Chapter

9 Assessing Current Prudential Arrangements

Author(s):
Jörg Decressin, Wim Fonteyne, and Hamid Faruqee
Published Date:
September 2007
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This chapter analyzes regulatory and supervisory frameworks in the European Union, building on assessments carried out under the IMF-World Bank Financial Sector Assessment Program(FSAP).1 The FSAP has so far covered about two-thirds of the IMF membership, including virtually the whole European Union (Table 9.1), and is therefore an important source of comparable information on the quality of supervisory frameworks.2 This chapter analyzes the information from the FSAP assessments in a comprehensive way, relying on a combination of quantitative and qualitative approaches, focusing on the EU countries, and paying particular attention to cross-border issues.

Table 9.1.EU Countries: Overview of FSAP Participation(As of June 26, 2006)
Public Availability
CountryFSAP Year1FSSADetailed Assessment2
Austria2004YesNo
Belgium2006YesNo
Cyprus2001(OFC)YesNo
Czech Republic2001YesNo
Denmark32006NoNo
Estonia42000NoNo
Finland2001YesNo
France2004YesYes
Germany2003YesNo1
Greece2006YesNo
Hungary42000(initial)NoNo
2005(update)YesNo1
Ireland42000YesNo
Italy2006YesYes
Latvia2002YesNo
Lithuania2002YesNo
Luxembourg2002YesNo
Malta2003YesNo
Netherlands2004YesYes
Poland2001YesNo
Portugal32006NoNo
Slovak Republic2002YesNo
Slovenia2001(initial)YesNo
2004(update)YesNo
Spain32006YesYes
Sweden2002YesNo
United Kingdom2003YesYes
Source: IMF’s FSAP tracking database.

Calendar year of the Board discussion of the Financial System Stability Assessment (FSSA).

Detailed assessment is the assessment of compliance with financial sector standards. Summaries of the assessments (without the underlying gradings) are contained in the FSSA.

Ongoing; analysis based on draft assessments.

Part of the pilot program, when publication was not an option.

Source: IMF’s FSAP tracking database.

Calendar year of the Board discussion of the Financial System Stability Assessment (FSSA).

Detailed assessment is the assessment of compliance with financial sector standards. Summaries of the assessments (without the underlying gradings) are contained in the FSSA.

Ongoing; analysis based on draft assessments.

Part of the pilot program, when publication was not an option.

The analysis is used to gain insights relevant for the EU’s Financial Services Action Plan. The plan, published in 1999 and endorsed in 2000, has as one of its objectives putting in place state-of-the-art prudential rules and supervision. Coincidently, both the Financial Sector Assessment Program and the Financial Services Action Plan go through life labeled with their common abbreviation, FSAP.3 Hence, this chapter looks into what the IMF-World Bank’s FSAP has to say about the European Union’s FSAP.

Methodology

To analyze supervision in the European Union, this chapter uses data on countries’ observance of internationally accepted standards in banking, insurance, and securities regulation (“standards”). The standards covered in this analysis are the Basel Core Principles for Effective Banking Supervision (BCP); the Insurance Core Principles (ICP), issued by the International Association of Insurance Supervisors (IAIS); and the Objectives and Principles of Securities Regulation of the International Association of Securities Commission (IOSCO).4 The BCP contains 25 Core Principles, and the ICP and IOSCO standards also comprise a number of principles (Tables 9.2, 9.3, and 9.4). Although the terminology differs, the extent to which each principle in the three standards is observed is rated on a four-point scale, ranging from fully observed to nonobserved. Most of the assessments used in the analysis were prepared as part of an FSAP, under which the gradings are normally confidential, and therefore the analysis in this chapter is presented so as to respect this confidentiality.5 The sample comprises all EU-25 countries, plus a non-EU control group consisting of 11 advanced and 9 emerging market economies (Table 9.5). ICP and IOSCO assessments are not available for all countries.6

