Chapter 10 Assessing Information and Governance Infrastructure 10 sion.It refers(a)to the legal and institutional arrangements and structures that affect the quality,availability,and transparency of information on monetary and financial condi- tions and policies at various levels and (b)to the incentives and organizational structures to set and implement policies by regulators,the regulated institutions,and their coun- erparties.The info ormation inf cure includes (a)the framework for monetar nd financial policy transparency (discuss in section 10.1)(b)the ac contingandaud framework that helps to define and validate the information that is disclosed to the public and the regulatory authorities (discussed in section 10.2);and (c)the arrangements to compile,process,and share information on financial conditions and credit exposures of borrowers and other issuers of financial claims(credit-reporting and financial information services,discussed in section 10.3). The ents for financial and non-financial firms that are publicly listed and traded are of particular interest because they directly affect the functioningof the financial markets where their securities are traded.The corporate governance arrange- ments and the Organisation for Economic Co-operation and Development(OECD)prin- ciples of corporate governance are discussed in section 10.4.The governance of financial firms and of financial sector regulators is covered in different degrees of detail in the standards for financial sector supervision.Selected aspects of financial sector governance are also highlighted in that section. A key aspect of financial institutions'govemnance is the institution's disclosure prac- tices,which are determined in part by the supervisory framework,including the listing requirements by securities regulators,and by the company laws.The appropriate scope of
241 1 I H G F E D C B A 12 11 10 9 8 7 6 5 4 3 2 Information and governance infrastructure for finance provides the foundation for financial development and effective market discipline, and it helps to reinforce official supervision. It refers (a) to the legal and institutional arrangements and structures that affect the quality, availability, and transparency of information on monetary and financial conditions and policies at various levels and (b) to the incentives and organizational structures to set and implement policies by regulators, the regulated institutions, and their counterparties. The information infrastructure includes (a) the framework for monetary and financial policy transparency (discussed in section 10.1); (b) the accounting and auditing framework that helps to define and validate the information that is disclosed to the public and the regulatory authorities (discussed in section 10.2); and (c) the arrangements to compile, process, and share information on financial conditions and credit exposures of borrowers and other issuers of financial claims (credit-reporting and financial information services, discussed in section 10.3). The governance arrangements for financial and non-financial firms that are publicly listed and traded are of particular interest because they directly affect the functioning of the financial markets where their securities are traded. The corporate governance arrangements and the Organisation for Economic Co-operation and Development (OECD) principles of corporate governance are discussed in section 10.4. The governance of financial firms and of financial sector regulators is covered in different degrees of detail in the standards for financial sector supervision. Selected aspects of financial sector governance are also highlighted in that section. A key aspect of financial institutions’ governance is the institution’s disclosure practices, which are determined in part by the supervisory framework, including the listing requirements by securities regulators, and by the company laws. The appropriate scope of Chapter 10 Assessing Information and Governance Infrastructure
Financial Sector Assessment a Handbook financial institutions'disclosure,including the disclosure standards under the New Basel Capital Ac cord,isdi cussed in section 10.5. he disclosure and govemance arrangeme context,there are significant linkages among the governance arrangements for the regula- tory agencies (including the central bank),the regulated entities,and the non-financial sector.This governance nexus should be taken into account in assessing the overall infor- mation and governance infrastructure.I 10.1 Monetary and Financial Policy Transparency Good transpar ractices for central banks and financial agencies in their conduct of policies can contribute policy effectivene policy consistency and good governance.The scope of good transparency practices and the issues in assessing their adequacy and effectiveness are discussed in this section. 10.1.1 Code of Good Practices The concept of transparency of monetary and financial policies refers to an environ- 10 ment in which the objectives of the policy;the policy's legal,institutional,and economic framework;the policy decisions and their rationale;the data and information related to monetary and financial policies;and the terms of agencies'accountability are provided to the public on an understandable,accessible,and timely basis.The Code of Good Practice parency practices for centra and financial agenci es in th of monetary and financial policies.The MFP Code was developed by the IMF in 1999.This document is a distillation of concepts and practices that are already in use and for which there is a record of experience.Together with the Supporting Document to the Code of Good Practices on Transparency in Monetary and Financial Policies(Supporting Document;IMF 2000b) the various guidance notes,and the specific templates,the MFP Code serves as the refer- ence material for assessing transpare practices in monetary and financial policies. spare y of m nd f inancial policies con s to policy effective fciareehebe e swarene ment to meeting the goals,can contribute to good policy making and can improve the effective ness of policies.Transparency in the mandate,as well as the rules and procedures in the operations of monetary and financial agencies,helps to ensure consistency in cases where conflicts might arise between or within government units.Good governance calls for central banks and financial agencies to be accountable,particularly where the monetary and financial authorities are granted a high degree of auto omy.In the case of moneta ansparency eved by the secto with a clea scription of the consid tio that guide monetary polic ensure that market expectations can be formed more efficiently and,thereby,make the monetary policy transmission mechanism generally more effective.Through good 242
