Evaluating the Effectiveness of Financial Supervision

Paul J.van Sluijs

World Bank

Nairobi, 15-17 May 2006

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Contents

1.1. Some observationsSome observations2.2. FSAP backgroundFSAP background3.3. Main components of regulatory Main components of regulatory

standardsstandards4.4. Reviews 2003 and 2006Reviews 2003 and 20065.5. Gaps in financial sector Gaps in financial sector

regulationregulation6.6. Strengthening standardsStrengthening standards

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1 Some observations FSAP: interesting experience for the country to be FSAP: interesting experience for the country to be

assessed as well as for the assessing expertsassessed as well as for the assessing experts Self assessments should be critically reviewedSelf assessments should be critically reviewed Assessment includes practical application of supervisory Assessment includes practical application of supervisory

standards: rule- or principle basedstandards: rule- or principle based Application in practice of supervisory rules and Application in practice of supervisory rules and

regulations is difficult to assess regulations is difficult to assess Stress testing important addition to assessmentStress testing important addition to assessment

EU used similar approach for new entrantsEU used similar approach for new entrants

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Relative security

1.1. Not even “perfect” formal implementation Not even “perfect” formal implementation of the existing principles or standards and of the existing principles or standards and codes will ensure financial system codes will ensure financial system stability.stability.

2.2. Not even the most thorough financial Not even the most thorough financial supervision regime can fully protect supervision regime can fully protect against risks to the financial system. against risks to the financial system.

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2 FSAP Background

Start in 1999 as voluntary programStart in 1999 as voluntary program Joint effort World Bank and IMFJoint effort World Bank and IMF 75 central banks, supervisory agencies etc 75 central banks, supervisory agencies etc

cooperatedcooperated Based on review in 2003 decision for Based on review in 2003 decision for

continuation continuation Further evaluation in 2006Further evaluation in 2006

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FSAP characteristics

Financial sector coverageFinancial sector coverage Analytical tools:Analytical tools:

FSIsFSIs Stress testingStress testing Assessment of standards and codes:Assessment of standards and codes:

BCP/CPSIPS/IAISCP/IOSCO BCP/CPSIPS/IAISCP/IOSCO principles/MFP codeprinciples/MFP code

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3 Main components of regulatory standards IntroductionIntroduction (Regulatory preconditions)(Regulatory preconditions) Regulatory governanceRegulatory governance Regulatory practicesRegulatory practices Supervisory practicesSupervisory practices Financial Integrity and Safety Nets Financial Integrity and Safety Nets

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Introduction

Financial sector regulatory standards Financial sector regulatory standards comprise essential, but minimum standardscomprise essential, but minimum standards

Good quality regulation is a key element of Good quality regulation is a key element of financial stabilityfinancial stability

Regulatory standards are internationally Regulatory standards are internationally adopted and locally implementedadopted and locally implemented

Cross sector review contributes to review of Cross sector review contributes to review of standards standards

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Introduction (continued)

Regulatory standards:Regulatory standards: BCP (1997 + 1999; draft revision 2006 )BCP (1997 + 1999; draft revision 2006 ) IOSCO (1998 + 2003)IOSCO (1998 + 2003) IAIS (2003)IAIS (2003)

Common groundCommon ground Some variations in similar risks (e.g. capital/risk Some variations in similar risks (e.g. capital/risk

treatment)treatment) Some variations arising from intrinsic differences Some variations arising from intrinsic differences

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Introduction (continued)

Main regulatory issues from financial stability viewpoint:Main regulatory issues from financial stability viewpoint: Regulatory governance: capacity and ability of regulatory Regulatory governance: capacity and ability of regulatory

bodies for sound policies and practicesbodies for sound policies and practices Prudential framework: rules, directives etc to govern Prudential framework: rules, directives etc to govern

operations of financial firmsoperations of financial firms Regulatory practices: practical application of regulatory Regulatory practices: practical application of regulatory

frameworkframework Financial integrity and safety net arrangements: Financial integrity and safety net arrangements:

instruments to promote fairness and integrity in operationsinstruments to promote fairness and integrity in operations

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(Regulatory preconditions)

BCP (1997)BCP (1997) Sound and sustainable macro-economic policiesSound and sustainable macro-economic policies Well developed public infrastructureWell developed public infrastructure Effective market disciplineEffective market discipline Procedure for efficient resolution of problems in Procedure for efficient resolution of problems in

banksbanks Mechanisms for providing an appropriate level of Mechanisms for providing an appropriate level of

systemic protection (public safety net)systemic protection (public safety net)(Similar preconditions in IAIS CP)(Similar preconditions in IAIS CP)

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(Regulatory preconditions)

Preconditions are basis for standardsPreconditions are basis for standards Linkages between preconditions and Linkages between preconditions and

regulations, for instance:regulations, for instance: ““well developed public infrastructure” well developed public infrastructure”

links with asset valuation, supervisory links with asset valuation, supervisory powers, enforcement, collateral, powers, enforcement, collateral, licensing, accounting framework licensing, accounting framework