Table 9.2.Basel Core Principles for Effective Banking Supervision (BCP)
PrincipleTopicComponent
1Objectives, autonomy, powers, and resourcesREG
2Permissible activitiesPRF
3Licensing criteriaPRF
4OwnershipPRF
5Investment criteriaREP
6Capital adequacyREP
7Credit policiesREP
8Loan evaluation and loan-loss provisioningREP
9Large exposure limitsREP
10Connected lendingREP
11Country riskREP
12Market risksREP
13Other risksREP
14Internal control and auditREP
15Money launderingFIN
16On-site and off-site supervisionPRF
17Bank management contactPRF
18Off-site supervisionPRF
19Validation of supervisory informationREG
20Consolidated supervisionPRF
21Accounting standardsFIN
22Remedial measuresPRF
23Globally consolidated supervisionPRF
24Host-country supervisionPRF
25Supervision over foreign banks’ establishmentPRF
Notes: See www.imf.org/external/standards/index.htm for further details on the assessment methodology. See IMF (2004) for more details. REG = regulatory governance, PRF = prudential framework, REP = regulatory practices, and FIN = financial integrity and safety nets.
Notes: See www.imf.org/external/standards/index.htm for further details on the assessment methodology. See IMF (2004) for more details. REG = regulatory governance, PRF = prudential framework, REP = regulatory practices, and FIN = financial integrity and safety nets.
Table 9.3.International Association of Insurance Supervisors: Insurance Core Principles (ICP)
PrincipleTopicComponent
2000 International Association of Insurance Supervisors Standard
1Organization of the supervisorREG
2LicensingPRF
3Changes in controlPRF
4Corporate governancePRF
5Internal controlsPRF
6AssetsREP
7LiabilitiesREP
8Capital adequacy and solvencyPRF
9Derivatives and off-balance-sheet itemsREP
10ReinsuranceREP
11Market conductFIN
12Financial reportingPRF
13On-site inspectionPRF
14SanctionsREP
15Cross-border business operationsPRF
16Coordination and cooperationREP
17ConfidentialityPRF
2003 International Association of Insurance Supervisors Standard
1Conditions for effective insurance supervisionREG
2Supervisory objectivesREG
3Supervisory authorityREG
4Supervisory processREG
5Supervisory cooperation and information sharingREP
6LicensingREP
7Suitability of personsREP
8Changes in control and portfolio transfersREP
9Corporate governancePRF
10Internal controlPRF
11Market analysisREP
12Reporting to supervisors and off-site monitoringREP
13On-site inspectionREP
14Preventive and Corrective MeasuresREP
15Enforcement or sanctionsREP
16Winding-up and exit from the marketREP
17Groupwide supervisionREP
18Risk assessment and managementPRF
19Insurance activityPRF
20LiabilitiesREP
21InvestmentsREP
22Derivatives and similar commitmentsREP
23Capital adequacy and solvencyPRF
24IntermediariesFIN
25Consumer protectionFIN
26Information, disclosure, and transparency towards the marketFIN
27FraudFIN
28Anti–money laundering, combating the financing of terrorism (AML/CFT)FIN
Notes: See www.imf.org/external/standards/index.htm for further details on the assessment methodology. REG = regulatory governance, PRF = prudential framework, REP = regulatory practices, and FIN = financial integrity and safety nets.
Notes: See www.imf.org/external/standards/index.htm for further details on the assessment methodology. REG = regulatory governance, PRF = prudential framework, REP = regulatory practices, and FIN = financial integrity and safety nets.
Table 9.4.International Organization of Securities Commissions (IOSCO): Objectives and Principles of Securities Regulation
PrincipleTopicComponent
1Responsibilities of the regulatorREG
2Operational independence and accountabilityREG
3Powers, resources, and capacity to perform the functions and exercise the powersREG
4Clear and consistent regulatory processes.REG
5Professional standards including standards of confidentialityREG
6Appropriate use of self-regulatory organizations (SROs)REG
7Standards for SROsREG
8Comprehensive inspection, investigation, and surveillance powersPRF
9Comprehensive enforcement powersPRF
10Effective and credible use of inspection, investigation, surveillance, and enforcement powers and implementation of an effective compliance programPRF
11Authority to share both public and nonpublic information with domestic and foreign counterpartsPRF
12Setting up information sharing mechanismsPRF
13Assistance foreign regulators who need to make inquiries in the discharge of their functions and exercise of their powersPRF
14Full, accurate, and timely disclosure of financial results and other information that is material to investors decisionsFIN
15Fair and equitable treatment of holders of securities in a companyFIN
16High and internationally acceptable quality of accounting and auditing standardsFIN
17Standards for the eligibility and the regulation of those who wish to market or operate a collective investment schemeREP
18Rules governing the legal form and structure of collective investment schemes and the segregation and protection of client assetsREP
19Disclosure necessary to evaluate the suitability of a collective investment scheme for a particular investor and the value of the investor’s interest in the schemeFIN
20Proper and disclosed basis for asset valuation and the pricing and the redemption of units in a collective investment schemeREP
21Minimum entry standards for market intermediariesREP
22Risk-based initial and ongoing capital and prudential requirements for market intermediaries.REP
23Standards for internal organization and operational conductREP
24Procedure for dealing with the failure of a market intermediaryFIN
25Regulatory authorization and oversight of the establishment of trading systemsREP
26Ongoing regulatory supervision of exchanges and trading systemsFIN
27Transparency of tradingREP
28Detecting and detering manipulation and other unfair trading practicesFIN
29Proper management of large exposures, default risk, and market disruptionPRF
30Systems for clearing and settlement of securities transactionsFIN
Notes: See www.imf.org/external/standards/index.htm for further details on the assessment methodology. See IMF (2004) for more details. REG = regulatory governance, PRF = prudential framework, REP = regulatory practices, and FIN = financial integrity and safety nets.
Notes: See www.imf.org/external/standards/index.htm for further details on the assessment methodology. See IMF (2004) for more details. REG = regulatory governance, PRF = prudential framework, REP = regulatory practices, and FIN = financial integrity and safety nets.
Table 9.5.Overview of Economies Included in the Survey in this Chapter
EUNon-EU
Advanced economies (EU-15)Advanced economies
AustriaAustralia
BelgiumCanada
DenmarkHong Kong SAR
FinlandIceland
FranceIsrael
GermanyKorea
GreeceJapan
IrelandNew Zealand
ItalyNorway
LuxembourgSingapore
NetherlandsSwitzerland
Portugal
Spain
Sweden
United Kingdom
Emerging markets (new member states)Emerging markets
Czech RepublicBrazil
CyprusBulgaria
EstoniaChile
HungaryCroatia
LatviaMexico
LithuaniaPhilippines
MaltaRomania
PolandRussia
Slovak RepublicSouth Africa
Slovenia
Note: The classification of advanced economies used in this paper follows the country classification in the IMF’s World Economic Outlook (IMF, 2006). The only exception is Cyprus, classified as an advanced economy in the WEO, but compared here with emerging markets because it is one of the new member states. The results do not change qualitatively if Cyprus is instead classified as advanced economy. Bulgaria and Romania are classified as non-EU, because this analysis is done on data prior to their EU entry in 2007.
Note: The classification of advanced economies used in this paper follows the country classification in the IMF’s World Economic Outlook (IMF, 2006). The only exception is Cyprus, classified as an advanced economy in the WEO, but compared here with emerging markets because it is one of the new member states. The results do not change qualitatively if Cyprus is instead classified as advanced economy. Bulgaria and Romania are classified as non-EU, because this analysis is done on data prior to their EU entry in 2007.