242 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 financial institutions’ disclosure, including the disclosure standards under the New Basel Capital Accord, is discussed in section 10.5. The disclosure and governance arrangements for financial and non-financial sectors should be seen in the broader context of public sector governance. Within this broader context, there are significant linkages among the governance arrangements for the regulatory agencies (including the central bank), the regulated entities, and the non-financial sector. This governance nexus should be taken into account in assessing the overall information and governance infrastructure.1 10.1 Monetary and Financial Policy Transparency Good transparency practices for central banks and financial agencies in their conduct of monetary and financial policies can contribute policy effectiveness, policy consistency and good governance. The scope of good transparency practices and the issues in assessing their adequacy and effectiveness are discussed in this section. 10.1.1 Code of Good Practices The concept of transparency of monetary and financial policies refers to an environment in which the objectives of the policy; the policy’s legal, institutional, and economic framework; the policy decisions and their rationale; the data and information related to monetary and financial policies; and the terms of agencies’ accountability are provided to the public on an understandable, accessible, and timely basis. The Code of Good Practices on Transparency in Monetary and Financial Policies (MFP Code) identifies desirable transparency practices for central banks and financial agencies in their conduct of monetary and financial policies. The MFP Code was developed by the IMF in 1999.2 This document is a distillation of concepts and practices that are already in use and for which there is a record of experience. Together with the Supporting Document to the Code of Good Practices on Transparency in Monetary and Financial Policies (Supporting Document; IMF 2000b), the various guidance notes, and the specific templates, the MFP Code serves as the reference material for assessing transparency practices in monetary and financial policies. The transparency of monetary and financial policies contributes to policy effectiveness, facilitates policy consistency, and strengthens governance. The public’s awareness of the goals and instruments of policy, as well as the authorities’ credible commitment to meeting the goals, can contribute to good policy making and can improve the effectiveness of policies. Transparency in the mandate, as well as the rules and procedures in the operations of monetary and financial agencies, helps to ensure consistency in cases where conflicts might arise between or within government units. Good governance calls for central banks and financial agencies to be accountable, particularly where the monetary and financial authorities are granted a high degree of autonomy. In the case of monetary policy, transparency about policy process—achieved by providing the private sector with a clear description of the considerations that guide monetary policy decisions—helps ensure that market expectations can be formed more efficiently and, thereby, makes the monetary policy transmission mechanism generally more effective. Through good
Chapter 10:Assessing Information and Govemance transparency practices,the central bank can establish a mechanism for strengthening its credibility by matching its actions to its public statements.Similarly,transparency of a regulatory agency's mandate,operations,and regulatory processes is essential in establish. ing the credibility and effectiveness of financial sector oversight.Although credibility is achieved by meeting the stated objectives and responsibilities,transparency may also limit self-interest on the part of the regulators and may foster increased commitment of regulated firms to regulatory compliance,prudent behavior,proper risk management,and The MFP Code lists 17 good practices on transparency of monetary policies by the central bank and 20 good practices on transparency of financial practices.The four groups of transparency practices and a summary description of each practice are presented in Annex 10.A.The four groups are(1)clarity of roles,responsi. bilities,and objectives of central banks and financial agencies;(2)the processes for the formulating and reporting of monetary policy decisions by the central bank and of finan. cial policies by fin ial policie and (4) and financial I agencies 10.1.2 Assessment Methodology and Assessment Experience 10 The objectives of MFP transparency assessments are to review the effectiveness of current practices and to recommend desirable transparency practices.I he assessments,therefore, are designed to Allow the authorities to evaluate the transparency of their monetary policy and their financial supervisory and regulatory frameworks. .Identify and,where appropriate,recommend desirable transparency practices for central banks and financial agencies. .Provide input into the overall asse ssment of the vulnerabilities of a country's mon ntify the evelopmental needs c a country pert ining spe cifically to trans parency issues and to assist in making informed policy decisions about the reforms needed .Provide input on the extent to which transparency practices contribute to policy effectiveness and to monetary and financial stability. The mep code is broad and takes into account the varied institutional and legal frameworks that are found in many countries across various stages of financial develop ment Conse of hich ently,the w of ti re as well as is apb oplied and achieved-in ming andn differ. ing different institutional arrangements and legal litions. ssessments should not be conducted ina mechanistic way because practical policy considerations may require that some disclosures not be made in certain contexts. In particular,benefits of transparency practices have to be weighed against the poten- tial costs,and it may be appropriate to limit the extent of transparency.For example 243
243 Chapter 10: Assessing Information and Governance Infrastructure 1 I H G F E D C B A 12 11 10 9 8 7 6 5 4 3 2 transparency practices, the central bank can establish a mechanism for strengthening its credibility by matching its actions to its public statements. Similarly, transparency of a regulatory agency’s mandate, operations, and regulatory processes is essential in establishing the credibility and effectiveness of financial sector oversight. Although credibility is achieved by meeting the stated objectives and responsibilities, transparency may also limit self-interest on the part of the regulators and may foster increased commitment of regulated firms to regulatory compliance, prudent behavior, proper risk management, and internal control. The MFP Code lists 17 good practices on transparency of monetary policies by the central bank and 20 good practices on transparency of financial policies, all grouped into four categories. Many of the good practices are further divided into more detailed practices. The four groups of transparency practices and a summary description of each practice are presented in Annex 10.A. The four groups are (1) clarity of roles, responsibilities, and objectives of central banks and financial agencies; (2) the processes for the formulating and reporting of monetary policy decisions by the central bank and of financial policies by financial agencies; (3) public availability of information on monetary and financial policies; and (4) accountability and assurances of integrity by the central bank and financial agencies. 