Banking Soundness and Monetary Policy
Chapter

7 Applying Basle Standards in Developing and Transition Economies

Editor(s):
Charles Enoch, and J. Green
Published Date:
September 1997
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Author(s)
FREDERIK C. MUSCH

The Basle Committee has now been in existence for more than twenty years, gradually moving from information gathering to coordination and then to harmonization of international banking standards. The thrust of its work over those years has been twofold: promoting sound banking standards, not only as regards capital; and encouraging cooperation among supervisors, which has gradually become more binding.

The evolution of the supervisory framework has been very flexible, moving forward whenever clear benefits could be shown and deliberately not imposing any integrated, rigid approach. The latter approach would have failed given the many institutional differences worldwide, even within the Group of Ten. Flexibility was therefore intentional and took several forms:

  • Only certain aspects of supervision were covered: neither the accounting area nor fiscal elements were considered, nor were clear standards set for management quality.
  • Standards, where set, could be at different levels. Minimum standards for capital were meant to be harmonized, but for certain other elements national discretion was allowed. With large exposures, for example, greater leniency was permitted, and with liquidity there was only a best-practices paper (which is still in demand). Deposit insurance was left entirely to national authorities.
  • Implementation was allowed to vary by region, making allowances for local circumstances.

Changes in the Banking Environment

The work of the Basle Committee has, to a very great extent, been restricted to the G-10 banking systems. The international banks tend to be located in the financial centers of the G-10 countries, from where they serve the world through branches and subsidiaries. Although this composition is gradually changing, the financial institutions headquartered in the G-10 countries still make up just under 80 percent of the world’s international banking system, a figure that takes in these banks’ worldwide branches or subsidiaries.

Since 1988, maintenance of the risk-based capital framework has been an ongoing project for the Basle Committee. Concepts are continuously evolving and becoming increasingly complex. In discussions on financial innovations, one should only think of new risk management structures and in-house financial models for market risk, among others, but just as much is happening in connection with the so-called traditional elements of the Basle Accord. Changes are taking place in many countries, mostly of a technical nature, that are decisive for the outcome of capital calculations, and thus for competition among banks. The Capital Liaison Group has been managing the Basle Accord; especially in the last few years, many inventive products and schemes have been put forward, which have been evaluated so as to ensure equal treatment in all G-10 countries. Below are several examples:

  • Asset-backed commercial paper programs. Such commercial paper typically receives the highest credit rating. The programs utilize a liquidity facility, which is usually provided by a commercial bank, typically for one year or less, in order to avoid risk-based capital requirements. By obtaining a one-year renewal as the paper matures, six months into the original commitment, the program is able to roll over the commercial paper for another six to nine months. Such facilities are converted to an on-balance-sheet credit equivalent, using the zero percent conversion factor.
  • Step-up clauses. Such clauses lead to a different treatment of subordinated term debt in banks’ capital. They provide for an increase in the interest rate paid to investors after a predetermined period of time (usually five years). Nevertheless, the issuer can avoid that increase by redeeming the subordinated debt. Supervisory authorities in such cases have to choose between a significant relaxation of prudential regulation and the imposition of inappropriate charges on banks. Complications also arise in the case of zero-coupon subordinated term debt.
  • Special-purpose vehicles. Banks set up such vehicles to purchase assets and issue securities. When several strict conditions are met, such vehicles do not require additional capital to support banks’ activities in this area.

Proposals for changing the risk-based capital framework usually—if not always—aim to lighten the burden for banks, for example, by stretching the definitions of Tier 2 capital to make it eligible for Tier 1 without the full qualifications. They are usually put forward by merchant bankers or lawyers in a member country. Another common tactic is trying to convince, say, U.K. regulators to consider a proposal by adding that the French authorities are at the last stage of approving, or have already approved, it. It is in such situations that very frequent exchanges among G-10 supervisors in the Capital Liaison Group become especially useful.

This practice of referring to schemes already allowed in other countries is not restricted to the G-10 countries. I could just as easily give the example of the Vietnamese authorities being approached with a proposal that has allegedly been allowed in Thailand. Not only are supervisors operating worldwide, but merchant bankers, too, are creating business for their clients on a global scale. The arguments can be quite persuasive, but the information provided must be verified. The framework is much more complicated than it is often perceived to be, and it is difficult to oversee all the consequences of tinkering with it.