To arrive at a concise summary of the assessments, the individual gradings are analyzed quantitatively. Grading is not an exact science, and one should always look also at the commentaries that accompany each principle grading. Nonetheless, the grades have proven useful in previous cross-country research on the quality of supervision. Following IMF (2004) and Čihák and Podpiera (2006), these calculations are used:

  • Principle-by-principle gradings: For each standard and each principle, the four-point scale assessment was transformed into a numeric value from 0 (nonobserved) to 100 (fully observed). The value of 67 percent corresponds to the “largely compliant” rating and the value of 33 percent to the “materially noncompliant” rating in the BCP assessment.
  • Summary grading: An unweighted average of the principle-by-principle gradings was calculated to arrive at a summary grading for each standard. This summary grading is also a number between 0 (nonobserved) and 100 (fully observed).
  • Component gradings: Given that the individual principles cover different subjects and that the composition of the principles differs for the three standards, it is easier to carry out cross-sectoral comparisons if the principles are aggregated into comparable groups that cover similar topics. As in IMF (2004), the principles are grouped into the following four components of a good supervisory framework: (1) regulatory governance, which includes aims, independence, and accountability of regulators; (2) prudential framework, which consists of regulations covering risk management, capital adequacy, internal control, and corporate governance; (3) regulatory practices, which include monitoring and supervision, enforcement, conglomerates, and licensing; and (4) financial integrity, including consumer protection and addressing financial crimes. Table 9.6 maps the individual principles into the four components. For each of the four components, an observance index was calculated as an unweighted average of the individual principles included in that component.
Table 9.6.Financial Standards and Their Four Main Components
Four Main

Components

(Abbreviation)
SubcomponentsSector (Principles)
Banking (BCP)Insurance (ICP)1Securities (IOSCO)
Regulatory

Governance

(REG)
Objectives of regulation

Idependence and adequate resources

Enforcement powers and capabilities

Clarity and transparency of regulatory process

External participation
1,192000 IAIS: 11,2,3,4,5,6,7
2003 IAIS: 1,2,3,4
Prudentia

Framework

(PRF)
Risk management

Risk concentration

Capital requirements

Corporate governance internal controls
2,3,4,6,16,17,18,20,22,23,24,252000 IAIS: 2,3,4,5,12, 13,15,16,178,9,10,11,12,13,29
2003 IAIS: 9,10,18,19,23
Regulatory

Practices

(REP)
Group-wide supervision

Monitoring and on-site inspection

Reporting to supervisors Enforcement

Cooperation and information sharing

Confidentiality

Licensing, ownership transfer, corporate control

Qualifications
5,6,7,8,9,10,11, 12,13,142000 IAIS: 6,7,9,10,14,1617,18,20,21,22, 23,25,27
2003 IAIS: 5,6,7,8,11,12,13,14,15,16,17,18,20,21,22
Financial Integrity and Safety Nets (FIN)Markets (integrity, financial crime)

Customer protection

Information, disclosure, transparency
15,212000 IAIS: 1114,15,16,19,24,26, 28,30
2003 IAIS: 24,25,26,27,28
Source: Adapted from IMF (2004).

For each component, the upper row corresponds to the original (2000) IAIS standard, and the lower row corresponds to the revised (2003) IAIS standard.

Source: Adapted from IMF (2004).

For each component, the upper row corresponds to the original (2000) IAIS standard, and the lower row corresponds to the revised (2003) IAIS standard.

When interpreting the results, one must bear in mind that the gradings are a series of country-by-country snapshots. The individual assessments were undertaken at different points during 2000–06, and some of the earlier gradings may have become outdated subsequent to the FSAP. Updated gradings were taken into account for those countries for which formal FSAP updates took place; for others, the FSAP gradings represent the most recent information available. The existence of lags between regulatory developments and a reassessment of the gradings means that older assessments are likely to underestimate the true quality of supervision in a country. Interestingly, however, statistical tests do not suggest a strong link between the “vintage” of an assessment and the overall grading.

Supervisory frameworks include elements that are not easy to quantify, and information may be lost if the focus is solely on quantitative analysis. Each assessment therefore contains a rich set of underlying, qualitative information from the FSAPs. Moreover, not all principles are equally relevant in all countries, and there are issues that may not be captured by the standards assessments. To address this, the FSAP reports use the standards assessments in combination with other analytical tools to form an integrated analysis of the financial sector. The key messages from these overall analyses are surveyed in the third section of this chapter.

Analysis of Compliance with Principles

EU member countries showed, on average, a higher level of observance of standards than non-EU countries. The degree of observance of the three standards and their subcomponents was on average about 8 percentage points higher in the EU countries than in the non-EU countries (Figure 9.1). This difference was only statistically significant for securities market regulation and for the regulatory governance component of insurance regulation, but was robustly positive across the various components of the regulatory framework. Similar results were obtained when EU-15 countries were compared against non-EU advanced economies, and when new EU member states were compared with a sample of non-EU emerging market countries (Table 9.7 and Figure 9.2).7

Figure 9.1.Banking, Insurance, and Securities Regulation: Overall Observance

Source: IMF staff calculations.

Note: Summary and component grading shown on the horizontal axis. B, I, and S stand for banking, insurance, and securities, respectively. REG = regulatory governance; PRU = prudential framework; REP = regulatory practices; and FIN = financial integrity and safety nets.