10.1.2 Assessment Methodology and Assessment Experience The objectives of MFP transparency assessments are to review the effectiveness of current practices and to recommend desirable transparency practices. The assessments, therefore, are designed to • Allow the authorities to evaluate the transparency of their monetary policy and their financial supervisory and regulatory frameworks. • Identify and, where appropriate, recommend desirable transparency practices for central banks and financial agencies. • Provide input into the overall assessment of the vulnerabilities of a country’s monetary and financial system. • Help identify the developmental needs of a country pertaining specifically to transparency issues and to assist in making informed policy decisions about the reforms needed. • Provide input on the extent to which transparency practices contribute to policy effectiveness and to monetary and financial stability. The MFP Code is broad and takes into account the varied institutional and legal frameworks that are found in many countries across various stages of financial development. Consequently, the ways in which transparency is applied and achieved—in terms of timing and manner of disclosure as well as the content of reports—may differ, reflecting different institutional arrangements and legal traditions. Assessments should not be conducted in a mechanistic way because practical policy considerations may require that some disclosures not be made in certain contexts. In particular, benefits of transparency practices have to be weighed against the potential costs, and it may be appropriate to limit the extent of transparency. For example
Financial Sector Assessment a Handbook extensive disclosure mentsabou intemal and exchange market operations might disrupt markets,constrain the free flow of discussion by policy makers,or prevent the adoption of contingency plans.Thus,there are circumstances in which it would not be appropriate for central banks to disclose their near-term monetary and exchange rate policy implementation tactics or to provide detailed information on foreign exchange operations.Similarly,there may be good reasons for the central bank (and financiala es)not to nake public speci emergency lending.Ho wever,th broa principles and procedures gov sions on emergency lending could be established and made transparent while maintaining "constructive ambiguity"about their applicability in specific situations (see chapter 5. section 5.2.1).However,limiting transparency in selected areas needs to be seen in the offer judgment on the e appropriatenes desirability of specific monetary and financial policies or frameworks that countries should adopt. The assessment of observance of the MFP Code should draw on a wide range of infor mation and should focus on the degree and means of disclosure to the public,as well as on the effect of disclosure practices on a policy's effectiveness.The sources of information needed for the as typically include relevant laws regulations,and instruction well as other documentation (reports,studies,public statements, unpublis 10 guidelines,directives,and assessments);counterparty agencies and officials with whom assessment-related discussions are held:meetings with other domestic authorities:any relevant government or industry associations(such as bankers'associations,auditors,and accountants):and key market participants and analysts who draw on the information disclosed.The r the me nt con of exami for each practice in the MFP co e,the various content of disclosure,and modes of disclosure.In addition,a fifth dimension-clarity and comprehensibility of transparency-is also examined.The content,clarity,and accessi. bility of the information that is disclosed are what transforms"disclosure"into"transpar. cy."An assessment of those five dim ensions is based on a broad qualitative judgm drawing on counry practices and is no tbased on any specified list essment cr Illustrative country practices are summarized in the Supporting Document,which also provides two-or three-part explanations of each transparency practice: ."Explanation and rationale"elaborates on what is meant and why it is desirable. ."Application"indicates where and how the practices are implemented,with some ntifcationandwhereaplicablewihe ation con derations"deals with practical cons and costs,intended audience,domestic versus international dimensions-where relevant.The supporting document also provides a list of references- -academic studies as well as official documents-on transparency and accountability issues. The qualitative judgment of various dimensions of transparency can be informed by the supporting document,and this judgmer classify the de ervance of each practice into five categories:observed,broadly observed,partly observed,non-observed,and not applicable.Detailed guidance on the procedures 244
244 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 extensive disclosure requirements about internal policy discussion on money and exchange market operations might disrupt markets, constrain the free flow of discussion by policy makers, or prevent the adoption of contingency plans. Thus, there are circumstances in which it would not be appropriate for central banks to disclose their near-term monetary and exchange rate policy implementation tactics or to provide detailed information on foreign exchange operations. Similarly, there may be good reasons for the central bank (and financial agencies) not to make public specific contingency plans, including possible emergency lending. However, the broad principles and procedures governing the decisions on emergency lending could be established and made transparent while maintaining “constructive ambiguity” about their applicability in specific situations (see chapter 5, section 5.2.1). However, limiting transparency in selected areas needs to be seen in the context of a generally transparent environment. Also, the MFP Code is not designed to offer judgment on the appropriateness or desirability of specific monetary and financial policies or frameworks that countries should adopt. The assessment of observance of the MFP Code should draw on a wide range of information and should focus on the degree and means of disclosure to the public, as well as on the effect of disclosure practices on a policy’s effectiveness. The sources of information needed for the assessment typically include relevant laws, regulations, and instructions, as well as other documentation (reports, studies, public statements, Web sites, unpublished guidelines, directives, and assessments); counterparty agencies and officials with whom assessment-related discussions are held; meetings with other domestic authorities; any relevant government or industry associations (such as bankers’ associations, auditors, and accountants); and key market participants and analysts who draw on the information disclosed. The methodology