Mr. de Swaan discusses the background, advantages and implementation of
the core principles for effective banking supervision Speech by Mr. de Swaan, an Executive
Director of the Netherlands Bank and Chairman of the Basle Committee on Banking
Supervision, at the 14th Annual Meeting of the Latin American and Caribbean Banking
Supervisory Organisations held in Santiago, Chile on 1/9/97.
The banking system is sometimes compared to traffic. This comparison is
justified for at least two reasons: first, the causes of traffic accidents are essentially the same
around the world, just like the causes of banking crises. It is therefore not surprising that almost
all countries adopt the same type of rules, like speed limits in the case of traffic, or some kind of
limitation of risk exposures in the case of banking. A second similarity between banking systems
and traffic is that with the increase of cross-border activity, such as air traffic, the need for
harmonisation of national regulations has grown. The minimum requirements for banking
supervision which the Basle Committee has recently developed in conjunction with supervisors
in emerging markets are an important step in this direction. Today, I would like to discuss with
you the background, advantages and implementation of these core principles.
Background
l. Banking crises in countries are no new phenomena at all. In this part of the world
a number of countries experienced severe banking problems in the early 1980s. In some western
countries, notably in the Scandinavian, the banking community also faced substantial
difficulties, albeit of a different nature. Since the Mexico crisis of 1995, awareness among
policy-makers of the potential damage that can result from banking problems has grown
significantly. In emerging markets, banking problems often result in much deeper recessions
than in industrialised countries. Generally, these economies are more vulnerable to banking
problems because almost all financial intermediation is carried out by banks. Most industrialised
countries are less dependent on banks, because the function of financial intermediation is also
performed by institutional investors and well-developed capital markets. Since the Mexico crisis,
it has also been recognised that the frequency of banking problems is significantly higher in
emerging markets. Recent research has shown that 85% of the severe banking crises which have
occurred in the past fifteen years concerned developing and transition economies. My
explanation for this striking fact is that the factors which cause banking crises are generally more
prevalent, but not essentially different in emerging markets than in industrialised countries. This
basic idea is the rationale behind the common set of core principles I would like to discuss with
you today.
2. But before that a short word on the way the principles have been developed
because it shows an important development in the cooperation between the members of the
Basle Committee and other countries. The principles were first drafted by a joint working group
consisting of a number of Basle Committee members and representatives from 15 other
countries. Subsequently a very lively exchange of views took place in a meeting in Basle in
March of this year in which representatives of approximately 40 countries, including the
chairmen of all regional groups, participated. To my satisfaction the consultation period
following that meeting produced a large number of reactions, nearly all of them favourable.
These reactions will be incorporated in the core principles. To endorse the final text of the
principles, a similar meeting to the one in March will take place on September 10th in Basle.
Two weeks later, in conjunction with the annual meeting in Hong Kong, the IMF and the Basle
Committee will co-sponsor a conference to introduce the principles to as wide as possible an
audience of Ministries of Finance and central banks.
3. As I said, the main rational behind the core principles has been the increased
awareness among policy-makers that banking crises can aggravate recessions. Another reason
for the formulation of core principles is the increased globalisation of economic activity. With
the strong growth of trade and financial flows between national economies, banking problems in
one country have much more potential to spread to other parts of the world. A specific form of
globalisation concerns the increasing international activities of large banks. Policy makers
generally welcome cross-border banking, because of the beneficial effects on the efficiency,
liquidity and depth of financial markets. However, the internationalisation of banking also
increases the risk of contagion of banking problems. In order to reduce this risk, the core
principles pay special attention to the supervision of cross-border banking. On this subject, the
most important message from the core principles is that home country supervisors should
practise consolidated supervision over their internationally-active banks. In order to enable home
country supervisors to fulfil this task most effectively, host country supervisors must share
information with them about the local operations of foreign banks. Finally, the core principles
state that banking supervisors must require the local operations of foreign banks to meet the
same high standards as are required of domestic institutions.
Advantages
4. You may wonder whether the core principles will really be able to reduce the
severity and frequency of banking problems around the world. Let me try to answer this
question by reviewing the main causes of banking crises and the way in which the core
principles deal with these causes. One important cause of banking crises is macro-economic
instability. High and variable inflation rates, booms and busts in economic activity and exchange
rate volatility complicate credit assessments by banks. Moreover, during the expansion phase of
a business cycle, there is often a tendency towards over-optimism and excessive lending by
banks, which in turn can result in asset price bubbles. This factor can be regarded as the main
cause of the current fragility of the Japanese financial sector. Thus, inadequate risk management
by banks is frequently a crucial link between macro-economic instability and banking problems.
