33797 Financial Sector Assessment A H A N D B O O K Financial Sector Assessment A H A N D B O O K Financial Sector Assessment A H A N D B O O K © 2005 The International Bank for Reconstruction and Development/The World Bank/The International Monetary Fund 1818 H Street NW Washington DC 20433 Telephone: 202-473-1000 Internet: www.worldbank.org E-mail: feedback@worldbank.org All rights reserved First printing September 2005 1 2 3 4 5 09 08 07 06 05 This volume is a product of the staff of the International Bank for Reconstruction and Development/The World Bank/The International Monetary Fund. The findings, interpretations, and conclusions expressed in this paper do not necessarily reflect the views of the World Bank, the International Monetary Fund, their Executive Directors, or the governments they represent. The World Bank and International Monetary Fund do not guarantee the accuracy of the data included in this work. 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All other queries on rights and licenses, including subsidiary rights, should be addressed to the Office of the Publisher, The World Bank, 1818 H Street NW, Washington, DC 20433, USA; fax: 202-522-2422; e-mail: pubrights@worldbank.org. ISBN-10: 0-8213-6432-4 ISBN-13: 978-0-8213-6432-1 eISBN: 0-8213-6433-8 DOI: 10.1596/978-0-8213-6432-1 Library of Congress Cataloging-in-Publication Data has been applied for. Cover and publication design: James E. Quigley, World Bank Institute. Original cover photo: Getty Images. Contents Abbreviations and Acronyms xvii Preface xxi Contributors xxiii Chapter 1 Financial Sector Assessments: Overall Framework and Executive Summary 1 1.1 Introduction 1 1.2 Overall Analytical and Assessment Framework--Executive Summary 3 Annex 1.A Tailoring Financial Sector Assessment to Country Needs 11 Notes 13 References and Other Sources 13 Chapter 2 Indicators of Financial Structure, Development, and Soundness 15 2.1 Financial Structure and Development 15 2.1.1 System-wide Indicators 15 2.1.2 Breadth of the Financial System 17 2.1.3 Competition, Concentration, and Efficiency 18 2.1.4 Scope and Coverage of Financial Services 20 2.2 Financial Soundness Indicators 22 2.2.1 FSIs for Non-financial Sectors 25 2.2.2 FSIs for Banking 26 2.2.3 FSIs for Insurance 27 2.2.4 FSIs for Securities Markets 27 2.2.5 Market-Based Indicators of Financial Soundness 28 2.3 Aggregate Balance Sheet Structure of Financial and Non-financial Sectors-- Inter-sectoral Linkages 28 Notes 31 References 32 v Contents Chapter 3 Assessing Financial Stability 35 3.1 Overall Framework for Stability Analysis and Assessment 35 3.2 Macroeconomic and Financial Market Developments 36 3.3 Macroprudential Surveillance Framework 38 3.3.1 Analysis of Financial Soundness Indicators 39 3.3.2 System-Focused Stress Testing 46 3.4 Analysis of Macrofinancial Linkages 47 3.4.1 Effect of Financial Soundness on Macroeconomic Developments 47 3.4.2 Effect of Financial System Soundness on Debt Sustainability 49 3.4.3 Effect of Financial Soundness on Growth and Financial Development 50 3.5 Special Topics in Financial Stability Analysis 51 3.5.1 International Financial Centers and Offshore Financial Centers 51 3.5.2 Capital Account Liberalization 54 3.5.3 Dollarization: Implications for Stability 54 3.5.4 Islamic Banking--Stability Issues 57 3.6 Key Policy Issues and Policy Priorities to Support Stability 57 Notes 59 References 62 Chapter 4 Assessing Financial Structure and Financial Development 69 4.1 Overview 69 4.1.1 Motivation for Assessing Financial Structure and Financial Development 69 4.1.2 Scope of Analysis 69 4.1.3 Stability and Development: Complementarities Despite the Different Perspective 72 4.2 Quantitative Benchmarking 73 4.3 Review of Legal, Informational, and Transactional Technology Infrastructures for Access and Development 75 4.3.1 Legal Infrastructure 75 4.3.2 Information Infrastructures 76 4.3.3 Transactional Technology Infrastructures 77 4.4 Sectoral Development Reviews 78 4.4.1 Banking 79 4.4.2 Near-banks 83 4.4.3 Insurance and Collective Investment Arrangements 84 4.4.4 Securities Markets 86 4.5 The Demand-Side Reviews and the Effect of Finance on the Real Sector 88 4.5.1 Enterprise Finance 89 4.5.2 Households, Firms, and Microenterprises 90 4.6 Reviews of Cross-Cutting Issues 91 4.6.1 Missing Markets and Missing Products 91 4.6.2 Taxation Issues 91 4.6.3 Competition Aspects 92 4.6.4 Development Obstacles Imposed by Unwarranted Prudential Regulation 93 4.7 From Finding Facts to Creating Policies 93 Notes 95 References 97 vi Contents Chapter 5 Evaluating Financial Sector Supervision: Banking, Insurance, and Securities Markets 101 5.1 Legal and Institutional Framework for Financial Supervision 102 5.2 Aspects of Financial Safety Nets 104 5.2.1 Frameworks for Liquidity Support 105 5.2.2 Deposit Insurance 106 5.2.3 Investor and Policyholder Protection Schemes 107 5.2.4 Crisis Management 109 5.3 Assessment of Banking Supervision 110 5.3.1 Basel Core Principles--Their Scope and Coverage, and Their Relevance to Stability and Structural Development 110 5.3.2 Preconditions for Effective Banking Supervision 114 5.3.3 Assessment Methodology and Assessment Experience 115 5.3.4 Basel II 120 5.3.5 Bank Insolvency Procedures: Emerging Bank-Fund Guidelines 121 5.3.6 Large and Complex Financial Institutions 123 5.3.7 Consolidated Supervision 125 5.3.8 Unique Risks in Islamic Banking 127 5.4 Assessment of Insurance Supervision 127 5.4.1 Relevance to Stability and Development 128 5.4.2 The Structure of the ICPs 129 5.4.3 Assessment Methodology and Assessment Experience 131 5.5 Assessment of Securities Market Regulation 140 5.5.1 IOSCO Core Principles--Relevance to Stability Considerations and Structural Development 141 5.5.2 Preconditions for Effective Securities Market Regulation 142 5.5.3 Assessment Methodology and Assessment Experience 143 5.5.4 Key Considerations in Conducting an Assessment 145 5.5.5 Assessment Experience 147 5.5.6 Special Topics in Securities Market Development and Regulation 149 Annex 5.A Legal and Institutional Environment for Effective Bank Insolvency Procedures 151 Autonomy of Banking Authority 151 Legal Mandate 152 Appropriate Legal Protection of Banking Authorities and Their Staff Members 152 Transparency 152 Accountability and Judicial Review 153 Coordination among Banking Authorities 153 Annex 5.B Consolidated Supervision 154 Annex 5.C IAIS Insurance Core Principles 156 Annex 5.D List of IOSCO Objectives and Principles of Securities Regulation 158 Principles Relating to the Regulator 158 Principles for Self-Regulation 158 Principles for the Enforcement of Securities Regulation 158 Principles for Cooperation in Regulation 159 Principles for Issuers 159 Principles for Collective Investment Schemes 159 Principles for Market Intermediaries 159 Principles for the Secondary Market 160 Annex 5.E IOSCO Methodology--Scope and Use of Principle 8 160 Principle 8 161 Annex 5.F Enforcement and the Exchange of Information 162 vii Contents Notes 164 References 167 Chapter 6 Assessing the Supervision of Other Financial Intermediaries 171 6.1 Overview 171 6.2 Objectives of the Legal and Regulatory Framework for OFIs 173 6.3 Assessing Institutional Structure and Regulatory Arbitrage 174 6.4 Assessing Regulatory Practice and Effectiveness 176 6.5 Selected Issues on the Regulation and Supervision of Leasing Companies 179 6.6 Selected Issues on the Regulation and Supervision of Factoring Companies 180 6.7 Selected Issues on the Regulation and Supervision of Pension Funds 182 Annex 6.A Regulation and Supervision of OFIs: A Few Guiding Principles 182 A. The regulatory framework should minimize adverse effects on competition and encourage competition 182 B. The regulatory framework should clearly define the power of the regulator and the permissible activities of OFIs. 183 C. Similar risks and functions should be supervised similarly to minimize scope for regulatory arbitrage. 183 D. The links between OFIs and other players in the financial sector should be closely monitored. 183 E. The unique risks of OFIs should be recognized within the supervisory structure and when defining prudential norms. 183 F. Supervision should be proportionate and consistent with costs and benefits. 184 G. Resources and skills should be targeted to the higher-impact and more-complex OFIs. 184 H. There should be a strengthening of the self-regulatory capacity 184 Notes 184 References 185 Chapter 7 Rural and Microfinance Institutions: Regulatory and Supervisory Issues 187 7.1 Overview 187 7.2 Rationale for Assessing the Regulatory Framework for Rural Finance and Microfinance Institutions 187 7.3 Institutional Providers of Rural Finance and Microfinance Services 189 7.3.1 Government Rural Finance, Microfinance, or SME Finance Programs or Agencies 191 7.3.2 Non-bank, Non-profit NGO MFIs 192 7.3.3 Membership-Based CFIs 193 7.3.4 Postal Savings Banks 193 7.3.5 Development Finance Institutions 193 7.3.6 Specialized Banking Institutions 194 7.3.7 Commercial Banks 194 7.4 Conceptual Framework for the Regulation of Rural Finance and Microfinance Institutions 194 7.5 Assessment of the Regulatory Framework Issues for Rural Finance and Microfinance Institutions 196 7.6 Some Cross-Cutting Issues Affecting Rural Finance and Microfinance Institutions 199 7.7 Ways to Address Rural Finance and Microfinance Regulatory Framework Issues 201 7.8 Consensus Guidelines on Regulating and Supervising Microfinance 202 Notes 203 References 204 viii Contents Chapter 8 Assessing Financial System Integrity--Anti-Money Laundering and Combating the Financing of Terrorism 207 8.1 AML­CFT Standards--Links to Stability and Institutional Development 210 8.2 AML­CFT Standards--Scope and Coverage 210 8.3 Preconditions for Effective Implementation of AML­CFT Standards 211 8.4 Assessment Methodology and Assessment Experience 212 8.4.1 AML­CFT Assessment Methodology 214 8.4.2 Assessment Experience 215 8.5 Special Topics in AML­CFT Assessments 215 8.5.1 Assessing Preventive Measures: The Example of Customer Due Diligence 216 8.5.2 Financial Intelligence Units 216 Annex 8.A FATF 40+8 Recommendations for AML­CFT 217 Forty Recommendations 217 Special Recommendations for Combating the Financing of Terrorism 219 Notes 220 References 221 Chapter 9 Assessing the Legal Infrastructure for Financial Systems 223 9.1 Financial Sector Legal Framework 223 9.1.1 Central Banking Law 224 9.1.2 Banking Law 224 9.1.3 Payment Systems 225 9.1.4 Government Debt Management 225 9.1.5 Capital Markets 226 9.1.6 Insurance 226 9.1.7 Financial Safety Nets 228 9.2 Commercial Laws 228 9.2.1 Company Law 228 9.2.2 Corporate Governance 228 9.2.3 Consumer Protection 229 9.3 Creditors Rights and Insolvency Systems 230 9.4 Access to Credit and Land Rights 234 9.5 The Judicial System 235 Notes 237 References 238 Chapter 10 Assessing Information and Governance Infrastructure 241 10.1 Monetary and Financial Policy Transparency 242 10.1.1 Code of Good Practices 242 10.1.2 Assessment Methodology and Assessment Experience 243 10.2 Accounting and Auditing Assessments 245 10.2.1 Role of the Accounting and Auditing Framework: Relevance to Development and Stability 247 10.2.2 Scope and Content of International Accounting and Auditing Standards 248 10.2.3 ROSCs and Role of the Bank and the Fund 252 10.2.4 Focus of A&A Assessments 254 10.2.5 ROSC A&A Methodology 255 10.2.6 Assessment Experience 255 10.3 Credit-Reporting Systems and Financial Information Services 256 10.3.1 Introduction to Credit-Reporting Systems 256 ix Contents 10.3.2 Elements of a Robust Credit-Reporting System 257 10.3.3 Credit Registries, Efforts to Strengthen Credit Risk Measurement, and New Basel Capital Accord (Basel II) 262 10.3.4 Role of Credit Rating Agencies in Financial Stability and Development 264 10.4 Corporate Governance Assessments 266 10.4.1 Rationale for Good Corporate Governance? 266 10.4.2 OECD Principles of Corporate Governance 267 10.4.3 World Bank ROSC Corporate Governance Assessments 269 10.4.4 Key Findings from Country Assessments 271 10.5 Disclosure Regime for Financial Institutions 272 10.5.1 Current Practices and Evolving Standards 273 10.5.2 Pillar III and Market Discipline 274 Annex 10.A Code of Good Practices on Transparency in Monetary and Financial Policies 276 1. Clarity of Roles, Responsibilities, and Objectives of Central Banks for Monetary Policy 276 2. Open Process for Formulating and Reporting Monetary Policy Decisions 276 3. Public Availability of Information on Monetary Policy 276 4. Accountability and Assurances of Integrity by the Central Bank 277 5. Clarity of Roles, Responsibilities, and Objectives of Financial Agencies Responsible for Financial Policies 277 6 Open Process for Formulating and Financial Policies 277 7. Public Availability of Information on Financial Policies 277 8. Accountability and Assurances of Integrity by Financial Agencies 278 Annex 10.B Methodology for Assessing Accounting and Auditing 278 Part I: Assessment of the Accounting and Auditing Environment 278 Part II: Assessment of National Accounting Standards with Reference to IAS 279 Part III: Assessment of Actual Accounting Practices (Review of Compliance with Selected Local Accounting Requirements) 279 Part IV: Assessment of Auditing Standards and Practices 280 Due Diligence and Final Report 280 Final Report 280 Development and Implementation of a Country Action Plan 281 Annex 10.C Financial Sector Governance--Selected Issues 281 Notes 283 References 285 Chapter 11 Assessing Systemic Liquidity Infrastructure 289 11.1 Payment and securities settlement systems 289 11.1.1 Payment Systems 290 11.1.2 Securities Settlement Systems 297 11.2 Monetary and Foreign Exchange Operations--Instruments and Effectiveness 301 11.3 Monetary and Foreign Exchange Markets--Microstructure and Functioning 305 11.4 Public Debt Management and the Government Securities Market 306 11.5 Foreign Exchange Reserve Management 308 11.6 Microstructure of Securities Markets--Trading Systems, Price Discovery, and Determinants of Market Liquidity and Efficiency 310 Notes 312 References 313 x Contents Chapter 12 Sequencing Financial Sector Reforms 317 12.1 Development with Stability: The Role of Sequencing 318 12.2 Strengthening Access to Foreign Capital 320 12.3 Principles of Sequencing 322 Notes 324 References 324 Appendix A Financial Sector Assessment Program--Objectives, Procedures, and Overall Framework 325 A.1 History and Objectives 325 A.2 Operational Procedures for FSAP, FSAP Updates, Follow­Up Technical Assistance, and Relationship to Bank-Fund Operations 326 A.2.1 Country Selection Process--Selection Criteria 329 A.2.2 Publication Policies 332 A.2.3 Confidentiality and Other Distribution 332 A.2.4 Review and Clearance of FSAP Documents 333 A.3 Selectivity and Tailoring of Assessments 334 A.4 Relationship to Standards and Codes Initiative--Role of Standards Assessments in FSAP 336 A.5 Selected Organizational Issues 340 A.5.1 Organization and Team-Design: Issues for the Development Assessment 340 A.5.2 Multitasking for the Sectoral Reviews 341 A.5.3 Organization and Team Design for Stability Assessments 341 A.6 Follow-Up Issues--FSAP Updates, On-Going Surveillance, and TA 342 Appendix B Illustrative Data Questionnaires for Comprehensive Financial Sector Assessment 345 Appendix C Data Sources for Financial Sector Assessments 367 C.1 Overview 367 C.2 National Data Sources 368 C.3 International Organizations 369 C.3.1 OECD Databases 369 C.3.2 European Central Bank Monetary Statistics 371 C.3.3 Bank for International Settlements (BIS) 371 C.3.4 Asia Regional Information Center 372 C.3.5 IMF 372 C.3.6 International Finance Corporation (IFC) 373 C.3.7 World Bank 373 C.3.8 Commercial Databases 373 References 376 Appendix D Stress Testing 379 D.1 Overview of Stress Testing 379 D.2 The Process 380 D.2.1 Identifying Vulnerabilities 381 D.2.2 Constructing Scenarios--Use of Macroeconomic Models 382 xi Contents D.2.3 Balance-Sheet Implementation 384 D.2.4 Interpretation and Publication 389 D.3 Examples of Stress-Testing Calculations 390 D.3.1 Exchange Rate Risk 390 D.3.2 Interest Rate Risk 393 D.3.3 Credit Risk 396 D.3.4 Other Risks 397 D.3.5 Second Round Effects 399 D.3.6 Stress Testing of Insurance Companies 401 D.4 Summary of FSAP Experience 402 Notes 403 References 404 Appendix E Benchmarking and Decomposing Interest Rate Spreads and Margins 409 Notes 413 References 413 Appendix F Institutional Structure of Financial Regulation and Supervision 417 Overview 417 Range of Financial Supervisory Structures 418 Importance of Institutional Structure 418 Case for the Fully Unified Model 420 Case Against the Fully Unified Model 422 Types of Unified Supervision 423 Internal Structure of Unified Supervisory Agencies 426 Role of the Central Bank 426 Conclusions 429 Notes 430 References 431 Appendix G Banking Resolution and Insolvency--Emerging World Bank and International Monetary Fund Guidelines 433 G.1 Bank Insolvency Framework: Objectives and Scope 433 G.1.1 Objectives 433 G.1.2 Background 433 G.1.3 Scope 434 G.1.4 Links with the Basel Core Principle 434 G.2 Key Institutional Aspects of the Bank Insolvency Regime 435 G.3 General Issues in Bank Insolvency Proceedings 435 G.3.1 Choice of Bank Insolvency Regime 435 G.3.2 Administrative or Court-Based Special Bank Insolvency Regime 435 G.3.3 Commencement of Bank Insolvency Proceedings 436 G.3.4 Licensing Implication of Bank Insolvency 437 G.3.5 Rights of Shareholders and Creditors in the Context of Bank Insolvency 438 G.4 Official Administration of Banks 439 G.4.1 Definition 439 G.4.2 Basic Principles 439 G.4.3 Basic Elements of the Official Administration Regime 440 G.5 Bank Restructuring 440 xii Contents G.5.1 Definition 440 G.5.2 Key Objectives 441 G.5.3 Basic Principles 441 G.5.4 Bank Restructuring and Cases with Actual or Potential Systemic Implications 442 G.5.5 Publicly Assisted Bank Restructuring 442 G.5.6 Main Restructuring Techniques and Basic Applicable Principles 443 G.6 Bank Liquidation 444 G.7 Key Features of the Legal Framework in the Context of Systemic Crises 445 Notes 446 Appendix H Assessment of Pension Schemes from a Financial Sector Perspective 449 H.1 Assessment Framework 450 H.2 Importance of Regulating and Supervising Pension Systems 451 H.2.1 Income and Household Security 451 H.2.2 Issues of Funding 451 H.2.3 Fiscal Management 451 H.2.4 Financial Markets 451 H.3 Regulation and Supervision of Public and Government Pension Funds: Risks and Regulatory Responses 452 H.4 Regulation and Supervision of Private Funds 454 H.5 Regulatory Oversight 454 H.6 The Regulation of Investment Regimes 455 H.7 Government Guarantee Funds 456 Notes 457 References 458 Boxes Box 1.1 Financial Sector Assessment Program (FSAP)--A Chronology 2 Box 2.1 The Balance Sheet Approach--An Overview 29 Box 3.1 Market-Based Indicators of Financial Soundness 40 Box 3.2 Capital Account Liberalization and Financial Stability 56 Box 3.3 Stability Issues in Islamic Banking 58 Box 4.1 Quantitative Indicators for Financial Structure and Development Assessment 74 Box 4.2 Access to Financial Services from Abroad 82 Box 4.3 Finance of Housing 84 Box 4.4 Role of Government-Owned Banks 85 Box 4.5 Standards Assessments and Financial Sector Development 87 Box 4.6 Use of Research-Based Micromodels--Liquidity Constraints in Capital Formation 89 Box 5.1 Basel Core Principles for Effective Banking Supervision 111 Box 5.2 Unique Risks in Islamic Banking 126 Box 5.3 Flexibility in Assessments. 133 Box 5.4 Key Issues in Ongoing Supervision and Prudential Requirements for Insurance 138 Box 6.1 The Case of Financial Institutions Providing Housing Finance 177 Box 6.2 Measures to Develop a Favorable Regulatory Environment for Leasing 180 Box 6.3 Factoring as a Sale and Purchase Transaction Rather Than as a Loan 181 Box 7.1 Benchmarks for Outreach and Financial Performance and Soundness of Rural Finance and Microfinance Institutions 192 Box 7.2 Conduct of Business Regulations for MFIs 197 Box 7.3 PSBs and CFIs and the Scope of Their Regulation 198 xiii Contents Box 7.4 Critical Issues in Delegating Prudential Supervision 199 Box 7.5 Supervision Standards, Technical Capacity, and Cost Issues 200 Box 7.6 Findings and Recommendations on Microfinance Regulatory Issues in Selected FSAPs 201 Box 8.1 United Nations Conventions and Security Council Resolution in Support of AML-CFT Regimes 208 Box 8.2 Core Principles and Guidelines of Financial Sector Supervision in Support of AML­CFT Regimes 209 Box 8.3 Weaknesses in AML/CFT Regimes: Results of Pilot Program Assessments 213 Box 9.1 Legal Framework for Securitization 227 Box 10.1 Main Weaknesses in the Transparency Practices of Central Banks and Monetary Policy 246 Box 10.2 Main Weaknesses in the Transparency Practices in Financial Policies 247 Box 10.3 IAS 39: Financial Instruments, Recognition, and Measurement 250 Box 10.4 IAS 32: Financial Instruments, Disclosure, and Presentation 251 Box 10.5 IAS 30: Disclosures in the Financial Statements of Banks and Similar Financial Institutions 251 Box 10.6 IAS 1: Presentation of Financial Statements 252 Box 10.7 International Convergence Process 253 Box 10.8 OECD Principles of Corporate Governance: Overview of the Main Areas of the OECD Principles 268 Box 10.9 Methodology and Format of Corporate Governance Assessments 270 Box 11.1 Summary of the CPSS Core Principles 293 Box 11.2 Responsibilities of Central Banks in Applying the CPSS Core Principles 294 Box 11.3 Summary of the RSSS 298 Box 11.4 Liquidity Forecasting Frameworks 302 Box 11.5 Monetary Policy Instruments 303 Box 12.1 Selected Principles of Sequencing 323 Box A.1. Assessing Observance of Financial Sector Standards When There Are Supranational Authorities 335 Box A.2. List of Standards and Codes and Core Principles Useful for Bank and Fund Operational Work and for Which ROSCs Are Produced 337 Box A.3. Assessing Offshore Financial Centers 338 Box A.4. Periodic Review of Standards Assessment Process 339 Tables Table 2.1. Sectoral Indicators of Financial Development 18 Table 2.2. Indicators of Financial System Performance 20 Table 2.3. The Core Set of Financial Soundness Indicators 23 Table 2.4. The Encouraged Set of Financial Soundness Indicators 24 Table 2.5. Insurance Financial Soundness Indicators: Core Set 27 Table 2.6. Stylized Framework for Presenting Financial Interlinkages between Sectors in an Economy 30 Table 5.1. Observance of Basel Core Principles for Effective Banking Supervision 118 Table 6.1. Main Regulatory and Prudential Aspects of Different Groups of Financial Institutions 175 Table 7.1. Institutional Providers of Financial Services 191 Table 7.2. Tiered Structures and Regulatory Triggers by Type of MFI 196 Table 10.1. Institutional Arrangements for Private Credit Registries 258 Table A.1. Institutions Cooperating in the FSAP 327 Table A.2. FSAP Confidentiality and Publication Policy at a Glance 331 xiv Contents Table B.1. Financial System Structure 348 Table B.2. Aggregate Balance Sheet for the Banking System 349 Table B.3. Profit and Loss Analysis for the Banking System 351 Table B.4. Measures of Financial System Interconnectedness 352 Table B.5. Financial Soundness Indicators for the Banking Sector 353 Table B.6. Data on Ownership, Exposures, Profitability, and Costs in Banking 354 Table B.7. Stress Testing of Banking Systems: Overview of Input Data 355 Table B.8. Statistics on Structure and Performance of Insurance Companies 356 Table B.9. Capital Markets Overview and Their Structure and Performance Selected 357 Table B.10. Structure and Performance of Pension and Investment Funds 359 Table B.11. Structure and Performance of Other Financial Institutions 360 Table B.12. Systemic Liquidity Infrastructure--Money, Exchange, and Debt Market 361 Table B.13. Systemic Liquidity Infrastructure--Payments and Securities Settlement Systems 362 Table B.14. Legal, Governance, and Information Infrastructure 363 Table B.15. Financial Sector Taxation 364 Table B.16. Indicators of Access to Financial Services 365 Table D.1. Matrix of Bank-to-Bank Exposures 400 Table E.1. Interest Rates, Spreads, and Margins in International Comparison 410 Table E.2. Kenya: Decomposition of Interest Spreads 410 Table E.3. Bank Productivity in International Comparison 411 Table E.4. Bank Productivity Across Different Kenyan Bank Groups 411 Table E.5. Net Interest Margins and Overhead Costs in International Comparison 412 Table F.1. Countries with a Single Supervisor, Semi-Integrated Supervisory Agencies and Multiple Supervisors in 2004 424 Table H.1. The Core Principles of Occupational Pension Regulation (OECD 2004) 453 Figures Figure 5.1. Financial Standards and Their Four Main Components 103 Figure 12.1. Financial Development: Stylized Sequencing of Reforms 319 Figure A.1. FSAP Process: Key Steps and Outputs 330 Figure D.1. Example of Contagion Effects of a Counterparty Failure 401 xv Abbreviations and Acronyms A&A Accounting and auditing AML­CFT Anti-Money Laundering and Combating the Financing of Terrorism ARIC Asia Regional Information Center ATM Automated teller machine BAAC Bank for Agriculture and Agricultural Cooperatives [Thailand] BCBS Basel Committee on Banking Supervision BCP Basel Core Principles (for Effective Banking Supervision) BIS Bank for International Settlements BRI Bank Rakyat Indonesia CAMEL Capital adequacy, Asset quality, Management soundness, Earnings and profitability, Liquidity, and Sensitivity to market risk CARAMELS Capital adequacy, Asset quality, Reinsurance, Adequacy of claims and actuarial, Management soundness, Earnings and profitability, Liquidity, and Sensitivity to market risk CGAP Consultative Group to Assist the Poorest CIDA Canadian International Development Agency CPSIPS Core Principles of Systemically Important Payment Systems CPSS Committee on Payment Settlement Systems or Committee on Payments and Settlements Systems CSD Central securities depository CSFB Credit Suisse First Boston DB Defined Benefit DC Defined Contribution DCP Domestic credit to the private sector DFI Development finance institution DFID UK Department for International Development DIS Deposit insurance system ECB European Central Bank EMDB Emerging Markets Database xvii Abbreviations and Acronyms EWS Early warning systems FAO Food and Agriculture Organization of the United Nations FASB Financial Accounting Standards Board FATF Financial Action Task Force on Money Laundering FCRA Fair Credit Reporting Act FIRST Financial Sector Reform and Strengthening Initiative FIU Financial Intelligence Units FSAP Financial Sector Assessment Program FSIs Financial soundness indicators FSLC Financial Sector Liaison Committee FSRB FATF-Style Regional Body FSSA Financial System Stability Assessment FX foreign exchange GAAP Generally Accepted Accounting Principles GDDS General Data Dissemination System GDP Gross domestic product GNP Gross national product GTZ Deutsche Gesellschaft für Technische Zusammenarbeit HI Herfindahl Index IAASB International Auditing and Assurance Board IAIS International Association of Insurance Supervisors IASs International Accounting Standards IASB International Accounting Standards Board IASC International Accounting Standards Committee ICP Insurance Core Principle ICR Insolvency and creditor rights IDA International Development Association IFAC International Federation of Accountants IFC International Finance Corporation IFCs International Financial Centers IFRSs International Financial Reporting Standards IFS International financial statistics IFSB Islamic Financial Services Board IIFS Institutions offering Islamic Financial Services IMF International Monetary Fund IOSCO International Organization of Securities Commissions IPSAS International Public Sector Accounting Standards ISA International Standards for Auditing KYC Know-your-customer LCFI Large and complex financial institution LGD Loss given default LIBOR London interbank offer rate LOLR Lender of last resort LSMS Living Standards Measurement Survey MFI Microfinance institution xviii Contents MFP Monetary and financial policies MIX Microfinance Information eXchange NBFI Non-bank financial institution NCD Negotiable certificate of deposits NGO Non-governmental organization NPL Non-performing loans OECD Organisation for Economic Co-operation and Development OFC Offshore Financial Center OFI Other Financial Intermediary OMO Open market operations OTC Over-the-counter PAYG Pay-as-you-go POS Point of sale PSB Postal savings bank ROA Return on assets ROE Return on equity ROSCs Reports on Observance of Standards and Codes RSSS Recommendations for Securities Settlement Systems SACCOs Savings and credit cooperative organizations SDDS Special Data Dissemination Standard SIC Standard Industrial Classification SIDA Swedish International Development Co-Operation Agency SME Small and medium enterprise SOE State-owned enterprise SRO self-regulatory organization TRWA Total risk-weighted assets UNCITRAL United Nations Commission on International Trade Law UNDP United Nations Development Programme USD U.S. dollars VAR Value-at-risk VAT Value-added tax WOCCU World Council of Credit Unions xix Preface The experience of many countries around the world clearly shows that while financial sector development can spur economic growth, financial fragility and instability can seriously harm growth. Following the financial crises of the late 1990s, there has been increasing interest in the systematic assessment of the strengths and weaknesses of finan- cial systems, with the ultimate goal of formulating appropriate policies to foster financial stability and stimulate financial sector development. The Financial Sector Assessment Program (FSAP), a joint World Bank­IMF program introduced in 1999, represents a response to this demand for systematic assessments. The emergence of various financial sector Standards and Codes and the associated Reports on Observance of Standards and Codes (ROSCs) are further examples of the increased focus on financial sector assess- ments. Consequently, there has been an increased demand from financial sector authorities in many countries, as well as from World Bank and IMF staff for information on key issues and sound practices in the assessment of financial systems and in the design of policy responses. This Handbook of Financial Sector Assessment is a response to this demand. The Handbook presents an overall analytical framework for assessing financial system sta- bility and developmental needs, providing broad guidance on approaches, methodologies, and techniques of assessing financial systems. Although the Handbook draws substantially on World Bank and IMF experience with the FSAPs and from the broader policy and operational work in both institutions, it is designed for generic use in financial sector assessments, whether conducted by country authorities themselves, or by World Bank and IMF teams. It is, therefore, our hope that the Handbook will serve as an authoritative source on the objectives, analytical frame- work and methodologies of financial sector assessments as well as a comprehensive refer- ence book for training on the techniques of such assessments. The Handbook was prepared under the general oversight of Messrs. Alexander E. Fleming (Sector Manager, Finance and Private Sector Division, World Bank Institute), Tomás J. T. Baliño (Deputy Director, Monetary and Financial Systems Department, IMF), and Larry Promisel (former Director, Financial Sector Global Partnership, World Bank). xxi It is the product of intense collaboration among a large number of staff and experts from both the World Bank and the IMF (primary contributors are listed on the next page). The design, drafting, and editing of the Handbook was coordinated by a team consisting of Mr. V. Sundararajan (Lead Project Consultant, Centennial Group Holdings and former Deputy Director, IMF), Mr. Abayomi A. Alawode (Senior Financial Sector Specialist, World Bank Institute), Mr. Mathew Jones (Senior Economist, IMF), and Mr. Martin Cihák (Economist, IMF). We wish to thank the entire team for their valuable efforts in bringing this project to fruition. Cesare Calari Stefan Ingves Vice-President Director Financial Sector Network Monetary and Financial Systems Department World Bank International Monetary Fund Contributors Lead Project Consultant: Mr. V. Sundararajan, Lead Project Consultant, Centennial Group Holdings and former Deputy Director, IMF World Bank Contributors: Rawan Abdelrazek, Ernesto Aguirre, Abayomi A. Alawode, Nagavalli Annamalai, Mehmet Can Atacik, Thorsten Beck, John Bruce, Alexander E. Fleming, Felice Friedman, Joselito Gallardo, Eric Haythorne, Patrick Honohan, Gordon Johnson, Peter Kyle, Margaret Miller, Bikki Randhawa, Dory Reiling, Paul Allan Schott, Vijay Tata, Craig Thorburn, and Fatouma Ibrahima Wane IMF Contributors: Greta Mitchell Casselle, Martin Cihák, Peter Clark, R. Sean Craig, Nigel Davies, Paulus Dijkstra, Jennifer Elliot, Gilda Fernandez, Mats Filipson, Eva Gutierrez, Geoffrey Heenan, Socorro Heysen, Matthew Jones, Cem Karacadag, Elias Kazarian, Richard Lalonde, Michael Moore, Aditya Narain, Obert Nyawata, Thordur Olafsson, Eric Parrado, Marc Quintyn, Michael Taylor, In Won Song, Kalin Tintchev, Jan-Willem van der Vossen, and Jan Woltjer xxiii 1 Chapter 1 Financial Sector Assessments: Overall Framework and Executive Summary 1.1. Introduction The design of policies to foster financial system stability and development has become a key area of focus among policy makers globally. This policy focus reflects the growing evidence that financial sector development can spur economic growth whereas financial instability can significantly harm growth and cause major disruptions, as was seen in the financial crises of the 1980s and 1990s (World Bank 2001).This focus also reflects the recognition that close two-way linkages between financial sector soundness and per- formance, on the one hand, and macroeconomic and real sector developments, on the other hand, need to be considered when designing macroeconomic and financial policies. Moreover, although the development and international integration of financial systems can strengthen access to foreign capital and can promote economic growth, there is a risk of cross-border spillovers of financial system disturbances. Effective surveillance of national financial systems, along with a harmonization and international convergence of key components of financial policies, will help minimize those types of risks and will pro- mote orderly development of the financial system. Thus, financial stability considerations and financial sector development policies are intrinsically interlinked. Recognizing the need for stronger policies to foster financial stability and development, several entities around the world, including national authorities, multilateral development agencies, regional development institutions, and various standard-setting bodies are focus- ing on further developing the tools and methodologies of financial sector analysis and assess- ments. The purposes of those tools have been to monitor financial system soundness and developments, to analyze the linkages between the financial sector and the macro-economy, to assess the effectiveness of various aspects of monetary and financial policies, and to pro- 1 Financial Sector Assessment: A Handbook 1 Box 1.1 Financial Sector Assessment Program (FSAP)--A Chronology The program was developed by the World Bank and First review of FSAP, December 13, 2000 2 the International Monetary Fund to help strengthen (Fund), and January 2001 (Bank). Bank and financial systems in the context of IMF's bilateral Fund Boards conducted a review of experience with 3 surveillance and World Bank's Financial Sector devel- the FSAP and established guidelines for the con- opment work. In consultation with the Bank's regions tinuation of the FSAP program for the period ahead; and the Fund's area departments, the World Bank­ sought priority for systemically important countries 4 Fund Financial Sector Liaison Committee (FSLC)a in any one year while maintaining broad country coordinated the initial development of the program coverage; affirmed the value of the Financial System and later has helped manage the program. The FSLC Stability Assessment (FSSA) reports prepared by the 5 has held several outreach meetings on FSAP with FSAP teams as "the preferred tool for strengthen- concerned country authorities and sought regular ing the monitoring of financial systems under the feedback on the program from participating countries Fund's bilateral surveillance"; and suggested that 6 to adapt the program to country needs and to use the Bank and Fund staff members should ensure that feedback as input into various Board reviews of the FSAP assessments are reflected in other aspects of 7 programs. country programming, including appropriate techni- cal assistance. Pilot program launch on May 1999. The man- 8 agements of the Bank and the Fund inform the Second review of FSAP, March­April 2003. Boards that they have decided to launch jointly, on Bank and Fund Boards conducted a comprehen- a pilot basis, the IMF­World Bank Financial Sector sive review of the FSAP and provided guidance in 9 Assessment Program. streamlining the program; achieving greater selec- tivity and flexibility in the scope and pace of the Interim Board discussion of the pilot program, program; broadening the range of tools of financial 10 September 1999. Bank and Fund Boards discussed sector surveillance that complement FSAP; increas- an interim report on FSAP summarizing the early ing the focus on medium-term and structural issues experience of the pilot. Directors provided guid- in low-income countries, with a greater role for the 11 ance on scope and procedures of the pilot. The World Bank in those countries; and including the International Monetary and Financial Committee anti-money-laundering and combating the financing and Development Committee express support for the 12 of terrorism (AML­CFT) assessments in all FSAPs. program in their fall 1999 communiqués. Third review of FSAP, February­March 2005. Comprehensive Board review of the pilot, March Bank and Fund Boards reviewed the developments A 2000. Bank and Fund Boards conducted a compre- in the program since the last review, acknowledged hensive review of the progress and lessons of the FSAP the value of the program, and broadly endorsed the pilot. Both Boards agreed to continue and expand the B ongoing efforts to strengthen and refine the pro- program and provided preliminary guidance on how gram, pending the upcoming further reviews of the to develop further the FSAP. Guidance covered the FSAP by the Fund's Independent Evaluation Office, scope and pace of the program, links to IMF surveil- C and the Bank's Operations Evaluation Department, lance and technical assistance, relationship to assess- whose recommendations will be considered by the ments of standards, confidentiality considerations, Boards later. D and publication and circulation procedures. Many Bank-Fund documents relating to the FSAP Program update, September 2000, and a joint are available on the Web sites of the IMF (http:// technical briefing on FSAP to both Boards, December E www.imf.org/external/np/fsap/fsap.asp) and of the 7, 2000. An update of the program was provided to World Bank (http://www.worldbank.org/finance/fsap. both Boards. The co-chairs of FSLC provided a joint html). For details on the March 2005 review of the F technical briefing for Bank and Fund Boards on the FSAP by the Bank and the Fund Boards of Directors, procedures and progress of the program in preparation see IMF and World Bank 2005. for a comprehensive program review. G a. The World Bank­Fund Financial Sector Liaison Committee was established in September 1998 by the Boards of the two H institutions to improve coordination of Bank and Fund operations related to financial sector stability and development. Among other things, the FSLC helps to coordinate country selection for FSAPs, organizes Bank-Fund teams for FSAPs, and builds consensus on various procedural and policy matters related to financial sector assessment. The activities of the FSLC I are reported in periodic progress reports. The FSLC has issued guidance on various FSAP procedures. 2 Chapter 1: Financial Sector Assessments: Overall Framework and Executive Summary mote harmonization and international convergence of key financial policy areas. Those 1 developments have increased the demand for guidance on good practices in conducting financial sector assessments and in designing appropriate policy responses. 2 In response, this Handbook presents a general analytical framework as well as specific techniques and methodologies for assessing the overall stability and development needs of financial systems in individual countries and for designing policy responses. The stabil- 3 ity and state of development of a financial system depend on a broad range of structural, institutional, and policy factors that operate through two channels. First, they affect the 4 attitude of the private sector toward risk taking, the scope and reach of financial services, and the quality of financial sector governance. Second, they influence the effectiveness 5 of financial policies in fostering sound and well-functioning financial institutions and markets. Those considerations are reflected in the organization of the Handbook, which 6 is explained more fully in section 1.2 below. The Handbook draws particularly on the World Bank­IMF experience in conducting 7 the Financial Sector Assessment Program (FSAP) and on the broader operational and policy development work on financial systems in both institutions. The World Bank and 8 the IMF introduced the FSAP in May 1999 to monitor and help strengthen financial sys- tems in the context of IMF's bilateral surveillance and of the World Bank's financial sector 9 development work and has since become a regular part of Bank and Fund operations (see box 1.1 for a chronology of the FSAP). The FSAP has been built on a range of analytical 10 techniques and assessment tools developed in the IMF, World Bank, Bank for International Settlements (BIS), international standard-setting bodies, and national authorities. 11 Appendix A at the end of this Handbook presents an overview of the current procedures for conducting FSAPs, updates, and follow-up work, including the preparation of relevant Reports on Observance of Standards and Codes (ROSCs) in the financial sector. 12 A key purpose of this Handbook is to help country authorities to conduct their own assessments of the soundness, structure, and development needs of the financial system. A It also can be useful for Bank-Fund teams preparing for FSAP assessments and for country authorities preparing for the Bank-Fund assessments under the FSAP. It is not an expert's B handbook designed to provide detailed guidance to sectoral specialists. It is mainly designed to provide broad guidance on methodology and policy design to policy makers, C team leaders, and specialists in one sector who are seeking background information on issues and topics in other related areas of assessment work. Detailed guidance for special- D ist assessors is available from standard-setting bodies and other sources that are referred to in the text. E 1.2. Overall Analytical and Assessment Framework-- F Executive Summary G This section provides the overall analytical framework for financial sector assessments, H motivates the structure of the Handbook in terms of this framework, explains how the subsequent chapters fit into the overall framework, and presents a high-level summary of I those chapters as a broad guide to policy makers and assessment teams. 3 Financial Sector Assessment: A Handbook The objective of financial sector assessments is to achieve an integrated analysis of 1 stability and development issues using a wide range of analytical tools and techniques that include the following: 2 · Macroprudential analysis, including stress testing, scenario analysis, and analysis of 3 financial soundness indicators and of macrofinancial linkages · Analysis of financial sector structure, including analysis of efficiency, competitive- ness, concentration, liquidity, and access 4 · Assessment of observance and implementation of relevant international standards, codes, and good practices in the financial sector 5 · Analysis of specific stability and development issues tailored to country circum- stances (e.g., role of public financial institutions, effect of dollarization, reasons for 6 low access or underdeveloped securities markets, etc.) 7 A broad definition of financial stability and development is used in the assessments. Financial stability refers to (a) an environment that would prevent a large number of financial institutions from becoming insolvent and failing and (b) conditions that would 8 avoid significant disruptions to the provision of key financial services such as deposits and investments for savers, loans and securities to investors, liquidity and payment services 9 to both, risk diversification and insurance services, monitoring of the users of funds, and shaping of the corporate governance of non-financial firms. Financial development is 10 a process of strengthening and diversifying the provision of those services to meet the requirements of economic agents in an effective and efficient manner and thereby sup- 11 port, as well as stimulate, economic growth. Such broad definitions imply that the extent of financial stability can vary from a situation of severe instability to one of sustained 12 overall stability; similarly, the scope of financial development also can vary from being broad based and balanced, covering several financial sector functions and sectors, to A being narrowly focused on a specific function or sector. Moreover, overall financial system development could be orderly, with smooth exit and entry of financial service providers B and with limited or no interruptions to the provision of financial services and to the real economy, or it could be disorderly, marked by bouts of financial instability and real eco- nomic disruption. C The complementarities and tradeoffs between financial stability and development need to be carefully considered in the assessment process. Policies to foster financial D stability also support orderly financial development, illustrating the fundamental comple- mentarities between financial stability and development. Nevertheless, in specific con- E texts, the assessors have to weigh the benefits of stability policies in terms of increased soundness and containment of risks with the costs of regulatory compliance and with the F possible side effects of prudential regulations on market functioning and access. Similarly, policies to foster financial development necessarily involve some increase in both mac- G roeconomic and financial risks, which need to be managed. Thus, promoting an orderly process of financial development with stability necessarily involves a proper sequencing H and coordination of a range of financial policies. In line with the broad definitions, a sound and well-functioning financial system is I viewed as comprising three pillars that make up the major policy and operational compo- nents that are necessary to support orderly financial development and sustained financial 4 Chapter 1: Financial Sector Assessments: Overall Framework and Executive Summary stability; the three pillars outlined in the following list also constitute the basis of the 1 assessment framework. · Pillar I--Macroprudential surveillance and financial stability analysis by the 2 authorities to monitor the impact of potential macroeconomic and institutional factors (both domestic and external) on the soundness (risks and vulnerabilities) 3 and stability of financial systems · Pillar II--Financial system supervision and regulation to help manage the risks 4 and vulnerabilities, protect market integrity, and provide incentives for strong risk management and good governance of financial institutions.1 Good practices in 5 most areas of financial system supervision and regulation are reflected in various international standards and codes and the related assessment methodologies; for 6 some areas of supervision and regulation such as microfinance institutions, agreed international standards do not yet exist. · Pillar III--Financial system infrastructure: 7 ­ Legal infrastructure for finance, including insolvency regime, creditor rights, 8 and financial safety nets ­ Systemic liquidity infrastructure, including monetary and exchange operations; 9 payments and securities settlement systems; and microstructure of money, exchange, and securities markets 10 ­ Transparency, governance, and information infrastructure, including monetary and financial policy transparency, corporate governance, accounting and audit- ing framework, disclosure regime and market monitoring arrangements for 11 financial and non-financial firms, and credit reporting systems 12 Those elements of financial system infrastructure constitute the preconditions for effective supervision and regulation that contribute to stability and serve as the foun- A dations for adequate access to financial services and sustained financial development. Again, international standards and guidelines exist to highlight good practices in some B areas of infrastructure design (e.g., payment and settlement systems, monetary and finan- cial policy transparency) but not in other areas (e.g., deposit insurance, design of market C microstructure). Elements within all three pillars support both development and stability. The infor- mation base for the technical analysis needed for stability assessments and that which is D needed for development assessments overlap and provide a common analytical platform for the prioritizing and sequencing of financial sector policy measures. The overall ana- E lytical framework for those assessments and the way it is reflected in the organization of the Handbook are described in the following paragraphs. F The first step in the assessment process outlined in the Handbook is to compile a set of key indicators of financial structure, soundness, and state of development of the sector. G Chapter 2 provides guidance on key system-wide and sectoral indicators of structure and soundness, including core and encouraged financial soundness indicators (FSIs), market- H based indicators of financial soundness, and indicators of access. Key data sources for those indicators are explained in appendix C. The precise scope and content of needed I data will be country specific to reflect their structural and institutional circumstances. 5 Financial Sector Assessment: A Handbook Nevertheless, chapter 2 seeks to present and motivate some generally useful indicators; 1 more-detailed listing of the sort of quantitative data that may be collected for financial sector assessments are shown in appendix B. Detailed analysis of and processes to deter- 2 mine benchmarks for those indicators is needed to assess financial stability and develop- ment. Chapters 3 and 4 form the core of the analytical framework needed for this kind of 3 an integrated assessment, with all other chapters, in effect, providing the specific building blocks for the assessment. 4 Chapter 3 presents the overall framework of financial stability assessment, which consists of the analysis and assessment of financial sector soundness and its economic 5 and institutional determinants. It encompasses not only quantitative analysis of risks and vulnerabilities but also qualitative assessments of the institutional capacity and financial 6 infrastructure that help manage the risks. The quantitative analysis typically involves monitoring at a suitable level of aggregation; analyzing the economic and institutional 7 determinants for a range of financial soundness indicators (FSIs) of banks, of key non- bank financial sectors, and of relevant non-financial sectors; and examining the impact of various plausible, but exceptional, macroeconomic and institutional shocks on the 8 financial soundness indicators. This type of monitoring and analysis of FSIs--referred to as macroprudential surveillance--includes testing stress levels of the system in response 9 to plausible shocks, which helps identify the key sources of risks and the vulnerabilities to various risk factors. Macroprudential surveillance also encompasses (a) a surveillance 10 of financial markets that helps assess likelihood of economic shocks and (b) an analysis of macro-financial linkages that focuses on the extent to which shifts in financial sound- 11 ness may itself affect macroeconomic and real sector developments. This combination of approaches captures the two-way linkages between the macroeconomy and financial 12 soundness in formulating an overall stability assessment. In addition, analysis should consider the linkages of domestic financial markets to global markets and the extent to A which government policies with respect to taxes, subsidies, monetary and exchange policy regime, and so forth generally affect market discipline and risk taking. B The above analysis should be complemented by information from qualitative assess- ments of effectiveness of financial sector supervision (Pillar II), and of the robustness of financial sector infrastructure (Pillar III). Such qualitative assessments help identify key C elements of the institutional framework and financial stability policies that would miti- gate the identified risks and vulnerabilities and thereby help formulate an overall finan- D cial stability assessment and identify key policies to foster stability. Chapter 3 motivates and explains the tools of quantitative analysis noted above, including system-wide stress E testing of the financial system (elaborated in appendix D), and illustrates how qualitative information on financial supervision and infrastructure can complement the quantitative F analysis. Chapter 4 presents the overall framework for financial structure and development G assessment. It consists of an assessment of the functioning of the financial sector, includ- ing its scope, concentration, efficiency, competition and adequacy of access, and its insti- H tutional and economic determinants. The chapter attempts to analyze the factors behind missing or underdeveloped services and markets, as well as the obstacles in the country I that prevent the provision of a broad range of financial services. The goal is to identify policy adaptations and structural changes in financial infrastructure, in supervision and 6 Chapter 1: Financial Sector Assessments: Overall Framework and Executive Summary regulation, in governance, and in the broader policy environment designed to strengthen 1 the contribution of the financial sector to economic growth and poverty reduction. This type of assessment involves both quantitative analysis of financial structure and qualita- 2 tive assessments of a range of institutional and financial policy factors affecting the struc- ture and performance of the sector. 3 The analysis will typically consider many of the factors already covered under financial stability analysis, notably, the qualitative assessments of key legal and institutional fea- tures. However, the analysis will go beyond stability issues and focus on the breadth and 4 efficiency of financial intermediation from a user perspective. Chapter 4 motivates and outlines the tools used in the quantitative benchmarking of financial structure and illus- 5 trates how developments in various dimensions of financial sector structure--efficiency, access, scope, and so forth­­can be analyzed. The chapter also provides an overview of 6 how those kinds of quantitative analysis can be combined with information from the qualitative assessments of legal and institutional infrastructure as well as from supervisory 7 regimes to formulate an overall development assessment and identify policies to enhance financial development. 8 Key steps in an integrated analysis and assessment of stability and development can be summarized as follows: 9 1. Assess conditions in the non-financial sector by analyzing financial soundness indica- 10 tors for those sectors and financial structure and access indicators. 2. Assess macroeconomic, sectoral and tax-subsidy policies affecting financial stability and development by analyzing macroeconomic forecasts, early warning indicators, finan- 11 cial market indicators, and tax and sectoral policy. This type of information typi- cally would be drawn from other sources such as local and external official sources 12 as well as data vendors and would help to form a view on the likelihood of shocks to the financial system from the broader economic environment and the way this A environment affects financial sector structure and functioning. 3. Assess financial system risks and vulnerabilities (a) by analyzing FSIs for banks, insur- B ance companies, the securities market, and key non-bank financial institutions (such as exposures to credit risk, market risk, liquidity risk, and operational risk as C well as availability of capital, earnings, and liquid assets that can be used to absorb risk); (b) by monitoring market-based indicators; and (c) by conducting stress tests. D The analysis in this step will draw on plausible shocks and linkages identified in steps 1 and 2 above. E 4. Assess financial sector structure and development needs, including its scope, competitive- ness, and access, by conducting quantitative benchmarking and analyzing structural F indicators and the data on access (survey-based data, if available). The above analysis will take into account macroeconomic and sectoral conditions affecting G financial development and access, drawing on analysis in steps 1 and 2 above. 5. Assess legal and institutional frameworks and operational effectiveness of financial poli- H cies, both financial supervision and financial infrastructure, including institutional and market development policies (Pillars II and III). This qualitative assessment I feeds into step 3 to design policies to foster overall financial stability. This qualita- 7 Financial Sector Assessment: A Handbook tive assessment also feeds into step 4 to formulate a program of reforms to foster 1 financial development. 2 Assessment of legal, institutional, and operational aspects of financial policies involves a wide range of tools, particularly, assessments of observance of international standards 3 and codes as well as of good practices relevant to a stable and well-functioning financial sector. The Handbook provides an overview of the scope, assessment methodology, and 4 assessment experience for those areas of financial supervision and financial infrastructure for which international standards, codes, and good practices exist. A list of international standards used in Bank-Fund operational work is listed in appendix A (box A.2) of the 5 Handbook. For areas of financial policies and institutional design where international standards do not exist, the Handbook provides an assessment framework drawing on good 6 practices identified in operational work and country experience. In some of the areas (e.g., public debt management, bank insolvency regimes, etc.), guidelines based on distillation 7 of country experiences are available. The principles, methodology, and lessons of experi- ence for assessing the legal, institutional, and operational frameworks are presented in 8 chapters 5­11 of the Handbook, and are summarized in the following paragraphs. Chapter 5 provides an overview describing the process for assessing the effectiveness 9 of financial supervision and regulation of banking, insurance, and securities markets. The assessments are based on the Basel committee's Core Principles for Effective Banking 10 Supervision (BCP); the International Association of Insurance Supervisors' Insurance Core Principles (ICP) and methodology ; and the International Organization of Securities 11 Commissions' Objectives and Principles of Securities Regulations. Those supervisory standards consist of a set of core principles that can be grouped into 12 four core components: · Regulatory governance--relating to the objectives, independence, enforcement A authority, and decision-making arrangements of the regulator · Regulatory practices--consisting of practical application of laws, rules, and proce- B dures · Prudential framework--referring to rules and guidance on internal controls and C governance of supervised entities · Financial integrity and safety net--dealing with policies and instruments to promote D fairness and integrity of operations of financial institutions and markets as well as safeguards of depositors, investors, and policy holders in times of stress and crises E Chapter 5 outlines the assessment methodology that provides detailed criteria--or practices--for each of the core principles. Those criteria can be compared with country F practices to identify significant gaps, if any, in the supervisory regime and to assess the materiality of the gaps from a stability or development perspective. In addition, assess- G ment of observance of each of the core principles will take into account the risk profile and sources of vulnerability of the sector as well as the robustness of infrastructure compo- H nents (such as accounting and auditing, payments system, insolvency regime) that serve as preconditions for effective supervision. Chapter 5 also explains the basic coverage of I legal and institutional frameworks for financial supervision and outlines key issues in designing institutional arrangements for supervision (see appendix F). Special attention is 8 Chapter 1: Financial Sector Assessments: Overall Framework and Executive Summary paid to elements of financial safety nets consisting of liquidity support, deposit insurance 1 and policyholder-investor's protection, and crisis management arrangements, including the bank insolvency regime (see appendix G). The chapter also summarizes the main 2 areas of weakness identified in many recent assessments, for example, weak independence and weak legal protection for banking supervisors, weak organization of the supervisory agency and weak supervision of asset risk management in insurance, lack of authority to 3 investigate and the limited enforcement mandate in securities regulation, and weak cor- porate governance of financial institutions. 4 Chapter 6 and chapter 7, respectively, discuss assessing regulatory frameworks for other financial institutions (specialized financial institutions and pension funds) and for rural 5 and microfinance institutions. The sectoral and regional significance of many specialized financial institutions (such as housing finance, leasing and factoring companies) and 6 the key role of pension funds in asset allocation and capital markets call for risk-focused and well-tailored regulation that is proportionate and consistent with costs and benefits. 7 Those considerations and the special supervisory issues that arise in leasing, factoring, and pension fund industry are discussed in chapter 6. The provision of financial services 8 to the poor and very poor, particularly those in rural areas, is the purpose of microfinance institutions (MFIs), and the assessment of the regulatory framework for MFIs is part of a 9 broader assessment of adequacy of access. Chapter 7 explains the rationale and scope of regulation of various categories of MFIs as well as the elements of a regulatory framework 10 that are consistent with the MFI functions, risk profile, and operational characteristics. Chapter 8 considers issues in assessing financial system integrity based on the 11 Financial Action Task Force's (FATF) recommendations for the anti-money-laundering and countering the financing of terrorism (AML­CFT) regime. This chapter covers the 12 scope and coverage of AML­CFT standards, preconditions for effective implementation of those standards, the content of assessment methodology, recent assessment experience, A and special topics in AML­CFT assessments such as customer due diligence, financial intelligence units, and scope of UN conventions and Security Council Resolutions. Chapter 9 discusses key components of the legal infrastructure for the effective opera- B tion of financial markets. The legal framework for the financial sector is wide ranging, covering the overall governance and rule of law, laws governing financial infrastructure, C and sector-specific laws. It includes the legal framework that empowers and governs the regulator and the rules for the regulation of various institutions and markets as well as the D broader legal framework that governs insolvency and the creditor rights regime, owner- ship, contracts, contract enforcement, accounting auditing and disclosure, and formation E of trusts and asset securitization. A review of the overall legal framework should cover both groups of laws. In particular, central banking law, legal foundations of payment F system functioning, and government debt management should be reviewed together with the laws governing banking, insurance, and capital markets to ensure that a sound legal G basis for macroeconomic policies is available to support stable financial markets. In addi- tion, an overview of company laws, other corporate governance laws, consumer protec- H tion laws, and land laws are also important for good governance of financial institutions. Finally, the World Bank's Principles and Guidelines for Effective Insolvency and Creditor I Rights regime can help assess enforcement systems for secured and unsecured credit, leg- 9 Financial Sector Assessment: A Handbook islative procedures for liquidation and rescue (restructuring), procedures for debt recovery 1 and informal workout practices, and mechanisms for carrying out legal procedures. Chapter 10 contains an overview describing key components of information and 2 governance infrastructure for finance and explains their role in both financial develop- ment and effective market discipline. Those infrastructure components refer to the legal 3 and institutional arrangements that affect the quality, availability, and transparency of information on monetary and financial conditions and policies at various levels as well 4 as the incentives and organizational structures to set and implement policies by regula- tors, regulated institutions, and their counterparts. The components of this infrastructure 5 consist of the following: 6 · The framework for Monetary and Financial Policy Transparency, assessed using International Monetary Fund's Code of Good Practices on Transparency of Monetary 7 and Financial Policies (chapter 10, section 10.1) · The accounting and auditing framework that helps to define and validate the 8 information that is disclosure, assessed according to International Financial Reporting Standards and International Standards for Auditing (chapter 10, section 10.2) 9 · Credit reporting and financial information services designed to compile, process, and share information on financial conditions and credit exposures of borrowers 10 and other issuers of financial claims (chapter 10, section 10.3) · Corporate governance arrangements for financial and non-financial firms, which are 11 assessed according to Organisation for Economic Co-operation and Development (OECD)'s Principles of Corporate Governance and which take into account spe- 12 cial considerations that apply to corporate governance of banks and other financial institutions (chapter 10, section 10.4) A · Disclosure practices of financial institutions, determined by the supervisory frame- work, listing requirements and company laws, which are assessed, in part, accord- B ing to the disclosure standards under the New Basel Accord (chapter 10, section 10.5) C Chapter 11 presents a framework for assessing systemic liquidity infrastructure. This framework refers to a set of institutional and operational arrangements that have a first- D order impact on market liquidity and on the efficiency and effectiveness of liquidity man- agement by financial firms. Key elements of this infrastructure consist of the following: E · Design and operation of payments and settlement systems as well as securities F settlement systems, which are assessed according to the Committee on Payment and Settlement Systems' (CPSS's) Core Principles of Systemically Important Payment G Systems, and International Organization of Securities Commissions (IOSCO)­ CPSS Recommendations for Securities Settlement Systems (chapter 11, section 11.1) H · Design of monetary policy instruments as well as procedures for money and exchange markets operations, which are analyzed from the perspective of their I impact on money market liquidity and on banks' ability to manage short-term liquidity (chapter 11, section 11.2) 10 Chapter 1: Financial Sector Assessments: Overall Framework and Executive Summary · Microstructure of money, exchange, and securities markets consisting of trading 1 systems, price discovery mechanisms, and other institutional determinants of mar- ket liquidity and efficiency (chapter 11, section 11.3) · Public debt and foreign exchange reserve management strategies and opera- 2 tions, which are analyzed according to IMF­World Bank Public Debt Management Guidelines and IMF's Foreign Exchange Reserve Management Guidelines; both guide- 3 lines are supplemented by supporting documents that summarize country experi- ences (chapter 11, section 11.4) 4 Chapter 12 provides guidance on sequencing of financial sector reforms. The subject of sequencing of reforms deals with factors that should be considered when setting priorities 5 among a multitude of policy, institutional, and operational reforms that have been identi- fied in a financial sector assessment exercise. Appropriate sequencing and coordination 6 of reforms will facilitate implementation of reforms in support of financial development while avoiding financial instability that could arise from inappropriate sequencing. Thus, 7 appropriate sequencing is an important aspect of financial sector assessments. Although the assessment framework outlined above is comprehensive, a tailoring 8 of assessments is necessary to reflect country-specific circumstances such as those men- tioned in Annex 1.A. Countries with less developed systems will need more attention 9 to medium-term development issues such as institution building and financial market development. Governance, transparency, and legal issues are often at the core of underde- 10 veloped financial systems. In countries that are systemically important, particular atten- tion to contagion and cross-border issues as well as the consequences of globalization and 11 consolidation may be required. Countries also differ in structural features such as extent of dollarization, scope of state-owned financial institutions, the scale of foreign-owned banks, degree of vulnerability to shocks, and the level of market discipline and quality 12 of internal governance. Those differences will affect the assessment priorities, design of policies, and the sequencing of reforms and policy measures. A Annex 1.A Tailoring Financial Sector Assessment to Country Needs B C Countries with less-developed financial systems may need more attention with respect to medium-term development issues such as institution building and financial market D development. Coverage of the financial sector in those countries may thus need to focus on specific aspects of financial sector development, including capacity of banking super- vision; the legal and regulatory framework for bank and non-bank institutions and pay- E ment systems; credit information systems, enforcement of creditor rights, and insolvency regimes; accounting and auditing practices and disclosure rules; the status of the central F bank and monetary policy implementation; and bank restructuring. Also, an analysis of factors explaining why markets are missing can help to identify the important structural G and capacity building needs for the country. Systemically important countries need attention to contagion and cross-border issues. H Countries particularly vulnerable to a rapid increase in competition from foreign financial institutions may need particular attention with respect to (a) the appropriate sequencing I of liberalization, including institutional preconditions, and (b) the ability of domestic 11 Financial Sector Assessment: A Handbook incumbents to withstand more intense competition. Of particular note are countries par- 1 ticipating in new free-trade arrangements or undertaking substantive financial services commitments in the World Trade Organization. Those types of agreements may facilitate 2 the cross-border provision of services or the establishment of subsidiaries and branches. Countries may commit to dispute settlement provisions and to constraints on their 3 recourse to capital controls. In those cases, emphasis might be placed on (a) the capacity of the regulatory authorities to conduct cross-border consolidated supervision of financial 4 institutions; (b) the conditions that might lead to an unsustainable buildup of short-term financial flows; (c) the dependence of local incumbents, including public service banks, 5 on fee-based and large-customer business that may be particularly vulnerable to foreign competition; and (d) any systemic vulnerabilities that may result from their failure. 6 In many countries, dollarization poses unique financial risks that need to be addressed. Where available, assessors should provide supporting quantitative information such as 7 shares of foreign currency deposits and loans, the degree of cocirculation, short-term foreign assets and liabilities of the main financial institutions, net foreign assets, and net open foreign currency positions of banks (Gulde and others 2003). 8 In non-crisis countries with significant financial distress where a large share of banks (or insurance companies or other financial institutions) are undercapitalized and under- 9 performing, the assessors will have to focus on vulnerabilities to various plausible shocks and to resolution measures.2 Vulnerabilities could be detected through stress testing and 10 estimation of likely macroeconomic consequences. In case a macroeconomic shock were to occur, sufficiently rapid financial restructuring could avert a crisis. This reasoning sug- 11 gests that the focus of assessment should be on measures to restore normalcy and imple- mentation of resolution strategies, including contingency planning and structural reforms 12 that could bolster the capacity for restructuring and liquidation of banks and non-banks. In cases such as those, FSIs would need to be carefully interpreted, possibly until excep- A tional resolution arrangements have run their course and normalcy has been fully restored (Hoelscher and Quintyn 2003). B In countries that are part of a currency union, assessors would have to be sensitive to the division of supervisory responsibility between the national and the supranational level (Van Beek and others 2000). In particular, supervisory responsibilities for financial C institutions may reside at the national level with varying degrees of harmonization of rules and practices such as loan classification and provisioning as well as licensing and other D entry requirements. The degree of control over cross-border transactions in relation to third countries may also differ. By contrast, monetary­exchange rate policy functions in E those cases are performed at the supranational level, creating the potential for ambiguities about lender of last resort and crisis resolution arrangements. F In countries with significant presence of Institutions offering Islamic Financial Services (IIFS), assessors would need to consider whether the supervisory framework is adequately G adapted to address the specific risk characteristics of IIFS. Risks in IIFS may differ from those in conventional finance because of the contractual design of instruments based on H Islamic Law (Sharia'a), and the overall infrastructure governing Islamic finance. In the absence of adequate institutional infrastructure and effective risk mitigation, IIFS may be I more vulnerable than conventional institutions for a range of risks (operational, liquidity, and market risk--including commodity prices). Where available and appropriate, asses- 12 Chapter 1: Financial Sector Assessments: Overall Framework and Executive Summary sors should also provide quantitative information on the size of the industry; the share of 1 Islamic modes of financing; and FSIs on capital, non-performing loans, provisioning, and earnings for Islamic banks. The definitions of those variables would need adjustments to reflect the specific accounting treatments of Islamic financial contracts. Although some 2 guidance is available in the IMF's Compilation Guide on Financial Soundness Indicators (International Monetary Fund 2004), work in this area is evolving. 3 4 Notes 5 1. For the purposes of the Handbook, a narrow definition of market integrity is used mainly to cover anti-money-laundering initiatives and efforts to counter the financ- 6 ing of terrorism. A broader concept also will cover transparency and governance ele- ments. 7 References and Other Sources 8 Gulde, Anne-Marie, David S. Hoelscher, Ize Alain, David Marston, and Gianni De 9 Nicolo. 2003. Financial Stability in Dollarized Economies. IMF Occasional Paper 230. Washington, DC: International Monetary Fund. 10 Hoelscher, David S., and Marc Quintyn. 2003. Managing Systemic Banking Crises. IMF Occasional Paper 224. Washington, DC: International Monetary Fund. 11 IMF (International Monetary Fund). 2004. Compilation Guide on Financial Soundness Indicators. Washington, DC: International Monetary Fund. Available on the IMF exter- nal Web site: http://www.imf.org/external/np/sta/fsi/eng/2004/guide/appendx.pdf. 12 IMF (International Monetary Fund), and World Bank. 2005. "Financial Sector Assessment Program--Review, Lessons, and Issues Going Forward." Papers prepared for the IMF A and World Bank Board Review. Washington, DC: International Monetary Fund. Available at http://www.imf.org/External/np/fsap/2005/022205.htm. B Lindgren, Carl-Johan, Tomás J. T. Baliño, Charles Enoch, Anne-Marie Gulde, Marc Quintyn, and Leslie Teo. 2000. Financial Sector Crisis and Restructuring­­Lessons from C Asia. IMF Occasional Paper 188. Washington, DC: International Monetary Fund. Van Beek, Frits, José Roberto Rosales, Mayra Zermeño, Ruby Randall, and Jorge Sheph. D 2000. The Eastern Caribbean Currency Union-Institutions, Performance, and Policy Issues. IMF Occasional Paper 195. Washington, DC: International Monetary Fund. E World Bank. 2001. Finance for Growth, Policy Choices in a Volatile World. New York: Oxford University Press. F G H I 13 2 Chapter 2 Indicators of Financial Structure, Development, and Soundness This chapter presents an overview of quantitative indicators of financial structure, devel- opment, and soundness. It provides guidance on key system-wide and sectoral indicators, including definitions, measurement, and usage. Key data sources for these indicators are explained in appendix C (Data Sources for Financial Sector Assessments). Detailed analysis and benchmarking of these indicators are discussed in chapters 3 and 4. More detailed data requirements are presented in appendix B (Illustrative Data Questionnaires for Comprehensive Financial Sector Assessments). 2.1 Financial Structure and Development Indicators of financial structure include system-wide indicators of size, breadth, and composition of the financial system; indicators of key attributes such as competition, concentration, efficiency, and access; and measures of the scope, coverage, and outreach of financial services. 2.1.1 System-wide Indicators Financial structure is defined in terms of the aggregate size of the financial sector, its sectoral composition, and a range of attributes of individual sectors that determine their effectiveness in meeting users' requirements. The evaluation of financial structure should cover the roles of the key institutional players, including the central bank, commercial and merchant banks, savings institutions, development finance institutions, insurance compa- nies, mortgage entities, pension funds, and financial market institutions. The functioning of financial markets, including money, foreign exchange, and capital markets (including 15 Financial Sector Assessment: A Handbook bonds, equities, and derivative and structured finance products) should also be covered. 1 For financial institutions, the structural overview should focus on identifying the number and types of institutions, as well as growth trends of major balance sheet aggregates; for 2 financial markets, a description of the size and growth trends in various financial market instruments (volume and value) would be appropriate. The overview should also reflect 3 new linkages among financial markets and institutions that may be forged from a variety of sources, including innovations in financial instruments, new entrants into financial 4 markets (e.g., hedge funds), and changing practices among financial market participants (e.g., energy trading and investments by financial institutions). 5 The overall size of the system could be ascertained by the value of financial assets, both in absolute dollar terms and as a ratio of gross domestic product (GDP).1 Although 6 identifying the absolute dollar amount of financial assets is informative, normalizing financial assets on GDP facilitates benchmarking of the state of financial development 7 and allows comparison across countries at different stages of development. Other indica- tors of financial size and depth that could be usefully examined include ratios of broad money to GDP (M2 to GDP),2 private sector credit to GDP (DCP to GDP),3 and ratio 8 of bank deposits to GDP (deposits/GDP). However, one should be careful in interpret- ing observed ratios because they are substantially influenced by the state of financial 9 and general economic development in individual countries. Cross-country comparisons of economies at similar stages of development are, therefore, useful in obtaining reliable 10 benchmarks for "low" or "high" ratios. The description of the number and types of financial intermediaries and markets is 11 also useful, and this information should be supplemented by information on the relative composition of the financial system. Even though many countries do have a wide range 12 of non-bank financial intermediaries (NBFIs), banking institutions still tend to dominate overwhelmingly. In advanced markets and in many emerging markets, NBFIs, particularly A pension funds or insurance companies, often play a larger part than do banks in domestic and global asset allocation (and, sometimes, in the providing of credit). Similarly, market B participants such as hedge funds play an increased role in financial markets and in the per- formance of various asset classes. Hence, for one to get a true view of financial structure, it is useful to focus on the share of various sub-sectors (banks, non-banks, financial markets, C etc.) in total financial assets by using assets of financial institutions in different sub-sectors and value of financial instruments in different markets as numerators. This type of focus D on market shares enables the assessor to get a quick indication of the "effective" structure of the financial system. In addition, the presence of large financial conglomerates--also E referred to as large and complex financial institutions (LCFIs)--in the domestic market (either foreign-owned or domestic) would warrant special attention to the scope and scale F of their activities, including exposures to other domestic institutions, as well as to intra- group and cross-border exposures, to ascertain their local systemic importance.4 G Evaluating the overall growth of the financial system and of major sub-sectors is important, and valuable information could be obtained by examining changes in the H number and types of financial intermediaries, as well as the growth of financial assets in each sector over time, in both nominal and real terms. Although a description of trends I is informative, it is also critical to indicate the driving forces behind (a) observed chang- es in institutions and their asset positions, and (b) the number of and growth rates of 16 Chapter 2: Indicators of Financial Structure, Development, and Soundness available money and capital market instruments. One factor that has accounted for the 1 observed growth of financial systems in many countries (number of institutions and size of assets) is financial liberalization, especially the softening of entry conditions for banks and other financial institutions and the liberalization of interest rates, which has stimu- 2 lated financial markets (especially money markets). In addition, changes in prudential regulation and accounting standards often have provided incentives for developing new 3 ways to manage risks (e.g., asset and liability management for insurance company and pension funds) and have led to development of new risk-transfer instruments in capital 4 markets. 