for the assessment consists of examining, for each practice in the MFP code, the various forms of disclosure used, frequency of disclosures, quality or content of disclosure, and modes of disclosure. In addition, a fifth dimension—clarity and comprehensibility of transparency—is also examined. The content, clarity, and accessibility of the information that is disclosed are what transforms “disclosure” into “transparency.” An assessment of those five dimensions is based on a broad qualitative judgment drawing on country practices and is not based on any specified list of assessment criteria. Illustrative country practices are summarized in the Supporting Document,3 which also provides two- or three-part explanations of each transparency practice: • “Explanation and rationale” elaborates on what is meant and why it is desirable. • “Application” indicates where and how the practices are implemented, with some quantification and, where applicable, with some country examples. • “Implementation considerations” deals with practical considerations—benefits and costs, intended audience, domestic versus international dimensions—where relevant. The supporting document also provides a list of references—academic studies as well as official documents—on transparency and accountability issues. The qualitative judgment of various dimensions of transparency can be informed by the supporting document, and this judgment is used to classify the degree of observance of each practice into five categories: observed, broadly observed, partly observed, non-observed, and not applicable. Detailed guidance on the procedures
Chapter 10:Assessing Information and Govemance tions in conducting the assesments are available in the .A supplementary document providing case studies for 15 countries is under prepa- ration. So far,the IMF Executive Board has conducted two reviews of experiences with assess ments of the MFP Code,drawing on MFP Code assessments for 57 countries.In general the two reviews indicated a high level of observance of transparency practices among the countries reviewed.Observance was strongest with respect to the public availability of information on monetary and financial policies.Many central banks and financial ncies are making of va ous channels of the public's acce In bar nking su rvision ar d pa yment syste in practices relating to clarity of the roles,responsibilities,an ransparency practic es with respect to the accountability an assurance of integrity of the central banks and financial agencies continue to be a challenge for many of the countries (see boxes 10.1 and 10.2).This finding also has been borne out in other Fund initiatives such as the Safeguards Assessments (IMF 2002)and in the assessments of Special Data Dissemination Standards(SDDS)(IMF 2003).Among all financial sectors banking supervisory agencies had the most-developed transparency practices whereas insurance regulatory ag gencies had the least-developed transparency practices. Standard-setting bodies have increasingly includedt y-related criteria in 10 their individual st ndards and codes.The lAIS standards emphasize the need for trans supr AIS C The Cr of the MFP Payment Systems (see Chapter 11 for ref ces and discussion) or en cave oversigh of such payment systems by the central bank and,consistent with the MFP code,calls for the central bank to define clearly its payment system objectives and to disclose publicly its role and major policies with respect to systemically important payment systems.The cov erage of transparency issues in regulatory standards is,however,rather uneven,and there have been recent efforts to specify transparency practices of regulatory agencies in greater detail as a component of good regulatory governance of those agencies(components of good regulatory governance consist of independence,accountability,transparency,and integrity). 10.2 Accounting and Auditing Assessments of accounting and auditing standards isa key t of the evaluation of ntry's fi market infr cture(th pillar of the Fin cia vernance core component of go corporate governance is an accurate disclosure that is based on high-quality acc ounting an auditing standards.A comprehensive assessment of those standards presents the strengths and weaknesses of accounting and auditing frameworks.The assessment also analyzes the framework's quality and enforcement,as well as its potential success in changing the effectiveness of supervision and the soundness of the financial system.A sound account- 245
245 Chapter 10: Assessing Information and Governance Infrastructure 1 I H G F E D C B A 12 11 10 9 8 7 6 5 4 3 2 and practical considerations in conducting the assessments are available in the guidance note (IMF 2000) for assessing the code. • A supplementary document providing case studies for 15 countries is under preparation. So far, the IMF Executive Board has conducted two reviews of experiences with assessments of the MFP Code, drawing on MFP Code assessments for 57 countries.4 In general, the two reviews indicated a high level of observance of transparency practices among the countries reviewed. Observance was strongest with respect to the public availability of information on monetary and financial policies. Many central banks and financial agencies are making more effective use of various channels of communication to increase the public’s access to information. In banking supervision and payment system oversight, transparency was weak in practices relating to clarity of the roles, responsibilities, and objectives of the institutions. Transparency practices with respect to the accountability and assurance of integrity of the central banks and financial agencies continue to be a challenge for many of the countries (see boxes 10.1 and 10.2). This finding also has been borne out in other Fund initiatives such as the Safeguards Assessments (IMF 2002) and in the assessments of Special Data Dissemination Standards (SDDS) (IMF 2003). Among all financial sectors, banking supervisory agencies had the most-developed transparency practices whereas insurance regulatory agencies had the least-developed transparency practices. Standard-setting bodies have increasingly included transparency-related criteria in their individual standards and codes. The IAIS standards emphasize the need for transparency by the supervisory agency, and various transparency practices of the MFP Code are embedded in the IAIS Core Principles. The Core Principles for Systemically Important Payment Systems (see Chapter 11 for references and discussion) calls for effective oversight of such payment systems by the central bank and, consistent with the MFP code, calls for the central bank to define clearly its payment system objectives and to disclose publicly its role and major policies with respect to systemically important payment systems. The coverage of transparency issues in regulatory standards is, however, rather uneven, and there have been recent efforts to specify transparency practices of regulatory agencies in greater detail as a component of good regulatory governance of those agencies (components of good regulatory governance consist of independence, accountability, transparency, and integrity). 10.2 Accounting and Auditing Assessments An assessment of accounting and auditing standards is a key part of the evaluation of robustness of a country’s financial market infrastructure (the third pillar of the Financial Sector Assessment) and includes financial sector governance. A core component of good corporate governance is an accurate disclosure that is based on high-quality accounting and auditing standards. A comprehensive assessment of those standards presents the strengths and weaknesses of accounting and auditing frameworks. The assessment also analyzes the framework’s quality and enforcement, as well as its potential success in changing the effectiveness of supervision and the soundness of the financial system. A sound account-