Table 9.7.Banking, Insurance, and Securities Regulation: Overall Observance1
Average2Standard Deviation2Maximum2Minimum2
EUNon-EUDifference3EUNon-EUDifference3EUNon-EUEUNon-EU
All Economies
Banking (summary)84.279.74.514.125.2–11.1100.0100.050.925.8
Regulatory governance85.083.11.918.420.1–1.7100.0100.036.133.3
Prudential framework85.781.34.414.524.2–9.8100.0100.050.027.8
Regulatory practices82.576.46.115.327.0–11.7100.0100.046.720.0
Financial integrity, safety nets83.376.76.715.227.1–11.9*100.0100.050.016.7
Insurance (summary)78.571.47.225.127.6–2.5100.0100.033.325.5
Regulatory governance78.859.019.8*22.520.02.5100.0100.033.333.3
Prudential framework78.370.97.515.216.8–1.7100.0100.051.951.9
Regulatory practices78.370.97.515.216.8–1.7100.0100.051.951.9
Financial integrity, safety nets74.461.912.518.828.8–10.0100.0100.050.016.7
Securities (summary)84.671.912.6*14.519.2–4.7100.094.452.234.4
Regulatory governance86.075.310.7*16.218.4–2.1100.0100.09.533.3
Prudential framework84.665.119.5*19.021.9–2.9100.095.219.028.6
Regulatory practices87.772.815.0*14.125.0–10.9*100.0100.022.229.2
Financial integrity, safety nets80.474.16.318.820.1–1.3100.0100.011.142.9
Advanced Economies
Banking (summary)91.686.05.66.722.8–16.0*100.0100.075.637.6
Regulatory governance91.989.42.512.517.2–4.7100.0100.066.750.0
Prudential framework93.389.34.06.918.8–11.9100.0100.077.847.2
Regulatory practices90.282.77.59.427.9–18.6*100.0100.066.720.0
Financial integrity, safety nets90.078.811.2*8.527.3–18.9*100.0100.083.333.3
Insurance (summary)86.077.58.518.924.0–5.1100.098.058.843.1
Regulatory governance85.761.124.6*17.813.64.2100.066.766.733.3
Prudential framework87.374.712.6*18.626.0–7.4100.0100.059.340.7
Regulatory practices87.374.712.6*18.626.0–7.4100.0100.059.340.7
Financial integrity, safety nets85.775.010.718.927.6–8.7100.0100.050.033.3
Securities (summary)89.981.68.311.614.4–2.7100.094.462.258.6
Regulatory governance91.384.96.48.810.6–1.8100.0100.071.471.4
Prudential framework89.575.414.1*12.917.4–4.6100.095.271.452.4
Regulatory practices91.779.212.514.023.4–9.4100.0100.058.333.3
Financial integrity, safety nets87.586.51.016.419.3–3.0100.0100.050.052.4
Emerging Markets
Banking (summary)73.172.01.115.225.0–9.893.398.950.933.7
Regulatory governance74.775.5–0.821.421.00.4100.0100.036.138.9
Prudential framework74.371.62.715.625.0–9.4*94.497.250.030.6
Regulatory practices71.068.62.415.623.4–7.8*93.396.746.736.7
Financial integrity, safety nets73.374.1–0.717.927.3–9.3100.0100.050.033.3
Insurance (summary)68.364.83.529.029.9–0.9100.098.025.533.3
Regulatory governance66.757.19.527.225.22.0100.0100.033.333.3
Prudential framework67.966.71.229.729.30.4100.096.325.929.6
Regulatory practices67.966.71.229.729.30.4100.096.325.929.6
Financial integrity, safety nets56.950.06.940.536.44.1*100.0100.016.70.0
Securities (summary)77.065.511.515.720.0–4.390.088.952.234.4
Regulatory governance78.468.99.521.720.11.6100.090.533.333.3
Prudential framework77.658.219.324.922.72.2100.090.528.628.6
Regulatory practices82.168.513.613.126.4–13.3*100.0100.058.329.2
Financial integrity, safety nets70.265.94.418.416.81.691.791.737.542.9
Source: Financial sector standards and codes assessments under the FSAP.

For each country, the summary grading of a standard (BCP, ICP, and IOSCO) is calculated as the average grading of the principles in the standard. For each principle, 100 is the maximum grading (observance), and 0 is the minimum grading (no observance).

Calculated across the countries in the sample.

The value for the EU countries minus the value for the non-EU countries.

Indicates that the difference is significant at a 10 percent level in tests of equality of means and variance, respectively.

Source: Financial sector standards and codes assessments under the FSAP.

For each country, the summary grading of a standard (BCP, ICP, and IOSCO) is calculated as the average grading of the principles in the standard. For each principle, 100 is the maximum grading (observance), and 0 is the minimum grading (no observance).

Calculated across the countries in the sample.

The value for the EU countries minus the value for the non-EU countries.

Indicates that the difference is significant at a 10 percent level in tests of equality of means and variance, respectively.

Figure 9.2.Basel Core Principles (EU-15 and NMS)

Source: IMF staff calculations.

Note: NMS = new member states.

Despite the relatively favorable performance vis-à-vis non-EU countries, compliance in the EU was not complete. The overall level of compliance ranged from 79 percent in insurance to 85 percent in securities regulation.8 For example, in banking, two EU countries observed all core principles, but no principle was observed fully across the EU. On average, there were about nine less-than-fully compliant EU countries for each principle. For some principles, more than half of EU countries were less than fully compliant (Figure 9.3). For both EU and non-EU countries, observance tended to be weakest in insurance supervision (Figure 9.1). For example, the difference between average levels of observance in banking and insurance was about 6 percentage points in the EU countries and about 8 percentage points in non-EU countries (Table 9.7).

Figure 9.3.Basel Core Principles—Closer Look

Source: IMF staff calculations.

EU member countries showed a slightly more even level of observance than non-EU countries (Figures 9.4, 9.5, and 9.6). Various measures of cross-country variability suggest that EU member countries have a lower variability in quality of supervision (Table 9.7). Cross-country variability in the European Union tended to be higher in regulatory governance than in other aspects of the supervisory framework. Both in banking and in insurance, regulatory governance showed higher cross-country variability than the prudential framework, regulatory practices, or financial integrity and safety nets. In securities regulation, the prudential framework was the component with the highest cross-country variability.

Figure 9.4.EU vs. Non-EU Countries: Basel Core Principles

Source: IMF staff calculations.

Figure 9.5.EU vs. Non-EU Countries: Insurance Core Principles

Source: IMF staff calculations.

Note: For ease of presentation, the results are presented in terms of the 2000 International Association Insurance Supervisions (IAIS) standard, which was used for a majority of EU countries that had the Insurance Core Principles (ICP) assessment. For those countries that had an ICP assessment according to the 2003 IAIS, gradings have been mapped into the 2000 IAIS standard (Tables 9.3 and 9.6).