Macro-economic instability is on average greater in emerging markets, reflecting less
diversification and greater structural rigidities. Unsound fiscal and monetary policies can add
further to this problem. As a consequence, the risks faced by banks in emerging markets tend to
be higher.
5. The core principles formulate prudential regulations and requirements in order to
promote a framework to control the risks inherent in banking. The application of this framework
can limit the negative influence of macro-economic volatility on the soundness of the financial
system. The requirements concerned cover capital adequacy, loan loss reserves, asset
concentrations, liquidity, risk management and internal controls. Of this group of principles, I
think those regarding risk management and internal controls deserve special attention. For
example, core principles 12 and 13 state that banking supervisors must be satisfied that banks
have in place risk management systems which accurately identify, measure, monitor and control
market risks and all other material risks. Furthermore, banks are required to hold an adequate
amount of capital against these risks. These principles reflect the growing recognition that banks
bear the principal responsibility for adequate risk management themselves. The main task of
supervisors is to set minimum standards and to monitor the policies and procedures through
which banks control their risks.
6. I would like to emphasise that adequate risk management by banks can reduce but
not eliminate the negative effects of macro-economic instability on the soundness of financial
systems. But it is evident that a sound financial sector is an important precondition for
macroeconomic stability. For instance, when macro-economic stabilisation calls for monetary
tightening, concerns about the effect of higher interest rates on the loan portfolios of weak banks
may delay policy action. In Mexico, this delay contributed to a sudden reversal of capital flows
and a deep recession in 1995. These so-called feedback effects from financial to
macro-economic instability underscore the need for the application of the core principles.
7. The second main cause of financial fragility is premature financial liberalisation.
It is widely recognised that financial liberalisation promotes competition among banks, thereby
improving the efficient allocation of financial resources in the long run. However, during the
transition, bank managers and supervisors often lack the expertise to deal with the higher risks
associated with the new activities in which their institutions get involved. This lack of
experience increases the probability of banking crises. Moreover, increased competition from
foreign banks often encourages domestic banks to finance riskier investments in order to keep up
their earnings. This chain of events has unfolded not only in emerging economies, but also in
well-developed Nordic countries and the United States. Policy makers have drawn an important
lesson from these banking crises, namely that financial liberalisation should be preceded by a
strengthening of risk management systems by banks. The core principles regarding risk
management and internal controls which I have just discussed can serve as a guide for the
supervision of the risk management systems adopted by banks.
8. The third culprit is government involvement in banking. One way in which
government policy can undermine the soundness of banks is by means of the tax treatment of
financial institutions. For example, tax systems which do not allow the deduction of loan loss
provisions from taxable earnings reduce the incentive of banks to recognise these losses on a
timely basis. A perhaps more damaging way of government involvement is the use of state
banks to finance government expenditures at below market rates. This channel has two apparent
advantages to the government; for one thing, it is cheap, at least in the short run. In addition,
bank financing does not show up in the official measurements of the budget deficit, which
reduces the possibilities for public scrutiny. Although state-owned banks are most prone to this
kind of political exploitation, privately-owned banks can also function as quasi-fiscal agents, for
example when they are forced to lend to particular sectors or industries. Obviously, these
financing practices reduce the viability of banks in the medium and long term.
9. I would point out that, while political involvement in banking tends to occur more
frequently in developing countries, it is not restricted to them. In South Korea and France, for
example, recent banking problems seem to be linked at least in part to government involvement.
However, in less wealthy countries the pressure on government funds is usually larger, which
increases the temptation to turn to state banks for funding. The risk of government influence on
banks in emerging markets is also larger, because state banks tend to control a much bigger
share of banking assets.
10. Core principle l contains a description of the preconditions for effective banking
supervision. In the context of problems related to government involvement, the following
elements of this first principle seem particularly relevant. First, the explanation of core
principle 1 says that each supervisory agency should possess operational independence to pursue
a sound banking system free from political pressure. A second important precondition is that
each supervisory agency should have adequate resources to meet the objectives set. These
resources should be provided on terms that do not undermine the autonomy and independence of
the supervisory agency. The emphasis of the first core principle on the independence of
supervisory agencies is important, first of all because independent supervisors are in a better
position to prevent political exploitation of banks. And secondly because it can limit forbearance
in dealing with problems in individual banks. A number of banking crises could have been
prevented or alleviated if the supervisory authorities would have had the independence and the
instruments to intervene in a timely and adequate way.