Financial Sector Assessment:A Handbook L.clargyctRoefesnataiesand lear in that e tives and Potential conflicts in the policy objectives,as 3.Public Availability of Information on Monetary Policy 。R even through man another authority(the nelin 10 albanks weakened by the a the their official duties.or both. ing framework is a precondition for effective supervision:thus,an examination of the accounting and auditing framework-not necessarily a comprehensive assessment-is an nce of supervisory standards This cha requisite for undertaking assessments of obser plains the rds Financial Rep ing Standards (IFRSs)andn Auditing (ISA)assessmen components of of the sta ls tha cularly relevant for financial sectora Bank's Report on Observan ce of Standards and Codes(ROSC)program on accounting and auditing standards,highlighting the key lessons of experience. 246
246 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 ing framework is a precondition for effective supervision; thus, an examination of the accounting and auditing framework—not necessarily a comprehensive assessment—is an essential prerequisite for undertaking assessments of observance of supervisory standards. This chapter explains the rationale of accounting and auditing standards and provides an overview of International Financial Reporting Standards (IFRSs) and International Standards for Auditing (ISA), highlighting the components of the standards that are particularly relevant for financial sector assessments. The chapter then outlines the World Bank’s Report on Observance of Standards and Codes (ROSC) program on accounting and auditing standards, highlighting the key lessons of experience. Box 10.1 Main Weaknesses in the Transparency Practices of Central Banks and Monetary Policy 1. Clarity of Roles, Responsibilities, and Objectives of Central Banks • A general lack of clarity about the hierarchy among a multiplicity of monetary policy objectives and about how potential conflicts among them would be resolved • Potential conflicts in the policy objectives, as provided for in different statutes • Lack of clarity in the responsibility over foreign exchange policy • Absence of specifics and conditions under which governments may override central bank policy decisions • Existence of legal provisions to use various instruments often encumbered by the need to seek approval from another authority (e.g., the Ministry of Finance) • Disclosure of certain information that is often limited by strict interpretations of secrecy rules governing operations of some central banks • Accountability of some central banks weakened by the absence of an explicit legal requirement to report to a legislative body or designated public authority to inform on the conduct of monetary policy and the fulfillment of policy objectives • Unclear institutional relationships between central banks and governments, as well as associated agency roles and financial transactions 2. Open Process for Formulating and Reporting Monetary Policy Decisions • Poor or nonexistent explanations for the rationale and functioning of its policy instruments • Insufficient frequency of disclosures (with some authorities arguing that the guidelines are not clear in that regard) • Reservations about announcing meeting schedules for policy-making bodies 3. Public Availability of Information on Monetary Policy • Remaining weaknesses in the availability of specific data templates even through many countries subscribe or plan to subscribe to the International Monetary Fund’s data dissemination standard (Special Data Dissemination Standard, or SDDS, and the General Data Dissemination System, or GDDS) • Timeliness and frequency of publications a common problem • Concerns about the quality of some of the information that is disclosed 4. Accountability and Assurances of Integrity by the Central Bank • Deficiencies in some of the procedures in the areas of auditing and accounting • Many cases of nondisclosure of internal governance procedures, including the standards for the personal conduct of staff members • Nondisclosure, lack of explicit legal protection for officials and staff members in the conduct of their official duties, or both
Chapter 10:Assessing Information and Govemance 10.2.1 Role of the Accou nting and Auditing Framework:Relevance to Development and Stability Accounting and auditing standards of high quality provide the basis for reliable and transparent disclosure of information to relevant stakeholders.Disclosure is crucial for informed financial decisions,efficient resource allocation,and effective functioning of markets.Chapter 4 discusses the fact that they form the core of the information infra. structure needed for financial development.Accounting,auditing,and disclosure require- ments of high quality for financial institutions are regarded as one of the key basic areas of financial reform necessary to prevent a financial crisis.By contributing to good corporate governance,high-quality accounting and auditing influence perceptions of risk,cost,and Box 10.2 Main Weaknesses in the Transparency Practices in Financial Policies Ob1.Clantyof Financial Agencies Responsible onsibilities 。ack of disclosu information sharing for Financial .Aemaggc of publ pay Lack of legal basis for the bjectives and respon. 3.Public Availabil 10 ment sytem and its relations with banking n of progres powers to isue and visory age ector to be m more user friendly (especially 。Sparse informat ncapital market develop .Pnt and proce r market s Lack of clarity with respect to terms of appoint in sal of k co vestor protection AC ntability of financial agencies not clearly 2.oegrapognd Absence of public disclosure of the relationships .hertcenfnancilenci ntemal a ing on financial agencies for periodic repor 247