5 2.1.2 Breadth of the Financial System 6 Data on the financial breadth or penetration often serve as proxies for access of the popu- lation to different segments of the financial sector. Well-functioning financial systems 7 should offer a wide range of financial services and products from a diversified set of finan- cial intermediaries and markets. Ideally, there should be a variety of financial instruments 8 that provide alternative rates of return, risk, and maturities to savers, as well as different sources of finance at varying interest rates and maturities. Evaluating the breadth or diver- sity of the financial system should, therefore, involve identifying the existing financial 9 institutions, the existing markets for financial instruments, and the range of available products and services. The relative composition of the financial system discussed above 10 is a first-cut approach to determining the extent of system diversification. In addition, comparisons between bank and non-bank forms of financial intermediation are useful, for 11 instance, comparisons between banking credit and issues of bonds by the private sector. Often, significant savings and financing through non-bank forms are indicators of finan- 12 cial diversity because bank deposits and loans constitute the traditional forms of savings and credit in many countries. It is, therefore, useful to compare the extent of financial A intermediation through banks with the amount of intermediation through insurance, pensions, collective investment schemes, money markets, and capital markets. In particu- B lar, the share of various classes of asset holders--specifically, households, non-financial corporations, banks, and NBFIs--within the total capital market instruments or mutual C fund assets can provide valuable information on financial diversification. To supplement the overall indicators of diversity, assessors should also focus on sec- D toral indicators of financial development. For instance, the development of the insurance industry could be measured by examining trends in the ratio of gross insurance premiums to GDP, which could be broken down further into life and non-life premiums. Similarly, E leasing penetration could be measured by the value of leased assets as a percentage of total domestic investment. Table 2.1 shows a few sub-sectors of the financial system and F suggests relevant indicators of their size and development. The breadth of the financial system also could be analyzed in terms of the outreach of existing financial institutions. A G common indicator related to this outreach is the branch network of the banking system, in particular, the total number of branches and the number of branches per thousand H inhabitants. A comparison of the distribution of branches between rural and urban areas or among different provinces could also be useful as an indicator of the outreach of bank- I ing outlets. 17 Financial Sector Assessment: A Handbook Table 2.1. Sectoral Indicators of Financial Development 1 Sub-sector Indicator 2 Banking · Total number of banks · Number of branches and outlets · Number of branches/thousand population · Bank deposits/GDP (%) 3 · Bank assets/total financial assets (%) · Bank assets/GDP (%) Insurance · Number of insurance companies 4 · Gross premiums/GDP (%) · Gross life premiums/GDP (%) · Gross non-life premiums/GDP (%) 5 Pensions · Types of pension plans · Percentage of labor force covered by pensions · Pension fund assets/GDP (%) 6 · Pension fund assets/total financial assets (%) Mortgage · Mortgage assets/total financial assets · Mortgage debt stock/GDP 7 Leasing · Leased assets/total domestic investment Money markets · Types and value of money market instruments 8 · New issues and growth in outstanding value · Number and value of daily (weekly) transactions in the instruments Foreign exchange markets · Volume and value of daily foreign exchange transactions 9 · Adequacy of foreign exchange (reserves in months of imports, as ratio to short-term external debt or to broad money) Capital markets · Number of listed securities (bonds and equities) 10 · Share of households, corporations, banks, and NBFIs in the holdings of securities · Number and value of new issues (bonds and equities) · Market capitalization/GDP (%) · Value traded/market capitalization (%) 11 · Size of derivative markets · Types and number of schemes (unique and mixed funds) · Total assets and growth rates (nominal and as percentage of GDP) 12 Colllective investment funds · Total number of investors and average balance per investor · Share of households, corporations, banks, and NBFIs, in total mutual funds assets A B 2.1.3 Competition, Concentration, and Efficiency Competition in the financial system can be defined as the extent to which financial C markets are contestable and the extent to which consumers can choose a wide range of financial services from a variety of providers. Competition is often a desirable feature D because it normally leads to increased institutional efficiency, lower costs for clients, and improvements in the quality and range of financial services provided. There are numer- E ous measures of competition, including the total number of financial institutions, changes in market share, ease of entry, price of services, and so forth. In addition, the degree of F diversity of the financial system could be an indicator of competition or the lack thereof because the emergence of vibrant non-bank intermediaries and capital markets often have G been a source of effective competition for banking systems in many countries. All things remaining equal, an increase in the number of financial institutions or an expansion in H available financial market instruments will increase competition by expanding the avail- able sources of financial services that consumers can access. Ease of entry into the system I could be judged by looking at the regulatory and policy requirements for licensing, for example, the required minimum paid-up capital. 18 Chapter 2: Indicators of Financial Structure, Development, and Soundness In many cases, the ownership structure of the financial system can be indicative of 1 competition or lack thereof. For instance, banks of different ownership often have dif- ferent mandates and clientele, leading to substantial market segmentation. Also, systems dominated by state-owned financial institutions tend to be less competitive than those in 2 which privately owned institutions are very active because state ownership often dampens commercial orientation. In some cases, the shares of domestic- and foreign-owned finan- 3 cial institutions in various financial sub-sectors could be relevant in assessing competition and incentives for financial innovations. 4 Measures of concentration often have been used as indicators of competition. Concentration is defined as the degree to which the financial sector is controlled by the 5 biggest institutions in the market (as defined by market shares). For example, the three- bank concentration ratio measures the market share of the top three banks in the system, 6 defined in terms of assets, deposits, or branches. Deciding what is concentrated and what is not depends a lot on judgment, and benchmarking becomes critical.5 A more sophisti- 7 cated measure of concentration is the Herfindahl Index (HI), which is the sum of squares of the market shares of all firms in a sector. Higher values of the index indicate greater 8 market concentration. When applied to the financial sector, this index uses information about the market share of each bank to obtain a single summary measure.6 The concept 9 of concentration also could be applied to financial markets, especially by examining the share of different market instruments in the total outstanding value of financial market instruments. For example, the relative shares of money and capital market instruments in 10 total financial assets could give an indication of the extent to which financial markets are positioned between short-term and long-term intermediation. Information on holdings of 11 the instruments by types of investors and by number of issuers of different instruments also helps assess market competition. 12 The sustainable development of a financial system and the degree to which it provides support to real sector activities depend to a large extent on the efficiency with which A intermediation occurs. Efficiency refers to the ability of the financial sector to provide high-quality products and services at the lowest cost. Competition and efficiency of the B financial system are related to a large extent because more competitive systems invari- ably turn out to be more efficient (all other things being equal). Quantitative measures C of efficiency that could be evaluated include (a) total costs of financial intermediation as percentage of total assets and (b) interest rate spreads (lending minus deposit rates). D Components of intermediation costs include operating costs (staff expenses and other overhead), taxes, loan­loss provisions, net profits, and so forth. Those costs can be derived from the aggregated balance sheet and income statements for financial institu- E tions. However, interest rate spreads sometimes remain high despite efficiency gains because of the need to build loan­loss provisions or charge a risk premium on lending to F high-risk borrowers. For money and capital markets, efficiency implies that current security prices fully G reflect all available information. Hence, in an efficient financial market, day-to-day movements of market prices tend to be random, and information on past prices would not H help predict future prices. The bid­ask spread (i.e., the difference between prices at which participants are willing to buy and sell financial instruments) is often used as a proxy for I measuring the efficiency of markets, with more efficient markets exhibiting narrower 19 Financial Sector Assessment: A Handbook Table 2.2. Indicators of Financial System Performance 1 Sub-sector Indicator 2 Competition and concentration · Total number of institutions · Interest rate spreads and prices of financial services · Intermediary concentration ratios (market share of 3 or 5 of the largest institutions) · Financial market concentration ratios (market share of the largest financial instruments, 3 as a percentage of total financial assets) · Herfindahl index Efficiency · Interest rate spreads 4 · Intermediation costs (as percentage of total assets) Liquidity · Ratio of value traded to market capitalization · Average bid­ask spread 5 6 bid­ask spreads. Because bid­ask spread also reflects market liquidity, as discussed below, 7 additional analysis of the extent of competition in the market and of volatility of price movements would be needed to assess efficiency. In addition, measures of price volatil- ity are sometimes used to substitute for market efficiency, although short-run changes in 8 volatility may reflect shifts in the amount of liquidity in that market. Two important dimensions of market liquidity should be considered: market depth and 9 market tightness. Market depth refers to the ability of the market to absorb large trade volumes without significant impact on market prices.7 This dimension is usually measured 10 by the ratio of value traded to market capitalization (turnover ratio), with higher ratios indicating more liquid markets. Another dimension of liquidity is market tightness--abil- 11 ity to match supply and demand at low cost that is measured by the average bid­ask spread. More liquid markets usually have narrower bid­ask spreads. Further discussion of 12 these indicators can be found in section 2.2.4. Table 2.2 summarizes the indicators of financial system performance that have been A discussed in this section. B 2.1.4 Scope and Coverage of Financial Services The financial system provides five key services: (a) savings facilities, (b) credit alloca- C tion and monitoring of borrowers, (c) payments, (d) risk mitigation, and (e) liquidity services. D Savings mobilization can be assessed by examining the effectiveness with which the financial system provides saving facilities and mobilizes financial resources from house- E holds and firms. The extent of financial savings could be ascertained by examining the level and trends in the ratio of broad money to GDP. As mentioned earlier, this indicator F may overstate the true picture if currency constitutes a high proportion of broad money. Other more specific indicators of access to savings facilities include the ratio of bank G deposits to GDP and the proportion of the population with bank accounts. Information on the outreach of the financial system can help interpret developments H in financial savings. Hence, indicators such as the total number of bank branches, the population per bank branch, and the distribution of branches and other outlets (e.g., rural I or urban) could provide valuable information on the access of the population to saving facilities. Further, it is important to assess the range of saving vehicles that are available 20 Chapter 2: Indicators of Financial Structure, Development, and Soundness because, in many countries, traditional bank deposits are the most common form of finan- 1 cial savings. Saving through non-bank forms of financial intermediation are, therefore, crucial to financial diversity, and development indicators for non-bank intermediaries such as insurance, pensions, and capital markets could be useful in gauging the degree to 2 which the population uses non-bank forms of financial savings. Hence, household and corporate holdings of non-bank financial assets (e.g., bonds) could provide extra informa- 3 tion on the degree of access to financial savings. The ratio of private sector bank credit to GDP is a common measure of the provision 4 of credit to the economy, as well as of banking depth. Often, this indicator is supple- mented by information on the ratio of loans to total bank deposits. Where available, the 5 volume of finance raised through the issuance of bonds and money market instruments should supplement information on bank credit. Analyzing trends in those indicators 6 should reveal the overall degree to which the banking sector provides credit to firms and households. It is also useful to assess the sectoral distribution of private sector credit to 7 gauge the alignment of bank credit with the distribution of domestic output. Therefore, the relative proportion of total credit going to agriculture, manufacturing, and services 8 would be relevant information in evaluating the adequacy of the level of credit provided to the economy. 9 A key function of financial systems in market economies is to offer fast and secure means of transferring funds and making payments for goods and services. The state of development of the payment system is of interest here, especially the focus on the various 10 instruments for making payments, including cash, checks, payment orders, wire transfers, and debit and credit cards. The proportion of payments (volume and value) made with 11 different payment instruments can reveal the developmental status of the payment sys- tem, with cash-based economies at the lower end of the spectrum. Some indicators such 12 as the number of days for clearing checks, the number and distribution of clearing centers, and the volume and value of checks cleared could provide general information on the A effectiveness of existing money transfer mechanisms. In addition, it is relevant to examine the various risks associated with the payments system, through indicators such as access B to settlement credit, size of settlement balances, and so forth, thereby complementing the qualitative information from assessments of Core Principles for Systemically Important C Payment Systems.8 The major risk mitigation services offered by the financial system include insur- D ance (life and non-life) and derivative markets. The ratio of gross premiums to GDP is a popular indicator of development in the insurance industry, and this indicator could be supplemented with a breakdown of premiums between life and non-life insurance. E A deep and well-functioning insurance industry would offer a wide range of products in both the life and non-life business, including motor vehicle, marine, fire, homeowners, F mortgage, workers' compensation, and fidelity insurance and life insurance, as well as disability, annuities, medical, and health insurance. In addition, coverage of derivative G markets--options, futures, swaps, and structured finance products­­where relevant in terms of available instruments, liquidity, and transaction costs, would be important, owing H to their role in managing risk and in facilitating price discovery in spot markets. Liquidity service provided by financial systems is reflected in maturity transforma- I tion and secondary market arrangements, which facilitate investment in high-yielding 21 Financial Sector Assessment: A Handbook projects. Most high-return projects require a long-term commitment of capital; however, 1 savers are often reluctant to give up their savings for long periods of time.9 The role of the financial system is to transform liquid, short-term savings into relatively illiquid, 2 long-term investments, thus promoting capital accumulation. The availability of liquid- ity, therefore, allows savers to hold assets that they can sell easily if they need to redeem 3 their savings. Against this background, it is important to examine the degree of access that specified 4 target groups (e.g., farmers, the poor, small and medium enterprises, or different geograph- ic regions) have to those financial services. Access is defined as the availability and cost of 5 financial services and could be measured in a variety of ways.10 First, relevant measures of the supply of financial services includes the numbers of different types of financial institu- 6 tions, the number of branches and other service outlets, the number of clients served, and the population per outlet. The volume of services (deposits, credit, money transmission, 7 etc.) provided is another useful measure, especially if it is broken down by clientele and size (i.e., in a breakdown by socioeconomic groups or broad sectors or by size distribution). Second, it is also relevant to consider demand-side measures of access. However, demand- 8 side indicators are not easy to construct and often require surveys to collect relevant data. Those surveys have often focused on collecting relevant information such as the savings 9 and credit needs of households and enterprises, the needs relative to the supply, and the ease or difficulty of meeting those needs.11 Finally, it is important to examine the costs 10 of financial services, usually by examining the level and trends in spreads between the borrowing and lending rates, the general interest rate structure, and the prices of other 11 financial services (e.g., fees and minimum balances for deposits, as well as cost and time of payment services). 12 In addition, indicators of the functioning of various elements of financial system infrastructure--the insolvency and creditor rights regime, the systemic liquidity arrange- A ments (other than those of payment systems, which have already been covered as a core financial system function), and the information and governance arrangements (e.g., B credit reporting, disclosure rules)--can provide useful insights into costs and efficiency of financial transactions. Appendix B (Illustrative Data Questionnaires for Comprehensive C Financial Sector Assessment) contains examples of those types of indicators. D 2.2 Financial Soundness Indicators E Financial soundness indicators (FSIs) are indicators of the current financial health and soundness of the financial institutions in a country, as well as of their corporate and F household counterparts, and FSIs play a crucial role in financial stability assessments. FSIs include both aggregated individual institution data and indicators that are representative G of the markets in which the financial institutions operate. FSIs are calculated and dissemi- nated for use in macroprudential surveillance, which is the assessment and monitoring of H the strengths and vulnerabilities of financial systems. FSIs are a relatively new body of economic statistics that reflect a mixture of influ- I ences. Some of the concepts are drawn from prudential and commercial measurement frameworks, which have been developed to monitor individual entities. Other concepts 22 Chapter 2: Indicators of Financial Structure, Development, and Soundness Table 2.3. The Core Set of Financial Soundness Indicators 1 Indicator Indicates Comment Deposit-taking institutionsa 2 Regulatory capital to risk-weighted assets Capital adequacy Broad measure of capital, including items giving less protection against losses, such as subordinated debt, 3 tax credits, and unrealized capital gains Regulatory Tier I capital to risk-weighted Capital adequacy Highest quality capital such as shareholder equity assets and retained earnings, relative to risk-weighted assets 4 Nonperforming loans net of provisions Capital adequacy Indicates the potential size of additional provisions to capital that may be needed relative to capital 5 Nonperforming loans to total gross loans Asset quality Indicates the credit quality of banks' loans Sectoral distribution of loans to total Asset quality Identifies exposure concentrations to particular 6 loans sectors Return on assets and return on equity Earnings and profitability Assesses scope for earnings to offset losses relative to capital or loan and asset portfolio 7 Interest margin to gross income Earnings and profitability Indicates the importance of net interest income and scope to absorb losses Noninterest expenses to gross income Earnings and profitability Indicates extent to which high noninterest expenses 8 weakens earnings Liquid assets to total assets and liquid Liquidity Assesses the vulnerability of the sector to loss of 9 assets to short-term liabilities access to market sources of funding or a run on deposits Net open position in foreign exchange Exposure to FX risk Measures foreign currency mismatch to capital 10 a. Domestically controlled institutions, that may be grouped in different categories according to control, business lines, or group structure. 11 12 are drawn from macroeconomic measurement frameworks, which have been developed to monitor aggregate activity in the economy. A list of FSIs, grouped into a core set and A an encouraged set, is presented in tables 2.3 and 2.4 and will be discussed in this chapter. Detailed exposition and guidance on those FSIs can be obtained from the Compilation B Guide on Financial Soundness Indicators (IMF 2004). It contains a discussion of the distinc- tion between a "core set" for which data are generally available and are found to be highly C relevant for analytic purposes in almost all countries and an "encouraged set" for which data are not as readily available and whose relevance could vary across countries.12 The list of FSIs discussed herein consists mainly of aggregate balance sheet measures. D This type of aggregation of individual institution-level indicators (microprudential indicators) into financial soundness indicators (macroprudential indicators) necessarily E involves a loss of information because the distribution of prudential indicators of indi- vidual institutions is also a crucial dimension of financial stability. Although aggregation F is required for facilitating macroprudential analysis and international comparison, the assessments could be strengthened by allowing some disaggregation through peer groups G or through the monitoring of the distributional characteristics of various indicators. In addition, FSIs themselves are either backward-looking or contemporaneous indicators H of financial soundness, available often with a lag or low frequency. Therefore, proper interpretation and use of FSIs requires a range of analytical tools (discussed in chapter I 3), which includes conducting stress tests of individual institutions and monitoring the 23 I H G F E D C B A 12 11 10 9 8 7 6 5 4 3 2 1 24 Financial Sector Assessment Table 2.4. The Encouraged Set of Financial Soundness Indicators Indicator Indicates Comment :A Encouraged seta Handbook Corporate sector Total debt to equity Leverage Provides an indication of credit risk because a highly leveraged corporate sector is more vulnerable to shocks Return on equity Earnings and profitability Indicates the extent to which earnings are available to cover losses Earnings to interest and principal expenses Debt service capacity Indicates the extent to which earnings available to cover losses are reduced by interest and principal payments Corporate net foreign exchange exposure to equity Foreign exchange risk Reveals corporate sector vulnerability to exchange rate movements Number of applications for protection from creditorsb Capital to assets Capital adequacy Broad measure of capital adequacy, which is a buffer for losses Geographical distribution of loans to total loans Asset quality Identifies credit exposure concentrations to particular countries by the banking system Gross asset position in financial derivatives to capitalc Exposure to derivatives Provides a crude indicator of exposure to derivatives Gross liability position in financial derivatives to capitalc Exposure to derivatives Provides a crude indicator of exposure to derivatives Large exposures to capital Asset quality Identifies credit exposure to large borrowers Trading income to total income Earning and profitability Indicates the dependence on trading income Personnel expenses to noninterest expenses Earnings and profitability Indicates the extent to which high noninterest expenses reduces earnings Spread between reference lending and deposit rates Earnings and profitability Indicates level of competition in the banking sector and the dependence of earnings on the interest rate spread Spread between highest and lowest interbank rate Liquidity Market indicator of counterparty risks in the interbank market Customer deposits to total (non-interbank) loans Liquidity Assesses the vulnerability to loss of access to customer deposits Foreign currency-denominated loans to total loans Foreign exchange risk Measures risk to loan portfolios from foreign exchange movements Foreign currency-denominated liabilities to total liabilities Foreign exchange risk Measures extent of dollarization Net open position in equities to capital Equity market risk Measures exposure to equity price movements Market liquidity Average bid-ask spread in the securities marketd Liquidity Indicates liquidity in the securities market Average daily turnover ratio in the securities marketd Liquidity Indicates liquidity in the securities market Other financial corporations Assets to total financial system assets Size Indicates size and significance within the financial sector Assets to GDP Size Indicates size and significance within the financial sector Households Household debt to GDP Leverage Provides an indication of credit risk because a highly leveraged household sector is more vulnerable to shocks Household debt service and principal payments to Debt service capacity Indicates a household's ability to cover its debt payments income Real estate markets Real estate prices Real estate prices Measures trends in the real estate market Residential real estate loans to total loans Exposure to real estate Measures banks' exposure to the residential real estate sector Commercial real estate loans to total loans Exposure to real estate Measures banks' exposure to the commercial real estate sector Other relevant indicators that are not formally part of the encouraged set of FSIse a. See Compilation Guide for Financial Soundness Indicators (IMF 2004) for a detailed definition and exposition of encouraged indicators. b. These may be grouped in different categories based on ownership, business lines, or group structure. c. May be in notional amounts or market value. The latter provides a better measure of exposure but may be more difficult to obtain. d. Or in other markets that are most relevant to bank liquidity, such as foreign exchange markets. e. Other indicators such as additional balance sheet data (e.g., maturity mismatches in foreign currency), data on the life insurance sector, or information on the corporate and household sector may be added. Chapter 2: Indicators of Financial Structure, Development, and Soundness distribution of stress tests results, as well as examining the determinants of FSIs and fore- 1 casting their future course. In addition, FSIs can be complemented by various market-based indicators, which are forward-looking indicators of soundness and are available with higher frequency. The 2 various categories of FSIs are discussed in the following sections. 3 2.2.1 FSIs for Non-financial Sectors 4 Corporate sector indicators tend to focus on indicators of leverage (or gearing), profit- ability, liquidity, and debt-servicing capacity because of those indicators' demonstrated 5 usefulness in predicting corporate distress or failure.13 Four commonly used measures of corporate sector health are the debt-to-equity ratio, the return on equity, the cash ratio, 6 and the debt service coverage (or interest coverage ratio). Total debt to equity measures leverage or the extent to which activities are financed out of other than own funds. High 7 corporate leverage increases the vulnerability of corporations to shocks and may impair their repayment capacity. Return on equity is commonly used to capture profitability and 8 efficiency in using capital. Over time, it can also provide information on the sustainability of capital positions. Profitability is a critical determinant of corporate strength, affecting the capital growth, the ability to withstand adverse events, and, ultimately, the repay- 9 ment capacity. Sharp declines in corporate sector profitability, for example, as a result of economic deceleration, may serve as a leading indicator of financial difficulties. 10 The cash ratio is a measure of short-term assets held against short-term liabilities, after deductions for inventories and receivables. The cash ratio measures the capacity 11 to absorb sudden changes in cash flows. Debt service coverage measures the capacity to cover debt service payments (interest and principal) and serves as an indicator of the risk 12 that a firm may not be able to make the required payments on its debts. One commonly used measure of debt service coverage is the earnings before interest, taxes, depreciation, A and amortization divided by debt servicing costs (principal plus interest). FSIs on the corporate sector can be compiled by aggregating data from the consolidated financial B statements of publicly listed corporations and, thus, are a direct analog of the indicators used by shareholders and market participants to monitor the financial health of individual C corporations. For the economy as a whole, domestically consolidated data (e.g., data based on National Income Accounts) can be used when corporate financial statements do not D provide sufficient coverage. Household sector indicators of leverage, liquidity, and debt servicing capacity can be useful in monitoring the health of the sector. Two common measures are used: the ratio E of household debt to GDP, and the ratio of household debt burden to income. The house- hold-debt-to-GDP ratio measures the overall level of household indebtedness (commonly F related to consumer loans and mortgages) as a share of GDP. High levels of borrowing increase the vulnerability of the household sector to economic and financial market G shocks and may impair their repayment capacity. The ratio of household debt burden to income measures the capacity of households to cover their debt payments (interest H and principal). It is also a potentially significant predictor of future consumer spending growth: a high debt-to-service ratio sustained over several quarters can affect the rate of I growth of personal consumption.14 25 Financial Sector Assessment: A Handbook Monitoring of the real estate sector tends to focus on indicators of significant swings 1 in prices or volumes of lending and construction because this information often signals future problems in credit quality and collateral. Rapid increases in real estate prices-- 2 often fueled by expansionary monetary policies or by large capital inflows--that are fol- lowed by a sharp economic downturn can have a detrimental impact on financial sector 3 health and soundness.15 Ideally, a range of indicators should be analyzed to get a sense of real estate market developments (demand, supply, prices, and links to the business cycle) 4 and to assess financial sector exposure to the real estate sector. If one is to determine the exposure of the banking sector to the real estate sector, it is important to have informa- 5 tion on the size of the credit exposure and the riskiness of the exposure. Different types of loans related to real estate may have very different risk characteristics, so it may be useful 6 to distinguish lending according to purpose (e.g., lending for commercial real estate or to construction companies and lending for residential real estate, including mortgages). 7 The level of sophistication of the mortgage market (e.g., mortgage interest rate structure, availability of home equity release products) may also have implications for risk manage- 8 ment and financial stability. 9 2.2.2 FSIs for Banking Banking sector FSIs can provide useful quantitative information on the stability or vul- 10 nerability of the banking system.16 Banking sector FSIs can be grouped according to six key areas of potential vulnerability in the CAMELS (Capital adequacy, Asset quality, 11 Management soundness, Earnings and profitability, Liquidity, and Sensitivity to market risk) framework. Most FSIs are compiled by aggregating microprudential indicators for 12 individual institutions to produce a measure for key peer groups such as domestically owned banks, local branches, foreign subsidiaries, state-owned banks, complex groups, or A the entire banking system.17 Non-bank FSIs (such as those for the corporate and house- hold sectors or those for insurance) can be used to assess credit risks arising for banks from B their credit and other exposures to non-bank sectors. Each of the six subgroups of bank FSIs has a different part in the stability assessment. Indicators of capital adequacy can be used to measure the capacity of the sector to absorb C losses. Because risks to the solvency of financial institutions most often derive from impairment of assets, the second category of FSIs is asset quality. FSIs in this category D monitor loan quality and exposure concentrations of bank asset portfolios. Indicators of management efficiency are used to capture the importance of sound management in E ensuring the health and stability of banks. A variety of data on margins, income, and expenses can be used to measure earnings and profitability because earnings indicate the F ability to absorb losses without drawing on capital. In contrast, rapid growth in earnings or profits may also signal excessive risk taking. Measures of liquidity indicate the ability of G a banking system to withstand shocks to cash flows. FSIs for liquidity measure the liquid assets available to a bank in the event of a loss of market funding or an outflow of depos- H its. Market liquidity measures also can be included to monitor the liquidity of the main securities held by banks. Banks are then exposed to market risk from their increasingly I diversified operations and positions in financial instruments. Sensitivity to market risk (changes in market prices, particularly interest rates and exchange rates and, occasionally, 26 Chapter 2: Indicators of Financial Structure, Development, and Soundness 1 equity prices) can be measured using information on net open positions, durations, and stress test results. 2 2.2.3 FSIs for Insurance 3 Quantitative soundness indicators for the insurance sector can be presented within a CARAMELS (Capital adequacy, Asset quality, Reinsurance, Adequacy of claims and 4 actuarial, Management soundness, Earnings and profitability, Liquidity, and Sensitivity to market risk) framework. This framework is analogous to the CAMELS framework for the 5 banking sector. Das, Davies, and Podpiera (2003) propose a set of core and encouraged soundness indicators for the insurance sector (grouped separately for life and non­life 6 insurance). The core indicators presented in table 2.5 are those considered necessary for adequate surveillance of the sector whereas the encouraged set includes additional indica- 7 tors that are useful in monitoring more specific areas of vulnerability. 8 2.2.4 FSIs for Securities Markets The stability of securities markets can be monitored using a range of quantitative indica- 9 tors that focus on market liquidity because of the important role that liquid securities play 10 Table 2.5. Insurance Financial Soundness Indicators: Core Set 11 Category Indicator Non-life Life Capital adequacy Net premium/capital X 12 Capital/total assets X Captial/technical reserves X Asset quality (Real estate + unquoted equities + debtors)/total assets X X A Receivables/(Gross premium + reinsurance recoveries) X X Equities/total assets X X B Nonperforming loans to total gross loans X Reinsurance and actuarial issues Risk retention ratio (net premium/gross premium) X X Net technical reserves/average of net claims paid in last three years X Net technical reserves/average of net premium received in last three X C years Management soundness Gross premium/number of employees X X Assets per employee (total assets/number of employees) X X D Earnings and profitability Loss ratio (net claims/net premium) X Expense ratio (expense/net premium) X X Combined ratio = loss ratio + expense ratio X E Revisions to technical reserves/technical reserves X Investment income/net premium X Investment income/investment assets X F Return on equity (ROE) X X Liquidity Liquid assets/current liabilities X X Sensitivity to market risk Net open foreign exchange position/capital X X G Duration of assets and liabilities X Note: Relevance to life or non-life segment of Insurance is indicated by X. Source: Das et al. (2003). The authors also propose a set of encouraged indicators for each of the above categories in order to H capture additional dimensions. These include sectoral and geographic distribution of investments and underwritten business, derivative exposures, risk weighted capital ratio, market based indicators (market/ book value, price/ earnings, and price/ gross premium ratios), and measures of Group exposures (group debts/ total assets, proportion of business from group companies I (Premium + claims)/ total business. 27 Financial Sector Assessment: A Handbook in the balance sheets of financial institutions.18 Market liquidity can be defined as a mea- 1 sure of volume of securities that can be sold in a relatively short period without having a significant effect on their price. The literature typically recognizes two key dimensions of 2 market liquidity: tightness and depth. Tightness is a market's ability to match supply and demand at low cost. The bid-ask spread FSI may serve as an approximate index of tight- 3 ness in each market, in that a narrower spread indicates a more competitive market with a larger number of buyers and sellers providing liquidity. Depth relates to the ability of 4 a market to absorb large trade flows without a significant effect on prices. When market participants raise concerns about the decline in market liquidity, they typically refer to 5 a reduced ability to deal without having prices move against them; that is, they refer to reduced market depth. The FSI of market turnover (gross average daily value of securities 6 traded relative to the stock) helps assess the liquidity of banks' balance sheets by giving an indication of the volume of securities that institutions can liquidate in the market. 7 Market depth also can be approximated by other volume variables, quota sizes, on-the- run­off-the-run spreads, and volatilities. 8 2.2.5 Market-Based Indicators of Financial Soundness 9 Market-based measures drawn from price and volatility measures of various capital market instruments can provide forward-looking indicators of financial soundness. For example, 10 default probabilities (for banks and non-banks) may be computed on the basis of models of credit risk, using equity prices and balance sheet data. In some cases, volatilities and 11 risk premiums in market prices themselves provide indicators of likelihood of default. Further discussion of those indicators is contained in chapter 3. 12 2.3 Aggregate Balance Sheet Structure of Financial and A Non-financial Sectors--Inter-sectoral Linkages B Analysis of stock variables in countries' sectoral balance sheets (assets and liabilities of financial firms, non-financial firms, households, government, and sub-sectors of those C sectors, as appropriate) and the consolidated aggregate balance sheet (for the country) can help highlight inter-sectoral linkages and can provide valuable information on the D adequacy of financial structure and on the potential for financial instability. The bal- ance sheet analysis focuses on (a) the determinants and evolution of stocks of assets and E liabilities and (b) the likely shocks to the stock variables, both of which can trigger large adjustments in flows (including cross-border capital flows, shifts in holdings of domestic F or foreign currency assets, etc.). An approach of this type can, therefore, be a useful complement to the traditional flow analysis that is based on data related to fiscal, balance- G of-payments, and financial programming. A classification of claims on and liabilities to any one sector from other sectors can reveal both the extent of access to financial services H (in providing savings instruments, in offering credit intermediation, and in providing risk diversification and insurance) and the extent of inter-sectoral linkages that highlight the I potential effect of shocks in one sector on the other. In addition, balance sheet data clas- sified by maturity, currency, contractual nature of liabilities (e.g., debt versus equity), and 28 Chapter 2: Indicators of Financial Structure, Development, and Soundness 1 Box 2.1 The Balance Sheet Approach--An Overview Applications and Policy Implications shocks on these balance sheets typically are analyzed 2 in financial sector assessments as part of the mac- Availability of comprehensive data on sectoral balance roprudential analysis and the related stress­testing sheets permits the analysis of relationship between exercises. (See chapter 3 for further details.) financial sector and real sectors (households, corpora- 3 tions, etc.) and how the deterioration in one can be Data Availability and Limitations reinforced or offset by a strengthening of the other. In 4 particular, capital account crises typically occur because A comprehensive analysis of sectoral balance sheets of a sudden loss of confidence in the soundness of the is often constrained by a lack of relevant data. The balance sheets of one of the countries' main sectors: the absence of this information often leads to a focus 5 banking system, the corporate sector, the households, on a few key stock positions in the public sector or the government. The negative impact of an initial balance sheet and in listed companies' balance adverse shock to a balance sheet will depend on the sheets. Therefore, for many countries, balance sheet 6 existing mismatches in the balance sheet. The cur- information beyond what is readily available must rency mismatch (a predominance of domestic currency be gathered before complete intersectoral analysis assets over foreign currency liabilities) or a maturity is feasible. Some efforts are under way to estab- 7 mismatch (a predominance of long-term illiquid assets lish good databases on balance sheets. The efforts over short-term liquid liabilities) can expose the vul- to promote the compilation and dissemination of 8 nerability of a sector to sharp movements in exchange financial soundness indicators focuses on the needs rate or interest rate or both, which arise from the initial of financial stability analysis. Other ongoing efforts confidence shock, and it can lead to spillover into other in improving the providing of data to the Fund are 9 sectors, often snowballing in the process. For example, designed to strengthen availability of detailed bal- a capital structure mismatch of firms (a predominance ance sheet data on external and public sector assets of debt over own funds and equity liabilities in the bal- and liabilities. 10 ance sheet) can result in unsustainable debt servicing Although it is widely recognized that balance burden because of an exchange rate or interest rate sheet analysis of the corporate sector is key to finan- shock, thus leading to insolvency of firms, and illiquid- cial stability analysis, the availability of data poses 11 ity and insolvency of financial firms with exposures to practical limitations. Typically, data are available the highly leveraged firms. only for listed companies; however, a much more 12 A loss of confidence in the banking system can lead, comprehensive and differentiated analysis of the in turn, to runs on deposits and flight from currency, sector is needed to understand fully the access to thereby exacerbating the initial currency and inter- financial services and vulnerabilities to financial A est rate shock. Banking crisis also could trigger the risks of this sector. realization of contingent liabilities of the government, Financial stability reports published by various as well as weaken the government balance sheet and countries have increasingly relied on systematic B threaten government debt sustainability. This type of analysis of balance sheet data, thereby creating a interaction among balance sheets could magnify the demand for strengthened data compilation and dis- negative impact of a shock on real output levels. Policy semination systems. When balance sheet data are C implications of the balance sheet analysis focus on not available in sufficient sectoral detail, the flow policies to foster a buffering and hedging of private bal- of funds information (data on changes in assets and D ance sheets, including effective banking supervision to liabilities of different sectors) can be a useful alterna- ensure strong risk management by banks, sound public tive because the real and financial transactions that debt and reserve management that effectively balances underpin the flow of funds accounts are the means E costs and rollover risks, and promotion of domestic by which balance sheet adjustments take place. Data capital markets to ensure currency diversification. from sectoral balance sheets and from the flow of Moreover, macroeconomic policy mix would need to funds suffer from a number of measurement difficul- F take into account the constraints posed by the balance ties: (a) available information is typically based on sheet mismatches such as the tradeoff between interest book (or transaction) values that may differ sharply rate and exchange rate adjustments in the presence of from market values, (b) data on off-balance sheet G maturity and exchange rate mismatches. exposures are not well captured, and (c) sharp portfo- The financial sector's balance sheets are key for the lio adjustments in response to shifts in relative asset H resilience of the economy. The relationship between prices and new information may render data that are the financial sector balance sheet and the corporate based on historical accounting records to become and household balance sheets as well as the impact of quickly outdated. I 29 Financial Sector Assessment: A Handbook Table 2.6. Stylized Framework for Presenting Financial Interlinkages between Sectors in an Economy 1 Sector A's balance sheeta 2 Assets of Sector A Liabilities of Sector A Financial claims on Financial obligations to 3 Sector B Sector B by currency by currency by maturity by maturity 4 Sector C Sector C by currency by currency by maturity by maturity 5 Sector D Sector D by currency by currency by maturity by maturity 6 Sector Eb Sector Eb by currency by currency by maturity by maturity 7 Net worth/netb International investmentb Note: A = government sector; B = banking system; C = non-bank financial sector; D = non-financial private; E = rest of world. 8 a. Similar sectoral balance sheets can be constructed for each sector in line with those in the System of National Accounts (United Nations, Commission of the European Communities, International Monetary Fund, Organisation for Economic Co-opera- tion and Development, and World Bank 1993); the Monetary and Financial Statistics Manual (IMF 2000) also provides advice for 9 compilation of accounts with limited data. In practice, presenting information on currency exposures and maturity may be chal- lenging in many countries. b. When consolidating the sectoral balance sheets into the country's balance sheet, the assets and liabilities held among resi- dents net out, leaving the country's external balance relative to the rest of the world (nonresidents), which is shown as sector 10 E. In the official balance-of-payments statistics, the difference between external financial assets and liabilities is the net interna- tional investment position. For other sectors, the difference between financial assets and liabilities is net worth or capital position of the sector. 11 12 A quality of the assets can help to analyze how balance sheet imbalances in one sector could trigger changes in demand for financial assets of one or more sectors that could trigger B financial instability. Recent work on the analytical uses and policy implications of balance sheet data--The Balance Sheet Approach--and some issues in compilation of balance C sheet information are highlighted in box 2.1. Illustrative sectoral balance sheets shown in table 2.6 highlight important information on sectoral interlinkages that will remain hidden in the consolidated country balance D sheets. If sectoral balance sheet data can be disaggregated, as shown in the table, to allow the measurement of mismatches in the balance sheet by currency, maturity, and capital E structure, then this type of information helps to analyze vulnerability to various shocks. Some sources of sectoral balance sheet data are noted, as follows. Company finance F statistics compiled by Bank of Korea (Financial Statements Analysis) provide balance sheet and income statements for listed and unlisted firms at a detailed level of indus- G trial classification. Annual data on financial assets and liabilities of households in New Zealand are published in Reserve Bank of New Zealand Web site.19 Those kinds of data H help to analyze the effects that macroeconomic shocks have on the soundness of firms and households. The framework for compiling and presenting a government balance sheet is I presented in the Government Finance Statistics Manual (IMF 2001), and this framework has been applied in several countries (e.g., Ecuador, Uruguay). The issues in the compilation 30 Chapter 2: Indicators of Financial Structure, Development, and Soundness of financial sector balance sheets are discussed in IMF's Compilation Guide on Financial 1 Soundness Indicators (IMF 2004). The balance sheet analysis of financial sector is routinely undertaken in all financial sector assessments as part of macroprudential analysis, which 2 is explained in chapter 3. 3 Notes 4 1. To get a more useful indication of financial size, central bank assets should be excluded from this calculation. 5 2. Although this ratio is one of the most popular measures of financial depth, the M2 to GDP ratio could be misleading if currency constitutes a high proportion of broad 6 money. 3. Where available, this ratio should include non-bank forms of intermediation, for 7 example, issues of bonds and money market instruments. 4. For a definition of large and complex financial institutions, see Miles (2002). 8 5. It is advisable to supplement these measures with other indicators of competition. See chapter 4 for a discussion of model-based indicators of competition. 9 6. For an example of the computation of the Herfindahl index, see chapter 15 of the Compilation Guide on Financial Soundness Indicators (IMF 2004). 10 7. See chapter 8 of the Compilation Guide on Financial Soundness Indicators (IMF 2004). 8. Issued by the Committee on Payment Settlement Systems of the Bank For International 11 Settlements. See Chapter 11 for a detailed discussion of these core principles. 9. See Levine (1997) for more information. 12 10.See World Bank (2004). Chapter 4 has a brief discussion of access, including an analy- sis of different approaches to measuring access. 11.See Honohan (2004) for a discussion of various sources of survey data and proposals A for basic national access indicators. 12.See also chapter 3. B 13.For a survey, see Altman and Narayanan (1997). In the wake of the Asian crisis, numerous authors have demonstrated the close links between poor corporate perfor- C mance and banking system distress; for example, see Pomerleano (1998). 14.See Debelle (2004) for an overview of household debt and its effect on the macro- D economy and implications for financial stability. 15.See Borio and McGuire (2004), and see Bank for International Settlements (2005) for E an overview of housing price dynamics and implications for financial stability. 16.For more details of how to use FSIs to assess banking soundness, see IMF (2004, chap- F ters 6, 8, and 14) and Evans and others (2000). 17.The particular peer groups chosen can be based on the structure of the banking system G and the underlying source of weaknesses, so vulnerabilities are not masked but are highlighted by the choice of peer group. H 18.See chapter 8 of IMF (2004) for an overview of statistics on securities markets. Two works of the Bank for International Settlements (BIS; 1999, 2001) also provide a I detailed discussion of market liquidity, including its measurement and analysis. 31 Financial Sector Assessment: A Handbook 19.The Web site for the Reserve Bank of New Zealand is available at http://www.rbnz. 1 govt.nz./statistics/monfin/index.html. 2 References 3 Altman, Edward I., and Paul Narayanan. 1997. "Business Failure Classification Models: 4 An International Survey." In International Accounting and Finance Handbook, ed. Frederick Choi, chapter 35, 2nd ed. New York: Wiley. 5 Bank for International Settlements (BIS). 1999. "Market Liquidity: Research Findings and Selected Policy Implications." CGFS Publication 11 (May), Bank for International Settlements, Basel, Switzerland. 6 ------. 2001. "Structural Aspects of Market Liquidity from a Financial Stability Perspective." A discussion note for the March 2001 meeting of the Financial Stability 7 Forum. Available at http://www.bis.org/publ/cgfs_note01.pdf. ------. 2005. "Real Estate Indicators and Financial Stability." BIS Paper 21, Bank for 8 International Settlements, Basel, Switzerland. Begum, Jahanara, May Khamis, and Kal Wajid. 2001. "Usefulness of Sectoral Balance 9 Sheet information for Assessing Financial System Vulnerabilities." Computer print- out, International Monetary Fund, Washington, DC. 10 Borio, Claudio, and Patrick McGuire. 2004. "Twin Peaks in Equity and Housing Prices?" BIS Quarterly Review 7 (March 2004): 79­96. Available at http://www.bis.org/publ/ 11 qtrpdf/r_qt0403.pdf. Das Udabir S., Nigel Davies, and Richard Podpiera. 2003. "Insurance Issues in Financial 12 Soundness." IMF Working Paper 03/138, International Monetary Fund, Washington, DC. Debelle, Guy. 2004. "Household Debt and the Macroeconomy." BIS Quarterly Review, A (March): 51­64. Evans, Owen, Alfredo Leone, Mahinder Gill, and Paul Hilbers. 2000. "Macroprudential B Indicators of Financial System Soundness." IMF Occasional Paper 192, International Monetary Fund, Washington, DC. C Honahan, Patrick. 2004. "Measuring Microfinance Access: Building on Existing Cross- Country Data." UNDP, World Bank, and IMF Workshop on Data on Access of Poor and D Low-Income People to Financial Services, World Bank, Washington DC, October 26. International Monetary Fund. 2000. Monetary and Financial Statistics Manual. Washington, E DC: International Monetary Fund. ------. 2001. Government Finance Statistics Manual. Washington DC: International F Monetary Fund. ------. 2002. "A Balance Sheet Approach to Financial Crisis." IMF Working Paper 02/210, International Monetary Fund, Washington, DC. G ------. 2004. Compilation Guide on Financial Soundness Indicators. Washington, DC: International Monetary Fund. Available at http://www.imf.org/external/np/sta/fsi/ H eng/2004/guide/index.htm. Levine, R. 1997. "Financial Development and Economic Growth: Views and Agenda." I Journal of Economic Literature Vol. 35, (June): 688­726. 32 Chapter 2: Indicators of Financial Structure, Development, and Soundness Miles, Colin. 2002. "Large Complex Financial Institutions (LCFIs): Issues to Be 1 Considered in the Financial Sector Assessment Program." International Monetary Fund, Monetary and Exchange Affairs Department, MAE Operational Paper 02/3. International Monetary Fund, Washington, DC. 2 Pomerleano, Michael. 1998. "The East Asia Crisis and Corporate Finances: The Untold Micro Story." World Bank Working Paper 1990 (October). World Bank Group, 3 Washington, DC. United Nations, Commission of the European Communities, International Monetary 4 Fund, Organisation for Economic Co-operation and Development, and World Bank. 1993. System of National Accounts. Series F, No. 2. New York: United Nations. 5 World Bank. 2004. Brazil: Access to Financial Services, Washington, DC: World Bank. 6 7 8 9 10 11 12 A B C D E F G H I 33 3 Chapter 3 Assessing Financial Stability Financial system stability in a broad sense means both the avoidance of financial institu- tions failing in large numbers and the avoidance of serious disruptions to the interme- diation functions of the financial system: payments, savings facilities, credit allocation, efforts to monitor users of funds, and risk mitigation and liquidity services. Within this broad definition, financial stability can be seen in terms of a continuum on which finan- cial systems can be operating inside a stable corridor, near the boundary with instability, or outside the stable corridor (instability).1 Financial stability analysis is intended to help identify threats to financial system stability and to design appropriate policy responses.2 It focuses on exposures, buffers, and linkages to assess the soundness and vulnerabilities of the financial system, as well as the economic, regulatory, and institutional determinants of financial soundness and stabil- ity. It considers whether the financial sector exhibits vulnerabilities that could trigger a liquidity or solvency crisis, amplify macroeconomic shocks, or impede policy responses to shocks.3 The monitoring and analysis of financial stability involves an assessment of mac- roeconomic conditions, soundness of financial institutions and markets, financial system supervision, and the financial infrastructure to determine what the vulnerabilities are in the financial system and how they are being managed. Depending on this assessment of the extent of the financial system's stability, policy prescriptions may include continu- ing prevention (when the financial system is inside the stable corridor), remedial action (when it is approaching instability), and resolution (when it is experiencing instability). 3.1 Overall Framework for Stability Analysis and Assessment The analytic framework to monitor financial stability is centered around macropruden- tial surveillance and is complemented by surveillance of financial markets, analysis of 35 Financial Sector Assessment: A Handbook macrofinancial linkages, and surveillance of macroeconomic conditions. These four key 1 elements play distinct roles in financial stability analysis. 2 · Surveillance of financial markets helps to assess the risk that a particular shock or a combination of shocks will hit the financial sector. Models used in this area of 3 surveillance include early warning systems (EWSs). Indicators used in the analysis include financial market data and macro-data, as well as other variables that can be used for constructing early warning indicators (see section 3.2). 4 · Macroprudential surveillance tries to assess the health of the financial system and its vulnerability to potential shocks. The key quantitative analytical tools used for 5 macroprudential surveillance are the monitoring of financial soundness indicators (FSIs) and the conducting of stress tests. Those tools are used to map the condi- 6 tions of non-financial sectors into financial sector vulnerabilities. The analysis also draws on qualitative data such as the results of assessments of quality of supervision 7 and the robustness of financial infrastructure (see section 3.3). · Analysis of macrofinancial linkages attempts to understand the exposures that can 8 cause shocks to be transmitted through the financial system to the macroeconomy. This analysis looks at data such as (a) balance sheets of the various sectors in the 9 economy and (b) indicators of access to financing by the private sector (to assess the extent to which private owners would be able to inject new capital to cover 10 the potential losses identified through macroprudential surveillance) (see section 3.4). 11 · Surveillance of macroeconomic conditions then monitors the effect of the finan- cial system on macroeconomic conditions in general and on debt sustainability in particular (see section 3.4). 12 Assessing financial stability is a complex process. In practice, the assessment requires A several iterations. For example, the effects of the financial system on macroeconomic conditions may produce feedback effects on the financial system. The profile of risks B and vulnerabilities (ascertained through macroprudential surveillance) could feed into qualitative assessments of effectiveness of supervision, and those effects, in turn, might C influence the analysis of vulnerabilities and overall assessment of financial stability. D 3.2 Macroeconomic and Financial Market Developments E An analysis of macroeconomic and financial developments provides an important con- text for the analysis of financial sector vulnerabilities. The goal of the surveillance of F macroeconomic developments and of financial markets is to provide a forward-looking assessment of the likelihood of extreme shocks that can hit the financial system. G The literature on EWSs--which deals with factors that cause financial crises--pro- vides useful guidance for this mode of analysis. EWSs try--in a statistically optimal way H (i.e., in a way that minimizes "false alarms" and missed crises)--to combine a number of indicators into a single measure of the risk of a crisis. EWSs do not have perfect forecast- I ing accuracy, but they offer a systematic method to predict crises. Two approaches to constructing EWS models have become common: the indicators approach (Kaminsky, 36 Chapter 3: Assessing Financial Stability Lizondo, and Reinhart 1998, and Kaminsky 1999) and limited dependent variable probit­ 1 logit models (Berg and Pattillo 1999). Berg and others (2000) assess the performance of those models and find that they have outperformed alternative measures of vulnerability, 2 such as bond spreads and credit ratings. However, although those models can anticipate some crises, they also generate many false alarms.4 EWS models are seen as one of a number of inputs into the IMF's surveillance pro- 3 cess, which encompasses a comprehensive and intensive policy dialogue. The IMF puts significant efforts into developing EWS models for emerging market economies, which 4 resulted, among other things, in influential papers by Kaminsky, Lizondo, and Reinhart (1998) and by Berg and Pattillo (1999). The IMF uses a combination of EWS approaches, 5 in particular, the Developing Country Studies Division model and a modification of the Kaminsky, Lizondo, and Reinhart model, both of which use macro-based indicators of cur- 6 rency crises (IMF 2002b). It also makes use of market-based models that rely on implied probability of default and balance-sheet-based vulnerability indicators (e.g., see Gapen 7 and others 2004). In recent years, other institutions and individuals have also developed EWS models. 8 Those efforts included EWS models developed or studied by staff members at the U.S. Federal Reserve (Kamin, Schindler, and Samuel 2001), the European Central Bank 9 (Bussiere and Fratzscher 2002), and the Bundesbank (Schnatz 1998). Academics and various private sector institutions also developed a range of EWS models. The private 10 sector EWS models include Goldman Sachs's GS-watch (Ades, Masih, and Tenengauzer 1998), Credit Suisse First Boston's (CSFB's) Emerging Markets Risk Indicator (EMRI) 11 (Roy 2001), Deutsche Bank's Alarm Clock (Garber, Lumsdaine, and Longato 2001), and Moody's Macro Risk model (e.g., Gray, Merton, and Bodie 2003). The EWS literature covers three main types of crises: currency crises (sudden, sizable 12 depreciation of the exchange rate and loss of reserves), debt crises (default or restructur- ing on external debt), and banking crises (rundown of bank deposits and widespread A failures of financial institutions). One can distinguish three "generations" of crises mod- els, depending on what determinants the models take into account. The first generation B focuses on macroeconomic imbalances (e.g., Krugman 1979). The second generation focuses on self-fulfilling speculative attacks, contagion, and weakness in domestic finan- C cial markets (e.g., Obstfeld 1996). The third generation of models introduces the role of moral hazard as a cause of excessive borrowing and suggests that asset prices can be a D useful leading indicator of crises (e.g., Chang and Velasco 2001). In general, empirical studies (e.g., Berg and others 2000) suggest that currency crises occur more often than E debt crises (roughly 6:1) and that a large portion of the debt crises happened along with or close to the currency crises. Banking crises are hard to identify, tend to be protracted, F and, thus, have a larger macroeconomic effect. Banking crises also tend to occur with or shortly after a currency crisis. G Forecasting banking crises is based on three approaches: · The macroeconomic approach is based on the idea that macroeconomic policies H cause crisis, and it tries to predict banking crises using macroeconomic variables. For example, Demirgüç-Kunt and Detragiache (1998) study the factors of systemic I banking crises in a large sample of countries using a multivariate logit model and 37 Financial Sector Assessment: A Handbook find that crises tend to erupt when growth is low and inflation is high. They also 1 find some association between banking sector problems, on the one hand, and high real interest rates, the vulnerability to balance of payments crises, the existence 2 of an explicit deposit insurance scheme, and weak law enforcement, on the other hand. 3 · The bank balance-sheet approach assumes that poor banking practices cause crises and that bank failures can be predicted by balance-sheet data (e.g., Sahajwala and 4 Van den Berg 2000; Jagtiani and others 2003). · The market indicators approach assumes that equity and debt prices contain infor- 5 mation on bank conditions beyond that of balance-sheet data. Market-based EWS models are based on the premise that financial asset prices contain information on 6 market beliefs about the future. In particular, option prices reflect market beliefs about the future prices of the underlying assets. This information can be used to extract a probability distribution, namely, the probability of default. The advan- 7 tage of equity and debt data is that they can be available in high frequency and that they should provide a forward-looking assessment (e.g., Bongini, Laeven, and 8 Majnoni 2002; Gropp, Vesala, and Vulpes 2002).5 9 3.3 Macroprudential Surveillance Framework 10 Surveillance of the soundness of the financial sector as a whole--which is macropruden- 11 tial surveillance--complements the surveillance of individual financial institutions by supervisors--which is microprudential surveillance. Macroprudential surveillance derives 12 from the need to identify risks to the stability of the system as a whole, resulting from the collective effect of the activities of many institutions. A Macroprudential analysis also closely complements and reinforces EWSs and other analytical tools for monitoring vulnerabilities and preventing crises. EWSs traditionally B focus on vulnerabilities in the external position while using macroeconomic indicators as key explanatory variables. Macroprudential analysis (analysis of FSIs and stress test- C ing) focuses on vulnerabilities in domestic financial systems arising from macroeconomic shocks, whose likelihood and severity can be judged from EWSs. At the same time, infor- mation from macroprudential analysis can provide input into assessing macroeconomic D vulnerabilities. Analysis of FSIs for individual banks, along with other supervisory infor- mation, serves as a form of EWS for the financial condition of individual banks in many E supervisory assessment systems (Sahajwala and Van den Berg 2000). Macroprudential surveillance uses a combination of qualitative and quantitative meth- F ods. The key qualitative methods focus on the quality of the legal, judicial, and regulatory framework, as well as governance practices in the financial sector and its supervision. An G important part of the qualitative information is often gathered through the assessments of internationally accepted standards and codes of best practice. The quantitative methods H include a combination of statistical indicators and techniques designed to summarize the soundness and resilience of the financial system. I The two key quantitative tools of macroprudential surveillance are the analysis of FSIs and stress testing. The analysis of FSIs includes assessing their variation over time 38 Chapter 3: Assessing Financial Stability and among peer groups, as well as assessing their determinants. FSIs help to assess the 1 vulnerability of the financial sector to shocks. Stress testing assesses the vulnerability of a financial system to exceptional but plausible events by providing an estimate of how the value of each financial institution's portfolio will change when there are large changes to 2 some of its risk factors (such as asset prices). 3 3.3.1 Analysis of Financial Soundness Indicators 4 FSIs are used to monitor the financial system's vulnerability to shocks and its capacity to absorb the resulting losses. Work on FSIs has produced a set of core FSIs and a set of 5 encouraged FSIs (see chapter 2).6 · The core set of FSIs covers only the banking sector, thereby reflecting its central 6 role. Those FSIs are considered essential for surveillance in virtually every financial system and, thus, serve as a small common set of FSIs across countries. Also, the 7 data to compile those FSIs are generally available. · The encouraged set of FSIs covers additional FSIs for the banking system and FSIs 8 for key non-financial sectors because balance-sheet weaknesses in those sectors are a source of credit risk for banks and, thus, help detect banking sector vulnerabilities 9 at an earlier stage. The encouraged set of FSIs are relevant in many, but not all, countries. 10 The choice of FSIs depends on the structure of a country's financial system and data availability. Although the core set provides an initial prioritization, the choice should not 11 be limited to this set. In bank-dominated systems, the core and some relevant encour- aged FSIs may be adequate. FSIs for other types of financial institutions may be needed if 12 those institutions are systemically important. Of course, some countries may have other relevant indicators that are not included in the core or encouraged sets that may need to A be monitored. In countries with well-developed markets, with information on key prices, spreads, and price volatility, other market information, including ratings, can be used as B market-based indicators to monitor risks in individual sectors and institutions and to help assess the evolution of relative risks, thereby facilitating supervision and macroprudential C surveillance (see box 3.1). The analysis of FSIs typically involves examination of trends, comparison between relevant peer groups of countries and institutions, and disaggregation into various group- D ings. Control is often an important criterion for disaggregation because it can indicate the sources of outside support that are potentially available to institutions in distress and thus E can influence their vulnerability to bank runs, as well as their exposure to cross-border contagion. F Domestically controlled banks are overseen by a country's central bank and supervisor and, in a crisis, would be recapitalized by the banks' domestic owners or otherwise by the G state. Within this peer group, public banks, which have a state guarantee, are typically distinguished from private banks, which may fail if losses exceed some minimum level of H capital and consequently may be more prone to bank runs. Within the group of domesti- cally owned, private banks, internationally active banks may be grouped into a separate I peer group because they are exposed to cross-border contagion. Those banks could entail 39 Financial Sector Assessment: A Handbook 1 Box 3.1 Market-Based Indicators of Financial Soundness Market-based indicators are among the key data sets and Majnoni 2002; Gropp, Vesala, and Vulpes 2002). 2 used by macroprudential analysis, along with aggre- In addition, confidentiality is generally not an issue gated prudential data, macroeconomic data, stress with market data, which should make it easier for 3 tests, structural data, and qualitative information. independent analysts to obtain input data and for the They include market prices of financial instruments, results to be publicly shared and verified. indicators of excess yields, market volatility, credit The quality of the market-based indicators depends 4 ratings, and sovereign yield spreads. on the extent and quality of the financial markets. The market-based indicators have a wide array of For asset prices to contain useful information, it is uses. In particular, market prices of financial instru- important that the market be robust and transpar- 5 ments issued by financial institutions and their cor- ent. If it is not, then asset prices may be substantially porate counterparts can be used to assess financial affected by factors other than the financial health of 6 soundness of the issuers. Sovereign yield spreads the issuer or the underlying quality of the asset. In are commonly watched indicators of country risk. addition, the usefulness of market-based indicators Market price data from the stock, bond, derivatives, to assess financial sector soundness may be limited if 7 real estate, and other financial markets can be used some financial institutions' securities are not publicly to monitor sources of shocks to the financial sector. traded or if their trading is limited (as may be the Indicators of market price volatility can help assess case, for instance, for government-owned banks or 8 the market risk environment. Finally, sovereign rat- family-owned banks). Finally, if relevant informa- ings and ratings of financial institutions and other tion is not publicly disclosed (e.g., loan classification firms (as well as the accompanying analysis by the data that are not disclosed in some countries), but if 9 rating companies) are important sources of informa- that type of information is collected by supervisors, tion to any analysis of vulnerabilities.a then prudential data can be superior to market-based 10 Analysis of the market-based indicators comple- indicators in measuring financial sector soundness. ments the analysis of aggregated microprudential However, market-based indicators can still be use- data. The use of market-based indicators to moni- ful in assessing the potential shocks to the financial 11 tor financial institutions' soundness is based on the institutions arising from or transmitted through premise that market prices of financial institutions' financial markets. securities could reveal information about their con- Empirical studies show that market prices can be 12 ditions beyond that of balance-sheet data and other helpful in forecasting bank distress. For example, aggregated microprudential data. If this premise is recent studies for the United States suggest that sub- true, then the market-based indicators can usefully ordinated yields explain not only bank rating chang- A complement the FSIs, a majority of which--includ- es but also regulatory capital ratios (Evanoff and Wall ing all core FSIs--are based on aggregating financial 2001), that equity prices provide useful information B institutions' microprudential data. The key premise is on bank failure (Gunther, Levonian, and Moore that the asset prices contain information on market 2001), and that both equity prices and bond yields beliefs, which, in turn, contain information about explain ratings (Krainer and Lopez 2003). C the future. In particular, option prices reflect market However, early warning systems that combine beliefs about the future prices of the underlying assets. market information with other data tend to perform This information can be used to extract a probability better than the nonmodel market-based indicators. D distribution, including the probability of default. Berg and Borensztein (2004) find that "market An advantage of using market prices rather than views," as expressed in spreads, ratings, and surveys, prudential data is that the price data are generally are not reliable crisis predictors, important as they E available at high frequency. The advantage of equity may be in determining market access. They find and debt data is that they are frequent, which allows that early warning system models, which combine F for more sophisticated analysis, such as the analysis a range of indicators, have outperformed purely of volatility and covariance. Also, although the market-based measures of vulnerability such as bond accounting measures of risk (such as nonperforming spreads and credit ratings. Their study was focused G loans [NPLs] and loan loss reserves) are essentially on predicting currency crises, but there is even less backward looking, market price data should provide evidence about the market indicators' efficiency in a forward-looking assessment (e.g., Bongini, Laeven, predicting banking sector crises. H a. When assigning ratings, rating companies typically use a range of analytical approaches and data, including available prudential indicators. Nonetheless, ratings are classified as market-based indicators, thus recognizing that they are produced I mainly for use by market participants. 40 Chapter 3: Assessing Financial Stability significant risk exposure through their foreign branches and subsidiaries. FSIs should 1 include the activities of those foreign branches and subsidiaries, even though the latter are not part of the domestic activity, because they are a source of risk to the banking system. 2 For the domestic branches and subsidiaries of foreign-controlled banks, support in a crisis can be expected to come in the first instance from their foreign owners. This type of 3 support may be based (a) on the foreign bank's legal obligation, which generally extends to branches but not to subsidiaries abroad; (b) on broader reputation or operating con- 4 cerns, which may lead the foreign bank to support its subsidiaries abroad in a crisis; or (c) both of those elements. At the same time, FSIs of the foreign parent banks may also 5 deserve examination because the soundness of the parent bank would influence not only the potential for support to its subsidiaries but also the risk of contagion. Those FSIs are 6 typically produced by the home country of the parent bank. When foreign-controlled deposit-takers play a significant role in the financial system, separate FSIs may need to be 7 compiled for the local subsidiaries of those deposit-takers. Quantitative information on the structure, ownership, and degree of concentration 8 of the financial system helps to set priorities for analyzing FSIs while also providing a basis for the identification of structural issues and developmental needs. This information 9 indicates the relative importance of different types of financial institutions (e.g., banks, securities companies, insurance companies, pension funds); the relative importance of dif- ferent types of ownership (private, public, foreign); and the concentration of ownership. 10 It provides a basic understanding of the main components of the sector and its degree of diversification (see chapters 2 and 4 for a further discussion of financial structure and its 11 determinants). 12 3.3.1.1 Analysis of FSIs for Banking7 A In most countries, banks form the core of the financial system and, thus, warrant close monitoring for indications of potential vulnerabilities. A range of quantitative indicators B can be used to analyze the health and stability of the banking system, including financial soundness indicators (aggregated microprudential indicators), market-based indicators of C financial conditions, structural indicators describing ownership and concentration pat- terns, and macroeconomic indicators. A range of qualitative information is also needed D to assess the banking system, including the strength of the regulatory framework (which is based on assessments of the Basel Core Principles, or BCP), the functioning of the payment system, accounting and auditing standards, the legal infrastructure, the liquidity E support arrangements, and the financial sector safety nets. Banking sector FSIs discussed in chapter 2 cover capital adequacy, asset quality, man- F agement soundness, earnings and profitability, liquidity, and sensitivity to market risk. An analysis of inter-linkages among those FSIs and their macroeconomic and institutional G determinants, together with an assessment of their sensitivity to various shocks through stress tests, provide the basic building blocks of financial stability analysis.8 H The linkages not only among the various groups of FSIs but also to other variables are derived from accounting and lending relationships within the financial sector and with I other non-financial sectors. They also reflect institutional determinants, such as the key 41 Financial Sector Assessment: A Handbook parameters of the prudential framework. Topics studied in this area include, for example, 1 determinants of asset quality, links between asset quality changes and capital, and deter- minants of profitability, all of which are discussed below. 2 One important topic of study involves determinants of asset quality. Asset quality is affected by the state of the business cycle, the corporate financial structure, and the level 3 of real interest rates, which, together, influence the capacity for debt servicing. Therefore, in empirical work, FSIs of asset quality are typically regressed on various explanatory 4 variables, such as corporate leverage, macroeconomic conditions, and interest rates. In some assessments, those types of regression estimates were based on panel data for banks 5 in a country; in other cases, time series of aggregate data were used. As an example of cross-country time series regression, the IMF (2003c) estimated the relationship between 6 corporate sector FSIs and banking sector asset quality FSIs on panel data compiled from large private databases for 47 countries over 10 years. It found that a 10 percentage point 7 increase in corporate leverage was generally associated with a 1.8 percentage point rise in NPLs relative to total loans after one year. Also, a 1 percentage point rise in GDP growth resulted in a 2.6 percentage point decline in the NPLs-to-loans ratio, reflecting 8 the fact that fewer corporations are likely to experience problems repaying loans during rapid growth. 9 Links between asset quality changes and capital are also studied. A deterioration in asset quality affects capital (and risk-weighted assets) through additional reserves that 10 banks need to hold against the additional bad assets. The additional reserves reflect the rules in the country involving loan loss provisioning and the application of those rules in 11 banking practice. Therefore, to model this link, one needs to understand well the pruden- tial and supervisory framework in the country in question, which is where the findings of 12 the BCP assessments can be of great help. The link between asset quality (and other risk factors) and capital is typically studied in the context of stress tests (see appendix D on A stress testing for references on this issue). Another important topic of study involves the determinants of profitability. There is B a large theoretical and empirical literature on the bank-level and country-level factors determining bank efficiency. This issue is further discussed in chapter 4. Quantitative analysis of FSIs can be complemented with information from assessments C of the effectiveness of financial sector supervision. BCP assessments9 provide a vast array of contextual information that can be useful in interpreting FSIs. First, they can clarify D the definition of data being used to compile FSIs by, for example, indicating the quality of capital. Second, they can help establish the underlying cause of observed movements E in FSIs when there are competing explanations, such as whether a fall in the capital ratio might be supervisory action rather than rapid balance-sheet expansion. Third, they F provide information on risks, such as operational and legal risk that cannot be captured adequately using FSIs. Fourth, they provide information on how effective the banks' risk G management is and, thus, how effectively the banking system is likely to respond to the risk associated with particular values for FSIs. Finally, they indicate the responsiveness of H the supervisory system to emerging financial sector problems, which reveals how quickly vulnerabilities identified by FSIs are likely to be corrected. A lack of compliance with I many of the BCP would suggest that the banking sector vulnerabilities detected using FSIs may be more serious than in a financial system with good compliance. Assessments 42 Chapter 3: Assessing Financial Stability of financial infrastructure­­corporate governance, accounting and auditing, insolvency 1 and creditor rights regimes, and systemic liquidity arrangements­­can also help interpret the liquidity and solvency indicators. 2 3.3.1.2 Analysis of FSIs for Insurance 3 Insurance is an important and growing part of the financial sector in virtually all devel- oped and in many emerging economies; consequently, insurance sector soundness is 4 important.10 Insurers help to allocate risks and to mobilize long-term savings (especially retirement savings) by spreading financial losses across the economy. Insurance compa- 5 nies facilitate economic activity in sectors, such as shipping, aviation, and the profession- al services that are particularly reliant on insurance. The insurance companies can help 6 to promote risk-mitigating activities through their incentives to measure and monitor the risks to which they are exposed. Finally, insurance companies help promote stability 7 by transferring risk to entities better able to evaluate, monitor, and mitigate those risks through specialization. 