It has often been stated that the Basle Committee’s work is about international banks, and is only relevant for those banks. This was the original intention behind the Basle Accord, but the lines between international and domestic banks have since become blurred. For instance, in the European Union, banking laws apply to both international and domestic banks, if that distinction can still be made. And increasingly in other countries, the rules are meant for the banking system as a whole. Thus, the distinction is no longer very relevant, although the Basle Committee still conducts statistical work on that basis. One could say that the rules agreed upon in Basle are designed for sound banking generally, not just international banking. In other words, the international supervisory framework is intended to ensure that banks, any banks, are adequately managed.

It would be misleading to give the impression that efforts to set up sound supervisory systems have been made only in the G-10 countries. On the contrary, much work has been undertaken by supervisors in the emerging-market and transition economies, and this on a voluntary and flexible basis, which may explain their clear progress. Much remains to be done, but maintaining flexibility in the approach has proved even more important in non—G-10 countries, where individual supervisors have not only built their own supervisory systems but also fit them into a global supervisory framework. In Basle, the committee has seen clear evidence of this in the enormous amount of correspondence asking for guidance and documentation on a broad range of supervisory issues.

Regional Issues

As important as the much-needed support for supervisors in individual countries is the work of the regional groups of supervisors and their training. The regional groups are all rather different: some are supervisory organizations only, others form part of central bank cooperation; some have been in existence for a long time; some are quite recent. (The Basle Committee played an important role in the formation of the latter.)

The long-established groups are the European Union’s Banking Advisory Committee, the Offshore Group of Banking Supervisors, the Gulf Cooperation Council Committee of Bank Supervisors, the Association of Banking Supervisory Authorities of Latin America and the Caribbean Supervisors, and the SEANZA Forum of Banking Supervisors. In 1990, the Basle Committee decided to strengthen its cooperation with existing regional groups and to encourage the creation of regional groups in areas where no coordination existed. Several groups were created under the auspices of the Basle Committee as a result of this new orientation: the Group of Banking Supervisors from Central and Eastern Europe in 1990; the Arab Committee on Banking Supervision in 1991; the East and Southern Africa Banking Supervisors in 1993; the West and Central African Group of Banking Supervisors in 1995; and the Transcaucasian and Central Asian Regional Group, also in 1995.

The secretariat of the Basle Committee has been very active in developing this now global network. It now has good relations with 11 regional groups, and very few countries are not a member of some regional group. The cooperation of the Basle Committee with the regional groups consists of joint annual meetings with the chairs of the regional groups and the participation of its representatives and the secretariat in the annual meetings of the groups. The secretariat often assists in the organization of these meetings. The training provided by the secretariat is channelled through the regional groups.

After an initial concentration on Eastern Europe lasting into 1994, the training work of the committee has taken on a more global perspective. While in 1994 training was provided for 494 participant days, the total was 690 in 1995 (an increase of 25 percent), and 987 in 1996 (an increase of 59 percent). The committee is by no means alone in these efforts. The International Monetary Fund and the World Bank, as well as our member central banks, are also actively involved, and the committee is increasing its cooperation with the IMF and the World Bank to avoid duplication and overlaps. In our training worldwide, it supports non-G-10 countries in their efforts to set up banking systems that are up to international standards. It is very gratifying, for instance, to see many supervisors from non-G-10 countries who attended the committee’s flagship training course (held once a year in Basle) subsequently occupying senior supervisory positions in their respective countries and now playing an important role in the international coordination of banking supervision.

Cross-Border Arrangements

Another positive development over the years has been the cooperation among national supervisors in the area of cross-border banking. This started with the Basle Concordat in 1975 and its subsequent revisions. This earlier work led to the Minimum Standards, in which four basic principles were established:

  • (1) All international banks should be supervised by a home country authority that capably performs consolidated supervision.
  • (2) The creation of a cross-border banking establishment should receive the prior consent of both host and home country authorities.
  • (3) Home country authorities should possess the right to gather information from their foreign banking establishments.
  • (4) If the host determines that any of these three standards is not being met, it can impose restrictive measures or prohibit the establishment of banking offices.

Home and host do not necessarily correspond to G-10 and non-G-10 countries, respectively. Some of the largest host countries are G-10 countries and, outside the G-10 group, one also finds important home supervisors. Very simply, countries first have to put their supervisory houses in order and in doing so they may then gradually influence each other to improve the general quality of supervision.