247 Chapter 10: Assessing Information and Governance Infrastructure 1 I H G F E D C B A 12 11 10 9 8 7 6 5 4 3 2 10.2.1 Role of the Accounting and Auditing Framework: Relevance to Development and Stability Accounting and auditing standards of high quality provide the basis for reliable and transparent disclosure of information to relevant stakeholders. Disclosure is crucial for informed financial decisions, efficient resource allocation, and effective functioning of markets. Chapter 4 discusses the fact that they form the core of the information infrastructure needed for financial development. Accounting, auditing, and disclosure requirements of high quality for financial institutions are regarded as one of the key basic areas of financial reform necessary to prevent a financial crisis.5 By contributing to good corporate governance, high-quality accounting and auditing influence perceptions of risk, cost, and Box 10.2 Main Weaknesses in the Transparency Practices in Financial Policies 1. Clarity of Roles, Responsibilities, and Objectives of Financial Agencies Responsible for Financial Policies • Lack of legal basis for the objectives and responsibilities for some financial agencies • Lack of documentation spelling out explicit and detailed definition of the institutional oversight role of some central banks with respect to payment systems and its relations with banking activities • Lack of explicit and clearly defined authority along with the necessary powers to issue and enforce accompanying regulations; little specific focus on the implicit risks of participation in payment systems • Insufficient published information on objectives, operations, and outcomes of financial agencies • Legal requirements for submission of reports on developments not sufficiently comprehensive • Lack of clarity with respect to terms of appointment and dismissal of key officers • Little information on formal arrangements for cooperation and exchange of information among various supervisory agencies • Absence of information on investor protection schemes in securities regulations • Lack of legal underpinning of the regulations and procedures for securities 2. Open Process for Formulating and Reporting Financial Policies • Absence of public disclosure of the relationships between financial agencies • Lack of specific requirements for periodic reporting on financial agencies • Lack of disclosure of information-sharing arrangements among agencies • Absence of public announcement of changes in payment systems policies 3. Public Availability of Information on Financial Policies • Inadequate coverage of payment system operations and banking supervision in many annual reports; insufficient discussion of progress on achieving policy objectives in insurance supervisory agencies periodic reports • Need for the body of applicable laws, regulations, and other guidelines for the insurance sector to be made more user friendly (especially for non-specialists) • Sparse information on capital market development and processes for market supervision • Poor disclosure of information on emergency financial support to institutions 4. Accountability and Assurances of Integrity by Financial Agencies • Accountability of financial agencies not clearly defined in legislation • Lack of a code of conduct for the staff members performing supervisory functions • Information on internal control and audit, internal governance procedures, accounting policies, and so forth, not consistently disclosed • Insurance sector frequently suffers from weak internal arrangements for the resolution of conflicts and disputes settlement processes
Financial Sector Assessment a Handbook availability of capital,as well as foster financial stability through strengthened marke disciplin Standards such as these are not well implemented in many emerging market and ran sition economies,and many countries do not require the reporting of key financial data by individual institutions,including their consolidated financial exposure.This gap can hamper the ability to filter out healthy from unhealthy institutions.Moreover,the lack of appropriate information can prevent the effective monitoring of financial institutions and their risk taking.For example,insufficient or incorrect disclosures of credit risks may con- strain the ability of investors to assess risks and the ability of supervisors to act in a timely manner (Mishkin 2001).Sound accounting and auditing standards and practices are also important prerequisit es for financial liberalization be e they for rm pa of the proper andadingae2 ha king.Ac ountin f the to effective operation of domestic and international financial systems,as already outlined in chapter 1. 10.2.2 Scope and Content of International Accounting and Auditing Standards International accounting and auditing standards have been developed respectively by the 10 International Accounting Standards Board(IASB)and its predecessor the International Accounting Standards Committee (IASC),and by the International Federation of tants (IFAC).IFRSs ss hoth the iously ador nd i nded oped,IA ational -issued IFRSs The original IASs were issued from 1973 to 2000 by the IASC,which was replaced by the IASB in 2001.The IASB has since amended or eliminated some IASs,has proposed to amend others,has proposed to replace some IASs with new IFRSs,and has adopted or proposed new IFRSs on topics for which there were no previous standards.Thus,stan dards are continuously changing and being upgraded to reflect the current conditions and needs of financial markets.Nar owlu int ed,IFRSs refer to the of pr stinct fr it pred adly,IFRSsr ody of IASB pr uncements as to the eir interpre tation approved by the predec cessor IASC. The standards issued by the IAS many of which were revised by the IASB in 2004,will continue to be designated as IASs Currently,36 effective IAS-IFRS standards,with 11 interpretations,are accompanied by documents providing the framework for the preparation and presentation of financial statements,as well as guidance on interpretation of standards.The framework defines the obiectives of financial stateme nts ide ntifies the qualitative characteristics that make information in the stater s useful,and defines the basic elen ents of financial state and the co epts in ned ors,employees,govemment agencies,and the publi meet the at larg for information about a public entity's financial position,performance,and cash flows. 248
248 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 availability of capital, as well as foster financial stability through strengthened market discipline. Standards such as these are not well implemented in many emerging market and transition economies, and many countries do not require the reporting of key financial data by individual institutions, including their consolidated financial exposure. This gap can hamper the ability to filter out healthy from unhealthy institutions. Moreover, the lack of appropriate information can prevent the effective monitoring of financial institutions and their risk taking.6 For example, insufficient or incorrect disclosures of credit risks may constrain the ability of investors to assess risks and the ability of supervisors to act in a timely manner (Mishkin 2001). Sound accounting and auditing standards and practices are also important prerequisites for financial liberalization because they form part of the proper institutional framework that places appropriate constraints on risk taking. Accounting and auditing are 2 of the 12 areas of standards that are recognized internationally as key to effective operation of domestic and international financial systems, as already outlined in chapter 1. 