In addition, the appendix of the core principles explicitly mentions the need for
supervisors to apply their supervisory methods in the same manner to government-owned
commercial banks as to other commercial banks. The implementation of this advice should also
reduce the opportunities for governments to use state banks as a source of cheap funding.
ll. A related cause of banking problems is connected lending, which refers to loans
extended to banks' managers, shareholders or to parties connected to them. Just like loans to
governments, loans to connected parties are often granted on a non-arm's length basis and at
below market rates. Another similarity with government involvement is that there is reason to
believe that connected lending is a more serious problem in emerging than in advanced
economies. The risks of connected lending encompass a lack of objectivity in credit assessment
and undue concentration of credit risk. Core principle 10 explicitly addresses the problem of
connected lending. This principle states that banking supervisors must 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. Moreover, core principle 9 calls for prudential limits to restrict
bank exposures to single borrowers or groups of related borrowers. If these principles are
implemented on a global scale, they will raise a significant barrier against connected lending.
12. I now turn to a fourth set of causes of banking problems, that can be labelled
inadequate corporate governance. This term refers to an absence of the right incentive structure
for bank owners, managers, depositors and supervisors to show prudent behaviour. Perhaps the
best way to throw light on these types of problems is by means of a well-known example,
namely the downfall of the US savings and loans institutions. In the early 1980s, the supervisory
authorities in the US sought ways to enable savings and loans institutions, which were generally
in bad shape, to continue in business. The range of activities in which these institutions were
permitted to engage was expanded, capital standards were relaxed and the level of deposit
insurance was increased. As a consequence, many savings and loans institutions tried to grow
out of their problems by investing in high-risk assets, such as property and so-called 'junk
bonds'. The point is that depositors were content to finance these risky investments, because of
the generosity of the US deposit insurance at that time. Moreover, with low capital standards,
equity holders or owners had little to lose. Finally, banking regulation in the US did not penalise
bank managers for excessive risk-taking and allowed supervisors to delay corrective measures.
When the property market started to collapse in the mid-eighties, many savings and loans
institutions became insolvent, which eventually resulted in a loss of at least $150 billion for the
US taxpayers. In order to prevent similar banking problems, bank regulation in advanced and
emerging economies must incorporate the right incentives for all participants in the banking
system.
13. If you look at the core principles you will find various sorts of incentives in this
field. Firstly, principle 3 requires that the licensing process should consist of, among other
things, an assessment of the bank's ownership structure as well as of its directors and senior
management. The explanation of this principle makes clear that if the supervisory agency doubts
the integrity and standing of a bank's owner or manager, it should have the authority to prevent
a specific ownership structure or the appointment of a certain bank manager. In this way, past
imprudent behaviour of bank owners and managers is penalised by excluding them from
responsible functions in the banking sector.
14. Secondly, core principle 6 prescribes that capital requirements for banks should
be no less than those established in the so-called Basle Capital Accord. The Basle Accord sets
minimum capital requirements of 8% of the risk-adjusted assets of banks. Bank capital
essentially serves three functions; it is a base for further growth, it provides a cushion against
exceptional losses and it promotes better governance. The governance function relates to the fact
that if shareholders have more money at stake, they have stronger incentives to ensure that banks
are managed in a safe and sound manner. Regarding the loss-absorption function of capital, it
must be stressed that the Basle capital requirements are considered a minimum standard. In
emerging economies, higher minimum capital requirements seem appropriate, because banks
there usually operate in a more volatile and therefore riskier environment. I therefore welcome
the initiatives of the supervisory authorities in Argentina and Colombia, who have already raised
their minimum capital requirements to 11.5 and 9% respectively.
15. As the example of the US thrift crisis showed, the design of deposit insurance
deserves special attention. The second appendix of the core principles contains a balanced view
on this delicate issue, which can be summarised as follows: On the one hand, deposit insurance
is desirable because it limits the effect that problems at one bank might have on other banks.