In numerous countries, much has been done to implement these Minimum Standards, and much is being done to further the mutual commitment to cooperate, to exchange experiences, and to share information. Recently, the implementation of these standards has been improved as well. A group comprising representatives of the Basle Committee and the Offshore Group of Banking Supervisors produced a report on cross-border banking that addresses how to better apply the Minimum Standards in practice. It sets out the following aims:

  • (1) Improve the access of home supervisors to information necessary for effective consolidated supervision.
  • (2) Improve the access of host supervisors to information necessary for effective host supervision.
  • (3) Ensure that all cross-border banking operations are subject to adequate home and host supervision.

These aims follow from several issues of concern to supervisors:

  • Determining the effectiveness of home country supervision. This entails focusing on the powers of global oversight and of the judgment of the host supervisor on whether consolidated supervision by the home supervisor is seen to be effective. This requires an information flow from the host to the home supervisor, with the need for home supervisors to verify that qualitative information received from banking organizations is accurate and to reassure the supervisors that there are no supervisory gaps;
  • Inspections by home country supervisors. As part of the exercise of comprehensive consolidated supervision, a standard routine has been laid down, in which the rights of both home and host supervisor are to be protected;
  • Information flow from the home to the host supervisor. It is also important for host supervisors to be informed of material adverse changes in the global condition of banking groups operating in their jurisdictions. This is recognized as important information to be shared but typically will be a highly sensitive issue for home supervisors;
  • Supervisory standards in host countries. This basically relates to the effectiveness of supervision in the host country itself. Here a process whereby supervisors in regional groups can meet general criteria is outlined. It should, however, be stressed that any decision making regarding membership in a regional group should be left to that group alone; and
  • Gaps in supervision. The Minimum Standards were designed to provide greater assurance that no international bank could operate without being subject to effective consolidated supervision. Gaps in supervision continue to pose a threat to that principle. In particular, shell branches and parallel-owned banks, as well as parent institutions incorporated in underregulated financial centers are at issue.

These cross-border arrangements were endorsed at the International Conference of Banking Supervisors in Stockholm last year, and their implementation will be reviewed at the next such conference in 1998.

Guidelines for Effective Banking Supervision

After the endorsement of the cross-border banking paper by supervisors from 140 countries at the International Conference of Banking Supervisors in June 1996, the Basle Committee followed up the discussion of national supervisory methods with written consultations and a meeting in November with the heads of supervision of 15 emerging-market countries. At that meeting, participants endorsed the Basle Committee’s proposal to draw up a set of guidelines for effective banking supervision, in agreement with the IMF and the World Bank.

The drafting work is being carried out by a joint group of Basle Committee and emerging market supervisors, and comments have also been invited from supervisory authorities in other countries. The intention is to prepare a normative and comprehensive document, laying down all the key principles for a sound supervisory system, applicable to any country (G-10 as well as non-G-10). The committee has also decided to prepare, for the convenience of supervisors, a compendium of the relevant policy documents that it has produced in recent years. This will have cross-references to the guidelines document.

The guidelines concentrate on core principles of banking supervision, which are to be put in place in emerging markets; they include, for example, rules where no fixed standard applies within the G-10 countries, such as limits on large exposures or connected lending. It is important that such rules are firmly established. It is of secondary importance, and very much related to the legal and general institutional framework, whether they should stipulate 10 percent or 25 percent, or any other number for that matter. There has to be a certain flexibility within the system, just as there is such flexibility in the G-10 countries. As an example, there is increasing recognition among G-10 supervisors that disclosure should be an important tool complementing supervision. However, even in the G-10 countries, only the framework regarding market risk has been harmonized (more or less); a framework covering the more traditional elements of banking has not been well developed. Furthermore, full disclosure, including wholly adequate loan loss provisioning, would reveal in many developing countries—and especially transition economies—a banking system with very weak solvency, to say the least. Flexibility, caution in interpretation, and time for transition will have to be the remedies here.

A legitimate question for further discussion is how much infrastructure is needed before a definite, generally acceptable, worldwide system can be applied. Questions like this would appear to be more a matter of the time needed for transition than fundamental issues regarding the working of the system, although a certain minimum clearly seems to be desirable.

Given the voluntary nature of implementing supervisory arrangements in non—G-10 countries, the committee is not systematically informed about developments in this area. The Basle Committee does not necessarily need to know “centrally,” as it were, what is in place in non-G-10 countries. Much information of this kind is made available bilaterally within the Minimum Standards arrangements. That is how such information should be provided: on a decentralized basis via worldwide bilateral contacts. Of course, the committee has conducted worldwide surveys of supervision practices in the past, but the results need to be interpreted cautiously.