8 The risk profiles of insurers and banks differ. Insurance companies generally are exposed to greater volatility in asset prices and face the potential for rapid deterioration in their capital base. Insurance companies typically have liabilities with longer maturities 9 and assets with greater liquidity than banks have, thus enabling the insurance companies to play a larger role in long-term capital markets. Life insurers often have significantly 10 higher exposure to equities and real estate and lower exposure to direct lending than do banks. In some countries, insurers offer products with guaranteed returns, further exacer- 11 bating risks for life insurers. The importance of the insurance sector for financial stability has increased recently 12 because of intensified links between insurers and banks, thereby increasing the risk of contagion. Those links can include cross-ownership, credit-risk transfers, and financial A reinsurance. Financial deregulation has caused insurers to diversify into banking and asset management products, thus exposing them to additional risk by making their liabilities B more liquid. Insurers have also increased their exposure to equities and complex risk management products in response to deregulation and declining yields on fixed-interest C products. Assessing the soundness of the insurance sector requires good understanding of link- D ages among, and determinants of, the various financial soundness indicators for the insur- ance sector discussed in chapter 2. In addition, the analysis of those indicators should be supplemented by information on the quality of risk management in the insurance indus- E try, which will draw on the assessment of observance of relevant supervisory standards (see discussion that follows). Capital adequacy can be viewed as the key indicator of insurance F sector soundness. However, analysis of capital adequacy depends on realistic valuation of both assets and liabilities of the insurance sector. Compared with banking, asset side risks G for the insurance sector are similar, but liability side risks depend on different factors, such as demographic and sectoral developments. Assessing the stability of the insurance sector H should take into account the size and growth of the sector, the importance of banking- type and asset-management-type products, the structure of the industry (including the I relative importance of the life sector), and the strength of linkages to the banking sector. 43 Financial Sector Assessment: A Handbook Data quality may be an issue because many countries lack the actuarial expertise, super- 1 visory authority, or capacity to collect sufficient information. The analysis and interpretation of soundness indicators should draw on an evaluation 2 of the observance of Insurance Core Principles issued by the International Association of Insurance Supervisors (IAIS 2003) (see also chapter 5). This set of principles provides 3 information on the effectiveness of supervision, the structure and characteristics of com- panies in the sector, and other useful qualitative information that is not always captured 4 by financial ratios.11 In particular, the specifics of supervisory and regulatory environment affect asset composition, as well as the mix of risks, and should be taken into account in 5 interpreting insurance FSIs. 6 3.3.1.3 Analysis of FSIs for Securities Markets12 Securities markets are a major component of the financial sector in many countries. The 7 capitalization of equity and bond markets in many industrialized countries, with savings in securities investments now exceeding savings in deposits, dwarfs the aggregate assets 8 of the banking system. Exposures of households, corporations, and financial institutions to securities markets have increased substantially through investments in primary and 9 secondary markets and through trading of risk in financial markets. Well-developed securities markets offer an alternative source of intermediation, thus 10 enhancing efficiency in the financial sector through competition. Well-functioning secu- rities markets provide a mechanism for the efficient valuation of assets and diversification 11 of risks, create liquidity in financial claims, and efficiently allocate risks. Those markets help reduce the cost of capital, thereby raising economy-wide savings and investment. 12 They also foster market discipline by providing incentives to corporations and financial institutions to use sound management and governance practices. A The stability of securities markets can be monitored using a range of quantitative indicators measuring depth, tightness, and resilience of markets.13 Most quantitative indi- B cators focus on market liquidity because of the important role that liquid securities play in the balance sheets of financial institutions. Chapter 2 discusses the FSIs that measure market tightness (bid­ask spreads) and depth (market turnover, measured by gross average C daily value of securities traded relative to the stock). The analysis of securities markets' FSIs focuses on trends in those key variables and their determinants, including institu- D tional factors and market structure (for an example of this type of analysis, see Wong and Fung 2002). The analysis also tries to assess resiliency of the market, which refers either E to the speed with which price fluctuations resulting from trades are dissipated or to the speed with which imbalances in order flows are adjusted. Although there is no consensus F yet on the appropriate measure for resiliency, one approach is to examine the speed of the restoration of normal market conditions (such as the bid­ask spread and order volume) G after large trades. For more on the robustness of market liquidity under conditions of stress, see the discussion in section 3.3.2 and in appendix D. For an alternative approach H to measuring soundness using market volatility as a financial soundness indicator, see Morales and Schumacher (2003). I Qualitative information drawn from standards assessments and other sources can also help assess stability of securities markets and can help interpret FSIs. The financial market 44 Chapter 3: Assessing Financial Stability infrastructure (trading systems, payment systems, clearing and settlement systems, cen- 1 tral bank operations and other systemic liquidity arrangements, and government foreign exchange reserve and debt management practices) affects financial institutions' access to funding on the liabilities side of their balance sheets, their ability to liquidate positions 2 on the asset side, and their exposure to systemic and operational risk in the clearing and settlement system. This information can be derived from assessments of the Organization 3 of Securities Commissions (IOSCO) objectives and principles (see also chapter 5), the Committee on Payment Settlement Systems (CPSS)­IOSCO recommendations for secu- 4 rities settlement systems (see also chapter 11), the CPSS core principles (see also chapter 11), and other sources such as event studies of past disturbances. 5 Information on market microstructures and the diversity of funding sources can be used to assess how well financial institutions can maintain access to funding in a crisis. 6 The robustness of market liquidity depends on market microstructure, including whether markets are based on over-the-counter (OTC) or are exchange-based. For OTC markets, 7 information on features affecting the capacity of market makers to make markets--for example, the number and capitalization of market makers and the size of the positions 8 they take--could be useful. For exchanges, information on the trading systems, price transparency, margining rules, and capital committed by the exchange to support trad- 9 ing could be used. For electronic trading systems, an indicator of liquidity is the standard transaction size. Also relevant is the extent to which closely related assets are traded on the different types of markets, which can substitute for one another if one market loses 10 liquidity. Information on the operation of the payment systems, the clearing and settlement 11 systems, and the safety nets is also useful for interpreting FSIs for securities markets, and it provides insights into access to liquidity in a crisis. Indicators of payment system function- 12 ing include the relative size of intraday, inter-bank exposures and daylight overdrafts, the length of settlement lags, the scope of loss-sharing arrangements, the level of reliance on A collateral, and the particular markets that have real time gross settlement. All those indi- cators provide information on the potential credit and settlement risks in the payment B system. The safety net and the central banks' providing of liquidity to markets influence the extent to which banks and other market intermediaries can continue to access market C liquidity in a crisis. Central bank operating procedures are a key determinant of money market liquidity and of the liquidity of other markets in longer-term paper, where position D taking by dealers is supported by access to money markets. E 3.3.1.4 Analysis of FSIs for Nonfinancial Sectors Monitoring the financial condition and vulnerabilities of the corporate, household, and F real estate sectors can enhance the capacity to assess risks to the financial sector. Loans to the corporate sector typically account for a significant portion of bank loan portfolios; G thus, the health of the corporate sector represents a major source of risk to the financial system.14 Households play an important role as consumers (of goods, as well as financial H products and services), as depositors, and as holders of risky assets; hence, changes in their financial position can have significant effect on both the real economy and financial I market activity.15 The real estate sector also has been an important source of risk because 45 Financial Sector Assessment: A Handbook of the key role that real estate plays as collateral, but this dimension has proved difficult 1 to monitor because of the paucity of data on real estate prices.16 FSIs for the corporate, household, and real estate sectors can serve as early warning 2 indicators of emerging asset quality problems. Shocks to their balance sheets, if signifi- cant, are eventually transmitted to the balance sheets of banks and other financial institu- 3 tions. However, if one is to make effective use of FSIs for those sectors for this purpose, it is necessary to assess the exposure of the financial system to each sector (e.g., using FSIs 4 of the sectoral distribution of lending) and to estimate how a deterioration of the financial condition of nonfinancial sectors, which would be based on FSIs for those sectors, is likely 5 to affect banking sector asset quality. In some assessments, FSIs for corporate and house- hold sectors were made endogenous by estimating the effect on those FSIs of changes in 6 the relative price of debt to equity, level of interest rates, cyclical position, profitability, and unemployment. The prospective evolution of corporate and household leverage can 7 then be projected by using the above variables, and such projections can help assess likely changes in asset quality of financial firms. 8 3.3.2 System-Focused Stress Testing 9 Stress testing, in the context of financial sector surveillance, refers to a range of techniques 10 to help assess the vulnerability of a financial system to exceptional but plausible events.17 It is based on applying a common set of shocks and scenarios to a set of individual finan- 11 cial institutions and subgroups of institutions to analyze both the aggregate effect and the distribution of that effect among the institutions. Stress tests were originally developed for use at the portfolio level so one can understand how the value of a portfolio changes 12 if there are large changes to some of its risk factors (such as asset prices). Those tests have now become widely used as a risk management tool by financial institutions. Gradually, A the techniques have been applied in a broader context, with the goal of measuring the sensitivity of a group of institutions (such as commercial banks) or even an entire finan- B cial system to common shocks. System-focused stress testing is best seen as a multi-step process that involves examin- C ing the key vulnerabilities in the system and providing a rough estimate of sensitivity of balance sheets to a variety of shocks. This process entails (a) identifying the major risks D and exposures in the system and formulating questions about those risks and exposures, (b) defining the coverage and identifying the data that are required and available, (c) E calibrating the scenarios or shocks to be applied to the data, (d) selecting and implement- ing the methodology, and (e) interpreting the results. System-focused stress tests attempt F to marry a forward-looking macro-perspective with an assessment of the sensitivity of a collection of institutions to major changes in the economic and financial environment. G The process of conducting a system-focused stress test begins first with the identifica- tion of specific vulnerabilities or areas of concern and then with the construction of a H scenario in the context of a consistent macroeconomic framework. Isolating key vulner- abilities is an iterative process involving both qualitative and quantitative elements. A I range of numerical indicators can be used to help isolate potential weaknesses, including the "big picture" or macro-level indicators, broad structural indicators, and more institu- tion-focused or micro-level indicators. Ideally, a macro-econometric or simulation model 46 Chapter 3: Assessing Financial Stability should form the basis of the stress-testing scenarios. A working group of selected experts 1 may facilitate the process. Once a set of adjustment scenarios has been produced in a consistent macro-frame- work, the next step is to translate the various outputs into the balance sheets and income 2 statements of financial institutions. There are two main approaches to translating macro-scenarios into balance sheets: (a) the "bottom-up" approach in which the effect 3 is estimated using data on an individual institution's portfolios and (b) the "top-down" approach in which the effect is estimated using aggregated data. 4 A variety of metrics can be used to summarize the results of stress tests. The most com- mon ones use measures that express the effect of a shock as a percentage of capital, assets, 5 or profitability. For example, the estimated decline in the value of assets (or in equity) or a reduction in net income caused by higher loan loss provisions or by interest rate shock 6 can be expressed as a ratio involving either (a) capital or assets or (b) profitability. The dispersion of the effect (the standard deviation of the effect across the sample of banks) 7 is also a key statistic to monitor. Public dissemination of the results of stress tests may present some difficulties, but the publication of results by a broad range of countries has 8 shown that those difficulties are not insurmountable. Stress tests are useful because they provide a quantitative measure of the vulnerability of the financial system to different shocks. This measure can be used with other analyses 9 to draw conclusions about the overall stability of a financial system. The value added from system stress tests derives from a consultative process that integrates a forward- 10 looking macroeconomic perspective, a focus on the financial system as a whole, and a uniform approach to the assessment of risk exposures across institutions. Recent trends in 11 Financial Sector Assessment Program (FSAP) stress testing show a shift toward greater integration of a macroeconomic perspective, more involvement by country authorities 12 and individual institutions, and greater coverage of the financial sector. A 3.4 Analysis of Macrofinancial Linkages B Macrofinancial linkages focus on macroeconomic and sectoral implications of financial instability, and they derive from the many ways in which different nonfinancial sectors C rely on intermediation by the financial sector to conduct their activities. Those linkages differ significantly across countries, but they are likely to include (a) the dependence of D nonfinancial sectors (e.g., corporate, household, and government sector) on financing by domestic and foreign banks; (b) the deposits and wealth of those sectors placed with E the financial sector that would be at risk in a financial crisis; (c) the role of the banking system on monetary policy transmission; and (d) the financial sector's holdings of securi- F ties issued by, and loans to, the government so that problems in the financial sector could adversely affect debt sustainability. Thus, the monitoring of financial sector vulnerabilities G using FSIs should be combined with an analysis of other data on macrofinancial linkages to assess the effect of shocks on macroeconomic conditions through the financial sector. H 3.4.1 Effect of Financial Soundness on Macroeconomic Developments I A key macrofinancial linkage that is important in almost all countries derives from the dependence of nonfinancial sectors on financing provided by banks.18 The potential effect 47 Financial Sector Assessment: A Handbook on macroeconomic conditions of banking soundness problems in the banking sector may 1 be detected using FSIs compiled by local and foreign authorities. Data on nonfinancial sectors' borrowing not only from the domestically controlled banking sector but also from 2 foreign-controlled banks by country are needed for analysis. The data on the former are the same data used to compile the exposure concentration of FSIs. Data on borrowing 3 by the nonfinancial private and government sectors from banks headquartered in BIS- reporting countries can be obtained from the BIS consolidated banking statistics.19 The 4 coverage of the data is comprehensive because almost all international banking activity is conducted by internationally active banks from those countries. These BIS data indicate 5 the scale of the potential reduction in financing to the domestic private and government sectors that could result from a deterioration in the soundness of the banking sector in 6 that country.20The prospects for this type of deterioration can be monitored by examining the FSIs for banking in each BIS reporting country. 7 An example of this type of macrofinancial linkage is trade finance. IMF (2003d) discusses this linkage in more detail, noting that during recent financial crises, the trade financing to the crisis countries fell dramatically (more sharply than would seem to be 8 justified by fundamentals and risks involved). The paper attributes the decline to the response by banks as leveraged institutions, to the lack of insurance when it was needed, 9 to herd behavior (among banks, official export credit agencies, and private insurers), and to weaknesses in domestic banking systems. Because bank-financed trade credits are typi- 10 cally short-term, are backed by receivables, and are self-liquidating, their performance, transfer, and convertibility risks are considered lower than those for other cross-border 11 lending. The loss of financing to the trade sector appears to have disrupted countries' trade and growth performance, possibly exacerbating the crisis. 12 Macrofinancial linkages also derive from residents' deposits and wealth placed with domestically owned and foreign-controlled financial institutions, which would be at risk A in crises at home or abroad. The importance of this linkage depends on institutional fea- tures such as the extent to which the deposits are covered by domestic and foreign deposit B insurance schemes. The linkage can be assessed using data on residents' deposit holdings, which, in principle, need to cover both (a) deposits held within the country with domesti- cally owned banks or the local branches and subsidiaries of foreign banks and (b) deposits C held abroad, either with domestic banks' branches and subsidiaries abroad or with foreign banks (in both domestic and foreign currency). Data from monetary statistics typically D capture the first but miss the second (which can be substantial, especially in dollarized economies). Some information on the latter can be obtained from international invest- E ment position data and from the locational BIS international banking data.21 In this case too, FSIs monitor the soundness of the banking sector while the data on wealth placed F with financial institutions give an indication of how much could be lost in the event of a banking crisis (taking into account the extent of protection provided by deposit insur- G ance schemes). Another linkage results from the effect of banking sector problems on the monetary H policy transmission mechanism. Both the domestically owned banks and branches and the subsidiaries of foreign banks play a role in monetary transmission, so a deterioration in I banking sector soundness, either domestically or abroad, could alter the effect of changes in monetary policy on the real economy. This linkage implies that it can be useful to ana- 48 Chapter 3: Assessing Financial Stability lyze FSIs in combination with monetary data to understand how the effect of monetary 1 policy could be affected by the soundness of the financial sector. The analysis would have to take account of financial structure, including the relative importance of market and bank financing, the role of foreign banks in financial intermediation, and the central 2 bank operating procedures. 3 3.4.2 Effect of Financial System Soundness on Debt Sustainability 4 Debt sustainability refers to the ability of a borrower to service a given stock of debt, given the anticipated payments of interest and principal. Debt servicing ability depends on the 5 stream of income accruing to the borrower, the stock and residual maturity profile of the borrowers' assets, the stock of debt outstanding, and the agreed terms--chiefly, the inter- 6 est rate, currency, and time profile.22 Developments in financial system soundness can have a significant effect on debt sus- 7 tainability of households, corporations, and governments; debt sustainability problems in different sectors are mutually reinforcing. The resulting financial instability can impose 8 massive restructuring costs on an economy and can lower overall growth rates, thus undermining the debt servicing capacity of the economy and potentially causing a sov- ereign default. Debt servicing difficulties in any one sector could arise because of market 9 risk, rollover risk, or liquidity risk--or more fundamentally because of unsustainable debt levels and insolvency risk--and difficulties can spread throughout the system. 10 Even when sovereign debt is initially at a sustainable level, the realization of contin- gent liabilities in the event of a crisis can result in deterioration of the government's bal- 11 ance sheet and unsustainable debt ratios. Debt sustainability problems in the nonfinancial sectors can further weaken the financial system by affecting the value of loans and secu- 12 rities held by the financial sector. Sovereign defaults, in particular, have a severe effect on the financial system because of the key role that government securities often play in A financial institutions' balance sheets as a risk-free asset, as a store of collateral, and as a liquid asset. In general, doubts about the debt servicing capacity of any large borrower or B group of borrowers can cause a loss of confidence by depositors and other holders of secu- rities, thereby prompting a flight to quality or a more widespread run on banks and other C institutions. The economic dislocation caused by debt defaults or by a loss of confidence can be magnified by the effect on financial prices as interest rates typically rise and as D credit becomes less readily available--unless the monetary authorities take concerted and credible actions. The exchange rate may also come under pressure if domestic assets as a whole become less attractive relative to foreign assets. The effect on financial markets can E thus magnify the effect of debt sustainability problems on the macroeconomy. Assessing debt sustainability and monitoring the two-way linkages between financial F system soundness and financial soundness of nonfinancial sectors are key to fostering financial stability. Although it is difficult to specify a precise level at which a given stock G of debt becomes "unsustainable," it is possible to detect warning signs of excessive debt accumulation by examining a few key indicators and ratios. At the most simple level, H growth rates of the stock of debt provide an indicator of potential problems if the growth rates exceed reasonable estimates of the growth rate of productive capacity, which ulti- I mately determine the ability to repay. The evolution of financial soundness indicators of 49 Financial Sector Assessment: A Handbook nonfinancial sectors--including the relative size of the debt stock (e.g., debt-to-GDP or 1 debt-to-equity ratios; see section 3.3.1) and its key determinants--provides some useful information on prospective developments in debt ratios or in debt service capacity. For 2 example, a common rule of thumb for public sector debt sustainability is to relate primary fiscal balance to the real interest rates and real growth rates. Similarly, an analysis of the 3 determinants of corporate debt-to-equity ratios (real interest rates, rate of profit, and real return on equity are likely to be among the determinants) could provide an indication of 4 the dynamics of this ratio. 5 3.4.3 Effect of Financial Soundness on Growth and Financial Development 6 The issue of whether financial sector soundness influences growth has received little attention in cross-country empirical research. There is a growing consensus that more 7 finance (i.e., a larger financial sector) causes more growth.23 Recent empirical evidence suggests that countries with better-developed financial systems indeed tend to grow faster. 8 Specifically, the size of the banking system and the liquidity of stock markets are each positively linked with economic growth. Better functioning financial systems ease the 9 external financing constraints that impede corporate and industrial expansion.24 Even though empirical cross-country studies on the issue are limited, there are cases of 10 countries with protracted output losses because of financial sector crises. There is ample case-study evidence (e.g., from the Asian crisis25 or bank restructuring episodes in the 11 Central and Eastern Europe [CEE] countries in the late 1990s) suggesting that financial sector problems can result in significant or protracted output losses. Although few empiri- 12 cal cross-country studies directly address the issue, there seems to be a consensus that is based on the theory and the analysis of country cases that, in the medium to long run, financial soundness is positively related to economic growth. A In the short run, country authorities may be faced with a tradeoff between economic growth and financial sector soundness. Fast growth can make financial markets vulnerable B to shocks, constraining potential output.26 In particular, rapid credit expansion may, at times, exceed banks' capacity to assess risks, thereby leading to reduced asset quality. At C the same time, credit expansions can be only a symptom of rapid financial deepening.27In a country experiencing rapid credit growth and rapid output growth, the key is to determine D whether the credit growth can be interpreted as a structural and positive development (e.g., if it follows a period of financial liberalization and bank restructuring). Even if credit E growth is determined to be the result of structural developments., as has arguably been the case in some transition countries in the late 1990s and early 2000s,28 policy makers F have to evaluate carefully its implications for financial stability and macroeconomic developments. In particular, they need to distinguish to what extent a rapid financial sector growth reflects improvements in access to finance and to what extent the growth G reflects a loosening in risk management practices and supervision. H I 50 Chapter 3: Assessing Financial Stability 3.5 Special Topics in Financial Stability Analysis 1 This section deals with selected topics in financial stability, namely, 2 · The analysis of international financial centers and offshore financial centers and of financial stability 3 · Key stability issues in the opening of capital accounts · The implications of dollarization for stability 4 · Implications of Islamic banking This list is not an exhaustive list of financial sector issues; it is a list of several issues that 5 are not common to all financial systems and, consequently, were not fully addressed in the general sections, but they are still important in several financial systems. 6 7 3.5.1 International Financial Centers and Offshore Financial Centers International Financial Centers (IFCs) are the primary markets where finance capital and 8 currency are collected, switched, disbursed, and exchanged on a regional or global basis.29 An IFC's share in the global financial business is disproportionately large relative to its 9 size as measured by area, population, or nonfinancial economic activity. In most rankings, London, New York, and Tokyo (in this order) are the world's three primary IFCs. They are complemented by a range of secondary and tertiary IFCs, which play important roles 10 as regional financial centers or as major offshore financial centers (OFCs). Although IFCs and OFCs are quite distinct in terms of scale and structure, they are treated together in 11 this section for convenience because they have in common certain stability issues that arise as a result of their international operations. 12 Although there is no generally approved definition of an OFC, a useful one defines it as a center where the bulk of financial sector activity is offshore on both sides of the A balance sheet (that is, the counterparties of the majority of the financial institution's liabilities and assets are nonresidents), where the transactions are initiated elsewhere, B and where the majority of the institutions involved are controlled by nonresidents. Thus, OFCs are usually referred to in the following ways (the third listed is the most popular): C · Jurisdictions that have relatively large numbers of financial institutions engaged primarily in business with nonresidents D · Financial systems with external assets and liabilities that are out of proportion to domestic financial intermediation designed to finance domestic economies (For E most OFCs, the funds that are on the books of the OFC are invested in the major international money-center markets.) F · Centers that provide some or all of the following services: low or zero taxa- tion, moderate or light financial regulation, and banking secrecy and anonymity G (Activities of OFCs are centered around international banking and around asset and risk management, including setting up special purpose vehicles and trusts that are aimed at large corporate entities and at high net worth.) H The key defining characteristics of an IFC are (a) the economies of scale and scope I in financial activities, (b) the extent of international economic and banking links, (c) 51 Financial Sector Assessment: A Handbook the credibility of government policies, and (d) the creditworthiness of the financial 1 sector. Important requirements or prerequisites are economically strong and credible banks within a strong legal system, including property rights, contract enforcement, a 2 functional and credible court system, and bankruptcy processes. Although those condi- tions are necessary to become an IFC, they are not necessarily sufficient; there are also 3 various historical and other reasons why certain places have become IFCs. Moreover, any financial center requires a long time to establish itself as an IFC. IFCs typically engage in 4 a variety of onshore and offshore financial activities, including foreign exchange trading such as cash, forward, and swap transactions. IFCs also engage in a wide range of equity 5 and debt securities and derivatives trading on the cash, futures, and options markets, not only in organized exchanges and over-the-counter transactions but also in activities such 6 as money management, payments clearing and settlement, merger and acquisition, and securities underwriting. In some cases, some of this activity is carried on in institutions 7 that are favorably treated for tax and other purposes. Development of an IFC has several potential benefits for the host economy. There 8 is some evidence in the literature quoted earlier that the large presence of foreign banks in IFCs tends to increase competition. More intensive competition, apart from its static 9 benefits, can also widen the range of financial services available to clients. However, there are also cases of IFCs in jurisdictions where domestic markets have failed to overcome 10 some inherent inefficiencies. An important issue to consider is the competition that is taking place among IFCs. From the viewpoint of global welfare, the competition among 11 countries to host offshore banking can result in a gain to a host center that may represent little net gain overall. 12 At the same time, the presence of an IFC or OFC may be an additional source of instability for the host economy. Financial surveillance needs to analyze not only the A complex structure of the key financial institutions operating in an IFC but also the opera- tions in which those institutions are engaged so people can understand the sources of B the risks (which are often outside the host jurisdiction) and the transfers of risks within and from the IFC. The effect on domestic financial stability caused by the presence of an C IFC or OFC arises from both macro-channels and structural channels. Financial stability would be affected if the domestic economy were more susceptible to shocks than would otherwise be the case, because a segment of the global or regional financial services that D are provided takes place in the domestic economy (through the OFC­IFC transactions). Some of those additional factors affecting financial stability follow: E · Additional cross-border business in an IFC or OFC could add to the demands on F domestic clearing and settlement systems. · The presence of an IFC or OFC may make it easier for domestic residents to invest G offshore or for nonresidents to invest in securities or claims issued by domestic residents. This condition may improve liquidity in domestic markets and facilitate H technology transfer; it may also facilitate excessive risk taking unless restrained by supervision or market forces. I · The effect on domestic economic activity and employment resulting from the pres- ence of an IFC or OFC could be substantial--as is often the case in many OFCs; 52 Chapter 3: Assessing Financial Stability hence, shocks to the volume and stability of IFC operations could affect the domes- 1 tic economy and could indirectly affect domestic financial stability. · Although foreign institutions operating in an IFC or OFC are supervised by their 2 home regulators, the trading activities among those institutions--particularly in OTC markets occurring in the IFC or OFC--may be largely self-regulated and may call for the involvement of host authorities to achieve stability. 3 · The global reach, large size, and complexity of transactions of domestic- or foreign- controlled institutions in an IFC or OFC may pose supervisory challenges for both 4 host and home jurisdictions. 5 The operations of large and complex financial institutions (LCFIs) in an IFC or OFC may have financial stability implications. An LCFI is typically a large player in both 6 wholesale and retail financial markets and has substantial international operations span- ning a number of financial activities. The group is likely to be prominent in the local payments, clearing, and settlements structure. The group is likely to encompass many 7 different legal entities, and the link between those and the group's internal management structure may appear complicated or even opaque. The group may not have an overall 8 lead supervisor monitoring its activities at an overall level on a consolidated basis. At the host-country level, responsibility for supervision of an LCFI's local affiliates may reside 9 within a single regulator or several functional regulators. The size of the LCFI and its geographical diversification has the potential to threaten financial stability not only in 10 the IFC but also in several countries and markets. The operations may be of concern not only to its many financial regulators but also to the central banks and insurance or guar- 11 antee agencies. The latter group of institutions, in the event of a crisis, could be involved in providing or facilitating liquidity or other official financial support, either to the LCFI 12 itself or to its local counterparties.30 The assessment and monitoring of offshore financial centers has increased in recent A years, in part, because of heightened concerns about consolidated supervision and money laundering and because of the associated emphasis on cross-border cooperation and infor- B mation exchange with OFCs.31 The assessment methodology for OFCs places emphasis on fostering compliance with international standards for supervision and financial integrity. C Because they reflect the concerns about consolidated supervision and money laundering or terrorist financing, the assessments generally focus on compliance with the supervisory standards in banking and standards for anti-money laundering and for countering the D financing of terrorism. In addition, when warranted, the assessments also include securi- ties and insurance supervision.32 E Levels of compliance with financial sector standards in OFCs tend to be, on average, higher than in other jurisdictions assessed by the Fund; however, shortcomings remain F in the supervisory systems of many of the OFCs. The higher level of financial standards compliance in OFCs reflects, in part, the higher income levels of the OFCs and their G concerns to protect their reputation. The shortcomings arise mainly from inadequate resources and expertise in the supervisory agencies located in OFCs with lower per capita H income. Those shortcomings are reflected in lower conformity with principles that are concerned with the effectiveness of onsite supervision and in technical areas such as risk I management and guidance for financial institutions (IMF 2004c). 53 Financial Sector Assessment: A Handbook The evidence that OFCs pose a risk to financial stability in non-OFC countries is 1 limited. The potential for risk is seen to lie in the following areas: 2 · Banks have been the most common source of financial instability, and most major OFCs have branches or subsidiaries of globally important banks. Many of those 3 banks are also conglomerates, which pose additional risks. Potential threats to financial instability may increase with weaknesses in consolidated supervision and 4 cross-border consolidated supervision of those institutions. · The lack of information about the activities booked in OFCs restricts the ability to understand global financial flows and to analyze potential stability effects. 5 · Hedge funds and reinsurance companies located offshore have the potential to affect stability through their high leverage and exposure to catastrophic events, 6 respectively. 7 However, an OFC itself may face significant macroeconomic risks, which result from its characteristics as an OFC. Given that financial intermediation in the OFC is typi- 8 cally out of proportion with the size of the domestic economy, most OFCs depend on the financial intermediation as a source of income. Shocks to the volume of financial inter- mediation (e.g., those caused by shocks to the reputation of the OFC) are likely to have 9 a substantial effect on the domestic macroeconomy. 10 3.5.2 Capital Account Liberalization 11 Capital account controls can have a significant effect on the way that external shocks are transmitted to the domestic financial system and on how domestic financial develop- 12 ments affect the macro-economy. When one considers the effect of the capital account on domestic financial stability, it is important to be aware of existing capital controls, A including the nature and scope of recent liberalizations and any plans to relax them.33 Experience has demonstrated that liberalizing the capital account before the home-coun- B try financial system has been adequately strengthened can contribute to serious economic problems.34 For example, studies have shown that a significant number of countries that C suffered from a financial crisis have liberalized their financial systems, including their capital accounts, within the past 5 years before the crisis.35 These experiences have high- lighted the importance of (a) appropriate sequencing and coordination when opening D capital accounts and (b) domestic financial liberalization policies to preserve financial stability. See box 3.2 and chapter 12 for additional discussion. E F 3.5.3 Dollarization: Implications for Stability Dollarization can have important implications for financial stability. A dollarized G economy can be defined as one where (a) households and firms hold a fraction of their portfolio (inclusive of money balances) in foreign currency assets, (b) the private and H public sector have debts denominated in foreign currency, or (c) both. Dollarization can be "official" when the U.S. dollar is adopted as the legal tender or "partial" when the I local currency remains the legal tender, but transactions are allowed to be denominated in dollars, thus effectively allowing a bicurrency system to take hold. It is useful to distin- 54 Chapter 3: Assessing Financial Stability guish among three generic types of dollarization that broadly match the three functions of 1 money: (a) payments dollarization (currency substitution) is the resident's use of foreign currency for transaction purposes in cash, demand deposits, or central bank reserves; (b) 2 financial dollarization (asset substitution) consists of the resident's holdings of financial assets or liabilities in foreign currency (either domestic or external); and (c) real dol- larization is the indexing, formally or de facto, of local prices and wages to the dollar.36 3 Dollarization can be measured using a variety of statistics, including the ratio of onshore foreign currency deposits to total onshore deposits, the ratio of foreign currency deposits 4 to broad money, the ratio of domestic government debt in foreign currency to total gov- ernment debt, and the share of private sector debt in total external debt.37 Additional 5 risks to financial stability resulting from dollarization and the implications for financial policy are discussed below. 6 Empirical evidence suggests that financial dollarization may increase the vulnerability of financial systems to solvency and liquidity risks. Cross-country estimates of the effect of 7 dollarization on key financial soundness indicators are consistent with the hypothesis that increased dollarization increases financial vulnerability. The variance of deposit growth is 8 positively and significantly correlated with dollarization, suggesting that dollarized finan- cial systems may be more exposed to credit cycles and liquidity risk. A cross-country com- 9 parison of estimates of nonperforming loans (NPLs) or a composite systemic risk measure will show that dollarized economies also tend to be more exposed to solvency risk. 10 The limited backing of banks' dollar liabilities by U.S. dollars and their convertibility at par subjects the financial system to a very specific type of liquidity risk. Systemic liquid- 11 ity risk arises when the demand for local assets falls because of a perceived increase in country or banking risk, thus prompting foreign banks to recall short-term lines of credit 12 and depositors to convert their deposits into dollars or to transfer them abroad. Unless liquid dollar liabilities are backed by sufficient liquid dollar assets abroad, banks could run A out of dollar liquid reserves and could fail to pay off dollar liabilities. Similarly, central banks could run out of international reserves to provide dollar lender-of-last-resort sup- port to distressed banks. When those international reserves are depleted, deposit (or loan) B contracts may need to be broken and disruptive or confiscatory measures taken, thereby imposing a heavy cost on the financial system. C Dollar deposits are often more vulnerable to runs than local currency deposits, even in the absence of exchange rate adjustments. In highly dollarized countries, local currency D deposits are mostly held for transaction purposes and are less affected by expected yield differentials than dollar deposits, which are predominantly held as store of value and are E close substitutes for deposits abroad or dollars cash. Moreover, even when the demand for local currency deposits is affected, the small size of these deposits in the most highly dol- F larized countries limits the threat they represent for banks' liquidity. The lack of dollar monetary instruments can further inhibit the scope for interest rate G defenses against deposit withdrawals. An interest rate defense may be ineffective once a run has started, because the central bank has limited ability to raise the interest rate on H dollar deposits. Banks are often reluctant to raise interest rates on dollar deposits, because of concerns that increasing rates may be interpreted as a sign of weakness, thus further I exacerbating deposit withdrawals. 55 Financial Sector Assessment: A Handbook 1 Box 3.2 Capital Account Liberalization and Financial Stability Capital account liberalization exposes the domestic is weak, the monetary authorities may be reluctant to 2 financial sector to greater competition and risk tak- increase interest rates to stabilize the exchange rate. ing. In the absence of appropriate bank supervision, The supervisory agency needs to have prudential 3 banks can expand risky activities at rates that exceed standards and technical skills to cope with the chal- their capacity to manage them, including the use of lenges that accompany capital account liberaliza- derivatives and other complex cross-border transac- tion. Experience shows that careful planning of the 4 tions that are difficult to monitor and regulate. Large sequencing and the pace of reforms could be critical capital inflows can also lead to rapid credit growth, to successful liberalization efforts, as further discussed 5 possibly to unproductive sectors of the economy such in chapter 12. Before liberalizing the capital account, as real estate and government-supported industries, particular attention should be given to the effective- thus contributing to asset price bubbles and financial ness of existing capital controls, the soundness of 6 sector difficulties.a Capital account liberalization can the macroeconomic environment and consistency of also increase banks' credit risk through aggressive for- macroeconomic policies, the prudential and super- eign currency lending to unhedged borrowers. visory framework, the financial system's level of 7 Capital account liberalization may facilitate a development, and the ability of both financial and faster transmission of economic and financial system nonfinancial corporations to manage potential risks 8 shocks, thereby increasing asset price volatility.b and shocks that may arise. Successful capital account Exchange rate risks tend to be more pronounced liberalization requires complementary monetary and when a fixed exchange rate peg has been maintained financial sector reforms. Policies should be focused 9 for a considerable period of time and if market per- on improving internal governance of financial insti- ception of an implicit exchange rate guarantee has tutions, developing deep and liquid financial mar- promoted inadequate hedging. If the banking system kets, and fostering market discipline. 10 a. In Korea, before the 1997 crisis, capital inflows helped finance sectors that subsequently experienced difficulties. In Sweden, 11 the large credit expansion that followed financial deregulation contributed to the asset price bubble in the 1980s. b. Cross-border contagion may be exacerbated if portfolio managers in developed countries bundle instruments from different countries in the same risk class. 12 A B The main solvency risk faced by dollarized financial systems results from currency mismatches in the event of large depreciations. Currency-induced credit risk is generally C the key source of vulnerability because borrowers are highly susceptible to defaulting on dollar-denominated loans in the event of a large depreciation. Banks with large domestic dollar liabilities must balance their foreign exchange positions either by extending dollar D lending to local currency earners or by holding dollar assets abroad. Thus, to maintain their profitability (especially in light of generally lower rates of return on foreign assets E than on local dollar assets) and to satisfy the pent-up demand for loans, banks gener- ally end up lending domestically a large share of their dollar deposits, thus effectively F transferring the currency risk to their unhedged clients and retaining the resulting credit risk. Borrowers' currency mismatch is enhanced by the fact that prices and wages may G continue to be set in local currency even when financial dollarization is widespread. Counterparty exposure is also amplified if collateral is denominated in domestic currency, H and it declines relative to the loan after a depreciation. Banks' direct exposure to currency risk is generally limited by tight regulatory limits on open foreign exchange positions, I but off balance-sheet positions (e.g., in derivatives) are often misreported and may cause exposures to be underestimated. 56 Chapter 3: Assessing Financial Stability In the event of large depreciations, widespread currency mismatches can have sys- 1 temic effects that compound the deterioration of banks' financial situation. Because of balance-sheet effects, large devaluations in highly dollarized economies are more likely to 2 be contractionary, further undermining borrowers' capacity to service their debts. Because it impairs the solvency of both borrowers and banks, the credit risk deriving from a large devaluation also increases the scope for a credit crunch and heightens the risk of deposit 3 withdrawals by concerned depositors. Thus, solvency and liquidity risks are closely inter- related. 4 The interaction between prudential risks and the monetary regime, which instills fear of floating, subjects the financial system to risks similar to those incurred under a rigid 5 exchange rate system. The more financially dollarized an economy is, the more vulner- able to large exchange rate fluctuations it becomes; hence, the less disposed the monetary 6 authorities are to let the exchange rate float. Empirical evidence indicates that both nominal and real (bilateral) exchange rates are less volatile in more dollarized economies 7 (see Gulde and Ize 2004). Instead, interest rates must bear the brunt of the adjustment to shocks, thereby raising interest rate risk both for local currency and for dollar intermedia- 8 tion and then heightening credit cycles. Credit booms are accentuated by the fact that incoming dollar flows feed domestic lending and, through the banking multiplier, boost 9 dollar intermediation. The dollarization of public debt can be an important collateral source of financial 10 fragility when banks have large holdings of public securities. Sharp exchange rate depre- ciations can undermine the sustainability of the public debt and, in turn, can undermine the solvency of banks when the latter hold large volumes of public securities. 11 In countries with a high degree of dollarization, stability assessments should indicate the extent to which dollarization is a potential source of vulnerability and should suggest 12 appropriate measures. Where available, reports also should provide supporting quantita- tive information such as the degree of co-circulation, shares of foreign currency deposits A and loans, short-term foreign assets and liabilities of the main financial institutions, net foreign assets, and net open foreign currency positions of banks. B 3.5.4 Islamic Banking--Stability Issues C The provision and use of financial services and products that conform to Islamic religious D principles pose special challenges for a stability assessment. Institutions offering Islamic Financial Services (IIFS) and Islamic capital market instruments constitute a significant E share of the overall financial system in several countries; in Sudan and Iran, the entire system is based on Islamic finance principles. This situation requires the recognition of the unique mix of risks in IIFS and key aspects of Islamic securities markets not only in F stability assessments but also in the design of policies. See box 3.3 for details. G 3.6 Key Policy Issues and Policy Priorities to Support Stability H The previous sections of this chapter (3.1­3.5) have described a range of qualitative and I quantitative information and techniques that can be used to identify potential strengths 57 Financial Sector Assessment: A Handbook 1 Box 3.3 Stability Issues in Islamic Banking Unique risks in Islamic finance arise both from con- · Another specific risk inherent in IIFS stems 2 tractual design of instruments that are based on Sharia from the special nature of investment deposits, Principles and from the overall legal, governance, and whose capital value and rate of return are not 3 liquidity infrastructure governing Islamic finance. guaranteed. This condition increases the poten- The following lista summarizes the features that need tial for moral hazard and creates an incentive for to be taken into account when assessing stability in a risk taking and for operating financial institu- 4 financial system that includes (or is based on) institu- tions without adequate capital. tions offering Islamic financial services (IIFS). · Finally, Islamic banks can use fewer risk-hedg- ing instruments and techniques than do con- 5 · Profit-and-loss-sharing (PLS) modes of financing ventional banks and can operate in an environ- shift the direct credit risk from banks to their ment (a) with underdeveloped or nonexistent investment depositors, but they also increase the interbank and money markets as well as govern- 6 overall degree of risk of the asset side of banks' ment securities and (b) with limited availability balance sheets because they make IIFS vulner- of, and access to, lender-of-last-resort facilities able to risks normally borne by equity investors 7 operated by central banks. rather than by holders of debt. In particular, operational risk is crucial in Islamic finance. It The above risk factors have historically forced arises from (a) the fact that the administration of IIFS into holding a comparatively larger proportion 8 PLS modes is more complex than conventional of their assets in reserve accounts with central banks financing (which also makes standardization of or in correspondent accounts than do conventional 9 the products more difficult to achieve) and (b) banks, and those risk factors have also led to reli- the fact that IIFS often have no or limited legal ance mostly on sales-based facilities on the asset side means to control the agent-entrepreneur. Non- rather than PLS modes. This situation has affected 10 PLS modes of financing are less risky and they their competitiveness and has increased their vulner- more closely resemble conventional financing ability to external shocks, with potential systemic facilities, but they also carry special risks that consequences. Sundararajan and Errico (2002) pro- 11 need to be recognized. vide suggestions on how to address the risks inherent · Sales-based methods of financing often bundle in Islamic banking.b 12 commodity price risks, operational risks, and credit risks in complex ways, making it difficult to price risks. A a. This subsection is based on Sundararajan and Errico (2002). b. For more on regulatory and risk management issues in Islamic banking, see exposure drafts of various prudential standards in B the Web site of the Islamic Financial Services Board (http://www.ifsb.org), an international organization that was established to promote good regulatory and supervisory practices and to develop international prudential standards for institutions offering Islamic financial services. C D E and vulnerabilities in the financial system. Once weaknesses have been identified, the next issues to consider are how this information can be used to help maintain financial F stability and how policies can be enacted or changed to minimize the risks to financial stability. The responses to those issues are multifaceted and depend on the nature of the G vulnerabilities that have been identified. Vulnerabilities and the corresponding policy actions can be categorized into four key areas: H · Macroeconomic (such as aggregate imbalance in payments to nonresidents) I · Institutional (relating to weaknesses in particular institutions or classes of institu- tions) 58 Chapter 3: Assessing Financial Stability · Regulatory or supervisory (relating to the design and implementation of regula- 1 tions and prudential standards) · Structural (relating to the operational infrastructure of markets, settlement sys- tems, and safety nets) 2 The mix and the timing of policy tools need to be appropriate for the vulnerability 3 addressed. For example, if rapid credit growth were mainly a result of macroeconomic imbal- ances, it would need to be addressed primarily by macroeconomic stabilization policies, 4 while prudential tools would play only an auxiliary role. Conversely, if a vulnerability were mainly a result of weaknesses in banking supervision and regulation, then using macroeco- nomic policies would be second best should reforms of supervision and regulation turn out 5 to be insufficient or slow to yield results. Weaknesses such as these should be addressed in a timely manner through improved prudential supervision and oversight, effective surveil- 6 lance of individual institutions and markets, and development and maintenance of a robust financial infrastructure. Macroeconomic policy adjustments, even when they are second 7 best, could be crucial, for example, to limit inflationary pressures, credit growth, or bubbles in certain sectors that could substantially affect the financial sector. In addition, by them- 8 selves, policies to develop institutions and markets (e.g., money or government securities market development) and to build infrastructure (e.g., design a large value payment system) 9 pose additional financial and macroeconomic risks, which need to be managed through prudential policies and macro-policy adjustments, as further discussed in chapter 12. 10 The calibration of policies can take into account information obtained from the quan- titative macroprudential tools, in particular, stress tests. For example, in the context of 11 macroeconomic policies, stress tests or sensitivity calculations can provide an assessment of how a certain interest-rate and exchange-rate policy mix can affect the financial sector and of what the resulting effect on the economy as a whole would be. Similarly, in the 12 context of regulatory policies, simulations can be used to assess what the effect would be of an envisaged policy change (e.g., an increase in the rate of providing loans) on the A health of the financial system. In the context of supervision, stress-test results can be used to direct supervisory attention to those groups of institutions that pose the greatest B risk for the system as a whole. Similarly, evolution of financial soundness indicators and information from macroprudential surveillance may call for more intensive supervision in C specified areas (e.g., market risks or country risks). An assessment of the overall stability of the financial system is based on combining D the analysis of risks and vulnerabilities with the assessment of various financial policy responses and policy frameworks. If the potential vulnerability to plausible shocks were E not high or if the policy framework and policy responses­­as seen, for example, from stan- dards assessments­­were considered appropriate, then the system would be judged stable. The stability considerations would typically dictate that a range of prudential and market F development policies be given high priority. G Notes H 1. See Houben, Kakes, and Schinasi (2004, appendix II) and Schinasi (2004) for a dis- I cussion of definitions of financial stability. 59 Financial Sector Assessment: A Handbook 2. Financial stability analysis is intended to assess the stability and efficiency of a financial 1 system as a whole and not of individual institutions. Although a focus on systemically important institutions is needed to assess stability, the analysis cannot be expected to 2 address legal or governance issues such as fraud that pertain to specific institutions. 3. See Borio (2003) for a discussion of this point. 3 4. For useful overviews of the EWS literature, see Kaminsky, Lizondo, and Reinhart (1998), Berg and others (2000), Altman and Narayanan (1997), and Abiad (2003). 4 See also Altman and Narayanan (1997). 5. See box 3.1 for further details on market-based indicators of financial soundness. 5 6. See IMF (2004b) for further details of the use of FSIs. 7. This section is based on Craig and Sundararajan (2004), Sundararajan and others 6 2003, and IMF (2004b, chapters 6, 8, and 14). 8. Several market-based indicators may also be used to analyze the evolution of financial 7 system risks, including credit risks. 9. Basel Core Principles (BCP) assessments examine compliance with 25 basic principles for effective banking supervision. The scope and coverage of BCP are analyzed in 8 chapter 5 and in IMF and World Bank (2002b). For more information on how BCP assessments can provide information that is useful for interpreting FSIs and for a map- 9 ping of FSIs with relevant core principles, see IMF (2003c). 10.A general introduction to insurance sector soundness is also provided in International 10 Association of Insurance Supervisors (IAIS; 2000, 2002). This section is based on the discussion in Das, Davies, and Podpiera (2003). Insurance firms often sell pensions or 11 manage pension funds, other mutual funds, and unit trusts. Those in the insurance and pension fund management industry can significantly affect the stability of markets and 12 financial stability generally through their investment behavior. See the IMF Global Financial Stability Report for April (2004d) and September (2004e). A 11.See Das, Davies, and Podpiera (2003, appendix I) for an explicit mapping of Insurance Core Principles into FSIs for the insurance sector and for examples of core FSIs in a B number of countries. 12.This section is based on Craig and Sundararajan (2004), IMF (2004b, chapter 8), and IMF and World Bank (2002a). C 13.The basic definitions of the FSIs are provided in chapter 2. See also chapter 8 of IMF (2004b) for an overview of statistics on securities markets, and see BIS (1999, 2001) D for a detailed discussion of market liquidity. 14.Chapter 5 of IMF (2004b) reports empirical analysis demonstrating a linkage between E corporate leverage and asset quality across a large number of countries. See also Pomerleano (1998). F 15.IMF (2005) examines household sector behavior, with a focus on assessing the shifting of market risks to the household sector. See also Debelle (2004). G 16.Hilbers, Lei, and Zacho (2001) conclude that unbalanced real estate price develop- ments often contribute to financial sector distress. Also, see chapter 9 of IMF (2004b) H for a discussion of real estate price indices. For a comprehensive analysis of real estate indicators, see BIS (2005). See also Borio and McGuire (2004). I 17.This section contains a general discussion on stress testing. For more technical details, see appendix D. 60 Chapter 3: Assessing Financial Stability 18.This section builds on IMF 2003, part I. 1 19.See the BIS Web site for more information: http://www.bis.org/statistics/consstats. htm. 2 20.In the limited number of countries where banks from a non-BIS-reporting country have a significant presence, other data must be used. Specifically, the local supervisory authorities may need to ask those banks to report their consolidated lending to the 3 country (if they are not doing so already). 21.The BIS locational international banking statistics are a separate set of data from the 4 BIS consolidated banking statistics that measure banking sector assets and liabilities in foreign countries but are not consolidated on a cross-border basis. See http://www. 5 bis.org/statistics/bankstats.htm for more details. 22.The debt sustainability will also depend on other policy and environmental elements 6 that affect future cash inflows and outflows, such as the expenditure policies of a sovereign borrower. See "Assessing Sustainability," IMF (2002a) for a comprehensive 7 discussion of different concepts of sustainability. 23.See Levine (2003) or Rajan and Zingales (1998), as well as other references in chap- 8 ter 4. 24.For a further discussion on this subject, see chapter 4. 9 25.See Ghosh and others (2002). 26.Bell and Pain (2000) review the literature suggesting that banking crises tend to be 10 preceded by credit booms. 27.Gourchinas, Valdes, and Landerretche (2001) find that financial development typi- 11 cally occurs in bouts that are characterized by short periods of intense financial deep- ening. 12 28.See Cottarelli, Dell'Ariccia, and Vladkova-Hollar (2003). 29.Analyses of IFCs by economists have been sparse. More attention has been devoted to A this area by geographers, who have focused primarily on why IFCs are located where they are. Good reviews of the literature are provided by Choi, Park, and Tschoegl (1990) and Tschoegl (2000). B 30.For more on the analysis of risks associated with LCFIs, see Miles (2002). 31.See IMF (2000, 2003b) for a more detailed discussion of rationale and lessons of the C OFC assessment program of the IMF. See also Financial Stability Forum (2000). 32.These types of standards assessments are done as part of a broader stability assessment D in FSAPs for countries that host an OFC or IFC. A stand-alone assessment of an OFC, however, is limited only to an assessment of observance of relevant international stan- E dards. 33.A detailed description of exchange arrangements and restrictions of individual coun- F tries is provided in IMF (2003a, 2004a). 34.Ishii and others (2002) provide country examples. For instance, capital account liber- G alization against a weak and poorly supervised financial sector contributed to the 1994 crises in Mexico and Turkey. Expansionary macroeconomic policies, a weak regulatory H environment, and a fixed exchange rate policy together with capital account liberal- ization fueled the 1992 crisis in Sweden. I 35.See Williamson and Mahar (1998) and Kaminsky and Reinhart (1999). 61 Financial Sector Assessment: A Handbook 36.See Gulde and Ize (2004) and De Nicoló, Honohan, and Ize (2003) for a discussion of 1 the various forms and consequences of dollarization. 37.These measures may not fully capture the extent of dollarization insofar as dollars are 2 held as cash and used for transactions. 3 References 4 Abiad, Abdul. 2003. "Early Warning Systems: A Survey and a Regime-Switching 5 Approach." IMF Working Paper 03/32, International Monetary Fund, Washington, DC. 6 Ades, Alberto, Rumi Masih, and Daniel Tenengauzer. 1998. GS-Watch: A New Framework for Predicting Financial Crises in Emerging Markets. Emerging Markets Economic 7 Research, December. New York: Goldman Sachs. 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IMF Occasional Paper 211, International Monetary Fund, Washington, I DC. Available at http://www.imf.org/external/pubs/nft/op/211/index.htm. 65 Financial Sector Assessment: A Handbook Jagtiani, Julapa, Kolari James, Catherine Lemieux, and Hwan Shin. 2003. "Early Warning 1 Models for Bank Supervision: Simpler Could Be Better." Federal Reserve Bank of Chicago Economic Perspectives 27(3): 49­60. 2 Kamin, Steven, John Schindler, and Shawna Samuel. 2001. "The Contribution of Domestic and External Factors to Emerging Market Devaluation Crises: An Early 3 Warning Systems Approach." International Finance Working Paper 711, Board of Governors of the Federal Reserve System, Washington, DC. 4 Kaminsky, Graciela. 1999. "Currency and Banking Crises--The Early Warnings of Distress." IMF Working Paper 99/178, International Monetary Fund, Washington, 5 DC. Available at http://www.imf.org/external/pubs/ft/wp/1999/wp99178.pdf. Kaminsky, Graciela, Saul Lizondo, and Carmen Reinhart. 1998. 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"Emerging Markets Risk Indicator (EMRI)." In Global Emerging H Markets Strategy. London: Credit Suisse First Bank. Sahajwala, Ranjana, and Paul Van den Berg. 2000. "Supervisory Risk Assessment and I Early Warning Systems." Basel Committee on Banking Supervision Working Paper 2, Bank for International Settlements, Basel, Switzerland. 66 Chapter 3: Assessing Financial Stability Schnatz, Bernd. 1998. "Macroeconomic Determinants of Currency Turbulences in 1 Emerging Markets." Discussion Paper 3/98, Economic Research Group of the Deutsche Bundesbank, Frankfurt, Germany. Schinasi, Gary J. 2004. "Defining Financial Stability." IMF Working Paper 04/187, World 2 Bank Group, Washington, DC. Available at http://www.imf.org/external/pubs/ft/ wp/2004/wp04187.pdf. 3 Sundararajan, Venkataraman, Charles Enoch, Armida San José, Paul Hilbers, Russell Krueger, Marina Moretti, and Graham Slack. 2003. "Financial Soundness Indicators: 4 Analytical Aspects and Country Practices." IMF Occasional Paper 212, International Monetary Fund, Washington, DC. Available at http://www.imf.org/external/pubs/nft/ 5 op/212/index.htm. Sundararajan, Venkataraman, and Luca Errico. 2002. "Islamic Financial Institutions 6 and Products in the Global Financial System: Key Issues in Risk Management and Challenges Ahead." IMF Working Paper 02/192, International Monetary Fund, 7 Washington, DC. Tschoegl, Adrian E. 2000. "International Banking Centers, Geography, and Foreign 8 Banks." Financial Markets, Institutions and Instruments 9, No. 1 (February): 1­32. Available at http://www.ingenta.com/journals/browse/bpl/fmii. Williamson, John, and Molly Mahar. 1998. "A Survey of Financial Liberalization." Essays 9 in International Finance (Princeton University) 211 (November). Available at http:// www.princeton.edu/~ies/IES_Essays/E211.pdf. 10 Wong, Jim, and Laurence Fung. 2002. Liquidity of the Hong Kong Stock Market since the Asian Financial Crisis. Basel, Switzerland: Bank for International Settlements. 11 Available at http://www.bis.org/cgfs/conf/mar02n.pdf. 12 A B C D E F G H I 67 1 2 3 4 Chapter 4 5 Assessing Financial Structure and 6 Financial Development 7 8 9 10 4.1 Overview 11 4.1.1 Motivation for Assessing Financial Structure and Financial Development 12 Extensive evidence confirms that creating the conditions for a deep and efficient financial A system can contribute robustly to sustained economic growth and lower poverty (e.g., see Beck, Levine, and Loayza 2000, Honohan 2004a, and World Bank 2001a). Moreover, in B all levels of development, continued efficient and effective provision of financial services requires that financial policies and financial system structures be adjusted as needed in response to financial innovations and shifts in the broader macroeconomic and institu- C tional environment. D 4.1.2 Scope of Analysis E The goals of financial structure analysis and development assessment for a country are to (a) assess the current provision of financial services, (b) analyze the factors behind miss- F ing or underdeveloped services and markets, and (c) identify the obstacles to the efficient and effective provision of a broad range of financial services. The dimensions along which G service provision must be assessed include the range, scale (depth) and reach (breadth or penetration), and the cost and quality of financial services provided to the economy. At a H high level of abstraction, those services are usually classified as including the following: · Making payments I · Mobilizing savings 69 Financial Sector Assessment: A Handbook · Allocating capital funds 1 · Monitoring users of funds · Transforming risk 2 Thus, the ideal financial system will provide, for example, reliable and inexpensive 3 money transfer within the country, reaching remote areas and poor households. There will be remunerative deposit facilities and other investment opportunities offering liquid- ity and a reasonable risk-return tradeoff. Entrepreneurs will have access to a range of 4 sources for funds for their working- and fixed-capital formation; affordable mortgage and consumer finance will be available to households. The credit renewal decisions of banks 5 and the market signals coming from organized markets in traded securities will help ensure that good use continues to be made of investable funds. Insurance intermediaries and 6 the portfolio possibilities offered by liquid securities markets will help maximize the risk pooling and the shifting of risk at a reasonable price to entities that are able and willing 7 to absorb it. The scope of financial structure analysis and of development assessment is fairly 8 extensive--as illustrated in the above list--and those structural issues cannot be simply broken into self-contained segments corresponding to existing institutional arrangements. 9 Structural and development issues arise across the entire spectrum of financial markets and intermediaries, including banking, insurance, securities markets, and nonbank 10 intermediation. They often demand consideration of factors for which well-adapted and standardized quantification is not readily available. Therefore, the challenge is to trans- 11 late those wide-ranging and somewhat abstract concepts into a concrete and practical assessment methodology. The suggested approach begins with a fact-finding dimension that seeks to benchmark 12 the existing financial services provided in (and available to) the national economy--in terms of range, scale and reach, cost, and quality--against international practice. Such A benchmarking should help pinpoint areas of systemic underperformance, which can then be further analyzed to diagnose the causes of the underperformance against realistic tar- B gets. To some extent, the benchmarking can be quantified, but, in practice, quantification must be supplemented by in-depth qualitative information. The question being asked in C every case is, if quality or quantity is deficient, then what has caused this deficiency? Deficiencies will often be traced to a wide range of structural, institutional, and policy D factors. · First, there may be gaps or needed changes in the financial infrastructure, both E in the soft infrastructures of legal, information, and regulatory systems and in the harder transactional technology infrastructures that include payments and settle- F ments systems and communications more generally. · Second, there may be flaws or needed adaptations in regulatory or tax policy G (including competition policy) whose inadequacies or unintended side effects dis- tort or suppress the functioning of the financial system to an extent not warranted H by the goals of the policy. · Third, digging deeper, there may be broad governance issues at the national level, I for example, where existing institutional structures impede good policy making (especially favoring incumbents over newcomers). 70 Chapter 4: Assessing Financial Structure and Financial Development · Fourth, financial sector deficiencies may also be traced to problems in the country's 1 wider economic infrastructures, including the education, transportation, and com- munications systems. Furthermore, many developing countries are faced with the 2 difficulty that effective finance requires a scale of activity that may be beyond the reach of small economies, populated as they are by a small number of small clients, small intermediaries, and small organized markets (see Bossone, Honohan, and 3 Long 2002). An effective financial system, while contributing to wider economic growth and development, is also somewhat dependent on the wider economic 4 environment--not least the macroeconomic and fiscal environment. 5 The most distinctive feature of financial structure analysis and development assess- ment is the focus on the users of financial services and on the efficiency and effectiveness 6 of the system in meeting user needs. Policy reforms that benefit users and that promote financial development are generally favored in such analysis and assessments.1 The pro- posed assessment framework is also guided by the presumption, which is based on a sizable 7 body of empirical evidence, that an effective and efficient financial system is best provided by market-driven financial service providers, with the main role of government being to 8 serve as regulator and provider of robust financial infrastructure. Therefore, the establish- ment of a government-sponsored financial service provider is not seen as likely to be the 9 first-best solution to deficiencies. Instead, the role and effectiveness of financial service providers are assessed regardless of whether they are government owned. Assessment has 10 two phases: information gathering and analytical reporting. 11 Phase 1: Information-Gathering Phase 12 To reflect this focus on users and the services they require, the overall assessment needs to adopt a functional approach and not to be confined to a perspective that is based on A existing institutional dividing lines between different groups of providers.2 Nevertheless, much of the information gathering will inevitably reflect those institutional divisions, not B the least because national regulatory structures are typically organized along those lines (notwithstanding the trend to integrated supervisory agencies in several countries). In addition, the adequacy of the legal, information, and payments infrastructures C and of other aspects of the overall policy environment are central to the development assessment: each has relevance cutting across any single sector. Yet, information about D the effectiveness of the infrastructures and about the unintended and hidden side effects of the policy environment is often obtained only by learning how each sector works. E Likewise, the competitive structure, efficiency, and product mix of the various sectors can be explained only on the basis of an understanding of the design and performance of F the infrastructures. So the information-gathering phase of the assessment needs to have a sectoral, as well as an infrastructural, dimension. Cross-cutting policy issues such as taxa- G tion also need to be kept in mind. Finally, user perspective can be helpful, especially in identifying gaps in providing markets and services, as well as in discovering deficiencies H in quality and cost that might not be revealed from analysis of the suppliers. The information-gathering phase of the assessment is multidimensional. Typical com- I ponents of the information-gathering phase may include the following: 71 Financial Sector Assessment: A Handbook · Quantitative benchmarking of the size, depth, cost and price efficiency, and the 1 penetration (breadth) of financial intermediaries and markets, using internation- ally comparable data (section 4.2) 2 · Reviews of legal, informational, and transaction technology infrastructures (sec- tion 4.3) 3 · Sectoral development reviews, providing a more in-depth assessment of service provision, structure, and regulation (Sectors covered will normally include com- 4 mercial banking and nearbanking, insurance, and securities sectors and may also include some or all of the collective savings institutions and of the financial aspects 5 of public pension funds, specialized development intermediaries, mortgage finance, and microfinance. Those sectors need to refer to the functioning both of the 6 industry [financial services providers] itself and of the regulatory apparatus [section 4.4].) 7 · Demand-side reviews of access to, and use of, financial services by households, microenterprises, small and medium enterprises (SMEs), and large enterprises (sec- tion 4.5) 8 · Reviews of selected additional cross-cutting aspects of the policy environment (for example, distorting taxation and subsidization of financial intermediation) and of 9 implications for competition of cross-sectoral ownership structures (Those reviews also may mention missing product issues, thus focusing on whether key financial 10 products--such as leasing, factoring, and venture capital--are available and iden- tifying the reasons for their absence [see section 4.6].) 11 12 Phase 2: Analytical and Reporting Phases The relative importance of the components of the information-gathering phase and the A scope of their analysis will vary according to country circumstances. This wide-ranging scope of information presents a challenge to assessors who must, in the analytical and B reporting phases, synthesize the information to identify the major axes of needed policy reform and of infrastructural strengthening for stability and development. Segments of the C financial system that are already active, but for which the benchmarking exercise suggests shortcomings, will deserve more-detailed attention. For segments that are missing or are D not very developed, the discussion of needed policies can be confined to the level of broad strategy. How those components can be integrated into a policy framework is discussed in section 4.7. E F 4.1.3 Stability and Development: Complementarities Despite the Different Perspective G Financial structure analysis and development assessment inevitably overlaps extensively with the stability assessment. Even if adequate from a stability perspective, the existing H regulatory framework and the supervisory practices may need reform from the develop- ment perspective. Certain areas not normally considered in stability-oriented assessments, I such as microfinance and development banking, warrant attention from the development perspective. Moreover, every sector that is relevant to stability can have an important 72 Chapter 4: Assessing Financial Structure and Financial Development development dimension. Notwithstanding the overlap of themes, the focus of the sectoral 1 and infrastructural development reviews is different from, and complementary to, that of the stability assessment. For each sector, the development review is designed to consider whether policy or legislative changes are needed to enhance the ability and incentive of 2 market participants to deliver financial services. The types of question asked in analyzing financial structure and development are 3 often different from those that take center stage in the stability assessment. For example, are regulatory restrictions on bank entry and conduct (including interest rate ceilings, 4 ownership, branching, and automated teller machines [ATMs]) unduly constraining, and do they act as barriers to competition and to the extension of financial services to 5 underserved segments? Is the regulation of insurance company investments hampering their contribution to long-term funding of enterprises? Is there an adequate enabling legal 6 framework for the emergence of widely accessed credit registries? Are judicial practice, funding, and skills supportive of speedy and low-cost debt recovery? Does the regulatory 7 framework for payments systems support an efficient and low-cost network of retail pay- ments throughout the country? 8 The overlap between stability and development raises both practical and conceptual issues for the sectoral reviews: At the practical level, there is the need to coordinate 9 information gathering to avoid duplication of effort. At the conceptual level, there is the need to ensure that the recommendations mesh well together. In practice, the two perspectives--stability and development, reinforce each other in terms of recommenda- 10 tions more often than they create a tension or tradeoff. For example, legal procedures for enhancing creditor rights tend both to reduce the risk of loan losses undermining 11 the soundness of the banking system and to increase the willingness of intermediaries to extend credit. Yet there can be some apparent tension, for example, when entry of 12 foreign-owned banks--although improving the quality and price of services to the rest of the economy--is seen as a threat to the profitability of incumbents (a stability issue). A Apparent conflicts must be considered and resolved from a wider perspective of ensuring long-term, stable financial development in the interest of the economy at large. One issue B in this context is whether the system is sufficiently robust (stability analysis) to withstand the potential shocks associated with liberalization that will eventually be needed for C development reasons. In this sense, the stability analysis can provide some guidance to the timing and sequencing of development-oriented reforms. A detailed analysis of sequenc- D ing issues is presented in chapter 12. E 4.2 Quantitative Benchmarking F If we are to obtain an overall picture of where the financial sector is, or is not, perform- ing well, then the performance of financial intermediaries and markets--in terms of total G assets, scope of activity, depth, efficiency, and penetration--can be compared to a care- fully chosen set of comparator countries. National authorities are likely to be interested in H countries in the same region, as well as those of a similar size and a similar level or higher levels of per capita income.3 The type of indicators that would be appropriate is discussed I in chapter 2 and summarized in box 4.1. 