Figure 9.6.EU vs. Non-EU Countries: IOSCO Principles

Source: IMF staff calculations.

Note: IOSCO = International Organization of Securities Commissions.

Within the European Union, the level of observance in the EU-15 countries was higher (by 13–18 percentage points, on average) and less uneven than in the new member states (the standard deviation being 4–10 percentage points lower, on average).

The principle-by-principle analysis of standard assessments suggested several specific areas for attention. Of the 72 principles contained in the three standards, 19 principles were fully observed by less than half of the assessed EU countries (Table 9.8). These comprise six principles in banking, nine in insurance, and four in securities.

Table 9.8.Least Observed Supervisory Principles1
Lagging Countries2
Percent of

all assessed
NumberSummary

Compliance3
Banking
CP13 Other risks6416 of 2575
CP10 Connected lending6015 of 2572
CP15 Money laundering6015 of 2579
CP1 Objectives, autonomy, powers, and resources6015 of 2585
CP22 Remedial measures5213 of 2575
CP20 Consolidated supervision5213 of 2575
Insurance
CP11 Market conduct699 of 1364
CP5 Internal controls699 of 1364
CP9 Derivatives and off-balance-sheet items699 of 1367
CP1 Organization of supervisor628 of 1379
CP4 Corporate governance547 of 1367
CP6 Assets547 of 1374
CP13 On-site inspection547 of 1377
CP2 Licensing547 of 1382
CP15 Cross-border business operations547 of 1385
Securities
Q10 Enforcement powers, compliance program539 of 1767
Q22 Capital and other prudential requirements539 of 1769
Q03 Powers, resources, capacity539 of 1769
Q02 Operational independence and accountability539 of 1771

The table lists principles that were less than fully observed by more than half of assessed EU countries. For each sector, the principles are ordered starting from the worst, defined by the percentage of less-than-fully observant countries (descending), and then by the grading (ascending).

Percent of EU countries with less-than-full compliance with the principle.

Average over the EU countries (100 = full compliance, 0 = no compliance).

The table lists principles that were less than fully observed by more than half of assessed EU countries. For each sector, the principles are ordered starting from the worst, defined by the percentage of less-than-fully observant countries (descending), and then by the grading (ascending).

Percent of EU countries with less-than-full compliance with the principle.

Average over the EU countries (100 = full compliance, 0 = no compliance).

Banking Supervision

In banking, the areas most in need of improvement included supervision of other risks; connected lending; issues related to money laundering; supervisory objectives, autonomy, powers, and resources; remedial measures; and consolidated supervision.

  • Supervision of other risks: The relevant Core Principle (CP13) requires that banking supervisors be satisfied that banks have in place a comprehensive risk management process to identify, measure, monitor, and control all other material risks and, where appropriate, to hold capital against these risks. Sixteen EU countries did not fully satisfy this criterion. The reasons for less-than-full compliance varied from country to country; in some cases the reason was lack of specific guidelines on interest rate risk and operational risk, and in other cases, the reason was weak guidelines on liquidity risk.
  • Connected lending: The relevant principle (CP10) requires that—to prevent abuses arising from connected lending—banking supervisors have in place requirements that banks lend to related companies and individuals on an arm’s-length basis, that such extensions of credit are effectively monitored, and that other appropriate steps are taken to control or mitigate the risks. Fifteen EU countries did not fully satisfy this criterion. The most frequent issues include absence of legal prohibition to lend to connected parties on more favorable terms than to nonrelated counterparts, absence of a limit above which exposures to connected parties are subject to board approval, absence of supervisory power to deem that a connection exists in cases others than those specified in the law, and absence of power to deduct connected lending from capital or require it to be collateralized.
  • Money laundering. The relevant principle (CP15) requires that banking supervisors determine that banks have adequate policies, practices, and procedures in place (including strict know-your-customer rules) that promote high ethical and professional standards in the financial sector and prevent the bank being used, intentionally or unintentionally, by criminal elements. Fifteen EU countries did not fully satisfy this criterion. One of the common issues was low frequency of the relevant onsite inspections.
  • Supervisory objectives, autonomy, powers, and resources. The relevant principle (CP1) requires clear responsibilities and objectives for each agency involved in the supervision of banks. Fifteen EU countries did not fully satisfy this criterion. The most frequent weaknesses related to the potential for political interference in day-to-day supervision, the lack of budgetary independence, and the need to strengthen the legal protection of supervisors.
  • Remedial measures. The relevant principle (CP22) requires that banking supervisors have at their disposal adequate supervisory measures to bring about timely corrective action when banks fail to meet prudential requirements, when there are regulatory violations, or when depositors are threatened in any other way. Fifteen EU countries did not fully satisfy this criterion. The most frequent problems included limited powers to remove individuals, lack of statutory “prompt corrective action” procedures, and lack of powers to restrict dividend payments.
  • Consolidated supervision. The relevant principle (CP20) notes that an essential element of banking supervision is the ability to supervise a banking group on a consolidated basis. Thirteen EU countries did not fully satisfy this criterion. The assessments often noted that supervisors need to rise to the challenge posed by conglomerization of systems, which can provide systems with more stability, but can also pose additional challenges resulting from possible draining of capital from one type of institutions to another. It can also create opportunities for arbitrage when prudential requirements are not well aligned across the different business lines. The most common issues include insufficient resources in insurance supervision or the absence of a fully articulated structure for sharing of information and assessments.

Insurance Supervision

In insurance regulation, the number of areas with low observance was much higher than in banking, ranging from market conduct issues to internal controls, derivatives and off-balance-sheet items, organization of the supervisor, corporate governance, assets, onsite inspection, licensing, and cross-border business operations.