10.2.2 Scope and Content of International Accounting and Auditing Standards International accounting and auditing standards have been developed respectively by the International Accounting Standards Board (IASB) and its predecessor the International Accounting Standards Committee (IASC),7 and by the International Federation of Accountants (IFAC).8 IFRSs encompass both the previously adopted—and, in some cases, amended—International Accounting Standards (IASs), as well as newly developed, IASB-issued IFRSs. The original IASs were issued from 1973 to 2000 by the IASC, which was replaced by the IASB in 2001. The IASB has since amended or eliminated some IASs, has proposed to amend others, has proposed to replace some IASs with new IFRSs, and has adopted or proposed new IFRSs on topics for which there were no previous standards. Thus, standards are continuously changing and being upgraded to reflect the current conditions and needs of financial markets. Narrowly interpreted, IFRSs refer to the new numbered series of pronouncements that the IASB has issued, distinct from the IAS series issued by its predecessor IASC. More broadly, IFRSs refer to the entire body of IASB pronouncements, including standards and their interpretations, as well as to the IASs and their interpretation approved by the predecessor IASC. The standards issued by the IASC, many of which were revised by the IASB in 2004, will continue to be designated as IASs. Currently, 36 effective IAS–IFRS standards, with 11 interpretations, are accompanied by documents providing the framework for the preparation and presentation of financial statements, as well as guidance on interpretation of standards. The framework defines the objectives of financial statements, identifies the qualitative characteristics that make information in the statements useful, and defines the basic elements of financial statements and the concepts in recognizing and measuring them (e.g., asset, liability, income). The framework addresses the general-purpose financial statements designed to meet the needs of shareholders, creditors, employees, government agencies, and the public at large for information about a public entity’s financial position, performance, and cash flows
Chapter 10:Assessing Information and Govemance Hence,it does not cover special-purpose reporting to tax and regulatory authorities.A complete set of financial statements includes a balance sheet,income statement,cash flow statement,statement of changes in equity,and notes composing the summary of accounting policies and other explanatory notes. Some of the IASs and IFRSs are particularly important in financial sector assess- ments.A number of the standards are more relevant for the financial institutions.For instance,IAS 32 and IAS 39 provide requirements on the recognition,measurement, nents,and IAS 30 applies to the disclost res hy banks nd other similar cies and mmi ment other off-balar nce sheet items IAS L is als parti pertinent becaus e it deals with th content of fi ancial statem s gen ally.Boxe 10.4,10.5,and 10.6,provide further details of the scope of IAS 39,IAS 32,IAS 30 and IAS 1,respectively.IAS 39,which seeks the measurement of specified assets at fair value,may have significant effect on the volatility of earnings,levels of provisioning and various observed prudential ratios.and it has raised concerns among regulators.las 32 on financial instruments calls for a range of financial risk disclosures,thus seeking to improve transparency of financial risks,which may pose a challenge for some classes of ocial institutions (particularly insurance comp es)with traditionally weak risk dis clost es Thos ons highlight the ng standard s and the enges in ali ing convergence of nationa and intern Evolving issues in interationa 10 convergence in major markets are summarized in box 10. There are 33 ISAs,accompanied by a"Code of Ethics for Professional Accountants" and other related engagement standards.The auditing standards provide requirements on a range of issues,including quality control (ISA 220),documentation (ISA 230) responsibility to consider fraud and error (ISA 240),risk assessments of internal control (ISA 400),analytical procedures(ISA 520),and the auditor's report on financial state ments (ISA 700) reflect currer trends and issues in finan I reporting and au hich reflect global- zation,capital flows,regionalization,technology changes,and so industrialized countries relating to corporate business failures and misstatements of finan cial information have also raised the attention to the role and oversight of the auditing profession,the governance of standard-setting bodies,and the scope of corporate gover nance as it relates to reporting and disclosure.the lasb has been issuing new standards (IFRSs),and revising current IASs,while IFAC and its numerous committees and have been actively revising ISAs.For example,it recently released proposed revisions to ISA 230 on audit docu ntation.The IFAC's Public Secto tee (PSC)focuses or ncial report ade of ng,a onal,regional,and local governmen as well nchmark guideline also undertaken a multiye ctor Accounting Standards(ISAS)for goverment budget reporting that is IASs.It has also published a guidance paper on anti-money-laundering. One issue of particular relevance,especially to developing and emerging market economies,is the role of small and medium enterprises (SMEs)and the need to have 249
249 Chapter 10: Assessing Information and Governance Infrastructure 1 I H G F E D C B A 12 11 10 9 8 7 6 5 4 3 2 Hence, it does not cover special-purpose reporting to tax and regulatory authorities. A complete set of financial statements includes a balance sheet, income statement, cash flow statement, statement of changes in equity, and notes composing the summary of accounting policies and other explanatory notes.9 Some of the IASs and IFRSs are particularly important in financial sector assessments. A number of the standards are more relevant for the financial institutions. For instance, IAS 32 and IAS 39 provide requirements on the recognition, measurement, and disclosure of financial instruments, and IAS 30 applies to the disclosures by banks and other similar institutions of their income statement, balance sheet, and contingencies and commitments, including other off-balance sheet items. IAS 1 is also particularly pertinent because it deals with the content of financial statements generally. Boxes 10.3, 10.4, 10.5, and 10.6, provide further details of the scope of IAS 39, IAS 32, IAS 30, and IAS 1, respectively. IAS 39, which seeks the measurement of specified assets at fair value, may have significant effect on the volatility of earnings, levels of provisioning, and various observed prudential ratios, and it has raised concerns among regulators. IAS 32 on financial instruments calls for a range of financial risk disclosures, thus seeking to improve transparency of financial risks, which may pose a challenge for some classes of financial institutions (particularly insurance companies) with traditionally weak risk disclosures. Those considerations highlight the