73 Financial Sector Assessment: A Handbook 1 Box 4.1 Quantitative Indicators for Financial Structure and Development Assessment The measures chosen as quantitative indicators for ing comparison; however, the assembly of breadth 2 financial structure and development assessment will and penetration indicators on a cross-country basis naturally include basic indicators of financial depth is in the beginning stages. There is a clear ranking 3 expressed as a percentage of gross domestic product of cross-country data availability among different (GDP). The indicators are proxies for the size of the sectors, with data on banking, insurance, and stock different components of the financial sector and could markets more readily available than on bond markets 4 include credit to the private sector and broad money and microfinance. Quantitative benchmarking may (M2) for banking; number of listed equities and bond also include some comparisons over time within issues, market capitalization, and value traded of countries where feasible and should serve as basis for 5 financial markets for financial markets; and insurance more detailed analysis. premium income and asset size for insurance. Infrastructuralqualitymeasures--contractenforce- 6 Data on breadth and penetration--which are prox- ment (including measures of the effectiveness of the ies for the population's access to different segments of court systems such as the speed of judicial conflict the financial sector and, thus, for outreach--of finan- resolution), speed and effectiveness of insolven- 7 cial markets include bank branch and outlet inten- cy procedures, creditor and minority shareholder sity and deposit and loan size distribution, as well as rights, presence of a credit registry, and firm entry number of clients in the banking, nearbanking, and regulations--can be drawn from the World Bank's 8 insurance sectors. The data gauge the share of the Doing Business Database. Also informative are user population with access to financial services. Data on assessments from the World Business Environment 9 market structure--number of banks, concentration Survey. in banking, and share of foreign-owned and govern- Finally, the quantitative indicators for finan- ment-owned banks--are also relevant. Efficiency cial structure and development assessment can be 10 measures include interest margins, overhead costs or rounded off by relevant summary economic and asset indicators, and turnover ratios for capital mar- social indicators such as GDP per capita, share of kets. Indicators of efficiency and quality of payment the informal economy, illiteracy rate, total popula- 11 services include cash-to-GDP ratio, lags in check or tion size, and so forth, which can be selected from payment order clearing, volume and value of checks the World Development Indicators published by the 12 or payment orders processed in retail and large value World Bank. payment systems, and number and density of ATMs. A more detailed presentation of financial structure Indicators for size, depth, and efficiency are avail- indicators, including definitional issues and data A able for a large cross-section of countries, thus allow- sources, is contained in chapter 2. B C Ideally, given data availability, it may be possible to use the results of research studies that have identified causal factors for cross-country differences in depth, efficiency, and D other dimensions of financial development. For example, several studies have attempted to explain differences in average bank margins--key indicators of the price efficiency of E banking in terms of policy, institutional, and macroeconomic variables. Those variables include the bank's size, a measure of property rights protection, and other bank- and F country-level characteristics, such as bank concentration, output gap, and interest rate level.4 If those policy and institutional variables are available for the country in ques- G tion, the results of the studies can be used to throw light on potential improvements that could be achieved through better policies and better institutions. The residual between H the expected value of average bank margins in the country predicted by the study and the actual margins, if positive, will point to the need for closer analysis of idiosyncratic I features in the country--features that may be contributing to the gap. (For an illustration of this technique in practice in Kenya, see appendix E.) A similar approach can be used 74 Chapter 4: Assessing Financial Structure and Financial Development for banking depth where macro-variables, such as inflation and the level of gross domestic 1 product (GDP) per capita, are key determinants along with institutional variables, such as shareholder and creditor rights (e.g., see Beck, Demirgüç-Kunt, and Levine 2003). 2 There are also some cross-country studies of other dimensions, including insurance penetration, stock market capitalization, and turnover, although those studies may not yet be sufficiently well established for heavy reliance to be placed on them for bench- 3 marking purposes. Along with other dimensions, including access to financial services, cross-country research is not yet sufficiently developed to support this kind of benchmark- 4 ing. In those cases, simple cross-country comparisons against peers can, nevertheless, be informative and can point to areas of deficiency. 5 4.3 Review of Legal, Informational, and Transactional Technology 6 Infrastructures for Access and Development 7 The major cross-cutting infrastructures can be grouped under the three headings of legal, 8 informational, and transactional technology.5 The robustness of legal infrastructures is universally acknowledged as crucial to a healthy financial system. Creditor protection in principle and in practice is central, as is bankruptcy law and its implementation. In 9 both of those areas, reform of the court system is often at the heart of needed reforms. Corporate governance law and practice can also be seen as coming under this heading. 10 Informational infrastructures include accounting and auditing rules and practice, plus the legal and organizational requirements for public or private credit registries and property 11 registries. Other aspects, such as the ratings industry, may be relevant in more-advanced, middle-income countries. Internationally recognized accounting and auditing standards 12 exist, and assessments of their observance, when available, can be useful for both stability and development assessments. The most important transactional technology infrastruc- A tures--relating to wholesale payments and settlements--may already be assessed using the Core Principles of Systemically Important Payment Systems (CPSIPS). (See chapter B 11 for details of CPSIPS.) The additional dimension required for development purposes is the functioning of the retail payments system: although it is not vulnerable to sudden C failure on a large scale, it is not considered "systemically important" in the sense of the CPSIPS. The efficiency with which the legal, information, and transactional technol- D ogy infrastructures support financial intermediation in the country plays a critical role in access and development. Detailed assessments of those areas are described in chapters 9, E 10, and 11 of this handbook, and they provide information on the quality of the infra- structure elements, which are discussed below. F 4.3.1 Legal Infrastructure G The efficient functioning of the legal system is indispensable for effective financial inter- mediation (e.g., see La Porta et al. 1997, 1998, and Levine, Loayza, and Beck 2000). H Although discussed in more detail in chapter 9 of this handbook, the following discus- sion highlights the aspects of the legal system that are important for development assess- I ment. 75 Financial Sector Assessment: A Handbook In addition to the cross-country quantitative evidence mentioned in box 4.1, underly- 1 ing factual information for this exercise can come both from any completed assessments of formal codes such as the Principles and Guidelines for Effective Insolvency and Creditor Rights 2 Systems (World Bank 2001b) and from interviews with banks, enterprises, academics, and other market participants.6 3 The effective creation, perfection, and enforcement of collateral is a cross-cutting issue for financial intermediation and requires assessing the appropriate legislation, the 4 property registries (including stamp duties and notary fees), the court system, and the out-of-court enforcement mechanisms. If collateral taking is limited to certain assets or 5 if high collateral-to-debt ratios are required, this limitation can ration credit to certain sectors or size groups of borrowers. The effectiveness of the collateral process can also 6 affect the terms of lending, such as interest rates, along with the competitiveness of the lending market. 7 The effectiveness of debt enforcement and insolvency procedures in terms of cost and time it takes, both through and outside the court system, is important for effective and 8 efficient intermediation. Expedited enforcement systems that use private negotiation and out-of-court settlement can be very helpful, if available. The possibility of flexible ways of achieving corporate financial restructuring, albeit without undermining creditors' 9 position, is important. A deficient insolvency framework can restrict the use of the court system overall and can lead to suboptimal out-of-court settlements or even restrictions on 10 the access to, and the terms of, lending. The functioning of the court system is crucial. The evaluation here could include 11 an assessment of the legal profession along several dimensions, such as education, skills funding, fees, and ethical behavior. The effectiveness of specialized courts in local cir- 12 cumstances can be examined if we bear in mind that those courts can help in situations where complex commercial issues arise and even in situations with less-complex issues, A such as loan recovery. The courts may work faster and more consistently than regular courts--though experience here is mixed, and it may be better in the long run to work B toward an overall improvement in the functioning of the court system. The state of corporate governance, including the relationships among management, C majority owners, and outside investors, can have an important effect on the ease with which outside investors provide finance and the price thereof. Both the rules and the practice of corporate governance need to be considered; if a formal corporate governance D assessment has been carried out, its findings can be drawn upon here.7 E 4.3.2 Information Infrastructures F Asymmetric information between borrowers and lenders and, thus, the transaction costs can be reduced if there is readily available information on the financial condition of bor- G rowers and especially on their history of credit performance. In particular, two areas of the information infrastructure should not be neglected: (a) transparency in borrowers' H financial statements enables lenders to assess borrowers' creditworthiness on present and past financial and operational performance, and (b) readily available credit information I on borrowers enables lenders to assess borrowers' creditworthiness according to their past performance within the financial system.8 76 Chapter 4: Assessing Financial Structure and Financial Development Credit registries, if they exist, vary widely in the information that is being collected 1 and that is available to financial institutions; hence, they vary in their effectiveness in improving access. The effect on access is influenced by characteristics such as (a) which 2 financial and nonfinancial institutions provide data and have access to the data (the more the better); (b) whether only negative information (i.e., on defaults and delinquencies) or also positive information, including interest rate, maturity, and collateral, is collected 3 and provided (positive information improves the potential use of the registry for credit appraisal); (c) for what kind of loans is the information collected; and (d) for how long 4 is information kept. While there are reasons to expect privately owned registries to out- perform those operated by public agencies, there are instances of effective publicly owned 5 registries. Local conditions can influence the choice here. Existing credit registries should be evaluated not only on their design features, but also on how they have performed in 6 practice. The legal and regulatory environment is important for existence and effective- ness of credit registries and other financial information vendors. While protection of con- 7 sumer privacy is important, unduly restrictive rules here can hamper information sharing on borrowers to the detriment of their access to credit. 8 Credit registries may be complemented by other providers of financial information on borrowers. Commercial information vendors, such as Bloomberg or Reuters, trade associa- 9 tions, chambers of commerce, or credit-rating agencies, might also contribute to transpar- ency in the financial market. Finally, there might be private information-sharing agree- 10 ments between financial institutions outside the formal structure of a credit registry. Accounting and auditing standards and practices are important elements of the infor- 11 mation environment in that they govern companies' disclosure of financial information to the public. A full assessment of the accounting and auditing standards (see chapter 10 12 for further details on these standards) in this area might not always be practicable, but the standards, nevertheless, represent the overall goals that should be aspired to and can A be used as a reference for identifying information-based barriers to enhanced financing for the corporate sector. B 4.3.3 Transactional Technology Infrastructures C The effective transfer of money between customers of the same and of different institu- tions is one of the main functions of the financial systems. While the stability assessment D of the payment system is mostly interested in wholesale systems, the development assess- ment focuses more on the cost of and access to retail payment services. Development E assessment includes evaluating the effectiveness of the check and money transfer system in terms of time and cost. It also entails assessing the access to those services, either F directly through banks or indirectly through other financial institutions that use banks as agents. Indicators to assess the effectiveness of the payment system include the cost and G time to transfer money. As alternative indicators of access, some studies have surveyed the small numbers of the population and of subgroups who have a transactions banking H account, debit card, or credit card, as well as the distribution of travel time to the nearest ATM or money transmission point. Unfortunately, as yet, there is no cross-country dataset I for such access indicators. 77 Financial Sector Assessment: A Handbook 4.4 Sectoral Development Reviews 1 2 Sectoral developmental reviews complement the assessments of regulatory standards. Over the past several decades, extensive institutional change and experimentation in 3 advanced economies have led to the emergence of elaborate regimes of regulation and supervision of the banking, insurance, and securities markets. Those regimes are designed 4 to ensure integrity of the functioning within the sectors and to avoid behavior that is likely to contribute to failure. They have evolved largely in response to the rapid develop- ment of the financial sector in advanced economies rather than as a means of promoting 5 the development of the sector--though, in several cases, regulatory liberalization has been influenced by a perceived risk to the competitiveness of domestic financial markets 6 in an increasingly global financial system. The standards and codes used for those sectors essentially codify what has emerged 7 as the common core of what remains a somewhat diverse set of regulatory institutions. While the standards and codes represent a fairly firm and widely agreed framework for 8 assessment on the prudential side, the mechanics of overcoming barriers to development of what are still unsophisticated financial systems in low- and middle-income countries 9 are not something for which a comprehensive template can be distilled from current prac- tice. Indeed, the standards and codes either explicitly or implicitly assume the presence 10 of much of what is sought in the goal of developing the financial system and at the same time contain (to some extent) principles that guide institutional development and good 11 practices in financial institutions. Promoting institutional development, however, raises issues of sequencing and absorptive capacity in implementing policy reforms. Because of 12 those considerations, conducting the development assessment for any given subsector is necessarily less categorical, more subjective, and arguably more difficult than assessing the A relevant standards and codes. For most low- and middle-income countries, a brief and selective review of devel- opment issues provides the information that is needed on the preconditions for a full B standards and codes assessment. Where standards and codes for a sector are not being fully assessed, the review of development issues can be accompanied by a less detailed, C stability-oriented, regulatory assessment. The assessor should highlight deficiencies in quantity (scale and reach), quality, and price of the services provided and should attempt D to identify the infrastructural weaknesses that have contributed to those deficiencies, as well as any policy flaws--including flaws in competition and tax policy--that have likely E contributed to the deficiencies. Although some of the needed data are covered in cross- country databases (as mentioned in chapter 2), for many other dimensions in each of the F sectors, only noncomparable national sources are currently available. Those dimensions would include aspects such as the stock market free-float, reliance by large firms on inter- G national depositary receipts, transactions costs for securities markets, prices of insurance and efficiency of insurance products, and maturity structure of intermediary portfolios. H The assessors must use their judgment in evaluating whatever information is available on such matters. I Because competitiveness issues have a pervasive influence on sectoral performance, the issues need to be analyzed in all sectors. The competitive structure of the industry 78 Chapter 4: Assessing Financial Structure and Financial Development is a multi-dimensional concept in itself. That structure is not merely measured by con- 1 centration ratios and by Herfindahl indices, but--in acknowledgment of the distinction between concentration and contestability--also requires an understanding of regulatory influences, including restrictive regulations on branching or cross-regional service provi- 2 sion, on permissible lines of business, on product pricing (e.g., interest ceilings and premi- um rate floors), or on portfolio allocation (especially for insurance companies, including 3 localization rules, but also including reserve requirements and so forth). Is the market de facto segmented, thereby limiting the pro-efficiency forces of competition? Is ownership 4 of the main intermediaries linked to government or to industrial groups, thereby tending to entrench incumbents rather than enabling new entrepreneurs? 5 In addition to our looking at the aggregate national position, it is important, though often difficult, to assess the reach of each financial sector along the dimensions of geo- 6 graphic region, economic sector, size of firm, and number of households. Of course, the large and well-established firms in the main cities will have greatest access. The question 7 is whether the gap between those and smaller firms and households in smaller centers and in rural areas is more than it should be. Sources of information on direct access to 8 financial services--with a focus on those at different levels of income--are diverse and scarce. There is a growing appreciation of the importance of compiling data on who has 9 access to what financial services, and efforts are under way to increase systematic cover- age of financial issues in surveys of households, business users, financial service providers and their regulators, and national experts. All four types of information are needed for a 10 comprehensive review.9 Going beyond aggregate measures of efficiency, availability, and cost of more-advanced 11 products needs to be benchmarked for each of the main sectors. What products do users identify as lacking? How much maturity transformation does each sector achieve? How 12 much is achieved overall through the interaction of the sectors? One may also mention consumer protection legislation, which, though present, is not uniformly at the fore in A stability assessments. Often, the review will reveal that the source of shortcomings is mostly in the policy B environment (including the nonprudential or unneeded prudential regulations and taxa- tion and the effects of state ownership) or in deficiencies in the legal, information, or C transactional technology infrastructures. Such policy and infrastructural issues will often have a cross-cutting effect on several subsectors and need to be reported as such (see sec- D tion 4.6). E 4.4.1 Banking The sectoral assessment for banking is at the heart of development issues in finance F because of the central role of banking in the financial systems of most developing coun- tries. In addition to what can be quantified on the basis of available statistics, the fact- G finding requires broad-ranging discussions with market participants, as well as with the regulators.10 An effective banking system will be characterized by considerable depth H (measured, for example, by total assets); breadth in terms both of customer base (lending to a wide range of sectors and regions, without neglecting the needs of creditworthy bor- I rowers in any sector or region) and of product range (maturities, repayment schedules, 79 Financial Sector Assessment: A Handbook flexibility, convenience, risk profile, and nonbanking products where permitted); and 1 efficiency. Overhead costs, interest spreads, and interest margins give an indication of efficiency, though taxes and other requirements can substantially influence the spread, as 2 explained below. 3 Quantitative Benchmarking 4 Benchmarking the performance of the banking system needs to go well beyond tabulation of cross-country comparisons of available indicators and should be based on an analysis of 5 factors governing the variations in the indicators. The main indicators need to be looked at in terms of their development over time, in relation to the rest of the national financial 6 system, and in terms of national causal factors. In addition, international comparisons should ideally be made in a more structured way, thus drawing on research findings. 7 As an example, assessment of bank efficiency and competitiveness requires information on interest rate spreads and margins,11 which are influenced by both bank- and country- level characteristics. The analysis and decomposition of interest spreads and margins can 8 help assess the existence and severity of deficiencies in the banking sector.12 A useful device is to use accounting identities to decompose interest rate spreads into five compo- 9 nents: (a) overhead costs, (b) loan­loss provisions, (c) reserve requirements, (d) taxes, and (e) (the residual) profits. Decomposition helps identify institutional and legal deficiencies 10 that explain high spreads. Both spreads and margins can be compared across countries and across the underlying factors derived (see appendix E, which is based on Kenya). 11 Penetration of and access to banking services are important dimensions for which a broad international database is not yet available, but for which national statistics can be 12 very informative. Geographic branch, ATM, and bank outlet data give a first indication of the penetration of banking services across geographic areas of the country. A comparison A of bank branch density with other countries can give an indication of bank penetration but has to be treated with care, because it does not include data on nonbank service pro- B viders. Similarly, a within-country geographic comparison of penetration should consider other nearbank providers, such as savings banks or cooperatives. Where appropriate, C account should also be taken of alternative delivery channels, such as ATMs, phone banking, and Internet banking, plus novel ways of providing access to financial services in more remote areas, such as mobile branches and correspondent banking. There may D be regulatory obstacles to penetration: What are the regulatory requirements for opening and closing branches and other delivery channels, and what are the licensing procedures E and fees for doing so? F Scope of Activities G If one is to understand the role of the banking system in contributing to the functions of finance in the country being assessed, it is necessary to clarify what are the range and H types of financial services being provided by both banks and nearbanks. The institutional organization of the financial service provision varies significantly across countries. On the I one extreme might be universal banks that offer not only deposit, loan, and payment ser- vices, but also leasing, factoring, insurance, and investment bank products. On the other 80 Chapter 4: Assessing Financial Structure and Financial Development extreme, one might find a system where banks are restricted to deposit, loan, and payment 1 services and where there is a large number and variety of other banklike and nonbanking institutions that offer leasing, factoring, and mortgage finance. The institutional organiza- 2 tion of the financial service provision is often driven by historic development and by the regulatory environment. Even if specialized financial services are offered by specialized financial institutions, there are often ownership links between them and banks. Finally, 3 an institutionally diverse financial system may have converged with nominally different institutions that offer the same services. In this case, it is important to assess whether 4 there is a level playing field between institutions and nondiscriminatory regulatory treat- ment. 5 6 Competition and Market Segmentation Market structure can be measured using concentration ratios (assets of largest three or 7 five banks to total banking assets), number of banks, and Herfindahl indices. One has to be careful, however, in equating market structure with competitiveness. Contestability of 8 the market--the threat of entry--can be a more important determinant of bank behav- ior. Regulatory indicators, such as formal entry requirements, share of bank applications 9 rejected over the past five years, and openness of the sector to foreign entrants, can give an indication of contestability of the market. Competition from other financial institu- 10 tions (such as insurance companies, large credit cooperatives, and capital markets) can play an important role in determining banking system competitiveness. The ownership 11 structure of banks (foreigners, closely held by locals, nonfinancial corporations, govern- ment, widely held, cooperative structure, and so forth) can be important for the degree 12 of competition, because banks of different ownership often have different mandates and different clienteles (e.g., see Claessens and Laeven 2004 and box 4.2). In turn, ownership patterns are influenced by regulation and policy on entry, exit, and mergers and acquisi- A tions. Is the market structure segmented (with less competition than might appear from an B overall concentration index) to the extent that different groups of banks deal with dif- ferent classes of customer (with each customer facing relatively few options)? Evidence C on market segmentation is often more anecdotal than quantitative. Interviews with both banks and enterprises often help to determine categories of banks, with competition D within each category but with little across categories. There might also be variation in competitiveness across different products. Loan and deposit size distribution data can give E supporting evidence for market segmentation, if such data are available. It is also impor- tant to assess segmentation between the banking system and other parts of the financial F system. This assessment can be important for microenterprises and small enterprises that start their "careers" as borrowers with cooperative or specialized financial institutions; G segmentation might prevent them from growing into customers of mainstream banks. If one has established the main features here, it is important to attempt to determine the H extent to which they are influenced in a harmful way by inappropriate regulation. This examination could include looking at limits on their lines of business, universal banking, I and branching restrictions. 81 Financial Sector Assessment: A Handbook 1 Box 4.2 Access to Financial Services from Abroad Development Role of Foreign Banks supervisor can accelerate technology transfer to the 2 local market. National authorities and local commentators often express concern at the likely development conse- 3 Access to Foreign Securities Markets quences of a growing share of the financial sector coming under foreign control. The typical fears are The tendency of larger companies to take their that small enterprises and remote, rural areas will not stock market listings to larger international mar- 4 be served by foreign-owned banks and that cherry- kets--whether through a primary listing or dual list- picking by foreign-owned banks will weaken local ing abroad, or by issuance of depository receipts--is 5 banks. In fact, although the client profile of foreign- often seen as an adverse development by local mar- owned banks often differs sharply from that of locally ket intermediaries because the intermediaries receive owned banks (especially when foreign-owned banks a smaller share of total fees and commissions. Thus, 6 have only a limited retail presence because of regula- local market liquidity may be adversely affected. tory restrictions or their own business strategy), it is However, from the perspective of the economy as a often observed that an expansion in a foreign-owned whole, the net benefit is likely to be positive, with 7 bank's share of the total market is associated with a not only a lower cost of capital, but also an indirect greater emphasis on the small and medium enterprise effect through the importation of enhanced stan- dards of corporate transparency, which are likely to 8 (SME) sector by local banks. Checking on such dimensions of the competitive dynamics of the sector be spread, at least partly, to firms that do not have will help alert national authorities to any shortcom- international listings. 9 ings along those dimensions. Opening the local equity market to foreign inves- The implicit training provided by the leading inter- tors is also generally seen as a positive dimension national banks both for other market participants and with lower average cost of capital and probably 10 for regulators can represent an almost costless gain lower net volatility. However, opening nonresident for national authorities. The relationship between access to domestic financial markets and enhanc- foreign-owned banks and regulators can be somewhat ing resident access to foreign financial markets will 11 delicate in that regulators are responsible for local require the careful sequencing of capital account oversight of the foreign entity. Nevertheless, that liberalization measures as part of a broader financial 12 entity likely enjoys superior risk management prac- market development strategy. These considerations tices and other systems and head office scrutiny. By are further explained in chapter 12. observing and learning from those practices, the local A B Taxation of Banking C Taxation and quasi-taxation issues are important for banking. Among the most prominent are (a) the issue of loan­loss provisioning (can banks deduct provisions allowed by the D banking regulator from income before calculating tax?) and (b) the implicit taxes through reserve requirements. The former can affect the incentive to make adequate provisions promptly, while the latter can affect interest spreads, especially in times of high inflation E and high nominal interest rates. F Other Issues G Are minimum deposit requirements or fees for customers effectively cutting out the small depositor? What lines of business do banks find most profitable and unprofitable? H Are there any pressures from government to do lines of business that are unprofitable? Do banks submit to such pressure? Analyzing the interbank market is important, so one I should ask the following: How liquid is the market, is there tiering (another indicator of segmentation), and who are the main takers? 82 Chapter 4: Assessing Financial Structure and Financial Development 4.4.2 Near-banks 1 While some nearbanks, such as finance companies, can be seen as an annex to the com- mercial banking system, some smaller scale near-banks may have sufficient development 2 importance to call for special treatment. Such near-banks consist of specialized micro- finance firms, cooperative credit unions, specialized mortgage banks, and government- 3 sponsored specialized development intermediaries. Because of their modest size or the fact that their source of funding is stable and may come from stable external or wholesale 4 sources, they do not raise systemic stability concerns but do expand access to financial services. Some near-banks provide a focused set of services to a broad clientele (e.g., postal 5 savings banks and mortgage banks); others specialize in serving a particular economic sec- tor (e.g., specialized microfinance institutions [MFIs] that may target microenterprises or 6 the poor and near-poor). Many categories of nearbanks are not operated on a for-profit basis (especially donor- 7 promoted microfinance entities, government-owned development banks, and, to an extent, cooperatively owned entities such as credit unions). This feature generally calls 8 for a distinct regulatory framework, and a review will be appropriate in many countries where those institutions are sizable.13 9 Among the major categories are non-depository finance companies, many of which specialize in particular types of lending such as leasing and factoring. Many of them are 10 captive subsidiaries of banks that have been separately constituted for reasons of legal convenience or in response to regulatory restrictions on banks. The funding of those insti- tutions is typically from the parent bank. Independent finance companies need to find 11 funding in the wholesale markets, typically through private placement of notes, though they may use an organized bond market if one is present. The entities can be important in 12 providing borrowing facilities for SMEs, and obstacles to their effective operation should be monitored. A Mortgage banks (see box 4.3), savings banks, and cooperative credit unions typically concentrate on the needs of households both in terms of deposits and for lending prod- B ucts. However, some savings banks operate as narrow banks, lending their resources to government. To the extent that they are locally or regionally based, their survival increas- C ingly depends on the effectiveness of national umbrella organizations. They also depend on not suffering from tax discrimination (though they will often go further and argue D for tax privileges that are hard to rationalize from a welfare point of view). Interviews with those entities will often reveal special environmental challenges that inhibit their E effective functioning. Because detailed prudential regulation of the institutions is not cost-effective, they often operate under blanket restrictions that limit their expansion F and activities. Judgment must be exercised as to whether such restrictions can safely be relaxed. G Non-deposit-taking microfinance firms (typically donor funded) may not require pru- dential regulation from the financial authorities, although an element of forced saving is H often built into their operations. Increasingly, though, MFIs seek to move into offering deposit services, so the challenge of ensuring that prudential regulation is no more intru- I sive than is needed arises here also. 83 Financial Sector Assessment: A Handbook 1 Box 4.3 Finance of Housing Financing residential mortgages is a key function effective duration of conventional mortgages, thus 2 of financial systems in advanced economies, there- creating a demand for price-index-linked or other by accounting for a relatively high share of total low-risk contracts (compare to Jaffee and Renaud 3 financial assets. Traditionally, specialized mortgage 1996). intermediaries offering a limited range of other ser- Availabilityoflong-termmortgagefinanceenhances vices were the major players in this segment, and they the quality of housing, especially for middle-income 4 often benefited from fiscal privileges. More recently, households. Cross-country experience suggests that the removal of fiscal privileges and the addition of macroeconomic stability and financial sector policies enhanced competition have tended to widen the are more important in ensuring such availability than 5 range of originating intermediaries for mortgage lend- is the general level of per capita income. Improved ing. Those intermediaries, in turn, have increasingly housing finance policy reaches well beyond the securitized much of the mortgages that they originated financial sector and includes measures to improve 6 and have sold them in the wholesale market. the supply of serviced land, building codes, adequate Long-term mortgages entail particular risks wheth- legal framework for land development and real 7 er they are at fixed or floating rates. Fixed-rate mort- estate, well-targeted subsidies for those who cannot gages may require high real yields or even may not be afford adequate housing, and so forth. Because of able to be sold in a volatile macroeconomic environ- this wide reach and because mortgage finance has 8 ment. Holders of such mortgages can face advance increasingly become part of mainstream finance, a repayment risk if the general level of market rates particular focus on the subsector of housing finance falls, unless prepayment penalties can be enforced. may not be warranted for financial sector assessments 9 Conversely, high inflation rates may shorten the in most countries. 10 11 The indications are that sustained effectiveness of MFIs will require that they should 12 operate on a relatively large scale. If so, policies that encourage larger-scale operation over a proliferation of small entities is to be preferred. Subsidized interest rates offered by MFIs A are not compatible with graduation to self-sustaining operation and are generally not to be encouraged, though the limited spillovers into mainstream finance mean that a subsidy B need not be considered crucial. Subsidized lending by larger government-sponsored development banks causes dis- C tortions (see box 4.4). Those banks can seriously distort the incentive for a balanced provision of lending products by commercial banks, as well as creating the conditions for D corruption. Moving government-sponsored development banks as far as possible either (downstream) toward a commercial operation or (upstream) to become explicitly the lending arm of the fiscal authority (with loans at unsubsidized rates) will, in most cases, E seem the optimal direction of policy. F 4.4.3 Insurance and Collective Investment Arrangements G As with the banking sector, insurance and collective savings generate financial services on both the asset and the liability side. On the liability side, they provide investment H outlets and risk-reduction instruments; on the asset side, they typically represent the most important block of professionally managed long-term funds. Both aspects need to be kept I in mind in the assessment. Insurance and fund management industries often overlap, in that insurance firms often sell pensions or manage pension funds, other mutual funds and 84 Chapter 4: Assessing Financial Structure and Financial Development 1 Box 4.4 Role of Government-Owned Banks The disappointing performance--not only of govern- tend to slow growth. However, development assess- 2 ment-owned banks but also, more important, of sys- ment must pay attention to subsidized and other tems in which the banks will play a major part--has loans made on other-than-commercial principles been extensively documented in recent cross-country insofar as those loans tend to discourage private 3 empirical literature (see Barth, Caprio, and Levine banks from incurring the cost of developing risk- 2004 and La Porta, Lopez-de-Silanes, and Shleifer assessment techniques that are needed to lend into 2002). This performance does not imply that indi- difficult segments, such as small and medium enter- 4 vidual countries and individual government-owned prises (SMEs) and rural areas. Government-owned banks cannot perform exceptionally well along this banks often fail to deliver services to their stated dimension, but it does call for special attention to target markets--with subsidies often being captured 5 some dimensions along which many government- by large, state-owned borrowers or politically con- dominated banking systems are known to underper- nected firms--which can damage the performance of 6 form. the sector as a whole. In the context of development assessment, the The mission of government-owned banks should, effect of government ownership is not simply a ques- therefore, be examined for compatibility with the 7 tion of embedded fiscal costs in a nonperforming or competitive provision of financial services generally; problematic loan portfolio reflecting the inheritance their governance structures should also be scrutinized of politically or socially motivated loans. Such fiscal for consistency with the stated mission. 8 costs can imply a future national tax burden that will 9 10 unit trusts, and so forth. Some investments of those industries are in the form of bank deposits or other unit trusts, so that a measuring scale in a manner that adequately nets 11 out intersectoral claims can be both important and sometimes difficult in the attempt to benchmark scale. In addition to one's looking at the current position, projections of future 12 developments, especially of pension funds, can be possible and relevant for a view as to the likely contribution of those sectors to funds availability.14 A The range of products supplied, as well as their pricing (relative to actuarial fairness), is also an area where deficiencies may exist. It is important to determine whether such B gaps are attributable to overregulation, to lack of competition (including restrictions on entry), or to lack of organizational capacity and skills in the industries. Because of the C diversity of potential insurance products,15 a comprehensive analysis of cost and avail- ability would be an extensive exercise. Absent such a study, information can, neverthe- D less, be obtained from market participants. Industry professionals will typically be vocal in identifying policy barriers (including regulatory failure to approve policy design) that inhibit their provision of particular services and products; users will be a better source for E identifying others that are unavailable or overpriced because of industry inefficiencies or market power. A similar situation prevails with regard to other collective investment F outlets. The tax and regulatory treatment of different insurance, pension, and mutual fund­type products has been a strong influence on the development of the insurance and G collective investment sectors, and the whole market can be skewed by distorting incen- tives that should be avoided as a matter of sound development policy.16 H Coverage of the subsectors also needs to examine market structure in terms of con- centration and ownership. In countries where there is a mandatory private tier to pension I provision, issues of competition become especially important, because the rules regarding 85 Financial Sector Assessment: A Handbook switching, fee structures, and the like can have a large effect on the net return to pension 1 investors. The investment policy of insurance firms, pension funds, and other collective savings 2 entities is a key to increasing the availability of term and risk finance to domestic industry. This policy can be subject to severe restrictions (such as ceilings on permissible percent- 3 ages of the portfolio that can be placed in certain broad categories of investment, such as property or equities), which must be examined for their appropriateness in the context of 4 local capacity. While most of the restrictions are supposedly intended to be prudential in nature, in practice some can have the opposite effect, lowering the return on the funds' 5 overall portfolio without reducing volatility. This effect can be especially true with regard to requirements to hold government securities and prohibitions on international diversi- 6 fication.17 Requirements to cede reinsurance to a state-owned reinsurance company have similar effects. 7 The long-term viability of the social security and government employee pension schemes needs some examination. Their wider effects on the economy, including the 8 effects of compulsory contributions, are generally fiscal matters that are beyond the scope of the financial sector assessment. However, it is necessary to be generally aware of those 9 wider dimensions if one is to understand the likely evolution of the system. Some exami- nation of the issues could strengthen the assessment of both the financial structure and 10 development. The health of the insurance and collective investment sectors is often intertwined 11 with that of the organized securities markets. Those sectors are the major investors in securities, and the level and volatility of asset returns in the sectors depend on the micro- 12 structure and soundness of securities markets. A 4.4.4 Securities Markets The sectoral development assessment is to some extent subsumed in International B Organization of Securities Commissions's (IOSCO's) Objectives and Principles of Securities Regulation (see box 4.5). Investor protection, fairness, efficiency, and trans- C parency are among the most important prerequisites for the development of organized securities markets. These important elements of effective securities regulation are also D covered in the IOSCO objectives and principles. When investors have confidence, the market tends to grow. E In addition, the assessor needs to verify, by looking at the quantitative measures, that the market is, in fact, deep and liquid; that transactions and issuing costs are reasonable; F and that an adequate range of both debt- and equity-type instruments are available. The range of instruments would include some derivatives if this inclusion can be supported by G the scale of activity and by the technical needs and sophistication of the market partici- pants. The assessor also needs to look at the degree to which the market can provide new H funding through public offerings. Benchmarking of the securities markets needs to pay attention to some hidden factors. For instance, in addition to market micro-structure and I market size, the liquidity of the securities markets also depends on the degree to which securities are not held in blocks by insiders and, as such, are not normally available for 86 Chapter 4: Assessing Financial Structure and Financial Development 1 Box 4.5 Standards Assessments and Financial Sector Development Standards assessments can inform development assess- for a range of policies to implement standards to help 2 ments. Sectoral reviews, plus an understanding of the improve efficiency of financial firms and to assist state of development and the soundness of sectors, with their institutional development. are needed to inform standards and stability assess- · All supervisory standards include a set of princi- 3 ment. The standards, codes, and core principles that ples relating to the prudent operations of finan- are important for the sound and efficient functioning cial intermediaries covering risk management, of the financial system cover both financial supervi- 4 risk concentration, capital adequacy, corporate sion and financial infrastructure, and they are listed governance and internal controls, customer in box A.2. protection, and prevention of financial abuse. International standards and codes for financial 5 Policies that promote such prudent operations systems supervision have been designed to promote can help strengthen the efficiency of the institu- effective supervision and regulation of individual tions, strengthen their governance, and enable 6 financial institutions and markets. Those standards (for banking, insurance, and securities market super- more effective and appropriately priced delivery vision) promulgate a set of objectives, core principles, of financial services. Information on those mat- 7 and good practices that cover regulatory governance, ters from standards assessments provides valu- regulatory practices, prudential framework for the able input into development-oriented policy operations of financial firms, and financial integrity formulation. 8 and safety net arrangements. All supervisory stan- · Some development concerns are addressed in dards recognize that a set of preconditions (outside IAIS Insurance Core Principle (ICP) 1. ICP 1 9 the scope of those standards) must be met to allow sets out preconditions for effective insurance effective implementation of the standards. The pre- supervision, which represent a subset of the pre- conditions include sound and sustainable macroeco- conditions for a well-developed insurance sec- 10 nomic policies; a well-developed public infrastructure tor. Prudential insurance assessments can also (accounting and auditing, corporate governance, help in the fact-finding efforts for the develop- legal framework, and so forth); procedures for resolv- ment assessment, for example, in relation to 11 ing problem institutions; and an appropriate level of investment requirements (ICP 21). Several systemic protection and safety nets. other useful sets of standards and guidelines A review of preconditions for effective supervi- have been developed for other elements of this 12 sion--some of which are covered by their own stan- broad subsector (for a compendium, see OECD dards--can clearly help identify gaps in infrastructure 2002). A and can provide inputs into development assessment. · IOSCO Objectives and Principles of Security Similarly, assessments of the financial infrastructure Regulations promote robust and efficient finan- as part of development assessment can give informa- cial markets. Thus, IOSCO principles 14­16 B tion on the adequacy of preconditions for effective aim to ensure that issuers are transparent and supervision. A significant part of financial sector fair, principles 17­20 to ensure that collective development policies relate to strengthening the investment schemes are equally trustworthy, C public infrastructure. This strengthening not only and principle 28 to ensure that secondary mar- promotes more efficient financial services with greater ket manipulation is inhibited. IOSCO principle D depth and access, but also creates conditions for effec- 23 deals with standards for the internal organi- tive supervision. zation and operational conduct of market inter- Standards assessments themselves provide key mediaries to ensure adequate client protection E information needed for development assessment and and risk management. F G trading. Estimates of this free-float can greatly reduce the apparent size of the market and can put its true scale into perspective. H The domestic bond market is often more weakly developed than equities, and causes of this weakness should be reviewed. The reasons typically lie in tax rules; in the systemic I dominance of banks, for whom a developed bond market would represent competition; or 87 Financial Sector Assessment: A Handbook in crowding out by heavy domestic government borrowing. More generally, government 1 debt management can have a decisive influence on the functioning of the bond market.18 Effective public debt management can help provide the benchmarks needed to price more 2 risky securities, and the physical and institutional infrastructures for government debt markets could reinforce and complement the needed infrastructure for bond markets gen- 3 erally. The transactions technology infrastructure--in this case, also potentially includ- ing such features as privileged market makers--may also be inadequate. These and other 4 prerequisites for bond market development are clearly described in World Bank (2001c), which also notes how sensitive bond market development is to monetary policy manage- 5 ment and generally macroeconomic stability--prerequisites that lie beyond the scope of development assessment. 6 Liquid securities markets require a minimum scale to be cost-effective. Certainly, the cost built into the design of the trading platform and the regulatory burden can become 7 decisive. Overheads of the market itself and of the regulator can also be too heavy to be borne by fees on the existing level of transactions. Where possible, the assessor should 8 attempt to calculate those costs and the degree to which they are being subsidized. This calculation is especially important where consideration is being given to further com- puterization, a step that often may not be cost-effective or necessary in small exchanges. 9 With many small securities markets, the inherent viability of the brokerage industry needs to be checked, which has been a problem in several countries. In some cases, most brokers 10 are subsidiaries or divisions of banks, an arrangement that may help reduce overheads but may limit the energy with which the brokers develop their services. Of course, the impor- 11 tant goal is not survival of the stockbrokers per se, but achievement of an optimal way of giving local firms and investors access to liquid securities markets. 12 Many securities markets have been subsidized through tax concessions to listing com- panies, but with limited success. Several countries have forgone substantial revenue in A this way with the objective of encouraging the development of the stock exchange but without generating any sizable activity in the market. B The degree to which larger firms are going outside the country to issue shares or depository receipts in advanced stock exchanges should be examined. While such behav- C ior can reduce local market liquidity, it also has the potential to result in the importation of improved transparency and other practices by a demonstration effect. It also results in lower funding costs for the companies that do have such access. D More generally, the question for small countries of whether outsourcing and closer integration with regional or global markets would be more effective than promotion of an E onshore securities market must be seriously considered (compare to Bossone, Honohan, and Long 2002). F 4.5 The Demand-Side Reviews and the Effect of Finance on the G Real Sector H Whereas stability assessments have normally emphasized the regulator and the regulated I financial intermediaries and markets with comparatively little focus on the system's users,19 development assessments are interested in the users and the extent to which the financial 88 Chapter 4: Assessing Financial Structure and Financial Development services they receive (including from abroad) are adequate to their needs. Development 1 assessments must express a general view on this issue, though in many countries, especially low-income countries, detailed quantification may be beyond the scope of the assessment. Special studies of the finances of the corporate sector or of household, microenterprise, 2 and SME access to finance can be considered where data can be made readily available. 3 4.5.1 Enterprise Finance 4 An assessment of demand for and access to financial and especially credit services by enterprises relies on financial information from firms and on surveys and anecdotal evi- 5 dence from financial institutions, banks, and other market participants. While data on listed companies are often readily available, few developing countries have consistent 6 databases on SMEs. Ideally, corporate data should be combined with bank data to assess both the different sectoral and business line focus of banks and the competitiveness of the 7 banking market (e.g., by considering the number of bank relationships per firm). Such analysis should also be informed by the available data on infrastructure, especially about the legal system and the information environment. The available data could reveal that 8 certain products, such as leasing or factoring, do not constitute valid financing options for enterprises. Factors behind such missing markets would have to be examined. 9 When one considers financing patterns, in addition to bank or equity finance, it is also important to focus on trade finance, which is an important financing source, espe- 10 11 Box 4.6 Use of Research-Based Micromodels--Liquidity Constraints in Capital Formation 12 Several research-based exercises carried out as back- constrained. In principle--given sufficient data--the ground for recent financial sector assessment pro- exercise could be divided by class, size, or geographi- A grams (FSAPs) have assessed financing conditions cal region of firm. using firm-level data for nonfinancial firms. In a world A similar exercise carried out for the Czech FSAP without financially constrained firms, investment and found that firms operating in the utilities, construc- B financing decisions are independent from each other. tion, and trading industries invested significantly However, the investment decisions of financially more than other nonfinancial firms. If the firms are C constrained firms often depend on the availability of listed and the stock market is sufficiently liquid, mar- cash flow (compare to Fazzari, Hubbard, and Petersen ginal accounting profitability can be substituted by 1988). Tobin's q-ratio. These kinds of data can throw addi- D For the recent Mexican FSAP accounting data for tional light on firms' financing characteristics. For 73 nonfinancial-listed Mexican firms were drawn from instance in the Czech FSAP, it was found that trade WorldScope, a commercial data provider. The exer- credit was generally not used as a financing source E cise estimated the extent to which firm investment for investment and that firms that were able to depended on cash flow rather than on the marginal attract new bank loans used them, to a large extent, profitability of capital. Although WorldScope tends for purposes other than investment, for example, F to include only larger firms, it may be assumed that to repay old loans. The results suggested that the smaller firms are at least as financially constrained. general reduction in the supply of bank credit during G Regressing investment ratios on marginal profit- 1999 may have increased the financing constraints ability, financial leverage, and cash flow found cash of firms, especially those of small and highly lever- flow to be a statistically significant variable, which aged firms. H can be evidence of Mexican firms being cash-flow Sources: Financial System Stability Assessments (FSSAs) for Czech Republic and Mexico, respectively. I 89 Financial Sector Assessment: A Handbook cially for small firms. Trade credit can be both a substitute to and a complement for other 1 external financing sources. Trade credit might vary systematically across size groups, with one group being a net creditor or debtor relative to others. For example, if the small firm 2 group is a net debtor in trade credit, this debtor position might indicate a trickle-down effect, with large firms effectively passing on bank credit to small firms through the trade 3 credit channel. Moreover, many developing countries and emerging markets rely on bank-financed trade credits to support exports at preshipment and postshipment stages, as 4 well as imports. Such financing provided by international banks tend to be channeled to local borrowers through domestic banks and to constitute an important source of working 5 capital. Development, directed credit, or both might be another important source for certain 6 enterprise groups in many developing countries. While it is typically beyond the scope of a financial sector assessment to produce a detailed cost-benefit analysis of the effectiveness 7 of such programs, an indication of whether those programs reach the target groups and whether they have complementary or crowding-out effects might be interesting. 8 If appropriate data are available, testing for financing constraints among firms can be an interesting complement (see box 4.5). A further step would be to link firm character- 9 istics, such as size, sector, and profitability, to financing constraints so one can compare access to finance across different firm groups and can test for potential segmentation in 10 the market. 11 4.5.2 Households, Firms, and Microenterprises While reliable data for a quantitative assessment of SMEs' access to financial services are 12 hard to come by, it is even more difficult to quantitatively assess households', firms', and microenterprises' access to financial services. There do not seem to be any cross-country A databases available, and only a few countries have detailed survey or census data on access to financial services by households, farms, and microenterprises. The World Bank has B undertaken Living Standards Measurement Surveys (LSMSs) in several countries, but the finance component is relatively small in most cases. C In other cases, the dearth of data precludes a detailed analysis of households', firms', and microenterprises' access to financial services. However, anecdotal and even limited D quantitative evidence can provide some indication of social and geographic variation in access by those groups and can help define follow-up work. E Additional evidence on access may be available from suppliers of financial services. If such evidence is available, for example, one can analyze loan and deposit size distribu- F tion data for corporate sectors, household sectors, or both. This analysis would indicate the extent of small loans and deposits, which would show indirect evidence about access G by small firms and households. In addition, data from the providers of financial services to those segments--such as microfinance, development finance institutions, or savings H banks--can provide further evidence on access. An indication of the outreach and pen- etration of the different provider groups can help evaluate their effectiveness. Sometimes, I quantitative and anecdotal evidence on the competitiveness and possible segmentation of household and microenterprise sector can be obtained. Unlike in the enterprise sec- 90 Chapter 4: Assessing Financial Structure and Financial Development tor, savings and payment services are often in greater demand in this sector than credit 1 services. 2 4.6 Reviews of Cross-Cutting Issues 3 The development assessment draws both on infrastructural assessments (for each of which one or more sets of standards have been developed by the relevant international bodies) 4 and on sectoral assessments. As explained, development dimensions must be added to, or built on, aspects of the sectoral prudential standards. Among the development dimensions 5 that have been highlighted in this regard are the competition issues such as entry and exit policies, the taxation issues, and the distorting or chilling side effects of poorly designed 6 prudential regulation. Some of the issues also arise on a cross-sectoral basis or in respect to undeveloped sectors and segments, which will now be discussed. 7 4.6.1 Missing Markets and Missing Products 8 Experience shows that a number of potentially useful products or markets, though readily observed in some low- and middle-income environments, are not present in others. The 9 sectoral and demand analyses of sections 4.4 and 4.5 should detect the absence of key markets or services, and those analyses should be assiduous in discovering the reasons for 10 missing products and markets. Many such products--leasing, factoring, reverse factoring, venture capital and other forms of private equity, and various types of long-term finance-- 11 can be provided by commercial banks. Otherwise, they may be provided through finance companies or other specialized banks or nearbanks, which are often nondeposit taking. 12 Insurance and collective savings funds are also important potential providers of those and other products (especially for longer terms and for higher-risk profiles). A It is useful to distinguish between the following underlying causes of underdeveloped or missing markets: macroeconomic or legal. Macroeconomic causes may include an infla- B tion history that impedes long-term contracting at reasonable interest rates. Regulatory impediments may include restrictions on contractual savings institutions to hold private C sector assets. Those factors effectively restrict the supply of long-term resources or prohibit financial institutions from entering certain markets. Taxation rules or the lack of clear rules D can result in higher costs for certain financing products, such as leasing. While deficiencies in the legal system can impede effective financial intermediation overall, the negative mar- ginal effect may be especially strong for certain products that depend more on its effective E functioning, such as leasing. It is important to analyze whether there is a lack of appropri- ate legislation, a consistent lack of application of the legislation by the court system, or a F lack of appropriate registration systems at reasonable costs. But there may also be demand factors; the demand for certain services may not be sufficient to justify the set-up costs. G H 4.6.2 Taxation Issues Tax policies are critical to the sound development of most segments of finance, yet taxa- I tion is a highly complex and country-specific matter within which the issues relating to 91 Financial Sector Assessment: A Handbook the financial sector cannot ever be fully isolated. A full analysis of taxation issues will 1 normally be outside the scope of financial sector assessments, but each sectoral review should be alert to particularly important tax aspects and should take a cross-cutting 2 overall view of how urgent or important it is to correct the most prominent distortions (Honohan 2003). 3 Taxation policies should aim at broad neutrality between similar financial products and services, especially between identical products provided through different institu- 4 tional forms. The tax burden on financial intermediation should be commensurate with that on other sectors. Tax design should avoid sensitivity to the inflation rate. Financial 5 transaction taxes have been used in several countries with weak fiscal systems as a means of tapping revenue quickly. Though they can be effective in the short run, they should 6 be scrutinized for the degree to which they are being arbitraged away (eventually result- ing in transactions costs rather than tax revenue), with the remaining revenue having an 7 unintended and perhaps regressive incidence. Although the application of a value added tax (VAT) to financial services raises administrative complications that are unlikely to 8 be overcome in low- or low-middle-income countries, a theoretical VAT does represent a useful benchmark against which to measure and compare the actual financial tax burden on intermediation and other financial services. This comparison can be especially useful 9 in checking how inflation-proof the financial tax system is. In some respects, especially through quasi-taxes that masquerade as regulations (such 10 as unremunerated reserve requirements), finance has been overtaxed in many countries. But it is the removal of such special impositions that will be beneficial, not the creation 11 of special privileges. Special pleading by financial sector participants must be treated with a degree of skepticism in this regard: Neutrality, rather than tax-based incentivizing of 12 particular markets or institutions, is preferred. Instead of attempting to use financial sec- tor taxes as "corrective instruments" in this way, the authorities would be well advised to A concentrate on making the financial tax system as arbitrage-proof and as inflation-proof as is practicable. B Subsidy of finance creates damaging distortions and can have a chilling effect on the development of more-effective and less-corruptible commercial substitutes for the product C or market being subsidized. Such distortions are especially relevant in the context of gov- ernment-sponsored providers of financial service, providers whose activities may undercut private provision without delivering adequate quality. Detailed examination of credit D programs from government agencies will typically be beyond the scope of financial sector assessments, but a general awareness of these and similar subsidies needs to inform analysis E of the missing market issue and of the performance of the nearbanks in particular. F 4.6.3 Competition Aspects G Effective competition can provide the incentives to expand financial services. Both pru- dential and competition policies (including licensing and entry, exit and merger policies, H and branching and similar regulations) should facilitate the presence of intermediary owners and management that are independent of government and of the major local, I nonfinancial groups. Line of business restrictions should avoid the creation of uncompeti- tive market segments. 92 Chapter 4: Assessing Financial Structure and Financial Development The structure of cross-ownership among financial institutions also matters for effec- 1 tive competition. Often seen as complements, banks and markets do compete for finan- cial sector value added. Where banks control the major nonbank financial institutions, 2 competition between the two will tend to be lower, resulting in less variety and higher cost in the provision of financial services. The same may apply to regulation, because 3 a bank-dominated regulator may be slow to sanction desirable institution building on the nonbank side. For example, if the banks own the collective investment institutions, they may discourage measures that tend to open up the development of that sector, to 4 the extent that it would undermine their future profitability. Information on such cross- ownership can be very informative as to the future development prospects of the financial 5 sector as a whole. 6 4.6.4 Development Obstacles Imposed by Unwarranted Prudential 7 Regulation Supervision and regulation have important implications for the effectiveness of interme- 8 diation and access to financial services, in addition to their roles in fostering stability. Entry regulation and uneven supervisory practices across different groups of financial 9 institutions (either by type or ownership) can hamper competitiveness and, thus, effec- tiveness. Different regulatory and supervisory standards across different financial institu- 10 tions that offer similar products and compete directly with each other can negatively affect competitiveness. Heavy regulation of branch openings (as already mentioned) or 11 other delivery channels can limit access to financial services. For example, prudential policies should avoid undue reliance on tools that are likely to disadvantage small and 12 new firms (such as excessive mandatory collateralization requirements for bank loans). Supervision and regulation also impose transaction costs on financial institutions and, A ultimately, on the users. The benefit of regulation and supervision in terms of promoting soundness and stability must be balanced with the costs that they may impose in terms of B efficiency and access. Given the high fixed-cost component of financial supervision, that balance is especially important for small financial systems and for components of finan- cial systems that are made up of small institutions, such as the cooperative movement or C microfinance. D 4.7 From Finding Facts to Creating Policies E Once the data gathering and analysis have been conducted (as outlined in sections 4.2 F through 4.6), policies and reforms must be identified and prioritized. The task of policy formulation consists of distilling those findings into an overview of the principal strategic G issues and development gaps--specifically in terms of the functions that finance is sup- posed to perform--and of opportunities. The reforms needed to enhance development of H the financial system typically fall under the headings of (a) infrastructural strengthening, (b) policy corrections to reduce unintended side effects of regulatory or tax policies, or I (c) governance reform. Those reforms must be prioritized and synthesized. 93 Financial Sector Assessment: A Handbook A medium-term vision for where the financial sector should be going helps to focus 1 the recommendations and to avoid being distracted by the immediate political impera- tives and obstacles that often make progress seem impossible. Because the quantity, term, 2 and price of credit and other financial services are crucial and will generally depend on the efficiency and competitiveness of the sector and on the cost structure facing market 3 participants (including the cost of taxation and regulation), these elements should be among the major dimensions considered in such a vision. Thus, the vision could include 4 an indication of likely ownership patterns: what share to be owned by government and by foreign concerns, how much competition in banking and insurance, what change in 5 the scope of activities allowed to banks, and what degree of subsectoral specialization. The vision could also address the likely growth in the assets of insurance, pension, and 6 contractual savings and how they are likely to be allocated among domestic and foreign equities, bonds, and bank deposits. The institutional prospects for the securities markets, 7 including the potential for collaboration or integration with securities markets abroad, will also be relevant. Institution building to enhance the soft infrastructure tends to be the least contentious 8 area, though the reforms are not always easy to accomplish in practice. In particular, the infrastructure for payments transactions can usually be strengthened with noncontrover- 9 sial legislation and with the introduction of cost-effective technology. Credit information and accounting improvements may take longer and may demand the formation of more 10 sustained human capital. Some legal reforms to enhance creditor rights (such as those needed to underpin a leasing industry) are also straightforward, but effective reforms in 11 such areas as bankruptcy and enforcement of collateral tend to be more controversial and difficult to bring into effect. 12 Shortcomings in regulatory and tax policy design often represent a judgment call relat- ing to some tradeoff (perhaps involving stability against efficiency) and, as such, require A careful analysis to arrive at an acceptable compromise. Even then, special interests may have congregated around the regulations (for example, entry restrictions) that hamper B reform. Nevertheless, the removal of regulatory and tax barriers to competitive provision of needed financial services is a crucial component of most financial sector development strategies. In some countries, the special interests of incumbent financial service provid- C ers (including the employees of government-owned financial agencies) have become entrenched through disproportionate representation in regulatory bodies or even in the D legislature. If so, implementation of reforms is likely to be blocked indefinitely. Wider constitutional reforms, such as establishing or strengthening independence of the regula- E tors from such special interests, may be a prerequisite for achieving deep reform of finance and--through that achievement--enhanced growth and poverty reduction. Yet such F recommendations are, of course, the most difficult to sell. Having identified the infrastructural weaknesses and policy flaws, assessors should G formulate a clear prioritization and justification of recommendations addressed to senior policy makers and top politicians. The reform program is likely to entail short-term politi- H cal costs, as well as fiscal outlays, and the program needs to be justifiable in terms of a simple and compelling rationale. In contrast to the stability assessment, where the con- I sensus behind the core principles may be sufficient justification for some policy reforms, the more debatable nature of the development assessment, as well as the often more 94 Chapter 4: Assessing Financial Structure and Financial Development far-reaching nature of the reforms, calls for reliance on careful justification of policy pro- 1 posals. For example, if what is needed is greater independence of the regulatory authority or greater liberalization of interest rate spreads, elimination of compulsory reinsurance cessions, commercialization and privatization of the major banks, or liberalization of entry 2 by foreign financial service providers, then this need must be embedded in terms of the vision of the future financial system and of the desired potential benefits. 3 Reforms will take time, and policy makers need to know what the priorities are--both what is more important and whether specific sequencing is required. Sequencing and 4 coordination of different measures are important to ensure a robust transition path. For example, early liberalization of deposit rates may not be appropriate in a system still 5 dominated by poorly managed state-owned banks whose insiders' apparent goal is market share rather than sustained profit. Similarly in a system with large nonperforming loans 6 and significant corporate financial fragility, some initial bank and corporate restructur- ing and some strengthening of prudential supervision may be needed before substantive 7 liberalization of interest rates and entry. Thus, the scope and priorities of policy measures would depend both on the state of development of the financial sector and on the initial 8 level of financial stability. Against this background, rather than (or in addition to) presenting a comprehensive 9 list of reforms, it is suggested that four or five themes may be identified in order of their importance, and the major thrusts of reform under each theme may be explained and pri- oritized. The particular conditions in each country would determine what those themes 10 should be. No template is offered here nor should one be. Some of the themes might cut across sectors. For example, it could be a needed strengthening of political independence 11 of regulatory authorities in several subsectors, or it could be a lack of competition and contestability reflecting inappropriate regulation in several sectors, or it could be the need 12 for a root-and-branch reform of the tax code. Identifying the fact that such problems crop up in several sectors will help decision makers who are concerned with each sector realize A the common position that they are in and may help point to the potential for organi- zational or legislative approaches that may not seem feasible to those in charge of any B one sector. Other themes may be sector specific, such as either inadequate enforcement of stock exchange rules on transparency or a chaotically dysfunctional credit registry. C Even if a similar problem exists to a lesser extent in other sectors, pointing the finger at a particularly damaging weakness can help ensure that top policy makers will allocate the D financial and political resources necessary to fix it. The design and prioritization of broad themes and specific measures under each theme should help support financial and mac- E roeconomic stability and should facilitate effective implementation. The principles and considerations in sequencing of reforms are more fully explained in chapter 12. F Notes G 1. For example, if it is found that some services, such as reinsurance or elements of invest- H ment banking, are more effectively provided to a particular small country by foreign markets or firms, then there is a presumption that policies blocking access to foreign I provision of those services should be dismantled, even though this dismantling may 95 Financial Sector Assessment: A Handbook damage the interests of local financial firms. Because of their specialist knowledge, 1 incumbent providers are often in a strong position to resist policy changes that, though good for growth and overall financial development in the economy generally, may 2 damage their sectoral interest. For a detailed and instructive account of how bank- ruptcy professionals, judges, and lawyers systematically blocked bankruptcy reform in 3 the United States throughout the twentieth century, see Skeel (2003). 2. For the importance of the functional approach as opposed to the institutional 4 approach, see Beck and Levine (2002) and Levine (1997). 3. Beck, Demirgüç-Kunt, and Levine (2000) provide a set of benchmark indicators for 5 different parts of the financial system. Research is ongoing to enrich the cross-country data, notably on access. 6 4. For example, Demirgüç-Kunt, Laeven, and Levine (2003) find a significant role for bank-level variables (such as bank size, equity and liquidity ratios, and fee income), 7 together with national-level variables (such as bank concentration, inflation, GDP per capita, quality of governmental institutions that are based on governance indicators 8 compiled by World Bank), property rights, and restrictiveness of bank conduct and entry regulations). 9 5. Regulation and supervision are also part of the infrastructure review, here covered in the information-gathering phase on a sector-by-sector basis. 10 6. Chapter 9 contains a discussion of the scope of the insolvency and creditor rights standards. 11 7. Chapter 10 contains a discussion of the scope of corporate governance standards. 8. Jappelli and Pagano (2002) present an early study on the positive relationship between the availability of debtor information through credit registries and financial develop- 12 ment. Miller (2003) is a collection of papers on different aspects of the issue. Levine, Loayza, and Beck (2000) discuss the importance of accounting standards for financial A intermediary development. The Center for International Financial Analysis and Research Inc. provides data for 44 countries on accounting standards. B 9. Honohan (2004b) describes of a wide range of data sources, including recent efforts to increase systematic coverage of financial issues in surveys. For example, the World C Bank­led Enterprise Surveys have already covered approximately 50 countries since 2002 and are being rolled out at the rate of about 20 countries per year. The World D Bank has also surveyed bank regulators in approximately 70 countries about overall access indicators--such as number of branches and ATMs, average loan and deposit E size--and provider banks in approximately 60 countries about product and process technology. F 10.The Basel Core Principles (BCPs) for Effective Banking Supervision state that "bank- ing supervision is only part of wider arrangements that are needed to promote stability G in financial markets" (see chapter 5). Those prerequisites are spelled out in the BCP source document, and they include much of what is needed for efficiency and reach, H as well as stability. If a BCP assessment is being conducted in parallel, the assessors will also be gathering information relevant to the sectoral development assessment I on banking. For an overview of relation between standards assessments and sectoral reviews, see box 4.5. 96 Chapter 4: Assessing Financial Structure and Financial Development 11.For recent cross-country studies on interest rate margins, see Demirgüç-Kunt and 1 Huizinga (1999) and Demirgüç-Kunt, Laeven, and Levine (2004). 12. The interest spread studies by the Brazilian Central Bank (http://www.bcb.gov.br/) are 2 a good example. 13.The Microfinance Consensus Guidelines by the Consultative Group to Assist the Poorest (CGAP) (Christen, Lyman, and Rosenberg 2003) provides a useful framework 3 defining good practice for the MFI subsector. 14.International Association of Insurance Supervisors (IAIS)'s Core Principles also 4 address aspects of development issues in Insurance. See box 4.4. 15.Even a listing of broad lines of business would include categories such as auto; employ- 5 er's liability, product liability, and medical malpractice; marine (including other transport); commercial fire and theft; machinery; flood and other weather-related 6 occurrences such as earthquake, etc.; mortgage protection, export credit, and other credit-related items; homeowners; health and disability; and life and annuity. 7 16.For example, overly generous tax incentives for life insurance can result in what are little more than tax-avoidance schemes dressed up as insurance policies. Or, onerous 8 regulation of the investment of insurance or pension funds can result in too much being placed in short-term bank deposits, effectively resulting in reverse maturity 9 transformation for the system as a whole. Again, unduly favorable differential tax and regulatory treatment of managed funds can result in a large fraction of investable 10 funds being diverted into inadequately regulated fund management concerns that are sometimes associated with self-dealing. 11 17.For a discussion of these restrictions and how development and prudential consider- ations may be balanced, see Vittas (1998). A draft code for the regulation of private 12 occupational pension schemes has been prepared for the Organisation for Economic Co-operation and Development (OECD) (OECD 2003). A 18.Indeed, weaknesses in the government's institutional and strategic arrangements for debt management may be the focus of a special side study, for example, using the B guidelines recently developed by the IMF and World Bank (2001). 