  • Market conduct issues. The relevant principle (CP11)9 requires insurance supervisors to ensure that insurers and intermediaries exercise the necessary knowledge, skills, and integrity in dealings with their customers. Nine of the thirteen assessed EU countries did not fully satisfy this criterion. The most frequent weaknesses relate to ensuring that market conduct issues are better handled at the point of sale when the agent is actually selling the product. Some assessments noted that this is especially relevant for unit-linked products, which may not be suitable for all customers (from a risk tolerance perspective) and may be purchased on the basis of unrealistic expectations.
  • Internal controls. The relevant principle (CP5) requires the insurance supervisor to be able to: review the internal controls that the board of directors and management approve and apply; request strengthening of the controls where necessary; and require the board of directors to provide suitable prudential oversight, such as setting standards for underwriting risks and setting qualitative and quantitative standards for investment and liquidity management. Nine of the thirteen assessed EU countries did not fully satisfy this criterion, in most cases because of a lack of legislative support for internal controls in the operations of insurance companies.
  • Derivatives and off-balance-sheet items. The relevant principle (CP9) requires the insurance supervisor to be able to set requirements with respect to the use of derivatives and off-balance-sheet items. Nine of the thirteen EU countries covered by this analysis failed to fully satisfy this criterion, most frequently because they instead suggested that insurers themselves be required to have in place risk management policies and systems covering any derivatives positions. In addition, the onsite inspection programs generally need to be amended to state more precisely the work that has to be done by supervisors with regard to derivatives.
  • Organization of the supervisor. The relevant principle (CP1) requires that the insurance supervisor be organized so as to be able to accomplish its primary task, which is to maintain efficient, fair, safe, and stable insurance markets for the benefit and protection of policyholders. Eight of the thirteen EU countries did not fully satisfy this criterion, with the most common reasons being potential political interference in supervision and lack of adequate resources.
  • Corporate governance. The relevant principle (CP4) requires establishing standards to deal with corporate governance. Seven of the thirteen EU countries did not fully satisfy this criterion, most frequently because the supervisory agency’s powers were insufficient.
  • Assets. The relevant principle (CP6) requires that standards be established with respect to the assets of companies licensed to operate in the jurisdiction. Seven of the thirteen EU countries did not fully satisfy this criterion, with most having in place only recommendations for supervisors to ensure that insurance companies and groups have proper internal controls for managing assets in accordance with the overall investment policy.
  • On-site inspection. The relevant principle (CP13) requires that the insurance supervisor be able to conduct on-site inspections to review the business activities and affairs of the company, including the books, records, accounts, and other documents. Seven of the thirteen EU countries did not fully satisfy this criterion, mainly because of extended periods between inspections for most companies and less-than-full implementation of a risk-based approach.
  • Licensing. The relevant principle (CP2) requires that companies wishing to underwrite insurance in the domestic insurance market be licensed. Seven of the thirteen EU countries did not fully satisfy this criterion.
  • Cross-border business operations. The relevant principle (CP15) notes that the insurance supervisor should ensure that all foreign insurance establishments and all insurance establishments of international insurance groups and international insurers are subject to effective supervision; that all newly created cross-border insurance establishments are subject to consultation between host and home supervisors; and that all foreign insurers providing insurance coverage on a cross-border services basis are subject to effective supervision. Seven of the thirteen EU countries did not fully satisfy this criterion. The reasons varied from country to country, but one main concern was a lack of resources for supervisors to actively supervise branches of financial institutions abroad.

Securities Supervision

In securities supervision, the number of low-compliance areas was relatively smaller than in banking and insurance. The main areas for improvement relate to enforcement powers and compliance program; capital and other prudential requirements; powers, resources, and capacity; and operational independence and accountability.

  • Enforcement powers and compliance program. The relevant principle (Q10) requires an effective and credible use of inspection, investigation, surveillance, and enforcement powers as well as implementation of an effective compliance program. Nine of the seventeen EU countries included in the analysis failed to fully satisfy this criterion, most frequently because of limits on the ability of the supervisor to carry out full inspections, investigations, surveillance, and enforcement.
  • Capital and other prudential requirements. The relevant principle (Q22) requires that there be initial and ongoing capital and other prudential requirements for market intermediaries that reflect the risks these intermediaries undertake. Nine of the seventeen EU countries did not fully satisfy this criterion, most frequently because of an absence of legal immunity for actions taken in good faith by the regulatory authority.
  • Powers, resources, and capacity. The relevant principle (Q03) requires that the regulator has adequate powers, proper resources, and the capacity to perform its functions and exercise its powers. Nine of the seventeen EU countries did not fully satisfy this criterion, with most needing more supervisory resources and some clarification of supervisory powers and institutional arrangements.
  • Operational independence and accountability. The relevant principle (Q02) requires that the regulator be operationally independent and accountable in the exercise of its functions and powers. Nine of the seventeen EU countries did not fully satisfy this criterion, with the most frequent reasons being a lack of budgetary independence and the potential for political interference.

Addressing Gaps in Supervision

Many of the above gaps were recognized by EU and national authorities and are being addressed as part of EU’s Financial Services Action Plan. Since the initiative began, directives have been adopted on the winding-up and liquidation of banks and insurance undertakings; a European Commission recommendation was issued on disclosure of financial instruments; and substantial improvements were made to the anti–money laundering framework by means of an amendment to the European Union’s money laundering directive, among other things. The Lamfalussy process is getting up to speed, and some of the remaining gaps identified during the FSAPs are being addressed by the CRD; the Financial Conglomerates Directive (FCD); and Solvency II, which is still under preparation. Also, prudential authorities have undertaken substantial improvements in their cross-border cooperation through formal memoranda of understanding and other efforts. Progress in regulatory frameworks was confirmed by recent FSAP updates and other IMF surveillance work.10

At the same time, the financial environment changed substantially since the implementation of the Financial Services Action Plan began. In particular, the role of international financial conglomerates has increased. Also, rapid credit growth in Central and Eastern Europe has raised pressing questions about the role of foreign banks.

Main FSAP Recommendations

In addition to the quantitative findings derived from gradings, several recurrent themes emerge from a qualitative survey of the main overall messages in the FSAP assessments on EU countries. To complement the quantitative analysis above, this section reviews the available Financial System Stability Assessment (FSSA) reports for EU member countries,11 and presents the results of a survey of IMF chiefs of FSAP missions in EU countries.

