simulations to increase awareness of potential issues and to resolve logistical impediments to the smooth handling of crises. Additional discussion of those issues is provided in Hoelscher and Quintyn (2003), Lindgren and others (2000), and World Bank and IMF (2004), especially with respect to
Financial Sector Assessment:A Handbook the legal titutional and regulatory framework to deal with insolvent banks.See also section 5.3.5 for a more detailed discussion of bank insolvency issues. 5.3 Assessment of Banking Supervision This section presents the core principles that form the basis for assessing the effectiveness of banking supervision,explains the assessment methodology,outlines the recent assess- ment experience,and discusses selected key issues in supervision:new capital adequacy 5 mplex finan cial institutio nsolidat supervision,and nique risks in Islamic banking 5.3.1 Basel Core Prin -Their r Scope and Co verage and Their The Basel Core Principles (BCPs)for Effective Banking Supervisio developed by the Basel Committee on Banking Supervision (BCBS),are the key global standard for prudential regulation and supervision of banks.The BCPs provide a benchmark against which the effectiveness of bank supervisory regimes can be assessed.The bCPs consist of a set of five preconditions for a robust financial system and 25 principles governing pects of sunervision (see box 5.1).The 25 core principles cover various aspects of c nd re iple 1);li ure ial re s and. ent Core Principles 6-15);metl ods of ong oing supervision (Core P 6-20):information requirements Principle 21);remedial measures and exit policie es(formal powers)(Core Principle 22); and cross-border banking (Core Principles 23-25). The purpose of the bCPs is to strengthen individual banks by ensuring a sound supervisory framework.Assessments of observance of the BCPs help identify areas that need strengthening and that contribute to stability of the financial system (a)directly b mproving good supervision and (b)indirectly by t romoting a robust financial infrastruc. ture.The BCPs se and that ban ein a safe nd sound manne The also c define the and resolution of problem banks;public safety nets;and sound macroeconomic frame works that should be in place for effective supervision.The BCP assessments provid useful qualitative information on the risk environment,on the responsiveness of the supervisor,and on the overall effectiveness of risk management. The BCPs highlight a set of prerequisites relating to regulatory governance and spell out principle and criteria to n sound remula a p ,and financial integrity in regulated fir x5.1)1 particular. :1 lays own a number of prerequisites to the effective exercise of supervisior such as clear and legally determined terms of reference,independence of supervisor,pow ers to address deficiencies,information sharing,and confidentiality and legal protection of the supervisor.What is needed to define the scope of banking supervision is a definition of banking and a licensing system to ensure that only the best-qualified institutions are 10
110 Financial Sector Assessment: A Handbook 1 I H G F E D C B A 12 11 10 9 8 7 6 5 4 3 2 the legal, institutional and regulatory framework to deal with insolvent banks. See also section 5.3.5 for a more detailed discussion of bank insolvency issues. 5.3 Assessment of Banking Supervision This section presents the core principles that form the basis for assessing the effectiveness of banking supervision, explains the assessment methodology, outlines the recent assessment experience, and discusses selected key issues in supervision: new capital adequacy standards (Basel II), bank insolvency procedures, supervision of large and complex financial institutions (LCFIs), consolidated supervision, and unique risks in Islamic banking. 5.3.1 Basel Core Principles—Their Scope and Coverage, and Their Relevance to Stability and Structural Development The Basel Core Principles (BCPs) for Effective Banking Supervision, developed by the Basel Committee on Banking Supervision (BCBS), are the key global standard for prudential regulation and supervision of banks. The BCPs provide a benchmark against which the effectiveness of bank supervisory regimes can be assessed. The BCPs consist of a set of five preconditions for a robust financial system and 25 principles governing aspects of supervision (see box 5.1). The 25 core principles cover various aspects of objectives, autonomy, powers, and resources (Core Principle 1); licensing and structure (Core Principles 2–5); prudential regulations and requirements (Core Principles 6–15); methods of ongoing supervision (Core Principles 16–20); information requirements (Core Principle 21); remedial measures and exit policies (formal powers) (Core Principle 22); and cross-border banking (Core Principles 23–25). The purpose of the BCPs is to strengthen individual banks by ensuring a sound supervisory framework. Assessments of observance of the BCPs help identify areas that need strengthening and that contribute to stability of the financial system (a) directly by improving good supervision and (b) indirectly by promoting a robust financial infrastructure. The BCPs seek to ensure that the supervisor can operate effectively and that banks operate in a safe and sound manner. The BCPs also define the necessary preconditions, including the legal, accounting, and auditing infrastructure; effective market discipline and resolution of problem banks; public safety nets; and sound macroeconomic frameworks that should be in place for effective supervision. The BCP assessments provide useful qualitative information on the risk environment, on the responsiveness of the supervisor, and on the overall effectiveness of risk management. The BCPs highlight a set of prerequisites relating to regulatory governance and spell out principles and criteria to govern sound regulatory practices, a prudent operational framework, and financial integrity in regulated firms (box 5.1). In particular, Core Principle 1 lays down a number of prerequisites to the effective exercise of supervision such as clear and legally determined terms of reference, independence of supervisor, powers to address deficiencies, information sharing, and confidentiality and legal protection of the supervisor. What is needed to define the scope of banking supervision is a definition of banking and a licensing system to ensure that only the best-qualified institutions are