19.Except to the extent that the financial condition of the corporate, household, govern- C ment, and external sectors has been examined with a view to forming an opinion on the quality of the banks' loan portfolio. See chapters 2 and 3 on the use and analysis of balance sheet-financial soundness indicators of those sectors. D E References F Barth, James, Gerard Caprio, and Ross Levine. 2004. "Bank Supervision and Regulation: What Works Best?" Journal of Financial Intermediation 13(2): 205­48. G Beck, Thorsten, Asli Demirgüç-Kunt, and Ross Levine. 2000. "A New Database on the Structure and Development of the Financial Sector." World Bank Economic Review 14: H 597­605. ------. 2003. "Law, Endowments, and Finance." Journal of Financial Economics 70(2): I 137­81. 97 Financial Sector Assessment: A Handbook Beck, Thorsten, and Michael Fuchs. 2004. "Structural Issues in the Kenyan Financial 1 System: Improving Competition and Access." World Bank Policy Research Working Paper 3363, World Bank, Washington, DC. 2 Beck, Thorsten, and Ross Levine. 2002. "Industry Growth and Capital Allocation: Does Having a Market- or Bank-Based System Matter?" Journal of Financial Economics 64: 3 147­80. Beck, Thorsten, Ross Levine, and Norman Loayza. 2000. "Finance and the Sources of 4 Growth." Journal of Financial Economics 58: 261­300. Bossone, Biagio, Patrick Honohan, and Millard Long. 2002. "Policy for Small Financial 5 Systems." In Financial Sector Policy for Developing Countries--A Reader, eds. G. Caprio, P. Honohan, and D. Vittas, 95­128. New York: Oxford University Press. See 6 also "Policy for Small Financial Systems," Financial Sector Discussion Paper No. 6. Washington, DC: World Bank, 1991. Available at http://wbln0018.worldbank.org/ html/FinancialSectorWeb.nsf/(attachmentweb)/Fs06/$FILE/Fs06.pdf. 7 Christen, Robert Peck, Timothy R. Lyman, and Richard Rosenberg. 2003. Microfinance Consensus Guidelines. Consultative Group to Assist the Poorest: Washington, DC. 8 Claessens, Stijn, and Luc Laeven. 2003. "What Drives Bank Competition? Some International Evidence." World Bank Policy Research Working Papers No. 3113. 9 Demirgüç-Kunt, Asli, and Harry Huizinga. 1999. "Determinants of Commercial Bank Interest Margins and Profitability: Some International Evidence." World Bank 10 Economic Review 13: 379­408. Demirgüç-Kunt, Asli, Luc Laeven, and Ross Levine. 2004. "The Impact of Bank 11 Regulations, Concentration, and Institutions on Bank Margins." Journal of Money, Banking, and Credit 36, (3 Part 2): 593­622. 12 Doing Business Database. World Bank. Available at http://rru.worldbank.org/ DoingBusiness/. A Fazzari, Steven, Glenn Hubbard, and Bruce Petersen. 1988. "Financing Constraints and Corporate Investment." Brookings Papers on Economic Activity 1: 141­95. FSF (Financial Stability Forum). "Compendium of Standards." Financial Stability Forum. B Available at http://www.fsforum.org/compendium/about.html. Honohan, Patrick, ed. 2003. "Avoiding the Pitfalls in Taxing Financial Intermediation." C In Taxation of Financial Intermediation: Theory and Practice for Emerging Economies, pp, 1­30. New York: Oxford University Press. D ------. 2004a. "Financial Development, Growth, and Poverty: How Close Are the Links?" World Bank Policy Research Working Paper 3203, World Bank, Washington, DC. E Available at http://econ.worldbank.org/files/32898_wps3203.pdf. See also Honohan, Patrick. 2004. "Financial Development, Growth, and Poverty: How Close Are the F Links?" 2004. In Financial Development and Economic Growth: Explaining the Links, ed. Charles Goodhard. London: Palgrave. G ------. 2004b. "Measuring Microfinance Access: Building on Existing Cross-Country Data." Prepared for the United Nations Development Programme, World Bank, and International Monetary Fund Workshop, "Data on the Access of Poor and Low- H Income People to Financial Services," Washington, DC, October 26. IMF (International Monetary Fund) and World Bank. 2001. Guidelines for Public Debt I Management. Washington, DC: International Monetary Fund and World Bank. Available at http://www.imf.org/external/np/mae/pdebt/2000/eng/index.htm. 98 Chapter 4: Assessing Financial Structure and Financial Development ------. 2003. "Development Issues in the FSAP." International Monetary Fund and 1 World Bank. Washington, DC. Available at http://www.imf.org/external/np/fsap/2003/ 022303b.htm. Impavido, Gregorio, Alberto Musalem, and Dimitri Vittas. 2003. "Promoting Pension 2 Funds." in Globalization and National Financial Systems, eds. James A. Hanson, Patrick Honohan, and Giovanni Majnoni. New York: Oxford University Press. 3 _________ "Contractual Savings in Countries with a Small Financial Sector." 2002. World Bank Policy Research Working Paper Series, No. 2841. 4 La Porta, Rafael, Florencio Lopez-de-Silanes, and Andrei Shleifer. 2002. "Government Ownership of Commercial Banks." Journal of Finance 57: 265­301. 5 La Porta, Rafael, Florencio Lopez-de-Silanes, Andrei Shleifer, and Robert W. Vishny. 1997. "Legal Determinants of External Finance." Journal of Finance 52: 1131­50. 6 ------. 1998. "Law and Finance." Journal of Political Economy 106: 1113­55. Levine, Ross. 1997. "Financial Development and Economic Growth: Views and Agenda." 7 Journal of Economic Literature 35: 688­726. Levine, Ross, Norman Loayza, and Thorsten Beck. 2000. "Financial Intermediation and 8 Growth: Causality and Causes." Journal of Monetary Economics 46: 31­77. Jaffee, Dwight M., and Betrand Renaud. 1996. "Strategies to Develop Mortgage Markets in Transition Economies." World Bank Policy Research Working Paper 1697. 9 Washington, DC. Jappelli, Tullio, and Marco Pagano. 2002. "Information Sharing, Lending, and Defaults: 10 Cross-Country Evidence." Journal of Banking and Finance 26: 2017­45. Miller, Margaret, ed. 2003. Credit Reporting Systems and the International Economy. 11 Cambridge, MA: MIT Press. OECD (Organisation for Economic Co-operation and Development). 2002. Insurance and 12 Private Pensions Compendium for Emerging Economies. Paris: Organisation for Economic Co-operation and Development. A ------. 2003. Occupational Pensions Core Principles and Methodology. Paris: Organisation for Economic Co-operation and Development. B Skeel. David A. Jr. 2003. Debt's Dominion: A History of Bankruptcy in America. Princeton, New Jersey: Princeton University Press. Vittas, Dimitri. 1998. "Regulatory Controversies of Private Pension Funds." World Bank C Policy Research Working Paper 1893, World Bank, Washington, DC. World Bank. 2001a. Finance for Growth: Policy Choices in a Volatile World. New York: D Oxford University Press. ------. 2001b. Principles and Guidelines for Effective Insolvency and Creditor Rights Systems. E Washington, DC: World Bank. ------. 2001c. Developing Government Bond Markets. Washington, DC: World Bank. F G H I 99 1 2 3 4 Chapter 5 5 Evaluating Financial Sector 6 Supervision: Banking, Insurance, 7 and Securities Markets 8 9 10 This chapter looks at the legal, institutional, and policy framework needed to ensure effec- tiveness of financial sector supervision. It focuses on banking, insurance, and securities 11 markets. Effective supervision, however, depends on a legal and institutional environment that provides the necessary preconditions. Those preconditions include the following: 12 · The provision and consistent enforcement of business laws--including corporate, bankruptcy, contract, consumer protection, and private property laws--and a A mechanism for fair resolution of disputes · Good corporate governance, including adoption of sound accounting, auditing, B and transparency procedures that carry wide international acceptance and that promote market discipline C · Appropriate systemic liquidity arrangements, including secure and efficient pay- ment clearing systems that enable adequate control of risks and efficient manage- D ment of liquidity · Adequate ways to minimize systemic risk, including appropriate levels of systemic E protection or safety nets and efficient procedures for handling problem institu- tions F The preconditions complement the legal and institutional framework governing the specific sectors of the financial system (banks, nonbank financial institutions, rural and G microfinance entities, securities markets, and insurance providers) and their supervision, which is discussed in section 5.1. The broader legal framework governing the precondi- H tions 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 I affecting governance and stability of banking institutions. The scope and content of inter- 101 Financial Sector Assessment: A Handbook national standards on financial sector supervision in banking, insurance, and securities 1 markets and the issues in assessing compliance with these standards are taken up in detail in the subsequent sections of this chapter (sections 5.3­5.5). 2 5.1 Legal and Institutional Framework for Financial Supervision 3 4 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 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, 6 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 sec- 7 tor laws are already part of the existing international standards on supervision. Effective supervision also requires certain preconditions that are embedded in a broader range 8 of laws such as laws on bankruptcy; company laws; contracts laws; and laws governing accounting, auditing, and disclosure, and so forth. 9 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, 10 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 11 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 deli- 12 cense 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 A governing financial sector supervision need to specify the relationships among the super- visory agency, any deposit insurance agency, and other financial sector supervisors. In B 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 C financial supervisory agency, then this arrangement needs to be laid down in a law, and its autonomy and powers need to be explicit. D 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- E lowing categories: · Regulatory governance, which refers to the objectives, independence, enforce- F ment, and other attributes that provide the capacity to formulate and to implement sound regulatory policies and practices G · Regulatory practices, which refer to the practical application of laws, rules, and procedures H · Prudential framework, which refers to internal controls and governance arrange- ments to ensure prudent management and operations by financial firms I · 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 Chapter 5: Evaluating Financial Sector Supervision: Banking, Insurance, and Securities Markets Figure 5.1. Financial Standards and Their Four Main Components and Their Four Main Components 1 Regulatory Governancea Regulatory Practicesc 2 · Objectives of regulation · Group-wide supervision · Independence and adequate resources · Monitoring and on-site inspection · Enforcement powers and capabilities · Reporting to supervisors 3 · Clarity and transparency of regulatory process · Enforcement · External participation · Cooperation and information sharing 4 · Confidentiality · Licensing, ownership transfer, and corporate control Prudential Frameworkb · Qualifications 5 · Risk management · Risk concentration · Captial requirements Financial Integrity and Safety Netd 6 · Corporate governance · Markets (integrity and financial crime) · Internal controls · Customer protection · Information, disclosure, and transparency 7 8 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. 9 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. 10 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 11 Note: This four-component framework is based on the paper "Financial Sector Regulation: Issues and Gaps" (IMF 12 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 5.3­5.5. A B tions of financial institutions and markets and (b) the creation of safeguards for depositors, investors, and policyholders, particularly during times of financial dis- C tress and crisis Those four components are illustrated in figure 5.1. For example, in the area of regu- D latory governance, Insurance Core Principles (ICPs) relating to supervisory objectives and supervisory authority require that insurance legislation include a clear statement on E 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 F relating to independence and accountability--could be part of primary legislation or part of regulations and bylaws issued pursuant to the legislation. G 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- H ment. 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 I financial innovation and development. For example, a poorly structured organizational 103 Financial Sector Assessment: A Handbook framework for supervision could impede financial innovation or cause overregulation 1 that stifles development. Similarly, an inappropriate organizational structure may cause regulatory gaps and regulatory arbitrage that may allow excessive risk taking and finan- 2 cial instability. An institutional framework for financial stability is, however, quite broad and goes beyond the institutions conducting financial supervision (such as the sectoral 3 supervisor or integrated supervisor or central bank with supervision responsibilities). It includes other institutions and policy authorities that have jurisdictions over the broader 4 financial infrastructure and macroeconomic policies. For example, accounting policies, competition policies, and insolvency regimes are matters outside the jurisdiction of 5 supervision but are critical for financial stability. The broader institutional framework also includes the specific coordinating arrangements to ensure information exchange 6 and policy coordination among all these policy components--supervisory, infrastructure, macroeconomic, and macroprudential--that interact to produce financial stability and 7 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 8 bring together representatives of different policy authorities. The appropriate design of the institutional structure of financial regulation and super- vision has become a major issue of policy and public debate in several countries. Although 9 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 10 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 11 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 12 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 A Regulation and Supervision). B 5.2 Aspects of Financial Safety Nets C 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 D 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 E intermediation function of financial markets and, thus, the broader economic activity. Facilities for liquidity support attempt to prevent liquidity difficulties in one institution F (or market) from being transmitted throughout the financial system. Deposit insurance and other protection schemes are designed to provide confidence to the least-informed G depositors and investors with respect to the safety of their funds and thereby avoid spill- overs from runs. Crisis management policies are established to minimize the disruption H 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 I the financial sector safety net, all three elements, including their legal underpinnings and their interconnections, should be considered. 104 Chapter 5: Evaluating Financial Sector Supervision: Banking, Insurance, and Securities Markets 5.2.1 Frameworks for Liquidity Support 1 Liquidity support is a key element of the financial sector safety net. Two somewhat dis- tinct functions­­one operating at normal times and another in times of crisis­­need to be 2 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 3 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 4 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 5 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- 6 kets--from interrupting the normal intermediation function of financial institutions and markets. 7 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 forbear- ance, with adverse consequences for the financial system. Thus, an important component 8 in understanding the adequacy of the financial safety net is assessing the adequacy of the central bank's operational procedures for LOLR support. 9 Somewhat distinct from the normal LOLR function is central bank emergency lend- ing. It is important for central banks to have procedures in place to provide emergency 10 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 11 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 12 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 A 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 poli- B cies­­a form of contingency planning­­should be in place for emergency lending, which should follow sound practices. In particular, the broad principles and the procedures gov- C erning the decisions on emergency lending could be established and made transparent. Key features of emergency lending procedures that should be considered include the D following:2 · Resources should be made available only to banks that are considered solvent but E are coping with liquidity problems that might endanger the entire system (e.g., too-big-to-fail cases). F · Lending should take place speedily. · Lending should be short term; even then, it should be provided conservatively G because the situation of a bank might deteriorate quickly. · Lending should not take place at subsidized rates, but the rate also should not be H penal because it might then deteriorate the bank's position. · The loan should be fully collateralized, and collateral should be valued conserva- I tively. However, at times of severe crisis, it might be necessary for the central bank 105 Financial Sector Assessment: A Handbook to relax this criterion or to organize government guarantees or to arrange govern- 1 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 2 contact and should monitor the situation of the bank. · Supervisory sanctions and remedial actions should be attached to the emergency 3 lending. 4 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 6 insurance--complemented by a larger policy package that includes effective supervision, prompt bank resolution methods, and well-designed LOLR procedures--should provide 7 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: 8 · The DIS should be explicitly and clearly defined in laws and regulations that are 9 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- 10 tives for large depositors and counterparty banks to monitor the bank conditions, "large" deposits, including interbank liabilities, should not be covered. 11 · Ex ante funding schemes are preferable to ex post schemes. · Membership should be compulsory; insurance premiums should be risk-adjusted, if 12 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 A deposits promptly, and it must be adequately funded so it can resolve failed institu- tions firmly and without delay. B · 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 C of political interference. · The DIS should be complemented by effective supervision and well-designed D LOLR policies. · Because the roles of the LOLR, the supervisor, and the DIS are different, it is E often advisable in large countries (but impractical in countries facing a shortage of financial skills) to house them in three separate agencies. Regardless, those agen- F cies need to share information and coordinate their actions. · If the DIS is to avoid regulatory capture by the industry it guarantees, then placing G 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, H where they can offer useful advice. · If a country operates insurance schemes for financial instruments other than (nar- I rowly defined) deposits--including capital market instruments and possibly insur- ance--then those types of investor and policyholder compensation schemes should 106 Chapter 5: Evaluating Financial Sector Supervision: Banking, Insurance, and Securities Markets conform broadly to the same standards as deposit insurance, as described in this 1 chapter. · Although the inclusion or exclusion of foreign currency deposits in deposit insur- ance would depend on the features of dollarization, adequacy of foreign exchange 2 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 3 regulatory framework that specifies who bears the exchange risk.4 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 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 only if circumstances are favorable for that guarantee to restore confidence and to stop 6 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 7 situation be sustainable. 8 5.2.3 Investor and Policyholder Protection Schemes 9 Related to the second element of safety net, deposit insurance, are investor and policy- holder compensation schemes, which are designed to promote investor confidence in the 10 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 11 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 12 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 A 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 B 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 C 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 D 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 E 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 F 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 G 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 H exchanges that are acting as the trust's sponsoring organizations--provide for compensa- tion arrangements. The compensation fund also may be established as a separate company I administered by the regulator. 107 Financial Sector Assessment: A Handbook The majority of investor compensation schemes are tailored to individual investors 1 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 2 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 3 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 4 limits on the maximum payment in the event of a successful claim. Funding arrangements for investor compensation schemes rely to a large extent on 5 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 6 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- 7 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 8 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. 9 The adequacy of investor protection measures depends on the full range of regula- tory responses in place to minimize investor losses and to protect customer assets in the 10 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 11 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 12 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 A failure of market intermediaries--can promote investor confidence. Some of the emerging good practices of compensation schemes are noted here. B 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 mecha- C nism--and industry representatives. Compensation schemes should be industry-funded to emphasize that prudential and fiduciary responsibility lies with industry participants. D The degree of government backing is likely to vary between jurisdictions, but such back- ing may increase moral hazard to market participants. Prefunded schemes offer greater E 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 F 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 G rate may vary from sector to sector, by size of contributor, or by the degree of financial health of the contributor. H 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 I 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 Chapter 5: Evaluating Financial Sector Supervision: Banking, Insurance, and Securities Markets ers, and the extent to which foreign consumers of domestic products should be compen- 1 sated 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 2 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 3 for redress have been exhausted (e.g., the bankruptcy process). These funds act to main- tain public confidence in the industry by protecting the interest of small entities or 4 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 6 5.2.4 Crisis Management A third key element of the financial sector safety net includes the policies and procedures 7 in place to manage crises. An assessment of the adequacy of the safety net should con- sider the readiness of the national authorities to tackle a systemic banking crisis (ideally, 8 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 9 may help raise awareness of the need to have policies and procedures in place to address a crisis. 10 Some key considerations in assessing the crisis management framework include the following: 11 · Is the legal framework during "normal times" robust enough to ensure a smooth banking sector restructuring once a crisis has been contained? This question 12 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. A Adequate bank insolvency law in normal times is critical to ensure smooth bank restructuring in crisis times. B · 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 C 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 D bank and the supervisory agency. · Although it is impossible to have a contingency plan that covers all contingencies E (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 F 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- G tries occasionally organize crisis management simulations to increase awareness of potential issues and to resolve logistical impediments to the smooth handling of crises. H Additional discussion of those issues is provided in Hoelscher and Quintyn (2003), I Lindgren and others (2000), and World Bank and IMF (2004), especially with respect to 109 Financial Sector Assessment: A Handbook the legal, institutional and regulatory framework to deal with insolvent banks. See also 1 section 5.3.5 for a more detailed discussion of bank insolvency issues. 2 5.3 Assessment of Banking Supervision 3 This section presents the core principles that form the basis for assessing the effectiveness 4 of banking supervision, explains the assessment methodology, outlines the recent assess- ment experience, and discusses selected key issues in supervision: new capital adequacy 5 standards (Basel II), bank insolvency procedures, supervision of large and complex finan- cial institutions (LCFIs), consolidated supervision, and unique risks in Islamic banking. 6 5.3.1 Basel Core Principles--Their Scope and Coverage, and Their 7 Relevance to Stability and Structural Development The Basel Core Principles (BCPs) for Effective Banking Supervision, developed by 8 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 9 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 10 aspects of supervision (see box 5.1). The 25 core principles cover various aspects of objec- tives, autonomy, powers, and resources (Core Principle 1); licensing and structure (Core 11 Principles 2­5); prudential regulations and requirements (Core Principles 6­15); meth- ods of ongoing supervision (Core Principles 16­20); information requirements (Core 12 Principle 21); remedial measures and exit policies (formal powers) (Core Principle 22); and cross-border banking (Core Principles 23­25). A 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 B improving good supervision and (b) indirectly by promoting a robust financial infrastruc- ture. The BCPs seek to ensure that the supervisor can operate effectively and that banks C operate in a safe and sound manner. The BCPs also define the necessary preconditions, including the legal, accounting, and auditing infrastructure; effective market discipline D and resolution of problem banks; public safety nets; and sound macroeconomic frame- works that should be in place for effective supervision. The BCP assessments provide E useful qualitative information on the risk environment, on the responsiveness of the supervisor, and on the overall effectiveness of risk management. F The BCPs highlight a set of prerequisites relating to regulatory governance and spell out principles and criteria to govern sound regulatory practices, a prudent opera- G tional 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 H 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 I 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 110 Chapter 5: Evaluating Financial Sector Supervision: Banking, Insurance, and Securities Markets 1 Box 5.1 Basel Core Principles for Effective Banking Supervision The Basel Core Principles comprise 25 basic prin- ­ CP 13 requires banks to have systems to 2 ciples that need to be in place for a supervisory system measure, monitor, and control all other to be effective. The core principles (CPs) relate to the material risks. following: ­ CP 14 calls for banks to have adequate inter- 3 nal control systems. · Objectives, Autonomy, Powers, and Resources ­ CP 15 sets out rules for the prevention of ­ CP 1.1* deals with the definition of respon- fraud and money laundering. 4 sibilities and objectives for the supervisory agency. · Methods of Ongoing Supervision ­ CP 1.2 deals with skills, resources, and inde- ­ CP 16 defines the overall framework for 5 pendence of the supervisory agency. onsite and offsite supervision. ­ CP 1.3 deals with the legal framework. ­ CP 17 requires supervisors to have regular ­ CP 1.4 deals with enforcement powers. contacts with bank management and staff 6 ­ CP 1.5 requires adequate legal protection for and to fully understand banks' operations. supervisors. ­ CP 18 sets out the requirements for offsite ­ CP 1.6 deals with information sharing. 7 supervision. · Licensing and Structure ­ CP 19 requires supervisors to conduct onsite ­ CP 2 deals with permissible activities of examinations or to use external auditors for 8 banks. validation of supervisory information. ­ CP 3 deals with licensing criteria and the ­ CP 20 requires the conduct of consolidated licensing process. supervision. 9 ­ CP 4 requires supervisors to review--and · Information Requirements have the power to reject--significant trans- ­ CP 21 requires banks to maintain adequate 10 fers of ownership in banks. records reflecting the true condition of the ­ CP 5 requires supervisors to review major bank and to publish audited financial state- acquisitions and investments by banks. ments. 11 · Prudential Regulations and Requirements · Remedial Measures and Exit ­ CP 6 deals with minimum capital adequa- ­ CP 22 requires the supervisor to have--and 12 cy requirements. For internationally active promptly apply--adequate remedial mea- banks, the requirements must not be less sures for banks when they do not meet stringent than those in the Basel Capital prudential requirements or when they are A Accord. otherwise threatened. ­ CP 7 deals with the granting and managing of loans and the making of investments. · Cross-Border Banking B ­ CP 8 sets out requirements for evaluating ­ CP 23 requires supervisors to apply global asset quality and the adequacy of loan­loss consolidated supervision over internation- C provisions and reserves. ally active banks. ­ CP 9 sets forth rules for identifying and lim- ­ CP 24 requires supervisors to establish con- iting concentrations of exposures to single tact and information exchange with other D borrowers or to groups of related borrowers. supervisors involved in international opera- ­ CP 10 sets out rules for lending to connected tions, such as host country authorities. or related parties. ­ CP 25 requires (a) that local operations of E ­ CP 11 requires banks to have policies for foreign banks are conducted to standards identifying and managing country and trans- similar to those required of local banks and fer risks. (b) that the supervisor has the power to F ­ CP 12 requires banks to have systems to mea- share information with the home-country sure, monitor, and control market risks. supervisory authority. G * CP 1 is divided into six parts. Source: BCBS (1999). H I 111 Financial Sector Assessment: A Handbook permitted into the market. The public needs to be aware of which financial institutions 1 are banks and that, as banks, they are subject to supervision. Consequently, the use of the word "bank" needs to be limited to licensed institutions. Those issues are dealt with in 2 Core Principles 2 and 3. The quality and integrity of the bank's owners and management are crucial elements 3 in longer-term safety and soundness of the bank, and they need to be vetted by the super- visory authorities. Without clear insight into the structure of the group to which a bank 4 belongs and its acquisitions of interests in other companies, supervisors may not be able to adequately monitor the risks. Core Principles 3, 4, and 5 address those questions. Core 5 Principle 6 requires that banks be subject to rules regulating the adequacy of their capital buffer against risks in the asset portfolio, a key requirement for safe and sound banking. 6 Core Principles 7­11 broadly relate to the quality of lending procedures, the adequacy of provisions (without which capital adequacy figures are overstated), the concentration 7 risks, the risks in lending to connected parties against which contract enforcement may be difficult, and the risks in lending abroad. Core Principles 12 and 13 relate to risks with respect to open positions in securities, currencies, and fixed-income instruments. Good 8 internal systems to monitor and manage risks, as required in Core Principle 14, are also of key importance because bank management is primarily responsible for the stability of 9 the institution and needs to be able to rely on its own information and control systems. Core Principles 16­20 relate to the need for the supervisory authority to have reliable and 10 comprehensive information on the operations and financial condition of a bank. Without this information, monitoring and timely corrective action are not possible. Related to 11 this need, but with a broader objective of informing the markets and the public, is the requirement in Core Principle 21 to disclose audited consolidated annual financial state- 12 ments that are prepared according to internationally acceptable accounting standards. The supervisory authority must have the means to preempt threats to the stability of A financial institutions through timely corrective actions, as envisaged in Core Principle 22. The remaining Core Principles 23­25 relate to the effective monitoring of groupwide B risks, the creation of an overview of the financial condition of the group as a whole, and the associated cross-border supervisory cooperation. Transparency of supervisory framework and policies can contribute to effective super- C vision. Although the transparency of supervision is not explicitly covered in the BCPs, good transparency practices are covered in IMF Code of Good Practices on Transparency D in Monetary and Financial Policies (IMF 2000). Supervisory policies and their imple- mentation need to be disclosed to the public, for instance, through annual reports of E the supervisory agency or through dedicated chapters in central bank annual reports. Web sites of supervisory agencies can be used to disseminate annual reports and other F periodicals and can serve as a repository for banking laws and regulations. For additional suggestions and guidance on transparency practices, reference is made to the "Supporting G Document" of the IMF Code of Good Practices on Transparency in Monetary and Financial Policies (IMF 2000). H Good BCP observance has a clear and positive effect on financial sector stability because it helps to ensure that the risks in the banking system--which, in many countries, I is by far the most important component of the financial system--are adequately monitored and that tools are in place to manage the risks. If the BCPs are properly implemented and 112 Chapter 5: Evaluating Financial Sector Supervision: Banking, Insurance, and Securities Markets if the preconditions are satisfied, then supervisory authorities have the means to remove 1 weak institutions from the market and to preempt more extensive damage to the banking system. Although risks in banking institutions may also arise from macroeconomic and external shocks (e.g., liberalization-induced credit booms or a foreign exchange crisis), 2 good BCP observance can help manage the effect of the shocks by constraining excessive buildup of exposures to risk factors.7 3 The links between observance of the BCPs and financial development are complex and multifaceted. At one level, the preconditions for observing the BCPs (discussed in 4 section 5.3.2) are also conditions that facilitate financial stability and help to promote financial development. Beyond the preconditions, the observance of best practices of 5 supervision and regulation can also promote strong governance and better risk manage- ment, as well as generate more efficient and robust institutions, markets, and infrastruc- 6 ture. In turn, this strengthening of institutions can help promote sustained economic growth. However, the precise mechanism through which this effective operation can 7 occur is far from clear because it also can be the case that developments in the regulatory infrastructure arise in response to financial development. This situation can arise when 8 market participants see that the public good aspects of financial stability outweigh the compliance costs of a stronger regulatory framework so a constituency in favor of a strong 9 regulatory framework emerges. The key area in supervision that is directly relevant to the ability of banks to contribute to sustainable economic growth relates to implementation of capital adequacy standards 10 and appropriate loan evaluation, as well as provisioning policies and practices. The rules on capital adequacy in a jurisdiction determine the relationship between banks' capital 11 and their loan and investment portfolios and, therefore, limit the amount of loans and investments banks can make against the amount of regulatory capital they hold. When 12 provisions for losses on assets are not adequate, a bank will overstate its capital and thus its capacity to intermediate funds. When a correction needs to be made, the action will A instantly decrease the intermediation function of the institution. If this dynamic occurs on a large scale, for instance, as a result of more widespread banking sector problems in B an economy, then the result can be a credit crunch, which can have fiscal consequences related to costs of bank resolution, including deposit protection. C Specific institutional features of the banking system need to be taken into account in applying the BCPs and in designing regulatory policies. For example, increasingly, the D presence of LCFIs with significant international operations requires an analysis of cross- border exposures to risks and an integrated management of risks across business lines. In some countries, state-owned commercial banks play an important role in the countries' E financial systems. In many cases, the weak profitability, governance, and efficiency of those institutions become a cause for concern. The factors may not immediately pose F a risk to the banking sector insofar as the implicit guarantee of their liabilities serves to maintain confidence, but they can distort incentive structures and can slow down G the growth of a viable commercial banking sector with more rigorous risk-management policies. Better risk-management policies with strong underwriting standards also impose H discipline on banks' borrowers to the benefit of the overall quality of the assets portfolio. Also, the balance between the scope of official supervision and the extent of market I discipline would vary among countries. The approaches and tools to observe the BCPs 113 Financial Sector Assessment: A Handbook may be strongly influenced by the extent to which the overall policy environment and 1 the supervisory policies themselves tend to harness market forces and bring about good governance of banks. For an analysis of the importance of bank supervisory and regula- 2 tory policies that facilitate market discipline, see Barth, Caprio, and Levine (2004). In addition, the appropriate balance between official supervision and market discipline could 3 change over time, depending on the extent of stress in the banking system, which might affect the incentives for risk taking. 4 5.3.2 Preconditions for Effective Banking Supervision 5 The BCPs include five preconditions for effective supervision. Although preconditions 6 are not formally part of the BCPs because they are normally beyond the jurisdiction of bank supervisors, "weaknesses or shortcomings in these areas may significantly impair the ability of the supervisory authority to implement effectively the Core Principles" (BCBS 7 1999), the preconditions are as follows: 8 · Sound and sustainable macropolicies (the precondition that has the most signifi- cant effect on risk exposures and capital adequacy) 9 · A well-developed public infrastructure that covers contract enforcement, a general insolvency regime, an accounting framework, and a corporate governance (all of 10 which affect supervisory powers and enforcement) · Effective market discipline that is based on transparency and disclosure (which affects the quality of prudential framework) 11 · Procedures for effective resolution of problem banks · Mechanisms for providing either an appropriate level of systemic protection or 12 a public safety net (which, along with the preceding precondition above, affects supervision of market conduct and enforcement of corrective actions) A The 2002 evaluation of the experience with the Financial Sector Assessment Program B (FSAP) in 60 countries8 drew attention to the importance of effective preconditions for bank supervision during recent banking crises. In many of the countries experiencing crises, these preconditions were not sufficiently met. It is also noted that "compliance C with the BCP is positively correlated to compliance with the preconditions and the stage of development of the financial sector"(IMF and World Bank 2002b). It was stated that D developing countries generally are characterized by less favorable preconditions, including unstable macroeconomic conditions, inadequacies of the laws and judicial systems, weak E credit culture and accounting systems, low disclosure, and incipient or nonexistent safety nets. F In view of these arguments, the evaluation emphasized the need for assessing the pre- conditions for effective banking supervision more explicitly in the context of an FSAP G process and the BCP assessment. It continued to explain that a more structured approach to their evaluation could improve the analysis of the BCPs. It could furthermore enhance H the discussion within an FSAP of linkages between the macroeconomy, the condition of the banking sector and the effectiveness of supervision. I Although an in-depth assessment of some of the preconditions may be beyond the scope of a BCP assessment, an effort should be made to present not only the weaknesses 114 Chapter 5: Evaluating Financial Sector Supervision: Banking, Insurance, and Securities Markets and shortcomings with respect to those preconditions but also the effect they may have 1 on the effectiveness of supervision and on the soundness of the financial system. Emphasis could be placed on the following issues: 2 · Although the assessment of macroeconomic policies remains in the purview of the broader surveillance, the assessor can focus on identifying vulnerabilities and risks 3 associated with macroeconomic policies both for the financial system and for the effectiveness of bank supervision. Assessors should note whether supervisors have 4 the capacity to assess those vulnerabilities and risks and to what extent the risks can be controlled by supervisors or by banks. 5 · To assess the adequacy of public infrastructure, the BCP assessors can draw from the conclusions of assessments of financial infrastructure, where available. Using that information, the assessors could note weaknesses in the credit culture, the 6 level of creditor protection, the effectiveness of the judicial system, the bankruptcy procedures, the accounting standards, the auditing profession, and the level of 7 information disclosure to the public. · An assessment of the strength of market discipline needs to consider (a) issues of 8 transparency, including quality, timeliness, and clarity of the information available to the public; (b) issues of corporate governance; and (c) the role of the govern- 9 ment in the financial system and the set of incentives that may weaken market discipline. 10 · The adequacy of procedures to address problem banks and the effectiveness of the safety net fall within the scope of the BCP assessment and should be examined 11 while assessing Core Principles 1 and 22. In this regard, the assessor should focus on whether supervisors have a sufficient and flexible range of procedures to achieve 12 the efficient resolution of problems in banks, including the capacity to conduct an orderly resolution with respect to problem banks. For the assessment of the safety A net, examiners should focus on the existence and design of the deposit insurance and lender-of-last-resort facilities. B In many cases, assessing the weaknesses and shortcomings in the preconditions for effective bank supervision may be time consuming and difficult, demanding a high degree C of coordination of different agencies and branches of the government. Important issues of priorities and sequencing arise when trying to prepare a road map to address weaknesses D in prudential aspects and preconditions for effective supervision. The question of whether shortcomings in preconditions should be addressed before addressing prudential weak- E nesses is not a trivial one. Coordination, prioritization, and sequencing of various reforms of infrastructure, supervision, and market and institutional development require careful consideration of the effect on financial stability and the technical interlinkages among F various reform components that affect implementation.9 G 5.3.3 Assessment Methodology and Assessment Experience H BCP assessments are a form of peer review that helps to (a) identify regulatory strengths, risks, and vulnerabilities; (b) assess the level of observance of financial sector standards; I (c) ascertain the financial sector's developmental and technical assistance needs; (d) 115 Financial Sector Assessment: A Handbook prioritize financial sector policies; and (e) provide a reform agenda for improving the 1 supervisory system.10 Furthermore, standards assessments support the analysis in the con- text of an analysis of the macroeconomic and structural risks affecting domestic financial 2 systems. A BCP assessment involves an examination of the adequacy of the legislative and reg- 3 ulatory framework and a determination of whether supervisors are effectively supervising and monitoring all of the important risks taken by the banks. The assessment should fol- 4 low the guidance provided in the Core Principles Methodology by the Basel Committee on Banking Supervision (BCBS 1999).11 To achieve full objectivity, compliance with 5 each principle is best assessed by a suitably qualified outside party consisting of at least two individuals with varied perspective so as to provide checks and balances. 6 Each principle is assigned criteria that are relevant for compliance with it. Two cat- egories of criteria are used: "essential criteria" and "additional criteria." The essential 7 criteria are those elements that should be generally present in individual countries for supervision to be considered effective. Typically, essential criteria specify certain policies and procedures that supervisors are expected to follow to comply with a core principle. 8 The additional criteria are elements that further strengthen supervision and that all coun- tries should strive to implement to improve financial stability and effective supervision. 9 Additional criteria may be particularly relevant to the supervision of more sophisticated banking organizations or may be needed in instances where international business is sig- 10 nificant or where local markets tends to be highly volatile. If one is to achieve full compliance with a core principle, the essential criteria gener- 11 ally must be met without any significant deficiencies. There may be instances, of course, where a country can demonstrate that the core principle has been achieved through dif- 12 ferent means. Conversely, because of the specific conditions in individual countries, the essential criteria may not always be sufficient to achieve the objective of the principle. A Therefore, additional criteria or other measures may also be needed for the particular aspect of banking supervision addressed by the principle to be considered effective. B Altogether, there are 227 essential and additional criteria. As an example of the assessment process and the role of different criteria, consider the case of Core Principle 1. For this principle, each subprinciple is assessed separately. A C "compliant" grading for Core Principle 1, for instance, requires that the essential criteria mentioned in the methodology be met, namely, that laws are in place and that responsi- D bilities are clearly defined, that minimum prudential standards are in place, that defined mechanisms exist for coordination, and that those mechanisms are actually used.12 E Furthermore, supervisors should have a role in deciding on resolution of banks, and laws should be updated as needed. Assessment of compliance with those criteria would, for F instance, require obtaining and reading the texts of the relevant laws and including the citations in the assessment report. If one is to assess whether responsibilities are, in fact, G clear, then information could be obtained on whether agencies cooperate effectively or whether turf issues arise frequently. Do annual reports of various agencies cover the same H ground, or are they complementary? Are prudential regulations readily accessible, and do they cover the main prudential areas? If one wishes to review which areas are essential, I the list of publications on the Basel Committee's Web site could be consulted to obtain an impression of which areas have been considered important. Coordination mechanisms 116 Chapter 5: Evaluating Financial Sector Supervision: Banking, Insurance, and Securities Markets should be established by a formal decision of the authorities and laid down in some form 1 of decree or similar instrument. This decree should also define the mechanics of coordina- tion, the exchange of information, the procedures for dealing with confidentiality issues, 2 and similar issues. The authorities should provide to the assessors descriptions of how recent bank resolutions were handled, showing, in particular, what role the supervisory authorities had played. 3 4 5.3.3.1 Key Considerations in Conducting an Assessment Consistency to the extent possible, fairness, and objectivity are key, but the primary 5 objective of the assessment remains, not to compare a country's performance with others, but to identify and to address individual countries' strengths and weaknesses. 6 Consistency--defined as a uniform approach to assessments and avoidance of contradic- tions in assessment grading--is reinforced through the use of assessment methodologies 7 and assessment guidance notes and through the review of draft assessments by other experts. "Calibrating" the BCPs or modifying the assessment criteria to country-specific 8 factors would, however, be contrary to the Basel Committee's intended objective of view- ing the BCPs as a standard to be universally adopted and implemented. The quality of the assessment is enhanced when the "four eyes" approach is used--that is, the reliance 9 on two experts with a mix of skills and backgrounds--because it helps mitigate the risk of individual bias. 10 A well-prepared self-assessment--including the summaries of the relevant legal and regulatory texts, as well as a thorough description of the institutional framework and 11 supervisory practices--is essential. The assessors should meet with the authorities, banks, and other agencies and private sector counterparts. Relevant issues should be discussed 12 not only with the supervisors but also, for instance, with other regulators, the Ministry of Finance, and the representatives from the central bank, as well as from the private sector A (e.g., bankers, insurance companies, securities market participants, external rating agen- cies, and external auditors).13 B The assessor may need to take into account the countries' level of development while assessing the supervisory prerequisites (Core Principle 1). Differences in prerequisites are C likely to have a bearing on the detailed principle-by-principle assessment. For example, when assessing how the collateral value is accounted for in prudential regulations, asses- D sors will have to consider the efficacy of the legal system and whether or not enforcement of regulatory and judicial decisions is problematic. Assessors should reflect the country- E specific factors in the "comment" section of the assessment template, and deficiencies can be incorporated in a forward-looking, sequenced action plan. Any considerations relating to the level of development and country-specific circumstances should be reflected fully F in the "comments" section of the assessment templates and in the "recommended action plan." G H 5.3.3.2 Assessment Experience14 A review of FSAP experience with BCP assessments reveals areas of strengths and weak- I nesses (see table 5.1). Notwithstanding better overall performance of industrialized 117 Financial Sector Assessment: A Handbook Table 5.1. Observance of Basel Core Principles for Effective Banking Supervision 1 Core principle (number and main topic) Issues raised by assessors 2 1.1 Framework for supervisory authority/ Fragmented responsibilities; unclear role of external auditors objectives 3 1.2. Independence Political interference in licensing and remedial measures; forbearance; insufficient legal protection; weak autonomy; insufficient staffing. 1.3. Legal framework Insufficient basis for cooperation and information exchange, also with foreign 4 supervisors. 1.4. Enforcement powers Legal basis inadequate or overly rigid; forbearance, court intervention, need to consult political authorities. 5 1.5. Legal protection Rules on legal protection not explicit, inadequate or absent; no rules on legal expenses; accountability concerns. 6 1.6. Information sharing Lack of legal basis or formal agreements; rigid confidentiality constraints, MOUs not implemented in practice. 2. Permissible activities No authority to act against unauthorized banks; laws unclear on licensing 7 requirements; no protection of the word "bank." 3. Licensing criteria Reputation of managers not tested; inadequate fit and proper tests, refusal to grant license can be appealed at Ministry of Finance; foreign supervisors not contacted; 8 political interference. 4. Ownership Prior supervisory approval not required; no fit and proper test for shareholders; no definition of significant ownership, nor qualitative criteria to determine ownership. 9 5. Investment criteria No approval authority; inadequate definitions of investments requiring approval; no criteria for impairment of supervision resulting from acquisitions. 10 6. Capital adequacy policies No calculation on a consolidated basis; no market risk charges, inadequate risk weightings, inappropriate capital components. 7. Credit policies Insufficient supervisory guidance on credit policies; no rules on arm's length lending; 11 unclear board and management responsibility for credit policies; no dissemination of policies to staff; insufficient supervisory monitoring. 8. Loan evaluation Insufficiently rigorous loan classification and provisioning rules, insufficient 12 monitoring, no cash flow based assessment, rules too lenient on use of collateral, restructured or evergreened loans, no tax deductibility for specific provisions, off­balance sheet items not included. A 9. Large exposures Exposures not reported/monitored on a consolidated basis, inadequate and/or overly rigid criteria to establish group connections. B 10. Connected lending Regulations absent or without sufficient legal basis; inadequate/overly rigid definitions of connectedness. 11. Country risk Absence of regulations, usually because banks have little or no exposure. C 12. Market risk Absence of regulations, or inconsistency with Basel guidance, usually because banks have little or no exposure; no supervision on a consolidated basis, weak or no enforcement. D 13. Other risks Absence or inadequacy of rules on risk management, absence of guidelines on interest rate, liquidity and operational risk; inadequate supervisory capacity. E 14. Internal control Inadequate or no standards, unclear responsibilities of management for internal controls, examination mandate inadequate, no rules on corporate governance. 15. Anti-Money laundering Inadequate or no legal framework. F 16. On-site and off-site supervision Inadequate frequency of visits, staff shortages, insufficient skills, no risk-based supervision, unclear objectives. 17. Contacts with bank management Insufficient frequency, no clear procedure to maintaining contact. G 18. Off-site supervision No supervision on a consolidated basis, reporting framework not set by supervisor, non-bank affiliates not covered, inaccurate reporting. H 19. Validation of information Inadequate response to weak audits, no control over external auditors, insufficient frequency of inspections. 20. Consolidated supervision No requirements on consolidation or consolidated supervision, no legal basis to I require consolidated reporting, scope of consolidation too limited, e.g., not covering non-bank affiliates, no reporting of related interests. 118 Chapter 5: Evaluating Financial Sector Supervision: Banking, Insurance, and Securities Markets Table 5.1. (continued) 1 Core principle (number and main topic) Issues raised by assessors 2 21. Accounting Standards do not comply with IAS, supervisor has no authority to set bank accounting standards. 22. Remedial measures Insufficient legal basis, enforcement ineffective, forbearance, limited range of 3 measures, proactive action not possible, court intervention. 23. Global consolidation Scope too limited, no supervision on a consolidated basis, insufficient authority to oversee foreign banks, insufficient information exchange and MoUs. 4 24. Host country supervision No formal arrangements for contacts with home supervisors, little contact in practice, confidentiality constraints. 5 25. Supervision of foreign establishments Insufficient exchange of information, insufficient MoUs, no inspection authority for foreign supervisors. Source: IMF 2004a. 6 7 8 countries, similarities in relative strengths and weaknesses exist across all country income 9 groups (industrialized, developing, and emerging). It is significant to note that, in all countries, the broad area of credit risk management has relatively low rates of compliance. 10 Principles relating to the overall foundation for supervision (i.e., the legal and regulatory framework, licensing, and supervisory practices) are relatively well observed when com- pared with the principles on credit policies, loan evaluation, and risks related to country, 11 market, and other variables. These are areas that affect banks' condition most directly, and their relatively low observance is a matter of concern. 12 Two crucial areas that are also relatively weak are those of capital adequacy and con- solidated supervision. The two areas are connected because, in a number of cases, capital A adequacy systems were considered noncompliant or materially noncompliant because capital adequacy was not calculated on a consolidated basis. Also, other prudential stan- B dards, such as those related to loan quality and other prudential standards, are much less meaningful if supervision is not exercised on the basis of consolidated reports, accounts, C and implementation of remedial action. The principle on anti-money-laundering is also among those that are insufficiently implemented in many countries. D The experience of assessments to date indicates that developing countries generally show lower levels of compliance with the BCPs, whereas many transition countries have intermediate levels of compliance. Advanced economies generally satisfy the precondi- E tions more robustly and achieve the highest level of compliance overall. Compliance with the BCPs is positively correlated with observance of the preconditions and the stage of F development of the financial sector. In general, the main areas of weakness identified by assessments of observance of the G BCPs relate to supervisory independence, legal protection for supervisors, and informa- tion sharing with other supervisors. Compliance with respect to the principles on credit H policies and connected lending, as well as the practices relating to loan classification and provisioning, also appears to be low. Consolidated supervision, especially for large I complex financial institutions, is another area of weakness that has been identified in 119 Financial Sector Assessment: A Handbook assessments performed to date. The rules on anti-money-laundering and combating the 1 financing of terrorism (AML­CFT) need to be more strongly implemented, as do prompt and effective remedial measures. Finally, systems for managing country risk and market 2 risk were identified as needing improvement in many countries that were assessed. 3 5.3.4 Basel II 4 The 1988 Capital Accord (Basel I) introduced capital adequacy measures for credit risk that were based on risk weights assigned to different classes of bank exposures. It was 5 originally intended to be applicable to internationally active banks in the G-10 and other member countries (Belgium, Canada, France, Germany, Italy, Japan, Luxembourg, 6 the Netherlands, Spain, Sweden, Switzerland, United Kingdom, and United States) of the Basel Committee on Banking Supervision. However, the framework was quickly adopted by national supervisors almost universally, making it an international standard. 7 Subsequently, a capital measure for market risk introduced in 1996 has also met with wide acceptance, though it has not been as widely implemented. Nevertheless, signifi- 8 cant deficiencies began to surface in the application of Basel I. The use of a uniform 100 percent risk weight for all commercial credits regardless of the risk profile of individual 9 exposures led to distortions. Similarly, the treatment of cross-border and interbank claims also caused biases in credit allocation. Moreover, rapid changes in risk-management 10 technology, including the increasing use of credit risk transfer instruments, needed to be recognized. The factors were among those that led to the development of a new capital 11 accord. The New Capital Framework (Basel II) represents a significant improvement over 12 the original accord and seeks to provide more risk-sensitive methodologies to align capi- tal requirements with riskiness of banks assets. Under Basel II, the risk weights can be A determined using different approaches based on ratings either assigned to bank exposures by external agencies (standardized approach) or internally assigned through supervisor- B validated, value-at-risk (VAR) approaches using default probabilities (internal-ratings- based [IRB] approaches). Extensive guidance has also been provided on the expanded credit risk mitigation techniques and their application, as well as on the treatment of C securitization and specialized lending. The methodology for market risk capital has been kept almost unchanged while a new capital charge for operational risk has been intro- D duced. Apart from laying out different approaches of varying degrees of sophistication, the Basel II framework also provides for a high degree of national discretion. In addition E to laying out methodology to compute minimum capital requirements (Pillar I), the new Basel framework also incorporates guiding principles on the supervisory review of bank F risk management (Pillar II) and promotes market discipline through enhanced disclosure requirements (Pillar III). G Member countries of the Basel Committee are expected to implement the Basel framework beginning at the end of 2006. Both the existing and new systems will be run H in parallel for a year. While most European Union (EU) countries are expected to imple- ment Basel II in full for their banking systems, many other countries can be expected to I implement a mixture of Basel I and Basel II for different parts of their banking systems. Thus, after 2007, assessors can expect banking systems to be applying a bifurcated stan- 120 Chapter 5: Evaluating Financial Sector Supervision: Banking, Insurance, and Securities Markets dard. The assessment of this bifurcated standard will be made further challenging by the 1 fact that there are several different approaches in Basel II for both credit and operational risk, as well as for several areas of national discretion in Pillar I, which could affect cross- institution and cross-country comparisons of capital regimes. 2 In the period before implementation, national authorities are beginning to examine more closely the various options, as well as the necessity and possibility of applying 3 them. National authorities are also under pressure from the banks in their jurisdictions to refrain from taking actions that would raise capital requirements or increase costs for 4 the system; the banking supervisors are worrying about the lack of capacity to deal with the technical issues in the new Basel framework. International banks face the possibility 5 of being subject to multiple capital regimes through national requirements in different jurisdictions, the resolution of which will require the development of effective systems 6 for cooperation between home and host country supervisors. In contrast, local banks in developing countries are apprehensive about competitive concerns because they fear that 7 foreign banks could gain advantage from using the more advanced approaches that could lower groupwide capital requirements. 8 Effective implementation of the new capital framework will promote better risk-man- agement practices, more risk-focused bank supervision, and stronger market discipline. 9 However, the framework has been written with the internationally active G-10 banks in mind. Many jurisdictions may not find the proposals easy, or even relevant, to implement. Further, there are other supervisory priorities to be addressed in many countries, and weak 10 implementation may not provide the required comfort but, instead, may divert scarce supervisory and other resources. For this reason, a good level of compliance with the BCPs 11 is considered to be a precondition to considering Basel II implementation. The Fund, together with the Bank and other international donors, would develop 12 technical assistance programs for countries that seek assistance to implement some or all parts of the new Basel framework within the constraints of available budgets. Finally, A countries will not be assessed under the BCPs on the basis of whether or not they have chosen to implement Basel II, but will be assessed against the standard that they have B chosen to apply, be it Basel I or Basel II. C 5.3.5 Bank Insolvency Procedures: Emerging Bank-Fund Guidelines D Effective bank insolvency procedures form an essential part of the supervisory framework and are also part of a proper financial safety net. Effective procedures help in reducing moral hazard. An analysis of the effectiveness and appropriateness of bank insolvency E procedures and exit policies is an important part of BCP assessment. Experience indicates that, in many countries, those types of procedures are weak, opening the door to interfer- F ence and forbearance. The World Bank and the IMF have developed a (draft) document titled "Global Bank G Insolvency Initiative," (IMF and World Bank 2004),15 which documents practices around the world in the area of insolvency procedures. Although not a "best practices" document H (given the diversity of judicial approaches around the globe, it is premature to develop best practices), this document could certainly be used to check country practices and to I provide advice. 121 Financial Sector Assessment: A Handbook When authorities face problem banks, the general principle is that the authorities 1 should take prompt action to restore them to health. The supervisors should have the authority to identify unsafe and unsound banking practices and then to require that those 2 practices be halted. Supervisors should be able to apply a series of corrective measures and penalties with increasing severity. If deterioration continues, supervisors should close, 3 merge, or otherwise resolve issues in troubled banks expeditiously before they become insolvent. Increasingly, countries are basing supervisory corrective action on a legal obli- 4 gation to take specific actions ("prompt corrective action" specifically identified in the law) against a bank as capital levels fall below values established in the law. Prompt action 5 reduces the likelihood that a failing bank will engage in risky and potentially expensive gambles for redemption. 6 Supervisors need good information on the condition of individual banks so they can take appropriate action. Appropriate disclosure of information to the public would sup- 7 port market discipline. These general issues should come out of the BCP assessment, particularly in Core Principle 22. However, the core principles do not deal specifically 8 with insolvency proceedings other than in the preconditions. That is where the Bank- Fund document on bank insolvency (IMF and World Bank 2004) becomes useful. When 9 making an assessment, assessors should bear in mind that legal and judiciary systems and traditions differ widely among countries. When a bank develops severe financial difficul- 10 ties, it will have to be either restructured or liquidated. The legal and institutional features that should be in place to allow for orderly restructuring or liquidation are discussed in 11 appendix G (Bank Resolution and Insolvency) and are summarized next. The broader legal environment for effective insolvency procedures is outlined in Annex 5.A. A special bank insolvency regime, or suitable modifications of a general corporate 12 insolvency regime, is needed to reflect the potential systemic effects of bank failures that call for prompt actions, effective protection of bank assets, and the key role of the banking A authorities in bank insolvency proceedings. A typical immediate first step is to have an official authority assume direct managerial control of an insolvent bank (insolvent either B in a regulatory sense or in a balance-sheet sense) with the goal of protecting its assets, assessing the true condition, and arranging or conducting either restructuring or liquida- C tion. Official administration continues until the institution has been restored or placed in liquidation. The key principles governing official administration, bank restructuring, and D bank liquidation are further discussed in appendix G. One of the key principles is that the authorities should choose the bank resolution option that costs the least. In particular, E the cost of bank restructuring should be viewed in terms of net outlays on recapitalization and other assistance operations after deducting the proceeds from reprivatization and asset F recoveries. When restructuring is not feasible or when it involves spinning off the viable operations of the bank and, thus, leaving behind only the nonviable part, then the bank G will have to be liquidated. In this process, the supervisory (licensing) agency should have the authority to with- H draw a bank's license on the basis of clearly defined criteria. Such criteria include (a) noncompliance with the conditions under which the license was initially granted (in I particular, when management is no longer fit and proper), (b) failure to meet prudential requirements, (c) failure to make payments, (d) following of unsafe and unsound banking 122 Chapter 5: Evaluating Financial Sector Supervision: Banking, Insurance, and Securities Markets practices, and (e) criminal activities by the bank. The supervisor could also be given the 1 responsibility to establish the list of qualified liquidators. Unless the supervisory authorities or some other government agency (such as a deposit insurance fund) is responsible for resolving the problems of insolvent banks, the liquida- 2 tor will be appointed by the courts, which oversee liquidation. Any deficiency in the court process that could impede bank liquidation should be identified. The authorities 3 should have contingency plans to deal with the emergence of systemic banking problems or large-scale bank closures. Plans should include ways to protect the payments system 4 and to maintain basic banking services. The authorities should also have an idea of how to organize the restructuring efforts, including which institutions would be charged with 5 guiding the restructuring efforts. In addition, the authorities should evaluate the legal framework for bank supervision and regulation to ensure that the authorities have the 6 necessary powers to act quickly and efficiently in the face of a systemic crisis. 7 5.3.6 Large and Complex Financial Institutions16 8 The activities of large and complex financial institutions (LCFIs)17 raise issues of cross- sectoral and cross-border transfer of financial risks that are especially relevant to a com- prehensive assessment of the strengths and weaknesses of financial systems and their 9 supervision. An LCFI is likely to have the following characteristics: 10 · An LCFI will be an important player in both wholesale and retail financial markets and in substantial international operations, regionally or globally. In some cases, 11 these operations could dwarf its business in the country under consideration. · The group may have its headquarters in the country or may be based abroad. In 12 the latter case, it will have a significant local presence in the form of branches or locally incorporated subsidiaries (perhaps including local holding companies). The legal form of its local presence may have important implications for the way it is A regulated.18 · The group's international and domestic business will span a number of financial B activities including commercial banking and other lending, such as the origination and securitization of credit; securities trading, dealing and underwriting, mergers C and acquisitions, and other capital market activity; life and general (property and casualty) insurance; and custody and asset management. In some cases, the opera- D tions of the wider group may include significant industrial and other nonfinancial activities. E · The group is likely to be prominent in the local payments, clearing, and settle- ments structure. F As a consequence of the characteristics of an LCFI, the group's liabilities will reflect very diverse sources of local and cross-border funding and reserves, while its assets will G include a full range of marketable and nonmarketable financial instruments held locally and abroad. Off-balance sheet items are likely to be particularly prominent and to reflect H complex funding, plus hedging and speculative trading strategies, all of which are carried out in both over-the-counter (OTC) markets and on organized exchanges. The group is I likely to comprise many different legal entities, and the link between those entities and 123 Financial Sector Assessment: A Handbook its internal management structure may appear complicated or even opaque. Complexity 1 or opaqueness in organizational structures could be a potential source of risk, as well as raising issues for supervisory and central bank coordination. 2 The group's activities may be subject to numerous different national legal and insol- vency, accounting, tax, and regulatory regimes, which will influence the management of 3 its business and balance sheet. The group may or may not have an overall lead supervisor monitoring its activities on a consolidated basis. At the host country level, responsibility 4 for supervision of an LCFI's local affiliates may reside within a single regulator or several functional regulators. The size of the group and of its geographical diversification has the 5 potential to threaten financial stability in several countries and markets. Its operations will thus be of concern both to its many financial regulators and also to the central banks 6 and guarantee agencies that could be involved in providing or facilitating liquidity or other official financial support. 7 The presence of foreign-owned LCFIs in the domestic financial market may not raise particular issues for local financial stability, when their share of local banking, securities, 8 and insurance markets is small and when the nature of their local business is straightfor- ward. While local and foreign affiliates of wider LCFI groups may well be counterparties 9 in foreign exchange and OTC derivatives transactions of local financial institutions, this need not warrant any special analysis, absent any significant concentrations of exposure. 10 Conversely, there may be cases where an internationally active institution has such a large share of the local market or is such a significant counterparty of local financial institu- 11 tions that its failure could constitute a serious local systemic risk. In such instances of high concentration, an understanding of the wider operations of the group, its reputation, 12 and the risks of its business should be important in assessing potential threats to financial stability. A In relation to LCFIs, there are clearly limits to the scope of assessments at the level of individual countries. Country assessments can be expected to cover only part of the B activities of LCFIs, given the international nature of such. Even if local supervision of an LCFI is effective in identifying and mitigating local risks as far as possible and if there is C good cooperation with the LCFI's home regulator(s), a host country is unlikely fully to escape the effects of a failure. The assessment process should focus mainly on those aspects over which the countries' authorities can reasonably be expected to exert an influence. D An examination of LCFIs can be approached in three stages, followed by a summary of the main risks identified and recommendations to the authorities: E · Stage I involves the identification of the scope and scale of LCFIs' activities within F the local financial system. An assessor will want to seek data on market shares of prominent, internationally active, financial institutions to determine if a focus G on LCFI activities is warranted. Where one or more LCFIs have been identified as having particular significance for local systemic stability, more detailed firm- H specific information on the legal entity and organizational structures, the nature of intra-group exposures, the main sources of earnings, and so forth may then be I needed to provide a sufficiently detailed map of their activities to identify the main channels of systemic risk. For some internationally prominent LCFIs, it may 124 Chapter 5: Evaluating Financial Sector Supervision: Banking, Insurance, and Securities Markets be possible to draw on information gathered from other assessments conducted for 1 other countries. · Stage II involves an assessment of the major systemic risks arising from the activi- 2 ties of LCFIs. Emphasis should be placed on the extent and nature of both intra- group transactions and the exposures of other domestic institutions to LCFIs. Key concerns will be not only potential direct losses in the event of an LCFI failure 3 but also contagion risks. The approach suggested here is that this assessment be built up by considering credit, technical,19 liquidity, market, and operational risks 4 from the different businesses of the group. LCFIs' participation in local payment and settlement systems should also form a significant part of the analysis. Drawing 5 on the preceding qualitative identification of risks, the assessor may also want to quantify the risks by considering further stress testing or scenario analyses. 6 · Stage III involves an assessment of the effectiveness of the authorities' policies and practices in addressing the risks. This stage should include a review of group 7 capital adequacy, the regulation of large exposures and of intra-group transactions, and the extent and effectiveness of information sharing between local and foreign 8 supervisors. Oversight of the role of LCFIs in local payment and settlement systems should also be considered. 9 Given the potential of LCFIs to be a conduit in the transmission of internal and external shocks, the authorities' approach to surveillance--the identification of potential 10 systemic risks from the activities of LCFIs--should be a prominent part of the assessment. The assessment team may want to assess the effectiveness of stress testing and scenario 11 analyses that are conducted by the authorities and that may be complemented by work conducted by the team itself as part of Stage II. The state of preparedness for managing 12 a crisis arising from a domestically headquartered LCFI that is in difficulties or from the failure of a major foreign, internationally active institution that threatens local financial A stability is an important issue for supervisors to consider. B 5.3.7 Consolidated Supervision Consolidated supervision is a supervisory tool that was developed in response to the grow- C ing trend in financial institutions of diversifying their activities across national borders and sectoral boundaries through ownership linkages. The creation of diversified financial D groups raises additional supervisory concerns, including contagion, conflicts of interest, lack of transparency, and regulatory arbitrage. Supervisory and regulatory arrangements E are geared at mitigating those concerns to ensure that risks are properly managed and that they do not threaten the safety and soundness of the financial system. F Consolidated supervision may be broadly defined as a qualitative and quantitative evaluation of the strength of a financial group that consists of several legal entities under G common ownership or control. The objective of consolidated supervision is (a) to ensure the safety of the financial system through monitoring and evaluating the additional risks H posed to the regulated financial institutions by the affiliated institutions in the financial group and (b) to assess the strength of the entire group. Consolidated supervision should I have both quantitative and qualitative elements: 125 Financial Sector Assessment: A Handbook · Quantitative consolidated supervision focuses on issues such as asset quality, capital 1 adequacy, liquidity, and large exposures that are measured on a consolidated basis. There is clearly a requirement that the group be able to produce (a) comprehensive 2 on-balance sheets and off-balance sheet data and (b) counterparty information. This input should be in a form sufficient for reliable capital adequacy, liquidity, 3 and exposure concentration calculations to be made. Because different entities in the group may be subject to different accounting regimes, the results of accounting 4 consolidation may need to be treated with caution. · Qualitative consolidated supervision is closely identified with comprehensive risk- 5 based supervision, which is designed to assess how well management identifies, measures, monitors, and controls risks in a timely manner. This supervision will 6 involve an assessment of the wider risks posed by other group companies in terms of their effect on the regulated entity. This assessment is likely to involve the 7 8 9 Box 5.2 Unique Risks in Islamic Banking 10 Islamic banking poses unique risks to the financial risks. In addition, for contracts with deferred delivery system because of the profit-and-loss-sharing (PLS) of products, significant additional price risks arise. modes of financing and specific contractual features 11 of Islamic financial products.a PLS not only shifts the Unique Risks of Islamic Banking risks in the institution to investment depositors to Addressing the unique risks of Islamic banking some extent but also makes Islamic banks vulnerable 12 requires adequate capital and reserves, as well as to a range of risks (including those normally borne by appropriate pricing and control of risks in a suitable equity investors) because of the following features: disclosure regime. Because information asymmetries A · Administration of PLS is more complex, requir- are particularly acute in Islamic banking, the need ing greater auditing of projects to ensure proper for strong rules and practices for governance, disclo- governance and appropriate valuation. sure, accounting, and auditing rules is paramount. B · PLS cannot be made dependent on collateral or The development of an infrastructure that facilitates guarantees to reduce credit risk. liquidity management is also a key priority. The · Product standardization is more difficult because challenge for supervisors in ensuring that this type of C of the multiplicity of potential financing meth- framework is in place is made more difficult by the ods, the increasing operational risk, and the legal absence of uniform prudential and regulatory rules D uncertainty in interpreting contracts. and standards. Currently, there is no uniformity in · Liquidity risks are substantial because of the income-loss recognition, disclosure arrangements, inability to manage asset and liability mismatch- loan classification and provisioning, treatment of E es as a result of the absence of Sharia-compliant reserves, practices in income smoothing, and so instruments such as treasury bills and lender-of- forth, although standards for those elements have last-resort facilities. been developed­­and are in increasing use­­by F accounting and auditing organizations for Islamic The presence of commodity inventories in Islamic financial institutions. bank balance sheets adds to operational and price G a. The Islamic Financial Services Board (IFSB) was established to adopt regulatory practices and policies to the specific features of Islamic finance and to promote its development. Establishment of IFSB was facilitated by IMF so it can develop H prudential standards for Islamic banking and can foster effective risk management. Several IFSB working groups are devel- oping standards and guidelines on capital adequacy, risk management, corporate governance, Islamic money markets, and market discipline and transparency; in addition, draft standards on capital adequacy and risk management have been issued I for public comments. 