Overall, the FSSAs described supervisory systems in most EU countries as being of high quality. Consistent with the findings of the quantitative analysis, 16 of the 22 FSSAs explicitly declared the country’s financial system to be well supervised, even though issues and gaps were identified in most cases and substantial gaps were found in some new member states.

Most FSSAs highlighted the need to adjust the supervisory frameworks to meet new challenges, in particular those relating to cross-sector and cross-border financial integration. A majority of FSSAs for EU member countries stressed that the consolidation of the financial markets has increased the importance of effective cooperation within and across national jurisdictions. In several countries, this issue was raised in the context of strengthening consolidated supervision.12 Additionally, a number of the FSSAs urged continued work, both domestically and internationally, in the areas of crisis management, deposit insurance, cross-border payment and settlement systems, and day-to-day cross-border supervisory cooperation. As a recent example, the 2006 FSAP on Belgium recommended that the supervisory agency position itself to meet new challenges stemming from the following cross-sector and cross-border issues: (1) the dominant role of conglomerates in the domestic market and their increasingly international character; (2) the demands of Basel II and Solvency II; (3) the implementation of the Financial Services Action Plan and the ongoing integration within the European market; and (4) the changes in, and special requirements of, new cross-border financial market infrastructures, such as Euronext and Euroclear. As another example, the 2004 FSAP for the Netherlands included key recommendations on cross-border securities settlement and cross-border crisis management, both of which require close cooperation with foreign counterparts, and a recommendation on the deposit guarantee system, suggesting that it take into account the broader European context of depositor/investor protection arrangements.

Box 9.1.Cross-Border Issues in Financial Supervision: A Survey

A survey of mission chiefs for FSAPs in EU countries suggests that, although cross-border issues have received attention in FSAPs, coverage of cross-border issues in most FSAPs was limited by resource constraints and access to data. Attention given to these issues was primarily driven by the presence of systemically important foreign banks, substantial foreign exposure of domestic banks, and, in some new member states, by foreign ownership of the banking system.

The United Kingdom FSAP (2003) focused on the role of London as an international financial center. Cross-border supervisory coordination was an important issue for the mission. The mission met with U.S. and German supervisors to get their perspectives on coordination with U.K. supervisors. There was no substantial emphasis on cross-border crisis management.

The Lithuania FSAP mission (2001) saw cross-border issues as central to the financial system of this small, open economy, which has considerable foreign ownership of financial sector assets. The prominence of these issues was emphasized by the (then) run-up to EU accession. However, the mission did not meet foreign supervisors or private sector representatives.

In the Netherlands (2004) and Belgium (2006) FSAPs, cross-border supervisory issues were important topics for the standards assessments. In addition, in the Netherlands, the general discussions and the vulnerability analysis focused on the substantial foreign operations of Dutch banks. Some FSAP recommendations related to the area of international coordination. In Belgium, both the issue of foreign operations of large Belgian banks and the issue of foreign ownership of some large Belgian banks were discussed. As the foreign operations of Belgian banks are mainly in Central and Eastern Europe, the systemic importance for the Belgian system was judged to be limited and no in-depth analysis was performed. The mission looked into the issue of cooperation with the Dutch supervisor, but did not meet foreign supervisors or private sector representatives.

The FSAPs for Norway (2005), Sweden (2002), and Finland (2001) highlighted cross-border issues as key aspects in the standards assessments. More generally, the scope for spillovers among the Nordic countries was seen as an important issue. Given the prominence of Swedish banks throughout the region, the stress tests and scenario analyses for the Swedish FSAP were based on the Nordic area. However, the mission was somewhat constrained by its limited capacity to analyze the exposures in the Nordic region in detail. In Finland and Norway, the issue was the foreign ownership of a systemically important bank. In Norway, an additional issue was the relatively generous Norwegian deposit insurance system and the implications for cross-border banking. No meetings with foreign supervisors took place.

The Greece FSAP (2006) mentioned the lack of a cross-border crisis-management framework, weak cooperation between Greek supervisors and the supervisors of other southeastern European countries, and the associated lack of clarity on lender-of-last-resort issues for Greek branches operating in southeastern European countries. In addition, differences in regulatory frameworks across the region raised concerns about regulatory arbitrage. After considering the costs and benefits, the mission decided not to meet with foreign supervisors or private sector representatives.

The Poland FSAP update (2006) mentioned that cross-border issues were important given that about three-quarters of the banking system was foreign owned. Cross-border issues were addressed as part of the stress tests, as part of a follow-up on standards assessments, and as part of more general discussions on the role of foreign-owned banks. However, the analysis of cross-border issues was to some extent overshadowed by domestic issues and limited by time and resource constraints. For example, the mission did not meet with foreign supervisors and representatives of the foreign owners of the local banks.

Although the FSAPs often noted the importance of cross-border issues, the process offers only limited scope to analyze them. In particular, FSAP missions have limited or no interaction with relevant foreign parties (both public and private), which means that the perspective of such parties is often not analyzed in depth.13 A survey of IMF FSAP mission chiefs (Box 9.1) suggests that this is primarily due to resource constraints and to a lesser extent to constraints on access to data and people abroad. FSAPs have also been able to give only limited coverage to important cross-border issues relating to crisis management, lender-of-last-resort support, safety nets, and risk management in international conglomerates, because their country focus does not lend itself to studying such supranational issues.14 Outside the FSAP, two assessments with a heavy cross-border component were performed for the euro area, one focusing on transparency in monetary and financial policies and another on payments systems regulations (IMF, 2001a).