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Regulatory governance

Objectives of regulationObjectives of regulation Independence and adequate resourcesIndependence and adequate resources Enforcement powers and capabilitiesEnforcement powers and capabilities Clarity and transparency of regulatory Clarity and transparency of regulatory

processprocess External participationExternal participation

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Prudential framework

Risk managementRisk management Risk concentrationRisk concentration Capital requirementsCapital requirements Corporate governanceCorporate governance Internal controlsInternal controls

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Regulatory practices

Group-wide supervisionGroup-wide supervision Monitoring and on-site supervisionMonitoring and on-site supervision Reporting to supervisorsReporting to supervisors EnforcementEnforcement Cooperation and information sharingCooperation and information sharing ConfidentialityConfidentiality Licensing, ownership transfer and corporate Licensing, ownership transfer and corporate

controlcontrol QualificationsQualifications

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Financial Integrity and Safety Net Markets (integrity and financial crime)Markets (integrity and financial crime) Customer protectionCustomer protection Information, disclosure and transparencyInformation, disclosure and transparency

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4 Review in 2003 and 2006

Comprehensive and system wide approach to Comprehensive and system wide approach to analyzing the financial sectoranalyzing the financial sector Independent review by objective outsidersIndependent review by objective outsiders Discuss supervisory matters with experts from Discuss supervisory matters with experts from

other countriesother countries Compare practicesCompare practices Benchmarking against international practicesBenchmarking against international practices Testing vulnerabilities in the financial systemTesting vulnerabilities in the financial system Selection of key issues and priorities for Selection of key issues and priorities for

improvements improvements

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Review in 2003 and 2006

Points of attention (2003):Points of attention (2003): Faster and more thorough understanding Faster and more thorough understanding

necessary of legal and regulatory traditionsnecessary of legal and regulatory traditions Limitations of data availability for stress testingLimitations of data availability for stress testing Large resource costs for authoritiesLarge resource costs for authorities Reduction of lag between assessment and report Reduction of lag between assessment and report

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Review in 2003 and 2006

FSAP increased depth and breath of coverage of FSAP increased depth and breath of coverage of financial issues:financial issues: Developing countries: strengthening medium Developing countries: strengthening medium

term financial system and supervisionterm financial system and supervisionAddress legal and regulatory frameworkAddress legal and regulatory framework

Emerging countries: non bank sector Emerging countries: non bank sector deficiencies in supervision and regulation; deficiencies in supervision and regulation; enforcement and prompt corrective actionenforcement and prompt corrective action

Industrial countries: large and complex Industrial countries: large and complex financial institutions financial institutions

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FSAP review recommendations (2003) Updates necessary for:Updates necessary for:

systematically important countriessystematically important countries Countries evolving at a rapid paceCountries evolving at a rapid pace

Selection of key topics per updateSelection of key topics per update For developing countries: focus on medium term For developing countries: focus on medium term

and structural issuesand structural issues AML/CFT issues to be includedAML/CFT issues to be included Possible basis for TAPossible basis for TA Promote publication on a voluntary basisPromote publication on a voluntary basis

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FSAP findings: areas for improvement (2003)For BCP:For BCP: Credit policies and connected lendingCredit policies and connected lending Provisioning practices in practice weaker than on paperProvisioning practices in practice weaker than on paper Increase attention for country, market, fc and interest Increase attention for country, market, fc and interest

rate riskrate risk Remedial actionRemedial action Large and complex financial institutionsLarge and complex financial institutions Consolidation of accounts and supervision on a Consolidation of accounts and supervision on a

consolidated basis consolidated basis AML/CFT issues AML/CFT issues

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FSAP evaluation 2006

Some issues:Some issues: Better understanding key linkagesBetter understanding key linkages Discussions with authorities and support institutional Discussions with authorities and support institutional

changeschanges Not all systemic countries assessedNot all systemic countries assessed FSIs generally not used in a meaningful mannerFSIs generally not used in a meaningful manner Quality of data needs to be emphasisedQuality of data needs to be emphasised Stress testing needs further developmentStress testing needs further development Cross border issues need more attentionCross border issues need more attention Surveillance and technical assistanceSurveillance and technical assistance

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6 Gaps in financial sector 6 Gaps in financial sector regulationregulation

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Conclusions (2004)

Average level of implementation of Average level of implementation of regulatory components across sectors regulatory components across sectors broadly satisfactorybroadly satisfactory

Implementation in industrial countries Implementation in industrial countries better than in emerging and developing better than in emerging and developing countriescountries

Level of implementation across sectors is Level of implementation across sectors is correlatedcorrelated

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Conclusions (2004)

High level of implementation in particular High level of implementation in particular for legal foundation of regulatorfor legal foundation of regulator

Prudential area: capital, solvency and Prudential area: capital, solvency and margin requirements prescribed across margin requirements prescribed across sectorssectors

Licensing process and entry standards Licensing process and entry standards largely adequate in most countries largely adequate in most countries

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Where are the Gaps?