126 Chapter 5: Evaluating Financial Sector Supervision: Banking, Insurance, and Securities Markets identification of significant activities or business units and an understanding not 1 only of their role within the group but also of the risks to the group posed by their activities. 2 Some of the key issues and principles governing consolidated supervision are summa- rized in Annex 5.B. 3 5.3.8 Unique Risks in Islamic Banking 4 Islamic banking can be defined as the providing of and use of financial services and products that conform to Islamic religious practices.20 Islamic financial services are 5 characterized by a prohibition against the payment and receipt of interest at a fixed or predetermined rate. Instead, profit-and-loss-sharing (PLS) arrangements or purchase and 6 resale of goods and services form the basis of contracts. In PLS modes, the rate of return on financial assets is not known or fixed before undertaking the transaction. In purchase- 7 resale transactions, a markup is determined on the basis of a benchmark rate of return, typically a return determined in international markets such as LIBOR (London interbank 8 offered rate). Islamic banks are also prohibited from engaging in certain activities such as (a) financing production or trade in alcoholic beverages or pork and (b) financing 9 gambling operations. A range of Islamic contracts is available, depending on the rights of investors in project management and the timing of cash flows. Special risks in Islamic 10 banking arise because of the specific features of Islamic contracts and the weak environ- ment for effective risk management, thereby reflecting the absence of risk-management tools that are Sharia compatible. Box 5.2 contains further details. 11 12 5.4 Assessment of Insurance Supervision A The International Association of Insurance Supervisors (IAIS) has developed the Insurance Core Principles (IAIS 2000) as the key global standard for prudential regulation B and supervision for the insurance sector. The objective of the Insurance Core Principles (ICPs), from the perspective of the standard setters, is to act as a diagnostic tool to assist in C improving supervision globally. To this end, the assessment of ICPs should include priori- tized recommendations that can serve as a roadmap for a reform agenda. Fundamentally, D insurance supervisors around the world have been concerned about improving insurance supervision and bringing about a basic level of effectiveness in all jurisdictions by facili- tating assessments (both internal and external) that are consistent and comprehensive. E The global nature of insurance markets (particularly the presence of conglomerates), the expansion of cross-border transactions, the global nature of reinsurance markets, and the F presence of active offshore centers all call for some convergence of regulatory practices and norms to ensure effectiveness of regulations and a level playing field. G The ICPs were updated through an extensive process culminating in a new version in October 2003 (IAIS 2003a). This version sets out the key elements of effective regula- H tion and supervision for the insurance sector and elaborates the requirements on the law, the supervisory process, and the functions and operations of market participants so as I to deliver an effective and positive contribution from the insurance sector to the wider 127 Financial Sector Assessment: A Handbook economy and to the long-term well-being of the population. The October 2003 version of 1 ICP incorporates additional core principles, including adequacy of risk-management oper- ations, AML­CFT (the subject of a separate standard; see later parts of this Handbook), 2 and transparency of insurance supervision policies (also the subject of a separate standard; see later parts of this Handbook). Moreover, the new version contains additional, more 3 specific criteria for assessment purposes as it draws on earlier assessment experience under the Financial Sector Assessment Program and other previously issued guidelines by IAIS 4 outside of the ICPs. For example, the principles also address issues such as management of risk and consumer protection, and they incorporate as essential criteria "principles on 5 capital adequacy and solvency" (IAIS 2002), which was adopted in 2002. The relevance of effective regulation and supervision of insurers for stability and development, the scope 6 of the new ICPs, and their use in assessments and lessons of assessment experience are summarized in the following sections. 7 5.4.1 Relevance to Stability and Development 8 Sound and effective regulation and supervision is important in sustaining a sound oper- ating sector that protects and maintains the confidence of policyholders and, therefore, 9 plays an effective role in overall economic development. Supervision of the insurance sector is not an end in itself. Rather, insurance supervision, when properly conducted, 10 plays a critical role in facilitating that sector's contribution to the effective management of risks for the wider economy; the mobilization of long-term savings, particularly in the 11 life insurance sector; and the allocation of investment in long-term fixed interest and equity markets, as well as in infrastructure and venture capital. 12 Sound regulation and supervision can also guard against the consequences of insurer failure for policyholders. The traditional focus of supervision on policyholder protection A is increasingly giving way to broader financial stability concern as activities of insurers in financial markets expand. Failure can have catastrophic consequences for the individual B policyholder, particularly because the choice of insurer may not be subject to market forces in all cases (e.g., third-party claimants) and may not be easily diversified. Some insurance contracts are not suitable for the insured party to take out contracts with several C providers--in the same way that many hold deposits with several institutions. The ICPs seek to protect policyholders, both as a group (by focusing on the institutional integrity D of the insurance companies) and individually (by promoting good marketing practices, adequately disclosing information about contracts to customers and potential customers, E and handling consumer complaints). At the same time, the increasing financial market activities of insurers, including a growing role in credit risk transfer, has raised a question F about the implications for financial stability arising from insurer's failures and the implica- tions for insurance supervision (see IMF 2002, 2004b). G Insurers have a role to play in guarding against fraud, money laundering, and terrorism financing. The ICPs recognize this role through a comprehensive set of requirements and H good practices in the custody and management of assets, corporate governance, and inter- nal controls. Specific obligations with respect to the fitness and propriety of those who act I as custodians (in a legal sense or otherwise) of the community's savings are recognized as critical to the maintenance of a sound insurance sector. 128 Chapter 5: Evaluating Financial Sector Supervision: Banking, Insurance, and Securities Markets 5.4.2 The Structure of the ICPs 1 The ICPs consist of 28 principles in total, grouped into seven categories.21 The principles cover all aspects of a supervisory framework--from licensing to closure of activities. The 2 seven groupings reflect commonality of purpose among the principles in each group, rang- ing from preconditions to prudential requirements and market conduct. See Annex 5.C 3 for a summary of the scope of each of the principles. The first ICP addresses the general conditions needed for effective supervision and is 4 similar in nature to the BCP "preconditions." This ICP addresses elements that are most usually not the direct responsibility of the insurance supervisory authority. The elements 5 relate to the overall policy settings for the financial sector, as well as the infrastructure of financial markets and their efficient operation. Effective policy settings are critical to the 6 supervisors' task because they provide the backdrop against which the institutional risk is assessed. Infrastructure in markets includes not only the broader financial policy aspects but also the legal and professional services that enable the supervisory process to function. 7 The role of accounting, auditing, and actuarial professions shows examples of particular relevance to insurance supervision. The efficiency of financial markets influences the 8 extent to which institutions are exposed to liquidity risk and market risk, as well as the options they have to address those risks. The first ICP is also concerned with the extent 9 to which companies are able to access statistical data to enable those data to assess market risks and liability risks. 10 The second group of ICPs (ICPs 2­5) deals with the organizational structure and governance aspects of the supervisory authority. Those ICPs cover the objectives of 11 the supervisor, the legal standing of the supervisory authority, the independence, the confidentiality requirements, and the existence of a transparent supervisory process. 12 Information sharing is also covered in this group of ICPs, which makes it consistent with the issue of confidentiality. A The third group of ICPs (ICPs 6­10) focuses on the establishment and operations of the insurance companies as supervised entities. The fundamental licensing obligation and B the effective stewardship of the organization under the continuing control of owners with integrity is emphasized through tests for fitness and propriety, as well as through control of changes in ownership and transfers of portfolios.22 Overall policies and obligations with C respect to corporate governance and internal controls also form part of this group. Ongoing supervision is the focus of the fourth group of ICPs (11­17). The principles D in this group set out the process for supervision and its key components at a high level and then elaborate on key elements of the supervisory process. First, to establish the basis E for sound assessment of individual institutions and prompt supervisory actions, ICP 11 stresses the role of an overall analysis of the market and identifies the potential risks and F vulnerabilities that affect insurance firms and markets23 and that arise as a result of the overall environment in which they operate. The ICPs that follow cover the reporting G obligations of companies, including the regular and ad hoc information requirements; the assessment of returns received by the supervisor; the conduct of onsite inspections; H the taking of action through preventative measures; the active enforcement and sanction powers; and, if necessary, the closeout of the insurer. In particular, ICP 12, which focuses I on reporting, also establishes the main obligations with respect to external audit and 129 Financial Sector Assessment: A Handbook accounting standards. ICP 12 largely focuses on the content and completeness of super- 1 visory reporting24 and includes a substantive role of offsite supervisory assessment as one of the criteria. ICP 16 includes the definition of insolvency, or at least the point at which 2 intervention is obligated to protect policyholders, and ICP 17 addresses the assessment of groupwide risks. 3 The group of insurance core principles that cover "prudential requirements" (ICPs 18­23) focuses on insurers' obligations with respect to the key areas of sound risk manage- 4 ment, which includes understanding the nature of insurance risks, liabilities, assets, risk instruments, and capital. However, there is no internationally uniform capital require- 5 ment or set of rules for assets and liabilities in the insurance sector at this stage. The most important characteristics of a capital adequacy and solvency regime are covered at a fairly 6 high level in the standard. Therefore, a wide range of approaches to capital adequacy and solvency are in use, some of which may be deficient in their ability to identify and 7 require capital for significant risks to financial stability or to the solvency of an insurer. For example, capital required under the regime used in the EU and other jurisdictions does not depend on the composition of the investment portfolio. The IAIS and other 8 organizations are working toward greater uniformity of capital adequacy standard.25 The ICPs within this group emphasize the need for a sound assessment of risk and adequate 9 resources to meet the risks assessed. The IAIS had already issued other supervisory stan- dards that are relevant and related to these ICPs. Because the ICPs themselves were being 10 revised, the supervisory standards available at the time were incorporated into the ICPs; some guidelines and issue papers were also under preparation at the time of the issuance 11 of ICPs, and those, too, would be relevant for the assessment.26 The remaining two groups (ICPs 24­28) deal with markets and consumers (the over- 12 sight of insurance intermediaries, customer protection, disclosure to the wider market, and fraud prevention) and with AML­CFT. The oversight of intermediaries (most commonly, A insurance agents and brokers) is an important element of insurance sector soundness that does not always have a direct equivalent in other sectors. The failure of an intermediary B can have a direct effect on those customers who have dealt with the insurer through the intermediary. The fitness and the propriety of intermediaries are also an important ele- ment in the maintenance of a sound system that preserves public confidence in the sector. C Customer protection goes beyond the customer's dealings with intermediaries to include (a) the requirements for information disclosure to explain the product and services to the D customer and (b) the manner by which a customer may seek to have complaints resolved. Complaint resolution needs to be accessible, to be timely, and not to impose an undue E cost, recognizing that customers have relatively limited financial and technical resources available. In some jurisdictions, this role is played by self-regulatory organizations (SROs). F In others, it is played by companies with supervisory oversight or even by the supervisors themselves. Wider market disclosure focuses on broader and less-specific disclosure than G is involved with individual customers and their individual products. The intent of this wider disclosure is to impose market discipline on companies. Again, it can be more or H less effective and needs to reflect the market structures as the system needs to consider all companies, not just those that are publicly listed. I Claims fraud is a key issue in the insurance sector and is addressed in the newly intro- duced ICP 27. Claims fraud, wherein customers might submit inflated or invalid claims, 130 Chapter 5: Evaluating Financial Sector Supervision: Banking, Insurance, and Securities Markets has an insidious effect on companies and can ultimately bring the solvency of a company 1 into question. As one addresses this issue, the diligence and integrity of the company is emphasized, as well as the linkages between the supervisory and prosecuting authorities. 2 The principles themselves have been deliberately drafted at a general level, and those principles should be interpreted according to the additional explanation provided for each principle. Each principle is elaborated with an explanatory note and followed by a set of 3 criteria. The explanatory note is intended to provide elaboration and clarification, setting out the rationale for the particular principle and sometimes referring to specific examples. 4 The criteria are divided between the so-called "essential criteria" and "advanced crite- ria." Essential criteria are considered necessary for all markets to be fully functional and 5 effective. Advanced criteria are considered either for particularly advanced and complex markets or, more likely, to provide a sense of direction for further improvement as markets 6 and practices evolve. 7 5.4.3 Assessment Methodology and Assessment Experience 8 ICP assessments are based on a set of essential and advanced criteria, as well as on an assessment methodology that has been issued as part of the document.27 The methodol- ogy is intended to assist the assessor in his or her goal to be both fair and objective. The 9 document itself speaks of the assessments being "comprehensive, precise, and consistent" (IAIS 2003a). In practice, the methodology and the ICPs themselves include some key 10 nuances that should be understood in carrying out the assessment and in interpreting the results. The following subsections highlight these key issues, without elaborating on every 11 feature of the ICPs and their assessment. 12 5.4.3.1 Essential and Advanced Criteria--Assessment Process A Assessments are normally carried out against the essential criteria for comparability with other assessments. As noted above, essential and advanced criteria are included B in the ICPs. However, it may be necessary or sensible to also consider the advanced criteria in some cases. When considering the advanced criteria, the assessor can prepare C the report on the observance of the standards by considering the essential criteria and making further comments or by using the advanced criteria to guide recommendations. Nevertheless, the IAIS methodology indicates that, even where the advanced criteria are D considered, the overall assessment of the principle will be based on the essential criteria only for consistency purposes. E There are five categories for the assessment of the criteria. Those categories are defined in the annex to the document as "observed," "largely observed," "partly observed," "not F observed," and "not applicable." Procedurally, the assessment process assesses each of the criteria first; only then can the principle be assessed after considering the overall situa- G tion with respect to all the underlying criteria. For a principle to be rated as "observed," it needs to have all its related criteria rated as "observed" or "not applicable." Consequently, H it is difficult to achieve full observance, particularly for the ICPs that have a larger num- ber of criteria as compared with an ICP that has a smaller number of criteria. Thus, an I overall summary that does not identify the criteria but simply summarizes the number 131 Financial Sector Assessment: A Handbook of ICPs at each rating will be misleading. ICP 3 is particularly difficult in this context 1 because it has 17 essential criteria and is wide ranging in scope. A rating of "largely observed" means that the shortcomings are minor and that the 2 authority would be able to achieve observance without an expectation of concern. For example, a shortcoming is recognized and is being addressed effectively. Thus, the assessor 3 has no reason to doubt its successful implementation. However, in situations where, for example, significant industry or political resistance is to be expected and has not yet been 4 overcome in implementing the reform program, then the observance of the relevant core principle would not be rated as "largely observed." 5 The rating is akin to a temperature reading at a point in time rather than an indi- cation of a future position. The reports provide the opportunity to recognize work in 6 progress through comments, but the rating has to reflect the actual current situation in fact. Differentiating between a rating of "largely observed" and "partly observed" will 7 mean--because of the definitions--that work in progress is influencing the decision to use one or the other of the two ratings. 8 The assessor can decide to show more than one rating for an ICP depending on the segment of the insurance industry. It may be the case that segments of the industry show a very different result for one or more ICPs. For example, the life and nonlife sectors may be 9 subject to different regulation, and one may be more complete than the other; similarly, reinsurance may not be subject to a particular element but the direct insurance companies 10 may be comprehensively covered. Showing more than one rating can be a useful way to reflect the positive elements of the situation while identifying the segment that may have 11 a missing element. 12 5.4.3.2 Usefulness of a Well-Prepared Self-Assessment A The authorities should prepare a self-assessment to benefit fully from an independent assessment of observance of ICPs. Self-assessment also helps the authorities to identify B the relevant parts of the law and the supervisory practice that will be of interest to the outside assessor. C Sometimes, a supervisory authority may prepare an assessment for another purpose, one that assesses the authority rather than the whole jurisdiction. In those cases, the assessment may rate a particular criterion as "not applicable" where it falls to a different D authority in the jurisdiction to undertake that task. Insurance assessment should, how- ever, be carried out in the context of the jurisdiction as a whole rather than for an indi- E vidual authority. Therefore, the assessor will need to obtain information on the relevant criteria, laws, practices, and oversight from several authorities, including the agency with F primary responsibility for insurance supervision. Obtaining this information will require coordinating the assessment process with many agencies. G 5.4.3.3 The Insurance Market Assessment H The ICPs can be properly assessed only in the context of an overall analysis of conditions I in the insurance sector, including an assessment of the performance of and prospects 132 Chapter 5: Evaluating Financial Sector Supervision: Banking, Insurance, and Securities Markets for the sector. Consequently, it is necessary to analyze and form a view on the adequacy 1 of provisions, profitability, business trends, and capitalization of the sector while using recent data (see chapter 4 for a discussion of sectoral analysis).28 A key feature of the assessments made in this context of an overall analysis needs to 2 be the assessment of ICP 1--the conditions for effective supervision. As noted earlier, the elements of this ICP are often outside the control of the supervisor. When a supervisor is 3 doing a self-assessment for other purposes or for an internal examination, then this ICP may be less important. However, within the context of a broader financial sector assess- 4 ment, it is a critical element because it provides the necessary links to considering devel- opment and stability. The ICPs also recognize some steps that the supervisor may take in 5 the face of weaknesses in the conditions.29 Examples would include the encouragement or sponsorship of statistical studies where they are not being done otherwise. Weaknesses 6 in the asset markets may signal that it is reasonable to impose more onerous or specific obligations on investments. Weaknesses in the legal system may lead to a response to 7 establish separate specific procedures for the sector. Those kinds of steps may be consid- ered in the context of recommendations to strengthen the system as a whole in the face 8 of weak conditions. 9 5.4.3.4 Flexibility Another feature of the assessment process is that "the framework described by the 10 Insurance Core Principles is general. Supervisors have flexibility in adapting it to the 11 12 Box 5.3 Flexibility in Assessments Core Principle 19 on insurance activity states that ing limits for each new policy issued by considering A "since insurance is a risk taking activity, the super- the extent to which catastrophe risk is increased or visory authority requires insurers to evaluate and the extent to which concentration becomes a greater manage the risks that they underwrite, in particular concern. Often, for example, this process involves B through reinsurance, and to have the tools to estab- detailed comparison of the distribution of the risks lish an adequate level of premiums." This principle insured in the portfolio with simulation models is elaborated through a set of five essential criteria, that help to quantify the risks from the catastrophe. C including supervisory review of adequacy of reinsur- Where a company provides liability insurance, then ance and the requirement that "the insurer has a clear it would not be sensible to impose or expect similar D strategy to mitigate and diversify risks by defining details in the modeling of catastrophes because limits on the amount of risk retained." aggregation of risk needs to be considered using dif- The level of detail and breadth of such a strategy ferent techniques. E clearly depend on the nature of the risks that the sec- In the case of a life insurance company, the detailed tor underwrites; therefore, the scope of the strategy is risk-management systems required for the investment a function of the product mix. The level of exposure portfolio would vary considerably, depending on the F to natural catastrophes is relevant to property insur- nature of the liabilities and the conditions in the ance firms, and the level of sophistication in the market place, including the access to derivatives and identification and measurement of catastrophe risks other risk-management instruments. For a company G will vary amongst jurisdictions. that undertakes investment-linked business, the risk- In the case where a company insures significant management focus should be different from that of H property risks in a jurisdiction where natural catastro- a company that writes long-term savings contracts phes are material, then it would be expected that the with stronger return guarantees. company would take a rigorous approach for establish- I 133 Financial Sector Assessment: A Handbook domestic context" (IAIS 2003a, 50). This characteristic leads the assessor to consider 1 whether an element may be inadequate in the context of a more complex aspect of the market, even though it may well be reasonable in another market or may have been 2 reasonable when it was established in times when the market was less complex. Box 5.3 illustrates the application of flexibility in the context of ICP 19, which requires insurers 3 to provide adequate monitoring and evaluation of insurance risks and to ensure adequate premiums and reinsurance to manage the risks. 4 5.4.3.5 Observance in Law and Practice 5 The methodology for the assessment of the ICPs calls for observance both in law and in 6 actual practice. For most criteria, it is not sufficient simply to consider whether or not the law or other legal obligations cover the necessary material. "Observance" usually requires the practices to be recognized in the law or legislation and to be enforced effectively. Here 7 is a useful set of questions to consider: 8 · Is the practice or power specified in the law, the regulations, or both? · How do the authorities know it is followed in practice? 9 The assessment is not clear-cut when the desirable practices are in the law but have not been used because the circumstance for their use has not arisen. For example, par- 10 ticular winding-up provisions may appear adequate but may not have had the benefit of any testing. A more clear-cut example arises when a well-constructed solvency margin 11 regulation exists but is not observed by the firms in practice. This situation will not be assessed as "observed," given the lack of implementation of the regulation. Similarly, if a 12 regulation or criterion cannot be monitored or implemented because the financial report- ing or supervisory staffing does not permit it, then it would be difficult to rate the mere A existence of a rule in the rule book as sufficient for a rating of "observance." The requirement of clarity of the law, as well as practice, in the current ICPs is oner- B ous; however, it is possible to consider observance by other means (as suggested in IAIS 2003a, 52). This suggestion is intended to bring an additional flexibility to the assess- ment. It may be that the approach taken in a jurisdiction is not consistent with the C wording of the criteria but the effective result is the same in terms of actual results. For example, the principle of establishing clear priority to policyholders in the event of wind- D ing-up an insurer is discussed in the explanatory notes to ICP16 (IAIS 2003a, 30), where the alternative priorities for other stakeholders are recognized. At the same time, essential E criteria "c" seeks a high level of priority to the policyholder. This example indicates that a low priority in the winding-up provisions of the law may be effectively erased in effect for F policyholders by a policyholder protection scheme, which provides additional or alterna- tive protection. Another example of observance by other means could be represented by G the operation of custom or by the role of SROs. In those cases, the custom or practice needs to be considered by the assessor. It should be undisputed and robust. H When using the term legislation, the ICPs are not taking a prescriptive view on whether or not an obligation is in the primary insurance law or whether it is in a subsidiary regula- I tion, instrument, or circular. This approach provides flexibility within the context of the legal system. There are, however, some places where the use of the word law is taken to 134 Chapter 5: Evaluating Financial Sector Supervision: Banking, Insurance, and Securities Markets mean the primary law. In those cases, the ICPs consider that it is of particular importance 1 to include the specified feature in the primary insurance law. 2 5.4.3.5 Reinsurers, Policyholders, Beneficiaries, and Customers The ICPs depend on the definitions of the terms that the IAIS uses in preparing all of 3 their documents. Most of the terms are defined in the IAIS glossary that is available on the IAIS Web site. Several other important definitions are included in the document, and 4 they influence the scope of the assessment of the criteria and the principle. The term insurers includes reinsurers. Even though the term generally refers to insur- 5 ers, the reinsurance sector is also included in all respects unless indicated. The only indi- cation that excludes them is with respect to consumer protection because reinsurance is 6 generally taken to be a market between more informed customers (IAIS 2003a, 41). A wide definition of the terms policyholders, beneficiaries, and customers is used in 7 the ICP. Policyholders, when used, describes not only the owner of the policy but also a beneficiary, for example, a third-party claimant or the widow of a deceased policyholder 8 awaiting claim payment. Customers is a term used to also include potential policyholders. The definitions are of most importance when considering the consumer protection in 9 particular. For example, under criterion "e" of ICP 25, the effectiveness or otherwise of an "accessible" complaint handling process will depend on whether or not a claimant can 10 access it regardless of whether or not he or she is the policyholder. Information and disclosure will also need to be interpreted in the context of the defi- 11 nitions but within practical rather than literal bounds. The relevance and timeliness of information provided to the potentially affected parties should be a key consideration. 12 The owner of a policy may need particular information not only before purchase but also during the time the contract is in force. The existence of a complaint scheme may A be relevant for general information but will be more pertinent to those who indicate that they have a claim and even more so to those who have had a claim denied by an B insurer. C 5.4.3.6 Difficulties That Can Have a Pervasive Effect on Assessments An underresourced supervisory body will have difficulty with many of the ratings if it is D not able to conduct an effective onsite inspection activity because a number of the criteria will be difficult to verify in the absence of such inspections, formal or otherwise. Where E this situation is the case, the commentary can be used to make clear the central reason for the situation. F G 5.4.3.7 Reporting Ultimately, the ICP assessment is intended to be a diagnostic instrument. As a result, ICP H methodology emphasizes that the report (a) summarize the findings to highlight areas for improvement and (b) prioritize them in a sensible order. In addition, the report should I explain the priorities. 135 Financial Sector Assessment: A Handbook 5.4.3.8 Key Assessment Experience 1 The experience of assessments to date indicates that the insurance sector generally shows 2 a weaker level of observance of international standards than does the banking sector.30 Most usually, the reason is reflected in a less well-resourced and less-independent super- 3 visory body and in an insurance law that fails to provide the full range of powers to the supervisor to carry out the task envisioned in the ICPs. It can also reflect, however, a lack of actual soundness in the insurance sector itself. This section considers country 4 experience with individual ICPs and reports the typical difficulties faced in achieving full observance.31 5 Overall, observance differs across core principles, with several weaknesses and strengths. The area in which insurance supervision is most deficient relates to corporate 6 governance of insurance companies. Less than one-third of countries are observant or broadly observant with this core principle. This low level is mainly a result of unclear 7 jurisdiction of the insurance supervisory bodies over corporate governance issues. In gen- eral, rules on corporate governance are to be found in corporate law. Also, in the field of 8 internal controls, the supervisory authorities seem to have limited jurisdiction, and the system depends on general corporate laws and regulations. 9 The major areas of assessed weaknesses are organization of the supervisor and asset risk management. The organization of a supervisory agency needs to be improved in 10 broadly one-third of the countries assessed. In a significant number of cases, the insur- ance regulator was incorporated into the Ministry of Finance, but insufficient resources 11 (both in numbers and technical capacity) and unclear budgetary autonomy proved to be problematic in many cases. Although observance with respect to risk management is bet- 12 ter, it is still weakly supervised with respect to asset portfolio in approximately one-third of countries, mostly concentrated in developing and emerging market countries. As in A the banking sector, this weakness is an area of serious concern, mainly because adverse developments in asset values would in all likelihood directly affect the financial viability of the institutions. Deficiencies also occur in supervision of off-balance sheet exposures, B notably in derivatives in more than half of the countries assessed. The issues arise mainly in developing and emerging market countries and primarily involve the absence of any C regulations in this area. Other areas of concern relate to market conduct. Rules in many cases were limited to D rules on registration of brokers and agents and cross-border operations. The most impor- tant issue with respect to this principle relates to deficiencies in the exchange of informa- E tion with other supervisors. Creating all the relevant conditions for effective insurance supervision can be a chal- F lenge in less fully developed markets. Statistics that can assist companies in correctly pricing and establishing provisions for insurance products may not be widely studied or G reported. Asset markets may suffer from a lack of liquidity or may provide insufficient instruments of a duration necessary to match insurance liabilities. Often, the actuarial H profession is particularly limited. In many cases, supervisors are able to take action to alleviate such problems, at least in part. Greater difficulties arise if the jurisdiction faces I more widespread challenges, particularly if corruption levels are high and extend to the legal system. 136 Chapter 5: Evaluating Financial Sector Supervision: Banking, Insurance, and Securities Markets Generally, all supervisors have the obligation to protect the interests of policyhold- 1 ers, and this objective needs to be made more clear and transparent. Opportunities still remain, however, to bring transparency practices into line with best practice by elaborat- 2 ing on the objectives in more detail and with more clarity rather than simply relying on the publication of the law itself. Usually, this stronger transparency practice represents an opportunity for the supervisory authority to take a greater leadership role in their public 3 statements and in commentary in annual reports. An issue that is of concern, although not universal, is that the supervisor in some cases has conflicting objectives, for example, 4 policyholder protection and industry growth. It is difficult for a supervisory office that remains part of a ministry and subject to 5 generic public service rules to demonstrate full observance of the ICP on adequate super- visory authority. Lack of independence from the Ministry of Finance has been a major 6 issue--mainly in developing countries, where more than half of the sample countries exhibit poor implementation. 7 Transparency of supervisory process is often inadequate. Many supervisors have inter- nal processes that are well structured and understood within the agency. Nevertheless, the 8 transparency of those processes is often inadequate. Some supervisors have legal constraints that make supervisory cooperation and 9 exchange of information and cooperation (ICP 5) difficult. Others may be able to cooper- ate in a legal sense, but the effective cooperation among supervisors inside and outside of 10 the jurisdiction may be less than is desirable. In many cases, cooperation was warranted but did not, in fact, occur. Sometimes, in the extreme, cases have been identified in 11 which the local supervisor made every effort to exchange and elicit information, but the counterpart did not respond. This type of case is difficult to assess, given the party that 12 should have participated but did not was outside the jurisdiction. In cases such as these, it is suggested that the authorities' efforts be congratulated explicitly in the report. Every A effort to translate the intent of the standards into practical results by the international associations is to be encouraged in this area. Weaknesses are found in rules concerning fitness and propriety (ICP 7 on suitability of B persons). Frequently, the scope of the persons covered by the rules is limited or legal sup- port (for the otherwise effective moral suasion) to remove unsuitable persons is lacking. C Less frequently, the law may not have provisions for testing fitness and propriety. Usually, changes in control and portfolio transfers (ICP 8) are well covered in law, D and transactions, when they arise, are given close attention by supervisors. The one weakness that may arise is the ability to look through the corporate structure beyond the E immediate parent and, in particular, to examine transactions that take place outside the jurisdiction (e.g., when two international firms merge with a local operation that does F not change direct ownership). The intent of the ICP is to protect policyholders from a change of control whether or not there is an intermediate holding company or other G corporate structure, so this possible weakness can present an issue. Often, supervisors do not have the legal power to require local change of ownership of a licensed insurer to H require shareholder divestment. That type of power would usually enable any concerns to be addressed by changes to proposed ownership arrangements, by conditions being placed I on the approach to the management of the local insurer, or by other solutions. This issue 137 Financial Sector Assessment: A Handbook 1 Box 5.4 Key Issues in Ongoing Supervision and Prudential Requirements for Insurance Ongoing Supervision the definition of the point of intervention is 2 considered to be open to interpretation and, Ongoing supervision of insurance (ICPs 11­17) shows therefore, gives rise to legal dispute. In cases different degrees of observance, with developing coun- 3 such as those, the supervisor may be rendered tries showing more pronounced weaknesses. The stress ineffective while his or her intervention is on macroprudential surveillance of the insurance sec- subject to lengthy challenge--an undesirable 4 tor is an important step in strengthening supervision. situation in the interests of policyholders. · Market analysis (ICP 11) is a relatively new · With respect to groupwide supervision (ICP ICP, and experience from assessments remains 17), historically, insurance laws have been 5 to be analyzed. This ICP formally recognizes the designed for "ring fencing" the supervised entity importance of analyzing market conditions in and limiting impositions on the rest of the 6 the sector and macroprudential surveillance of group, whether they be subsidiaries or siblings the sector as key inputs into insurance supervi- or parents in the corporate structure. sion. For a discussion of financial soundness indi- 7 cators for use in macroprudential surveillance Observance of Prudential Requirements and market analysis, see chapter 3. · Reporting to supervisors and offsite monitoring Observance relating to prudential requirements must 8 (ICP 12) incorporates financial reporting, audit, be interpreted with care because the lack of risk and offsite analysis. Usual problems include a sensitivity of the principles and standards renders it possible for almost every jurisdiction to score highly. 9 lack of audit requirements, accounting standards that are adequate for general purposes but short General levels of observance are high on liability of supervisory needs, or an overly compliance- valuation and capital adequacy because the criteria 10 oriented supervisory approach to the assessment cannot differentiate between stronger and weaker of returns. loss reserves (both within a jurisdiction and between · Some supervisors do not have the powers or the jurisdictions) or determine the appropriateness of 11 resources for onsite inspections (ICP 13). a capital buffer regime. Weaknesses are more pro- · Although many supervisors have powers of inter- nounced on asset quality regulation. vention (ICP 14 on preventive and corrective 12 · Risk assessment and management (ICP 18) and measures), they may be subject to legislatively insurance activity (ICP 19) are new principles, imposed trigger points that are too low, thus and experience from assessments remains to be A preventing early intervention with sound legal analyzed. support earlier in the process. · Core principles on capital adequacy and solvency · A full set of enforcement sanction powers (ICP critically depend on realistic and consistent val- B 15), whether they have been applied in the past uations for assets and liabilities. If liabilities are in every case or not, is important to the supervi- inadequate or if assets are overvalued, then the sor. Sometimes, they add only to the ability to use C capital regime is undermined. Asset valuation moral suasion effectively. The ICP is oriented in standards vary greatly among jurisdictions, and this way so the weaknesses tend to reflect certain liability valuation standards vary both within D limitations in the law where the supervisor is and among jurisdictions. Significant efforts are provided with powers limited to those that will be under way in a number of countries and regions expected to be used in practice. Sometimes, the to develop better standards. Nevertheless, quan- E supervisor finds it useful to threaten to use powers titative benchmarks have yet to be developed or even if he or she does not ever use them in fact. proposed by the IAIS, and until this change hap- In those situations, the full armory is desirable. pens, the lack of differentiation between stron- F · It is usual that the processes of winding-up and ger and weaker prudential regimes will remain a exit from the market (ICP 16) are set out in feature of ICP assessments--and will necessitate G the law but, in some cases, the normal com- a more detailed technical analysis. mercial rules apply, which would not provide the · The core principle on derivatives and similar necessary policyholder protection. Policyholder commitments (ICP 22) is either observed (hav- H protection schemes do not exist in every juris- ing had supervisory attention) or not applicable diction, and the assessor may wish to take this (where the activity has been prohibited). Many information into consideration when reviewing developing and emerging markets commonly I the market exit arrangements. In some cases, lack regulation over this activity. 138 Chapter 5: Evaluating Financial Sector Supervision: Banking, Insurance, and Securities Markets can also be related to the lack of a full set of sanction powers to facilitate and support the 1 supervisor in its activities. Corporate governance (ICP 9) and internal control (ICP 10) tend to show strengths or weaknesses together. Where the powers exist, the topics of corporate governance and 2 internal control may have been the subject of recent rules but may not have yet found their way into reliable evidence of effective practice in the institutions; instead, new rules 3 are being formulated on these topics and their robustness remains untested. In addition, where onsite inspections are not carried out, it is difficult for the supervisor to verify the 4 full observance of these requirements. Ongoing supervision, prudential requirements, and AML­CFT procedures for insur- 5 ance were generally well observed (according to 2000 standards), but weaknesses were evident in implementation despite strong laws being in place. Some of the core principles 6 in this area (e.g., market analysis, risk management, insurance fraud, AML­CFT) are relatively new; implementation experience at the country level is new, and assessment 7 experience remains to be analyzed. Nevertheless, available evidence suggests that nearly one-third of all sample countries (and the majority of developing countries) demonstrated 8 weak regulation of asset quality, and 60 percent of developing countries insufficiently supervised reinsurance practices of insurance companies. Procedures for orderly winding- 9 up of failed insurers (and securities firms) were missing in a significant number of coun- tries sampled. Approximately, only one-third of the countries had adequate insolvency and bankruptcy regimes. Box 5.4 provides additional details on key weaknesses and issues 10 in the ongoing supervision and prudential requirements for insurance. Development issues related to the insurance sector will need specific attention in the 11 course of ICP assessments. To this end, the assessor will need to consider the factors that affect the contribution of the insurance sector to overall economic development. The 12 usual starting point is the development of the sector itself. The insurance sector, particu- larly the life insurance sector, can play a key role as a mobilizer and manager of savings A and as a long-term institutional investor. The sector cannot do so, however, if the custody of policyholder funds is at risk or if the population does not have the capacity to invest B in the sector's products. Over time, it can be expected that this situation will improve as the sector develops, but limitations may exist. In the long run, a sector that is growing, C that acts as an effective investor, and that provides long-term capital will be good for the economy and good for the overall well-being of the population--not just for those who D are policyholders--as the economy develops. Systemic risk should also be considered. In the case of insurance, this kind of risk can arise from two main sources and should be--in a reasonably well-run system--limited. E First, the sector itself may be weak. Solvency may be in question or the economic envi- ronment may be such that it could reasonably be at risk, which can be serious, particu- F larly if resolution measures are inadequate or if supervisory intervention is restricted. The failure of an insurer leads to significant hardship for those immediately affected32 and may G lead to a loss of confidence in the sector as a whole that could take a considerable period to restore. The second source of risk rests in the linkages, if any, with the banking sector H or with securities markets. For example, where an insurance company is owned by a bank, any potential weakness in the insurer may cause difficulty, or at least an imposition, on I the capital of the bank. Insofar as the insurance sector is a significant protection seller 139 Financial Sector Assessment: A Handbook in credit derivatives markets, weaknesses of insurers could have implications for finan- 1 cial stability. Moreover, when insurance companies are major holders of key instruments traded in the capital market, then market volatility may be significantly influenced by 2 portfolio decisions of insurers. 3 5.5 Assessment of Securities Market Regulation 4 Securities markets are a critical component of many economies, and the regulation of 5 securities markets can be fundamental to a country's financial development and integra- tion into the global market. Consequently, securities market regulation is an important element of financial stability. This section looks at the objectives and principles of securi- 6 ties regulation (core principles), which were developed by the International Organization of Securities Commissions (IOSCO)33 as the key global standard for securities regulation. 7 The section briefly reviews the development of the core principles and examines the ways in which they reflect the broad responsibilities of securities regulators and the nature of 8 IOSCO as a whole. The section then looks at the preconditions for effective securities regulation, which, though fundamental, can be both difficult to achieve and challenging 9 to assess. The section next turns to the IOSCO methodology, which is the principal tool used to assess securities market regulation, and addresses key considerations in conduct- 10 ing an assessment. After reviewing assessment experience to date and discussing some of the key findings, the section concludes by addressing three key topics in securities market 11 regulation and development: (a) demutualization, (b) creation of an integrated regulator or supervisor, and (c) enforcement and the exchange of information. 12 Securities markets are tremendously varied, both in terms of their legal framework and their level of development. The specific responsibilities of securities regulators are equally varied. Therefore, it is not practical to set forth a single legal or institutional framework A suitable for securities market regulation or to identify typical country practice. Indeed, this limitation was a major challenge for the drafters of the IOSCO core principles. B Therefore, instead of presenting a single, unified regulatory framework, the core principles identify three key objectives that "form a basis for an effective system of securities regula- C tion" (IOSCO 2003b, 1). Those objectives, which are discussed in greater detail next, are (a) protecting investors; (b) ensuring that markets are fair, efficient, and transparent; D and (c) reducing systemic risk. After identifying the three objectives, IOSCO sets forth 30 principles that are intended to give "practical effect" to the objectives. IOSCO then E elaborates on the principles through extensive discussion, while noting that, as markets change, the strategies for implementing the principles also will necessarily change. The F principles state that "there is often no single correct approach to a regulatory issue. Legislation and regulatory structures vary between jurisdictions and reflect local market conditions and historical development" (IOSCO 2003b, 3). As a result of those factors, G assessing securities market regulation can be fraught with numerous challenges. This sec- tion seeks to shed light on some of those challenges. H I 140 Chapter 5: Evaluating Financial Sector Supervision: Banking, Insurance, and Securities Markets 5.5.1 IOSCO Core Principles--Relevance to Stability Considerations and 1 Structural Development The Objectives and Principles of Securities Regulation (the IOSCO core principles) of the 2 International Organization of Securities Commissions is the key global standard for secu- rities market regulation. The IOSCO bylaws state that the organization's members (a) 3 will exchange information about their experiences so they can foster the development of domestic markets, (b) will work together to establish standards and improve market 4 surveillance of international transactions, and (c) will provide mutual assistance to pro- mote market integrity. IOSCO adopted the core principles in September 1998, and they 5 have been identified by the Financial Stability Forum as one of the 12 key international standards. The IOSCO core principles provide evidence of "IOSCO's commitment to the 6 establishment and maintenance of high regulatory standards for the securities industry" (IOSCO 2003b, 2). Over the years, IOSCO has produced many resolutions and numerous technical reports relating to different aspects of securities market regulation. However, 7 before the development of the IOSCO core principles, the organization had never pro- duced a framework statement covering the fundamental aspects of securities regulation. 8 The purpose of the core principles is to strengthen securities markets by enhancing the regulatory framework. As noted above, the core principles set out three objectives on 9 which securities regulation is based: (a) promoting investor protection; (b) ensuring that markets are fair, efficient, and transparent; and (c) reducing systemic risk. Although each 10 of the principles is presented as equally important, the document underscores the state- ment in the IOSCO bylaws that IOSCO members should be guided at all times by their 11 concern for investor protection. Investors are to be protected from misleading, manipula- tive, and fraudulent practices. The most important means for doing so is full disclosure. 12 Regulation should also promote fair and efficient markets with the highest levels of trans- parency, defined to include both pretrade and posttrade transparency. Finally, the core A principles call for regulators to reduce systemic risk. Although regulators cannot prevent firms from failing, the regulations should contain the risks and mitigate the impact of any B such failures. The core principles then set out 30 principles of securities regulation that are intended to give "practical effect" to the objectives. Each of the 30 principles is elabo- C rated and explained in significant detail. Because the three objectives are overlapping, it is impossible to link each principle to a specific objective. However, certain principles promote one or two of the objectives in particular. D The IOSCO objectives and core principles (IOP) are stated at a general level--as is the case with other regulatory standards--and permit considerable flexibility in imple- E mentation. Each of the 30 principles is supplemented by narrative discussion, illustrating how the objective of the principle might be achieved while simultaneously recognizing F that the nature of a particular market will necessarily dictate how the principle is imple- mented. "The particular manner in which a jurisdiction implements the objectives and G principles described in this document must have regard to the entire domestic context, including the relevant legal and commercial framework" (IOSCO 2003b, 3). In addition, H the IOSCO core principles were drafted with the recognition that markets change over time and that regulators must have the flexibility to adapt their supervision to changing I market conditions. The document notes that there is not a single approach for imple- 141 Financial Sector Assessment: A Handbook menting the principles and that multiple approaches, often depending on the broader 1 legal and regulatory system, may be effective. The IOSCO core principles also reflect the broad scope of responsibilities possessed 2 by most securities regulators. Securities regulators are responsible for a much broader array of activities than banking supervisors. Like banking supervisors, securities regulators 3 supervise the activities of market intermediaries. However, they also supervise securities markets, collective investment schemes, investment managers or advisers, and issuer 4 disclosure. Some securities regulators also have responsibility for enforcing company law. The core principles thus cover a large range of issues. The 30 core principles, therefore, 5 are grouped into eight subject areas as illustrated in Annex 5.D. Principles 1­5 relate to the regulator and to its powers, resources, independence, and accountability. Principles 6 6­7 relate to self-regulatory organizations and their supervision. Principles 8­10 relate to enforcement, and Principles 11­13 relate to cooperation, including international coop- 7 eration for enforcement and regulatory purposes. Principles 14­16 relate to issuers and the disclosure of information. Principles 17­20 relate to collective investment schemes 8 and their operation. Principles 21­24 relate to the supervision of market intermediaries, and Principles 25­30 relate to how a jurisdiction's overall regulatory structure ensures the integrity of secondary markets, including through robust clearance and settlement func- 9 tion that is addressed in Principle 30.34 Because of securities regulators' broad responsibilities for the effective functioning 10 of the markets, the links between (a) observance of the IOSCO core principles and (b) market development and stability are fundamental. As the core principles themselves 11 note, securities markets are vital to the development and strength of national economies. They not only support "corporate initiatives, finance the exploitation of new ideas, and 12 facilitate the management of financial risk" (IOSCO 2003b, 1) but also--with the growth of collective investment schemes--have become increasingly important to individual A wealth and retirement planning. Sound domestic markets are important to domestic financial development; with globalization, they have become increasingly important to B the strength and stability of the global economy. Indeed, much work has been done to show (a) that financial diversification and development outside of the banking system C enhances efficiency, as well as encourages development and promotes stability and (b) that an alternative source of intermediation may help strengthen the banking sector, which, again, will enhance financial development and stability.35 Improving the quality D of regulation and enhancing the supervision and surveillance promotes investor confi- dence, better risk management, and more efficient and robust institutions and markets. E These actions, in turn, will promote economic growth. In addition, the preconditions for a strong securities market, including a well-functioning legal system and observance F of contract and property rights, are the institutional factors that promote both financial stability and financial development. G 5.5.2 Preconditions for Effective Securities Market Regulation H Effective securities regulation depends on the existence of a number of "preconditions." I The IOSCO core principles recognize that "securities law and regulation cannot exist in isolation from the other laws and the accounting requirements of a jurisdiction" (IOSCO 142 Chapter 5: Evaluating Financial Sector Supervision: Banking, Insurance, and Securities Markets 2003b, 8). In particular, the principles note that "there must be an appropriate and effec- 1 tive legal, tax and accounting framework within which the securities markets can oper- ate" (IOSCO 2003b, 8). The preconditions are not formally part of the core principles because they are outside the jurisdictional authority of most securities regulators. IOSCO 2 identifies in an annex to the core principles certain elements of the legal framework that are particularly important for effective securities regulation. These elements include (a) 3 company law; (b) a commercial code or established contract law, including recognition and enforcement of property rights; (c) clear and consistent tax laws, especially with 4 respect to the treatment of investments and investment products; (d) bankruptcy and insolvency laws; (e) competition law; (f) banking law; and (g) a fair and efficient judicial 5 system or other dispute resolution system in which orders can be enforced and illegal behavior sanctioned (IOSCO 2003b, annex III). 6 Weaknesses in the preconditions can have a significant deleterious impact on the effectiveness of securities regulation and on market development. Investor protection 7 must be grounded in a legal framework for investors to have confidence in the markets. For example, without an effective bankruptcy law, investors will be reluctant to risk 8 investing in a company that may fail because they will be without any legal recourse. Similarly, investors would be reluctant to leave assets in accounts with a securities firm 9 or an asset management company if bankruptcy and property law did not support a clear separation of client assets from the general assets of a firm. Without uniform accounting standards, companies will not be able to present a consistent and meaningful financial 10 picture to investors. The absence of a fair and impartial judicial system that can mediate disputes or enforce sanctions will weaken the credibility and effectiveness of securities 11 regulation. As part of the IOSCO assessment, it is important to gain an understanding of the 12 relevant preconditions in a particular country, which will require access to information from a wide variety of other sources, including assessments of other financial sector com- A ponents. Information will be needed from country authorities other than the securities regulator and from market participants. Assessments of the legal system and accounting B standards would provide information on shortcomings, if any, that might affect securities regulator's activities. In addition, when considering actions to enhance securities regula- C tion, country authorities will need to determine whether the preconditions themselves should be addressed first to ensure that the proposed action will achieve its objective. D 5.5.3 Assessment Methodology and Assessment Experience E The core principles were initially adopted as a stand-alone document, without an accom- panying methodology for implementation. When IOSCO adopted the core principles, F they were intended as an incentive document, expressing the commitment of IOSCO members "insofar as it is within their authority to use their best endeavors within their G jurisdiction to ensure adherence to those principles" (IOSCO 2003b, 3). At the same time, IOSCO also recognized that the core principles could serve as a benchmark or, as IOSCO H put it, a "yardstick against which progress towards effective regulation can be measured" (IOSCO 2003b, 2). Therefore, IOSCO began the development of detailed questionnaires I to help securities regulators assess the extent to which they were implementing the core 143 Financial Sector Assessment: A Handbook principles. The questionnaires included a "high-level" questionnaire and five additional 1 questionnaires that focused on specific areas of securities regulation. The Methodology for Assessing Implementation of the IOSCO Objectives and Principles of 2 Securities Regulation (IOSCO 2003a; hereinafter, the Methodology) has been developed as a tool to provide guidance on assessing the level of implementation of the IOSCO 3 core principles. The core principles were themselves helpful as a starting point for assess- ing securities market regulation; however, they were drafted at a broad conceptual level 4 to accommodate differences in the laws, regulatory framework, and market structures among IOSCO members. They, therefore, provided little or no guidance to assessors as 5 to how to assess whether they were implemented in practice. Although the self-assess- ment questionnaires could be used by third-party assessors, they were a cumbersome tool, 6 particularly for those assessors who were less familiar with the market and the regulatory system that they were assessing. As an alternative, the World Bank and the International 7 Monetary Fund developed a guidance note for use by assessors as they worked with the IOSCO core principles. Although helpful, this note was quite general, and IOSCO mem- bers believed that more detailed and comprehensive guidance could be of greater assis- 8 tance. In response, IOSCO set up a task force that was specifically mandated to develop a methodology that could be used by both self-assessors and third-party assessors such as 9 the Bank and the Fund. The task force consisted of IOSCO member regulators from both developed and emerging markets. Staff members from the Bank and the Fund also par- 10 ticipated. The Methodology built on the self-assessment questionnaires and the guidance note that were already in existence. 11 IOSCO developed the Methodology for its own use and for use by third-party asses- sors. IOSCO intended all along for the Methodology to be used as a tool for conducting 12 self-assessments. At the same time, IOSCO recognized that the Methodology would be used by third-party assessors, some of whom might not be securities regulators. Thus, A IOSCO members tried to achieve multiple objectives in drafting the Methodology. To reflect the complexity of regulating a wide variety of types of markets in different stages B of development, IOSCO sought to ensure that the Methodology was sufficiently multifac- eted. IOSCO also wanted to be sure, however, that the Methodology--and assessments based on the Methodology--would reflect the high standards of regulation that the core C principles embodied and would not be watered down or diluted for different markets. IOSCO also sought to ensure a degree of consistency in assessments across different mar- D kets. Consequently, the Methodology is a long and complex document, with numerous "key issues" and "key questions" for assessors to draw on and a rather strict benchmarking E system. The benchmarking system is intended to add consistency and objectivity to an inherently subjective assessment process while allowing for some flexibility. F The organization of the Methodology follows the format of the core principles. The Methodology groups each of the principles into the eight subject areas used in the pre- G sentation of IOSCO core principles. Each grouping of the principles is introduced with an introductory note. It then introduces each individual principle and sets forth that H principle's "key issues" and associated "key questions." These descriptions are followed by an elaborate benchmarking system through which IOSCO essentially indicates the I relative importance of different aspects of the principles. The benchmarking system rec- ognizes five levels of observance of each principle: "fully implemented," "broadly imple- 144 Chapter 5: Evaluating Financial Sector Supervision: Banking, Insurance, and Securities Markets mented," "partly implemented," "not implemented," and "not applicable." An explana- 1 tory note may accompany these levels. (Annex 5.E illustrates the structure and use of the Methodology for one of the core principles.) The work of the IOSCO task force reflected the experience being gained in the 2 context of Bank-Fund assessments and country self-assessments. For example, in the Methodology's benchmarking system, IOSCO initially had not included a "broadly imple- 3 mented" category. However, IOSCO concluded that the benchmarks should be expanded to reflect those situations in which the regulatory system or regulator had implemented 4 nearly all aspects of a particular principle, though not every detail. To reflect this situation, IOSCO incorporated the new category "broadly implemented" into the benchmarking 5 system. Similarly, as a result of feedback from assessors that the application of benchmarks was too rigid, explicit language was included in the instructions to the Methodology to 6 make clear that the benchmarks were intended to be applied in a flexible manner that would take account of the specific regulatory context. 7 The Methodology represents a compendium of all of IOSCO's work and provides a comprehensive framework for analyzing implementation of the principles. It references 8 in one place many of IOSCO's technical reports, resolutions, statements of good practice, and other relevant materials on securities regulation. It thus is a tremendous resource, 9 giving an assessor the tools to access more in-depth material on a given topic. In addi- tion, the Methodology serves an effective diagnostic and action-planning function. The Methodology is especially strong in establishing the market and regulatory context for the 10 various principles. By organizing the core principles into key issues and key questions and by providing detailed criteria for each topic, the Methodology not only provides a vehicle 11 for analyzing a securities regulatory regime across the entire range of securities regulation but also provides a measure of consistency across markets. 12 5.5.4 Key Considerations in Conducting an Assessment A An assessment generally begins with an overview of the structure and state of develop- B ment of securities markets and key institutions in a particular country. Although an in-depth assessment of this information is generally beyond the scope of the assessment C of IOSCO core principles, the assessor must understand the effect of the information gathered on the effectiveness of securities regulation in the country being assessed.36 The D nature of the market being assessed and its legal framework must be comprehended fully for the assessment to be well-founded. For example, "markets with a single or a few issu- ers, that are totally domestic in nature, or that are predominantly institutional, will pose E different questions and issues as to the sufficiency of application of the Principles, and as to the potential vulnerabilities likely to arise from their non-application" than markets F that feature different characteristics (IOSCO 2003a, 6). In addition, any weaknesses or shortcoming in the preconditions and the effect they have on securities regulation must G be considered. Assessors obtain much of this information through the use of a securities markets questionnaire, which seeks data on the structure and performance of securities H markets and on the legal and regulatory framework for supervision in the country being assessed (for an example of the sort of quantitative information analyzed, see appendix I B, table B.9). 145 Financial Sector Assessment: A Handbook An assessment of securities regulation requires the assessor to be familiar with all the 1 relevant laws and regulations, as well as with other key documents and practices. As noted earlier in the discussion of preconditions, effective securities regulation not only is based 2 on the securities law but also is integrally connected to company law. In addition, account- ing and audit standards, investment fund law, bankruptcy law, and other parts of the legal 3 framework are critical. In many countries, codes of conduct and other policy documents that may or may not have the force of law may also be important. Consequently, an asses- 4 sor must be familiar with a wide range of relevant laws and regulations, as well as with other types of government and nongovernment guidance. 5 A critical foundation of a third-party assessment is a self-assessment completed by the regulator. The availability of a thorough and candid self-assessment is critical to enable 6 a third-party assessor to complete a fair and accurate assessment. A well-prepared self- assessment that includes the summaries of the relevant legal and regulatory texts and a 7 thorough description of the institutional framework and supervisory practices is essen- tial. As noted earlier, before the development of the Methodology, IOSCO members 8 completed a series of self-assessment questionnaires, including a so-called "high-level" assessment and additional assessments covering specific aspects of securities regulation. 9 Those questionnaires are highly informative and, though cumbersome to use, have been helpful to the third-party assessors, especially since IOSCO developed a concordance key 10 to cross-reference specific items in the questionnaires to the Methodology. However, with the adoption of the Methodology, IOSCO members may undertake updated self-assess- 11 ments directly pursuant to the Methodology. A number of IOSCO members have already started to do so, and some are undergoing "assisted self-assessments" in which they obtain the assistance of other IOSCO members to help them complete the self-assessment. A 12 comprehensive and candid self-assessment prepared pursuant to the new Methodology would serve as a good foundation for developing a complete profile of the market and for A assessing how it is regulated, as well as for identifying strengths and weaknesses for further consideration. B Third-party assessors must conduct in-depth discussions with the securities regulator, other relevant authorities, and market participants on the relative strengths and weak- C nesses of the securities regulator. Assessors should meet with authorities, securities firms, exchanges, SROs, industry groups, depositories, and other agencies and must share the D draft assessment with the regulator and discuss comments. An IOSCO self-assessment and an FSAP assessment follow similar formats. Both E types of assessments begin with a discussion of the institutional and market structure of securities regulation in the country being assessed. The information and the methodol- F ogy used for the assessment are then set forth, followed by a discussion of the sufficiency of the preconditions for effective securities regulation. The heart of the assessment is the G principle-by-principle assessment, which contains a detailed discussion of each principle, noting relevant factual information, actual practices that are followed, and effectiveness H of oversight. Comments by the assessor are important to document how the assessor arrived at his or her conclusions. Thus, this information should be described in reasonable I detail, with reference to the supporting authority as necessary. The assessment concludes with recommended actions and the securities regulator's response. 146 Chapter 5: Evaluating Financial Sector Supervision: Banking, Insurance, and Securities Markets An assessment must take into account what is actually taking place in practice. The 1 IOSCO methodology explicitly recognizes that there is a significant difference in terms of effective securities regulation between laws and rules that may look good on paper and 2 those that are enforced in practice. The Methodology specifically states that it envisions that assessors will conduct their assessments from two perspectives: first, whether the laws and rules are sufficient and the programs or procedures intended to implement those laws 3 and rules are effective and, second, whether the laws, rules, and programs and procedures are actually implemented in practice. It can be challenging for assessors to gain a realistic 4 understanding of how securities regulation operates in practice, requiring candid discus- sions with regulators, market practitioners, investor representatives, and others. 5 6 5.5.5 Assessment Experience As of the end of April 2004, 54 IOSCO assessments had been completed in the FSAP 7 process. This number is approximately one-half of the 105 assessments that had been completed or were under way or planned. Not all FSAP assessments include an IOSCO 8 assessment. In April 2002, Bank and Fund staff members issued a report reviewing the experience with the assessment of the IOSCO core principles (see IMF and World Bank 9 2002a). Assessors have had some difficulty in applying the Methodology's benchmarks in 10 practice. As the Methodology was being completed, the Bank and the Fund conducted a testing program in which they undertook eight IOSCO assessments pursuant to the 11 Methodology. The eight assessments took place across all geographic regions and in both industrialized and emerging market economies. The assessors comprised World Bank staff 12 members, IMF consultants, and experts nominated by IOSCO. Uniformly, the assessors found that the benchmarking system set forth in the Methodology made it difficult to apply the Methodology with the flexibility they believed IOSCO had intended. Members A of IOSCO who had conducted self-assessments pursuant to the Methodology had a similar reaction. B As a result, IOSCO has drafted new instructions on the use of the Methodology to clarify that the Methodology contemplates "the exercise of disciplined flexibility" in the C benchmarking process. Assessors are expected to use their discretion in arriving at a rat- ing but must document their conclusions, particularly to the extent they may depart from D the benchmarking parameters. Thus, for example, in assessing under Principle 2 whether a securities regulator operates independently from the Ministry of Finance, an assessor E must consider whether the regulator must consult with the government ministry on par- ticular matters of regulatory policy. If the circumstances of such consultation include any F decision making on day-to-day matters, then under the benchmarking as strictly applied, the regulator would receive a "not implemented" on this principle. However, the assessor G may conclude that the matters on which the regulator must consult do not impair the independence of the regulator. In that case, the assessor may give the regulator a higher H rating, as long as the reasons for this assessment are well documented. By maintaining the benchmarks but permitting them to be applied with discretion, IOSCO is hoping I that the benchmarks will be able simultaneously to bring objectivity to, and a measure of 147 Financial Sector Assessment: A Handbook consistency across, assessments while allowing for the flexibility necessary to ensure that 1 the resulting assessment is appropriate for the regulatory system assessed. Several key conclusions on securities market regulatory practices have emerged from 2 the assessments so far.37 Weaknesses in the implementation of many of the principles were evident across the range of jurisdictions assessed, although the most marked concerns 3 related to assessments of developing and emerging markets. The assessment experience also highlighted the difficulties in drawing clear connections between the weaknesses 4 identified in the regulation of securities market and financial sector vulnerabilities. An analysis of completed IOSCO assessments indicates that there are specific areas of 5 weakness in the implementation of the IOSCO principles. Weaknesses in implementation are particularly evident with respect to principles for enforcement of securities regulation 6 (Principles 8­10) and principles for issuers (Principles 14­16). Overall, assessors found that regulators had a lack of authority to investigate; had limited access to time-sensitive 7 data needed for surveillance purposes; had insufficient resources for inspection, surveil- lance, and investigation; and often had a limited enforcement mandate. With respect to issuers, there is a clear need for more efficient methods to disseminate information to the 8 public and to improve the quality of the information being released. In addition, there is a need to improve the legislative and policy framework relating to the treatment of share- 9 holders, a need to enhance the regulatory regime for auditors, and a need to address the lack of harmonization between international and domestic accounting and auditing stan- 10 dards. Improvements in those preconditions would help improve securities regulation. In turn, the principles that have relatively higher levels of full and broad implementa- 11 tion are the following: (a) Principles 18­19 (regulation of collective investment schemes, (b) Principles 21 and 25 (regulation of market intermediaries and the secondary market), 12 and (c) Principles 1 and 4­5 (activities of the regulator). Some common deficiencies noted by the assessors in terms of the issues relating to the regulator include the follow- A ing: a lack of operational independence; limited enforcement powers; and inadequate resources, which thus hamper the ability to perform regulatory functions efficiently and B effectively. The lack of operational independence raises particular questions as to control of resources (both human and financial). The lack of a clear mandate--or the lack of clear regulatory powers--also inhibits regulatory functions such as licensing, access to neces- C sary (sometimes confidential) data, and so forth. Other common deficiencies include the need for appropriate regulations dealing with collective investment schemes, the need to D expand the scope of the regulator's responsibilities, the need to improve licensing require- ments for trading systems, and the need to increase the scope of trading arrangements. E Although assessors are not able to readily consider preconditions, the comments in specific assessments do, nevertheless, allude to the poor state of legal and accounting F systems in many jurisdictions. For example, many assessments note the inadequacy of the accounting framework--both in terms of standards and professional arrangements--as G being linked to weaknesses in the implementation of the principles for issuers. Likewise, audit issues are commonplace, and aspects of the oversight of auditors feature prominently H in many assessments. The insolvency regime is, not surprisingly, often cited as requiring attention in those jurisdictions that exhibit lower levels of implementation of the prin- I ciples related to market intermediaries. An efficient court system, a highly skilled legal profession, and a set of well-designed administrative review processes would no doubt 148 Chapter 5: Evaluating Financial Sector Supervision: Banking, Insurance, and Securities Markets support strengthening the enforcement of laws in the countries that have been assessed 1 as not having fully implemented the principles relating to enforcement and cooperation (Principles 8­10 and 11­13). (See section 5.5.6 and Annex 5.F for a further discussion 2 of enforcement issues.) 3 5.5.6 Special Topics in Securities Market Development and Regulation Three key topics in securities market regulation and development are discussed in this 4 section: (a) demutualization of stock exchanges, (b) creation of integrated regulator or supervisor, and (c) enforcement and exchange of information. 5 5.5.6.1 Demutualization 6 The past decade has witnessed tremendous changes in the structure of securities markets 7 as lawmakers, regulators, and market participants try to contend with the effects of glo- balization and the development of advanced technology. New forms of markets have been created, and traditional markets have struggled to stay competitive. Regulators have been 8 forced to face difficult questions of what constitutes the essential elements of a market and how they should be regulated going forward. The viability of self-regulation, which, 9 in fact, in many countries predated stand-alone securities regulators, has also come into question. 10 One increasingly common consequence of those developments is a worldwide trend toward the demutualization of stock exchanges. Many stock exchanges began as mutual-- 11 or member--organizations where, in exchange for the privilege of membership, an indi- vidual or a securities firm was (a) given certain benefits, including the right to trade on 12 the exchange and to make a market in certain securities, and (b) certain responsibilities, including the obligation to act in accordance with the membership rules for the benefit of A the exchange at large. This system worked effectively for many years, and, indeed, many would argue that it still does. However, others believe that this membership structure B served to constrain the exchanges from competing effectively with their rivals, including fast and efficient electronic systems that could execute trades rapidly at little cost. To mar- C shal greater resources that would enable them to compete more aggressively, a significant number of exchanges decided to transform themselves into for-profit stock companies in which shares would be offered to the public and even, in some cases, listed on the D exchange itself. In a number of cases, government authorities initiated the demutualiza- tion of domestic exchanges, believing that this action would improve the competitiveness E and efficiency of their markets. According to the World Federation of Exchanges, a total of 42 exchanges had demutualized as of March 2003. This figure includes exchanges in both F developed and emerging markets, including, for example, the London Stock Exchange, Australian Stock Exchange, Deutsche Borse, Athens Stock Exchange, Philippines Stock G Exchange, and Kuala Lumpur Stock Exchange, among others. The transformation of stock exchanges into for-profit share companies raises sig- H nificant issues for securities regulators. Although many of the issues exist in the case of traditional stock exchanges, demutualization served to highlight the potential conflicts of I interest.38 In particular, exchanges that have demutualized may have a heightened con- 149 Financial Sector Assessment: A Handbook flict of interest between their business and regulatory functions, including in the adminis- 1 tration of their own operating rules. For example, when operated by a management team whose main goal is to create a profit, an exchange may have less interest in devoting 2 resources to its regulatory functions. Furthermore, as a for-profit enterprise, an exchange may come into conflict in regulating its own competitors. Regulators have handled those 3 potential conflicts in a variety of ways. Some regulators have removed regulation from the exchange function entirely, giving it to an independent self-regulatory organization or 4 even assuming all or part of the functions themselves. In other cases, improving internal controls at the exchange--coupled with enhanced regulatory oversight or strengthened 5 corporate governance--has been considered sufficient. From an assessor's perspective, the key issue is to be aware of the market structure 6 that exists in the country being assessed, to recognize the regulatory implications of that structure, and to have a comprehensive understanding of the way in which the 7 regulatory authorities have addressed those implications. When assessing a market with a demutualized exchange, the assessor should consider how the regulatory responsibilities 8 of the exchange are being handled, what procedures the exchange or other parts of the regulatory system have in place to address potential conflicts of interest, and whether the 9 regulator has an effective program of oversight. 