This obviously increases the stability of the financial system. However, deposit insurance can
also increase the risk of imprudent behaviour by banks, because depositors will be less inclined
to withdraw funds even if the bank pursues high-risk strategies. Therefore, governments should
incorporate mechanisms in the system of depositor protection that prevent excessive risk-taking
by banks. This can for example be achieved by a partial deposit insurance, so that depositors still
have funds at risk. Another method is withholding deposit insurance from large, institutional
investors. The precise form of such a program should be tailored to the specific circumstances of
each country.
16. The last item on my list of crisis factors is a poor market infrastructure. It is
widely accepted that imperfect accounting systems, limited disclosure practices and inadequate
legal frameworks can hinder effective banking supervision and market discipline. Again, these
deficiencies are more pronounced in developing countries, but deserve continuous efforts for
improvement in developed countries as well. The first problem concerns the accuracy of
accounting systems. In many countries, the accounting standards for classifying bank loans as
non-performing are not tight enough to prevent banks from making bad loans look good. If
non-performing loans are systematically understated and are not properly provided against,
figures about profitability and bank capital become meaningless. On the disclosure side, the
ability to distinguish healthy from unhealthy banks is often hampered by the absence of financial
statements on a consolidated basis. Differences in accounting standards across countries and the
absence of serious penalties for publishing inaccurate information can also obstruct a meaningful
assessment of banks. Finally, the legal system sometimes impedes prudent banking, for example
when it hinders banks to seize collateral behind delinquent loans.
17. Core principle 21 relates to the information requirements of bank organisations,
which is an important part of the market infrastructure. This principle states that banking
supervisors must be satisfied that each bank maintains adequate records drawn up in accordance
with consistent accounting policies and practices. This information should enable supervisors to
obtain a true and fair view of the financial condition and profitability of banks. Banks should
also publish financial statements that fairly reflect their condition on a regular basis. Moreover.
the explanation of this principle prescribes that if a bank provides false or misleading
information, supervisory action or criminal prosecution should be taken against the individuals
involved and the institution.
18. Having elaborated on the contribution that the core principles can make towards
alleviating the main causes of banking problems, I think it is now time for an overall assessment.
First of all, it would be an illusion to think that a global application of the core principles can by
itself prevent financial crises occurring in the future. As I already mentioned with regard to
capital standards, the core principles contain minimum requirements. Individual countries,
particularly those in emerging areas, should therefore consider to what extent they need to
supplement the core principles with requirements addressing particular risks of their financial
systems. Moreover, banking supervision is a dynamic function that needs to respond to changes
in the marketplace. Therefore, the principles will need periodic, but not necessarily frequent,
refinement and readjustment. Finally, the core principles provide guidelines for bank regulation.
I hope my description of the causes of financial crises has made clear that financial stability not
only requires prudential behaviour by banks, but also macro-economic stability, a transparent
government budget and an adequate legal framework. In these areas, which all have to do with
government policy, the World Bank and the International Monetary Fund can make an important
contribution to financial stability.
Implementation
19. In the near future, the implementation of the core principles should be a top
priority. Of course the main burden of this lies with the governments of the individual countries.
I don't underestimate the wide-ranging legal, infrastructural and educational changes the
implementation of the principles call for in a large number of countries. Every country should
put in place an ambitious program with clear time-frames for the implementation. It is obvious
that the IMF and the World Bank should have a leading role with regard to monitoring the
implementation of the core principles. The main argument for this structure is that the
international financial institutions already send missions to almost all countries in the world.
However, it is generally acknowledged that the Basle Committee possesses great expertise in
bank regulation. I therefore plead for a model in which the Basle Committee, the IMF and the
World Bank each and together assist countries in realising financial stability in their respective
fields of competence. In this model, the IMF and the World Bank are primarily responsible for
creating a sound environment for banking, which is highly dependent on viable government
policies. As part of the assessment of government policies, these institutions will of course also
pay attention to the quality of bank supervision.
20. The Basle Committee is primarily responsible for the amendment and
interpretation of the principles and will review compliance with the principles at the
International Conference of Banking Supervisors in October 1998 and bi-annually thereafter.
The Basle Committee can furthermore make a major contribution towards the implementation of
the principles by offering technical assistance and courses to supervisors in emerging countries.
In this respect, banking and traffic again look alike. It is all a matter of knowing your
responsibility; if you do not make a timely agreement about who drives home, you both end up
drinking too much.