A. Regulatory GovernanceA. Regulatory Governance

B. Regulatory practicesB. Regulatory practices

C. Prudential framework C. Prudential framework

D. Financial Integrity and Safety NetD. Financial Integrity and Safety Net

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A. Regulatory governance

Lack of formal and informal independenceLack of formal and informal independence Ill-defined accountability arrangementsIll-defined accountability arrangements Different categories of deposit taking institutions Different categories of deposit taking institutions

under different laws and regulatorsunder different laws and regulators Regulatory forbearance is a problem in some Regulatory forbearance is a problem in some

countriescountries Ill-defined oversight responsibilities in case of Ill-defined oversight responsibilities in case of

regulators and SRO”sregulators and SRO”s Lacking legal protection of supervisors and clarity Lacking legal protection of supervisors and clarity

of regulatory powersof regulatory powers

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B. Regulatory practices

In many cases robust regulatory standards In many cases robust regulatory standards but weaker regulatory practicesbut weaker regulatory practices

Consolidated supervision and – regulation Consolidated supervision and – regulation needs more attentionneeds more attention

Shortcomings in regulatory data and Shortcomings in regulatory data and reporting, including consolidated reportingreporting, including consolidated reporting

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B. Regulatory practices (continued) Limited powers to enforce regulations and Limited powers to enforce regulations and

impose sanctionsimpose sanctions Inadequate cooperation between home and Inadequate cooperation between home and

host supervisorshost supervisors Lack of clear definition of “control”Lack of clear definition of “control” (Quality of management, administration and (Quality of management, administration and

internal control??) internal control??)

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C. Prudential framework

Strong focus on prudential regulation, but:Strong focus on prudential regulation, but: Deficiencies in oversight and monitoring Deficiencies in oversight and monitoring

of country riskof country risk Insufficient requirements for connected Insufficient requirements for connected

lendinglending Weaknesses corporate governance in Weaknesses corporate governance in

particular in banking and insurance particular in banking and insurance

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C. Prudential framework (continued)Sector specific issues:Sector specific issues: Banking: Credit risk management, loan classification Banking: Credit risk management, loan classification

and provisioning, large exposures, country and and provisioning, large exposures, country and transfer risktransfer risk

Asset quality regulation in insuranceAsset quality regulation in insurance Monitoring and inspection systems ensuring Monitoring and inspection systems ensuring

compliance with capital and prudential requirementscompliance with capital and prudential requirements Collective investment schemes: improvement needed Collective investment schemes: improvement needed

of information, asset valuation and pricing of unitsof information, asset valuation and pricing of units

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D. Financial integrity and safety netIn general differences along sectoral lines:In general differences along sectoral lines: Content and timeliness of disclosureContent and timeliness of disclosure Protection of minority shareholdersProtection of minority shareholders Accounting and auditing issuesAccounting and auditing issues Procedures for winding up insurers and Procedures for winding up insurers and

securities forms missingsecurities forms missing Weak AML effortsWeak AML efforts

Strengthening regulatory standards

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Strengthening regulatory standardsChallenges from three factors:Challenges from three factors: Diversity of financial systems a.o.Diversity of financial systems a.o.

OwnershipOwnership Role governmentRole government CompetitionCompetition Intermediation patternsIntermediation patterns

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Strengthening regulatory standards Cross-sectoral and cross border issues a.o.Cross-sectoral and cross border issues a.o.

Linkages in financial sector growingLinkages in financial sector growing Role of international financial centersRole of international financial centers Role of off-shore centersRole of off-shore centers Cross-sector and cross-border financial groupsCross-sector and cross-border financial groups Arbitrage possibilities across sectorsArbitrage possibilities across sectors Different cross-sector and cross-border capital Different cross-sector and cross-border capital

calculationscalculations Cross country differences in preconditions and Cross country differences in preconditions and

governancegovernance

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Strengthening regulatory standards Objectives and design of regulatory Objectives and design of regulatory

standards a.o.standards a.o. Regulatory issues and components more Regulatory issues and components more

linked to system-wide financial stabilitylinked to system-wide financial stability Interrelationships among key components Interrelationships among key components

of regulatory standards more explicitof regulatory standards more explicit Improve standards on information Improve standards on information

disclosuredisclosure

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Issues for standards setters

Diversity in financial systems require Diversity in financial systems require diversity in regulatory standards?diversity in regulatory standards?

More focus on preconditionsMore focus on preconditions Cross-sectoral and cross-border issuesCross-sectoral and cross-border issues Guidance on regulatory governance issuesGuidance on regulatory governance issues Information exchange arrangements Information exchange arrangements

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Issues for country authorities

Greater attention to preconditionsGreater attention to preconditions Periodic review of governance in regulatory Periodic review of governance in regulatory

bodiesbodies Periodic self assessment of regulatory Periodic self assessment of regulatory

standardsstandards Attention for cross-sector and cross-border Attention for cross-sector and cross-border

issuesissues Attention for system-wide issues Attention for system-wide issues

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Sources:

* Financial Sector Assessment Program – Review, lessons and issues going forward

IMF/World Bank February 2003

* Report on the evaluation of the Financial Sector Assessment Program

IMF January 2006

* Financial Sector Regulation: Issues and GapsIMF August 2004