10 5.5.6.2 Creation of an Integrated Regulator or Supervisor­­Security Regulator's Perspective During the past decade, a number of securities regulators in both developed and emerging 11 markets have been merged into or reorganized as an integrated regulator or supervisor.39 That is, the securities regulator has become part of an organization with the broader 12 mandate of regulating or supervising not only securities firms and markets but also other segments of the financial sector. Thus, securities regulators may now be merged with A authorities responsible for banking supervision, insurance supervision, or both or may, in fact, have even broader authority over pensions or other forms of financial activity. The B effect of this development on the effectiveness of securities regulation remains unclear. In particular, it is not yet clear whether an integrated supervisor promotes effective imple- C mentation of the IOSCO core principles. Some of the fundamental objectives of securi- ties regulation--particularly market conduct and market integrity--are not identical to, D and indeed may be inconsistent with, the objectives of other forms of regulatory supervi- sion. This situation may cause a conflict within the integrated supervisor. This possible E conflict raises questions relating to whether sectoral integration of supervisory functions should be based on specific objectives of supervision and whether appropriate internal F organization of an integrated supervisor could facilitate efficient resolution of conflicts, if any. See appendix F for further details. G From an assessor's perspective, a number of factors are important to consider. What were the reasons that motivated the country authorities to establish a single regulator? H Are they being achieved? Is the supervisor effectively monitoring risk transfers among dif- ferent financial firms in different sectors? Has the supervisor retained personnel and expe- I rienced staff members from the securities regulator? Is the investor protection objective of securities regulation being achieved? For example, how would the integrated supervisor 150 Chapter 5: Evaluating Financial Sector Supervision: Banking, Insurance, and Securities Markets handle a situation in which a financial intermediary in that country were to develop a 1 significant problem? How would the supervisor protect investors in such a case? 2 5.5.6.3 Enforcement and the Exchange of Information Enforcement plays a central part in the operation of well-run capital markets. It is essen- 3 tial for a securities regulator to be diligent in administering the laws and rules and to take effective enforcement action against those who contravene them. Only by taking strong 4 and immediate action can the regulator send a message to the market that wrongdoing will not be tolerated. In many countries that have been assessed, enforcement is very 5 weak, in part because of an inadequacy in resources and insufficient authority. Enforcement is one area where securities regulation differs markedly from banking 6 supervision. As with bank supervisors, securities regulators are responsible for oversee- ing market intermediaries and their relationship with their clients. However, securities 7 regulators also are responsible for overseeing the markets more broadly, including the regulation of collective investment schemes and their advisers or operators, as well as 8 the supervision of issuers and listings. Thus, to achieve their investor protection objec- tive, securities regulators must cast a broad enforcement net as they seek to detect and 9 deter fraud, including accounting and financial fraud, in both organized and unorganized markets, between intermediaries and their clients, and in public statements by issuers. In 10 addition, the scope of cooperation and exchange of information among securities regula- tors for law enforcement purposes is often quite wide ranging, going well beyond the safety 11 and soundness information. Those and other considerations pose challenges in the assess- ment process. Some of the issues in assessing enforcement are highlighted in Annex 5.F. 12 Annex 5.A Legal and Institutional Environment for Effective Bank A Insolvency Procedures B Autonomy of Banking Authority C The basic framework for bank insolvency needs to (a) be set out in the law that states the goals to be pursued by the banking authorities when dealing with insolvent banks and (b) D empower the authorities to implement the bank insolvency framework. Moreover, the law should grant operational autonomy to official decision makers who are responsible for E enforcing prudential rules; initiating and supervising insolvency proceedings; and acting as official administrators, liquidators, or all of the preceding. F To ensure the autonomy of banking authorities, the law should include provisions that do the following: G · Grant security of tenure to high-level officials of the banking authorities. In par- ticular, the law should stipulate who can dismiss the heads or high-level officials H of banking authorities and under what conditions. Dismissal should occur only for cause, and the grounds should be limited to, for instance, (a) inability, (b) illness I or other forms of incapacitation preventing one from performing one's duties over 151 Financial Sector Assessment: A Handbook a significant period of time, (c) willful misconduct, (d) gross negligence, or (e) 1 noncompliance with explicit fitness criteria. · Grant banking authorities the appropriate degree of budgetary autonomy and 2 flexibility in using its financial resources within the framework of the law, subject always to appropriate accounting and auditing. 3 · Allow banking authorities to act without interference in their day-to-day opera- tions and decisionmaking, and insulate them from potential pressure from the 4 political establishment and market participants. 5 Legal Mandate 6 The legal mandates and functions of each of the official agencies and authorities involved in the resolution of insolvent banks such as (a) the central bank, (b) the supervisory agen- 7 cy, (c) the deposit insurance agency, and (d) the Ministry of Finance should be clearly delineated in a manner that avoids gaps or overlaps. While the legal framework should 8 provide for the exchange of information and coordination, it also should require each agency to exercise its powers independently. A mechanism for the resolution of potential disputes in an open and transparent manner should be provided for in the law. 9 10 Appropriate Legal Protection of Banking Authorities and Their Staff Members 11 Laws should grant legal protection for bank authorities and their staff members to fulfill their responsibilities. Legal protection should be coupled in a balanced manner with 12 the legal accountability necessary to prevent any abuse of power so as not to discourage authorities and officials from taking prompt and decisive action. A Of particular importance is personal protection from civil and criminal liability of senior staff members and other officers or agents of the banking authorities who are B involved in the declaration of a bank's insolvency and in the administration of its restruc- turing, liquidation (including individuals who are appointed as official administrators or liquidators), or both--other than for intentional wrongdoing (e.g., abuse of power, C theft, conversion of assets, conspiracy, etc.). This type of protection can be extended (a) by granting express statutory immunity from liability for actions and omissions that the D persons concerned have taken in discharge of their legal responsibilities, (b) by making their agency vicariously liable for their faults, (c) by including appropriate indemnifica- E tion provisions in their contracts of employment, or, perhaps, (d) by a combination of the three mechanisms, depending on the specific legal position of the officials concerned. F Transparency G For a banking authority, the combination of a precise mandate with a high degree of transparency in its implementation is crucial because it reduces simultaneously the oppor- H tunities for (a) the pursuit of personal interests on the part of supervisors, (b) the exercise of undue influence over the decision-making process by market participants (so-called I "regulatory capture"), and (c) political interference. The legal framework should require agencies dealing with insolvent banks to operate with the maximum degree of transpar- ency compatible with the need to preserve confidentiality.40 152 Chapter 5: Evaluating Financial Sector Supervision: Banking, Insurance, and Securities Markets The transparency of the supervisory function is often difficult to achieve in practice 1 because decisions are typically highly invisible for cogent reasons of confidentiality. This lack of transparency makes supervisory decisions an easy target for interference by politi- cians and market participants requesting forbearance. The scope for interference can be 2 limited if the decision making relating to supervisory enforcement (including revocation of a license), and the commencement of insolvency proceedings is based on precise rules 3 and on well-specified criteria. In principle, considerations of confidentiality are less likely to justify nontransparency of the official decision makers' evaluations and actions after 4 the commencement of insolvency proceedings.41 Even where reasons of confidentiality preclude open decision making or the disclosure by an agency of detailed information to 5 the public at large, the provision of more comprehensive information to the politically responsible executive branch of government will still be appropriate. 6 Accountability and Judicial Review 7 Banking authorities are subject to various forms of accountability. First, they will need to explain the way in which they conduct their affairs and perform their mandate to the 8 government, the legislature, and the public (and those authorities are thus subject to some measure of hierarchical, political, and public accountability). Second, in certain cases, 9 they are legally accountable in civil and criminal law proceedings, with appropriate legal protection as noted earlier. In addition, they will occasionally need to substantiate before 10 the courts of law the legality of their decisions. The possibility of judicial scrutiny helps to ensure that administrative decisions are 11 made consistently and on proper grounds. To guarantee the legality of official actions and the protection of the legitimate interests of private parties, affected parties should be able 12 to challenge the decisions made by the banking authorities in administrative law by bring- ing judicial review proceedings before the administrative courts or by appealing to a spe- A cial tribunal.42 Where the external review of decisions takes the form of a special appeals mechanism, it should be entrusted to an independent and impartial tribunal established by law and comprising persons with requisite experience and skills. B At the same time, the mechanisms of legal accountability should not undermine the effectiveness and credibility of the banking authorities' actions. In particular, the banking C authorities' margin of discretion should be respected, and a court or appeals tribunal (or both) should not be able to substitute its own policy decisions for those of the relevant D authority. Accordingly, the review mechanism should seek only to ensure that the bank- ing authorities act legally and within the limits of their powers and should not allow a E reassessment of their actions on substantive grounds. Any reconsideration of decisions on the merits should be confined within the agency and incorporated into its internal F operating procedures. G Coordination among Banking Authorities If one is to deal with an insolvent bank effectively, the following are essential: timely H cooperation and coordination between the various banking authorities and other pub- lic bodies concerned (e.g., the central bank; the operators of payment and settlement I systems; the deposit insurance agency; and, where required, the supervisors of other sec- tors and jurisdictions, including the securities and insurance sectors).43 Whenever the 153 Financial Sector Assessment: A Handbook restructuring stage is reached (see chapter 5, section 5.3.5), coordination with the officials 1 responsible for the restructuring will be crucial. At the domestic level, there should be a sound legal basis for the exchange of informa- 2 tion and coordination among all the public bodies involved. The law should not impede the sharing of information; in particular, the duties of secrecy owed by official decision 3 makers should not prevent interagency disclosures. Furthermore, means should be clari- fied for coordination among agencies, particularly with respect to banks that belong to 4 financial conglomerates. In this context, there should be clear principles for determin- ing which supervisory authority bears primary responsibility, and the obligation of each 5 authority to keep other bodies informed should be recognized. Where an insolvent bank operates in several jurisdictions, the banking authorities 6 should be able to exchange information and to coordinate actions with their foreign counterparts. The operational terms of cooperation should be laid down in bilateral 7 arrangements between the respective national authorities, for example, in the form of memoranda of understanding or through an exchange of letters. A duty of confidentiality should apply to all information shared between the authorities, in accordance with the 8 national legislation of the countries concerned. The flow of information between host and home supervisors should be in both directions. 9 10 Annex 5.B Consolidated Supervision 11 Given the complexities in conducting effective consolidated supervision, it is critical that the supervisory authorities have the necessary tools to carry out their responsibilities. 12 Some of the preconditions and prerequisites for effective banking supervision, which were discussed earlier (particularly, an appropriate legal framework and operational indepen- A dence of the supervisory agency or agencies), are especially important in the conduct of effective consolidated supervision. B · The legal framework must grant the supervisor the necessary powers to conduct consolidated supervision over the entire span of institutions under its jurisdiction. C Supervisors should have (a) sufficient flexibility in licensing and authorization, (b) the power to request information sufficient to effectively assess the banking group's D risk profile and the adequacy of its risk management, and (c) sufficient enforcement powers to address technical compliance not only with laws and regulations but also E with safety and soundness concerns that may arise within the banking group. In addition, they must have the ability to sanction intragroup transactions that, while strictly legal from a groupwide perspective, have undesirable consequences for the F regulated group entities. · Additional important considerations are the agency's (or agencies') operational G independence and adequacy of resources. Issues to be reconciled include reporting requirements and accountability for the agency, as well as its funding and staffing. H A supervisory agency that must report to another ministry may suffer political interference, especially when controversial decisions need to be made. Likewise, an I agency that is underfunded or that cannot retain qualified staff members will not be able to maintain an effective supervisory program. 154 Chapter 5: Evaluating Financial Sector Supervision: Banking, Insurance, and Securities Markets · Consolidated supervision allows financial sector supervisors to better understand 1 the relationship among the different legal entities so they can assess the potential for adverse developments in one part of the group that may affect the operation of others. This assessment is done by monitoring and evaluating the additional risks 2 posed to regulated financial institutions by affiliated institutions. It is important to stress, however, that consolidated supervision is a complement to, not a substitute 3 for, single entity supervision. The supervisor responsible for consolidated supervi- sion will, inter alia, have to be cognizant of the effect of the policies of the various 4 supervisors of entities within the group. 5 Consolidation of accounts is a necessary prerequisite for obtaining meaningful finan- cial information on groups of corporations and for supervising banks on a consolidated basis. Taking into account the groupwide financial exposures and intragroup financial 6 relationships allows a better assessment of the implication of group membership for the financial condition of individual group members. 7 The consolidation of financial accounts, however, is not sufficient to capture many of the risks facing the bank through group membership. For example, consolidated financial 8 accounts do not provide qualitative information about the group, such as the quality of management or internal controls. Similarly, some group entities, for technical reasons, 9 may not be subject to consolidation in the financial accounts. A robust consolidated supervision program must thus incorporate both qualitative and quantitative analyses of 10 the group's risk profile. In many other jurisdictions, the concepts of consolidation and supervision on a con- 11 solidated basis are still not firmly established. The legal framework is still insufficiently developed; the concept of "group" and the question of how to deal with not only limited liability but also communalities of interest between corporations belonging to a group 12 still need to be clarified. Also, the distinction between consolidation of accounts and supervision on a consolidated basis need to be kept clearly in mind. Those two concepts A are clearly connected, but each poses different legal questions. Effective consolidated supervision requires close cooperation among domestic sectoral B supervisors. Similarly, the administrative and management arrangements within the various responsible authorities need to ensure the good coordination and the smooth C exchange of information among home or host regulators abroad. Those exchanges will often be conducted within the auspices of a memorandum of understanding (MOU). D However, the existence of an MOU will not in itself ensure that relevant information is provided. Much will depend on a relationship of trust being developed between the dif- E ferent regulators so information is exchanged proactively and in a timely manner. The importance of assessing wider risks from other group members to the regulated F entity is stressed in the core principles for banks, securities firms, and insurance com- panies, although there are differences in emphasis in the respective approaches. Gaps could expose a major bank or other financial institution within the group entity--and, G hence, expose the system at large--to unacceptable risks from unregulated group entities. Similarly, overlaps could mean a diversion of scarce regulatory resources, either impos- H ing unnecessary burdens on both regulated firms and taxpayers or, even more seriously, leading to an underfunding of regulatory effort in other areas of potentially high systemic I risk. 155 Financial Sector Assessment: A Handbook Annex 5.C IAIS Insurance Core Principles 1 2 The IAIS Insurance Core Principles comprise 28 principles that need to be in place for a regulatory and supervisory system to be effective (IAIS 2003a). The principles relate to 3 the following: · Conditions for effective insurance supervision help set out the elements of the 4 environment where supervision can be most effective. ­ ICP 1 Conditions for effective insurance supervision include broad require- 5 ments in financial policy and financial market infrastructure to support effec- tive supervision. 6 · The supervisory system deals with the mandates and responsibilities of the supervisor. 7 ­ ICP 2 Supervisory objectives seek clarity in law. ­ ICP 3 Supervisory authority seeks adequate powers, resources, and legal 8 protection. ­ ICP 4 Supervisory process seeks transparency and accountability. 9 ­ ICP 5 Supervisory cooperation and information sharing cover cooperation within the insurance sector and across the financial services sector, as well as nationally and internationally. 10 · The supervised entity deals with the form and governance of insurers. 11 ­ ICP 6 Licensing calls for requirements for licensing to be clear, objective, and public. 12 ­ ICP 7 Suitability of persons requires ongoing assessment of fitness and propriety of significant owners and key functionaries. A ­ ICP 8 Changes in control and portfolio transfers require supervisory approval of changes in significant ownership and control, in mergers, and in portfolio B transfer. ­ ICP 9 Corporate governance requires prudent management of an insurer's C business on the basis of standards that stress the role of board and senior management. ­ ICP 10 Internal control states the requirements for internal control systems, D including internal audit and reporting, as well as compliance functions. E · Ongoing supervision outlines the actual practice of the supervisor. ­ ICP 11 Market analysis requires macro­prudential surveillance of the sector. F ­ ICP 12 Reporting to supervisors and conducting off-site monitoring require comprehensive reporting that is done on a solo and a group basis, plus mainte- G nance of an ongoing monitoring framework. ­ ICP 13 Onsite inspection requires comprehensive inspection powers for both H the insurer and outsourced companies, plus clarified scope of inspections. ­ ICP 14 Preventive and corrective measures require an adequate, timely, and graduated spectrum of remedial measures. I 156 Chapter 5: Evaluating Financial Sector Supervision: Banking, Insurance, and Securities Markets ­ ICP 15 Enforcement or sanctions will require measures that are based on clear 1 objective criteria. ­ ICP 16 Winding-up and exit from the market will require criteria and proce- dures for insolvency and calls for priority with respect to policyholders. 2 ­ ICP 17 Groupwide supervision calls for consolidated--groupwide--supervision of the insurance group or conglomerate. 3 · Prudential requirements address the key financial and risk-management processes 4 that should be imposed on and in place within insurance companies. ­ ICP 18 Risk assessment and management state the requirements for risk- 5 management systems and their review by supervision. ­ ICP 19 Insurance activity requires strategic underwriting and pricing policies, 6 as well as limits on risk retained through reinsurance. ­ ICP 20 Liabilities specify supervisory requirements to assess adequacy of techni- 7 cal provisions held against the policy liabilities. ­ ICP 21 Investments require compliance with standards on investment policy, asset mix, valuation, risk management, and asset­liability management. 8 ­ ICP 22 Derivatives and similar commitments cover restrictions on their use and on requirements for disclosures. 9 ­ ICP 23 (capital adequacy and solvency) covers sufficiency of technical provi- sions to cover expected claims and expenses as well as sufficiency of capital to 10 cover significant unexpected losses. · Markets and consumers deal with distribution, customer protections, disclosure, 11 and fraud. 12 ­ ICP 24 Intermediaries cover licensing and business requirements for insurance intermediaries. A ­ ICP 25 Consumer protection covers requirements on the providing of informa- tion to consumers before and during a contract. ­ ICP 26 Information, disclosure, and transparency toward the market call for B adequate disclosure by insurance firms. ­ ICP 27 Fraud calls for measures to prevent, detect, and remedy insurance C fraud. D · Anti-money-laundering should aid in combating the financing of terrorism. ­ ICP 28 Anti-money laundering and combating the financing of terrorism [AML­CFT]) requires effective measures to deter, detect, and report AML­ E CFT offenses in line with FATF standards. F Each principle is elaborated through criteria. It is in the criteria that the full meaning of each principle is found in considerable detail. Although those criteria are not repro- G duced here, they need to be carefully reviewed if one is to gain a full understanding of the meaning and intention of each core principle. The IAIS emphasizes that the criteria are intended to be implemented both in form and in practice. The criteria consist of two H distinct groupings: I 157 Financial Sector Assessment: A Handbook · Essential criteria--those components that are intrinsic to the implementation of 1 the core principle (all of which should be met for a supervisory authority to dem- onstrate "observed" status for each principle) 2 · Advanced criteria--those components that are considered to improve on the essential criteria and thus enhance the supervisory regime (which are not used 3 for assessing observance with a principle but are used when commenting on a jurisdiction's supervisory framework and making recommendations) 4 5 Annex 5.D List of IOSCO Objectives and Principles of Securities Regulation 6 The three core objectives of securities regulation are (a) protecting investors; (b) ensuring 7 that markets are fair, efficient, and transparent; and (c) reducing systemic risk. 8 Principles Relating to the Regulator 9 1. The responsibilities of the regulator should be clear and objectively stated. 2. The regulator should be operationally independent and accountable in the exercise 10 of its functions and powers. 3. The regulator should have adequate powers, proper resources, and the capacity to perform its functions and exercise its powers. 11 4. The regulator should adopt clear and consistent regulatory processes. 5. The staff of the regulator should observe the highest professional standards, includ- 12 ing appropriate standards of confidentiality. A Principles for Self-Regulation B 6. The regulatory regime should make appropriate use of self-regulatory organizations C (SROs) that exercise some direct oversight responsibility for their respective areas of competence, to the extent appropriate to the size and complexity of the markets. D 7. SROs should be subject to the oversight of the regulator and should observe stan- dards of fairness and confidentiality when exercising powers and delegated respon- E sibilities. F Principles for the Enforcement of Securities Regulation G 8. The regulator should have comprehensive inspection, investigation, and surveil- H lance powers. 9. The regulator should have comprehensive enforcement powers. I 158 Chapter 5: Evaluating Financial Sector Supervision: Banking, Insurance, and Securities Markets 10. The regulatory system should ensure effective and credible use of inspection, 1 investigation, surveillance, and enforcement powers, as well as implementation of an effective compliance program. 2 Principles for Cooperation in Regulation 3 11.The regulator should have authority to share public and nonpublic information 4 with domestic and foreign counterparts. 12.Regulators should establish information sharing mechanisms that set out when and 5 how they will share both public and nonpublic information with their domestic and foreign counterparts. 6 13.The regulatory system should allow for assistance to be provided to foreign regula- tors who need to make inquiries in connection with the discharge of their func- tions and the exercise of their powers. 7 8 Principles for Issuers 9 14.There should be full, timely, and accurate disclosure of financial results and other information that is material to investors' decisions. 10 15.Holders of securities in a company should be treated in a fair and equitable manner. 11 16.Accounting and auditing standards should be of a high and internationally accept- able quality. 12 Principles for Collective Investment Schemes A 17.The regulatory system should set standards for the eligibility and the regulation of B those who wish to market or operate a collective investment scheme. 18.The regulatory system should provide rules for governing the legal form and struc- C ture of collective investment schemes, as well as the segregation and protection of client assets. D 19.Regulation should require disclosure, as set forth under the principles for issuers, which is necessary to evaluate the suitability of a collective investment scheme for a particular investor and the value of the investor's interest in the scheme. E 20.Regulation should ensure that there is a proper and disclosed basis for asset valua- tion, as well as for the pricing and the redemption of units in a collective invest- F ment scheme. G Principles for Market Intermediaries H 21.Regulation should provide for minimum entry standards for market intermediaries. I 159 Financial Sector Assessment: A Handbook 22.There should be requirements concerning initial and ongoing capital and other 1 prudential requirements for market intermediaries; the requirements should reflect the risks that the intermediaries undertake. 2 23.Market intermediaries should be required to comply with standards for internal organization and operational conduct that are designed to protect the interests of 3 clients and to ensure proper management of risk; under such standards, manage- ment of the intermediary should accept primary responsibility for those matters. 4 24.Procedures for dealing with the failure of a market intermediary should minimize damage and loss to investors and should contain ways to handle systemic risk. 5 6 Principles for the Secondary Market 25.The establishment of trading systems, including securities exchanges, should be 7 subject to regulatory authorization and oversight. 26.Ongoing regulatory supervision of exchanges and trading systems should strive 8 to ensure that the integrity of trading is maintained through fair and equitable rules that strike an appropriate balance amid the demands of different market 9 participants. 27.Regulation should promote transparency of trading. 10 28.Regulation should be designed to detect and deter manipulation and other unfair trading practices. 11 29.Regulation should strive to ensure the proper management of large exposures, default risk, and market disruption. 30.Systems for clearance and settlement of securities transactions should be subject to 12 regulatory oversight and should be designed to ensure not only that they are fair, effective, and efficient but also that they reduce systemic risk. A B Annex 5.E IOSCO Methodology--Scope and Use of Principle 8 C The IOSCO methodology document (IOSCO 2003a) introduces the group of principles relating to enforcement (Principles 8 through 10) with a preamble that defines the term D enforcement and explains each of the core principles in this group. The methodology calls for a broad interpretation of enforcement, covering wide-ranging powers of surveillance, E inspection, and investigation. It then explains each of the principles under this group. In particular, it states that Principle 8 deals with preventive measures and with the methods F for obtaining information by the regulator. It then clarifies that the scope of those prin- ciples encompasses all agencies involved in enforcement and is not limited only to the G primary regulator. Key issues relating to Principle 8 are then listed, which spell out in greater detail spe- H cific powers of the regulator that would be needed--including (a) power to require regular reporting or to seek information through inspections of a market participant's business operations and (b) types of documents and records to which access should be required. I This list is followed by key questions, which are listed below. 160 Chapter 5: Evaluating Financial Sector Supervision: Banking, Insurance, and Securities Markets Principle 8 1 Principle 8: The regulator should have comprehensive inspection, investigation, and surveillance powers. 2 Key Questions 3 1. Can the regulator inspect a regulated entity's business operations, including its 4 books and records, without giving prior notice? 2. Can the regulator obtain books and records and request data or information from 5 regulated entities without judicial action, even in the absence of suspected miscon- duct, 6 a. In response to a particular inquiry? b. On a routine basis? 3. Does the regulator have the power to supervise its authorized exchanges and regu- 7 lated trading systems through surveillance? 4. Does the regulator have record-keeping and record-retention requirements for 8 regulated entities? 5. Are regulated entities required 9 a. To maintain records concerning client identity? b. To maintain records that permit tracing of funds and securities in and out of 10 brokerage and bank accounts related to securities transactions? c. To put in place measures to minimize potential money laundering? 11 6. Does the regulator have the authority to determine or have access to the identity of all customers of regulated entities? 12 7. Where a regulator outsources inspection or other regulatory enforcement authority to an SRO or a third party? a. Does the regulator supervise the outsourced functions of third parties? A b. Does the regulator have full access to information maintained or obtained by the third parties? B c. Can the regulator cause changes or improvements to be made in the third par- ties' processes? C d. Are the third parties subject to disclosure and confidentiality requirements that are no less stringent than those applicable to the regulator? D Benchmarking Rubric for Principle 8 E · Fully Implemented--Requires affirmative responses to all applicable questions F · Broadly Implemented--Requires affirmative responses to all applicable questions, except to Question 7(c) G · Partly Implemented--Requires affirmative responses to all applicable questions, except to Questions 7(c) and 7(d) or, where the regulator must cooperate with H other authorities to obtain records of regulated entities, such cooperation is not sufficiently timely I 161 Financial Sector Assessment: A Handbook · Not Implemented--Inability to respond affirmatively to one or more of Questions 1, 1 2(a), 2(b), 3, 4, 5(a), 5(b), 5(c), 6, 7(a), or 7(b) 2 The questions stated earlier serve as a set of criteria by which implementation is graded. For example in the case of New Zealand, the securities commission had affirma- 3 tive responses to all the questions except 7c; the securities commission cannot require a registered securities exchange--which performs significant inquiry and enforcement functions--to improve its processes or conduct rules. Therefore, a grading of "broadly 4 implemented" was assigned. In another country (an emerging market), although the regulator had comprehensive surveillance and investigative powers and had determined 5 affirmative answers to all questions, the scope of existing regulations relating to Question 4 was assessed as requiring some further improvements. The assessors recommended the 6 preparation of an explicit and comprehensive record-keeping standard for the regulated firms (including information on investment objectives, audit trails, etc.) to facilitate the 7 inspection of the firm's operations. A "broadly implemented" grading was assigned. 8 Annex 5.F Enforcement and the Exchange of Information 9 Securities regulators have a range of enforcement powers. According to the IOSCO core principles and the methodology, securities regulators must, in addition to their inspection 10 and surveillance powers, be able to conduct investigations of possible violations of the securities laws. To conduct those investigations, a securities regulator needs to be able to 11 "monitor the entities subject to its supervision, to collect information on a routine and ad hoc basis, and to take enforcement action to ensure that persons and entities comply with 12 relevant securities laws" (IOSCO 2003a, 37). The methodology makes very clear that the principles envision a broad definition of enforcement in which regulators will be able A to demonstrate effective and credible use of their enforcement powers, including taking effective actions to investigate and address misconduct or abuses. "An effective program, B for example, could combine various means to identify, detect, deter, and sanction such misconduct. A wide range of possible sanctions could meet the standards according to C the nature of the legal system assessed. The regulator, however, should be able to provide documentation that demonstrates that sanctions available (whatever their nature) are effective, proportionate, and dissuasive" (IOSCO 2003a, 37). In many countries, the D criminal prosecutor is responsible for prosecuting securities violations, and the regulator will turn over its investigative file to the prosecutor for follow-up. In those situations, E effective securities enforcement can be a challenge, particularly if the prosecutor has other priorities. F To implement those principles, a regulator needs to be able to obtain information from the organizations that it regulates, both on a routine and for-a-cause basis, when it G believes that a breach may have occurred. The regulator needs also to be able to obtain both bank and brokerage records, even when banks may be subject to the supervision H of a different government agency. Those records must include information relating to client identity so the regulator can conduct its investigation. In addition, the regulator I must be able to require the production of information from third parties. If the regulator does not have such powers itself, it needs to be able to cooperate effectively with other 162 Chapter 5: Evaluating Financial Sector Supervision: Banking, Insurance, and Securities Markets government regulators and to be able to obtain this information through the competent 1 authority. The powers must be used effectively and credibly for an effective enforcement program to exist. However, as the principles make clear, because securities transactions are often global 2 in nature and can cross many geographic borders both easily and quickly and because pro- ceeds of securities transactions similarly can be transferred elsewhere, securities enforce- 3 ment is no longer a purely domestic matter. Rather, securities regulators have to cooperate with their foreign counterparts to conduct an effective domestic enforcement program. 4 As the methodology states, "[E]ffective regulation can be compromised when necessary information is located in another jurisdiction and is not available or accessible" (IOSCO 5 2003a, 50). Exchange of information for securities enforcement purposes is also unlike that which 6 occurs for the purposes of banking supervision. Bank supervisors, of course, also operate in a global environment where the banks they supervise may have branches or subsidiar- 7 ies in another country or, indeed, may be the branches or subsidiaries of banks that are themselves headquartered elsewhere. To ensure effective consolidated supervision, bank 8 supervisors must cooperate with their foreign counterparts and must obtain information about the activities of banks in other countries that have a bearing on the operation of 9 banks under their supervision. Information on safety and soundness is critical. Securities regulators cooperate in a similar fashion for regulatory oversight purposes and maintain similar cooperative regulatory relationships with their foreign counterparts. However, for 10 purposes of enforcement, the type of cooperation and information exchange that takes place is of a different order. 11 First, for enforcement purposes, securities regulators often need detailed, client-spe- cific information. A securities regulator may need to know what the name of an account 12 holder is, how much money was in the account during a specified time period, where the funds came from, and where they were transferred to if they are no longer in the account. A If the client withdrew the funds or securities from the account, the regulator will want to know when and how they were withdrawn and who signed on behalf of the client. B Moreover, because of the speed with which evidence can disappear, the regulator may need to know this information overnight. Unlike most bank supervisors, the securities C regulator may need this information to conduct a civil or criminal investigation or to support its request for an emergency court order to freeze funds or securities. In addition, D unlike bank supervision, the regulator who is receiving the information request may or may not supervise any of the entities in question (neither the account holder nor the entity where the account is located). The target regulator may, in fact, have no interest E in the matter whatsoever. Thus, although traditional safety and soundness concerns are important to both bank supervisors and securities regulators, information exchange for F securities regulation extends well beyond those concerns. It can be challenging for assessors to attain a comprehensive and realistic understand- G ing of the effectiveness of a regulator's securities enforcement program because there are few concrete standards of measurement and there is a great diversity in approaches. H Bringing a large number of enforcement actions does not necessarily mean that enforce- ment is effective. Assessors should consider the full range of enforcement powers that I the regulator possesses and how it uses those powers to pursue enforcement actions. The 163 Financial Sector Assessment: A Handbook assessor should evaluate how the regulator obtains information, from whom it gets infor- 1 mation, and what kind of information it can obtain. The assessor must then consider how the regulator then uses this information to build an enforcement case. Can and does the 2 regulator bring enforcement actions that are based on the investigation it has conducted? If not, does the regulator turn this information over to another domestic authority who 3 can bring an enforcement case? Does that authority bring the case? The assessor also must consider whether there are barriers to domestic information exchange and whether 4 there are gateways for information exchange with foreign counterparts. In particular, the assessor must consider whether there are blocking, bank-secrecy, or other types of privacy 5 laws that could interfere with information exchange. The assessor must determine (a) whether the securities regulator can and does obtain information, including client identi- 6 fying information, on behalf of a foreign counterpart even if it has no underlying interest in the matter; (b) on what conditions, if any, this information is obtained; and (c) how 7 long it will take. 8 Notes 9 1. Typical LOLR instruments are a discount window, or a standing facility, often linked to a payment system. 10 2. The IMF­Monetary and Financial System Department (MFD), Operational Paper OP/00/01, Emergency Liquidity Support Facilities, provides a detailed discussion of the 11 various elements of LOLR activities. 3. The details of this type of "incentive-compatible" system are discussed in Garcia 12 (1999, 2000, 2001) and in Beck (2003). The adverse impact of deposit insurance on bank soundness is analyzed in Barth, Caprio, and Ross (2004) and in Demirguc-Kunt A and Detragiache (2003). Also note that poorly designed deposit insurance could have a negative impact on financial development, as noted in Cull, Senbet, and Sorge B (2001). 4. Nearly two-thirds of the schemes established since 2000 cover deposits in foreign cur- C rency. 5. Pros and cons of, as well as country experiences with, blanket guarantees are discussed D in IMF Occasional Paper 223, "Managing Systemic Banking Crises" (Hoelscher and Quintyn 2003). E 6. For further details on protection funds for insurance companies, see Takahiro (2001). 7. See Sundararajan, Marston, and Basu (2001) for a discussion of empirical evidence on F the links between stability and observance of the BCP. For a comprehensive analysis of links between bank regulation and banking performance, see Barth, Caprio, and G Levine (2005). 8. See IMF and World Bank (2002b). For a more recent update, see IMF (2004a) on H issues and gaps in financial sector regulation. 9. See chapter 9 for a discussion. Sequencing and prioritization of reform programs may I require technical assistance in some country circumstances. 10.This section is based on Basel Committee on Banking Supervision (1999). 164 Chapter 5: Evaluating Financial Sector Supervision: Banking, Insurance, and Securities Markets 11.For more detailed guidance on how to perform a self-assessment, see the Basel 1 Committee document (http://www.bis.org/publ/bcbs81.htm) Conducting a Supervisory Self-Assessment--Practical Application (Basel 2001). 12.For each core principle, the assessment methodology requires a categorization of prac- 2 tices according to the degree of compliance. Four categories are envisaged: "compli- ant," "largely compliant," "materially noncompliant," and "noncompliant." Whether 3 or not efforts to achieve full compliance are under way is also noted. 13.In countries with significant cross-border financial services, it is important to meet 4 with supervisory authorities of home countries of major financial institutions to dis- cuss supervisory cooperation, information sharing, and related issues in consolidated 5 supervision. 14.This section is based on IMF and World Bank (2002a) and the IMF (2004a) paper 6 "Financial Sector Regulation--Issues and Gaps." 15.See also World Bank (2001). 7 16.This section is based on Miles (2002). 17.Another term for an LCFI is financial conglomerate (a formal definition of which is 8 being adopted in EU legislation) or, in the United States, Large Complex Banking Organizations (LCBOs). 9 18.For example, for EU member states, a host regulator of a branch of a bank incorporated in another member state has very limited supervisory powers. However, the branch may be a very large player, in both the domestic banking system and capital markets, 10 as well as in international financial market activity conducted from the host country. 19.Technical risk is the risk of a shortfall of an insurance company's technical provisions 11 held against its policy liabilities. The assessment of provisions will take into account the size and timing of expected payments on the policy, future premium receipts, and 12 future investment income. 20.This section is based on Sundararajan and Errico (2002). A 21.The earlier version that was adopted in October 2000 consisted of only 17 principles. B 22.In the insurance context, portfolio transfers can be particularly relevant because they enable the transfer of obligations through means other than the change of control of C the insurer, in effect, changing the control over the policyholder interests without sale of shares in the company. Thus, it is important that the supervisory assessment of D change of control also be extended to the processes for portfolio transfer. 23.A quantitative analysis of the market could include, for example, the development in financial markets generally; the number of insurers and reinsurers subdivided by E ownership structure, whether a branch, domestic, or foreign; the number of insurers and reinsurers entering and exiting the market; the market indicators such as premi- F ums, balance­sheet totals, and profitability; the investment structure; the new product developments and market share; the distribution channels; and the use of reinsurance G (IAIS 2003a, 23). 24.See Essential Criteria C--the last of 7 bullets (IAIS 2003a). H 25.For example, see IAIS 2002 on capital adequacy. Also, in the EU, the solvency II project is working toward the development of a harmonized, risk-based, three-pillar I approach (similar to Basel II) for use throughout the EU. This effort is part of a broader 165 Financial Sector Assessment: A Handbook initiative of supervisory and multijurisdictional organizations to strengthen capital 1 adequacy and solvency frameworks. For example, the IAIS and the International Actuarial Association are working on a global framework for insurers' insolvency 2 assessment. 26.The IAIS approved the following supervisory guidelines or issues papers in October 3 2003: "Quantifying and Assessing Insurance Liabilities" (IAIS 2003d), "Stress Testing by Insurers" (IAIS 2003c), "Nonlife Insurance Securitization" (IAIS 2003e), and 4 "Solvency Control Levels" (IAIS 2003b). A guidance paper on investment risk man- agement was issued in October 2004 (IAIS 2004a). The IAIS also prepared "Principles 5 on the Supervision of Insurance Activities on the Internet" (IAIS 2004b), and "Standard on Disclosures Concerning Technical Performance and Risks of Nonlife 6 Insurers and Reinsurers"(IAIS 2004c) was issued in October 2004. 27.The essential and advanced criteria for assessment purposes are integrated with the 7 ICPs into one single document (Takahiro 2003), with the procedural and benchmark- ing aspects of the assessment process presented in annex 2 of the same document. 8 28.For a discussion of issues in analyzing soundness and structure of insurance sector, including suggestions on indicators to analyze, see Das, Davies, and Podpiera (2003). 9 29.See paragraph 1.7. of the explanatory note to ICP 1 (Takahiro 2003). 30.This section is based mainly on a survey conducted in 2002 of assessment experiences 10 of 42 jurisdictions, which were assessed using the ICPs adopted in October 2000. See International Monetary Fund and World Bank (2001), "Experience with Insurance 11 Core Principles--Assessment under the Financial Sector Assessment Program." For an update of information on insurance assessment, see IMF (2004a), "Financial Sector Regulation--Issues and Gaps--Background Paper." 12 31.For a detailed principle-by-principle listing of typical issues that arise to reach full compliance, see the IMF background paper (IMF 2004a) "Financial Sector A Regulation--Issues and Gaps--Background Paper." 32.Insurance company counterparts do not, because of the nature of the product, have B the opportunity to diversify credit risk and may often be in situations of hardship in the absence of the insurance claim proceeds in any event. C 33.IOSCO was established in 1983 to bring together securities regulators from around the world in an effort to ensure better regulation of securities markets. It was created from D its predecessor organization, the Inter-American Regional Association of Securities Regulations that was established in 1974. IOSCO has grown considerably since its E inception and currently has more than 180 members. The core principles are presented in IOSCO public document 125 "Objectives and Principles of Securities Regulation," F originally issued in September 1998 and last updated in May 2003 (IOSCO 2003b). 34.The assessment of Principle 30 is intended to be supplemented by reference to the G IOSCO­CPSS Recommendations for Securities Settlement Systems and the associ- ated assessment methodology. H 35.See, for example, Schinasi (2003) and Dalla (2003). 36.See chapter 4 for a discussion of the scope of analysis of securities markets and their I structure and functioning as part of the development assessment. See also chapter 2 for a discussion of indicators of structure and performance of securities markets. 166 Chapter 5: Evaluating Financial Sector Supervision: Banking, Insurance, and Securities Markets 37.For a detailed principle-by-principle listing of typical issues that arise to reach full 1 compliance, see IMF (2004a). 38.See, IOSCO (2001) and Carson (2003) for a discussion. 2 39.This subject of integrated supervision is discussed in greater detail in appendix F of this Handbook. See also De Luna Martinez and Rose (2003). 40.The IMF Code of Good Practices on Transparency of Monetary and Financial Policies 3 (IMF 2000) should serve in this context as an important vehicle in promoting good regulatory governance. 4 41.Even then, however, it would be impermissible for the authority responsible for the official administration or liquidation of the bank to divulge legally protected informa- 5 tion relating to the affairs of particular clients. And in the context of bank restructur- ing, the need to protect the bank's commercial interests could preclude the publication 6 of detailed transactional or operational information. 42.In jurisdictions where bank insolvency proceedings are court-based, the insol- 7 vency courts should have exclusive jurisdiction to determine all relevant disputes. Accordingly, the actions of the supervisory authority relating to its participation 8 in the insolvency proceedings--including its decision to commence such proceed- ings--should not be subject to judicial review by the administrative courts. Allowing 9 parties to challenge the authority's actions by way of judicial review would be unnec- essary because the authority cannot make fully determined decisions on the issues 10 but, instead, needs the approval of the insolvency court. Moreover, the possibility of parallel proceedings in insolvency and administrative law could produce conflicts and 11 serious disruption of the insolvency process. 43.Coordination with the Ministry of Finance is also key, especially in those cases that 12 may involve the actual or potential use of public funds. A References B Barth, James R., Gerard Caprio, and Ross Levine. 2004. Rethinking Bank Regulation and Supervision: Till Angels Govern. Cambridge: Cambridge University Press. C Basel Committee on Banking Supervision. 2004. "International Convergence of Capital Measurement and Capital Standards--A Revised Framework." June, Bank for D International Settlements, Basel, Switzerland. ------. 2001. "Conducting Supervisory Self-Assessment, Practical Application. Bank for E International Settlements, Basel, Switzerland. ------. 1999. Core Principles Methodology. Basel, Switzerland: Basel Committee on F Banking Supervision. Available at http://www.bis.org/publ/bcbs61.pdf. Beck, Thorsten. 2003. "The Incentive Compatible Design of Deposit Insurance and Bank G Failure Resolution­­Concepts and Country Studies." World Bank Policy Research Working Paper 3043, World Bank, Washington, DC. H Carson, John W. 2003. "Conflicts of Interest in Self-Regulation: Can Demutualized Exchanges Successfully Manage Them?" Policy Research Working Paper 3183, World I Bank, Washington, DC. 167 Financial Sector Assessment: A Handbook Cull, Robert, W. Senbet Lemma, and Sorge Marco. 2001. "Deposit Insurance and 1 Financial Development." World Bank Policy Research Paper 2682, World Bank, Washington, DC. 2 Dalla, Ismail. 2003. "Harmonization of Bond Market Rules and Regulations in Selected APEC Economies." Manila, Philippines: Asian Development Bank. 3 Das Udaibir, Nigel Davies, and Richard Podpiera. 2003. "Insurance and Issues in Financial Soundness." IMF Working Paper 03/138, International Monetary Fund, Washington, 4 DC. de Luna Martinez, Jose, and Thomas A. Rose. 2003. "International Survey of Integrated 5 Financial Sector Supervision." Policy Research Working Paper 3096, World Bank, Washington, DC. 6 Demirguc-Kunt, A., and Enrica Detragiache. 2002. "Does Deposit Insurance Increase Banking System Stability?" Journal of Monetary Economics 49 (7): 1373­406. 7 Dong, He. 2000. "Emergency Liquidity Support Facilities." IMF Working Paper 00/79, International Monetary Fund, Washington, DC. 8 Garcia, Gillian G. H. 1999. "Deposit Insurance: A Survey of Actual and Best Practices." Working Paper WP/99/54, International Monetary Fund, Washington, DC. Available 9 at http://www.imf.org/external/pubs/ft/wp/1999/wp9954.pdf. ------. 2000. "Deposit Insurance and Crisis Management." Working Paper WP/00/57, 10 International Monetary Fund, Washington, DC. Available at http://www.imf.org/ external/pubs/ft/wp/2000/wp0057.pdf. 11 ------. 2001. "Deposit Insurance: Actual and Good Practices." Occasional Paper 197,,International Monetary Fund, Washington, DC. Available at http://www.imf. org/external/pubs/nft/op/197/index.htm. 12 Hoelscher, David S., and Marc Quintyn. 2003. "Managing Systemic Banking Crises." Occasional Paper 224, International Monetary Fund, Washington, DC. A International Association of Insurance Supervisors (IAIS). 2000. Insurance Core Principles. Basel ,Switzerland: IAIS B ------. 2002. Principles on Capital Adequacy and Solvency. Basel, Switzerland: IAIS. ------. 2003a. Insurance Core Principles and Methodology. Basel, Switzerland: IAIS. C ------. 2003b. "Solvency Control Levels." Guidance Paper 6, IAIS, Basel, Switzerland. ------. 2003c. "Stress Testing by Insurers." Guidance Paper 8, IAIS, Basel, Switzerland. D ------. 2003d. "Quantifying and Assessing Insurance Liabilities." Discussion Paper, IAIS, Basel, Switzerland. E ------. 2003e. "Nonlife Insurance Securitization." Issues Paper, IAIS, Basel, Switzerland. F ------. 2004a. "Investment Risk Management." Guidance Paper 9, IAIS, Basel, Switzerland. G ------. 2004b. "Principles on the Supervision of Insurance Activities on the Internet." Principle No. 4, IAIS, Basel, Switzerland. H ------. 2004c. "Standard on Disclosures Concerning Technical Performance and Risks of Nonlife Insurers and Reinsurers." Standard No. 9, IAIS, Basel, Switzerland. I International Monetary Fund (IMF). 2000. IMF Code of Good Practices on Transparency in Monetary and Financial Policies. Washington, DC: IMF. 168 Chapter 5: Evaluating Financial Sector Supervision: Banking, Insurance, and Securities Markets ------. 02002. "The Financial Market Activities of Insurance and Reinsurance 1 Companies." In Global Financial Stability Report, ed. International Capital Market Department of the IMF, 30­47. Washington, DC: International Monetary Fund. 2 ------. 2004a. "Financial Sector Regulations--Issues and Gaps--Background Paper." International Monetary Fund, Washington, DC. Available at www.imf.org/external/ np/mfd/2004/eng/081704.htm. 3 ------. 2004b. "Risk Transfer and the Insurance Industry." In Global Financial Stability Report, ed. International Capital Markets Department of the IMF, 77­110. 4 Washington, DC: International Monetary Fund. International Monetary Fund (IMF) and World Bank. 2001. "Experience with the 5 Insurance Core Principles Assessments under the Financial Sector Assessment Program." IMF, Washington, DC. 6 ------. 2002a. "Experience with the Assessments of the IOSCO Objectives and Principles of Securities Regulation under the Financial Sector Assessment Program." 7 International Monetary Fund, Washington, DC. ------. 2002b. "Implementation of the Basel Core Principles for Effective Banking 8 Supervision: Experiences, Influences, and Perspectives." International Monetary Fund, Washington,DC.Availableathttp://www.imf.org/external/np/mae/bcore/2002/092302. 9 pdf. ------. 2004. Global Bank Insolvency Initiative. Draft report by IMF and World Bank staff, 10 World Bank, Washington, DC. International Organization of Securities Commissions (IOSCO). 2001. "Issues Paper on 11 Exchange Demutualization." Technical Committee, IOSCO, Madrid, Spain. ------. 2003a. Methodology for Assessing Implementation of the IOSCO Objectives and 12 Principles of Securities Regulation. Madrid, Spain: IOSCO. ------. 2003b. Objectives and Principles of Securities Regulation. Madrid, Spain: IOSCO. A Available at http://www.iosco.org/pubdocs/pdf/IOSCOPD154.pdf. Lindgren, Carl-Johan, Tomás J. T. Baliño, Charles Enoch, Anne-Marie Gulde, Marc Quintyn, and Leslie Teo. 2000. "Financial Sector Crisis and Restructuring: Lessons B from Asia." Occasional Paper 188, International Monetary Fund, Washington, DC. Available at http://www.imf.org/external/pubs/ft/op/opfinsec/op188.pdf. C Miles, Colin. 2002. "Large and Complex Financial Institutions (LCFIs): Issues to Be Considered in the Financial Sector Assessment Program." MAE Operational Paper D 02/3, Monetary and Exchange Affairs Department, International Monetary Fund, Washington, DC. E Schinasi, Gary J. 2003. "The Development of Effective Securities Markets." Paper pre- sented November 2003 at the First Annual Asian Bond Forum, Hong Kong. F Sundararajan, Venkataraman, and Luca Erric. 2002. "Islamic Financial Institutions and Products in the Global Financial System: Key Issues in Risk Management and G Challenges Ahead." IMF Working Paper WP/02/192, International Monetary Fund, Washington, DC. Available at http://www.imf.org/external/pubs/ft/wp/2002/wp02192. H pdf. Sundararajan, Venkataraman, David Marston, and Ritu Basu. 2001. "Financial System I Standards and Financial Stability: The Case of the Basel Core Principles." IMF 169 Financial Sector Assessment: A Handbook Working Paper WP/01/62, International Monetary Fund, Washington, DC. Available 1 at http://www.imf.org/external/pubs/ft/wp/2001/wp0162.pdf. Takahiro, Yasui. 2001. "Policyholder Protection Funds: Rationale and Structure." In 2 Insurance and Private Pensions Compendium for Emerging Economies, Book 1, ed. Insurance and Private Pensions Unit; Financial Affairs Division; Directorate for 3 Financial, Fiscal, and Enterprise Affairs, Part 1:2, 1­20. Paris: Organisation for Economic Co-operation and Development (OECD). 4 Taylor, Michael, and Alex Fleming. 1999. "Integrated Financial Supervision: Lessons of Northern European Experience." Policy Research Working Paper 2223, World Bank, 5 Washington, DC. World Bank. 2001. "Principles and Guidelines for Effective Insolvency and Creditor 6 Rights Systems." World Bank, Washington, DC. Available at http://www.worldbank. org/ifa/ipg_eng.pdf. 7 8 9 10 11 12 A B C D E F G H I 170 1 2 3 4 Chapter 6 5 Assessing the Supervision of 6 Other Financial Intermediaries 7 8 9 10 6.1 Overview 11 This chapter focuses on issues in the regulation of a range of non-bank financial institu- tions (NBFIs), categorized as Other Financial Intermediaries (OFIs). OFIs refer to those 12 financial corporations that are primarily engaged in financial intermediation--that is, corporations that channel funds from lenders to borrowers through their own account or A in auxiliary financial activities that are closely related to financial intermediation--but are not classified as deposit takers (IMF 2004a).1 OFIs include insurance corporations; B pension funds; securities dealers; investment funds; finance, leasing, and factoring com- panies; and asset management companies. This chapter discusses considerations in assess- C ing the regulation and supervision of OFIs (other than insurance companies and security market intermediaries) generally, with a focus on specialized finance institutions, leasing D and factoring companies, and pension funds. Although OFIs are often dwarfed by commercial banks in terms of volume of business E and size of assets, OFIs should receive adequate attention during the assessment process for various reasons. OFIs play an important developmental role through their activity in F areas and markets where the presence of commercial banks is not fully felt. Moreover, the development of OFIs could increase bank competition, which could lead to greater access G to finance. In many countries, pension funds are major contractual savings institutions with a significant effect on financial markets and the macroeconomy. H Specialized financial institutions (such as thrifts, building societies, and mortgage institutions) have emerged in many countries to carry out real estate finance. However, in I many countries, other than their specialization in housing finance, those institutions are 171 Financial Sector Assessment: A Handbook indistinguishable from deposit-taking institutions such as banks, and they require atten- 1 tion from both the stability and the development perspectives. Leasing companies engage in relatively simple transactions where the lessee (a busi- 2 ness owner) uses the asset (owned by the leasing company) for a fixed period of time, while making payments on a set schedule. At the end of the lease, the lessee buys the asset 3 for a nominal fee, giving the lessee the opportunity to make a capital investment. Leasing companies can serve as a significant source of finance for small firms wanting to invest 4 in equipment, and that investment in leasing companies can yield attractive returns if conditions are right. 5 Factoring companies are financial institutions that specialize in the business of accounts receivable management. Factoring is an important source of external financing 6 for corporations and small and medium enterprises (SMEs), which receive credit based on the value of their accounts receivables. Under this form of asset-based finance, the credit 7 provided by a lender is explicitly linked on a formula basis to the value of a borrower's underlying assets (working capital), not to the borrower's overall creditworthiness. In 8 developing countries, factoring offers several advantages over other types of lending. First, factoring may be particularly useful in countries with weak secured-lending laws, inef- 9 ficient bankruptcy systems, and imperfect records of upholding seniority claims, because factored receivables are not part of the estate of a bankrupt SME. Second, in a factoring 10 relationship the credit is primarily based on quality of the underlying accounts, not on the quality of the borrower. Thus, factoring may be especially attractive to high-risk SMEs 11 (Bakker, Klapper, and Udell 2004). The development of OFIs such as leasing and factoring companies (especially if they were operated by groups that were independent of large banks and insurance companies) 12 increases lending to smaller borrowers. Some practitioners argue that stand-alone OFIs tend to compete more vigorously. For that reason, the International Finance Corporation A prefers to finance stand-alone leasing companies despite their disadvantage when compet- ing with leasing subsidiaries of commercial banks, which can tap into low-cost depositors' B funding from their parent companies) (International Finance Corporation 1996). While the small size of the OFI sector in some countries may limit OFI's systemic C effect on the rest of the financial sector in case of crisis, stress in OFIs could have systemic effects in specific circumstances. In particular, difficulties in OFIs may have some systemic D effect, insofar as they trigger a loss of confidence in deposit-taking activities. For instance, a crisis of confidence can spread from one subsector of the financial system to another E subsector, owing to perceived ownership or balance-sheet linkages. Moreover, the lack of effective regulations for OFIs can exacerbate the fragility of the overall financial system F through regulatory arbitrage (Herring and Santomero 1999). In many countries, pension funds are a major source of contractual savings, providing G a stable source of long-term investment to support growth and at the same time playing a key role in financial markets through their investment behavior. National pension sys- H tems provide retirement income from a mixture of government, employment, and indi- vidual savings. Pension funds affect the stability of financial markets and the distribution I of risks among different sectors of the economy by their investment behavior and the way they manage their risk. 172 Chapter 6: Assessing the Supervision of Other Financial Intermediaries 6.2 Objectives of the Legal and Regulatory Framework for OFIs2 1 Against this background, the assessment of the regulation and supervision of OFIs should 2 not only account for their effectiveness in meeting the traditional objectives of financial supervision, but should also consider whether the regulatory framework helps build a 3 sound environment that fosters the development of those institutions. For instance, an inadequate regulatory framework that promotes regulatory arbitrage in the OFI sector 4 could restrict the potential developmental role of OFIs and at the same time could lead to the buildup of substantial undetected vulnerabilities and risks. 5 While both competition regulation and conduct of business (including market integri- ty) regulation apply to all sectors and institutions in the financial system, assessing which 6 type of OFIs warrants prudential regulation is, in practice, a difficult exercise. Three char- acteristics of financial institutions are critical in judging the scope of prudential regula- 7 tion: (a) the difficulty of honoring the contractual obligations, (b) the difficulty faced by the consumer in assessing the creditworthiness or soundness of the institution, and (c) the 8 adversity caused by a breach of contractual obligations (see Carmichael and Pomerleano 2002). For instance, banks are subject to systemic liquidity risks that may lead to the 9 breach of obligations, financial conglomerates have complex structures whose soundness and creditworthiness are difficult to assess, and the failure of a large bank or insurance 10 company is likely to generate great adversity. Each group of institutions could be ranked using those characteristics to judge the desirability and scope of prudential oversight. An appropriate regulatory environment is required to foster the development of OFIs 11 as recognized legal entities that are well integrated with the rest of the financial system. In many emerging economies, the legal and regulatory framework for finance, leasing, 12 and other specialized financial institutions is ambiguous, fragmented, and incomplete. Assembling and analyzing the laws and regulations governing the operations of each A group of institutions to ensure clarity and completeness is an important step in the assess- ment of OFIs. While repressive regulation can retard the growth of OFIs, an inappropriate B and poorly designed regulatory structure can create incentives for regulatory arbitrage. However, even when high-quality legislation exists, enforcement is sometimes poor. C Those factors are all impediments to the development of the financial system in general, but the impediments become more pronounced in the case of OFIs that, in many emerg- D ing economies, are often not supported by a clear legal framework. Legislation should permit effective enforcement. The legal framework for financial E system supervision could be somewhat prescriptive, spelling out specific prudential rules within the scope of the governing law, or could be general, thereby providing guidelines F and principles while conferring broad regulatory powers on the regulator. The guidelines approach could provide more discretion and flexibility to the regulator, which may be G particularly important for OFIs, because separate laws governing specific types of OFIs and markets often overlap, which gives rise to conflicts and ambiguity regarding the H applicable rules. If, however, the regulator's lack of operational independence hampers the effective use of discretion, a more-prescriptive law, if well designed, could provide a I workable alternative. 173 Financial Sector Assessment: A Handbook 6.3 Assessing Institutional Structure and Regulatory Arbitrage 1 2 The appropriateness of the institutional structure for supervising OFIs should consider the overall institutional framework for financial supervision and the scope of the OFIs' 3 activities within that framework. The number and size of OFIs (individual and aggregate), as well as their links to banks and other players in the financial system, are major fac- tors influencing the appropriate institutional structure for supervising OFIs. The stage of 4 financial development, the legislative environment generally, and the range of regulators' skills available would also affect the appropriate institutional structure for supervising 5 OFIs. An institutional structure that is sectorally focused rather than focused on the nature 6 of functions to be regulated may result in gaps in the regulation of OFIs. In some country circumstances, therefore, bringing the regulation and supervision of all types of financial 7 institutions, including OFIs, under a unified supervisory framework would help reduce the possibilities of regulatory arbitrage and regulatory gaps and allow for more-efficient 8 oversight. A unified structure facilitates the adoption of a common set of standards for institutions with the same profile of risk--for instance, uniform application of conduct 9 of business and financial integrity regulations, and adjustments in the scope of prudential regulations according to risk profile. However, under a structure with more than one 10 regulatory body involved in institutional regulation and supervision, special attention should be given to the definition of the legal power of responsible bodies, the identifica- 11 tion of conflicting areas of jurisdiction, and the extent of regulatory duplication. This sectorally focused structure is a source of inconsistencies and ambiguities that have cre- ated weaknesses in the regulatory and supervisory process in many countries. For instance, 12 this structure's inability to undertake "fit-and-proper" tests and impose minimum capital requirements or other specific guidelines creates loose regulatory and supervisory regimes A that allow OFIs to develop their business recklessly and get involved in banking activi- ties. B In countries with separate, sectorally focused regulators, the assessment should focus on verifying the differences in the types of risk posed by various categories of service C providers, since the application of different rules to products and services that are func- tionally equivalent can give rise to increased incentives for regulatory arbitrage (OECD D 2002). For instance, institutions assuming the main banking functions should be con- sidered banks and regulated and supervised as such. In some countries, OFIs became an E important segment of the financial system as a result of efforts to circumvent prudential norms and exploit loopholes in the banking sector. F Table 6.1 compares the regulatory features of banks and OFIs. Raising the following four questions when completing table 6.1 can help regulators verify the differences in the rules applied to different group of institutions (Carmichael and Pomerleano 2002): G · Can institutions subjected to different regulation provide similar products? H · Is a financial institution capable of choosing among different regulators by altering its corporation form, regulatory jurisdiction, or institutional label? For example, is I a parent institution able to reduce its regulatory burden by shifting business into an unregulated subsidiary? 174 Chapter 6: Assessing the Supervision of Other Financial Intermediaries Table 6.1. Main Regulatory and Prudential Aspects of Different Groups of Financial Institutionsa 1 Commercial Non-deposit-taking Regulation banks Deposit-taking institutions institutions 2 Main regulator/supervisor Restriction on loans 3 Participation in the clearing/settlement system Issuing deposits Subject to onsite supervision 4 Subject to offsite supervision Minimum paid-up capital 5 Minimum risk weighted capital/asset ratio Liquidity ratio 6 Cash reserve requirements 7 Required provisions Limit to a single borrower Insider lending 8 a. This table can be adapted to individual country situations. 9 10 · Can new OFIs offer banking-type products under a different banner to remain outside the jurisdiction of the main regulator? 11 · Is there a regulatory structure in which at least one regulator has overall responsi- bility for financial conglomerates? 12 In a unified supervisory structure where the number of OFIs is significant but OFIs operate independently from the main players in the financial sector (i.e., banks and A insurance companies), establishing a separate department that is exclusively dedicated to the supervision of OFIs is a common practice. In such structure, there are cases where B the same regulators are responsible for both onsite supervision and offsite supervision for a group of OFIs, or cases where there is separation between the responsibility for onsite C and offsite functions. On the one hand, having the same regulators be responsible for both onsite and offsite functions helps ensure continuity in monitoring events in the sector, as D well as coherence in supervision. On the other hand, separating offsite and onsite func- tions provides a certain degree of specialization in the related processes and procedures. In E either case, the regulators' skill levels should be adequate to avoid having inexperienced and unqualified regulators be systematically assigned to supervising OFIs. F In a unified structure where the links between OFIs and banks are significant through investment and ownership, regulators with responsibility for a group of related institu- G tions (including banks and OFIs) help monitor development in related sectors in a con- solidated manner. Moreover, specialization helps enhance the regulation and supervision H of OFIs. Regulators in charge of supervising banks can usually supervise OFIs, provided they receive adequate training and guidance to specifically deal with OFIs. As stressed in I the Basel Core Principles (BCPs) for Effective Banking Supervision, an essential element 175 Financial Sector Assessment: A Handbook of banking supervision is regulators' ability to supervise the banking organization on a 1 consolidated basis, which includes their ability to review both banking and non-banking activities conducted by the bank. 2 3 6.4 Assessing Regulatory Practice and Effectiveness 4 The regulatory regime for OFIs should help meet regulatory objectives--effective compe- tition, good conduct of business and financial integrity, and prudent operations--while 5 ensuring that regulations reflect the specific operational characteristics of the OFIs and promote their development. From this perspective, many core principles of effective bank 6 supervision and regulation also apply to OFIs. The general rule is that financial institu- tions that do not have deposit-like liabilities to the general public do not need to be regulated and supervised as closely as those that do. The tools and techniques for deposit- 7 taking OFIs would follow the standards contained in the BCPs. Financial institutions that are banklike in all but name should also be just as closely regulated and supervised. In 8 several countries, OFIs that were (formally or informally) taking deposits from the general public and were either not required to conform to banking regulations or did not come 9 under the supervision of the main supervisory authority have faced difficulties that neces- sitated the intervention of the government (World Bank 1999). 10 Given the diversity of institutions that make up the group of OFIs, certain additional principles and considerations can complement the BCPs and help adapt them to the 11 supervision of OFIs. Such principles and considerations, regardless of the institutional structure (unified or segmented), include modifying prudential rules to accommodate the 12 operational characteristics of OFIs; ensuring consistency in decision making; recognizing the unique risks of OFI; ensuring that supervision is proportionate and consistent with A costs and benefits; and maintaining resources and skills sufficient and adequate to face the growth of the OFIs sector. Those principles are similar to those applying to banks, and are B further explained in Annex 6.A. Their implementation can be a challenge. For example, housing finance institutions, including building societies, often offer deposit services (not necessarily checking accounts) and may need to be regulated as banking institutions (see C box 6.1). In many cases, tailoring regulations to the specific operational characteristics of the OFIs and avoiding overregulation is important for the development of the sector. D For the majority of OFIs where retail deposits and systemic issues are not involved, competition and market conduct regulations--such as entry and disclosure requirements E and monitoring association with other institutions--should be sufficient. With regard to entry requirements, the regulator would encourage low barriers to entry into these sec- F tors by ensuring that there are minimal restrictions on the corporate form and ownership structure of OFIs, freedom of entry for foreign firms, and strong antitrust conditions to G prevent excessive concentration in the industry. Disclosure of correct and timely infor- mation to market participants complements supervision.3 Regarding the association of H OFIs with other institutions, particular attention should be given to OFIs established as subsidiaries of regulated institutions as a means of circumventing the regulation. The I dangers of excessive growth in unregulated subsidiaries were highlighted in a number of crises (see World Bank 2001). 176 Chapter 6: Assessing the Supervision of Other Financial Intermediaries 1 Box 6.1 The Case of Financial Institutions Providing Housing Finance In the housing sector, banks and other specialized banks, which have more diversified balance sheets, 2 financial institutions such as thrifts, mortgage societ- there is even a case for stricter regulation of those ies, primary mortgage institutions, or mortgage banks institutions. The concentration in housing and real often offer the same products. Those institutions estate finance means that their risks may be highly 3 face similar risks, including credit risk exposure to concentrated, and a large overconcentration can the borrowers, liquidity risk from the possible loss of be the source of systemic failures. However, in some short-term funding, and market risk at the time of countries, the availability of a mortgage-backed 4 maturity. securities market may help those institutions manage The conditions under which deposits can be with- their risk profile and minimize the concentration of drawn from those institutions are often mentioned as 5 exposures. differentiating factors between banks and specialized In some countries, building societies--which are housing finance institutions and are viewed as justi- very similar to banks in terms of the range of finan- 6 fication to impose different prudential rules (such as on liquidity). The general rule, however, is that when cial services offered--are grouped together with specialized housing finance institutions solicit deposits other nonbank financial institutions (NBFIs) and 7 directly from the public and when those institutions' are supervised separately, even though they need to deposits are guaranteed implicitly or explicitly by the be regulated with standards similar to those of banks. government, those institutions must be regulated at More generally, the heterogeneity of other financial 8 least to the standards of banks. institutions often results in inappropriate regulation Given that the risks of specialized housing finance and supervision of some financial institutions provid- institutions are sometimes greater than those of ing housing finance. 9 10 11 When corporate laws are still evolving, however, additional conditions in financial regulation can support the good market conduct and prudent operation of OFIs. Those 12 additional conditions could cover the following: · Licensing requirements. As with any financial institution, the purpose of licens- A ing OFIs should be to ensure adequate capitalization and sound management, not to limit entry or restrict competition. Regulators should have the authority B to screen potential owners and managers to prevent those lacking professional qualifications, financial backing, or moral standing from obtaining a license. An C OFI license should not become a simple alternative for applicants who could not meet the requirements to be granted a commercial bank license. Liberal entry into D the financial system should not mean unqualified entry. Countries with easy entry have often experienced problems with insufficiently regulated, undercapitalized, E and poorly managed institutions. In some countries, once an OFI has been licensed, it conducts activities that are F normally not permissible under the range of activities specified in its license. The balance sheet restrictions for each group of financial institution should, therefore, G be closely monitored (e.g., limits on assets and liabilities, prohibition on particular classes of assets or liabilities, restrictions on the types of assets held, and mandated H maximum or minimum holdings of particular assets). · Minimum capital requirements. With regard to minimum capital requirements (and I all the main rules for the conduct of the institution), the requirements for banks 177 Financial Sector Assessment: A Handbook should not be applied to OFIs when not adequately justified. The minimum capital 1 requirement is usually part of the financial institution's licensing requirements, but should not inhibit the start-up of new institutions or act as barrier to competition. 2 The amount of capital appropriate for a group of OFIs or an individual institution is a function of the institution's potential to incur unexpected losses. A higher than 3 necessary limit could restrict the industry's growth. · Accountability requirements. In many countries, accountability requirements, includ- 4 ing accounting and auditing practices by OFIs, are inadequate.4 This deficiency increases the chance that misleading information could cause market instability. 