In preparation for the 1996 conference a survey was carried out, with the help of virtually all 140 participating countries, and some relevant statistics can be quoted from it. As the committee’s chairman Tommaso Padoa-Schioppa mentioned in his introductory remarks, it is interesting that supervisors around the world seem to be relying increasingly on a common box of tools for supervising banks. The similarities are remarkable, especially as regards the acceptance of the key components of the Basle Committee approach. Capital requirements, albeit computed differently, are used almost everywhere. In 92 percent of cases, a Basle-like risk-weighted approach is being followed. Nearly 90 percent of the countries surveyed do not allow lending to any individual customer to exceed 60 percent of a bank’s capital. A stricter ceiling—25 percent of capital—is applied by 55 percent of industrialized countries, compared with a striking 72 percent of other countries. As for the more complicated market risk exposure measures, almost 85 percent of non-G-10 countries intended to implement the amendment to the Basle Accord. Supervisors in all countries devoted special attention to internal control systems, frequently in the context of on-site examinations. An important conclusion of this survey was that the vast differences between countries in both structural and institutional frameworks are coupled with notable similarities in the basic instruments for domestic supervision.

There are, however, substantial differences: significant participation by the state in banks’ capital is to be found in nearly half the countries surveyed. The majority of countries adhering to regional groups, other than the offshore centers, report extensive government ownership, but privatization is planned almost everywhere. This present state influence must have an important effect on the application of the rules.

From the same survey emerged the interesting fact that a lower degree of convergence seems to exist for supervisory instruments that have not been harmonized at the Basle level. Significant discrepancies, for instance, are recorded in the fields of crisis management and deposit insurance schemes. Where the Basle Committee had set rules for best-practice recommendations, there appeared to be much more consistency, possibly because these recommendations include ready-to-use concepts.

Of course, there are important differences in infrastructure, accounting systems, and legal frameworks, which make comparisons difficult, and sometimes meaningless. But much work has already been done worldwide, and much has been accomplished.

Several economists observe a much higher volatility in emerging markets and, predominantly for that reason, have proposed a set of international supervisory standards for those countries alone, different from the ones for the G-10 countries. There seems, however, to be a growing consensus that it would be wiser to steer supervision in emerging-market countries toward adopting the Basle capital and other standards to the greatest extent possible. From this viewpoint it would be best, as a general rule, to aim at essentially the same set of minimum prudential standards for all countries, and, many supervisors from those countries are moving in that direction. The world is seeing a globalization of capital markets. It does not seem appropriate to make an arbitrary distinction between banks that should have stricter capital requirements because of higher local market volatility—would be difficult to maintain over a longer time frame—and those that could have lower capital standards. It would lead to unequal competition within countries between branches of banks from G-10 countries and local banks, and, most important, it would create the wrong environment for all countries aspiring to become active in interdependent worldwide markets.

At the same time, markets are continuously changing. Banks in G-10 countries are increasingly using new financial instruments, generating higher income from trading portfolios, and concentrating activities in risk management efforts. Nor are banks restricting themselves solely to banking. In many countries, banks are allowed to enter into securities or insurance businesses, creating financial conglomerates that need their own management practices. The Joint Forum on Financial Conglomerates in cooperation with the International Organization of Securities Commissions (IOSCO) and the International Association of Insurance Supervisors (IAIS) has led the Basle Committee to work in this direction as well.

Where does this leave supervisors in emerging-market economies? Supervisors cannot stop evolution in the financial industry by setting artificial lines of demarcation. It is naive to say that in a certain country there are no derivatives or trading portfolios in the banking system, when it is very likely that a local bank will conduct such business through a branch in New York or London. Some foreign banks from G-10 countries may already be conducting such operations in these countries. Whether supervisors in emerging-market countries like it or not, they have to master the latest techniques being introduced in the worldwide banking system because they will confront them, and sooner than they think. All supervisors in emerging-market countries must jump onto a moving train, getting up to speed as quickly as they can. This means preparing and training for the whole gamut of financial activities—not only banking but also securities and insurance—as well as adapting to the deregulation of markets, which paradoxically means an increasing need for supervision.

The focus of supervision may be different in the various countries. The more advanced countries are moving toward more qualitative supervision, focusing on management processes. Less developed countries, by contrast, tend to emphasize strict rules. As such, different sets of supervisory practices emerge. Nonetheless, most supervisors use the same basic rules and tools, which may, in the end, lend a common focus to the gradually emerging worldwide market of financial products.

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