With respect to domestic prudential issues, several themes emerged:

  • Virtually all FSSAs highlighted the need to improve monitoring of new systemwide risks. This was typically worded in terms of a need to improve macroprudential surveillance processes and outputs, related to monitoring and analyzing new risks, implementing stress tests, and collecting and disseminating additional or more timely indicators.
  • Strengthening of regulations was proposed in specific segments. Substantial improvements in insurance regulation were recommended most frequently (in about half of the surveyed FSSAs), which is consistent with the relatively lower level of compliance in this area. In some FSSAs, regulators were urged to focus on certain types of activities, for example, risks related to large and growing portfolios of residential mortgage loans.
  • The need to strengthen regulatory governance was raised in a majority of FSSAs. This is consistent with the quantitative findings of the previous section. The exact recommendations ranged from the need to reduce the potential for political interference in day-to-day supervision, to issues such as the need to strengthen the legal protection of supervisors or the lack of budgetary independence.
  • Corporate governance and disclosures in the financial sector were also a recurrent theme. About one-third of the FSSAs highlighted the need for improvements in corporate governance of financial institutions and their public disclosures.

Other issues not explicitly covered by the standards have been prominent in some EU country FSAPs. This includes the role of public ownership in the financial sector (for example, in Germany) and the relationship between concentration, competition, and stability (for example, in France and Italy). Prudential regulation can play a role, but only a secondary one, in addressing these issues.

Conclusions

The main finding of this chapter is that financial supervisory systems in the European Union are generally of high quality but need to evolve further to close remaining gaps and meet new challenges. FSAP assessments of the extent to which EU supervisory systems comply with international standards found them to be of higher and more even quality than those in comparable non-EU countries. However, the analysis of FSAP recommendations points out a need to close gaps in existing frameworks and also to adjust them to meet emerging challenges. Some of the gaps (Table 9.8) are relatively small and may have already been closed since the respective assessments were carried out, but new challenges have emerged as financial systems have become more integrated. These include those posed by the growing role of conglomerates and their increasingly international character, ongoing integration within the European market, and the emergence of new cross-border financial market infrastructures, such as Euronext and Euroclear. To a significant extent, international standards are evolving to take these new challenges into account. The BCP, for example, have recently been revised in part to better address cross-border banking and the increased importance of supervisory cooperation, as well as to ensure consistency with Basel II. However, international standards not only constitute something of a sort of “moving goal line,” they are also by necessity rather general, they take time to elaborate and adapt, and they cannot take country idiosyncrasies into account. The European Union’s sophisticated and rapidly evolving financial systems and the EU objective of creating a fully integrated market for financial services both imply that its financial supervisory systems will often need to go beyond such established international standards.

As the FSAPs indicate, adapting the European Union’s supervisory arrangements for an integrated market will involve continued work, both domestically and internationally, in the areas of crisis management, deposit insurance, day-to-day cross-border supervisory cooperation, and system-wide monitoring of risks. With the European Commission and the EU parliament, supported by the Lamfalussy process, having become the main regulators of the EU financial system, there is a great need for EU-wide cooperation and an EU-level perspective in meeting the challenges of safeguarding financial stability in an integrated financial system.

1In this chapter, the term “supervision” is used to mean “regulation and supervision.”
2For an overview of the FSAP, the related policy papers, and the published country documents, see http://www.imf.org/external/np/fsap/fsap.asp.
3In this chapter, FSAP refers to the Financial Sector Assessment Program. In the rest of the book, it refers to the Financial Services Action Plan.
4See http://www.imf.org/external/standards/index.htm for a full listing of the standards and other relevant materials. The focus of this chapter is on the internationally accepted standards, not on EU standards; the two are closely, but not perfectly, aligned.
5Most countries have chosen to publish summaries of the FSAPs that do not contain the gradings of the individual principles (Reports on Standards and Codes, or ROSCs). Only three EU countries have opted to publish detailed assessments with the underlying gradings. The published ROSCs and detailed assessments are available at http://www.imf.org/external/standards/index.htm.
6Not all assessments are carried out in all FSAPs. ICP assessments are available for only 13 EU member countries and 13 of the non-EU countries in our sample; IOSCO assessments are available only for 17 EU member countries and 15 of the non-EU countries. In order to have as many observations as possible, some assessments were included that were available only in a draft form (in particular, Australia, Denmark, and Portugal).
7The standards were designed to be universally applicable. In principle, therefore, the level of economic development need not be taken into account. However, in practice, the level of compliance is positively correlated with economic development, as illustrated in Table 9.7 and in IMF (2004). It is therefore useful to analyze the gradings not only for all countries, but also by peer groups of countries, as done in Table 9.7.
8As mentioned, the value of 67 percent corresponds to the “largely compliant” grading, and so it could be said that on average, the EU regulatory systems were more than “largely compliant.” However, they were significantly less than “fully compliant” (100 percent), and some were even less than “largely compliant” (Table 9.7).
9For simplicity, the references to individual ICP principles are based on the 2000 IAIS standard, which has so far been used for a majority of EU countries that had the ICP assessment. ICP assessments based on the 2003 IAIS standards were also included in the analysis and are reflected in this summary.
10However, among the EU-25 countries, formal FSAP updates have so far been completed only for Hungary, Ireland, Poland, and Slovenia.
11This survey was based on FSSAs available for 22 EU countries (for Hungary and Slovenia, FSSAs from FSAP updates are available and were used instead of FSSAs from initial FSAPs). FSSAs from initial assessments for Denmark, Portugal, and Spain were not available when the analysis was done.
12This is consistent with the finding of Section C that the principles on consolidated supervision have been among those with the lowest level of observance.
13However, the U.K. FSAP team met with the German supervisory agency BaFin, and the Belgian FSAP team held discussions with Euroclear entities and customers abroad.
14In a sense, the FSAPs for euro area countries are only partial, because they could not fully assess important elements of the financial stability framework that are wholly or partially determined at the European level. The FSAP’s country-based format also limits its ability to assess vulnerabilities related to cross-border conglomerates if an important part of the risk management of these conglomerates takes place abroad. Bottom-up stress tests of such conglomerates might not reflect the full nature of the risks presented by a particular scenario when the foreign risk management team has not been involved in the exercise.

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