significant challenges in aligning prudential standards with evolving accounting standards and the complexities involved in achieving convergence of national and international standards. Evolving issues in international convergence in major markets are summarized in box 10.7. There are 33 ISAs, accompanied by a “Code of Ethics for Professional Accountants” and other related engagement standards.10 The auditing standards provide requirements on a range of issues, including quality control (ISA 220), documentation (ISA 230), responsibility to consider fraud and error (ISA 240), risk assessments of internal control (ISA 400), analytical procedures (ISA 520), and the auditor’s report on financial statements (ISA 700). The IASB and the IFAC’s IAASB constantly revise and update the standards to reflect current trends and issues in financial reporting and auditing, which reflect globalization, capital flows, regionalization, technology changes, and so forth. Recent events in industrialized countries relating to corporate business failures and misstatements of financial information have also raised the attention to the role and oversight of the auditing profession, the governance of standard-setting bodies, and the scope of corporate governance as it relates to reporting and disclosure. The IASB has been issuing new standards (IFRSs), and revising current IASs, while IFAC and its numerous committees and have been actively revising ISAs. For example, it recently released proposed revisions to ISA 230 on audit documentation. The IFAC’s Public Sector Committee (PSC) focuses on the accounting, auditing, and financial reporting needs of national, regional, and local governments, as well as on related agencies, and it proposes benchmark guidelines. It has also undertaken a multiyear initiative that is focusing on developing International Public Sector Accounting Standards (IPSAS) for government budget reporting that is based on IASs. It has also published a guidance paper on anti-money-laundering. One issue of particular relevance, especially to developing and emerging market economies, is the role of small and medium enterprises (SMEs) and the need to have
Financial Sector Assesment:A Handbook Box 10.3 IAS 39:Financial Instruments,Recognition,and Measurement ,banks are heavy of macro owing: ging and ine ges in the Ac and loan revable and equently. w : Employers rihts and obligations under pension contracts 10 .Financial assets at fair value through profit o naseentobiectireandtategyfornde loss ing instrument,the hedged item,the nature of Avabie-for-enc Held-to-maturity investments he itnotiedcos cial liabilities d Financial liabilities at fair ,the European Unions on of mortized cost using s it AS 39 has be ()allowed the of fair value derivatives,shares,an ging an simplified financial nd indus hat the sp themselves to identifying and addressing the needs of SMEs The IASB undertook a research project in 2001 in response to the growing call in the field to support a separate set of accounting 250
250 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 simplified financial reporting requirements for those enterprises. The financial reporting needs of SMEs in both developing and industrial countries are gaining greater attention by regulators. In that regard, the IASB and the IFAC have committed themselves to identifying and addressing the needs of SMEs. The IASB undertook a research project in 2001 in response to the growing call in the field to support a separate set of accounting Box 10.3 IAS 39: Financial Instruments, Recognition, and Measurement IAS 39 (revised March 2004) covers a broad range of financial instruments, including the following: • Cash • Demand and time deposits • Commercial paper • Accounts, notes, and loans receivable and payable • Debt and equity securities • Asset-backed securities (collateralized mortgages, repurchase agreements, and securitized receivables) • Derivatives (swaps, forwards, futures, options, rights, and warrants) and embedded derivatives • Leases • Rights and obligations with insurance risk under insurance contracts • Employers rights and obligations under pension contracts IAS 39 requires that financial assets be classified in one of the following categories to determine how a particular asset is recognized and measured in financial statements: • Financial assets at fair value through profit or loss • Available-for-sale financial assets • Loan and receivables • Held-to-maturity investments The general principle is that available-for-sale financial assets are to be valued at fair value, whereas held-to-maturity may be valued at amortized cost. IAS 39 recognizes two classes of financial liabilities: • Financial liabilities at fair value through profit and loss • Other liabilities measured at amortized cost using the effective interest method IAS 39 has been a source of debate within financial markets, especially among commercial banks. IAS 39 requires entities to value derivatives, shares, and bonds at fair market value, not at historical costs, but does not recognize macro-hedging and internal-risk transfers. However, banks are heavy users of macrohedging and inter-group transfers of risks. Not recognizing macro-hedging (see below) would mean that marked-to-market changes in the value of derivative position would be booked to earnings and would raise volatility. If recognized, derivative position would be booked to equity and not earnings. Consequently, a number of European banks, especially in France, have opposed IAS 39 because they believe that it could damage their risk management practice (especially in a fixed interest rate environment) and could lead to earnings fluctuations and, thus, lower share prices. The European Central Bank, prudential supervisors, and securities regulators are also opposed to the fair value option on the grounds that it may, in their view, be used inappropriately (see Europe case below). IAS 39 permits hedge accounting only under certain circumstances, provided that the hedge accounting meets the following criteria (see IAS 39.88): • The hedge accounting is formally designated and documented, including the entity’s risk management objective and strategy for undertaking the hedge, the identification of the hedging instrument, the hedged item, the nature of the risk being hedged, and the process of how the entity will assess the hedging instrument’s effectiveness. • The hedge accounting is expected to be highly effective in achieving offsetting changes in fair value or cash flows that are attributed to the hedged risk as designated and documented, and this effectiveness can be reliably measured. In October 2004, the European Union’s Accounting Regulatory Committee opposed the adoption of the extant IAS 39 as issued by the IASB. Instead, it adopted a “carved out” version of IAS 39, which (a) removed the fair value option as it applies to liabilities and (b) allowed the use of fair value hedge accounting for the interest rate hedges for core deposits on a portfolio basis. European banks will be able to choose between the original or altered set of rules for hedge accounting