5 Facilitating market discipline and sound practices for accounting and auditing helps reinforce supervisory efforts to encourage OFIs to maintain sound risk man- 6 agement practices and internal controls. As with any financial institution, OFIs need sound accounting standards to achieve satisfactory transparency--public 7 disclosure of reliable information that enables market participants and other users of that information to make an accurate assessment of the institution's financial 8 condition and performance, its business activities, and the risks related to those activities. 9 · Risk management practices commensurate with the risk profile in the industry. Measuring, monitoring, and controlling risks are often issues of concern with OFIs, especially 10 in countries where licenses were granted too liberally. It is important that the OFI put in place a risk management process adequate for the size and the nature 11 of its activities. Regulators should ensure that such a risk management system is not static, but rather adjusted to the OFI's risk profile (concentration, credit, cur- rency, or tax-related risks). This process is not only helpful in identifying potential 12 systemically important OFIs, but also in setting priorities for allocation of limited supervisory capacity, for instance, to determine the frequency of reporting and the A depth and focus of onsite supervision. B Building supervisory capacity does not mean that all OFIs need to be supervised, and when they do, they usually do not require the same level of supervision and resources as C banks. The supervisory authority must establish priorities for the allocation of regulators' supervisory capacity. There is sometimes little benefit in trying to regularly visit small, D dispersed OFIs that, with modest change in regulation (e.g., licensing, minimum capital, accounting, auditing, and disclosure requirements), could present negligible risk. E After establishing supervisory priorities, regulators should also ensure that OFIs (particularly small non­deposit-taking institutions) are not overwhelmed by excessive reporting requirements when they do not present major variations in their portfolios from F one period to the other. In most cases, quarterly or even semiannual returns (instead of monthly returns) would be appropriate. For those institutions accuracy and completeness G are far more important than frequency. At the same time, more attention should be given to OFIs with substantial assets whose reporting should be more frequent. Other recurrent H issues relate to the following: I · Deficiencies with offsite supervision, which weaken early warning systems to iden- tify weak OFIs 178 Chapter 6: Assessing the Supervision of Other Financial Intermediaries · Unreliable and rudimentary working methods, which prevent regulators from 1 efficiently and accurately assessing the OFI's exposure to various risks and, for the most part, its soundness and financial performance · The lack of internal guidelines or manual for onsite and offsite supervision, which 2 are important to determine the examination procedures and policies for OFIs 3 An adequate information system and a guideline or manual are useful tools to help address the specific risks inherent to OFIs. 4 6.5 Selected Issues on the Regulation and Supervision of Leasing 5 Companies 6 In some circumstances, a separate legal and regulatory framework for leasing companies can be helpful to create a suitable environment for leasing and promote confidence in 7 the industry. Many developed countries, despite their long history of leasing, do not have a separate leasing law (Amembal, Lowder, and Ruga 2000). Those countries usually have 8 well-developed common and civil laws that provide an adequate basis to support leasing transactions. In countries where the leasing industry is still in the very early stages of 9 development, a new legal and regulatory framework could help promote confidence in the efficiency and fairness of the market. Specialized leasing laws may not be necessary, 10 however, provided that existing regulations designed to deal with financial institutions do not discriminate against the industry.5 When the industry develops, however, it will be important that the fundamental elements of an efficient financial leasing law be put 11 in place. Those elements include the following (see International Finance Corporation 1998): 12 · Freedom of contract A · Recognition of the three-party structure of the modern financial lease · Duties consistent with party's role in the transaction B - Lessee's duty to pay after acceptance - Lessor's lack of equipment responsibilities C - Lessee's recourse against the seller - Equipment not liable to other creditor's claims D - Transfer freedom and restraint · Default remedies, including the right to accelerate the remaining lease payments E · Expedient repossession and recovery The rights and duties of the lessor as legal owner of the asset and the rights and duties F of the lessee as user of the asset should be clearly stated. The legal owner needs a clear, simple, workable, timely process to reclaim an asset if the terms of the lease are breached G by the user, including the automatic right of repossession without lengthy court proceed- ings and the right to claim payments due and other damages. The lessee must have the H right to use the asset unimpeded and gain the full productivity of the asset. In some coun- tries, it may be necessary to clarify that the lessee does not have the right to create a lien I on leased assets (International Finance Corporation 1996). One advantage of the leasing 179 Financial Sector Assessment: A Handbook 1 Box 6.2 Measures to Develop a Favorable Regulatory Environment for Leasing Legal Framework · Prudential requirements. Regulations may have 2 lower minimum capital requirements than many · Lessor's ownership. Ownership should be clearly other financial institutions. Other prudential 3 stated, with simple, effective, and timely proce- requirements may be less strict than for deposit- dures for repossession if lessee defaults. taking institutions. · Lessee's rights. Rights should be clear--uninter- 4 rupted use of leased asset for the lease period if Tax Treatment the lease payments are current. 5 · Lessor. The lessor should be allowed to depre- Regulations ciate the asset, with lease payments taxed as income and asset depreciation computed over 6 · Licensing. Regulation should recognize the exis- life shorter than or equal to lease contract. tence of leasing. Restricting leasing to licensed · Lessee. The lessee should be allowed to treat institutions (and requiring commercial banks lease payments as an expense for tax purposes. 7 to set up separate subsidiaries to write leasing · Sales tax. The postcontract sale of the asset contracts) may help the industry develop aggres- should be exempt from sales tax. sively. Leasing companies should be allowed to 8 · Capital allowances. Allowances should be given mobilize term deposits only. to lessor or lessee, with equal treatment com- pared to other financing. 9 Source: International Finance Corporation (1996). 10 11 companies over banks is that they own the leased asset. However, physical repossession can still prove difficult. For instance, the mobility of the leased asset has made reposses- 12 sion even more difficult. In its lessons of experience, International Finance Corporation (1996) has identified a set of measures to develop a favorable regulatory environment for A leasing (box 6.2). In many countries, leasing companies are not regulated and supervised because they B do not take deposits. However, many leasing companies are bank subsidiaries, and regu- lators should be interested in such companies for the purpose of consolidated supervi- C sion. Moreover, as previously stated, even for NBFIs where retail deposits and systemic issues are not involved and where corporate laws are still evolving, additional condi- tions--including licensing requirements, minimum capital requirements, accountability D requirements, and risk conditions consistent with the risk involved in the industry--can support market conduct. E F 6.6 Selected Issues on the Regulation and Supervision of Factoring Companies G Factoring companies are financial institutions that specialize in the business of accounts H receivable financing and management. If a factoring company chooses to purchase a firm's receivables, then it will pay the firm a prenegotiated, discounted amount of the face value I of the invoices (Sopranzetti 1998). A moral hazard problem develops when the seller's credit management efforts are unobservable to the factoring company: Once the entire 180 Chapter 6: Assessing the Supervision of Other Financial Intermediaries 1 Box 6.3 Factoring as a Sale and Purchase Transaction Rather Than as a Loan A key issue for factoring is whether a financial ties. The strength of the regime for creditor rights 2 system's commercial law views factoring as a sale and will affect underwriting standards because factors purchase transaction rather than as a loan. If it is a must consider the anticipated cost and efficiency sale and purchase transaction, creditor rights and loan of their collection activities when they make credit 3 contract enforcement are less important for factoring decisions about which invoices to purchase. Second, because factors are not creditors--that is, if a firm under recourse factoring, the factoring company has went bankrupt, its factored receivables would not be a contingent claim against the borrowing firm if 4 part of its bankruptcy estate because they would be there is a deficiency in the collection of a receivable. the property of the factor. This contingent claim can be secured or unsecured, Still, creditor rights and loan contract enforce- depending on whether the factoring company filed a 5 ment are not irrelevant to factoring for at least two security interest in some or all of the firm's assets as a reasons. First, they define the environment in which secondary source of repayment. 6 the factoring company engages in collection activi- Source: Bakker, Klapper, and Udell (2004). 7 8 9 receivable is sold (factored), the seller has no incentive to monitor that receivable, as the seller no longer bears any credit risk. Factoring is not one homogeneous product. Most 10 factoring companies do not simply provide immediate cash services; they also offer a range of other professional services such as collecting payments, pursuing late payers, providing 11 credit management advise, and protecting clients against bad debts. Factoring companies typically fall under three categories: banks, large industrial companies, or independent 12 factoring companies. One fundamental issue with factoring resides in recognizing the commercial status of A the industry, which in turn determines the oversight structure. In some countries, factor- ing is recognized as a commercial activity and is, therefore, regulated by commercial law, B but it is not unusual in certain countries to see factoring companies undertake the func- tions of financial intermediation without authorization (see box 6.3 for further details). C The regulatory environment has an important effect on the factoring industry. In some countries, factoring operates entirely outside the purview of any regulatory structure or D authority, and in others it is regulated along with other financial services such as bank- ing and insurance. In most countries, however, the level of regulation falls somewhere in E between (Bakker, Klapper, and Udell 2004). For countries where factoring is developing, a law setting out minimum standards for the management of factoring companies and speci- F fying the tools to be used to manage key risks in factoring operations could be envisaged. Some countries simply restrict market entry to formally registered financial institutions G such as banks or other specialized financial institutions. However, those restrictions could hinder competition by excluding the emergence of independent factors. To address the H potential lack of discipline in some markets, International Finance Corporation (1998) recommends that governments consider requiring minimum capital and prudential guide- I lines as a barrier to entry into the market. 181 Financial Sector Assessment: A Handbook 6.7 Selected Issues on the Regulation and Supervision of Pension 1 Funds 2 National pension systems are typically characterized as multipillar structures that are 3 defined in many ways, depending on the purpose of analysis.6 From the perspective of analyzing financial stability and development, it is useful to distinguish between (a) 4 state-provided pension schemes, which are a combination of a universal entitlement and an earnings related component; (b) occupational pension funds, which are funded by and organized in the workplace as Defined Benefit (DB), Defined Contribution (DC), 5 or a hybrid; and (c) private savings plans, which are often tax advantaged. As a result of increasing longevity and rising dependency ratios, the funding of promised retirement 6 benefits (in DB plans) has become a challenge in many countries. This funding challenge has led to pension reforms that reduce benefits, increase contributions (i.e., taxes to pay 7 state pensions), redefine risk sharing between sponsors and beneficiaries, and raise retire- ment age. Increased funding of pension obligations (by both the private and public sec- 8 tors) and greater retirement savings by individuals are increasingly part of the solution. While funded pension plans' size and importance vary greatly among countries, in 9 many countries pension funds are among the largest institutional investors. As a result, pension fund asset allocations could affect financial markets and the flow of investment 10 funds quite significantly. As pension funds became increasingly underfunded and shift toward DC and hybrid plans, the issues of appropriate asset liability management and 11 asset allocation have become pressing. As a result, both pension fund management and the approaches to its regulation have changed. The regulatory framework for pension 12 funds is increasingly focusing on risk management, in addition to the traditional focus on protection of pensioner and employee benefits and rights.7 Key issues in assessing pension funds' regulatory framework from a financial sector perspective and the emerging practices A are covered in appendix H. B Annex 6.A Regulation and Supervision of OFIs: A Few Guiding C Principles D As one puts in place a regulatory framework for Other Financial Intermediaries (OFIs), some regulations common in traditional banking must be adjusted to accommodate those E institutions. The challenges facing a given country's supervisory agency--and the realis- tic obstacles to meeting those challenges--must be weighted seriously when examining F proposals for the regulation of OFIs. G A. The regulatory framework should minimize adverse effects on competition and encourage competition. H 1. Repressive and inappropriate regulation can have a negative influence on the I development of OFIs. Examples of repressive regulation include restrictive licens- ing and pricing and investment regimes. Excessive regulation of banks can stimu- 182 Chapter 6: Assessing the Supervision of Other Financial Intermediaries late the growth of non-banks or the establishment of non-bank subsidiaries as a 1 means to circumvent regulation. Discriminatory tax treatment is an example of inappropriate regulation. 2 B. The regulatory framework should clearly define the power of the 3 regulator and the permissible activities of OFIs. 4 2. The regulatory framework should be clear with regard to (a) the establishment and powers of the regulator and (b) the legal existence and the behavior of the entities 5 being regulated. The regulatory frameworks also should be supported by adequate infrastructure such as accounting and disclosure rules, property rights, and contract 6 enforcement. 3. The regulatory framework should define the permissible activities of OFIs, includ- 7 ing the regulatory distinction between banks and non-banks, as well as the activi- ties retained solely for banks. There should be no ambiguity as to the meaning of "bank," "lease," "factor," or "deposit" or to what constitutes the illegal acceptance 8 of deposit without a license. 9 C. Similar risks and functions should be supervised similarly to minimize 10 scope for regulatory arbitrage. 11 4. "Banklike" financial institutions should be supervised like banks. The supervisory authority should also ensure that no new activity is undertaken without the prior 12 consent of the regulator (e.g., taking deposits). A D. The links between OFIs and other players in the financial sector should be closely monitored. B 5. Exposition to risks through investment and ownership linkages (particularly with C banks) should be evaluated, because those linkages make each sector vulnerable to adverse development in other sectors. D E. The unique risks of OFIs should be recognized within the supervisory E structure and when defining prudential norms. F 6. There should be a dedicated focus within the institutional framework to recognize those unique risks of the regulation and supervision of OFIs, whether financial G institutions are under a unified or a separate supervisory framework. 7. When appropriate, prudential norms ought to be specifically defined for OFIs. H The following set of regulations will commonly require reexamination: minimum statutory capital, capital adequacy ratio, asset classification, provisioning, liquidity, I acquisition, and investment. 183 Financial Sector Assessment: A Handbook F. Supervision should be proportionate and consistent with costs and 1 benefits. 2 8. Simple and less-risky institutions should not be burdened by the full regulatory requirements imposed on more-complex and riskier institutions. 3 G. Resources and skills should be targeted to the higher-impact and more- 4 complex OFIs. 5 9. The frequency of offsite supervision and the depth of onsite supervision should consider the scale of the institution to avoid having scarce supervisory resources 6 be wasted or institutions be saddled with unnecessary compliance burdens. 10.Staff members responsible for supervising OFIs should have the resources and skills 7 to understand the specific risk related to those institutions. The methodology used should help identify sources of risks (credit, market, liquidity, operational, legal, 8 and reputation), as well as risk management practice. 11.Supervisory staff members should have guidelines to provide direction to reach 9 appropriate conclusions on a consistent basis. 12.Staff members should have access to training for upgrading their skills to ensure 10 that regulatory and supervisory frameworks meet the industry's needs. 11 H. There should be a strengthening of the self-regulatory capacity. 12 13.Associations can play an important role in representing the OFIs' views on appro- priate regulatory and supervisory frameworks. They can also voice the opinions of A the market participants to government authorities, particularly when there is no regulatory body directly involved with the regulation. Moreover, they can provide B educational, promotional, legal, financial, and other services tailored to the needs of the OFIs. C D Notes E 1. See IMF (2004a) for the definition of deposit taker and Other Financial Corporation (OFC). This Handbook uses the term Other Financial Intermediary (OFI) instead of F OFC to avoid confusion with references to Offshore Financial Centers. IMF (2004a) uses the term deposit takers as units that engage in financial intermediation as a G principal activity and that have liabilities in the form of deposits payable on demand, transferable by checks, or otherwise used for making payments. Or they have liabilities H in the form of instruments that may not be readily transferable such as certificates of deposits, but that are close substitutes for deposits and are included in measures of I broad money. 2. This section is partly drawn from Carmichael and Pomerleano (2002). 184 Chapter 6: Assessing the Supervision of Other Financial Intermediaries 3. Where the institutions are the beneficiaries of government tax incentives, subsidies, 1 or other privileges, there is a case for imposing reporting requirements, additional disclosures, and even inspections and audit requirements to ensure that the incentives and privileges are not subject to abuse. 2 4. Comprehensive standards addressing financial instruments are essential if an account- ing standards regime is to be credible. The International Accounting Standard (IAS) 3 Board provides guidance for all financial instruments not only on disclosure and pre- sentation (IAS 32), but also on recognition and measurement (IAS 39) at fair value 4 or at amortized cost. See http://www.iasplus.com/standard/ias39.htm and chapter 10, section 10.2. 5 5. In some countries, the leasing industry is one part of the financial system that is not burdened by heavy government regulations. In the absence of a leasing law, however, 6 leasing regulations are usually fragmented and unclear. Many countries have opted for a separate leasing law to avoid confusion and to clearly define the rights and obliga- 7 tions of the various parties (see International Finance Corporation 1996). 6. World Bank (1994) describes Pillar 1 as noncontributory state pension; Pillar 2, man- 8 datory contributory; and Pillar 3, voluntary contributory. This classification is useful to the discussion of the social safety net, the redistribution of income, and the fiscal 9 aspects of pensions. 7. For a discussion of risk management issues in the pension fund industry, see IMF (2004b). 10 11 References 12 Amembal, Sudhir P., Loni L. Lowder, and Jonathan M. Ruga. 2000. International Leasing: The Complete Guide. Salt Lake City, UT: Amembal Associates. A Bakker, Marie H. R., Leora Klapper, and Gregory F. Udell. 2004. Financing Small- and Medium-Size Enterprises with Factoring: Global Growth in Factoring--and Its Potential in B Eastern Europe. Washington, DC: World Bank. Bank for International Settlements, 1997. Core Principles for Effective Banking Supervision. C Basel, Switzerland: Bank for International Settlements. Carmichael, Jeffrey, and Michael Pomerleano. 2002. The Development and Regulation of D Non-Bank Financial Institutions. Washington, DC: World Bank. Herring,Richard,andAnthonySantomero.1999."WhatIsOptimalFinancialRegulation." Financial Institutions Center, The Wharton School, University of Pennsylvania, E Philadelphia. International Finance Corporation. 1996. "Leasing in Emerging Markets." International F Finance Corporation, Washington, DC. ------. 1998. "Overview of Legislation on Leasing: Recommendations on Legal G Framework." International Finance Corporation, Russia Leasing Development Group. Available at http://www2.ifc.org/russianleasing/eng/analit/2/2.htm#num5. H IMF (International Monetary Fund). 2004a. Compilation Guide on Financial Soundness Indicators. Washington, DC: International Monetary Fund. Available at http://www. I imf.org/external/np/sta/fsi/eng/2004/guide/index.htm. 185 Financial Sector Assessment: A Handbook ------. 2004b. "Risk Management and the Pension Fund Industry." In Global Financial 1 Stability Report: Markets and Issues, 81­120. Washington, DC: International Monetary Fund. Available at http://www.imf.org/External/Pubs/FT/GFSR/2004/02/pdf/chp3.pdf. 2 OECD (Organisation for Economic Co-operation and Development). 2002. "Highlights of Recent Trends in Financial Markets." Financial Market Trends 81 (April): 1­47. 3 Available at http://www.oecd.org/dataoecd/19/1/2080704.pdf. Sopranzetti, Ben J. 1998. "The Economics of Factoring Accounts Receivable." Journal of 4 Economics and Business 50 (4): 339­59. Available at http://www.sciencedirect.com/sci- ence/article/B6V7T-3X6J8JJ-2/2/989f666d01da736e1ef28877aba328e4#fn1. 5 World Bank. 1994. Averting the Old Age Crisis: Policies to Protect the Old and Promote Growth. World Bank Policy Research Papers. New York: Oxford University Press. 6 ------.1989. World Development Report: Financial Systems and Development. Washington, DC: World Bank. ------. 2001. Finance for Growth: Policy Choices in a Volatile World. Washington, DC: 7 World Bank. 8 9 10 11 12 A B C D E F G H I 186 1 2 3 4 Chapter 7 5 Rural and Microfinance Institutions: 6 Regulatory and Supervisory Issues 7 8 9 10 7.1 Overview 11 The providing of financial services to the poor and the very-poor, particularly in rural areas, is the purpose of microfinance institutions (MFIs), and the assessment of the regu- 12 latory framework for MFIs is part of broader assessment of adequacy of access. Access, however, is multidimensional, and assessing its adequacy requires a review of (a) the A range of financial services provided--and target groups served--by several tiers of formal, semiformal, and informal financial institutions; (b) the demand for financial services B from households, microenterprises, and small businesses at different levels of the income strata; and (c) the different combinations of financial service providers, the users of those C services, and the range of services that prevail in different geographical segments of the market. The primary objectives of the assessment of the adequacy of access are (a) to D identify the gaps that exist (and that need to be corrected) in the range of products that are available for different layers of households, microenterprises, and small businesses in various geographic markets; and (b) to assess whether the regulatory framework for finan- E cial transactions helps expand or restrict access to the needed financial services. F 7.2 Rationale for Assessing the Regulatory Framework for Rural G Finance and Microfinance Institutions H The core objectives for the regulatory framework are the same for microfinance activities and institutions as for other components and segments of the overall financial system. I However, the key principles and standards for the design of a regulatory framework for 187 Financial Sector Assessment: A Handbook institutions providing financial services to the rural finance and microfinance sector are 1 likely to be different from those for formal banking and finance institutions, because the design must consider the operational, market, and client characteristics of the rural 2 finance and microfinance sector. This section focuses on the regulatory framework issues that have an important influence on access to financial services for low-income rural 3 households. The term financial services extends beyond the traditional credit products and savings 4 deposits facilities provided to varying degrees by different types of rural finance and micro- finance institutions. See section 7.3 and table 7.1 in that section for a listing and discus- 5 sion of various types of MFIs, including those linked to nongovernmental organizations (NGOs) and various non-bank institutions). The term includes payments, money transfer 6 and remittance services, and insurance and contractual savings products. It is important to focus on access to payments and savings products by different segments of the popula- 7 tion and the supply of those products by different institutions. Payment and savings prod- ucts are often the most important financial services for low-income households. Improved access to savings product can help households achieve higher returns on their savings and 8 smoother cash flows, and can reduce vulnerability to external shocks. The degree and quality of access to financial services available to low-income rural 9 households and their small businesses is influenced by the quality of the legal and regulatory framework. This framework should be guided by the following core principles of good micro- 10 finance: (a) to provide a level playing field among participants in the provision of a range of financial services beyond credit and savings facilities; (b) to allow the institutional trans- 11 formation of nontraditional and non-regulated MFIs (such as multipurpose and microcredit NGOs) into specialized, regulated, or licensed rural finance and microfinance intermediar- 12 ies; (c) to promote and reward transparency in financial accounting and transaction report- ing; and (d) to foster the exchange and sharing of credit histories of borrowing clients. A Available data and information show that deeper, more-efficient financial markets can contribute to accelerated agricultural growth and better food security. Scaling-up B access in rural markets to a wider array of financial services through a varied range of financial intermediaries becomes critical to help low-income rural households smooth consumption and enhance labor productivity, which is the most important production C factor controlled by the poor. Also, agriculture has strong forward and backward multi- plier effects for the overall economy. Economic growth in agriculture is a key precondition D for overall economic growth and poverty reduction, given that most of the world's poor still live in rural areas (Robinson 2001; Zeller 2003) E There are examples of agricultural development banks, MFIs, and credit unions devel- oping strong rural portfolios, while commercial banks do not generally seem to fit this F market niche as readily. Some MFIs have tried to transform from nongovernmental status to a regulated, supervised financial institution; however, with notable exceptions, this G has not proven to be a reliable route to improved rural outreach of financial services. In general, commercial banks have not entered the rural and agricultural credit markets on H a substantial scale in most developing countries, despite incentives designed to encourage downscaling and rural market penetration. I In a few countries, agricultural development banks have succeeded in transforming themselves into more-sustainable institutions by offering demand-driven financial ser- 188 Chapter 7: Rural and Microfinance Institutions: Regulatory and Supervisory Issues vices, building credible lending contracts, and using full-cost recovery interest rates. The 1 experiences of Thailand's Bank for Agriculture and Agricultural Cooperatives (BAAC, Bank Rakyat Indonesia's (BRI) village units in its microbanking system (Yaron and Charitonenko 1999; Zeller 2003), and the revival and restructuring for privatization 2 of Mongolia's Agricultural Bank (Boomgard, Boyer, and Dyer 2003) and of Tanzania's National Microfinance Bank demonstrate that state-owned banks can be transformed 3 into dynamic, profitable, and successful rural-oriented financial intermediaries with busi- ness-oriented management reforms. Of course, such transformation of state owned banks 4 can be achieved only with firm political commitment, ownership of reforms, management autonomy, and incentives (Zeller 2003). 5 Group-based models have built impressive portfolios in rural markets; savings and loan cooperatives and credit unions have grown rapidly in diverse settings.1 Emphasis on the 6 importance of large-scale operations, internal systems, attractive products, and portfolio quality has contributed to improvements in performance. In addition, the village banking 7 methodology2 pioneered by FINCA International has shown, in many cases, that rural community-based and self-managed financial entities can become self-sustaining. This 8 model was later adapted with changes by CARE, Catholic Relief Services, World Vision, and even a few commercial banks. 9 Several MFIs have shown that they can profitably serve large numbers of relatively poor households, microenterprises, and small businesses. Although the client base is typi- cally in peri-urban markets or in off-farm business activities in rural markets, those expe- 10 riences have renewed interest in the feasibility of reorienting rural finance and microfi- nance institutions. There is a growing list of MFIs that have moved beyond their initial 11 urban client base to tailor their products to rural clients, including the Equity Building Society in Kenya, CrediAmigo, a bank-affiliated MFI in Brazil and the Development 12 Bank of Brazil (BNDES), MiBanco in Peru, Financiera Calpia in El Salvador, and Basix India Ltd, a micro­credit institution serving the rural poor in India. The experiences of A these MFIs point toward the possibilities of adaptation and replication by other MFIs operating in predominantly rural markets. B The rural finance and microfinance sector is small relative to the commercial financial sector, with limited effect on the overall stability of the financial system. In a large number C of developing countries, the total loans outstanding in the rural finance and microfinance sector was about 1 percent of broad money supply (M2), with this sector reaching fewer D than 1 percent of the population as clients. A handful of countries stand out from the rest with higher levels of microfinance outreach and penetration, especially in Indonesia (6.5 E percent); Thailand (6.2 percent); Vietnam and Sri Lanka (4.5 percent); Bangladesh and Cambodia (3.0 percent); Malawi (2.5 percent); and Bolivia, El Salvador, Honduras, India, and Nicaragua (at 1.0 percent or slightly more) (Honohan 2004).3 F G 7.3 Institutional Providers of Rural Finance and Microfinance Services H The distinction between microfinance and small and medium enterprise (SME) finance I and the recognition of the different types of financial institutions catering to those 189 Financial Sector Assessment: A Handbook segments are important to the assessment of the adequacy of access and the effect of 1 regulation. While different categories of borrowers often face similar constraints, lend- ers commonly distinguish between microfinance, which refers to credit provided to poor 2 households and to informal (i.e., unregistered) microenterprises, and SME finance, which refers to credit given to enterprises registered as large microenterprises, small businesses, 3 and medium-size enterprises. There are several important differences between the two categories of borrowers. 4 Microfinance is most often provided by non-bank institutions such as NGO MFIs that are often based on the group-lending approach (although numerous microfinance loans 5 may consist of loans to individuals rather than to groups), as well as various membership- based financial cooperatives and mutual-assistance associations. SME finance is provided 6 mainly by banks, building societies, and non-bank financial institutions (NBFIs) and does not use a group-lending approach. Another important difference is security: Microfinance 7 is almost never formally secured, although informal security (i.e., not legally binding) in the form of collateral interest over household goods and tools is commonly used, while 8 SME finance usually allows a firm's assets or personal guarantees to legally secure small business loans. Those differences create a natural separation between the institutions that 9 specialize mainly in microfinance and the institutions that provide small business loans, although some institutions do provide both kinds of finance services. 10 Institutional providers of financial services to low-income rural households, microen- terprises, and small businesses fall into several categories according to the scope of regula- 11 tion, type of ownership, and type of services offered. The institutions can be differentiated on (a) whether they are required to obtain a license to carry out financial intermediation activities, to be registered with some central agency (but not required to obtain a license) 12 that will provide nondeposit credit-only services, or to be registered as a legal entity; (b) what type of organizational format, including ownership and governance aspects, they A have; and (c) what types of financial services are permitted and provided. The principal categories are B · government programs or agencies for rural finance, microfinance, or SME finance C · non-bank, nonprofit NGO MFIs · membership-based cooperative financial institutions (CFIs) D · postal savings banks (PSBs) or institutions · development finance institutions E · specialized banking institutions (usually licensed for limited operations, activities, or services to differentiate them from full-service commercial banks) such as rural banks, microfinance banks, and non-bank finance companies F · commercial banks G Key differences in the organization and operation of those different institutions are highlighted in table 7.1. The institutions differ in terms of what products and services H they are allowed by law and regulation to offer; whether they are subject to rigorous prudential regulation, internal governance structure, and accountability; and how funds I for administrative and business operations are sourced. The differences arise from the applicability of legal and regulatory requirements, and those differences have important 190 Chapter 7: Rural and Microfinance Institutions: Regulatory and Supervisory Issues Table 7.1. Institutional Providers of Financial Services 1 Financial services Organizational Regulatory status permitted to Institutional provider format Ownership and how regulated be offered 2 Government rural Trust fund or agency Government Not regulated by Wholesale or onlending or micro or SME banking authority funds to participating finance programs or institutions 3 agencies Non-bank/nonprofit/ Nonprofit foundation, Private sector entities Not regulated by Microfinance loans NGO MFIs trust, or association or organizations banking authority only; no voluntary 4 deposits Membership-based Savings and Members Not regulated by Savings and time 5 cooperative financial credit cooperative banking authority, deposits and loans to institutions (CFIs) organization (SACCO) but may be regulated members only or credit union by department in cooperative 6 Postal savings banks State-chartered Government Not regulated by Savings and time (PSBs) institution banking authority (fixed) deposits only and money transfers 7 Development finance State-chartered Government May or may not be Wholesale certificates institutions institution regulated by banking of deposit, loans, and authority credits 8 Specialized banking institutions Rural banks Limited liability Private sector investors Licensed or supervised Savings and time 9 company or shareholders by banking authority deposits, loans, and money transfers Microfinance banks Limited liability Private sector investors Licensed or supervised Savings deposits, 10 company or shareholders by banking authority microfinance loans, and money transfers Non-bank finance Limited liability Private sector investors Licensed but not Wholesale certificates 11 companies company or shareholders necessarily supervised of deposit, loans, and by banking authority credits Commercial banks Limited liability Private sector investors Licensed or supervised Demand and savings 12 company or shareholders, or by banking authority and time deposits, state-owned institution loans, credits, money transfers, and foreign A exchange; full banking services B C implications for the outreach and sustainability of the institutions. For indicators of struc- D ture, outreach, and performance of MFIs, see box 7.1. Not all institutional providers of financial services listed in table 7.1 may exist in a E given country for a number of important reasons, including the stage of development of the rural finance and microfinance sector. In a number of countries, rural finance and microfinance services may be provided by several types of institutions. F G 7.3.1 Government Rural Finance, Microfinance, or SME Finance Programs or Agencies H The direct provision of rural finance, microfinance, and SME finance loans and credit facilities by government agencies or programs should be noted and examined in the I assessment of adequacy of access. Those government programs usually have an unfair 191 Financial Sector Assessment: A Handbook 1 Box 7.1 Benchmarks for Outreach and Financial Performance and Soundness of Rural Finance and Microfinance Institutions 2 Standards and indicators for the breadth and depth - average loan balance or amount per borrow- of outreach, the operating and financial performance, er, and as a percentage of (a) gross national 3 and the financial soundness of rural finance and product (GNP) per capita and (b) national microfinance institutions have been developed by an poverty income level international network of donors and practitioners. 4 · Financial structure Those standards and indicators have been adopted - ratio of institutional capital to average total by prudential supervisory agencies and regulatory assets authorities in a number of countries. Among the 5 - ratio of equity to debt more prominent examples are the standards and indicators developed and detailed in the monitor- - ratio of average total loans outstanding to average total assets 6 ing systems developed by ACCION International (ACCION "CAMEL"), World Council of Credit - commercial funding (market-price liabili- Unions (WOCCU "PEARLS") and Microfinance ties) as a percentage of gross loan portfolio 7 Information eXchange (MIX). For purposes of com- · Overall financial performance and soundness parison with and reference to best practices, the - adjusted Return on Assets (ROA) benchmarking standards published periodically by - adjusted Return on Equity (ROE) 8 WOCCU, MIX (MicroBanking Bulletin), MicroRate, - operational self-sufficiency (revenue from and Microfinance Centre for Central and Eastern loans, investments, and other financial ser- Europe (CEE) and the Newly Independent States 9 vices as a percentage of administrative and (NIS) are easily accessible. Those benchmarks can be operating expenses) useful in carrying out the assessment of adequacy of - financial self-sufficiency (revenue from 10 access for rural finance and microfinance institutions, loans, investments, and other financial ser- and are summarized here. vices as a percentage of financial or interest · Breadth and depth of outreach expenses, loan-loss provisions, and adminis- 11 - number of deposit accounts (because some trative and operating expenses) institutions such as postal savings banks - on-time loan repayment rate 12 [PSBs] provide only deposit services) - portfolio at risk overdue greater than 30 days - number of active borrowers, and as a percent- as a percentage of gross loan portfolio age of total population and of population at - loan­loss reserve as a percentage of portfolio A or below poverty line at risk overdue greater than 30 days B C competitive advantage over and tend to crowd out the private sector-based providers of similar financial services to households, microenterprises, and small businesses. In a number of countries, state-owned development finance institutions or specialized banks D are the institutional vehicles used. The key issues to address in the assessment, aside from whether the institutional vehicles are reaching their target sector or client base E and have, in fact, contributed to the development and expansion of the target sector, are (a) efficiency of loan collection, (b) incidence of loan defaults and adequacy of loan-loss F provisions, (c) claims on budgetary or fiscal resources for loan guarantees and additional capital to cover operating losses, and (d) level of solvency or insolvency. G 7.3.2 Non-bank, Non-profit NGO MFIs H Non-bank, non-profit NGO MFIs include (a) mixed-purpose NGOs that have credit provisions in their socially oriented activities and (b) specialized credit-only MFIs. Those I MFIs are generally private sector-owned institutions and are typically organized as non- 192 Chapter 7: Rural and Microfinance Institutions: Regulatory and Supervisory Issues profit foundations, trusts, or associations. In a number of cases, the MFIs are organized 1 as formally incorporated entities under a country's Companies Act. Some MFIs are stand-alone local entities, while others may be affiliated with or sponsored by interna- 2 tional NGOs such as FINCA, CARE, Catholic Relief Services, World Vision, ACCION International, and Women's World Banking. The geographical reach of their operations vary depending on their organizational and legal status and on the type of NGO sponsor, 3 with some MFIs operating only at the district or county level others on a province-wide or region-wide basis, and a few on a nationwide scale. 4 5 7.3.3 Membership-Based CFIs CFIs are (a) multipurpose cooperative associations (e.g., producers, services, marketing, 6 and rural cooperatives) that include savings and credit functions; and (b) single-purpose, membership-based, financial cooperative organizations (e.g., credit unions and savings 7 and credit cooperative organizations [SACCOs]). CFIs, which have been in existence in many countries much longer than non-bank, nonprofit NGO MFIs, are clearly distin- 8 guishable from the NGO MFIs in that their financial transactions (deposit taking and credit giving) are generally limited to registered members under a closed- or open-com- 9 mon bond, typically defined by geography (residence), occupation, or place of employ- ment. The rights and privileges of ownership in CFIs are based on the one person­one vote principle, and management is exercised by members­owners. In general, CFIs will 10 outnumber NGO MFIs in many countries, and their combined outreach will tend to be larger as well. 11 12 7.3.4 Postal Savings Banks A PSB has the ability to reach a very large number of depositors for savings and time A deposits in generally small amounts, and to provide payments and transfer or remittance services, particularly in the rural areas in a number of countries, including Azerbaijan, B Kenya, Pakistan, and Tanzania. However, PSBs are limited to deposit-taking and payment services and do not extend credit. PSBs are intended primarily to provide a safe and secure C facility for the small savings of poor and low-income households, especially in rural areas, even though the management and boards of PSBs may be tempted to expand into rural D finance and microfinance lending services to improve earnings. In practice, the priority should be on improving efficiency, cost-effectiveness, and governance before broadening the asset portfolio beyond safe assets such as bank deposits and government issues. E F 7.3.5 Development Finance Institutions In many countries, Development Finance Institutions (DFIs) have been established and G funded by the Government to develop and promote certain strategic sectors of the econ- omy (e.g., highly capital intensive investments, the agricultural sector) and to achieve H social goals. DFIs are expected primarily to fill in the gaps in the supply of financial services that are not normally provided by the banking institutions. The DFIs also play a I crucial role in the development of SMEs, the housing sector, and in some countries micro- 193 Financial Sector Assessment: A Handbook credit. The key issue to monitor is the extent to which DFIs are accorded special benefits 1 in the form of funding at lower rates, implicit government guarantees to the institutions's debts, favourable tax treatment etc. 2 3 7.3.6 Specialized Banking Institutions The regulatory framework for banking and finance in a number of countries also cov- 4 ers lower-tier licensed banks that have the legal capability for deposit-taking activities (generally limited to savings and fixed deposits) and for providing loans, but the capabil- 5 ity excludes trust and investment services and foreign exchange or trading facilities. In some countries, banking activities may be limited to the geographical market area that 6 is serviced (county or district, province, or region). The limited-service banking institu- tions, (e.g., rural banks and microfinance banks) are subject to prudential supervision by 7 a country's central supervisory authority, and they are required to comply with reporting requirements and with applicable prudential standards. Non-bank finance companies involved in rural finance, microfinance, and SME finance--which do not take retail 8 public deposits but are permitted to fund their operations and loan portfolios through commercial borrowings and wholesale, large-value, institutional deposits--are generally 9 required to register and to obtain a license. However, those companies may not be pru- dentially supervised by a country's central supervisory authority. 10 11 7.3.7 Commercial Banks Commercial banks may have direct participation in low-income markets as a result of 12 their complying with directed or credit quota policies of government for targeted sectors. Sometimes, banks have indirect involvement in rural and microfinance as depositories of A the operating funds of MFIs and CFIs, or they have involvement through commercially priced wholesale loans and credit facilities to MFIs and CFIs as bank clients. An important B area to focus on is the existence of vertical and horizontal business relationships between commercial banks, on the one hand, and MFIs and CFIs, on the other. The importance of this point stems from the synergistic relationships that the smaller MFIs and CFIs can C form with the larger commercial institutions from the formal sector, whereby the combi- nation can reach a larger number of clients with resources than may be obtained from the D latter large institution at commercial--not subsidized--rates and terms. E 7.4 Conceptual Framework for the Regulation of Rural Finance and F Microfinance Institutions The aim of a supportive regulatory framework is to build strong regulated and unregu- G lated institutions of all types (a) to provide services on a sustainable basis under uniform, common, shared performance standards and (b) to encourage the regulatory authority H to develop appropriate prudential regulations and staff capacity that are tailored to the institutions' operational and risk profiles. This objective requires defining different tiers of I financial institutions with different degrees of regulatory requirements. The requirements could vary from (a) simply registering as legal entities, to (b) preparing and publishing 194 Chapter 7: Rural and Microfinance Institutions: Regulatory and Supervisory Issues periodic reports on operations and financial results, to (c) observing non-prudential rules 1 of conduct in business operations, to (d) securing a proper license and being subject to prudential regulation by a regulatory authority, prudential supervision, or both by a cen- tral supervisory authority. Lower-tiers institutions serving the lower end of the market can 2 enable non-bank microlenders to seek greater formalization without actual licensing. As the rural finance and microfinance sector grows, adding a licensing tier that per- 3 mits MFIs to legally mobilize savings and other commercial sources of funds can encourage capacity building and innovation that are aimed at self-sufficiency and greater outreach. 4 Another approach that has been used is to open a special window for micro-lending as a product that enables commercial banks, as well as alternative specialized institutions, to 5 benefit from different cost and regulatory structures. Licensing of rural and community banks can also facilitate the emergence of new types of MFIs that serve specific markets. 6 However, the premature creation of special tiers with easy entry may result in weak insti- tutions, may affect the development of the commercial financial system, and may risk 7 overwhelming inadequate supervisory resources.4 Thus, the licensing of MFIs should be designed to balance promotional and pruden- 8 tial objectives. The main potential threats pertaining to deposit-taking MFIs are that (a) deposit-taking MFIs could collapse, thus adversely affecting the commercial system, and 9 that (b) prudential regulation of deposit-taking MFIs could prove to be an administrative burden that distracts supervisors from adequately protecting the safety and soundness of the main financial system. The Consultative Group to Assist the Poorest (CGAP) 10 Microfinance Consensus Guidelines (Christen, Lyman, and Rosenberg 2003) takes a bal- anced view, arguing that deposit taking on a small scale may essentially go unsuper- 11 vised--especially where the deposits consist of only forced-savings components of the lending product, so that most depositors are net borrowers from the MFI at most times. 12 This approach would leave the supervisory apparatus unencumbered from having to deal in-depth with a profusion of tiny MFIs. A A consensus on the framework for the regulation of rural finance and microfinance institutions has evolved on the basis of country experiences in recent years. This frame- B work (summarized in table 7.2) identifies different categories and tiers of institutional providers of microfinance, and it specifies the thresholds of financial intermediation C activities that trigger the need for progressively stronger types of regulation and supervi- sion. The legal and regulatory framework for banking and finance in many countries may D not include lower tiers for rural finance and microfinance banks. Some countries may be in the process of establishing the legal and regulatory framework specifically to create new tiers for rural finance or microfinance banks, which usually have a limited geographical E coverage specified by law. Regulation of microfinance activities and institutions may take three main forms: (a) simple registration as a legal entity; (b) non-prudential regula- F tions that provide standards of business operations and oversight, such as operating and financial reports to be submitted, to protect the interests of clients or members; and (c) G full prudential supervision. Global experience illustrates that the benefits from regulating microfinance may be limited when commercial banking standards are applied to MFIs H without adequate consideration of microfinance methodologies. Non-bank finance companies and other types of registered institutions providing rural I finance and microfinance services are not subject to statutory prudential regulation and 195 Financial Sector Assessment: A Handbook Table 7.2. Tiered Structures and Regulatory Triggers by Type of MFI 1 Type of microfinance Activities that trigger Forms of external Recommended regulatory institution (MFI) regulation regulation authority 2 Informal savings and credit None None required None required groups funded by members fees and savings 3 Category A: Nongovernmental organizations (NGOs) funded by donor funds 4 Category A1: Funding only None, if total loans do not Registration as a nonprofit A registrar of societies or self- from grants exceed donated funds, grants, society, association, or trust regulating body, if any 5 and accumulated surplus Category A2: Funding from Generating liabilities through Registration as a legal A registrar of companies, donor grants and from borrowings to fund microloan corporate entity; authorization banking authority, or 6 commercial borrowings or portfolio and operations by a banking authority or securities agency securities issues securities commission Category B: Financial Accepting deposits from and Registration as a financial A registrar of cooperatives or 7 cooperatives and credit making loans to members cooperative banking authority unions funded members' money and savings 8 Category C: Special-licensed Accepting wholesale and Registration as a corporate A registrar of cooperatives or banks and MFIs funded by retail public deposits for legal entity; licensing as banking authority the public's money (deposits, intermediation into loans and a finance company or investor capital, and investments bank (with full prudential 9 commercial borrowings) requirements) Note: This regulatory framework for the classification of MFIs was originally proposed by van Greuning, Gallardo, and Randhawa (1999) and modified by Randhawa (2003). Except for informal groups, MFIs are classified into four categories that are based on the 10 structure of their liabilities (i.e., sources of funding). Cooperatives in category B have a long but inefficient history of regulation. If their deposit taking is small in scale and limited to their members, they should be given low regulatory priority. Category C should not include MFIs that require mandatory savings to secure loans as long as most customers are net borrowers most of 11 the time. Formal banks with a microfinance department are not included in this regulatory framework because they are subject to prudential supervision, even if it is usually not adapted to the specific features of this segment of the financial system. 12 A supervision by a central supervisory authority, because they do not mobilize retail deposits B from the public and intermediate those deposits into loans and investments. Nevertheless, such institutions should observe and adhere to a set of rules and standards with respect to C the conduct of their business operations to provide protection for their borrowing custom- ers and for third-party providers of wholesale commercial funds, even though commercial D fund providers and institutional investors are presumed to be well informed and to be capable of any required due diligence.5 An overview of desirable standards for conduct of E business is provided in box 7.2. F 7.5 Assessment of the Regulatory Framework Issues for Rural Finance and Microfinance Institutions G H The assessment of the regulatory framework for the rural finance and microfinance sector covers both the institutional aspects and the benchmarks used to evaluate the sector's per- I formance and soundness. The considerations include (a) assessing the need for prudential supervision versus non-prudential regulation and for the technical capacity for supervi- 196 Chapter 7: Rural and Microfinance Institutions: Regulatory and Supervisory Issues 1 Box 7.2 Conduct of Business Regulations for MFIs Listed below are basic standards and rules covering · annual reports on operating and financial 2 the conduct of business operations of "non-pruden- results, which have been reviewed by accept- tially regulated" non-bank finance companies and able external auditors and that include periodic other types of registered institutions providing rural reporting and publication of financial results 3 and microfinance services. Generally, company regis- · written policies and procedures approved by the tration laws and regulations require legally registered institution's board and management covering companies to prepare and submit audited annual loan approval and documentation; loan account 4 reports and financial statements to the registry agen- aging, classification, and provisioning for pos- cy. Because there may not be any onsite examination sible loan losses; loan delinquency control pro- or supervision by a regulatory body, the burden of cesses; loan loss write-offs; and internal audit 5 observance and compliance falls substantially on an and control systems institution's internal governance structure and, with- · observance of industry standards with respect to 6 out doubt, on the institutions that may be the sources debt-to-equity ratio, equity-to-risk assets ratio, for wholesale funds. short-term assets-to-short-term liabilities ratio, portfolio at risk (loans overdue greater than 30 · adherence to and use of uniform accounting 7 days as a percentage of total loan portfolio), standards and procedures for internal and exter- and portfolio at risk coverage (provisions and nal reporting of operating and financial results reserves for loan losses as a percentage of port- 8 folio at risk) 9 10 sion, as well as the costs of that supervision; (b) determining which agency should carry 11 out the supervision or regulation, and whether delegated or auxiliary supervision may be warranted or justified; and (c) establishing benchmarks and standards for evaluating 12 outreach and for financial performance and soundness. In addition, certain cross-cutting issues­­taxes that may obstruct more effective outreach and costs, and credit information- sharing systems that can help MFIs manage loan delinquencies and reduce costs­­need to A be considered. Also, PSBs and CFIs--though significant components of the rural finance and microfinance sector--are often excluded from the scope of the regulatory framework. B However, an analytical evaluation of their outreach, operating performance, and financial soundness--as well as the primary problems they face or may pose to the rest of the sec- C tor--may be an important aspect of the assessment of adequacy of access. A discussion of regulatory issues relating to PSBs and CFIs is contained in box 7.3. D Some key questions in assessing the regulatory framework of rural finance and micro- finance institutions include the following: E · Is there a need to regulate (but not prudentially supervise) those other institutions? If so, what is the scope of the regulation? Very often the distinctions between broad F regulatory oversight (sometimes called non-prudential regulation) and detailed pru- dential supervision are ignored in a number of countries. Inappropriate regulatory G approach has led to the misallocation of scarce supervisory and staff resources in the attempt to impose prudential standards and requirements on rural finance and H microfinance institutions that are not engaged in mobilizing and intermediating public deposits, a step that poses a systemic risk. Prudential supervision involves I the regulatory authorities' verifying the compliance of institutions with mandatory 197 Financial Sector Assessment: A Handbook 1 Box 7.3 PSBs and CFIs and the Scope of Their Regulation Postal savings banks (PSBs) are generally not includ- need to focus more attention on measures to treat 2 ed in the prudential regulatory framework for bank- CFIs as part of the financial services segment, rather ing and financial institutions, which can aggravate than as part of the cooperative segment. There have 3 weaknesses that often exist in the PSBs' internal been only a few cases of countries adopting special- governance structure and accountability processes. ized laws and regulations for CFIs. Individual members' deposits in PSBs are not included Individual members' deposits in CFIs may be 4 in formal deposit insurance or in protection schemes protected when a deposit insurance fund has been (when those schemes exist), but they are implicitly established privately by an upper-level regional or guaranteed by the government. Thus, the risk exists national cooperatives federation. While the deposits 5 for potential claims on the government treasury or of a CFI with a commercial bank may be included budget in the event of losses from mismanagement or in formal deposit insurance or protection schemes fraud. Furthermore, savings and time deposits collect- (when those schemes exist), the recognized legal 6 ed by PSBs are not intermediated into rural finance depositor is the CFI, not the individual members or microfinance loans, but they are often used to help who may own the deposits. There exists the risk 7 fund treasury or budget operations by the requirement of potential claims on the government treasury or that PSBs' investments be limited to government budget in the event of losses from mismanagement treasury bills and bonds. or fraud, if the CFI segment of the rural finance and 8 Cooperative financial institutions (CFIs) offer microfinance sector is fairly large. important potential ways to decentralize the access to As a closed-circuit financial system, deposits col- financial services, particularly in rural areas that banks lected by CFIs from individual members are inter- 9 and commercial microfinance institutions (MFIs) may mediated into rural finance or microfinance loans find too costly to reach. In many countries, CFIs con- to members only, but there are instances where CFIs stitute an important and comparatively large segment 10 effectively offer deposit services to nonmembers and of the rural finance and microfinance sector in terms the general public, because the "common bond" for of the number of institutions and their membership membership is loosely specified. 11 base. Governments, as well as the donor community, 12 A B C standards--such as minimum capital levels and adequacy, liquidity management D ratios, and asset quality standards--as measures for financial soundness. Prudential supervision of deposit-taking category C institutions (see table 7.2) is aimed at E protecting public savings that are being mobilized and lent out or intermediated, which puts public savings at risk of being lost if loans are not repaid. In contrast, F for various categories of institutions­­institutions in category A2 and similar insti- tutions in category B­­may require only non-prudential supervision or regulatory G oversight, as outlined in table 7.2. · Which agency should regulate the institutions? An important issue is the extent to H which regulatory authority should be centralized, delegated, or decentralized (see box 7.4 for further discussion). Box 7.5 contains a further discussion of supervision I standards, technical capacity and cost considerations that enter into the assess- ments. 198 Chapter 7: Rural and Microfinance Institutions: Regulatory and Supervisory Issues 1 Box 7.4 Critical Issues in Delegating Prudential Supervision Delegated supervision covers arrangements where the sory authority's oversight and monitoring of the 2 central banking and financial institutions supervisor agency? delegates direct supervision of an identified set of · Should the delegated or auxiliary supervision institutions to a body or agency outside the central arrangement prove to be unreliable or ineffec- 3 supervisory authority, while monitoring and control- tive, and should the mandate to the delegated ling that other body's or agency's supervisory work or auxiliary supervisory agency need to be with- (see Christen, Lyman, and Rosenberg 2003). Limited drawn, does a realistic and practicable fallback 4 examples of delegated supervision are being used or alternative option exist for the central super- for microfinance institutions (MFIs); thus, there is visory authority? 5 little experience to date on the effectiveness of this · In the event that a supervised institution fails, approach. which agency--the central supervisory author- If the approach were to be applied even on an ity or the delegated or auxiliary supervisory 6 interim basis, it is critical to answer the following agency--will have the authority and capability questions in advance (see Christen, Lyman, and to clean up and rectify the situation by suspen- Rosenberg 2003): 7 sion, intervention, or liquidation? · Who bears the costs (which may be substantial) · Does a delegated or auxiliary supervisory agency of the delegated or auxiliary supervisory agency bear any legal liabilities in the exercise of the 8 and the additional costs of the central supervi- delegated or auxiliary responsibilities? 9 10 7.6. Some Cross-Cutting Issues Affecting Rural Finance and Microfinance Institutions 11 12 Tax issues may present obstacles to rural finance and microfinance institutions from more effectively providing access to financial services. The legal and nonprofit status of non- bank NGO MFIs may sometimes be questioned by tax authorities on the grounds that A the credit services they are providing to their clientele are priced at commercial rates, rather than at "charitable" levels, as in the case of NGO MFIs in India. In other instances, B licensed specialized banks and non-bank finance institutions may not be permitted by tax accounting laws and regulations to expense provisions for possible loan losses, in spite of C prudential regulations issued by the central supervisory authority, as in Tanzania, which creates an unnecessary real economic burden to such specialized banks and non-bank D finance institutions. A related problem stems from the requirement by tax authorities that delinquent loans may be written off only when the sale and disposition of collateral E securing such a defaulted loan results in recovering a monetary value that is less than the value of the collateral, as in the case of Kenya. F Credit registries allow borrowers to build up a credit history and can assist lenders in assessing risk, thereby reducing the cost of lending and improving access. Credit registries G that give easy and reliable access to a client's credit history can dramatically reduce the time and costs of obtaining such information from individual sources and, therefore, H can reduce the total costs of financial intermediation. Credit reporting makes borrower quality much more transparent, which benefits good borrowers and increases the cost of I defaulting on obligations. It helps borrowers build up a credit history and eases access to 199 Financial Sector Assessment: A Handbook credit. Credit registries are especially important for SMEs, because their creditworthiness 1 is more difficult to evaluate and because they have less visibility and transparency relative to large enterprises. 2 Often, current regulations may provide for the sharing of only negative information (i.e., information on nonperforming loans). It is preferable that regulations allow for shar- 3 ing of both positive and negative information to improve reliability of credit risk evalua- tion and to increase competition.6 Reporting positive information significantly increases 4 the predictability of rating and scoring models used by lenders, thereby translating into lower loss rates, higher acceptance rates of credit applicants, or both (see Staten 2001). 5 Sharing positive information will also allow borrowers to build their credit history, which can especially benefit small borrowers, because it will allow them to establish a good bor- 6 rowing reputation and to improve their chances to increase borrowings as their business grows. Regulations governing information sharing should also allow for adequate consum- er and data protection mechanisms. Allowing all finance providers to share both positive 7 and negative information on their borrowers will allow small business to participate in 8 9 Box 7.5 Supervision Standards, Technical Capacity, and Cost Issues 10 In an assessment of the prudential regulatory and rural banking department of the supervisory supervisory framework for microfinance, the following authority. key questions need to be addressed: 11 · What is the comparative workload (number of licensed institutions, or number of days needed · Are the prudential standards applied to special- to complete onsite examination or supervision) ized banks and financial institutions in the rural 12 of supervisory staff members assigned to com- finance and microfinance sector consistent with mercial banks versus that of members assigned and adapted to the nature and characteristics of to specialized banks and financial institutions in A the market clientele they service (e.g., microfi- nance loans are short term, repeating, and unse- the rural finance and microfinance sector? cured with group guarantees being widespread · What is the judgmental assessment of the tech- B practice), or are the prudential standards used nical capability of staff members and the quality the same as those that apply to regular commer- of their examination and supervision of special- cial banks? ized banks and financial institutions in the rural C · Does the central bank or supervisory author- finance and microfinance sector in comparison ity have rural finance- or microfinance-dedi- with technical staff members responsible for cated staff members assigned to the supervision commercial banks? Is this a fair comparison? D and examination of the specialized banks and · Is it possible to estimate and compare the costs financial institutions in the rural finance and associated with the examination and supervision E microfinance sector? In a number of countries, of specialized banks and financial institutions in including Kenya, Pakistan, the Philippines, and the rural finance and microfinance sector in Tanzania, the supervisory authority has a sepa- comparison with the costs for the examination F rate specialized microfinance section that deals and supervision of commercial banks? Is this a with policy issues (including appropriate stan- fair comparison? dards), but actual examination and supervision · Does the central bank or monetary authority G of all licensed banks and financial institutions require the commercial banks and the special- are carried out by technical staff members from ized banks and financial institutions in the rural H the banking supervision department. In other finance and microfinance sector to pay for or countries, including Ghana, Indonesia, and the to defray the costs associated with examina- Philippines, rural and community banks are tion and supervision? If so, what charges are I examined and supervised by staff members in the imposed? 200 Chapter 7: Rural and Microfinance Institutions: Regulatory and Supervisory Issues 1 Box 7.6 Findings and Recommendations on Microfinance Regulatory Issues in Selected FSAPs Case I: A Transition Economy Case II: A Developing Country 2 Key Issues Key Issues Access to financial services through microcredit pro- The regulatory regime for microfinance is uneven 3 grams is primarily through microfinance institutions and tilted toward overregulation. The policy direc- (MFIs) and credit cooperative organizations (CCOs) tion is unclear as to whether the provision of micro- registered with and licensed by the central bank. The finance and small-scale finance services will depend 4 microfinance sector is small in terms of total credit more on formally licensed banks and institutions volume and number of households and enterprises reaching down, or will depend on developing the 5 reached. The most critical issues for development of scaling-up of community- or nongovernmental orga- the microfinance sector are (a) diversification of fund- nization (NGO)­based MFIs, including savings and ing sources, as authorization for mobilizing deposits credit cooperative organizations (SACCOs). 6 does not come automatically with licensing, even for CCO members' deposits; and (b) striking a balance Policy Recommendations between developing a safe and sustainable sector and 7 imposing unreasonable burdens on both the regulated · The move toward a more systematic and thor- institutions and the regulatory authority. ough regulatory regime for the few MFIs to be taking more than a specified amount of deposits 8 Policy Recommendations is commendable, but smaller NGO MFIs and SACCOs able to reach remote rural areas 9 · MFIs and CCOs should be allowed to take should not be suppressed by excessive regula- deposits from their members or borrowers, pro- tion. vided they meet established prudential norms · The development and strengthening of umbrel- 10 related to expected financial and operational la organizations and the greater reliance by risks. MFIs on funding from local banks rather than · The legal and regulatory environment for MFIs external donors should be encouraged. 11 or CCOs that do not take deposits should be · A specialized agency for cooperative financial reviewed and simplified commensurate to their institutions should be considered for focusing on risk profile. capacity building and financial infrastructure. 12 · Improvement of the regulatory and supervisory framework through better prudential reporting A standards and more-effective sanctions could make supervision more effective. B Sources: FSAP reports C D the process of reputation building and generation of credit history. It would help facilitate E the process of borrowers' graduating from microfinance to bank finance as their business develops. Information sharing among all finance providers could contribute significantly to reducing segmentation and increasing competition. F G 7.7 Ways to Address Rural Finance and Microfinance Regulatory Framework Issues H The core issues in the legal and regulatory framework for rural finance and microfinance I will differ from one country to another because of country differences in the structure 201 Financial Sector Assessment: A Handbook and stage of development of the rural finance and microfinance sector and because of 1 the regulatory approach used. This difference is illustrated by highlighting key issues and policy recommendations in selected Financial Sector Assessment Program (FSAP) 2 reports, which are summarized in box 7.6. 3 7.8 Consensus Guidelines on Regulating and Supervising Microfinance 4 5 CGAP published consensus guidelines approved by 29 international donor agencies that support microfinance (Christen, Lyman, and Rosenberg 2003). Those guidelines were 6 approved by CGAP members in September 2002. The consensus guidelines list 21 key policy recommendations on regulation and supervision of microfinance, which create a 7 good checklist of issues to focus on in the assessment of regulatory aspects that pertain to access to financial services. The particular set of key policy recommendations in the 8 checklist that may be applicable to a given situation will vary from one country to another depending, among other things, on the range and variety of institutional providers of rural finance and microfinance services, on the size and relative importance of each type of 9 rural finance and microfinance institution category, and on the size of the rural finance and microfinance sector relative to the formal commercial finance sector. Several of the 10 key policy recommendations are selected for emphasis and are highlighted next:7 11 · Problems that do not require the government to oversee and attest to the financial soundness of regulated institutions should not be dealt with through 12 prudential regulation. Relevant forms of non-prudential regulation, including regulation under the commercial or criminal codes, tend to be easier to enforce and less costly than prudential regulation. A · Before regulators decide on the timing and design of prudential regulation, they should obtain a competent financial and institutional analysis of the leading B MFIs, at least if the existing MFIs are the main candidates for a new licensing window being considered. C · Minimum capital needs to be set high enough so that the supervisory authority is not overwhelmed by more new institutions than it can supervise effectively. D · Where possible, regulatory reform should include adjusting any regulations that would preclude existing financial institutions (banks, finance companies, E etc.) from offering microfinance services, or that would make it unreasonably difficult for such [regulated and licensed] institutions to lend to MFIs. F · Prudential regulation should not be imposed on "credit-only" MFIs that merely lend out their own capital, or whose only borrowing is from foreign commercial G or non-commercial sources or from prudentially regulated local commercial banks. H · As a corollary to the above principle and] depending on practical costs and benefits, prudential regulation may not be necessary for MFIs taking cash col- I lateral (compulsory savings) only, especially if the MFI is not lending out (i.e., not able to intermediate these funds). 202 Chapter 7: Rural and Microfinance Institutions: Regulatory and Supervisory Issues · Design of microfinance regulation should not proceed very far without estimat- 1 ing supervision costs realistically and identifying a sustainable mechanism to pay for them. Donors who encourage governments to take on supervision of new types of (licensed) institution should be willing to help finance the start- 2 up costs of such supervision. · In developing countries, "self-supervision" by an entity under the control of 3 those supervised is not likely to be effective in protecting the soundness of the supervised financial institutions. 4 · A microlending institution should not receive a license to take deposits until it has demonstrated that it can manage its lending profitably enough so that 5 it can cover all its costs, including the additional financial and administrative costs of mobilizing the deposits it proposes to capture. 6 · Financial cooperatives (credit unions and savings and credit cooperatives)--at least large ones--should be prudentially supervised by a specialized financial 7 authority, rather than by an agency that is responsible for all types of coopera- tives (financial and non-financial). 8 The Bibliography includes a number of reference works and guidelines that are useful in addressing the above questions--particularly on relevant prudential standards, tools 9 for supervision, and costs of supervision--as well as providing the benefit of lessons from the experience of a number of countries that have had to address similar questions and 10 issues. 11 Notes 12 1. Example of rapid growth in cooperatives and credit unions include Burkina Faso, Ecuador, Guatemala, and the Philippines. A 2. Village banking is a means of delivering financial services such as small loans and savings products to those people who could not otherwise obtain them. While many B agencies and organizations provide small loans to low-income families, not all use the village banking method. Developed by FINCA (http://villagebanking.org/), the village C banking method is unique in the responsibility and autonomy given to borrowers in running their banks and in the method's emphasis on community, as well as individual D development. The village banking method has been shared widely with 40 voluntary agencies and development organizations that currently operate more than 80 programs worldwide. The village banking method is highly participatory in nature. It gives the E beneficiaries a voice and involves them in the development process. Not only do members receive loans, but also they form cohesive groups that manage and collect F repayments on those loans, that save diligently, and that decide on ways to invest those savings, and progress together, thus forming networks for mutual support. G 3. Data cited as of 2003. 4. See Honohan (2004) for a discussion of this point. H 5. In some countries, wholesale borrowings through commercial paper or money market instruments and through medium- to long-term large-value certificates of deposit I may require prior authorization from a securities or capital market authority or, where 203 Financial Sector Assessment: A Handbook the institutional investor or lender is an insurance company, from the insurance 1 commissioner. 6. Positive information includes repayment history with amounts and terms of the loans, 2 while negative information includes delays in repayment and defaults. 7. See Christen, Lyman, and Rosenberg (2003). The selected set of key policy recom- 3 mendations is presented and reproduced verbatim, except for those terms in brackets, which have been inserted for purposes of further clarification, and except for some 4 changes in the order of presentation. 5 References 6 Barron, John M. and Michael Staten. 2001. "The Value of Comprehensive Credit 7 Reports: Lessons from the U.S. Experience." In Making Small Business Lending Profitable--Proceedings from the Global Conference on Credit Scoring. International 8 Finance Corporation: Washington, DC. Boomgard, James, Debra Boyer, and James Dyer. 2003. "The Agricultural Bank of 9 Mongolia: From Insolvent State Bank to Thriving Private Bank." Case Study present- ed at the International Conference on Best Practices titled "Paving the Way Forward 10 for Rural Finance," Washington, DC, June 2003. Christen, Robert Peck, and Richard Rosenberg. 2000. The Rush to Regulate: Legal 11 Frameworks for Microfinance. Washington, DC: Consultative Group to Assist the Poorest. 12 Christen, Robert Peck, Timothy R. Lyman, and Richard Rosenberg. 2003. Microfinance Consensus Guidelines. Washington, DC: Consultative Group to Assist the Poorest. A Fiebig, Michael. 2001. Prudential Regulation and Supervision for Agricultural Finance. Rome: Food and Agriculture Organization of the United Nations (FAO) and B Deutsche Gesellschaft für Technische Zusammenarbeit (GTZ), Agriculture Finance Revisited No. 5. C Gallardo, Joselito. 2002. "A Framework for Regulating Microfinance Institutions: The Experience in Ghana and the Philippines" World Bank Policy Research Working D Paper No. 2755, World Bank, Washington, DC. Gallardo, Joselito, Korotoumou Ouattara, Bikki Randhawa, and William F. Steel. 2005. E "Comparative Review of Microfinance Regulatory Framework Issues in Benin, Ghana, and Tanzania." World Bank Policy Research Working Paper WPS3585, World Bank, F Washington, DC. Honohan, Patrick. 2004. "Financial Sector Policy and the Poor: Selected Findings and G Issues." World Bank Working Paper No.43, World Bank, Washington, DC. Robinson, Marguerite S. 2001. The Microfinance Revolution: Sustainable Finance for the H Poor. World Bank: Washington, DC, and Open Society Institute: New York. Staschen, Stefan. 2003. Regulatory Requirements for Microfinance--A Comparison of I Regulatory Frameworks in Eleven Countries Worldwide. Deutsche Gesellschaft für Technische Zusammenarbeit. 204 Chapter 7: Rural and Microfinance Institutions: Regulatory and Supervisory Issues van Greuning, Hennie, Joselito Gallardo, and Bikki Randhawa. 1999. "A Framework for 1 Regulating Microfinance Institutions." World Bank Policy Research Working Paper No. 2061, World Bank, Washington, DC. World Bank. 2001. "Finance for Growth: Policy Choices in a Volatile World," World 2 Bank Policy Research Report, World Bank and Oxford University Press, Washington, DC. 3 World Bank Institute. 2004. Interactive CD-ROM on Microfinance Regulation. Washington, DC: World Bank Institute. 4 Yaron, Jacob, and Stephanie Charitonenko. 1999. "Making the Transition from State Agricultural Credit Institution to Rural Finance Intermediary: Role of the State and 5 Reform Options." Paper prepared for the panel on Strategies for Microfinance in Rural Areas, Second Inter-American Forum on Microenterprise, Buenos Aires, Argentina, 6 June 1999. Zeller, Manfred. 2003. "Models of Rural Financial Institutions." Lead theme paper pre- 7 sented at the International Conference on Best Practices, "Paving the Way Forward for Rural Finance," Washington, DC, June 2003. 8 9 10 11 12 A B C D E F G H I 205 1 2